Ratio Analysis 107. Part II Management & Cost Accounting

Transcription

1 Ratio Anaysis 107 Part II Management & Cost Accounting

2 Ratio Anaysis 109 Chapter 4 Ratio Anaysis LEARNING OBJECTIVES In this chapter we wi study: Introduction Concept of Ratio Types of Ratios Measurement and Interpretation of Ratios Appication of Ratios Methodoogy for Ratio Anaysis Du-pont Chart for Ratio Anaysis Advantages of Ratio Anaysis Limitations of Ratio Anaysis

3 110 Accounting and Financia Management for I.T. Professionas 4.1 INTRODUCTION Ratio anaysis is a technique used to evauate the financia heath of the concerned organisation from interested groups point of view using different ratios as a too. It comprises of two terms viz. ratio and anaysis and therefore both the terms shoud be deat separatey whie studying ratio anaysis. Ratio Anaysis Ratio + Anaysis 1 Concept of Ratio Trend Anaysis Types of Ratios Inter-firm Comparison Measurement of Ratios Comparison with Industria Average Interpretation of Ratios Horizonta/Vertica Anaysis 4.2 CONCEPT OF RATIOS Absoute financia data of an organization does not provide usefu information but whenever it is compared with another financia data of the same organization it provides usefu information and constitutes a ratio. Iustration Suppose foowing is the data reated to Company A. Profit Rs.10,000 Saes Rs.1,00,000 Data deat separatey is not usefu. [(Profit/Saes)*100/Saes = 10%] is usefu information as it represents profit margin ratio. 4.3 TYPES OF RATIOS There are various groups, which are interested in financia heath of the organization. These groups are Owners/Sharehoders, Short-term creditors (suppiers, suppiers of short-term oans), Long-term creditors (Debenture hoders, Banks and Financia Institutions providing term oans), Management and government. Furthermore, the risk and return perceived by abovesaid groups are varying in nature and since risk return trade off is the objective of any group, this eads to basis for cassification of financia heath. Thus financia heath of the organization can viewed as foows: 1. Financia heath from owner s point of view. 2. Financia heath from short-term creditor s point of view. 3. Financia heath from ong-term creditor s point of view. 4. Financia heath from management s point of view. 5. Financia heath from government s point of view. Here Financia heath means abiity to serve the concerned group. The cassification of ratios is done on the basis of the purpose of different groups mentioned above having direct interest in the organization concerned. 1. Anaysis refers to appication of ratios in different ways (mentioned above) for the purpose of panning financia decisions and in soving decision-making probems. This portion is beyond the scope of this book.

4 Ratio Anaysis 111 There are five broad categories of ratios on the basis of its nature: 1. Liquidity ratios 2. Profitabiity ratios 3. Sovency ratios 4. Turnover ratios 5. Market ratios Liquidity ratios measure iquidity position of the organization. Liquidity means abiity to meet short-term obigations. Short-term obigation incudes bis payabes, outstanding expenses, bank overdraft etc. Profitabiity ratios measure profitabiity position i.e. abiity to earn profit. Higher the ratio better it is. Sovency ratios measure sovency position of the organization. Sovency means abiity to meet ong-term obigations. Long-term obigation incudes oan repayments, debt servicing i.e. interest payments etc. Turnover ratios measure position of resources utiization. A higher turnover ratio indicates better utiization of resources. Resources incude fixed assets, current assets, working capita etc. Market ratios refect performance of the organization within industry concerned/economy. Market ratios are usefu to secondary market (stock market) investors. Tabe 1 and Tabe 2 stated beow, describe the summary of ratios with groups having direct interest. Tabe 1 Groups having direct interest Owners/sharehoders Short-term creditors Long-term creditors Management Government. Reevant ratios - Profitabiity ratios - Market ratios - Liquidity ratios - Turnover ratios - Sovency ratios - Turnover ratios - Market ratios - Profitabiity ratios - Market ratios Tabe 2 (Summary of ratios) Type of ratios Name of the ratios Liquidity ratios 1. Current Ratio (CR) 2. Quick Ratio (QR) 3. Cash Ratio Profitabiity ratios 1. Gross Profit Margin (GPM) 2. Operating Profit Margin (OPM) 3. Net Profit Margin (NPM) Contd...

