Ratio analysis ratios at a glance1


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Ratio analysis ratios at a glance1

  1. 1. Compiled by Prof. M B. Thakoor RATIO ANALYSIS15. RATIOS AT A GLANCE StandardNo. Ratio Formula Composition Test of Interpretation Ratio1. Current Current Current Assets : 2:1 Short- 1. Measures short-term Ratio Assets 1. Debtors, term financial strength. 2. Stock, solvency 2. Ability to pay current Current 3. Loose tools, obligations. Liabilities 4. Accrued income 3. Adequacy of working 5. Pre-payments, capital-a quantitative 6. Bills receivables, test and not qualitative 7. Cash & Bank. test. 4. Higher ratio implies Current Liabilities sound financial 1. Creditors position but may also 2. Bills payable mean idle funds, under 3. Outstanding trading. expenses, 5. Lower ratio indicates 4. Unclaimed Inadequate working dividends, capital, short-term 5. Provision for solvency in danger, taxation, over trading. 6. Proposed dividend, 7. Bank overdraft.2 Liquid Quick Quick Assets = 1:1 Imme- 1. Stringent (tough) test Ratio/A Assets Current Assets diate of solvency. cid test Less stock and pre- solvency 2. Measures ability to Ratio Quick payments meet the immediate Liabilities liabilities. Quick Liabilities = 3. Qualitative test to Current Liabilities measure liquidity. less Bank overdraft. 4. Higher Ratio : Sound financial position, idle funds. 5. Lower Ratio : dangerous financial position inability to met immediate obligations.3 Stock to Closing Stock = Closing Should be Investm 1. Extent of working working Stock stock less than ents in capital blocked in capital Working capital = 100 % stocks stock. Working Current Assets Less 2. Higher ratio : Unsound Capital Current Liabilities working capital position; if stock is not / x 100 saleable, situation becomes dangerous. 3. Lower Ratio : Sound working capital position and effective inventory management. 4. Should be studied with quick and current ratio. 1
  2. 2. Compiled by Prof. M B. Thakoor StandardNo. Ratio Formula Composition Test of Interpretation Ratio4 Propriet Prop’s Proprietor’s 65% to Long 1. Shows percentage of ary Ratio Fund Funds = 75% term total assets financed Preference Capital stability by the proprietor / Total + or organisation. Assets Equity Capital + solvency 2. All fixed assets and Reserves & part of current assets x 100 Surplus should be financed out Losses Fictitious of proprietors Fund in Assets like order to build a solid miscellaneous foundation for the expenditure. company. Total Assets = 3. Higher ratio : Lesser Total Liabilities = dependence on Fixed assets + outside funds-sound Current Assets + financial position but Investments over capitalization and (Excluding fictitious low returns. assets) 4. Lower Ratio : More dependence on outside funds, under capitalization, over- trading, unsound financial position.5 Capital Preference Capital with fixed -- Capital High Gearing : Gearing Capital + interest bearing Gearing 1. IF fixed interest, Ratio Debentures securities dividend bearing + term ----------------- capital exceeds the loans Equity Share equity capital & Capital + Reserves reserves, the company Equity & Surplus – Losses is said to be highly Share & Fictitious Assets geared. Capital + 2. High gearing is Reserves & favorable only when Surplus rate of earning of the - Losses & business is greater Fictitious than fixed interest. Assets 3. It may amount to under capitalization. 4. Equity shareholders expect higher dividend and share become speculative. Low Gearing : 1. Majority interest lies with equity share holders. 2. Over capitalization. 3. Low rate of return or equity shares. 2
  3. 3. Compiled by Prof. M B. Thakoor StandardNo. Ratio Formula Composition Test of Interpretation Ratio6 Debt- (1) Debt Debt includes : (i) 2 : 1 Long- 1. Test of long-term Equity i) Debentures term financial position or Equity Ratio ii) Long term loans financial capital structure of the iii) Redeemable position company. OR Preference share 2. Higher ratio indicates capital greater dependence (2) Debt Equity includes : (ii) 65% on loans, higher Debt + i) Equity Capital to 75% amount of interest Equity ii) Reserves and payable. Such trading Surplus on equity affects iii) Preference adversely during Capital other than recession. redeemable 3. Lower ratio indicates Preference Shares low owed funds and Less fictitious high equity. assets. Compulsory payment like interest, low returns for equity holders, over capitalization.7 Gross Gross Gross Profit = Should be Profitabi 1. Used for analyzing Profit Profit Sales compared lity trading results. Ratio Less : over the 2. Higher ratio means Sales Cost of good sold years or greater profitability with the attained by x 100 Sales = Net Sales other a. Increasing sales prices i.e. Gross Sales – company- b. Cost Saving Sales Returns or ies ratio c. Over-Valuing return inwards. closing stock 3. Lower ratio indicates low profitability. 4. Limitations-indirect expenses are not considered hence overall profitability cannot be known.8. Operating COGS + Cost of goods Should Operatio 1. Indicates profitability & Ratio Operating sold (COGS) = be nal managerial efficiency Expenses opening stock + compare efficienc in controlling costs. purchases + direct over the y& 2. Higher ratio means Sales expenses – Closing years profitabi lower margin of profit. Stock : lity 3. Lower ratio means X 100 greater margin of Operating profit. Expenses = 4. Comparison with office & previous year would administrative indicate saving or expenses + selling increase in cost. & distribution 5. For better results this expenses + ratio is broken into financial expenses various cost ratios. 3
