Ratio analysis

2.2..1 Introduction

Financial statements by themselves do not give the required information both for internal management
and for outsiders. They are passive statements showing the results of the business i.e. Profit or loss and
the financial position of the business. They will not disclose any reasons for dismal performance of the
business if it is so. What is wrong with the business, where it went wrong, why it went wrong, etc. Are
some of the questions for which no answers will be available in the financial statements. Similarly, no
information will be available in the financial statements about the financial strengths and weaknesses of
the concern. Hence, to get meaningful information from the financial statements which would facilitate
vital decisions to be taken, financial statements must be analysed and interpreted. Through the analysis
and interpretation of financial statements full diagnosis of the profitability and financial soundness of
the business is made possible. The term `analysis of financial statements’ means methodical
classification of the data given in the financial statements. The term `interpretation of financial
statements’ means explaining the meaning and significance of the data so classified. A number of tools
are available for the purpose of analysing and interpreting the financial statements. This lesson
discusses in brief tools like common size statement, trend analysis, etc., and gives a detailed discussion
on ratio analysis.

2.2.2 Learning Objectives

Ֆ After reading this lesson the reader should be able to:

Ֆ understand the nature and types of financial analysis

Ֆ know the various tools of financial analysis

Ֆ understand the meaning of ratio analysis

Ֆ ppreciate the significance of ratio analysis

Ֆ understand the calculation of various kinds of ratios

Ֆ calculate the different ratios from the given financial statements

Ֆ interpret the calculated ratios

2.2.3 Contents

2.2.3.1 Nature Of Financial Analysis

2.2.3.2 Types Of Financial Analysis

2.2.3.3 Tools Of Financial Analysis

2.2.3.4 Meaning And Nature Of Ratio Analysis

2.2.3.5 Classification Of Ratios

2.2.3.6 Capital Structure Or Leverage Ratios

 2.2.3.7 Fixed Assets Analysis

2.2.3.8 Analysis Of Turnover (Or) Analysis Of Efficiency

2.2.3.9 Analysis Of Liquidity Position

2.2.3.10 Analysis Of Profitability

2.2.3.11 Analysis Of Operational Efficiency

2.2.3.12 Ratios From Share Holders’ Point Of View

2.2.3.13 Illustrations

2.2.3.14 Summary

2.2.3.15 Key Words

2.2.3.16 Self Assessment Questions

2.2.3.17 Key To Self Assessment Questions

2.2.3.18 Case Analysis

2.2.3.19 Books For Further Reading

2.2.3.1 Nature Of Financial Analysis

The focus of financial analysis is on the key figures contained in the financial statements and the
significant relationship that exists between them. “analyzing financial statements is a process of
evaluating the relationship between the component parts of the financial statements to obtain a better
understanding of a firm’s position and performance”. The type of relationship to be investigated
depends upon the objective and purpose of evaluation. The purpose of evaluation of financial
statements differs among various groups: creditors, shareholders, potential investors, management and
so on. For example, short-term creditors are primarily interested in judging the firm’s ability to pay its
currently-maturing obligations. The relevant information for them is the composition of the short-term
(current) liabilities. The debenture-holders or financial institutions granting long-term loans would be
concerned with examining the capital structures, past and projected earnings and changes in the
financial position. The shareholders as well as potential investors would naturally be interested in the
earnings per share and dividends per share as these factors are likely to have a significant bearing on the
market price of shares. The management of the firms, in contrast, analyses the financial statements for
self-evaluation and decision making.

The first task of the financial analyst is to select the information relevant to the decision under
consideration from the total information contained in the financial statements. The second step
involved in financial analysis is to arrange the information in such a way as to highlight significant
relationships. The final step is the interpretation and drawing of inferences and conclusions. In brief,
financial analysis is the process of selection, relation and evaluation.

2.1.3.2 Types Of Financial Analysis

Financial analysis may be classified on the basis of parties who are undertaking the analysis and on the
basis of methodology of analysis. On the basis of the parties who are doing the analysis, financial
analysis is classified into external analysis and internal analysis.

External Analysis:

When the parties external to the business like creditors, investors, etc. Do the analysis, the analysis is
known as external analysis. This analysis is done by them to know the credit-worthiness of the concern,
its financial viability, its profitability, etc.

Internal Analysis:

This analysis is done by persons who have control over the books of accounts and other information of
the concern. Normally this analysis is done by management people to enable them to get relevant
information to take vital business decision.

On the basis of methodology adopted for analysis, financial analysis may be either horizontal analysis or
vertical analysis.

Horizontal Analysis:

When financial statements of a number of years are analysed, then the analysis is known as horizontal
analysis. In this type of analysis, figures of the current year are compared with the standard or base
year. This type of analysis will give an insight into the concern’s performance over a period of years. This
analysis is otherwise called as dynamic analysis as it extends over a number of years.

Vertical Analysis:

This type of analysis establishes a quantitative relationship of the various items in the financial
statements on a particular date. For e.g. The ratios of various expenditure items in terms of sales for a
particular year can be calculated. The other name for this analysis is `static analysis’ as it relies upon one
year figures only.

2.1.3.3 Tools Of Financial Analysis

The following are the important tools of financial analysis which can be appropriately used by the
financial analysts:

1. Common-size financial statements

2. Comparative financial statements

3. Trend percentages

4. Ratio analysis

5. Funds flow analysis

6. Cash flow analysis

Common-Size Financial Statements:

 In this type of statements, figures in the original financial statements are converted into percentages in
relation to a common base. The common base may be sales in the case of income statements (profit and
loss account) and total of assets or liabilities in the case of balance sheet. For e.g. In the case of
common-size income statement, sales of the traditional financial statement are taken as 100 and every
other item in the income statement is converted into percentages with reference to sales. Similarly, in
the case of common-size balance sheet, the total of asset/liability side will be taken as 100 and each
individual asset/liability is converted into relevant percentages.

Comparative Financial Statements:

This type of financial statements are ideal for carrying out horizontal analysis. Comparative financial
statements are so designed to give them perspective to the review and analysis of the various elements
of profitability and financial position displayed in such statements. In these statements, figures for two
or more periods are compared to find out the changes both in absolute figures and in percentages that
have taken place in the latest year as compared to the previous year(s). Comparative financial
statements can be prepared both for income statement and balance sheet.

Trend Percentages:

Analysis of one year figures or analysis of even two years figures will not reveal the real trend of
profitability or financial stability or otherwise of any concern. To get an idea about how consistent is the
performance of a concern, figures of a number of years must be analysed and compared. Here comes
the role of trend percentages and the analysis which is done with the help of these percentages is called
as trend analysis.

Trend analysis:

Is a useful tool for the management since it reduces the large amount of absolute data into a simple
and easily readable form. The trend analysis is studied by various methods. The most popular forms of
trend analysis are year to year trend change percentage and index-number trend series. The year to
year trend change percentage would be meaningful and manageable where the trend for a few years,
say a five year or six year period is to be analysed.

Generally trend percentage are calculated only for some important items which can be logically related
with each other. For e.g. Trend ratio for sales, though shows a clear-cut increasing tendency, becomes
meaningful in the real sense when it is compared with cost of goods sold which might have increased at
a lower level.

