Ratio Analysis

Compute the standard financial ratios

Accounting Ratio
Arithmetical relation between two accounting variables, having a cause and effect relationship Accounting ratios can be expressed as:
Pure or as a quotient Percentage Times Fraction Number of days
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Types of Accounting Ratios

Accounting ratios can be classified into Liquidity or Short-Term Solvency ratios Activity or Asset Management Ratios Financial Structure or Capitalisation Ratios Profitability Ratios Market Test Ratios
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Liquidity / Solvency Ratios

Measures the firms ability to pay off the current dues Current Ratio/Working capital ratio Quick Ratio/Acid test Ratio Current Ratio of 2 is ideal Debtors outstanding for more than 6 months not normally considered Prepaid expenses are treated as current assets.
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Ability to Pay Current Liabilities

Working capital measure of amount of current asset remaining after all current liabilities have been paid

Current assets Current liabilities

Ability to Pay Current Liabilities

Current ratio measures ability to pay current assets with current liabilities

Current assets Current liabilities

Example
From the following compute Current Ratio Sundry Debtors 100000 Prepaid expenses 10000 Cash in hand and bank 30000 Short term investments 20000 Machinery 7000 Bills payable 20000 Sundry Creditors 40000 Debentures 200000 Stock 40000 Expenses payable 40000
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Ability to Pay Current Liabilities

Quick Ratio (Acid test ratio) if the entity could pay all its current liabilities if they came due immediately
Quick assets - cash, short-term investments, net current receivables Exclude stock and prepaid expenses

Quick assets Current liabilities

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Following is the balance sheet of XYZ Limited as on 31st December, 2002

Liabilities Rs Assets Rs.

Equity Share Capital Profit and Loss A/c 10% Debentures

Sundry Creditors Provision for taxation

24000 Machinery and equipment 6000 Stock 15000 Sundry Debtors

23400 Cash at Bank 600 Prepaid expenses 69000

45000 12000 9000

2280 720 69000

Activity Ratios
Also termed as Performance or Turnover ratios Measures the effectiveness with which the concern uses resources at its disposal Higher the turnover ratio better the use of resources better profitability ratio This ratio represents the efficiency of asset usage to generate sales revenue

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Ability to Sell Inventory & Collect Receivables

Inventory turnover how many times a year the company sells its average level of inventory Cost of goods sold Average inventory*
Cost of good sold = Sales Gross Profit *Average inventory = (Beginning inventory + Ending Inventory)/2
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 Higher the ratio, indicates more sales are being produced by a unit of investment in stocks Purpose : to check if the investment in stocks is optimal Industries in which the inventory turnover ratio is high usually work on a comparatively lower profit margin
Note: Sometimes this ratio is calculated from sales also

Debtors/Receivables Turnover Ratio

how quickly the company collects cash from credit customers Net credit sales Average net accounts receivable*
Accounts Receivables includes Trade Debtors and Bills Receivable *Average net accounts receivable = (Beginning receivables + Ending receivables)/2
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Important points to note.

Doubtful debts are not deducted from total debtors In case details regarding opening and closing receivables and credit sales is not given, then the ratio is worked out as Total sales Accounts Receivable

Average Collection Period or Debtor days

how many days sales remain uncollected in accounts receivable

Accounts Receivable (Credit Sales for the year/360)

The shorter the average collection period, the better the quality of debtors
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Creditors Turnover Ratio

Net credit Purchases Average accounts payables*
*Average accounts payable = (Beginning creditors + Beginning Bills Payable + Ending receivables + Ending Bills Payable)/2

Average Payment Period

Accounts Payable (Credit Purchases/360)

Capital Turnover Ratio

Efficient rotation of capital leads to higher profitability Relation between sales and capital employed Sales Capital Employed*
*Capital Employed= Fixed Assets + Net Working Capital

Fixed Asset Turnover Ratio

Sales Net Fixed Assets*
*Net Fixed Assets = Fixed Assets - Depreciation

Working Capital Turnover Ratio

Sales Net Working Capital

The following is the Balance Sheet of K Co. Ltd., as on 31st December 2008 Liabilities Share Capital General Reserve Profit & Loss A/c Loan @ 10% Creditors Bills Payable Rs. Assets 80000 Fixed Assets 30000 Debtors 50000 Bills Receivable 80000 Cash at Bank 40000 Preliminary Exps 20000 300000 Rs. 160000 60000 20000 50000 10000 300000

Sales during the year amounted to Rs.160,000. Calculate (a) Capital Turnover Ratio, (b) Fixed Asset Turnover Ratio and (c ) Working Capital Turnover Ratio

Capital Turnover Ratio = 160000 = 0.70 230000 Fixed Asset Turnover Ratio = 160,000 = 1 160,000 Working Capital Turnover Ratio
= 160,000 = 2.29 70,000

Financial Structure or Capitalisation Ratios

Debt is a true "double-edged" sword as it allows for the generation of profits with the use of other people's (creditors) money, but creates claims on earnings with a higher priority than those of the firm's owners There are two types of Debt Measures Degree of Indebtedness Ability to Service Debts

Degree of Indebtedness
Debt ratio proportion of companys assets financed with debt Total liabilities Total assets Debt Equity Ratio
Ascertains the soundness of the financial policies of the company

Debt (Long term loans) Equity (shareholders funds)

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Ability to Service Debt

Times-interest-earned (interest coverage) how many times operating income covers interest expense Debt Service Ratio or Fixed Charges Cover

Income from operations* Interest expense

*Income from operations = Income before income tax & interest expense
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Fixed Asset Ratio

Fixed Assets should be financed only through long term loans

Shareholders funds + Long term Loans Net Fixed Assets

If ratio < 1 means firm has used short term funds to finance long term assets

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Profitability Ratios
Profitability Ratios assess the firm's ability to operate efficiently Of concern to owners, creditors and management A Common-Size Income Statement, which expresses each income statement item as a percentage of sales, allows for easy evaluation of the firms profitability relative to sales
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Profitability Ratios
Rate of return on net sales (Gross profit ratio Gross Profit x 100 Net sales

Net Profit Ratio

Net Profit x 100 Net sales
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Overall Profitability Ratios

Return on Investment relation between profit earned and capital employed Measures the earning power of the net assets in business

Profit before Interest, tax and Dividends Capital Employed

Return on Equity profits available to the equity shareholders Net Profit Equity Shareholders funds*
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*Equity Shareholders funds = Paid up capital and reserves

Profitability
Trading on the equity (using leverage) company borrows at a lower rate then invests the money to earn a higher rate A company is favorably leveraged if return on assets > return on stockholders equity

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Market Test Ratios

Based on the share market's perception of the company.

The higher the ratio, the higher the perceived quality of the earnings by the share market.

Market Test Ratios

Earnings per share = Net Profit after tax
Number of issued ordinary shares

Dividends per share =

Dividends
Number of issued ordinary shares

Dividend payout ratio = Dividends per share *100 Earnings per share Price Earnings ratio = Market price per share Earnings per share

Red Flags
Strange movement of sales, inventory, and receivables Earnings problems Decreased cash flow Too much debt Inability to collect receivables Inventory buildup
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