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RATIO ANALYSIS

Ratio-analysis is a concept or technique which is as old as accounting concept. Financial analysis is a scientific tool. It has assumed important role as a tool for appraising the real worth of an enterprise, its performance during a period of time and its pit falls. Financial analysis is a vital apparatus for the interpretation of financial statements. It also helps to find out any cross-sectional and time series linkages between various ratios.

RATIO ANALYSIS

Unlike in the past when security was considered to be sufficient consideration for banks and financial institutions to grant loans and advances, nowadays the entire lending is need-based and the emphasis is on the financial viability of a proposal and not only on security alone. Further all business decision contains an element of risk. The risk is more in the case of decisions relating to credits. Ratio analysis and other quantitative techniques facilitate assessment of this risk.

RATIO ANALYSIS

Ratio-analysis means the process of computing, determining and presenting the relationship of related items and groups of items of the financial statements. They provide in a summarized and concise form of fairly good idea about the financial position of a unit. They are important tools for financial analysis.

Lenders’ need it for carrying out the following

Technical Appraisal

Commercial Appraisal

Financial Appraisal

Economic Appraisal

Management Appraisal

WHY FINANCIAL ANALYSISIt’s a tool which enables the banker or lender to arrive at the following factors :

- Liquidity position
- Profitability
- Solvency
- Financial Stability
- Quality of the Management
- Safety & Security of the loans & advances to be or already been provided

Before looking at the ratios there are a number of cautionary points concerning their use that need to be identified :

- The dates and duration of the financial statements being compared should be the same. If not, the effects of seasonality may cause erroneous conclusions to be drawn.
- The accounts to be compared should have been prepared on the same bases. Different treatment of stocks or depreciations or asset valuations will distort the results.
- In order to judge the overall performance of the firm a group of ratios, as opposed to just one or two should be used. In order to identify trends at least three years of ratios are normally required.

The utility of ratio analysis will get further enhanced if following comparison is possible.

- Between the borrower and its competitor
- Between the borrower and the best enterprise in the industry
- Between the borrower and the average performance in the industry
- Between the borrower and the global average

As Percentage - such as 25% or 50% . For example if net profit is Rs.25,000/- and the sales is Rs.1,00,000/- then the net profit can be said to be 25% of the sales.

- As Proportion - The above figures may be expressed in terms of the relationship between net profit to sales as 1 : 4.
- As Pure Number /Times - The same can also be expressed in an alternatively way such as the sale is 4 times of the net profit or profit is 1/4th of the sales.

Liabilities have Credit balance and Assets have Debit balance

Current Liabilities are those which have either become due for payment or shall fall due for payment within 12 months from the date of Balance Sheet

Current Assets are those which undergo change in their shape/form within 12 months. These are also called Working Capital or Gross Working Capital

Net Worth & Long Term Liabilities are also called Long Term Sources of Funds

Current Liabilities are known as Short Term Sources of Funds

Long Term Liabilities & Short Term Liabilities are also called Outside Liabilities

Current Assets are Short Term Use of Funds

Some important notesAssets other than Current Assets are Long Term Use of Funds

Installments of Term Loan Payable in 12 months are to be taken as Current Liability only for Calculation of Current Ratio & Quick Ratio.

If there is profit it shall become part of Net Worth under the head Reserves and if there is loss it will become part of Intangible Assets

Investments in Govt. Securities to be treated current only if these are marketable and due. Investments in other securities are to be treated Current if they are quoted. Investments in allied/associate/sister units or firms to be treated as Non-current.

Bonus Shares as issued by capitalization of General reserves and as such do not affect the Net Worth. With Rights Issue, change takes place in Net Worth and Current Ratio.

Some important notesCurrent Ratio : It is the relationship between the current assets and current liabilities of a concern.

