RATIO ANALYSIS

1
RATIO ANALYSIS

• R K MOHANTY
• FACULTY MEMBER, SIR SPBT COLLEGE,
• CENTRAL BANK OF INDIA, MUMBAI

2
RATIO ANALYSIS
Ratio-analysis is a concept or technique which
is as old as accounting concept. Financial
analysis is a scientific tool. It has assumed
important role as a tool for appraising the real
worth of an enterprise, its performance during a
period of time and its pit falls. Financial
analysis is a vital apparatus for the
interpretation of financial statements. It also
helps to find out any cross-sectional and time
series linkages between various ratios.
3
RATIO ANALYSIS
Unlike in the past when security was considered
to be sufficient consideration for banks and
financial institutions to grant loans and
advances, nowadays the entire lending is
need-based and the emphasis is on the financial
viability of a proposal and not only on security
alone. Further all business decision contains an
element of risk. The risk is more in the case of
decisions relating to credits. Ratio analysis and
other quantitative techniques facilitate
assessment of this risk.
4
RATIO ANALYSIS
Ratio-analysis means the process of computing,
determining and presenting the relationship of
related items and groups of items of the
financial statements. They provide in a
summarized and concise form of fairly good idea
about the financial position of a unit. They are
important tools for financial analysis.
5
WHY FINANCIAL ANALYSIS

• Lenders need it for carrying out the following
• Technical Appraisal
• Commercial Appraisal
• Financial Appraisal
• Economic Appraisal
• Management Appraisal

6
Ratio Analysis

• Its a tool which enables the banker or lender to
  arrive at the following factors
• Liquidity position
• Profitability
• Solvency
• Financial Stability
• Quality of the Management
• Safety Security of the loans advances to be
  or already been provided

7

• Before looking at the ratios there are a number
  of cautionary points concerning their use that
  need to be identified
• The dates and duration of the financial
  statements being compared should be the same. If
  not, the effects of seasonality may cause
  erroneous conclusions to be drawn.
• The accounts to be compared should have been
  prepared on the same bases. Different treatment
  of stocks or depreciations or asset valuations
  will distort the results.
• In order to judge the overall performance of the
  firm a group of ratios, as opposed to just one or
  two should be used. In order to identify trends
  at least three years of ratios are normally
  required.

8

• The utility of ratio analysis will get further
  enhanced if following comparison is possible.
• Between the borrower and its competitor
• Between the borrower and the best enterprise in
  the industry
• Between the borrower and the average performance
  in the industry
• Between the borrower and the global average

9
How a Ratio is expressed?

• As Percentage - such as 25 or 50 . For
  example if net profit is Rs.25,000/- and the
  sales is Rs.1,00,000/- then the net profit can be
  said to be 25 of the sales.
• As Proportion - The above figures may be
  expressed in terms of the relationship between
  net profit to sales as 1 4.
• As Pure Number /Times - The same can also be
  expressed in an alternatively way such as the
  sale is 4 times of the net profit or profit is
  1/4th of the sales.

10
Classification of Ratios
Balance Sheet Ratio PL Ratio or Income/Revenue Statement Ratio Balance Sheet and Profit Loss Ratio
Financial Ratio Operating Ratio Composite Ratio
Current Ratio Quick Asset Ratio Proprietary Ratio Debt Equity Ratio Gross Profit Ratio Operating Ratio Expense Ratio Net profit Ratio Stock Turnover Ratio Fixed Asset Turnover Ratio, Return on Total Resources Ratio, Return on Own Funds Ratio, Earning per Share Ratio, Debtors Turnover Ratio,
11
Format of balance sheet for ratio analysis
LIABILITIES ASSETS
NET WORTH/EQUITY/OWNED FUNDS Share Capital/Partners Capital/Paid up Capital/ Owners Funds Reserves ( General, Capital, Revaluation Other Reserves) Credit Balance in PL A/c FIXED ASSETS LAND BUILDING, PLANT MACHINERIES Original Value Less Depreciation Net Value or Book Value or Written down value
LONG TERM LIABILITIES/BORROWED FUNDS Term Loans (Banks Institutions) Debentures/Bonds, Unsecured Loans, Fixed Deposits, Other Long Term Liabilities NON CURRENT ASSETS Investments in quoted shares securities Old stocks or old/disputed book debts Long Term Security Deposits Other Misc. assets which are not current or fixed in nature
CURRENT LIABILTIES Bank Working Capital Limits such as CC/OD/Bills/Export Credit Sundry /Trade Creditors/Creditors/Bills Payable, Short duration loans or deposits Expenses payable provisions against various items CURRENT ASSETS Cash Bank Balance, Marketable/quoted Govt. or other securities, Book Debts/Sundry Debtors, Bills Receivables, Stocks inventory (RM,SIP,FG) Stores Spares, Advance Payment of Taxes, Prepaid expenses, Loans and Advances recoverable within 12 months
CURRENT LIABILTIES Bank Working Capital Limits such as CC/OD/Bills/Export Credit Sundry /Trade Creditors/Creditors/Bills Payable, Short duration loans or deposits Expenses payable provisions against various items INTANGIBLE ASSETS Patent, Goodwill, Debit balance in PL A/c, Preliminary or Preoperative expenses
12
Some important notes

