Financial Management - Financial Ratio Analysis

 

Financial Management

Financial Ratio Analysis

 

Part A: This part contains (1) Introduction to “Financial Ratio Analysis” including definition of the same, (2) Formulas for calculating various financial ratios, and (3) Explanation of different terms used in the formulas of financial ratios.

 

Part B: 9 Illustrations with Solutions.

Part A

Introduction

A ratio is defined as “the indicated quotient of two mathematical expressions and as the relationship between two or more things”. In this article I am going to discuss how financial ratios are calculated and interpreted with the objective of utilising them in the process of taking managerial decisions. Financial ratios or accounting ratios are actually mathematical expressions of the relationships between two or more accounting figures appearing in the financial statements i.e. in Profit and Loss Account, Balance Sheet and Cash Flow Statement of the firm.

 

Financial Ratio Analysis can thus be defined as the process of determining and interpreting the numerical relationships between two or more accounting figures appearing in the financial statements i.e. in the Profit and Loss Account, Balance Sheet and Cash Flow Statement of a business enterprise.

 

Interpretation of different financial ratios is usually carried out by –

i)                 Comparing current year’s ratios of the firm with that of earlier years;

ii)              Comparing the ratios of the firm with that of its competitors;

iii)            Comparing the ratios of the firm with that of the industry which the firm belongs to;

iv)         Comparing the ratios of the firm with certain standard/benchmark which usually vary from industry to industry.

 

Proper analysis/interpretation of different financial ratios may bring to light the efficiency level at which different operating departments of an enterprise are performing, for example –

i)                 How efficiently the sales, production and purchase departments are working in tandem ensuring an optimum inventory level;

ii)              How efficiently the collection department is working ensuring prompt collection of payments from the trade debtors so that a low credit period (i.e. debt collection period) is maintained;

iii)            How efficiently the finance department is working ensuring maintenance of short-term as well as long-term solvency of the firm at reasonably safe and satisfactory levels;

iv)         How efficient each of the different operating departments and the business as a whole is in maintaining both the direct and indirect expenses well under control; and

v)            How efficiently the overall business, especially the top management, is performing ensuring a reasonably high level of profit margins, return on investment, and return on capital employed, return on equity, and return on assets.

 

