FINANCIAL STATEMENT ANALYSISMEANING OF FINANCIAL STATEMENTSAccording to Himpton John, "A financial statement is an organiz...
4.    The net income is the result of personal judgment and bias of      accountants cannot be removed in the matters of d...
The two main financial statements, viz the Income Statement and theBalance sheet, can either be presented in the horizonta...
To Dividend                        xxx By Net profit b/d                 xxxTo Balance c/f                     xxx        ...
Liabilities              Rs.              Assets                Rs.Share Capital                      xxx Fixed Assets:(wi...
7. Proposed Dividends         xxx8.    Proposed   funds   &    xxxpensionfund contingent liabilitiesnotProvided for       ...
(ii) Vertical Form:      Balance sheet of ………………………. as on …………………Particulars                    Schedule No.   Current   ...
(ii) Vertical Form for analysis       Balance sheet of ……… as on ……………..                      Particulars                 ...
required)                                   By          Reserves                                   withdrawn              ...
Advantages:       Comparative statements vidicate trends in sales, cost of production,profits etc., and help the analyst t...
Particulars      2010     2011     Particulars      2010      2011                   Rs.      Rs.                       Rs...
Solution:                             ASHOK LTD.Comparative Income Statement for the years ending 2000 and 2001      Parti...
Rs.             Rs. Liabilities Equity share capital                         2,00,000        3,30,000 Preference share cap...
(B)        9,30,000          66.4GrossProfit              (A) -         4,70,000          33.6(B)Less:          Administra...
Preference Share Capital                       1,00,000            10.6    General reserve                                ...
Selling expenses           600         3.75    800       4.00    Total           Operating 1,000        6.25    1,200     ...
TREND ANALYSIS       In trend analysis ratios of different items are calculated for various periods for comparison purpose...
Land                                      800     1,000         1,000Buildings                            1,600        2,0...
RATIO ANALYSISINTRODUCTION      The financial statements viz. the income statement, the Balance sheetThe Income statement,...
Activity ratios      Operating ratios      Market test ratiosLong-Term Solvency Ratios      The long-term financial stabil...
The use of debt capital has direct implications for the profit accruingto the ordinary shareholders, and expansion is ofte...
debt-equity ratio and includes capital which is invested in fictitious assetslike deferred expenditure and carried forward...
7. Interest Cover:                  Profil before interest depreciationand tax                                       Inter...
The corporate liquidity has two dimensions viz., quantitative andqualitative concepts. The quantitative concept includes t...
3. Absolute Liquid Ratio (Super Quick Ratio):        It is the ratio of absolute liquid assets to quick liabilities. Howev...
than the rate in a manufacturing concern. The level of inventory in acompany may be assessed by the use of the inventory r...
(i) Creditors Turnover Period      The measurement of the creditor turnover period shows the averagetime taken to pay for ...
(ii) Total Assets Turnover RatioThis ratio indicates the number of times total assets are being turned over ina year.     ...
(h) Return on Net worth (or Return on Shareholders equity)I. Return on Capital Employed (ROCE) or Return on Investment (RO...
Table-1: Computation of Capital Employed  Share capital of the company                                  xxx  Reserves and ...
EPS is one of the most important ratios which measures the net profitearned per share. EPS is one of the major factors aff...
(ii)   Cost increases: The price which a company pay its suppliers duringperiod       of inflation, is likely to rise and ...
Cash profit ratio measures the cash generation in the business as aresult of trie operations expressed in terms of sales. ...
the cost content is high or low in the figure of sales. If the annualcomparison shows that the sales has increased the man...
4. Price/Earnings ratio1. Dividend Payout Ratio:                             Dividend per share                           ...
management and liberal distribution policy have high P/E ratios whereascompanies with moderate track record, conservative ...
(a)      Debt-equity ratio      (b)      Liquid ratio      (c)      Fixed assets to current assets ratio      (d)      Fix...
Stock                                                  30,000      Debtors                                                ...
Other           Current              20,000 Stock                        4,80,000liabilities                              ...
Cash Debtors                   1,60,000                                     3,20,000                                     4...
To Wages                            1,425  To Gross Profit                    34,000                                     9...
Debtors                         7,100       Stock                          14,900                                      25,...
Illustration 4; The following is the Trading and Profit and Loss a/c andBalance Sheet of a firm.                          ...
Solution:(a) Inventory Turnover ratio        = Cost of goods sold                                        Average stock    ...
(d) Operating Profit = Cost of goods sold + Operating expresses        = 100                                Net SalesCost ...
(i)     Profit margin is increased by 5% ?       (ii)    Asset turnover is decreased to 2 times?       (iii)   Profit marg...
Illustration 7: Calculate the P/E ratio from the following:                                                          (Rs.)...
10% Preference shares of Rs.10 each                        50,00,000  Equity shares of Rs. 100 each                       ...
Rs. 14.29(iv) The Net Funds Flow:                                         (Rs.)    Profit after tax            15,00,000  ...
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Financial statment analysis

  1. 1. FINANCIAL STATEMENT ANALYSISMEANING OF FINANCIAL STATEMENTSAccording to Himpton John, "A financial statement is an organized collectionof data according to logical and consistent accounting procedures. Itspurpose is to convey an understanding of some financial aspects of abusiness firm. It may show assets position at a moment of time as in thecase of a balance sheet, or may reveal a series of activities over a givenperiod of limes, as in the case of an income statement ". On the basis of the information provided in the financial statements,management makes a review of the progress of the company and decides thefuture course of action.DIFFERENT TYPES OF FINANCIAL STATEMENTS 1. Income Statement 2. Balance Sheet 3. Statement of Retained earnings 4. Funds flow statement 5. Cash flow statement. 6. Schedules.FUNDAMENTAL CONCEPTS OF ACCOUNTING 1. Going concern concept 2. Matching concept ( Accruals concept) 3. Consistency concept 4. Prudence concept ( conservation concept) 5. Business entity concept 6. Stable monetary unit concept 7 Money measurement concept 7. Objectivity concept 8. Materiality concept 9. Realization concept.LIMITATIONS OF FINANCIAL STATEMENTS1. In profit and loss account net profit is ascertained on the basis ofhistorical costs.2. Profit arrived at by the profit and loss account is of interim nature. Actual profit can be ascertained only after the firm achieves the maximum capacity.3. The net income disclosed by the profit and toss account is not absolute but only relative.
