FINANCIAL STATEMENT ANALYSIS

MEANING OF FINANCIAL STATEMENTSAccording to Himpton John, "A financial statement is an organized collection of data according to logical and consistent accounting procedures. Its purpose is to convey an understanding of some financial aspects of a business firm. It may show assets position at a moment of time as in the case of a balance sheet, or may reveal a series of activities over a given period of limes, as in the case of an income statement ".

On the basis of the information provided in the financial statements, management makes a review of the progress of the company and decides the future course of action.

DIFFERENT TYPES OF FINANCIAL STATEMENTS

1. Income Statement2. Balance Sheet3. Statement of Retained earnings4. Funds flow statement5. Cash flow statement.6. Schedules.

FUNDAMENTAL CONCEPTS OF ACCOUNTING

1. Going concern concept2. Matching concept ( Accruals concept)3. Consistency concept4. Prudence concept ( conservation concept)5. Business entity concept6. Stable monetary unit concept7 Money measurement concept7. Objectivity concept8. Materiality concept9. Realization concept.

LIMITATIONS OF FINANCIAL STATEMENTS

1. In profit and loss account net profit is ascertained on the basis of historical

costs.

2. Profit arrived at by the profit and loss account is of interim nature. Actual profit can be ascertained only after the firm achieves the maximum capacity.

3. The net income disclosed by the profit and toss account is not absolute but only relative.

4. The net income is the result of personal judgment and bias of accountants cannot be removed in the matters of depreciation, stock valuation, etc.,

5. The profit and loss account does not disclose factors like quality of product, efficiency of the management etc.,

6. There are certain assets and liabilities which are not disclosed by the balance sheet. For example the most tangible asset of a company is its management force and a dissatisfied labour force is its liability which are not disclosed by the balance sheet.

7. The book value of assets is shown as original cost less depreciation. But in practice, the value of the assets may differ depending upon the technological and economic changes.

8. The assets are valued in a Balance sheet on a going concern basis. Some of the assets may not relate their value on winding up.

9. The accounting year may be fixed to show a favorable picture of the business. In case of Sugar Industry the Balance sheet prepared in off season depicts a better liquidity position than in the crushing season.

10. Analysis Investor likes to analyse the present and future prospectus of the business while the balance sheet shows past position. As such the use of a balance sheet is only limited.

11. Due to flexibility of accounting principles, certain liabilities like provision for gratuity etc. are not shown in the balance sheet giving the outsiders a misleading picture.

12. The financial statements are generally prepared from the point of view of shareholders and their use is limited in decfsion making by the management, investors and creditors.

13. Even the audited financial statements does not provide complete accuracy.

14. Financial statements do not disclose the changes in managernent, Loss of markets, etc. which have a vital impact on the profitability of the concern.

15. The financial statements are based on accounting policies which vary form company to company and as such cannot be formed as a reliable basis of judgment.

FORMATS OF FINANCIAL STATEMENTS

The two main financial statements, viz the Income Statement and the Balance sheet, can either be presented in the horizontal form or the vertical form where statutory provisions are applicable, the statement has to be prepared in accordance with such provisions.

Income Statement :

There is no legal format for the profit and loss A/C. Therefore, it can be presented in the traditional T form, or vertically, in statement form. An example of the two formats is given as under.

(i) Horizontal, or “T” form:

Manufacturing, Trading and profit and loss A/C of ………........... for the year ending .........................

Dr Cr

Particulars Rs. Particualrs Rs.To opening stock By cost of finished Goods

c/dXxxx

Raw materials xxx By closing stock Work in progress xxx Raw materials xxx

Work in progress xxxTo purchases of raw materials

xxx

To manufacturing wages xxxTo carriage inwards xxxTo other Factory Expenses xxx

xxx xxxBy sales xxx

To opening stock of finished

xxx By closing stock of finished

xxx

goods goods To cost of Finished goods b/d

xxx By Gross Loss c/d xxx

To Gross Profit c/d xxxxxx xxx

To Gross Loss b/d xxx By Gross profit b/d xxxTo office and Admn. Expense

xxx By Miscellaneous Receipts xxx

To Interest and financial expenses

xxx By Net Loss c/d xxx

To provision for Income-tax

xxx

To Net Profit c/d xxxxxx xxx

To net loss b/d xxx By Balance b/d xxx

To general reserve xxx (from previous year)To Dividend xxx By Net profit b/d xxxTo Balance c/f xxx

xxx xxx

(ii) Vertical Form

Income statement of ………… for the year ending ……………...

Particulars Rs. Rs.Sales xxxxLess: Sales Returns xxx

Sales Tax/ Exise Duty xxx xxxxNet sales (1) xxxxCost of Goods Sold Materials Consumed xxxxDirect Labour xxxxManufacturing Expenses xxxxAdd / less Adjustment for change in stock

(2)xxxx

xxxxGross Profit (1) – (2) xxxLess: Operating Expenses

Office and Administration ExpensesSelling and Distribution Expenses xxx

xxx xxxOperating Profit Xxxx

Add: Non-operating Income XxxLess: Non-oprating Expenses (including Interest) xxxx

Profit before Tax xxxxxxx

Less : Tax xxxProfit After Tax xxxx

Appropriations Transfer to reservesDividend declared /paid xxxxSurplus carried to Balance sheet xxx

xxxxxxx

Balance Sheet

The Companies Activities, 1956 stipulates that the Balance sheet of a joint stock company should be prepared as per part I of schedule VI of the Activities. However, the statement form has been emphasized upon by accountants for the purpose of analysis and Interpretation. The permission of the Centra! Government is necessary for adoption of the 'statement* form.

(i) Horizontal FormBalance sheet of .................... as on ....................

Liabilities Rs. Assets Rs.Share Capital xxx Fixed Assets:(with all paticulars of Authorized, Issued, Subscribed capital) Called up capital

xxx

1. Goodwill2. Land & Building 3. Leasehold property4. Plant and Machinery 5. Furniture and Fittings

xxxxxxxxxxxxxxx

Less: Calls in Arrears xxx 6. Patents and Trademarks xxxAdd: Forfeited Shares xxx 7. Vehicles xxxReserves and Surplus : Investments 1. Capital Reserve xxx Current Assets, loans

and 2. Capital Redemption Advancesreserve xxx (A) Current Assets3. Share premium xxx 1. Interest accured on 4. Other premium xxx Investments xxxLess: debit balance of Profit xxx 2. Loose tools xxxand loss A/C (if any) 3. Stock in trade xxx5. Profit and Loss xxx 4. Sundry Debtors xxxAppropriation A/C Less: Provision for doubtful 6. Sinking Fund xxx debts

5. cash in hand xxx6. cash in Bank xxx

Secured Loans (B) Loans and AdvancesDebentures xxx 7. Advances to subsidiaries xxx

Add: Outstanding Interest xxx 8. Bills Receivable xxx

Loans from Banks xxx 9. Prepaid Expenses xxxUnsecured Loans Miscellaneous Expenditure

(to the extent not written off or

Fixed Deposits xxx adjusted) xxxShort-term loans and advances

xxx

Current Liabilities and Provisions

1. Preliminary expenses2. Discount on Issue of shares

xxxxxx

and debentures A. Current Liabilites 3. Underwriting Commssion xxx1. Bills Payable xxx2. Sudnry Creditors xxx Profit and Loss account

(Loss),3. Income received in advance

xxx if any

4. unclaimed Dividends xxx5. Other Liabilities xxx

B. Provisions6. Provisions for Taxation xxx7. Proposed Dividends xxx8. Proposed funds & pension

xxx

fund contingent liabilities not Provided for

xxx xxx

(ii) Vertical Form:

Balance sheet of ………………………. as on …………………

Particulars Schedule No. Current year

Previous Year

I. Source of funds1. Share holders funds

a. capital xxxx xxxxb. Reserves and surplus xxxx xxxx

2. Loans funds a. Secured Loans xxxx xxxxb. Unsecured Loans xxxx xxxx

TotalII. Application of funds 1. Fixed Assets

a. Gross Block xxxx xxxxb. less Deprciation xxxx xxxxc. Net block xxxx xxxxd. Capital work in progress xxxx xxxx

2. Investments xxxx xxxx

3. Current Assets, Loans and Advances a. Inventions xxxx xxxxb. Sundry Debtors xxxx xxxxc. Cash and Bank balance xxxx xxxxd. other current assets xxxx xxxxe. Loans and Advances xxxx xxxx

Less : current Liabilities and Provisions a. Current Laibilities xxxx xxxxb. Provisions xxxx xxxx

xxxx xxxxNet Current Assets4. a. Miscellaneuos Expenditure to xxxx xxxxthe extent not written off or adjusted

b. Profit and Loss Account (debit) xxxx xxxxTotal xxxx xxxx

(ii) Vertical Form for analysis Balance sheet of ……… as on ……………..