Ratio Analysis:

Of all the tools of financial analysis available with a financial analyst the most important and the most
widely used tool is ratio analysis. Simply stated ratio analysis is an analysis of financial statements done
with the help of ratios. A ratio expresses the relationship that exists between two numbers and in
financial statement analysis a ratio shows the relationship between two interrelated accounting figures.
Both the accounting figures may be taken from the balance sheet and the resulting ratio is called a
balance sheet ratio. But if both the figures are taken from profit and loss account then the resulting ratio
is called as profit and loss account ratio. Composite ratio is that ratio which is calculated by taking one
figure from profit and loss account and the other figure from balance sheet. A detailed discussion on
ratio analysis is made available in the pages to come.

Funds Flow Analysis:

The purpose of this analysis is to go beyond and behind the information contained in the financial
statements. Income statement tells the quantum of profit earned or loss suffered for a particular
accounting year. Balance sheet gives the assets and liabilities position as on a particular date. But in an
accounting year a number of financial transactions take place which have a bearing on the performance
of the concern but which are not revealed by the financial statements. For e.g. A concern collects
finance through various sources and uses them for various purposes. But these details could not be
known from the traditional financial statements. Funds flow analysis gives an opening in this respect. All
the more, funds flow analysis reveals the changes in working capital position. If there is an increase in
working capital what resulted in the increase and if there is a decrease in working capital what caused
the decrease, etc. Will be made available through funds flow analysis.

Cash Flow Analysis:

While funds flow analysis studies the reasons for the changes in working capital by analysing the
sources and application of funds, cash flow analysis pays attention to the changes in cash position that
has taken place between two accounting periods. These reasons are not available in the traditional
financial statements. Changes in the cash position can be analysed with the help of a statement known
as cash flow statement. A cash flow statement summarises the change in cash position of the concern.
Transactions which increase the cash position of the concern are labelled as `inflows’ of cash and those
which decrease the cash position as `outflows’ of cash.

2.2.3.4 Meaning And Nature of Ratio Analysis

Ratio expresses numerical relationship between two numbers. In the words of kennedy and mcmullen,
“the relationship of one item to another expressed in simple mathematical form is known as a ratio”.
Thus, the ratio is a measuring device to judge the growth, development and present condition of a
concern. It plays an important role in measuring the comparative significance of the income and position
statement. Accounting ratios are expressed in the form of time, proportion, percentage, or per one
rupee. Ratio analysis is not only a technique to point out relationship between two figures but also
points out the devices to measure the fundamental strengths or weaknesses of a concern. As james
c.van horne observes: “to evaluate the financial condition and performance of a firm, the financial
analyst needs certain yardsticks. One of the yardsticks frequently used is a ratio. The main purpose of
ratio analysis is to measure past performance and project future trends. It is also used for inter-firm and
intra-firm comparison as a measure of comparative productivity. The significance of the various
components of financial statements can be judged only by ratio analysis. The financial analyst x-rays the
financial conditions of a concern by the use of various ratios and if the conditions are not found to be
favourable, suitable steps can be taken to overcome the limitations. The main objectives of ratio analysis
are:

Ֆ To simplify the comparative picture of financial statements.

Ֆ To assist the management in decision making.

Ֆ To guage the profitability, solvency and efficiency of an enterprise, and

Ֆ To ascertain the rate and direction of change and future potentiality.

2.2.3.5 Classification of Ratios

Financial ratios may be categorised in various ways. Van horne has divided financial ratios into four
categories, viz., liquidity, debt, profitability and coverage ratios. The first two types of ratios are
computed from the balance sheet. The last two are computed from the income statement and
sometimes, from both the statements. For the purpose of analysis, the present lesson gives a detailed
description of ratios, the formula used for their computation and their significance. The ratios have been
categorised under the following headings:-

(i) ratios for analysis of capital structure or leverage.

(ii) ratios for fixed assets analysis.

(iii) ratios for analysis of turnover.

(iv) ratios for analysis of liquidity position.

(v) ratios for analysis of profitability.

(vi) ratios for analysis of operational efficiency.

2.2.3.6 Capital Structure or Leverage Ratios

Financial strength indicates the soundness of the financial resources of an organisation to perform its
operations in the long run. The parties associated with the organisation are interested in knowing the
financial strength of the organisation. Financial strength is directly associated with the operational
ability of the organisation and its efficient management of resources. The financial strength analysis can
be made with the help of the following ratios:

(1) Debt-equity ratio

(2) Capital gearing ratio

(3) Financial leverage

(4) Proprietary ratio and

(5) Interest coverage.

Debt-Equity Ratio:

The debt-equity ratio is determined to ascertain the soundness of the long-term financial policies of the
company. This ratio indicates the proportion between the shareholders’ funds (i.e. Tangible net worth)
and the total borrowed funds. Ideal ratio is 1. In other words, the investor may take debt equity ratio as
quite satisfactory if shareholders’ funds are equal to borrowed funds. However, creditors would prefer a
low debt-equity ratio as they are much concerned about the security of their investment. This ratio can
be calculated by dividing the total debt by shareholders’ equity. For the purpose of calculation of this
ratio, the term shareholders’ equity includes share capital, reserves and surplus and borrowed funds
which includes both long-term funds and short-term funds.

Debt

Debt-equity ratio = -----------

Equity

A high ratio indicates that the claims of creditors are higher as compared to owners’ funds and a low
debt-equity ratio may result in a higher claim of equity.

Capital Gearing Ratio: This ratio establishes the relationship between the fixed interest-bearing
securities and equity shares of a company. It is calculated as follows:

Fixed interest-bearing securities

Capital gearing ratio = -------------------------------------

Equity shareholders’ funds

Fixed-interest bearing securities carry with them the fixed rate of dividend or interest and include
preference share capital and debentures. A firm is said to be highly geared if the lion’s share of the total
capital is in the form of fixed interest-bearing securities or this ratio is more than one. If this ratio is less
than one, it is said to be low geared. If it is exactly one, it is evenly geared. This ratio must be carefully
planned as it affects the firm’s capacity to maintain a uniform dividend policy during difficult trading
periods that may occur. Too much capital should not be raised by way of debentures, because
debentures do not share in business losses.

Financial Leverage Ratio:

Financial leverage results from the presence of fixed financial charges in the firm’s income stream.
These fixed charges do not vary with the earnings before interest and tax (ebit) or operating profits.
They have to be paid regardless of the amount of earnings before interest and taxes available to pay
them. After paying them, the operating profits (ebit) belong to the ordinary shareholders. Financial
leverage is concerned with the effects of changes in earnings before interest and taxes on the earnings
available to equity holders. It is defined as the ability of a firm to use fixed financial charges to magnify
the effects of changes in ebit on the firm’s earning per share. Financial leverage and trading on equity
are synonymous terms. The ebit is calculated by adding back the interest (interest on loan capital +
interest on long term loans + interest on other loans) and taxes to the amount of net profit. Financial
leverage ratio is calculated by dividing ebit by ebt (earnings before tax). Neither a very high leverage nor
a very low leverage represents a sound picture.

(ebit ÷ ebt).

