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- 1. Ratio Analysis MEANING Ratios show the relationship between two numbers. Accounting ratio shows the relationship between two accounting figure. Ratio analysis is the process of computing and presenting the relationships between the items in the financial statement. It is an important tool of financial analysis, because it helps to study the financial performance and position of a concern. FORMS There are three different forms in which an accounting ratio can be expressed 1. Pure ratio: A pure ratio is a simple division of one number by another. The relationship between current asset & current liabilities is expressed in this way. 2. Percentage: Certain accounting ratio becomes more meaning full if expressed as a percentage. The relationship between profit and sales is expressed in this way 3. Rate: Sometimes ratios are expressed as rates i.e. ‘number of times’ over a certain period .relationship between stock and sales is expressed in this way. ****11****
- 2. Ratio Analysis CLASSIFICATION 1) Based on financial statement According ratio express the relationship between figures taken from financial statement. Figures may be taken from balance sheet, profit & loss account or both. One way of classification of ratio is based upon the sources from which figure are taken A) Balance sheet ratios: If ratio are base on the figure of balance sheet they are called balance sheet ratio E.g. ratio of current assets to current liabilities or ratio of Debt to equity .while calculating these ratio, there is no need to refer to the revenue statement .these ratio study the relationship between the assets and the liabilities of the concern. These ratio help to judge the liquidity, solvency and capital structure of the concern. There are six type of balance sheet ratio as follow: Current ratio, Liquid ratio, Proprietor ratio, Capital gearing ratio, Debt equity ratio a Stock working capital ratio. B) Revenue statement ratios: Ratio based on the figure from the revenue statement are called revenue statement ratio. These ratios study the relationship between the profitability and the sale of the concern. There are six revenue statement ratios, viz Gross profit ratio, Operating ratio, Expenses ratio, Net profit ratio & Net operating profit ratio & Stock turn over ratio. C) Composite ratios: This ratio indicates the relationship between two items, of which one is found in the balance sheet and another in the revenue statement. there are two types of composite ratios i) Some composite ratio study the relation ship between the profit and the investment of the concern E.g. Return on capital employed, Return on proprietors fund, Return on equity capital etc. ii) Other composite ratios that we are going to study are Debtors turnover, Creditors turnover, Dividend payout and Debt services. ****22****
- 3. Ratio Analysis 2) Based on function: Accounting ratios can be classified according to their function (i.e. their purpose) into Liquidity ratios, Leverage ratios, Activity ratios, Profitability ratios, and Turnover ratios. A) Liquidity ratios: show the relationship between the current assets and current liabilities of the concern. B) Leverage ratios: show the relationship between the proprietor fund and debt used in financing the assets of the concern .Example are Capital gearing ratio ,Debt equity ratio and Proprietary ratio .these ratio s are also known as SOLVENCY RATIOS. C) Activity ratios (also known as TURNOVER RATIOS or PRODICTIVITY RATIOS) show the relationship between the sales and the assets .E.g. Stock turnover ratio, Debtor turnover ratio etc. D) Profitability ratios show the relationship between i. Profit and sales ,for example – Operation ratio, Gross profit ratio, Operating net profit ratio, Expenses ratios Etc, or ii. Profit and investment, for Example-Return on investment, Return on equity capital Etc. E) Coverage ratios show the relationship between the profits on one hand and the claims of outsiders (dividend, interest Etc) to be paid out of such profits. Examples are Dividend payout ratio and debt service ratio. 3) Based on user A) Ratios for short term creditors: current ratio, Liquid ratio & Stock working capital. B) Ratios for Share holder: Return on proprietors’ funds, Return on Equity capital. C) Ratios for Management: Return on capital employed, Turnover ratio, Operating ratio, Expenses ratios. D) Ratios for long term creditors: Debt equity ratio, Return on capital employed, preparatory ratio. ]] ****33****
- 4. Ratio Analysis 1) CURRENT RATIO (CR) = CURRENT ASSETS (CA) CURRENT LIABILITIES (CL) 2) QUICK / LIQUIDITY RATIO (QR) = QUICK ASSETS (QA) QUICK LIABILITIES (QL) 3) STOCK WORKING CAPITAL (SWC) STOCK (CST) X 100 WORKING CAPITAL (WC) 4) PROPRIETORS RATIO (PR) = PROPRIETORS FUNDS (PF) X 100 TOTAL ASSETS (TA) 5) DEBT EQUITY RATIO (DER) = BF PF 6) CAPITAL GEARING RATIO (CGR) = PC+BF EF ****44****
