(3) ACTIVITY RATIO

The Activity Ratios are also known as turnover ratios or efficiency ratios. They indicate the efficiency with which the capital employed is rotated in the business. The 2 factors on which overall profitability of the business depends are: (i) the rate of return on capital employed (ii) the turnover(the speed at which the capital employed in the business rotates. Higher the rate of rotation the greater the profitability Higher turnover means better use of capital or resources, which in turn means better profitability ratio. The important turnover ratios are as follows: 1.Fixed Assets Turnover Ratio: It indicated whether investment in fixed assets has been judicious or not. The ratio is calculated as follows: Net Sales Net Fixed assets A high ratio indicates efficient utilization of fixed assets. 2. Working Capital Turnover Ratio/ Working Capital Leverage Ratio: This ratio indicates whether or not working capital has been efficiently utilized in making sales. The ratio is calculated as follows: Net Sales Working Capital Working capital turnover ratio may take different forms for different purposes, which have been explained as below: (i) Debtors Turnover Ratio/Receivables Turnover Ratio( Debtors Velocity):It establishes a relationship between net credit sales and average debtors(or receivables) of the year. Average debtors are calculated by dividing the sum of debtors in the beginning and at the end by 2.

The ratio is calculated as follows: Net Credit Sales Avg. Accounts receivables The term receivables include Trade Debtors and Bills Receivables A high ratio is better as it indicates that debts are being collected more promptly. The ratio helps in cash budgeting since the flow of cash from customers can be worked out on the basis of sales. (ii) Debt collection period ratio: The ratio indicates the extent to which the debts have been collected in time. It gives the average debt collection period. An increase in the period will result in greater blockage of funds in debtors. The ratio may be calculated by any of the following methods: (a) Months( or days) in a year Debtors Turnover (b) Avg. Accounts Receivable X Months in a Year Credit Sales for the year Accounts Receivables (c) Avg monthly or daily credit sales

Debtors collection period measures the quality of debtors since it measures the rapidity or slowness with which money is collected from them. A longer collection period implies too liberal and inefficient credit collection performance. It should be neither too liberal nor too restrictive. A restrictive policy will result in lower sales which will reduce profits. (iii) Creditors Turnover Ratio (Creditors Velocity) :It is similar to Debtors turnover ratio. It indicated the speed with which the payments for credit purchases are made to the creditors. The ratio can be computed as follows: Credit Purchases Avg. Account Payable

Accounts payable include Trade Creditors and Bills Payable In case details regarding credit purchases, opening and closing accounts payable have not been given the ratio may be calculated as follows: Total Purchases Accounts payable (iv) Debt Payment Period enjoyed Ratio (Average age of Payable): The ratio gives the average credit period enjoyed from the creditors. The ratio may be calculated by any of the following methods: (a) Months( or days) in a year Creditors Turnover (b) Avg. Accounts receivable X Months(or days) in a Year Credit Purchases in the year Accounts Payable (c) Avg monthly or daily credit purchases (v) Stock turnover ratio. This ratio indicates whether investment in inventory is efficiently used or not. It therefore, explains whether investment in inventories within proper limits or not. The ratio is calculated as follows; Cost of goods sold during the year Avg inventory Avg inventory=Inv. at the begin of the accounting period +Inv. at the end of the accounting period 2 (vi) Working Capital Leverage Ratio: Working Capital Leverage indicates the way in which the profitability and return on the investments are affected due to Working Capital Management.

Working Capital Turnover Ratio = Sales Working Capital Working Capital =Current assets Current Liabilities Higher the ratio the better it is. But a very high ratio may indicate overtrading the working capital being inadequate for the scale of operations. Working Capital Leverage Ratio shows the number of times a unit invested in working capital produces sales.