• Liabilities have Credit balance and Assets have
  Debit balance
• Current Liabilities are those which have either
  become due for payment or shall fall due for
  payment within 12 months from the date of Balance
  Sheet
• Current Assets are those which undergo change in
  their shape/form within 12 months. These are also
  called Working Capital or Gross Working Capital
• Net Worth Long Term Liabilities are also called
  Long Term Sources of Funds
• Current Liabilities are known as Short Term
  Sources of Funds
• Long Term Liabilities Short Term Liabilities
  are also called Outside Liabilities
• Current Assets are Short Term Use of Funds

13
Some important notes

• Assets other than Current Assets are Long Term
  Use of Funds
• Installments of Term Loan Payable in 12 months
  are to be taken as Current Liability only for
  Calculation of Current Ratio Quick Ratio.
• If there is profit it shall become part of Net
  Worth under the head Reserves and if there is
  loss it will become part of Intangible Assets
• Investments in Govt. Securities to be treated
  current only if these are marketable and due.
  Investments in other securities are to be treated
  Current if they are quoted. Investments in
  allied/associate/sister units or firms to be
  treated as Non-current.
• Bonus Shares as issued by capitalization of
  General reserves and as such do not affect the
  Net Worth. With Rights Issue, change takes place
  in Net Worth and Current Ratio.

14

• Current Ratio It is the relationship between
  the current assets and current liabilities of a
  concern.
• Current Ratio Current Assets/Current
  Liabilities
• If the Current Assets and Current
  Liabilities of a concern are Rs.4,00,000 and
  Rs.2,00,000 respectively, then the Current Ratio
  will be Rs.4,00,000/Rs.2,00,000 2 1
• The ideal Current Ratio preferred by
  Banks is 1.33 1
• Net Working Capital This is worked out as
  surplus of Long Term Sources over Long Tern Uses,
  alternatively it is the difference of Current
  Assets and Current Liabilities.
• NWC Current Assets Current
  Liabilities

15

• Current Assets Raw Material, Stores, Spares,
  Work-in Progress. Finished Goods, Debtors, Bills
  Receivables, Cash.
• Current Liabilities Sundry Creditors,
  Installments of Term Loan, DPG etc. payable
  within one year and other liabilities payable
  within one year.
• This ratio must be at least 1.33 1 to ensure
  minimum margin of 25 of current assets as margin
  from long term sources.
• Current Ratio measures short term liquidity of
  the concern and its ability to meet its short
  term obligations within a time span of a year.
• It shows the liquidity position of the
  enterprise and its ability to meet current
  obligations in time.
• Higher ratio may be good from the point of view
  of creditors. In the long run very high current
  ratio may affect profitability ( e.g. high
  inventory carrying cost)
• Shows the liquidity at a particular point of
  time. The position can change immediately after
  that date. So trend of the current ratio over the
  years to be analyzed.
• Current Ratio is to be studied with the changes
  of NWC. It is also necessary to look at this
  ratio along with the Debt-Equity ratio.