Particulars Rs.ASSETS Current Assets

Cash and Bank Balances xxxxDebtors xxxxStock xxxxOther Current Assets xxxx

(1) xxxx

Fixed Assets xxxxLess: Depreciation xxxxInvestments xxxx

(2) xxxxTotal (1) + (2) xxxxx

LIABILITIESCurrent Liabilities :

Bills Payable xxxxCreditorsOther Current Liabilities

(3) xxxxLong Term Debt

Debentures xxxxOther Long-term Debts xxxx

(4) xxxxCapital and Reserves

Share Capital xxxxReserves and surplus xxxx

(5) xxxxTotal Long term funds

Total (3)+(4)+(5) xxxxx

Statement of Retained Earnings:Profit and Loss Appropriation Account

Particulars Rs. Particulars Rs.To transfer to Reserves

xxx By Last year’s balance

xxx

To Dividend xxx By Current Year’s net profit (Transferred from profit and loss A/C)

xxx

To Dividend proposed

xxx

To surplus carried to xxx By Excess provisions xxx

Balance sheet (which are no longer required)By Reserves withdrawn(if any) xxx

xxx xxxx

Techniques of Financial Statement Analysis:

The following techniques are adopted in analysis of financial statements of a business organization:

Comparative Statements Common size Statements Trend Analysis Funds flow Analysis Cash flow Analysis Ratio Analysis Value Added Analysis.

Comparative Financial StatementsComparative financial statements are statements of financial

position of a business designed to provide time perspective to the consideration of various elements of financial position embodied in such statements. Comparative Statements reveal the following: .i. Absolute data (money values or rupee amounts) ii. Increase or reduction in absolute data (in terms of moiwy

values) iii. Increase or reduction in absolute data (in terms of

percentages)iv. Comparison (in terms of ratios) v. Percentage of totals.

a. Comparative Income Statement or Profit and Loss Account:

A comparative income statement shows the absoluie figures for two or more periods and the absolute change from one period to another. Since the figures are shown side by side, the user can quickly understand the operational performance of the firm in different periods and draw conclusions.

b. Comparative Balance Sheet

Balance sheet as on two or more different dates are used for comparing the assets, liabilities and the net worth of the company Comparative balance sheet is useful for studying the trends of analysis undertaking.

Financial Statements of two or more firms can also be compared for drawing inferences. This is called interfirm Comparison.

Advantages:

Comparative statements vidicate trends in sales, cost of production, profits etc., and help the analyst to evaluate the performance of the company.

Comparative statements can also be used to compare the performance of the industry or inter-firm comparison. This helps in identification of the weaknesses of the firm and remedial measures can be taken; accordingly.

Weaknesses:Inter-firm comparison can be misleading if the firms are not identical

in size and age and when they follow different accounting procedures with regard to depreciation, inventory valuation etc.,

Inter-period comparison may also be misleading if the period has witnessed changes in accounting policies, inflation, recession etc.

Illustration 3:The following is the profit and loss account of Ashok Ltd., for the

years 2010 and 2011. Prepare comparative Income Statement and comment on the profitability of the undertaking.

Particulars 2010 2011 Particulars 2010 2011Rs. Rs. Rs. Rs.

To Cost of goods sold

2,31,625

2,41,950

By Sales 3,60,728

4,17,125

To Office expenses

23,266 27,068 Less Returns 5,794 6,952

To Interest expenses

45,912 57,816 3,54,934

4,10,173

To Loss on sale of fixed

627 1,750 By Other incomes :

To Income Tax

21,519 40,195 By Discount on purchase

2,125 1,896

To Net Profit 35,371 44,425 By Profit on sale of land

1,500

3,60,457

4,13,379

3,60,457

4,13 ,379

Solution:ASHOK LTD.

Comparative Income Statement for the years ending 2000 and 2001

Particulars 2000 Rs.

2001 Rs.

Increase (+)Decrease (-)Amount (Rs.)

Increase (+)Decrease (-)Percentages

Sales 3,60,728

4,17,125

+56,397 +15.63

Less: Sales returns 5,794 6,952 +1.158 +19.983,54,93

44,10,17

3+55,239 +15.56

Less: Cost of goods sold

2,31,625

2,41,950

+ 10,325 +4.46

Gross Profit 1,23,309

1,68,223

+44.914 +36.42

Operating Expenses:Office expenses 23,266 27,068 +3,802 + 16.34Selling

expenses45,912 57,816 +11,904 +25.93

Total operating expenses

69,178 84,884 +15,706 +22.70

Operating profit 54,131 83,339 +29,208 +53.96Add: Other incomes 5,523 3,206 -2,317 -41.95

59,654 86,545 +26.891 +45.08Less: Other expenses 2,764 1,925 -839 -30.35Profit before tax 56,890 84,620 +27,730 +48.74Less: Income tax 21,519 40,195 +18,676 +86.79Net Profit after tax 35,371 44,425 +9,054 +25.60

The comparative Income statement reveals that while the net sales has been increased by 15.5%, the cost of goods sold increased by 4.46%. So gross profit is increased by 36.4%. The total operating expenses has been increased by 22.7% and the gross profit is sufficient to compensate increase in operating expenses. Net profit after tax is 9,054 (i.e., 25.6%) increased. The overall profitability of the undertaking is satisfactory.

Illustration: 4The following are the Balance Sheets of Gokul Ltd., for the years

ending 31s1 December, 2000,2001.Particulars 2000 2001

Rs. Rs.LiabilitiesEquity share capital 2,00,000 3,30,000Preference share capital 1,00,000 1,50,000Reserves 20,000 30,000Profit and Loss a/c 15,000 20,000Bank overdraft 50,000 50,000Creditors 40,000 50,000Provision for taxation 20,000 25,000Proposed Dividend 15,000 25,000

Total 4,60,000 6,80,000Fixed Assets

Less: Depreciation 2,40,000 3,50,000Stock 40,000 50,000Debtors 1,00,000 1,25,000Bills Receivable 20,000 60,000Prepaid expenses 10,000 12,000Cash in hand 40,000 53,000Cash at Bank 10,000 30,000

Total 4,60,000 6,80,000

COMMON SIZE STATEMENTS

The figures shown in financial statements viz. Profit / Loss Account and Balance sheet are converted to percentages so as to establish each element to the total figure of the statement and these statement are called Common Size Statements. These statements are useful in analysis of the performance of the company by analyzing each individual element to the total figure of the statement. These statements will also assist in analyzing the performance over years and also with the figures of the competitive firm in the industry for making analysis of relative efficiency. The following statements show the method of presentation of the data.

Illustration: 5Common Size Income Statement of XYZ Ltd., for the year ended 31st

March, 2001.

