CHAPTER 3

FINANCIAL ANALYSIS AND

PLANNING– RATIO ANALYSIS

LEARNING OUTCOMES

 Discuss Sources of financial data for Analysis

 Discuss financial ratios and its Types
 Discuss use of financial ratios to analyse the financial
statement.
 Analyse the ratios from the perspective of investors,
lenders, suppliers, managers etc. to evaluate the
profitability and financial position of an entity.
 Describe the users and objective of Financial Analysis:- A
Birds Eye View
 Discuss Du Pont analysis
 State the limitations of Ratio Analysis

© The Institute of Chartered Accountants of India

 3.2
FINANCIAL MANAGEMENT

RATIO ANALYSIS

Application of Ratio Analysis

Types of
in decision making
Ratios

 Liquidity Ratios/Short-
term solvency ratios Relationship of Financial
 Leverage Ratio/Long Management with other
term solvency Ratios disciplines of accounting.
 Activity Ratios/Efficiency
Ratios/Performance
Ratios/Turnover ratios
Profitability Ratios

3.1 INTRODUCTION
The basis for financial analysis, planning and decision making is financial
statements which mainly consist of Balance Sheet and Profit and Loss
Account. The profit & loss account shows the operating activities of the
concern and the balance sheet depicts the balance value of the acquired
assets and of liabilities at a particular point of time.
However, the above statements do not disclose all of the necessary and
relevant information. For the purpose of obtaining the material and relevant
information necessary for ascertaining the financial strengths and
weaknesses of an enterprise, it is necessary to analyse the data depicted in
the financial statement.
The financial manager has certain analytical tools which help in financial
analysis and planning. One of the main tool is Ratio Analysis. Let us discuss
the Ratio Analysis.
FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.3

3.2 RATIOS AND RATIO ANALYSIS

Let us first understand the definition of ratio and meaning of ratio analysis
3.2.1 Definition of Ratio
A ratio is defined as “the indicated quotient of two mathematical
expressions and as the relationship between two or more things.” Here
ratio means financial ratio or accounting ratio which is a mathematical
expression of the relationship between accounting figures.

3.2.2 Ratio Analysis

The term financial ratio can be explained by defining how it is calculated
and what the objective of this calculation is
a. Calculation Basis (Basis of Calculation)
 A relationship expressed in mathematical terms;
 Between two individual figures or group of figures;
 Connected with each other in some logical manner; and
 Selected from financial statements of the concern
b. Objective for financial ratios is that all stakeholders (owners, investors,
lenders, employees etc.) can draw conclusions about the
 Performance (past, present and future);
 Strengths & weaknesses of a firm; and
 Can take decisions in relation to the firm.
Ratio analysis is based on the fact that a single accounting figure by itself
may not communicate any meaningful information but when expressed
relative to some other figure, it may definitely provide some significant
information.
Ratio analysis is not just comparing different numbers from the balance sheet,
income statement, and cash flow statement. It is comparing the number
against previous years, other companies, the industry, or even the economy in
general for the purpose of financial analysis.

3.2.3 Sources of Financial Data for Analysis

The sources of information for financial statement analysis are:
1. Annual Reports
 3.4
FINANCIAL MANAGEMENT

2. Interim financial statements

3. Notes to Accounts
4. Statement of cash flows
5. Business periodicals.
6. Credit and investment advisory services

3.3 TYPES OF RATIOS

Liquidity Ratios*/
Short- term Solvency
Ratios
Capital Structure Ratios

Leverage Ratios/ Long

term Solvency Ratios Coverage
Types of
Ratios Ratios Realted
Activity Ratios/
Efficiency Ratios/
Performance Ratios/
Turnover Ratios* to Sales

Related to overall Return

Profitability Ratios on Investment (Assets/
Capital Employed/ Equity)

Required for analysis

from Owner's point
of view

Related to Market/
Valuation/ Investors

Classification of Ratios
*Liquidity ratios should be examined taking relevant turnover ratios into
consideration.
3.3.1 Liquidity Ratios
The terms ‘liquidity’ and ‘short-term solvency’ are used synonymously.
FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.5

Liquidity or short-term solvency means ability of the business to pay its

short- term liabilities. Inability to pay-off short-term liabilities affects its
credibility as well as its credit rating. Continuous default on the part of the
business leads to commercial bankruptcy. Eventually such commercial
bankruptcy may lead to its sickness and dissolution. Short-term lenders and
creditors of a business are very much interested to know its state of liquidity
because of their financial stake. Both lack of sufficient liquidity and excess

Various Liquidity Ratios are:

(a) Current Ratio
(b) Quick Ratio or Acid test Ratio
(c) Cash Ratio or Absolute Liquidity Ratio
(d) Basic Defense Interval or Interval Measure Ratios
(e) Net Working Capital Ratio
liquidity is bad for the organization.
(a) Current Ratio: The Current Ratio is one of the best known measures
of short term solvency. It is the most common measure of short-term
liquidity.
The main question this ratio addresses is: "Does your business have
enough current assets to meet the payment schedule of its current debts with
a margin of safety for possible losses in current assets?"
Current Ratio = Current Assets
Current Liabilities

Where,

Current Assets = Inventories + Sundry Debtors + Cash and Bank

Balances + Receivables/ Accruals + Loans
and Advances + Disposable Investments +
Any other current assets.
Current Liabilities = Creditors for goods and services + Short-
term Loans + Bank Overdraft + Cash Credit
+ Outstanding Expenses + Provision for
Taxation + Proposed Dividend + Unclaimed
Dividend + Any other current liabilities.
 3.6
FINANCIAL MANAGEMENT

The main question this ratio addresses is: "Does your business have
enough current assets to meet the payment schedule of its current debts with
a margin of safety for possible losses in current assets?"
Interpretation
A generally acceptable current ratio is 2:1. But whether or not a specific ratio is
satisfactory depends on the nature of the business and the characteristics of its
current assets and liabilities.
(b) Quick Ratio: The Quick Ratio is sometimes called the "acid-test" ratio
and is one of the best measures of liquidity.
Quick Ratio or Acid Test Ratio = Quick Assets
Current Liabilities

Where,
Quick Assets = Current Assets  Inventories  Prepaid expenses
Current Liabilities = As mentioned under Current Ratio.
The Quick Ratio is a much more conservative measure of short-term liquidity
than the Current Ratio. It helps answer the question: "If all sales revenues
should disappear, could my business meet its current obligations with the
readily convertible quick funds on hand?"
Quick Assets consist of only cash and near cash assets. Inventories are
deducted from current assets on the belief that these are not ‘near cash
assets’ and also because in times of financial difficulty inventory may be
saleable only at liquidation value. But in a seller’s market inventories are also
near cash assets.
Interpretation
An acid-test of 1:1 is considered satisfactory unless the majority of "quick
assets" are in accounts receivable, and the pattern of accounts receivable
collection lags behind the schedule for paying current liabilities.
(c) Cash Ratio/ Absolute Liquidity Ratio: The cash ratio measures the
absolute liquidity of the business. This ratio considers only the absolute
liquidity available with the firm. This ratio is calculated as:
FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.7

Cash Ratio = Cash and Bank balances + Marketable Securities

Current Liabilities
Or,
Cash and Bankbalances + Current Investments Current Liabilities

Interpretation
The Absolute Liquidity Ratio only tests short-term liquidity in terms of cash and
marketable securities/ current investments.
(d) Basic Defense Interval/ Interval Measure:
Basic Defense Interval = Cash and Bank balances + Marketable Securities
Opearing Expenses÷No. of days (say 360)
Or
Interval Measure = Current Assets - Inventories
Daily Operating Expenses

Cost of GoodsSold+Selling Administartion and other

Daily Operating Expenses General expenses - Depreciationand othernon cash expenditure
No. of days in a year
=

Interpretation
If for some reason all the company’s revenues were to suddenly cease, the
Basic Defense Interval would help determine the number of days for which
the company can cover its cash expenses without the aid of additional
financing.
(e) Net Working Capital Ratio: Net working capital is more a measure of
cash flow than a ratio. The result of this calculation must be a positive
number. It is calculated as shown below:
Net Working Capital Ratio= Current Assets-Current Liabilities
(Excluding short-term bank borrowing)
 3.8
FINANCIAL MANAGEMENT

Interpretation
Bankers look at Net Working Capital over time to determine a company's ability
to weather financial crises. Loans are often tied to minimum working
capital requirements.

3.3.2 Long-term Solvency Ratios /Leverage Ratios

The leverage ratios may be defined as those financial ratios which measure
the long term stability and structure of the firm. These ratios indicate the
mix of funds provided by owners and lenders and assure the lenders of the
long term funds with regard to:
(i) Periodic payment of interest during the period of the loan and
(ii) Repayment of principal amount on maturity.

Leverage ratios are of two types:

1. Capital Structure Ratios
(a) Equity Ratio
(b) Debt Ratio
(c) Debt to Equity Ratio
(d) Debt to Total Assets Ratio
(e) Capital Gearing Ratio
(f) Proprietary Ratio
2. Coverage Ratios
(a) Debt-Service Coverage Ratio (DSCR)
(b) Interest Coverage Ratio
(c) Preference Dividend Coverage Ratio
(d) Fixed Charges Coverage Ratio

3.3.2.1 Capital Structure Ratios

These ratios provide an insight into the financing techniques used by a business
and focus, as a consequence, on the long-term solvency position.
FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.9

From the balance sheet one can get only the absolute fund employed and
its sources, but only capital structure ratios show the relative weight of
different sources.
Various capital structure ratios are:
(a) Equity Ratio:
Equity Ratio = Shareholders' Equity
CapitalEmployed

This ratio indicates proportion of owners’ fund to total fund invested in the
business. Traditionally, it is believed that higher the proportion of owners’ fund
lower is the degree of risk.
(b) Debt Ratio:
Debt Ratio = Total outside liabilities
Total Debt+ Net worth
Or,
Total Debt Net Assets

Debt Ratio =

Total debt or total outside liabilities includes short and long term
borrowings from financial institutions, debentures/bonds, deferred payment
arrangements for buying capital equipment, bank borrowings, public
deposits and any other interest bearing loan.
Interpretation
This ratio is used to analyse the long-term solvency of a firm.
(c) Debt to Equity Ratio:

Total Outside
Debt to Equity Ratio =
Liabilities Total Debt *
= Shareholders'Equity
Shareholders'Equity

Or,

Long- term Debt * *

= Shareholders'equity

*Not merely long-term debt.