  2. 2. 4. The net income is the result of personal judgment and bias of accountants cannot be removed in the matters of depreciation, stock valuation, etc.,5. The profit and loss account does not disclose factors like quality of product, efficiency of the management etc.,6. There are certain assets and liabilities which are not disclosed by the balance sheet. For example the most tangible asset of a company is its management force and a dissatisfied labour force is its liability which are not disclosed by the balance sheet.7. The book value of assets is shown as original cost less depreciation. But in practice, the value of the assets may differ depending upon the technological and economic changes.8. The assets are valued in a Balance sheet on a going concern basis. Some of the assets may not relate their value on winding up.9. The accounting year may be fixed to show a favorable picture of the business. In case of Sugar Industry the Balance sheet prepared in off season depicts a better liquidity position than in the crushing season.10. Analysis Investor likes to analyse the present and future prospectus of the business while the balance sheet shows past position. As such the use of a balance sheet is only limited.11. Due to flexibility of accounting principles, certain liabilities like provision for gratuity etc. are not shown in the balance sheet giving the outsiders a misleading picture.12. The financial statements are generally prepared from the point of view of shareholders and their use is limited in decfsion making by the management, investors and creditors.13. Even the audited financial statements does not provide complete accuracy.14. Financial statements do not disclose the changes in managernent, Loss of markets, etc. which have a vital impact on the profitability of the concern.15. The financial statements are based on accounting policies which vary form company to company and as such cannot be formed as a reliable basis of judgment.FORMATS OF FINANCIAL STATEMENTS
  3. 3. The two main financial statements, viz the Income Statement and theBalance sheet, can either be presented in the horizontal form or the verticalform where statutory provisions are applicable, the statement has to beprepared in accordance with such provisions.Income Statement : There is no legal format for the profit and loss A/C. Therefore, it canbe presented in the traditional T form, or vertically, in statement form. Anexample of the two formats is given as under.(i) Horizontal, or “T” form: Manufacturing, Trading and profit and loss A/C of ………........... forthe year ending .........................Dr Cr Particulars Rs. Particualrs Rs.To opening stock By cost of finished Goods Xxxx c/d Raw materials xxx By closing stock Work in progress xxx Raw materials xxx Work in progress xxxTo purchases of raw xxxmaterialsTo manufacturing wages xxxTo carriage inwards xxxTo other Factory Expenses xxx xxx xxx By sales xxxTo opening stock of xxx By closing stock of xxxfinished finishedgoods goodsTo cost of Finished goods xxx By Gross Loss c/d xxxb/dTo Gross Profit c/d xxx xxx xxxTo Gross Loss b/d xxx By Gross profit b/d xxxTo office and Admn. xxx By Miscellaneous Receipts xxxExpenseTo Interest and financial xxx By Net Loss c/d xxxexpensesTo provision for Income-tax xxxTo Net Profit c/d xxx xxx xxxTo net loss b/d xxx By Balance b/d xxxTo general reserve xxx (from previous year)
  4. 4. To Dividend xxx By Net profit b/d xxxTo Balance c/f xxx xxx xxx(ii) Vertical Form Income statement of ………… for the year ending ……………... Particulars Rs. Rs.Sales xxxxLess: Sales Returns xxx Sales Tax/ Exise Duty xxx xxxxNet sales (1) xxxxCost of Goods SoldMaterials Consumed xxxxDirect Labour xxxxManufacturing Expenses xxxxAdd / less Adjustment for change in stock xxxx (2) xxxxGross Profit (1) – (2) xxxLess: Operating Expenses Office and Administration Expenses Selling and Distribution Expenses xxx xxx xxx Operating Profit XxxxAdd: Non-operating Income XxxLess: Non-oprating Expenses (including Interest) xxxx Profit before Tax xxx xxxxLess : Tax xxx Profit After Tax xxxxAppropriations Transfer to reserves Dividend declared /paid xxxx Surplus carried to Balance sheet xxx xxx xxxxBalance Sheet The Companies Activities, 1956 stipulates that the Balance sheet of ajoint stock company should be prepared as per part I of schedule VI of theActivities. However, the statement form has been emphasized upon byaccountants for the purpose of analysis and Interpretation. The permissionof the Centra! Government is necessary for adoption of the statement* form.(i) Horizontal FormBalance sheet of .................... as on ....................
  5. 5. Liabilities Rs. Assets Rs.Share Capital xxx Fixed Assets:(with all paticulars of 1. Goodwill xxxAuthorized, Issued, 2. Land & Building xxxSubscribed capital) Called xxx 3. Leasehold property xxxup capital 4. Plant and Machinery xxx 5. Furniture and Fittings xxxLess: Calls in Arrears xxx 6. Patents and Trademarks xxxAdd: Forfeited Shares xxx 7. Vehicles xxxReserves and Surplus : Investments1. Capital Reserve xxx Current Assets, loans and2. Capital Redemption Advancesreserve xxx (A) Current Assets3. Share premium xxx 1. Interest accured on4. Other premium xxx Investments xxxLess: debit balance of Profit xxx 2. Loose tools xxxand loss A/C (if any) 3. Stock in trade xxx5. Profit and Loss xxx 4. Sundry Debtors xxxAppropriation A/C Less: Provision for doubtful6. Sinking Fund xxx debts 5. cash in hand xxx 6. cash in Bank xxxSecured Loans (B) Loans and Advances Debentures xxx 7. Advances to subsidiaries xxxAdd: Outstanding Interest xxx 8. Bills Receivable xxxLoans from Banks xxx 9. Prepaid Expenses xxxUnsecured Loans Miscellaneous Expenditure (to the extent not written off or Fixed Deposits xxx adjusted) xxxShort-term loans and xxxadvancesCurrent Liabilities and 1. Preliminary expenses xxxProvisions 2. Discount on Issue of xxx shares and debenturesA. Current Liabilites 3. Underwriting Commssion xxx1. Bills Payable xxx2. Sudnry Creditors xxx Profit and Loss account (Loss),3. Income received in xxx if anyadvance4. unclaimed Dividends xxx5. Other Liabilities xxxB. Provisions6. Provisions for Taxation xxx
  6. 6. 7. Proposed Dividends xxx8. Proposed funds & xxxpensionfund contingent liabilitiesnotProvided for xxx xxx
  7. 7. (ii) Vertical Form: Balance sheet of ………………………. as on …………………Particulars Schedule No. Current Previous year YearI. Source of funds1. Share holders funds a. capital xxxx xxxx b. Reserves and surplus xxxx xxxx2. Loans funds a. Secured Loans xxxx xxxx b. Unsecured Loans xxxx xxxx TotalII. Application of funds1. Fixed Assets a. Gross Block xxxx xxxx b. less Deprciation xxxx xxxx c. Net block xxxx xxxx d. Capital work in progress xxxx xxxx2. Investments xxxx xxxx3. Current Assets, Loans and Advances a. Inventions xxxx xxxx b. Sundry Debtors xxxx xxxx c. Cash and Bank balance xxxx xxxx d. other current assets xxxx xxxx e. Loans and Advances xxxx xxxxLess : current Liabilities and Provisions a. Current Laibilities xxxx xxxx b. Provisions xxxx xxxx xxxx xxxxNet Current Assets4. a. Miscellaneuos Expenditure to xxxx xxxxthe extent not written off or adjusted b. Profit and Loss Account (debit) xxxx xxxx Total xxxx xxxx
  8. 8. (ii) Vertical Form for analysis Balance sheet of ……… as on …………….. Particulars Rs.ASSETSCurrent Assets Cash and Bank Balances xxxx Debtors xxxx Stock xxxx Other Current Assets xxxx (1) xxxxFixed Assets xxxxLess: Depreciation xxxxInvestments xxxx (2) xxxx Total (1) + (2) xxxxxLIABILITIESCurrent Liabilities : Bills Payable xxxx Creditors Other Current Liabilities (3) xxxxLong Term Debt Debentures xxxx Other Long-term Debts xxxx (4) xxxxCapital and Reserves Share Capital xxxx Reserves and surplus xxxx (5) xxxxTotal Long term funds Total (3)+(4)+(5) xxxxxStatement of Retained Earnings: Profit and Loss Appropriation Account Particulars Rs. Particulars Rs.To transfer to xxx By Last year’s xxxReserves balanceTo Dividend xxx By Current Year’s net xxx profit (Transferred from profit and loss A/C)To Dividend proposed xxxTo surplus carried to xxx By Excess provisions xxxBalance sheet (which are no longer
  9. 9. required) By Reserves withdrawn (if any) xxx xxx xxxxTechniques of Financial Statement Analysis: The following techniques are adopted in analysis of financialstatements of a business organization: Comparative Statements Common size Statements Trend Analysis Funds flow Analysis Cash flow Analysis Ratio Analysis Value Added Analysis.Comparative Financial Statements Comparative financial statements are statements of financial positionof a business designed to provide time perspective to the consideration ofvarious elements of financial position embodied in such statements.Comparative Statements reveal the following: . i. Absolute data (money values or rupee amounts) ii. Increase or reduction in absolute data (in terms of moiwy values) iii. Increase or reduction in absolute data (in terms of percentages) iv. Comparison (in terms of ratios) v. Percentage of totals.a. Comparative Income Statement or Profit and Loss Account: A comparative income statement shows the absoluie figures for two ormore periods and the absolute change from one period to another. Since thefigures are shown side by side, the user can quickly understand theoperational performance of the firm in different periods and drawconclusions.b. Comparative Balance Sheet Balance sheet as on two or more different dates are used forcomparing the assets, liabilities and the net worth of the companyComparative balance sheet is useful for studying the trends of analysisundertaking. Financial Statements of two or more firms can also be compared fordrawing inferences. This is called interfirm Comparison.
  10. 10. Advantages: Comparative statements vidicate trends in sales, cost of production,profits etc., and help the analyst to evaluate the performance of thecompany. Comparative statements can also be used to compare the performanceof the industry or inter-firm comparison. This helps in identification of theweaknesses of the firm and remedial measures can be taken; accordingly.Weaknesses: Inter-firm comparison can be misleading if the firms are not identicalin size and age and when they follow different accounting procedures withregard to depreciation, inventory valuation etc., Inter-period comparison may also be misleading if the period haswitnessed changes in accounting policies, inflation, recession etc.Illustration 3: The following is the profit and loss account of Ashok Ltd., for the years2010 and 2011. Prepare comparative Income Statement and comment onthe profitability of the undertaking.
