Unit 8
ANALYSIS OF FINANCIAL STATEMENTS
Once the financial statements of an organization are prepared they then need to be analyzed. One such tool to analyze and assess the financial situation of a firm is Ratio Analysis. It allows the stakeholder to make better sense of the accounts and better understand the current fiscal scenario of an entity.
Ratio analysis refers to the analysis of various pieces of financial information in the financial statements of a business. They are mainly used by external analysts to determine various aspects of a business, such as its profitability, liquidity, and solvency.
Analysts rely on current and past financial statements to obtain data to evaluate the financial performance of a company. They use the data to determine if a company’s financial health is on an upward or downward trend and to draw comparisons to other competing firms.
1. Comparisons
One of the uses of ratio analysis is to compare a company’s financial performance to similar firms in the industry to understand the company’s position in the market. Obtaining financial ratios, such as Price/Earnings, from known competitors and comparing it to the company’s ratios can help management identify market gaps and examine its competitive advantages, strengths, and weaknesses. The management can then use the information to formulate decisions that aim to improve the company’s position in the market.
2. Trend line
Companies can also use ratios to see if there is a trend in financial performance. Established companies collect data from the financial statements over a large number of reporting periods. The trend obtained can be used to predict the direction of future financial performance, and also identify any expected financial turbulence that would not be possible to predict using ratios for a single reporting period.
3. Operational efficiency
The management of a company can also use financial ratio analysis to determine the degree of efficiency in the management of assets and liabilities. Inefficient use of assets such as motor vehicles, land, and building results in unnecessary expenses that ought to be eliminated. Financial ratios can also help to determine if the financial resources are over or under-utilized.
4. Measure of Profitability
Profit is the ultimate aim of every organization. Context is required to measure profitability, which is provided by ratio analysis. Gross Profit Ratios, Net Profit Ratio, Expense ratio etc provide a measure of the profitability of a firm. The management can use such ratios to find out problem areas and improve upon them.
5. Ensure Suitable Liquidity
Every firm has to ensure that some of its assets are liquid, in case it requires cash immediately. So the liquidity of a firm is measured by ratios such as Current ratio and Quick Ratio. These help a firm maintain the required level of short-term solvency.
There are numerous financial ratios that are used for ratio analysis, and they are grouped into the following categories:
1. Liquidity ratios
Liquidity ratios measure a company’s ability to meet its debt obligations using its current assets. When a company is experiencing financial difficulties and is unable to pay its debts, it can convert its assets into cash and use the money to settle any pending debts with more ease.
Some common liquidity ratios include the quick ratio, the cash ratio, and the current ratio. Liquidity ratios are used by banks, creditors, and suppliers to determine if a client has the ability to honor their financial obligations as they come due.
2. Solvency ratios
Solvency ratios measure a company’s long-term financial viability. These ratios compare the debt levels of a company to its assets, equity, or annual earnings.
Important solvency ratios include the debt to capital ratio, debt ratio, interest coverage ratio, and equity multiplier. Solvency ratios are mainly used by governments, banks, employees, and institutional investors.
3. Profitability Ratios
Profitability ratios measure a business’ ability to earn profits, relative to their associated expenses. Recording a higher profitability ratio than in the previous financial reporting period shows that the business is improving financially. A profitability ratio can also be compared to a similar firm’s ratio to determine how profitable the business is relative to its competitors.
Some examples of important profitability ratios include the return on equity ratio, return on assets, profit margin, gross margin, and return on capital employed.
4. Efficiency ratios
Efficiency ratios measure how well the business is using its assets and liabilities to generate sales and earn profits. They calculate the use of inventory, machinery utilization, turnover of liabilities, as well as the usage of equity. These ratios are important because, when there is an improvement in the efficiency ratios, the business stands to generate more revenues and profits.
Some of the important efficiency ratios include the asset turnover ratio, inventory turnover, payables turnover, working capital turnover, fixed asset turnover and receivables turnover ratio.
5. Coverage ratios
Coverage ratios measure a business’ ability to service its debts and other obligations. Analysts can use the coverage ratios across several reporting periods to draw a trend that predicts the company’s financial position in the future. A higher coverage ratio means that a business can service its debts and associated obligations with greater ease.
Key coverage ratios include the debt coverage ratio, interest coverage, fixed charge coverage, and EBIDTA coverage.
6. Market prospect ratios
Market prospect ratios help investors to predict how much they will earn from specific investments. The earnings can be in the form of higher stock value or future dividends. Investors can use current earnings and dividends to help determine the probable future stock price and the dividends they may expect to earn.
Key market prospect ratios include dividend yield, earnings per share, the price-to-earnings ratio, and the dividend payout ratio.
