Ratio analysis ratios at a glance1

Compiled by Prof. M B. Thakoor

RATIO ANALYSIS

15. RATIOS AT A GLANCE

No. Ratio Formula CompositionStandard

RatioTest of Interpretation

1. Current Ratio

CurrentAssets

Current Liabilities

Current Assets :1. Debtors, 2. Stock, 3. Loose tools, 4. Accrued income 5. Pre-payments, 6. Bills receivables, 7. Cash & Bank.

Current Liabilities 1. Creditors2. Bills payable 3. Outstanding

expenses, 4. Unclaimed

dividends, 5. Provision for

taxation, 6. Proposed

dividend,7. Bank overdraft.

2:1 Short-term solvency

1. Measures short-term financial strength.

2. Ability to pay current obligations.

3. Adequacy of working capital-a quantitative test and not qualitative test.

4. Higher ratio implies sound financial position but may also mean idle funds, under trading.

5. Lower ratio indicates Inadequate working capital, short-term solvency in danger, over trading.

2 Liquid Ratio/Acid test Ratio

Quick Assets

Quick Liabilities

Quick Assets = Current Assets Less stock and pre-payments

Quick Liabilities = Current Liabilities less Bank overdraft.

1:1 Imme-diate solvency

1. Stringent (tough) test of solvency.

2. Measures ability to meet the immediate liabilities.

3. Qualitative test to measure liquidity.

4. Higher Ratio : Sound financial position, idle funds.

5. Lower Ratio : dangerous financial position inability to met immediate obligations.

3 Stock to working capital

Closing Stock

Working Capital

/ x 100

Stock = Closing stock Working capital =Current Assets LessCurrent Liabilities

Should be less than 100 %

Investments in stocks

1. Extent of working capital blocked in stock.

2. Higher ratio : Unsound working capital position; if stock is not saleable, situation becomes dangerous.

3. Lower Ratio : Sound working capital position and effective inventory management.

4. Should be studied with quick and current ratio.

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4 Proprietary Ratio

Prop’s Fund

Total Assets

x 100

Proprietor’s Funds =Preference Capital +Equity Capital +Reserves & Surplus Losses Fictitious Assets like miscellaneous expenditure. Total Assets = Total Liabilities = Fixed assets + Current Assets + Investments (Excluding fictitious assets)

65% to 75%

Long term stability or solvency

1. Shows percentage of total assets financed by the proprietor / organisation.

2. All fixed assets and part of current assets should be financed out of proprietors Fund in order to build a solid foundation for the company.

3. Higher ratio : Lesser dependence on outside funds-sound financial position but over capitalization and low returns.

4. Lower Ratio : More dependence on outside funds, under capitalization, over-trading, unsound financial position.

5 Capital Gearing Ratio

Preference Capital + Debentures + term loans

Equity Share Capital + Reserves & Surplus

- Losses & Fictitious Assets

Capital with fixed interest bearing securities -----------------Equity Share Capital + Reserves & Surplus – Losses & Fictitious Assets

-- Capital Gearing

High Gearing : 1. IF fixed interest,

dividend bearing capital exceeds the equity capital & reserves, the company is said to be highly geared.

2. High gearing is favorable only when rate of earning of the business is greater than fixed interest.

3. It may amount to under capitalization.

4. Equity shareholders expect higher dividend and share become speculative.

Low Gearing :1. Majority interest lies

with equity share holders.

2. Over capitalization.3. Low rate of return or

equity shares.

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6 Debt-EquityRatio

(1) Debt

Equity

OR

(2) Debt

Debt + Equity

Debt includes :i) Debenturesii) Long term loansiii) RedeemablePreference share

capital Equity includes : i) Equity Capitalii) Reserves and Surplusiii) Preference Capital other than redeemable Preference Shares Less fictitious assets.

(i) 2 : 1

(ii) 65% to 75%

Long-term financial position

1. Test of long-term financial position or capital structure of the company.

2. Higher ratio indicates greater dependence on loans, higher amount of interest payable. Such trading on equity affects adversely during recession.

3. Lower ratio indicates low owed funds and high equity. Compulsory payment like interest, low returns for equity holders, over capitalization.

7 Gross Profit Ratio

Gross Profit

Sales

x 100

Gross Profit = Sales Less : Cost of good sold

Sales = Net Sales i.e. Gross Sales – Sales Returns or return inwards.

Should be compared over the years or with the other company-ies ratio

Profitability

1. Used for analyzing trading results.

2. Higher ratio means greater profitability attained by

a. Increasing sales pricesb. Cost Savingc. Over-Valuing closing stock3. Lower ratio indicates

low profitability.4. Limitations-indirect

expenses are not considered hence overall profitability cannot be known.

8. Operating Ratio

COGS + Operating Expenses Sales

X 100

Cost of goods sold (COGS) = opening stock + purchases + direct expenses – Closing Stock :

Operating Expenses = office & administrative expenses + selling & distribution expenses + financial expenses

Should be compare over the years

Operational efficiency & profitability

1. Indicates profitability & managerial efficiency in controlling costs.

2. Higher ratio means lower margin of profit.

3. Lower ratio means greater margin of profit.

4. Comparison with previous year would indicate saving or increase in cost.

5. For better results this ratio is broken into various cost ratios.

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9 Expenses Ratio

Expense

Sales

x 100

Respective expenses viz. factory overheads, office expenses, selling & distribution expenses.

