© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Managem...
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2 ratio analysis

  1. 1. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 116 -6 - 11 Financial Statements AnalysisFinancial Statements Analysis By Dr. B. Krishna ReddyBy Dr. B. Krishna Reddy Professor and Head_SKIMProfessor and Head_SKIM
  2. 2. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 226 -6 - 22 FINANCIAL STATEMENTS ANALYSIS Ratio Analysis Importance and Limitations of Ratio Analysis Common Size Statements
  3. 3. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 336 -6 - 33 Ratio AnalysisRatio Analysis Ratio analysis is a widely used tool of financial analysis. It is defined as the systematic use of ratio to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical performance and current financial condition can be determined.
  4. 4. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 446 -6 - 44 Basis of ComparisonBasis of Comparison 1) Trend Analysis involves comparison of a firm over a period of time, that is, present ratios are compared with past ratios for the same firm. It indicates the direction of change in the performance – improvement, deterioration or constancy – over the years. 2) Interfirm Comparison involves comparing the ratios of a firm with those of others in the same lines of business or for the industry as a whole. It reflects the firm’s performance in relation to its competitors. 3) Comparison with standards or industry average.
  5. 5. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 556 -6 - 55 Types of RatiosTypes of Ratios Liquidity RatiosLiquidity Ratios Capital Structure RatiosCapital Structure Ratios Profitability RatiosProfitability Ratios Efficiency ratiosEfficiency ratios Integrated Analysis Ratios Integrated Analysis Ratios Growth RatiosGrowth Ratios
  6. 6. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 666 -6 - 66 Net working capital is a measure of liquidity calculated by subtracting current liabilities from current assets. Table 1: Net Working Capital Particulars Company A Company B Total current assets Total current liabilities NWC Rs 1,80,000 1,20,000 60,000 Rs 30,000 10,000 20,000 Table 2: Change in Net Working Capital Particulars Company A Company B Current assets Current liabilities NWC Rs 1,00,000 25,000 75,000 Rs 2,00,000 1,00,000 1,00,000 Net Working CapitalNet Working Capital
  7. 7. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 776 -6 - 77 Liquidity ratios measure the ability of a firm to meet its short-term obligations Liquidity RatiosLiquidity Ratios
  8. 8. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 886 -6 - 88 Particulars Firm A Firm B Current Assets Rs 1,80,000 Rs 30,000 Current Liabilities Rs 1,20,000 Rs 10,000 Current Ratio = 3:2 (1.5:1) 3:1 Current Ratio is a measure of liquidity calculated dividing the current assets by the current liabilities Current Ratio Current Ratio = Current Assets Current Liabilities
  9. 9. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 996 -6 - 99 The quick or acid test ratio takes into consideration the differences in the liquidity of the components of current assets Quick Assets = Current assets – Stock – Pre-paid expenses Acid-Test RatioAcid-Test Ratio Acid-test Ratio = Quick Assets Current Liabilities
  10. 10. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 10106 -6 - 1010 Example 1:Example 1: Acid-Test RatioAcid-Test Ratio Cash Debtors Inventory Total current assets Total current liabilities Rs 2,000 2,000 12,000 16,000 8,000 (1) Current Ratio (2) Acid-test Ratio 2 : 1 0.5 : 1
  11. 11. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 11116 -6 - 1111 Supplementary Ratios forSupplementary Ratios for LiquidityLiquidity Inventory Turnover Ratio Inventory Turnover Ratio Debtors Turnover RatioDebtors Turnover Ratio Creditors Turnover RatioCreditors Turnover Ratio
  12. 12. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 12126 -6 - 1212 Inventory Turnover Ratio The cost of goods sold means sales minus gross profit. The average inventory refers to the simple average of the opening and closing inventory. The ratio indicates how fast inventory is sold. A high ratio is good from the viewpoint of liquidity and vice versa. A low ratio would signify that inventory does not sell fast and stays on the shelf or in the warehouse for a long time. Inventory turnover ratio = Cost of goods sold Average inventory
  13. 13. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 13136 -6 - 1313 Example 2:Example 2: Inventory Turnover Ratio A firm has sold goods worth Rs 3,00,000 with a gross profit margin of 20 per cent. The stock at the beginning and the end of the year was Rs 35,000 and Rs 45,000 respectively. What is the inventory turnover ratio? Inventory turnover ratio = (Rs 3,00,000 – Rs 60,000) = 6 (times per year)(Rs 35,000 + Rs 45,000) ÷ 2 Inventory holding period = 12 months = 2 months Inventory turnover ratio, (6)