When employed correctly, ratio analysis throws light on many problems of the firm and also highlights some positives. Ratios are essentially whistleblowers. They draw the management’s attention towards issues needing attention. Let us take a look at some advantages of ratio analysis.
While ratios are very important tools of financial analysis, they have some limitations, such as
VARIOUS FINANCIAL RATIOS
Gross profit ratio (GP ratio) is a profitability ratio that shows the relationship between gross profit and total net sales revenue. It is a popular tool to evaluate the operational performance of the business. The ratio is computed by dividing the gross profit figure by net sales.
Formula:
GP Ratio = Gross Profit/Net Sales
When gross profit ratio is expressed in percentage form, it is known as gross profit margin or gross profit percentage. The formula of gross profit margin or percentage is given below:
GP Ratio = Gross Profit/Net Sales x 100
The basic components of the formula of gross profit ratio (GP ratio) are gross profit and net sales. Gross profit is equal to net sales minus cost of goods sold. Net sales are equal to total gross sales less returns inwards and discount allowed. The information about gross profit and net sales is normally available from income statement of the company.
Example:
The following data relates to a small trading company. Compute the gross profit ratio (GP ratio) of the company.
Solution:
With the help of above information, we can compute the gross profit ratio as follows:
= 2,35,000/ 9,10,000
= 0.2582 or 25.82%
*Gross profit = Net sales – Cost of goods sold
= 910,000 – 675,000
= Rs 235,000
Net sales = Gross sales – Sales returns
= 1,000,000 – 90,000
= Rs 9,10,000
The GP ratio is 25.82%. It means the company may reduce the selling price of its products by 25.82% without incurring any loss.
Significance and interpretation:
Gross profit is very important for any business. It should be sufficient to cover all expenses and provide for profit.
There is no norm or standard to interpret gross profit ratio (GP ratio). Generally, a higher ratio is considered better.
The ratio can be used to test the business condition by comparing it with past years’ ratio and with the ratio of other companies in the industry. A consistent improvement in gross profit ratio over the past years is the indication of continuous improvement . When the ratio is compared with that of others in the industry, the analyst must see whether they use the same accounting systems and practices.
Net profit ratio (NP ratio) is a popular profitability ratio that shows relationship between net profit after tax and net sales. It is computed by dividing the net profit (after tax) by net sales.
Formula:
NP Ratio = Net Profit after Tax/Net Sales x 100
Example:
The following data has been extracted from income statement of Akbar corporation.
Gross sales: Rs 2,10,000
Returns inwards: Rs 10,000
Net profit before tax: Rs 50,000
Income tax: 10%
Required: Compute net profit ratio of Akbar corporation using above information.
Solution:
Net Profit Ratio:
= (45,000 / 2,00,000)
= 0.225 or 22.5%
Net profit after tax:
= 50,000 – (50,000 × 0.1)
= Rs 45,000
Net sales:
= 2,10,000 – 10,000
= Rs 2,00,000
Significance and Interpretation:
Net profit (NP) ratio is a useful tool to measure the overall profitability of the business. A high ratio indicates the efficient management of the affairs of business.
There is no norm to interpret this ratio. To see whether the business is constantly improving its profitability or not, the analyst should compare the ratio with the previous years’ ratio, the industry’s average and the budgeted net profit ratio.
The use of net profit ratio in conjunction with the assets turnover ratio helps in ascertaining how profitably the assets have been used during the period.
Operating ratio (also known as operating cost ratio or operating expense ratio) is computed by dividing operating expenses of a particular period by net sales made during that period. Like expense ratio, it is expressed in percentage.
Formula:
Operating ratio = Operating Cost / Net Sales x 100
i.e (COGS + operating expense) / Net Sales x 100
The basic components of the formula are operating cost and net sales. Operating cost is equal to cost of goods sold plus operating expenses. Non-operating expenses such as interest charges, taxes etc., are excluded from the computations.
The following example may be helpful in understanding the computation of operating ratio:
Example:
The selected data from the records of Good Luck Company limited is given below:
a) Net sales: Rs 4,00,000
b) Cost of goods sold: Rs 1,60,000
c) Administrative expenses: Rs 35,000
d) Selling expense: Rs 25,000
e) Interest charges: Rs 10,000
Required: Compute operating ratio for Good Luck Company Limited from the above data.
Solution:
Operating Ratio = 2,20,000/4,00,000 x 100
= 55%
The operating profit ratio is 55%. It means 55% of the sales revenue would be used to cover cost of goods sold and other operating expenses of Good Luck Company Limited.
*Computation of operating expenses:
Cost of goods sold + Administrative expenses + Selling expenses
= 1,60,000 + 35,000 + 25,000
= Rs 2,20,000
Notice that the interest charges of Rs 10,000 have not been included because they are categorized as financial expenses, not operating expenses.