Important Ratios

	SHORT TERM SOLVENCY RATIOS:
1	Current Ratio (also known as Working Capital Ratio) =
	Current Assets ÷ Current Liabilities
2	Quick Ratio (also known as Acid Test Ratio or Liquidity Ratio) =
	Quick Assets ÷ Current Liabilities [Note: Quick Assets are also known as Liquid Assets]
3	Super-quick Ratio =
	Super-quick Assets ÷ Current Liabilities
4	Defensive-Interval Ratio =
	Quick Assets ÷ Projected Daily Cash Requirements
	LONG TERM SOLVENCY RATIOS:
5	Debt-Equity Ratio =
	Long-Term Debts ÷ Shareholders' Equity
6	Proprietary Ratio =
	Shareholders’ Funds ÷ Total Assets (excluding fictitious assets and accumulated losses)
7	Fixed Assets Ratio =
	Net Fixed Assets ÷ Long-Term Funds
8	Fixed Interest coverage ratio =
	EBIT ÷ Interest on long-term borrowings
9	Fixed Dividend Coverage Ratio =
	PAT ÷ Preference Dividend
10	Capital Gearing Ratio =
	Same as Debt-Equity Ratio
11	Debt service coverage ratio (DSCR) =
	[EBITDA – Cash Taxes] ÷ [Interest + Principal]
	Where,
	1. EBITDA = Earnings Before Interest, Tax, Depreciation, and Amortization
	2. Principal = The total amount of loan principal due within the measurement period (often expressed as the current portion of long-term debt or CPLTD)
	3. Interest = The total aggregate amount of interest due within the measurement period, calculated on both the current portions and the non-current portions of long-term debt
	4. Cash Taxes = The proportion of total income tax that’s due in cash during the current measurement period
	ACTIVITY RATIOS ( also called TURNOVER RATIOS):
12	Trade Receivable Turnover Ratio =
	Net Credit Revenue from Operation ÷ Average Trade Receivables
13	Debt Collection Period (in days) =
	365 ÷ Trade Receivable Turnover Ratio
	Alternatively: Average Trade Receivables ÷ Average Credit Revenue from Operation per day
14	Trade Payable Turnover Ratio =
	Net Credit Purchases ÷ Average Trade Payables
15	Creditors’ Payment Period (in days) =
	365 ÷ Trade Payable Turnover Ratio
	Alternatively: Average Trade Payables ÷ Average Credit Purchases per day
16	Working Capital Turnover Ratio =
	Revenue from Operations ÷ Working Capital
17	Inventory Turnover Ratio [For Finished Goods] =
	Cost of Revenue from Operation (i.e. Cost of Goods Sold) ÷ Average Inventory of Finished Goods
18	Inventory Turnover Ratio [For Raw Materials] =
	Cost of Raw Materials Consumed ÷ Average Inventory of Raw Materials
19	Inventory Holding Period (in days) =
	365 ÷ Inventory Turnover Ratio
20	Fixed Assets Turnover Ratio =
	Net Revenue from Operation ÷ Net Fixed Assets
21	Overall Turnover Ratio  (also called Capital Turnover Ratio) =
	Net Revenue from Operation ÷ Capital Employed
	PROFITABILITY RATIOS:
22	Gross Profit Ratio =
	[Gross Profit ÷ Revenue from Operations] × 100
23	Net Profit Ratio =
	[PAT ÷ Revenue from Operations] × 100
24	Operating Ratio =
	[Operating Cost ÷ Net Revenue from Operations] × 100
25	Operating Profit Ratio =
	[EBIT ÷ Revenue from Operations] × 100
26	Operating expenses ratio =
	[Operating Expenses ÷ Net Revenue from Operations] x 100
27	Earnings per share (EPS) =
	[PAT − Preference Dividend] ÷ Number of Equity Shares
28	Price Earnings Ratio (P/E Ratio) =
	Market Price of an Equity share ÷ Earnings per share
29	Return on Assets (ROA) =
	(PAT ÷ Average Total Assets) × 100
30	Return on Capital Employed (ROCE) [also called Overall Profitability Ratio] =
	(EBIT ÷ Average Capital Employed) x 100
31	Dividend Pay-out Ratio =
	(Dividend Per Equity Share ÷ EPS) x 100
32	Dividend Yield Ratio =
	(Dividend Per Equity Share ÷ Market Price Per Equity Share) x 100
33	Earning Yield Ratio =
	(EPS ÷ Market Price Per Equity Share) x 100
34	Return on Equity (ROE) =
	[(PAT – Preference Dividend) ÷ Average Net Worth] x 100
35	Return on Net Worth =
	(PAT ÷ Average Net Worth) × 100
36	Return on Investment (ROI) =
	(PAT ÷ Average Capital Employed) × 100

 

 

Important Notes Related To Ratio Analysis

1.  Current Assets will include

a)          Inventories (excluding Loose Tools and Spare Parts),

b)          Trade Receivables,

c)          Bills Receivables,

d)          Cash at Bank,

e)          Cash in Hand,

f)               Prepaid Expenses,

g)          Accrued Incomes,

h)           Advance Payment of Tax,

i)                 Current Investments,

j)                 Accrued Interest on Investments,

k)            Marketable Securities,

l)                Short-term Loans and Advances.

 

2.  Current Liabilities will include

a)          Trade Payables,

b)          Bills Payables,

c)          Liability for Taxes,

d)          Outstanding Expenses,

e)          Unclaimed    Dividend,

f)               Incomes Received In Advance,

g)          Int. Accrued but not Due on Debentures & Loans,

h)           Provision for Tax,

i)                 Proposed Dividend,

j)                 Bank Overdraft,

k)            Cash Credit,

l)                Short-term loans.

 

3.  Quick Assets (also called Liquid Assets)

= All Current Assets – Inventories (excluding Loose Tools and Spare Parts) – Prepaid Expenses

 

4.  Super-quick Assets

= All Current Assets − Inventories (excluding Loose Tools and Spare Parts) – Prepaid Expenses − Debtors

 

5.    In Debtors’ Turnover Ratio Debtors will include bills receivables. Average Debtors is the average of opening debtors and closing debtors. Net credit sales consist of gross credit sales minus returns, if any, from customers.

 

6.    In Inventory Turnover Ratio

(I)   Cost Of Goods Sold can be calculated in two ways as follows :

a)      Cost of Goods Sold = Opening Inventory + Purchases + Direct Expenses (e.g. Wages, Carriage Inwards, Freight Inwards, Import Duties) – Closing Inventory.

b)      Cost of Goods Sold = Sales – Gross Profit.

