Ratio Analysis
Ratio Analysis
- Meaning of Ratio analysis
Ratio analysis—the foundation of fundamental analysis—helps to gain a deeper insight into the financial health and the current and probable performance of the company being studied. For this insight, the analysts use the quantitative method where the information recorded in the company’s financial statements are compared and analyzed. And there are certain formulae that are used for the same.
Objectives of Ratio Analysis
Interpreting the financial statements and other financial data is essential for all stakeholders of an entity. Ratio Analysis hence becomes a vital tool for financial analysis and financial management. Let us take a look at some objectives that ratio analysis fulfils.
1] Measure of Profitability
Profit is the ultimate aim of every organization. So if I say that ABC firm earned a profit of 5 lakhs last year, how will you determine if that is a good or bad figure? Context is required to measure profitability, which is provided by ratio analysis. Gross Profit Ratios, Net Profit Ratio, Expense ratio etc provide a measure of the profitability of a firm. The management can use such ratios to find out problem areas and improve upon them.
2] Evaluation of Operational Efficiency
Certain ratios highlight the degree of efficiency of a company in the management of its assets and other resources. It is important that assets and financial resources be allocated and used efficiently to avoid unnecessary expenses. Turnover Ratios and Efficiency Ratios will point out any mismanagement of assets.
3] Ensure Suitable Liquidity
Every firm has to ensure that some of its assets are liquid, in case it requires cash immediately. So the liquidity of a firm is measured by ratios such as Current ratio and Quick Ratio. These help a firm maintain the required level of short-term solvency.
4] Overall Financial Strength
There are some ratios that help determine the firm’s long-term solvency. They help determine if there is a strain on the assets of a firm or if the firm is over-leveraged. The management will need to quickly rectify the situation to avoid liquidation in the future. Examples of such ratios are Debt-Equity Ratio, Leverage ratios etc.
5] Comparison
The organizations’ ratios must be compared to the industry standards to get a better understanding of its financial health and fiscal position. The management can take corrective action if the standards of the market are not met by the company. The ratios can also be compared to the previous years’ ratio’s to see the progress of the company. This is known as trend analysis.
USE AND SIGNIFICANCE OF RATIO ANALYSIS
The ratio analysis is one of the most powerful tools of financial analysis. It is used as a device to analyse and interpret the financial health of enterprise. Ratios have wide applications and are of immense use today.
Managerial Uses of Ratio Analysis
- Helps in decision-making: Financial statements are prepared primarily for decision-making.
- Helps in financial forecasting and planning: Ratio Analysis is of much help in financial forecasting and
- Helps in communicating: The financial strength and weakness of a firm are communicated in a more easy and understandable manner by the use of
- Helps in co-ordination: Ratios even help in co-ordination which is of utmost importance in effective business management.
- Helps in Control: Ratio analysis even helps in making effective control of the
Utility to Shareholders/Investors
An investor in the company will like to assess the financial position of the concern where he is going to invest His first interest will be, the security of his investment and then a return in the form of dividend of interest.
Utility to Creditors:
The creditors or suppliers extend short-term credit to the concern. They are interested to know whether financial position of the concern warrants their payments at a specified time or not.
Utility to Employees:
The employees are also interested in the financial position of the concern especially profitability. Their wage increases and amount of fringe benefits are related to the volume of profits earned by the concerns.
Utility to Government:
Government is interested to know the overall strength of the industry. Various financial statements published by industrial units are used to calculate ratios for determining short financial position of the concerns.
Tax audit requirements.
LIMITATIONS OF RATIO ANALYSIS:
- Limited Use of a Single Ratio: “A single ratio, usually, does not convey much of a sense. To make better interpretation a number of ratios have to be calculated which is likely to confuse the analyst than help making any meaningful
- Lack of adequate standards: there are no well accepted standards or rules of thumb for all ratios which can be accepted as norms. It renders interpretation of the ratios
- Inherent Limitations of Accounting: Like financial statements, ratios also suffer from the inherent weakness of accounting records such as their historical
- Change of Accounting Procedure: Change in accounting procedure by a firm often makes ratio analysis misleading.
- Window Dressing: Financial statements can easily be window dressed to present a better picture of its financial and profitability position to outsiders.
- Personal Bias: Ratio are only means of financial analysis and not an end in Ratios have to be interpreted and different people may interpret the same ratio in different ways.
