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Ratio analysis-ppt-1

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Ratio analysis-ppt-1

  1. 1. Ratio analysisRatio analysis  Is a method or process by which theIs a method or process by which the relationship of items or groups of items in therelationship of items or groups of items in the financial statements are computed, andfinancial statements are computed, and presented.presented.  Is an important tool of financial analysis.Is an important tool of financial analysis.  Is used to interpret the financial statements soIs used to interpret the financial statements so that the strengths and weaknesses of a firm, itsthat the strengths and weaknesses of a firm, its historical performance and current financialhistorical performance and current financial condition can be determined.condition can be determined.
  2. 2. RatioRatio  ‘‘A mathematical yardstick that measuresA mathematical yardstick that measures the relationship between two figures orthe relationship between two figures or groups of figures which are related togroups of figures which are related to each other and are mutually inter-each other and are mutually inter- dependent’.dependent’.  It can be expressed as a pure ratio,It can be expressed as a pure ratio, percentage, or as a ratepercentage, or as a rate
  3. 3. Words of cautionWords of caution  A ratio is not an end in itself. They are only aA ratio is not an end in itself. They are only a means to get to know the financial position ofmeans to get to know the financial position of an enterprise.an enterprise.  Computing ratios does not add any informationComputing ratios does not add any information to the available figures.to the available figures.  It only reveals the relationship in a moreIt only reveals the relationship in a more meaningful way so as to enable us to drawmeaningful way so as to enable us to draw conclusions there from.conclusions there from.
  4. 4. Objective of Ratio AnalysisObjective of Ratio Analysis  Ratio analysis is a useful device to evaluate theRatio analysis is a useful device to evaluate the position of an enterprise. It is used to judge theposition of an enterprise. It is used to judge the operating efficiency, financial soundness andoperating efficiency, financial soundness and earning capacity of an enterprise.earning capacity of an enterprise.  To know the areas of weakness which requireTo know the areas of weakness which require attention of management.attention of management.  To provide information for making time-seriesTo provide information for making time-series analysisanalysis  To provide information for making inter-firmTo provide information for making inter-firm comparisoncomparison
  5. 5. ……ContinuedContinued  Information derived from ratio analysis can beInformation derived from ratio analysis can be used for making useful projections for futureused for making useful projections for future  Ratio analysis supplements the informationRatio analysis supplements the information provided by other analytical tools so thatprovided by other analytical tools so that rational decisions may be taken about anrational decisions may be taken about an enterprise.enterprise.
  6. 6. Utility of RatiosUtility of Ratios  Accounting ratios are very useful inAccounting ratios are very useful in assessing the financial position andassessing the financial position and profitability of an enterprise.profitability of an enterprise.  However its utility lies in comparison ofHowever its utility lies in comparison of the ratios.the ratios.
  7. 7. Utility of RatiosUtility of Ratios  Comparison may be in any one of the followingComparison may be in any one of the following forms:forms:  For the same enterprise over a number of yearsFor the same enterprise over a number of years  For two enterprises in the same industryFor two enterprises in the same industry  For one enterprise against the industry as a wholeFor one enterprise against the industry as a whole  For one enterprise against a pre-determined standardFor one enterprise against a pre-determined standard  For inter-segment comparison within the sameFor inter-segment comparison within the same organisationorganisation
  8. 8. Classification of RatiosClassification of Ratios Ratios can be broadly classified into four groupsRatios can be broadly classified into four groups namely:namely:  Liquidity ratiosLiquidity ratios  Solvency Ratio/Capital structure/leverage ratiosSolvency Ratio/Capital structure/leverage ratios  Profitability ratiosProfitability ratios  Activity ratiosActivity ratios
  9. 9. Liquidity ratiosLiquidity ratios These ratios analyse the short-term financialThese ratios analyse the short-term financial position of a firm and indicate the ability of the firmposition of a firm and indicate the ability of the firm to meet its short-term commitments (currentto meet its short-term commitments (current liabilities) out of its short-term resources (currentliabilities) out of its short-term resources (current assets).assets).  Current ratioCurrent ratio  Liquidity ratio or Quick ratio or acid test ratioLiquidity ratio or Quick ratio or acid test ratio
  10. 10. Current ratioCurrent ratio It is calculated by dividing current assets byIt is calculated by dividing current assets by current liabilities.current liabilities. Current ratio =Current ratio = Current assetsCurrent assets wherewhere Current liabilitiesCurrent liabilities Conventionally a current ratio of 2:1 isConventionally a current ratio of 2:1 is considered satisfactoryconsidered satisfactory
  11. 11. CURRENT ASSETSCURRENT ASSETS include –include – Inventories of raw material, WIP, finished goods,Inventories of raw material, WIP, finished goods, stores and spares,stores and spares, sundry debtors/receivables,sundry debtors/receivables, short term loans deposits and advances,short term loans deposits and advances, cash in hand and bank,cash in hand and bank, prepaid expenses,prepaid expenses, incomes receivables andincomes receivables and marketable investments and short term securitiesmarketable investments and short term securities..
