Unit 4
Analysis of Financial Statement
Q1) What is Ratio Analysis?
A1) Ratio analysis is used to evaluate relationships among financial statement items. The ratios are used to identify trends over time for one organisation or to compare two or more organisations at one point in time. Ratio analysis focuses on three key aspects of a business: liquidity, profitability, and solvency. Ratio Analysis is an important tool for any business organisation. The computation of ratios facilitates the comparison of firms which differ in size. Ratios can be used to compare a firm's financial performance with industry averages. In addition, ratios can be used in a form of trend analysis to identify areas where performance has improved or deteriorated over time. Generally, ratio analysis involves four steps:
(i) Collection of relevant accounting data from financial statements.
(ii) Constructing ratios of related accounting figures.
(iii) Comparing the ratios thus constructed with the standard ratios which may be the corresponding past ratios of the firm or industry average ratios of the firm or ratios of competitors.
(iv) Interpretation of ratios to arrive at valid conclusions.
Q2) What are the objectives of Ratio Analysis?
A2) Ratio analysis is indispensable part of interpretation of results revealed by the financial statements. It provides users with crucial financial information and points out the areas which require investigation. Ratio analysis is a technique which involves regrouping of data by application of arithmetical relationships, though its interpretation is a complex matter. It requires a fine understanding of the way and the rules used for preparing financial statements. Once done effectively, it provides a lot of information which helps the analyst:
1. To know the areas of the business which need more attention;
2. To know about the potential areas which can be improved with the effort in the desired direction;
3. To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business;
4. To provide information for making cross-sectional analysis by comparing the performance with the best industry standards; and
5. To provide information derived from financial statements useful for making projections and estimates for the future.
Q3) What is the Nature of Ratio Analysis?
A3) Ratios are designed to show how one number is related to another. It is worked out by dividing one number by another. Ratios are customarily presented either in the form of a coefficient or a percentage or as a proportion.
For example, the current assets and current liabilities of a business on a particular date are Rs.2 lakhs and Rs.1 lakh respectively. The resulting ratio of Current Assets and Current Liabilities could be expressed as 2 (i.e., 2, 00,000/1, 00,000) or as 200 per cent.
Alternatively in the form of a proportion the same ratio may be expressed as 2:1, i.e., the current assets are two times the current liabilities. Ratios are invaluable aids to management and others who are interested in the analysis and interpretation of financial statements. Absolute figures may be misleading unless compared, one with another.
Ratios provide the means of showing the relationship that exists between figures. Though there is no special magic in ratio analysis, many prefer to base conclusions on ratios as they find them highly useful for making judgments more easily.
However, the numerical relationships of the kind expressed by ratio analysis are not an end in themselves but are a means for understanding the financial position of a business.
Generally, simple ratios or ratios compiled from a single year’s financial statements of a business concern may not serve the real purpose. Hence, ratios are to be worked out from the financial statements of a number of years.
Ratios, by themselves, are meaningless. They derive their status partly from the ingenuity and experience of the analyst who uses the available data in a systematic manner.
Besides, in order to reach valid conclusions, ratios have to be compared with some standards that are established with a view to represent the financial position of the business under review.
However, it should be borne in mind that after computing the ratios one cannot categorically say whether a particular ratio is good or bad as the conclusions may vary from business to business. A single ideal ratio cannot be applied for all types of business.
Speedy compiling of ratios and their presentation in the appropriate manner is essential. A complete record of ratios employed is advisable; and explanation of each and actual ratios year by year should be included.
This record may be treated as a part of an Account Manual or a special Ratio Register may be maintained.
Q4) What is Profitability ratios?
A4) Profit is the primary objective of all businesses. All businesses need a consistent improvement in profit to survive and prosper. A business that continually suffers losses cannot survive for a long period. Profitability ratios measure the efficiency of management in the employment of business resources to earn profits. These ratios indicate the success or failure of a business enterprise for a particular period of time. Profitability ratios are used by almost all the parties connected with the business. A strong profitability position ensures common stockholders a higher dividend income and appreciation in the value of the common stock in future. Creditors, financial institutions and preferred stockholders expect a prompt payment of interest and fixed dividend income if the business has good profitability position. Management needs higher profits to pay dividends and reinvest a portion in the business to increase the production capacity and strengthen the overall financial position of the company. Some important profitability ratios are given below:
(i) Net profit (NP) ratio
(ii) Gross profit (GP) ratio
(iii) Price earnings ratio (P/E ratio)
(iv) Operating ratio
(v) Expense ratio
(vi) Dividend yield ratio
(vii) Dividend pay-out ratio
(viii) Return on capital employed ratio
(ix) Earnings per share (EPS) ratio
(x) Return on shareholder’s investment/Return on equity
(xi) Return on common stockholders’ equity ratio
Q5) What are Liquidity ratios?