- Uncomparable: Not only industries differ in their nature but also the firms of the similar business widely differ in their size and accounting procedures, etc. It makes comparison of ratios difficult and
- Absolute Figures Distortive: Ratios devoid of absolute figures may prove distortive as ratio analysis is primarily a quantitative analysis and not a qualitative
- Price Level Changes: While making ratio analysis, no consideration is made to the changes in price levels and this makes the interpretation of ratios
- Ratios no Substitutes: Ratio analysis is merely a tool of financial statements. Hence, ratios become useless if separated from the statements from which they are computed.
- Clues not Conclusions: Ratios provide only clues to analysts and not fmal These ratios have to be interpreted by these experts and there are no standard rules for interpretation.
CLASSIFICATION OF RATIOS
There are different parties interest in the ratio analysis for knowing the financial position of a firm for different purposes.
LIQUIDITY RATIOS
Liquidity refers to the ability of a concern to meet its current obligations as and when these become due. The short-term obligations are met by realising amounts from current, floating or circulating assets. These should be convertible into cash for paying obligations of short-term nature. If current assets can pay off current liabilities, then liquidity position will be satisfactory. On the other hand, if current liabilities may not be easily met out of current assets en liquidity position will be bad.
The following ratios can be calculated:
- Current Ratio
- Quick or Acid Test or Liquid Ratio
- Absolute Liquid Ratio or Cash Position Ratio
CURRENT RATIO
Current ratio may be defined as the relationship between current assets and current liabilities. This ratio, also known as working capital ratio, is a measure of general liquidity and is
| Current Ratio = Current Assets / Current Liabilities Or Current Assets : Current Liabilities |
most widely used to make the analysis of a short-term financial position or liquidity of a firm. It is calculated by dividing the total of current assets by total of the current liabilities.
The two basic components of this ratio are :
- current assets
- current liabilities.
- Current assets include cash and those assets which can be easily converted into cash within a short period of time generally, one year/ such as marketable securities, bills receivables, sundry debtors, inventories, work-in-progress, etc. Prepaid expenses should also be included in current assets because they represent payments made in advance which will not have to be paid in near future.
- Current Liabilities are those obligations which are payable within a short period of generally one year and include outstanding expenses, bills payables, sundry creditors, accrued expenses, short-term advances, income-tax payable, dividend payable, etc. Bank overdraft.
| COMPONENTS OF CURRENT RATIO | ||
| Sl.No. | Current Assets | Current Liabilities |
| 1 | Cash in Hand | Outstanding Expenses/Accrued Expenses |
| 2 | Cash at Bank | Bills Payable |
| 3 | Marketable Securities (Short-term) | Sundry Creditors |
| 4 | Short-term Investments | Short-term Advances |
| 5 | Bills Receivable | Income-tax Payable |
| 6 | Sundry Debtors | Dividends Payable |
|
7 |
Inventories (stocks) |
Bank Overdraft (if not a permanent arrangement) |
| 8 | Work-in-process | |
| 9 | Prepaid Expenses | |
As a convention the minimum of ‘two to one ratio’ is referred to as a banker’s rule of thumb or arbitrary standard of liquidity for a firm. A ratio equal or near to the rule of thumb of 2 : 1 i.e., current assets double the current liabilities is considered to be satisfactory.
SIGNIFICANCE AND LIMITATIONS OF CURRENT RATIO
Current ratio is a general and quick measure of liquidity of a firm. It represents the ‘margin of safety’ or cushion’ available to the creditors and other current liabilities. It is most widely used for making short-term analysis of the financial position or short-term solvency of a firm.
Current Ratio: It is a crude ratio because it measures only the quantity and not the quality of Current assets.
Window Dressing: Valuation of current assets and window dressing is another problem of current. Current assets and liabilities are manipulated in such a way that current ratio loses its significance. Window dressing may be indulged in the following ways: Over-valuation of closing stock.
Calculation of Current Ratio:
This ratio is calculated by comparing current assets with current liabilities. Take for example, current assets of a concern as Rss.250000 and current liabilities as Rs. 100000; current ratio will be calculated as follows:
Current Ratio = Current Assets / Current Liabilities Current Ratio = 250000 / 100000 = 2.5
The current ratio of 2.5 means that current assets are 2.5 times of current liabilities. This ratio can also be presented as 2.5 :1. In current ratio, current liabilities are taken as 1 and current assets are given in comparison to it.