- 5. Ratio Analysis 1. CURRENT RATIO (CR) MEANING : This ratio compares the current assets with the current liabilities. It is expressed in the form of a pure ratio. FORMULA : CURRENT RATIO (CR) = CURRENT ASSETS (CA) CURRENT LIABILITIES (CL) COMPONENTS : Current assets: Sundry debtors(less Provision), loose tools, income accrued /Due, Bill receivable, cash and Bank balance, Marketable investment, closing stock of raw material, Working in progress, finished goods, store and spares, Pre payments, short term loan and advance tax.. Current liabilities: Sundry creditors, bill payable, outstanding expenses, unclaimed dividend and proposed dividend, provision for taxation, income received in advanced, bank overdraft. FUNCTION/PURPOSE : Current ratio is a liquidity/solvency ratio which indicates the ability of the concern to meet its short-term liabilities. It measure the short term solvency of the concern .it is used by a creditors to judge the safety margin available and to decide the amount and the term of the credit. LIMITATION Ignore composition: Current ratio ignores the composition of working capital. Two companies A & B may have the same current ratio; but if company A has more stocks and company B has more cash, company B has a better liquidity / solvency. Ignores Quality: current ratio also ignores the quality of working capital. two companies A & B may have the same current ratio and the same amount of stock and debtors ,but if company A has more absolute stock and doubtful debts, company B has a better liquidity /solvency. INTERACTION WITH OTHER RATIOS This ratio should be studied with liquid and ratio and stock working capital ratio for judging the short term solvency of the concern. ****55****
- 6. Ratio Analysis COMMENTS Actual Ratio:- Rs. XX of current assets available for each Re. of current liability. Higher than Standard:- 1. Very good short term liquidity/solvency. 2. Excess stocks, bad debts, idle cash. 3. Under-trading. Lower than Standard:- 1. Unsatisfactory short-term liquidity/solvency. 2. Shortage of stocks, bad debts, idle cash. 3. Over-trading. 2. QUICK/LIQUID RATIO (QR) MEANING: Liquid ratio compares the quick assets with the quick liabilities .it is expressed in the form of a pure ratio .it is also known as quick ratio or Acid test ratio. FORMULA: QUICK / LIQUIDITY RATIO (QR) = QUICK ASSETS (QA) QUICK LIABILITIES (QL) COMPONENTS Quick assets (QA): Current assets (-) l closing stock (-) pre payment i.e. Debtors, loose tools, income accrued, income accrued /Due, Bill receivable, cash and Bank balance, Marketable investment. NOTE: stock is exclude because it is in certain as to when and how much ,it will realise.Prepayment are exclude because ,they cannot be converted into cash. QUICK LIABILITIES (QL): Sundry creditors, bill payable, outstanding expenses, unclaimed dividend and proposed dividend, provision for taxation NOTE: bank overdraft is excluded ,because it is almost a permanent arrangement with the bank and is not required to be paid in full as long as the concern existing. ****66****
- 7. Ratio Analysis FUNCTION/PURPOSE: Liquid ratio is a liquid/solvency ratio which indicates the ability of the concern to meet its short term liabilities without selling stocks, it measure the immediate solvency of the concern .it overcome the imitation of the current ratio .it consider both the composition and the quality of the working capital .it is qualitative test of solvency .it emphasizes the quality of the current assets (i.e. their convertibility in to cash) rather than their quantum. INTERACTION WITH OTHER RATIOS Liquid ratio should be studied with current ratio for commenting on short term solvency COMMENTS Actual Ratio:- Rs. XX of liquid assets available for each Re. of quick liability. Higher than Standard:- 1. Very good day-to-day liquidity/solvency. 2. Idle cash balances. 3. Under-investment. Lower than Standard:- 1. Unsatisfactory day-to-day liquidity/solvency. 2. Low cash balances. 3. Over-investment. ****77****
- 8. Ratio Analysis 3. STOCK TO WORKING CAPITAL RATIO MEANING: This ratio shows the relationship between the closing stock and the working capital. It helps to judge the quantum of inventories in relation o the working capital of the business. It is expressed as a percentage. It is also known as Inventory Working Capital Ratio. FORMULA: STOCK TO WORKING CAPITAL RATIO =STOCK (CST) X 100 WORKING CAPITAL(WC) COMPONENTS Stock [CST] would mean closing stock. Working Capital [WC] = Current Assets less Current Liabilities FUNCTION/PURPOSE Stock to working capital ratio is a liquidity ratio. It indicates the composition and quality of the working capital. This ratio also helps to study the solvency of a concern. It is qualitative test of solvency. It shows the extent of funds blocked in stocks. If investment in stock is higher it means that the amount of liquid assets is lower. INTERACTION WITH OTHER RATIOS This ratio should be studied with stock-turnover ratio, current ratio and quick ratio. Best combination for short-term solvency would be: (1)Current Ratio 2:1 (2)Quick ratio slightly greater than one. (3)Good stock-turnover during the say 6 to 7 times, and Stock to working capital ratio lower than 100% COMMENTS Actual Ratio:- % of WC blocked in stocks. Higher than Standard:- 1. More other current assets available to pay current liabilities. Lower than Standard:- 1. Less other current assets available to pay current liabilities. ****88****