A5) Liquidity ratios measure the adequacy of current and liquid assets and help evaluate the ability of the business to pay its short-term debts. The ability of a business to pay its short-term debts is frequently referred to as short-term solvency position or liquidity position of the business. Generally, a business with sufficient current and liquid assets to pay its current liabilities as and when they become due is considered to have a strong liquidity position and a business with insufficient current and liquid assets is considered to have weak liquidity position. Short-term creditors like suppliers of goods and commercial banks use liquidity ratios to know whether the business has adequate current and liquid assets to meet its current obligations. Financial institutions hesitate to offer short-term loans to businesses with weak short-term solvency position. Three commonly used liquidity ratios are given below: (i) Current ratio or working capital ratio (ii) Quick ratio or acid test ratio (iii) Absolute liquid ratio (i)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. 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:
Current assets Current liabilities
Cash Accounts payable /
Creditors Marketable securities Accrued
Payable Accounts receivables / debtors Bonds
Payable Inventories / stock
Prepaid expenses
(ii) 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. The formula for the calculation of quick ratio is given below:
Quick ratio= Liquid assets/ current liabilities
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.
(iii) Absolute Liquid ratio-some analysts also compute absolute liquid ratio to test the liquidity of the business. Absolute liquid ratio is computed by dividing the absolute liquid assets by current liabilities. The formula to compute this ratio is given below:
Absolute liquid ratio= Absolute liquid assets/ Current liabilities
Absolute liquid assets are equal to liquid assets minus accounts receivables (including bills receivables). Some examples of absolute liquid assets are cash, bank balance and marketable securities etc.
Q6) What are Leverage ratios?
A6) Long term financial strength of the firm is measured in terms of the ability to pay interest regularly or repay principal on due dates or at the time of maturity. Such long-term solvency of a firm can be judged by using leverage.
- Debt-Equity Ratio (DE Ratio): This Ratio is a basic measure of studying the indebtedness if the firm or Debt-equity Ratio measures the debt proportion relative to the equity financing for the firm.
Debt-equity ratio= Debts/ Equity (Shareholders' Funds)
Or
Debts/ Long - term Funds (Shareholders' Funds + Debts)
- Total Debt Ratio: The Ratio compares the total debts of the firm with the total assets available. It measures the relative size of the firm’s debt load and the firm’s ability to pay the debt.
Total debt ratio= Total debts/total assets
- Interest Coverage Ratio (IC Ratio): This ratio is also called the times interest earned ratio and it measures the ability of the firm to pay the fixed interest liability.
Interest coverage ratio= EBIT/Interest expense
Q7) 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.
A7)
- Gross Profit Ratio= Gross Profit/Sales x 100
= 2,00,000/5,00,000 x 100
= 40%
2. Expense Ratio= Operating expenses/Sales x 100
= (1,01,000+12,000)/5,00,000 x 100
= 22.60%
3. 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
4. Net Profit Ratio= Net Profit/Sales x 100
= 84,000/5,00,000 x 100
= 16.8%
5. Stock Turnover Ratio= COGS/ Average Stock
= 3,00,000/87,375
= 3.43 times
Average Stock = open Stock + Cl Stock / 2
= (76,250+98,500)/2
= 87,375
Q8) 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.
A8)
- Current Ratio= Current Assets/Current Liabilities
= 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
Q9) 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
A9)
- Gross Profit Ratio= Gross Profit/Sales x 100
= 7,50,000/15,00,000 x 100
= 50%
2. Stock Turnover Ratio= COGS/ Average Stock
= 7,50,000/2,50,000
= 3 times
Average Stock = Open Stock + Cl Stock / 2
= (3,25,000+1,75,000)/2
= 2,50,000
COGS= Sales – GP
= 15,00,000 – 7,50,000
= 7,50,000
3. 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
4. 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
5. 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 B/R+ Cl Debtors B/R) / 2
= (3,00,000+1,00,000+3,50,000+50,000)/2
= Rs 4,00,000
Q10) 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 15,00,000
Closing Inventory 8,00,000 Debt. 9,00,000
Current Liabilities 6,00,000Opening Inventory7,00,000
A10)
- Gross Profit Ratio= Gross Profit/Sales x 100
= 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
Q11) 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.
A11)
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.
Q12) Calculate the operating Ratio from the following figures.
Items (Rs 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
A12) Operating Ratio = (Cost of Goods Sold + Operating Expenses x 100) / Sales
= ((15,440 + 1,843)/ 17,870) x100
= 97%
Q13) The following is the Trading and Profit and loss account of Mathan Bros Private Limited for the year ended June 30,2001.
Particulars Rs. Particulars Rs.
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 1,01,00 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
A13) Gross Profit Ratio =Gross Profit/ Sales x 100
= 2,00,000 / 500000 x 100
= 40%
- Net Profit Ratio = Net Profit/ Sales x100
= 84000/ 500000 x100
= 16.8%
2. 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
3. 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
Q14) What is Return on capital employed ratio?
A14) Return on capital employed ratio is computed by dividing the net income before interest and tax by capital employed. It measures the success of a business in generating satisfactory profit on capital invested. The ratio is expressed in percentage.
Return on capital employed ratio=
Net income before interest and tax/ Capital employed x 100
The basic components of the formula of return on capital employed ratio are net income before interest and tax and capital employed. Net income before the deduction of interest and tax expenses is frequently referred to as operating income. Here, interest means interest on long term loans. If company pays interest expenses on short-term borrowings, that is deducted to arrive at operating income. Return on capital employed ratio measures the efficiency with which the investment made by shareholders and creditors is used in the business. Managers use this ratio for various financial decisions. It is a ratio of overall profitability and a higher ratio is, therefore, better.
