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# Ratio analysis

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### Ratio analysis

1. 1. Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV 1 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM Ratio Analysis Ratio: Relationship between two numbers. Accounting of Ratio: Relationship between accounting figure. Ratio Analysis: It is a process of computing and presenting the relationship between the items in the financial statements. Ratio analysis is the important tool of financial analysis because it helps to the study the financial performance and position of the firm. Why ratios are used? Ratio speaks about a business  Is profitable?  Is assign its assets efficiency?  Has a gearing problem?  Can the employee be paid higher wages?  Is a target/investor? List of Users 1. Investors 5. Employees 2. Managers 6. Customers 3. Government 7. Other agencies 4. Suppliers & trade creditors.  Has a business made a good profit compared to the turnover? profitability
2. 2. Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV 2 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM  Does a business have enough money to pay its bill? Liquidity  Have a business made a enough profit as compared to assts and capital employed? Return ratio  How has a company used its fixed and current assets? Turnover, activity & uses Forms of Ratio Analysis  Pure Ratio - Relationship between current assets & current liabilities.  Percentage - Profit & Sales  Rates – number of items Classification of Ratio 1. Based on financial statement 2. Based on function 3. Based on users 1. Based on Financial Statement  Based on Balance Sheet Liquidity ratio, quick ratio, proprietary ratio, debt equity ratio, working capital, capital gearing ratio.  Based on Revenue Statement Gross profit ratio, net profit ratio, operating ratio, stock turnover, Net-operating profit ratio.
3. 3. Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV 3 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM  Based on composite Ratio Return on capital employed, return on equity capital, debtor turnover ratio, creditor turnover ratio, dividend payout, debt service coverage ratio. 2. Based on function  Liquidity / Solvency  Leverage Ratio Debt equity Ratio Proprietary Ratio Capital Gearing  Activity Ratio (turnover or productivity) Inventory turnover Ratio Debtor turnover Ratio All turnover Ratios.  Profitability Ratio Gross profit Ratio relation of profit Net profit Ratio & sales Expenses Ratio Return on Investment relation of profit &Return on capital employed investment  Coverage Ratio Debt service coverage Ratio Dividend payout Ratio
4. 4. Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV 4 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM Based on Users  For short term Creditors Current ratio, quick ratio, working capital ratio  Long term Creditors Debt equity ratio, return on capital employed  For management Operating ratio, expenses ratio, return on capital employed, turnover ratio  For shareholders Return on equity, return on proprietor fund Current ratio “Comparison between current assets & current liabilities” “Pure ratio” Formula: Current Assets Current Liabilities Components of Current Assets  Debtors (less provision)  Income accrued (due)  Bill receivable  Cash & bank balance  Marketable investment and securities  Closing stock of row material, work in progress, finished goods, stores & spare.  Any prepaid expenses  Short term loan & advances  Advance tax payment
5. 5. Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV 5 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM Components of Current Liabilities  Creditors  Bill payable  Any outstanding expenses  Unclaimed and proposed dividend  Provision for any taxation  Income received in advance  Bank overdraft Purpose “Help to understanding the ability of the firm to meet its short term obligation” Uses “It is used by creditor to judge the safety margin available, which help them to ascertain the amount and the term of the credit” Limitation  Ignores comparison of working capital EX: company A & company B have the same current ratio, company A has more of stock and company B has more cash. Company B has a better liquidity and solvency.  Ignores quality EX: company A and company B have a same current ratio and the same amount of stock & debtor, but the company A has more stock and doubtful debts than company B has a better liquidity.