- 9. Ratio Analysis 4. PROPRIETORY RATIO MEANING: Proprietary ratio compares proprietor’s funds with total liabilities (or total assets). It is usually expressed in the form of percentage. It is also known as Net Worth to Total Assets Ratio, Equity Ratio, and Net worth Ratio or Asset Backing Ratio. FORMULA: PROPRIETORY RATIO = PROPRIETORS’ FUNDS OR SHAREHOLDER’S EQUITY (PF) X 100 TOTAL ASSETS OR TOTAL LIABILITIES (TA OR TL) COMPONENTS: Proprietors’ Funds [PF] will include: 1. Paid up Equity capital (EC) 2. Reserves & Surplus (RS) including capital reserves, revenue reserves, P&L a/c Cr. Balance Less: Accumulated losses (i.e. P & L a/c Dr. Balance) Less: Fictitious Assets like Miscellaneous Expenditure not written off. 3. Paid up Preference Capital (PC) Thus, PF = EC + RS + PC or EF + PC Total Assets [TA] (Fixed Assets + Investments + Current Assets) = Total Liabilities [TL] (Own Funds + Loans + Current Liabilities) = Total of the (Horizontal) Balance Sheet excluding fictitious assets & Accumulated losses (if any). = Capital Employed + Current Liabilities FUNCTION/PURPOSE: Proprietary ratio is a solvency ratio which indicates (i) The long term solvency; and (ii) The extent of funds invested by the owners in relation to total funds employed in the business (i.e. capitalization). INTERACTION WITH OTHER RATIOS: This ratio should be studied with Debt-Equity ratio to study the capital structure and with Current and Liquid ratio to comment on the long term and short term solvency of the business. ****99****
- 10. Ratio Analysis COMMENTS Actual Ratio:- % of total assets financed by owner’s funds. Higher than Standard:- 1. Very good solvency position. 2. No trading on equity. Lower than Standard:- 1. Unsatisfactory solvency position. 2. Trading on equity. 5. DEBT-EQUITY RATIO MEANING: THIS ratio compares the long term debts with shareholders’ funds. It is usually expressed as a pure ratio. FORMULA: This ratio is calculated in two ways (1) Debt = Borrowed Funds(BF) Equity Proprietors’ Funds (PF) (2) BF . BF + PF COMPONENTS Borrowed Funds [BF] includes 1. Debentures, Loans, etc. 2. Interest accrued and due on such BF. Proprietors’ Funds [PF] includes 1. Equity share capital (EC) 2. Reserves & Surplus (RS) Less: (a) Profit & Loss A/c Dr. Balance (loss (b) Miscellaneous Expenditure not written-off, if any. 3. Preference share capital (PC) ****1010****
- 11. Ratio Analysis PURPOSE/FUNCTION Debt-equity ratio is a solvency ratio which indicates the proportion of debt and equity in financing of the assets of the concern. Debt-equity ratio shows the (i) margin of safety for long term creditors; and (ii) The balance between debt and equity (i.e. capitalization). INTERACTION WITH CAPITAL GEARING RATIO This ratio differs from Capital Gearing Ratio in one aspect. Preference share capital is considered as a part of Equity in Debt-equity ratio whereas it is clubbed with loans and debentures in Capital Gearing Ratio. COMMENTS Actual Ratio:- Rs. X obtained from debt, for each Re. 1 from shareholders. Higher than Standard:- 1. Low safety margin for lenders. 2. More interest payments. 3. Less scope for more loans. 4. Trading on equity. Lower than Standard:- 1. High safety margin for lenders. 2. Less interest payments. 3. Scope for more loans. 4. No trading on equity. ****1111****
- 12. Ratio Analysis 6. CAPITAL GEARING RATIO MEANING ‘Gearing’ means the process of increasing the equity shareholder’s return through the use of debt. Equity Shareholders earn more when the rate of return on total capital is more than the rate of interest on debts. This is also known as ‘leverage’ or ‘trading on equity’. The Capital Gearing Ratio shows the relationship between two types of capital viz. (i) Equity capital including reserves and (ii) Preference share capital and long term borrowings. It is usually expressed as a pure ratio. This is also known as ‘Capital Structure Ratio’. FORMULA Capital Gearing Ratio = Capital Entitled to fixed Rate of Interest or Dividend = PC + BF Capital not so entitled to Fixed Rate of Interest or Dividend EF COMPONENTS Capital entitled to fixed rate of interest or dividend 1. Preference capital (PC) 2. Debentures, Long term loans, i.e. Borrowed Funds (BF) Capital not entitled to fixed rate of interest or dividend (Equity holders’ Fund or EF) 1. Equity Capital (EC) 2. Reserves & Surplus (RS) Less: Profit & Loss A/c Dr. Balance Less: Fictitious Assets Thus, CGR = PC + BF EF PURPOSE/FUNCTION Capital Gearing Ratio is a leverage ratio which indicates the proportion of debt and equity in the financing of assets of a concern. ‘Leverage’ means his process of increasing the equity shareholders’ return through the use of debt also known as ‘gearing’ or ‘trading on equity’. Capital Gearing Ratio shows the balance between debt and equity. ****1212****
