Accounting Ratios PDF

CHAPTER 3
FINANCIAL ANALYSIS
AND PLANNING-RATIO
ANALYSIS
LEARNING OUTCOMES
r Discuss Sources of financial data for Analysis.
r Discuss financial ratios and its Types.
r Discuss use of financial ratios to analyse the financial
statement.
r Analyse the ratios from the perspective of investors, lenders,
suppliers, managers etc. to evaluate the profitability and
financial position of an entity.
r Describe the users and objective of Financial Analysis:- A
Birds Eye View.
r Discuss Du Pont analysis.
r State the limitations of Ratio Analysis.
© The Institute of Chartered Accountants of India

3.2 FINANCIAL MANAGEMENT
CHAPTER OVERVIEW
RATIO ANALYSIS
Application of Ratio
Types of Ratio Analysis in decision
making
Liquidity Ratio/Short-
term solvency ratio Relationship of Financial
Leverages Ratio/Short- Management with other
term solvency ratios disciplines of accounting
Activity Ratio/Efficency
R a t i o / Pe r f o r m a n c e
Ratio/Turnover ratio
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. The main tools are Ratio Analysis and Cash Flow Analysis. We will first discuss
the Ratio Analysis.
3.2 RATIO AND RATIO ANALYSIS

Let us first understand the definition of ratio and meaning of ratio analysis

FINANCIAL ANALYSIS AND PLANNING-RATIO ANALYSIS 3.3
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
 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 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.
3.2.3 Sources of Financial Data for Analysis
The sources of information for financial statement analysis are:
(i) Annual Reports
(ii) Interim financial statements
(iii) Notes to Accounts
(iv) Statement of cash flows
(v) Business periodicals.
(vi) Credit and investment advisory services

3.3 TYPES OF RATIOS
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.
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 liquidity is bad for the organization.
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
(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 Assets
Current Ratio =
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.
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 to 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 Ratios: The Quick Ratio is sometimes called the “acid-test” ratio and is one
of the best measures of liquidity.
Quick Assets
Quick Ratio or Acid Test Ratio =
Current Liabilities
Where,
Quick Assets = Current Assets - Inventories
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:
Cash and Bank balances + Marketable Securities

Cash Ratio =
Current Liabiilities
Or,
Cash and Bank balances + Current Investments
Current Liabillities
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:
Cash and Bank balances + Marketable Securities

Basic Defense Interval =
Operating Expenses ÷ No.of days (say 360)
Or,
Current Assets - Inventories
Interval Measure =
Daily Operating Expenses
Daily Operating Expenses =

Cost of Goods Sold + Selling Administartion and other
Generall expenses - Depreciation and other non 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 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 borrowing)
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 Ratio /Leverage Ratio
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.
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:
Shareholders' Equity
Equity Ratio = Capital Employed
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:
Total outside liabilities

Debt Ratio =
Total Debt+Net worth
Or,
Total Debt
Debt Ratio =
Net Assets
Total debt or total outside liabilities includes short and long term borrowings from
financial institutions, debentures/bonds, deferred payment arrangements for buying
capital equipments, 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 Liabilities
Debt to Equity Ratio = Shareholders' Equity
Total Debt *
= Shareholders' Equity
or
Long- termDebt * *
= Shareholders' equity
*Not merely long-term debt.

** Sometimes only interest-bearing, long term debt is used instead of total liabilities
(exclusive of current liabilities)
The shareholders’ equity is equity and preference share capital + post accumulated
profits (excluding fictitious assets etc).

Interpretation
A high debt to equities 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 leverage.

