Transcript RATIO ANALYSIS

RATIO ANALYSIS
Ratio-analysis is a concept or technique
which is as old as accounting concept.
Financial analysis is a scientific tool. It has
assumed important role as a tool for
appraising the real worth of an enterprise, its
performance during a period of time and its pit
falls. Financial analysis is a vital apparatus for
the interpretation of financial statements. It
also helps to find out any cross-sectional and
time series linkages between various ratios.
RATIO ANALYSIS
Unlike in the past when security was considered to
be sufficient consideration for banks and financial
institutions to grant loans and advances, nowadays
the entire lending is need-based and the emphasis is
on the financial viability of a proposal and not only
on security alone. Further all business decision
contains an element of risk. The risk is more in the
case of decisions relating to credits. Ratio analysis
and other quantitative techniques facilitate
assessment of this risk.
RATIO ANALYSIS
Ratio-analysis means the process of
computing, determining and presenting the
relationship of related items and groups of
items of the financial statements. They
provide in a summarized and concise form
of fairly good idea about the financial
position of a unit. They are important tools
for financial analysis.
WHY FINANCIAL ANALYSIS
Lenders’ need it for carrying out the following
• Technical Appraisal
• Commercial Appraisal
• Financial Appraisal
• Economic Appraisal
• Management Appraisal
Ratio Analysis
It’s a tool which enables the banker or lender to
arrive at the following factors :
Liquidity position
Profitability
Solvency
Financial Stability
Quality of the Management
Safety & Security of the loans & advances to be
or already been provided
Before looking at the ratios there are a number of cautionary
points concerning their use that need to be identified :
a. The dates and duration of the financial statements being
compared should be the same. If not, the effects of
seasonality may cause erroneous conclusions to be drawn.
b. The accounts to be compared should have been prepared
on the same bases. Different treatment of stocks or
depreciations or asset valuations will distort the results.
c. In order to judge the overall performance of the firm a
group of ratios, as opposed to just one or two should be
used. In order to identify trends at least three years of
ratios are normally required.
The utility of ratio analysis will get further
enhanced if following comparison is
possible.
1.Between the borrower and its competitor
2.Between the borrower and the best
enterprise in the industry
3.Between the borrower and the average
performance in the industry
4.Between the borrower and the global
average
How a Ratio is expressed?
 As Percentage - such as 25% or 50% . For example
if net profit is Rs.25,000/- and the sales is
Rs.1,00,000/- then the net profit can be said to be
25% of the sales.
 As Proportion
- The above figures may be
expressed in terms of the relationship between net
profit to sales as 1 : 4.
 As Pure Number /Times - The same can also be
expressed in an alternatively way such as the sale is 4
times of the net profit or profit is 1/4th of the sales.
Classification of Ratios
Balance Sheet
Ratio
P&L Ratio or
Income/Revenue
Statement Ratio
Balance Sheet and
Profit & Loss Ratio
Financial Ratio
Operating Ratio
Composite Ratio
Current Ratio
Quick Asset Ratio
Proprietary Ratio
Debt Equity Ratio
Gross Profit Ratio
Operating Ratio
Expense Ratio
Net profit Ratio
Stock Turnover Ratio
Fixed Asset Turnover
Ratio, Return on Total
Resources Ratio,
Return on Own Funds
Ratio, Earning per
Share Ratio, Debtors’
Turnover Ratio,
Format of balance sheet for ratio analysis
LIABILITIES
ASSETS
NET WORTH/EQUITY/OWNED FUNDS
FIXED ASSETS : LAND & BUILDING, PLANT &
Share Capital/Partner’s Capital/Paid up Capital/ MACHINERIES
Owners Funds
Original Value Less Depreciation
Reserves ( General, Capital, Revaluation & Other Net Value or Book Value or Written down value
Reserves)
Credit Balance in P&L A/c
LONG TERM LIABILITIES/BORROWED FUNDS :
Term Loans (Banks & Institutions)
Debentures/Bonds, Unsecured Loans, Fixed
Deposits, Other Long Term Liabilities
NON CURRENT ASSETS
Investments in quoted shares & securities
Old stocks or old/disputed book debts
Long Term Security Deposits
Other Misc. assets which are not current or fixed in
nature
CURRENT LIABILTIES
Bank Working
Capital Limits such as
CC/OD/Bills/Export Credit
Sundry /Trade Creditors/Creditors/Bills Payable,
Short duration loans or deposits
Expenses payable & provisions against various
items
CURRENT ASSETS : Cash & Bank Balance,
Marketable/quoted Govt. or other securities, Book
Debts/Sundry Debtors, Bills Receivables, Stocks &
inventory (RM,SIP,FG) Stores & Spares, Advance
Payment of Taxes, Prepaid expenses, Loans and
Advances recoverable within 12 months
INTANGIBLE ASSETS
Patent, Goodwill, Debit balance in P&L A/c,
Preliminary or Preoperative expenses
Some important notes
• Liabilities have Credit balance and Assets have Debit balance
• Current Liabilities are those which have either become due for
payment or shall fall due for payment within 12 months from the
date of Balance Sheet
• Current Assets are those which undergo change in their
shape/form within 12 months. These are also called Working
Capital or Gross Working Capital
• Net Worth & Long Term Liabilities are also called Long Term
Sources of Funds
• Current Liabilities are known as Short Term Sources of Funds
• Long Term Liabilities & Short Term Liabilities are also called
Outside Liabilities
• Current Assets are Short Term Use of Funds
Some important notes
• Assets other than Current Assets are Long Term Use of Funds
• Installments of Term Loan Payable in 12 months are to be taken as
Current Liability only for Calculation of Current Ratio & Quick Ratio.