Illustration
Calculate current ratio from the following information :
| Rs. | Rs. | ||
| Stock | 60,000 | Sundry Creditors | 20,000 |
| Sundry Debtors | 70,000 | Bills Payable | 15,000 |
| Cash Balances | 20,000 | Tax Payable | 18,000 |
| Bills Receivables | 30,000 | Outstanding Expenses | 7,000 |
| Prepaid Expenses | 10,000 | Bank Overdraft | 25,000 |
| Land and Building | 1,00,000 | Debentures | 75,000 |
| Goodwill | 50,000 |
Solution:
Current Ratio = Current Assets / Current Liabilities
Current Assets = Rs. 60,000 + 70,000 + 20,000 + 30,000 + 10,000 = Rs. 1,90,000
Current Liabilities = Rs. 20,000 + 15,000 + 18,000 + 7,000 + 25,000 = Rs. 85,000
Current Ratio = 1,90,000 / 85,000 = 2.24:1
QUICK OR ACID TEST OR LIQUID RATIO
| Quick / Liquid or Acid Test Ratio = Quick or Liquid Assets / Current Liabilities |
Quick Ratio, also known as Acid Test or Liquid Ratio, is a more rigorous test of liquidity than the current ratio. The term ‘liquidity’ refers to the ability of a firm to pay its short-term obligations as and when they become due. Quick ratio may be defined as the relationship between quick/liquid assets and current or liquid liabilities.
| Components of Quick/Liquid Ratio | |
| Quick/Liquid Assets | Current Liabilities |
| Cash in hand | Outstanding or accrued |
| Cash at bank | expenses Bills payable |
| Bills receivables | Sundry creditors |
| Sundry debtors | Short-term advances |
| Marketable | (payable shortly) |
| securities | Income-tax payable |
| Temporary
investments |
Dividends payable
Bank overdraft |
Quick assets can also be calculated as:
Current Assets-(Inventories +Prepaid Expenses)
Quick/Acid Test / Liquid Ratio = Liquid Assets / Current Liabilities
Quick / Liquid or Acid Test Ratio = Quick or Liquid Assets / Current Liabilities
=200000/150000 = 1.33:1
Interpretation of Quick Ratio
Usually, a high acid test ratio is an indication that the firm is liquid and has the ability to meet its current or liquid liabilities in time and on the other hand a low quick ratio represents that the firm’s liquidity position is not good. As a rule of thumb or as a convention quick ratio of 1 : 1 is considered satisfactory.
Significance of Quick Ratio: The quick ratio is very useful in measuring the liquidity position of a firm It measures the firm’s capacity to pay off current obligations immediately and is a more rigorous test of liquidity than the current ratio. It is used as a complementary ratio to the current ratio.
ABSOLUTE LIQUID RATIO OR CASH RATIO
| Absolute Liquid Ratio = Absolute Liquid Assets / Current Liabilities
OR Cash Ratio = Cash & Bank + Short-term Securities / Current Liabilities |
Absolute Liquid Assets include cash in hand and at bank and marketable securities or temporary investments. The acceptable norm for this ratio is 50% or 05:1 or 1:2 i.e.
Problem:
The following is the balance sheet of New India Ltd., for the year ending 31st Dec. 2016.
| Rs. | Rs. | ||
| 9% Preference Share Capital | 500000 | Goodwill | 100000 |
| Equity Share Capital | 1000000 | Land and Building | 650000 |
| 8%Debentures | 200000 | Plant | 800000 |
| Long-term Loan | 100000 | Furniture & Fixture | 150000 |
| Bills Payable | 60000 | Bills Receivables | 70000 |
| Sundry Creditors | 70000 | Sundry Debtors | 90000 |
| Bank Overdraft | 30000 | Bank Balance | 45000 |
| Outstanding Expenses | 5000 | Short-term Investments | 25000 |
| Prepaid expenses | 5000 | ||
| Stock | 30000 | ||
| 1965000 | 1965000 |
From the balance sheet calculate
- Current Ratio
- Acid Test Ratio
- Absolute Liquid Ratio
Solution:
- Current Ratio = Current Assets / Current Liabilities
Current Assets = Rs. 70000 + Rs. 90000 + Rs. 45000 + Rs. 25000 + Rs.5000
+ Rs. 30000 = Rs. 265000
Current Liabilities = Rs. 60000 + Rs. 70000 + Rs. 30000 + Rs. 5000 = Rs. 165000 Current Ratio = 265000 / 165000 = 1.61
- Acid Test Ratio = Liquid Assets / Current liabilities
Liquid Assets = Rs. 70000 + Rs. 90000 + Rs. 45000 + Rs. 25000 = Rs. 230000
Stock and prepaid Expenses have been excluded from current assets in order to arrive at liquid assets.