  14. 14. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 14146 -6 - 1414 Debtors Turnover Ratio Net credit sales consist of gross credit sales minus returns, if any, from customers. Average debtors is the simple average of debtors (including bills receivable) at the beginning and at the end of year. The ratio measures how rapidly receivables are collected. A high ratio is indicative of shorter time-lag between credit sales and cash collection. A low ratio shows that debts are not being collected rapidly. Debtors turnover ratio = Net credit sales Average debtors
  15. 15. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 15156 -6 - 1515 Example 3: Debtors Turnover Ratio A firm has made credit sales of Rs 2,40,000 during the year. The outstanding amount of debtors at the beginning and at the end of the year respectively was Rs 27,500 and Rs 32,500. Determine the debtors turnover ratio. Debtors turnover ratio = Rs 2,40,000 = 8 (times per year)(Rs 27,500 + Rs 32,500) ÷ 2 Debtors collection period = 12 Months = 1.5 MonthsDebtors turnover ratio, (8)
  16. 16. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 16166 -6 - 1616 Creditors Turnover RatioCreditors Turnover Ratio Net credit purchases = Gross credit purchases - Returns to suppliers. Average creditors = Average of creditors (including bills payable) outstanding at the beginning and at the end of the year. A low turnover ratio reflects liberal credit terms granted by suppliers, while a high ratio shows that accounts are to be settled rapidly. The creditors turnover ratio is an important tool of analysis as a firm can reduce its requirement of current assets by relying on supplier’s credit. Creditors turnover ratio = Net credit purchases Average creditors
  17. 17. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 17176 -6 - 1717 Example 4: Creditors Turnover Ratio The firm in previous Examples has made credit purchases of Rs 1,80,000. The amount payable to the creditors at the beginning and at the end of the year is Rs 42,500 and Rs 47,500 respectively. Find out the creditors turnover ratio. Creditors turnover ratio = (Rs 1,80,000) = 4 (times per year)(Rs 42,500 Rs 47,500) ÷ 2 Creditor’s payment period = 12 months = 3 months Creditors turnover ratio, (4)
  18. 18. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 18186 -6 - 1818 The summing up of the three turnover ratios (known as a cash cycle) has a bearing on the liquidity of a firm. The cash cycle captures the interrelationship of sales, collections from debtors and payment to creditors. Inventory holding period Add: Debtor’s collection period Less: Creditor’s payment period 2 months + 1.5 months – 3 months 0.5 months As a rule, the shorter is the cash cycle, the better are the liquidity ratios as measured above and vice versa. The combined effect of the three turnover ratios is summarised below:
  19. 19. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 19196 -6 - 1919 Defensive interval ratio is the ratio between quick assets and projected daily cash requirement. DEFENSIVE INTERVAL RATIO Defensive- interval ratio = Liquid assets Projected daily cash requirement Projected daily cash requirement = Projected cash operating expenditure Number of days in a year (365)
  20. 20. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 20206 -6 - 2020 Example 5: Defensive Interval Ratio The projected cash operating expenditure of a firm from the next year is Rs 1,82,500. It has liquid current assets amounting to Rs 40,000. Determine the defensive-interval ratio. Projected daily cash requirement = Rs 1,82,500 = Rs 500 365 Defensive-interval ratio = Rs 40,000 = 80 days Rs 500
  21. 21. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 21216 -6 - 2121 Cash-flow from operation ratio measures liquidity of a firm by comparing actual cash flows from operations (in lieu of current and potential cash inflows from current assets such as inventory and debtors) with current liability. Cash-flow From Operations Ratio Cash-flow from operations ratio = Cash-flow from operations Current liabilities
  22. 22. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 22226 -6 - 2222 Leverage Capital Structure RatioLeverage Capital Structure Ratio Capital structure or leverage ratios throw light on the long-term solvency of a firm. There are two aspects of the long-term solvency of a firm: (i) Ability to repay the principal when due, and (ii) Regular payment of the interest . Accordingly, there are two different types of leverage ratios. First type: These ratios are computed from the balance sheet Second type: These ratios are computed from the Income Statement (a) Debt-equity ratio (b) Debt-assets ratio (c) Equity-assets ratio (a) Interest coverage ratio (b) Dividend coverage ratio