• If there is profit it shall become part of Net Worth under the head
Reserves and if there is loss it will become part of Intangible Assets
• Investments in Govt. Securities to be treated current only if these
are marketable and due. Investments in other securities are to be
treated Current if they are quoted. Investments in
allied/associate/sister units or firms to be treated as Non-current.
• Bonus Shares as issued by capitalization of General reserves and as
such do not affect the Net Worth. With Rights Issue, change takes
place in Net Worth and Current Ratio.
LIQUIDITY RATIOS
Indicate the short term solvency of the firm, i.e. the attitude of
covering day by day current obligations through an efficient
usage of current assets.
Current Ratio : It is the relationship between the current assets and
current liabilities of a concern.
Current Ratio = Current Assets/Current Liabilities
If the Current Assets and Current Liabilities of a concern are
Rs.4,00,000 and Rs.2,00,000 respectively, then the Current Ratio
will be : Rs.4,00,000/Rs.2,00,000 = 2 : 1
The ideal Current Ratio preferred by Banks is 1.33 : 1
Net Working Capital : This is worked out as surplus of Long Term
Sources over Long Tern Uses, alternatively it is the difference of
Current Assets and Current Liabilities.
NWC = Current Assets – Current Liabilities
Current Assets : Raw Material, Stores, Spares, Work-in Progress. Finished
Goods, Debtors, Bills Receivables, Cash.
Current Liabilities : Sundry Creditors, Installments of Term Loan, DPG etc.
payable within one year and other liabilities payable within one year.
This ratio must be at least 1.33 : 1 to ensure minimum margin of 25% of current
assets as margin from long term sources.
 Current Ratio measures short term liquidity of the concern and its ability to
meet its short term obligations within a time span of a year.
 It shows the liquidity position of the enterprise and its ability to meet current
obligations in time.
Higher ratio may be good from the point of view of creditors. In the long run
very high current ratio may affect profitability ( e.g. high inventory carrying cost)
 Shows the liquidity at a particular point of time. The position can change
immediately after that date. So trend of the current ratio over the years to be
analyzed.
 Current Ratio is to be studied with the changes of NWC. It is also necessary to
look at this ratio along with the Debt-Equity ratio.
STOCK/INVENTORY TURNOVER RATIO :
(Average Inventory/Sales) x 365 for days
(Average Inventory/Sales) x 52 for weeks
(Average Inventory/Sales) x 12 for months
Average Inventory or Stocks = (Opening Stock + Closing Stock)
----------------------------------------2
This ratio indicates the number of times the inventory is rotated
during the relevant accounting period
DEBTORS TURNOVER RATIO : This is also called Debtors
Velocity or Average Collection Period or Period of Credit
given .
(Average Debtors/Sales ) x 365 for days
(52 for weeks & 12 for months)
CREDITORS TURNOVER RATIO : This is also called Creditors
Velocity Ratio, which determines the creditor payment
period.
(Average Creditors/Purchases)x365 for days
(52 for weeks & 12 for months)
ACID TEST or QUICK RATIO : It is the ratio between Quick Current
Assets and Current Liabilities. It should be at least equal to 1.