Current Ratio = Current Assets/Current Liabilities

If the Current Assets and Current Liabilities of a concern are Rs.4,00,000 and Rs.2,00,000 respectively, then the Current Ratio will be : Rs.4,00,000/Rs.2,00,000 = 2 : 1

The ideal Current Ratio preferred by Banks is 1.33 : 1

Net Working Capital : This is worked out as surplus of Long Term Sources over Long Tern Uses, alternatively it is the difference of Current Assets and Current Liabilities.

NWC = Current Assets – Current Liabilities

Current Assets : Raw Material, Stores, Spares, Work-in Progress. Finished Goods, Debtors, Bills Receivables, Cash.

- Current Liabilities : Sundry Creditors, Installments of Term Loan, DPG etc. payable within one year and other liabilities payable within one year.
- This ratio must be at least 1.33 : 1 to ensure minimum margin of 25% of current assets as margin from long term sources.
- Current Ratio measures short term liquidity of the concern and its ability to meet its short term obligations within a time span of a year.
- It shows the liquidity position of the enterprise and its ability to meet current obligations in time.
- Higher ratio may be good from the point of view of creditors. In the long run very high current ratio may affect profitability ( e.g. high inventory carrying cost)
- Shows the liquidity at a particular point of time. The position can change immediately after that date. So trend of the current ratio over the years to be analyzed.
- Current Ratio is to be studied with the changes of NWC. It is also necessary to look at this ratio along with the Debt-Equity ratio.

3. ACID TEST or QUICK RATIO : It is the ratio between Quick Current Assets and Current Liabilities. The should be at least equal to 1.

Quick Current Assets : Cash/Bank Balances + Receivables upto 6 months + Quickly realizable securities such as Govt. Securities or quickly marketable/quoted shares and Bank Fixed Deposits

Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities

Example :

Cash 50,000

Debtors 1,00,000

Inventories 1,50,000 Current Liabilities 1,00,000

Total Current Assets 3,00,000

Current Ratio = > 3,00,000/1,00,000 = 3 : 1

Quick Ratio = > 1,50,000/1,00,000 = 1.5 : 1

DEBT EQUITY RATIO : It is the relationship between borrower’s fund (Debt) and Owner’s Capital (Equity).

- Long Term Outside Liabilities / Tangible Net Worth
- Liabilities of Long Term Nature
- Total of Capital and Reserves & Surplus Less Intangible Assets
- For instance, if the Firm is having the following :
- Capital = Rs. 200 Lacs
- Free Reserves & Surplus = Rs. 300 Lacs
- Long Term Loans/Liabilities = Rs. 800 Lacs
- Debt Equity Ratio will be => 800/500 i.e. 1.6 : 1

5. PROPRIETARY RATIO : This ratio indicates the extent to which Tangible Assets are financed by Owner’s Fund.

Proprietary Ratio = (Tangible Net Worth/Total Tangible Assets) x 100

The ratio will be 100% when there is no Borrowing for purchasing of Assets.

6. GROSS PROFIT RATIO : By comparing Gross Profit percentage to Net Sales we can arrive at the Gross Profit Ratio which indicates the manufacturing efficiency as well as the pricing policy of the concern.

Gross Profit Ratio = (Gross Profit / Net Sales ) x 100

Alternatively , since Gross Profit is equal to Sales minus Cost of Goods Sold, it can also be interpreted as below :

Gross Profit Ratio = [ (Sales – Cost of goods sold)/ Net Sales] x 100

A higher Gross Profit Ratio indicates efficiency in production of the unit.

7. OPERATING PROFIT RATIO :

- It is expressed as => (Operating Profit / Net Sales ) x 100
- Higher the ratio indicates operational efficiency
- NET PROFIT RATIO :
- It is expressed as => ( Net Profit / Net Sales ) x 100
- It measures overall profitability.