Debt to Total Assets Ratio =
Total Assets
or,
Total Debt
=
Total Assets
(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.
Capital Gearing Ratio =
(Preference Share Capital + Debentures + OtherBorrowedfun nds)
(Equity Share Capital + Reserves & Surplus - Losse
es)
(f) Proprietary Ratio:
Proprietary Fund
Proprietary Ratio =
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.
3.3.2.2 Coverage Ratios
The coverage ratios measure the firm’s ability to service the fixed liabilities. These ra-
tios 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.
Earnings available for debt services

Debt Service Coverage Ratio =
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 operation (or cash from operation) 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:
Earnings before interest and taxes (EBIT)

Interest Coverage Ratio =
Interest
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:
Net Profit/Earning after taxes (EAT)

Preference Dividend Coverage Ratio =
Preference dividend lia ability
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 is more than 1 is
considered as safe.
EBIT+Depreciation
Fixed Charges Coverage Ratio =
Repayment of loan
Interest +
1-tax rate
Notes for calculating Ratios:

1. EBIT (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)
2. Ratios shall be calculated based on requirement and availability and may
deviate from original formulae.
3. Numerator should be taken in correspondence with the denominator and
vice-versa.
3.3.3 Activity Ratio/ Efficiency Ratio/ Performance Ratio/ Turnover Ratio
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 Ratio/ Efficiency Ratio/ Performance Ratio/ Turnover Ratio:

(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:
Sales/ Cost of Goods Sold

Total Asset Turnover Ratio =
Total Assets
(b) Fixed Assets Turnover Ratio: It measures the efficiency with which the firm uses
its fixed assets.

Fixed Assets Turnover Ratio =
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 =
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 assts
by the firm.
Current Assets Turnover Ratio = Sales/ Cost of Goods Sold

Current Assets
(e) Working Capital Turnover Ratio:
Working Capital Turnover Ratio = Sales/ Cost of Goods Sold

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 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:
Cost of Goods Sold/Sales

Inventory Turnover Ratio =
Average Inventory *
Opening Stock + Closing Stock

*Average Inventory =
2
In the case of inventory of raw material the inventory turnover ratio is calculated using
the following formula :
Raw Material Consumed

Raw Material Inventory Turnover Ratio =
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:
Credit Sales
Receivable (Debtor) Turnover Ratio =
Average Accounts Receivable
Receivables (Debtors’) Velocity: Debtors’ turnover ratio indicates the average

collection period. However, the average collection period can be directly calculated as
follows:
Average Accounts Receivables
Receivable Velocity/ Average Collection Period =
Average Daily Credit Sales
Or,
12 months/52 weeks/ 360 days
=
Receivable Turnover Ratio
Credit Sales
Average Daily Credit Sales =
No. of days in year (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:

Annual Net Credit Purchases

Payables Turnover Ratio =
Average Accounts Payables
A low creditor’s turnover ratio reflects liberal credit terms granted by supplies. 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 Purchasess
Or,
12 months/52 weeks/ 360 days
=
Payables Turnover Ratio
In determining the credit policy, debtor’s turnover and average collection period
provide a unique guideline.
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.
The above three ratios i.e. Inventory Turnover Ratio/ Receivables Turnover Ratio is also
relevant to examine liquidity of an organization.

1. Only selling & distribution expenses differentiate Cost of Goods Sold (COGS)
and Cost of Sales (COS) in absence of it, 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
Capita/ 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
(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 (MV/BV)
(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 goods sold.
Gross Profit
Gross Profit Ratio = ×100
Sales
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 Earnings after taxes (EAT)

(i) Net Profit Ratio = ×100 or ×100
Sales Sales
Earnings before taxes (EBT)

(ii) Pre-tax Profit Ratio = ×100
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
Operating Profit Ratio = ×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
(i) Cost of Goods Sold (COGS) Ratio = ×100
Sales

Administrative Selling&Distribution
+
exp. Overhead
(ii) Operating Expenses Ratio = ×100
Sales
COGS + Operating expenses

(iii) Operating Ratio = ×100
Sales
Financial expenses *
(iv) Financial Expenses Ratio = ×100
Sales
*It excludes taxes, loss due to theft, goods destroyed by fire etc.
Administration Expenses Ratio, Selling & Distribution Expenses Ratio also can 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/Profit/Earnings
Return on Investment = ×100
Investment
or
Return/Profit Earnings Sales
= ×
Sales Investment
Return/Profit/Earnings
= Profitability Ratio
Sales
Sales
(i) 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.
(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:
Net Profit after taxes Net Profit after taxes Net Profit after taxes
ROA = or or
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:
Net Profit after taxes + Interest
=
Average Total Assets/ Average Tang
gible Assets/ Average Fixed Assets
Or
EBIT(1- t)
Average Total Assets {also known as Return on Total Assets (ROTA)}
Or
EBIT(1- t)
Average Net Assets {also known as Return on Net Assets (RONA)}
(ii) Return on Capital Employed (ROCE): It is another variation of ROI.

