UNIT 3 RATIO ANALYSIS CONTENTS A B C

UNIT – 3 RATIO ANALYSIS

CONTENTS A. B. C. D. E. F. G. Meaning of ratio Classification of ratios Profitability ratios Turnover ratios Financial ratios Du Pent control chart Practical problems

COMPARATIVE ANALYSIS There are three types of comparisons to provide decision usefulness of financial information: • Intra-company basis Inter-company basis Industry averages • •

COMPARATIVE ANALYSIS Ø Intra-company basis – comparisons within the company. Ø Inter-company basis – comparisons with other companies. Ø Industry averages – comparisons with other companies in the same industry.

FINANCIAL 1) • 2) ü ü 3) STATEMENT ANALYSIS Three basic tools are used in financial statement analysis : Horizontal analysis - It is a technique for evaluating a series of financial statement data over a period of time. Did an increase or decrease take place? Vertical analysis - Expresses each item in a financial statement as a percent of a base amount. Income statement Balance Sheet Ratio analysis (for cross sectional analysis)

RATIO ANALYSIS ‘A mathematical yardstick that measures the relationship between two figures or groups of figures which are related to each other and are mutually inter-dependent’. It can be expressed as a pure ratio, percentage, or as a rate

WORDS OF CAUTION A ratio is not an end in itself. They are only a means to get to know the financial position of an enterprise. Computing ratios does not add any information to the available figures. It only reveals the relationship in a more meaningful way so as to enable us to draw conclusions there from.

UTILITY OF RATIOS Comparison may be in any one of the following forms: For the same enterprise over a number of years For two enterprises in the same industry For one enterprise against the industry as a whole For one enterprise against a pre-determined standards For inter-segment comparison within the same organisation

PROFITABILITY RATIO These ratios measure the operating efficiency of the firm and its ability to ensure adequate returns to its shareholders. é é é WHY? A company’s income affects: its ability to obtain debt and equity financing its liquidity position its ability to grow Further the profitability ratios can be determined (i) in relation to sales and (ii) in relation to investments

1. PROFITABILITY IN RELATION TO SALES Gross Profit Ratio – It measures the relationship between gross profit & sales. GPR = Gross Profit/ Net Sales × 100 Gross Profit = Sales – Cost of goods sold b) Net Profit Ratio - This ratio is indicative of the firm’s ability to leave a margin of reasonable compensation to the owners for providing capital, after meeting the cost of production, operating charges and the cost of borrowed funds. Ø It measures the relationship b/w net profit & sales of a firm. NPR = Profit after tax / Net sales × 100 a)

Operating profit ratio – It establishes the relationship between total operating expenses & net sales. Operating profit ratio = Operating expenses × 100 Net sales ü Operating expenses include = cost of goods sold, general & administrative expenses, selling & distribution expenses. ü Operating profit = Net sales – Cost of goods sold – administrative expenses – selling & distribution expenses Operating Ratio = COGS + Operating expenses Net sales c)

d) i. ii. iii. Expenses Ratio – While some of the expenses may be increasing & other may be declining. To know the behavior of specific items of expenses the ratio of each individual operating expenses to net sales should be calculated. Cost of goods sold = COGS/ Net sales × 100 Admini. Expenses Ratio = Admin. Exp. × 100 Net sales Selling & distribution = Selling & distrib. Exp. × 100 expense ratio Net sales

PROFITABILITY IN RELATION TO INVESTMENTS a) Return on gross investment or gross capital employed – This ratio establishes the relationship between net profit & the gross capital employed. The term gross capital employed refers to the total investment made in the business. ROCE = Earnings After Tax (EAT) × 100 Gross capital employed b) Return on Net capital employed RNCE = EBIT/ Net capital employed × 100 Net capital = Gross capital – current liabilities

