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Chapter 3,


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Chapter 3,

  1. 1. CHAPTER – III  Theoretical Frame Work
  2. 2. RATIO ANALYSIS INTRODUCTION Defination: According to Myers “Study of relationship among the various financial factors of the enterprise.” Ratio analysis is one of the popular tools of financial statement analysis. In simple words, ratio is the quotient formed when magnitude is divided by another measure in the same unit. A ratio is defined as “The indicated quotient of two mathematical expressions” and as the relation between two or more things. Usually the ratio is stated as percentage that is distribution expenses might be stated as 20% of scales. A financial ratio is defined as relationship between two variables taken from the financial statements of the concern. Financial ratios expedite the analysts by reducing the large number of items involved in a relatively small set of readily comprehended and economically meaningful indicators. INTERPRETATION OF RATIO One of the most difficult problems confronting the analyst is the interpretation and analysis of financial ratios. An adequate financial analysis involves more than an understanding and interpretation of each of the individual ratios. Further analysts requires an insight into the meaning of inter-relations among the ratios and the financial data in the statements. The followings factors must be considered while analyzing the financial ratios.      General economic conditions of the firm. Risk acceptance. Future expectations. Accounting system of the industry. Analyzing and interpreting the system used by the other industry.
  3. 3. The interpretation of ratios can be made by comparing them with:  Previous figures  Similar firms-inter firm comparisons.  Targets-individuals ratio set to meet the objectives. Purposes of the Ratio Analysis are:     To study the short term solvency of the firm – liquidity of the firm To study the long term solvency of the firm – leverage position of the firm To interpret the profitability of the firm – Profit earning capacity of the firm To identify the operating efficiency of the firm. – turnover of the ratios Utilities of the Ratio Analysis are: i. Easy to understand the financial position of the firm: The ratio analysis facilitates the parties to read the changes taken place in the financial performance of the firm from one time period to another. ii. Measure of expressing the financial performance and position: It acts as a measure of financial position through Liquidity ratios and Leverage ratios and also a measure of financial performance through Profitability ratios and Turnover Ratios. iii. Intra-firm analysis on the financial information over many number of years: The financial performance and position of the firm can be analyzed and interpreted within the firm in between the available financial information of many number of years; which portrays either increase or decrease in the financial performance. iv. Inter-firm analysis on the financial information within the industry: The Financial performance of the firm is studied and interpreted along with the similar firms in the industry to identify the presence and status of the respective firm among others. v. Possibility for Financial planning and control: It not only guides the firm to earn in accordance with the financial forecasting but also facilitates the firm to identify the major source of expense which drastically has greater influence on the earnings
  4. 4. ADVANTAGES OF RATIO ANALYSIS: Ratio analysis helps management pinpoint specific deterioration, as well as detects any trouble spot that may prevent the attainment of objectives. The interested parties undertake frequent examination of different areas of business to evaluate managements ability to maintain a satisfactory balance of operations. The following are the advantages claimed by the ratio analysis: 1. It guides management in formulating future financial planning policies. 2. It throws light on efficiency of the business organization. 3. It permits comparison of the firms figures with data for similar firms, and possibility with industry wise date 4. It also permits the data to be measured against yard sticks of performance or of sound financial condition. 5. It ensure effective cost control it provides greater clarity, perspective, or meaning to the data, and it brings out information. 6. It measures profitability of the concerns and its solvency. 7. It permits monitory figures of many digits to be condensed two or three digits which enhances the managerial efficiency. LIMITATIONS OF RATIO ANALYSIS 1.It is dependant tool of analysis: The perfection and effectiveness of the analysis mainly depends upon the preparation of accurate and effectiveness of the financial 2. Statements: It is subject to the availability of fair presentation of data in the financial statements. 3. Ambiguity in the handling of terms: If the tool of analysis taken for the study of inter firm analysis on the profitability of the firms lead to various complications. To study the profitability among the firms, most required financial information are profits of the enterprise. The profit of one enterprise is taken for analysis is Profit After Taxes (PAT) and another is considering Profit Before Interest and Taxes (PBIT) and third one is taking Net profit for study consideration. The term profit among the firms for the inter firm analysis is getting complicated due to ambiguity or poor clarity on the terminology.