** Sometimes only interest-bearing, long term debt is used instead of total
liabilities (exclusive of current liabilities)
 3.10
FINANCIAL MANAGEMENT

The shareholders’ equity is equity and preference share capital + post

accumulated profits (excluding fictitious assets etc).
Interpretation
A high debt to equity ratio here means less protection for creditors, a low
ratio, on the other hand, indicates a wider safety cushion (i.e., creditors feel
the owner's funds can help absorb possible losses of income and capital). This
ratio indicates the proportion of debt fund in relation to equity. This ratio is
very often referred in capital structure decision as well as in the legislation
dealing with the capital structure decisions (i.e. issue of shares and
debentures). Lenders are also very keen to know this ratio since it shows
relative weights of debt and equity. Debt equity ratio is the indicator of
firm’s financial leverage.
(d) Debt to Total Assets Ratio: This ratio measures the proportion of
total assets financed with debt and, therefore, the extent of financial
Debt to Total Assets Ratio = Total Outside Liabilities
Total Assets

Or,
= Total Debt Total Assets

leverage.
(e) Capital Gearing Ratio: In addition to debt-equity ratio, sometimes
capital gearing ratio is also calculated to show the proportion of fixed interest
(dividend) bearing capital to funds belonging to equity shareholders i.e. equity
funds or net
worth.
(Preference Share Capital + Debentures + Other Borrowedfunds)
Capital Gearing ratio
(Equity Share Capital + Reserves & Surplus - Losses)
=

(f) Proprietary Ratio:

Proprietary Ratio = Proprietary Fund

Total Assets
Proprietary fund includes Equity Share Capital + Preference Share Capital +
Reserve & Surplus. Total assets exclude fictitious assets and losses.
Interpretation
It indicates the proportion of total assets financed by shareholders.
 FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.11

3.3.2.2 Coverage Ratios

The coverage ratios measure the firm’s ability to service the fixed
liabilities. These ratios establish the relationship between fixed claims and
what is normally available out of which these claims are to be paid. The
fixed claims consist of:
(i) Interest on loans
(ii) Preference dividend
(iii) Amortisation of principal or repayment of the instalment of loans or
redemption of preference capital on maturity.
The following are important coverage ratios:
(a) Debt Service Coverage Ratio (DSCR): Lenders are interested in debt
service coverage to judge the firm’s ability to pay off current interest and
instalments.
Debt Service Coverage Ratio = Earnings available for debt services
Interest + Instalments

Earning for debt service* = Net profit (Earning after taxes) + Non-cash operating
expenses like depreciation and other amortizations + Interest +other adjustments like loss on sale of Fixed Asset etc.

*Fund from operations (or cash from operations) before interest and taxes also
can be considered as per the requirement.
Interpretation
Normally DSCR of 1.5 to 2 is satisfactory. You may note that sometimes in
both numerator and denominator lease rentals may be added.
(b) Interest Coverage Ratio: This ratio also known as “times interest earned
ratio” indicates the firm’s ability to meet interest (and other fixed-charges)
obligations. This ratio is computed as:

Earningsbeforeinterestandtaxes(EBIT) Interest
Interest Coverage Ratio =
 3.12
FINANCIAL MANAGEMENT

Interpretation
Earnings before interest and taxes are used in the numerator of this ratio
because the ability to pay interest is not affected by tax burden as interest
on debt funds is deductible expense. This ratio indicates the extent to which
earnings may fall without causing any embarrassment to the firm regarding the
payment of interest charges. A high interest coverage ratio means that an
enterprise can easily meet its interest obligations even if earnings before
interest and taxes suffer a considerable decline. A lower ratio indicates
excessive use of debt or inefficient operations.
(c) Preference Dividend Coverage Ratio: This ratio measures the ability
of a firm to pay dividend on preference shares which carry a stated rate of
return. This ratio is computed as:
Preference Dividend Coverage Ratio = Net Profit / Earning after taxes (EAT)
Preference dividend liability

Earnings after tax is considered because unlike debt on which interest is

charged on the profit of the firm, the preference dividend is treated as
appropriation of profit.
Interpretation
This ratio indicates margin of safety available to the preference shareholders. A
higher ratio is desirable from preference shareholders point of view.
Similarly Equity Dividend coverage ratio can also be calculated taking
(EAT – Pref. Dividend) and equity fund figures into consideration.
(d) Fixed Charges Coverage Ratio: This ratio shows how many times the
cash flow before interest and taxes covers all fixed financing charges.
This ratio of more than 1 is considered as safe.
EBIT+Depreciation
Fixed Charges Coverage Ratio =
Repaymentofloan
Interest+ 1-taxrate
Notes for calculating Ratios:
EBIT1.
(Earnings before interest and taxes) = PBIT (Profit before interest and taxes),
EAT (Earnings after taxes) = PAT (Profit after taxes), EBT (Earnings before taxes) = PBT (Profit before taxes)
 FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.13

Ratios
2. shall be calculated based on requirement and availability and may deviate from original formulae.
Numerator should be taken in correspondence with the denominator and vice-versa.
3.

3.3.3 Activity Ratios/ Efficiency Ratios/ Performance Ratios/ Turnover

Ratios
These ratios are employed to evaluate the efficiency with which the firm
manages and utilises its assets. For this reason, they are often called ‘Asset
management ratios’. These ratios usually indicate the frequency of sales with
respect to its assets. These assets may be capital assets or working capital or
average inventory.
Activity Ratios/ Efficiency Ratios/ Performance Ratios/ Turnover Ratios:
(a) Total Assets Turnover Ratio
(b) Fixed Assets Turnover Ratio
(c) Capital Turnover Ratio
(d) Current Assets Turnover Ratio
(e) Working Capital Turnover Ratio
(i) Inventory/ Stock Turnover Ratio
(ii) Receivables (Debtors) Turnover Ratio
(iii) Payables (Creditors) Turnover Ratio.

These ratios are usually calculated with reference to sales/cost of goods sold and
are expressed in terms of rate or times.
Asset Turnover Ratios: Based on different concepts of assets employed, it
can be expressed as follows:
(a) Total Asset Turnover Ratio: This ratio measures the efficiency with
which the firm uses its total assets. This ratio is computed as:
Total Asset Turnover Ratio = Sales / Costof GoodsSold
Total Assets
 3.14
FINANCIAL MANAGEMENT

(b) Fixed Assets Turnover Ratio: It measures the efficiency with which the
firm uses its fixed assets.
Fixed Assets Turnover Ratio = Sales / Cost of Goods Sold
Fixed Assets

Interpretation
A high fixed assets turnover ratio indicates efficient utilisation of fixed assets
in generating sales. A firm whose plant and machinery are old may show a
higher fixed assets turnover ratio than the firm which has purchased them
recently.
(c) Capital Turnover Ratio/ Net Asset Turnover Ratio:
Capital Turnover Ratio = Sales / Costof GoodsSold
Net Assets

Interpretation
This ratio indicates the firm’s ability of generating sales/ Cost of Goods Sold per
rupee of long term investment. The higher the ratio, the more efficient is
the utilisation of owner’s and long-term creditors’ funds. Net Assets
includes Net Fixed Assets and Net Current Assets (Current Assets – Current
Liabilities). Since Net Assets equals to capital employed it is also known as
Capital Turnover Ratio.
(d) Current Assets Turnover Ratio: It measures the efficiency using the
current assets by the firm.
Current Assets Turnover Ratio = Sales / Costof GoodsSold
Current Assets

(e) Working Capital Turnover Ratio:

Working Capital Turnover Ratio = Sales / Costof GoodsSold
Working Capital

Interpretation
Working Capital Turnover is further segregated into Inventory Turnover, Debtors
Turnover, and Creditors Turnover.
Note: Average of Total Assets/ Fixed Assets/ Current Assets/ Net Assets/ Working
Capita also can be taken.
(i) Inventory/ Stock Turnover Ratio: This ratio also known as stock
turnover ratio establishes the relationship between the cost of goods sold
during the
FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.15

year and average inventory held during the year. It measures the efficiency with
which a firm utilizes or manages its inventory. It is calculated as follows:

Inventory Turnover Ratio = Costof GoodsSold / Sales

Average Inventory *

*Average Inventory = OpeningStock+ClosingStock

2

In the case of inventory of raw material the inventory turnover ratio is calculated
using the following formula :
Raw Material Inventory Turnover Ratio= Raw Material Consumed
Average Raw Material Stock

Interpretation
This ratio indicates that how fast inventory is used or sold. A high ratio is good
from the view point of liquidity and vice versa. A low ratio would indicate that
inventory is not used/ sold/ lost and stays in a shelf or in the warehouse for a long
time.
(ii) Receivables (Debtors) Turnover Ratio: In case firm sells goods on
credit, the realization of sales revenue is delayed and the receivables are
created. The cash is realised from these receivables later on.
The speed with which these receivables are collected affects the liquidity
position of the firm. The debtor’s turnover ratio throws light on the collection
and credit policies of the firm. It measures the efficiency with which
management is managing its accounts receivables. It is calculated as
follows:
Receivable (Debtor) Turnover Ratio = Credit Sales
Average AccountsReceivable

Receivables (Debtors’) Velocity: Debtors’ turnover ratio indicates the average

collection period. However, the average collection period can be directly
calculated as follows:
 3.16
FINANCIAL MANAGEMENT

Receivable Velocity/ Average Collection Period = Average Accounts Receivables

Average Daily Credit Sales

Or, 12 months
= / 52 weeks / 360 days Receivable Turnover Ratio

= Credit Sales
Average Daily Credit Sales = Average Daily Credit Sales
No. of daysinyear(say 360)

Interpretation
The average collection period measures the average number of days it takes
to collect an account receivable. This ratio is also referred to as the number of
days of receivable and the number of day’s sales in receivables.
(iii) Payables Turnover Ratio: This ratio is calculated on the same lines as
receivable turnover ratio is calculated. This ratio shows the velocity of
payables payment by the firm. It is calculated as follows:
Payables Turnover Ratio = Annual Net Credit Purchases
Average Accounts Payables

A low creditor’s turnover ratio reflects liberal credit terms granted by suppliers,
while a high ratio shows that accounts are settled rapidly.
Payable Velocity/ Average payment period can be calculated using:
Average Accounts Payable Average Daily Credit Purchases
=
Or,
12months / 52 weeks / 360 days Payables Turnover Ratio

In determining the credit policy, debtor’s turnover and average collection period
provide a unique guidance.
Interpretation
The firm can compare what credit period it receives from the suppliers and
what it offers to the customers. Also it can compare the average credit period
offered to the customers in the industry to which it belongs.
FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.17

The above three ratios i.e. Inventory Turnover Ratio/ Receivables Turnover
Ratio are also relevant to examine liquidity of an organization.
Notes for calculating Ratios:
1. Only selling & distribution expenses differentiate Cost of Goods Sold
(COGS) and Cost of Sales (COS) in its absence, COGS will be equal to
sales.
2. We can consider Cost of Goods Sold/ Cost of Sales to calculate turnover
ratios eliminating profit part.
3. Average of Total Assets/ Fixed Assets/ Current Assets/ Net Assets/ Working
Capital/ also can be taken in calculating the above ratios. Infact when
average figures of total assets, net assets, capital employed, shareholders’
fund etc. are available it may be preferred to calculate ratios by using this
information.
4. Ratios shall be calculated based on requirement and availability and may
deviate from original formulae.

