Ratio Analysis lecture notes United University

Lecture notes

1. Ratio analysis Ratio analysis is a quantitative method of gaining insight into a company's liquidity, operational efficiency, and profitability by studying its financial statements such as the balance sheet and income statement. 

2. Objectives of Ratio Analysis   Helps in Evaluating Operational Efficiency Few of the ratios are targeted to evaluate the firm’s degree of efficiency at how it is handling its assets and other resources . It is a must for a firm that assets and financial resources are well utilized, and unnecessary expense levels are kept to a bare minimum. To get an overall picture of the efficiency of  assets, turnover ratios  and efficiency ratios can play a major role.

3. Objectives of Ratio Analysis Maintaining Liquidity The liquidity problem is the major issue that many firms face these days, and thus every firm should maintain a certain amount of liquidity to meet its urgent cash requirement. Specifically to main short term solvency issues, quick ratio and  current ratio can play  a major role. Determining Financial Condition Some ratios are handy to determine the overall financial health and performance of a company. This can be indicated by determining the overall long term solvency of the firm. This helps in judging whether there is too much pressure on the assets or if the firm is over-leveraged. Thus, to avoid future liquidation problem, the business has to quickly recognize this. Ratios that prove handy in such scenarios are leverage ratios and  debt-equity ratios .

4. Objectives of Ratio Analysis Helps in Comparing C ertain ratios are used to compare the benchmarks prevalent in the industry to get a better outlook of the company’s financial performance and position. Businesses can take rectifying actions if the company does not maintain the standard. Here generally, the ratios are compared to the previous year’s ratio to understand the company’s track record .

5. Limitations of Ratio Analysis Ratio analysis is an important aspect; however, a range of drawbacks of ratio analysis are listed below. 1. Use of Historical Data All the information used in ratio analysis is based on historical numbers only. These data are drawn from historical actuals and by no means will remain the same in the future as business performance changes with every passing time.

6. Limitations of Ratio Analysis The Concept of Inflation When we compare period-wise numbers for trend analysis, and if the inflationary rate has changed in between the periods, the comparison makes no sense . Ratio analysis does not account for the inflation factor at all. The Problem of Aggregation The data from the financial statement for a particular line item that we are using for our study or comparison may have been aggregated in a different proportion in the past, and thus doing a trend analysis based on this data doesn’t give a true picture.

7. Limitations of Ratio Analysis The Policies of Accounting When we are doing peer to peer comparison, different companies may use different accounting policies and thus, it makes it hard to conclude on such cases. No Standard Definition of Ratios Some firms may include some items when calculating a ratio, and few may include others. Thus when it comes to a comparison of both companies, it becomes difficult

8. Types of Ratio Analysis 1 . Liquidity Ratios Liquidity ratios  measure a company's ability to pay off its short-term debts as they become due , using the company's current or quick assets. Liquidity ratios include the current ratio, quick ratio, and working capital ratio. 2. Solvency Ratios Also called financial leverage ratios,  solvency ratios   compare a company's debt levels with its assets, equity, and earnings, to evaluate the likelihood of a company staying afloat over the long haul, by paying off its long-term debt as well as the interest on its debt. Examples of solvency ratios include: debt-equity ratios, debt-assets ratios, and interest coverage ratios.

9. 3 . Profitability Ratios These ratios convey how well a company can generate profits from its operations. Profit margin, return on assets, return on equity, return on capital employed, and gross margin ratios are all examples of   profitability ratios .

10. 4 . Efficiency Ratios Also called activity ratios,  efficiency ratios  evaluate how efficiently a company uses its assets and liabilities to generate sales and maximize profits. Key efficiency ratios include: turnover ratio, inventory turnover, and days' sales in inventory. 5. Coverage Ratios Coverage ratios   measure a company's ability to make the interest payments and other obligations associated with its debts. Examples include the  times interest earned ratio  and the  debt-service coverage ratio . 6. Market Prospect Ratios These are the most commonly used ratios in fundamental analysis. They include  dividend yield ,  P/E ratio ,  earnings per share  (EPS), and  dividend payout ratio . Investors use these metrics to predict earnings and future performance.

