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RATIO ANALYSIS
CA. Dhruv Sethds@sethspro.com
MEANING OF RATIO ANALYSIS
It is an analysis of strength and weakness of an organization by establishing the quantitative relation among the items of Balance Sheet or Income Statement of such an organization
PURPOSE/IMPORTANCE/ADVANTAGES
Analysis of financial Position
Simplification of Accounting Figures
Assessment of Operational Efficiency
Determining Trends in the long-run
Identification of Strength & Weakness
Taking Remedial Measures
Comparison of Performance
LIMITATIONS OF RATIO ANALYSIS
Based on Historical Data
Change in Real Value of Monetary Unit
No Standard Interpretation
Ignoring Qualitative Aspects
Difference in Accounting Methods make
comparison difficult
Ambiguity in Terms Used
CLASSIFICATION OF RATIOSLiquidity Ratios – Ability to Pay
Solvency Ratios – Loans to Capital
Activity Ratios – Conversion of Stock to cash
Profitability Ratios – Profit to sales
Shareholders' Ratios - Enable decision making
A. LIQUIDITY RATIOS Used for
Study the ability of the organization in meeting short-term payments or obligations
Includes: 1) Current Ratio 2) Acid Test Ratio 3) Working Capital Turnover Ratio
MEASUREMENT OF CURRENT RATIO
Current Assets
Current Ratio = -------------------------------
Current Liabilities
Current Assets – Recoverable within 12 months from reporting date
Current Liabilities – Payable within 12 months from reporting date
CURRENT RATIO Relation between current assets and
current liabilities
Long Term Sources Financing the Current assets give a stable base for the liquidity of the organisation
Normally , the ratio should not be less than 2 i.e., the current assets should be double the size of current liabilities
WHICH BALANCE SHEET IS BETTER ?
Particulars ABC Ltd XYZ Ltd
Fixed Assets 10.00 20.00
Inventory 20.00 25.00
Sundry Debtors 35.00 60.00
Cash and Bank 15.00 25.00
Deferred Revenue Expenditure 50.00 0.00
ASSETS TOTAL 130.00 130.00
Share Capital 70.00 60.00
Long Term Loans 40.00 30.00
Current Liabilities 20.00 40.00
LIABILITIES TOTAL 130.00 130.00
ACID TEST RATIO/QUICK RATIO It is the ratio between quick assets and
quick liabilities Quick assets include current assets
except inventory and pre-paid expenses
Quick liabilities include current liabilities other than bank overdraft
MEASUREMENT OF ACID TEST RATIO
Quick AssetsAcid Test Ratio = ----------------------
Quick Liabilities
A 1:1 ratio is healthy Healthy indicator of cash management
WHICH BALANCE SHEET IS BETTER ?
Particulars ABC Ltd XYZ Ltd
Fixed Assets 20.00 20.00
Inventory 30.00 25.00
Sundry Debtors 55.00 60.00
Cash and Bank 15.00 25.00
Deferred Revenue Expenditure 10.00 0.00
ASSETS TOTAL 130.00 130.00
Share Capital 50.00 60.00
Long Term Loans 20.00 30.00
Current Liabilities 60.00 40.00
LIABILITIES TOTAL 130.00 130.00
WORKING CAPITAL TURN-OVER RATIO
Shows the efficiency of usage of working capital
Relation between Sales and Working Capital
Determination of number of times the working capital is turned over to achieve the maximum profit
MEASUREMENT OF WORKING CAPITAL TURNOVER RATIO
Turnover
WCT = ----------------------Average Working Capital
Average working capital = Opening Working capital plus closing working capital divided by two
SOLVENCY RATIOS Measure long-term liquidity ratio
Reflect the ability of the firm to pay interest and repayment of loans at due dates on the long-term loans taken
Avoidance of over-borrowing (over-leverage)
Avoidance of bankruptcy by maintaining healthy solvency ratios
TYPES OF SOLVENCY RATIOS
1) Interest Coverage Ratio2) Debt Ratio3) Debt-Equity Ratio4) Proprietary Ratio
INTEREST COVERAGE RATIO EBIT
Interest Coverage = ------------------
Interest
Acts as a cushion to the lenders with regard to the availability of profit to serve the interest.
