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Ratio analysis
Meaning of ratios – It’s a relationshipbetween two variables, which are
interrelated. e.g. Height and weight todiagnose the financial strength andweakness of a company
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On the basis of statement
Balance sheet ratios-it sets the relationship between the items given in balancesheet e.g. Debt equity ratio ,
P/L a/c ratios. – relationship betweenitems of P/L a/c e.g. NP ratio, GP ratio
Combined ratios –relationship betweenone item of balance sheet and one item ofP/L a/c. e.g. debtors turnover ratio, etc.
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Benefits of ratios
To help in decision making
ControlFinding out the trend in the industry
To know the competitive position
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Limitations With Ratio Analysis
Ignore price level changes
Ignore , nature , establishment year , etc for
comparison .
Single ratios are not useful, it needs to be comparedi.e. intra firm and inter firm
Limitation of accounting data –
it is dependent onthe data provided in financial statements and therewindow dressing is possible
Ignore qualitative factors
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1. Liquidity/ short term solvency – the ability of the
firm to pay its way2. Investment/shareholders – information to enable
decisions to be made on the extent of the riskand the earning potential of a businessinvestment
3. Gearing/ long term solvency – information on therelationship between the exposure of thebusiness to loans as opposed to share capital
4. Profitability – how effective the firm is atgenerating profits given sales and or its capital
assets5. Turnover /Financial/Activity – the rate at which
the company sells its stock and the efficiencywith which it uses its assets
5 major types / categories are---
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Liquidity
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13 - 7Current Ratio
Current ratio looks at the liquidity of the business
Looks at the ratio between Current Assets and CurrentLiabilities
Current Ratio = Current Assets : Current Liabilities
Ideal level –
approx 1.5 : 1 or 2:1
Need enough current assets to cover current liabilities
If its too high means too many current assets e.g. might
have too much stock, could use the money tied up incurrent assets more effectively
If its too low you run the risk of not being able to meetcurrent liabilities and you could have liquidity problems
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Acid Test
Acid test ratio is another way of looking at liquidity
It has been argued that stock takes a while to convert to cash so a
more realistic ratio would ignore stock (Current assets – stock) : liabilities
1:1 seen as ideal
Again if it is too high means that the business is very liquid – may beable to use the cash for other activities to increase performance
If it is too low then the business may face working capital problems
Some types of business need more cash than others so acid testwould be expected to be higher
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Absolute liquid ratio
It is represented by cash and near cash items
This ratio is –
Cash+bank+marketeable securities liquidliabilities
Ideal ratio is .50 :1
Liquid liabilities mean current liabilities –bank OD
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Gearing
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Gearing
This is an efficiency ratio
Looks at the relationship between borrowing and
fixed assets
Gearing Ratio = Long term loans (fixed chargesbearing funds)/ Capital employed (net Asset ) x 100
The higher it is the greater the risk the business isunder if interest rates increase
Net asset = total asset –current liability
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13 - 12 Debt equity ratio-
Long term debts /long term funds (borrowed and ownedfunds)
Or
Long term debts/ Eq.shareholders fund
Ideal ratio is 1:2
Proprietary ratio-
Proprietors fund /total tangible assets
Higher is the ratio , higher is the solvency
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Profitability
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Profitability
Profitability measures look at how much profit thefirm generates
Profit is the number one objective of most firms Different measures of profit – gross and net
Gross profit –total revenue – variable costs (cost
of sales)Net Profit – Gross profit – overheads
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Profitability
Gross profit looks at how much of the sales revenue isconverted into profit
Gross Profit Margin = Gross profit / turnover x 100 The higher the better
Allows the firm to assess the impact of its sales and
how much it cost to generate (produce) those sales A gross profit margin of 35% means that for every 1
of sales, the firm makes 35p in gross profit
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Profitability
Net profit looks at how much of the salesrevenue is left as net profit
Net Profit Margin = Net Profit / Turnover x 100
Net profit is more important than gross profit for a business as all costs are included
A business would like to see that this ratio hasimproved over time
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Profitability
Another profitability ratio –
looks at operatingprofit and capital employed by the business
Return on Capital Employed (ROCE) = Profit /
capital employed x 100
Need to compare to previous years andcompetitors to get a clear picture
Can improve this by increasing profitswithout increasing fixed assets / capital
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Financial
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Asset Turnover ratio
Looks at a businesses sales compared to the assets used togenerate the sales
Asset turnover = sales (turnover) / net assets
Net assets = Total assets
–
current liabilities The value will vary with the type of business:
Businesses with a high value of assets who have few sales
will have a low asset turnover ratioIf a business has a high sales and a low value of assets it
will have a high asset turnover ratio
Businesses can improve this by either increasing salesperformance or getting rid of any additional assets
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13 - 20Stock turnover ratio
Another efficiency ratio
Looks at how efficiently a company convertsstock to sales
Stock turnover ratio = cost of sales (COGS)/avg. stock or Net sales /avg. inventory
High stock turnover means increased efficiency
However it depends on the type of business
Low stock turnover could mean poor customer satisfaction as people might not be
buying the stock
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Debtors turnover ratio
Credit sales/ avg. debtors
High ratio mean quick conversion of
debtor into cash
Low means liberal policy
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Debtors collection period
This is another efficiency ratio This looks at how long it takes for the business to
get back money it is owed
Debtors collection ratio = Avg. debtors x 365 /turnover (credit sales )
The lower the figure the better as get cash morequickly
However sometimes need to offer credit terms tocustomers so this may increase it
Need to ensure keep track of any changes in credit
terms as these should impact this ratio
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Creditors turnover ratio
Net credit purchase / Avg. Accountspayable (cres.)
It signifies the credit period allowedby vendors / suppliers
High means frequent payment (less
interval )..low means (high interval )
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Creditors payment period
Avg. creditors x 365/net creditpurchases
It signifies the time period .
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Investments/ shareholders
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13 - 26Investment/Shareholders
Shareholders are interested in the following ratios:
Dividends per share –
total dividends / number of sharesissued
A higher figure means the shareholder got a larger return
Good to compare with competitors
Businesses can improve this themselves by increasing dividendpayments
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13 - 27 Besides following are the other ratios -
Earning per share (EPS) –
EAITD/No. of equity share
Higher is the ratio , higher is the return
Price earning ratio –
Market price per Equity share /EPS
A high ratio is preferred
dividend payout ratio –
Div per share/ Earning per share
A high DP ratio is always better
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Some other ratios
Expenses ratio=expenses(factory/admin/selling/particular)/net
salesOperating ratio=total operating cost
x100/sales
Interest coverage ratio =EBIT/interest
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