Proprietary Ratio:

This ratio establishes the relationship between the proprietors’ funds and the total tangible assets. The
general financial strength of a firm can be understood from this ratio. The ratio is of particular
importance to the creditors who can find out the proportion of shareholders’ funds in the capital assets
employed in the business. A high ratio shows that a concern is less dependent on outside funds for
capital. A high ratio suggests sound financial strength of a firm due to greater margin of owners’ funds
against outside sources of finance and a greater margin of safety for the creditors. A low ratio indicates a
small amount of owners’ funds to finance total assets and more dependence on outside funds for
working capital. In the

form of formula this ratio can be expressed as:-

Net Worth

Proprietary Ratio = --------------

Total Assets

Interest Coverage:

This ratio measures the debt servicing capacity of a firm in so far as fixed interest on long-term loan is
concerned. It is determined by dividing the operating profits or earnings before interest and taxes (ebit)
by the fixed interest charges on loans. Thus,

EBIT

Interest Coverage = ----------

Interest

It should be noted that this ratio uses the concept of net profits before taxes because interest is
tax-deductible so that tax is calculated after paying interest on long-term loans. This ratio, as the name
suggests, shows how many times the interest charges are covered by the ebit out of which they will be
paid. In other words, it indicates the extent to which a fall in ebit is tolerable in the sense that the ability
of the firm to service its debts would not be adversely affected. From the point of view of creditors, the
larger the coverage, the greater the ability of the firm to handle fixedcharge liabilities and the more
assured the payment of interest to the creditors. However, too high a ratio may imply unused debt
capacity. In contrast, a low ratio is danger signal that the firm is using excessive debt and does not have
the ability to offer assured payment of interest to the creditors.

2.2.3.7 Fixed Assets Analysis

The successful operation of a business generally requires some assets of fixed character. These assets
are used primarily in producing goods and in operating the business. With the help of these, raw
materials are converted into finished products. Fixed assets are not meant for sale and are kept as a rule
permanently in the business in order to carry on dayto-day operations.

Analysis of fixed assets is very important from investors’ point of view because investors are more
concerned with long term assets. Fixed assets are properties of non-current nature which are acquired
to provide facilities to carry on business. They include land, building, equipment, furniture, etc. They are
generally shown in balance sheet by aggregating them into groups of gross block as reduced by the
accumulated amount of depreciation till date. Investment in fixed assets is of a permanent nature and
therefore should be financed by owners’ funds (permanent sources of funds). The owners’ funds should
be sufficient to provide for fixed assets. Fixed assets are generally financed by owners’ equity and long-
term borrowings. The long-term borrowings are in the form of long-term loans and of almost permanent
nature. Under such a situation it becomes more or less irrelevant to relate the fixed assets with only the
owners’ equity. Therefore, the analysis of the source of financing of fixed assets has been done with the
help of the following ratios:-

(a) Fixed Assets To Net Worth

(b) Fixed Assets To Long-Term Funds

Fixed Assets To Net Worth: in the words of anil b.roy choudhary, “this ratio indicates the relationship
between net worth (i.e. Shareholders’ funds) and investments in net fixed assets (i.e. Gross block minus
depreciation)”.

The higher the ratio the lesser would be the protection to creditors. If the ratio is less than 1, it indicates
that the net worth exceeds fixed assets. It will further indicate that the working capital is partly financed
by shareholders’ funds. If the ratio exceeds 1, it would mean that part of the fixed assets has

been provided by creditors. The formula for derivation of this ratio is:-

Net Fixed Assets

Fixed Assets To Net Worth Ratio = ------------------

Net Worth

Fixed Assets To Long-Term Funds: this ratio establishes the relationship

Between the fixed assets and long-term funds and it is obtained by the formula:

Fixed Assets

FIXED ASSET RATIO = --------------------

Long-Term Funds

The ratio should be less than one. If it is less than one, it shows that a part of the working capital has
been financed through long-term funds. This is desirable because a part of working capital termed as
“core working capital” is more or less of a fixed nature. The ideal ratio is 0.67.

If this ratio is more than one, it indicates that a part of current liability is invested in long-term assets.
This is a dangerous position. Fixed assets include “net fixed assets” i.e. Original cost less depreciation to
date and trade investments including shares in subsidiaries. Long-term funds include share capital,
reserves and long-term borrowings.

2.2.3.8 Analysis Of Turnover (Or) Analysis Of Efficiency

Turnover ratios also referred to as activity ratios are concerned with measuring the efficiency in asset
management. Sometimes, these ratios are also called as efficiency ratios or asset utilisation ratios. The
efficiency with which the assets are used would be reflected in the speed and rapidity with which assets
are converted into sales. The greater the rate of turnover or conversion, the more efficient the
utilisation/management, other things being equal. For this reason such ratios are also designated as
turnover ratios. Turnover is the primary mode for measuring the extent of efficient employment of
assets by relating the assets to sales. An activity ratio may, therefore, be defined as a test of the
relationship between sales (more appropriately with cost of sales) and the various assets of a firm.
Depending upon the various types of assets, there are various types of activity ratios. Some of the more
widely used turnover ratios are:Ֆ Fixed Assets Turnover Ratio

Ֆ Current Assets Turnover Ratio

Ֆ Working Assets Turnover Ratio

Ֆ Inventory (Or Stock) Turnover Ratio

Ֆ Debtors Turnover Ratio

Ֆ Creditors Turnover Ratio

Fixed Assets Turnover Ratio:

The fixed assets turnover ratio measures the efficiency with which the firm is utilising its investment in
fixed assets, such as land, building, plant and machinery, furniture, etc. It also indicates the adequacy of
sales in relation to investment in fixed assets. The fixed assets turnover ratio is sales divided by the net
fixed assets (i.e., the depreciated value of fixed assets).

Sales

Fixed Assets Turnover Ratio = ----------------

Net Fixed Assets

The turnover of fixed assets can provide a good indicator for judging the efficiency with which fixed
assets are utilised in the firm. A high fixed assets turnover ratio indicates efficient utilisation of fixed
assets in generating operating revenue. A low ratio signifies idle capacity, inefficient utilisation and
management of fixed assets.

Current Assets Turnover Ratio:

The current assets turnover ratio ascertains the efficiency with which current assets are used in a
business. Professor guthmann observes that “current assets turnover is to give an overall impression of
how rapidly the total investment in current assets is being turned”. This ratio is strongly associated with
efficient utilisation of costs, receivables and inventory. A higher value of this ratio indicates greater
circulation of current assets while a low ratio indicates a stagnation of the flow of current assets. The
formula for the computation of current assets turnover ratio is:

Sales

Current Assets Turnover Ratio = -----------------

Current Assets

Working Capital Turnover Ratio: this ratio shows the number of times working capital is turned-over in a
stated period. Working capital turnover ratio reflects the extent to which a business is operating on a
small amount of working capital in relation to sales. The ratio is calculated by the following formula:-

Sales
Working Capital Turnover Ratio = ----------------------

Net Working Capital

The higher the ratio, the lower is the investment in working capital and greater are the profits.
However, a very high turnover of working capital is a sign of over trading and may put the firm into
financial difficulties. On the other hand, a low working capital turnover ratio indicates that working
capital is not efficiently utilised.