Particulars Amount (Rs.) % to Sales

Sales (A) 14,00,000 100

Raw materials 5,40,000 16.4

Direct wages 2,30,000 16.4

Faciory expenses 1,60,000 11.4

(B) 9,30,000 66.4

GrossProfit (A) - (B)

4,70,000 33.6

Less: Administrative expenses

1,10,000 7.9

Selling and distribution expenses

80,000 5.7

Operating Profit 2,80,000 20.0

Add: Non-operative income 40,000 2.9

3,20,000 22.9

Less: Non-operating expenses

60,000 43

Profit before tax 2,60,000 18.6

Less: Income tax 80,000 5.7

Profit after tax 1,80,000 12.9

Common Size Balance Sheet of XYZParticulars Amount (Rs.) % to Total

ASSETS

Fixed Assets

Land 50,000 5.3

Buildings 1,10,000 11.7

Plant and Machinery 2,50,000 26.6

Current Assets :

Inventory

Raw materials 80,000 8.5

Work-in-progress 50,000 5.3

Finished goods 1,60,000 17.0

Sundry debtors 2,10,000 22.4

Cash at Bank 30,000 3.2

Total 9,40,000 100.0

Capital and Liabiltiies

Euqity Share capital 2,50,000 26.6

Preference Share Capital 1,00,000 10.6

General reserve 1,60,000 17.0

Debentures 80,000 8.5

Current Liabilities

Sundry Creditors 2,20,000 23.4

Creditors for expenses 40,000 4.3

Bills payable 90,000 9.6

9,40,000 100.0

Analysis of performance and position can be made from the above Common Size Statements.

llustration: 6From the following P&L A/c prepare a Common Size Income

Statement-Particulars 2000 2001 Particulars 2000 2001

Rs. Rs. Rs. Rs.To Cost of goodssold

12,000 1 5,000 By Net Sales 16,000 20,000

To Administrative 400 400expensesTo Selling expenses

600 800

To Net Profit 3,000 3,80016,000 20,000 16,000 20,000

Common Size Income StatementParticulars 2000 2001

Rs. % Rs. %Net sales 16,000 100.00 20,000 100.00

Less: Cost of goods sold

12,000 75.00 15,000 7500

Gross Profit

4,000 25.00 5,000 25.00

Less: Operating expensesAdministration expenses

400 2.50 400 2.00

Selling expenses 600 3.75 800 4.00

Total Operating 1,000 6.25 1,200 6.00

expenses Net Profit 3,000 18.75 3,800 19.00

Illustration: 7Following are Balance sheet of Vinay Ltd. for the year ended 31st

December 2000 and 2001.

Liabilities 2000 2001 Assets 2000 2001

Rs. Rs. Rs. Rs.

Equity capital 1,00,000 1 ,65,000 Fixed Assets (Net)

1 ,20,000 1,75,000

Pref. Capital 50,000 75,000 Stock 20,000 25,000

Reserves 10,000 15,000 Debtors 50,000 62,500

P&L A/c 7,500 10,000 Bills receivable 10,000 30,000

Creditors 20,000 25,000 Cash at Bank 20,000 26,500

Provision for taxation

10,000 12,500 Cash in hand 5,000 15,000

Proposed dividends

7,500 12,500

2,30,000 3,40,000 2,30,000 3,40,000

Prepare a common size balance sheet and interpret the same.

TREND ANALYSIS

In trend analysis ratios of different items are calculated for various periods for comparison purpose. Trend analysis can be .done by trend percentage, trend ratios and graphic and diagrammatic representation. The trend analysis is a simple technique and does not involve tedious calculations.

Illustration: 8From the following data, calculate trend percentage taking 1999 as

base.

Particulars 1999 2000 2001Rs. Rs. Rs.

Sales 50,000 75,000 1,00,000

Purchases 40,000 60,000 72,000

Expenses 5,000 8,000 15,000

Profit 5,000 7,000 13,000

Solution:Particulars 1999 Rs. 2000

Rs.2001 Rs. Trend Percentage Base

1999Rs. Rs. Rs. 1999 2000 2001

Purchases 40,000 60,000 72,000 100 150 180

Expenses 5,000 8,000 15,000 100 160 300

Profit 5,000 7,000 13,000 100 140 260

Sales 50,000 75,000 1,00,000 100 150 200

Illustration: 9From the following data, calculate trend percentages (1999 as base)

Particulars 1999 2000 2001

Rs. Rs. Rs.

Cash 200 240 160Debtors 400 500 650

Stock 600 800 700

Other Current Assets 450 600 750

Land 800 1,000 1,000

Buildings 1,600 2,000 2,400

Plant 2,000 2,000 2,400

Solution:

Particulars 2000 2001 (Base Year 1999)

Rs. Rs. Rs. 1999 2000 2001

Cash 200 240 160 100 120 80

Debtors 400 500 650 100 125 163

Other Current Assets

450 600 750 100 133 167

Total Current Assets

1,650 2,140 2,260 100 130 137

Fixed Assets:

Land 800 1,000 1,000 100 125 125

Buildings 1,600 2,000 2,400 100 125 150

Plant 2,000 2,000 2,400 100 100 120

Total Fixed Assets 4,400 5,000 5,800 100 114 132

RATIO ANALYSIS

INTRODUCTION

The financial statements viz. the income statement, the Balance sheet The Income statement, the Statement of retained earnings and the Statement of changes in financial position report what has actually happened to earnings during a specified period. The balance sheet presents a summary of financial position of the company at a given point of time. The statement of retained. earnings reconciles income earned during the year and any dividends distributed with the change in retained, earnings between the start and end of the financial. year under study. The statement of changes in financial position provides a summary of funds flow during the period of financial statements.

Ratio analysis is a very powerful analytical tool for measuring performance of an organisation. The ratio analysis concentrates on the interrelationship among the figures appearing in the aforementioned four financial-statements. The ratio analysis helps the management to analyse the past. performance of the firm and to make further projections. Ratio analysis allow1-interested parties like shareholders, investors, creditors, Government analysts to make an evaluation of certain aspects of a firm's performance.

Ratio analysis is a process of comparison of one figure against another, which make a ratio, and the appraisal of the ratios to make proper analysis about the strengths and weaknesses of the firm's operations. The calculation of ratios is a relatively easy and simple task but the proper analysis and interpretation of the ratios can be made only by the skilled analyst. While interpreting the financial information, the analyst has to be careful in limitations imposed by the accounting concepts and methods of valuation. Information of non-financial nature will also be taken into consideration before a meaningful analysis is made.Ratio analysis is extremely helpful in providing valuable insight into a company's financial picture. Ratios normally pinpoint a business strengths and weakness in two ways:

Ratios provide an easy way to compare today's performance with past.

Ratios depict the areas in which a particular business is competitively advantaged or disadvantaged through comparing ratios to those of other businesses of the same size within the same industry.

CATEGORIES OF RATIOSThe ratio analysis is made under six broad categories as follows:

Long-term solvency ratios

Short-term solvency ratios Profitability ratios Activity ratios Operating ratios Market test ratios

Long-Term Solvency Ratios

The long-term financial stability of the firm may be considered as dependent upon its ability to meet all its liabilities, including those not current payable. The ratios which are important in measuring the 'long-term solvency L as follows:

Debt-Equity Ratio Shareholders Equity Ratio . Debt to Networth Ratio Capital Gearing Ratio Fixed Assets to Long-term Funds Ratio Proprietary Ratio Dividend Cover Interest Cover Debt Service Coverage Ratio

1. Debt-Equity Ratio:

Capital is derived from two sources: shares and loans. It is quite hkely for only shares to be issued when the company is formed, but loans are invariably raised at some later date. There are numerous reasons for issuing loan capital. For instance, the owners might want to increase their investment but avoid the'risk which attaches to share capital, and they can do this by making a secured loan. Alternatively, management might require additional finance which the shareholders are unwilling to supply and so a loan is raised instead. In either case, the effect is to introduce an element of gearing or leverage into the capital structure :of the company. There are numerous ways of measuring gearing, but the debt-equity ratio is perhaps most commonly used.