5 112 Accounting and Financia Management for I.T. Professionas Type of ratios Name of the ratios 4. Return on Investment (ROI):- Return on Net worth (RO Net worth) Return on Capita Empoyed (ROCE) Return on Tota Asset (ROTA) Sovency ratios 1. Debt-equity ratio 2. Fixed charge coverage ratio Turnover ratios 1. Fixed Asset Turnover Ratio (FATOR) 2. Current Asset Turnover Ratio (CATOR) 3. Tota Asset Turnover Ratio (TATOR) 4. Debtors Turnover Ratio (Drs TOR)/Average Coection Period (ACP). 5. Creditors Turnover Ratio (Crs TOR)/Average Payabe Period (APP) 6. Working Capita Turnover Ratio (WCTOR) 7. Stock Turnover Ratio (a) Raw materia turnover ratio (b) Work in progress turnover ratio (c) Finished goods turnover ratio Market ratios 1. Dividend Payout Ratio (D/P ratio) 2. Price-Earning Ratio (P/E Ratio) 3. Dividend Yied 4. Earnings Yied 4.4 MEASUREMENT AND INTERPRETATION OF RATIOS Liquidity Ratio Liquidity ratio measures iquidity position of the organization. Liquidity means abiity to meet short-term obigations i.e. current iabiities (bank overdraft, bis payabe, outstanding expenses etc.). Remark Liquidity of asset is different from iquidity of organization stated above. Liquidity of asset means ease of convertibiity of that asset into cash. The extent of iquidity depends upon the eve of current assets. (Current assets are those, which convert into cash within one year e.g. cash, debtors, stock, marketabe securities, prepaid expenses, oans and advances (given) etc.). Types of Liquidity Ratios The different types of iquidity ratios are as foows: 1. Current ratio 2. Quick ratio or acid test ratio

6 Ratio Anaysis Cash ratio or super quick ratio. Higher the iquidity ratios, higher wi be the iquidity position. Higher the iquidity ratios, higher wi be the amount of Working Capita (WC). Working capita means excess of Current Assets (CA) over Current Liabiities (CL). Current Assets (CA) Current Ratio (CR) = Current Liabiity (CL) A very high Current Ratio indicates inadequate empoyment of funds. A very ow Current Ratio indicates that business is trading beyond its resources and is signa of danger for management. CR is a measure of margin of safety to short-term creditors i.e. higher the CR, greater the safety of funds of short-term creditors. Current Assets Inventory (Stock) Quick Ratio = Current Liabiity Quick ratio is used to measure the iquidity position, when stock (inventory) is doubtfu. (Cash + Marketabe Securities) Cash Ratio = Current Liabiity Cash ratio is the most penetrating test regarding the iquidity position and is used when debtors are aso doubtfu. A very high cash ratio is not desirabe because it indicates the organization has an ide cash baance eading to decrease in profitabiity. Note: The idea current ratio is 2:1 The idea quick ratio is 1:1 The idea cash ratio is 0.5:1 Profitabiity Ratios Profitabiity Ratios measures the profitabiity position of the organization. Profitabiity means abiity to earn more profit. Foowing are the different types of profitabiity ratios: 1. Gross Profit Margin (GPM) 2. Operating Project Margin (OPM) and Operating Ratio (OR) 3. Net Profit Margin (NPM) 4. Return on investment (i) Return on Net Worth (ii) Return on Capita Empoyed (ROCE) (iii) Return on Tota Assets (ROTA) Gross Profit Gross Profit Margin = 100 Saes Operating Profit Operating Profit Margin = 100 Saes

7 114 Accounting and Financia Management for I.T. Professionas Operating Expenses Operating Ratio = 100 Saes Net Profit Net Profit Ratio = 100 Saes Higher the profitabiity ratios (GPM, OPM, NPM), higher wi be the profitabiity position of the concerned organization. Lower the operating ratio (OR = OE/Saes), the better it is. In case gross profit margin is satisfactory but the operating profit margin is not satisfactory then it indicates that the organization is incurring huge operating expenses. Again if operating profit margin is satisfactory but net profit margin is not satisfactory then it indicates that the organization has heavy debt burden. In this situation, to improve the net profit margin, the organization shoud try to reduce debt burden in order to reduce the interest payment obigation eading to improvement of net profit and hence net profit margin. Note Income Statement for the Year Particuars Amount (Rs.) Saes Less Cost of Goods Sod (COGS) Trading A/c Gross Profit (GP)/(Gross Less Operating Expenses (OE) Operating Profit Add Non operating income/ess non operating osses Earning Before Interest and Tax Less Interest P & L A/c Earning Before Tax Less Tax Profit After Tax (PAT)/Net profit Less Provision for dividend Less Provision for tax Less Transfer to genera reserves P & L (appropr.) A/c Profit & oss Goes to Baance sheet iabiity side (under the head Reserves and surpus as Profit & Loss A/c or Retained Earnings Stands for baancing figure. OE incudes genera and administrative expenses pus seing and distribution expenses pus depreciation. Gross Profit (G.P.) = Saes Cost of Goods Sod (COGS)