  23. 23. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 23236 -6 - 2323 I. Debt-equity ratioI. Debt-equity ratio Debt-equity ratio measures the ratio of long- term or total de3bt to shareholders equityDebt-equity ratio = Total Debt Shareholders’ equity Long-term Debt + Short term debt + Other Current Liabilities = Total external Obligations Debt-equity ratio measures the ratio of long-term or total debt to shareholders equity. If the D/E ratio is high, the owners are putting up relatively less money of their own. It is danger signal for the lenders and creditors. If the project should fail financially, the creditors would lose heavily. A low D/E ratio has just the opposite implications. To the creditors, a relatively high stake of the owners implies sufficient safety margin and substantial protection against shrinkage in assets.
  24. 24. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 24246 -6 - 2424 For the company also, the servicing of debt is less burdensome and consequently its credit standing is not adversely affected, its operational flexibility is not jeopardised and it will be able to raise additional funds. The disadvantage of low debt-equity ratio is that the shareholders of the firm are deprived of the benefits of trading on equity or leverage.
  25. 25. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 25256 -6 - 2525 Trading on EquityTrading on Equity Trading on Equity (Amount in Rs thousand) Particular A B C D (a) Total assets 1,000 1,000 1,000 1,000 Financing pattern: Equity capital 1,000 800 600 200 15% Debt — 200 400 800 (b)Operating profit (EBIT) 300 300 300 300 Less: Interest — 30 60 120 Earnings before taxes 300 270 240 180 Less: Taxes (0.35) 105 94.5 84 63 Earnings after taxes 195 175.5 156 117 Return on equity (per cent) 19.5 21.9 26 58.5 Trading on equity (leverage) is the use of borrowed funds in expectation of higher return to equity-holders.
  26. 26. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 26266 -6 - 2626 II. Debt to Total CapitalII. Debt to Total Capital The relationship between creditors’ funds and owner’s capital can also be expressed using Debt to total capital ratio. Debt to total capital ratio = Total debt Permanent capital Permanent Capital = Shareholders’ equity + Long-term debt.
  27. 27. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 27276 -6 - 2727 III. Debt to total assets ratioIII. Debt to total assets ratio Debt to total assets ratio = Total debt Total assets Proprietary ratio indicates the extent to which assets are financed by owners funds. Proprietary ratio = Proprietary funds Total assets X 100 Capital gearing ratio is used to know the relationship between equity funds (net worth) and fixed income bearing funds (Preference shares, debentures and other borrowed funds. Proprietary Ratio Capital Gearing Ratio
  28. 28. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 28286 -6 - 2828 Coverage RatioCoverage Ratio Interest Coverage Ratio measures the firm’s ability to make contractual interest payments. Interest coverage ratio = EBIT (Earning before interest and taxes) Interest Dividend coverage ratio = EAT (Earning after taxes) Preference dividend Dividend Coverage Ratio measures the firm’s ability to pay dividend on preference share which carry a stated rate of return. Interest Coverage Ratio Dividend Coverage Ratio
  29. 29. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 29296 -6 - 2929 Total fixed charge coverage ratio measures the firm’s ability to meet all fixed payment obligations. Total fixed charge coverage ratio EBIT + Lease Payment Interest + Lease payments + (Preference dividend + Instalment of Principal)/(1-t) = Total fixed charge coverage ratio However, coverage ratios mentioned above, suffer from one major limitation, that is, they relate the firm’s ability to meet its various financial obligations to its earnings. Accordingly, it would be more appropriate to relate cash resources of a firm to its various fixed financial obligations. Total Cashflow Coverage Ratio Total cashflow coverage ratio Lease payment + Interest EBIT + Lease Payments + Depreciation + Non-cash expenses = (Principal repayment) (1– t) (Preference dividend) (1 - t) + +
  30. 30. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 30306 -6 - 3030 Debt Service Coverage RatioDebt Service Coverage Ratio Debt-service coverage ratio (DSCR) is considered a more comprehensive and apt measure to compute debt service capacity of a business firm. DEBT SERVICE CAPACITY DSCR = Instalmentt ∑ n t=1 EATt OAt+ +∑∑ n t=1 Depreciationt +Interestt Debt service capacity is the ability of a firm to make the contractual payments required on a scheduled basis over the life of the debt.