(ii)   Average Inventory is the average of opening and closing Inventories.

 

7.    In Creditors’ Turnover Ratio Creditors will include bills payables. Average Creditors is the average of opening creditors and closing creditors. Net credit purchases consist of gross credit purchases minus returns, if any, to suppliers.

 

8.    In calculating Debt-Equity Ratio and Gearing Ratio

(I)   Long-Term Debt = Preference Share Capital + Debentures + Long Term Loans from Banks and Financial Institutions + Dividend/Interest Accrued and Due on Preference Share Capital, Debentures and Long Term Loans.

(ii)   Shareholders’ Equity = Equity share capital + Reserves and Surplus – All Fictitious Assets (e.g. Preliminary Expenses, Discount on Issue of Shares & Debentures, Underwriting Commission on Issue of Shares & Debentures, Capital Work-in-Progress) – Debit Balance of Profit and Loss account (i.e. accumulated losses)

 

Important Note:

The classification of preference shares in the financial statements of the issuer depends on the terms and rights attached to the shares with regards to redemption and dividends.

 

Preference shares are likely to be recognised as a liability (i.e. long-term debt) when:

1)            They carry fixed dividend rights where there is a contractual obligation to deliver cash;

2)            They provide for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date; and

3)            They give the holder the right to require the issuer to redeem the instrument at or after a particular date for a fixed or determinable amount.

 

The absence of the terms stated above is likely to indicate that preference shares may be classified as equity.

 

All along throughout this article preference share capital has been assumed to be redeemable carrying fixed dividend rights and accordingly has been treated as long-term debt.

 

9.    Shareholders’ Funds = Shareholders’ Equity + Preference Share Capital

 

10.  Long-Term Funds = Shareholders’ Equity + Long-Term Debt

 

11.  EBIT (Earnings Before Interest & Tax) = EBT + Interest

                           OR

EBIT (Earnings Before Interest & Tax) = Net Sales – Operating Cost [See Note-11 below]

 

12.  EBT (Earnings Before Tax) will not include abnormal and non-recurring gains or losses, such as,

1)            Gains or Losses on Sale of Fixed Assets,

2)            Gains or losses from Foreign Exchange Transactions,

3)            Abnormal Losses Due to Fire,

4)            Losses Due to Legal Disputes, etc.

 

13.  Capital Employed

Asset side approach

	Particulars	Rs
	All assets at market price (excluding intangible fixed assets, non-trading investments and fictitious assets) as at the end of the year	×××
L:	Current liabilities and provisions at market price as at the end of the year	×××
=	Capital employed	×××

 

Notes:

1.       If assets, current liabilities and provisions are taken at market price as at the beginning of the year, half of current year’s profit after tax is to be added to the capital employed to arrive at the average capital employed.

2.       Example of intangible fixed asset: goodwill (non-purchased), patents, copyrights, etc.

3.       Example of non-trading investments: investments in shares or debentures of other companies.

4.       Example of fictitious asset: preliminary expenses.

 

Liability side approach

Capital employed

= Share capital + Reserves and surplus + Long-term debts – Intangible fixed assets – Non-trading investments – Fictitious assets.

 

Note:

Share capital and long-term debts should be taken at market price either as at the beginning or as at the end of the year, as the case may be.

 

14.  Average Capital Employed = ½ (Op. Capital Employed + Cl. Capital Employed)

 

15.  In calculating Proprietary Ratio, Total Assets Turnover Ratio and Return on Investment, Total Assets will not include fictitious assets.

 

16.  In calculating Operating Ratio and Operating Expenses Ratio

(I)   Operating Cost

= Cost of Goods Sold + Operating Expenses.

= Direct Materials + Direct Wages + Direct Expenses + All Overheads

(ii)  Operating Expenses

= Manufacturing Expenses + Administration Expenses + Selling Expenses + Distribution Expenses [Financial Expenses like interest and taxes shall not be included in Operating Expenses].

 

17.  In calculating Gross Profit Ratio and Net Profit Ratio, Net Sales will be arrived at by deducting Sales Returns from Total Sales.

 

18.  Working Capital = Current Assets – Current Liabilities

 

19.  Net worth = Equity Share Capital + Reserves and Surplus − All Fictitious Assets

 

20. Average Net Worth = ½ (Op. Net Worth + Cl. Net Worth)

 

21. Projected Daily Cash Requirement = Projected cash operating expenditure in a year ÷ Number of days in the year

 

Notes:

1.             Debtors for Current Ratio are “Net Debtors” (Gross Debtors – Provision for doubtful debts), whereas Debtors for Trade Receivables Turnover Ratio are “Gross Debtors”.

