financial condition.
a more meaningful way so as to enable equity investors, management and lenders to arrive at the following factors for making better investment and credit decisions.
Liquidity position Profitability Solvency Financial Stability
been provided
Classification of Ratios
Liquidity Ratios Current Ratio Quick Ratio (Acid Test Ratio) Turnover Ratios Stock Turnover Ratio Debtor Turnover Ratio Asset Turnover Ratio Solvency Ratios Debt Equity Ratio Interest Coverage ratio Profitability Ratios Gross Profit Ratio Net Profit Ratio
Operating ratio
Cash Ratio
Liquidity Ratios
Liquidity refers to the ability of the firm to meet its current
liabilities
Liquidity ratios are therefore called Short-term Solvency Ratios
resources.
Of prime importance to Short term creditors as they want to know
how promptly or readily the firm can meet its current liabilities
Assets= Assets which can be converted into cash in less than 1 year Eg. Cash in hand + Cash in bank, Cash equivalent, Accounts Receivable, Inventory, Prepaid Expenses, Marketable Securities, Short term investments Of prime importance to creditors since these assets can be easily liquidated if the company goes bankrupt Source of funds for day to day business operations
Current
Liabilities=Liabilities which are due to be paid by the company within a period of one year Eg. Accounts payable, Short term loans
Current Ratio
It is the relationship between the current assets and current liabilities of a concern. Current Ratio = Current Assets/Current Liabilities
Significance: Used to assess the firms ability to meet its short term liabilities on time EXAMPLE: If the Current Assets and Current Liabilities of a concern are Rs.4,00,000 and Rs.2,00,000 respectively, then the Current Ratio will be : Rs.4,00,000/Rs.2,00,000 = 2 : 1
According to Accounting principle a current ratio of 2:1 is supposed to be an ideal ratio i.e. Current Assets should be at least twice of its current liabilities. If current ration less than 2:1. it indicates lack of liquidity and shortage of working capital However, a very high current ratio also not necessarily good for the company as it may indicate poor investment policies of the management.
inefficient collection policy 3. Cash and bank balances lying idle due to non availability of proper investment options
Includes all current assets excluding stock and prepaid expenses Liquid Assets= Current assets stock- prepaid expenses
Significance:
Indicates whether the firm is in a position to pay its current liabilities within a period of 3 months or immediately Ideal quick ratio is said to be 1:1 Rationale being for every rupee of current liabilities there should be at least one rupee of current assets Better test of short term financial position of a firm than the current ratio, as it considers only those assets which can be readily and easily converted into cash
Example :
Current Assets Cash Debtors Prepaid Expenses Amount 50,000 1,00,000 20,000 Current liabilities Creditors Pre Received income Amount 100,000 30,000
Inventories
TOTAL
1,50,000
3,20,000 TOTAL 1,30,000
Cash Ratio
It is a ratio of cash and cash equivalents to current liabilities
Trade investment or marketable securities are equivalent of cash Significance: Cash is the most liquid asset
refines both the current ratio and the quick ratio by measuring the amount of cash, cash equivalents or invested funds there are in current assets to cover current liabilities.
Problem 1
Following is the Balance Sheet of X ltd.
Liabilities Equity Share Capital 12% Preference Share capital General Reserve P&L a/c 14% Debentures Sundry Creditors Amount Assets Amount 50,000 150,000 140,000 60,000 1,20,000 50,000 200,000 Goodwill 1,00,000 Land and Building 60,000 Machinery 150,000 Long Term Investments 50,000 Stock 35,000 Debtors
Bills Payable
Outstanding Expenses Provision For Taxation Proposed Dividends
26,000
20,000 30,000 4,000 650,000
Calculate:
1. 2. 3. 4.
