10. RATIO ANALYSIS
Mere statistics/data presented in the different financial statements do not
reveal the true picture of a financial position of a firm. Properly analyzed and
interpreted financial statements can provide valuable insights into a firm’s
performance. To extract the information from the financial statements, a
number of tools are used to analyse such statements. The most popular tool
is the Ratio Analysis.
Financial ratios can be broadly classified into three groups: (I) Liquidity
ratios, (II) Leverage/Capital structure ratio, and (III) Profitability ratios.
(I) Liquidity ratios:
Liquidity refers to the ability of a firm to meet its financial obligations in the
short-term which is less than a year. Certain ratios, which indicate the
liquidity of a firm, are (i) Current Ratio, (ii) Acid Test Ratio, (iii) Turnover
Ratios. It is based upon the relationship between current assets and current
liabilities.
(i) Current ratio =
Current Liabilitie s
Current Assets
.
.
The current ratio measures the ability of the firm to meet its current
liabilities from the current assets. Higher the current ratio, greater the
short-term solvency (i.e. larger is the amount of rupees available per rupee
of liability).
(ii) Acid-test Ratio =
Current Liabilitie s
Quick Assets
.
.
Quick assets are defined as current assets excluding inventories and prepaid
expenses. The acid-test ratio is a measurement of firm’s ability to convert
its current assets quickly into cash in order to meet its current liabilities.
Generally speaking 1:1 ratio is considered to be satisfactory.
86
(iii) Turnover Ratios:
Turnover ratios measure how quickly certain current assets are converted
into cash or how efficiently the assets are employed by a firm. The
important turnover ratios are:
Inventory Turnover Ratio, Debtors Turnover Ratio, Average Collection
Period, Fixed Assets Turnover and Total Assets Turnover
Inventory Turnover Ratio =
AverageInventory
CostofGoodsSold
Where, the cost of goods sold means sales minus gross profit. ‘Average
Inventory’ refers to simple average of opening and closing inventory. The
inventory turnover ratio tells the efficiency of inventory management.
Higher the ratio, more the efficient of inventory management.
Debtors’ Turnover Ratio =
AverageAccountsRe ceivable(Debtors)
NetCreditSales
The ratio shows how many times accounts receivable (debtors) turn over
during the year. If the figure for net credit sales is not available, then net
sales figure is to be used. Higher the debtors turnover, the greater the
efficiency of credit management.
Average Collection Period =
AverageDailyCreditSales
AverageDebtors
Average Collection Period represents the number of days’ worth credit sales
that is locked in debtors (accounts receivable).
Please note that the Average Collection Period and the Accounts Receivable
(Debtors) Turnover are related as follows:
Average Collection Period =
DebtorsTurnover
365 Days
87
Fixed Assets turnover ratio measures sales per rupee of investment in fixed
assets. In other words, how efficiently fixed assets are employed. Higher
ratio is preferred. It is calculated as follows:
Fixed Assets turnover ratio =
NetFixedAssets
Net.Sales
Total Assets turnover ratio measures how efficiently all types of assets are
employed.
Total Assets turnover ratio =
AverageTotalAssets
Net.Sales
(II) Leverage/Capital structure Ratios:
Long term financial strength or soundness of a firm is measured in terms of
its ability to pay interest regularly or repay principal on due dates or at the
time of maturity. Such long term solvency of a firm can be judged by using
leverage or capital structure ratios. Broadly there are two sets of ratios:
First, the ratios based on the relationship between borrowed funds and
owner’s capital which are computed from the balance sheet. Some such
ratios are: Debt to Equity and Debt to Asset ratios. The second set of ratios
which are calculated from Profit and Loss Account are: The interest coverage
ratio and debt service coverage ratio are coverage ratio to leverage risk.
(i) Debt-Equity ratio reflects relative contributions of creditors and owners to
finance the business.
Debt-Equity ratio =
Total Equity
Total Debt
The desirable/ideal proportion of the two components (high or low ratio)
varies from industry to industry.
(ii) Debt-Asset Ratio: Total debt comprises of long term debt plus current
liabilities. The total assets comprise of permanent capital plus current
liabilities.
Debt-Asset Ratio =
Total Assets
Total Debt
88
The second set or the coverage ratios measure the relationship between
proceeds from the operations of the firm and the claims of outsiders.
(iii) Interest Coverage ratio =
Interest
Earnings Before Interest and Taxes
Higher the interest coverage ratio better is the firm’s ability to meet its
interest burden. The lenders use this ratio to assess debt servicing capacity
of a firm.