  11. 11. Particulars 2010 2011 Particulars 2010 2011 Rs. Rs. Rs. Rs.To Cost of 2,31,625 2,41,950 By Sales 3,60,728 4,17,125goods soldTo Office 23,266 27,068 Less Returns 5,794 6,952expensesTo Interest 45,912 57,816 3,54,934 4,10,173expensesTo Loss on 627 1,750 By Othersale of fixed incomes :To Income 21,519 40,195 By Discount on 2,125 1,896Tax purchaseTo Net Profit 35,371 44,425 By Profit on 1,500 sale of land 3,60,457 4,13,379 3,60,457 4,13 ,379
  12. 12. Solution: ASHOK LTD.Comparative Income Statement for the years ending 2000 and 2001 Particulars 2000 Rs. 2001 Rs. Increase (+) Increase (+) Decrease (-) Decrease (-) Amount (Rs.) PercentagesSales 3,60,728 4,17,125 +56,397 +15.63Less: Sales returns 5,794 6,952 +1.158 +19.98 3,54,934 4,10,173 +55,239 +15.56Less: Cost of goods 2,31,625 2,41,950 + 10,325 +4.46soldGross Profit 1,23,309 1,68,223 +44.914 +36.42Operating Expenses: Office expenses 23,266 27,068 +3,802 + 16.34 Selling expenses 45,912 57,816 +11,904 +25.93Total operating 69,178 84,884 +15,706 +22.70expensesOperating profit 54,131 83,339 +29,208 +53.96Add: Other incomes 5,523 3,206 -2,317 -41.95 59,654 86,545 +26.891 +45.08Less: Other expenses 2,764 1,925 -839 -30.35Profit before tax 56,890 84,620 +27,730 +48.74Less: Income tax 21,519 40,195 +18,676 +86.79Net Profit after tax 35,371 44,425 +9,054 +25.60 The comparative Income statement reveals that while the net saleshas been increased by 15.5%, the cost of goods sold increased by 4.46%. Sogross profit is increased by 36.4%. The total operating expenses has beenincreased by 22.7% and the gross profit is sufficient to compensate increasein operating expenses. Net profit after tax is 9,054 (i.e., 25.6%) increased.The overall profitability of the undertaking is satisfactory.Illustration: 4 The following are the Balance Sheets of Gokul Ltd., for the yearsending 31s1 December, 2000,2001. Particulars 2000 2001
  13. 13. Rs. Rs. Liabilities Equity share capital 2,00,000 3,30,000 Preference share capital 1,00,000 1,50,000 Reserves 20,000 30,000 Profit and Loss a/c 15,000 20,000 Bank overdraft 50,000 50,000 Creditors 40,000 50,000 Provision for taxation 20,000 25,000 Proposed Dividend 15,000 25,000 Total 4,60,000 6,80,000 Fixed Assets Less: Depreciation 2,40,000 3,50,000 Stock 40,000 50,000 Debtors 1,00,000 1,25,000 Bills Receivable 20,000 60,000 Prepaid expenses 10,000 12,000 Cash in hand 40,000 53,000 Cash at Bank 10,000 30,000 Total 4,60,000 6,80,000COMMON SIZE STATEMENTS The figures shown in financial statements viz. Profit / Loss Accountand Balance sheet are converted to percentages so as to establish eachelement to the total figure of the statement and these statement are calledCommon Size Statements. These statements are useful in analysis of theperformance of the company by analyzing each individual element to thetotal figure of the statement. These statements will also assist in analyzingthe performance over years and also with the figures of the competitive firmin the industry for making analysis of relative efficiency. The followingstatements show the method of presentation of the data.Illustration: 5 Common Size Income Statement of XYZ Ltd., for the year ended 31stMarch, 2001. Particulars Amount (Rs.) % to Sales Sales (A) 14,00,000 100 Raw materials 5,40,000 16.4 Direct wages 2,30,000 16.4 Faciory expenses 1,60,000 11.4
  14. 14. (B) 9,30,000 66.4GrossProfit (A) - 4,70,000 33.6(B)Less: Administrative 1,10,000 7.9expensesSelling and distribution 80,000 5.7expensesOperating Profit 2,80,000 20.0Add: Non-operative income 40,000 2.9 3,20,000 22.9Less: Non-operating 60,000 43expenses Profit before tax 2,60,000 18.6Less: Income tax 80,000 5.7 Profit after tax 1,80,000 12.9 Common Size Balance Sheet of XYZ Particulars Amount (Rs.) % to TotalASSETSFixed AssetsLand 50,000 5.3Buildings 1,10,000 11.7Plant and Machinery 2,50,000 26.6Current Assets :InventoryRaw materials 80,000 8.5Work-in-progress 50,000 5.3Finished goods 1,60,000 17.0Sundry debtors 2,10,000 22.4Cash at Bank 30,000 3.2 Total 9,40,000 100.0Capital and LiabiltiiesEuqity Share capital 2,50,000 26.6
  15. 15. Preference Share Capital 1,00,000 10.6 General reserve 1,60,000 17.0 Debentures 80,000 8.5 Current Liabilities Sundry Creditors 2,20,000 23.4 Creditors for expenses 40,000 4.3 Bills payable 90,000 9.6 9,40,000 100.0 Analysis of performance and position can be made from the above Common Size Statements. llustration: 6 From the following P&L A/c prepare a Common Size Income Statement- Particulars 2000 2001 Particulars 2000 2001 Rs. Rs. Rs. Rs.To Cost of goods 12,000 1 5,000 By Net Sales 16,000 20,000soldTo Administrative 400 400expensesTo Selling 600 800expensesTo Net Profit 3,000 3,800 16,000 20,000 16,000 20,000 Common Size Income Statement Particulars 2000 2001 Rs. % Rs. % Net sales 16,000 100.00 20,000 100.00 Less: Cost of goods sold 12,000 75.00 15,000 7500 Gross 4,000 25.00 5,000 25.00 Profit Less: Operating expenses Administration 400 2.50 400 2.00 expenses
  16. 16. Selling expenses 600 3.75 800 4.00 Total Operating 1,000 6.25 1,200 6.00 expenses Net Profit 3,000 18.75 3,800 19.00 Illustration: 7 Following are Balance sheet of Vinay Ltd. for the year ended 31st December 2000 and 2001. Liabilities 2000 2001 Assets 2000 2001 Rs. Rs. Rs. Rs.Equity capital 1,00,000 1 ,65,000 Fixed Assets (Net) 1 ,20,000 1,75,000Pref. Capital 50,000 75,000 Stock 20,000 25,000Reserves 10,000 15,000 Debtors 50,000 62,500P&L A/c 7,500 10,000 Bills receivable 10,000 30,000Creditors 20,000 25,000 Cash at Bank 20,000 26,500Provision 10,000 12,500 Cash in hand 5,000 15,000for taxationProposed 7,500 12,500dividends 2,30,000 3,40,000 2,30,000 3,40,000 Prepare a common size balance sheet and interpret the same.