Q15) What is Earnings per share ratio?
A15) Earnings per share (EPS) ratio measures how many dollars of net income have been earned by each share of common stock. It is computed by dividing net income less preferred dividend by the number of shares of common stock outstanding during the period. It is a popular measure of overall profitability of the company and is usually expressed in dollars. Earnings per share ratio (EPS ratio) is computed by the following formula:
EPS Ratio= Net income- preferred dividend/ Weighted avg. Numbers of shares outstanding
The numerator is the net income available for common stockholders’ (net income less preferred dividend) and the denominator is the average number of shares of common stock outstanding during the year. The formula of EPS ratio is similar to the formula of return on common stockholders’ equity ratio except the denominator of EPS ratio formula is the number of average shares of common stock outstanding rather than the average common stockholders’ equity. The higher the EPS figure, the better it is. A higher EPS is the sign of higher earnings, strong financial position and, therefore, a reliable company to invest money.
Q16) What is Return on common stockholder’s equity ratio?
A16) Return on common stockholders’ equity ratio measures the success of a company in generating income for the benefit of common stockholders. It is computed by dividing the net income available for common stockholders by common stockholders’ equity. The ratio is usually expressed in percentage.
Return on common stockholder’s equity=
Net income-preferred dividend/Avg, common stockholder’s equity x100
The numerator in the above formula consists of net income available for common stockholders which are equal to net income less dividend on preferred stock. The denominator consists of average common stockholders’ equity which is equal to average total stockholders’ equity less average preferred stockholders’ equity. If preferred stock is not present, the net income is simply divided by the average common stockholders’ equity to compute the common stock equity ratio. Like return on equity (ROE) ratio, a higher common stock equity ratio indicates high profitability and strong financial position of the company and can convert potential investors into actual common stockholders.
Q17) What is Return on shareholder’s investment ratio?
A17) Return on shareholders’ investment ratio is a measure of overall profitability of the business and is computed by dividing the net income after interest and tax by average stockholders’ equity. It is also known as return on equity (ROE) ratio and return on net worth ratio. The ratio is usually expressed in percentage
Return on shareholder’s investment=
Net income after interest and tax/ Avg. Stockholders’ equity x 100
The numerator consists of net income after interest and tax because it is the amount of income available for common and preference stockholders. The denominator is the average of stockholders’ equity (preference and common stock). The information about net income after interest and tax is normally available from income statement and the information about preference and common stock is available from balance sheet. Return on equity (ROE) is widely used to measure the overall profitability of the company from preference and common stockholders’ view point. The ratio also indicates the efficiency of the management in using the resources of the business.
Q18) What is Operating ratio?
A18) Operating ratio is computed by dividing operating expenses by net sales. It is expressed in percentage. Operating ratio is computed as follows:
Operating ratio= Operating cost/ Net sales x100
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. This ratio is used to measure the operational efficiency of the management. It shows whether the cost component in the sales figure is within normal range. A low operating ratio means high net profit ratio i.e., more operating profit. 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. The operating ratio varies from industry to industry.
Q19) What is Gross Profit Ratio?
A19) 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. The following formula/equation is used to compute gross profit ratio:
Gross profit 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:
Gross profit margin= 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.
Q20) What is Net profit ratio?
A20) 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.
Net profit ratio= Net profit after tax/ Net sales
For the purpose of this ratio, net profit is equal to gross profit minus operating expenses and income tax. All non-operating revenues and expenses are not taken into account because the purpose of this ratio is to evaluate the profitability of the business from its primary operations. 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.
Unit 4
Analysis of Financial Statement
Q1) What is Ratio Analysis?
A1) Ratio analysis is used to evaluate relationships among financial statement items. The ratios are used to identify trends over time for one organisation or to compare two or more organisations at one point in time. Ratio analysis focuses on three key aspects of a business: liquidity, profitability, and solvency. Ratio Analysis is an important tool for any business organisation. The computation of ratios facilitates the comparison of firms which differ in size. Ratios can be used to compare a firm's financial performance with industry averages. In addition, ratios can be used in a form of trend analysis to identify areas where performance has improved or deteriorated over time. Generally, ratio analysis involves four steps:
(i) Collection of relevant accounting data from financial statements.
(ii) Constructing ratios of related accounting figures.
(iii) Comparing the ratios thus constructed with the standard ratios which may be the corresponding past ratios of the firm or industry average ratios of the firm or ratios of competitors.
(iv) Interpretation of ratios to arrive at valid conclusions.
Q2) What are the objectives of Ratio Analysis?
A2) Ratio analysis is indispensable part of interpretation of results revealed by the financial statements. It provides users with crucial financial information and points out the areas which require investigation. Ratio analysis is a technique which involves regrouping of data by application of arithmetical relationships, though its interpretation is a complex matter. It requires a fine understanding of the way and the rules used for preparing financial statements. Once done effectively, it provides a lot of information which helps the analyst:
1. To know the areas of the business which need more attention;
2. To know about the potential areas which can be improved with the effort in the desired direction;
3. To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business;
4. To provide information for making cross-sectional analysis by comparing the performance with the best industry standards; and
5. To provide information derived from financial statements useful for making projections and estimates for the future.
Q3) What is the Nature of Ratio Analysis?