Significance and interpretation:
The operating ratio is used to measure the operational efficiency of the management. It shows whether or not the cost component in the sales figure is within the normal range. A low operating ratio means a high net profit ratio (i.e., more operating profit) and vice versa.
The ratio should be compared:
(1) with the company’s past years ratio,
(2) with the ratio of other companies in the same industry.
An increase in the ratio should be investigated and brought to attention of management as soon as possible. The operating ratio varies from industry to industry.
Inventory turnover ratio (ITR) is an activity ratio and is a tool to evaluate the liquidity of company’s inventory. It measures how many times a company has sold and replaced its inventory during a certain period of time.
Formula:
Inventory turnover ratio is computed by dividing the cost of goods sold by average inventory at cost. The formula/equation is given below:
Inventory Turnover Ratio = Cost of Goods Sold/Average inventory at cost
Where, Cost of Goods Sold = Op Stock+ Net Purchases – Cl Stock
Average inventory = (Opening stock + Closing stock)/2
Two components of the formula of inventory turnover ratio are cost of goods sold and average inventory at cost. Cost of goods sold is equal to cost of goods manufactured (purchases for trading company) plus opening inventory less closing inventory. Average inventory is equal to opening balance of inventory plus closing balance of inventory divided by two.
Note for students: If cost of goods sold is unknown, the net sales figure can be used as numerator and if the opening balance of inventory is unknown, closing balance can be used as denominator. For example if both cost of goods sold and opening inventory are not given in the problem, the formula would be written as follows:
Formula: Inventory turnover ratio = Sales / Inventory
Example 1
Compute the inventory turnover ratio and average selling period from the following data of a trading company:
a) Sales: Rs 75,000
b) Gross profit: Rs 35,000
c) Opening inventory: Rs 9,000
d) Closing inventory: Rs 7,000
Solution:
Inventory Turnover Ratio = 40,000 / 8,000
= 5 times
Computation of cost of goods sold and average inventory:
COGS = 75,000 – 35,000 = Rs 40,000
Avg Inv = (9,000 + 7,000) / 2
Average selling period is computed by dividing 365 by inventory turnover ratio:
= 365 days / 5 times
= 73 days
The company will take 73 days to sell average inventory.
Example 2
The ITM trading company provides you the following data for the year 2016:
a) Inventory turnover ratio: 12 times
b) Opening inventory at cost: Rs 36,000
c) Closing inventory at cost: Rs 54,000
Calculate cost of goods sold for the year 2016.
Solution:
Inventory turnover ratio = Cost of goods sold/Average inventory at cost
12 times = Cost of goods sold/45,000
Cost of goods sold = 45,000 × 12 times
= Rs 540,000
Average Inventory = (36,000 + 54,000)/2
Significance and Interpretation:
Inventory turnover ratio may vary significantly among industries. A high ratio indicates fast moving inventories and a low ratio, on the other hand, indicates slow moving or obsolete inventories in stock. A low ratio may also be the result of maintaining excessive inventories needlessly. Maintaining excessive inventories unnecessarily indicates poor inventory management because it involves tiding up funds that could have been used in other business operations.
Users must also observe various factors that can affect inventory turnover ratio (ITR) before interpreting or making any decision. For example, companies using FIFO cost flow assumption may have a higher ITR in the days of inflation because the latest inventories purchased at higher prices remain in the stock under FIFO. On the other hand, companies using LIFO cost flow assumption may have comparatively lower ITR than others because the oldest inventory purchased at comparatively lower prices remain in the stock under LIFO.
Another factor that could influence this ratio is the use of just-in-time inventory method. Companies using just in time system of inventory management usually have high inventory turnover ratio as compared to others in the industry.
Receivables turnover ratio (also known as debtors turnover ratio) is computed by dividing the net credit sales during a period by average receivables.
Accounts receivable turnover ratio simply measures how many times the receivables are collected during a particular period. It is a helpful tool to evaluate the liquidity of receivables.
Formula:
Debtors Turnover Ratio = Net Credit Sales/Average Debtors/Trade Receivables (net)
Two components of the formula are “net credit sales” and “average trade accounts receivable”. It is clearly mentioned in the formula that the numerator should include only credit sales. But in examination questions, this information may not be given. In that case, the total sales should be used as numerator assuming all the sales are made on credit.
Average receivables are equal to opening receivables (including notes receivables) plus closing receivables (including notes receivables) divided by two. But sometimes opening receivables may not be given in the examination questions. In that case closing balance of receivables should be used as denominator.
Example:
The data of a trading company is given below:
Total sales | 55,00,000 |
Cash sales | 25,00,000 |
Accounts receivables – opening | 4,00,000 |
Accounts receivables – closing | 2,50,000 |
Notes receivables – opening | 1,50,000 |
Notes receivables – closing | 2,00,000 |
Required: How many times (on average) company collects accounts receivables?