Long - term debt

Share holders fundsThis ratio indicates the relationship between loan funds and net

worth of the company, which is known as gearing. If the proportion of debt to equity is low, a company is said to be low-geared, and vice versa. A debt equity ratio of 2:1 is the norm accepted by financial institutions for financing of projects. Higher debt-equity ratio may be permitted for highly capital intensive industries like petrochemicals, fertilizers, power etc. The higher the gearing, the more volatile the return to the shareholders.

The use of debt capital has direct implications for the profit accruing to the ordinary shareholders, and expansion is often financed in this manner with the objective of increasing the shareholders' rate of return. This objective is achieved only if the rate earned on the additional funds raised exceeds that payable to the providers of the loan.

The shareholders of a highly geared company reap disproportionate benefits when earnings before interest and tax increase. This is because interest payable on a large proportion of total finance remains unchanged. The converse is also true, and a highly geared company is likely to find itself in severe financial difficulties if it suffers a succession of trading losses. It is not possible to specify an optimal level of gearing for companies but, as a general rule, gearing should be low in those industries where demand is volatile and profits are subject to fluctuation.

A debt-equity ratio which shows a declining trend over the years is usually taken as a positive sigh reflecting on increased cash accrual and debt repayment. In fact, one of the indicators of a unit turning sick is a rising debt-equity ratio. Usually in calculating the ratio, the preference share capital is excluded from debt, but if the ratio is to show effect of use of fixed interest sources on earnings available to the shareholders then it is to be included. On the other hand, if the ratio is to examine financial solvency, then preference shares shall form part of the capital.

2. Shareholders Equity Ratio :This ratio is calculated as follows:

Shareholders Equity

Total assets (tan gible)

It is assumed that larger the proportion of the shareholders' equity, the stronger is the financial position of the firm, This ratio will supplement the debt-equity ratio. In this ratio the relationship is established between the shareholders funds and the total assets. Shareholders funds represent both equity and preference capital plus reserves and surplus less losses. A reduction in shareholder's equity signaling the over dependence on outside sources for long-term financial needs and this carries the risk of higher levels of gearing. This ratio indicates the degree to which unsecured creditors are protected against iosr in the event of liquidation.

3. Debt to Net worth Ratio :This ratio is calculated as follows:

Long - term debtNetworth

The ratio compares long-term debt to the net worth of the firm i.e., the capital and free reserves less intangible assets. This ratio is finer than the debt-equity ratio and includes capital which is invested in fictitious assets like deferred expenditure and carried forward tosses. This ratio would be of more interest to the contributories of long-term finance to the firm, as the ratio gives a S factual idea of the assets available to meet the long-term liabilities.

4. Capital Gearing Ratio : It is the proportion of fixed interest bearing funds to Equity

shareholders, funds: Fixed int eresi bearing funds :

Equity Shareholder's fundsThe fixed interest bearing funds include debentures, long-term loans and preference share capital. The equity shareholders funds include equity share capital, reserves and surplus. Capital gearing ratio indicates the degree of vulnerability of earnings available for equity shareholders. This ratio signals the firm which is operating on trading on equity. It also indicates the changes in benefits accruing to equity shareholders by changing the levels of fixed interest bearing funds in the organisation.

5. Fixed Assets to Long-term Funds Ratio :The fixed assets is shown as a proportion to long-term funds as

follows:

Fixed Assets

Long - term Funds

The ratio includes the proportion of long-term funds deployed in fixed assets. Fixed assets represents the gross fixed assets minus depreciation provided on this till the date of calculation. Long-term funds include share capital, reserves and surplus and long-term loans. The higher the ratio indicates the safer the funds available in case of liquidation. It also indicates the proportion of long-term funds that is invested in working capital.

6. Proprietor Ratio :It express the relationship between net worth and total asset

Net worthTotal Assets

Net worth = Equity Share Capital-t-Preference Share Capital+Fictitious Assets Total Assets = Fixed Assets + Current Assets (excluding fictitious assets)

Reserves earmarked specifically for a particular purpose should not be included in calculation of Net worth. A high proprietory ratio indicative

of strong financial position of the business. The higher the ratio, the better it is.

7. Interest Cover:Profil before interest depreciationand tax

Interest

The interest coverage ratio sLjws how many times interest charges are covered by funds that are available for payment of interest. An interest cover of 2:1 is considered reasonable by financial institutions. A very high ratio indicates that the firm is conservative in using debt and a very low ratio indicates excessive use of debt.

8. Dividend Cover : Net Profit after tax

Dividend

This ratio indicates the number of times the dividends are covered

by net profit his highlights the amount retained by a company for

financing of future operations.

9. Debt Service Coverage Ratio :

It indicates whether the business is earning sufficient profits to pay

not only the interest charges, but also the instalments due to the

'principal' amount. It is calculated as:

PBIT

Interest + Periodic Loan Instalment

(1 - Rate of Income Tax)

The greater the debt service coverage ratio, the better rs the

servicing ability of the organisation.

Short-term Solvency Ratios

The short-term solvency ratios, which measure the liquidity of the

firm and its liability of the firm and its ability to meet it- maturing short-

term obligations. Liquidity is defined as the ability to realise value in

money, the most liquid of assets. It refers to the ability to pay in cash, the

obligations that -are due.

The corporate liquidity has two dimensions viz., quantitative and qualitative concepts. The quantitative concept includes the quantum, structure and utilisation of liquid assets and in the qualitative concept, it is the ability to meet all present and potential demands on cash" from any source in a manner that minimizes cost and maximizes the value of the firm. Thus, corporate liquidity is, a vital factor in business - excess liquidity, though a guarantor of solvency would reflect lower profitability, deterioration in managerial efficiency, increased speculation and unjustified expansion, extension of too liberal credit and dividend policies. Too little liquidity then may lead to frustration' of-i business objectives, reduced rate of return, business opportunity missed and& weakening of morale. The important ratios in measuring short-term solvency are:

(1) Current Ratio(2) Quick Rarip(3) Absolute Liquid Ratio (4) Net working capital ratio

1. Current Ratio :

Current Assets, Loans & Advances

Current Liabilities & Provisions

This ratio measures the solvency of the company in the short-term. Current assets are those assets which can be converted into cash within a year. Current liabilities and provisions are those liabilities that are payable within a year. A current ratio 2:1 indicates a highly solvent position. A current ratio 1.33:1 is considered by banks as the minimum acceptable level for providing working capital finance. The constituents of the current assets are as important as the current assets themselves for evaluation of a company's solvency position, A very high current ratio will have adverse impact on the profitability of the organisation. A high current ratio may be due to the piling up of inventory, inefficiency in collection of debtors, high balances in Cash and Bank accounts without proper investment2. Quick Ratio or Liquid Ratio:

Current Assets, Loans & Advances - Inventories

Current Liabilities & Provisions- Bank Overdraft

Quick ratio used as measure of the company's ability to meet its current obligations. Since bank overdraft is secured by the inventories, the other current assets must be sufficient to meet other current liabilities. A quick ratio of 1:1 indicates highly solvent position. This ratio is

also called acid test ratio. This ratio serves as a supplement to the current ratio in analysing liquidity.

3. Absolute Liquid Ratio (Super Quick Ratio):

It is the ratio of absolute liquid assets to quick liabilities. However, for calculation'purposes, it is taken as ratio of absolute liquid assets to current liabilities. Absolute liquid assets include cash in hand, cash at bank and short term or temporary investments.

Absolute Liquid Assets

Current Liabilities

Absolute Liquid Assets =Cash in Hand + Cash at Bank + Short term investments

The ideal Absolute liquid ratio is taken as 1:2 or 0.5.