Current Liabilities = Rs. 165000
Acid Test Ratio = Rs. 230000 / Rs. 165000 = 1.39
- Absolute Liquid Ratio = Absolute Liquid Ratio / Current Liabilities Absolute Liquid Assets = Rs. 45000 + Rs. 25000 = Rs. 70000 Absolute Liquid Ratio = 70000 / 165000 = 42
Problem:
The following information of a company is given :
Current Ratio, 2.5 : 1 : Acid-test ratio, 1.5 : 1; Current liabilities Rs. 50000 Find out:
- Current Assets
- Liquid Assets
Solution:
- Current Ratio = Current Assets / Current Liabilities
2.5 = Current assets / Rs. 50000
Current Assets = 50000 x 2.5 = Rs. 125000
- Acid Test Ratio = Liquid Assets / Current liabilities
1.5 = Liquid Assets / Rs. 50000
Liquid Assets = 50000 x 1.5 = Rs. 75000
Problem:
Given:
Current Ratio = 2.8 Acid –test Ratio = 1.5
Working Capital = Rs. 1,62,000 Find out:
- Current Assets
- Current Liabilities
- Liquid Assets
Solution:
Working Capital = Current Assets- Current Liabilities 1,62,000 =2.8x-1.0x
1,62,000 = 1.8x
Or , X Current liabilities = 162000 / 1.8 = Rs. 90,000 Current assets = 90,000×2.8 = Rs. 252000
Acid Test Ratio = Liquid Assets / Current Liabilities
1.5 = Liquid Assets / 90000
Liquid assets = 90000 x 1.5 = Rs. 135000
INVENTORY TURNOVER OR STOCK TURNOVER RATIO
Every firm has to maintain a certain level of inventory of finished goods so as to be able to meet the requirements of the business. But the level of inventory should neither be too high nor too low. It will therefore, be advisable to dispose of inventory as early as possible. On the other hand, too low inventory may mean loss of business opportunities. Thus, it is very essential to keep sufficient stocks in business.
| Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory at Cost |
Problem:
The cost of goods sole of E.S.P. Limited is Rs. 5,00,000. The opening stock/inventory is Rs. 40,000 and the closing inventory is Rs. 60,000 (at cost). Find out inventory turnover ratio.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory at Cost
= 500000/ 40000 + 60000 / 2 = 500000 / 50000 = 10 times
Problem:
If Inventory Turnover Ratio is 5 times and average stock at cost is Rs. 75000, find out cost of goods sold.
Solution:
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory at Cost 5 = Cost of Goods Sold / Rs. 75000
Cost of Goods Sold = 75000 x 5 = Rs. 375000
Interpretation of Inventory Turnover Ratio
Inventory turnover ratio measures the velocity of conversion of stock into sales. Usually, a high inventory turnover/Stock velocity indicates efficient management of inventory because more frequently the stocks are sold, the lesser amount of money is required to finance the inventory. A low inventory turnover ratio indicates an inefficient management of inventory.
Illustration
Determine the sales of a firm with the following financial data :
Current ratio 1.5
Acid test ratio 1.2
Current liabilities Rs. 400000
Inventory turnover ratio 5 times
Solution:
Current Ratio = Current Assets / Current Liabilities
1.5 = Current assets / 400000
Current Assets = 400000 x 1.5 = Rs. 600000
Acid Test Ratio = Liquid Assets / Current Liabilities
1.2 = Liquid Assets / 400000
Liquid Assets = 400000x 1.2 = Rs. 480000
Inventory = Current Assets – Liquid Assets
= Rs. 600000 – Rs. 480000 = Rs. 120000
Inventory Turnover Ratio = Sales / Inventory
5 = Sales / 120000
Sales = 120000 x 5 = Rs. 600000
DEBTORS OR RECEIVABLE TURNOVER RATIO AND AVERAGE COLLECTION PERIOD
A concern may sell goods on cash as well as on credit. Credit is one of the important elements of sales promotion. The volume of sales can be increased by following a liberal credit policy.
a) Debtors/Receivables Turnover or Debtors Velocity
Debtors turnover ratio indicates the velocity of debt collection of firm. In simple words, it indicates the number of times average debtors (Receivables) are turned over during a year, thus:
| Debtors (Receivables) Turnover/Velocity = Net Credit Annual Sales / Average
Trade Debtors = No. of Times |
Trade Debtors = Sundry Debtors + Bills Receivables and Accounts Receivables Average Trade Debtors = Opening Trade Debtors + Closing Trade Debtors / 2
Interpretation of Debtors Turnover/Velocity
Debtors velocity indicates the number of times the debtors are turned over during a year. Generally, the higher the value of debtors turnover the more efficient is the management of debtors/sales or more liquid are the debtors.