Sales = Net Sales = Gross Sales – Sales Returns or Return inward.

Should be compared with last years.

Operational efficiency

1. Shows portion of sales consumed by various items of expenses.

2. Trend over the years should be studied. Management should concentrate on those expenses which increase disproportionately.

3. Higher ratio means lower profitability and inefficiency of management in controlling expenses.

10. Net Profit Ratio

Net Profit

Sales

x 100

ii) Op. NP

Sales

x 100

Operating Net Profit = Net profit excluding non-trading income and not-trading expenses

Sales = Net Sales = Gross Sales – Sales Returns or Return inward.

To be compared with the previous year’s ratios

Profita-bility & efficie-ncy

1. It measures overall profitability and operating efficiency.

2. Should be studied with G.P. ratio and operating ratio.

3. Higher ratio indicates higher profitability and lower ratio indicates lower profitability.

11 Stock Turnover Ratio

Cost of good sold

Average Stock

OR Sales

Closing Stock

Cost of goods sold = Sales less Gross Profit Average Stock = Op.Stock + Cl.Stock

2

When Opening stock is not given the denominator is closing stock and not zero + closing stock / 2

5 – 6 times

Operational efficiency & investment in stock

1. It shows efficiency in inventory management.

2. Higher ratio indicates favorable trading situation, no loss due to obsolescence as stock is turned into sales regularly, no excessive blocking of funds in inventory, over-trading.

3. Lower ratio indicates stock is not movable, blocking of funds, wrong buying or excessive production, under trading.

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12 Return on Capital Employed (RoCE)

Net Profit

Capital Employed

x 100

Net Profit (NP) = Net profit before interest and tax less abnormal, non-recurring items.Capital Employed = Fixed Assets + Current Assets – Current Liabilities. (Excluding Fictitious Assets)

To be Compared with similar ratio of other companies

Profitability Productivity

1. This is the broadest measure of performance

2. It combines the effect of Net profit Ratio and Capital turnover ratio Turnover ratio measures productivity and Net Profit ratio measures profitability.

3. This ratio with other expenses ratio and turnover ratios is helpful in financial analysis.

4. Higher ratio is regarded as favorable and lower ratio is unfavorable.

13 Return on proprietor’s Fund/Net-wroth

Net Profit available to the Share holders

Prop. Fund x 100

Proprietor’s Funds = Preference Capital + Reserves & Surplus Less : Fictitious assets.

--- Profit Earning Capacity

1. It shows earning power of proprietors Funds. Minimum return must be earned to keep proprietors happy.

2. This ratio is helpful to a future investor.

3. Useful for inter-Company comparisons.

4. High rate of return means growing & prosperous company. Lower is unfavorable.

14 Return on Equity Capital

OR

Return on Equity Share holders Fund

Net Profit available to Equity Share holder

Eq. Share Cap x 100

Net Profit available to Equity Share holder = Divisible NP = Net Profit after tax & pref. Div. and trsfd. To Reserves. Equity Capital = Paid up Capital

--- Earning Per Equity Share

1. It shows the profitability of the company in terms of earnings available for equity shareholders.

2. Higher ratio means effective use of equity capital & advantage of trading on equity.

3. Lower ratio indicates low profitability.

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15 Debtor’s Turnover

Drs. + BR

Cr. Sales

x 365

Debtors (Drs.) will include only trading debtors, prevision for doubtful debt should not be deducted BR = Bills Receivable Less dishonored bill.

Should be compared with the credit terms

Receivables Management

1. It shows average credit granted to customers.

2. Should be compared with credit terms granted to know efficiency of credit collection department.

3. Higher ratio means greater funds blocked in receivables, liberal credit terms for increasing sales, laxity of collection dept. or debtors no longer liquid assets.

4. Low ratio would mean Funds not blocked in receivables, efficient, collection department, debtors are liquid assets. This ratio should be studied with other short term solvency ratios.

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RATIO ANALYSIS

RATIOS FROM INVESTORS POINT OF VIEW

(1) Return on Total Shareholders Equity = Profit after Tax

Total Networth / Shareholders Funds

(2) Return on Equity Shareholders Equity = Profit after Tax – Preference Dividend

Equity Shareholders Fund

(3) Earning Per Share (EPS) = Profit after Tax available to Equity Holders

No. of Equity Shares

(4) Dividend Per Share (DPS) = Profit Paid to Equity Shareholders

No. of Equity Shares

(5) Dividend Payout Ratio = Dividend Per Share i.e. DPS

Earning Per Share EPS

(6) Price Earning Ratio = Market Price Per Share i.e. MPS

Earning Per Share EPS

(7) Dividend Yield = Dividend Per Share i.e. DPS

Market Price Per Share MPS

(8) Earning Yield or Earning Price Ratio = Earning Per Share i.e. EPS

Market Price Per Share MPS

(9) Cover for Ordinary Dividend =

i.e. Cover for Equity Dividend

PAT – Preference Dividend – transfer to reserves

Equity Dividend Payable

(10) Cover for Preference Dividend = Profit after Tax

Preference Dividend Payable

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Ratio analysis ratios at a glance1

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