(iv) Debt Service Coverage Ratio (DSCR) is a more comprehensive and apt
to compute debt service capacity of a firm. Financial institutions calculate
the average DSCR for the period during which the term loan for the project
is repayable. The Debt Service Coverage Ratio is defined as follows:
Interest onTerm loan payment of term loan
ofit after tax Depreciation OtherNoncashExpenditure Interest on term loan
Re
Pr . . . . .
+
+ + +
(III) Profitability ratios:
Profitability and operating/management efficiency of a firm is judged mainly
by the following profitability ratios:
(i) Gross Profit Ratio (%) =
Net Sales
Gross Profit
* 100
(ii) Net Profit Ratio (%) =
Net Sales
Net Profit
* 100
Some of the profitability ratios related to investments are:
(iii) Return on Total Assets =
FixedAssets CurrentAssets
ofit Before Interest And Tax
+
Pr . . . .
(iv) Return on Capital Employed =
TotalCapital Employed
Net ProfitAfterTax
(Here, Total Capital Employed = Total Fixed Assets + Current Assets -
Current Liabilities)
89
(v) Return on Shareholders’ Equity
=
AverageTotal Shareholders Equity or NetWorth
Net ofit AfterTax
'
Pr
(Net worth includes Shareholders’ equity capital plus reserves and surplus)
A common (equity) shareholder has only a residual claim on profits and
assets of a firm, i.e., only after claims of creditors and preference
shareholders are fully met, the equity shareholders receive a distribution of
profits or assets on liquidation. A measure of his well being is reflected by
return on equity. There are several other measures to calculate return on
shareholders’ equity of which the following are the stock market related
ratios:
(i) Earnings Per Share (EPS): EPS measures the profit available to the equity
shareholders per share, that is, the amount that they can get on every share
held. It is calculated by dividing the profits available to the shareholders by
number of outstanding shares. The profits available to the ordinary
shareholders are arrived at as net profits after taxes minus preference
dividend.
It indicates the value of equity in the market.
EPS =
Numberof Ordinary Shares Outs ding
Net ofit AvailableToThe Shareholder
tan
Pr . . . .
(ii) Price-earnings ratios = P/E Ratio =
EPS
Market Pr ice per Share
90
Illustration:
Balance Sheet of ABC Co. Ltd. as on March 31, 2005
(Rs. in Crore)
Liabilities Amount Assets Amount
Share Capital 16.00 Fixed Assets (net) 60.00
(1,00,00,000 equity shares
of Rs.10 each)
Reserves & Surplus 22.00 Current Assets: 23.40
Secured Loans 21.
Mere statistics/data presented in the different financial statements do not
reveal the true picture of a financial position of a firm. Properly analyzed and
interpreted financial statements can provide valuable insights into a firm’s
performance. To extract the information from the financial statements, a
number of tools are used to analyse such statements. The most popular tool
is the Ratio Analysis.
Financial ratios can be broadly classified into three groups: (I) Liquidity
ratios, (II) Leverage/Capital structure ratio, and (III) Profitability ratios.
(I) Liquidity ratios:
Liquidity refers to the ability of a firm to meet its financial obligations in the
short-term which is less than a year. Certain ratios, which indicate the
liquidity of a firm, are (i) Current Ratio, (ii) Acid Test Ratio, (iii) Turnover
Ratios. It is based upon the relationship between current assets and current
liabilities.
(i) Current ratio =
Current Liabilitie s
Current Assets
.
.
The current ratio measures the ability of the firm to meet its current
liabilities from the current assets. Higher the current ratio, greater the
short-term solvency (i.e. larger is the amount of rupees available per rupee
of liability).
(ii) Acid-test Ratio =
Current Liabilitie s
Quick Assets
.
.
Quick assets are defined as current assets excluding inventories and prepaid
expenses. The acid-test ratio is a measurement of firm’s ability to convert
its current assets quickly into cash in order to meet its current liabilities.
Generally speaking 1:1 ratio is considered to be satisfactory.
86
(iii) Turnover Ratios:
Turnover ratios measure how quickly certain current assets are converted
into cash or how efficiently the assets are employed by a firm. The
important turnover ratios are:
Inventory Turnover Ratio, Debtors Turnover Ratio, Average Collection
Period, Fixed Assets Turnover and Total Assets Turnover
Inventory Turnover Ratio =
AverageInventory
CostofGoodsSold
Where, the cost of goods sold means sales minus gross profit. ‘Average
Inventory’ refers to simple average of opening and closing inventory. The
inventory turnover ratio tells the efficiency of inventory management.
Higher the ratio, more the efficient of inventory management.
Debtors’ Turnover Ratio =
AverageAccountsRe ceivable(Debtors)
NetCreditSales
The ratio shows how many times accounts receivable (debtors) turn over
during the year. If the figure for net credit sales is not available, then net
sales figure is to be used. Higher the debtors turnover, the greater the
efficiency of credit management.