  12. 12. CURRENT LIABILITIESCURRENT LIABILITIES include –include – sundry creditors/bills payable,sundry creditors/bills payable, outstanding expenses,outstanding expenses, unclaimed dividend,unclaimed dividend, advances received,advances received, incomes received in advance,incomes received in advance, provision for taxation,provision for taxation, proposed dividend,proposed dividend, instalments of loans payable within 12 months,instalments of loans payable within 12 months, bank overdraft and cash creditbank overdraft and cash credit
  13. 13. Quick Ratio or Acid Test RatioQuick Ratio or Acid Test Ratio This is a ratio between quick current assets and currentThis is a ratio between quick current assets and current liabilities (alternatively quick liabilities).liabilities (alternatively quick liabilities). It is calculated by dividing quick current assets byIt is calculated by dividing quick current assets by current liabilities (quick current liabilities)current liabilities (quick current liabilities) Quick ratio =Quick ratio = quick assetsquick assets wherewhere Current liabilities/(quick liabilities)Current liabilities/(quick liabilities) Conventionally a quick ratio of 1:1 is consideredConventionally a quick ratio of 1:1 is considered satisfactory.satisfactory.
  14. 14. QUICK ASSETS & QUICKQUICK ASSETS & QUICK LIABILITIESLIABILITIES QUICK ASSETSQUICK ASSETS are current assets (as statedare current assets (as stated earlier)earlier) less prepaid expenses and inventories.less prepaid expenses and inventories. QUICK LIABILITIESQUICK LIABILITIES are current liabilities (asare current liabilities (as stated earlier)stated earlier) less bank overdraft and incomes received inless bank overdraft and incomes received in advance.advance.
  15. 15. Capital structure/ leverageCapital structure/ leverage ratios/Solvency Ratioratios/Solvency Ratio These ratios indicate the long term solvencyThese ratios indicate the long term solvency of a firm and indicate the ability of the firmof a firm and indicate the ability of the firm to meet its long-term commitment withto meet its long-term commitment with respect torespect to (i)(i) repayment of principal on maturity or inrepayment of principal on maturity or in predetermined instalments at due dates andpredetermined instalments at due dates and (ii)(ii) periodic payment of interest during theperiodic payment of interest during the period of the loan.period of the loan.
  16. 16. Capital structure/ LeverageCapital structure/ Leverage ratios/Solvency Ratioratios/Solvency Ratio The different ratios are:The different ratios are:  Debt equity ratioDebt equity ratio  Proprietary ratioProprietary ratio  Total Assets to Debt ratioTotal Assets to Debt ratio  Interest coverage ratioInterest coverage ratio  Debt service coverage ratioDebt service coverage ratio
  17. 17. Debt equity ratioDebt equity ratio This ratio indicates the relative proportion of debt andThis ratio indicates the relative proportion of debt and equity in financing the assets of the firm. It isequity in financing the assets of the firm. It is calculated by dividing long-term debt by shareholder’scalculated by dividing long-term debt by shareholder’s funds.funds. Debt equity ratio =Debt equity ratio = long-term debtslong-term debts wherewhere Shareholders fundsShareholders funds Generally, financial institutions favour a ratio of 2:1Generally, financial institutions favour a ratio of 2:1.. However this standard should be applied having regardHowever this standard should be applied having regard to size and type and nature of business and the degree ofto size and type and nature of business and the degree of risk involved.risk involved.