Solution:
Current Assets Stock Debtors B/R Short Term Investments Cash Prepaid Expenses Amount 120,000 50,000 26,000 20,000 30,000 4,000 Current Liabilities Sundry Creditors Bills Payable Outstanding Expenses Provision for Tax Proposed Dividends Amount 35,000 5,000 10,000 20,000 20,000 ______ _ 90,000
250,000 1. Net Working Capital= Current Assets Current Liabilities = 250,000-90,000 = Rs. 160,000
2. Current Ratio= Current Assets/ Current Liabilities = 250,000/90,000 = 2.7: 1 3. Quick Assets= Current Assets- Stock- Prepaid Expenses = 250,000- 120,000- 4,000 = Rs. 126,000 Quick Ratio= Quick Assets/ Current Liabilities = 126,000/90,000 = 1.2:1
4.Cash Ratio= (Cash+ Cash Equivalents)/ Current Liabilities = (30,000+ 20,000)/ 90,000 = 0.55: 1
Turnover ratios
Measure how well the resources at disposal of the concern are
being utilized
Indicate the rapidity with which the resources available to the
Stock Turnover Ratio= Cost of Goods Sold/ Average stock a) Cost of Goods Sold= Opening Stock+ Purchases+ Carriage Inwards+ wages+ Other Direct Charges- Closing Stock OR Cost of Goods Sold= Net - Gross Profit b) Average Stock = Opening Stock + Closing Stock/ 2
Significance Indicates whether stock has been efficiently used or not It shows the speed with which stock is rotated into sales or the number of times the stock is
turned into sales during the year Higher the better, since it indicates that stock is selling quickly Low ratio indicates that stock does not sell quickly and remains lying in the godown for a long time. Can be used for comparing the efficiency of sales policies of two firms doing same type of business Stock policy of the management of that firm, whose stock turnover ratio is higher, will be treated as more efficient.
EXAMPLE:
Trading Account
Particulars Opening Stock Purchases Carriage inwards Wages Gross Profit Amount Particulars 5,40,000 40,000 5,00,000 68,000 ________ _ 5,68,000 Amount 60,000 Sales 2,50,000 Less: Returns 20,000 Closing stock 58,000 1,80,000 5,68,000 Cost of goods sold = 60,000 + 250,000+ 20,000+ 58,000- 68,000 = 320,000
Average Stock= 60,000+ 68,000/2l= 64,000 Stock Turnover Ratio= 320,000/ 64,000= 5 Times
Debtors Turnover Ratio= Net Credit Sales/ Average Debtors+ Average Bills Receivable
i.e. credit sales have been made to customers who do not deserve much credit assessed whether the sales policy of management is efficient or not.
By comparing the debtors turnover ratio of the current year and previous year, it may be
EXAMPLE:
Particulars Total Sales for the Year Amount 1,75,000
1,40,000
10,000 8,000 12,000
investment in fixed assets is quite high Reveals how efficiently the fixed assets are being utilized High asset turnover ratio indicates better utilization of fixed assets
Debt Equity Ratio= Debt/ Equity OR Long term Loans/ shareholders Funds or net worth
Long Term Loans: these refer to long-term liabilities which mature after one year. These include
Debentures, Mortgage Loan, Bank Loan, Loan from financial institutions and Public Deposits etc. premium, general reserve, capital reserve, other reserves and credit balance of P&L account.
Shareholders funds: These include equity share capital, preference share capital, share
Significance:
Calculated to assess the ability of a firm to meet its long term liabilities Debt equity ratio of 2:1 considered safe Higher debt equity ratio shows a risky financial position from the long term point of view
as it indicates more and more funds invested in the business are provided by long term lenders.
EXAMPLE:
Liabilities
Equity Share Capital Preference Share Capital Reserves P&L a/c Current Liabilities 15% Debentures
Rs
2,00,000 50,000 50,000 60,000 70,000 100,000
Assets
Fixed Assets Current Assets
Rs.
3,80,000 2,20,000
Bank Loan
70,000
6,00,000
_________
6,00,000
Long Term Debt= 1,00,000 + 70,000= 170,000 Shareholders Funds= 2,00,000+ 50,000+ 50,000+ 60,000= 3,60,000 Debt Equity Ratio= 170,000/ 360,000= 0.47:1
interest charges
Interest Coverage Ratio= NPBIT/ Fixed interest charges Significance Indicates how many times the interest charges are covered by the profits available to pay
interest charges.
Long term lender is interested in finding out whether the business will earn sufficient
Higher ratio implies greater safety for long term lenders. Also indicates the extent to which profits can decline without in any way affecting the
EXAMPLE:
Amount
3,60,000 2,00,000
Fixed Interest = 2,00,000*15%= 30,000 Interest Coverage Ratio= Rs. 360,000/ 30,000= 12 Times
Particulars Sales
Trading Account
P&L account
Appropriation A/c
Profitability Ratios
Main object of every business is to earn profits
the risk and capital invested in it The efficiency and success of a business can be measured with the help of profitability ratios Can be of two types: based on sales and based on investment in business Profitability ratios based on investment in business reflect the true earning capacity of the resources employed in the business
Operating Ratio
Expenses Ratio
to earn it.