 

2.         Alternative formulas of Capital employed

= Shareholders’ Funds + Non-current liabilities – intangible fixed assets − non-trade investments

OR

= Non-current assets (excluding intangible fixed assets and Non-trade investments) + Working Capital

OR

= Fixed Assets (excluding intangible fixed assets) + Trade Investments + Working Capital

OR

= Share capital + Reserves and surplus + Long-term debts – Intangible fixed assets – Non-trading investments – Fictitious assets.

Part B

Financial Management

Financial Ratio Analysis

Selected Problems

 

 

Illustration: 1

From the Profit and Loss Account and Balance Sheet of P. K. Jain Limited as given below calculate the following ratios:

1)            Gross Profit Ratio

2)            Overall Profitability Ratio

3)            Current Ratio

4)            Debt-Equity Ratio

5)            Stock-Turnover Ratio

6)            Finished goods Turnover Ratio

7)            Liquidity ratio

 

Profit and Loss Account

Particulars	Rs	Particulars	Rs
Op. Stock of Finished Goods	1,00,000	Sales	10,00,000
Op. Stock of Raw Materials	50,000	Cl. Stock of Raw Materials	1,50,000
Purchase of Raw Materials	3,00,000	Cl. Stock of Finished Goods	1,00,000
Direct Wages	2,00,000	Profit on sale of shares	50,000
Mfg. Exp.	1,00,000
Admn. Exp.	50,000
S & D Exp.	50,000
Loss on sale of plant	55,000
Interest on Debentures	10,000
Net Profit	3,85,000
	13,00,000		13,00,000

 

Balance Sheet

Liabilities	Rs	Assets	Rs
Eq. Share Cap.	1,00,000	Fixed Assets	2,50,000
Pref. Share Cap.	1,00,000	Stock of R/Mat	1,50,000
Reserves	1,00,000	Stock of F/G	1,00,000
Debentures	2,00,000	Cash at Bank	50,000
Sundry Creditors	1,00,000	Sundry Debtors	1,00,000
Bills Payable	50,000
	6,50,000		6,50,000

 

 Click here for Solution: 1 in PDF

 

Illustration: 2

The following is the Balance Sheet of M/S Yamuna Enterprise for the year ended 31-12-2015:

Balance Sheet as at 31.12.2015

Liabilities	Rs	Assets	Rs
Eq. Share Cap.	1,00,000	Goodwill	35,000
12% Pref. Share Capital	1,00,000	Land & Building	2,20,000
Reserves	1,50,000	Machinery	1,00,000
P/L A/c	20,000	Furniture	30,000
16% Debentures	40,000	Current Inv.	20,000
18% Public debts	20,000	Stock	40,000
Bank O/D	40,000	Debtors	70,000
Creditors	60,000	Bills Receivable	30,000
O/S Expenses	7,000	Cash at bank	10,000
Proposed Div.	10,000	Cash in hand	2,000
Prov. For Tax	20,000	Preliminary Exp,	10,000
	5,67,000		5,67,000

 

During the year provision for taxation was Rs 20,000. Dividend was proposed at Rs 10,000. Profit carried forward from the last year was Rs 15,000. You are required to calculate:

(a)                 Short term solvency ratios, and

(b)                 Long term solvency ratios.

 

Click here for Solution: 2 in PDF

Illustration: 3

Following is the Balance Sheet of Sun Ltd., as on December 31, 2015:

 

Balance Sheet as at 31.12.2015

Liabilities	Rs	Assets	Rs
Eq. Share Cap.	20,000	Goodwill	12,000
Reserves	4,000	Other Fixed Assets	28,000
P/L A/c	6,000	Current Inv.	2,000
8% Loan on Mortgage	16,000	Stock	6,000
Future Tax	2,000	Debtors	6,000
Bank O/D	2,000	Cash in hand	6,000
Creditors	8,000
Current Tax	2,000
	60,000		60,000

 

Sales amounted to Rs 1, 20,000, transfer to reserves from current year’s PAT Rs 4,000 and dividend paid from current year’s PAT Rs 2,000. Calculate ratios for (a) testing liquidity, and (b) testing solvency.

 

Click here for Solution: 3 in PDF 

Illustration: 4

With the help of the following information complete the Balance Sheet of Pristine Ltd.