  5. 5. 4. Qualitative factors are not considered: Under the ratio analysis, the quantitative factors only taken into consideration rather than qualitative factors of the enterprise. The qualitative aspects of the customers and consumers are not considered at the moment of preparing the financial statements but while granting credit on sales is normally considered. 5. Not ideal for the future forecasts: Ratio analysis is an outcome of analysis of historical transactions known as Postmortem Analysis. The analysis is mainly based on the yester performance which influences directly on the future planning and forecasting ; it means that the analysis is mainly constructed on the past information which will also resemble the same during the future analysis. 6. Time value of money is not considered: It does not give any room for time value of money for future planning or forecasting of financial performance; the main reason is that the fundamental base for forecasting is taken from the yester periods which never denominate the timing of the benefits. CLASSIFICATION OF RATIOS: From the financial data we can calculate several ratios which are grouped in to various classes as per the financial activities or function of firm these ratios help the management of the firm to assess the financial performance. These ratios are classified into four categories they are     Liquidity ratios Leverage ratios Activity ratios Profitability ratios LIQUIDITY RATIO: These are the ratios which measures the firm’s ability to meet its current obligations. A firm should see that it does not suffer from lack of liquidity and also that it does not have excess liquidity if the firm cannot meet its obligation because of insufficient liquidity, which will lead to poor credit worthiness, loss of creditors confidence and even in legal terms which could result in closing of the company. And a very higher degree of liquidity is also not good for the company, because there are no earnings. Therefore, it is necessary to make a proper balance between high liquidity and insufficient liquidity. The most common ratios which indicate the extent of liquidity or lack of it are:
  6. 6. 1. 2. 3. 4. CURRENT RATIO. QUICK RATIO (ACID TEST RATIO). CASH RATIO. NET WORKING CAPITAL RATIO. 1.CURRENT RATIO: The current ratio is the ratio of the total current assets to total current liabilities. It is calculated as. Current ratio = current assets / current liabilities  Standard norm: The ideal norm is that 2:1; which means that every one rupee of current liability is appropriately covered by Two rupees of current assets.  Objective: The objective of computing this ratio is to measure the ability of the firm to meet its short term obligations and to reflect the short term financial strength/solvency of the firms. Current assets Marketable securities Debtors & inventories Prepaid expenses Bills receivables, accrued incomes Current liabilities Creditors Bills payable Accrued expenses Short term bank loan, income tax liability 2.QUICK RATIO OR ACID TEST RATIO: Quick ratio establishes a relationship between quick assets and current liabilities. It is calculated as QUICK RATIO = QUICK ASSETS / CURRENT LIABILITIES  Standard norm : It indicates amount of quick assets available for meeting current liquidity. Traditionally, a quick ratio of 1:1 is considered to be satisfactory deal.  Objective : The objective of computing this ratio is to measure the ability of the firm to meet its short term obligations as and when due without relying upon the realization of the stock
  7. 7. Quick assets Marketable Securities Debtors Bill Receivable Cash at Bank Cash in Hand 3. CASH RATIO: cash ratio establishes a relationship between cash and cash equilants and current liabilities. To get the cash ratio only absolute liquid assets readily realizable securities are taken into consideration as satisfactory. CASH RATIO = (CASH IN HAND+CASH AT BANK+MARKETABLE SECURITIES) / CURRENT LIABILITIES  Standard norm: Higher the ratio is the better the position of the firm  Objective: The objective of computing this ratio is to stringently test on and ability of the firm to meet its short term obligations. 4. NET WORKING CAPITAL RATIO: Working capital ratio is the difference between the current assets and current liabilities. The amount of working capital is sometimes used as a measure of the firm’s liquidity. It is considered that if a firm has more working capital ratios has the greater ability to meet its current obligations. WORKING CAPITAL RATIO = CURRENT ASSETS - CURRENT LIABILITIES  Standard norm : Standard ratio should be 1:1, the long term debt should not be more than the net working capital