Generally, the higher the net profit, the higher the ROC The higher the ROCE, the more efficient is the use of capital
employed.
Question - ROCE Assets 10,00,000 Liabilities 2,00,000 Revenue 3,00,000 Operating Expenses 2,00,000 Calculate ROCE if Capital Employed can be calculated as (Assets Liabilities)
Holders Funds)*100
Earnings for equity share holders in the table Equity Share Holders Funds= Equity Share Capital + Reserves+ P&L a/c
Question - RoE Equity share capital 10,00,000 9% preference share capital 5,00,000 Tax rate 50 % Net profit 4,00,000 Calculate Return on Equity
per-share basis has changed over the year. Generally, the higher the net profit, the higher the ROC The higher the ROCE, the more efficient is the use of capital employed.
Problem 2
Following is the Balance Sheet of X Ltd
Liabilities Equity Share Capital 12% Preference Share Capital Reserves Rs 4,00,000 2,00,000 50,000 Assets Fixed Assets Current Assets Underwriting Commission Rs 8,00,000 3,80,000 20,000
P&L a/c
15% Debentures Current Liabilities
2,20,000
1,00,000 2,30,000 12,00,000 __________ 12,00,000
Profit for Current Year before interest and tax= Rs. 3,55,000 Tax Rate 50% Calculate: a) ROCE b) Return on Equity Shareholders Funds
SOLUTION:
ROCE= (NPBIT/ Capital Employed)*100 Capital Employed= Equity Share Capital + Preference Share Capital + Reserves+ P&L A/c + DebenturesUnderwriting Commission Capital Employed = 400,000+ 200,000+ 50,000+ 220,000 +100,000- 20,000= Rs. 9,50,000 ROCE= (355,000/ 950,000)*100 = 37.43%
a)
NPBIT
Less: Interest in Debentures @ 15% on Rs. 100,000 Less: Tax@ 50%
3,55,000
15,000 3,40,000 1,70,000
NPAT
Less: Dividend on Pref. Share Capital @ 12% on Rs. 200,000 Net Profit after interest, tax and preference dividend
1,70,000
24,000 1,46,000
Equity Share Holders Funds= Equity Share Capital + Preference Share Capital +Reserves+ P&L a/c+ Debentures - Underwriting Commission = 400,000+ 200,000+ 220,000- 20,000 =Rs. 650,000 ROE= (146,000/ 650,000)*100= 22.46%
Problem 3
Liabilities
Sundry creditors Bills payable Tax provision Outstanding expenses 10% Mortgage Loan
Rs.
60,000 100,000 130,000 10,000 700,000
Assets
Bank Investment @ 12% Debtors Stock Fixed Assets: 18,00,000
100,000 500,000
400,000 20,00,000
Less: Dep:
5,00,000
_______ 20,00,000
Other information: 1. Net Sales = Rs. 27,00,000 2. Cost of goods sold= Rs. 22,80,000 3. Net profit before tax= Rs.2,00,000 4. Net profit after tax= Rs. 1,20,000
Calculate:
1. Net Working Capital
2. Current Ratio
3. Interest Coverage Ratio 4. Stock Turnover Ratio 5. Debtors Turnover Ratio 6. Fixed Asset Turnover Ratio 7. ROCE 8. ROE
Solution:
Current Assets = Bank + Debtors + Stock = 50,000+ 200,000 + 300,000 = Rs. 550,000 Current Liabilities = Creditors+ Bills Payable + Tax Provision+ O/S Expenses = 60,000 + 100,000 + 130,000 + 10,000 = Rs. 300,000
1.
Current Ratio= 550,000/ 300,000 = 1.83: 1 Interest Coverage Ratio = NPBIT/ Fixed Interest Charges = (200,000+ 70,000)/70,000 = 3.86 Times
4.
5.
6.
12,000 108,000
PBIT
252,000
Amount
100,000 500,000
400,000 700,000 17,00,000 150,000 15,50,000