The ROCE is calculated as follows:
Earnings before interest and taxes(EBIT)
ROCE (Pre-tax) = ×100
Capital Employed
EBIT(1- t)
ROCE (Post-tax) = ×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, 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:
Net Profit after taxes-Preference dividend (if any)
ROE = ×100
Net worth
eq
quity 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 margins vary
across industries, making it important to compare a potential 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 higher sales.
Profitability Profit Sales
= ÷
Net profit margin Net Income Revenue
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 multiplier.)
Return on Equity = (Profitability/Net profit margin) (Investment Turnover/Asset
Turnover//Capital Turnover (Equity Multiplier )
Example: XYZ Company’s details are as under:

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:
Return on Equity = Net Profit Margin × Asset Turnover × Equity Multiplier
= (0.1439) × (1.0455) × (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 number of equity shares. This is
known as Earnings per share. It is calculated as follows:
Net profit available to equity shareholders

Earnings per Share (EPS) =
Number of equity shares outstanding
(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 calculated as:
Total Dividend paid to equity shareholders

Dividend per Share (DPS) =
(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:
Dividendper equity share(DPS)

Dividend payout Ratio =
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
Market Price per Share(MPS)

Price-Earnings per Share (P/E Ratio) =
Earning per Share(EPS)

Interpretation
It indicates the payback period to the investors or prospective investors.
(b) Dividend and Earning Yield:
Dividend ± Change in share peice

Dividend Yield = ×100
Initial share price
Sometime it is calculated as
Dividend per Share (DPS)
×100
Market Price per 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 per Share(EPS)

Earnings Yield = ×100
Also known as Earnings Price (EP) Ratio.
(c) Market Value /Book Value per Share (MVBV): It provides evaluation of how
investors view the company’s past and future performance.
Market value per share Average share price
=
Book value per share Net wo
orth ÷ No.of equity shares
Or
Closing share price
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 off assets


1. EBIT (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)
2. In absence of preference dividend PAT can be taken as earnings available to
equity shareholders.
3. If information is available then average capital employed shall be taken while
calculating ROCE.
3. Ratios shall be calculated based on requirement and availability and may deviate
from original formulae.
4. Numerator should be taken in correspondence with the denominator and vice-versa.
3.4 USERS AND OBJECTIVE OF FINANCIAL ANAL-

YSIS : A BIRDS EYE VIEW
Financial Statement analysis is useful to various shareholders to obtain the derived
information about the firm
Sl.No. Users Objectives Ratios used in general
1. Shareholders Being owners of the • Mainly Profitability

organisation they are Ratio [In particular
interested to know about Earning per share
profitability and growth of (EPS), Dividend
the organization per share (DPS), 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 lended to the • Turnover Ratios
organisation • Profitability Ratios
4. Creditors They are interested to • Liquidity Ratios

know liability position • Short term solvency
of the organisation Ratios/ Liquidity Ratios
particularly in short
term. Creditors would
like to know whether the
organisation will be able
to pay the amount on due
date.
5. Employees They will be interested to • Liquidity Ratios

know the overall financial • Long terms solvency
wealth of the organisation Ratios
and compare it with • Profitability Ratios
competitor company. • Return of 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 • Input output Ratio

Managers to know various data • Raw material
regarding input output, consumption.
production quantities etc.