  8. 8.  Objective: The ratio computes the total long term debt financed by external sources. LEVERAGE RATIOS: The long term creditors like debenture holder like financial institutions etc. are more concerned with the long term financial strength on the other side the short term creditors like bankers suppliers of raw materials are more concerned with the firm’s current debt paying ability. Financial leverage of capital structure ratios are calculated to judge the long term position of the firm the ratios indicate the funds provide by owners and creditors. Creditors consider mostly the owner’s equity as a safety margin, if it is less than the creditors risk will be high. Thus, leverage ratios are calculated to measure the financial risk and the firm’s ability of using debt for the benefit of share holders. The important leverage ratios which are calculated from balance sheet items to determine the proportion of debt in total financing are:     DEBT EQUITY RATIO PROPRIETORY RATIO FIXED ASSETS RATIO CAPITAL EMPLOYED TO NETWORTH DEBT-EQUITY RATIO: It reflects the relative claims of creditors and share holders against the assets of the business. Debt, usually, refers to long term liabilities. Equity includes equity and preference share capital and reserves. This ratio establishes a relationship between long term debts and share holders funds. DEBT EQUITY RATIO = LONGTERM LIABILITIES/ SHARE HOLDERS FUNDS  Standard norm: A Debt Equity ratio of 2:1 is considered ideal. A firm with a debt equity ratio of 2or less exposes its creditors to relatively lesser risk
  9. 9.  Objective: The objective of computing this ratio is to measure the relative proportion of debt and equity in financing the assets of the firm. PROPRIETORY RATIO: It expresses the relationship between net worth and total assets. PROPRIETORY RATIO = NETWORTH / TOTAL ASSETS NET WORTH = EQUITY SHARE CAPITAL+RESERVES- FICITIOUSASSETS. CAPITAL + PREFERENCE SHARE TOTALASSETS = FIXED ASSETS + CURRENT ASSETS (excluding fictitious assets)  Objective: The objective of computing this ratio is to find out how proprietors have financed the assets.  Standard norm: A high proprietary ratio is indicator of strong financial position of the business. The higher the ratio, the better it is FIXED ASSETS RATIO: It establishes the a relation between fixed assets to capital employed FIXED ASSETS = FIXED ASSETS / CAPITAL EMPLOYED CAPITAL EMPLOYED = EQUITY SHARE CAPITAL + PREFERANCE SHARECAPITAL + RESERVE + LONG TERM LIABILITIES- FICTITIOUSASSETS
  10. 10.  Standard norm: Fixed assets ratio should not be more than 1. A ratio of 0.67 is Considered to be ideal.  Objective: This ratio indicates the proportion of fixed assets financed by long term funds of the firm CAPITAL EMPLOYED TO NETWORTH: The ratio can be calculated by dividing capital employed or net assets by net worth. Net worth includes share capital and reserves and surplus. Generally, capital employed net assets to net worth ratio should be more than one. NET ASSETS -------------------NET WORTH ACTIVITY RATIOS OR TURNOVER RATIO: Activity ratio measures the effectiveness with which a firm uses its available resources or assets. They are also called as “TURNOVER RATIOS”, since they indicate the speed with which the resources are being converted into sales. The better management of assets, larger the amount of sales. Hence the funds of creditors and owners are invested in various kinds of assets to generate sales and profits. Several activity ratios can computed to for evaluating the effective utilization of assets. Some of them are given below:        INVENTORY TURNOVER RATIO DEBTORS TURN OVER RATIO FIXED ASSETS TURN OVER RATIO AVERAGE PAYMENT PERIOD RATIO CREDITORS TURNOVER RATIO CAPITAL EMPLOYED TUR OVER RATIO WORKING CAPITAL TURNOVER RATIO
  11. 11. INVENTORY TURNOVER RATIO: It indicates the number of items average stock has turned over during the period. It indicates the efficiency of the firm’s inventory management. This ratio is usually expressed as time.  The cost of goods is an expenditure including operating , administration, project establishment, interest on loans, and depreciation on fixed assets, provision for bad debts.  The average inventory used in the determination, in the average of opening and closing inventories. It is calculated by dividing the cost of goods sold by average inventory. INVENTORY TURNOVER AVERAGE INVENTORY RATIO = COST OF GOODS SOLD/  But in VPT it is calculated by dividing the average inventory by stores consumed. INVENTORY TURN OVER RATIO = AVERAGE INVENTORY/STORES CONSUMED. {AVERAGE INVENTORY=(OP.INVENTORY+CL.INVENTORY)/2} {CGS=OP.INV+NET PURCHASES+DIRECT EXPENSES-CL.INV} DEBTORS TURN OVER RATIO: Debtors turnover ratio is calculated by dividing credit sales by average debtors. When the information regarding credit sales and opening and closing balance of debtors may not be available, then debtor turnover ratio can be calculated by dividing total sales by the yearend balance of the debtors. DEBTORS TURN OVER RATIO = NETCREDITSALES/AVERAGE DEBTORS AVERAGE DEBTORS = (OPENING DEBTORS + CLOSING DEBTORS)/2  OBJECTIVE: The objective of computing this ratio is to determine the efficiency with which trade debtors is trade debtors are managed.