8 Ratio Anaysis 115 Operating Profit (OP) = G.P. Operating Expenses (O.E.) Earning Before Interest and Tax (EBIT) = OP + Non-Operating Profit (NOP)/Less Non-Operating Expenses (NOE) Net Profit (N.P.) = EBIT (Interest + tax). Interest is tax-deductibe item which means interest is charged before the tax is evied. Whereas dividend is not tax-deductibe item which means dividend is paid after tax is paid. This is the reason why debt is cheaper source of finance as compared to equity. Return on Investment There are three approaches regarding definition of investment.: Tota Asset (TA) Investment Net worth or equity Capita Empoyed (CE) Net Profit ROTA = 100 Tota Asset ROTA measures overa profitabiity of the organization because TA incudes tota resources of the organization. ROTA is the most popuar measure of Return On Investment (ROI). NP Return on net worth or equity = Net worth of equity Net Profit = (Equity Capita + Reserve & Surpus) Return on equity measures the productivity of the owner s capita (i.e. risk capita) empoyed in the firm. Net Profit ROCE = Capita Empoyed (CE) CE = Tota ong-term fund = Tota asset Current iabiity Higher the return on investment (ROTA, RO net worth, ROCE) higher wi be the profitabiity. Sovency Ratios Sovency ratios measure sovency position of the concerned organization. Sovency means abiity to meet ong-term obigations. There are two categories of iabiities arising out of ong-term obigations i.e. ongterm creditors viz. fixed charge/interest payment obigation and principa repayment. Thus there are two ratios to measure the sovency position. 1. Fixed Charge/Interest Coverage Ratio (for fixed charge obigation): EBIT Fixed Charge/Interest Coverage Ratio = ( Unit Times) Fixed Charges Higher the ratio, better it is. This ratio indicates the extent of EBIT towards fixed charge/interest payment obigation.

9 116 Accounting and Financia Management for I.T. Professionas 2. Debt Equity (D/E) ratio (for principa repayment obigation): Long - term Debt D/E ratio = (Equity Capita + Reserve & Surpus) Lower the ratio, better it is. D/E ratio measures the margin of safety of principa amount invested by ong-term creditors. More the equity, more safe wi be principa of ong-term creditors. Equity capita acts as cushion to ong-term creditors. Leverage means making use of ow cost debt capita in order to boost the earnings on equity i.e. return on equity. Low cost debt means, Rate of earnings > Interest rate of debt capita. Trading on equity is possibe when everage exits. Iustration (Trading on equity): (In Rs.) Particuars Company A Company B Equity 1,00,000 40,000 Long-term debt at 10% rate of interest - 60,000 Tota capita empoyed 1,00,000 1,00,000 EBIT (Earnings Before Interest and Tax) 15% (say) 15,000 15,000 Less: Interest - 6,000 EBT (Earning Before Tax) 15,000 9,000 Less: 40% (say) 7,500 3,600 EAT (Earnings After Tax)/PAT/NP 7,500 6,400 Return on equity = (NP/Equity) x % 10.6% From above tabe it is cear that Company B is in better position as it gives more return to its sharehoders in comparison to Company A. This is known as trading on equity. Thus trading on equity means maximizing sharehoder s weath (measured in terms of return on equity) through use of ow cost debt capita in tota capita empoyed. Here we can trace out that trading on equity is possibe because everage exists. Company B has used ow cost debt capita means Rate of earning (Rate of EBIT 15%) > Interest rate of debt capita 10%). This excess earning (15% 10% = 5%) goes to equity as equity sharehoders have residua caim on income. Turnover Ratios It measures the position of resources utiization. Resources incude 5M (men, machine, materia, money, method) + IT. Higher the turnover ratio, better it is. The unit of turnover ratio is Times. The different turnover ratios are as foows: Cost of Goods Sod (COGS) X Turnover Ratio ( X T.O.R.) = Average X

10 Ratio Anaysis 117 Note: Opening Baance (X) + Cosing Baance (X) Average X = 2 TA,FA,CA etc. Cost of Goods Sod (COGS) Tota Asset Turnover Ratio (T.A.T.O.R.) = Average tota asset Cost of Goods Sod (COGS) Fixed Asset Turnover Ratio (F.A.T.O.R.) = Average fixed asset Cost of Goods Sod (COGS) Current Asset Turnover Ratio (C.A.T.O.R.) = Average current asset Cost of Goods Sod (COGS) Working Capita Turnover Ratio (W.C.T.O.R.) = Average current asset If previous year s Baance Sheet (B/S) is not given, then repace average figure with cosing baance figure. If COGS is not avaiabe, repace it with saes figures. Stock or Inventory Turnover Ratio q q (COGS) Stock Turnover Ratio = (unit in times) Average Stock Opening stock + Cosing stock Average Stock = 2 If COGS is not avaiabe, repace it with saes. Stock veocity or stock hoding period 360 or 365 = days Stock turnover ratio 360 Average stock or, Stock veocity or stock hoding period = COGS Stock turnover ratio shows how fast (in times) the average stock is sod during the year. Higher the stock turnover ratio, better it is. Stock veocity shows the average time (in days) the stocks remain ying in warehouse before being sod. Lower inventory turnover ratio shows that the stock is bocked and not immediatey sod means stock is piing up in warehouse. In case of manufacturing organization, there are three categories of stocks viz. raw materia stock, semi finished goods or work in progress and finished goods stock. The formua shown above is meant for finished goods stock. The formua for other category of stocks are as foows: m Raw Materia Stock Turnover Ratio Raw materia consumed during the year = Average raw materia stock