9. STOCK/INVENTORY TURNOVER RATIO :

(Average Inventory/Sales) x 365 for days

(Average Inventory/Sales) x 52 for weeks

(Average Inventory/Sales) x 12 for months

Average Inventory or Stocks = (Opening Stock + Closing Stock)

-----------------------------------------

2

. This ratio indicates the number of times the inventory is rotated during the relevant accounting period

10. DEBTORS TURNOVER RATIO : This is also called Debtors Velocity or Average Collection Period or Period of Credit given .

(Average Debtors/Sales ) x 365 for days

(52 for weeks & 12 for months)

11. ASSET TRUNOVER RATIO : Net Sales/Tangible Assets

12. FIXED ASSET TURNOVER RATIO : Net Sales /Fixed Assets

13. CURRENT ASSET TURNOVER RATIO : Net Sales / Current Assets

14. CREDITORS TURNOVER RATIO : This is also called Creditors Velocity Ratio, which determines the creditor payment period.

(Average Creditors/Purchases)x365 for days

(52 for weeks & 12 for months)

15. RETRUN ON ASSETS : Net Profit after Taxes/Total Assets

16. RETRUN ON CAPITAL EMPLOYED :

( Net Profit before Interest & Tax / Average Capital Employed) x 100

Average Capital Employed is the average of the equity share capital and long term funds provided by the owners and the creditors of the firm at the beginning and end of the accounting period.

Composite Ratio

- 17. RETRUN ON EQUITY CAPITAL (ROE) :
- Net Profit after Taxes / Tangible Net Worth
- EARNING PER SHARE : EPS indicates the quantum of net profit of the year that would be ranking for dividend for each share of the company being held by the equity share holders.
- Net profit after Taxes and Preference Dividend/ No. of Equity Shares
- 19. PRICE EARNING RATIO : PE Ratio indicates the number of times the Earning Per Share is covered by its market price.
- Market Price Per Equity Share/Earning Per Share

20. DEBT SERVICE COVERAGE RATIO : This ratio is one of the most important one which indicates the ability of an enterprise to meet its liabilities by way of payment of installments of Term Loans and Interest thereon from out of the cash accruals and forms the basis for fixation of the repayment schedule in respect of the Term Loans raised for a project.(The Ideal DSCR Ratio is considered to be 2 )

PAT + Depr. + Annual Interest on Long Term Loans & Liabilities

---------------------------------------------------------------------------------

Annual interest on Long Term Loans & Liabilities + Annual Installments payable on Long Term Loans & Liabilities

( Where PAT is Profit after Tax and Depr. is Depreciation)

EXERCISE 1

- What is the Net Worth : Capital + Reserve = 200
- Tangible Net Worth is : Net Worth - Goodwill = 150
- Outside Liabilities : TL + CC + Creditors + Provisions = 600
- Net Working Capital : C A - C L = 350 - 250 = 50
- Current Ratio : C A / C L = 350 / 300 = 1.17 : 1
- Quick Ratio : Quick Assets / C L = 200/300 = 0.66 : 1

EXERCISE 2

1. Tangible Net Worth for 1st Year : ( 300 + 140) - 50 = 390

2. Current Ratio for 2nd Year : (170 + 30 +170+20+ 240 + 190 ) / (580+70+80+70)

820 /800 = 1.02

3. Debt Equity Ratio for 1st Year : 320+150 / 390 = 1.21

Exercise 3.

1. Debt Equity Ratio will be : 600 / (200+100) = 2 : 1

2. Tangible Net Worth : Only equity Capital i.e. = 200

3. Total Outside Liabilities / Total Tangible Net Worth : (600+400+100) / 200

= 11 : 2

4. Current Ratio will be : (300 + 150 + 50 ) / (400 + 100 ) = 1 : 1

Exercise 4.