Average Collection Period =
AverageDailyCreditSales
AverageDebtors
Average Collection Period represents the number of days’ worth credit sales
that is locked in debtors (accounts receivable).
Please note that the Average Collection Period and the Accounts Receivable
(Debtors) Turnover are related as follows:
Average Collection Period =
DebtorsTurnover
365 Days
87
Fixed Assets turnover ratio measures sales per rupee of investment in fixed
assets. In other words, how efficiently fixed assets are employed. Higher
ratio is preferred. It is calculated as follows:
Fixed Assets turnover ratio =
NetFixedAssets
Net.Sales
Total Assets turnover ratio measures how efficiently all types of assets are
employed.
Total Assets turnover ratio =
AverageTotalAssets
Net.Sales
(II) Leverage/Capital structure Ratios:
Long term financial strength or soundness of a firm is measured in terms of
its ability to pay interest regularly or repay principal on due dates or at the
time of maturity. Such long term solvency of a firm can be judged by using
leverage or capital structure ratios. Broadly there are two sets of ratios:
First, the ratios based on the relationship between borrowed funds and
owner’s capital which are computed from the balance sheet. Some such
ratios are: Debt to Equity and Debt to Asset ratios. The second set of ratios
which are calculated from Profit and Loss Account are: The interest coverage
ratio and debt service coverage ratio are coverage ratio to leverage risk.
(i) Debt-Equity ratio reflects relative contributions of creditors and owners to
finance the business.
Debt-Equity ratio =
Total Equity
Total Debt
The desirable/ideal proportion of the two components (high or low ratio)
varies from industry to industry.
(ii) Debt-Asset Ratio: Total debt comprises of long term debt plus current
liabilities. The total assets comprise of permanent capital plus current
liabilities.
Debt-Asset Ratio =
Total Assets
Total Debt
88
The second set or the coverage ratios measure the relationship between
proceeds from the operations of the firm and the claims of outsiders.
(iii) Interest Coverage ratio =
Interest
Earnings Before Interest and Taxes
Higher the interest coverage ratio better is the firm’s ability to meet its
interest burden. The lenders use this ratio to assess debt servicing capacity
of a firm.
(iv) Debt Service Coverage Ratio (DSCR) is a more comprehensive and apt
to compute debt service capacity of a firm. Financial institutions calculate
the average DSCR for the period during which the term loan for the project
is repayable. The Debt Service Coverage Ratio is defined as follows:
Interest onTerm loan payment of term loan
ofit after tax Depreciation OtherNoncashExpenditure Interest on term loan
Re
Pr . . . . .
+
+ + +
(III) Profitability ratios:
Profitability and operating/management efficiency of a firm is judged mainly
by the following profitability ratios:
(i) Gross Profit Ratio (%) =
Net Sales
Gross Profit
* 100
(ii) Net Profit Ratio (%) =
Net Sales
Net Profit
* 100
Some of the profitability ratios related to investments are:
(iii) Return on Total Assets =
FixedAssets CurrentAssets
ofit Before Interest And Tax
+
Pr . . . .
(iv) Return on Capital Employed =
TotalCapital Employed
Net ProfitAfterTax
(Here, Total Capital Employed = Total Fixed Assets + Current Assets -
Current Liabilities)
89
(v) Return on Shareholders’ Equity
=
AverageTotal Shareholders Equity or NetWorth
Net ofit AfterTax
'
Pr
(Net worth includes Shareholders’ equity capital plus reserves and surplus)
A common (equity) shareholder has only a residual claim on profits and
assets of a firm, i.e., only after claims of creditors and preference
shareholders are fully met, the equity shareholders receive a distribution of
profits or assets on liquidation. A measure of his well being is reflected by
return on equity. There are several other measures to calculate return on
shareholders’ equity of which the following are the stock market related
ratios:
(i) Earnings Per Share (EPS): EPS measures the profit available to the equity
shareholders per share, that is, the amount that they can get on every share
held. It is calculated by dividing the profits available to the shareholders by
number of outstanding shares. The profits available to the ordinary
shareholders are arrived at as net profits after taxes minus preference
dividend.
It indicates the value of equity in the market.
EPS =
Numberof Ordinary Shares Outs ding
Net ofit AvailableToThe Shareholder
tan
Pr . . . .
(ii) Price-earnings ratios = P/E Ratio =
EPS
Market Pr ice per Share
90
Illustration:
Balance Sheet of ABC Co. Ltd. as on March 31, 2005
(Rs. in Crore)
Liabilities Amount Assets Amount
Share Capital 16.00 Fixed Assets (net) 60.00
(1,00,00,000 equity shares
of Rs.10 each)
Reserves & Surplus 22.00 Current Assets: 23.40
Secured Loans 21.