11. Liquidity Ratios Liquidity ratios  measure a company's ability to pay off its short-term debts as they become due , using the company's current or quick assets. Liquidity ratios include the current ratio, quick ratio, and working capital ratio. Liquidity ratios measure a company's ability to pay debt obligations and its margin of safety through the calculation of metrics including the  current ratio ,  quick ratio , and  operating cash flow ratio . The ideal current ratio is 2:1 but it also depends on the characteristics of the current assets and current liabilities along with the nature of the business of the firm.

12. Types of Liquidity Ratios Current Ratio The current ratio measures a company's ability to pay off its current liabilities (payable within one year) with its total current assets such as cash, accounts receivable, and inventories. The higher the ratio, the better the company's liquidity position Current Ratio= Current Assets​ Current liabilities CURRENT ASSET S = Sundry Debtors + Inventories + Cash-at-Bank + Cash-in-hand +Bills Receivables +Short term Loans and Advances + Advance Tax + Marketable securities+ Prepaid expense Current Liabilities = Creditors + Short-term Loans + Bank Overdraft + Cash Credit + Outstanding expenses + Dividend payable + Provision for Taxation

13. Quick Ratio It is also known as Acid-test Ratio. It is a measure of the liquidity calculated on the basis of the relationship between Quick Assets and Current Liabilities. It is used to calculate if the readily convertible quick funds are enough to pay the current debts. The ideal Quick Ratio or Acid-test Ratio is 1:1 . 

14. The Quick Ratio Quick Assets = Current Assets – Inventories – Prepaid Expenses QUICK LIABILITY WHICH HAVE TO PAY WITH IN THE SPECIFIED TIME SOME LIABILITY ARE NON QUICK LIABILITY SUCH AS BANK OVERDRAFT,CASH CREDIT CURRENT ASSET S= Sundry Debtors + Inventories + Cash-at-Bank + Cash-in-hand +Bills Receivables +Short term Loans and Advances + Advance Tax + Marketable securities+ outstanding expense+ Prepaid expense The quick ratio measures a company’s ability to meet its very short-term obligations with its most liquid assets and therefore excludes inventories from its current assets. It is also known as the acid-test ratio : Quick ratio= QUICK ASSETS QUICK LIABILITY OR QUICK ASSETS CURRENT LIABILITY

15. Cash Ratio or Absolute Liquidity Ratio It measures the absolute liquidity of the firm. It is used by creditors for determining the relative ease with which company can clear short term liabilities It measures whether a firm can pay the current debts by using only the cash balances, bank balances and marketable securities. Do not include Inventory and Debtors because there is no guarantee of their realization. Thus, Cash Ratio= Cash and Bank Balances + Marketable Securities + CurrentInvestments Current Liabilities Net Working Capital Ratio It is a measure of cash flow. Usually, the bankers keep an eye on this ratio to see whether there is a financial crisis or not. Thus, Net Working Capital Ratio = Current Assets – Current Liabilities (exclude short-term bank borrowing)

16. From the following particulars calculate the liquidity ratios: Particulars Amount Inventory 140000 Sundry Debtors 280000 Cash 50000 Bills receivable 20000 Creditors 300000 Bank Overdraft 50000

17. Current Ratio= Current Assets Current Liabilities Current Assets = Sundry Debtors + Inventories + Cash- inhand + Bills Receivable = 280000 + 140000 + 50000 + 20000 = 490000 Current Liabilities = Creditors + Bank Overdraft = 300000 + 50000 = 350000 Current Assets Current Liabilities =490000/350000=1.4:1