11 118 Accounting and Financia Management for I.T. Professionas m Work-in-Progress (WIP) Turnover Ratio Cost of manufacturing during the year = Average work - in - progress stock The raw materia stock turnover ratio measures how many times the average raw materia stock is being send for production during the year. Note: A high inventory turnover ratio may be caused by maintaining a ow eve of inventory as inventory turnover ratio is inversey proportiona to average inventory (see formua). This may resut into frequent stock outs eading to possibe oss of saes and customer goodwi. This favourabe high turnover ratio may be used for window dressing i.e. a firm may prepare its baance sheet at a point when its eve of inventory is very ow. As a resut, it may appear that the firm has a very comfortabe iquidity position aongwith adequate inventory turnover, which is not correct. Debtors Turnover Ratio Credit saes q Debtors Turnover Ratio = (unit is times) Average debtors If credit saes are not avaiabe, repace it with saes. q Average Coection Period (ACP) ACP = Or, Average Coection Period (ACP) = 360 or 365 = days Debtors turnover ratio 360 Average debtors Credit saes 12 Months Debtors turnover ratio months Debtors turnover ratio shows how prompty debtors are making payments. Higher the ratio shows debtors are paying frequenty. ACP shows the average time (in days) taken by the debtors in making the payment. Lower the ACP (or higher the debtors turnover ratio), better it is because it reduces the chances of bad debts. Creditors Turnover Ratio m Creditors Turnover Ratio = Credit purchases Average creditors (unit is times) If Credit Purchases are not avaiabe, repace it with purchases. m Average Payabe Period (APP) = APP = 360 or 365 Creditors turnover ratio Days 360 Average creditors Credit purchase 12 Months Or, Average Payabe Period (APP) = Creditors turnover ratio Months Creditors turnover ratio shows how frequenty trade creditors (suppiers) are paid. This ratio refects the credit worthiness of the organization.

12 Ratio Anaysis 119 Higher the ratio shows organization is paying frequenty. APP shows the average time (in days) taken by the organization in cearing suppiers bi (Bis payabe). Lower the APP (or higher the creditors turnover ratio), better it is, because it improves credit worthiness of the concerned organization. Again a very high creditors turnover ratio is not desirabe as it shows that the organization is not fuy utiizing the credit period extended by suppiers. Creditors turnover ratio acts as spontaneous source of finance as in case of favourabe credit worthiness fund can be made avaiabe through postponement of payment of suppiers bi. Market Ratios Market ratios refect the performance of concerned organization in secondary market. Market ratios are usefu for investors of stock market as it heps in fundamenta anaysis of concerned organization. Foowing are different types of market ratios: Tota distributabe profit 1. Dividend per Share (DPS) = Number of outstanding shares 2. Earnings per Share (EPS) Earnings avaiabe to equity sharehoder = Number of outstanding shares PAT ess preference dividend OR Earnings per Share (EPS) = Number of outstanding shares Where PAT = Profit after Tax DPS 3. Dividend payout ratio (D/P Ratio) = 100 EPS m 40% Dividend payout ratio means organization has paid Rs. 40 as dividend against earnings of Rs MP 4. Price-Earning Ratio (P/E Ratio) = 100 EPS m P/E Ratio is a mutipier used for evauating market vaue of share as: Market Price per share = (P/E) EPS 5. Earnings yied EPS = 100 MP DPS 6. Dividend yied = 100 MP Where MP is market price per share. Note1: 1. Stock veocity Stock (Inventory) hoding period 2. A/R veocity Average Coection Period (ACP) 3. A/P veocity Average Payabe Period (APP)

13 120 Accounting and Financia Management for I.T. Professionas 4. Cost of saes COGS (Cost of Goods Sod in case Cosing stock is zero) 5. If Gross Profit (GP) = x% of saes, where x = GPM (Gross Profit Margin) is given, then GP can be written in terms of COGS as given beow, x% of saes 100 GP = %of COGS (100 x% of saes) e.g. If GPM = 20% Then GP = 20% of saes as GPM = (GP/saes) 100 Or, GP = %of COGS (100 20) Or, GP = 25% of COGS Note 2: The three turnover ratios viz. inventory turnover ratio, debtors turnover ratio, and creditors turnover ratio have bearing on the iquidity of the concerned firm. The combined effect of the three turnover ratios is summarized beow: Inventory hoding period = 2 Months Add: Debtors coection period = +1.5 Months (Say) Less: Creditors payment period = 3 Months Tota = 0.5 Months As a rue, the shorter the period, the better is the iquidity position and vice-versa. Note 3: Reationship between working Capita (WC) and Liquidity Working capita represents capita empoyed in current asset components viz. cash, stock and debtors. Though WC is not a ratio but it is frequenty used as a measure of firm s iquidity position. An enterprise shoud have sufficient WC in order to be abe to meet the caims of creditors and meeting day to day needs of business. The greater the amount of WC, the greater the iquidity of the firm. In other words, Liquidity WC Thus, inadequate working capita is the 1 st sign of financia probems for concerned firm. 4.5 APPLICATION OF RATIOS Foowing are different ways for appication of ratios, which hep in panning financia decisions and in soving decision-making probems. Trend anaysis Inter-firm comparison Comparison with industria average i.e., digging out strength and weakness.