- 13. Ratio Analysis COMMENTS Actual Ratio:- For every Rs. XX from funds with fixed returns, Re. 1 is from equity shareholders. Higher than Standard:- Higher returns for equity shareholders if rate of fixed returns is less than ROI. Lower than Standard:- Low returns/loss to equity shareholders if rate of fixed returns is more than ROI. ****1313****
- 14. Ratio Analysis 1. Gross Profit Ratio: GPR= GP/Sales x 100 2. Operating Ratio: OR= COGS + OE/Sales x100 3. Expense Ratio: ER= AE or SE or FE/Sales x100 4. Operating Profit Ratio: OPR= OP/Sales x100 5. Net Profit Ratio: NPR= NPBT/Sales x100 6. Stock Turnover Ratio: STR= COGS/OST+CST/2 ****1414****
- 15. Ratio Analysis 1. GROSS PROFIT RATIO MEANING: THIS ratio compares gross profit with net sales. It is usually expressed in the form of percentage. FORMULA: GROSS PROFIT = GROSS PROFIT/NET SALES X 100 COMPONENTS Gross Profit = Sales less Cost of Goods Sold Cost of goods sold [COGS] [In case of a Trading Concern] 1) Opening stock 2) Add: Purchases 3) Add: Direct expenses 4) Less: closing Stock = COGS [In case of a manufacturing concern] 1) Opening stock of finished goods 2) Add: Cost of goods produced [Direct/Prime Cost (Material + Labour + Expenses)] 3) Less: Closing stock of finished goods = COGS Net sales [S] = Sales less Sales returns less Allowances FUNCTION/ PURPOSE Gross profit ratio is a profitability ratio, which shows the relationship between profits and sales. This ratio helps to judge (i) how efficient the concern is in managing its production, purchase, selling and inventory; (ii) how good its control is over the direct costs; (iii) how productive the concern is; and (iv) how much amount is left to meet other expenses and earn net profits. INTERACTION WITH OTHER RATIO: This ratio should be studied with net profit ratio, operating ratio and return on investment ratio to know the over all profitability of the concern. ****1515****
- 16. Ratio Analysis COMMENTS Actual Ratio:- 1. Margin of Rs. xx on sale of Rs. 100. 2. Rs. xx is available to meet other expenses. Higher than Standard:- 1. High efficiency in managing purchases, production, labour, sales and inventory. 2. High productivity. 3. Large amount available to meet other expenses. Lower than Standard:- 1. Low efficiency in managing purchases, production, labour, sales and inventory. 2. Low productivity. Small amount available to meet other expenses 2. OPERATING RATIO MEANING: Operating ratio expresses the relationship between total operating costs and net sales. It is expressed by the way of a percentage. FORMULA: OPERATING RATIO = COST OF GOODS SOLD + OPERATING EXPENSES X 100 NET SALES COMPONENTS Cost of Goods Sold [COGS] Operating Expenses [OE] 1. Office and Administration Expenses 2. Selling and Distribution Expenses 3. Finance Expenses Excluding Interest on Loans and Debentures Net Sales [S] = Sales less Sales returns less Allowances FUNCTION/ PURPOSE Operating ratio indicates cost of operations. Its purpose is to measure and ascertain the efficiency of the management as regards operations. This ratio helps ****1616****
- 17. Ratio Analysis to judge (i) how efficient the concern is in controlling its cost of production, purchase, labour, administration, selling and inventory; and (ii) how much amount out of sales revenue is used up in carrying the operations of the concern. INTERACTION WITH OTHER RATIO : operating ratio show total of all coast in all area such as administration, sale etc.it is advisable to break it up into various expenses ratio so that we can know which expenditures in particulars is increasing disproportionately. Operating ratio should always be studied with expenses ratio and operating net profit ratio before commenting on the profitability of the concern. COMMENTS Actual Ratio:- 1. Operating cost of Rs. xx on sale of Rs. 100. 2. Rs. (100 - xx) is the operating profit. Higher than Standard:- 1. Low efficiency in managing purchases, production, labour, sales and inventory. 2. Low productivity. 3. Small amount available to meet other expenses. Lower than Standard:- 1. High efficiency in managing purchases, production, labour, sales and inventory. 2. High productivity. 3. Large amount available to meet other expenses. ****1717****
- 18. Ratio Analysis 3. EXPENSES RATIO MEANING: THIS ratio expresses the relationship between each item of expenditure and net sales. It is expressed as a percentage. Total of all expenses will be equal to Operating ratio. FORMULA ANY EXPENSE RATIO = EXPENDITURE X 100 NET SALES E.g. Administrative Expenses Ratio = Administrative Expenses x 100 Net Sale Selling Expenses Ratio = Selling Expenses / Net Sales x 100 FUNCTION/ PURPOSE Expenses ratios are supplementary to the Operating ratio. Study of Expense ratios helps us to know the cause behind overall change in the Operating ratio. Management can take corrective action accordingly. Expense ratios indicate the efficiency of management in controlling the expenses and thereby improving profitability. Expenses ratios over a number of years should be studied to find out trend. While interpreting these ratios, it must be kept in mind that if expenses are fixed in nature, ratio would decrease as sales increase but if expenses are variable, same percentage would be maintained. COMMENTS Actual Ratio:- 1. Expense of Rs. xx on sale of Rs. 100. 2. Rs. xx is available to meet other expenses. Higher than Standard:- 1. Less control on that expenditure. 2. Low productivity. 3. Small profit available to meet other expenses. Lower than Standard:- 1. Very good control over that expenditure. 2. High productivity. 3. Large profit available to meet other expenses. ****1818****