A3) Ratios are designed to show how one number is related to another. It is worked out by dividing one number by another. Ratios are customarily presented either in the form of a coefficient or a percentage or as a proportion.
For example, the current assets and current liabilities of a business on a particular date are Rs.2 lakhs and Rs.1 lakh respectively. The resulting ratio of Current Assets and Current Liabilities could be expressed as 2 (i.e., 2, 00,000/1, 00,000) or as 200 per cent.
Alternatively in the form of a proportion the same ratio may be expressed as 2:1, i.e., the current assets are two times the current liabilities. Ratios are invaluable aids to management and others who are interested in the analysis and interpretation of financial statements. Absolute figures may be misleading unless compared, one with another.
Ratios provide the means of showing the relationship that exists between figures. Though there is no special magic in ratio analysis, many prefer to base conclusions on ratios as they find them highly useful for making judgments more easily.
However, the numerical relationships of the kind expressed by ratio analysis are not an end in themselves but are a means for understanding the financial position of a business.
Generally, simple ratios or ratios compiled from a single year’s financial statements of a business concern may not serve the real purpose. Hence, ratios are to be worked out from the financial statements of a number of years.
Ratios, by themselves, are meaningless. They derive their status partly from the ingenuity and experience of the analyst who uses the available data in a systematic manner.
Besides, in order to reach valid conclusions, ratios have to be compared with some standards that are established with a view to represent the financial position of the business under review.
However, it should be borne in mind that after computing the ratios one cannot categorically say whether a particular ratio is good or bad as the conclusions may vary from business to business. A single ideal ratio cannot be applied for all types of business.
Speedy compiling of ratios and their presentation in the appropriate manner is essential. A complete record of ratios employed is advisable; and explanation of each and actual ratios year by year should be included.
This record may be treated as a part of an Account Manual or a special Ratio Register may be maintained.
Q4) What is Profitability ratios?
A4) Profit is the primary objective of all businesses. All businesses need a consistent improvement in profit to survive and prosper. A business that continually suffers losses cannot survive for a long period. Profitability ratios measure the efficiency of management in the employment of business resources to earn profits. These ratios indicate the success or failure of a business enterprise for a particular period of time. Profitability ratios are used by almost all the parties connected with the business. A strong profitability position ensures common stockholders a higher dividend income and appreciation in the value of the common stock in future. Creditors, financial institutions and preferred stockholders expect a prompt payment of interest and fixed dividend income if the business has good profitability position. Management needs higher profits to pay dividends and reinvest a portion in the business to increase the production capacity and strengthen the overall financial position of the company. Some important profitability ratios are given below:
(i) Net profit (NP) ratio
(ii) Gross profit (GP) ratio
(iii) Price earnings ratio (P/E ratio)
(iv) Operating ratio
(v) Expense ratio
(vi) Dividend yield ratio
(vii) Dividend pay-out ratio
(viii) Return on capital employed ratio
(ix) Earnings per share (EPS) ratio
(x) Return on shareholder’s investment/Return on equity
(xi) Return on common stockholders’ equity ratio
Q5) What are Liquidity ratios?
A5) Liquidity ratios measure the adequacy of current and liquid assets and help evaluate the ability of the business to pay its short-term debts. The ability of a business to pay its short-term debts is frequently referred to as short-term solvency position or liquidity position of the business. Generally, a business with sufficient current and liquid assets to pay its current liabilities as and when they become due is considered to have a strong liquidity position and a business with insufficient current and liquid assets is considered to have weak liquidity position. Short-term creditors like suppliers of goods and commercial banks use liquidity ratios to know whether the business has adequate current and liquid assets to meet its current obligations. Financial institutions hesitate to offer short-term loans to businesses with weak short-term solvency position. Three commonly used liquidity ratios are given below: (i) Current ratio or working capital ratio (ii) Quick ratio or acid test ratio (iii) Absolute liquid ratio (i)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. 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:
Current assets Current liabilities
Cash Accounts payable /
Creditors Marketable securities Accrued
Payable Accounts receivables / debtors Bonds
Payable Inventories / stock
Prepaid expenses
(ii) 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. The formula for the calculation of quick ratio is given below:
Quick ratio= Liquid assets/ current liabilities
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.
(iii) Absolute Liquid ratio-some analysts also compute absolute liquid ratio to test the liquidity of the business. Absolute liquid ratio is computed by dividing the absolute liquid assets by current liabilities. The formula to compute this ratio is given below:
Absolute liquid ratio= Absolute liquid assets/ Current liabilities
Absolute liquid assets are equal to liquid assets minus accounts receivables (including bills receivables). Some examples of absolute liquid assets are cash, bank balance and marketable securities etc.
Q6) What are Leverage ratios?
A6) Long term financial strength of the firm is measured in terms of the ability to pay interest regularly or repay principal on due dates or at the time of maturity. Such long-term solvency of a firm can be judged by using leverage.
- Debt-Equity Ratio (DE Ratio): This Ratio is a basic measure of studying the indebtedness if the firm or Debt-equity Ratio measures the debt proportion relative to the equity financing for the firm.
Debt-equity ratio= Debts/ Equity (Shareholders' Funds)
Or
Debts/ Long - term Funds (Shareholders' Funds + Debts)
- Total Debt Ratio: The Ratio compares the total debts of the firm with the total assets available. It measures the relative size of the firm’s debt load and the firm’s ability to pay the debt.