14 Ratio Anaysis METHODOLOGY FOR RATIO ANALYSIS Methodoogy for ratio anaysis is as foows: Step 1: Seection of reevant data from the financia statements depending upon the objective of the anaysis. Step 2: Cacuation of appropriate ratios from the above data. Step 3: Comparison of the cacuated ratio with the ratios of the same firm in the past, or the ratios deveoped from projected financia statements or the ratios of competitor firms or comparison with the average ratios of the industry to which the firm beongs. Step 4: Interpretation of ratios. Note: The source of financia data for ratio anaysis may be the audited financia statements pubished in annua report of the organization concerned. 4.7 DU-PONT CHART FOR RATIO ANALYSIS Du-Pont chart is designed by Du-Pont Company of America. This chart shows how change in any resource/monetary activity of organization affects overa profitabiity measured in terms of return on tota asset. This chart heps the management to exercise contro, as it incorporates a the resources/monetary activities of the organization. ROTA = NP/TA TATOR = Saes/TA X NPM = NP/Saes FA + CA Saes Œ Tota Cost Cash & Bank baance + Stock + Receivabes Cost of goods sod + OE + +NOP/ŒNOE + Interest & Tax Gen. & Adm. Expenses + Seing & Distribution Expenses + Depreciation

15 122 Accounting and Financia Management for I.T. Professionas Where, TATOR : Tota Asset Turnover Ratio NP : Net Profit NPM : Net Profit Margin TA : Tota Asset FA : Fixed Asset CA : Current Asset OE : Operating Expenses NOP : Non Operating Profit NOE : Non Operating Expenses According to this chart: Return on Investment = Asset Turnover Profit Margin Iustration Return on Investment = Asset Turnover Profit Margin 12 % = 6 % 2 % case 1 OR 12 % = 2 % 6 % case 2 This means ROI can be achieved by increasing asset turnover (= Saes/TA) in case profit margin is ow (case 1) or by increasing profit margin in case asset turnover is ow (case 2). Deaers and footpath traders work on this principe as with ow profit margin they achieve ROI through higher asset turnover (case 1). Whereas showroom traders with ow asset turnover achieve ROI through higher profit margin. To assess the financia position of the firm or for inter-firm comparison, the foowing steps shoud be foowed- Evauate the foowing ratios and make assessment as suggested beow: 1. Current Ratio (CR) 2. Quick Ratio (QR) 3. Inventory Turnover Ratio 4. Debtors Turnover Ratio or ACP 5. Creditors Turnover Ratio or APP 6. Gross Profit Margin (GPM) 7. Net Profit Margin (NPM) 8. Return on Investment (ROI) 9. Debt Equity Ratio 10. Tota asset turnover ratio, working capita turnover ratio etc. Ratios (1) and (2) measure iquidity position of the firm. Whereas the cause of iquidity position (good or bad) ies in ratios (3), (4) and (5). Ratios (6) and (7) measures the profitabiity position of the firm. Cause of profitabiity approach (favourabe/adverse) ies in ROI i.e. ratio (8). Again, cause of profitabiity approach aso ies in COGS. As COGS increases, GP (= Saes COGS) decreases. Debt Equity ratio measures oad of debt on equity. It measures margin of safety to creditors and everage avaiabe to equity.

16 Ratio Anaysis 123 Ratio (10), (3) and (4) measures the efficiency of management. Lower the T.A.T.O. ratio means under utiization of assets (resources). In this situation, the eve of activity can be enhanced without making capita investment. Iustration: (Appication of ratios as too in decision-making probem) From the foowing information taken from the records of two companies (A and B) of the same industry, answer the questions given at the end using ratios as too. Particuars Company A Company B Cash 2,10,000 3,20,000 Debtors 3,30,000 6,30,000 Stock 12,30,000 9,50,000 Pant and equipment 16,95,000 24,00,000 Tota Assets 34,65,000 43,00,000 Sundry creditors 9,00,000 10,50,000 8% Debentures 5,00,000 10,00,000 Equity share capita 11,00,000 17,50,000 Retained earnings 9,65,000 5,00,000 Tota Liabiities 34,65,000 43,00,000 Saes 56,00,000 82,00,000 Cost of Goods Sod (COGS) 40,00,000 64,80,000 Other Operating Expenses (OE) 8,00,000 8,60,000 Interest expenses 40,000 80,000 Income taxes 38,00,000 3,90,000 Dividends 10,000 1,80,000 Questions 1. Which company is using the sharehoder s money more profitaby? 2. Which company is better abe to meet its current debts? 3. If you were to purchase the debentures of one company, which company s debenture woud you buy? 4. Which company coects its receivabes faster, assuming a saes to be credit saes? 5. Which company has extended credit for a greater period by the creditors, assuming a purchases (equivaent to COGS) to be credit purchases? 6. How ong does it take each company to convert an investment in stock to cash? Soution Foowing are the reevant ratios used for answering the above questions:

17 124 Accounting and Financia Management for I.T. Professionas S.No. Reevant ratios Company A Company B 1 Return on equity % % 2 Liquidity Ratios: 2.1 Current ratio Quick ratio Cash ratio Sovency Ratios: 3.1 Debt service coverage ratio 20 times 10.7 times 3.2 Debt equity ratio Average coection period 21 days 27 days 5 Average payabe period 81 days 58 days 6 Stock hoding period 110 days 53 days Answer to Question No. 1: From the above tabe it is evident that return on equity in case of Company A is comparativey more than Company B, therefore it can be concuded that Company A is using sharehoders money more profitaby as compared to Company B, as return on equity represents yied on sharehoders fund. Answer to Question No. 2: From the above tabe it is evident that CR in case of Company A is sighty higher than Company B but QR and cash ratio in case of Company B is higher than Company A and since QR and cash ratio are more rigorous test for assessing iquidity position as compared to CR it can be concuded that iquidity i.e. abiity to meet current debts in case of Company B is more than Company A. Answer to Question No. 3: From the above tabe it is evident that sovency position of Company A is better than Company B which represents abiity to meet ong-term obigations in terms of interest payment obigation as we as principa repayment obigation. It can, therefore, be concuded that one shoud purchase debentures of Company A instead of Company B. Answer to Question No. 4: Since ACP of Company A is comparativey ess than Company B which means average coection time for Company A is ess than Company B, it can be concuded that Company A coects its receivabes faster than Company B. Answer to Question No. 5: Since APP of Company B is comparativey ess than Company A which means average payment time for Company B is ess than Company A, it can be concuded that Company A has extended credit for a greater period by the creditors than Company B. Answer to Question No. 6: Since Stock hoding period of Company B is comparativey ess than Company A which means stock hoding time for Company B is ess than Company A, it can be concuded that Company A is hoding its stock before being sod for a greater period than Company B.

18 Working notes Given, Saes 56,00,000 82,00,000 Less: COGS 40,00,000 64,80,000 GP 16,00,000 17,20,000 Less: OE 8,00,000 8,60,000 OP/EBIT 8,00,000 8,60,000 Less: Interest expenses 40,000 80,000 EBT 7,60,000 7,80,000 Income tax 3,80,000 3,90,000 PAT/NP 3,80,000 3,90, Return on net worth or equity For Company A: Return on equity = 3,80,000 (11,00, ,65,000) Return on equity = 3,80, ,65,000 Return on equity = % For Company B: Return on equity = 3,90,000 (17,50, ,00,000) Return on equity = 3,90, ,50,000 Return on equity = % 2.1 Current Ratio (CR) For Company A: For Company B: NP = Net worth or equity Net Profit = (Equity capita + Reserve & surpus) Current Asset (CA) = Current Liabiity (CL) (2,10, ,30, ,30,000) CR = 9,00,000 CR = 17,00,000 9,00,000 CR = 1.88 CR (3,20, ,30, ,50,000) = 10,50,000 Ratio Anaysis 125

19 126 Accounting and Financia Management for I.T. Professionas 2.2 Quick Ratio (QR) For Company A: 19,00,000 CR = 10,50,000 CR = 1.81 QR QR QR = 0.6 For Company B: QR QR (Current asset Stock) = Current Liabiity (CL) [(2,10, ,30, ,30,000) 12,30,000] = 9,00,000 5,40,000 = 9,00,000 [(3,20, ,30, ,50,000) 9,50,000] = 9,50,000 = 10,50,000 QR = ,50,000 (Cash + Marketabe securities) 2.3 Cash Ratio = Current Liabiity (CL) For Company A: 2,10,000 Cash ratio = 9,00,000 Cash ratio = 0.23 For Company B: 3,20,000 Cash ratio = 10,50,000 Cash ratio = Debt service coverage ratio (for fixed charge obigation): Debt service coverage ratio EBIT = ( Unit times) Interest expenses For Company A: 8,00,000 Debt service coverage ratio = 40,000 Debt service coverage ratio = 20 times For Company B: 8,60,000 Debt service coverage ratio = 80,000 Debt service coverage ratio = 10.7 times 3.2 Debt Equity (D/E) ratio (for principa repayment obigation): Long - term debt D/E ratio = (Equity capita + Reserve & surpus)

20 Ratio Anaysis 127 For Company A: For Company B: 5,00,000 D/E ratio = 20,65,000 D/E ratio = ,00,000 D/E ratio = 22,50,000 D/E ratio = Average Coection Period (ACP): ACP For Company A: ACP ACP 360 Average debtors = Credit saes 360 3,30,000 = 56,00, = 56 ACP = 21 days For Company B: ACP ACP 360 6,30,000 = 82,00, = 82 ACP = 27 days 5. Average Payabe Period (APP): APP For Company A: 360 Average creditors = Credit purchases 360 9,00,000 APP = 40,00, ACP = 4 APP = 81 days For Company B: ,50,000 APP = 64,80, APP = 648 APP = 58 days 6. Stock hoding period: Stock hoding period 360 Average stock = COGS