(b) Sales Data related to quantities • Turnover ratios

Managers of sales for various years, (basically receivable
other associated figures turnover ratio)
and produced future sales • Expenses Ratios
figure will be an area of
interest for them
(c) Financial They are interested to • Profitability Ratios

Manager know various ratios for (particularly related to
their future predictions of Return on investment)
financial requirement. • Turnover ratios
• Capital Structure
Ratios
(d) Chief They will try to find the • All Ratios

Executives/ entire perspective of the
General company, starting from
Manager Sales, Finance, Inventory,
Human resources,
Production etc.
8. Different
Industry
(a) Telecom • Ratio related to ‘call’
• Revenue and expenses
Finance Manager /Analyst per customer
(b) Bank will calculate ratios of their • Loan to deposit Ratios
company and compare it • Operating expenses
with Industry norms. and income ratios

(c) Hotel • Room occupancy 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:
3.5.1 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.
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 may also influence financial data.

Example: A company deals in summer 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) There is 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) It is very difficult 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 may be of two types: - Horizontal and vertical:
Horizontal Analysis: When financial statement of one year of are analysed and
interpreted after comparing with another year or years, it is known as horizontal
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 A simple measure that
Current Assets
estimates whether the business
Current Liabilities can pay short term debts. Ideal
Quick Ratio It measures the ability
Quick Assets
to meet current debt
Current Liabilities
immediately. Ideal ratio is 1
Cash Ratio It measures absolute liquidity
 Cash and Bank balances + of the business.
 Marketable Securities 
Current Liabilities
Basic Defense It measures the ability of the
Interval Ratio  CashandBankbalances + business to meet regular
 Marketable Securities 
cash expenditures.
Opearing Expenses ÷ No. of days
Net Working Current Assets – Current Liabilities It is a measure of cash flow

Capital Ratio to determine the ability of
business to survive financial
Capital Structure Ratio
Equity Ratio It indicates owner’s fund
Shareholders' Equity
in companies to total fund
Capital Employed
invested.
Debt Ratio It is an indicator of use of
Total outside liabilities
outside funds.
Total Debt + Net worth

Debt to equity It indicates the composition

Ratio Total Outside Liabilities of capital structure in terms
Shareholders' Equity of debt and equity.
Debt to Total It measures how much of

Assets Ratio total assets is financed by
Total Assets
the debt.
Capital Gearing It shows the proportion of
Ratio  Preference Share Capital +  fixed interest bearing capital
 Debentures+ Other Borrowed to equity shareholders’ fund.
  It also signifies the advantage
 funds 
of financial leverage to the
 Equity Share Capital + 
 Reserves & Surplus - Losses equity shareholder.
Proprietary Ratio Proprietary Fund It measures the proportion

Total Assets of total assets financed by
shareholders.
Coverage Ratios
Debt Service It measures the ability to
Earnings available for
Coverage Ratio meet the commitment of
(DSCR) debt services various debt services like
Interest + Instalments interest, instalment etc. Ideal
Interest Coverage EBIT It measures the ability of the
Ratio Interest business to meet interest.
Ideal ratio is > 1.
Preference It measures the ability to pay
NetProfit/Earning after
Dividend the preference shareholders’
Coverage Ratio taxes (EAT) dividend. Ideal ratio is > 1.
nd
Preference dividen
liability
Fixed Charges This ratio shows how many

Coverage Ratio times the cash flow before
EBIT+Depreciation
interest and taxes covers all
Re-payment of loan
Interest+ fixed financing charges. The
1-tax rate
ideal ratio is > 1.

Activity Ratio/ Efficiency Ratio/ Performance Ratio/ Turnover Ratio

Total Asset A measure of total asset
Turnover Ratio utilisation. It helps to answer
Average Total Assets
the question - What sales
are being generated by
each rupee’s worth of assets
invested in the business?
Fixed Assets This ratio is about fixed asset
Turnover Ratio capacity. A reducing sales
Fixed Assets
or profit being generated
from each rupee invested
in fixed assets may indicate
overcapacity or poorer-
performing equipment.
Capital Turnover This indicates the firm’s
Ratio ability to generate sales
Net Assets
per rupee of long term
Working Capital It measures the efficiency
Sales/ COGS
Turnover Ratio of the firm to use working
Working Capital
Inventory Turnover It measures the efficiency
COGS/Sales
Ratio of the firm to manage its
Average Inventory
inventory.
Debtors Turnover It measures the efficiency at
Credit Sales
Ratio which firm is managing its
Average Accounts Receivable
receivables.
Receivables It measures the velocity of
Average Accounts Receivables
(Debtors’) Velocity collection of receivables.
Average Daily Credit Sales
Payables Turnover It measures the velocity of
Annual Net Credit Purchases
Ratio payables payment.
Average Accounts Payables
Profitability Ratios based on Sales