Inventory Turnover Ratio:

The inventory turnover ratio, also known as stock turnover ratio normally establishes the relationship
between cost of goods sold and average inventory. This ratio indicates whether investment in inventory
is within proper limit or not. In the words of S.C.Kuchal, “this relationship expresses the frequency with
which average level of inventory investment is turned over through operations”. The formula for the
computation of this ratio may be expressed thus:

Cost Of Goods Sold

Inventory Turnover Ratio = -------------------------

Average Inventory

In general, a high inventory turnover ratio is better than a low ratio. A high ratio implies good inventory
management. A very high ratio indicates under-investment in, or very low level of inventory which
results in the firm being out of stock and incurring high stock-out cost. A very low inventory turnover
ratio is dangerous. It signifies excessive inventory or over-investment in inventory. A very low ratio may
be the results of inferior quality goods, over-valuation of closing inventory, stock of unsaleable/obsolete
goods.

Debtors Turnover Ratio And Collection Period:

One of the major activity ratios is the receivables or debtors turnover ratio. Allied and closely related to
this is the average collection period. It shows how quickly receivables or debtors are converted into
cash. In other words, the debtors turnover ratio is a test of the liquidity of the debtors of a firm. The
liquidity of a firm’s receivables can be examined in two ways: (i) debtors/receivables turnover and (ii)
average collection period. The debtors turnover shows the relationship between credit sales and
debtors of a firm. Thus,

Net Credit Sales

Debtors Turnover Ratio = ---------------------

Average Debtors

Net credit sales consists of gross credit sales minus returns if any, from the customers. Average debtors
is the simple average of debtors at the beginning and at the end of the year.

The second type of ratio measuring the liquidity of a firm’s debtors is the average collection
period. This ratio is, in fact, interrelated with and dependent upon, the receivables turnover ratio. It is
calculated by dividing the days in a year by the debtors turnover. Thus,
 Days In Year

Average Collection Period = --------------------

Debtors Turnover

This ratio indicates the speed with which debtors/accounts receivables are being collected. The higher
the turnover ratio and shorter the average collection period, the better the trade credit management
and better the liquidity of debtors. On the other hand, low turnover ratio and long collection period
reflects that payments by debtors are delayed. In general, short collection period (high turnover ratio) is
preferable.

Creditors’ Turnover Ratio And Debt Payment Period:

Creditors’ turnover ratio indicates the speed with which the payments for credit purchases are made to
the creditors. This ratio can be computed as follows:-

Average Accounts Payable

Creditors’ Turnover Ratio = -----------------------------

Net Credit Purchases

The term accounts payable include trade creditors and bills payable. A high ratio indicates that creditors
are not paid in time while a low ratio gives an idea that the business is not taking full advantage of credit
period allowed by the creditors.

Sometimes, it is also required to calculate the average payment period or average age of payables or
debt period enjoyed to indicate the speed with which payments for credit purchases are made to
creditors. It is calculated as:

Days In A Year

Average Age Of Payables = --------------------------

Creditors’ Turnover Ratio

Both the creditors’ turnover ratio and the debt payment period enjoyed ratio indicate about the
promptness or otherwise in making payment for credit purchases. A higher creditors’ turnover ratio or
lower credit period enjoyed ratio signifies that the creditors are being paid promptly.

2.2.3.9 Analysis Of Liquidity Position

The liquidity ratios measure the ability of a firm to meet its short- term obligations and reflect the short-
term financial strength/solvency of a firm. The term liquidity is described as convertibility of assets
ultimately into cash in the course of normal business operations and the maintenance of a regular cash
flow. A sound liquid position is of primary concern to management from the point of view of meeting
current liabilities as and when they mature as well as for assuring continuity of operations. Liquidity
position of a firm depends upon the amount invested in current assets and the nature of current assets.
The under mentioned ratios are used to measure the liquidity position:-

Ֆ current ratio
Ֆ liquid (or) quick ratio

Ֆ cash to current assets ratio

Ֆ cash to working capital ratio

Current Ratio:

The most widely used measure of liquid position of an enterprise is the current ratio, i.e., the ratio of
the firm’s current assets to current liabilities. It is calculated by dividing current assets by current
liabilities:

Current Assets

Current Ratio = -------------------

Current Liabilities

The current assets of a firm represent those assets which can be in the ordinary course of business,
converted into cash within a short period of time, normally not exceeding one year and include cash and
bank balance, marketable securities, inventory of raw materials, semifinished (work-in-progress) and
finished goods, debtors net of provision for bad and doubtful debts, bills receivable and pre-paid
expenses. The current liabilities defined as liabilities which are short-term maturing obligations to be
met, as originally contemplated, within a year, consist of trade creditors, bills payable, bank credit,
provision for taxation, dividends payable and outstanding expenses. N.l.hingorani and others observe:
“current ratio is a tool for measuring the short-term stability or ability of the company to carry on its
day-to-day work and meet the short-term commitments earlier”. Generally 2:1 is considered ideal for a
concern i.e., current assets should be twice of the current liabilities. If the current assets are two times
of the current liabilities, there will be no adverse effect on business operations when the payment of
current liabilities is made. If the ratio is less than 2, difficulty may be experienced in the payment of
current liabilities and day-to-day operations of the business may suffer. If the ratio is higher than 2, it is
very comfortable for the creditors but, for the concern, it indicates idle funds and lack of enthusiasm for
work.

Liquid (Or) Quick Ratio: liquid (or) quick ratio is a measurement of a firm’s ability to convert its current
assets quickly into cash in order to meet its current liabilities. It is a measure of judging the immediate
ability of the firm to pay-off its current obligations. It is calculated by dividing the quick assets by current
liabilities:

Quick Assets

Liquid Ratio = ---------------------

Current Liabilities

The term quick assets refers to current assets which can be converted into cash immediately or at a
short notice without diminution of value. Thus quick assets consists of cash, marketable securities and
accounts receivable. Inventories are excluded from quick assets because they are slower to convert into
cash and generally exhibit more uncertainty as to the conversion price.
This ratio provides a more stringent test of solvency. 1:1 ratio is considered ideal ratio for a firm
because it is wise to keep the liquid assets atleast equal to the current liabilities at all times.

Cash To Current Assets Ratio:

Efficient management of the inflow and outflow of cash plays a crucial role in the overall performance
of a business. Cash is the most liquid form of assets which safeguards the security interest of a business.
Cash including bank balances plays a vital role in the total net working capital. The ratio of cash to
working capital signifies the proportion of cash to the total net working capital and can be calculated by
dividing the

cash including bank balance by the working capital. Thus,

Cash

Cash To Working Capital Ratio = --------------------

Working Capital

Cash is not an end in itself, it is a means to achieve the end. Therefore, only a required amount of cash
is necessary to meet day-to-day operations. A higher proportion of cash may lead to shrinkage of profits
due to idleness of resources of a firm.

2.2.3.10 Analysis Of Profitability

Profitability is a measure of efficiency and control. It indicates the efficiency or effectiveness with which
the operations of the business are carried on. Poor operational performance may result in poor sales
and therefore low profits. Low profitability may be due to lack of control over expenses resulting in low
profits. Profitability ratios are employed by management in order to assess how efficiently they carry on
business operations. Profitability is the main base for liquidity as well as solvency. Creditors, banks and
financial institutions are interested in profitability ratios since they indicate liquidity or capacity of the
business to meet interest obligations and regular and improved profits enhance the long term solvency
position of the business. Owners are interested in profitability for they indicate the growth and also the
rate of return on their investments. The importance of measuring profitability has been stressed by
Hingorani, Ramanathan And Grewal in these words: “a measure of profitability is the overall measure of
efficiency”.