Hint: Compute accounts receivable/debtors turnover ratio.
Solution:
Debtors Turnover Ratio = Net Credit Sales/Average Debtors/Trade Receivables (net)
= 30,00,000 / 500,000
= 6 times
On average, the company collects its receivables 6 times a year.
Credit Sales
55,00,000 – 25,00,000 = 30,00,000
Average trade receivables
(4,00,000+2,50,000+1,50,000+2,00,000)/2 = 5,00,000
Significance and Interpretation:
This ratio is very helpful when used in conjunction with short term solvency ratios i.e., current ratio and quick ratio. Short term solvency ratios measure the liquidity of the company as a whole and accounts receivable turnover ratio measures the liquidity of accounts receivables.
There is no rule of thumb to interpret this ratio. Analysts can compare the ratio with industry’s standard. Generally, a high ratio indicates that the receivables are more liquid and are being collected promptly. A low ratio is a sign of less liquid receivables and may reduce the true liquidity of the business in the eyes of the analyst even if the current and quick ratios are satisfactory.
Current ratio (also known as working capital ratio) is a popular tool to evaluate short-term solvency position of a business. Short-term solvency refers to the ability of a business to pay its short-term obligations when they become due. Short term obligations (also known as current liabilities) are the liabilities payable within a short period of time, usually one year.
A higher current ratio indicates strong solvency position and is therefore considered better.
Formula
Current ratio is computed by dividing total current assets by total current liabilities of the business. This relationship can be expressed in the form of following formula or equation:
Current Ratio = Current Assets / Current Liabilities
Above formula comprises of two components i.e., current assets and current liabilities. Both the components are available from the balance sheet of the company. Some examples of current assets and current liabilities are given below:
Some common examples of current assets are given below:
a) Cash
b) Marketable securities
c) Accounts receivables/debtors
d) Inventories/stock
e) Bills receivable
f) Short-term totes receivable
g) Prepaid expenses
Some common examples of current liabilities are given below:
a) Accounts payable/creditors
b) Bills payable
c) Short-term notes payable
d) Short term bonds payable
e) Interest payable
f) Unearned revenues
g) current portion of long term debt
Example 1
On December 31, 2016, the balance sheet of Marshal Ltd shows the total current assets of Rs11,00,000 and the total current liabilities of Rs 4,00,000. You are required to compute current ratio of the company.
Solution:
Current ratio = Current assets/Current liabilities
= 11,00,000 / 4,00,000
= 2.75 times
The current ratio is 2.75 which means the company’s currents assets are 2.75 times more than its current liabilities.
Significance and interpretation
Current ratio is a useful test of the short-term-debt paying ability of any business. A ratio of 2:1 or higher is considered satisfactory for most of the companies but analyst should be very careful while interpreting it. Simply computing the ratio does not disclose the true liquidity of the business because a high current ratio may not always be a green signal. It requires a deep analysis of the nature of individual current assets and current liabilities. A company with high current ratio may not always be able to pay its current liabilities as they become due if a large portion of its current assets consists of slow moving or obsolete inventories. On the other hand, a company with low current ratio may be able to pay its current obligations as they become due if a large portion of its current assets consists of highly liquid assets i.e., cash, bank balance, marketable securities and fast moving inventories. Consider the following example to understand how the composition and nature of individual current assets can differentiate the liquidity position of two companies having same current ratio figure.
Liquidity comparison of two or more companies with same current ratio
We may find situations where two or more companies have the same current ratio figures but their real liquidity position is far different from each other. It happens because of the quality and nature of individual items that make up the total current assets of the companies. Consider the following example to understand this point in more detail:
Example 2
The following data has been extracted from the financial statements of two companies – company A Ltd and B Ltd.
Particulars A Ltd(Rs) B Ltd(Rs)
Cash 50,000 4,000
Trade Receivable 1,20,000 16,000
Prepaid Expenses 10,000 10,000
Inventory 1,70,000 3,20,000
Total Current Assets 3,50,000 3,50,000
Total Current Liabilities 1,75,000 1,75,000
Current Ratio 2:1 2:1
Both company A and company B have the same current ratio (2:1). Do both the companies have equal ability to pay its short-term obligations?
The answer is no. Company B is likely to have difficulties in paying its short-term obligations because most of its current assets consist of inventory. Inventory is not quickly convertible into cash. The company A is likely to pay its current obligations as and when they become due because a large portion of its current assets consists of cash and accounts receivables. Accounts receivables are highly liquid and can be quickly converted into cash.