16
3. ACID TEST or QUICK RATIO It is the ratio
between Quick Current Assets and Current
Liabilities. The should be at least equal to
1. Quick Current Assets Cash/Bank Balances
Receivables upto 6 months Quickly realizable
securities such as Govt. Securities or quickly
marketable/quoted shares and Bank Fixed
Deposits Acid Test or Quick Ratio Quick
Current Assets/Current Liabilities Example
Cash 50,000 Debtors
1,00,000 Inventories
1,50,000 Current Liabilities
1,00,000 Total Current Assets 3,00,000 Current
Ratio gt 3,00,000/1,00,000
3 1 Quick Ratio gt
1,50,000/1,00,000 1.5 1
17

• DEBT EQUITY RATIO It is the relationship
  between borrowers fund (Debt) and Owners
  Capital (Equity).
• Long Term Outside Liabilities / Tangible
  Net Worth
• Liabilities of Long Term Nature
• Total of Capital and Reserves Surplus Less
  Intangible Assets
• For instance, if the Firm is having the
  following
• Capital
  Rs. 200 Lacs
• Free Reserves Surplus Rs.
  300 Lacs
• Long Term Loans/Liabilities Rs. 800
  Lacs
• Debt Equity Ratio will be gt
  800/500 i.e. 1.6 1

18
5. PROPRIETARY RATIO This ratio indicates the
extent to which Tangible Assets are financed by
Owners Fund. Proprietary Ratio (Tangible Net
Worth/Total Tangible Assets) x 100 The
ratio will be 100 when there is no Borrowing for
purchasing of Assets. 6. GROSS PROFIT RATIO
By comparing Gross Profit percentage to Net Sales
we can arrive at the Gross Profit Ratio which
indicates the manufacturing efficiency as well as
the pricing policy of the concern. Gross
Profit Ratio (Gross Profit / Net Sales ) x
100 Alternatively , since Gross Profit
is equal to Sales minus Cost of Goods Sold, it
can also be interpreted as below
Gross Profit Ratio (Sales Cost of goods
sold)/ Net Sales x 100 A higher Gross
Profit Ratio indicates efficiency in production
of the unit.
19

• 7. OPERATING PROFIT RATIO
• It is expressed as gt (Operating
  Profit / Net Sales ) x 100
• Higher the ratio indicates operational
  efficiency
• NET PROFIT RATIO
• It is expressed as gt ( Net
  Profit / Net Sales ) x 100
• It measures overall profitability.
• 
  

20
9. STOCK/INVENTORY TURNOVER RATIO
(Average Inventory/Sales) x 365
for days (Average Inventory/Sales) x 52
for weeks (Average Inventory/Sales) x
12 for months Average Inventory or
Stocks (Opening Stock Closing Stock)

-----------------------------------------

2 . This ratio indicates
the number of times the inventory is rotated
during the relevant accounting period


21
10. DEBTORS TURNOVER RATIO This is
also called Debtors Velocity or Average
Collection Period or Period of Credit given .
(Average Debtors/Sales ) x 365 for days

(52 for weeks 12 for months)
11. ASSET TRUNOVER RATIO
Net Sales/Tangible Assets 12. FIXED
ASSET TURNOVER RATIO Net Sales /Fixed
Assets 13. CURRENT ASSET TURNOVER
RATIO Net Sales / Current Assets
14. CREDITORS TURNOVER RATIO This is also
called Creditors Velocity Ratio, which determines
the creditor payment period. (Average
Creditors/Purchases)x365 for days

(52 for weeks 12 for months)


22
15. RETRUN ON ASSETS Net
Profit after Taxes/Total Assets 16.
RETRUN ON CAPITAL EMPLOYED ( Net
Profit before Interest Tax / Average Capital
Employed) x 100 Average Capital
Employed is the average of the equity share
capital and long term funds provided by the
owners and the creditors of the firm at the
beginning and end of the accounting period.