6. 6. Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV 6 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM 1.Current Ratio “This ratio has to be studied with ‘Quick Ratio’ and ‘stock to working capital Ratio’ for judging the short term solvency” 2:1 is standard ratio. When result are higher than standard?  Good short term liquidity position  It might significance excess stock  Bad debts –credit prepaid may be more  Idle cash  Under treading –not utilised full capacity When results are lower than standard?  Unsatisfactory liquidity  Over trading  Lower stocks  Idle cash 2.Quick Ratio  Used to check liquidity of the firm.  Also define as a pure ratio Formula: Quick Assets Quick Liabilities  Quick Assets = Current assets – (Stock + Prepaid expenses) A. Stock is executed because it is uncertain as to when & how it will be realise. B. Prepaid expenses are executed because they can’t be converted into cash.  Quick Liabilities = Current Liabilities – Bank Over Draft
7. 7. Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV 7 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM A. Bank over draft is excluded because it is a permanent arrangement & it is not required to be paid as long as the firm exists. Purpose: It is a solvency ratio which indicates the ability of the firm to meet its short term liabilities without selling the stock. How it is helpful?  It measures the immediate solvency of the firm.  It overcomes the limitation of current ratio. i.e. It considers both the composition and quality of working capital.  It emphasises of quality of Current Assets rather than the quantity. The standard of this is 1:1 Higher Than Standard:  It indicates very good day to day solvency/liquidity.  Idle cash balance.  Under investment. Lower Than Standard:  Not satisfactory day to day liquidity/solvency.  Low cash balance.  High investment.
8. 8. Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV 8 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM 3.Debt Equity Ratio This ratio compares a long term debts with shareholder funds. It is also expressed as a Pure Ratio. FORMULA: Debt => Borrowing Funds Equity proprietor’s fund Borrowing Funds Proprietor’s Fund  Debenture - Equity Share Capital  Loans - Preference Share - Reserve & Surplus – (losses + item not written off) Purpose or Function: This ratio is a solvency ratio which indicates the proportion of debt & equity in financing the assets of the firm. Helpful:  It helps to understand and analyse margin of safety for long term credits.  Standard is 2:1  It also helps to ascertain the balance between debt & equity. Higher Than Standard:  Low safety margin for lender.  More interest payment.  Low scope for loan.  Treading on equity.
9. 9. Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV 9 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM 4.Gross Profit Ratio This ratio compares gross profit with net sales. It is expressed in form of percentage. FORMULA: Gross Profit * 100 Net Sales Gross Profit = sales – cost of goods sold Cost of goods sold in treading firm = Opening stock+ purchase+ direct exp. – closing stock Cost of goods sold for manufacturing firm = Opening stock+ cost of materials+ labour+ exp. – closing stock Net Sales = Sales – (sales return + any allowances) Purpose or Function: It is profitability ratio. This ratio helps to judge-  How efficiently the firm is managing its production, purchase, selling & inventory.  How good is the control over direct cost?  How productive the firm is?  How much amount is left to meet other expenses & earn net profit? Higher Then Standard:  It indicates higher efficiency in managing purchase production labour, sales & inventory.  High productivity.  Large amount available to meet other expenses.
10. 10. Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV 10 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM 5.Stock Turnover/ Inventory Turnover Ratio This ratio shows the relationship between the costs of goods sold and average stock this ratio is normally expressed as time or rate. FORMULA: Cost of Goods sold Average Stock Average stock = opening stock + closing stock 2 NOTE: in the absence of information, closing stock can be used instead of average stock. Stock holding period Month = 12 STR Days = 365 STR Function or Purpose: This is an activity ratio, which shows the relationship between sales & stock. Its purpose is to:  Calculate the speed at which stock is being turned over into sales.  Calculate the stock holding period.  To judge how efficient the stock are managed and utilised to generate sales.
11. 11. Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV 11 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM Higher Than Standard:  Stock sold out very quickly.  Working capital requirement is less.  Over trading. 6.Operating Ratio This ratio expresses the relationship between total operating cost and net sales. It is expressed by the way of percentage. FORMULA: Cost of goods sold + operating expenses * 100 Net sales Operating expenses = office & administration exp., selling & distribution exp., financial exp. (OD) Function or Purpose:  This ratio indicates cost of operations.  Its purpose to measure and ascertain efficiency of management with regard to operations. Helpful:  This ratio helps to judge how much amount of sales revenue is used in carrying the operation if the firm.  Operating ratio shows total of all cost in all the area such as administration, sales etc. It is advisable to break it up into various expenses ratio so that we can identify which expenditures are increasing disproportionately.  This ratio has to be studied with expenses ratio and operating net profit ratio before commenting on profitability of the firm.