An appraisal of the financial position of any enterprise is incomplete unless its overall profitability is
measured in relation to the sales, assets, capital employed, net worth and earnings per share. The
following ratios are used to measure the profitability position from various angles:

Ֆ Gross Profit Ratio

Ֆ Net Profit Ratio

Ֆ Return On Capital Employed

Ֆ Operating Ratio

Ֆ Operating Profit Ratio

Ֆ Return On Owners’ Equity

Ֆ Earnings Per Share

Ֆ Dividend Pay Out Ratio

Gross Profit Ratio:

The gross profit ratio or gross profit margin ratio expresses the relationship of gross profit on sales / net
sales. B.r.rao opines that “gross profit margin ratio indicates the gross margin of profits on the net sales
and from this margin only, all expenses are met and finally net income emerges”. The basic components
for the computation of this ratio are gross profits and net sales. `net sales’ means total sales minus sales
returns and `gross profit’ means the difference between net sales and cost of goods sold. The formula
used to compute gross profit ratio is:

Gross Profit

Gross Profit Ratio = ------------------ X 100

Sales

Gross profit ratio indicates to what extent the selling prices of goods per unit may be reduced without
incurring losses on operations. A low gross profit ratio will suggest decline in business which may be due
to insufficient sales, higher cost of production with the existing or reduced selling price or the all-round
inefficient management. A high gross profit ratio is a sign of good and effective management.

Net Profit Ratio:

Net profit is a good indicator of the efficiency of a firm. Net profit ratio or net profit margin ratio is
determined by relating net income after taxes to net sales. Net profit here is the balance of profit and
loss account which is arrived at after considering all non-operating incomes such as interest on
investments, dividends received, etc. And non-operating expenses like loss on sale of investments,
provisions for contingent liabilities, etc. This ratio indicates net margin earned on a sale of rs.100. The
formula for calculating the ratio is:

Net Profit

Net Profit Ratio = ---------------- X 100

Sales

This ratio is widely used as a measure of overall profitability and is very useful for proprietors. A higher
ratio indicates better position.

Return On Capital Employed:

The prime objective of making investments in any business is to obtain satisfactory return on capital
invested. Hence, the return on capital employed is used as a measure of success of a business in
realising this objective. Otherwise known as return on investments, this is the overall profitability ratio.
It indicates the percentage of return on capital employed in the business and it can be used to show the
efficiency of the business as a whole. The formula for calculating the ratio is:
 Operating Profit

Return On Capital Employed = --------------------- X 100

Capital Employed

The term “capital employed” means [share capital + reserves and surplus + long term loans] minus
[non-business assets + fictitious assets] and the term “operating profit” means profit before interest and
tax. The term `interest’ means interest on long-term borrowings. Non-trading income should be
excluded for the above purpose. A higher ratio indicates that the funds are invested profitably.

Operating Ratio:

This ratio establishes the relationship between total operating expenses and sales. Total operating
expenses includes cost of goods sold plus other operating expenses. A higher ratio indicates that
operating expenses are high and the profit margin is less and therefore lower the ratio, better is the
position. The operating ratio is an index of the efficiency of the conduct of business operations. An ideal
norm for this ratio is between 75% to 85% in a manufacturing concern. The formula for calculating the
operating ratio is thus:

Cost Of Goods Sold + Operating Experience

Operating Ratio = ----------------------------------------------------- X 100

Sales

Operating Profit Ratio: this ratio indicates net-margin earned on a sale of rs.100. It is calculated as
follows:

Net Operating Profit

Operating Profit Ratio = ------------------------- X 100

Sales

The operating profit ratio helps in determining the efficiency with which affairs of the business are
being managed. An increase in the ratio over the previous period indicates improvement in the
operational efficiency of the business provided the gross profit ratio is constant. Operating profit is
estimated without considering non-operating income such as profit on sale of fixed assets, interest on
investments and nonoperating expenses such as loss on sale of fixed assets. This is thus, an effective tool
to measure the profitability of a business concern.

Return On Owners’ Equity (Or) Shareholders’ Fund (Or) The Net Worth:

The ratio of return on owners’ equity is a valuable measure for judging the profitability of an
organisation. This ratio helps the shareholders of a firm to know the return on investment in terms of
profits. Shareholders are always interested in knowing as to what return they earned on their invested
capital since they bear all the risk, participate in management and are entitled to all the profits
remaining after all outside claims including preference dividend are met in full. This ratio is computed as
a percentage by using the formula:
 Net Profit After Interest And Tax

Return On Owners’ Equity = ------------------------------------------ X 100

Owners’ Equity (Net Worth)

This is the single most important ratio to judge whether the firm has earned a satisfactory return for its
equity-shareholders or not. A higher ratio indicates the better utilisation of owners’ fund and higher
productivity. A low ratio may indicate that the business is not very successful because of inefficient and
ineffective management and over investment in assets.

Earnings Per Share (EPS):

The profitability of a firm from the point of view of the ordinary shareholders is analysed through the
ratio `EPS’. It measures the profit available to the equity shareholders on a per share basis, i.e. The
amount that they can get on every share held. It is calculated by dividing the profits available to the
shareholders by the number of the outstanding shares. The profits available to the ordinary
shareholders are represented by net profit after taxes and preference dividend.

Net Profit After Tax – Preference Dividend

Earnings Per Share = ----------------------------------------------------

Number Of Equity Shares

This ratio is an important index because it indicates whether the wealth of each shareholder on a per-
share basis has changed over the period. The performance and prospects of the firm are affected by eps.
If eps increases, there is a possibility that the company may pay more dividend or issue bonus shares. In
short, the market price of the share of a firm will be affected by all these factors.

Dividend Pay Out Ratio:

This ratio measures the relationship between the earnings belonging to the ordinary shareholders and
the dividend paid to them. In other words, the dividend pay out ratio shows what percentage share of
the net profits after taxes and preference dividend is paid out as dividend to the equity shareholders. It
can be calculated by dividing the total dividend paid to the owners by the earnings available to them.
The formula for computing this ratio is:

Dividend Per Equity Share

Dividend Payout Ratio = -------------------------------

Earnings Per Share

This ratio is very important from shareholder’s point of view as its tells him that if a firm has used whole,
or substantially the whole of its earnings for paying dividend and retained nothing for future growth and
expansion purposes, then there will be very dim chances of capital appreciation in the price of shares of
such firms. In other words, an investor who is more interested in capital appreciation must look for a
firm having low payout ratio.