  17. 17. TREND ANALYSIS In trend analysis ratios of different items are calculated for various periods for comparison purpose. Trend analysis can be .done by trend percentage, trend ratios and graphic and diagrammatic representation. The trend analysis is a simple technique and does not involve tedious calculations. Illustration: 8 From the following data, calculate trend percentage taking 1999 as base. Particulars 1999 2000 2001 Rs. Rs. Rs. Sales 50,000 75,000 1,00,00 0 Purchases 40,000 60,000 72,000 Expenses 5,000 8,000 15,000 Profit 5,000 7,000 13,000 Solution: Particulars 1999 Rs. 2000 2001 Rs. Trend Percentage Base 1999 Rs. Rs. Rs. Rs. 1999 2000 2001Purchases 40,000 60,000 72,000 100 150 180Expenses 5,000 8,000 15,000 100 160 300Profit 5,000 7,000 13,000 100 140 260Sales 50,000 75,000 1,00,000 100 150 200 Illustration: 9 From the following data, calculate trend percentages (1999 as base) Particulars 1999 2000 2001 Rs. Rs. Rs. Cash 200 240 160 Debtors 400 500 650 Stock 600 800 700 Other Current Assets 450 600 750
  18. 18. Land 800 1,000 1,000Buildings 1,600 2,000 2,400Plant 2,000 2,000 2,400Solution: Particulars 2000 2001 (Base Year 1999) Rs. Rs. Rs. 1999 2000 2001Cash 200 240 160 100 120 80Debtors 400 500 650 100 125 163Other Current 450 600 750 100 133 167AssetsTotal Current 1,650 2,140 2,260 100 130 137AssetsFixed Assets:Land 800 1,000 1,000 100 125 125Buildings 1,600 2,000 2,400 100 125 150Plant 2,000 2,000 2,400 100 100 120Total Fixed Assets 4,400 5,000 5,800 100 114 132
  19. 19. RATIO ANALYSISINTRODUCTION The financial statements viz. the income statement, the Balance sheetThe Income statement, the Statement of retained earnings and theStatement of changes in financial position report what has actuallyhappened to earnings during a specified period. The balance sheet presentsa summary of financial position of the company at a given point of time. Thestatement of retained. earnings reconciles income earned during the yearand any dividends distributed with the change in retained, earnings betweenthe start and end of the financial. year under study. The statement ofchanges in financial position provides a summary of funds flow during theperiod of financial statements. Ratio analysis is a very powerful analytical tool for measuringperformance of an organisation. The ratio analysis concentrates on theinterrelationship among the figures appearing in the aforementioned fourfinancial-statements. The ratio analysis helps the management to analysethe past. performance of the firm and to make further projections. Ratioanalysis allow1-interested parties like shareholders, investors, creditors,Government analysts to make an evaluation of certain aspects of a firmsperformance. Ratio analysis is a process of comparison of one figure againstanother, which make a ratio, and the appraisal of the ratios to make properanalysis about the strengths and weaknesses of the firms operations. Thecalculation of ratios is a relatively easy and simple task but the properanalysis and interpretation of the ratios can be made only by the skilledanalyst. While interpreting the financial information, the analyst has to becareful in limitations imposed by the accounting concepts and methods ofvaluation. Information of non-financial nature will also be taken intoconsideration before a meaningful analysis is made.Ratio analysis is extremely helpful in providing valuable insight into acompanys financial picture. Ratios normally pinpoint a business strengthsand weakness in two ways: Ratios provide an easy way to compare todays performance with past. Ratios depict the areas in which a particular business is competitively advantaged or disadvantaged through comparing ratios to those of other businesses of the same size within the same industry.CATEGORIES OF RATIOS The ratio analysis is made under six broad categories as follows: Long-term solvency ratios Short-term solvency ratios Profitability ratios
  20. 20. Activity ratios Operating ratios Market test ratiosLong-Term Solvency Ratios The long-term financial stability of the firm may be considered asdependent upon its ability to meet all its liabilities, including those notcurrent payable. The ratios which are important in measuring the long-termsolvency L as follows: Debt-Equity Ratio Shareholders Equity Ratio . Debt to Networth Ratio Capital Gearing Ratio Fixed Assets to Long-term Funds Ratio Proprietary Ratio Dividend Cover Interest Cover Debt Service Coverage Ratio1. Debt-Equity Ratio: Capital is derived from two sources: shares and loans. It is quite hkelyfor only shares to be issued when the company is formed, but loans areinvariably raised at some later date. There are numerous reasons for issuingloan capital. For instance, the owners might want to increase theirinvestment but avoid therisk which attaches to share capital, and they cando this by making a secured loan. Alternatively, management might requireadditional finance which the shareholders are unwilling to supply and so aloan is raised instead. In either case, the effect is to introduce an element ofgearing or leverage into the capital structure :of the company. There arenumerous ways of measuring gearing, but the debt-equity ratio is perhapsmost commonly used. Long - term debt Share holders funds This ratio indicates the relationship between loan funds and net worthof the company, which is known as gearing. If the proportion of debt toequity is low, a company is said to be low-geared, and vice versa. A debtequity ratio of 2:1 is the norm accepted by financial institutions forfinancing of projects. Higher debt-equity ratio may be permitted for highlycapital intensive industries like petrochemicals, fertilizers, power etc. Thehigher the gearing, the more volatile the return to the shareholders.
  21. 21. The use of debt capital has direct implications for the profit accruingto the ordinary shareholders, and expansion is often financed in thismanner with the objective of increasing the shareholders rate of return.This objective is achieved only if the rate earned on the additional fundsraised exceeds that payable to the providers of the loan. The shareholders of a highly geared company reap disproportionatebenefits when earnings before interest and tax increase. This is becauseinterest payable on a large proportion of total finance remains unchanged.The converse is also true, and a highly geared company is likely to find itselfin severe financial difficulties if it suffers a succession of trading losses. It isnot possible to specify an optimal level of gearing for companies but, as ageneral rule, gearing should be low in those industries where demand isvolatile and profits are subject to fluctuation. A debt-equity ratio which shows a declining trend over the years isusually taken as a positive sigh reflecting on increased cash accrual anddebt repayment. In fact, one of the indicators of a unit turning sick is arising debt-equity ratio. Usually in calculating the ratio, the preference sharecapital is excluded from debt, but if the ratio is to show effect of use of fixedinterest sources on earnings available to the shareholders then it is to beincluded. On the other hand, if the ratio is to examine financial solvency,then preference shares shall form part of the capital.2. Shareholders Equity Ratio : This ratio is calculated as follows: Shareholders Equity Total assets (tan gible) It is assumed that larger the proportion of the shareholders equity,the stronger is the financial position of the firm, This ratio will supplementthe debt-equity ratio. In this ratio the relationship is established betweenthe shareholders funds and the total assets. Shareholders funds representboth equity and preference capital plus reserves and surplus less losses. Areduction in shareholders equity signaling the over dependence on outsidesources for long-term financial needs and this carries the risk of higherlevels of gearing. This ratio indicates the degree to which unsecuredcreditors are protected against iosr in the event of liquidation.3. Debt to Net worth Ratio : This ratio is calculated as follows: Long - term debt Networth The ratio compares long-term debt to the net worth of the firm i.e., thecapital and free reserves less intangible assets. This ratio is finer than the
  22. 22. debt-equity ratio and includes capital which is invested in fictitious assetslike deferred expenditure and carried forward tosses. This ratio would be ofmore interest to the contributories of long-term finance to the firm, as theratio gives a S factual idea of the assets available to meet the long-termliabilities.4. Capital Gearing Ratio : It is the proportion of fixed interest bearing funds to Equityshareholders, funds: Fixed int eresi bearing funds : Equity Shareholders fundsThe fixed interest bearing funds include debentures, long-term loans andpreference share capital. The equity shareholders funds include equity sharecapital, reserves and surplus. Capital gearing ratio indicates the degree ofvulnerability of earnings available for equity shareholders. This ratio signalsthe firm which is operating on trading on equity. It also indicates thechanges in benefits accruing to equity shareholders by changing the levels offixed interest bearing funds in the organisation.5. Fixed Assets to Long-term Funds Ratio : The fixed assets is shown as a proportion to long-term funds asfollows: Fixed Assets Long - term Funds The ratio includes the proportion of long-term funds deployed in fixedassets. Fixed assets represents the gross fixed assets minus depreciationprovided on this till the date of calculation. Long-term funds include sharecapital, reserves and surplus and long-term loans. The higher the ratioindicates the safer the funds available in case of liquidation. It also indicatesthe proportion of long-term funds that is invested in working capital.6. Proprietor Ratio : It express the relationship between net worth and total asset Net worth Total AssetsNet worth = Equity Share Capital-t-Preference Share Capital+FictitiousAssets Total Assets = Fixed Assets + Current Assets (excluding fictitiousassets) Reserves earmarked specifically for a particular purpose should not beincluded in calculation of Net worth. A high proprietory ratio indicative ofstrong financial position of the business. The higher the ratio, the better itis.
  23. 23. 7. Interest Cover: Profil before interest depreciationand tax Interest The interest coverage ratio sLjws how many times interest charges arecovered by funds that are available for payment of interest. An interest coverof 2:1 is considered reasonable by financial institutions. A very high ratioindicates that the firm is conservative in using debt and a very low ratioindicates excessive use of debt.8. Dividend Cover : Net Profit after tax Dividend This ratio indicates the number of times the dividends are covered bynet profit his highlights the amount retained by a company for financing offuture operations.9. Debt Service Coverage Ratio : It indicates whether the business is earning sufficient profits to paynot only the interest charges, but also the instalments due to the principalamount. It is calculated as: PBIT Interest + Periodic Loan Instalment (1 - Rate of Income Tax) The greater the debt service coverage ratio, the better rs the servicingability of the organisation.Short-term Solvency Ratios The short-term solvency ratios, which measure the liquidity of the firmand its liability of the firm and its ability to meet it- maturing short-termobligations. Liquidity is defined as the ability to realise value in money, themost liquid of assets. It refers to the ability to pay in cash, the obligationsthat -are due.