18. Quick Ratio or Acid-test Ratio= Quick Assets Current Liabilities =350000/350000=1:1 Quick Assets = Current Assets – Inventories = 490000 – 140000 = 350000 Cash Ratio= Cash Balance Current Liabilities =50000/350000=0.14:1 Net Working Capital Ratio = Current Assets – Current Liabilities (exclude short-term bank borrowing) = 490000 – 300000 = 190000

19. QUES.2 PARTICULARS AMOUNT INVENTORY 1,50,000 CASH 50,000 SUNDRY DEBTORS 3,00,000 CREDITORS 3,50,000 BILLS RECEIVABLE 30,000 BANK OVERDRAFT 30,000

20. Current Ratio= Current Assets/ Current Liabilities Current Assets = Sundry Debtors + Inventories + Cash-in-hand + Bills Receivable Current Liabilities = Creditors + Bank Overdraft Current Assets= 300,000 + 150,000+ 50,000+ 30,000= 530,000 Current Liabilities = 350,000+ 30,000= 380,000 Current Ratio= 530,000 / 400,000= 1.3 :1 Quick Ratio or Acid Test Ratio= Quick Assets / Current Liabilities Quick Assets = Current Assets – Inventories Quick Assets= 530,000 - 150,000= 380,000 Quick Ratio or Acid Test Ratio= 380,000 / 380,000 = 1:1 Cash Ratio = Cash Balance / Current Liabilities Cash Ratio = 50,000 / 380,000= 0.13:1 Net Working Capital Ratio = Current Assets – Current Liabilities (exclude short-term bank borrowing) Net Working Capital Ratio = 530,000- 350,000= 180,000

21. = 32,000 60,000   = 0.53 : 1  

22. PROFITABILITY RATIO GROSS PROFIT RATIO = GROSS PROFIT NET SALES NET PROFIT RATIO = NET PROFIT NET SALES OPERATIG PROFIT RATIO = OPERATING PROFIT NET SALES OPERATIG RATIO/OPERATING EXP RATIO = TOTAL OPERATING EXPENSE NET SALES 1-GROSS PROFIT= SALES-COGS NET PROFIT=GROSS PROFIT-INDIRECT EXPENSE-INCOMETAX

23. TURNOVER RATIO OR ACTIVITY RATIO FIXED ASSET TURNOVER RATIO = SALES NET FIXED ASSETS IF SALES IS NOT AVAILABLE THAN WE CAN WRITE = COGS NET FIXED ASSETS CURRENT ASSET TURNOVER RATIO = SALES CURRENT ASSETS WORKING CAPITAL TURNOVER RATIO = SALES WORKING CAPITAL WORKING CAPITAL= CURRENT ASSETS-CURRENT LIABILITIES

24. STOCK TURNOVER RATIO = COGS AVERAGE STOCK DEBT TURNOVER RATIO = NET CREDIT SALES AVERAGE ACCOUNTRECEIVABLES (AVERGAE ACCOUNTS RECEIVABLES=DEBTORS+B/R) CREDITORS TURNOVER RATIO = NET CREDIT SALES AVERAGE ACCOUNTSPAYABLES (ACCOUNTSPAYABLES=CRETORS+B/P)

25. Return on Equity This ratio measures Profitability of equity fund invested the company.   Formula: Profit after Tax ÷ Net worth  Where, Net worth = Equity share capital, and Reserve and Surplus Earnings Per Share This ratio measures profitability from the point of view of the ordinary shareholder. A high ratio represents better the company is .  Formula: Net Profit ÷ Total no of shares outstanding

26. Dividend Per Share This ratio measures the amount of dividend distributed by the company to its shareholders. The high ratio represents that the company is having surplus cash.   Formula: Amount Distributed to Shareholders ÷ No of Shares outstanding Price Earnings Ratio This ratio also indicates Expectation about the earning of the company and payback period to the investors .  Formula: Market Price of Share ÷ Earnings per share