Gross Profit Ratio This ratio tells us something
Gross Profit about the business’s ability
×100
Sales consistently to control
its production costs or to
manage the margins it
makes on products it buys
Net Profit Ratio Net Profit It measures the relationship

×100 between net profit and sales
Sales
of the business.
Operating Profit Operating Profit It measures operating
Ratio ×100 performance of business.
Sales
Expenses Ratio
Cost of Goods COGS
Sold (COGS) Ratio ×100
Sales
Operating
Expenses Ratio  Administrative exp.+ 
 Selling & 
  It measures portion of
 Distribution Overheads 
× 100 a particular expenses in
Sales comparison to sales.
Operating Ratio COGS + Operating expenses
×100
Sales
Financial Expenses Financial expenses
Ratio ×100
Sales
Profitability Ratios related to Overall Return on Assets/ Investments

Return on It measures overall return of
Investment (ROI) Return/Profit/Earnings the business on investment/
×100
Investments equity funds/ capital
employed/ assets.
Return on Assets It measures net profit per
Net Profit after taxes
(ROA) rupee of average total
Average total assets
assets/ average tangible
assets/ average fixed assets.
Return on Capital It measures overall earnings
EBIT
Employed ×100 (either pre-tax or post tax)
Capital Employed
on total capital employed.
ROCE (Pre-tax)

Return on Capital
EBIT(1- t)
Employed ×100
Capital Employed It indicates earnings
ROCE (Post-tax) available to equity
Return on Equity shareholders in comparison
(ROE)  NetProfitafter taxes-
 Preferencedividend  to equity shareholders’ net
  worth.
 (if any) 
×100
Net worth/ equity
shareholders' fund
Profitability Ratios Required for Analysis from Owner’s Point of View

Earnings per Share EPS measures the overall
Net profit available to
(EPS) profit generated for each
equity shareholders share in existence over a
Number of equity sharess particular period.
outstanding
Dividend per Proportion of profit

Dividend paid to equity
Share (DPS) distributed per equity
shareholders share.
Number of equity shares
anding
outsta
Dividend payout It shows % of EPS paid
Dividend per equity share
Ratio (DP) as dividend and retained
earnings.
Profitability Ratios related to market/ valuation/ Investors
Price-Earnings per At any time, the P/E ratio is
Share (P/E Ratio) an indication of how 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.

Dividend Yield It measures dividend paid

Dividend ± Change in
based on market price of
share peice shares.
×100
Initial share price
or
Dividend per Share (DPS)
×100
Earnings Yield It is the relationship of

Earnings per Share (EPS)
×100 earning per share and
market value of shares.
Market Value / It indicates market response
Market value per share
Book Value per of the shareholders’
Book value per share
Share investment.
Q Ratio It measures market value
Market Value of equity and
of equity as well as debt in
liabilities comparison to all assets at
Estimated repplacement cost their replacement cost.
of assets
ILLUSTRATION 1
In a meeting held at Solan towards the end of 2016, 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 01.01.2017 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 2016 ( ` ) 2017 ( ` )
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
Selling 11,000 49,000 14,000
2,000 59,000
Net Profit 15,000 17,000
Balance Sheet
Assets & Liabilities 2016 ` 2017 `
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 2016/2017.
(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.
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 2017. Ignore Taxation.
SOLUTION
Computation of Ratios
1. Gross profit ratio 2016 2017
64,000 ×100
Gross profit/sales 76,000 ×100
3,00,000
3,74,000
21.3% 20.3%
2. Operating expense to sales ratio