Activity Ratios or Turnover Ratios

Activity ratios measure how effectively the firm employs its resources. These ratios are also called turnover ratios which involve comparison between the level of sales and investment in various accounts - inventories, debtors, fixed assets etc. activity ratios are used to measure the speed with which various accounts are converted into sales or cash. The following activity ratios are calculated for analysis:

1. Inventory :

A considerable amount of a company's capital may be tied up in the financing of raw materials, work-in-progress and finished goods. It is important to ensure that the level of stocks is kept a low as possible, consistent with the need to fulfill customer's orders in time.

Inventory Turnover Ratio = Cost of goods soldAverage Inventory

SalesAverage Inventory

Average inventory = Opening stock+Closing stock2

The higher the stock turn over rate the lower the stock turnover period the better, although the ratios will vary between companies. For example, the stock turnover rate in a food retailing company must be higher than the rate in a manufacturing concern. The level of inventory in a company may be assessed by the use of the inventory ratio, which measures how much has been tied up in inventory.

Inventory Ratio = InventoryCurrent Assets

The inventory turnover ratio measures how many times a company's inventory has been sold during the year. If the inventory turnover ratio has decreased from past, it means that either inventory is growing or sales are dropping. In addition to that, if a firm has a turnover that is slower than for its industry, then there may be obsolete goods on hand, or inventory stocks may be high. Low inventory turnover has impact on the liquidity of the business.

2. Debtors :The three main debtor ratios are as follows:

(1) Debtor Turnover Ratio

Debtor turnover, which measures whether the amount of resources tied up in debtors is reasonable and whether the company has been efficient in converting debtors into cash. The formula is:

Credit SalesAverage Debtors

The higher the ratio, the better the position.

(ii) Average Collection Period

Average collection period, which measures how long it take to collect amounts from debtors. The formula is:

Average debtorsCredit Safes

The actual collection period can be compared with the stated credit terms of the company. If it is longer than those terms, then this indicates some insufficiency in the procedures for collecting debts.

(ii) Bad DebtsBad debts, which measures the proposition of bad debts to sales:

Bad debtsSales

This ratio indicates the efficiency of the credit control procedures of the company. Its level will depend on the type of business. Mail order-companies have to accept a fairly high level of bad debts, white retailing organisations should maintain very low levels or, if they do not allow

X 100

X 365

credit accounts, none at all. The actual ratio is compared with the target or norm to decide whether or not it is acceptabie.

3. Creditors:(i) Creditors Turnover Period

The measurement of the creditor turnover period shows the average time taken to pay for goods and services purchased by the company. The formula is:

Average creditorsPurchases

In general the longer the credit period achieved the better, uecause delays in payment mean that the operation of the company are being financed interest free by, suppliers of funds. But there will be a point beyond which-delays in payment will damage relationships with suppliers which, if they are operating in a seller's market, may harm the company. If too long a period is taken to pay creditors, the credit rating of the company may suffer, thereby making it more difficult to obtain suppliers in the future.

(ii) Creditors Turnover Ratio

Credit purchasesAverage creditors

The term creditors include trade creditors and bills payable.

4. Assets Turnover Ratios:

This measures the company's ability to generate sales revenue in relation to the size of the asset investment A low asset turnover may be remedied by increasing sales or by disposing of certain assets or both. To assist in establishing which part of the asset structure is not being used efficiently, the asset turnover ratio should be sub-analysed.

(i) Fixed Assets Turnover RatioSales

Fixed assetsThis ratio will be analysed further with ratios for each main category

of asset This is a difficult set of ratios to interpret as asset values are based on historic cost An increase in the fixed asset figure may result from the replacement of an asset at an increased price or the purchase of an additional asset intended to increase production capacity. The later transaction might be expected to result in increased sales whereas the former would more probably be reflected in reduced operating costs.

The ratio of the accumulated depreciation provision to the total of fixed assets at cost might be used as an indicator of the average age of the assets; particularly when depreciation rates are noted in the accounts.

X 365

The ratio of sales value per share foot of floor space occupied is particularly significant, for trading concerns, such as a wholesale warehouse or a department store.

(ii) Total Assets Turnover RatioThis ratio indicates the number of times total assets are being turned over in a year.

SalesTotal assets

The higher the ratio indicates overtrading of total assets while a low ratio indicates idle capacity.

5. Working Capital Turnover Ratio :

This ratio is calculated as follows:Sales

Working capitalThis ratio indicates the extent of working capital turned over in

achieving sales of the firm.

6. Sales to Capital Employed Ratio :This ratio is ascertained by dividing sales with capital employed.

Sales——————————Capital employed

This ratio indicates, efficiency in utilisation of capital employed in generating revenue.

Profitability Ratios

The purpose of study and analysis of profitability ratios are to help assess the adequacy of profits earned by the company and also to discover whether profitability is increasing or declining. The profitability of the firm is the net result of a large number of policies and decisions. The profitability ratios are measured with reference to sales, capital employed, total assets employed; shareholders funds etc. The major profitability rates are as follows:

(a) Return on capital employed (or Return on investment) [ROI or ROCE]

(b) Earnings per share (EPS)

(c) Cash earnings per share (Cash EPS)

(d) Gross profit margin

(e) Net profit margin

(f) Cash profit ratio

(g) Return on assets

(h) Return on Net worth (or Return on Shareholders equity)

I. Return on Capital Employed (ROCE) or Return on Investment (ROI)

The strategic aim of a business enterprise is to earn a return on capital. If in any particular case, the return in the long-run is not satisfactory, then the deficiency should be corrected or the activity be abandoned for a more favourable one. Measuring the historical performance of an investment center calls for a comparison of the profit that has been earned with capital employed. The rate of return on investment is determined by dividing net profit or income by the capital employed or investment made to achieve that profit.

ROI = Profit

Invested capitalROI consists of two components viz, I. Profit margin, and fl.

Investment turnover, as shown below:ROI = Net profit = Net profit Sales

Investment Sales Investment in assets

It will be seen from the above formula that ROI can be improved by increasing one or both of its components viz., the profit margin and the investment turnover in any of the following ways:

Increasing the profit margin Increasing the investment turnover, or Increasing both profit margin and investment turnover

The obvious generalisations that can be made about the ROI formula are that any action is beneficial provided that it:

Boosts sales Reduces invested capital Reduces costs (while holding the other two factors constant)

X 100

X

Table-1: Computation of Capital EmployedShare capital of the company xxxReserves and surplus xxxLoans (secured/ unsecured) xxx

xxxLess: (a) Capital-in-progress xxx

(b) Investment outside the business

xxx

(c) Preliminary expenses(d) Debit balance of Profit and Loss

A/cxxx xxx

Capital employed xxx

Return on in vestment analysis provides a strong incentive for optimal utilisation of these assets of the company. This encourages mangers to obtain, assets that will provide a satisfactory return on investment and to dispose of assets that are not providing an acceptable return. In selecting amongst alternative long-term investment proposals, ROI provides a suitable measure for assessment of profitability of each proposal.

2. Earnings Per Share (EPS):

The objective of financial Management is wealth or value maximisation of a corporate entity. The value is maximized when market price of equity shares is maximised. The use of the objective of wealth maximisation or net present value maximisation has been advocated as an appropriate and operationally feasible criterion to choose among the alternative financial actions. In practice, the performance of a corporation Is better judged in terms of its earnings per share (EPS). The EPS is one of the important measures of economic performance of a corporate entity.

The flow of capital to the companies under the present imperfect capital market conditions woold be made on the evaluation of EPS. Investors lacking inside and detailed information would look upon the EPS as the best base to lake their investment decisions. A higher EPS means better capital productivity.