3.3.4 Profitability Ratios

The profitability ratios measure the profitability or the operational efficiency
of the firm. These ratios reflect the final results of business operations. They
are some of the most closely watched and widely quoted ratios.
Management attempts to maximize these ratios to maximize firm value.
The results of the firm can be evaluated in terms of its earnings with reference
to a given level of assets or sales or owner’s interest etc. Therefore, the
profitability ratios are broadly classified in four categories:
(i) Profitability Ratios related to Sales
(ii) Profitability Ratios related to overall Return on Investment
(iii) Profitability Ratios required for Analysis from Owner’s Point of View
(iv) Profitability Ratios related to Market/ Valuation/ Investors.
Profitability Ratios are as follows:
1. Profitability Ratios based on Sales
(a) Gross Profit Ratio
(b) Net Profit Ratio
(c) Operating Profit Ratio
 3.18
FINANCIAL MANAGEMENT

(d) Expenses Ratio

2. Profitability Ratios related to Overall Return on Assets/ Investments
(a) Return on Investments (ROI)
(i) Return on Assets (ROA)
(ii) Return of Capital Employed (ROCE)
(iii) Return on Equity (ROE)
3. Profitability Ratios required for Analysis from Owner’s Point of View
(a) Earnings per Share (EPS)
(b) Dividend per Share (DPS)
(c) Dividend Payout Ratio (DP)
4. Profitability Ratios related to Market/ Valuation/ Investors
(a) Price Earnings (P/E) Ratio
(b) Dividend and Earning Yield
(c) Market Value/ Book Value per Share (MVBV)
(d) Q Ratio

3.3.4.1 Profitability Ratios based on Sales

(a) Gross Profit (G.P) Ratio/ Gross Profit Margin: It measures the
percentage of each sale in rupees remaining after payment for the
Gross Profit Ratio = Gross Profit×100
Sales

goods sold.

Interpretation
Gross profit margin depends on the relationship between price/ sales, volume and
costs. A high Gross Profit Margin is a favourable sign of good management.
(b) Net Profit Ratio/ Net Profit Margin: It measures the relationship
between net profit and sales of the business. Depending on the concept of net
profit it can be calculated as:
 Net Profit Ratio = NetProfit×100 or Earningsafter taxes (EAT)×100
(i)
Sales Sales
FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.19

Pre-tax Profit Ratio = Earnings before taxes (EBT)×100

(ii)
Sales

Interpretation
Net Profit ratio finds the proportion of revenue that finds its way into
profits. A high net profit ratio will ensure positive returns of the business.
(c) Operating Profit Ratio:
Operating profit ratio is also calculated to evaluate operating performance of business.
Operating Profit Ratio = Operating Profit×100
Sales
or,
Earnings before interest and taxes (EBIT)×100
Sales

Where,
Operating Profit = Sales – Cost of Goods Sold (COGS) – Expenses
Interpretation
Operating profit ratio measures the percentage of each sale in rupees
that remains after the payment of all costs and expenses except for interest
and taxes. This ratio is followed closely by analysts because it focuses on
operating results. Operating profit is often referred to as earnings before
interest and taxes or EBIT.
(d) Expenses Ratio: Based on different concepts of expenses it can be
expresses in different variants as below:
= COGS×100
(i)Cost of Goods Sold (COGS) Ratio
Sales

(ii)Operating Expenses Ratio = Administrative exp.+ Selling & Distribution OH×100

Sales
Operating Ratio = COGS+Operating expenses ×100
(iii)
Sales
Financial Expenses Ratio = Financialexpenses *×100
(iv)
Sales

*It excludes taxes, loss due to theft, goods destroyed by fire etc.
 3.20
FINANCIAL MANAGEMENT

Administration Expenses Ratio and Selling & Distribution Expenses Ratio can
also be calculated in similar ways.
3.3.4.2 Profitability Ratios related to Overall Return on Assets/ Investments
(a) Return on Investment (ROI): ROI is the most important ratio of all. It is
the percentage of return on funds invested in the business by its owners. In
short, this ratio tells the owner whether or not all the effort put into the
business has been worthwhile. It compares earnings/ returns/ profit with the
investment in the company. The ROI is calculated as follows:
Return on Investment = Return /Profit /Earnings×100
Investment
Or,

= Return /Profit /Earnings× Sales

Sales Investment

Return /Profit /Earnings Sales

= Profitability Ratio

= Sales
Investment Turnover Ratio
Investments

So, ROI = Profitability Ratio  Investment Turnover Ratio. ROI can be

improved either by improving Profitability Ratio or Investment Turnover Ratio or
by both.
The concept of investment varies and accordingly there are three broad
categories of ROI i.e.
(i) Return on Assets (ROA),
(ii) Return on Capital Employed (ROCE) and
(iii) Return on Equity (ROE).
We should keep in mind that investment may be Total Assets or Net
Assets. Further funds employed in net assets are also known as capital
employed which is nothing but Net worth plus Debt, where Net worth is
equity shareholders’ fund. Similarly the concept of returns/ earnings/
profits may vary as per the requirement and availability of information.
FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.21

(i) Return on Assets (ROA): The profitability ratio is measured in terms

of relationship between net profits and assets employed to earn that profit.
This ratio measures the profitability of the firm in terms of assets employed in
the firm. Based on various concepts of net profit (return) and assets the
ROA may be measured as follows:
ROA= Net Profit after taxes or Net Profit after taxes or Net Profit after taxes
Average Total Assets Average Tangible Assets Average Fixed Assets

Here net profit is exclusive of interest. As Assets are also financed by lenders,
hence ROA can be calculated as:
= NetProfitafter taxes+Interest
Average Total Assets / Average Tangible Assets / AverageFixed Assets
Or,

EBIT(1- t){also known as Return on Total Assets (ROTA)}

Average Total Assets

Or,
EBIT(1- t){also known as Return on Net Assets (RONA)}
Average Net Assets

(ii) Return on Capital Employed (ROCE): It is another variation of

ROI. The ROCE is calculated as follows:
ROCE (Pre-tax) = Earnings before interest and taxes(EBIT)×100
Capital Employed

ROCE (Post-tax) = EBIT(1- t)×100

Capital Employed

Sometime it is calculated as
= Net Profit after taxes(PAT /EAT)+Interest ×100
Capital Employed

Where,
Capital Employed = Total Assets – Current Liabilities
 3.22
FINANCIAL MANAGEMENT

Or
= Fixed Assets + Working Capital
ROCE should always be higher than the rate at which the company borrows.
Intangible assets (assets which have no physical existence like goodwill,
patents and trade-marks) should be included in the capital employed. But
no fictitious asset should be included within capital employed. If information
is available then average capital employed shall be taken.
(iii) Return on Equity (ROE): Return on Equity measures the profitability of
equity funds invested in the firm. This ratio reveals how profitably of the
owners’ funds have been utilised by the firm. It also measures the
percentage return generated to equity shareholders. This ratio is
computed as:
ROE = Net Profit after taxes-Preferencedividend (if any)×100
Net worth
equity shareholders'fund

Return on equity is one of the most important indicators of a firm’s

profitability and potential growth. Companies that boast a high return on
equity with little or no debt are able to grow without large capital
expenditures, allowing the owners of the business to withdraw cash and
reinvest it elsewhere. Many investors fail to realize, however, that two
companies can have the same return on equity, yet one can be a much better
business. If return on total shareholders is calculated then Net Profit after
taxes (before preference dividend) shall be divided by total shareholders’
fund includes preference share capital.
Return on Equity using the Du Pont Model:
A finance executive at E.I. Du Pont de Nemours and Co., of Wilmington,
Delaware, created the DuPont system of financial analysis in 1919. That
system is used around the world today and serves as the basis of
components that make up return on equity.
There are various components in the calculation of return on equity using
the traditional DuPont model- the net profit margin, asset turnover, and the
equity multiplier. By examining each input individually, the sources of a
company's return on equity can be discovered and compared to its
competitors.
(i) Profitability/Net Profit Margin: The net profit margin is simply the
after-tax profit a company generates for each rupee of revenue. Net profit
margin varies across industries, making it important to compare a
potential
 FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.23

investment against its competitors. Although the general rule-of-thumb is that

a higher net profit margin is preferable, it is not uncommon for
management to purposely lower the net profit margin in a bid to attract
Profitability Profit Sales
= ÷
Net profit marginNet IncomeRevenue

higher sales.
Net profit margin is a safety cushion; the lower the margin, the less room
for error. A business with 1% margins has no room for flawed execution.
Small miscalculations on management’s part could lead to tremendous losses
with little or no warning.
(ii) Investment Turnover/Asset Turnover/Capital Turnover: The asset
turnover ratio is a measure of how effectively a company converts its
assets into sales. It is calculated as follows:
Investment Turnover/Asset Turnover/Capital Turnover
= Sales/Revenue ÷ Investment/Assets/Capital

The asset turnover ratio tends to be inversely related to the net profit margin;
i.e., the higher the net profit margin, the lower the asset turnover. The
result is that the investor can compare companies using different models
(low-profit, high- volume vs. high-profit, low-volume) and determine which
one is the more attractive business.
(iii) Equity Multiplier: It is possible for a company with terrible sales and
margins to take on excessive debt and artificially increase its return on equity.
The equity multiplier, a measure of financial leverage, allows the investor to
see what portion of the return on equity is the result of debt. The equity
multiplier is calculated as follows:
Equity Multiplier = Investment /Assets /Capital ÷ Shareholders’ Equity

Calculation of Return on Equity

To calculate the return on equity using the DuPont model, simply multiply
the three components (net profit margin, asset turnover, and equity
turn on Equity= (Profitability/Net profit margin) (Investment Turnover / Asset Turnover / Capital Turnover) Equity Multiplie

multiplier.)
Example: XYZ Company’s details are as under:
 3.24
FINANCIAL MANAGEMENT

Revenue: `29,261; Net Income: `4,212; Assets: `27,987; Shareholders’ Equity:

`13,572. CALCULATE return on equity.
Solution
Net Profit Margin = Net Income (` 4,212) ÷ Revenue (` 29,261) = 0.14439, or
14.39% Asset Turnover = Revenue (` 29,261) ÷ Assets (` 27,987) =
1.0455

Equity Multiplier = Assets (` 27,987) ÷ Shareholders’ Equity ( ` 13,572) = 2.0621

Finally, we multiply the three components together to calculate the return

on equity: (` 27,987)
Return on Equity = Net Profit Margin x Asset Turnover x Equity Multiplier
= (0.1439) x (1.0455) x (2.0621) = 0.3102, or 31.02%
Analysis: A 31.02% return on equity is good in any industry. Yet, if you
were to leave out the equity multiplier to see how much company would
earn if it were completely debt-free, you will see that the ROE drops to
15.04%. 15.04% of the return on equity was due to profit margins and
sales, while 15.96% was due to returns earned on the debt at work in the
business. If you found a company at a comparable valuation with the same
return on equity yet a higher percentage arose from internally-generated
sales, it would be more attractive.
3.3.4.3 Profitability Ratios Required for Analysis from Owner’s Point of View
(a) Earnings per Share (EPS): The profitability of a firm from the point of
view of ordinary shareholders can be measured in terms of earnings n per
share basis. This is known as Earnings per share. It is calculated as
follows:
Earnings per Share (EPS) = Netprofitavailabletoequity shareholders
Number of equity sharesoutstanding

(b) Dividend per Share (DPS): Earnings per share as stated above reflects the
profitability of a firm per share; it does not reflect how much profit is paid as
dividend and how much is retained by the business. Dividend per share ratio
indicates the amount of profit distributed to equity shareholders per share. It is
Dividend per Share (DPS) = Total Dividend paid to equity shareholders
Number of equity shares outstanding

calculated as:
(c) Dividend Payout Ratio (DP): This ratio measures the dividend paid in
relation to net earnings. It is determined to see to how much extent earnings per
share have been retained by the management for the business. It is computed as:
FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.25

Dividend payout Ratio = Dividendper equity share(DPS)

Earning per Share(EPS)

3.3.4.4 Profitability Ratios related to market/ valuation/ Investors

These ratios involve measures that consider the market value of the
company’s shares. Frequently share prices data are punched with the
accounting data to generate new set of information. These are (a) Price-
Earnings Ratio, (b) Dividend Yield, (c) Market Value/ Book Value per share,
(d) Q Ratio.
(a) Price- Earnings Ratio (P/E Ratio): The price earnings ratio indicates
the expectation of equity investors about the earnings of the firm. It relates
earnings to market price and is generally taken as a summary measure of
growth potential of an investment, risk characteristics, shareholders
orientation, corporate image and degree of liquidity. It is calculated as
Price-Earnings per Share (P/E Ratio) = Market Price per Share(MPS)
Earning per Share(EPS)

Interpretation
It indicates the payback period to the investors or prospective investors.
(b) Dividend and Earning Yield:
Dividend Yield = Dividend ±Change in share price×100
Initial share price

Sometime it is calculated as
Dividendper Share(DPS)
×100
Market Priceper Share(MPS)

Interpretation
This ratio indicates return on investment; this may be on average investment
or closing investment. Dividend (%) indicates return on paid up value of shares.
But yield (%) is the indicator of true return in which share capital is taken at its
market value. Earning Yield also can be calculated as
Earnings Yield = Earningsper Share(EPS)×100
Market Price per Share(MPS)

Also known as Earnings Price (EP) Ratio.

 3.26
FINANCIAL MANAGEMENT

(c) Market Value /Book Value per Share (MVBV): It provides evaluation
of how investors view the company’s past and future performance.
Market valueper share Averageshareprice
Book valueper =
Net worth÷No. of equity shares
share
Or,
Closingshareprice
Net worth÷No. of equity
shares
Interpretation
This ratio indicates market response of the shareholders’ investment.
Undoubtedly, higher the ratios better is the shareholders’ position in terms
of return and capital gains.
(d) Q Ratio: This ratio is proposed by James Tobin, a ratio is defined as
Market Value of equity and liabilities Estimated replacement cost of assets

Notes for calculating Ratios:

EBIT1.(Earnings before interest and taxes) = PBIT (Profit before interest and taxes),
EAT (Earnings after taxes) = PAT (Profit after taxes), EBT (Earnings before taxes) = PBT (Profit before taxes)
In absence of preference dividend PAT can be taken as earnings available to equity shareholders.
If information is available then average capital employed shall be taken while calculating ROCE.
Ratios2. shall be calculated based on requirement and availability and may deviate from original formulae.
Numerator should be taken in correspondence with the denominator and vice-versa.
3.

3.

4.
FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.27

3.4 USERS AND OBJECTIVE OF FINANCIAL

ANALYSIS:- A BIRDS EYE VIEW
Financial Statement analysis is useful to various shareholders to obtain the
derived information about the firm

S.No. Users Objectives Ratios used in

general
1. Shareholders Being owners of the  Mainly Profitability
organisation they are Ratio [In particular
interested to know Earning per share
about profitability and (EPS), Dividend
growth of the per share (DPS),
organization Price Earnings
(P/E), Dividend
Payout ratio (DP)]
2. Investors They are interested to  Profitability Ratios
know overall financial  Capital structure
health of the organisation Ratios
particularly future  Solvency Ratios
perspective of the
 Turnover Ratios
organisations.
3. Lenders They will keep an eye on  Coverage Ratios
the safety perspective of  Solvency Ratios
their money lent to the  Turnover Ratios
organisation
 Profitability Ratios
4. Creditors They are interested to  Liquidity Ratios
know liability position of  Short term
the organisation solvency Ratios/
particularly in short term. Liquidity Ratios
Creditors would like to
know whether the
organisation will be able
to pay the amount on
due date.
 3.28
FINANCIAL MANAGEMENT

5. Employees They will be interested  Liquidity Ratios

to know the overall  Long terms
financial wealth of the solvency Ratios
organisation and  Profitability Ratios
compare it with
 Return of
competitor company.
investment
6. Regulator / They will analyse the Profitability Ratios
Government financial statements to
determine taxations and
other details payable to
the government.
7. Managers:-
(a) Production They are interested to  Input output Ratio
Managers know about data  Raw material
regarding input output, consumption
production quantities etc. ratio.
(b) Sales Data related to units  Turnover ratios
Managers sold for various years, (basically
other associated figures receivable
and predicted future turnover ratio)
sales figure will be an  Expenses Ratios
area of interest for them
(c) Financial They are interested to  Profitability Ratios
Manager know various ratios for (particularly
their future predictions of related to Return
financial requirement. on investment)
 Turnover ratios
 Capital Structure
Ratios
Chief Executive/ They will try to assess  All Ratios
General the complete
Manager perspective of the
company, starting from
Sales, Finance,
Inventory, Human
resources, Production etc.
FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.29

8. Different
Industry
(a) Telecom  Ratio related to
‘call’
 Revenue and
expenses per
customer
(b) Bank  Loan to deposit
Ratios
 Operating
Finance Manager /Analyst expenses and
will calculate ratios of their income ratios
company and compare it
(c) Hotel  Room occupancy
with Industry norms.
ratio
 Bed occupancy
Ratios

 Passenger -
kilometre
 Operating cost -
per passenger
kilometre.

3.5 APPLICATION OF RATIO ANALYSIS IN

FINANCIAL DECISION MAKING
A popular technique of analysing the performance of a business concern is that
of financial ratio analysis. As a tool of financial management, they are of
crucial significance.
The importance of ratio analysis lies in the fact that it presents facts on a
comparative basis and enables drawing of inferences regarding the performance
of a firm.
Ratio analysis is relevant in assessing the performance of a firm in respect
of following aspects:
 3.30
FINANCIAL MANAGEMENT

3.5.1 Financial Ratios for Evaluating Performance

(a) Liquidity Position: With the help of ratio analysis one can draw
conclusions regarding liquidity position of a firm. The liquidity position of
a firm would be satisfactory if it is able to meet its obligations when they
become due. This ability is reflected in the liquidity ratios of a firm. The
liquidity ratios are particularly useful in credit analysis by banks and
other suppliers of short-term loans.
(b) Long-term Solvency: Ratio analysis is equally useful for assessing the
long- term financial viability of a firm. This aspect of the financial
position of a borrower is of concern to the long term creditors, security
analysts and the present and potential owners of a business.
The long term solvency is measured by the leverage/capital structure and
profitability ratios which focus on earning power and operating efficiency.
The leverage ratios, for instance, will indicate whether a firm has a
reasonable proportion of various sources of finance or whether heavily
loaded with debt in which case its solvency is exposed to serious
strain.
Similarly, the various profitability ratios would reveal whether or not the
firm is able to offer adequate return to its owners consistent with the risk
involved.
(c) Operating Efficiency: Ratio analysis throws light on the degree of efficiency
in the management and utilisation of its assets.
The various activity ratios measure this kind of operational efficiency. In
fact, the solvency of a firm is, in the ultimate analysis, dependent upon the
sales revenues generated by the use of its assets – total as well as its
components.
(d) Overall Profitability: Unlike the outside parties which are interested in
one aspect of the financial position of a firm, the management is
constantly concerned about the overall profitability of the enterprise. That
is, they are concerned about the ability of the firm to meet its short-term
as well as long- term obligations to its creditors, to ensure a reasonable
return to its owners and secure optimum utilisation of the assets of the
firm. This is possible if an integrated view is taken and all the ratios
are considered together.
(e) Inter-firm Comparison: Ratio analysis not only throws light on the
financial position of a firm but also serves as a stepping stone to remedial
measures. This is made possible due to inter-firm comparison/comparison
with industry averages.
FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.31

A single figure of particular ratio is meaningless unless it is related to

some standard or norm. One of the popular techniques is to compare the
ratios of a firm with the industry average. It should be reasonably
expected that the performance of a firm should be in broad conformity
with that of the industry to which it belongs.
An inter-firm comparison would demonstrate the relative position vis-a-vis
its competitors. If the results are at variance either with the industry
average or with those of the competitors, the firm can seek to identify
the probable reasons and, in the light, take remedial measures.
Ratios not only perform post mortem of operations, but also serve as
barometer for future. Ratios have predictor value and they are very helpful
in forecasting and planning the business activities for a future. It helps
in budgeting.
Conclusions are drawn on the basis of the analysis obtained by using
ratio analysis. The decisions affected may be whether to supply goods on
credit to a concern, whether bank loans will be made available, etc.
(f) Financial Ratios for Budgeting: In this field ratios are able to provide a
great deal of assistance. Budget is only an estimate of future activity
based on past experience, in the making of which the relationship between
different spheres of activities are invaluable.
It is usually possible to estimate budgeted figures using financial ratios.
Ratios also can be made use of for measuring actual performance with
budgeted estimates. They indicate directions in which adjustments should be
made either in the budget or in performance to bring them closer to each
other.