27. Return on Capital Employed This ratio computes percentage return in the company on the funds invested in the business by its owners. A high ratio represents better the company is.        Formula: Net Operating Profit ÷ Capital Employed × 100  Capital Employed = Equity share capital, Reserve and Surplus, Debentures    and long-term Loans Capital Employed Capital Employed = Total Assets – Current Liability Return on Assets This ratio measures the earning per rupee of assets invested in the company. A high ratio represents better the company is.   Formula: Net Profit ÷ Total Assets

28. Particulars Amount Shareholder Equity   Equity Shares, 2346 share outstanding, Par value 0.05 118 Paid In Capital 5858 Retained Earning 13826 Total Shareholder Equity 19802 Total Assets 30011 Current Liability 8035 Total Sales 53553 Gross Profit 16147 Net Operating Profit 3028.65 Net Profit 3044

29. Profitability Ratios: 1)  Return on Equity = Profit After tax / Net worth,                                                 = 3044/19802       =  15.37% 2)   Earnings Per share = Net Profit / Total no of shares outstanding                  =3044/2346 = 1.30 %

30. Return on Capital Employed =Net Operating Profit / Capital Employed * 100 =3028.65/(30011-8035)*100 = 13.78% 4) Return on Assets = Net Profit / Total Assets = 3044/30011 = 10.14% 5) Gross Profit = Gross Profit / sales * 100 = 16147/53553*100 = 30.15% 6) Net Profit = Net Profit / Sales*100 = 3044/53553*100 = 5.68%

31. DEBT EQUIT RATIO = DEBT (LONG TERM LOAN+DEBENTURE) EUITY(SHARE HOLDER”S FUNS) TOTAL ASSET TO DEBT RATIO = TOTAL ASSETS DEBT (LONG TERM LOAN+DEBENTURE) PROPRIETARY RATIO = PROPRIETARY FUND (SHARE HOLDER’S FUND+ EQUITY) TOTAL ASSETS INTEREST COVERAGE RATIO = PROFIT BEFORE INTEREST TAX AND DIVIDEND INTEREST ON LONG TERM LOAN ANND DEBENTURE CAPITAL EMPLOYED=EQUITY CAPITAL+RESERVES AND SURPLUS-FICTITIOUS ASSETS+PREFERENCE SHARECAPITAL+LOAN ADNDEBENTURES+CURRENT LIABILITY SHAREHOLDERS FUND= EQUITY CAPITAL+RESERVES AND SURPLUS-FICTITIOUS ASSETS+PREFERENCE SHARECAPITAL DEBT=LOAN AND DEBENTURE SOLVENCY RATIO

32. SOLVENCY RATIO DEBT SERVICE RATIO = PROFIT AFTER TAX BEFORE INTEREST INTEREST ON LOAN AND DEBENTURE+ INSTALMENT (DEB SERVICE=INT+INST) CAPITAL COVERAGE RATIO = DEBENTURE+PREFERENCE SHARE CAOPITAL EQUITY FUND

33. From the following information calculate the debt-equity ratio .

34. Explanation: – Debt equity ratio= Long term debt/shareholders fund = 650000/250000 = 2.6 : 1 Working note 1 : Long term Debt = 12 % Debentures + Long term borrowings + Long term provisions Long term Debt = 500000 + 50000 + 100000 Long term Debt = 650000 Working note 2 : Shareholders fund = Equity Share Capital + Preference share capital + Reserve and surplus + Securities premium + Profit and loss balance Shareholders fund = 150000 + 50000 + 30000 + 15000 + 5000 Shareholders fund = 250000

35. Calculate equity ratio Equity Ratio = 600000/300000 Equity Ratio = 2 Working note 1 : Shareholders’ Equity = Share Capital + Reserves + Surplus = 500000 + 300000 + -200000 = 600000 Capital employed = Non Current Assets + Current Assets (-) Trade Payables Capital employed = 250000 + 100000 (-) 50000 Capital employed = 300000

36. Compute Debt to Total Assets Ratio from the above information Debt to Total Assets Ratio = 250000/125000 Debt to Total Assets Ratio = 2 :1 Working note 1 : Total Assets = Fixed Assets + Non Current Investments + Current Assets = 80000 + 20000 + 25000 Total Assets = 125000