- 19. Ratio Analysis 4. OPERATING PROFIT RATIO MEANING: Operating profit ratio indicates the relationship between Operating profit and the Sales. It is usually expressed in the form of a percentage. It is also known as Net Operating Profit Ratio. FORMULA OPERATING PROFIT = OPERATING PROFIT X 100 NET SALES COMPONENTS Operating Profit [OP] = 1. Gross Profit 2. Less: Operating expenses [OE] Net Sales [S] = Sales less Returns less Allowances. FUNCTION/ PURPOSE Operating profit ratio is a profitability ratio, which shows the relationship between profits and sales. It indicates profits from operations. This ratio helps to judge (i) How efficient the concern is in managing all its operations of production, purchase, inventory, administration, selling, distribution etc. and (ii) How much amount is left to meet non-operating expenses and earn profits? INTERACTION WITH OTHER RATIO: operating profit ratio should be studied with return on capital employed and return on proprietors’ funds. COMMENTS Actual Ratio:- 1. Operating margin of Rs. xx on sale of Rs. 100. 2. Rs. xx is available to meet non-operating profit. Higher than Standard:- 1. Good control over direct and indirect costs. 2. High productivity. ****1919****
- 20. Ratio Analysis 3. Large amount available to meet non-operating expenses/losses. Lower than Standard:- 1. Less control over direct and indirect costs. 2. Low productivity. 3. Small amount available to meet non-operating expenses/losses. 5. NET PROFIT RATIO MEANING Net Profit ratio indicates the relationship between net profit and sales. It is usually expressed in the form of a percentage. FORMULA NET PROFIT = NET PROFIT (BEFORE TAX) X 100 NET SALES COMPONENTS Net Profit before Tax [NPBT] = A) Operating net profit B) Add: Non Operating Income C) Less: Non Operating Expenses = NPBT Net Sales [S] =Sales less Returns less Allowances FUNCTION / PURPOSE Net profit ratio is a profitability ratio, which shows the relationship between profits and sales. It indicates net profits from all types of activities of the entire business. It measures the overall profitability from (a) operating activities of buying/selling products; (b) financing activities of borrowing/lending; and (c) buying/selling investments. This ratio helps to judge (i) how efficient the concern is in managing all its activities of operations, financing and investment; and (ii) how much amount is available for appropriations. INTERACTION WITH OTHER RATIO: Net profit ratio should be studied with return on capital employed and return on proprietors’ funds. ****2020****
- 21. Ratio Analysis COMMENTS Actual Ratio:- 1. Net margin of Rs. xx on sale of Rs. 100. 2. Rs. xx is available for appropriations. Higher than Standard:- 1. Good control over all expenses. 2. Unusual gains. 3. Large amount available for appropriations. 4. High increase in net worth. 5. Strong capacity to face bad economic situation. Lower than Standard:- 1. Less control over all expenses. 2. Unusual losses. 3. Small amount available for appropriations. 4. Less increase in net worth. 5. Weak capacity to face bad economic situation. ****2121****
- 22. Ratio Analysis 6. STOCK TURNOVER RATIO MEANING Stock turnover ratio shows the relationship between the cost of goods sold and the average stock. This ratio is normally expressed as a ‘rate’. FORMULA A. Stock Turnover Ratio = Cost of Goods Sold (COGS) Average stock (AS) If stock is valued at sales price, formula will be = Net Sales Average Stock (at selling price) Average Stock = Opening Stock + Closing Stock 2 Note: In the absence of information, closing stock can be used instead of average stock in the above formula. B. Stock Velocity [Stock Holding Period] Stock velocity means the period (months or days) taken for converting average stock into sales. It shows the Stock Holding Period. 12___________ = Number of months production on hand or Number of Stock Turnover Ratio months it takes for converting stock into sales. 365________ = Number of days production on hand or Number of Stock Turnover Ratio days it takes for converting stocks into sales. COMPONENTS Cost of Goods Sold [COGS] = Sales less Gross Profit Average Stock [AS] = Opening Stock + Closing Stock 2 FUNCTION / PURPOSE Stock Turnover Ratio is an activity ratio, which shows the relationship between sales and stock. Its purpose is to (i) calculate the speed at which stock is being turned over into sales; (ii) calculate the stock velocity to indicate the period taken by the average stock to be sold out; and (iii) judge how efficiently the stocks are managed and utilized to generate sales. ****2222****