Total debt ratio= Total debts/total assets
- Interest Coverage Ratio (IC Ratio): This ratio is also called the times interest earned ratio and it measures the ability of the firm to pay the fixed interest liability.
Interest coverage ratio= EBIT/Interest expense
Q7) 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.
A7)
- Gross Profit Ratio= Gross Profit/Sales x 100
= 2,00,000/5,00,000 x 100
= 40%
2. Expense Ratio= Operating expenses/Sales x 100
= (1,01,000+12,000)/5,00,000 x 100
= 22.60%
3. 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
4. Net Profit Ratio= Net Profit/Sales x 100
= 84,000/5,00,000 x 100
= 16.8%
5. Stock Turnover Ratio= COGS/ Average Stock
= 3,00,000/87,375
= 3.43 times
Average Stock = open Stock + Cl Stock / 2
= (76,250+98,500)/2
= 87,375
Q8) 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.
A8)
- Current Ratio= Current Assets/Current Liabilities
= 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
Q9) 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
A9)
- Gross Profit Ratio= Gross Profit/Sales x 100
= 7,50,000/15,00,000 x 100
= 50%
2. Stock Turnover Ratio= COGS/ Average Stock
= 7,50,000/2,50,000
= 3 times
Average Stock = Open Stock + Cl Stock / 2
= (3,25,000+1,75,000)/2
= 2,50,000
COGS= Sales – GP
= 15,00,000 – 7,50,000
= 7,50,000
3. 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
4. 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
5. 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 B/R+ Cl Debtors B/R) / 2
= (3,00,000+1,00,000+3,50,000+50,000)/2
= Rs 4,00,000
Q10) 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 15,00,000
Closing Inventory 8,00,000 Debt. 9,00,000
Current Liabilities 6,00,000Opening Inventory7,00,000
A10)
- Gross Profit Ratio= Gross Profit/Sales x 100
= 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
Q11) 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.
A11)
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.
Q12) Calculate the operating Ratio from the following figures.
Items (Rs 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
A12) Operating Ratio = (Cost of Goods Sold + Operating Expenses x 100) / Sales
= ((15,440 + 1,843)/ 17,870) x100
= 97%
Q13) The following is the Trading and Profit and loss account of Mathan Bros Private Limited for the year ended June 30,2001.
Particulars Rs. Particulars Rs.
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 1,01,00 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
A13) Gross Profit Ratio =Gross Profit/ Sales x 100
= 2,00,000 / 500000 x 100
= 40%
- Net Profit Ratio = Net Profit/ Sales x100
= 84000/ 500000 x100
= 16.8%
2. 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
3. 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
Q14) What is Return on capital employed ratio?
A14) Return on capital employed ratio is computed by dividing the net income before interest and tax by capital employed. It measures the success of a business in generating satisfactory profit on capital invested. The ratio is expressed in percentage.
Return on capital employed ratio=
Net income before interest and tax/ Capital employed x 100
The basic components of the formula of return on capital employed ratio are net income before interest and tax and capital employed. Net income before the deduction of interest and tax expenses is frequently referred to as operating income. Here, interest means interest on long term loans. If company pays interest expenses on short-term borrowings, that is deducted to arrive at operating income. Return on capital employed ratio measures the efficiency with which the investment made by shareholders and creditors is used in the business. Managers use this ratio for various financial decisions. It is a ratio of overall profitability and a higher ratio is, therefore, better.
Q15) What is Earnings per share ratio?
A15) Earnings per share (EPS) ratio measures how many dollars of net income have been earned by each share of common stock. It is computed by dividing net income less preferred dividend by the number of shares of common stock outstanding during the period. It is a popular measure of overall profitability of the company and is usually expressed in dollars. Earnings per share ratio (EPS ratio) is computed by the following formula:
EPS Ratio= Net income- preferred dividend/ Weighted avg. Numbers of shares outstanding
The numerator is the net income available for common stockholders’ (net income less preferred dividend) and the denominator is the average number of shares of common stock outstanding during the year. The formula of EPS ratio is similar to the formula of return on common stockholders’ equity ratio except the denominator of EPS ratio formula is the number of average shares of common stock outstanding rather than the average common stockholders’ equity. The higher the EPS figure, the better it is. A higher EPS is the sign of higher earnings, strong financial position and, therefore, a reliable company to invest money.
Q16) What is Return on common stockholder’s equity ratio?
A16) Return on common stockholders’ equity ratio measures the success of a company in generating income for the benefit of common stockholders. It is computed by dividing the net income available for common stockholders by common stockholders’ equity. The ratio is usually expressed in percentage.
Return on common stockholder’s equity=
Net income-preferred dividend/Avg, common stockholder’s equity x100
The numerator in the above formula consists of net income available for common stockholders which are equal to net income less dividend on preferred stock. The denominator consists of average common stockholders’ equity which is equal to average total stockholders’ equity less average preferred stockholders’ equity. If preferred stock is not present, the net income is simply divided by the average common stockholders’ equity to compute the common stock equity ratio. Like return on equity (ROE) ratio, a higher common stock equity ratio indicates high profitability and strong financial position of the company and can convert potential investors into actual common stockholders.