  12. 12.  STANDARD NORM: Higher the value of debtors turnover , the more efficient is the management of credit. High ratio indicates the shorter collection period which implies prompt payment by debtors and low ratio indicates a longer collection period which indicates longer collection period which implies delayed payments by debtors. FIXED ASSETS TURNOVER RATIO: Fixed assets turnover ratio establishes a relationship between net sales and fixed assets. This ratio measures the efficiency of the firm utilizing its investments in fixed assets, and also the adequacy of sales relation to the investment in fixed assets. FIXED ASSETS TURN OVER RATIO = NET SALES/ NET FIXED ASSETS NET SALES means Gross Sales – Sales Returns. NET FIXED ASSETS which means Gross fixed assets – Depreciation.  STANDARD NORM: Generally a high fixed assets turnover ratio indicates efficient utilization of fixed assets by the management  OBJECTIVE: Objective of computing this ratio is to determinethe efficiency with which fixed assets are utilized. AVERAGE PAYMENTS PERIOD: This period shows an average period for which the credit purchases remain outstanding Average payment period = average trade creditors / credit purchases per day AVERAGE NET CREDITORS = NET CREDIT PURCHASES FOR THE YEAR/ NO OF WORKING DAYS PER YEAR
  13. 13. CREDITORS TURNOVER RATIO: Creditors turnover ratio express the relation between creditors and purchases. It calculated as CREDITORS TURN CREDITORS. OVER RATIO = NET CREDIT PURCHASES/ AVERAGE NET CREDIT PURCHASES = CREDIT PURCHASES-PURCHASE RETURNS. The creditors turnover ratio indicates the speed with which the creditors turnover on an average each year. In general, a high ratio indicates the shorter payment period which implies either the availability of less credit or earlier payments, and a low rate indicates a larger payment period which implies either the availability of more credit or delayed payme  STANDARED NORM: Credit turnover rate can also be expressed in terms of number of days taken by the business to pay off its debts. It is termed as debt payment period  NUMBER OF DAYS IN YEAR/CREDITORS TURNOVER RATIO. WORKING CAPITAL TURNOVER RATIO: This ratio show the firm able to generate sales by using its limited recourses of working capital. The firm may also take the ratio relating to net current assets to sales. Working capital turnover ratio establishes the relationship between net sales and working capital. WORKINGCAPITAL TURNOVERRATIO = NETSALES/WORKING CAPITAL CAPITAL EMPLOYED TURNOVER RATIO: A firm’s ability to generate a large volume of sales for a given amount of net assets is most important aspect of the operating performance. The unutilized of underutilized assets increase the firm need for costly financing as well as expenses for maintenance and upkeep. This net assets turnover ratio should be interpreted cautiously. The net assets turnover ratio can be calculated as sales divided by net assets where net assets includes net fixed assets, net current assets.