(4) PROFITABILITY RATIOS Profitability is an indication of the efficiency with which the operations of the business are carried on. Profit as compared to the capital employed indicates profitability of the enterprise. Thus profitability is of utmost importance for a concern. A measure of profitability is the over all measure of efficiency. The overall profitability ratios are (i) Overall Profitability Ratio: It is called as Return on Investment or Return on Capital employed. It indicates the percentage of return on the total capital employed in the business. It is calculated on the basis of the following formula: Operating Profit X 100 Capital employed The term, capital employed has been given different meanings by different accountants. In management accounting, the term capital employed is generally used as sum total of long term funds employed in the business ,i.e, Share Capital + Reserves and surplus + long term loans (non-business assets + fictitious assets) The term operating profit means profit before Interest & Tax. The term interest means Interest on long- term borrowings. Interest on short- term borrowings will be deducted for

computing operating profit. Non-trading incomes such as interest on govt. Securities or non-trading losses or expenses such as loss on account of fire etc. will also be excluded. (ii) Earning per share (E.P.S) In order to avoid confusion on account of the varied meanings of the term capital employed, the overall profitability can also be judged by calculating earning per share with the help of the following Formula: Net Profit after Tax and Preference Dividend Number of Equity Shares Earnings per share will help in determining the market price of the equity shares of the company. A comparison of earning per share of the company with another will also help in deciding whether the equity share capital is being effectively used or not. It also helps in determining companys capacity to pay dividend to its equity shareholders.

(iii) Price Earning Ratio (P.E.R): This ratio indicates the number of times the earning per share is covered by its market price.. It is calculated as per following formula: Market Price per equity Share Earning per share The ratio is useful in financial forecasting. It also helps in knowing whether the companys shares are under or over valued for example: If the earning per share of AB limited is Rs. 20,its market price Rs. 140 and price earning ratio of similar companies is 8,it means that the market value of a share of AB ltd. should be Rs. 160(8x20). The share of AB ltd. Is therefore, undervalued in the market by Rs.20. In case the price earning ratio of similar companies is only 6, the value of share of AB ltd. Should have been Rs.120(6x 20),thus the share is overvalued by Rs. 20.

P.E.R. helps the investor in deciding whether to buy or not to buy the share of a company at a particular market price. (iv) Gross Profit Ratio: This ratio expresses relationship between Gross Profit and net sales. Its formula is: Gross Profit X 100 Net Sales This ratio indicates the degree to which the selling price of goods per unit may decline without resulting in losses from operations to the firm. It also helps in ascertaining whether the average percentage of mark up on the goods is maintained. (v) Net Profit Ratio: This ratio indicates net margin earned on a sale of Rs. 100. It is calculated as follows: Net Operating profit x 100 Net Sales Net Operating Profit is arrived at, by deducting operating expenses from gross profit. This ratio helps in determining the efficiency with which affairs of the business are being managed. An increase in the ratio over the previous period indicates an improvement in the operational efficiency of the business provided the gross profit ratio is constant. The ratio is thus an effective measure to check the profitability of business. (vi)Operating or Expenses Ratio: this ratio is a complementary of net profit ratio. In case the net profit ratio is 20%, it means that the operating ratio is 80%. It is calculated as follows: Operating Costs X 100 Net Sales Operating costs include the cost of direct materials, direct labor and other overheads. Financial charges such as interest, provision for taxation, etc, are generally excluded from operating costs. The Operating costs should be low

enough to leave a portion of sales to give a fair return to the investors. (vii) Pay out Ratio: This ratio indicates what proportion of earning per share has been used for paying dividend. The ratio can be calculated as follows: Dividend per Equity Share Earning per equity share A complementary of this ratio is Retained Earning Ratio. It is calculated as follows: Retained Earning per Equity Share Earning per equity share Or Retained earnings X 100 Total Earnings (viii) Dividend Yield Ratio: This ratio is particularly useful for those investors who are interested only in dividend income. The ratio is calculated by comparing the ratio of dividend per share with its market value. Its formula is: Dividend per Share X 100 Market Price per share

(5)

COVERAGE RATIO

These ratios indicate the extent to which the interests of the persons entitled to get a fixed return or a scheduled repayment as per the agreed terms, are safe. The higher the cover, the better it is. These ratios are of three types: (i) Fixed interest cover: This is very important from lenders point of view. It indicates whether the business would earn

sufficient profits to pay periodically the interest charges, The higher the number, the more secure the lender is in respect of his periodical interest income. It is calculated as follows: Income before interest & Tax Interest Charges The standard for this ratio for an industrial company is that interest charges should be covered six to seven times.

(ii) Fixed Dividend cover: The ratio is important for preference shareholders entitled to get dividend at a fixed rate in priority to other shareholders. The ratio is calculated as follows: Fixed Dividend cover = Net Profit after Interest and tax Preference dividend (iii) Debt Service coverage Ratio: The interest coverage ratio does not tell us anything about the ability of a company to make payment of principal amount also on time. For this purpose debt service coverage ratio is calculated as follows: = Net Profit before Interest and tax Interest + Principal Payment Installment 1-Tax Rate The principal payment installment is adjusted for tax effects since such payment is not deductible from net profit for tax purposes.