2.2.3.11 Analysis Of Operational Efficiency

 The operational efficiency of an organisation is its ability to utilise the available resources to the
maximum extent. Success or failure of a business in the economic sense is judged in relation to
expectations, returns on invested capital and objectives of the business concern. There are many
techniques available for evaluating financial as well as operational performance of a firm. The two
important techniques adopted in this study are:

1. Turnover to capital employed or return on investment (ROI)

2. Financial operations ratio

Turnover To Capital Employed:

This is the ratio of operating revenue to capital employed. This is one of the important ratios to find out
the efficiency with which the firms are utilising their capital. It signifies the number of times the total
capital employed was turned into sales volumes. The term capital employed includes total assets minus
current liabilities. The ratio for calculating turnover to capital employed (in percentage) is:

Operating Revenue

Turnover To Capital Employed = --------------------------- X 100

Capital Employed

The higher the ratio, the better is the position.

Financial Operations Ratio:

The efficiency of the financial management of a firm is calculated through financial operations ratio.
This ratio is a calculating device of the cost and the return of financial charges. This ratio signifies a
relationship between net profit after tax and operating profit. The formula for the computation of this
ratio is:

Net Profit After Tax

Financial Operations Ratio = --------------------------- X 100

Operating Profit

Here, the term “operating profit” means sales minus operating expenses. A higher ratio indicates the
better financial performance of the firm.

2.2.3.12 Ratios From Shareholders’ Point Of View

1. Preference dividend cover: this ratio expresses net profit after tax as so many times of
preference dividend payable. This is calculated as:

Net Profit After Tax

-------------------------

Preference Dividend
2. Equity Dividend Cover: this ratio gives information about net profit available to equity
shareholders. This ratio expresses profit as number of times of equity dividend payable. This ratio is
calculated using the following formula:

Net Profit After Tax – Preference Dividend

-------------------------------------------------

Equity Dividend

3. Dividend Yield On Equity Shares Or Yield Ratio: this ratio interprets dividend as a percentage of
market price per share. It is calculated as:

Dividend Per Share

--------------------------- X 100

Market Price Per Share

4. Price Earning Ratio: this ratio tells how many times of earnings per share is the market price of
the share of a company. The formula to calculate this ratio is:

Market Price Per Share

---------------------------

Earnings Per Share

2.2.3.13 Illustrations

Illustration 4: the following are the financial statements of yesye limited for the year 2005.

Balance Sheet As At 31-12-2005

Rs. Rs.

Equity Share Capital 1,00,000 Fixed Assets 1,50,000

General Reserve 90,000 Stock 42,500

Profit & Loss Balance 7,500 debtors 19,000

Sundry Creditors 35,000 Cash 61,000

6% Debentures 30,000 Proposed

Dividends 10,000

2,72,500 2,72,500

--------------------------------------------------------------------------------Trading And Profit And Loss Account

For The Year Ended 31-12-2005

 Rs. Rs.

To Cost Of Goods Sold 1,80,000 By Sales 3 ,00,000 To Gross Profit C/D

1,20,000

3,00,000 3,00,000 To Expenses

1,00,000 By Gross Profit B/D 1,20,000

To Net Profit 20,000

1,20,000 1,20,000

You are required to compute the following:

1) Current Ratio

2) Acid Test Ratio

3) Gross Profit Ratio

4) Debtors’ Turnover Ratio

5) Fixed Assets To Net Tangible Worth6) Turnover To Fixed Assets Solution:

Current Assets

1) Current Ratio = ---------------------

Current Liabilities

1,22,500

= ----------- = 2.7:1. 45,000

Quick Assets

2) Acid Test Ratio = -------------------

Quick Liabilities

80,000

= ----------- = 1.8:1.

45,000

Gross Profit

3) Gross Profit Ratio = ---------------------- X 100

Sales
 1,20,000

= ------------- X 100 = 40%

3,00,000

Net Sales

4) Debtors’ Turnover Ratio = ---------------------

Average Debtors

3,00,000

= ------------- = 15.78 Times. 19,000

No. Of Days In The Year

Collection Period = -----------------------------

Debtors’ Turnover

365

= ----------- = 23 Days

15.78

5) Fixed Asset To Fixed Assets

Net Tangible Worth = ----------------------- X 100

Proprietor’s Fund

1,50,000

= ------------- X 100 = 76%

1,97,500

Net Sales

6) Turnover To Fixed Assets = ------------------

Fixed Assets

3,00,000

= ----------- = 2 Times

1,50,000

Illustration 5: from the following details prepare a statement of proprietary fund with as many details as
possible.

1) Stock Velocity 6
2) Capital Turnover Ratio 2

3) Fixed Assets Turnover Ratio 4

4) Gross Profit Turnover Ratio 20%

5) Debtors’ Velocity 2 Months

6) creditors’ velocity 73 days

Gross profit was rs.60,000. Reserves and surplus amount to 20,000. Closing stock was rs.5,000 in excess
of opening stock.

Solution:

1. Calculation Of Sales

Gross Profit

Gross Profit Ratio = --------------- X 100 = 20%

Sales

Rs.60,000 20

= --------------- = ------- Sales 100

= ---

Sales: Rs.3,00,000

2. Calculation Of Sundry Debtors

Debtors

Debtors’ Velocity = ------------ X 12 Months

Sales

Let Debtors Be X

2 = ----------- X 12

3,00,000

X 1

------------- = -- 3,00,000 6

X = Rs.50,000
Debtors: Rs.50,000

It Is Assumed That All Sales Are Credit Sales.

3. Calculation Of Stock

Cost Of Goods Sold

Stock Turnover Ratio = --------------------------- =6

= Average Stock

Cost Of Goods Sold = Sales – Gross Profit

= Rs.3,00,000 – Rs.60,000

= Rs.2,40,000

Rs.2,40,000

------------------ = 6 Average Stock

Rs.2,40,000

Average Stock = --------------- = Rs.40,000

Opening Stock + Closing Stock

Average Stock = --------------------------------------

Let Opening Stock Be Rs.X.

Then Closing Stock Will Be X + 5,000

X + X + 5,000

----------------

2X + 5,000 = 40,000

--------------

Cross Multiplying = 40,000

2X + 5,000 = 80,000

2X = 80,000 – 5,000

= 75,000
X = 37,500

4. Calculation Of Creditors

Total Creditors

Creditors’ Velocity = ------------------------------ X 365

Days Credit Purchases

= 73 Days

Purchase = Cost Of Goods + Closing Stock – Opening Stock

= Rs.2,40,000 + 42,500 – 37,500 = Rs.2,45,000

Let The Creditors Be X

-------------- X 365 = 73

2,45,000

365 X = 2,45,000 X 73

2,45,000 X 73

X = ----------------

365

Creditors = Rs.49,000

5. Calculation Of Fixed Assets

Costs Of Goods Sold

Fixed Assets Turnover Ratio = ----------------------------- = 4

Fixed Assets

Let Fixed Assets Be X

2,40,000

---------- = 4

X = 60,000

Fixed Assets = Rs.60,000

6. Shareholders’ Fund
 Cost Of Goods Sold

Capital Turnover Ratio = ----------------------- = 2

Proprietary Fund

2,40,000

--------------------- =2

Proprietary Fund

Proprietary Fund = Rs.1,20,000

Shareholders’ Fund Includes Share Capital, Profit & Reserve.

