Ratio analysis

RATIO ANALYSIS

CHAPTER OBJECTIVES

Ratio Analysis

– Measure relationships between resources and financial flows

– Show ways in which firm’s situation deviates from• Its own past• Other firms• The industry

Ratio Analysis

The study and interpretation of the

relationships between various financial variables,

by investors or lenders.

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Ratio Analysis - SignificanceRatio Analysis - SignificanceRatio Analysis - SignificanceRatio Analysis - Significance

The discussion of ratios will include the following types of comparisons.

A single ratio by itself is not very meaningful.

• To identify aspects of a business’s performance to aid decision making

• Quantitative process – may need to be supplemented by qualitative factors to get a complete picture

• Standardize financial information for comparisons

Ratio Analysis - PurposeRatio Analysis - PurposeRatio Analysis - PurposeRatio Analysis - Purpose

• Provide the all-important early warning indications that allow us to solve our business problems before our business is destroyed by those problems.

• Enables the business owner/manager to spot trends in a business

Ratio Analysis - SignificanceRatio Analysis - SignificanceRatio Analysis - SignificanceRatio Analysis - Significance

How a Ratio is expressed?

As Percentage - such as 25% or 50% . For example if net profit is Rs.25,000/- and the sales is Rs.1,00,000/- then the net profit can be said to be 25% of the sales.

As Proportion - The above figures may be expressed in terms of the relationship between net profit to sales as 1 : 4.

As Pure Number /Times - The same can also be expressed in an alternatively way such as the sale is 4 times of the net profit or profit is 1/4th of the sales.

Ratio Analysis

Ratio Analysis

1. Liquidity – the ability of the firm to pay its way

2. Investment/shareholders – information to enable decisions to be made on the extent of the risk and the earning potential of a business investment

3. Gearing – information on the relationship between the exposure of the business to loans as opposed to share capital

4. Profitability – how effective the firm is at generating profits given sales and or its capital assets

5. Financial – the rate at which the company sells its stock and the efficiency with which it uses its assets

TERMS USED IN RATIO ANALYSIS• Current Assets• Quick Assets (Current Assets- Inventories- Prepaid

Expenses)• Absolute Liquid Assets (Cash, bank & short term

securities)• Working Capital• Receivables• Payables• Fixed Assets• Fictitious Assets• Intangible Assets

TERMS USED IN RATIO ANALYSIS

• Capital Employed• Investments• Current Liabilities• Debt• Equity• Cost of Goods Sold• Cost of Sales• Long term funds• Long term loans

Classification of RatiosBalance Sheet

RatioP&L Ratio or

Income/Revenue Statement Ratio

Balance Sheet and Profit & Loss

Ratio

Financial Ratio Operating Ratio Composite Ratio

Current RatioQuick Asset RatioDebt Equity Ratio

Gross Profit RatioOperating RatioExpense RatioNet profit RatioStock Turnover Ratio

Fixed Asset Turnover Ratio, Return on Total Resources Ratio, Return on Own Funds Ratio, Earning per Share Ratio, Debtors’ Turnover Ratio,

Format of balance sheet for ratio analysisLIABILITIES ASSETS

NET WORTH/EQUITY/OWNED FUNDSShare Capital/Partner’s Capital/Paid up Capital/ Owners FundsReserves ( General, Capital, Revaluation & Other Reserves) Credit Balance in P&L A/c

FIXED ASSETS : LAND & BUILDING, PLANT & MACHINERIES Original Value Less DepreciationNet Value or Book Value or Written down value

LONG TERM LIABILITIES/BORROWED FUNDS : Term Loans (Banks & Institutions)Debentures/Bonds, Unsecured Loans, Fixed Deposits, Other Long Term Liabilities

NON CURRENT ASSETSInvestments in quoted shares & securitiesOld stocks or old/disputed book debtsLong Term Security DepositsOther Misc. assets which are not current or fixed in nature

CURRENT LIABILTIESBank Working Capital Limits such as CC/OD/Bills/Export CreditSundry /Trade Creditors/Creditors/Bills Payable, Short duration loans or depositsExpenses payable & provisions against various items