  18. 18. ……..Continued..Continued LONG-TERM FUNDSLONG-TERM FUNDS are long-term loans whetherare long-term loans whether secured or unsecured like – debentures, bonds, loanssecured or unsecured like – debentures, bonds, loans from financial institutions etc.from financial institutions etc. SHAREHOLDER’S FUNDSSHAREHOLDER’S FUNDS are equity shareare equity share capital plus preference share capital plus reserves andcapital plus preference share capital plus reserves and surplus minus fictitious assets (eg. Preliminarysurplus minus fictitious assets (eg. Preliminary expenses, past accumulated losses, discount on issueexpenses, past accumulated losses, discount on issue of shares etc.)of shares etc.)
  19. 19. Proprietary ratioProprietary ratio This ratio indicates the general financial strength of theThis ratio indicates the general financial strength of the firm and the long- term solvency of the business. Itfirm and the long- term solvency of the business. It indicates the proportion of total assets financed by theindicates the proportion of total assets financed by the proprietors fund. A higher ratio is considered good fromproprietors fund. A higher ratio is considered good from the view of financial soundness of the company.the view of financial soundness of the company. This ratio is calculated by dividing proprietor’s funds byThis ratio is calculated by dividing proprietor’s funds by total funds.total funds. Proprietary ratio =Proprietary ratio = Proprietor’s fundsProprietor’s funds Total funds/assetsTotal funds/assets As a rough guide a 65% to 75% proprietary ratio isAs a rough guide a 65% to 75% proprietary ratio is advisableadvisable
  20. 20. ……..Continued..Continued PROPRIETOR’S FUNDSPROPRIETOR’S FUNDS are same asare same as explained in shareholder’s fundsexplained in shareholder’s funds TOTAL FUNDSTOTAL FUNDS are all fixed assets and allare all fixed assets and all current assets.current assets. Alternatively it can be calculated asAlternatively it can be calculated as proprietor’s funds plus long-term funds plusproprietor’s funds plus long-term funds plus current liabilities.current liabilities.
  21. 21. Total Assets to Debt RatioTotal Assets to Debt Ratio  This ratio is computed to find out the long-This ratio is computed to find out the long- term financial soundness of the firm. Itterm financial soundness of the firm. It establishes relationship between total assetsestablishes relationship between total assets and long-term debt.and long-term debt.  Total Assets to Debt Ratio =Total Assets to Debt Ratio = Total AssetsTotal Assets Long-term debtsLong-term debts Total assets = Non-current Asset + Current AssetTotal assets = Non-current Asset + Current Asset
  22. 22. ……..Continued..Continued  This ratio establishes safety margin availableThis ratio establishes safety margin available to long term debt.to long term debt.  It shows the extent to which long term debtsIt shows the extent to which long term debts are covered by the total assets of the businessare covered by the total assets of the business entity.entity.  A higher ratio represents more security toA higher ratio represents more security to lenders of long term debt and vice versa.lenders of long term debt and vice versa.
  23. 23. Debt to Total capital ratioDebt to Total capital ratio In this ratio the outside liabilities are related toIn this ratio the outside liabilities are related to the total capitalisation of the firm. It indicatesthe total capitalisation of the firm. It indicates what proportion of the permanent capital of thewhat proportion of the permanent capital of the firm is in the form of long-term debt.firm is in the form of long-term debt. Debt to total capital ratio =Debt to total capital ratio =long- term debtlong- term debt Shareholder’s funds + long- term debtShareholder’s funds + long- term debt Conventionally a ratio of 2/3 is consideredConventionally a ratio of 2/3 is considered satisfactorysatisfactory..