Share Capital = Shareholders’ Fund – (Profit + Reserve)

= Rs.1,20,000 – Rs.80,000 = Rs.40,000

7. Calculation Of Bank Balance

Shareholders’ Fund + Current Liabilities = Fixed Assets + Current Assets

Rs.1,20,000 + 49,000 = Rs.60,000 + Current Assets

Current Assets = Rs.1,09,000

Current Assets = Stock + Debtors + Bank

Bank Balance = Current Assets – (Stock +

Debtors)

= Rs.1,09,000– (42,500 + 50,000)

= Rs.1,09,000 – 92,500 =
Rs.16,500

Balance Sheet As On …

---------------------------------------------------------------------------------

Liabilities Rs. Assets Rs.

---------------------------------------------------------------------------------

Share Capital 40,000 Fixed Assets 60,000 Reserves & Surplus 20,000
Current Assets:

Profit 60,000 Stock 42,500

Current Liabilities 49,000 Debtors 50,000

Bank 16,500
 ---------- ------------

1,69,000 1,69,000

---------------------------------------------------------------------------------

Illustration 6: The Following Data Is Furnished:

A) Working Capital Rs.45,000

B) Current Ratio 2.5

C) Liquidity Ratio 1.5

D) Proprietary Ratio – (Fixed Assets To Proprietary Funds) 0.75

E) Overdraft Rs.10,000

F) Retained Earnings Rs.30,000

There Are No Long Term Loans And Fictitious Assets.

Find Out:

1) Current Assets

2) Current Liabilities

3) Fixed Assets

4) Quick Assets

5) Quick Liabilities

6) Stock 7) Equity

Solution:

Current Assets

Current Assets 2.5

Current Liability 1.0

--Working Capital 1.5

If Working Capital Is 1.5, Current Asset Will Be 2.5.

If Working Capital Is Rs.45,000, Current Assets Will Be Rs.75,000

Current Assets = Rs.75,000

Current Liability

Current Liability = Current Assets – Working Capital

= Rs.75,000 – Rs.45,000
 = Rs.30,000

Fixed Assets

Shareholders’ Fund+ Current Liabilities = Fixed Assets + Current Assets

Shareholders’ Fund=Fixed Assets + Current Assets – Current Liabilities

= Fixed Assets + Rs.75,000 – Rs.30,000

= Fixed Assets + Rs.45,000

Let The Shareholders’ Fund Be X, Fixed Assets Will Be ¾ X

X = Rs. ¾ X + Rs.45,000

¼X = Rs.45,000

X = Rs.1,80,000

¾X = Rs.1,35,000

Fixed Assets = Rs.1,35,000

Shareholders Funds = Rs.1,35,000 + Rs.45,000

Stock Rs.1,80,000

Quick Assets

Liquid Ratio = -------------------

Quick Liabilities

Quick Assets = Current Assets – Stock

Quick Liabilities = Let The Value Of Stock Be X. Current Liabilities – Bank Overdraft

Quick Assets Rs.75,000 – X

-------------------- = ---------------------

Quick Liabilities 30,000 – 10,000

75,000 - X

= ------------- = 1.5

20,000

Cross Multiplying

75,000 – X = 20,000 X 1.5

75,000 – X = 30,000
 X = 45,000

Stock = Rs.45,000

Quick Assets = Rs.75,000 – Rs.45,000

= Rs.30,000

Quick Liabilities = Rs.20,000

Equity

Shareholders’ Fund = Equity + Retained Earnings Shareholders’ Fund = Rs.1,80,000 (As

Calculated)

Retained Earnings = Rs.30,000 (As Given) Equity = Rs.1,50,000

Illustration 7:

From the following balance sheet of dinesh limited calculate (i) current ratio (ii) liquid ratio (iii) debt-
equity ratio (iv) proprietary ratio, and (v) capital gearing ratio.

Balance Sheet Of Dinesh Limited As On 31-12-2005

---------------------------------------------------------------------------------

Liabilities Rs. Assets Rs.

---------------------------------------------------------------------------------

Equity share capital 10,00,000 goodwill 5,00,000

6% preference capita l 5,00,000 plant & machinery 6,00,000

Reserves 1,00,000 land & buildings 7,00,000

Profit & loss a/c 4,00,000 furniture 1,00,000

Tax provision 1,76,000 stock 6,00,000

Bills payable 1,24,000 bills receivables 30,000 Bank overdraft 20,000 sundry debtors
1,50,000 Sundry creditors 80,000 bank account 2,00,000

12% debentures 5,00,000 short term investment 20,000

------------ ---------

29,00,000
29,00,000

-------------------------------------------------------------------------------- Current Assets

(I) Current = ------------------------

Ratio Current Liabilities

 Stock + Bills Receivables + Debtors + Bank + S.T. Investments

= --------------------------------------------------------------- S.Creditors + Bills Payable

+ Bank O.D. + Tax Provision

10,00,000

= ------------ = 2.5 : 1. 4,00,000

Interpretation:

The current ratio in the said firm is 2.5:1 against a standard ratio of 2:1. It is a good sign of liquidity.
However, the stock is found occupying 60 percent of current assets which may not be easily realisable.

Current Assets – Stocks

(II) Liquid Ratio = --------------------------------

Current Liabilities

Liquid Assets

= ------------------------

Current Liabilities

4,00,000

= --------- 4,00,000 = 1:1.

Interpretation:

The standard for quick ratio is 1:1. The calculated ratio in case of dinesh limited is also 1:1. The above
two ratios show the safety in respect of liquidity in the said firm.

Long Term Debt

(III) Debt Equity Ratio = -------------------------------------

Equity Shareholders’ Fund

Debentures

= ---------------------------------------------------------------------------

Equity Capital + Preference Capital + Reserves + Profit & Loss A/C

5,00,000

= -------------------------------------------------------

10,00,000 + 5,00,000 + 1,00,000 + 4,00,000

= 1:4.

Interpretation:
 Debt-equity ratio indicates the firm’s long term solvency. It can be observed that the firm’s long term
loans are constituting 25 percent to that of the owners’ fund. Although such a low ratio indicates better
long term solvency, the less use of debt in capital structure may not enable the firm to gain from the full
stream of leverage effects.

Proprietors’ Funds

(IV) Proprietary Ratio = ---------------------------

Total Assets

20,00,000

= ------------ = 20:29 29,00,000

Interpretation:

Out of total assets, seven-tenths are found financed by owners’ funds. In other words a large majority
of long term funds are well invested in various long term assets in the firm.

Owners’ Resources

(V) Capital Gearing Ratio = -------------------------------------------

Fixed-Interest Bearing Resources

Equity Share Capital + Reserves + P&L A/C

= -----------------------------------------------

Preference Capital + Debentures

10,00,000 + 1,00,000 + 4,00,000

= --------------------------------------------

5,00,000 + 5,00,000

15,00,000

= --------------- = 1.5:1. 10,00,000

Interpretation:

Keeping rs.15 lakhs of equity funds as security, the firm is found to have mobilised rs.10 lakhs from
fixed interest bearing sources. It indicates that the capital structure is low geared.

Illustration 8:

The following are the balance sheet and profit and loss account of sundara products limited as
on 31st december 2005.