CURRENT ASSETS : Cash & Bank Balance, Marketable/quoted Govt. or other securities, Book Debts/Sundry Debtors, Bills Receivables, Stocks & inventory (RM,SIP,FG) Stores & Spares, Advance Payment of Taxes, Prepaid expenses, Loans and Advances recoverable within 12 months

INTANGIBLE ASSETSPatent, Goodwill, Debit balance in P&L A/c, Preliminary or Preoperative expenses

Some important notes • Liabilities have Credit balance and Assets have Debit balance• Current Liabilities are those which have either become due for payment

or shall fall due for payment within 12 months from the date of Balance Sheet

• Current Assets are those which undergo change in their shape/form within 12 months. These are also called Working Capital or Gross Working Capital

• Net Worth & Long Term Liabilities are also called Long Term Sources of Funds

• Current Liabilities are known as Short Term Sources of Funds• Long Term Liabilities & Short Term Liabilities are also called Outside

Liabilities• Current Assets are Short Term Use of Funds

Some important notes

• Assets other than Current Assets are Long Term Use of Funds • Installments of Term Loan Payable in 12 months are to be taken as

Current Liability only for Calculation of Current Ratio & Quick Ratio.• Investments in Govt. Securities to be treated current only if these

are marketable and due. Investments in other securities are to be treated as Current if they are quoted. Investments in allied/associate/sister units or firms to be treated as Non-current.

• Bonus Shares as issued by capitalization of General reserves and as such do not affect the Net Worth. With Rights Issue, change takes place in Net Worth and Current Ratio.

Groups of Financial Ratios

LiquidityActivityDebtProfitability

Liquidity

Analyzing Liquidity

Liquidity refers to the solvency of the firm's overall financial position, i.e. a "liquid firm" is one that can easily meet its short-term obligations as they come due.

A second meaning includes the concept of converting an asset into cash with little or no loss in value.

1. Current Ratio : It is the relationship between the current assets and current liabilities of a concern.

Current Ratio = Current Assets/Current Liabilities

If the Current Assets and Current Liabilities of a concern are Rs.4,00,000 and Rs.2,00,000 respectively, then the Current Ratio will be : Rs.4,00,000/Rs.2,00,000 = 2 : 1

Current Ratio• Ideal level? – 2 : 1• The ideal Current Ratio preferred by Banks is 1.33 : 1• A ratio of 5 : 1 would imply the firm has Rs.5 of assets to cover

every Rs.1 in liabilities• A ratio of 0.75 : 1 would suggest the firm has only 75p in assets

available to cover every Rs.1 it owes• Too high – Might suggest that too much of its assets are tied up

in unproductive activities – too much stock, for example?• Too low - risk of not being able to pay your way

2. ACID TEST or QUICK RATIO or Liquid Ratio : It is the ratio between Quick Current Assets and Current Liabilities.

Quick Current Assets : Cash/Bank Balances + Receivables upto 12 months + Quickly realizable securities such as Govt. Securities or quickly marketable/quoted shares and Bank Fixed Deposits

Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities

(Current assets – stock-prepaid expenses) : liabilities• 1.5:1 seen as ideal• The omission of stock gives an indication of the cash the firm has in relation to its liabilities (what it owes)• A ratio of 3:1 therefore would suggest the firm has 3 times as much cash as it owes – very healthy!• A ratio of 0.5:1 would suggest the firm has twice as many liabilities as it has cash to pay for those liabilities. This might put the firm under pressure but is not in itself the end of the world!

3. ABSOLUTE LIQUIDITY TEST or Cash Ratio : It is the ratio between Absolute liquid assets and Current Liabilities.

Quick Current Assets : Cash/Bank Balances + Quickly realizable securities such as Govt. Securities or quickly marketable/quoted shares and Bank Fixed Deposits

Absolute Liquidity Ratio = Absolute Liquid Assets/Current Liabilities

(Current assets – stock-receivables) : liabilities0.5:1 seen as ideal• The omission of stock and receivables gives an indication of the cash the firm has in relation to its liabilities (what it owes)• A ratio of 3:1 therefore would suggest the firm has 6 times as much cash as it owes – very healthy!• A ratio of 0.2:1 would suggest the firm has five times as many liabilities as it has ready cash to pay for those liabilities. This might put the firm under pressure but is not in itself the end of the world!