23

• Composite Ratio
• 17. RETRUN ON EQUITY CAPITAL (ROE)
• Net Profit after Taxes /
  Tangible Net Worth
• EARNING PER SHARE EPS indicates the quantum of
  net profit of the year that would be ranking for
  dividend for each share of the company being held
  by the equity share holders.
• Net profit after Taxes and Preference
  Dividend/ No. of Equity Shares
• 19. PRICE EARNING RATIO PE Ratio indicates the
  number of times the Earning Per Share is covered
  by its market price.
• Market Price Per Equity Share/Earning Per
  Share

24
20. DEBT SERVICE COVERAGE RATIO This ratio is
one of the most important one which indicates the
ability of an enterprise to meet its liabilities
by way of payment of installments of Term Loans
and Interest thereon from out of the cash
accruals and forms the basis for fixation of the
repayment schedule in respect of the Term Loans
raised for a project. (The Ideal DSCR Ratio is
considered to be 2 ) PAT Depr. Annual
Interest on Long Term Loans Liabilities
--------------------------------------------------
------------------------------- Annual
interest on Long Term Loans Liabilities
Annual Installments payable on Long Term Loans
Liabilities ( Where PAT is Profit
after Tax and Depr. is Depreciation)


25
EXERCISE 1



LIABILITES ASSETS
Capital 180 Net Fixed Assets 400
Reserves 20 Inventories 150
Term Loan 300 Cash 50
Bank C/C 200 Receivables 150
Trade Creditors 50 Goodwill 50
Provisions 50
800 800

• What is the Net Worth Capital Reserve
  200
• Tangible Net Worth is Net Worth -
  Goodwill 150
• Outside Liabilities TL CC Creditors
  Provisions 600
• Net Working Capital C A - C L 350 -
  250 50
• Current Ratio C A / C L 350 /
  300 1.17 1
• Quick Ratio Quick Assets / C L
  200/300 0.66 1

26
EXERCISE 2
LIABILITIES 2005-06 2006-07 2005-06 2006-07
Capital 300 350 Net Fixed Assets 730 750
Reserves 140 160 Security Electricity 30 30
Bank Term Loan 320 280 Investments 110 110
Bank CC (Hyp) 490 580 Raw Materials 150 170
Unsec. Long T L 150 170 S I P 20 30
Creditors (RM) 120 70 Finished Goods 140 170
Bills Payable 40 80 Cash 30 20
Expenses Payable 20 30 Receivables 310 240
Provisions 20 40 Loans/Advances 30 190
Goodwill 50 50
Total 1600 1760 1600 1760
1. Tangible Net Worth for 1st Year ( 300
140) - 50 390
2. Current Ratio for 2nd Year (170 30
17020 240 190 ) / (580708070)
820
/800 1.02
3. Debt Equity Ratio for 1st Year 320150 /
390 1.21
27
Exercise 3.

LIABIITIES ASSETS
Equity Capital 200 Net Fixed Assets 800
Preference Capital 100 Inventory 300
Term Loan 600 Receivables 150
Bank CC (Hyp) 400 Investment In Govt. Secu. 50
Sundry Creditors 100 Preliminary Expenses 100
Total 1400 1400
1. Debt Equity Ratio will be 600 /
(200100) 2 1
2. Tangible Net Worth Only equity Capital
i.e. 200
3. Total Outside Liabilities / Total Tangible Net
Worth (600400100) / 200

11 2
4. Current Ratio will be (300 150 50 ) /
(400 100 ) 1 1
28
Exercise 4.
LIABILITIES ASSETS
Capital Reserves 355 Net Fixed Assets 265
P L Credit Balance 7 Cash 1
Loan From S F C 100 Receivables 125
Bank Overdraft 38 Stocks 128
Creditors 26 Prepaid Expenses 1
Provision of Tax 9 Intangible Assets 30
Proposed Dividend 15
550 550

• What is the Current Ratio ? Ans (1125
  1281) / (3826915)
• 
  255/88 2.89 1
• Q What is the Quick Ratio ? Ans (1251)/
  88 1.43 11
• Q. What is the Debt Equity Ratio ? Ans LTL
  / Tangible NW
• 
  100 / ( 362 30)
• 
  100 / 332 0.30 1

29
Exercise 4. contd
LIABILITIES ASSETS
Capital Reserves 355 Net Fixed Assets 265
P L Credit Balance 7 Cash 1
Loan From S F C 100 Receivables 125
Bank Overdraft 38 Stocks 128
Creditors 26 Prepaid Expenses 1
Provision of Tax 9 Intangible Assets 30
Proposed Dividend 15
550 550
Q . What is the Proprietary Ratio ? Ans (T NW
/ Tangible Assets) x 100