  24. 24. The corporate liquidity has two dimensions viz., quantitative andqualitative concepts. The quantitative concept includes the quantum,structure and utilisation of liquid assets and in the qualitative concept, it isthe ability to meet all present and potential demands on cash" from anysource in a manner that minimizes cost and maximizes the value of the firm.Thus, corporate liquidity is, a vital factor in business - excess liquidity,though a guarantor of solvency would reflect lower profitability, deteriorationin managerial efficiency, increased speculation and unjustified expansion,extension of too liberal credit and dividend policies. Too little liquidity thenmay lead to frustration of-i business objectives, reduced rate of return,business opportunity missed and& weakening of morale. The importantratios in measuring short-term solvency are: (1) Current Ratio (2) Quick Rarip (3) Absolute Liquid Ratio (4) Net working capital ratio1. Current Ratio : Current Assets, Loans & Advances Current Liabilities & Provisions This ratio measures the solvency of the company in the short-term.Current assets are those assets which can be converted into cash within ayear. Current liabilities and provisions are those liabilities that are payablewithin a year. A current ratio 2:1 indicates a highly solvent position. Acurrent ratio 1.33:1 is considered by banks as the minimum acceptable levelfor providing working capital finance. The constituents of the current assetsare as important as the current assets themselves for evaluation of acompanys solvency position, A very high current ratio will have adverseimpact on the profitability of the organisation. A high current ratio may bedue to the piling up of inventory, inefficiency in collection of debtors, highbalances in Cash and Bank accounts without proper investment2. Quick Ratio or Liquid Ratio: Current Assets, Loans & Advances - Inventories Current Liabilities & Provisions- Bank Overdraft Quick ratio used as measure of the companys ability to meet itscurrent obligations. Since bank overdraft is secured by the inventories, theother current assets must be sufficient to meet other current liabilities. Aquick ratio of 1:1 indicates highly solvent position. This ratio is also calledacid test ratio. This ratio serves as a supplement to the current ratio inanalysing liquidity.
  25. 25. 3. Absolute Liquid Ratio (Super Quick Ratio): It is the ratio of absolute liquid assets to quick liabilities. However, forcalculationpurposes, it is taken as ratio of absolute liquid assets to currentliabilities. Absolute liquid assets include cash in hand, cash at bank andshort term or temporary investments. Absolute Liquid Assets Current LiabilitiesAbsolute Liquid Assets =Cash in Hand + Cash at Bank + Short terminvestmentsThe ideal Absolute liquid ratio is taken as 1:2 or 0.5.Activity Ratios or Turnover Ratios Activity ratios measure how effectively the firm employs its resources.These ratios are also called turnover ratios which involve comparisonbetween the level of sales and investment in various accounts - inventories,debtors, fixed assets etc. activity ratios are used to measure the speed withwhich various accounts are converted into sales or cash. The followingactivity ratios are calculated for analysis:1. Inventory : A considerable amount of a companys capital may be tied up in thefinancing of raw materials, work-in-progress and finished goods. It isimportant to ensure that the level of stocks is kept a low as possible,consistent with the need to fulfill customers orders in time.Inventory Turnover Ratio = Cost of goods sold Average Inventory Sales Average InventoryAverage inventory = Opening stock+Closing stock 2 The higher the stock turn over rate the lower the stock turnoverperiod the better, although the ratios will vary between companies. Forexample, the stock turnover rate in a food retailing company must be higher
  26. 26. than the rate in a manufacturing concern. The level of inventory in acompany may be assessed by the use of the inventory ratio, which measureshow much has been tied up in inventory. Inventory Ratio = Inventory Current Assets X 100 The inventory turnover ratio measures how many times a companysinventory has been sold during the year. If the inventory turnover ratio hasdecreased from past, it means that either inventory is growing or sales aredropping. In addition to that, if a firm has a turnover that is slower than forits industry, then there may be obsolete goods on hand, or inventory stocksmay be high. Low inventory turnover has impact on the liquidity of thebusiness.2. Debtors : The three main debtor ratios are as follows:(1) Debtor Turnover Ratio Debtor turnover, which measures whether the amount of resourcestied up in debtors is reasonable and whether the company has been efficientin converting debtors into cash. The formula is: Credit Sales Average DebtorsThe higher the ratio, the better the position.(ii) Average Collection Period Average collection period, which measures how long it take to collectamounts from debtors. The formula is: Average debtors Credit Safes X 365 The actual collection period can be compared with the stated creditterms of the company. If it is longer than those terms, then this indicatessome insufficiency in the procedures for collecting debts.(ii) Bad Debts Bad debts, which measures the proposition of bad debts to sales: Bad debts Sales This ratio indicates the efficiency of the credit control procedures ofthe company. Its level will depend on the type of business. Mail order-companies have to accept a fairly high level of bad debts, white retailingorganisations should maintain very low levels or, if they do not allow creditaccounts, none at all. The actual ratio is compared with the target or normto decide whether or not it is acceptabie.3. Creditors:
  27. 27. (i) Creditors Turnover Period The measurement of the creditor turnover period shows the averagetime taken to pay for goods and services purchased by the company. Theformula is: Average creditors Purchases X 365 In general the longer the credit period achieved the better, uecausedelays in payment mean that the operation of the company are beingfinanced interest free by, suppliers of funds. But there will be a pointbeyond which-delays in payment will damage relationships with supplierswhich, if they are operating in a sellers market, may harm the company. Iftoo long a period is taken to pay creditors, the credit rating of the companymay suffer, thereby making it more difficult to obtain suppliers in thefuture.(ii) Creditors Turnover Ratio Credit purchases Average creditors The term creditors include trade creditors and bills payable.4. Assets Turnover Ratios: This measures the companys ability to generate sales revenue inrelation to the size of the asset investment A low asset turnover may beremedied by increasing sales or by disposing of certain assets or both. Toassist in establishing which part of the asset structure is not being usedefficiently, the asset turnover ratio should be sub-analysed.(i) Fixed Assets Turnover Ratio Sales Fixed assets This ratio will be analysed further with ratios for each main categoryof asset This is a difficult set of ratios to interpret as asset values are basedon historic cost An increase in the fixed asset figure may result from thereplacement of an asset at an increased price or the purchase of anadditional asset intended to increase production capacity. The latertransaction might be expected to result in increased sales whereas theformer would more probably be reflected in reduced operating costs. The ratio of the accumulated depreciation provision to the total offixed assets at cost might be used as an indicator of the average age of theassets; particularly when depreciation rates are noted in the accounts.The ratio of sales value per share foot of floor space occupied is particularlysignificant, for trading concerns, such as a wholesale warehouse or adepartment store.