4. NET WORKING CAPITAL : Current Assets – Current Liabilities

Example : Cash 50,000Debtors 1,00,000Inventories 1,50,000 Current Liabilities 1,00,000Total Current Assets 3,00,000

Current Ratio = > 3,00,000/1,00,000 = 3:1Quick Ratio = > 1,50,000/1,00,000 = 1.5:1Absolute Liquidity Ratio = > 50,000/1,00,000 = .5:1Net Working Capital => 300000-100000 = 200000

Analyzing Activity

Activity is a more sophisticated analysis of a firm's liquidity, evaluating the speed with which certain accounts are converted into sales or cash; also measures a firm's efficiency

Inventory Turnover (IT)

Average Collection Period (ACP)

Average Payment Period (APP)

Fixed Asset Turnover (FAT)

Total Asset Turnover (TAT)

Cost of Goods SoldIT =

Average Inventory

Accounts ReceivableACP =

Annual Sales/360

Accounts PayableAPP=

Annual Purchases/360

Sales FAT =

Net Fixed Assets

SalesTAT =

Total Assets

Five Important Activity Measures

STOCK/INVENTORY TURNOVER RATIO :

STR = COGS/ Average Stock

Average Conversion period = 365/12/52 STR

Average Inventory or Stocks = (Opening Stock + Closing Stock) -----------------------------------------

2• This ratio indicates the number of times the inventory is rotated during

the relevant accounting period• A high stock turnover might mean increased efficiency? But: dependent on

the type of business – supermarkets might have high stock turnover ratios whereas a shop selling high value musical instruments might have low stock turnover ratio• Low stock turnover could mean poor customer satisfaction if people are

not buying the goods

DEBTORS TURNOVER RATIO : This is also called Debtors Velocity or

Average Collection Period or Period of Credit given .

DTR = Net Credit Sales/ Average Receivables

Average Collection period (Debtors Days) = 365/52/12

DTRThis ratio tells about the time taken to collect money

from the debtors

ACP:• Shorter the better• Gives a measure of how long it takes the business to recover debts• Can be skewed by the degree of credit facility a firm offers

CREDITORS TURNOVER RATIO : This is also called Creditors Velocity Ratio,

which determines the creditor payment period.

CTR = Net Credit Purchase/ Average Payables

Average Payment period (Creditors Days) = 365/52/12

CTRThis ratio tells about the time available to make

payment to the creditors

APP:• Higher the better• Gives a measure of how long it takes the business to pay

its debts

ASSET TRUNOVER RATIO : Net Sales/Tangible Assets

FIXED ASSET TURNOVER RATIO : Net Sales /Fixed Assets

CURRENT ASSET TURNOVER RATIO : Net Sales / Current Assets

Asset Turnover

• Asset Turnover = Sales turnover / assets employed

• Using assets to generate profit• Asset turnover x net profit margin = ROCE

Profitability

Profitability ratios measure the overall performance of a firm and its efficiency in managing assets, liabilities, and equity.

Key Financial RatiosProfitability Ratios

Profitability ratios include• gross profit margin• operating profit margin• net profit margin• cash flow margin• return on total assets (ROA) or return on investment

(ROI)• return on equity (ROE)• cash return on assets

Key Financial RatiosProfitability Ratios

Profitability

• Gross Profit Margin = Gross profit / turnover x 100

• The higher the better• Enables the firm to assess the impact of its sales

and how much it cost to generate (produce) those sales

• A gross profit margin of 45% means that for every £1 of sales, the firm makes 45p in gross profit

Profitability

• Net Profit Margin = Net Profit / Turnover x 100• Net profit takes into account the fixed costs involved

in production – the overheads• Keeping control over fixed costs is important – could

be easy to overlook for example the amount of waste - paper, stationery, lighting, heating, water, etc.– e.g. – leaving a photocopier on overnight uses enough electricity to

make 5,300 A4 copies. (1,934,500 per year)– 1 ream = 500 copies. 1 ream = £5.00 (on average)– Total cost therefore = £19,345 per year – or 1 person’s salary