Ideal Ratio is 1.5
DEBT TO TOTAL FUNDTotal Debt
Debt to total fund = ------------------
Debt + Equity
AND
Total DebtDebt Equity Ratio = ------------------
Total Equity
PROPRIETARY RATIO Equity
Proprietary Ratio = ------------------
Total Assets
High Ratio = Comfort for creditors / Highlights under utilization of capital
Low Ratio = Over Leveraged / High utilization of capital
WHICH BALANCE SHEET IS BETTER ?Particulars ABC Ltd XYZ Ltd
Earning Before Interest and Tax 45.00 40.00
Interest 8.00 8.00
Tax 18.00 17.00
Net Profit 19.00 15.00
Balance Sheet Liabilities side
Share Capital 50.00 60.00
Long Term Loans 20.00 30.00
Current Liabilities 60.00 40.00
LIABILITIES TOTAL 130.00 130.00
Industry Average Debt Equity 0.60 0.60
ACTIVITY RATIOS1) Inventory Turnover Ratio2) Debtors Turnover Ratio3) Average Collection Period4) Fixed Assets Turnover Ratio5) Total Assets Turnover Ratio
INVENTORY TURNOVER RATIO Sales
Inventory Turnover = ------------------
Inventory
Low turnover = bad products Extreme High Turnover = Cases of
fraudulent sales possible
DEBTORS TURNOVER RATIO Sales
Debtors Turnover = -----------------------
Average Debtors
High turnover = Better realization Low Turnover = Cases of fraudulent sales
AVERAGE COLLECTION PERIOD365 days
ACP = -----------------------
Debtors Turnover
Approximate time for a business to receive payments from debtors
High turnover = Better realization Low Turnover = Slow realization
WHICH BALANCE SHEET IS BETTER ?Particulars ABC Ltd XYZ Ltd
Sales 150.00 200.00
Expenses 100.00 140.00
Net Profit 35.00 40.00
Balance Sheet Assets side
Fixed Assets 200.00 300.00
Cash and Bank Balances 50.00 60.00
Inventories 80.00 100.00
Sundry Debtors 75.00 120.00
Assets TOTAL 405.00 580.00
Industry Avg Inventory turnover 2.00 2.00
Industry Avg Debtors recovery 150 days 150 days
PROFITABILITY RATIOS 1) Net Profit Ratio
2) Gross Profit Ratio
3) Return on Total Assets
4) Return on Equity
NET PROFIT RATIO NP after tax
Net Profit Ratio = -----------------------
Net Turnover
Interpretation Against Industry average Against previous years
NET PROFIT RATIO Gross Profit
Gross Profit Ratio = -----------------------
Net Turnover
Interpretation Against Industry average Against previous years
RETURN ON TOTAL ASSETSEBIT
ROTA = -----------------------
Total Net Assets
Interpretation Higher Number = Better Realization Lower Lumber = Less Utilization of assets
RETURN ON NET EQUITY
Net ProfitEquity Return = ---------------------------
Shareholders Equity
FIND THE ANOMALY Particulars 2014 2013
Sales 150.00 160.00
Purchases 60.00 55.00
Interest Paid 12.00 15.00
Staff Salary 50.00 48.00
Administrative Expenses 20.00 22.00
Bad Debts 10.00 12.00
Staff Welfare 3.00 9.00
Electricity 6.00 7.00
Opening Stock 35.00 50.00
Closing Stock 55.00 35.00
Debtors 30.00 80.00
ANALYZE THE BALANCE SHEETSParticulars 2014 2013
Shareholders Equity 150.00 160.00
Reserves and Surplus 100.00 90.00
Unsecured Loans 70.00 80.00
Current Liabilities 80.00 90.00
LIABILITIES TOTAL 400.00 420.00
Fixed Assets 200.00 220.00
Inventories 50.00 50.00
Sundry Debtors 120.00 130.00
Cash and Bank 30.00 20.00
ASSETS TOTAL 400.00 420.00
Sales 150.00 160.00
FIND THE ANOMALY Particulars 2014 2013
Sales 175.00 185.00
Purchases 85.00 95.00
Interest Paid 15.00 17.00
Staff Salary 30.00 31.00
Administrative Expenses 30.00 29.00
Staff Welfare 7.00 9.00
Electricity 8.00 4.00
Opening Stock 45.00 50.00
Debtors 30.00 80.00
Closing Stock 55.00 35.00
Gross Profit %age 20.00% 27.00%
THANK YOU