Q17) What is Return on shareholder’s investment ratio?
A17) Return on shareholders’ investment ratio is a measure of overall profitability of the business and is computed by dividing the net income after interest and tax by average stockholders’ equity. It is also known as return on equity (ROE) ratio and return on net worth ratio. The ratio is usually expressed in percentage
Return on shareholder’s investment=
Net income after interest and tax/ Avg. Stockholders’ equity x 100
The numerator consists of net income after interest and tax because it is the amount of income available for common and preference stockholders. The denominator is the average of stockholders’ equity (preference and common stock). The information about net income after interest and tax is normally available from income statement and the information about preference and common stock is available from balance sheet. Return on equity (ROE) is widely used to measure the overall profitability of the company from preference and common stockholders’ view point. The ratio also indicates the efficiency of the management in using the resources of the business.
Q18) What is Operating ratio?
A18) Operating ratio is computed by dividing operating expenses by net sales. It is expressed in percentage. Operating ratio is computed as follows:
Operating ratio= Operating cost/ Net sales x100
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. This ratio is used to measure the operational efficiency of the management. It shows whether the cost component in the sales figure is within normal range. A low operating ratio means high net profit ratio i.e., more operating profit. 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. The operating ratio varies from industry to industry.
Q19) What is Gross Profit Ratio?
A19) 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. The following formula/equation is used to compute gross profit ratio:
Gross profit 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:
Gross profit margin= 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.
Q20) What is Net profit ratio?
A20) 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.
Net profit ratio= Net profit after tax/ Net sales
For the purpose of this ratio, net profit is equal to gross profit minus operating expenses and income tax. All non-operating revenues and expenses are not taken into account because the purpose of this ratio is to evaluate the profitability of the business from its primary operations. 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.
Unit 4
Analysis of Financial Statement
Q1) What is Ratio Analysis?
A1) Ratio analysis is used to evaluate relationships among financial statement items. The ratios are used to identify trends over time for one organisation or to compare two or more organisations at one point in time. Ratio analysis focuses on three key aspects of a business: liquidity, profitability, and solvency. Ratio Analysis is an important tool for any business organisation. The computation of ratios facilitates the comparison of firms which differ in size. Ratios can be used to compare a firm's financial performance with industry averages. In addition, ratios can be used in a form of trend analysis to identify areas where performance has improved or deteriorated over time. Generally, ratio analysis involves four steps:
(i) Collection of relevant accounting data from financial statements.
(ii) Constructing ratios of related accounting figures.
(iii) Comparing the ratios thus constructed with the standard ratios which may be the corresponding past ratios of the firm or industry average ratios of the firm or ratios of competitors.
(iv) Interpretation of ratios to arrive at valid conclusions.
Q2) What are the objectives of Ratio Analysis?
A2) Ratio analysis is indispensable part of interpretation of results revealed by the financial statements. It provides users with crucial financial information and points out the areas which require investigation. Ratio analysis is a technique which involves regrouping of data by application of arithmetical relationships, though its interpretation is a complex matter. It requires a fine understanding of the way and the rules used for preparing financial statements. Once done effectively, it provides a lot of information which helps the analyst:
1. To know the areas of the business which need more attention;
2. To know about the potential areas which can be improved with the effort in the desired direction;
3. To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business;
4. To provide information for making cross-sectional analysis by comparing the performance with the best industry standards; and
5. To provide information derived from financial statements useful for making projections and estimates for the future.
Q3) What is the Nature of Ratio Analysis?
A3) Ratios are designed to show how one number is related to another. It is worked out by dividing one number by another. Ratios are customarily presented either in the form of a coefficient or a percentage or as a proportion.
For example, the current assets and current liabilities of a business on a particular date are Rs.2 lakhs and Rs.1 lakh respectively. The resulting ratio of Current Assets and Current Liabilities could be expressed as 2 (i.e., 2, 00,000/1, 00,000) or as 200 per cent.
Alternatively in the form of a proportion the same ratio may be expressed as 2:1, i.e., the current assets are two times the current liabilities. Ratios are invaluable aids to management and others who are interested in the analysis and interpretation of financial statements. Absolute figures may be misleading unless compared, one with another.
Ratios provide the means of showing the relationship that exists between figures. Though there is no special magic in ratio analysis, many prefer to base conclusions on ratios as they find them highly useful for making judgments more easily.
However, the numerical relationships of the kind expressed by ratio analysis are not an end in themselves but are a means for understanding the financial position of a business.
Generally, simple ratios or ratios compiled from a single year’s financial statements of a business concern may not serve the real purpose. Hence, ratios are to be worked out from the financial statements of a number of years.
Ratios, by themselves, are meaningless. They derive their status partly from the ingenuity and experience of the analyst who uses the available data in a systematic manner.
Besides, in order to reach valid conclusions, ratios have to be compared with some standards that are established with a view to represent the financial position of the business under review.
However, it should be borne in mind that after computing the ratios one cannot categorically say whether a particular ratio is good or bad as the conclusions may vary from business to business. A single ideal ratio cannot be applied for all types of business.
Speedy compiling of ratios and their presentation in the appropriate manner is essential. A complete record of ratios employed is advisable; and explanation of each and actual ratios year by year should be included.