Profitability

• Operating Profit Margin = Operating Profit / Turnover x 100

Measures overall operating efficiency and incorporates all of the expenses associated with ordinary business activities

Profitability

• Return on Capital Employed (ROCE) = Profit / capital employed x 100

• Be aware that there are different interpretations of what capital employed means – see http://www.bized.ac.uk/compfact/ratios/ror3.htm for more information!

http://www.bized.ac.uk/compfact/ratios/ror3.htm

Profitability RatiosOverall Efficiency and Performance

Measures ability to translate sales into cash

Cash Flow Margin

Cash flow from operating activitiesCash flow from operating activities

Net salesNet sales


Measures overall efficiency of firm in managing investment in assets and generating profits

Return on Total Assets (ROA) or Return on Investment (ROI)

Net earningsNet earnings

Total assetsTotal assets


Measures rate of return on stockholders’ investment

Return on Equity (ROE)


Stockholders’ equityStockholders’ equity


Measures firm’s ability to generate cash from the utilization of its assets

Cash Return on Assets

Cash flow from operating activitiesCash flow from operating activities

Total assetsTotal assets

Operating RatioThais ratio establishes relationships between operating cost & net

sales. This ratio indicates the proportion that the cost of sales. Cost of sale included direct cost of good sold & as well as other

operating expenses administration, selling & distribution expenses

Operating ratio = Cost of good sold + operating expenses X 100

Net sale

= Operating cost X 100Net sale

Cost of good sold = opening stock + purchase + direct expenses – closing stock – GP

Operating expenses = administrative expenses + selling &

distribution expenses

OBJECTIVE & SIGNIFICANCE Operating ration is the test of the operational

efficiency of the business .it shows the percentage of sales that is absorbed by the cost of sales & operating expenses.

This ratio serves following objective

1. To determine whether the cost content has

increased or decreased in the figure of sales. 2. To determine which element of the cost has

gone up.

Example: Cost of good sales 6 lacOperating expenses 40,000Sales 8,20,000Sales returns 20,000 Operating Ratio = Cost of good sold + operating expenses X 100

Net Sales

= 6 lac + 40000 X 100 820000-20000

= 640000 X 100 800000 = 80%

Profitability

• The higher the better• Shows how effective the firm is in using its

capital to generate profit• A ROCE of 25% means that it uses every

Rs.1 of capital to generate 25p in profit• Partly a measure of efficiency in

organisation and use of capital

Key Financial RatiosLeverage Ratios

Leverage ratios measure the extent of a firm’s financing with debt relative to equity and its ability to cover interest and other fixed charges.

Key Financial RatiosLeverage Ratios

Leverage ratios include• Debt ratio• Long-term debt to total capitalization• Debt to equity• Times interest earned• Fixed charge coverage• Cash flow adequacy

Analyzing Debt Debt is a true "double-edged" sword as it

allows for the generation of profits with the use of other people's (creditors) money, but creates claims on earnings with a higher priority than those of the firm's owners.

Financial Leverage is a term used to describe the magnification of risk and return resulting from the use of fixed-cost financing such as debt and preferred stock.

SOLVENCY RATIOS

The term ‘solvency’ implies ability of an enterprise to meet its long-term indebtedness and thus, solvency ratios convey an enterprises ability to meet its long-term obligations. Some important solvency ratios are :

• Debt-Equity Ratio,• Interest Coverage Ratio,• Debt to Total Funds Ratio,• Fixed Asset Ratio,

Debt Equity Ratio.

The debt-equity ratio is worked out to ascertain soundness of the long-term financial policies of the firm.

The ratio ascertained as follows;

Debt-Equity Ratio = Debt (Long-Term Loans) Equity (Shareholders’ Funds)

Dept – equity ratio indicates the proportion between shareholders’ funds and the long-term borrowed funds. A higher ratio indicates a risky financial position while a lower ratio indicates safer financial position.