From this analysis, it is clear that the two companies with same current ratio might have different liquidity position. The analyst should, therefore, not only focus on the current ratio figure but also consider the composition of current assets while determining a company’s real short-term debt paying ability.
Limitations of current ratio
Current ratio suffers from a number of limitations. Some are given below:
1. Different ratio in different parts of the year:
Some businesses have different trading activities in different seasons. Such businesses may show low current ratio in some months of the year and high in others.
2. Change in inventory valuation method:
To compare the ratio of two companies it is necessary that both the companies use same inventory valuation method. For example, comparing current ratio of two companies would be like comparing apples with oranges if one uses FIFO cost flow assumption and the other uses LIFO cost flow assumption for the valuation of inventories. The analyst would, therefore, not be able to compare the ratio of two companies even in the same industry.
3. Current ratio is a test of quantity, not quality:
It is not an exact science to test liquidity of a company because the quality of each individual asset is not taken into account while computing this ratio.
4. Possibility of manipulation:
Current ratio can be easily manipulated by equal increase and/or equal decrease in current assets and current liabilities. For example, if current assets of a company are Rs 10,000 and current liabilities are Rs 5,000, the current ratio would be 2:1 as computed below:
10,000 : 5,000
i. e. 2:1
If both current assets and current liabilities are reduced by Rs 1,000, the ratio would be increased to 2.25:1 as computed below:
9,000 : 4,000
i.e. 2.25:1
In order to overcome these limitations, current ratio may be used in conjunction with some other ratios like inventory turnover ratio, debtors turnover ratio, average collection period ratio, current cash debt coverage ratio, debt to equity ratio and quick ratio etc. These ratios can test the quality of some individual current assets and together with current ratio provide a better idea of company’s solvency.
Example 3 – computation of current liabilities when current assets and current ratio are given
The T & D company’s current ratio is 2.5 : 1 for the most recent period. If total current assets of the company are 75,00,000, what are total current liabilities?
Solution:
Current ratio = Current assets/Current liabilities
2.5/1 = 75,00,000/Current liabilities
2.5 × Current liabilities = 75,00,000
Current liabilities = 75,00,000/2.5
Current liabilities = Rs 30,00,000
Example 4 – computation of current assets when current liabilities and current ratio are given
If current ratio is 1.5 and total current liabilities are Rs 5,00,000, what are total current assets?
Solution:
Current ratio = Current assets/Current liabilities
1.5/1 = Current assets/5,00,000
Current assets = 1.5 × 5,00,000
Current assets = Rs 7,50,000
Quick ratio (also known as “acid test ratio” and “liquid ratio”) is used to test the ability of a business to pay its short-term debts. It measures the relationship between liquid assets and current liabilities. Liquid assets are equal to total current assets minus inventories and prepaid expenses.
Formula:
Liquid Ratio/Quick Ratio = Liquid Assets / Current Liabilities
Example 1
The following are the current assets and current liabilities of PQR Limited:
Current assets:
a) Cash: Rs 2,400
b) Accounts receivable: Rs 12,000
c) Inventory: Rs 16,000
d) Prepaid expenses: Rs 600
Current liabilities:
a) Accounts payable: Rs 11,600
b) Accrued payables: Rs 1,800
c) Notes payable: Rs 600
Calculate quick ratio of PQR Limited.
Solution:
Liquid Ratio = 14,400*/14,000**
= 1.03
(rounded to two decimal places)
Liquid assets= (Total current assets) – (Inventories + Prepaid expenses)
= 31,000 – (16,000 + 600)
= 31,000 – 16,600
= Rs 14,400
Current liabilities= 11,600 + 1,800 + 600
= Rs14,000
Significance and Interpretation
Quick ratio is considered a more reliable test of short-term solvency than current ratio because it shows the ability of the business to pay short term debts immediately.
Inventories and prepaid expenses are excluded from current assets for the purpose of computing quick ratio because inventories may take long period of time to be converted into cash and prepaid expenses cannot be used to pay current liabilities.
Generally, a quick ratio of 1:1 is considered satisfactory. Like current ratio, this ratio should also be interpreted carefully. Having a quick ratio of 1:1 or higher does not mean that the company has a strong liquidity position because a company may have high quick ratio but slow paying debtors. On the other hand, a company with low quick ratio may have fast moving inventories. The analyst, therefore, must have a hard look on the nature of individual assets.
Debt to equity ratio (also termed as debt equity ratio) is a long term solvency ratio that indicates the soundness of long-term financial policies of a company. It shows the relation between the portion of assets financed by creditors and the portion of assets financed by stockholders. As the debt to equity ratio expresses the relationship between external equity (liabilities) and internal equity (stockholder’s equity), it is also known as “external-internal equity ratio”.
Formula:
Debt to equity ratio is calculated by dividing total long term liabilities by stockholder’s equity.