b) Average Collection Period Ratio
The average collection period represents the average number of days for which a firm has to wait before its receivables are converted into cash. The ratio can be calculated as follows:
| Average Collection Period = Average Trade Debtors (Drs + B/R) / Sales per day
= Average Trade Debtors x No. of Working Days / Net sales |
Find out a) Debtors Turnover, and B) average Collection period from the following information:
| 31st March 2015
Rs. |
31st March 2016
Rs. |
|
| Annual credit sales | 500000 | 600000 |
| Debtors in the beginning | 80000 | 100000 |
| Debtors at the end | 100000 | 120000 |
Days to be taken for the year : 360.
Solution:
| Average Debtors | = Opening Debtors + Closing
Debtors / 2 |
|
| Debtors Turnover | Net Credit Annual Sales / Average
Debtors |
|
| Year 2007 | Year 2008 | |
| Average Debtors | 80,000+1,00,000 / 2 | 1.00,000+1,20,000 / 2 |
| = Rs. 90,000 | Rs. 1,10,000 | |
| (a) Debtors Turnover | 5,00,000 / 90,000 | 6,00,000 / 1,10,000 |
| 5.56 times | 5.45 times | |
| (b) Average Collection Period | No. of Working Days / Debtors
Turnover |
|
| Year 2007 | Year 2008 | |
| Average Collection Period | = 360 / 5.56 | 360 / 5.45 |
| = 64.7 days
= 65 days (approximately) |
= 66.05 days
= 66 days (appx.) |
The analysis for creditors turnover is basically the same as of debtors turnover ratio except that in place of trade debtors, the trade creditors are taken as one of the components of the ratio and in place of average daily sales, average daily purchases are taken as the other component of the ratio. Same as debtors turnover ratio, creditors turnover ratio can be calculated in two forms:
|
CREDITORS/PAYABLES TURNOVER RATIO = Net Credit Annual Purchases / Average Trade Creditors AVERAGE PAYMENT PERIOD RATIO= Average Trade Creditors (Creditors + Bills Payable) / Average Daily Purchases AVERAGE DAILY PURCHASES = Annual Purchases / No. of Working Days in a Year AVERAGE PAYMENT PERIOD = Trade Creditors x No. of Working Days / Net Annual Purchases |
Illustration:
From the following information calculate creditors turnover ratio average payment period:
| Total purchases | 400000 |
| Cash purchases (included in above) | 50000 |
| Purchase returns | 20000 |
| Creditors at the end | 60000 |
| Bills payable at the end | 20000 |
| Reserve for discount on creditors | 5000 |
| Take 365 days in a year | 5000 |
CREDITORS TURNOVER RATIO = Annual Net Purchases / Average Trade Creditors
| Rs. | |
| Net Credit purchases | |
| Total purchases | 400000 |
| Less: Cash purchases | 50000 |
| 350000 | |
| Less: Returns | 20000 |
| 330000 |
Creditors Turnover Ratio = 330000 / 60000 + 20000 (Trade creditor include creditors and bills payable)
= 330000 / 80000 = 4.13 times
AVERAGE PAYMENT PERIOD = No. of Working Days / Creditors Turnover Ratio
= 365 / 4.13 = 88 Days
Alternatively:
AVERAGE PAYMENT PERIOD = 60000 + 20000 / 330000 x 365
= 80000 / 330000 x 365 = 88 Days
WORKING CAPITAL TURNOVER RATIO
Working capital of a concern is directly related to sales. The current assets like debtors, bills receivables, cash, stock etc. change with the increase or decrease in sales. the working capital is taken as :
Working Capital = Current assets – Current Liabilities
Working Capital turnover ratio indicates the velocity of the utilisation of net working capital. This ratio indicates the number of times the working capital is turned over in the course of a year.
|
Working Capital Turnover Ratio=Cost of Sales / Average Working Capital Average Working Capital = Opening Working Capital +Closing Working Capital \ 2 Working Capital Turnover Ratio= Cost of Sales (or, Sales) / Net Working Capital |
Illustration
| Find out working capital turnover ratio : | |
| Rs. | |
| Cash | 10,000 |
| Bills Receivables | 5,000 |
| Sundry Debtors | 25,000 |
| Stocks | 20,000 |
| Sundry Creditors | 30,000 |
| Cost of Sales | 1,50,000 |
Solution
Working Capital Turnover Ratio = Cost of Sales / Net Working Capital Current assets = Rs. 10,000 + 5,000 + 25,000 + 20,000
= Rs. 60,000
Current liabilities =30,000
Net working capital = CA – CL = Rs. 60,000 -30,000
= Rs.30,000
So, Working Capital Turnover Ratio = 1,50,000 / 30000 = 5 Times.