Quick Current Assets : cash + cash equivalents
Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities
Example :
Cash
50,000
Debtors
1,00,000
Inventories
1,50,000
Total Current Assets 3,00,000
Current Ratio = >
Quick Ratio
=>
Current Liabilities 1,00,000
3,00,000/1,00,000
1,50,000/1,00,000
= 3:1
= 1.5 : 1
STRUCTURE AND SOLIDITY RATIOS
DEBT EQUITY RATIO : It is the relationship between borrower’s fund
(Debt) and Owner’s Capital (Equity).
Long Term Outside Liabilities / Tangible Net Worth
Liabilities of Long Term Nature
Total of Capital and Reserves & Surplus Less Intangible Assets
For instance, if the Firm is having the following :
Capital = € 200
Free Reserves & Surplus = € 300
Long Term Loans/Liabilities = € 800
Debt Equity Ratio will be => 800/500 i.e. 1.6 : 1
PROPRIETARY RATIO (≈ INVESTMENT/SHAREHOLDER RATIO)
Indicates the extent to which Tangible Assets are financed by Owner’s
Fund.
Proprietary Ratio = (Tangible Net Worth/Total Tangible Assets) x 100
The ratio will be 100% when there is no Borrowing for purchasing of
Assets.
Earnings per share – profit after tax / number of shares
Price earnings ratio – market price / earnings per share – the higher the
better generally. Comparison with other firms helps to identify value
placed on the market of the business.
OPERATING PROFIT RATIO (ROS1):
It is expressed as =>
(Operating Profit / Net Sales ) x 100
Higher the ratio indicates operational efficiency
NET PROFIT RATIO (ROS2):
It is expressed as =>
( Net Profit / Net Sales ) x 100
It measures overall profitability.
ASSET TURNOVER RATIO :
Net Sales/Tangible Assets
FIXED ASSET TURNOVER RATIO :
Net Sales /Fixed Assets
CURRENT ASSET TURNOVER RATIO :
Net Sales / Current Assets
GEARING RATIO:
(Long Term Loans / Capital Employed) x 100
The higher the ratio the more the business is exposed to interest
rate fluctuations and to having to pay back interest and loans before
being able to re-invest earnings
PROFITABILITY measures look at how much profit the
firm generates from sales or from its capital assets
(composite ratios)
Different measures of profit – gross and net
Gross profit – effectively total revenue (turnover) – variable
costs (cost of sales)
Net Profit – effectively total revenue (turnover) – variable costs
and fixed costs (overheads)
GROSS PROFIT RATIO : By comparing Gross Profit percentage to Net Sales we can
arrive at the Gross Profit Ratio which indicates the manufacturing efficiency as well
as the pricing policy of the concern.
Gross Profit Ratio = (Gross Profit / Net Sales ) x 100
Alternatively , since Gross Profit is equal to Sales minus Cost of Goods Sold, it can
also be interpreted as below:
Gross Profit Ratio = [ (Sales – Cost of goods sold)/ Net Sales] x 100
A higher Gross Profit Ratio indicates efficiency in production of the unit.
RETURN ON EQUITY CAPITAL (ROE) :
Net Profit after Taxes / Equity
RETURN ON CAPITAL EMPLOYED (ROCE)
Net Profit after Taxes / Average Capital Employed
Average Capital Employed is the average of the
equity share capital and long term funds provided
by the owners and the creditors of the firm at the
beginning and end of the accounting period.
Evaluation of the overall profitability of the business and
opinion about the convenience of the investment to
the shareholder
EARNING PER SHARE : EPS indicates the quantum of
net profit of the year that would be ranking for
dividend for each share of the company being held
by the equity share holders.
Net profit after Taxes and Preference Dividend/
No. of Equity Shares
PRICE EARNING RATIO : PE Ratio indicates the number
of times the Earning Per Share is covered by its
market price.
Market Price Per Equity Share/Earning Per Share
DIVIDEND YIELD – ordinary share dividend / market
price x 100 – higher the better. Relates the return
on the investment to the share price.
RETURN ON ASSETS :
Net Profit after Taxes/Total Assets
RETURN ON INVESTMENTS: :
Operating Profit /Operating Assets
Operating profit is Net Profit before Interests & Taxes and before
extraordinary items (=EBITnorm)
Operating Assets are all assets employed in the core business (i.e.
Investments)
Evaluation of the sole profitability of the core business.
ROI = Operating Profit/Sales * Sales/Operating Assets
LEVERAGE EFFECT
ROE = ROI + (ROI – i)(Liabilities/Net Worth)
Investing in the core business is convenient until the cost of
borrowing money (i) becomes higher than ROI
If i ≤ ROI borrowing money is convenient up to infinite
ROE
ROI – i
ROI
L/NW