Debt-Equity Ratio = Total Long term Debt/Total Stockholder’s Equity
The numerator consists of the total long term liabilities and the denominator consists of the total stockholders’ equity including preferred stock. Both the elements of the formula are obtained from company’s balance sheet.
Example 1:
ABC company has applied for a loan. The lender of the loan requests you to compute the debt to equity ratio as a part of the long-term solvency test of the company.
The “Liabilities and Stockholders’ Equity” section of the balance sheet of ABC company is given below:
Liabilities & Stockholder’s Equity |
|
Sundry Creditors | 2,900 |
Accrued expenses payable | 450 |
Short term liabilities | 150 |
Total current liabilities | 3,500 |
|
|
Long Term Liabilities |
|
6% Bonds | 3,750 |
|
|
Total Liabilities | 7,250 |
|
|
Stockholder’s Equity |
|
6% Preference Share Capital | 1,000 |
Equity Share Capital | 3,500 |
Total Capital | 4,500 |
Reserves & Surplus | 4,000 |
Total Stockholder’s Equity | 8,500 |
|
|
Total Liabilities & Stockholder’s Equity | 15,750 |
Compute Debt to Equity Ratio.
Solution:
Debt-Equity Ratio = Total Long term Debt/Total Stockholder’s Equity
= 3,750/8,500
= 0.44
The debt to equity ratio of ABC company is 0.85 or 0.85 : 1. It means the liabilities are 85% of stockholders equity or we can say that the creditors provide 85 cents for each dollar provided by stockholders to finance the assets.
Significance and interpretation:
A ratio of 1 (or 1 : 1) means that creditors and stockholders equally contribute to the assets of the business.
A less than 1 ratio indicates that the portion of assets provided by stockholders is greater than the portion of assets provided by creditors and a greater than 1 ratio indicates that the portion of assets provided by creditors is greater than the portion of assets provided by stockholders.
Creditors usually like a low debt to equity ratio because a low ratio (less than 1) is the indication of greater protection to their money. But stockholders like to get benefit from the funds provided by the creditors therefore they would like a high debt to equity ratio.
Debt equity ratio varies from industry to industry. Different norms have been developed for different industries. A ratio that is ideal for one industry may be worrisome for another industry. A ratio of 1 : 1 is normally considered satisfactory for most of the companies.
If debt to equity ratio and one of the other two equation elements is known, we can work out the third element. Consider the example 2 and 3.
Example 2 – computation of stockholders’ equity when total liabilities and debt to equity ratio are given
The Petersen Trading Company has total liabilities of Rs 937,500 and a debt to equity ratio of 1.25. Calculate total stockholders’ equity of Petersen Trading Company.
Solution
Debt to equity ratio = Total liabilities/Total stockholder’s equity
Or
Total stockholder’s equity = Total liabilities/Debt to equity ratio
= 9,37,500/1.25
= Rs 7,50,000
Example 3 – computation of total liabilities when stockholders’ equity and debt to equity ratio are given
The Steward Corporation’s debt to equity ratio for the last year was 0.75 and stockholders’ equity was Rs 750,000. What were the total liabilities of the corporation?
Solution
Debt to equity ratio = Total liabilities/Total stockholder’s equity
Or
Total liabilities = Stockholders’ equity/Debt to equity ratio
= 7,50,000/0.75
= Rs 10,00,000
Q.1
The following Trading and Profit and Loss Account of Fantasy Ltd. for the year 31‐3‐2000 is given below:
Particular | Rs. | Particular | Rs. |
To Opening Stock Purchases Carriage and Freight Wages Gross Profit b/d
To Administration expenses To Selling and Dist. Expenses To Non‐operating expenses To Financial Expenses To Net Profit c/d | 76,250 3,15,250 2,000 5,000 2,00,000 5,98,500
1,01,000 12,000 2,000 7,000 84,000 2,06,000 | By Sales By Closing stock
By Gross Profit b/d Non‐operating incomes By Interest on Securities By Dividend on shares By Profit on sale of shares | 5,00,000 98,500
5,98,500 2,00,000
1,500 3,750 750 2,06,000 |
Calculate:
1. Gross Profit Ratio
2. Expenses Ratio
3. Operating Ratio
4. Net Profit Ratio
5. Stock Turnover Ratio.
Solution:
Gross Profit Ratio = Gross Profit/Sales x 100
= 2,00,000/5,00,000 x 100
= 40%
Expense Ratio = Operating expenses/Sales x 100
= (1,01,000+12,000)/5,00,000 x 100
= 22.60%
Operating Ratio = (COGS + Operating expenses)/Sales x 100
= (3,00,000+1,13,000)/5,00,000 x 100
= 82.60%
COGS = Op. stock + purchases + carriage and Freight + wages – Closing Stock
= 76,250 + 3,15,250 + 2,000 + 5,000 - 98,500
= Rs 3,00,000
Net Profit Ratio = Net Profit/Sales x 100
= 84,000/5,00,000 x 100
= 16.8%
Stock Turnover Ratio= COGS/ Average Stock
= 3,00,000/87,375
= 3.43 times
Average Stock = OPn Stk + Cl Stk / 2
= (76,250+98,500)/2
= 87,375
Q.2
The Balance Sheet of Punjab Auto Limited as on 31‐12‐2002 was as follows:
Particulars | Rs. | Particulars | Rs. |
Equity Share Capital Capital Reserve 8% Loan on Mortgage Creditors Bank overdraft Taxation: Current Future Profit and Loss A/c | 40,000 8,000 32,000 16,000 4,000
4,000 4,000 12,000 1,20,000 | Plant and Machinery Land and Buildings Furniture & Fixtures Stock Debtors Investments (Short‐term) Cash in hand | 24,000 40,000 16,000 12,000 12,000 4,000 12,000
1,20,000 |
From the above, compute (a) the Current Ratio, (b) Quick Ratio, (c) Debt‐Equity Ratio.
Solution:
= 40,000/28,000
= 1.43:1
Current Assets = Stock + debtors + Investments (short term) + Cash In hand
= 12,000+12,000+4,000+12,000
= Rs 40,000
Current Liabilities = Creditors + bank overdraft + Provision for Taxation (current & Future)
= 16,000+4,000+4,000+4,000
= Rs 28,000
2. Quick Ratio = Quick Assets/Quick Liabilities
= 28,000/20,000
= 1.40:1
Quick Assets = Current Assets ‐ Stock
= 40,000 - 12,000
= Rs 28,000
Quick Liabilities = Current Liabilities – (BOD + PFT future)
= 28,000 – (4,000 + 4,000)
= 20,000
3. Debt Equity Ratio = Debt/Equity
= 32,000/60,000
= 0.53:1
Debt = Debentures + long term loans
= Rs 32,000
Equity = Eq. Sh. Cap. + Reserves & Surplus + Preference Sh. Cap. – Fictitious Assets
= 40,000+8,000+12,000
= Rs 60,000
Q.3
The details of Shreenath Company are as under:
Sales (40% cash sales) |
| 15,00,000 |
Less: Cost of sales |
| 7,50,000 |
| Gross Profit: | 7,50,000 |
Less: Office Exp. (including int. on debentures) 1,25,000 | ||
Selling Exp. | 1,25,000 | 2,50,000 |
| Profit before Taxes: | 5,00,000 |
Less: Taxes |
| 2,50,000 |
| Net Profit: | 2,50,000 |
Balance Sheet
Particular | Rs. | Particular | Rs. |
Equity share capital 10% Preference share capital Reserves 10% Debentures Creditors Bank‐overdraft Bills payable Outstanding expenses | 20,00,000
20,00,000 11,00,000 10,00,000 1,00,000 1,50,000 45,000 5,000 64,00,000 | Fixed Assets Stock Debtors Bills receivable Cash Fictitious Assets | 55,00,000 1,75,000 3,50,000 50,000 2,25,000 1,00,000
64,00,000 |
Besides the details mentioned above, the opening stock was of Rs. 3,25,000 & Opening Debtors was Rs 3,00,000, Opening Bills Receivable was Rs 1,00,000. Calculate the following ratios; also discuss the position of the company:
(1) Gross profit ratio. (2) Stock turnover ratio. (3) Current ratio. (4) Liquid ratio. (5) Debtors Turnover Ratio
Solution:
Gross Profit Ratio = Gross Profit/Sales x 100
= 7,50,000/15,00,000 x 100
= 50%
Stock Turnover Ratio = COGS/ Average Stock
= 7,50,000/2,50,000
= 3 times
Average Stock = OPn Stk + Cl Stk / 2
= (3,25,000+1,75,000)/2
= 2,50,000
COGS = Sales – GP
= 15,00,000 – 7,50,000
= 7,50,000
Current Ratio = Current Assets / Current Liabilities
= 8,00,000/3,00,000
= 2.67:1
Current Assets = Stock + debtors + Bills receivable + Cash
= 1,75,000 + 3,50,000 + 50,000 + 2,25,000
= Rs 8,00,000
Current Liabilities = Creditors + bank overdraft + Bills payable + O/s Expenses