3.6 LIMITATIONS OF FINANCIAL RATIOS

The limitations of financial ratios are listed below:
(i) Diversified product lines: Many businesses operate a large number of
divisions in quite different industries. In such cases ratios calculated on
the basis of aggregate data cannot be used for inter-firm comparisons.
(ii) Financial data are badly distorted by inflation: Historical cost values
may be substantially different from true values. Such distortions of
financial data are also carried in the financial ratios.
(iii) Seasonal factors :It may also influence financial data.
 3.32
FINANCIAL MANAGEMENT

Example: A company deals in cotton garments. It keeps a high

inventory during October - January every year. For the rest of the year its
inventory level becomes just 1/4th of the seasonal inventory level.
So liquidity ratios and inventory ratios will produce biased picture. Year end
picture may not be the average picture of the business. Sometimes it is
suggested to take monthly average inventory data instead of year end data to
eliminate seasonal factors. But for external users it is difficult to get monthly
inventory figures. (Even in some cases monthly inventory figures may not
be available).
(iv) To give a good shape to the popularly used financial ratios (like current
ratio, debt- equity ratios, etc.): The business may make some year-
end adjustments. Such window dressing can change the character of financial
ratios which would be different had there been no such change.
(v) Differences in accounting policies and accounting period: It can make the
accounting data of two firms non-comparable as also the accounting
ratios.
(vi) No standard set of ratios against which a firm’s ratios can be compared:
Sometimes a firm’s ratios are compared with the industry average. But if a
firm desires to be above the average, then industry average becomes a
low standard. On the other hand, for a below average firm, industry
averages become too high a standard to achieve.
(vii) Difficulty to generalise whether a particular ratio is good or bad: For
example, a low current ratio may be said ‘bad’ from the point of view
of low liquidity, but a high current ratio may not be ‘good’ as this may
result from inefficient working capital management.
(viii) Financial ratios are inter-related, not independent: Viewed in isolation one
ratio may highlight efficiency. But when considered as a set of ratios they
may speak differently. Such interdependence among the ratios can be
taken care of through multivariate analysis.
Financial ratios provide clues but not conclusions. These are tools only in
the hands of experts because there is no standard ready-made
interpretation of financial ratios.

3.7 FINANCIAL ANALYSIS

It may be of two types: - Horizontal and vertical:
Horizontal Analysis: When financial statement of one year are analysed
and interpreted after comparing with another year or years, it is known as
horizontal
FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.33

analysis. It can be based on the ratios derived from the financial information
over the same time span.
Vertical Analysis: When financial statement of single year is analyzed then it
is called vertical analysis. This analysis is useful in inter firm comparison.
Every item of Profit and loss account is expressed as a percentage of gross
sales, while every item on a balance sheet is expressed as a percentage of
total assets held by the firm.

3.8 SUMMARY OF RATIOS

Another way of categorizing the ratios is being shown to you in a tabular
form. A summary of the ratios has been tabulated as under:

Ratio Formulae Interpretation

Liquidity Ratio
Current Ratio Current Assets A simple measure that
CurrentLiabilities estimates whether the
business can pay short
term debts.
Quick Ratio Quick Assets It measures the ability to
CurrentLiabilities meet current debt
immediately. Ideal ratio is
1
Cash Ratio CashandBank balances + It measures absolute
 
Marketable Securities liquidity of the business.
 
Current Liabilities
Basic Defense CashandBankbalances + It measures the ability of
 
Interval Ratio Marketable Securities the business to meet
 
Opearing Expenses÷No. of days regular cash expenditures.

Net Working Current Assets – Current It is a measure of cash

Capital Ratio Liabilities flow to determine the
ability of business to
survive financial crisis.
Capital Structure Ratio
Equity Ratio Shareholders' Equity It indicates owner’s fund
CapitalEmployed in companies to total
fund invested.
 3.34
FINANCIAL MANAGEMENT

Debt Ratio Totaloutsideliabilities It is an indicator of use of

TotalDebt+Net worth outside funds.
Debt to equity TotalOutsideLiabilities It indicates the
Ratio Shareholders'Equity composition of capital
structure in terms of
debt and equity.
Debt to Total TotalOutsideLiabilities It measures how much
Assets Ratio TotalAssets of total assets is
financed by the debt.
Capital Gearing Preference Share Capital +Debentures  It shows the proportion
Ratio + OtherBorrowedfunds of fixed interest
 
 Equity Share Capital +  bearing capital to equity
Reserves & Surplus - Losses  shareholders’ fund. It also
  signifies the advantage of
financial leverage to the
equity shareholder.
Proprietary Ratio Proprietary Fund It measures the
Total Assets proportion of total assets
financed by
shareholders.
Coverage Ratios
Debt Service Earningsavailablefor debtservices It measures the ability
Coverage Ratio Interest+Instalments to meet the
(DSCR) commitment of various
debt services like
interest, instalment etc.
Ideal ratio is 2.
Interest EBIT It measures the ability of
Coverage Ratio Interest the business to meet
interest obligations. Ideal
ratio is > 1.
Preference NetProfit / Earning after taxes It measures the ability
Dividend (EAT) to pay the preference
Coverage Ratio Preferencedividendliability shareholders’ dividend.
Ideal ratio is > 1.
FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.35

Fixed Charges EBIT+Depreciation This ratio shows how

Coverage Ratio Re-paymentofloan many times the cash flow
Interest+
1-taxrate before interest and taxes
covers all fixed financing
charges. The ideal ratio
is > 1.
Activity Ratio/ Efficiency Ratio/ Performance Ratio/ Turnover Ratio
Total Asset Sales / Costof GoodsSold A measure of total asset
Turnover Ratio Average TotalAssets utilisation. It helps to answer
the question - What sales
are being generated by
each rupee’s worth of
assets invested in the
business?
Fixed Assets Sales / Costof GoodsSold This ratio is about fixed
Turnover Ratio Fixed Assets asset capacity. A reducing
sales or profit being
generated from each rupee
invested in fixed assets
may indicate
overcapacity or poorer-
performing equipment.
Capital Turnover Sales / Costof GoodsSold This indicates the firm’s
Ratio Net Assets ability to generate sales
per rupee of long term
investment.
Working Capital Sales / COGS It measures the efficiency
Turnover Ratio WorkingCapital of the firm to use working
capital.
Inventory COGS / Sales It measures the efficiency
Turnover Ratio AverageInventory of the firm to manage its
inventory.
Debtors Turnover Credit Sales It measures the efficiency at
Ratio Average Accounts which firm is managing its
Receivable receivables.
Receivables Average Accounts Receivables It measures the velocity of
(Debtors’) Average Daily Credit Sales collection of receivables.
Velocity
 3.36
FINANCIAL MANAGEMENT

Payables AnnualNet CreditPurchases It measures the velocity of

Turnover Ratio Average AccountsPayables payables payment.
Profitability Ratios based on Sales
Gross Profit Ratio GrossProfit This ratio tells us
Sales ×100 something about the
business's ability
consistently to control its
production costs or to
manage the margins it
makes on products it
buys and sells.
Net Profit Ratio NetProfit It measures the relationship
Sales ×100 between net profit and
sales of the business.
Operating Profit Operating Profit It measures operating
Ratio Sales ×100 performance of business.
Expenses Ratio
Cost Goods COGS It measures portion of a
(COGS) Sales ×100 particular expenses in
of Sold comparison to sales.
Ratio
Operating  Administrative exp.  
 .
Expenses Ratio  Selling & Distribution Overhead 
x100
 Sales 
 
 
Operating Ratio COGS+Operatingexpenses
Sales ×100

Financial Financialexpenses
Expenses Ratio Sales ×100

Profitability Ratios related to Overall Return on Assets/ Investments

Return on Return / Profit / Earnings It measures overall return
Investment (ROI) Investments ×100 of the business on
investment/ equity
funds/capital
employed/ assets.
FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.37

Return on Assets Net Profitafter taxes It measures net profit per

(ROA) Averagetotal assets rupee of average total
assets/ average tangible
assets/ average fixed assets.
Return on Capital EBIT It measures overall earnings
Employed ROCE ×100
CapitalEmployed (either pre-tax or post
(Pre-tax) tax) on total capital
employed.
Return on Capital EBIT(1- t) It indicates earnings
Employed ROCE ×100
CapitalEmployed available to equity
(Post-tax) shareholders in
NetProfitafter taxes-  comparison to equity
Return on Equity  
(ROE)  Preferencedividend(if any)
 shareholders’ net worth.
×100
Net worth / equity shareholders'fund

Profitability Ratios Required for Analysis from Owner’s Point of View

Earnings per Netprofitavailabletoequity shareholders EPS measures the overall
Share (EPS) Numberof equity sharesoutstanding profit generated for each
share in existence over a
particular period.
Dividend per Dividendpaidtoequity shareholders Proportion of profit
Share (DPS) Number of equity sharesoutstanding distributed per equity share.
Dividend payout Dividendper equity share It shows % of EPS paid as
Ratio (DP) Earningper Share(EPS) dividend and retained
earnings.
Profitability Ratios related to market/ valuation/ Investors
Price-Earnings MarketPriceper Share(MPS) At any time, the P/E ratio
per Share (P/E Earningper Share(EPS) is an indication of how
Ratio) highly the market "rates"
or "values" a business. A
P/E ratio is best viewed in
the context of a sector or
market average to get a
feel for relative value and
stock market pricing.
 3.38
FINANCIAL MANAGEMENT

Dividend Yield Dividend±Changeinsharepeice It measures dividend paid

Initialshareprice ×100 based on market price of
OR shares.