  31. 31. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 31316 -6 - 3131 Agro Industries Ltd has submitted the following projections. You are required to work out yearly debt service coverage ratio (DSCR) and the average DSCR. (Figures in Rs lakh) Year Net profit for the year Interest on term loan during the year Repayment of term loan in the year 1 2 3 4 5 6 7 8 21.67 34.77 36.01 19.20 18.61 18.40 18.33 16.41 19.14 17.64 15.12 12.60 10.08 7.56 5.04 Nil 10.70 18.00 18.00 18.00 18.00 18.00 18.00 18.00 The net profit has been arrived after charging depreciation of Rs 17.68 lakh every year. Example 6: Debt-Service Coverage RatioExample 6: Debt-Service Coverage Ratio
  32. 32. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 32326 -6 - 3232 SolutionSolution Table 3: Determination of Debt Service Coverage Ratio (Amount in lakh of rupees) Ye ar Net profit Depreciation Interest Cash available (col. 2+3+4) Principal instalment Debt obligation (col. 4 + col. 6) DSCR [col. 5 ÷ col. 7 (No. of times)] 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 21.67 34.77 36.01 19.20 18.61 18.40 18.33 16.41 17.68 17.68 17.68 17.68 17.68 17.68 17.68 17.68 19.14 17.64 15.12 12.60 10.08 7.56 5.04 Nil 58.49 70.09 68.81 49.48 46.37 43.64 41.05 34.09 10.70 18.00 18.00 18.00 18.00 18.00 18.00 18.00 29.84 35.64 33.12 30.60 28.08 25.56 23.04 18.00 1.96 1.97 2.08 1.62 1.65 1.71 1.78 1.89 Average DSCR (DSCR ÷ 8) 1.83
  33. 33. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 33336 -6 - 3333 Profitability RatioProfitability Ratio Profitability ratios can be computed either from sales or investment. Profitability Ratios Related to Sales Profitability Ratios Related to Investments (i) Profit Margin (ii) Expenses Ratio (i) Return on Investments (ii) Return on Shareholders’ Equity
  34. 34. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 34346 -6 - 3434 Profit MarginProfit Margin Gross profit margin measures the percentage of each sales rupee remaining after the firm has paid for its goods. Gross profit margin = Gross Profit Sales X 100 Gross Profit Margin
  35. 35. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 35356 -6 - 3535 Net profit margin can be computed in three ways iii. Net Profit Ratio = Earning after interest and taxes Net sales ii. Pre-tax Profit Ratio = Earnings before taxes Net sales i. Operating Profit Ratio = Earning before interest and taxes Net sales Net profit margin measures the percentage of each sales rupee remaining after all costs and expense including interest and taxes have been deducted. Net Profit Margin
  36. 36. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 36366 -6 - 3636 Example 7: From the following information of a firm, determine (i) Gross profit margin and (ii) Net profit margin. 1. Sales 2. Cost of goods sold 3. Other operating expenses Rs 2,00,000 1,00,000 50,000 (1) Gross profit margin = Rs 1,00,000 = 50 per cent Rs 2,00,000 (2) Net profit margin = Rs 50,000 = 25 per cent Rs 2,00,000
  37. 37. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 37376 -6 - 3737 Expenses RatioExpenses Ratio i. Cost of goods sold = Cost of goods sold Net sales X 100 ii. Operating expenses = Administrative exp. + Selling exp. Net sales X 100 iii. Administrative expenses = Administrative expenses Net sales X 100 iv. Selling expenses ratio = Selling expenses Net sales X 100 v. Operating ratio = Cost of goods sold + Operating expenses Net sales X 100 vi. Financial expenses = Financial expenses Net sales X 100
  38. 38. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 38386 -6 - 3838 Return on InvestmentReturn on Investment Return on Investments measures the overall effectiveness of management in generating profits with its available assets. i. Return on Assets (ROA) ROA = EAT + (Interest – Tax advantage on interest) Average total assets ii. Return on Capital Employed (ROCE) ROCE = EAT + (Interest – Tax advantage on interest) Average total capital employed
  39. 39. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 39396 -6 - 3939 Return on Shareholders’ EquityReturn on Shareholders’ Equity Return on total shareholders’ equity = Net profit after taxes Average total shareholders’ equity X 100 Return on ordinary shareholders’ equity (Net worth) = Net profit after taxes – Preference dividend Average ordinary shareholders’ equity X 100 Return on shareholders equity measures the return on the owners (both preference and equity shareholders ) investment in the firm.