Objective and Significance

This ratio is sufficient to assess the soundness of long-term financial position. It also indicates the extent to which the firm depends upon outsiders for its existence

Ascertain Dept-Equity ratio;

Equity share capital 2,00,000General reserve 1,60,00010% debenture 1,50,000Current liabilities 1,00,000Preliminary expenses 10,000 Solution ;Dept-equity Ratio = Dept

Equity Dept = debentures = Rs. 1,50,000Equity= Equity Share Capital + General Reserve- preliminary Expenses = 2,00,000+1,60,000-10,000 = 3,50,000Dept-Equity ratio= 1,50,000

3,50,000 = 15:35= 3:7

Interest Coverage ratio: when a business borrows money, the lender is

interested in finding out whether the business would earn sufficient profit to pay periodically the interest charge. A ratio which expresses this is called Interest Coverage Ratio or Dept service Ratio or fixed charges cover.

This ratio is determined by dividing profit before interest by the interest charges

Interest Coverage Ratio =Net profit before interest and tax Interest on fixed (long-term) loans or

Debentures

Objective and Significance :This ratio indicates how many times the profit

covers fixed interest. It measures the margin of safety for the lenders. The higher the number, more secure the lender is in respect of his periodical interest income.

Example: The operating profit of Exe. Ltd. After charging interesr on

debentures and tax is Rs 1,00,000. The amount of interest is Rs 20,000 and the provision for tax has been made at Rs 40,000. Calculate the interest coverage ratio.

Solution: Interest Coverage Ratio = net profit before interest and tax Interest charges

= 1,60,000 20,000

DEBT TO TOTAL FUNDS RATIO

• The Debt to Total Funds Ratio is a measure for long term financial soundness.

• Debt Total Funds Ratio = Debt

Equity + Debt

• Objective and Significance:

The main purpose of the ratio is to determine the relative stock of outsiders and shareholders.

Calculate Debt to Total Funds Ratio:

9% Pref. Share Capital 10,00,000

Equity Share Capital 20,00,000

Reserves 10,00,000

10% Debentures 30,00,000

Loans From Industrial Finance corporation 20,00,000

Current liabilities 8,00,000

Debt to Total Funds Ratio = Long-term loans

Shareholders funds + Long-term loans = 30,00,000 + 20,00,000

10,00,000 + 20,00,000 + 10,00,000 + 30,00,000

+ 20,00,000

= Rs. 50,00,000 = 5 : 9 or 0.56.

Rs. 90,00,000

FIXED ASSETS RATIO

Fixed Assets Ratio = Shareholders’ funds + Long-term loans Net Fixed Assets

Objective and Significance. This ratio indicates as to what extent

fixed assets are financed out of long-term solvency.

Calculate Fixed Assets Ratio:

Share capital 2,00,000

Reserves 50,000

9% Debentures 2,00,000

Trade Creditors 75,000

Plant and Machinery 2,00,000

Land and Building 2,00,000

Furniture 50,000

Trade Debtors 60,000

Cash Balance 40,000

Bills Payable 24,000

Stock 80,000

Fixed Assets Ratio = Long-term Funds

Fixed Assets = 2,00,000 + 50,000 + 2,00,000 = 4,50,000 = 1

2,00,000 + 2,00,000 + 50,000 4,50,000

RETURN ON EQUITY Common shareholders are entittled to the residual

profit.The rate of divident is not fixed and earning may be distributed to shareholders or retained in the business.

A ROE is calculated to se the profitability of owner’s investment.

ROE indicates how well the firm has used the resources of owners.

It is a most important relationship in financial analysis.

Formula:ROE= PAI .

Net Worth Equity

Earning per share

• It is a measure for calculating the profitability of shareholder’s investment.

• EPS is calculated as;EPS=PAT/NO. OF OUTSTANDING SHARES

• EPS shows the profitability of the firm on share basis,it does’t reflect how much is paid as dividend and how much is retained in the business? But as profitability index as it is valuable.