49,000×100 57,000 ×100
Operating exp / Total sales
3,00,000 3,74,000
16.3% 15.2%
3. Operating profit ratio
Operating profit / Total sales 15, 000 × 100 19,000 ×100

3, 00, 000 3,74,000
5% 5.08%
4. Capital turnover ratio
Sales / capital employed 3,00,000 3,74,000

=3 = 2.54
1,00,000 1, 47,000
5. Stock turnover ratio
COGS / Average stock 2,36,000 2,98,000

= 4 .7 = 3 .9
50,000 77,000
6. Net Profit to Networth
15,000 ×100 17,000 ×100
Net profit / Networth = 15% = 14.5%
1,00,000 1,17,000
7. Receivables collection period
Average receivables / Average daily 50,000 82,000
sales (Refer to working note) 739.73 936.99
67.6 days 87.5 days
Working note:
2,70,000 3, 42,000
Average daily sales = Credit sales / 365
365 365
` 739.73 ` 936.99
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 be interpreted as an increase in 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 the 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 31st March,
2017:
(i) The company went in for reorganisation of capital structure, with share
capital remaining the same as follows:
Share capital 50%
Other Shareholders’ funds 15%
5% Debentures 10%
Payables 25%
Debentures were issued on 1st April, interest being paid annually on 31st March.
(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 x 60/100 = ` 1,20,000
Calculation of additions to Plant & Machinery
`
Total fixed assets 1,20,000
Less: Land & Buildings 80,000
Plant and Machinery (after providing depreciation) 40,000
Depreciation on Machinery up to 31-3-20X2 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: = =1
Current liabilities
` 80,000 − stock
= =1
` 50,000
` 50,000 = ` 80,000 – Stock

Stock = ` 80,000 - ` 50,000
= ` 30,000
Receivables = 4/5th of quick assets
= (` 80,000 – 30,000)x 4/5
= ` 40,000
Receivables turnover ratio
Receivables
= ×365days = 60 days
CreditSales
40,000 ×12
= × 365 = 2 months
Credit Sales
2 credit sales = 4,80,000
Credit sales = 4,80,000/2
= 2,40,000
Gross profit (15% of sales)
` 2,40,000 x 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 x 10/100 = ` 13,000
Debenture interest = ` 20,000 x 5/100 = ` 1,000
Projected profit and loss account for the year ended 31-3-2017
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 other 22,000
expenses
To net profit 13,000 ______
36,000 36,000

Projected Balance Sheet as at 31st March, 2017

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 Debtors 40,000
_ Bank 10,000 80,000
2,00,000 2,00,000
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 taxes ` 64,000

(i) Net profit margin = = = 0.89 or 8.9%
Sales ` 7,20,000
EBIT (1 - T) ` 1,60,000(1- 0.5) = 0.111 or 11.1%

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

(ii) Return on assets = =
Assets 8,00,000
= 0.10 or 10%
Sales ` 7,20,000
(iii) Asset turnover = = = 0.9 times
Assets ` 8,00,000
Net Profit after taxes ` 64,000
(iv) Return on equity = =
Owners' equity 50% of ` 8,00,000
` 64,000
= = 0.16 or 16%
` 4,00,000
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 2015 2016 2017
(`) (`) (`)
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?

SOLUTION
Ratios 2015 2016 2017
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 0.33 0.32 0.32
capitalization
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 informations are available for Navya Ltd. along with various ratio relevant to
the particulars industry it belongs to. Gives your comments on strength and weakness of
Navya Ltd. comparing its ratios with the given industry norms.

Navya Ltd.
Balance Sheet as at 31.3.2017
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 31.3.2017
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
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 52,800
1. = 2.60 2.50
Current Liabilities 19,800
Sales 1,10,000
2. = 10.0 8.00
Debtors 11,000
Sales 1,10,000
3. = 3.33 9.00
Stock 33,000
Sales 1,10,000
4. = 1.43 2.00
Total Assets 77,000
Net Profit 2,32,000
5. = 2.11% 3.50%
Sales 1,10,000
Net Profit 2,32,000
6. = 3.01% 7%
Total Assets 77,000
Net Profit 2,32,000
7. = 4.65% 10.5%
Net Worth 49,86,000
Total Debt 29,000
8. = 37.66% 60%
Total Assets 77,000
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.
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
TEST YOUR KNOWLEDGE