Illustration
The following information is given about M/s. S.P. Ltd. for the year ending Dec. 31, 2017
- Stock turnover ratio = 6 times
- Gross profit ratio = 20% on sales
- Sales for 2007 =Rs. 3,00,000
- Closing stock is 10,000 more than the opening stock
- Opening creditors = Rs. 20,000
- Closing creditors =Rs. 30,000
- Trade debtors at the end = Rs. 60,000
- Net Working Capital =Rs. 50,000 Find out :
- Average Stock
- Creditor Turnover Ratio
- Purchases
- Average Collection period
- Average Payment Period
- Working Capital Turnover Ratio
Solution:
Cost of goods sold = Sales – Gross Profit
= 300000 – (20% of sales)
= 300000 – 60000
= Rs. 240000
Average Stock:
Stock Turnover Ratio = Cost of goods sold / Average Stock
6 = 240000 / Average Stock
Average Stock = 240000 / 6 = Rs. 40000
Calculation of Purchases:
Cost of goods sold = Opening Stock + purchases – Closing stock
Purchases = Cost of goods sold + Closing Stock – Opening stock Average Stock = Opening Stock + Closing stock / 2
Since, Closing stock is Rs. 10000 more than the opening stock so, Rs. 40000 = Opening Stock + (Rs. 10000 + opening stock) / 2
Rs. 80000 = 2 Opening stock + Rs. 10000
Opening stock = 70000 / 2 = Rs. 35000
Closing stock = 35000+10000 = 45000
Purchases = 240000 + 45000 + 35000 = 250000
Credit Turnover Ratio = Net annual Credit Purchases / Average Trade Creditors All purchases are taken as credit purchases = 250000 / (20000+30000 / 2) Credit turnover ratio = 250000 / 25000 = 10 Times
Average Payment Period = Average Trade Creditors x No. of Working days/ Net Annual Purchases
= 25000 / 250000 x 365 = 36.5 days or 37 days Average collection period = Average Trade Debtors xx No. of Working Days / Net Annual Sales
= 60000 x 365 / 300000 = 73 Days
Working Capital Turnover Ratio = Cost of Goods Sold / Net Working Capital
= 240000 / 50000 = 4.8 times.
ANALYSIS OF LONG-TERM FINANCIAL POSITION OR SOLVENCY RATIO
The term ‘solvency’ refers to the ability of a concern to meet its long term obligations. The long-term indebtedness of a firm includes debenture holders, financial institutions providing medium and long-term loans and other creditors selling goods on instalment basis.
| ANALYSIS OF LONG-TERM FINANCIAL POSITION OR TEST OF
SOLVENCY |
|
| (a) | Capital Structure Ratios |
| 1 | Debt-Equity Ratio. |
| 2 | Funded-Debt to Total Capitalisation Ratio. |
| 3 | Proprietory Ratio or Equity Ratio.) |
| 4 | Solvency Ratio or Ratio of Total Liabilities to Total Assets. |
| 5 | Fixed Assets to Net Worth or Proprietor’s Funds Ratio. |
DEBT-EQUITY RATIO
Debt–Equity Ratio, also known as External -Internal Equity Ratio is calculated to measure the relative claims of outsiders and the owners (i.e., shareholders) against the firm’s assets. This ratio indicates the relationship between the external equities or the outsiders funds and the internal equities or the shareholders’ funds, thus :
|
Debt- Equity Ratio = Outsiders Funds / Shareholders’ Funds or Debt to Equity Ratio =External Equities / Internal Equities |
| Long- term Debt to Shareholders’ Funds (Debt-Equity Ratio) =
Long term Debt / Shareholders |
The two basic components of the ratio are outsiders’ funds, i.e., external equities and shareholders‘ funds, i.e., internal equities. The outsiders’ funds include all debts/liabilities to outsiders.
Illustration
| Liabilities | Rs. | Assets | Rs. |
| 2,000 Equity Shares of Rs. 100 each | 200000 | Fixed Assets | 400000 |
| 1,000 9% Preference Shares of Rs. 100 each | 100000 | Current Assets | 200000 |
| 1,000 10% Debentures of Rs. 100 each | 100000 | ||
| Reserves: | |||
| General Reserve | 50000 | ||
| Reserves for contingencies | 50000 | ||
| Current liabilities | 100000 |
Calculate Debt-Equity Ratio.