  24. 24. Interest coverage ratioInterest coverage ratio This ratio measures the debt servicing capacity of a firmThis ratio measures the debt servicing capacity of a firm in so far as the fixed interest on long-term loan isin so far as the fixed interest on long-term loan is concerned. It shows how many times the interestconcerned. It shows how many times the interest charges are covered by EBIT out of which they will becharges are covered by EBIT out of which they will be paid.paid. Interest coverage ratio =Interest coverage ratio = EBITEBIT InterestInterest A ratio of 6 to 7 times is considered satisfactoryA ratio of 6 to 7 times is considered satisfactory.. Higher the ratio greater the ability of the firm to payHigher the ratio greater the ability of the firm to pay interest out of its profits. But too high a ratio mayinterest out of its profits. But too high a ratio may imply lesser use of debt and/or very efficient operationsimply lesser use of debt and/or very efficient operations
  25. 25. Debt service coverage ratioDebt service coverage ratio This is a more comprehensive measure to compute theThis is a more comprehensive measure to compute the debt servicing capacity of a firm. It shows how manydebt servicing capacity of a firm. It shows how many times the total debt service obligations consisting oftimes the total debt service obligations consisting of interest and repayment of principal in instalments areinterest and repayment of principal in instalments are covered by the total operating funds after payment ofcovered by the total operating funds after payment of tax.tax. Debt service coverage ratio =Debt service coverage ratio = EAT+ interest + depreciation + other non-cash expEAT+ interest + depreciation + other non-cash exp Interest + principal instalmentInterest + principal instalment EAT is earnings after tax.EAT is earnings after tax. Generally financial institutions consider 2:1 as aGenerally financial institutions consider 2:1 as a satisfactory ratiosatisfactory ratio..
  26. 26. Profitability ratiosProfitability ratios These ratios measure the operating efficiency ofThese ratios measure the operating efficiency of the firm and its ability to ensure adequate returnsthe firm and its ability to ensure adequate returns to its shareholders.to its shareholders. The profitability of a firm can be measured by itsThe profitability of a firm can be measured by its profitability ratios.profitability ratios. Further the profitability ratios can be determinedFurther the profitability ratios can be determined (i) in relation to sales and(i) in relation to sales and (ii) in relation to investments(ii) in relation to investments
  27. 27. Profitability ratiosProfitability ratios Profitability ratios in relation to sales:Profitability ratios in relation to sales:  Gross Profit marginGross Profit margin  Net Profit marginNet Profit margin  Operating Profit ratioOperating Profit ratio  Expenses ratioExpenses ratio
  28. 28. Profitability ratiosProfitability ratios Profitability ratios in relation to investmentsProfitability ratios in relation to investments  Return on assets (ROA)Return on assets (ROA)  Return on capital employed (ROCE)Return on capital employed (ROCE)  Return on shareholder’s equity (ROE)Return on shareholder’s equity (ROE)  Earnings per share (EPS)Earnings per share (EPS)  Dividend per share (DPS)Dividend per share (DPS)  Dividend payout ratio (D/P)Dividend payout ratio (D/P)  Price earning ratio (P/E)Price earning ratio (P/E)
  29. 29. Gross profit marginGross profit margin This ratio is calculated by dividing grossThis ratio is calculated by dividing gross profit by sales. It is expressed as a percentage.profit by sales. It is expressed as a percentage. Gross profit is the result of relationshipGross profit is the result of relationship between prices, sales volume and costs.between prices, sales volume and costs. Gross profit margin =Gross profit margin = gross profitgross profit x 100x 100 Net salesNet sales
  30. 30. Gross profit marginGross profit margin  A firm should have a reasonable gross profitA firm should have a reasonable gross profit margin to ensure coverage of its operatingmargin to ensure coverage of its operating expenses and ensure adequate return to theexpenses and ensure adequate return to the owners of the business ie. the shareholders.owners of the business ie. the shareholders.  To judge whether the ratio is satisfactory orTo judge whether the ratio is satisfactory or not, it should be compared with the firm’snot, it should be compared with the firm’s past ratios or with the ratio of similar firms inpast ratios or with the ratio of similar firms in the same industry or with the industry average.the same industry or with the industry average.