EPS = Net Profit after tax and preference dividendNo. of Equity Shares

I EPS when Debt and Equity used= (EBIT – 1) (1 – T)

NII. EPS when Debt, Preference and Equity used

= (EBIT – I ) (1 – T) - DP

NWhere EBIT = Earnings before interest and tax

I = InterestT = Rate of Corporate tax

DP = Preference DividendN = Number of Equity shares

EPS is one of the most important ratios which measures the net profit earned per share. EPS is one of the major factors affecting the dividend policy of the firm and the market prices of the company. Growth in EPS is more relevant for pricing of shares from absolute EPS. A steady growth in EPS year after year indicates a good track of profitability.

3. Cash Earnings Per Share :

The cash earnings per share (Cash EPS is calculated by dividing the net profit before depreciation with number of equity shares.

Net profit + Depreciation

No. of Equity Shares

This is a more reliable yard stick for measurement of performance of companies, especially for highly capital intensive industries where provision for depreciation is substantial. This measures the cash earnings per share and is also a relevant factor for determining the price for the company's shares. However, this method is not as popular as EPS and is used as a supplementary measure of performance only.

4. Gross Profit Margin :

The gross profit margin is calculated as follows:= Sales - Cost of goods sold Gross profit

Sales Sales

The ratio measures the gross profit margin on the total net sales made by the company. The grosi, profit represents the excess of sales proceeds during the 1 period under observation over their cost, before taking into account administration, selling and distribution and financing charges. The ratio . measures the efficiency of the company's operations and this can also be; compared with the previous years results to ascertain the efficiency partners with respect to the previous years.

When everything normal, the gross profit margin should remain unchanged, irrespective of the level of production and sales, since it is based on the assumption that all costs deducted when computing gross profit which are directly variable with sales. A stable gross profit margin is therefore, the norm and any variation from it call for careful investigations, which may be caused; due to the following reasons:

X 100 X 100

(i) Price cuts: A company need to reduce its selling price to achieve the desired increase in sales.

(ii) Cost increases: The price which a company pay its suppliers during period of inflation, is likely to rise and this reduces the gross profit margin unless an appropriate adjustment is made to the selling price.

(iii) Change in mix: A change in the range or mix of products sold causes the overall gross profit margin assuming individual product lines earn different gross profit percentages.(iv) Under or Over-valuation of stocks.

If closing stocks are under-valued, cost of goods sold is inflated and profit understated. An incorrect valuation may be the result of an error during stock taking or it may be due to fraud The gross profit margin may be compared with that of competitors in the industry to assess the operational performance relative to the other players in the industry.

5. Net Profit Margin:The ratio is calculated as follows:

Net profit before interest and taxSales

The ratio is designed to focus attention on the net profit margin arising from business operations before interest and tax is deducted. The convention is to express profit after tax and interest as a percentage of sales. A drawback is that the percentage which results, varies depending on the sources employed to finance business activity; interest is charged 'above the line while dividends are deducted 'below the line'. It is for this reason that net profit i.e. earnings before interest and tax (EBIT) is used.

This ratio reflects nt: profit margin on the total sales after deducting all expenses but before deducting interest and taxation. This ratio measures the efficiency of operation of the company. The net profit is arrived at from gross profit after deducting administration, selling and distribution expenses. The non-operating incomes and expenses are ignored in computation of net profit before tax, depreciation and interest

This ratio could be compared with that of the previous year's and with that of competitors to determine the trend in net profit margins of the company and its performance in the industry. This measure will depict the correct trend of performance where there are erratic fluctuations in the tax provisions from year to year. It is to be observed that majority of the costs debited to the profit and loss account are fixed in nature and any increase in sales will cause the cost per unit to decline because of the spread of same fixed cost over the increased number of units sold.

6. Cash Profit RatioCash profit

X 100

X 100

Sales

Where Cash profit = Net profits Depreciation

Cash profit ratio measures the cash generation in the business as a result of trie operations expressed in terms of sales. The cash profit ratio is a more reliable indicator of performance where there are sharp fluctuations in the profit before tax and net profit from year to year owing to difference in depreciation charged. Cash profit ratio eva)'iates the efficiency of operations in terms of cash generation and is not affected y the method of depreciation charged. It also facilitate the inter-firm comparison of performance since different methods of depreciation may be adopted by different companies.

7. Return on Assets :This ratio is calculated as follows:

Net profit after taxTotal assets

The profitability, of the firm is measured by establishing relation of net profit with the total assets of the organisation. This ratio indicates the efficiency of utilisation of assets in generating revenue.

8. Return on Shareholders Funds or Return on Net WorthNet profit after interest and tax

Net worth

Where, Net worth = Equity capital + Reserves and Surplus.

This ratio expresses (he nel profit in Icrms of the equity shareholders funds. This ratio is an important yardstick of performance of equity shareholders since it indicates the return on the funds employed by them. However, this measure is based on the historical net worth and will be high for old plants and low for new plants.

The factor which motivates shareholders to invest in a company is the expectation of an adequate rate of return on their funds and periodically, they will want to assess the rate of return earned in order to decide whether to continue with their investment. There are various factors of measuring the return including the earnings yield and dividend yield which are examined at later stage. This ratio is useful in measuring the rate of return as a percentage of the book value of shareholders equity.

The further modification of this ratio is made by considering the profitability from equity shareholders point of view can also be worked out by taking the profits after preference dividend and comparing against

X 100

X 100

capital employed after deducting both long-term loans and preference capital.

Operating RatiosThe ratios of all operating expenses (i.e. materials used, labour,

factory-overheads, administration and selling expenses) to sales is the operating ratio. A comparison of the operating ratio would indicate whether the cost content is high or low in the figure of sales. If the annual comparison shows that the sales has increased the management would be naturally interested and concerned to know as to which element of the cost has gone up. It is not necessary that the management should be concerned only when the operating ratio goes up. If the operating ratio has fallen, though the unit selling price has remained the same, still the position needs analysis as it may be the sum total of efficiency in certain departments and inefficiency in others, A dynamic management should be interested in making a complete analysis.

It is, therefore, necessary to break-up the operating ratio into various cost ratios. The major components of cost are: Material, labour and overheads. Therefore, it is worthwhile to classify the cost ratio as:

1. Materials Cost Ratio = MaterialsConsumed Sales

2. Labour Cost Ratio = Labour Cost SalesSales

3. Factory Overhead Ratio = Factory ExpensesSales

4. Administrative Expense Ratio = Administrative ExpensesSales

5. Selling and distribution expenses ratio = Selling and Distribution Expenses

Sales

Generally all these ratios are expressed in terms of percentage. Then total up all the operating ratios. This is deducted from 100 will be equal to the net profit ratio. If possible, the total expenditure for effecting sales should be divided into two categories, viz. Fixed and variable and then ratios should be worked out. The ratio of variable expenses to sales will be generally constant; that of fixed expenses should fall if sales increase, it will increase if sales fall.

Market Test Ratios

The market test ratios relates the firm's stock price to its earnings and book value per share. These ratios give management an indication of what investors think of the company's past performance and future

X 100

X 100

X 100

X 100

X 100

prospectus. If firm's profitability, solvency and turnover ratios are good, then the market test ratios will be high and its share price is also expected to be high. The market test ratios are as follows: -

1. Dividend payout ratio2. Dividend yield ;

3. Book value4. Price/Earnings ratio

1. Dividend Payout Ratio:

Dividend per shareEarnings per share

Dividend payout ratio is the dividend per share divided by the earnings per share. Dividend payout indicates the extent of the net profits distributed to the shareholders as dividend. A high payout signifies a liberal distribution policy and a low payout reflects conservative distribution policy.

2. Dividend YieldDividend per share

Market price

This ratio reflects the percentage yield that an investor receives on this investment at the current market price of the shares. This measure is useful forinvestors who are interested in yield per share rather than capital appreciation.