37. Interest Coverage Ratio – Solvency Ratio Analysis Compute Interest Coverage ratio if equity share capital is Rs. 1200000, Preference Share Capital is Rs. 720000, Capital Reserve is Rs. 360000, Profit & Loss Balance is Rs. 600000. The Value of 13 % debentures is Rs. 250000 and 11 % Mortgage loan of Rs. 300000. The value of Current Liabilities is Rs. 1180000 Non-Current Assets is worth Rs. 2400000 Value of Current Assets is Rs. 3000000 . Interest Coverage Ratio = 589500/65500 Interest Coverage Ratio = 9 times Working Notes: Interest on debenture = 13% x 250000 = 32500 Interest on loan = 11% x 300000 33000 Total interest charges = 6550

38. From the following information, compute Proprietary Ratio PARTICULARS AMOUNT SHARE CAPITAL 5,000 NON CURRENT ASSETS 220000 RESRVES AND SURPLUS 30000 CURRENT ASSETS 100000

39. From the following information, compute Proprietary Ratio Solution: Shareholders Funds= Share Capital + Reserves and Surplus =Rs 50000 + Rs 30000= Rs 80000 Total Assets= Current Assets +Non-Current assets =Rs 100000 + Rs 220000= Rs 320000 Proprietary Ratio= Proprietors funds or shareholders funds or equity/Total Assets =80000/320000=0.25 PARTICULARS AMOUNT SHARE CAPITAL 5,000 NON CURRENT ASSETS 220000 RESRVES AND SURPLUS 30000 CURRENT ASSETS 100000

40. From the following information, compute Interest Coverage Ratio Prakash Ltd. has a term loan of Rs 100000. Interest on the loan for the year is Rs 12500, and its profit before interest and tax is Rs 50000.

41. From the following information, compute Interest Coverage Ratio Prakash Ltd. has a term loan of Rs 100000. Interest on the loan for the year is Rs 12500, and its profit before interest and tax is Rs 50000. Solution: Interest on the loan = Rs 12500 Profit before interest and tax =Rs 50000 Interest Coverage Ratio = Profit before Interest and Taxes /Interest on Long term Debt =50000/12500= 4 times Therefore, the interest coverage ratio is 4 times.

42. Particulars Amount Profit after interest and taxes 497000 Rate of Income tax 30% 12% Debentures 600000 From the following information, compute Interest Coverage Ratio Solution:

43. Particulars Amount Profit after interest and taxes 497000 Add: Taxes(497000 X30/70) 213000 Add: Interest on Debentures (600000 X 12%) 72000 Net profit before interest and taxes 782000 Solution: Computation of net profit before interest and taxes Interest Coverage Ratio = Profit before Interest and Taxes /Interest on Long term Debt =782000/72000= 10.86 times Therefore the interest coverage ratio is 10.86 times.

44. Calculation of Proprietary Ratio – Solvency Ratio Analysis – Question 5 Compute Proprietary ratio if equity share capital is Rs. 125000, Preference Share Capital is Rs. 100000, Capital Reserve is Rs. 80000, Profit & Loss Balance is Rs. 55000. The value of 7 % Debentures is Rs. 62500 and 9 % Mortgage loan- Rs. 112500. Value of Current Liabilities is Rs. 262500 Non-Current Assets is worth Rs. 275000 Value of Current Assets is Rs. 125000. Proprietary Ratio = 360000/400000 Proprietary Ratio = 0.9 Working note 1: Shareholders’ Funds = Equity share capital + Preference share capital + Capital reserve + Profit and loss balance Shareholders’ Funds = 125000 + 100000 + 80000 + 55000 Shareholders’ Funds = 360000 Working note 2 : Total Assets = Non current assets + Current assets Total Assets = 275000 + 125000 Total Assets = 400000