12. 12. Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV 12 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM Higher Than Standard:  Low efficiency in managing purchase, production, labour, inventory & sales.  Low productivity.  Small amount available to meet other expenses. 7.Return on Capital Employed Ratio (ROCE) or Return on Investment (ROI) The ratio measures the relationship between profit (before interest & tax) and the capital to earn it. The ratio is also known as return on investment (ROI). FORMULA: Profit before Interest & Tax * 100 Capital Employed Capital employed = Equity capital + preference share + reserve & surplus +credit balance of P&L + debenture + long term loans – debit balance of P&L. Purpose or Function:  It is a profitability ratio.  It purposes is to measure overall profitability from the total funds made available by the owners and lenders. Helpful:  The ratio helps to judge how efficiently the firm is managing the funds at its disposal.
13. 13. Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV 13 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM Higher than Standard:  It signifies more profit on each of the rupee invested.  Scope to attract fresh fund both from owner & lender.  It signifies higher amount of sales.  High increase in net worth.  Large amount of appropriation (interest, taxes, dividend) 8.Dividend Payout Ratio This ratio shows the relationship between the dividends paid to equity shareholders out of the profit available. It is expressed in percentage. FORMULA: Dividend Paid * 100 Profit Available to Equity Shareholder (PAT) Profit availability to equity share holder means net profit after interest, income tax & Preference dividend. Purpose or Function:  This ratio is type of coverage ratio.  A coverage ratio shows the relationship between the profit and the claim of outsider to be paid out if such profits.  Its purpose is to measure to dividend paying capacity of the firm.
14. 14. Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV 14 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM Higher than Standard:  Scope to issue fresh equity share at a higher price. Called FPO: follow up public offering.  High price in stick exchange.  During merger high price of shares.  Very high dividend makes shirt term equity holders happy.  Less reserve may mean low growth in future.  No possible of bonus issue. 9.Debt Service Coverage Ratio  This ratio shows the relation between net profit and interest + instalment payable on loan. It is expressed as pure number.  Coverage means availability of profits for debts servicing. FORMULA: Cash profit available for debt servicing (Interest + instalment due on loan) Cash profit available for debt servicing  PAT + non cash debits  CFAT / no pat / NCF Purpose:  It helps to measure debt service capacity of the company.
15. 15. Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV 15 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM Higher than Standard:  Strong capacity to pay interest as and when due.  Further loans easily available at the lower rate.  Large amount of profit available for taxes & dividend.  It also signifies that the firm is not treading on equity. 10. Debtor Turnover Ratio This ratio shows the relationship between credit sales & average debtors. It is expressed as a rate or as a time. Formula: Credit Sales Average Debtor Average Debtor = Bill Receivable + Debtor Debtor Collection Period 12 OR 365 DTR DTR Purpose:  To calculate speed at wage debtor get settled on an average during the year.  It calculates the debtor collection period which helps to indicate the period of credit allowed who an average debtor.  It helps to judge how efficiently the debtors are managed.
16. 16. Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV 16 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM Higher Than Standard:  Debts are collected at lower rate.  More chances of bad debts.  More credits are provided. 11. Creditors Turnover Ratio This ratio shows the relationship between credit purchases and average creditors. This also expressed in the form of rates or times. Formula: Credit Purchase Average Creditors Average Creditors = Bills payable + Creditors Creditors Payment Period: 12 OR 365 CTR CTR Purpose:  It helps to analyse as to how quickly the creditors are paid off on an average during the year.  It helps to calculate the period taken to pay off creditors. Note: This ratio should be studied with STR & DTR to understand the combined effect over the operating cycle.