• The higher the EPS,the more attractive will be the investment plan or vice-versa

Return on investment The term investment refer to total asset or net asset. the conventional approach of calculating ROI is to divide PAT by

investment,investment represents pool of funds,supplied by shareholders and lenders,

while pat represents residue income of shareholders. The formulae for calculating ROI is; ROI=ROTA=EBIT(1-T)/ TA OR NA

Since taxes are not controllable by management and firm’s opportunities far availing tax incentives differ,it may be more prudent to use before tax measure of ROI,thus the before tax ratios are;

ROI=ROTA=EBIT/TA OR NA

Investment/Shareholders

Key Financial RatiosMarket Ratios

Market ratios measure returns to stockholders and the value the marketplace puts on a company’s stock. Market ratios include

• earnings per common shareearnings per common share• price-to-earningsprice-to-earnings• dividend payoutdividend payout• dividend yielddividend yield

Market RatiosEarnings per Common Share

Provides the investor with a common denominator to gauge investment returns

Earnings per Common Share


Average shares outstandingAverage shares outstanding

Market RatiosPrice-to-Earnings

Relates earnings per common share to the market price at which the stock trades, expressing the “multiple” that the stock market places on a firm’s earnings

Price-to-Earnings

Market price of common stockMarket price of common stock

Earnings per shareEarnings per share

PEG Ratio

• The market is usually more concerned about the future than the present, it is always looking for some way to figure out what is going to happen in the companies future.

• PEG = (P/E) / (projected growth in earnings)

• The lower the PEG number, the less you pay for each unit of future earnings growth. So even a stock with a high P/E, but high projected earning growth may be a good value.

You have a stock with a low P/E. Since the stock has a low P/E, you start do wonder why the stock has a low P/E. Is it that the stock market does not like the stock? Or is it that the stock market has overlooked a stock that is actually fundamentally very strong and of good value?

• If the PEG ratio is big (or close to the P/E ratio), kind of stock that the stock market thinks is of not much value.

On the other hand, if the PEG ratio is small (or very small as compared to the P/E ratio, kind of fundamentally strong stock that the market has overlooked for some reason.

Market RatiosDividend Payout

Determined by the formula cash dividends per share divided by earnings per share

Dividend Payout

Dividends per shareDividends per share

Earnings per shareEarnings per share

Market RatiosDividend Yield

Shows the relationship between cash dividends and market price

Dividend Yield

Dividends per shareDividends per share

Market price of common stockMarket price of common stock

Analyzing the Data

There are five broad areas that would typically constitute a fundamental analysis of financial statements:

• Background on the firm, industry, economy, and outlook

• Short-term liquidity• Operating efficiency• Capital structure and long-term solvency• Profitability

Background: Economy, Industry, and Firm

Economic developments and the actions of competitors affect the ability of any business enterprise to perform successfully.

It is necessary to evaluate the environment in which the firm conducts business.

This process involves blending hard facts with guess and estimates.

Short-Term Liquidity

Especially important to creditors, suppliers, management, and others who are concerned with the ability of a firm to meet near-term demands for cash

Should include analysis of selected financial ratios and a comparison with industry averages

Predicts the future ability of the firm to meet prospective needs for cash

Operating Efficiency

Turnover ratios measure the operating efficiency of a firm.

The efficiency in managing a company’s accounts receivable, inventory, and accounts payable is discussed in the short-term liquidity analysis.

Capital Structure and Long-Term Solvency

Analytical process includes an evaluation of the amount and proportion of debt in a firm’s capital structure as well as the ability to service debt.

Debt financing implies risk and leverage.

Profitability

Analysis of how well the firm has performed in terms of profitability, beginning with the evaluation of several key ratios

DuPont Framework

• The DuPont framework was developed internally at DuPont around 1920.

• It provides a systematic approach to identifying general factors causing ROE to deviate from normal.

• It establishes a framework for computing financial ratios to yield more in-depth analysis of a company’s areas of strength and weakness.

The number of pennies in profits generated from

each dollar of sales

The number of dollars in sales generated by each dollar of assets

The number of dollars of assets a company is able to acquire using each dollar invested by

stockholders

$180,000

$5,700,000

$5,700,000

$5,700,000

$2,278,000

$2,278,000

$2,278,000

$1,468,000

DuPont Framework

Coleville’s ROE for 2011 is 12.3%. The ROE for 2010 would be calculated the same way.

Relating the RatiosThe Du Pont System

Helpful to complete the evaluation of a firm by considering the interrelationship among the individual ratios

Looks at how the various pieces of financial measurement work together to produce an overall return

Helps analyst see how the firm’s decisions and activities over the course of an accounting period interact to produce overall return to shareholders


The first three ratios reveal that return on investment is a product of the net profit margin and the total asset turnover.