MCQs based Questions
1. Ratio of Net sales to Net working capital is a:
(a) Profitability ratio
(b) Liquidity ratio
(c) Current ratio
(d) Working capital turnover ratio

2. Long-term solvency is indicated by:

(a) Debt/ equity ratio
(b) Current Ratio
(c) Operating ratio
(d) Net profit ratio
3. Ratio of net profit before interest and tax to sales is:
(a) Gross profit ratio
(b) Net profit ratio
(c) 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
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. What do you mean by 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 carried by the firm, if an inventory 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, 2016
2016
I Accounting Information:
Gross Profit 15% of Sales
Net profit 8% of sales
Raw materials consumed 20% of works cost
Direct wages 10% of works cost
Stock of raw materials 3 months’ usage
Stock of finished goods 6% of works cost
Debt collection period 60 days
All sales are on credit
II Financial Ratios:
Fixed assets to sales 1:3
Fixed assets to Current assets 13 : 11
Current ratio 2:1
Long-term loans to Current liabilities 2:1
Capital to Reserves and Surplus 1:4
If value of fixed assets as on 31st December, 2015 amounted to ` 26 lakhs, prepare
a summarised Profit and Loss Account of the company for the year ended 31st
December, 2016 and also the Balance Sheet as on 31st December, 2016.
4. Ganpati Limited has furnished the following ratios and information relating to
the year ended 31st March, 2017.

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 sold) 12
Cost of goods sold ` 18,00,000
Interest 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, 2017.
(b) Prepare a balance sheet as on 31st March in the following format:
Balance Sheet as on 31st March, 2017
Share Capital Fixed Assets
Reserve and Surplus Current Assets
15% Debentures Stock
Payables Receivables
Cash
5. Using the following information, complete this balance sheet:
Long-term debt to net worth 0.5 to 1
Total asset turnover 2.5 x
Average collection period* 18 days
Inventory turnover 9×
Gross profit margin 10%
Acid-test ratio 1 to 1
*Assume a 360-day year and all sales on credit.
` `
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 liabilities and equity —

ANSWERS/ 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
5. Please refer paragraph 3.5
Answers to the Practical Problems
Cost of goods sold

1. (a) 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.
Thus, = ` 5, 44,000
=5
Average inventory
` 5, 44,000
Average inventory = = ` 1,08,800
5
Average Receivables
(b) Average collection period = ×360days
Credit Sales
(Opening Receivables + Closing Receivables)

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

(ii) Equity =
Dividend payyable to equity shareholders at current
rate of ` 2 per share
` 2,70,000 - ` 27,000
= ` 1,60,000 (80,000 shares × ` 2) = 1.52 times
(c) Earnings per equity share

Earnings available to equity shareholders
=
` 2, 43,000
= = ` 3.04 per share
80,000
Market price per share ` 40
(d) Price-earning (P/E) ratio = = = 13.2 times
Equity per share ` 3.04
3. (a) Working Notes:
(i) Calculation of Sales
Fixed Assets 1
=
Sales 3

26,00,000 1
\ = ⇒ Sales = ` 78,00,000
Sales 3
(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)
3
= 13,26,000 × = `3,31,500
12
(v) Calculation of Stock of Finished Goods (= 6% of Works Cost)

6
= 66,30,000 × = ` 3,97,800
100
(vi) Calculation of Current Liabilities

Current Assets
=2
Current Liabilities
22,00,000
= 2 ⇒ Current Liabilities = ` 11,00,000
Current Liabilities
(vii) Calculation of Receivables

Receivables
Average collection period = ×365
CreditSales
Receivables
× 365 = 60 ⇒ Receivables = `12,82,191.78 or `12,82,192
78,00,000