(362 - 30 ) / (550 30) x 100

(332 / 520) x 100 64
Q . What is the Net Working Capital ? Ans
C. A - C L. 255 - 88 167
Q . If Net Sales is Rs.15 Lac, then What would
be the Stock Turnover Ratio in Times ? Ans
Net Sales / Average Inventories/Stock
1500 / 128
12 times approximately
30
Exercise 4. contd
LIABILITIES ASSETS
Capital Reserves 355 Net Fixed Assets 265
P L Credit Balance 7 Cash 1
Loan From S F C 100 Receivables 125
Bank Overdraft 38 Stocks 128
Creditors 26 Prepaid Expenses 1
Provision of Tax 9 Intangible Assets 30
Proposed Dividend 15
550 550

• What is the Debtors Velocity Ratio ? If the
  sales are Rs. 15 Lac.
• Ans ( Average Debtors / Net Sales) x 12
  (125 / 1500) x 12
• 
  1 month

Q. What is the Creditors Velocity Ratio if
Purchases are Rs.10.5 Lac ? Ans (Average
Creditors / Purchases ) x 12 (26 / 1050) x
12 0.3 months
31
Exercise 5. Profit to sales is 2 and
amount of profit is say Rs.5 Lac. Then What is
the amount of Sales ? Answer Net Profit
Ratio (Net Profit / Sales ) x 100
2 (5 x100)
/Sales Therefore Sales
500/2 Rs.250 Lac
Exercise 6. A Company has Net Worth of Rs.5
Lac, Term Liabilities of Rs.10 Lac. Fixed Assets
worth RS.16 Lac and Current Assets are Rs.25 Lac.
There is no intangible Assets or other Non
Current Assets. Calculate its Net Working
Capital.
Answer Total Assets 16 25 Rs.
41 Lac Total Liabilities NW LTL CL 5
10 CL 41 Lac Current Liabilities 41 15
26 Lac Therefore Net Working Capital C. A
C.L
25 26 (- )1 Lac
32
Exercise 7 Current Ratio of a concern is 1
1. What will be the Net Working Capital ? Answer
It suggest that the Current Assets is equal to
Current Liabilities hence the NWC would be NIL (
since NWC C.A - C.L )
Exercise 8 Suppose Current Ratio is 4 1.
NWC is Rs.30,000/-. What is the amount of
Current Assets ? Answer 4a - 1a
30,000 Therefore a 10,000
i.e. Current Liabilities is Rs.10,000
Hence Current Assets would be 4a 4 x
10,000 Rs.40,000/-
Exercise 9. The amount of Term Loan installment
is Rs.10000/ per month, monthly average interest
on TL is Rs.5000/-. If the amount of
Depreciation is Rs.30,000/- p.a. and PAT is
Rs.2,70,000/-. What would be the DSCR ? DSCR
(PAT Depr Annual Intt.) / Annual Intt
Annual Installment (270000
30000 60000 ) / 60000 120000
360000 / 180000 2
33
Exercise 10 Total Liabilities of a firm is
Rs.100 Lac and Current Ratio is 1.5 1. If Fixed
Assets and Other Non Current Assets are to the
tune of Rs. 70 Lac and Debt Equity Ratio being 3
1. What would be the Long Term Liabilities?
Ans We can easily arrive at the amount of
Current Asset being Rs. 30 Lac i.e. ( Rs. 100 L
- Rs. 70 L ). If the Current Ratio is 1.5 1,
then Current Liabilities works out to be Rs. 20
Lac. That means the aggregate of Net Worth and
Long Term Liabilities would be Rs. 80 Lacs. If
the Debt Equity Ratio is 3 1 then Debt works
out to be Rs. 60 Lacs and equity Rs. 20 Lacs.
Therefore the Long Term Liabilities would be
Rs.60 Lac.
Exercise 11 Current Ratio is say 1.2 1 .
Total of balance sheet being Rs.22 Lac. The
amount of Fixed Assets Non Current Assets is
Rs. 10 Lac. What would be the Current
Liabilities? Ans When Total Assets is Rs.22
Lac then Current Assets would be 22 10 i.e
Rs. 12 Lac. Thus we can easily arrive at the
Current Liabilities figure which should be Rs.
10 Lac
34