This record may be treated as a part of an Account Manual or a special Ratio Register may be maintained.
Q4) What is Profitability ratios?
A4) Profit is the primary objective of all businesses. All businesses need a consistent improvement in profit to survive and prosper. A business that continually suffers losses cannot survive for a long period. Profitability ratios measure the efficiency of management in the employment of business resources to earn profits. These ratios indicate the success or failure of a business enterprise for a particular period of time. Profitability ratios are used by almost all the parties connected with the business. A strong profitability position ensures common stockholders a higher dividend income and appreciation in the value of the common stock in future. Creditors, financial institutions and preferred stockholders expect a prompt payment of interest and fixed dividend income if the business has good profitability position. Management needs higher profits to pay dividends and reinvest a portion in the business to increase the production capacity and strengthen the overall financial position of the company. Some important profitability ratios are given below:
(i) Net profit (NP) ratio
(ii) Gross profit (GP) ratio
(iii) Price earnings ratio (P/E ratio)
(iv) Operating ratio
(v) Expense ratio
(vi) Dividend yield ratio
(vii) Dividend pay-out ratio
(viii) Return on capital employed ratio
(ix) Earnings per share (EPS) ratio
(x) Return on shareholder’s investment/Return on equity
(xi) Return on common stockholders’ equity ratio
Q5) What are Liquidity ratios?
A5) Liquidity ratios measure the adequacy of current and liquid assets and help evaluate the ability of the business to pay its short-term debts. The ability of a business to pay its short-term debts is frequently referred to as short-term solvency position or liquidity position of the business. Generally, a business with sufficient current and liquid assets to pay its current liabilities as and when they become due is considered to have a strong liquidity position and a business with insufficient current and liquid assets is considered to have weak liquidity position. Short-term creditors like suppliers of goods and commercial banks use liquidity ratios to know whether the business has adequate current and liquid assets to meet its current obligations. Financial institutions hesitate to offer short-term loans to businesses with weak short-term solvency position. Three commonly used liquidity ratios are given below: (i) Current ratio or working capital ratio (ii) Quick ratio or acid test ratio (iii) Absolute liquid ratio (i)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. 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:
Current assets Current liabilities
Cash Accounts payable /
Creditors Marketable securities Accrued
Payable Accounts receivables / debtors Bonds
Payable Inventories / stock
Prepaid expenses
(ii) 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. The formula for the calculation of quick ratio is given below:
Quick ratio= Liquid assets/ current liabilities
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.
(iii) Absolute Liquid ratio-some analysts also compute absolute liquid ratio to test the liquidity of the business. Absolute liquid ratio is computed by dividing the absolute liquid assets by current liabilities. The formula to compute this ratio is given below:
Absolute liquid ratio= Absolute liquid assets/ Current liabilities
Absolute liquid assets are equal to liquid assets minus accounts receivables (including bills receivables). Some examples of absolute liquid assets are cash, bank balance and marketable securities etc.
Q6) What are Leverage ratios?
A6) Long term financial strength of the firm is measured in terms of the ability to pay interest regularly or repay principal on due dates or at the time of maturity. Such long-term solvency of a firm can be judged by using leverage.
- Debt-Equity Ratio (DE Ratio): This Ratio is a basic measure of studying the indebtedness if the firm or Debt-equity Ratio measures the debt proportion relative to the equity financing for the firm.
Debt-equity ratio= Debts/ Equity (Shareholders' Funds)
Or
Debts/ Long - term Funds (Shareholders' Funds + Debts)
- Total Debt Ratio: The Ratio compares the total debts of the firm with the total assets available. It measures the relative size of the firm’s debt load and the firm’s ability to pay the debt.
Total debt ratio= Total debts/total assets
- Interest Coverage Ratio (IC Ratio): This ratio is also called the times interest earned ratio and it measures the ability of the firm to pay the fixed interest liability.
Interest coverage ratio= EBIT/Interest expense
Q7) 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.
A7)
- Gross Profit Ratio= Gross Profit/Sales x 100
= 2,00,000/5,00,000 x 100
= 40%
2. Expense Ratio= Operating expenses/Sales x 100
= (1,01,000+12,000)/5,00,000 x 100
= 22.60%
3. 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
4. Net Profit Ratio= Net Profit/Sales x 100
= 84,000/5,00,000 x 100
= 16.8%
5. Stock Turnover Ratio= COGS/ Average Stock
= 3,00,000/87,375
= 3.43 times
Average Stock = open Stock + Cl Stock / 2
= (76,250+98,500)/2
= 87,375
Q8) 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.
A8)
- Current Ratio= Current Assets/Current Liabilities
= 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
Q9) 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
A9)
- Gross Profit Ratio= Gross Profit/Sales x 100
= 7,50,000/15,00,000 x 100
= 50%
2. Stock Turnover Ratio= COGS/ Average Stock
= 7,50,000/2,50,000
= 3 times
Average Stock = Open Stock + Cl Stock / 2
= (3,25,000+1,75,000)/2
= 2,50,000
COGS= Sales – GP
= 15,00,000 – 7,50,000
= 7,50,000
3. 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
4. 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
5. 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 B/R+ Cl Debtors B/R) / 2
= (3,00,000+1,00,000+3,50,000+50,000)/2
= Rs 4,00,000
Q10) 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 15,00,000
Closing Inventory 8,00,000 Debt. 9,00,000
Current Liabilities 6,00,000Opening Inventory7,00,000
A10)
- Gross Profit Ratio= Gross Profit/Sales x 100
= 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
Q11) 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.
