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RATIO ANALYSISRatio-analysis is a concept or techniquewhich is as old as accounting concept.Financial analysis is a scientific tool. It hasassumed important role as a tool forappraising the real worth of an enterprise, itsperformance during a period of time and itspit falls. Financial analysis is a vital apparatusfor the interpretation of financial statements. Italso helps to find out any cross-sectional andtime series linkages between various ratios. 1
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RATIO ANALYSISUnlike in the past when security was considered tobe sufficient consideration for banks and financialinstitutions to grant loans and advances, nowadaysthe entire lending is need-based and the emphasis ison the financial viability of a proposal and not onlyon security alone. Further all business decisioncontains an element of risk. The risk is more in thecase of decisions relating to credits. Ratio analysisand other quantitative techniques facilitateassessment of this risk. 2
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RATIO ANALYSISRatio-analysis means the process ofcomputing, determining and presenting therelationship of related items and groups ofitems of the financial statements. Theyprovide in a summarized and concise formof fairly good idea about the financialposition of a unit. They are important toolsfor financial analysis. 3
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Lenders’ need it for carrying out the following• Technical Appraisal• Commercial Appraisal• Financial Appraisal• Economic Appraisal• Management Appraisal 4
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It’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 5
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Before looking at the ratios there are a number of cautionarypoints concerning their use that need to be identified :c.The dates and duration of the financial statements beingcompared should be the same. If not, the effects ofseasonality may cause erroneous conclusions to be drawn.e.The accounts to be compared should have been preparedon the same bases. Different treatment of stocks ordepreciations or asset valuations will distort the results.g.In order to judge the overall performance of the firm a groupof ratios, as opposed to just one or two should be used. Inorder to identify trends at least three years of ratios arenormally required. 6
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The utility of ratio analysis will get further enhanced if following comparison is possible.3.Between the borrower and its competitor4.Between the borrower and the best enterprise in the industry5.Between the borrower and the average performance in the industry6.Between the borrower and the global average 7
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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. 8
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Balance Sheet P&L Ratio or Balance Sheet Ratio Income/Revenue and Profit & Loss Statement Ratio Ratio Financial Ratio Operating Ratio Composite RatioCurrent Ratio Gross Profit Ratio Fixed AssetQuick Asset Ratio Operating Ratio Turnover Ratio,Proprietary Ratio Expense Ratio Return on TotalDebt Equity Ratio Net profit Ratio Resources Ratio, Stock Turnover Ratio Return on Own Funds Ratio, Earning per Share Ratio, Debtors’ Turnover Ratio, 9
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LIABILITIES ASSETSNET WORTH/EQUITY/OWNED FUNDS FIXED ASSETS : LAND & BUILDING, PLANTShare Capital/Partner’s Capital/Paid up Capital/ & MACHINERIESOwners Funds Original Value Less DepreciationReserves ( General, Capital, Revaluation & Net Value or Book Value or Written down valueOther Reserves)Credit Balance in P&L A/cLONG TERM LIABILITIES/BORROWED NON CURRENT ASSETSFUNDS : Term Loans (Banks & Institutions) Investments in quoted shares & securitiesDebentures/Bonds, Unsecured Loans, Fixed Old stocks or old/disputed book debtsDeposits, Other Long Term Liabilities Long Term Security Deposits Other Misc. assets which are not current or fixed in natureCURRENT LIABILTIES CURRENT ASSETS : Cash & Bank Balance,Bank Working Capital Limits such as Marketable/quoted Govt. or other securities,CC/OD/Bills/Export Credit Book Debts/Sundry Debtors, Bills Receivables,Sundry /Trade Creditors/Creditors/Bills Stocks & inventory (RM,SIP,FG) Stores &Payable, Short duration loans or deposits Spares, Advance Payment of Taxes, PrepaidExpenses payable & provisions against various expenses, Loans and Advances recoverableitems within 12 months INTANGIBLE ASSETS Patent, Goodwill, Debit balance in P&L A/c, 10 Preliminary or Preoperative expenses
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• 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 11• Current Assets are Short Term Use of Funds