Equity share capital	Rs 1,00,000
Current debt to total debt	40%
Total debt to owner’s equity	60%
Fixed assets to owner’s equity	60%
Total assets turnover ratio	2 Times
Inventory turnover ratio	8 Times

 

Click here for Solution: 4 in PDF

Illustration: 5

Using the following data, prepare the Balance Sheet:

Gross Profits	Rs 54,000
Shareholders’ Equity	Rs 6,00,000
Gross Profit Margin	20%
Credit Sales to Total Sales	80%
Total Assets Turnover Ratio	0.3 Times
Inventory Turnover Ratio	4 Times
Average Collection Period	20 Days
Current Ratio	1.8: 1
Debt-Equity Ratio	40%

Assume 360 days in a year.

 

Click here for Solution: 5 in PDF

Illustration: 6

Lotus Limited has the following Balance Sheets as on March 31, 2016 and March 31, 2015:

                                                    (Rs in Lakhs)

Particulars	As on 31.03.2016	As on 31.03.2015
Sources of Funds:
Shareholders’ Funds	2,377	1,472
Loan Funds	3,570	3,083
Current Liabilities	3,937	3,794
	9,884	8,349
Applications of Funds:
Fixed Assets	3,466	2,900
Cash and bank	489	470
Debtors	1,495	1,168
Stock	2,867	2,407
Other Current Assets	1,567	1,404
	9,884	8,349

 

The Income Statement of the Lotus Ltd. for the year ended 31.03.2016 and 31.03.2015 is as follows:

                                                    (Rs in Lakhs)

Particulars	For the year ended
	31.03.2016	31.03.2015
Sales	22,165	13,882
L: Cost of Goods Sold	20,860	12,544
Gross Profit	1,305	1,338
L: Operating Expenses	1,135	752
EBIT	170	586
L: Interest Expenses	113	105
EBT	57	481
L: Tax	23	192
EAT / PAT	34	289

 

Required:

1.  Calculate for the year 2015-16:

a)          Inventory Turnover Ratio

b)         Financial Leverage

c)         Return on Investment (ROI)

d)        Return on Equity (ROE)

e)         Average Collection period.

2. Give a brief comment on the Financial Position of Lotus Limited.

 

Click here for Solution: 6 in PDF

Illustration: 7

The following figures and ratios are related to a company:

 

(a)	Sales for the year (all credit)	Rs 30,00,000
(b)	Gross Profit Ratio	25%
(c)	Fixed Assets Turnover Ratio (on the basis of Cost of Goods Sold)	1.5 Times
(d)	Stock Turnover Ratio (on the basis of Cost of Goods Sold)	6 Times
(e)	Liquidity Ratio	1: 1
(f)	Current Ratio	1.5: 1
(g)	Debtors’ Collection Period	2 months
(h)	Reserves and Surplus to Equity Share Capital	0.6: 1
(i)	Capital Gearing Ratio	0.5: 1
(j)	Fixed Assets to Net Worth	1.2: 1

 

You are required to prepare Balance Sheet of the company on the basis of above details.

 

Click here for Solution: 7 in PDF 

Illustration: 8

Puritan Limited has made plans for the next year 2015-16. It is estimated that the company will employ total assets of Rs 25, 00,000; 30% of assets being financed by debt at an interest cost of 9% p.a. The direct costs for the year are estimated at Rs 15, 00,000 and all other operating expenses are estimated at Rs 2, 40,000. The sales revenue is estimated at Rs 22, 50,000. Tax rate is assumed to be 40%.

 

You are required to calculate:

(a)                 Net Profit Margin

(b)                 Return on Assets

(c)                 Total Assets Turnover Ratio

(d)                 Return on Equity

Click here for Solution: 8 in PDF

Illustration: 9

With the help of the following financial ratios of Indu Films Limited draw the Balance Sheet of the company for the year 2015:

Current Ratio	2.5: 1
Liquidity Ratio	1.5: 1
Net Working Capital	Rs 3,00,000
Stock Turnover Ratio (Cost of Sales / Closing Stock)	6 Times
Gross Profit Ratio	20%
Fixed Assets Turnover Ratio (on the basis of Cost of Sales)	2 Times
Debt Collection Period	2 months
Fixed Assets to Net Worth	0.8: 1
Reserves and Surplus to Share Capital	0.5: 1

 

Click here for Solution: 9 in PDF