- 23. Ratio Analysis INTERACTION WITH OTHER RATIO: THIS ratio should be studied with the current ratio and liquid ratio while commenting on short term liquid/solvency .if Company’s current ratio is 2:1 & liquid ratio is 0.5:1, it means that the concern has larger stocks and low quick assets. This fact can be proved if company’s stocks turnover ratio is very low say 1 or 2 which means low stocks – turnover is the reason for good current ratio but bad quick ratio. COMMENTS Actual Ratio:- Stock Holding Period is xx. Higher than Standard:- 1. Stock sold out fast. 2. Same volume of sales from less stock. 3. More sales from less stock. 4. Working Capital requirement is less. 5. Too high ratio shows stock-outs or over-trading. Lower than Standard:- 1. Stock sold out at a slow speed. 2. Same volume of sales from more stocks. 3. Less sales from less stock. 4. Working Capital requirement is more. 5. Too low ratio shows obsolete stocks or less trading. ****2323****
- 24. Ratio Analysis 1. Return on Investment/ Capital Employed ROI = PBIT x 100 CE 2. Return on Proprietors Fund RPF = NPAT X 100 PF 3. Return on Equity Capital ROE = PAES x 100 EF 4. Dividend Pay Out DP = _ _ED_ X 100 PAES 5. Debt Service / Interest Coverage Ratio DSR = PBIT INT 6. Debtors Turnover Ratio DTR = CSR DR+BR 7. Creditors Turnover Ratio CTR = CRP CD + BP ****2424****
- 25. Ratio Analysis 1. RETURN ON CAPITAL EMPLOYED MEANING The ratio measures the relationship between net profit (before interest and tax) and the capital employed to earn it. It is expressed as a percentage. This ratio is also known as ‘Return on Investment’ [ROI]. FORMULA RETURN ON CAPITAL EMPLOYED = PROFIT (BEFORE INTEREST, TAX) (PBIT) X 100 CAPITAL EMPLOYED X 100 (CE) COMPONENTS Profit (before Interest, Tax) [PBIT] = 1. Profit before interest on long-term borrowing, tax and dividends 2. Less abnormal, non-recurring items. Capital Employed [CE] = 1. Equity capital 2. Add: Preference Capital + Reserves & Surplus 3. Add: Long term Borrowings (Term Loans + Debentures) 4. Less: Fictitious assets like Miscellaneous Expenses not written off 5. Less: Profit & loss A/c Dr. Balance (loss). Note: Capital employed may be taken to mean Assets Employed, in which case, Capital Employed [CE] can also be computed as 1. Fixed Assets (Less depreciation) (including investments) 2. Add: Current Assets 3. Less: Current Liabilities 4. Exclude Fictitious assets FUNCTION/ PURPOSE Return on capital employed ratio is a profitability ratio, which shows the relationship between profits and investments. Its purpose is to measure the overall profitability from the total funds made available by the owners and lenders. This ratio helps to judge how efficient the concern is in managing the funds at its disposal. ****2525****
- 26. Ratio Analysis COMMENTS Actual Ratio:- 1. Return of Rs. xx on each Rs. 100 of capital. 2. Rs. xx is available for tax, interest and appropriations. Higher than Standard:- 1. Good profit ratios (more profit on each rupee of sales). 2. Good turnover ratios (more sales on each rupee of asset used). 3. Large amount for appropriations. 4. High increase in net worth. 5. Scope to attract fresh funds from owners or lenders. Lower than Standard:- 1. Unsatisfactory profit ratios (less profit on each rupee of sales). 2. Unsatisfactory turnover ratios (less sales on each rupee of asset used). 3. Small amount for appropriations. 4. Low increase in net worth. 5. Less scope to attract fresh funds from owners or lenders. 2. RETURN ON PROPRITORS FUND MEANING: This ratio measures the relationship between profit (after interest rate and tax) and the proprietor’s capital. It is usually expressed as a percentage. It is also known as Return on Proprietor’s Equity or Return on Net Worth. FORMULA RETURN ON PROPRIETOR’S FUNDS = NET PROFIT (AFTER TAX) (NPAT) X 100 PROPRIETOR’S FUNDS (PF) COMPONENTS Net profit [NPAT] =profit after interest and tax Proprietors Funds [PF] 1. Equity capital[EC] 2. Add: Reserves & Surplus[RS] Less: Fictious assets like miscellaneous Expresses not written off Less: profit & loss A/C Dr. Balance (loss) 3. Add: preference capital [PC] ****2626****
- 27. Ratio Analysis FUNCTION/ PURPOSE Return on proprietor’s funds is a profitability ratio, which shows the relationship between profits and investments by the proprietors in the concern. Its purpose is to measure the rate of return on the total funds made available by the owners. This ratio helps to judge how efficient the concern is in managing the owner’s funds at its disposal. INTERACTION WITH OTHER RATIOS: this ratio should be studied with the debt equity ratio to know the effect of capital structure on earning of the proprietors. COMMENTS Actual Ratio:- 1. Return of Rs. xx on each Rs. 100 of owner’s funds. 2. Rs. xx is available for appropriations. Higher than Standard:- 1. Large amount for appropriations. 2. Scope to attract fresh funds from owners. Lower than Standard:- 1. Small amount for appropriations. 2. Less scope to attract fresh funds from owners. 3. RETURN ON EOUITY CAPITAL MEANING This ratio measures the relationship between net profit (after interest, tax and preference dividend) and the equity shareholder’s funds. It is usually expressed as a percentage. FORMULA RETURN ON EQUITY CAPITAL = PROFIT AVAILABLE TO EQUITY SHAREHOLDERS (PAES) X 100 EQUITY SHAREHOLDER’S FUNDS (EF) ****2727****