The second three ratios show how the return on equity is the product of return on investment and financial leverage.


By reviewing this series of relationships, the analyst can identify strengths and weaknesses as well as trace potential causes of problems in the overall financial condition and performance of the firm.

Analyst can evaluate changes in condition and performance.

Evaluation can then focus on specific areas contributing to changes.

Projections and Pro Forma Statements

Pro forma financial statements are projections based on a set of assumptions regarding

• future revenues• expenses• level of investment in assets• financing methods and costs• working capital management

Projections and Pro Forma Statements

Pro forma financial statements are used primarily for long-range planning and long-term credit decisions.

Many firms have made up their own definitions of pro forma statements, which should not be confused with the pro forma statement described above.

Summary of Analysis

Analysis of any firm’s financial statements consists of a mixture of steps and pieces that interrelate and affect each other.

No one part of the analysis should be interpreted in isolation.

The last step of analysis is to integrate the separate pieces into a whole, leading to conclusions about the business enterprise.

LIABILITES ASSETS

Capital 180 Net Fixed Assets 400

Reserves 20 Inventories 150

Term Loan 300 Cash 50

Bank C/C 200 Receivables 150

Trade Creditors 50 Goodwill 50

Provisions 50

800 800

EXERCISE 1

a. What is the Net Worth : Capital + Reserve = 200b. Tangible Net Worth is : Net Worth - Goodwill = 150 c. Outside Liabilities : TL + CC + Creditors + Provisions = 600

d. Net Working Capital : C A - C L = 350 - 250 = 50 e. Current Ratio : C A / C L = 350 / 300 = 1.17 : 1f. Quick Ratio : Quick Assets / C L = 200/300 = 0.66 : 1

EXERCISE 2

LIABILITIES 2005-06 2006-07 2005-06 2006-07

Capital 300 350 Net Fixed Assets

730 750

Reserves 140 160 Security Electricity 30 30

Bank Term Loan 320 280 Investments 110 110

Bank CC (Hyp) 490 580 Raw Materials 150 170

Unsec. Long T L 150 170 S I P 20 30

Creditors (RM) 120 70 Finished Goods 140 170

Bills Payable 40 80 Cash 30 20

Expenses Payable 20 30 Receivables 310 240

Provisions 20 40 Loans/Advances

30 190

Goodwill 50 50

Total 1600 1760 1600 1760 1. Tangible Net Worth for 1st Year : ( 300 + 140) - 50 = 390

2. Current Ratio for 2nd Year : (170 + 20 + 240 + 2+ 190 ) / (580+70+80+70) 820 /800 = 1.02

3. Debt Equity Ratio for 1st Year : 320+150 / 390 = 1.21

Exercise 3.

LIABIITIES ASSETS

Equity Capital 200 Net Fixed Assets 800

Preference Capital 100 Inventory 300

Term Loan 600 Receivables 150

Bank CC (Hyp) 400 Investment In Govt. Secu.

50

Sundry Creditors 100 Preliminary Expenses 100

Total 1400 1400

1. Debt Equity Ratio will be : 600 / (200+100) = 2 : 1

2. Tangible Net Worth : Only equity Capital i.e. = 200

3. Total Outside Liabilities / Total Tangible Net Worth : (600+400+100) / 200 = 11 : 24. Current Ratio will be : (300 + 150 + 50 ) / (400 + 100 ) = 1 : 1

LIABILITIES ASSETS

Capital + Reserves 355 Net Fixed Assets 265

P & L Credit Balance 7 Cash 1

Loan From S F C 100 Receivables 125

Bank Overdraft 38 Stocks 128

Creditors 26 Prepaid Expenses 1

Provision of Tax 9 Intangible Assets 30

Proposed Dividend 15

550 550

Q. What is the Current Ratio ? Ans : (125 +128+1+30) / (38+26+9+15) : 255/88 = 2.89 : 1

Q What is the Quick Ratio ? Ans : (125+1)/ 88 = 1.43 : 11

Q. What is the Debt Equity Ratio ? Ans : LTL / Tangible NW = 100 / ( 362 – 30) = 100 / 332 = 0.30 : 1

Exercise 4.