A11)
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.
Q12) Calculate the operating Ratio from the following figures.
Items (Rs 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
A12) Operating Ratio = (Cost of Goods Sold + Operating Expenses x 100) / Sales
= ((15,440 + 1,843)/ 17,870) x100
= 97%
Q13) The following is the Trading and Profit and loss account of Mathan Bros Private Limited for the year ended June 30,2001.
Particulars Rs. Particulars Rs.
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 1,01,00 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
A13) Gross Profit Ratio =Gross Profit/ Sales x 100
= 2,00,000 / 500000 x 100
= 40%
- Net Profit Ratio = Net Profit/ Sales x100
= 84000/ 500000 x100
= 16.8%
2. 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
3. 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
Q14) What is Return on capital employed ratio?
A14) Return on capital employed ratio is computed by dividing the net income before interest and tax by capital employed. It measures the success of a business in generating satisfactory profit on capital invested. The ratio is expressed in percentage.
Return on capital employed ratio=
Net income before interest and tax/ Capital employed x 100
The basic components of the formula of return on capital employed ratio are net income before interest and tax and capital employed. Net income before the deduction of interest and tax expenses is frequently referred to as operating income. Here, interest means interest on long term loans. If company pays interest expenses on short-term borrowings, that is deducted to arrive at operating income. Return on capital employed ratio measures the efficiency with which the investment made by shareholders and creditors is used in the business. Managers use this ratio for various financial decisions. It is a ratio of overall profitability and a higher ratio is, therefore, better.
Q15) What is Earnings per share ratio?
A15) Earnings per share (EPS) ratio measures how many dollars of net income have been earned by each share of common stock. It is computed by dividing net income less preferred dividend by the number of shares of common stock outstanding during the period. It is a popular measure of overall profitability of the company and is usually expressed in dollars. Earnings per share ratio (EPS ratio) is computed by the following formula:
EPS Ratio= Net income- preferred dividend/ Weighted avg. Numbers of shares outstanding
The numerator is the net income available for common stockholders’ (net income less preferred dividend) and the denominator is the average number of shares of common stock outstanding during the year. The formula of EPS ratio is similar to the formula of return on common stockholders’ equity ratio except the denominator of EPS ratio formula is the number of average shares of common stock outstanding rather than the average common stockholders’ equity. The higher the EPS figure, the better it is. A higher EPS is the sign of higher earnings, strong financial position and, therefore, a reliable company to invest money.
Q16) What is Return on common stockholder’s equity ratio?
A16) Return on common stockholders’ equity ratio measures the success of a company in generating income for the benefit of common stockholders. It is computed by dividing the net income available for common stockholders by common stockholders’ equity. The ratio is usually expressed in percentage.
Return on common stockholder’s equity=
Net income-preferred dividend/Avg, common stockholder’s equity x100
The numerator in the above formula consists of net income available for common stockholders which are equal to net income less dividend on preferred stock. The denominator consists of average common stockholders’ equity which is equal to average total stockholders’ equity less average preferred stockholders’ equity. If preferred stock is not present, the net income is simply divided by the average common stockholders’ equity to compute the common stock equity ratio. Like return on equity (ROE) ratio, a higher common stock equity ratio indicates high profitability and strong financial position of the company and can convert potential investors into actual common stockholders.
Q17) What is Return on shareholder’s investment ratio?
A17) Return on shareholders’ investment ratio is a measure of overall profitability of the business and is computed by dividing the net income after interest and tax by average stockholders’ equity. It is also known as return on equity (ROE) ratio and return on net worth ratio. The ratio is usually expressed in percentage
Return on shareholder’s investment=
Net income after interest and tax/ Avg. Stockholders’ equity x 100
The numerator consists of net income after interest and tax because it is the amount of income available for common and preference stockholders. The denominator is the average of stockholders’ equity (preference and common stock). The information about net income after interest and tax is normally available from income statement and the information about preference and common stock is available from balance sheet. Return on equity (ROE) is widely used to measure the overall profitability of the company from preference and common stockholders’ view point. The ratio also indicates the efficiency of the management in using the resources of the business.
Q18) What is Operating ratio?
A18) Operating ratio is computed by dividing operating expenses by net sales. It is expressed in percentage. Operating ratio is computed as follows:
Operating ratio= Operating cost/ Net sales x100
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. This ratio is used to measure the operational efficiency of the management. It shows whether the cost component in the sales figure is within normal range. A low operating ratio means high net profit ratio i.e., more operating profit. 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. The operating ratio varies from industry to industry.
Q19) What is Gross Profit Ratio?
A19) 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. The following formula/equation is used to compute gross profit ratio:
Gross profit 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:
Gross profit margin= 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.
Q20) What is Net profit ratio?
A20) 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.
Net profit ratio= Net profit after tax/ Net sales
For the purpose of this ratio, net profit is equal to gross profit minus operating expenses and income tax. All non-operating revenues and expenses are not taken into account because the purpose of this ratio is to evaluate the profitability of the business from its primary operations. 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.