  28. 28. (ii) Total Assets Turnover RatioThis ratio indicates the number of times total assets are being turned over ina year. Sales Total assets The higher the ratio indicates overtrading of total assets while a lowratio indicates idle capacity.5. Working Capital Turnover Ratio : This ratio is calculated as follows: Sales Working capital This ratio indicates the extent of working capital turned over inachieving sales of the firm.6. Sales to Capital Employed Ratio :This ratio is ascertained by dividing sales with capital employed. Sales —————————— Capital employed This ratio indicates, efficiency in utilisation of capital employed ingenerating revenue.Profitability Ratios The purpose of study and analysis of profitability ratios are to helpassess the adequacy of profits earned by the company and also to discoverwhether profitability is increasing or declining. The profitability of the firm isthe net result of a large number of policies and decisions. The profitabilityratios are measured with reference to sales, capital employed, total assetsemployed; shareholders funds etc. The major profitability rates are asfollows: (a) Return on capital employed (or Return on investment) [ROI orROCE] (b) Earnings per share (EPS) (c) Cash earnings per share (Cash EPS) (d) Gross profit margin (e) Net profit margin (f) Cash profit ratio (g) Return on assets
  29. 29. (h) Return on Net worth (or Return on Shareholders equity)I. Return on Capital Employed (ROCE) or Return on Investment (ROI) The strategic aim of a business enterprise is to earn a return oncapital. If in any particular case, the return in the long-run is notsatisfactory, then the deficiency should be corrected or the activity beabandoned for a more favourable one. Measuring the historical performanceof an investment center calls for a comparison of the profit that has beenearned with capital employed. The rate of return on investment isdetermined by dividing net profit or income by the capital employed orinvestment made to achieve that profit. ROI = Profit X 100 Invested capital ROI consists of two components viz, I. Profit margin, and fl.Investment turnover, as shown below:ROI = Net profit = Net profit Sales X Investment Sales Investment in assets It will be seen from the above formula that ROI can be improved byincreasing one or both of its components viz., the profit margin and theinvestment turnover in any of the following ways: Increasing the profit margin Increasing the investment turnover, or Increasing both profit margin and investment turnoverThe obvious generalisations that can be made about the ROI formula arethat any action is beneficial provided that it: Boosts sales Reduces invested capital Reduces costs (while holding the other two factors constant)
  30. 30. Table-1: Computation of Capital Employed Share capital of the company xxx Reserves and surplus xxx Loans (secured/ unsecured) xxx xxx Less: (a) Capital-in-progress xxx (b) Investment outside the business xxx (c) Preliminary expenses (d) Debit balance of Profit and Loss xxx xxx A/c Capital employed xxx Return on in vestment analysis provides a strong incentive for optimalutilisation of these assets of the company. This encourages mangers toobtain, assets that will provide a satisfactory return on investment and todispose of assets that are not providing an acceptable return. In selectingamongst alternative long-term investment proposals, ROI provides a suitablemeasure for assessment of profitability of each proposal.2. Earnings Per Share (EPS): The objective of financial Management is wealth or value maximisationof a corporate entity. The value is maximized when market price of equityshares is maximised. The use of the objective of wealth maximisation or netpresent value maximisation has been advocated as an appropriate andoperationally feasible criterion to choose among the alternative financialactions. In practice, the performance of a corporation Is better judged interms of its earnings per share (EPS). The EPS is one of the importantmeasures of economic performance of a corporate entity. The flow of capital to the companies under the present imperfectcapital market conditions woold be made on the evaluation of EPS. Investorslacking inside and detailed information would look upon the EPS as the bestbase to lake their investment decisions. A higher EPS means better capitalproductivity. EPS = Net Profit after tax and preference dividend No. of Equity SharesI EPS when Debt and Equity used = (EBIT – 1) (1 – T) NII. EPS when Debt, Preference and Equity used = (EBIT – I ) (1 – T) - DP N Where EBIT = Earnings before interest and tax I = Interest T = Rate of Corporate tax DP = Preference Dividend N = Number of Equity shares
  31. 31. EPS is one of the most important ratios which measures the net profitearned per share. EPS is one of the major factors affecting the dividendpolicy of the firm and the market prices of the company. Growth in EPS ismore relevant for pricing of shares from absolute EPS. A steady growth inEPS year after year indicates a good track of profitability.3. Cash Earnings Per Share : The cash earnings per share (Cash EPS is calculated by dividing thenet profit before depreciation with number of equity shares. Net profit + Depreciation No. of Equity Shares This is a more reliable yard stick for measurement of performance ofcompanies, especially for highly capital intensive industries where provisionfor depreciation is substantial. This measures the cash earnings per shareand is also a relevant factor for determining the price for the companysshares. However, this method is not as popular as EPS and is used as asupplementary measure of performance only.4. Gross Profit Margin : The gross profit margin is calculated as follows:= Sales - Cost of goods sold Gross profit X 100 Sales X 100 Sales The ratio measures the gross profit margin on the total net sales madeby the company. The grosi, profit represents the excess of sales proceedsduring the 1 period under observation over their cost, beforetaking into account administration, selling and distribution andfinancing charges. The ratio . measures the efficiency of the companysoperations and this can also be; compared with the previous years results toascertain the efficiency partners with respect to the previous years. When everything normal, the gross profit margin should remainunchanged, irrespective of the level of production and sales, since it is basedon the assumption that all costs deducted when computing gross profitwhich are directly variable with sales. A stable gross profit margin istherefore, the norm and any variation from it call for careful investigations,which may be caused; due to the following reasons:(i) Price cuts: A company need to reduce its selling price to achieve the desired increase in sales.
  32. 32. (ii) Cost increases: The price which a company pay its suppliers duringperiod of inflation, is likely to rise and this reduces the gross profitmargin unless an appropriate adjustment is made to the selling price.(iii) Change in mix: A change in the range or mix of products sold causesthe overall gross profit margin assuming individual product lines earndifferent gross profit percentages.(iv) Under or Over-valuation of stocks. If closing stocks are under-valued, cost of goods sold is inflated andprofit understated. An incorrect valuation may be the result of an errorduring stock taking or it may be due to fraud The gross profit margin maybe compared with that of competitors in the industry to assess theoperational performance relative to the other players in the industry.5. Net Profit Margin: The ratio is calculated as follows: Net profit before interest and tax X 100 Sales The ratio is designed to focus attention on the net profit marginarising from business operations before interest and tax is deducted. Theconvention is to express profit after tax and interest as a percentage of sales.A drawback is that the percentage which results, varies depending on thesources employed to finance business activity; interest is charged above theline while dividends are deducted below the line. It is for this reason thatnet profit i.e. earnings before interest and tax (EBIT) is used. This ratio reflects nt: profit margin on the total sales after deductingall expenses but before deducting interest and taxation. This ratio measuresthe efficiency of operation of the company. The net profit is arrived at fromgross profit after deducting administration, selling and distributionexpenses. The non-operating incomes and expenses are ignored incomputation of net profit before tax, depreciation and interest This ratio could be compared with that of the previous years and withthat of competitors to determine the trend in net profit margins of thecompany and its performance in the industry. This measure will depict thecorrect trend of performance where there are erratic fluctuations in the taxprovisions from year to year. It is to be observed that majority of the costsdebited to the profit and loss account are fixed in nature and any increase insales will cause the cost per unit to decline because of the spread of samefixed cost over the increased number of units sold.6. Cash Profit Ratio Cash profit Sales X 100Where Cash profit = Net profits Depreciation