3. Book Value:

Equity Capitalf +Reserves - Prqfit&Lass debit balance.Total number of equity shares;

This ratio indicates the net worth per equity share. The book value is a reflection of the past earnings and the distribution policy of the company. A high book value indicates that a company has huge reserves and is a potential bonus candidate. A low book value signifies liberal distribution policy of bonus and dividends, or alternatively, a poor track record of profitability. Book value is considered less relevant for the m^ker price as compared to EPS, as it reflects the past record whereas the market discounts the future prospects.

4. Price Earnings Ratio (P/E Ratio):

Current market priceEarnings per share

X 100

This ratios measures the number of times the earnings of the latest year at which the share price of a company is quoted. It signifies the number of years, in which the earnings can equal to current market price. This ratio reflects the market's assessment of the future earnings potential of the company. A high P/e ratio reflects earnings potential and a low P/E ratio low earnings potential. The P/E ratio reflects the market's confidence in the company's equity. P/e ratio is a barometer of the market sentiment Companies with excellent track record of profitability, professional management and liberal distribution policy have high P/E ratios whereas companies with moderate track record, conservative distribution policy and average prospects quote a low P/E ratios. The market price discounts the expected earnings of a company for the current year as opposed to the historical EPS.

LIMITATIONS IN THE USE OF RATIO ANALYSISRatios by themselves mean nothing. They must always be

compared with: a norm or a target previous ratios in order to assess trends the ratios achieved in other com; arable companies (inter-company

comparisons), and caution has to be exercised in using ratios.

The following limitations must be taken into account:

Ratios are calculated from financial statements w'.ach are affected by the financial bases and policies adopted on such matters as depreciation and the valuation of stocks.

Financial statements do not represent a complete picture of the business, but merely a collection of facts which can be expressed in monetary terms. They may not refer to other factors which affect performance.

Over use of ratios as controls on managers could be dangerous, in that management might concentrate more on simply improving the ratio than on dealing with the significant issues. For example, the return on capital employed can be improved by reducing assets rather than increasing profits.

A ratio is a comparison of two figures, a numerator and a denominator In comparing ratios it may be difficult to determine whether differences are due to changes in the numerator, or in the denominator or in both.

Ratios are inter-connected. They should not be treated in isolation. The effective use of ratios, therefore, depends on being aware of all these limitations and ensuring that, following comparative analysis,

they are used as a trigger point for investigation and corrective action rather than being treated as meaningful in themselves.

The analysis of ratios clarifies trends and weaknesses in performance as a guide to action as long as proper comparisons are made and the reasons for adverse trends or deviations from the norm are investigated thoroughly.

Illustration 1: From the given Balance Sheets calculate:(a) Debt-equity ratio(b) Liquid ratio(c) Fixed assets to current assets ratio(d) Fixed assets to Net worth ratio

Balance SheetLiability Rs. Assets Rs.

Share Capital 1,00,000 Goodwill 60,000Reserve 20,000 Fixed assets (Cost) 1,40,000Profit and Loss a/c 30,000 Stock 30,000Secured Loans 80,000 Debtors 30,000Creditors 50,000 Advances 10,000 Provisions for taxation

20,000 Cash 30,000

3,00,000 3,00,000

Solution:(a) Debt-equity ratio = Outsiders Funds

Shareholders Funds

Outsider's Funds Rs. Shareholders' Funds

Rs.

Secured Loans 80,000 Share Capital 1,00,000

Creditors 50,000 Reserves 20,000

Provisions for taxation

20,000 Profit and Loss a/c 30,000

1,50,000 1,50,000

Debt-equity ratio = 1,50,0001,50,000

(b) Liquid ratio = Liquid Assets Current Liabilities

= 1:1

Note: Advances are treated as current asset.Secured Joans are treated as current liability.

Liquid ratio = 70,0001,50,000

(c) Fixed Assets to Currents Assets Ratio = Fixed AssetsCurrent Liabilities

Fixed Assets = 1,40,000 Current Assets (Rs)Cash 30,000

Stock 30,000

Debtors 30,000

Advances 10,000

1,00,000

Fixed assets to current assets ratio = 1,40,000 1,00,000

(d) Fixed Assets to Net worth Ratio = Fixed AssetsNet worth

Share Capital

1,00,000

Reserves 20,000P & L a/c 30,000

1,50,000Less: Provision for taxation 20,000

1,30,000

Fixed Assets to Net worth ratio = = 1.08:1

Illustration 2: From the following data calculate;(a) Current ratio(b) Quick ratio(c) Stock Turnover ratio(d) Operating ratio(e) Rate of return on equity capital

Balance Sheet as on Dec., 31,2001

Liabilities Rs. Assets Rs.

Equity Share 1,00,000 Plant and 6,40,000

= 0.47:1

= 1.4:1

1,40,000

1,30,000

Capital (Rs. 10 shares)

Machinery

Profit and loss account

3,68,000 Land and buildings 80,000

Creditors 1,04,000 Cash 1, 60,000Bills payable 2,00,000 Debtors

3,60,000Less: Provision for bad debts 40,000

3,20,000

Other Current liabilities

20,000 Stock 4,80,000

Prepaid Insurance 12,00016,92,000 16,92,000

Income Statement for the year ending 31st Dec., 2001(Rs.)

Sales 4,00,000Less: Cost of goods sold 30,80,000

9,20,000Less: Operating expenses 6,80,000Net Profit 2,40,000Less: Income tax paid 50% 1,20.000New Profit after tax 1,20,000

Balances at the beginning of the year:Debtors Rs. 3,00,000 Stock Rs. 4,00,000

Solution:

(a) Current ratio = Current AssetsCurrent Liabilities

Current Assets Rs. Current Liabilities Rs.

Cash Creditors 1,04,000

Debtors 3,20,000 Bills Payable 2,00,000

Stock 4,80,000 Other Current Liabilities

20,000

Prepaid insurance 12,000

9,72,000 3,24,000

Current ratio = 9,72,0003,24,000

(b) Quick ratio = Liquid AssetsCurrent Liabilities

Liquid assets (Rs.) Cash Debtors 1,60,000

3,20,000

4,80,000

Liquid ratio = 4,80,000 3,24,000

(c) Stock Turnover Ratio = Cost of goods sold Average slock

Cost of goods sold = 30,80,000Average Stock = Opening Stock + Closing Stock

2= 4,00,000 + 4,80,000

2

Stock Turnover Ratio = 3,80,0004,40,000

(d) Operating Ratio = Cost of goods sold + Operating expresses Net Sales

= 30,80,000 + 6,80,000 + 40,00,000

40,00,000

(e) Rate of return on equity capital:= Net profit afer laxEquity share capital

= 1,20,000 = 12%10,00,000

3:1

Current liabilities Rs.3,24,000

= 1.48:1

= 4,40,000

= 7 times

X 100

X 100

X 100

= 94%

Illustration 3: The following are the Trading and P&L A/c for the year ended 31st December 2001 and the Balance Sheet as on that date of K. Ltd.

Trading and P & L A/c

Particulars Rs. Particulars Rs.

To Opening Stock 9,950 By Sales 85,000

To Purchases 54,5.25 By Closing Stock 14,900

To Wages 1,425

To Gross Profit 34,000

99,900 99,900

To Administrative Expenses

15,000 By Gross Profit 34,000

To Selling Expenses 3,000 By Interest 300

To Financial Expenses 1,500 By Profit on sale of shares

600

To Loss on sale of assets 400

To Net Profit 15,000

34,900 34,900

Balance SheetLiabilities Rs. Assets Rs.