- 28. Ratio Analysis COMPONENTS Profit for equity shareholders [PF] =profit after interest, tax and preference dividend. Equity shareholders Funds [EF] = 1. Equity capital[EC] 2. Add: Reserves & Surplus[RS] Less: Fictious assets like miscellaneous Expresses not written off Less: profit & loss A/C Dr. Balance (loss) FUNCTION / PURPOSE Return on equity capital is a profitability ratio, which shows the relationship between profits and the equity shareholder’s funds in the concern. Its purpose is to calculate the amount of profits available to take care of equity dividends, transfer to reserves etc. it is used by the present or prospective investor for deciding whether to purchase, keep or sell the equity shares. INTERACTION WITH OTHER RATIOS This ratio should be studied with capital gearing ratio to know the effect of higher or low gearing on earning per share. COMMENTS Actual Ratio:- 1. Return of Rs. xx on each Rs. 100 of equity shareholder’s funds. 2. Rs. xx is available for appropriations. Higher than Standard:- 1. Large amount for appropriations. 2. High increase in net worth. 3. Scope to attract fresh funds from equity shareholders. 4. High price for each equity share on stock exchange or in a merger. Lower than Standard:- 1. Small amount for appropriations. 2. Low increase in net worth. 3. Less scope to attract fresh funds from shareholders. 4. Low price for each equity share on stock exchange or in a merger. ****2828****
- 29. Ratio Analysis 4. DIVIDEND PAYOUT RATIO MEANING: Dividend Payout Ratio shows the relationship between the dividends paid to equity shareholders out of the profits available to the equity shareholders. FORMULA: DP (TOTAL) = DIVIDEND TO EQUITY SHAREHOLDERS(ED) X 100 PROFITS AVAILABLE TO EQUITY SHAREHOLDERS (PAES) COMPONENTS Dividend to Equity shareholders[ED] means the cash dividend paid to equity shareholders Profits Available to Equity SHAREHOLDERS (PAES) means net profit after interest, income tax and preferences dividend i.e. NPAT-PD FUNCTION / PURPOSE: Dividend Payout Ratio is a type of coverage ratio. A coverage ratio shows the relationship between the profits and the claims of outsiders to be paid out of such profits. Its purpose is to measure the dividend-paying capacity of the company. Comments Actual Ratio:- 1. Rs. xx is paid as dividend out of each Rs. 100 available for distribution. 2. Balance (100 – xx) can be transferred to reserves. Higher than Standard:- 1. Very high dividends make short term equity shareholders very happy. 2. Scope to issue fresh equity shares at high price. 3. High price on stock exchange or in merger for equity shares. 4. Less reserve may mean low growth in future and no bonus issue. Lower than Standard:- 1. Very low dividends make short term equity shareholders very unhappy 2. Less scope to issue fresh equity shares. 3. Low price on stock exchange or in merger for equity shares. 4. If transfers to reserves are more, it may mean high growth in future or bonus issue in future. ****2929****
- 30. Ratio Analysis 5. DEBT SERVICE RATIO MEANING: A Debt service ratio shows the relationship between net profits and interest payable on loans. It expressed as a pure number. It is also known as Interest Coverage Ratio. FORMULA: DEBT SERVICE RATIO = PROFITS BEFORE INTEREST AND TAX (PBIT) INTEREST (INT) COMPONENTS PBIT means the amount of net profit interest and tax. Interest means the interest payable on loans. INTERST means interest on long term loans. FUNCTION/ PURPOSE: Debt Service Ratio is a type of coverage ratio. A coverage ratio shows the relationship between the profits and the claims of outsiders to be paid of such profits. It purposes is to measure the interest-paying capacity of the company. ****3030****
- 31. Ratio Analysis 6. DEBT SERVICE COVERAGE RATIO MEANING: Debt Service Coverage Ratio shows the relationship between net profits and interest + installments payable on loans. It is expressed as a pure number. Debt Service means the payment of interest + installments on loans. Coverage means the availability of profits for debt servicing. FORMULA: DEBT SERVICE COVERAGE RATIO = CASH PROFITS AVAILABLE FOR DEBT SERVICING INTEREST + INSTALLMENT DUE ON LOANS COMPONENTS: Cash profits available for debt servicing are computed as follows: A. Net profits after interest and tax [NPAT] B. Add: 1. Non-cash debits to P & L A/c (Depreciation, goodwill w/o, deferred revenue expenses w/o, etc.) 2. Interest on loan C. Cash profits for debt servicing Interest means interest on long term loans during the year. Installments mean installments due on long term loans during the year. FUNCTION/PURPOSE: Debt Service Coverage Ratio (DSCR) is a type or coverage ratio. A coverage ratio shows the relationship between the profits and the claims of outsiders to be paid out of such profits. The purpose of DSCR is to measure the debt-servicing capacity of the company. ****3131****