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• Assets 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. 12
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Current 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. 13 NWC = Current Assets – Current Liabilities
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Current Assets : Raw Material, Stores, Spares, Work-in Progress. FinishedGoods, 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 currentassets as margin from long term sources. Current Ratio measures short term liquidity of the concern and its ability tomeet its short term obligations within a time span of a year. It shows the liquidity position of the enterprise and its ability to meet currentobligations in time.Higher ratio may be good from the point of view of creditors. In the long run veryhigh current ratio may affect profitability ( e.g. high inventory carrying cost) Shows the liquidity at a particular point of time. The position can changeimmediately after that date. So trend of the current ratio over the years to beanalyzed. Current Ratio is to be studied with the changes of NWC. It is also necessary tolook at this ratio along with the Debt-Equity ratio. 14
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3. ACID TEST or QUICK RATIO : It is the ratio between Quick CurrentAssets 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/quotedshares and Bank Fixed Deposits Acid Test or Quick Ratio = Quick Current Assets/Current LiabilitiesExample :Cash 50,000Debtors 1,00,000Inventories 1,50,000 Current Liabilities 1,00,000Total Current Assets 3,00,000Current Ratio = > 3,00,000/1,00,000 = 3:1Quick Ratio => 1,50,000/1,00,000 = 1.5 : 1 15
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• 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 16
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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. 17
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7. OPERATING PROFIT RATIO : It is expressed as => (Operating Profit / Net Sales ) x 100 Higher the ratio indicates operational efficiency8. NET PROFIT RATIO : It is expressed as => ( Net Profit / Net Sales ) x 100 It measures overall profitability. 18
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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 19
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10. DEBTORS TURNOVER RATIO : This is also called DebtorsVelocity 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 CreditorsVelocity Ratio, which determines the creditor payment period.(Average Creditors/Purchases)x365 for days (52 for weeks & 12 for months) 20
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15. RETRUN ON ASSETS : Net Profit after Taxes/Total Assets16. 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. 21
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Composite Ratio17. 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 Shares19. 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 22
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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) 23
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EXERCISE 1 LIABILITES ASSETS Capital 180 Net Fixed Assets 400 Reserves 20 Inventories 150 Term Loan 300 Cash 50 Bank C/C 200 Receivables 150 Trade Creditors 50 Goodwill 50 Provisions 50 800 800a. What is the Net Worth : Capital + Reserve = 200b. Tangible Net Worth is : Net Worth - Goodwill = 150c. Outside Liabilities : TL + CC + Creditors + Provisions = 600d. Net Working Capital : C A - C L = 350 - 250 = 50e. Current Ratio : C A / C L = 350 / 300 = 1.17 : 1f. Quick Ratio : Quick Assets / C L = 200/300 = 0.66 : 1 24
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EXERCISE 2LIABILITIES 2005-06 2006-07 2005-06 2006-07Capital 300 350 Net Fixed 730 750 AssetsReserves 140 160 Security Electricity 30 30Bank Term Loan 320 280 Investments 110 110Bank CC (Hyp) 490 580 Raw Materials 150 170Unsec. Long T L 150 170 S I P 20 30Creditors (RM) 120 70 Finished Goods 140 170Bills Payable 40 80 Cash 30 20Expenses Payable 20 30 Receivables 310 240Provisions 20 40 Loans/Advance 30 190 s Goodwill 50 50Total 1600 1760 1600 1760 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 25
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Exercise 3. LIABIITIES ASSETS Equity Capital 200 Net Fixed Assets 800 Preference Capital 100 Inventory 300 Term Loan 600 Receivables 150 Bank CC (Hyp) 400 Investment In Govt. 50 Secu. Sundry Creditors 100 Preliminary Expenses 100 Total 1400 1400 1. Debt Equity Ratio will be : 600 / (200+100) = 2:12. Tangible Net Worth : Only equity Capital i.e. = 2003. 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 26