(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
(x) Calculation of Net worth
Fixed Assets 26,00,000
Current Assets 22,00,000
Total Assets 48,00,000
Less: Long term Loan 22,00,000
Current Liabilities 11,00,000 33,00,000
Net worth 15,00,000
Net worth = Share capital + Reserves = 15,00,000
Capital 1 1
= ⇒ Share Capital = 15,00,000 × = ` 3,00,000
Reserves and Surplus 4 5
4
Reserves and Surplus =15,00,000 × = ` 12,00,000
5
Profit and Loss Account of PQR Ltd.
for the year ended 31st December, 2016
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 Distribution 5,46,000 By Gross Profit b/d 11,70,000
Expenses (Balancing
figure)
To Net Profit (8% of Sales) 6,24,000 _
11,70,000 11,70,000
Balance Sheet of PQR Ltd.
as at 31st December, 2016
Share Capital 3,00,000 Fixed Assets 26,00,000
Reserves and Surplus 12,00,000 Current Assets:

Long term loans 22,00,000 Stock of Raw 3,31,500
Material
Current liabilities 11,00,000 Stock of Finished 3,97,800
Goods
Receivables 12,82,192
_ Cash 1,88,508
48,00,000 48,00,000
4. (a) Calculation of Operating Expenses for the year ended 31st March, 2017.
`
Net Profit [@ 6.25% of Sales] 3,75,000
Add: Income Tax (@ 50%) 3,75,000
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, 2017
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
The return on net worth is 25%. Therefore, the profit after tax of ` 3,75,000
should be equivalent to 25% of the net worth.
25
Net worth × = ` 3,75,000
100
` 3,75,000×100
\ Net worth = = ` 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
60,000 ×100
\ Debentures = = ` 4,00,000
15
(iii) Current Assets
Current Ratio = 2
Payables = ` 2,00,000
Current Assets = 2 Current Liabilities = 2 x 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
5.
Long- term debt Long- term debt
= 0.5 =
Net worth 2,00,000
Long- term debt = ` 1,00,000
Total liabilities and net worth = ` 4,00,000

Total assets = ` 4,00,000
Sales Sales
Total assets = 2.5 = 4,00,000 = Sales = ` 10,00,000
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
1,00,000
Cash = `50,000
Plant and equipment = ` 2,00,000.
Balance Sheet
` `
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 equity 4,00,000

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CHAPTER 3

© The Institute of Chartered Accountants of India

3.2 RATIO AND RATIO ANALYSIS

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3.2.1 Definition of Ratio

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3.3 TYPES OF RATIOS

Current Liabilities = Creditors for goods and services + Short-term Loans +

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Cash and Bank balances + Marketable Securities

Cash and Bank balances + Marketable Securities

Daily Operating Expenses =

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3.3.2.1 Capital Structure Ratios

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Various capital structure ratios are:

Total outside liabilities

*Not merely long-term debt.

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Total Outside Liabilities

(f) Proprietary Ratio:

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(i) Interest on loans

Earnings available for debt services

Earnings before interest and taxes (EBIT)

Net Profit/Earning after taxes (EAT)

Notes for calculating Ratios:

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Activity Ratio/ Efficiency Ratio/ Performance Ratio/ Turnover Ratio:

Sales/ Cost of Goods Sold

Sales/ Cost of Goods Sold

Sales/ Cost of Goods Sold

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Current Assets Turnover Ratio = Sales/ Cost of Goods Sold

(e) Working Capital Turnover Ratio:

Working Capital Turnover Ratio = Sales/ Cost of Goods Sold

Cost of Goods Sold/Sales

Opening Stock + Closing Stock

Raw Material Consumed

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

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Annual Net Credit Purchases

Average Accounts Payable

Notes for calculating Ratios:

3.3.4 Profitability Ratios

3.3.4.1 Profitability Ratios based on Sales

Net Profit Earnings after taxes (EAT)

Earnings before taxes (EBT)

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COGS + Operating expenses

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

= Net Profit after taxes(PAT/EAT)+Interest ×100

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(ii) Investment Turnover/Asset Turnover/Capital Turnover: The asset turnover ratio

Investment Turnover/Asset Turnover/Capital Turnover

Example: XYZ Company’s details are as under:

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Net profit available to equity shareholders