21 128 Accounting and Financia Management for I.T. Professionas For Company A: Stock hoding period ,30,000 = 40,00, Stock hoding period = 40 Stock hoding period = 110 days For Company B: Stock hoding period 360 9,50,000 = 64,80,000 Stock hoding period = 648 Stock hoding period = 53 days 4.8 ADVANTAGES OF RATIO ANALYSIS Financia Heath: Ratio anaysis heps in anayzing financia heath of the concerned organization from different interested groups (Suppiers, Lenders, Empoyees, Management, Government and Investors) point of view. Panning and Forecasting: Ratio anaysis over a period of time for concerned organization heps the management in panning and forecasting future activities. Corrective Measures: Ratio anaysis heps in identifying strength and weaknesses of the concerned organization. It aso heps in identifying causes for weakness and thus heps in taking corrective action in time. Decision Making: Ratio anaysis heps in improving operationa efficiency of the concerned organization. Usefuness: Ratio anaysis is the simpest too for fundamenta anaysis, which is of great hep to Investors. Furthermore, information expressed in financia statements and presented through ratio anaysis is easiy understandabe and hence more usefu for a those having interest in the organization. 4.9 LIMITATIONS OF RATIO ANALYSIS Reiabiity: The accuracy of ratio anaysis depends upon the accuracy of data used for ratio anaysis. Since for the purpose of ratio anaysis, data is taken from financia statements viz. income statement and baance sheet, and most of the time financia statements get manipuated, carefu interpretation of ratio anaysis after thorough investigation is required. Comparative measure: Ratio anaysis depicts ony comparative picture of financia heath of the concerned organization. It does not give absoute measure of financia heath. Distorted resut: Inter-firm comparison on the basis of ratio anaysis may be miseading because of different practices foowed by different firms in respect of inventory vauation, cost of investments etc. Externa factor: Price eve changes make ratio anaysis difficut.

22 Ratio Anaysis 129 Exercises Q. 1. State whether the foowing statements are true or fase : (a) A ratio is a quotient. (b) Liquidity ratios indicate financia soundness of a company. (c) Gross profit margin covers administrative and seing expenses. (d) Debt ratios have no impications in overa capita structure of the company. (e) Earning per share shows turnover ratio. Q. 2. State whether foowing transactions wi resut in decine, improvement or have no effect on current ratios. (a) Payment of a current iabiity. (b) Purchase of fixed assets in cash. (c) Cash coected form debtors. (d) Issue of new shares. (e) Se 15% debenture. Q. 3. Give the formua for cacuating the foowing ratios: (a) Current ratio (b) Acid test ratio (c) Debt equity ratio (d) Inventory turnover ratio (e) Gross profit margin (f) Earning per share (g) Return on investment. Q. 4. Describe three iquidity ratios. Q. 5. Discuss the important turnover ratios. Q. 6. Which ratios are used to evauate financia structure of the company? Discuss. Q. 7. A firm s current assets and current iabiities are Rs. 600 and 1,500 respectivey. How much can the firm borrow from the bank without reducing the current ratio beow 1:5? Q. 8. A company s net profit margin is 5%, tota assets turnover ratio is 1.5 times, debt to tota assets ratio is 0.7. What is the return for the company? Q. 9. Which of the foowing ratios are more ikey to be of interest to the short-term creditors and why? (a) Inventory turnover. (b) Debt to equity ratio. Q. 10. Expain the foowing financia ratios (a) Acid test ratio (b) Debt equity ratio (c) Stock turnover ratio Q. 11. Which financia ratios are most ikey to be consuted by you if you identify oursef with the foowing position and why? (a) Equity investor (b) Long term ender (c) Trade creditors

