RATIO ANALYSIS

Aditi Shanbhag 2010122 Kezia Fernandes 2010142 Nandini Chaudhury 2010149

What is Ratio Analysis? A tool used to conduct a quantitative analysis of information in a company's financial statements. Why is it used? Ratio Analysis enables to spot trends in a business and to compare its performance and condition with the average performance of similar businesses in the same industry. It enables analysts to evaluate past performance, assess current financial position, and gain insights for projecting future results.

CATEGORIES OF FINANCIAL RATIOS

A) Liquidity or short term solvency analysis: 1. Working capital position 2. Current ratio 3. Acid test or quick ratio 4. Cash ratio 5. Receivable turnover 6. Inventory turnover B) Profitability analysis 1. Return on capital employed 2. Return on equity 3. Asset turnover ratio

C) Capital Structure / Solvency analysis 1. Debt Equity ratio 2. Interest Coverage ratio

A) LIQUIDITY RATIOS
Liquidity is the ability of a firm to meet its current liabilities. It is of great importance to creditors. EgCurrent Ratio, Quick Ratio, Cash Ratio. Current Assets are the assets which can be converted into cash within a period of one year. It includes cash in hand, cash in bank, Accounts Receivable, Inventory, Prepaid Expenses, Marketable Securities, Short term investments.

Current Liabilities are liabilities which are due to be paid by the company within a period of one year. It includes Accounts payable, Short term loans.

1.WORKING CAPITAL POSITION

Net Working Capital = Current Assets Current Liabilities

2.CURRENT RATIO
Current Ratio = Current Assets/Current Liabilities

Indicates a firms ability to meet its short term liabilities on time. Current Assets= Rs 40000 & Current Liabilities =Rs.20,000 Current Ratio will be : Rs.40,000/Rs.20,000 = 2 : 1 The ideal current ratio is 2:1 i.e. Current Assets should be at least twice of its current liabilities. If current ratio is less than 2:1, it indicates lack of liquidity and shortage of working capital. If current ratio is higher than 2:1, then stock might be piling up, large amount in debtors due to inefficient debt collection policy & cash laying idle due to poor inadequate investments.

3. ACID TEST/ QUICK RATIO

Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities
Quick Current Assets= Current assets stock- prepaid expenses.

Indicates whether the firm is in a position to pay its current liabilities within a month or immediately Ideal quick ratio is said to be 1:1 The quick ratio is a more conservative and realistic than current ratio because it includes only the more liquid assets. Better test of short term financial position of a firm than the current ratio.

4. CASH RATIO
Cash Ratio= (Cash+ Short-term marketable investments)/ Current Liabilities
The cash ratio is even more conservative than the quick ratio. It measures the amount of cash & short-term marketable investments to cover current liabilities.

Problem 1
Following is the Balance Sheet of X ltd.
Liabilities Equity Share Capital 12% Preference Share capital Bank Loan P&L a/c 14% Debentures Sundry Creditors Amount Assets Amount 80,000 150,000 130,000 50,000 1,10,000 20,000 150,000 Goodwil 1,30,000 Land and Building 80,000 Machinery 110,000 Long Term Investments 50,000 Stock 35,000 Debtors

Bills Payable
Outstanding Expenses Provision For Taxation Proposed Dividends

25,000 Bills Receivable

10,000 Short Term Investments 15,000 Cash 20,000 Prepaid Expenses 625,000

40,000
10,000 30,000 5,000 625,000

 Calculate: 1. Net Working Capital 2. Current Ratio 3. Quick Ratio 4. Cash Ratio

Solution:
Current Assets Stock Debtors B/R Short Term Investments Cash Prepaid Expenses Amount 110,000 20,000 40,000 10,000 30,000 5,000 215,000 1. Net Working Capital= Current Assets Current Liabilities = 215000-105000 = Rs. 110000 Current Liabilities Sundry Creditors Bills Payable Outstanding Expenses Provision for Tax Proposed Dividends Amount 35,000 25,000 10,000 15,000 20,000 _______ 105000