  4. 4. Compiled by Prof. M B. Thakoor StandardNo. Ratio Formula Composition Test of Interpretation Ratio9 Expenses Expense Respective Should Operatio 1. Shows portion of sales Ratio expenses viz. be nal consumed by various Sales factory overheads, compare efficienc items of expenses. office expenses, d with y 2. Trend over the years x 100 selling & last should be studied. distribution years. Management should expenses. concentrate on those expenses which Sales = Net Sales increase = Gross Sales – disproportionately. Sales Returns or 3. Higher ratio means Return inward. lower profitability and inefficiency of management in controlling expenses.10. Net Net Profit Operating Net To be Profita- 1. It measures overall Profit Sales Profit = Net profit compared bility & profitability and Ratio excluding non- with the efficie- operating efficiency. x 100 trading income and previous ncy 2. Should be studied with not-trading year’s G.P. ratio and expenses ratios operating ratio. ii) Op. NP 3. Higher ratio indicates Sales Sales = Net Sales higher profitability and x 100 = Gross Sales – lower ratio indicates Sales Returns or lower profitability. Return inward.11 Stock Cost of Cost of goods 5–6 Operatio 1. It shows efficiency in Turnove good sold sold = Sales less times nal inventory r Ratio Average Gross Profit efficienc management. Stock Average Stock = y& 2. Higher ratio indicates Op.Stock + Cl.Stock investm favorable trading 2 ent in situation, no loss due stock to obsolescence as OR When Opening stock is turned into Sales stock is not given sales regularly, no the denominator is excessive blocking of Closing closing stock and funds in inventory, Stock not zero + closing over-trading. stock / 2 3. Lower ratio indicates stock is not movable, blocking of funds, wrong buying or excessive production, under trading. 4
  5. 5. Compiled by Prof. M B. Thakoor StandardNo. Ratio Formula Composition Test of Interpretation Ratio12 Return on Net Profit Net Profit (NP) = To be Profitabi 1. This is the broadest Capital Capital Net profit before Compar lity measure of Employed Employed interest and tax ed with Producti performance (RoCE) less abnormal, similar vity 2. It combines the effect x 100 non-recurring ratio of of Net profit Ratio and items. other Capital turnover ratio Capital Employed compani Turnover ratio = Fixed Assets + es measures productivity Current Assets – and Net Profit ratio Current Liabilities. measures profitability. (Excluding 3. This ratio with other Fictitious Assets) expenses ratio and turnover ratios is helpful in financial analysis. 4. Higher ratio is regarded as favorable and lower ratio is unfavorable.13 Return Net Profit Proprietor’s --- Profit 1. It shows earning on available Funds = Earning power of proprietors propriet to the Preference Capital Capacity Funds. or’s Share + Reserves & Minimum return must Fund/Ne holders Surplus be earned to keep t-wroth Prop. Less : Fictitious proprietors happy. Fund x assets. 2. This ratio is helpful to 100 a future investor. 3. Useful for inter- Company comparisons. 4. High rate of return means growing & prosperous company. Lower is unfavorable.14 Return Net Profit Net Profit --- Earning 1. It shows the on available available to Per profitability of the Equity to Equity Equity Share Equity company in terms of Capital Share holder = Divisible Share earnings available for holder NP = Net Profit equity shareholders. OR Eq. Share after tax & pref. 2. Higher ratio means Cap Div. and trsfd. To effective use of equity Return x 100 Reserves. capital & advantage of on Equity Capital = trading on equity. Equity Paid up Capital 3. Lower ratio indicates Share low profitability. holders Fund 5
  6. 6. Compiled by Prof. M B. Thakoor StandardNo. Ratio Formula Composition Test of Interpretation Ratio15 Debtor’s Drs. + BR Debtors (Drs.) will Should be Receiva 1. It shows average credit Turnover Cr. Sales include only trading compared bles granted to customers. debtors, prevision with the Manage 2. Should be compared x 365 for doubtful debt credit ment with credit terms should not be terms granted to know deducted efficiency of credit BR = Bills collection department. Receivable Less 3. Higher ratio means dishonored bill. greater funds blocked in receivables, liberal credit terms for increasing sales, laxity of collection dept. or debtors no longer liquid assets. 4. Low ratio would mean Funds not blocked in receivables, efficient, collection department, debtors are liquid assets. This ratio should be studied with other short term solvency ratios. 6
  7. 7. Compiled by Prof. M B. Thakoor RATIO ANALYSISRATIOS FROM INVESTORS POINT OF VIEW(1) Return on Total Shareholders Equity = Profit after Tax Total Networth / Shareholders Funds(2) Return on Equity Shareholders Equity = Profit after Tax – Preference Dividend Equity Shareholders Fund(3) Earning Per Share (EPS) = Profit after Tax available to Equity Holders No. of Equity Shares(4) Dividend Per Share (DPS) = Profit Paid to Equity Shareholders No. of Equity Shares(5) Dividend Payout Ratio = Dividend Per Share i.e. DPS Earning Per Share EPS(6) Price Earning Ratio = Market Price Per Share i.e. MPS Earning Per Share EPS(7) Dividend Yield = Dividend Per Share i.e. DPS Market Price Per Share MPS(8) Earning Yield or Earning Price Ratio = Earning Per Share i.e. EPS Market Price Per Share MPS(9) Cover for Ordinary Dividend = PAT – Preference Dividend – transfer to reserves i.e. Cover for Equity Dividend Equity Dividend Payable(10) Cover for Preference Dividend = Profit after Tax Preference Dividend Payable 7