  40. 40. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 40406 -6 - 4040 Efficiency RatioEfficiency Ratio Activity ratios measure the speed with which various accounts/assets are converted into sales or cash. i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold Inventory Turnover Ratio = Cost of goods sold Average inventory i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold Raw materials turnover = Cost of raw materials used Average raw material inventory i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold Work-in-progress turnover = Cost of goods manufactured Average work-in-progress inventory Inventory turnover measures the efficiency of various types of inventories.
  41. 41. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 41416 -6 - 4141 Liquidity of a firm’s receivables can be examined in two ways. i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold i. Debtors turnover = Credit sales Average debtors + Average bills receivable (B/R) 2. Average collection period = Months (days) in a year Debtors turnover i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold Alternatively = Months (days) in a year (x) (Average Debtors + Average (B/R) Total credit sales Ageing Schedule enables analysis to identify slow paying debtors. Debtors Turnover RatioDebtors Turnover Ratio
  42. 42. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 42426 -6 - 4242 Assets Turnover RatioAssets Turnover Ratio i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold i. Total assets turnover = Cost of goods sold Average total assets ii. Fixed assets turnover = Cost of goods sold Average fixed assets i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold iii. Capital turnover = Cost of goods sold Average capital employed iv. Current assets turnover = Cost of goods sold Average current assets i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold v. Working capital turnover = Cost of goods sold Net working capital Assets turnover indicates the efficiency with which firm uses all its assets to generate sales.
  43. 43. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 43436 -6 - 4343 1) Return on shareholders’ equity = EAT/Average total shareholders’ equity. 2) Return on equity funds = (EAT – Preference dividend)/Average ordinary shareholders’ equity (net worth). 3) Earnings per share (EPS) = Net profit available to equity shareholders’ (EAT – Dp)/Number of equity shares outstanding (N). 4) Dividends per share (DPS) = Dividend paid to ordinary shareholders/Number of ordinary shares outstanding (N). 5) Earnings yield = EPS/Market price per share. 6) Dividend Yield = DPS/Market price per share. 7) Dividend payment/payout (D/P) ratio = DPS/EPS. 8) Price-earnings (P/E) ratio = Market price of a share/EPS. 9) Book value per share = Ordinary shareholders’ equity/Number of equity shares outstanding.