- What is the Current Ratio ? Ans : (1+125 +128+1) / (38+26+9+15)
- : 255/88 = 2.89 : 1
- Q What is the Quick Ratio ? Ans : (125+1)/ 88 = 1.43 : 11
- Q. What is the Debt Equity Ratio ? Ans : LTL / Tangible NW
- = 100 / ( 362 – 30)
- = 100 / 332 = 0.30 : 1

Exercise 4. contd…

Q . What is the Proprietary Ratio ? Ans : (T NW / Tangible Assets) x 100

[ (362 - 30 ) / (550 – 30)] x 100

(332 / 520) x 100 = 64%

Q . What is the Net Working Capital ?

Ans : C. A - C L. = 255 - 88 = 167

Q . If Net Sales is Rs.15 Lac, then What would be the Stock Turnover Ratio in Times ? Ans : Net Sales / Average Inventories/Stock

1500 / 128 = 12 times approximately

Exercise 4. contd…

- What is the Debtors Velocity Ratio ? If the sales are Rs. 15 Lac.
- Ans : ( Average Debtors / Net Sales) x 12 = (125 / 1500) x 12
- = 1 month

Q. What is the Creditors Velocity Ratio if Purchases are Rs.10.5 Lac ?

Ans : (Average Creditors / Purchases ) x 12 = (26 / 1050) x 12 = 0.3 months

Exercise 5. : Profit to sales is 2% and amount of profit is say Rs.5 Lac. Then What is the amount of Sales ?

Answer : Net Profit Ratio = (Net Profit / Sales ) x 100

2 = (5 x100) /Sales

Therefore Sales = 500/2 = Rs.250 Lac

Exercise 6. A Company has Net Worth of Rs.5 Lac, Term Liabilities of Rs.10 Lac. Fixed Assets worth RS.16 Lac and Current Assets are Rs.25 Lac. There is no intangible Assets or other Non Current Assets. Calculate its Net Working Capital.

Answer

Total Assets = 16 + 25 = Rs. 41 Lac

Total Liabilities = NW + LTL + CL = 5 + 10+ CL = 41 Lac

Current Liabilities = 41 – 15 = 26 Lac

Therefore Net Working Capital = C. A – C.L

= 25 – 26 = (- )1 Lac

Exercise 7 : Current Ratio of a concern is 1 : 1. What will be the Net Working Capital ?

Answer : It suggest that the Current Assets is equal to Current Liabilities hence the NWC would be NIL ( since NWC = C.A - C.L )

Exercise 8 : Suppose Current Ratio is 4 : 1. NWC is Rs.30,000/-. What is the amount of Current Assets ?

Answer : 4a - 1a = 30,000

Therefore a = 10,000 i.e. Current Liabilities is Rs.10,000

Hence Current Assets would be 4a = 4 x 10,000 = Rs.40,000/-

Exercise 9. The amount of Term Loan installment is Rs.10000/ per month, monthly average interest on TL is Rs.5000/-. If the amount of Depreciation is Rs.30,000/- p.a. and PAT is Rs.2,70,000/-. What would be the DSCR ?

DSCR = (PAT + Depr + Annual Intt.) / Annual Intt + Annual Installment

= (270000 + 30000 + 60000 ) / 60000 + 120000

= 360000 / 180000 = 2

Exercise 10 : Total Liabilities of a firm is Rs.100 Lac and Current Ratio is 1.5 : 1. If Fixed Assets and Other Non Current Assets are to the tune of Rs. 70 Lac and Debt Equity Ratio being 3 : 1. What would be the Long Term Liabilities?

Ans : We can easily arrive at the amount of Current Asset being Rs. 30 Lac i.e. ( Rs. 100 L - Rs. 70 L ). If the Current Ratio is 1.5 : 1, then Current Liabilities works out to be Rs. 20 Lac. That means the aggregate of Net Worth and Long Term Liabilities would be Rs. 80 Lacs. If the Debt Equity Ratio is 3 : 1 then Debt works out to be Rs. 60 Lacs and equity Rs. 20 Lacs. Therefore the Long Term Liabilities would be Rs.60 Lac.