Dividendper Share(DPS)
×100
MarketPriceper Share(MPS)

Earnings Yield Earningsper Share(EPS) It is the relationship of

×100
MarketPriceper Share(MPS) earning per share and
market value of shares.
Market Value Market valueper share It indicates market response of
/Book Value per Book valueper share the shareholders’ investment.
Share
Q Ratio Market Valueof equity and liabilities It measures market value
Estimatedreplacement cost of of equity as well as debt
assets in comparison to all assets
at their replacement
cost.
ILLUSTRATION 1
In a meeting held at Solan towards the end of 2018, the Directors of M/s HPCL Ltd.
have taken a decision to diversify. At present HPCL Ltd. sells all finished goods from
its own warehouse. The company issued debentures on 01.01.2019 and purchased
fixed assets on the same day. The purchase prices have remained stable during the
concerned period. Following information is provided to you:
INCOME STATEMENTS

Particulars 2018 (`) 2019 (`)

Cash Sales 30,000 32,000
Credit Sales 2,70,000 3,00,000 3,42,000 3,74,000
Less: Cost of goods sold 2,36,000 2,98,000
Gross profit 64,000 76,000
Less: Operating Expenses
Warehousing 13,000 14,000
Transport 6,000 10,000
Administrative 19,000 19,000
FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.39

Selling 11,000 14,000

49,000 57,000
Net Profit 15,000 19,000
BALANCE SHEET
Assets & Liabilities 2018 (`) 2019 (`)
Fixed Assets (Net Block) - 30,000 - 40,000
Receivables 50,000 82,000
Cash at Bank 10,000 7,000
Stock 60,000 94,000
Total Current Assets (CA) 1,20,000 1,83,000
Payables 50,000 76,000
Total Current Liabilities (CL) 50,000 76,000
Working Capital (CA - CL) 70,000 1,07,000
Total Assets 1,00,000 1,47,000
Represented by:
Share Capital 75,000 75,000
Reserve and Surplus 25,000 42,000
Debentures  30,000
1,00,000 1,47,000

You are required to CALCULATE the following ratios for the years 2018 and 2019.
(i) Gross Profit Ratio
(ii) Operating Expenses to Sales Ratio.
(iii) Operating Profit Ratio
(iv) Capital Turnover Ratio
(v) Stock Turnover Ratio
(vi) Net Profit to Net Worth Ratio, and
(vii) Receivables Collection Period.
 3.40
FINANCIAL MANAGEMENT

Ratio relating to capital employed should be based on the capital at the end of the
year. Give the reasons for change in the ratios for 2 years. Assume opening stock of
` 40,000 for the year 2019. Ignore Taxation.
SOLUTION
Computation of Ratios
Ratio 2018 (`) 2019 (`)
1. Gross profit ratio 64,000 100 76,000 100
=21.3% =20.3%
(Gross profit/sales) 3,00,000 3,74,000
2. Operating expense to 49,000×100 57,000 100
=16.3% =15.2%
sales ratio (Operating exp/ 3,00,000 3,74,000
Total sales)
3. Operating profit ratio 15,000 100 19,000 100
=5% =5.08%
(Operating profit / Total sales) 3,00,000 3,74,000
4. Capital turnover ratio 3,00,000 3,74,000
3  2.54
(Sales / capital employed) 1,00,000 1,47,000
5.Stock turnover ratio (COGS 2,36,000 2,98,000
=4.72 =3.87
/ Average stock) 50,000 77,000
6. Net Profit to Networth 15,000 100 17,000 100
(Net =15% =14.5%
profit / Networth) 1,00,000 1,17,000
50,000 82,000
7.Receivables collection =67.6 days =87.5 days
period( Average receivables / 739.73 936.99
Average daily credit sales)
(Refer to working note)
Working note: 2,70,000 3,42,000
=739.73 =936.99
Average daily sales = Credit 365 365
sales / 365

Analysis: The decline in the Gross profit ratio could be either due to a
reduction in the selling price or increase in the direct expenses (since the
purchase price has remained the same). Similarly there is a decline in the ratio
of operating expenses to sales. However since operating expenses have
little bearing with sales, a decline in this ratio cannot be necessarily
interpreted as an increase in
FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.41

operational efficiency. An in-depth analysis reveals that the decline in the

warehousing and the administrative expenses has been partly set off by
an increase in the transport and the selling expenses. The operating profit
ratio has remained the same in spite of a decline in the Gross profit margin
ratio. In fact the company has not benefited at all in terms of operational
performance because of the increased sales.
The company has not been able to deploy its capital efficiently. This is indicated
by a decline in the Capital turnover from 3 to 2.5 times. In case the capital
turnover would have remained at 3 the company would have increased sales and
profits by ` 67,000 and ` 3,350 respectively.
The decline in stock turnover ratio implies that the company has increased
its investment in stock. Return on Net worth has declined indicating that
the additional capital employed has failed to increase the volume of sales
proportionately. The increase in the Average collection period indicates that
the company has become liberal in extending credit on sales. However,
there is a corresponding increase in the current assets due to such a
policy.
It appears as if the decision to expand the business has not shown the desired results.
ILLUSTRATION 2
Following is the abridged Balance Sheet of Alpha Ltd. :-

Liabilities ` Assets ` `
Share Capital 1,00,000 Land and Buildings 80,000
Profit and Loss Account 17,000 Plant and Machineries 50,000
Current Liabilities 40,000 Less: Depreciation 15,000 35,000
1,15,000
Stock 21,000
Receivables 20,000
Bank 1,000 42,000
Total 1,57,000 Total 1,57,000
With the help of the additional information furnished below, you are required to
PREPARE Trading and Profit & Loss Account and a Balance Sheet as at 31 st March,
2019:
(i) The company went in for reorganisation of capital structure, with share capital
remaining the same as follows:
 3.42
FINANCIAL MANAGEMENT

Share capital 50%

Other Shareholders’ funds 15%
5% Debentures 10%
Payables 25%
Debentures were issued on 1 April, interest being paid annually on 31st March.
st

(ii) Land and Buildings remained unchanged. Additional plant and machinery has
been bought and a further ` 5,000 depreciation written off.
(The total fixed assets then constituted 60% of total fixed and current assets.)
(iii) Working capital ratio was 8 : 5.
(iv) Quick assets ratio was 1 : 1.
(v) The receivables (four-fifth of the quick assets) to sales ratio revealed a credit
period of 2 months. There were no cash sales.
(vi) Return on net worth was 10%.
(vii) Gross profit was at the rate of 15% of selling price.
(viii) Stock turnover was eight times for the
year. Ignore Taxation.
SOLUTION

Particulars % (` )
Share capital 50% 1,00,000
Other shareholders funds 15% 30,000
5% Debentures 10% 20,000
Payables 25% 50,000
Total 100% 2,00,000

Land and Buildings

Total liabilities = Total Assets
` 2,00,000 = Total Assets
Fixed Assets = 60% of total fixed assets and current
assets
= ` 2,00,000  60/100 = ` 1,20,000
Calculation of additions to Plant & Machinery
 FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.43

`
Total fixed assets 1,20,000
Less: Land & Buildings 80,000
Plant and Machinery (after providing depreciation) 40,000
Depreciation on Machinery up to 31-3-20X8 15,000
Add: Further depreciation 5,000
Total 20,000

Current assets = Total assets – Fixed assets

= ` 2,00,000 – ` 1,20,000 = ` 80,000
Calculation of stock

Current assets - stock

Quick ratio: = Current
=1
liabilities

` 80,000 - stock
= ` 50,000 =1

` 50,000 = ` 80,000 – Stock

Stock = ` 80,000 - ` 50,000
= ` 30,000
Receivables = 4/5th of quick assets
= (` 80,000 – 30,000)
= 4/5
` 40,000
Receivables turnover ratio

Receivables
= Credit
×12Sales = 2 months
Months

40,000 ×12
= = 2 months
Credit Sales
2×credit sales = 4,80,000
Credit sales = 4,80,000/2
= ` 2,40,000
 3.44
FINANCIAL MANAGEMENT

Gross profit (15% of sales)

` 2,40,000  15/100 = ` 36,000
Return on net worth (net profit)
Net worth = ` 1,00,000 + `
30,000
= ` 1,30,000
Net profit = ` 1,30,000  10/100 = ` 13,000
Debenture interest = ` 20,000  5/100 = ` 1,000
Projected profit and loss account for the year ended 31-3-2019

To cost of goods sold 2,04,000 By sales 2,40,000

To gross profit 36,000 ________
2,40,000 2,40,000
To debenture interest 1,000 By gross profit 36,000
To administration and 22,000
other expenses
To net profit 13,000 ______
36,000 36,000
st
Projected Balance Sheet as at 31 March, 2019

Liabilities ` Assets `
Share capital 1,00,000 Fixed assets
Profit and loss A/c 30,000 Land & buildings 80,000
(17,000+13,000) Plant & machinery 60,000
5% Debentures 20,000 Less: Depreciation 20,000 40,000
Current liabilities Current assets
Stock 30,000
Trade creditors 50,000 Recivables 40,000
_ Bank 10,000 80,000
2,00,000 2,00,000
FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.45

ILLUSTRATION 3
X Co. has made plans for the next year. It is estimated that the company will
employ total assets of ` 8,00,000; 50 per cent of the assets being financed by
borrowed capital at an interest cost of 8 per cent per year. The direct costs for the
year are estimated at `4,80,000 and all other operating expenses are estimated at
` 80,000. the goods will be sold to customers at 150 per cent of the direct costs. Tax
rate is assumed to be 50 per cent.
You are required to CALCULATE: (i) net profit margin; (ii) return on assets; (iii) asset
turnover and (iv) return on owners’ equity.
SOLUTION
The net profit is calculated as follows:

Particulars ` `
Sales (150% of ` 4,80,000) 7,20,000
Direct costs 4,80,000
Gross profit 2,40,000
Operating expenses 80,000
Interest changes (8% of ` 4,00,000) 32,000 1,12,000
Profit before taxes 1,28,000
Taxes (@ 50%) 64,000
Net profit after taxes 64,000
Profit after
(i) Net profit margin = ` 64,000
taxes = ` 7,20,000 = 0.89 or 8.9%

Sales
EBIT (1 -
Net profit margin = ` 1,60,000(1-
T) = = 0.111 or 11.1%
0.5)
7,20,000
Sales

(ii) Return on assets = EBIT (1 -

`1,60,000(1- 0.5)
T) = 8,00,000 = 0.10 or 10%
Assets
Sales
(iii) Asset turnover = `
Assets = = 0.9 times
7,20,000
` 8,00,000
 3.46
FINANCIAL MANAGEMENT

NetProfitafter taxes
(iv) Return on equity = ` 64,000
= 50% of ` 8,00,000
Owners'equity

` 64,000
= ` 4,00,000 = 0.16 or 16%
ILLUSTRATION 4
ABC Company sells plumbing fixtures on terms of 2/10, net 30. Its financial
statements over the last 3 years are as follows:

Particular 2017 2018 2019

` ` `
Cash 30,000 20,000 5,000
Accounts receivable 2,00,000 2,60,000 2,90,000
Inventory 4,00,000 4,80,000 6,00,000
Net fixed assets 8,00,000 8,00,000 8,00,000
14,30,000 15,60,000 16,95,000
` ` `
Accounts payable 2,30,000 3,00,000 3,80,000
Accruals 2,00,000 2,10,000 2,25,000
Bank loan, short-term 1,00,000 1,00,000 1,40,000
Long-term debt 3,00,000 3,00,000 3,00,000
Common stock 1,00,000 1,00,000 1,00,000
Retained earnings 5,00,000 5,50,000 5,50,000
14,30,000 15,60,000 16,95,000
` ` `
Sales 40,00,000 43,00,000 38,00,000
Cost of goods sold 32,00,000 36,00,000 33,00,000
Net profit 3,00,000 2,00,000 1,00,000

ANALYSE the company’s financial condition and performance over the last 3 years.
Are there any problems?
FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.47

SOLUTION

Ratios 2017 2018 20179

Current ratio 1.19 1.25 1.20
Acid-test ratio 0.43 0.46 0.40
Average collection period 18 22 27
Inventory turnover NA* 8.2 6.1
Total debt to net worth 1.38 1.40 1.61
Long-term debt to total capitalization 0.33 0.32 0.32
Gross profit margin 0.200 0.163 0.132
Net profit margin 0.075 0.047 0.026
Asset turnover 2.80 2.76 2.24
Return on assets 0.21 0.13 0.06
Analysis: The company’s profitability has declined steadily over the period.
As only ` 50,000 is added to retained earnings, the company must be
paying substantial dividends. Receivables are growing slower, although the
average collection period is still very reasonable relative to the terms
given. Inventory turnover is slowing as well, indicating a relative buildup in
inventories. The increase in receivables and inventories, coupled with the
fact that net worth has increased very little, has resulted in the total debt-to-
worth ratio increasing to what would have to be regarded on an absolute
basis as a high level.
The current and acid-test ratios have fluctuated, but the current ratio is
not particularly inspiring. The lack of deterioration in these ratios is clouded
by the relative build up in both receivables and inventories, evidencing
deterioration in the liquidity of these two assets. Both the gross profit and net
profit margins have declined substantially. The relationship between the
two suggests that the company has reduced relative expenses in 2016 in
particular. The build-up in inventories and receivables has resulted in a
decline in the asset turnover ratio, and this, coupled with the decline in
profitability, has resulted in a sharp decrease in the return on assets ratio.
ILLUSTRATION 5
Following information are available for Navya Ltd. along with various ratio relevant to
the particulars industry it belongs to. APPRAISE your comments on strength and
weakness of Navya Ltd. comparing its ratios with the given industry norms.
 3.48
FINANCIAL MANAGEMENT

Navya Ltd.
BALANCE SHEET AS AT 31.3.2019
Liabilities Amount (`) Assets Amount (`)
Equity Share Capital 48,00,000 Fixed Assets 24,20,000
10% Debentures 9,20,0000 Cash 8,80,000
Sundry Creditors 6,60,000 Sundry debtors 11,00,000
Bills Payable 8,80,000 Stock 33,00,000
Other current Liabilities 4,40,000 -
Total 77,00,000 Total 77,00,000
STATEMENT OF PROFITABILITY
FOR THE YEAR ENDING 31.3.2019
Particulars Amount (`) Amount (`)
Sales 1,10,00,000
Less: Cost of goods sold: - -
Material 41,80,000 -
Wages 26,40,000 -
Factory Overhead 12,98,000 81,18,000
Gross Profit - 28,82,000
Less: Selling and Distribution Cost 11,00,000 -
Administrative Cost 12,28,000 23,28,000
Earnings before Interest and Taxes - 5,54,000
Less: Interest Charges - 92,000
Earning before Tax - 4,62,000
Less: Taxes & 50% - 2,31,000
Net Profit (PAT) 2,31,000
INDUSTRY NORMS
Ratios Norm
Current Assets/Current Liabilities 2.5
Sales/ debtors 8.0
Sales/ Stock 9.0
Sales/ Total Assets 2.0
FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.49

Net Profit/ Sales 3.5%

Net profit /Total Assets 7.0%
Net Profit/ Net Worth 10.5%
Total Debt/Total Assets 60.0%

SOLUTION
Ratios Navya Ltd. Industry Norms
Current Assets 52, 80, 000 2.50
1. Current =
2.67
Liabilities
19, 80, 000
1,10, 00, 000 8.00
Sales
2 Debtors =10.0
11, 00, 000
Sales 1,10, 00, 000 9.00
3. Stock =
3.33
33, 00, 000
1,10, 00, 000 2.00
4. Sales =1.43
Total Assets 77, 00, 000
Net Profit 2,31, 000 3.50%
5 Sales 1,10, 00, 000= 2.10%
Net Profit 2,31,000 7%
6. Total Assets =
3.00%
77,00,000
Net 2,31,000 10.5%
7. Profit Net =
Worth 4.81%
48,00,000
Total Debt 29, 00, 000 60%
8. =
Total Assets 37.66%
77, 00, 000
Comments:
1. The position of Navya Ltd. is better than the industry norm with
respect to Current Ratios and the Sales to Debtors Ratio.
2. However, the position of sales to stock and sales to total assets is
poor comparing to industry norm.
3. The firm also has its net profit ratios, net profit to total assets and net
profit to total worth ratio much lower than the industry norm.
4. Total debt to total assets ratio suggest that, the firm is geared at lower
level and debt are used to Asset.
 3.50
FINANCIAL MANAGEMENT

SUMMARY
 Financial Analysis and its Tools: For the purpose of obtaining the material
and relevant information necessary for ascertaining the financial strengths and
weaknesses of an enterprise, it is necessary to analyze the data depicted
in the financial statement. The financial manager has certain analytical
tools which help in financial analysis and planning. The main tools are
Ratio Analysis and Cash Flow Analysis.
 Ratio Analysis:- The ratio analysis is based on the fact that a single
accounting figure by itself may not communicate any meaningful
information but when expressed as a relative to some other figure, it may
definitely provide some significant information. Ratio analysis is not just
comparing different numbers from the balance sheet, income statement,
and cash flow statement. It is comparing the number against previous
years, other companies, the industry, or even the economy in general for
the purpose of financial analysis.
 Type of Ratios and Importance of Ratios Analysis:- The ratios can be
classified into following four broad categories:
(i) Liquidity Ratios
(ii) Capital Structure/Leverage Ratios
(iii) Activity Ratios
(iv) Profitability Ratios
 A popular technique of analyzing the performance of a business concern is
that of financial ratio analysis. As a tool of financial management, they are
of crucial significance. The importance of ratio analysis lies in the fact
that it presents facts on a comparative basis and enables drawing of
inferences regarding the performance of a firm.
 Ratio analysis is relevant in assessing the performance of a firm in respect
of following aspects:
I Liquidity Position
II Long-term Solvency
III Operating Efficiency
IV Overall Profitability
V Inter-firm Comparison
VI Financial Ratios for Supporting Budgeting

© The Institute of Chartered Accountants of India

 FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.51

TEST YOUR KNOWLEDGE

MCQs based Questions
1. Ratio of Net sales to Net working capital is a:
(a) Profitability ratio
(b) Liquidity ratio
Current ratio
Working capital turnover ratio Long-term solvency is indicated by:

2.
(a) Debt/ equity ratio
(b) ent Ratio
(c) Curr
(d) Rat (a) eratin g ratio
Op
(b)
Net(c)profit ratio
t profit b Gross profit ratio Net profit ratio
3. ntere st a nd tax to sales is:
io of ne efore i

Operating profit ratio

(d) Interest coverage ratio.
4. Observing changes in the financial variables across the years is:
(a) Vertical analysis
(b) Horizontal Analysis
(c) Peer-firm Analysis
(d) Industry Analysis.
5. The Receivable-Turnover ratio helps management to:
(a) Managing resources
(b) Managing inventory
(c) Managing customer relationship
(d) Managing working capital

© The Institute of Chartered Accountants of India

 3.52
FINANCIAL MANAGEMENT

Theoretical Questions
1. DISCUSS any three ratios computed for investment analysis.
2. DISCUSS the financial ratios for evaluating company performance on operating
efficiency and liquidity position aspects.
3. DISCUSS Stock Turnover ratio and Gearing ratio?
4. DISCUSS the composition of Return on Equity (ROE) using the DuPont model.
5. EXPLAIN briefly the limitations of Financial ratios.
6. DISCUSS DuPont Model.
Practical Problems
1. The total sales (all credit) of a firm are ` 6,40,000. It has a gross profit
margin of 15 per cent and a current ratio of 2.5. The firm’s current
liabilities are ` 96,000; inventories ` 48,000 and cash ` 16,000.
(a)DETERMINE the average inventory to be ied carrby the firm, if an
tory
turnover of 5 times is expected? (Assume a 360 day
year).
(b)DETERMINE the average collection period if the opening balance of
debtors is intended to be of ` 80,000? (Assume a 360 day year).
2. The capital structure of Beta Limited is as follows:

Equity share capital of ` 10 each 8,00,000

9% preference share capital of ` 10 each 3,00,000
11,00,000
Additional information: Profit (after tax at 35 per cent), ` 2,70,000; Depreciation,
` 60,000; Equity dividend paid, 20 per cent; Market price of equity shares, `
40. You are required to COMPUTE the following, showing the necessary
workings:
(a) Dividend yield on the equity shares
(b) Cover for the preference and equity dividends
(c) Earnings per shares
(d) Price-earnings ratio.
3. The following accounting information and financial ratios of PQR Ltd.
relate to the year ended 31st December, 2018
© The Institute of Chartered Accountants of India
 FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.53

2016
I Accounting Information:
Gross Profit 15% of Sales
Net profit 8% of
Raw materials consumed sales 20% of
Direct wages works cost 10%
Stock of raw materials of works cost 3
Stock of finished goods months’ usage
Debt collection period 6% of works cost
All sales are on credit 60 days
II Financial Ratios:
Fixed assets to sales
Fixed assets to Current assets 1:3
Current ratio 13 : 11
Long-term loans to Current 2:1
liabilities Capital to Reserves and 2:1
Surplus 1:4
If value of fixed assets as on 31st December, 2017 amounted to ` 26 lakhs,
PREPARE a summarised Profit and Loss Account of the company for the
year ended 31st December, 2018 and also the Balance Sheet as on 31st
December, 2018.
4. Ganpati Limited has furnished the following ratios and information relating
to the year ended 31st March, 2019.