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Exercise 4. LIABILITIES ASSETS Capital + Reserves 355 Net Fixed Assets 265 P & L Credit Balance 7 Cash 1 Loan From S F C 100 Receivables 125 Bank Overdraft 38 Stocks 128 Creditors 26 Prepaid Expenses 1 Provision of Tax 9 Intangible Assets 30 Proposed Dividend 15 550 550• What is the Current Ratio ? Ans : (1+125 +128+1) / (38+26+9+15) : 255/88 = 2.89 : 1Q What is the Quick Ratio ? Ans : (125+1)/ 88 = 1.43 : 11Q. What is the Debt Equity Ratio ? Ans : LTL / Tangible NW = 100 / ( 362 – 30) = 100 / 332 = 0.30 : 1 27
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Exercise 4. contd… LIABILITIES ASSETS Capital + Reserves 355 Net Fixed Assets 265 P & L Credit Balance 7 Cash 1 Loan From S F C 100 Receivables 125 Bank Overdraft 38 Stocks 128 Creditors 26 Prepaid Expenses 1 Provision of Tax 9 Intangible Assets 30 Proposed Dividend 15 550 550Q . 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 28 1500 / 128 = 12 times approximately
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Exercise 4. contd… LIABILITIES ASSETS Capital + Reserves 355 Net Fixed Assets 265 P & L Credit Balance 7 Cash 1 Loan From S F C 100 Receivables 125 Bank Overdraft 38 Stocks 128 Creditors 26 Prepaid Expenses 1 Provision of Tax 9 Intangible Assets 30 Proposed Dividend 15 550 550 A. 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 monthQ. 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 29
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Exercise 5. : Profit to sales is 2% and amount of profit is sayRs.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 30
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Exercise 7 : Current Ratio of a concern is 1 : 1. What will be the NetWorking Capital ?Answer : It suggest that the Current Assets is equal to Current Liabilitieshence the NWC would be NIL ( since NWC = C.A - C.L )Exercise 8 : Suppose Current Ratio is 4 : 1. NWC is Rs.30,000/-. Whatis 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 31 = 360000 / 180000 = 2
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Exercise 10 : Total Liabilities of a firm is Rs.100 Lac and Current Ratiois 1.5 : 1. If Fixed Assets and Other Non Current Assets are to the tuneof Rs. 70 Lac and Debt Equity Ratio being 3 : 1. What would be the LongTerm Liabilities? Ans : We can easily arrive at the amount of Current Asset being Rs. 30 Laci.e. ( Rs. 100 L - Rs. 70 L ). If the Current Ratio is 1.5 : 1, then CurrentLiabilities works out to be Rs. 20 Lac. That means the aggregate of NetWorth and Long Term Liabilities would be Rs. 80 Lacs. If the Debt EquityRatio 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 beingRs.22 Lac. The amount of Fixed Assets + Non Current Assets is Rs. 10Lac. What would be the Current Liabilities?Ans : When Total Assets is Rs.22 Lac then Current Assets would be 22 – 10i.e Rs. 12 Lac. Thus we can easily arrive at the Current Liabilities figurewhich should be Rs. 10 Lac 32
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EXERCISE 12. A firm sold its stocks in CASH, in order to meet itsliquidity needs. Which of the following Ratio would be affected by this?•Debt Equity Ratio•Current Ratio•Debt Service Coverage Ratio•Quick RatioEXERCISE 13. A company is found to be carrying a high DEBT EQUITYRatio. To improve this, a bank may suggest the company to :3.Raise long term interest free loans from friends and relatives4.Raise long term loans from Institutions5.Increase the Equity by way of Bonus Issue6.Issue Rights share to existing share holders. EXERCISE 14. Which of the following is a fictitious Asset? 3.Goodwill 4.Preliminary Expenses 5.Pre-operative expenses 33 6.Book Debts which have become doubtful of recovery
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EXERCISE 15. Under which of the following methods of depreciation onFixed Assets, the annual amount of depreciation decreases?3.Written Down Value method4.Straight Line method5.Annuity method6.Insurance policy method EXERCISE 16 Debt Service Coverage Ratio (DSCR) shows : 3.Excess of current assets over current liabilities 4.Number of times the value of fixed assets covers the amount of loan 5.Number of times the company’s earnings cover the payment of interest and repayment of principal of long term debt 6.Effective utilisation of assets EXERCISE 17. Which of the following is not considered a Quick Asset? 3.Cash and Bank balances 4.Bank Fixed Deposits 5.Current Book Debts 6.Loans and Advances 34
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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.AssetsSales 1500 Inventories 125Cost of sales 1000 Debtors 250Gross profit 500 Cash 225 C. Liabilities Trade Creditors 200(i) Current Ratio : 600/200 = 3 : 1(x)Acid Test Ratio : Debtors+Cash /Trade creditors = 475/200 = 2.4 : 1(xi) Inventory Turnover Ratio : Cost of sales / Inventories = 1000/125 = 8 times(xii) Average Debt collection period : (Debtors/sales) x 365 = (250/1500)x365 =61 days(xiii)Average Creditors’ payment period : (Trade Creditors/Cost of sales) x 365 (200/100) x 365 = 73 days 35