Profit And Loss Account

To Opening Stock 1,00,000 By Sales 8,50,000

Purchases 5,50,000

Direct Expenses 15,000 Gross Profit 3,35,000 Closing Stock 1,50,000

------------ ------------

10,00,000 10,00,000

------------ ------------

To Admn. Expenses 50,000 By Gross Profit 3,35,000

Office Establishment 1,50,000

Income 15,000

Financial Expenses 50,000

Non-Operating

Expenses/Losses 50,000

Net Profit 50,000 Non-Operating

----------- -----------

3,50,000 3,50,000

---------------------------------------------------------------------------------

Liabilities Rs. Assets Rs.

Equity Share Capital Land & Buildings 1,50,000

(2000 @ 100) 2,00,000 Plant & Machinery 1,00,000

Reserves 1,50,000 Stock In Trade 1,50,000

Balance Sheet

Current Liabilities 1,50,000 Sundry Debtors 1,00,000

P&L A/C Balance 50,000 Cash & Bank 50,000

---------- ----------

5,50,000 5,50,000

--------------------------------------------------------------------------------Calculate Turnover Ratios.

Solution:

(I) Share Capital To Turnover Ratio

Sales
 = --------------------------------- Total Capital Employed

Sales

= ----------------------------------------------- Equity + Reserve + P & L A/C

Balance

8,50,000

= ----------

4,00,000

= 2.13 Times.

Interpretation:

This turnover ratio indicates that the firm has actually converted its share capital into sales for about
2.13 times. This ratio indicates the efficiency in use of capital resources and a high turnover ratio
ensures good profitability on operations on an enterprise.

(ii) fixed asset’s turnover ratio

Sales

= ---------------------------

Total fixed assets

Sales

= ------------------------------------

Land + Plant & Machinery

8,50,000

= ------------

2,50,000

= 3.4 times.

Interpretation:

Although fixed assets are not directly involved in the process of generating sales, these are said to back
up the production process. A ratio of 3.4 times indicates the efficient utilisation of various fixed assets in
this organisation.

(iii) Net working capital turnover:

Sales

= ----------------------------
 Net Working Capital

Sales

= --------------------------------------------

Current Assets – Current Liabilities

8,50,000

= -----------------------

3,00,000 – 1,50,000

= 5.67 Times.

Interpretation:

Net working capital indicates the excess of current assets financed by permanent sources of capital. An
efficient utilisation of such funds is of prime importance to ensure sufficient profitability along with
greater liquidity. A turnover ratio of 5.7 times is really appreciable.

(iv) Average Collection Period:

Credit Sales

Debtor’s Turnover = -----------------------

Average Debtors

Assuming that 80% of the sales of 8,50,000 as credit sales:

6,80,000

= ------------

1,00,000

= 6.8 times

Average collection period

360 Days

= -------------------------

Debtors’ Turnover

360

= -------

6.8 = 53 Days

Interpretation:
 Average collection period indicates the time taken by a firm in collecting its debts. The calculated ratio
shows that the realisation of cash on credit sales is taking an average period of 53 days. A period of
roughly two months indicate that the credit policy is liberal and needs a correction.

(v) Stock Turnover Ratio

Cost Of Goods Sold

= ---------------------------

Average Stock

Sales – Gross Profit

= ----------------------------------------------- (Opening Stock + Closing

Stock) + 2

5,15,000

= ----------

1,25,000

= 4.12 times.

Interpretation:

Stock velocity indicates the firm’s efficiency and profitability. The stock turnover ratio shows that on an
average inventory balances are cleared once in 3 months. Since there is no standard for this ratio, the
period of operating cycle of this firm is to be compared with the industry average for better
interpretation.

Illustration 9:

Comment on the performance of arasu limited from the ratios given below:

Industry average Ratios of

Ratios Arasu ltd.

1. Current ratio 2:1 2.5:1

2. Debt-equity ratio 2:1 1:1

3. Stock turnover ratio 9.5 3.5

4. Net profit margin ratio 23.5% 15.1%

Solution:

(i) Current Ratio:

This ratio indicates the liquidity position of a firm. The ability of a firm in meeting its current liabilities
could be understood by this ratio. The calculated results show that the liquidity in arasu limited is even
greater than industry average, showing the safety. However, excess liquidity locks up the capital in
unnecessary current assets. (ii) Debt-Equity Ratio:

It is an indicator of a firm’s solvency in terms of its ability to repay long term loans in time. The
calculated ratio shows better solvency of 1:1 indicating that for every one rupee of debt capital, to repay
one rupee of equity base exists in arasu ltd. However, this ratio is not likely to ensure the leverage
benefits that a firm gains by using higher dose of debt.

(iii) Stock Turnover Ratio:

Stock velocity is an indicator of a firm’s activeness. It directly influences the profitability of a firm. The
calculated ratio for arasu ltd. Is very poor when compared to industry average. This poor ratio indicates
the inefficient use of capacities, consequently, the likely low profitability.

(iv) Net Profit Margin Ratio:

Although the firms in a particular industry could sell the product more or less at same price, the net
profits differ among firms due to their cost of production, excessive administrative and establishment
expenses etc. This picture is found true in case of arasu ltd. A poor profitability of 15.1% compared to an
industry average of 23.5% may be due to low stock turnover, inefficiency in management, excess
overhead cost and excessive interest burdens.

2.2.3.14 Summary

Financial statements by themselves do not give the required information both for internal management
and for outsiders. They must be analysed and interpreted to get meaningful information about the
various aspects of the concern. Analysing financial statements is a process of evaluating the relationship
between the component parts of the financial statements to obtain a proper understanding of a firm’s
performance. Financial analysis may be external or internal analysis or horizontal or vertical analysis.
Financial analysis can be carried out through a number of tools like ratio analysis, funds flow analysis,
cash flow analysis etc. Among the various tools available for their analysis, ratio analysis is the most
popularly used tool. The main purpose of ratio analysis is to measure past performance and project
future trends. It is also used for inter-firm and intra-firm comparison as a measure of comparative
productivity. The financial analyst x-rays the financial conditions of a concern by the use of various ratios
and if the conditions are not found to be favourable, suitable steps can be taken to overcome the
limitations.

2.2.3.15 Key Words

Analysis: analysis means methodical classification of the data given in the financial statements.

Interpretation: interpretation means explaining the meaning and significance of the data so classified.

Financial Statements: income statement and balance sheet.

Ratio: the relationship of one item to another expressed in simple mathematical form is known as a
ratio.

Ratio Analysis: the process of computing, determining and presenting the relationship of items and
groups of items in financial statements.
Financial Leverage: the ability of a firm to use fixed financial charges to magnify the effects of changes in
ebit on the firm’s earnings per share.

Net Worth: proprietors’ funds – intangible assets – fictitious assets. Debt: both long term and short term
liabilities.

Operating Profit: gross profit – operating expenses. Equity: proprietors’ fund.

Capital Employed: net worth + long term liabilities.

2.2.3.16 Self Assessment Questions

1. Explain the meaning of the term `financial statements’. State their nature and limitations.

2. Explain the different types of financial analysis.

3. Explain the various tools of financial analysis.

4. Justify the need for analysis and interpretation of financial statements.

5. Collect the annual reports of any public limited company for a period of 5 years. Calculate the
trend percentages and prepare a report.

6. What is meant by ratio analysis? Explain its significance in the analysis and interpretation of
financial statements.

7. Explain the importance of ratio analysis in making comparisons between firms.