• EXERCISE 12. A firm sold its stocks in CASH,
  in order to meet its liquidity needs. Which of
  the following Ratio would be affected by this?
• Debt Equity Ratio
• Current Ratio
• Debt Service Coverage Ratio
• Quick Ratio

• EXERCISE 13. A company is found to be carrying a
  high DEBT EQUITY Ratio. To improve this, a bank
  may suggest the company to
• Raise long term interest free loans from friends
  and relatives
• Raise long term loans from Institutions
• Increase the Equity by way of Bonus Issue
• Issue Rights share to existing share holders.

• EXERCISE 14. Which of the following is a
  fictitious Asset?
• Goodwill
• Preliminary Expenses
• Pre-operative expenses
• Book Debts which have become doubtful of recovery

35

• EXERCISE 15. Under which of the following methods
  of depreciation on Fixed Assets, the annual
  amount of depreciation decreases?
• Written Down Value method
• Straight Line method
• Annuity method
• Insurance policy method

• EXERCISE 16 Debt Service Coverage Ratio (DSCR)
  shows
• Excess of current assets over current liabilities
• Number of times the value of fixed assets covers
  the amount of loan
• Number of times the companys earnings cover the
  payment of interest and repayment of principal of
  long term debt
• Effective utilisation of assets

• EXERCISE 17. Which of the following is not
  considered a Quick Asset?
• Cash and Bank balances
• Bank Fixed Deposits
• Current Book Debts
• Loans and Advances

36

• Exercise 18. From the following financial
  statement calculate (i) Current Ratio (ii) Acid
  test Ratio (iii) Inventory Turnover (iv) Average
  Debt Collection Period (v) Average Creditors
  payment period.
• 
  C.Assets
• Sales 1500 Inventories
  125
• Cost of sales 1000
  Debtors
  250
• Gross profit 500
  Cash
  225
• 
  C.
  Liabilities
• Trade Creditors 200
• (i) Current Ratio 600/200 3 1
• Acid Test Ratio DebtorsCash /Trade creditors
  475/200 2.4 1
• Inventory Turnover Ratio Cost of sales /
  Inventories 1000/125 8 times
• Average Debt collection period
  (Debtors/sales) x 365 (250/1500)x365 61 days
• Average Creditors payment period (Trade
  Creditors/Cost of sales) x 365
• 
  (200/100) x 365 73 days

37
Questions on Fund Flow Statement

• Q . Fund Flow Statement is prepared from the
  Balance sheet
• Of three balance sheets
• Of a single year
• Of two consecutive years
• None of the above.

• Q. Why this Fund Flow Statement is studied for
  ?
• It indicates the quantum of finance required
• It is the indicator of utilisation of Bank funds
  by the concern
• It shows the money available for repayment of
  loan
• It will indicate the provisions against various
  expenses

• Q . In a Fund Flow Statement , the assets are
  represented by ?
• Application of Funds
• Sources of Funds
• Surplus of sources over application
• Deficit of sources over application

38

• Q . In Fund Flow Statements the Liabilities are
  represented by ?
• Sources of Funds
• Use of Funds
• Deficit of sources over application
• All of the above.

• Q . When the long term sources are more than
  long term uses, in the fund flow statement, it
  would suggest ?
• Increase in Current Liabilities
• Decrease in Working Capital
• Increase in NWC
• Decrease in NWC

• Q . When the long term uses in a fund flow
  statement are more than the long term sources,
  then it would mean ?
• Reduction in the NWC
• Reduction in the Working Capital Gap
• Reduction in Working Capital
• All of the above

39

• Q. How many broader categories are there for
  the Sources of funds, in the Fund Flow Statement
  ?
• Only One, Source of Funds
• Two, Long Term and Short Term Sources
• Three , Long, Medium and Short term sources
• None of the above.

• R K MOHANTY
• email ID rajendra2411_at_gmail.com,
• rajendra2411_at_hotmail.com