ANALYSIS OF FINANCIAL STATEMENTS

Analysis of Financial statement is a systematic process of the critical examination of the financial information contained in the financial statements in order to understand and make decisions regarding the operations of the firm. Analysis of financial statement is a study of relationship among various financial facts and figures as set out in the financial statements .i.e., Balance sheet and Profit and Loss Account. The analysis and interpretation of financial statements are an attempt to determine the significance and meaning of financial statement data so that the forecast may be made of the prospects for future earnings, ability to pay interest and debt maturities (both current and long-term) and profitability and sound dividend policy.- Kennedy & Muller. Types of Financial Analysis: 1. On the basis of Material Used: According to this basis, financial analysis can be of two types: (i) External Analysis: This analysis is done by those, who are the outsiders for business. The term, outsiders includes investors, credit agencies, govt. agencies and other creditors who have no access to the internal records of the company. These persons mainly depend upon the published financial statements. Their analysis serves only a limited purpose.

(ii)

Internal Analysis: This analysis is done by persons who have the access to the books of accounts and other information related to the business, such an analysis can, therefore, be done by executives and employees of the organization or by officers appointed for this purpose by the govt. or the court under powers vested in them. The analysis is done depending upon the objective to be achieved through this analysis.

2. On the basis of modus operandi: According to this, financial analysis can also Be of two types: Horizontal Analysis, Vertical Analysis Basis Period Horizontal Analysis It requires comparative financial statements of two or more accounting periods. It deals with same item of different periods. It provides information in absolute and percentage form. It is generally used for time series analysis. It is a part of comparison. Vertical Analysis It requires a statement of one period. It deals with different items of same period. It provides information in percentage for money. It is generally used for cross -section analysis. It is a step towards comparison

Items Information Usefulness Comparison

Tools or Techniques Of Financial Statement Analysis Financial statements indicate certain absolute information about assets, liabilities, equity revenues, expenses and profit or loss of an enterprise. They are not readily understandable to the external users of financial statements. The users of financial statements need information about profitability, solvency and liquidity of the

enterprise. Accordingly various techniques are employed for analyzing the financial statements. A financial analyst can adopt the following tools and techniques for analysis of the financial statements: (i) Comparative Financial Statements: these are the statements in which figures of 2 or more periods are placed side by side along with change in figures in absolute and percentage terms to facilitate comparison. Both the Income Statement (Profit & Loss Account) and Position Statement (Balance sheet) are prepared in the form of Comparative financial statements. (ii) Common-size Financial Statement: Common-size Financial Statement express all figures of a financial statement as percentage of some common base. In P & L Account the sale figure is assumed to be 100 and all figures are expressed as a percentage of sales. Similarly in the Balance sheet the total assets or liabilities is taken as 100 and all the figures are expressed as percentage of total. (iii) Trend percentages: These are immensely helpful in making comparative study of the financial statements for several years. The method of calculating trend percentages involves the calculation of percentage relation ship that each item bears to the same item in the base year. Base year is usually the earliest year. Each item of base year is taken as 100 and on the basis the percentages for each of the items of each of the years are calculated. (iv) Ratio analysis: Ratio analysis expresses the relationship between two financial variables taken from financial statements of an accounting period in the form of ratio. It is the most important tool available to financial analysts for their work. (v) Funds Flow Statement: Funds Flow Statement shows the changes in working capital position. It shows the sources

from which the working capital was obtained and the purposes for which it was used. (vi) Cost-volume Profit analysis-It is an important tool of profit planning. It studies the relationship between cost, volume of production, sales and profit. It is not strictly a technique for analysis of financial statements but tool for the management for decision making since the date is provided by both cost and financial records. Process Of Financial Statement Analysis Objectives of Financial Analysis: 1.To judge the financial stability of an enterprise. 2.To measure the enterprises short term & long - term solvency. 3.To measure the enterprises operating efficiency and profitability. 4.To compare intra-firm position, inter-firm position and the pattern position within industry. 5.To access the future prospects of the enterprise.(making fore cast and preparing budgets) Uses of Financial analysis 1.Security Analysis 2.Credit analysis 3.Debt analysis 4.Dividend Decision 5.General Business Analysis