  31. 31. Net profit marginNet profit margin This ratio is calculated by dividing net profit byThis ratio is calculated by dividing net profit by sales. It is expressed as a percentage.sales. It is expressed as a percentage. This ratio is indicative of the firm’s ability toThis ratio is indicative of the firm’s ability to leave a margin of reasonable compensation toleave a margin of reasonable compensation to the owners for providing capital, after meetingthe owners for providing capital, after meeting the cost of production, operating charges and thethe cost of production, operating charges and the cost of borrowed funds.cost of borrowed funds. Net profit margin =Net profit margin = net profit after interest and taxnet profit after interest and tax x 100x 100 Net salesNet sales
  32. 32. Net profit marginNet profit margin Another variant of net profit margin is operatingAnother variant of net profit margin is operating profit margin which is calculated as:profit margin which is calculated as: Operating profit margin =Operating profit margin = net profit before interest and taxnet profit before interest and tax x 100x 100 Net salesNet sales Higher the ratio, greater is the capacity of theHigher the ratio, greater is the capacity of the firm to withstand adverse economic conditionsfirm to withstand adverse economic conditions and vice versaand vice versa
  33. 33. Expenses ratioExpenses ratio These ratios are calculated by dividing the various expenses byThese ratios are calculated by dividing the various expenses by sales. The variants of expenses ratios are:sales. The variants of expenses ratios are: Material consumed ratio =Material consumed ratio = Material consumedMaterial consumed x 100x 100 Net salesNet sales Manufacturing expenses ratio =Manufacturing expenses ratio =Manufacturing expensesManufacturing expenses x 100x 100 Net salesNet sales Administration expenses ratio =Administration expenses ratio = Administration expensesAdministration expenses x 100x 100 Net salesNet sales Selling expenses ratio =Selling expenses ratio = Selling expensesSelling expenses x 100x 100 Net salesNet sales Operating ratio =Operating ratio =Cost of goods sold + Operating expenseCost of goods sold + Operating expenses x 100s x 100 Net salesNet sales Financial expense ratio =Financial expense ratio = Financial expensesFinancial expenses x 100x 100 Net salesNet sales
  34. 34. Expenses ratioExpenses ratio The expenses ratios should be compared overThe expenses ratios should be compared over a period of time with the industry average asa period of time with the industry average as well as with the ratios of firms of similar type.well as with the ratios of firms of similar type. A low expenses ratio is favourable.A low expenses ratio is favourable. The implication of a high ratio is that only aThe implication of a high ratio is that only a small percentage share of sales is available forsmall percentage share of sales is available for meeting financial liabilities like interest, tax,meeting financial liabilities like interest, tax, dividend etc.dividend etc.
  35. 35. Return on Assets (ROA)Return on Assets (ROA) This ratio measures the profitability of the total funds ofThis ratio measures the profitability of the total funds of a firm. It measures the relationship between net profitsa firm. It measures the relationship between net profits and total assets. The objective is to find out howand total assets. The objective is to find out how efficiently the total assets have been used by theefficiently the total assets have been used by the management.management. Return on assets =Return on assets = net profit after taxes plus interestnet profit after taxes plus interest x 100x 100 Total assetsTotal assets OROR net profit after taxnet profit after tax // total assetstotal assets Total assets exclude fictitious assets. As the total assets at theTotal assets exclude fictitious assets. As the total assets at the beginning of the year and end of the year may not be the same,beginning of the year and end of the year may not be the same, average total assets may be used as the denominator.average total assets may be used as the denominator.
  36. 36. Return on Capital Employed (ROCE)Return on Capital Employed (ROCE) This ratio measures the relationship between profit (EBIT) andThis ratio measures the relationship between profit (EBIT) and capital employed. It indicates how efficiently the long-termcapital employed. It indicates how efficiently the long-term funds of owners and creditors are being used.funds of owners and creditors are being used. Return on capital employed =Return on capital employed = PProfit before interest & Tax (EBIT)rofit before interest & Tax (EBIT) x 100x 100 Capital employedCapital employed CAPITAL EMPLOYEDCAPITAL EMPLOYED denotes shareholders funds and long-denotes shareholders funds and long- term borrowings.term borrowings. To have a fair representation of the capital employed, averageTo have a fair representation of the capital employed, average capital employed may be used as the denominator.capital employed may be used as the denominator.
  37. 37. Return on shareholders equityReturn on shareholders equity This ratio measures the relationship of profits toThis ratio measures the relationship of profits to owner’s funds. Shareholders fall into twoowner’s funds. Shareholders fall into two groups i.e. preference shareholders and equitygroups i.e. preference shareholders and equity shareholders. So the variants of return onshareholders. So the variants of return on shareholders equity areshareholders equity are Return on total shareholder’s equity =Return on total shareholder’s equity = net profits after taxesnet profits after taxes x 100x 100 Total shareholders equityTotal shareholders equity ..