- 32. Ratio Analysis COMMENTS Actual Ratio:- Earnings are xx times the interest. Higher than Standard:- 1. Strong capacity to pay interest as and when due. 2. Large balance profits left for tax, dividends. 3. Good scope to get more loans at a low rate of interest. 4. But less benefits of trading on equity, if assets are financed less by debt and more by equity. Lower than Standard:- 1. Weak capacity to pay interest as and when due. 2. Small balance profits left for tax, dividends. 3. Less scope to get more loans at a low rate of interest. 4. But more benefits of trading on equity, if assets are financed less by debt and more by equity. ****3232****
- 33. Ratio Analysis 7. DEBTORS TURNOVER RATIO MEANING This ratio shows the relationship between net credit sales and average trade debtors. It is expressed as a rate. FORMULA A. Debtors Turnover Debtors Turnover = Credit Sales = Credit Sales = CRS . Accounts Receivable Debtors + Bills Receivable DR + BR Note: Debtors & Bills Receivable may be taken at the average of the opening and closing amounts. If the details are not available, only the closing balance may be considered. B. Debtors Velocity (Debt Collection Period) Debtors Velocity means the period (months or days) taken by the debtors for settlement of their bills. It shows the number of days for which credit sales remain outstanding. = Debtors + Bills Receivable or 12 months or 365 days Daily Credit Sales Debtors Turnover Ratio COMPONENTS Debtors = Net debtors arising out of sales less bad debts. Note: Provision for doubtful debts against which there are no bad debts should not be deducted from debtors. Bills Receivable = Bills arising out of sales less bills receivable dishonored. Credit Sales = Gross credit sales Less Allowances Less Returns. FUNCTION/PURPOSE Debtors Turnover Ratio is a turnover ratio, which shows the relationship between credit sales and debtors. Its purpose is to (i) calculate the speed with which debtors get settled on an average during the year; (ii) calculate the debtors velocity to indicate the period of credit allowed to an average debtor; and (iii) judge how efficiently the debtors are managed. ****3333****
- 34. Ratio Analysis COMMENTS Actual Ratio:- Debt Collection Period is xx. Higher than Standard:- 1. Debts are collected at a slow speed. 2. More credit is given to debtors. 3. More chances of bad-debts. Lower than Standard:- 1. Debts are collected at a high speed. 2. Less credit is given to debtors. 3. Less chances of bad-debts. 8. CREDITORS TURNOVER RATIO MEANING Creditors’ turnover ratio shows the relationship between net credit purchases and the average trade creditors. It is normally expressed as a ‘rate’. FORMULA A. Creditors Turnover Creditors Turnover = Credit Purchases = Credit Purchases = CRP. Accounts Payable Creditors + Bills Payable CD + BP B. Creditors Velocity (Debt Payment Period) Creditors Velocity means the period (months or days) taken by the concern to pay off its creditors. Credit Period Enjoyed = 365 days or 12 months or Creditors + BP . Creditors Turnover Ratio Daily Credit Purchases COMPONENTS Credit Purchases = Gross Credit Purchases Less Returns. Creditors may be taken at the average of the opening and closing amounts. If the details are not available, only the closing balance may be considered. ****3434****
- 35. Ratio Analysis PURPOSE/FUNCTION Creditors Turnover Ratio is a turnover ratio, which shows the relationship between credit purchases and creditors. Its purpose is to (i) calculate the speed with which creditors are paid off on an average during the year; (ii) calculate the creditors velocity to indicate the period taken by the average creditor to be paid off; and (iii) judge how efficiently the creditors are managed. INTERACTION WITH OTHER RATIO This ratio should be studied along with the other two turnover ratio, viz stock turnover and debtors’ turnover .the combined effect of turnover ratios show the durations shows the duration of the operation cycle. THUS, Stock holding period 2 months Add: Debtors collection period (+) 1 month Less: Creditors payments period (-) 2 months Net period 1 month A short net period indicates fast operating cycle requiring less working capital and hence strong liquidity and vice versa. COMMENTS Actual Ratio:- Debt Payment Period is xx. Higher than Standard:- 1. Creditors are paid late. 2. More credit is available from creditors. 3. Working Capital requirement is less. Lower than Standard:- 1. Creditors are paid early. 2. Less credit is available from creditors. 3. Working Capital requirement is more. ****3535****

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