  33. 33. Cash profit ratio measures the cash generation in the business as aresult of trie operations expressed in terms of sales. The cash profit ratio is amore reliable indicator of performance where there are sharp fluctuations inthe profit before tax and net profit from year to year owing to difference indepreciation charged. Cash profit ratio eva)iates the efficiency of operationsin terms of cash generation and is not affected y the method of depreciationcharged. It also facilitate the inter-firm comparison of performance sincedifferent methods of depreciation may be adopted by different companies.7. Return on Assets : This ratio is calculated as follows: Net profit after tax Total assets X 100 The profitability, of the firm is measured by establishing relation of netprofit with the total assets of the organisation. This ratio indicates theefficiency of utilisation of assets in generating revenue.8. Return on Shareholders Funds or Return on Net Worth Net profit after interest and tax Net worth X 100 Where, Net worth = Equity capital + Reserves and Surplus. This ratio expresses (he nel profit in Icrms of the equity shareholdersfunds. This ratio is an important yardstick of performance of equityshareholders since it indicates the return on the funds employed by them.However, this measure is based on the historical net worth and will be highfor old plants and low for new plants. The factor which motivates shareholders to invest in a company is theexpectation of an adequate rate of return on their funds and periodically,they will want to assess the rate of return earned in order to decide whetherto continue with their investment. There are various factors of measuringthe return including the earnings yield and dividend yield which areexamined at later stage. This ratio is useful in measuring the rate of returnas a percentage of the book value of shareholders equity. The further modification of this ratio is made by considering theprofitability from equity shareholders point of view can also be worked outby taking the profits after preference dividend and comparing against capitalemployed after deducting both long-term loans and preference capital.Operating Ratios The ratios of all operating expenses (i.e. materials used, labour,factory-overheads, administration and selling expenses) to sales is theoperating ratio. A comparison of the operating ratio would indicate whether
  34. 34. the cost content is high or low in the figure of sales. If the annualcomparison shows that the sales has increased the management would benaturally interested and concerned to know as to which element of the costhas gone up. It is not necessary that the management should be concernedonly when the operating ratio goes up. If the operating ratio has fallen,though the unit selling price has remained the same, still the position needsanalysis as it may be the sum total of efficiency in certain departments andinefficiency in others, A dynamic management should be interested inmaking a complete analysis. It is, therefore, necessary to break-up the operating ratio into variouscost ratios. The major components of cost are: Material, labour andoverheads. Therefore, it is worthwhile to classify the cost ratio as:1. Materials Cost Ratio = MaterialsConsumed Sales X 1002. Labour Cost Ratio = Labour Cost Sales 100 X Sales3. Factory Overhead Ratio = Factory Expenses Sales X 1004. Administrative Expense Ratio = Administrative Expenses X 100 Sales5. Selling and distribution expenses ratio = Selling and Distribution Expenses X 100 SalesGenerally all these ratios are expressed in terms of percentage. Then totalup all the operating ratios. This is deducted from 100 will be equal to the netprofit ratio. If possible, the total expenditure for effecting sales should bedivided into two categories, viz. Fixed and variable and then ratios should beworked out. The ratio of variable expenses to sales will be generallyconstant; that of fixed expenses should fall if sales increase, it will increaseif sales fall.Market Test Ratios The market test ratios relates the firms stock price to its earnings andbook value per share. These ratios give management an indication of whatinvestors think of the companys past performance and future prospectus. Iffirms profitability, solvency and turnover ratios are good, then the markettest ratios will be high and its share price is also expected to be high. Themarket test ratios are as follows: - 1. Dividend payout ratio 2. Dividend yield ; 3. Book value
  35. 35. 4. Price/Earnings ratio1. Dividend Payout Ratio: Dividend per share Earnings per share Dividend payout ratio is the dividend per share divided by theearnings per share. Dividend payout indicates the extent of the net profitsdistributed to the shareholders as dividend. A high payout signifies a liberaldistribution policy and a low payout reflects conservative distribution policy.2. Dividend Yield Dividend per share Market price X 100 This ratio reflects the percentage yield that an investor receives onthis investment at the current market price of the shares. This measure isuseful forinvestors who are interested in yield per share rather than capitalappreciation.3. Book Value: Equity Capitalf +Reserves - Prqfit&Lass debit balance. Total number of equity shares; This ratio indicates the net worth per equity share. The book value isa reflection of the past earnings and the distribution policy of the company.A high book value indicates that a company has huge reserves and is apotential bonus candidate. A low book value signifies liberal distributionpolicy of bonus and dividends, or alternatively, a poor track record ofprofitability. Book value is considered less relevant for the m^ker price ascompared to EPS, as it reflects the past record whereas the marketdiscounts the future prospects.4. Price Earnings Ratio (P/E Ratio): Current market price Earnings per share This ratios measures the number of times the earnings of the latestyear at which the share price of a company is quoted. It signifies thenumber of years, in which the earnings can equal to current market price.This ratio reflects the markets assessment of the future earnings potentialof the company. A high P/e ratio reflects earnings potential and a low P/Eratio low earnings potential. The P/E ratio reflects the markets confidencein the companys equity. P/e ratio is a barometer of the market sentimentCompanies with excellent track record of profitability, professional
  36. 36. management and liberal distribution policy have high P/E ratios whereascompanies with moderate track record, conservative distribution policyand average prospects quote a low P/E ratios. The market price discountsthe expected earnings of a company for the current year as opposed to thehistorical EPS.LIMITATIONS IN THE USE OF RATIO ANALYSIS Ratios by themselves mean nothing. They must always be comparedwith: a norm or a target previous ratios in order to assess trends the ratios achieved in other com; arable companies (inter-company comparisons), and caution has to be exercised in using ratios.The following limitations must be taken into account: Ratios are calculated from financial statements w.ach are affected by the financial bases and policies adopted on such matters as depreciation and the valuation of stocks. Financial statements do not represent a complete picture of the business, but merely a collection of facts which can be expressed in monetary terms. They may not refer to other factors which affect performance. Over use of ratios as controls on managers could be dangerous, in that management might concentrate more on simply improving the ratio than on dealing with the significant issues. For example, the return on capital employed can be improved by reducing assets rather than increasing profits. A ratio is a comparison of two figures, a numerator and a denominator In comparing ratios it may be difficult to determine whether differences are due to changes in the numerator, or in the denominator or in both. Ratios are inter-connected. They should not be treated in isolation. The effective use of ratios, therefore, depends on being aware of all these limitations and ensuring that, following comparative analysis, they are used as a trigger point for investigation and corrective action rather than being treated as meaningful in themselves. The analysis of ratios clarifies trends and weaknesses in performance as a guide to action as long as proper comparisons are made and the reasons for adverse trends or deviations from the norm are investigated thoroughly.Illustration 1: From the given Balance Sheets calculate:
  37. 37. (a) Debt-equity ratio (b) Liquid ratio (c) Fixed assets to current assets ratio (d) Fixed assets to Net worth ratio Balance Sheet Liability Rs. Assets Rs. Share Capital 1,00,000 Goodwill 60,000 Reserve 20,000 Fixed assets (Cost) 1,40,000 Profit and Loss a/c 30,000 Stock 30,000 Secured Loans 80,000 Debtors 30,000 Creditors 50,000 Advances 10,000 Provisions for taxation 20,000 Cash 30,000 3,00,000 3,00,000Solution:(a) Debt-equity ratio = Outsiders Funds Shareholders Funds Outsiders Funds Rs. Shareholders Rs. FundsSecured Loans 80,000 Share Capital 1,00,000Creditors 50,000 Reserves 20,000Provisions for taxation 20,000 Profit and Loss a/c 30,000 1,50,000 1,50,000 Debt-equity ratio = 1,50,000 = 1:1 1,50,000(b) Liquid ratio = Liquid Assets Current LiabilitiesNote: Advances are treated as current asset. Secured Joans are treated as current liability.Liquid ratio = 70,000 1,50,000 = 0.47:1(c) Fixed Assets to Currents Assets Ratio = Fixed Assets Current Liabilities Fixed Assets = 1,40,000 Current Assets (Rs) Cash 30,000