  44. 44. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 44446 -6 - 4444 Integrated Analysis RatioIntegrated Analysis Ratio Integrated ratios provide better insight about financial and economic analysis of a firm. (1) Rate of return on assets (ROA) can be decomposed in to (i) Net profit margin (EAT/Sales) (ii) Assets turnover (Sales/Total assets) (2) Return on Equity (ROE) can be decomposed in to (i) (EAT/Sales) x (Sales/Assets) x (Assets/Equity) (ii) (EAT/EBT) x (EBT/EBIT) x (EBIT/Sales) x (Sales/Assets) x (Assets/Equity)
  45. 45. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 45456 -6 - 4545 Rate of Return on Assets EAT as percentage of sales Assets turnover EAT SalesDivided by Sales Total AssetsDivided by Current assetsFixed assets Gross profit = Sales less cost of goods sold Minus Expenses: Selling Administrative Interest Minus Income-tax Shareholder equity Plus Long-term borrowed funds Plus Current liabilities Plus Alternatively
  46. 46. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 46466 -6 - 4646 Return on AssetsReturn on Assets Earning Power Earning power is the overall profitability of a firm; is computed by multiplying net profit margin and assets turnover. Earning power = Net profit margin × Assets turnover Where, Net profit margin = Earning after taxes/Sales Asset turnover = Sales/Total assets i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold Earning Power = Earning after taxes Sales Sales Total Assets EAT Total assets xx x
  47. 47. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 47476 -6 - 4747 Assume that there are two firms, A and B, each having total assets amounting to Rs 4,00,000, and average net profits after taxes of 10 per cent, that is, Rs 40,000, each. Table 4: Return on Assets (ROA) of Firms A and B Particulars Firm A Firm B 1. Net sales 2. Net profit 3. Total assets 4. Profit margin (2 ÷ 1) (per cent) 5. Assets turnover (1 ÷ 3) (times) 6. ROA ratio (4 × 5) (per cent) Rs 4,00,000 40,000 4,00,000 10 1 10 Rs 40,00,000 40,000 4,00,000 1 10 10 Firm A has sales of Rs 4,00,000, whereas the sales of firm B aggregate Rs 40,00,000. Determine the ROA of firms A and B. Table 4 shows the ROA based on two components. EXAMPLE: 8
  48. 48. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 48486 -6 - 4848 Return on Equity (ROE)Return on Equity (ROE) ROE is the product of the following three ratios: Net profit ratio (x) Assets turnover (x) Financial leverage/Equity multiplier Three-component model of ROE can be broadened further to consider the effect of interest and tax payments. As a result of three sub-parts of net profit ratio, the ROE is composed of the following 5 components. i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold EAT Earnings before taxes EBT EBIT EBIT Sales Net Profit Sales xx = EAT EBT EBT EBIT EBIT Sales Sales Assets Assets Equity x x x x
  49. 49. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 49496 -6 - 4949 A 5-way break-up of ROE enables the management of a firm to analyse the effect of interest payments and tax payments separately from operating profitability. To illustrate further assume 8 per cent interest rate, 35 per cent tax rate and other operating expense of Rs 3,22,462 (Firm A) and Rs 39,26,462 (Firm B) for the facts contained in Example 8. Table 5 shows the ROE (based on the 5 components) of Firms A and B. Table 5: ROE (Five-way Basis) of Firms A and B Particulars Firm A Firm B Net sales Less: Operating expenses Earnings before interest and taxes (EBIT) Less: Interest (8%) Earnings before taxes (EBT) Less: Taxes (35%) Earnings after taxes (EAT) Total assets Debt Equity EAT/EBT (times) EBT/EBIT (times) EBIT/Sales (per cent) Sales/Assets (times) Assets/Equity (times) ROE (per cent) Rs 4,00,000 3,22,462 77,538 16,000 61,538 21,538 40,000 4,00,000 2,00,000 2,00,000 0.65 0.79 19.4 1 2 20 Rs 40,00,000 39,26,462 73,538 12,000 61,538 21,538 40,000 4,00,000 2,50,000 1,50,000 0.65 0.84 1.84 10 1.6 16
  50. 50. © Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 -6 - 50506 -6 - 5050 Common Size StatementsCommon Size Statements Preparation of common-size financial statements is an extension of ratio analysis. These statements convert absolute sums into more easily understood percentages of some base amount. It is sales in the case of income statement and totals of assets and liabilities in the case of the balance sheet. Ratio analysis in view of its several limitations should be considered only as a tool for analysis rather than as an end in itself. The reliability and significance attached to ratios will largely hinge upon the quality of data on which they are based. They are as good or as bad as the data itself. Nevertheless, they are an important tool of financial analysis. Limitations

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