2. Current Ratio= Current Assets/ Current Liabilities = 215000/105000 = 2.05:1 3. Quick Assets= Current Assets- Stock- Prepaid Expenses = 215,000- 110,000- 5,000 = Rs. 100000 Quick Ratio= Quick Assets/ Current Liabilities = 100,000/105,000 = 0.95:1

4.Cash Ratio= (Cash+ Short term investments)/ Current Liabilities = (30000+10000)/ 105,000 = 0.38:1

TURNOVER RATIOS
Measures how well the resources of the company are being utilized. Measures the rapidity with which the resources like stock, debtors, fixed assets, working capital etc. are being used to produce sales. Eg- Stock Turnover, Receivable Turnover, Fixed Asset Turnover Ratio

5. RECEIVABLES/ DEBTORS TURNOVER RATIO

Debtors Turnover Ratio= Net Credit Sales/ Average Debtors+ Average Bills Receivable (NOTE: use Net Sales if Net Credit Sales is not given)
Indicates the speed with which the amount is collected from debtors Higher the ratio, the better since it indicates the collection from debtors are more rapid. Lower Debtor turnover ratio indicates inefficient credit sales policy of the management .

 EXAMPLE:
Particulars Total Sales for the Year Amount 1,75,000

Credit Sales @ 60% of total sales

Sales Return out of credit sales Sundry Debtors: Opening Balance Closing Balance

1,05,000
5,000 8,000 12,000

Net Credit Sales= 1,05,000- 5,000= 1,00,000 Average Debtors= 8,000+ 12,000/ 2= 10,000 Debtors Turnover Ratio= 1,00,000/ 10,000= 10 Times

6. INVENTORY/ STOCK TURNOVER RATIO

Stock Turnover Ratio= Cost of Goods Sold/ Average stock
Cost of Goods Sold= Opening Stock+ Purchases - Closing Stock Average Stock = Opening Stock + Closing Stock/ 2 Indicates the efficiency in utilization of stock. It shows the number of times the stock is converted into sales during the year. Low ratio indicates that stock is lying idle in the godown for long. High Ratio indicates the stock is being utilized efficiently.

 EXAMPLE: Calculate the Stock Turnover ratio. Trading Account

Particulars Opening Stock Purchases Gross Profit Amount Particulars 1,40,000 1,00,000 68,000 1,68,000 Amount 60,000 Sales 8,000 1,68,000 Closing stock

1,00,000 Less: Sales Returns40,000

Cost of goods sold = 60,000 +1,00,000-68,000 = 92,000 Average Stock= 60,000+ 68,000/2= 64,000 Cost of goods sold = 60,000 +1,00,000-68,000 = 92,000

B) PROFITABILITY RATIOS
Profitability Ratios measure the return earned by the company during a period. It reflects a companys competitive position in the market.

Eg -Return on capital employed, Return on equity, Asset turnover ratio

1.RETURN ON CAPITAL EMPLOYED

ROCE= (NPBITD/ Capital employed)*100
NPBITD= Net profit before interest, tax and dividends Capital Employed= Equity Share Capital + Preference Share Capital + Reserves+ P&L A/C + Debentures

The higher the ratio, the more efficient is the use of capital employed.

2. RETURN ON SHAREHOLDERS EQUITY

ROE= (Net Profit after tax, interest and preference dividend/Equity Share Holders Funds)*100
Equity Share Holders Funds= Equity Share Capital + Reserves+ P&L A/C ROE is calculated to see the profitability of equity shareholders investment.