17. 17. Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV 17 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM Higher Than Standard:  It signifies slow rate of payment.  More credit is available from creditors.  Working capital requirements is less. Operating Cycle = STR + DTR – CTR 12. Stock to Working Capital Ratio This ratio shows the relationship between the closing stock and working capital. It helps to judge the quantum of inventories in relation to the working capital of the business. It is expressed as a percentage. It is also known as inventory working capital ratio. Formula: Stock * 100 Working Capital Stock = closing stock Purpose:  It is liquidity ratio.  It indicates the composition and quality of the working capital and also helps to study the salvage of the firm.  It shows the extant of the funds blocked in stock.  If investment of stock is higher it signifies that the amount of liquid assets is lower.  This ratio should be studied with stock turnover ratio, current ratio and quick ratio.
18. 18. Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV 18 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM Higher Than Standard:  More other current assets are available to pay current liabilities. 13. Return on Equity Capital This ratio measures the relationship between net profit (after interest, tax & preference dividend) and the equity share holders. Formula: Net Profit * 100 Equity Share Holders Funds Equity Share Holders Funds = equity capital and reserve & surplus. This ratio is expected as a percentage. Purpose:  It is a profitability ratio.  Its purpose is to calculate the amount of profit available to take care of equity dividends, transfer to reserve etc.  It is used by the present or perspective investor for deciding whether to purchase, keep or selling the equity shares.  This ratio should be studied with capital gearing ratio to know the effect of gearing on EPS.
19. 19. Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV 19 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM Higher Than Standard:  Large amount of appropriations (reserve & surplus, dividend, etc.)  Higher EPS, in case of merger & acquisition it gives batter purchase consideration.  Higher increase in net worth in the company. 14. Capital Gearing Ratio Gearing means the process of increasing equity shareholders return through the case of debt. Equity share holders earn more when the rate of return on the capital is more than the rate of interest on debt. This is also known as leverage or treading on equity. This ratio shows the relationship between two type of capital, equity capital increasing reserves & preference share capital and long term borrowings. It is usually expressed as a pure ratio. This is also known as capital structure ratio. Formula: Preference Capital + Borrowed Funds Equity Funds Purpose:  It indicates the proportion of debt & equity in the financing of assets of a firm. Higher Than Standard:  Higher return for the shareholder if rate of the fixed return is less than return on investment.
20. 20. Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV 20 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM 15. Return on proprietor’s Fund This ratio measures the relationship between profit (after interest & tax) & the proprietor’s capital. It is usually expressed as a percentage. It is also known as return on net worth. Formula: Net Profit (after tax) Proprietor’s Fund Proprietor’s fund = equity, reserve & surplus and preference capital Purpose:  It is profitability ratio.  It measures the rate of return on the total funds made available from owners.  It helps to judge how efficiently the firm is managing the owners fund at the disposal.  This ratio should be studied with debt equity ratio to know the effect of capital structure on earnings of the proprietors. Higher Than Standards:  Large amount available for appropriation.  Scope to attract fresh funds from the owner.
21. 21. Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV 21 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM 16. Net Profit Ratio The ratio indicates the relationship between net profit and sales. It is usually expressed in the form of percentage. Formula: Net Profit (before tax) Sales Net profit before tax: Net operating profit Add: non operating income Less: non operating expenses. Purpose:  It is profitability ratio.  It indicates net profit for all types or activities of the entire business.  It measures the overall profitability from: - Operating activities of buying or selling the products. - Financing activity of borrowing or lending. - Buying or selling of investment.  This ratio helps to judge: - How efficiently the firm is managing all its activities of operations, financing & investments. - How much amount is available for appropriations?  This ratio is studied with return on capital employed & return on proprietor’s fund. Higher Than Standard:  Good control over all expenses.  Large amount available for appropriation.  Strong capacity to face bad economic condition.  High increase in net worth.  It signifies unusual gain.