Exercise 11 : Current Ratio is say 1.2 : 1 . Total of balance sheet being Rs.22 Lac. The amount of Fixed Assets + Non Current Assets is Rs. 10 Lac. What would be the Current Liabilities?

Ans : When Total Assets is Rs.22 Lac then Current Assets would be 22 – 10 i.e Rs. 12 Lac. Thus we can easily arrive at the Current Liabilities figure which should be Rs. 10 Lac

EXERCISE 12. A firm sold its stocks in CASH, in order to meet its liquidity needs. Which of the following Ratio would be affected by this?

Debt Equity Ratio

Current Ratio

Debt Service Coverage Ratio

Quick Ratio

EXERCISE 13. A company is found to be carrying a high DEBT EQUITY Ratio. To improve this, a bank may suggest the company to :

Raise long term interest free loans from friends and relatives

Raise long term loans from Institutions

Increase the Equity by way of Bonus Issue

Issue Rights share to existing share holders.

EXERCISE 14. Which of the following is a fictitious Asset?

Goodwill

Preliminary Expenses

Pre-operative expenses

Book Debts which have become doubtful of recovery

EXERCISE 15. Under which of the following methods of depreciation on Fixed Assets, the annual amount of depreciation decreases?

Written Down Value method

Straight Line method

Annuity method

Insurance policy method

EXERCISE 16 Debt Service Coverage Ratio (DSCR) shows :

Excess of current assets over current liabilities

Number of times the value of fixed assets covers the amount of loan

Number of times the company’s earnings cover the payment of interest and repayment of principal of long term debt

Effective utilisation of assets

EXERCISE 17. Which of the following is not considered a Quick Asset?

Cash and Bank balances

Bank Fixed Deposits

Current Book Debts

Loans and Advances

Exercise 18. From the following financial statement calculate (i) Current Ratio (ii) Acid test Ratio (iii) Inventory Turnover (iv) Average Debt Collection Period (v) Average Creditors’ payment period.

- C.Assets
- Sales 1500 Inventories 125
- Cost of sales 1000 Debtors 250
- Gross profit 500 Cash 225
- C. Liabilities
- Trade Creditors 200
- (i) Current Ratio : 600/200 = 3 : 1
- Acid Test Ratio : Debtors+Cash /Trade creditors = 475/200 = 2.4 : 1
- Inventory Turnover Ratio : Cost of sales / Inventories = 1000/125 = 8 times
- Average Debt collection period : (Debtors/sales) x 365 = (250/1500)x365 = 61 days
- Average Creditors’ payment period : (Trade Creditors/Cost of sales) x 365
- (200/100) x 365 = 73 days

Questions on Fund Flow Statement

Q . Fund Flow Statement is prepared from the Balance sheet :

Of three balance sheets

Of a single year

Of two consecutive years

None of the above.

Q. Why this Fund Flow Statement is studied for ?

It indicates the quantum of finance required

It is the indicator of utilisation of Bank funds by the concern

It shows the money available for repayment of loan

It will indicate the provisions against various expenses

Q . In a Fund Flow Statement , the assets are represented by ?

Application of Funds

Sources of Funds

Surplus of sources over application

Deficit of sources over application

Q . In Fund Flow Statements the Liabilities are represented by ?

Sources of Funds

Use of Funds

Deficit of sources over application

All of the above.

Q . When the long term sources are more than long term uses, in the fund flow statement, it would suggest ?

Increase in Current Liabilities

Decrease in Working Capital

Increase in NWC

Decrease in NWC

Q . When the long term uses in a fund flow statement are more than the long term sources, then it would mean ?

Reduction in the NWC

Reduction in the Working Capital Gap

Reduction in Working Capital

All of the above

Q. How many broader categories are there for the Sources of funds, in the Fund Flow Statement ?

Only One, Source of Funds

Two, Long Term and Short Term Sources

Three , Long, Medium and Short term sources

None of the above.

- R K MOHANTY
- email ID : [email protected],
- [email protected]

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