Solution
Debt – Equity Ratio= Outsiders‘ Fund / Shareholders‘ Funds
= 100000 (Debentures) + 100000(Current Liabilities) / 200000 +100000+50000+50000
= 200000 / 400000 = 1:2
Debt Equity Ratio = Long term Debt / Shareholders‘ Funds
= 100000 / 400000 = 1:4
Interpretation of Debt-Equity Ratio
The debt-equity ratio is calculated to measure the extent to which debt financing has been used a business. The ratio indicates the proportionate claims of owners and the outsiders against the firm‘s assets.
PROPRIETORY RATIO OR EQUITY RATIO
A variant to the debt-equity ratio is the proprietary ratio which is also known as equity ratio or shareholders to total equities ratio or net worth to Total asset ratio. This ratio establishes the relationship between shareholders‘ funds to total assets of the firm. The ratio of proprietors‘ funds to total funds proprietors outsiders‘ funds or total funds or total assets is an important ratio for determining long-term solvency of a firm.
Proprietory Ratio or Equity Ratio = Shareholder‘s Funds / Total Assets
If shareholder’s funds are Rs. 4,00,000 and total assets are Rs. 6,00,000. Proprietory Ratio or Equity Ratio = 400000 / 600000 = 2.3
Interpretation of Equity Ratio
As equity ratio represents the relationship of owner’s funds to total assets, higher the ratio or the share of the shareholders in the total capital of the company, better is the long-term solvency position of the company.
THE RATIO OF TOTAL LIABILITIES TO TOTAL ASSETS
This ratio is a small variant of equity ratio and can be simply calculated as 100-equity ratio, i.e., continuing the example taken for the equity ratio, solvency ratio
= 100 – 66.67 or say 33.33%. The ratio indicates the relationship between the total liabilities to outsiders to total assets of a firm and can be calculated as follows:
Solvency Ratio = Total Liabilities to Outsiders / Total Assets
If the total liabilities to outsiders are Rs. 2,00,000 and total assets are Rs. 6,00,000, then
olvency Ratio = 200000 / 600000 x 100=33.33%
FIXED ASSETS TO NET WORTH RATIO OR FIXED ASSETS TO PROPRIETOR’S FUNDS
The ratio establishes the relationship between fixed assets and shareholder’s funds, i.e., share capital plus reserves, surpluses and retained earnings. The ratio can be calculated as follows:
Fixed Assets to Net Worth Ratio =
Fixed Assets (After Depreciation) / Shareholders’ Funds
Thus, where the deprecated book value of fixed asset is Rs. 400000 and shareholders‘ funds are also Rs. 400000 the ratio of fixed assets to net worth / proprietors‘ funds represented in terms of percentage would be
= 400000 / 400000 x 100 = 100%
ANALYSIS OF PROFITABILITY OR PROFITABILITY RATIOS
The various profitability ratios are discussed below:
(A) GENERAL PROFITABILITY RATIOS
The following ratios are known as general profitability ratios :
- Gross Profit Ratio
- Operating Ratio
- Operating Profit Ratio
- Expenses Ratio
- Net Profit Ratio
GROSS PROFIT RATIO
Gross profit ratio measures the relationship of gross profit to net sales and is usually represented as a percentage. Thus, it is calculated by dividing the gross profit by sales :
Gross Profit Ratio = Gross Profit / Net Sales x 100
= Sales – Cost of Goods Sold / Sales x 100
Illustration
Calculate, Gross Profit Ratio :
Solution :
Gross Profit Ratio = Gross Profit / Net Sales x 100 Net sales = Total sales – Sales returns
= Rs. 520000 – 20000 = Rs. 500000
Gross Profit = Net Sales – Cost of Goods Sold Rs. 500000 -400000 = Rs. 100000
Gross Profit Ratio = 100000 / 500000 x 100 20%
Interpretation of Gross Profit Ratio
The gross profit indicates the extent to which selling prices of goods per unit may decline without resulting in losses on operations of a firm.
OPERATING RATIO
Operating ratio establishes the relationship between cost of goods sold and other operating expenses on the one hand and the sales on the other.