  38. 38.  TOTAL SHAREHOLDER’S EQUITYTOTAL SHAREHOLDER’S EQUITY includes preference share capital plus equityincludes preference share capital plus equity share capital plus reserves and surplus lessshare capital plus reserves and surplus less accumulated losses and fictitious assets. Toaccumulated losses and fictitious assets. To have a fair representation of the totalhave a fair representation of the total shareholders funds, average total shareholdersshareholders funds, average total shareholders funds may be used as the denominatorfunds may be used as the denominator
  39. 39. Return on OrdinaryReturn on Ordinary Shareholders EquityShareholders Equity Return on ordinary shareholders equity =Return on ordinary shareholders equity = net profit after taxes – pref. dividendnet profit after taxes – pref. dividend x 100x 100 Ordinary shareholders equity or netOrdinary shareholders equity or net worthworth ORDINARY SHAREHOLDERS EQUITYORDINARY SHAREHOLDERS EQUITY OR NET WORTHOR NET WORTH includes equity share capitalincludes equity share capital plus reserves and surplus minus fictitious assets.plus reserves and surplus minus fictitious assets.
  40. 40. Earnings per share (EPS)Earnings per share (EPS) This ratio measures the profit available to theThis ratio measures the profit available to the equity shareholders on a per share basis. Thisequity shareholders on a per share basis. This ratio is calculated by dividing net profit availableratio is calculated by dividing net profit available to equity shareholders by the number of equityto equity shareholders by the number of equity shares.shares. Earnings per share =Earnings per share = net profit after tax – preference dividendnet profit after tax – preference dividend Number of equity sharesNumber of equity shares
  41. 41. Dividend per share (DPS)Dividend per share (DPS) This ratio shows the dividend paid to theThis ratio shows the dividend paid to the shareholder on a per share basis. This is a bettershareholder on a per share basis. This is a better indicator than the EPS as it shows the amount ofindicator than the EPS as it shows the amount of dividend received by the ordinary shareholders,dividend received by the ordinary shareholders, while EPS merely shows theoretically how muchwhile EPS merely shows theoretically how much belongs to the ordinary shareholdersbelongs to the ordinary shareholders Dividend per share =Dividend per share = Dividend paid to ordinary shareholdersDividend paid to ordinary shareholders Number of equity sharesNumber of equity shares
  42. 42. Dividend payout ratio (D/P)Dividend payout ratio (D/P) This ratio measures the relationship between theThis ratio measures the relationship between the earnings belonging to the ordinary shareholders and theearnings belonging to the ordinary shareholders and the dividend paid to them.dividend paid to them. Dividend pay out ratio =Dividend pay out ratio = total dividend paid to ordinary shareholderstotal dividend paid to ordinary shareholders x 100x 100 Net profit after tax –preference dividendNet profit after tax –preference dividend OROR Dividend pay out ratio =Dividend pay out ratio = Dividend per shareDividend per share x 100x 100 Earnings per shareEarnings per share
  43. 43. Price earning ratio (P/E)Price earning ratio (P/E) This ratio is computed by dividing the marketThis ratio is computed by dividing the market price of the shares by the earnings per share. Itprice of the shares by the earnings per share. It measures the expectations of the investors andmeasures the expectations of the investors and market appraisal of the performance of the firm.market appraisal of the performance of the firm. Price earning ratio =Price earning ratio = market price per sharemarket price per share Earnings per shareEarnings per share
  44. 44. Activity ratiosActivity ratios These ratios are also called efficiency ratios / assetThese ratios are also called efficiency ratios / asset utilization ratios or turnover ratios. These ratiosutilization ratios or turnover ratios. These ratios show the relationship between sales and variousshow the relationship between sales and various assets of a firm. The various ratios under this groupassets of a firm. The various ratios under this group are:are:  Inventory/stock turnover ratioInventory/stock turnover ratio  Debtors turnover ratio and average collectionDebtors turnover ratio and average collection periodperiod  Asset turnover ratioAsset turnover ratio  Creditors turnover ratio and average creditCreditors turnover ratio and average credit periodperiod  Working Capital Turnover ratioWorking Capital Turnover ratio
  45. 45. Inventory /stock turnover ratioInventory /stock turnover ratio This ratio indicates the number of times inventory isThis ratio indicates the number of times inventory is replaced during the year. It measures the relationshipreplaced during the year. It measures the relationship between cost of goods sold and the inventory level.between cost of goods sold and the inventory level. There are two approaches for calculating this ratio,There are two approaches for calculating this ratio, namely:namely: Inventory turnover ratio =Inventory turnover ratio = cost of goods soldcost of goods sold Average stockAverage stock AVERAGE STOCKAVERAGE STOCK can be calculated ascan be calculated as Opening stock + closing stockOpening stock + closing stock 22 AlternativelyAlternatively Inventory turnover ratio =Inventory turnover ratio = salessales__________________ Closing inventoryClosing inventory
  46. 46. Inventory /stock turnover ratioInventory /stock turnover ratio A firm should have neither too high nor tooA firm should have neither too high nor too low inventory turnover ratio. Too high a ratiolow inventory turnover ratio. Too high a ratio may indicate very low level of inventory and amay indicate very low level of inventory and a danger of being out of stock and incurring highdanger of being out of stock and incurring high ‘stock out cost’. On the contrary too low a‘stock out cost’. On the contrary too low a ratio is indicative of excessive inventoryratio is indicative of excessive inventory entailing excessive carrying cost.entailing excessive carrying cost.