Return on share capital employed – This ratio establishes the relationship b/w earnings after taxes & the shareholder investments in the business. ü This ratio revels how profitability the owners’ funds have been utilized by the firm. ü RSCE = EAT/ Shareholders capital employed × 100 d) Return on equity share capital employed – This ratio establishes the relationship b/w earning after tax & preference dividend & equity shareholder investment or capital employed or net worth. RESCE = EAT- preference dividends × 100 Equity share capital employed c)

i. iii. Earning per share (EPS) – It measures the profit available to the equity shareholders on a per share basis. EPS = Earnings after tax – preference dividends Equity shares outstanding Dividend per share – the dividends paid to the shareholders on a per share basis is called as DPS = Earnings paid to ordinary shareholders No. of ordinary shares outstanding Dividend payout ratio (pay out ratio) – It measures the relationship b/w the earnings belonging to the equity shareholders & the dividend paid to them DPR = Dividend per share / Earnings per share

Pay out ratio shows what percentage shares of the earnings are available for the ordinary shareholders are paid out as dividends to the ordinary shareholders. d) Price Earning ratio – The reciprocal of the earnings yield is called P/ER. P/E Ratio = Market Price of shares Earning per share ü

2) TURNOVER RATIOS Turnover ratios are also known as activity ratios or efficiency ratios with which a firm manages its current assets. The various turnover ratios are as follows: a) Inventory Turnover Ratio b) Debtor Turnover Ratio c) Creditors Turnover Ratio d) Assets Turnover Ratio

a) Inventory Turnover Ratio This ratio indicates the number of times the inventory has been converted into sales during the period. Inventory/stock Turnover Ratio = Cost of goods Sold Average Inventory COGS = Opening stock+ purchases+ wages – Closing stock Average Inventory = Opening Inventory + Closing inventory 2 Debtor Turnover Ratio This indicates the number of times average debtor have been converted into cash during a year. Debtor Turnover Ratio = Net credit sales Average Trade Debtors Average Trade debtor = Operating Trade Dr. + Closing Trade Dr. 2 or DTR = Total Sales Trade Debtors b)

c) Creditor Turnover Ratio It indicates number of times sundry creditors have been paid during a year. CTR = Net Credit Purchases Aveg. Trade Creditor Net Credit purchase = Gross Credit - Purchase or CTR = Total Purchases Total Trade Creditors Return

d) Assets Turnover Ratio The relationship between assets & sales is known as assets turnover ratio. It includes following ratios: i. Total assets turnover ii. Net assets turnover iii. Fixed assets turnover iv. Current assets turnover v. Net working capital turnover ratio i) Total Assets Turnover – This ratio shows the firms ability to generate sales from all financial resources committed to total assets. Total Assets Turnover = Total sales Total Assets

ii) Net Assets Turnover = Total Sales Net Assets = Total Assets - Current Liabilities iii) Fixed Assets Turnover = Total sales Net Fixed Assets Net Fixed assets = Cost of fixed assets – depreciation iv) Current Assets Turnover = Total sales Current Assets

v) Net working capital Turnover Ratio A higher ratio is an indicator of better utilization of current assets & working capital & vice-versa. NWCTR = Total Sales Working capital = Current Assets – current Liabilities

From the following P&L account of Brilliant Products Ltd. For the year ending 31 st march 1990 & balance sheet as on 31 st march 2009: Particulars (Dr. ) To opening stock To purchases To incidental charges To Gross profit Amt. 1, 99, 000 10, 90, 500 28, 500 6, 80, 000 Particulars (Cr. ) By sales By Closing Stock 19, 98, 000 To operating expenses: Selling & Distib. Administration Finance To non-operating expenses Loss on sale of assets To Net profit 60, 000 3, 000 30, 000 Amt. 17, 000 2, 98, 000 19, 98, 000 By Gross Profit Non-operating income By profit on sale of shares 6, 80, 000 6, 000 12, 000 3, 90, 000 8, 000 3, 000 6, 98, 000