  38. 38. Stock 30,000 Debtors 30,000 Advances 10,000 1,00,000Fixed assets to current assets ratio = 1,40,000 1,00,000 = 1.4:1(d) Fixed Assets to Net worth Ratio = Fixed Assets Net worth 1,00,000 Share Capital Reserves 20,000 P & L a/c 30,000 1,50,000 Less: Provision for taxation 20,000 1,30,000Fixed Assets to Net worth ratio = 1,40,000 = 1.08:1 1,30,000Illustration 2: From the following data calculate; (a) Current ratio (b) Quick ratio (c) Stock Turnover ratio (d) Operating ratio (e) Rate of return on equity capital Balance Sheet as on Dec., 31,2001 Liabilities Rs. Assets Rs.Equity Share 1,00,000 Plant and Machinery 6,40,000Capital (Rs. 10 shares)Profit and loss 3,68,000 Land and buildings 80,000accountCreditors 1,04,000 Cash 1, 60,000Bills payable 2,00,000 Debtors 3,60,000 Less: Provision for 3,20,000 bad debts 40,000
  39. 39. Other Current 20,000 Stock 4,80,000liabilities Prepaid Insurance 12,000 16,92,000 16,92,000 Income Statement for the year ending 31st Dec., 2001 (Rs.)Sales 4,00,000Less: Cost of goods sold 30,80,000 9,20,000Less: Operating expenses 6,80,000Net Profit 2,40,000Less: Income tax paid 50% 1,20.000New Profit after tax 1,20,000 Balances at the beginning of the year: Debtors Rs. 3,00,000 Stock Rs. 4,00,000Solution:(a) Current ratio = Current Assets Current Liabilities Current Assets Rs. Current Liabilities Rs.Cash Creditors 1,04,000Debtors 3,20,000 Bills Payable 2,00,000Stock 4,80,000 Other Current 20,000 LiabilitiesPrepaid insurance 12,000 9,72,000 3,24,000Current ratio = 9,72,000 3:1 3,24,000(b) Quick ratio = Liquid Assets Current Liabilities Liquid assets (Rs.) Current liabilities Rs.3,24,000
  40. 40. Cash Debtors 1,60,000 3,20,000 4,80,000 Liquid ratio = 4,80,000 = 1.48:1 3,24,000(c) Stock Turnover Ratio = Cost of goods sold Average slock Cost of goods sold = 30,80,000Average Stock = Opening Stock + Closing Stock 2 = 4,00,000 + 4,80,000 = 4,40,000 2Stock Turnover Ratio = 3,80,000 4,40,000 = 7 times(d) Operating Ratio = Cost of goods sold + Operating expresses X 100 Net Sales = 30,80,000 + 6,80,000 + 40,00,000 X 100 = 94% 40,00,000(e) Rate of return on equity capital: = Net profit afer lax Equity share capital = 1,20,000 X 100 = 12% 10,00,000Illustration 3: The following are the Trading and P&L A/c for the yearended 31st December 2001 and the Balance Sheet as on that date of K. Ltd. Trading and P & L A/c Particulars Rs. Particulars Rs. To Opening Stock 9,950 By Sales 85,000 To Purchases 54,5.25 By Closing Stock 14,900
  41. 41. To Wages 1,425 To Gross Profit 34,000 99,900 99,900 To Administrative 15,000 By Gross Profit 34,000 Expenses To Selling Expenses 3,000 By Interest 300 To Financial Expenses 1,500 By Profit on sale 600 of shares To Loss on sale of assets 400 To Net Profit 15,000 34,900 34,900Balance Sheet Liabilities Rs. Assets Rs. Share Capital 20,000 Land and Buildings 15,000 Reserves 9,000 Plant & Machinery 8,000 Current Liabilities 13,000 Stock 14,900 P&LA/c 6,000 Debtors 7,1000 Cash at Bank 3,000 48,000 48,000You are required to Calculate; (a) Current Ratio (b) Operating Ratio (c) Stock Turnover Ratio (d) Net Profit Ratio (e) Fixed Assets Turnover RatioSolution:(a) Current ratio = Current Assets Current Liabilities Current Assets (Rs.) Cash at Bank 3,000 Current liabilities Rs. 13,000
  42. 42. Debtors 7,100 Stock 14,900 25,000 Rs. 1.923:1Current ratio = 25,000 13,000(b) Operating Ratio = Cost of goods sold + Operating expresses X 100 Net SalesCost of goods sold = 9,950 + 54,525 + 1,425 - 14,900 = 51,000Operating expenses = 19,500Operating Ratio = 51,000 + 19,500 X 100 = 82.94% 85,000(c) Stock Turnover Ratio = Cost of goods sold Average stock Average Stock = 9,950 + 14,900 = 12,425 2Stock Turnover Ratio = 51,000 = 4.1 times 12,425(d) Net Profit Ratio = Net Profit = 100 Net Sales = 15,000 = 17.65% = 100 85,000(e) Fixed Assets Turnover Ratio = Net Sales Fixed Assets = 85,000 = 3.7 times 23,000
  43. 43. Illustration 4; The following is the Trading and Profit and Loss a/c andBalance Sheet of a firm. Trading and P & L A/c Particulars Rs. Particulars Rs.To Opening Stock 10,000 By Sales 1,00,000To Purchases 55,000 By Closing Stock 15,000To Gross Profit c/d 50,000 1,15,000 1,15,000To Administrative Expenses 15,000 By Gross Profit b/d 50,000To Interest 3,000To Selling Expenses 12,000To Net Profit 20,000 50,000 50,000 Balance Sheet Liabilities Rs. Assets Rs.Capital 1,00,000 Land and Buildings 50,000Profit and Loss a/c 20,000 Plant & Machinery 30,000Creditors 25,000 Stock 15,000Bills Payable 15,000 Debtors 15,000 Bills receivable 12,500 Cash at Bank 17,500 Furniture 20,000 1,60,000 1,60,000Calculate the following ratios: (a) Inventory turnover ratio (b) Current Ratio (c) Gross profit ratio (d) Net profit ratio (e) Operating ratio (f) Liquidity ratio (g) Proprietary ratio
  44. 44. Solution:(a) Inventory Turnover ratio = Cost of goods sold Average stock Cost of goods sold Opening Stock 10,000 Purchases 55,000 65,000 Less: Closing Stock 1 5,000 50,000Average Stock = Opening Stock + Closing Stock 2 = 10,000 + 15,000 2 = 12,500 Stock Turnover ratio = 50,000 = 4 times 12,500(b) Current ratio = Current Assets Current LiabilitiesCurrent Assets (Rs.) Current Assets Rs. Current liabilities Rs. Stock 15,000 Creditors 25,000 Debtors 15,000 Bills Payable 15,000 B/R 12,500 Cash at Bank 17,500 60,000 40,000Current ratio = 60,000 40,000 = 1.5:1(b) Gross Profit Ratio = Gross Profit Net Sales X 100 = 50%(c) Net Profit Ratio = Net Profit X 100 Net Sales = 20,000 = 20% 1,00,000
  45. 45. (d) Operating Profit = Cost of goods sold + Operating expresses = 100 Net SalesCost of goods sold = 50,000 Operating expenses (Rs.) Administration expenses Selling expenses 15,000 12,000 27,000Operating ratio = 50,000 + 27,000 X 100 77 % 1,00,000(e) Liquidity ratio = Liquid Assets Current LiabilitiesCurrent Assets (Rs.) Liquid Assets Rs. Current liabilities Rs. Cash at Bank 17,500 Creditors 25,000 Bills Receivable 12,500 Bills Payable 15,000 Debtors 15,000 45,000 40,000Liquidity ratio = 45,000 40,000(f) Proprietary ratio = Shareholder’s Funds X 100 Total AssetsShareholders Furuis (Rs.) Capital Profit and Loss a/c 1,00,000 Total Assets Rs. 1,60,000 20,000 1,20,000Proprietary ratio = 1,20,000 X 100 = 75% 1,60.000Illustration 5: A company has a profit margin of 20% and asset turnover of3 times. What is the companys return on investment? How will this returnon investment vary if –
  46. 46. (i) Profit margin is increased by 5% ? (ii) Asset turnover is decreased to 2 times? (iii) Profit margin is decreased by 5% and asset turnover is increased to 4 times.Calculation of impact of change in profit margin and change in assetturnover on return on investmentReturn on investment = Profit Margin x Asset Turnover = 20% x 3 times = 60%(i) If profit margin is increased by 5% : ROI = 25% x 3 = 75%(ii) If asset turnover is decreased to 2 times: ROI = 20% x 2 = 40%(iii) If profit margin decreased, by 5% and asset turnover is increased to 4times: ROI = 15% x 4 = 60%Illustration 6: There are three companies in the country manufacturing aparticular chemical. Following data are available for the year 2000-2001. (Rs. lakhs)Company Net Sales Operating Cost Operating AssetsA Ltd. 300 255 125B Ltd. 1,500 1,200 750C Ltd. 1,400 1,050 1,250Which is the best performer as per your assessment and why? Comparative Statement of Performance Particulars A Ltd. B Ltd. C Ltd. Sales 300 1,500 1,400 Less: Operating Cost 255 1,200 1,050 OperatingProfit (A) 45 300 350 Operating Assets (B) 125 750 1,250 Return on capital employed 36% 40% 28% (A) / (B) x 1 00Analysis: Basing on the return on capital employed, B Ltd., is the bestperformer as compared to A Ltd. and C Ltd.
  47. 47. Illustration 7: Calculate the P/E ratio from the following: (Rs.) Equity Share Capital (Rs. 20 each) 50,00,000Reserves and Surplus 5,00,000Secured Loans at 15% 25,00,000Unsecured Loans at 12.5% 10,00,000Fixed Assets 30,00,000Investments 5,00,000Operating Profit 25,00,000,Income-taxRate50% (Rs.)Operating Profit 25,00,000Less: Interest onSecured Loans @ 15% 3,75,000Unsecured Loans @ 12.5% 1,25,000 5,00,000Profit before tax (PBT) 20,00,000Less: Income-tax @ 50% 10,00,000Profit aaer tax (PAT) 10,00,000No. of Equity shares 2,50,000EPS = Profit after tax No. of Equity shares = Rs. 10,00,000 = Rs. 4 Rs. 2,50,000Market price per share = Rs. 50P/E Ratio = Market price per share / EPS = Rs.50/Rs.4 = 12.50Illustration 8: The capital of Growfast Co. Ltd., is as follows:
  48. 48. 10% Preference shares of Rs.10 each 50,00,000 Equity shares of Rs. 100 each 70,00,000 1,20,00,000Additional information:Profit after tax at 50% Rs. 15,00,000Deprication Rs. 6,00,000Equity dividend paid 10%Market price per equity share Rs. 200Calculate the following: (i) The cover for the preference and equity dividends (ii) The earnings per share (iii) The price earnings ratio (iv) The net funds flowSolution:(i) The cover for the Preference and Equity dividends: Profit after tax = Preference dividend + Equity dividend = Rs. 15,00,000 = 1.25 times Rs. 5,00,000 + to 7,00,000(ii) The Earning Per Share: = Net profit after preference dividend No. of Equity Shares = Rs. 15,00,000 – Rs. 5,00,000 = Rs. 14.29 Rs.7,00,000(iii) The Price Earnings Ratio: = Market price per share Earning per share = Rs.200 = 14 times
  49. 49. Rs. 14.29(iv) The Net Funds Flow: (Rs.) Profit after tax 15,00,000 Add: Depreciation 6,00,000 21,00,000

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