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RATIO ANALYSIS

Financial analysis is used primarily to gain insights into:(a) Operating problems(b) Financial problems confronting the firm

One of the major tools of financial analysis is Ratio analysis

A ratio expresses the relationship between two related variables, which is not obvious from the raw data

Liquidity ratios examine the adequacy of funds and are based as the relationship between current assets and current liabilities

Current assetsCurrent Ratio=------------ > 1.33: 1

Current liabilities

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RATIO ANALYSISContd….

A low ratio may indicate that a firm may not be able to pay its obligations on time. A high ratio may possibly a failure to properly utilise the firm’s resources.

Current assets – InventoriesAcid Test ratio = ----------------------------------

Current liabilities – Bank borrowings

This ratio concentrates on the immediately arising liabilities and the highly liquid assets that will be used to meet these obligations

A high quick ratio indicates that cash and / or receivables are excessive, both possible signs of lax management

A low quick ratio indicates the possibility of difficulties in prompt payment of bills in the near future.

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RATIO ANALYSISContd

SalesAccount receivables Turnover = -----------------------

Accounts ReceivablesA high ratio indicates a strict credit policy and aggressive

collection procedures. A lower ratio indicates a large quantity of receivables and

that perhaps the firm is experiencing difficulties in collecting its unpaid bills.

Accounts ReceivablesAverage Collection period = ---------------------------- x 365

SalesThis ratio indicates how many days it took to accumulate

the account receivables.

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RATIO ANALYSISContd

ROFITABILITY RATIOS :

Operating Profit(EBIT)

Profit margin ratio = --------------------------

Sales

This ratio indicates the overall operational efficiency of the firm to withstand adverse conditions, which may arise from several sources such as, falling prices, rising costs, and declining sales.

Goss Profit

Gross profit margin ratio = -----------------

Sales

(Gross profit = Sales – cost of Sales)

It indicates the relation between production costs and selling

price.

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RATIO ANALYSISContd

SalesAsset turn over Ratio = --------------

Total AssetsHigh ratio indicates, Increasing profits

Operating profit (EBIT)Return on Investment = ----------------------------

AssetsA high ratio indicates efficient use of the assets and

management’s skill Leverage Ratios: These are also called capital structure

ratios, indicate the long-term financial position of the firm and the relative position of debt and equity in the financial structure of the firm

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RATIO ANALYSISContd

Debt Equity Ratio: Two version of the ratio are: Term Liabilities Total outside liabilities

Debt Equity Ratio =(i) ------------------ (ii)------------------------- Tangible Net worth Tangible Net worth

Should be 3:1 upto 10 lakh & 2:1 above 10 lakhTotal outside liabilities

Debt Assets Ratio = ---------------------------------- Total Assets

A high ratio represents a great risk to creditors. A low ratio represents security to creditors.

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RATIO ANALYSISContd

Coverage Ratios indicate the relationship between debt servicing commitments and the sources for meeting task burdens

Operating income (EBIT)Interest coverage Ratio=-----------------------------

Debt interestThis ratio measures the margin of safety between the earning of

the firm and its interest liability. A high ratio means the firm can easily meet its interest burden .

A low ratio may result in financial embarrassment, when earnings decline

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RATIO ANALYSISContd

Cash flow coverage ratio:This ratio is a wider measure of the debt servicing ability as it

considers both the interest and the principal repayment obligations

Cash flow coverage ratio == Earning before Interest & tax + Depreciation

Debt interest + Repayment of loan 1 - Tax rate

The ratio can be calculated including other fixed changes like base payments and preference dividend.

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RATIO ANALYSIS Contd……Production costs Assets Sales

InterestHigh/ Low How many Adequate is it excessive

Idle ?affect

affectexplains

Selling price Asset Turnover Return ofEquity

Gross Profit explains explainsMargin

Profit Return on Earningexplains Margin explains Investment Power

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RATIO ANALYSIS Contd….

Measures ability of Management to earn:Return on Investment – a return on resourcesReturn on equity - to cover operating profits to after tax returns

for shareholderEarning power - to achieve an after tax return on resources.Uses and limitations of Ratio Analysis:These ratios might help in answering the following questions:a) Is the firm in a position to meet its current obligations ?b) What sources of long-term fund do the firm and what is the

relationship between them ? c) Is there any danger to the solvency of the firm due to excessive-

debt ?d) How effectively does the firm adequate ?e) Are the earnings of the firm adequate ?f) Do the investors consider the firm profitable enough, for the purpose

of investing in the share of the firm ?

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RATIO ANALYSIS Contd….

COMMON WINDOW DRESSING PRACTICESBalance sheet: i) Date of Balance sheet coinciding with end of season ii) Indicating Current expenses as Capital in Balance Sheet iii) Capitalisation of interest on term loans – leading to equated

annual liability iv) Preparing Balance sheet on different dates for associate

concerns.(lead to manipulation of accounts by paper entries-leads to non-detection of interlocking of funds / stocks)

v) Temporary reduction in CL ( for a day or so). Setting off current

liabilities against Current Assets. Issuing cheques in payment of current liabilities but not dispatching them( decrease in sundry creditors)

vi) Maximising collection of receivables on balance sheet date thus showing a large cash balance ( including cheques yet to be realised)

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RATIO ANALYSIS Contd….

vii) Withdrawal of intercorporate investments on Balance sheet date

viii) Delaying declaration of commencement of productionix) Revaluation of fixed assts-leading to inflating the fixed

assets value and improvement in Net worth positionProfit & Loss Account: i) Restoring to heavy billing of sales on date of Balance sheet

–leading to increase in sales, decrease in closing inventory and increases in profit

ii) Changing the method of valuation of stocksiii) Changing the method of Depreciation – particularly with

retrospective effectiv) Booking unrealised income (e.g. Export incentives) as

revenue