  47. 47. Debtors turnover ratio and averageDebtors turnover ratio and average collection periodcollection period This ratio is a test of the liquidity of the debtorsThis ratio is a test of the liquidity of the debtors of a firm. It shows the relationship betweenof a firm. It shows the relationship between credit sales and debtors.credit sales and debtors. Debtors turnover ratio =Debtors turnover ratio = Credit salesCredit sales Average Debtors and bills receivablesAverage Debtors and bills receivables Average collection period =Average collection period = Months/days in a yearMonths/days in a year Debtors turnoverDebtors turnover
  48. 48. Debtors turnover ratio and averageDebtors turnover ratio and average collection periodcollection period These ratios are indicative of the efficiency ofThese ratios are indicative of the efficiency of the trade credit management. A high turnoverthe trade credit management. A high turnover ratio and shorter collection period indicateratio and shorter collection period indicate prompt payment by the debtor. On theprompt payment by the debtor. On the contrary low turnover ratio and longercontrary low turnover ratio and longer collection period indicates delayed paymentscollection period indicates delayed payments by the debtor.by the debtor. In general a high debtor turnover ratio andIn general a high debtor turnover ratio and short collection period is preferableshort collection period is preferable..
  49. 49. Asset turnover ratioAsset turnover ratio Depending on the different concepts of assets employed, thereDepending on the different concepts of assets employed, there areare many variants of this ratio. These ratios measure the efficiencymany variants of this ratio. These ratios measure the efficiency of a firm in managing and utilising its assets.of a firm in managing and utilising its assets. Total asset turnover ratio =Total asset turnover ratio = sales/cost of goods soldsales/cost of goods sold Average total assetsAverage total assets Fixed asset turnover ratio =Fixed asset turnover ratio = sales/cost of goods soldsales/cost of goods sold Average fixed assetsAverage fixed assets Capital turnover ratio =Capital turnover ratio = sales/cost of goods soldsales/cost of goods sold Average capital employedAverage capital employed Working capital turnover ratio =Working capital turnover ratio = sales/cost of goods soldsales/cost of goods sold Net working capitalNet working capital
  50. 50. Asset turnover ratioAsset turnover ratio Higher ratios are indicative of efficientHigher ratios are indicative of efficient management and utilisation of resources whilemanagement and utilisation of resources while low ratios are indicative of under-utilisation oflow ratios are indicative of under-utilisation of resources and presence of idle capacity.resources and presence of idle capacity.
  51. 51. Creditors turnover ratio and averageCreditors turnover ratio and average credit periodcredit period This ratio shows the speed with which paymentsThis ratio shows the speed with which payments are made to the suppliers for purchases madeare made to the suppliers for purchases made from them. It shows the relationship betweenfrom them. It shows the relationship between credit purchases and average creditors.credit purchases and average creditors. Creditors turnover ratio =Creditors turnover ratio = credit purchasescredit purchases Average creditors & bills payablesAverage creditors & bills payables Average credit period =Average credit period = months/days in a yearmonths/days in a year Creditors turnover ratioCreditors turnover ratio
  52. 52. Creditors turnover ratio and averageCreditors turnover ratio and average credit periodcredit period Higher creditors turnover ratio and short creditHigher creditors turnover ratio and short credit period signifies that the creditors are beingperiod signifies that the creditors are being paid promptly and it enhances thepaid promptly and it enhances the creditworthiness of the firm.creditworthiness of the firm.

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