23 130 Accounting and Financia Management for I.T. Professionas Q. 12. The higher the rate of return on investment, the better the corporate management. Is this statement true for a companies? Expain. Q. 13. (a) A firm s saes are Rs. 4,50,000, cost of goods sod is Rs. 2,40,000 and inventory is Rs. 90,000. What is Stock turnover? Aso cacuate the gross margins. (b) The ony current assets possessed by a firm are cash Rs. 1,05,000, inventories Rs. 5,60,000 and debtors Rs. 4,20,000. If the current ratio for the firm is 2 to 1, determine its current iabiities. Aso, cacuate the firm s quick ratio. Q. 14. What ratio woud you use to measure profitabiity of a company? Q. 15. Discuss the significance and imitations of ratios as toos for decision-making? Q. 16. Write a short note on the merit and demerit of ratio anaysis. Q. 17. What is the difference between current and acid test ratios? Q. 18. If a company has saes of Rs. 2,00,000 and average accounts receivabe of Rs. 40,000, what are its accounts receivabe turnover ratio and average coection period? Q. 19. A company has saes of Rs. 7,50,000, cost of goods sod of Rs. 4,00,000 and inventory of Rs. 1,50,000. What is its inventory turnover ratio? Q. 20. A company s request for a ine of credit at a bank was turned down. The bank said company s 2:1 current ratio was not adequate. Give reasons why a 2:1 current ratio was found inadequate. Q. 21. A company has a gross profit margin of 10% and asset turnover of 3. What is its ROI? Q. 22. A company has current iabiities of Rs. 2,00,000, mortgage of Rs. 3,00,000 and bonds of Rs. 5,00,000. Its tota equity is Rs. 1,50,000. What is its debt equity ratio? Q. 23. A company has net income after tax of Rs. 4,00,000 and pays cash dividend of Rs. 2,40,000 on its Rs. 2,00,000 shares when the stock is seing for Rs. 20. What is the dividend yied and dividend payout ratio of the company. Q. 24. The tota saes of a firm are Rs. 4,00,000 and it has a gross profit margin of 20 percent. If the company has an average inventory of Rs. 50,000, determine the inventory turnover. Q. 25. A company has an inventory of Rs. 18,00,000, debtors of Rs. 1,15000 and an inventory turnover of 6. The gross profit margin of the company is 10 percent and its credit saes are 20 percent of tota saes. Cacuate the average coection period (assume a 360 day year). Q. 26. A company has sharehoders equity of Rs. 2,00,000. Tota assets are 160 percent of the sharehoders equity whie the assets turnover is 4. If the company has an inventory turnover of 5, determine the amount of inventory. Q. 27. A firm has cost of Rs. 2,00,000, saes of Rs. 2,50,000 and asset turnover of 4. What is the rate of return on asset? Q. 28. A firm has profit before interest and taxes of Rs. 30,000, tota assets of Rs. 5,00,000 and tota iabiities Rs. 3,00,000. What is its (1) return of equity (2) interest coverage? Q. 29. Determine the P/E ratio of a firm that has a net profit after taxes of Rs. 1,50,000 and 30,000 outstanding shares seing at a market price of Rs. 10 per share. What rate of return do share hoders expect? Q. 30. A company has a net profit after taxes of Rs. 1,20,000 and pays a cash dividend of Rs. 48,000 on it and 36,000 outstanding shares when the share is seing for Rs. 12. What is the yied and dividend payout?

24 Q. 31. The XYZ company financia statement contain the foowing information. Previous Year (Rs) Ratio Anaysis 131 Current Year (Rs) Cash 2,00,000 1,60,000 Sundry Debtors 3,20,000 4,00,000 Temporary Investment 2,00,000 3,20,000 Stock 18,40,000 21,60,000 Prepaid Expenses 28,000 12,000 Tota Current Asset 25,88,000 30,25,000 Tota Asset 56,00,000 64,00,000 Current Liabiities 6,40,000 8,00,000 10% Debentures 16,00,000 16,00,000 Equity Share Capita 20,00,000 20,00,000 Retained Capita 4,68,000 8,12,000 Statement of profit for the year ended June 30, current year Rs. Saes 40,00,000 Less cost of goods sod 28,00,000 Less interest 1,60,000 Net profit for current year 10,40,000 Less 50% 5,20,000 Earning after taxes 5,20,000 Dividends decared on Equity shares 2,20,000 From the above appraise the financia position of the company from the point of view 1. Liquidity 2. Sovency 3. Profitabiity 4. Activity Q. 32. You have been suppied data for the Roya Pastic Company Ltd. Indicate the company s strengths and weakness in terms of iquidity, sovency and profitabiity as reveaed by your anaysis. Baance Sheet Dec. 31 Current year Liabiities Rs. Assets Rs. Equity share capita 1,00,000 Pant and equipment 1,51,000 10% preferences share capita 40,000 Cash 12,300 Retained earnings 27,400 Debtors 36,000 Contd...

25 132 Accounting and Financia Management for I.T. Professionas Liabiities Rs. Assets Rs. Long term debts 34,000 Stock 60,800 Sundry creditors 31,500 Outstanding expenses 1,200 Other current iabiities 26,000 2,60,100 2,60,100 Statement of Profit for the year ending December 31 Rs. Rs. Saes net 2,25,000 Less cost of goods sod 52,500 Seing expensed 29,500 Administrative expensed 14,800 Research & deveopment 65,00 Interest 2,900 2,06,200 Earnings before tax 18,800 Less income taxes 9,400 Net income 9,400 Dividends paid to equity hoders 5000 Q. 33. From the foowing information of a textie company compete the proforma baance sheet if its saes are Rs. 32,00,000 Saes to net worth Current debt to net worth 42% Tota debt to net worth 75% Current ratio Net saes to inventory Average coection period 2.3 times 2.9 times 4.7 times 64 days Fixed asset to net worth 53% Proforma Baance Sheet Net worth? Fixed asset? Long term debt? Cash? Current debt? Stock? Sundry debtors?

26 Ratio Anaysis 133 Q. 34. The foowing is the summary of the financia ratios of a company reating to its iquidity position. Year 1 Year 2 Year 3 Current ratio Acid test ratio Debtors turnover Stock turnover The current ratio is increasing whie is acid test ratio is decreasing. Expain the contributing factors for this apparenty divergent trend.