LIABILITIES ASSETS








550 550

Q . What is the Proprietary Ratio ? Ans : (T NW / Tangible Assets) x 100 [ (362 - 30 ) / (550 – 30)] x 100 (332 / 520) x 100 = 64%

Q . What is the Net Working Capital ? Ans : C. A - C L. = 255 - 88 = 167

Q . If Net Sales is Rs.15 Lac, then What would be the Stock Turnover Ratio in Times ? Ans : Net Sales / Average Inventories/Stock 1500 / 128 = 12 times approximately

Exercise 4. contd…

LIABILITIES ASSETS








550 550

Q. What is the Debtors Velocity Ratio ? If the sales are Rs. 15 Lac.

Ans : ( Average Debtors / Net Sales) x 12 = (125 / 1500) x 12 = 1 month

Q. What is the Creditors Velocity Ratio if Purchases are Rs.10.5 Lac ? Ans : (Average Creditors / Purchases ) x 12 = (26 / 1050) x 12 = 0.3 months

Exercise 4. contd…

Exercise 5. : Profit to sales is 2% and amount of profit is say Rs.5 Lac. Then What is the amount of Sales ?

Answer : Net Profit Ratio = (Net Profit / Sales ) x 100 2 = (5 x100) /Sales Therefore Sales = 500/2 = Rs.250 Lac

Exercise 6. A Company has Net Worth of Rs.5 Lac, Term Liabilities of Rs.10 Lac. Fixed Assets worth RS.16 Lac and Current Assets are Rs.25 Lac. There is no intangible Assets or other Non Current Assets. Calculate its Net Working Capital. AnswerTotal Assets = 16 + 25 = Rs. 41 LacTotal Liabilities = NW + LTL + CL = 5 + 10+ CL = 41 Lac Current Liabilities = 41 – 15 = 26 Lac

Therefore Net Working Capital = C. A – C.L = 25 – 26 = (- )1 Lac

Exercise 7 : Current Ratio of a concern is 1 : 1. What will be the Net Working Capital ?

Answer : It suggest that the Current Assets is equal to Current Liabilities hence the NWC would be NIL

Exercise 8 : Suppose Current Ratio is 4 : 1. NWC is Rs.30,000/-. What is the amount of Current Assets ?

Answer : 4 x - 1 x = 30,000 Therefore x = 10,000 i.e. Current Liabilities is Rs.10,000 Hence Current Assets would be 4x = 4 x 10,000 = Rs.40,000/-

Exercise 9. The amount of Term Loan installment is Rs.10000/ per month, monthly average interest on TL is Rs.5000/-. If the amount of Depreciation is Rs.30,000/- p.a. and PAT is Rs.2,70,000/-. What would be the DSCR ?

DSCR = (PAT + Depr + Annual Intt.) / Annual Intt + Annual Installment = (270000 + 30000 + 60000 ) / 60000 + 120000 = 360000 / 180000 = 2

Exercise 10 : Total Liabilities of a firm is Rs.100 Lac and Current Ratio is 1.5 : 1. If Fixed Assets and Other Non Current Assets are to the tune of Rs. 70 Lac and Debt Equity Ratio being 3 : 1. What would be the Long Term Liabilities?

Ans : We can easily arrive at the amount of Current Asset being Rs. 30 Lac i.e. ( Rs. 100 L - Rs. 70 L ). If the Current Ratio is 1.5 : 1, then Current Liabilities works out to be Rs. 20 Lac. That means the aggregate of Net Worth and Long Term Liabilities would be Rs. 80 Lacs. If the Debt Equity Ratio is 3 : 1 then Debt works out to be Rs. 60 Lacs and equity Rs. 20 Lacs. Therefore the Long Term Liabilities would be Rs.60 Lac.

Exercise 11 : Current Ratio is say 1.2 : 1 . Total of balance sheet being Rs.22 Lac. The amount of Fixed Assets + Non Current Assets is Rs. 10 Lac. What would be the Current Liabilities?

Ans : When Total Assets is Rs.22 Lac then Current Assets would be 22 – 10 i.e Rs. 12 Lac. Thus we can easily arrive at the Current Liabilities figure which should be Rs. 10 Lac

THANK YOU

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Ratio analysis

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