Problem 2
Following is the Balance Sheet of X Ltd
Liabilities Equity Share Capital 12% Preference Share Capital Reserves P&L a/c 15% Debentures Current Liabilities Rs 4,00,000 2,00,000 30,000 2,20,000 1,00,000 2,30,000 11,80,000 __________ 11,80,000 Assets Fixed Assets Current Assets Rs 8,00,000 3,80,000

Profit for Current Year before interest and tax= Rs. 3,55,000 Tax Rate 50% Calculate: a) ROCE b) Return on Equity Shareholders Funds

 SOLUTION: a) ROCE= (NPBIT/ Capital Employed)*100

Capital Employed= Equity Share Capital + Preference Share Capital + Reserves+ P&L A/c + Debentures Capital Employed = 4,00,000+ 2,00,000+ 30,000+ 220,000+100,000= Rs. 9,50,000 ROCE= (355,000/ 950,000)*100 = 37.37%

b) ROE= NPAT/ Equity Share holders funds Calculation of NPAT

Particulars Amount

NPBIT
Less: Interest in Debentures @ 15% on Rs. 100,000 Less: Tax@ 50%

3,55,000
15,000 3,40,000 1,70,000

NPAT
Less: Dividend on Pref. Share Capital @ 12% on Rs. 200,000 Net Profit after interest, tax and preference dividend

1,70,000
24,000 1,46,000

Equity Share Holders Funds= Equity Share Capital +Reserves+ P&L a/c = 400,000+30,000+220,000 =Rs. 6,50,000 ROE= (1,46,000/ 6,50,000)*100= 22.46%

3. ASSET TURNOVER RATIO

Asset Turnover Ratio = Revenue / Total Assets
Assets = Fixed Assets + Current Assets Indicates how efficiently the assets are being utilized High asset turnover ratio indicates that the Company is growing along with the Sales

C) SOLVENCY RATIO
Indicates the long term solvency of the firm. Long term lenders are interested to in these ratios to learn how able is the company to make timely interest payments & repay principal. Eg-Debt-Equity Ratio, Interest Coverage Ratio

1. DEBT- EQUITY RATIO

Debt Equity Ratio= Debt/ Equity OR Debt Equity Ratio= Long term Loans/ Shareholders Funds
Long Term Loans: Long-term liabilities which mature after one year like Debentures, Mortgage Loan, Bank Loan, Loan from financial institutions and Public Deposits.

Shareholders funds: Equity share capital, preference share capital, share premium, General reserve, Capital reserve, Other reserves and credit balance of P&L account.
Ratio indicates the ability of a firm to meet its long term liabilities

Debt equity ratio of 2:1 is appropriate. Higher debt equity ratio shows a risky financial position as it indicates more and more funds invested in the business are provided by long term lenders.

EXAMPLE:
Liabilities
Equity Share Capital Preference Share Capital Reserves P&L a/c Current Assets 15% Debentures Bank Loan

Rs
2,00,000 50,000 50,000 60,000 70,000 100,000 70,000 6,00,000

Assets
Fixed Assets Current Assets

Rs.
3,80,000 2,20,000

_________ 6,00,000

Long Term Debt= 1,00,000 + 70,000= 170,000 Shareholders Funds= 2,00,000+ 50,000+ 50,000+ 60,000 = 3,60,000 Debt Equity Ratio= 170,000/ 360,000= 0.47:1

2. INTEREST COVERAGE RATIO

Interest Coverage Ratio= NPBIT/ Fixed interest charges
Ratio indicates the no. of times interest charges are covered by the profits to pay interest charges.
Higher ratio implies greater safety for long term lenders. Appropriate interest coverage ratio must be 6-7 times.

 EXAMPLE: From the Following Data Calculate the Interest Coverage ratio:

Particulars
Net Profit before Interest and Tax 15% Debentures

Amount
3,60,000 2,00,000

Fixed Interest = 2,00,000*15%= 30,000

Interest Coverage Ratio= Rs. 360,000/ 30,000= 12 Times

LIMITATIONS
The homogeneity of a companys operating activities: difficult to find comparable industries Indicator of some aspect of a companys performance The use of alternative accounting methods: the difference in accounting can distort ratios, and for a meaningful comparison may involve adjustment to the financial data. Company size sometimes confers economies of scale, so the absolute amounts of net income and revenue are useful. But, ratios reduce the effect of size to enhance comparison between companies and over time.

THANK YOU!!