Operating Ratio = Operating Cost / Net Sales X 100
= Cost of goods sold + operating expenses / Net sales x 100
Illustration
Find out operating Ratio:
| Rs. | |
| Cost of goods sold | 350000 |
| Selling and distribution Expenses | 20000 |
| Administrative & office Expenses | 30000 |
| Net sales | 500000 |
Solution:
OPERATING RATIO = = Cost of goods sold + operating expenses / Net sales x 100
= 3,50,000+20,000+30,000 / 500000 X 100
= 400000 / 500000 x 100 = 80%
Interpretation of Operating Ratio
Operating ratio indicates the percentage of net sales that is consumed by operating cost.
OPERATING PROFIT RATIO
This ratio is calculated by dividing operating profit by sales. Operating profit is calculated as:
Operating Profit = Net Sales-Operating Cost
or= Net Sales-(Cost of goods sold + Administrative and Office Expenses
+ Selling and Distributive Expenses)
Operating Profit can also be calculated as :
Operating Profit = Net Profit + Non-operating Expenses – Non-operating income
| So, Operating Profit Ratio = Operating profit / sales x 100 |
This ratio can also be calculated as :
Operating Profit Ratio = 100-Operating Ratio.
Illustration
From the information given below, calculate operating profit ratio Cost of Goods Sold = Rs. 4,00,000
Administrative & Office Expenses = Rs. 35,000 Selling & Distributive Expenses =Rs. 45,000 Net Sales= Rs. 6,00,000.
Solution:
Operating Profit Ratio = Operating Profit / Net Sales x 100 Operating Profit = Sales – (Cost of goods sold + Administrative Office expenses+ Selling & Distributive Expenses)
=Rs. 6,00,000-(Rs. 4,00,000+Rs. 35,000+Rs. 45,000)=Rs. 1,20,000
Operating profit ratio = 120000 / 600000 x 100 = 20%
EXPENSES RATIOS
Expenses ratios indicate the relationship of various expenses to net sales. The operating ratio re the average total variations in expenses.
| Cost of goods sold ratio = Particular Expenses / Net Sales x 100 Administrative & Office Expenses Ratio
= Administrative & Office Expenses / Sales x 100 Selling & Distributive Expenses Ratio = selling & Distributive Expenses / Sales x 100 Non-Operating Expenses Ratio = Non-Operating Expenses / Sales x 100 |
NET PROFIT RATIO
Net Profit ratio establishes a relationship between net profit (after taxes) and sales, and indicates the efficiency of the management m manufacturing, selling, administrative and other activities of the firm This ratio is the overall measure of firm’s profitability and is calculated as:
Net Profit Ratio = Net Profit After Tax / Net Sales x 100 Net profit Ratio = Net Operating Profit / Net Sales x 100
Illustration:
Following is the Profit and Loss Account to Royal Matrix Ltd. for the ended 31st December 2016.
| Dr. | Rs. | Cr. | Rs. |
| To Opening stock | 100000 | By Sales | 560000 |
| To Purchases | 350000 | By Closing stock | 100000 |
| To Wages | 9000 | ||
| To Gross profit c/d | 201000 | ||
| 660000 | 660000 | ||
| To Administrative expenses | 20000 | By Gross profit b/d | 201000 |
| To Selling and distribution expenses | 89000 | By Interest on investments
(outside business) |
1000 |
| To Non-operating expenses | 30000 | By Profit on sales of
investments |
8000 |
| To Net profit | 80000 | ||
| 219000 | 219000 |
You are required to calculate:
- Gross profit Ratio
- Net profit Ratio
- Operating Ratio
- Operating profit Ratio
- Administrative Expenses
Solution:
- Gross profit = Gross profit / Net sales x 100
= 201000 / 560000 x 100 = 35.9%
2. Net profit ratio = Net profit (after tax) / Net sales x 100
= 80000 / 560000 x 100 = 14.3%
Alternatively, Net Profit Ratio = Net operating profit /Net sales x 100
= (80000 + 30000) – (10000 + 8000)/ 560000 x 100
= 92000 / 560000 x 100 = 16.4%
3. Operating Ratio = Cost of goods sold + operating Exp. / Net sales
Cost of goods sold = Op. stock + Purchases + Wages – Closing Stock
= 100000+350000 + 9000 – 100000 = Rs. 359000
Operating Expenses = Administrative + Selling & Distribution Exp.
= 20000 + 89000 = 109000
Operating Ratio = 359000 + 109000 / 560000 x 100 = 83.6%
4. Operating profit Ratio = 100 – Operating Ratio
= 100 – 83.6% = 16.4%
5. Administrative Expenses Ratio = Administrative Expense / Net sales x 100
= 20000 / 560000 x 100 = 3.6%