  14. 14. PROFITABILITY RATIOS: A Company should earn profits to survive and grow over a long period of time. Profit is the ultimate output of a company and it will have no future if it fails to make sufficient profits. Profit is the difference revenues and expenses over a period of time. Therefore, the finance manager should continuously evaluate the efficiency of its company in terms of profits. So the profitability ratio are calculated to measure the operating efficiency of the company. Apart from management of the company, creditors and owners are also interested in the financial soundness of the firm. The management is eager to measure the operating efficiency to show how good it has been in managing the financial resources. On the other and owners or shareholders who invest their funds in the company want to get a fair return on their investments. Creditors want to get interest and repayment of principal regularly. This is possible only when the company earns enough profits. Profitability ratios can be determined on the basis of sales and investments. 1) The profitability ratios in relation to sales are: Gross profit ratio Net profit ratio Operating expenses ratio Operating profit ratio. 2) The profitability ratios in relation to investments are: Return of capital Return of shareholder equity Return of total assets. Earnings per share
  15. 15. I . The profitability ratios in relation to sales are: 1) GROSS PROFIT RATIO It is the first profitability ratio calculated in relation to sales. This ratio can be called as gross profit margin or gross margin ratio. This ratio establishes a relationship between gross profit and sales to measure the efficiency of the firm and it reflects it pricing policy. The ratio is calculated by dividing the gross profit by sales. A high gross profit margin indicates that the firm is able to produce at relatively lower cost and it is also a sign of good management. Whereas, a low gross profit margin reflects a higher cost of goods sold due to the firm’s inefficient management. GROSS PROFIT GROSS PROFIT RATIO = ------------------------- x 100 NET SALES This ratio indicates on an average gross margin earned on a scale of rupees 100. Higher the ratio better will be the performance Gross profit which is excess of net sales over cost of goods sold The main objective of computing this ratio is to determine the efficiency with which production / purchase operations are carried on. 2).NET PROFIT RATIO: Net profit ratio measures the relationship between the net profit & net sales. It indicates the result of overall operation of the firm. This ratio is computed by dividing the net profit by the net sales This expressed as a percentage. Its formula is as follows. NET PROFIT RATIO= NET PROFIT AFTER TAX ------------------------------------------- x 100 NET SALES
  16. 16. This ratio indicates on an average net margin earned on a scale of 100/-. Higher is the ratio greater is the capacity of the firm to with stand adverse economic conditions 3) OPERATING PROFIT RATIO: Operating profit ratio measures the relationship between operating profit and net sales this ratio is computed by dividing the operating profit by the net sales, and expressed as percentage. OPERATING PROFIT OPERATING PROFIT RATIO = ---------------------------- x 100 NET SALES Operating profit is the excess of gross profit over other operating expenses. The main objective of computing this ratio is to determine the operating efficiency of the management. 4) OPERATING EXPENSES RATIO: This ratio measures the relation between operating expenses and sales. It also explains the changes in profit margins (EBIT to sales) ratio. This operating expenses ratio is a yardstick of operating efficiency but it should be used continuously. Further, the operating ratio cannot be used as a test of financial conditions in case of those firms where non operating revenues and expenses form a substantial part of the total income. This ratio can be calculated by dividing by sales. Operating expenses include cost of goods sold plus selling expenses, general and administrative expenses (excluding interest, taxes etc) A higher operating expenses ratio is unfavorable since it leaves a small amount of operating income to meet interest dividends etc. A lower operating expenses ratio is favorable because it will have large amount to meet necessary needs of the firm.
  17. 17. CGS + OPERATING EXPENSES OPERATING EXPENSES RATIO = ------------------------------- x 100 SALES II) The profitability ratios in relation to investments are:  RETURN ON CAPITAL EMPLIOYED RATIO: The ratio illustrates that how much return is earned in the form of Net profit after taxes out of the total capital employed. The capital employed is nothing but the combination of both noncurrent liabilities and owners’ equity. The ratio expresses the relationship in between the total earnings after taxation and the total volume of capital employed Return on total capital employed Net profit after taxes × 100=Total capital employed  Standard norm of the ratio: Higher the ratio is better the utilization of the long term funds raised under the capital structure means that greater profits are earned out of the total capital employed.  RETURN ON SHARE HOLDERS EQUITY: Return on share holders equity is calculated to see the profits earned by the firms or owners investments. The share holder equity will include the paid up share capital, share premiums and reserves and surplus less accumulated losses. In other words share holders equity is some called as net worth and it can also be found by subtracting total liabilities from total assets. But the net worth refers to the market value of the owners equity is recorded at book value in the balance sheet. The return on share holder equity is calculated by net profit after tax divided by share holders equity or net worth. PROFIT AFTER TAX RETURN ON SHARE HOLDERS EQUITY = --------------------------------- x 100 SHARE HOLDERS EQUTY
  18. 18.  EARNINGS PER SHARE: Earnings per share is the net profit after tax and preferences dividend which is earned on capital representative of one equity share. It is calculated as. Profit After Tax –Preference Dividend Number Of Equity Shares The EPS, the better is the performance of the company. The EPS is one of the driving factors in investment analysis and perhaps the most widely calculated ratio amongst all ratios used for financial analysis.  RETURN ON TOTAL ASSETS RATIO: It is calculated as PROFIT AFTER TAX ---------------------------TOTAL ASSETS Total assets do not include fictitious assets. The higher ratio the better it is.