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Ratio analysis


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  • 1. Ratio analysis
  • 2. Types of ratios
    • Liquidity ratios
    • Capital structure/Leverage/Solvency ratios
    • Profitability ratios
    • Activity/Efficiency ratios
    • Integrated analysis of ratios.
  • 3. Liquidity ratios
    • There is always a time lag between cash inflow & cash outflow. When there is excess of cash surplus funds must be invested & in case of shortage cheapest sources of funds must be found out.
    • Thus liquidity management involves constant cash flow monitoring.
    • Current ratio
    • Quick/acid test ratio
    • Super quick ratios
    • Net working capital ratio
  • 4. Current ratio
    • Current Assets/Current Liabilities
    • Ideal is 2:1
    • CA= cash & bank Balance, marketable securities, inventory (raw materials, W.I.P & finished goods), debtors( less provision for bad & doubtful debts), bills receivable & prepaid expenses.
    • CL= creditors, bills payable, bank credit, provision for taxation, dividends payable, & outstanding expenses.
  • 5. Interpretation
    • CR>1 indicates that for each rupee of CL , there is more than one rupee of CA available.
    • CR<1 indicates that CL have partially been invested in Non CA.
    • CR=2:1( rule of thumb) is based on the logic that even with a drop out of 50% in value of CA , a firm can meet its obligations.
    • CR may differ on the basis of nature of industry, availability of long term funds & development of capital markets.
  • 6. Limitation
    • CR is the quantitative measure of liquidity rather than a qualitative measure.
    • It does not consider the various types of current assets which may defer in liquidity.
    • Even a CR of 2:1 may not be an indicator of liquidity, since it might include non readily realizable assets like high inventory & customers balance.
  • 7. Acid test ratio
    • Quick Assets/ Quick liabilities
    • QA= CA- (prepaid expenses+ inventory+ doubtful debtors)
    • QL = CL- cash credit
    • Measures firm’s ability to convert its CA quickly into cash in order to meet its CL.
  • 8. Interpretation
    • Ideal is 1:1.
    • It is more rigorous test of liquidity but not a conclusive proof.
    • But then it is widely accepted as a test of liquidity position.
  • 9. Super quick ratio
    • Super quick assets/ CL
    • Super quick assets= cash + marketable securities.
    • Most rigorous test.
  • 10. Profitability ratios
    • The management is interested in knowing the operating efficiency & the shareholders or the owners want to know about returns, this depends upon profits.
    • Profitability ratios can be determined on the basis of sales or investments.
  • 11. Types of profitability ratios PR ratios related to Sales PR ratios related to investment Gross profit ratio ratio Net profit ratio Expenses ratio Return on assets ratio Return on capital Employed ratio Return on shareholders’ equity ratio
  • 12. Gross profit ratio
    • (Gross profit/sales)* 100
    • Gross profit = Sales –COGS
    • COGS= O.S+ Purchases+ Direct expenses-C.S
    • It shows the relationship between price , sales & costs.
    • High GP ratio shows that cost of production is low.
    • Low GP ratio may be due to high production cost, inefficient utilisation of resources, lack of demand, low selling price etc.
  • 13. Net profit ratio
    • Operating profit ratio=EBIT/ Net sales
    • Pre-tax profit ratio=EBT/ Net sales
    • Net profit ratio=EAT/ Net sales
    • These variants of net profit show ratio indicate the management’s ability to operate business with success, to earn revenue so as to cover cost; the expenses of operating business, cost of borrowed funds & also to earn some incentive for the owners who have provided the capital at risk.
  • 14. Operating profit & net profit
    • Operating profit= {sales+(CS-OS)} – OC ( operating costs = raw materials consumed + manufacturing expenses+ direct expenses+ administration expenses+selling & distribution expenses+depreciation ).
    • It is also know as EBIT
    • Net profit= operating profit – (finance charges +non operating incomes + tax)
  • 15.
    • Operating profit ratio & operating ratio=100 per cent.
    • Now If sales = 40,00,000
    • & COGS = 32,00,000
    • other operating expenses = 5,00,000
    • Calculate GP & NP
  • 16. Expenses ratio
    • COGS ratio= (COGS/ Net sales)*100
    • Operating Expenses ratio= (Admt. & selling expenses/ Net sales)*100
    • Administration expenses Ratio=(Admt. Expenses/ Net sales)* 100
    • Selling expenses Ratio=(Selling Expenses/ Net sales)* 100
    • Operating ratio=(COGS & operating expenses / Net sales)*100
    • Financial expenses ratio=(financial expenses/ Net sales)*100