= 1,00,000 + 1,50,000 + 45,000 + 5,000
= Rs 3,00,000
Quick Ratio/
Liquid Ratio = Quick Assets/Quick Liabilities
= 6,25,000/1,50,000
= 4.17:1
(Liquid) Quick Assets = Current Assets ‐ Stock
= 8,00,000 – 1,75,000
= Rs 6,25,000
(Liquid) Quick Liabilities = Current Liabilities – BOD
= 3,00,000-1,50,000
= Rs 1,50,000
Debtors Turnover Ratio = Net Credit Sales/Average Debtors
= (15,00,000 x 60%)/4,00,000
= 9,00,000/4,00,000
= 2.25 times
Average Debtors = (Op Debtors+Op B/R+ Cl Debtors+Cl B/R) / 2
= (3,00,000+1,00,000+3,50,000+50,000)/2
= Rs 4,00,000
Q.4
From the data calculate :
(i) Gross Profit Ratio, (ii) Net Profit Ratio, (iii) Inventory Turnover, (iv) Current Ratio (v) Debt-Equity Ratio
Sales 25,20,000 Other Current Assets 7,60,000
Cost of sale 19,20,000 Fixed Assets 14, 40,000
Net profit 3,60,000 Equity & Reserves 5,00,000
Closing Inventory 8,00,000 Debt. 9,00,000
Current Liabilities 6,00,000 Opening Inventory 7,00,000
Solution:
= 6,00,000/25,20,000 x 100
= 23.81%
Gross Profit = Sales – COGS
= 25,20,000 – 19,20,000
= 6,00,000
2. Net Profit Ratio = Net Profit / Sales x 100
= 3,60,000/25,20,000 x 100
= 14.29%
3. Inventory Turnover Ratio = COGS/ Average Inventory
= 19,20,000/ 7,50,000
= 2.56 times
Average Inventory = (Opening Inventory + Closing inventory) / 2
= (7,00,000+8,00,000) / 2
= Rs 7,50,000
4. Current Ratio = Current Assets/ Current Liabilities
= 7,60,000/6,00,000
= 1.27:1
5. Debt Equity Ratio = Debt/Equity
= 9,00,000/15,00,000
= 0.60:1
Q.5
Calculate stock turnover ratio from the following information :
Opening stock 8,000
Purchases 4,84,000
Sales 6,40,000
Gross Profit Rate – 25% on Sales.
Solution :
Stock Turnover Ratio = Cost of Goods Sold / Average Stock
Cost of Goods Sold = Sales- G.P
= 6,40,000 – 1,60,000 = 4,80,000
Stock Turnover Ratio = 4,80,000 /58000
= 8.27 times
Here, there is no closing stock. So there is no need to calculate the average stock.
Q.6
Calculate the operating Ratio from the following figures.
Items ($ in Lakhs)
Sales 17874
Sales Returns 4
Other Incomes 53
Cost of Sales 15440
Administration and Selling Exp. 1843
Depreciation 63
Interest Expenses (Non- operating 456
Solution:
Operating Ratio = (Cost of Goods Sold + Operating Expenses x 100) / Sales
= ((15,440 + 1,843)/ 17,870)x100
= 97%
Q.7
The following is the Trading and Profit and loss account of Mathan Bros Private Limited for the year ended June 30,2001.
$ $
To Stock in hand 76250 By Sales 500000
To Purchases 315250 By Stock in hand 98500
To Carriage and Freight 2000
To Wages 5000
To Gross Profit 200000
598500 598500
To Administration
Expenses 1,01,000 By Gross profit 2,00,000
To Finance Expenses. : By Non-operating Incomes
Interest 1200 Interest on Securities 1,500
Discount 2400 Dividend on Shares 3, 750
Bad Debts 3400 7000 Profit on Sale of Shares 750 6,000
To Selling Distribution Expenses 12000
To Non-operating expenses
Loss on sale of securities 350
Provision for legal suit 1,650 2000
To Net profit 84000
206000 206000
You are required to calculate :
(i) Gross profit Ratio (ii) Net profit Ratio
(iii) Operating Ratio (iv) Stock turnover Ratio
Solution:
= 2,00,000 / 500000 x 100
= 40%
2. Net Profit Ratio = Net Profit/ Sales x100
= 84000/ 500000 x100
= 16.8%
3. Operating Ratio = ( Cost of Goods Sold + Operating Expenses)/Sales* 100
= (3,00,000 + 1,20,000)/ 500000 x 100
= 84%
Cost of Goods Sold = Sales – Gross profit
= 5,00,000 – 2,00,000
= Rs 3,00,000
Operating Expenses
All Expenses Debited in the Profit & Loss A/c Except Non-Operating Expenses
[including Finance expense] = 1,01,000 + 7,000 + 12,000 = 1,20,000
4. Stock Turnover Ratio = Cost of Goods Sold / Average Stock
= 3,00,000/87,375
= 3.43 times
Average Stock = (Opening Stock + Closing Stock)/2
=(76,250 + 98,500) / 2
= 87,375