Share Capital 20,000 Land and Buildings 15,000

Reserves 9,000 Plant & Machinery 8,000

Current Liabilities 13,000 Stock 14,900

P&LA/c 6,000 Debtors 7,1000

Cash at Bank 3,000

48,000 48,000

You are required to Calculate;(a) Current Ratio(b) Operating Ratio(c) Stock Turnover Ratio(d) Net Profit Ratio(e) Fixed Assets Turnover Ratio

Solution:(a) Current ratio = Current Assets

Current Liabilities

Current Assets (Rs.)Cash at Bank 3,000

Debtors 7,100

Stock 14,900

25,000

Current ratio = 25,000

13,000

(b) Operating Ratio = Cost of goods sold + Operating expresses

Net Sales

Cost of goods sold = 9,950 + 54,525 + 1,425 - 14,900

Operating expenses = 19,500Operating Ratio = 51,000 + 19,500

85,000

(c) Stock Turnover Ratio = Cost of goods sold Average stock

Average Stock = 9,950 + 14,900 2

Stock Turnover Ratio = 51,000 12,425

(d) Net Profit Ratio = Net Profit Net Sales

Current liabilities Rs. 13,000

Rs. 1.923:1

X 100

= 51,000

X 100 = 82.94%

= 12,425

= 4.1 times

= 100

= 15,000 85,000

(e) Fixed Assets Turnover Ratio = Net Sales Fixed Assets= 85,000 23,000

Illustration 4; The following is the Trading and Profit and Loss a/c and Balance Sheet of a firm.

Trading and P & L A/cParticulars Rs. Particulars Rs.

To Opening Stock 10,000 By Sales 1,00,000

To Purchases 55,000 By Closing Stock 15,000

To Gross Profit c/d 50,000

1,15,000

1,15,000

To Administrative Expenses 15,000 By Gross Profit b/d 50,000

To Interest 3,000

To Selling Expenses 12,000

To Net Profit 20,000

50,000 50,000

Balance SheetLiabilities Rs. Assets Rs.

Capital 1,00,000 Land and Buildings 50,000

Profit and Loss a/c 20,000 Plant & Machinery 30,000

Creditors 25,000 Stock 15,000

Bills Payable 15,000 Debtors 15,000

Bills receivable 12,500

Cash at Bank 17,500

Furniture 20,000

1,60,000 1,60,000

= 100 = 17.65%

= 3.7 times

Calculate the following ratios:(a) Inventory turnover ratio(b) Current Ratio(c) Gross profit ratio(d) Net profit ratio(e) Operating ratio(f) Liquidity ratio(g) Proprietary ratio

Solution: (a) Inventory Turnover ratio = Cost of goods sold

Average stock Cost of goods sold

Opening Stock 10,000Purchases 55,000

65,000Less: Closing Stock 1 5,000

50,000

Average Stock = Opening Stock + Closing Stock2

= 10,000 + 15,000 2

Stock Turnover ratio = 50,00012,500

(b) Current ratio = Current Assets

Current Liabilities

Current Assets (Rs.)Current Assets Rs. Current liabilities Rs.

Stock 15,000 Creditors 25,000

Debtors 15,000 Bills Payable 15,000

B/R 12,500

Cash at Bank 17,500

60,000 40,000

Current ratio = 60,000 40,000

= 12,500

= 4 times

= 1.5:1

(b) Gross Profit Ratio = Gross Profit Net Sales

(c) Net Profit Ratio = Net Profit Net Sales

= 20,000 1,00,000

(d) Operating Profit = Cost of goods sold + Operating expressesNet Sales

Cost of goods sold = 50,000

Operating expenses (Rs.)Administration expenses Selling expenses

15,000

12,000

27,000

Operating ratio = 50,000 + 27,000 1,00,000

(e) Liquidity ratio = Liquid Assets Current Liabilities

Current Assets (Rs.)Liquid Assets Rs. Current liabilities Rs.

Cash at Bank 17,500 Creditors 25,000Bills Receivable 12,500 Bills Payable 15,000

Debtors 15,000

45,000 40,000

Liquidity ratio = 45,000 40,000

(f) Proprietary ratio = Shareholder’s FundsTotal Assets

Shareholder's Furuis (Rs.)Capital Profit and Loss a/c 1,00,000

20,000

X 100

X 100

= 50%

= 20%

= 100

X 100 77 %

X 100

Total Assets Rs.

1,60,000

1,20,000

Proprietary ratio = 1,20,0001,60.000

Illustration 5: A company has a profit margin of 20% and asset turnover of 3 times. What is the company's return on investment? How will this return on investment vary if –

(i) Profit margin is increased by 5% ? (ii) Asset turnover is decreased to 2 times?(iii) Profit margin is decreased by 5% and asset turnover is increased

to 4 times.

Calculation of impact of change in profit margin and change in asset turnover on return on investment

Return on investment = Profit Margin x Asset Turnover= 20% x 3 times = 60%

(i) If profit margin is increased by 5% :ROI = 25% x 3 = 75%

(ii) If asset turnover is decreased to 2 times:ROI = 20% x 2 = 40%

(iii) If profit margin decreased, by 5% and asset turnover is increased to 4 times:

ROI = 15% x 4 = 60%

Illustration 6: There are three companies in the country manufacturing a particular chemical. Following data are available for the year 2000-2001.

(Rs. lakhs)Company Net Sales Operating

CostOperating Assets

A Ltd. 300 255 125

B Ltd. 1,500 1,200 750

C Ltd. 1,400 1,050 1,250

Which is the best performer as per your assessment and why?Comparative Statement of Performance

Particulars A Ltd. B Ltd. C Ltd.

X 100 =

75%

Sales 300 1,500 1,400Less: Operating Cost 255 1,200 1,050OperatingProfit (A) 45 300 350Operating Assets (B) 125 750 1,250

Return on capital employed (A) / (B) x 1 00

36% 40% 28%

Analysis: Basing on the return on capital employed, B Ltd., is the best performer as compared to A Ltd. and C Ltd. Illustration 7: Calculate the P/E ratio from the following:

(Rs.)Equity Share Capital (Rs. 20 each) 50,00,000

Reserves and Surplus 5,00,000Secured Loans at 15% 25,00,000Unsecured Loans at 12.5% 10,00,000Fixed Assets 30,00,000Investments 5,00,000

Operating Profit 25,00,000,

Income-taxRate50% (Rs.)

Operating Profit 25,00,000

Less: Interest onSecured Loans @ 15% 3,75,000

Unsecured Loans @ 12.5% 1,25,000 5,00,000Profit before tax (PBT) 20,00,000Less: Income-tax @ 50% 10,00,000Profit aaer tax (PAT) 10,00,000

No. of Equity shares 2,50,000

EPS = Profit after tax

No. of Equity shares

= Rs. 10,00,000

Rs. 2,50,000

Market price per share = Rs. 50

P/E Ratio = Market price per share / EPS

= Rs.50/Rs.4 = 12.50

= Rs. 4

Illustration 8: The capital of Growfast Co. Ltd., is as follows:

10% Preference shares of Rs.10 each 50,00,000Equity shares of Rs. 100 each 70,00,000

1,20,00,000

Additional information:Profit after tax at 50% Rs. 15,00,000 Deprication Rs. 6,00,000 Equity dividend paid 10% Market price per equity share Rs. 200

Calculate the following:(i) The cover for the preference and equity dividends

(ii) The earnings per share

(iii) The price earnings ratio

(iv) The net funds flow

Solution:

(i) The cover for the Preference and Equity dividends:

Profit after tax

= Preference dividend + Equity dividend

= Rs. 15,00,000

Rs. 5,00,000 + to 7,00,000

(ii) The Earning Per Share:

= Net profit after preference dividend

No. of Equity Shares

= Rs. 15,00,000 – Rs. 5,00,000

Rs.7,00,000

(iii) The Price Earnings Ratio:

= Market price per share

Earning per share

= Rs.200

Rs. 14.29

= 1.25 times

= Rs. 14.29

= 14 times

(iv) The Net Funds Flow:

(Rs.)Profit after tax Add: Depreciation

15,00,000 6,00,000

21,00,000