Balance sheet as on 31 st March 2009 Liabilities Issued Capital 4, 000 equity shares of Rs. 100/- each Reserves & surplus Current Liabilities P& L A/c Amt. 4, 000 1, 800 2, 60, 000 1, 20, 000 Assets Land & Buildings Plant & Machinery Stock in trade Sundry Debtors Cash & bank 9, 60, 000 Calculate a) Current Assets turnover ratio b) Operating ratio c) Stock turnover ratio d) Fixed assets turnover ratio e) Gross profit ratio f) Net profit ratio g) Return on equity share capital Amt. 3, 000 1, 60, 000 2, 98, 000 1, 42, 000 60, 000 9, 60, 000

a) b) c) Current Assets Turnover Ratio = Total Sales/ Current assets =17, 000/ (298000+142000+60000) =17, 000/500000 = 3. 4: 1 Operating Ratio = COGS + Operating expenses/ net sales = 10, 20, 000 + 390000/17, 000 = 0. 83: 1 COGS = OS + Purchases+ incidental charges – CS Stock Turnover ratio = COGS/ Average Inventory = 10, 20, 000/ 248500 = 4. 1: 1 Average Inventory = OS + CS/ 2

d) e) f) g) Fixed Assets Turnover Ratio = Total sales/ Net fixed assets = 17, 000/ 4, 60, 000 = 3. 7: 1 Gross Profit Ratio = Gross profit/ Net sales × 100 = 6, 80, 000/ 17, 000 × 100 = 40% Net Profit Ratio = Net profit/ Net sales × 100 = 3, 000/ 17, 000 × 100 =17. 7% Return on equity share capital = EAT – Preference dividend/ Eqty. Share capital× 100 = 3, 000/ 4, 000 × 100 = 75%

FINANCIAL RATIOS These ratios analyse the short-term financial position of a firm and indicate the ability of the firm to meet its short-term commitments (current liabilities) out of its short-term resources (current assets). These are also known as ‘solvency ratios’. The ratios which indicate the liquidity of a firm are: Current ratio Liquidity ratio or Quick ratio or acid test ratio Absolute liquid Ratio

1) CURRENT RATIO ü It is calculated by dividing current assets by current liabilities. Current ratio = Current assets Current liabilities Where, Ø Conventionally a current ratio of 2: 1 is considered satisfactory

Ø Current Assets Includes: - ü Inventories of raw material, WIP, finished goods, ü stores and spares, ü sundry debtors/receivables, ü short term loans deposits and advances, ü cash in hand bank, ü prepaid expenses, ü incomes receivables and ü marketable investments and short term securities.

Current Liabilities: ü sundry creditors/bills payable, ü outstanding expenses, ü unclaimed dividend, ü advances received, ü incomes received in advance, ü provision for taxation, ü proposed dividend, ü instalments of loans payable within months, ü bank overdraft and cash credit 12

2) QUICK RATIO OR ACID TEST RATIO This ratio measures the immediate ability of the company to pay off its current obligations. Quick Ratio = Quick Assets Quick or current liabilities ü QUICK ASSETS are current assets (as stated earlier) less prepaid expenses and inventories. ü QUICK/ CURRENT LIABILITIES are current liabilities (as stated earlier) less bank overdraft and incomes received in advance.

3) ABSOLUTE LIQUID RATIO It measures the absolute liquidity of the firm. Absolute liquid Ratio = Cash in hand + Cash at bank Quick/Current Liabilities

4) DU-PONT CONTROL CHART It is the system of management control designed by an American company named Du-Pont company is popularly called Du-pont control chart. This system uses the ratio inter-relationship to provide charts for managerial attention. The standard ratios of the company are compared to present ratios & changes in performance are judged. ROI = Net Profit × 100 Capital Employed

Net profit includes both net profit before interest, tax & dividends & net profit after tax (PAT). Capital i. iii. iv. Employed includes any of these: Net fixed assets + working capital Net fixed assets + current assets Gross fixed assets + working capital