Sales
` 60,00,000
Return on net worth
25%
Rate of income tax
50%
Share capital to reserves
7:3
Current ratio
2
Net profit to sales
6.25%
Inventory turnover (based on cost of goods
12
sold) Cost of goods sold
` 18,00,000
© The Institute of Chartered Accountants of India
 3.54
FINANCIAL MANAGEMENT

I nterest on debentures ` 60,000

Receivables ` 2,00,000
Payables ` 2,00,000

You are required to:

(a) CALCULATE the operating expenses for the year ended 31st March, 2019.
(b) PREPARE a balance sheet as on 31st March in the following format:
Balance Sheet as on 31st March, 2019

Liabilities ` Assets `
Share Capital Fixed Assets
Reserve and Surplus Current Assets
15% Debentures Stock
Payables Receivables
Cash

5. Using ht e following information, PREPARE this balance sheet:

Long- term de bt to net worth 0.5 to 1

Total asset turnove r 2.5 
Avera ge col lectio n period* 18 days
Invent ory tur nove r 9
Gross profit margin 10%
Acid-test ratio 1 to 1
all sales on credit.
Assume a 360-day year and

` `
Cash ____________ Notes and payables 1,00,000
Accounts receivable ____________ Long-term debt ____________
Inventory ____________ Common stock 1,00,000
Plant and equipment ____________ Retained earnings 1,00,000
Total assets ____________
Total equity liabilities and ____________

© The Institute of Chartered Accountants of India

FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.55

ANSW ERS/SOLUTIONS
Answers to the MCQs based Questions
1. (d) 2. (a) 3. (c) 4. (b) 5. (d)
Answers to the Theoretical Questions
1. Please refer paragraph 3.3.4.2
2. Please refer paragraph 3.3.4
3. Please refer paragraph 3.3.3. & 3.3.2
4. Please refer paragraph 3.3.4.2
5. Please refer paragraph 3.5
6. Please refer paragraph 3.3.4.2
Answers to the Practical Problems
1. (a) Cost of goods sold
Inventory turnover =
Average inventory

Since gross profit margin is 15 per cent, the cost of goods sold should
be 85 per cent of the sales.
Cost of goods sold = 0.85 × ` 6,40,000 = `
5,44,000. ` 5, 44,000
Thus,  =5
Average inventory
` 5,
Average inventory = 
44,000 = `1,08,800

5
Average Receivables
(b) Average collection period = ×360 days
Credit Sales

(Opening Receivables+ClosingReceivables)
Average Receivables = 2
Closing balance of receivables is found as follows:
` `
Current assets (2.5 of current liabilities) 2,40,000
Less: Inventories 48,000
Cash 16,000 64,000
 Receivables 1,76,000
© The Institute of Chartered Accountants of India
 3.56
FINANCIAL MANAGEMENT

(` 1,76,000 + ` 80,000)
Average Receivables = 2
` 2,56,000 ÷2 = ` 1,28,000
` 1,28,000
Average collection period = × 360 = 72 days
` 6, 40,000
2. (a) Dividend yield on the equity shares
Dividend per share ` 2 (= 0.20 × ` 10)
= ×100 = ×100 = 5 per cent
Market price per share ` 40

(b) Dividend coverage ratio

(i) Profit after taxes
Preference =
Dividend payable to preference shareholders
` 2,70,000
= ` 27,000 (= 0.09 × ` 3,00,000)
=10 times

(ii) Equity =
Profit after taxes - Preference share dividend
Dividend payable to equity shareholders at current rate of ` 2 per share

` 2,70,000 - `27,000
 ` 1,60,000 (80,000 shares ×=` 1.52
2) times

(c)
Earnings available to equity shareholders
Earnings per equity share =
Number of equity shares outstanding
` 2, 43,000
= = ` 3.04 per share
80,000
Market price per share ` 40
(d) Price-earning(P/E)ratio = = =13.2 times
Earnings per ` 3.04
share
3. (a) Working Notes:
(i) Calculation of Sales
= Fixed Assets
1 
Sales 3
26,00,000 1
 =  Sales =` 78,00,000
Sales 3
© The Institute of Chartered Accountants of India
FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.57

(ii) Calculation of Current Assets

Fixed Assets 13

Current Assets 11
26,00,000 13
 =  Current Assets = ` 22,00,000
Current Assets 11
(iii) Calculation of Raw Material Consumption and Direct Wages
`
Sales 78,00,000
Less: Gross Profit 11,70,000
Works Cost 66,30,000

Raw Material Consumption (20% of Works Cost) ` 13,26,000

Direct Wages (10% of Works Cost) ` 6,63,000

(iv)Calculation of Stock of Raw Materials (= 3 months usage)

= 13,26,000  3 = ` 3,31,500
12
Calculation of Stock of Finished Goods (= 6% of Works Cost)
(v)
= 30,000  6 =` 3,97,800
66,
100
(vi) Calculation of
Cu rrent Lia bilities
CurrentsAssets
2
Current Liabilitie
22,00,000
Current Liabilities
 = 2  Current Liabilities = `11,00,000

(vii)Calculation of Receivables
Average collection period = Receivables ×365
Credit Sales
Receivables
× 365 = 60  Receivables = `12,82,191.78 or `12,82,192
78,00,000

© The Institute of Chartered Accountants of India

 3.58
FINANCIAL MANAGEMENT

(viii) Calculation of Long term Loan

Long term Loan 2
Current Liabilities =1
Long term loan 2
=  Long term loan = ` 22,00,000.
11,00,000 1
(ix) Calculation of Cash Balance
`
Current assets 22,00,000
Less: Receivables
12,82,192

Raw materials stock 3,31,500

Finished goods stock 3,97,800 20,11,492
Cash balance 1,88,508
culati
(x)Cal on of Net worth
Fixed Ass ets 26,00,000
rent A 22,00,000
Cur ssets
Tot al Ass ets 48,00,000
Less : Lon g ter m Lo an 22,00,000
Current Liab ilities 11,00,000 33,00,000
Net worth 15,00,000

Net worth = Share capital + Reserves = 15,00,000

Capital 1
= =  Share
Capital Reserves and Surplus
4
1
=15,00,000 × =` 3,00,000
5
4
Reserves and Surplus =15,00,000 × = ` 12,00,000
5

© The Institute of Chartered Accountants of India

FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.59

Profit and Loss Account of PQR Ltd.

for the year ended 31st December, 2018
Particulars ` Particulars `
To Direct Materials 13,26,000 By Sales 78,00,000
To Direct Wages 6,63,000
To Works (Overhead) 46,41,000
Balancing figure
To Gross Profit c/d
(15% of Sales) 11,70,000 _
78,00,000 78,00,000
To Selling and 5,46,000 By Gross Profit 11,70,000
Distribution b/d
Expenses (Balancing
figure)
To Net Profit (8% of 6,24,000 _
Sales)
11,70,000 11,70,000
Balance Sheet of PQR
Ltd. as at 31st December
, 2018
Liab ilities ` Assets `
Share tal 3,00 ,000 Fixed Assets 26,00,000
Capi
Reser ves nd plus 12,0 0,00 0 Curren t Assets:
a Sur22,0 0,00 0 Sto
Lon g loans ck of Raw Material 3,31,500
Currterm
ent liabilities 11,0 0,00 0 Sto ck of Finished 3,97,800
Goods
Receivables 12,82,192
_ Cash 1,88,508
48,0 0,000 48,00,000

4. (a) Calculation of Operating Expenses for the year ended 31st March, 2019.
(` )
Net Profit [@ 6.25% of Sales] 3,75,000
Add: Income Tax (@ 50%) 3,75,000

© The Institute of Chartered Accountants of India

3.60
FINANCIAL MANAGEMENT

Profit Before Tax (PBT) 7,50,000

Add: Debenture Interest 60,000
Profit before interest and tax (PBIT) 8,10,000
Sales 60,00,000
Less: Cost of goods sold 18,00,000
PBIT 8,10,000 26,10,000
Operating Expenses 33,90,000

(b) Balance Sheet as on 31st March, 2019

Liabilities ` Assets `
Share Capital 10,50,000 Fixed Assets 17,00,000
Reserve and Surplus 4,50,000 Current Assets:
15% Debentures 4,00,000 Stock 1,50,000
Payables 2,00,000 Receivables 2,00,000
- - Cash 50,000
21,00,000 21,00,000
Working Notes:
(i)
Share Capital and Reserves
n net
Theworth
returis
no 25%. Therefore, the profit after tax of ould be
equivalent
` 3,75,0 to00 25% of the net worth.
25 sh
 ` 3,75,000
N
et worth  100

 Net worth ` 3,75,000×100

= = ` 15,00,000
25
The ratio of share capital to reserves is 7:3
7
Share Capital = 15,00,000   ` 10,50,000
10
3
Reserves = 15,00,000   ` 4,50,000
10
(ii) Debentures
Interest on Debentures @ 15% = ` 60,000
© The Institute of Chartered Accountants of India
FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.61

 Debentures 60,000
= = ` 4,00,000
100
15
(iii) Current Assets
Current Ratio =2
Payables = ` 2,00,000
 Current Assets = 2 Current Liabilities = 2  2,00,000 = ` 4,00,000
(iv) Fixed Assets
Liabilities `
Share capital 10,50,000
Reserves 4,50,000
Debentures 4,00,000
Payables 2,00,000
21,00,000
Less: Current Assets 4,00,000
Fixed Assets 17,00,000
(v) Composition of Current Assets
Inventory Turnover = 12
Cost of goods sold
 12
Closing stock

` 18,00,000
Closing stock = = Closing stock = ` 1,50,000
12

Composition `

Stock 1,50,000
Receivables 2,00,000
Cash (balancing figure) 50,000
Total Current Assets 4,00,000

© The Institute of Chartered Accountants of India

 3.62
FINANCIAL MANAGEMENT

Long- term debt Long- term debt

5. Net worth = 0.5 =2,00,000
Long- term debt = ` 1,00,000
Total liabilities and net worth = `
4,00,000 Total assets = ` 4,00,000
Sales= 2.5 = Sales= Sales = ` 10,00,000
Total assets 4,00,000
Cost of goods sold = (0.9) (` 10,00,000) = ` 9,00,000.
Cost of goods sold = 9,00,000 = 9= Inventory = `1,00,000
Inventory Inventory

Receivables × 360 =18 days

10,00,000
Receivables = ` 50,000

Cash + 50, 000

1, 00, 000 =1
Cash = ` 50, 000

Plant and equipment = ` 000.

2,00,
nce Sheet
Bala
` `

Cash 50,000 Notes and payables 1,00,000

Accounts receivable 50,000 Long-term debt 1,00,000
Inventory 1,00,000 Common stock 1,00,000
Plant and equipment 2,00,000 Retained earnings 1,00,000
Total assets 4,00,000 Total liabilities and 4,00,000
equity

© The Institute of Chartered Accountants of India