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RATIO ANALYSIS

CAIIB – Financial Management – MODULE C – RATIO ANALYSIS R K MOHANTY FACULTY MEMBER, SIR SPBT COLLEGE, CENTRAL BANK OF INDIA, MUMBAI. RATIO ANALYSIS. Financial Statements generally consists of the following two types :

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RATIO ANALYSIS

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  1. CAIIB – Financial Management – MODULE C – RATIO ANALYSIS R K MOHANTY FACULTY MEMBER, SIR SPBT COLLEGE, CENTRAL BANK OF INDIA, MUMBAI RATIO ANALYSIS

  2. Financial Statements generally consists of the following two types : Profit & Loss Account – which summarises the expenses incurred and revenues received during the period covered by it ; and Balance Sheet – which lists out the Assets and Properties owned by the Unit and the Liabilities it owes to outsiders and also to its owners. FINANCIAL STATEMENTS

  3. Who are interested in financial statements ?

  4. Who are interested in financial statements ?

  5. Who are interested in financial statements ?

  6. Major Components of Profit & Loss Statement • NET SALES : This is the key figure in the Income Statement. Which can be arrived from the following : • Net Sales = Gross Sales – Excise Duty • Where Gross Sales = (Total Domestic Sales + Export Sales) – (Sales Tax + Octroi + Sales Return)

  7. 2. COST OF PRODUCTION : It is the sum of Cost of Raw Materials consumed and all Manufacturing Expenses. COP = Cost of R.M. + Manufacturing Expenses Manufacturing Expenses include : (i) Spares (ii) Power & fuel (iii) Wages & Salaries (Direct Labour) (iv) Other Manufacturing Expenses (v) Depreciation (vi) Difference between Opening & Closing Stock of SIP Major Components of Profit & Loss Statement

  8. 3. COST OF SALES : It is the sum of Cost of Production and Difference between Opening & Closing Stock of Finished Goods Major Components of Profit & Loss Statement

  9. 4. GROSS PROFIT : Net Sales – Cost of Sales The percentage of Gross Profit to Net sales indicates whether the average sale price is sufficient to cover all expenses. Major Components of Profit & Loss Statement

  10. 5. OPERATING EXPENSES : These are the expenses which are required to run the business on daily basis, such as; • Selling Expenses • Administrative Expenses • General Expenses • Provision for Bad Debts • Other Misc. Expenses Major Components of Profit & Loss Statement

  11. 5. OPERATING PROFIT : When you deduct all the operating expenses from the Gross Profit you arrive at the Operating Profit. Operating Profit = Gross Profit - All Operating Expenses Finally to this Operating Profit, Other incomes not arising out from normal operations are added and other Non-operating expenses are deducted to arrive at the figure of NET PROFIT BEFORE TAX (NPBT). From this NPBT so arrived, Income Tax is adjusted first and thereafter Dividend is distributed as per Management’s Policy. The Balance amount is reinvested in business in the form of RESERVES or added in the Capital Account. Major Components of Profit & Loss Statement

  12. Balance Sheet is a statement of Assets & Liabilities as on a given date. It reflects the Financial Position of a concern as on a date. The Balance Sheet can be looked at from two angles: ASSETS as USES and LIABILITIES as SOURCES OF FUNDS ASSETS as what the Business Owns and LIABILITIES as what the Business Owes. Major Components of balance sheet

  13. 1. Net Worth : It is the total investment of the owners in the Business. For a Limited Company it comprises of a sum of Share Capital + Reserves Share Capital is the direct investment of the owners in the business. This includes Equity Share Capital and Preference Share Capital. Reserves : Profits of the business which have been reinvested in the business. In Proprietorship and Partnership Firms they are added to Capital and not shown separately. Major Components of balance sheet

  14. 2. TERM LIABILITIES : All those borrowings made by the concern which are repayable after One Year of the Balance Sheet date are called Term Liabilities. These include TERM LOANS DEBENTURE TERM DEPOSITS REDEEMABLE PREFERENCE SHARE CAPITAL (Maturing with 12 years of Balance Sheet Date) Major Components of balance sheet

  15. 3. CURRENT LIABILITIES : All those borrowings made by the concern which are expected to be repaid within 12 months of the date of the Balance Sheet. These include CREDITORS PROVISIONS FOR EXPENSES BANK BORROWING FOR WORKING CAPITAL DEPOSITS MATURING WITHIN 12 MONTHS INSTALLMENTS OF TERM LOANS DEBENTURES/REDEEMABLE PREFERENCE SHARES MATURING WITHIN ONE YEAR Total of Term Liabilities + Current Liabilities is calledOutside Liabilities and is the Total Borrowings of the Firm Major Components of balance sheet

  16. 4. FIXED ASSETS: These are the assets which help in the production of goods & services of the concern. They are tangible in nature and have a long life. The examples of Fixed Assets are : Land Building Plant & Machineries Furniture & Fixtures etc. Major Components of balance sheet

  17. 5. CURRENT ASSETS: These are the assets which are expected to be consumed or converted into cash through the normal business operations and usually within one year. Such as: Cash & Bank Balances FDs with Banks Short Term Govt .Securities Stocks of R.M., Semi F.G and F.G Stores, Spares Advance Payment for Suppliers Prepaid Insurance Debtors & Bills Receivables Major Components of balance sheet

  18. 6. NON CURRENT ASSETS: These are the assets which do not fall in the above two categories of assets. They are: Corporate Investments Loans not recoverable within 1 year Non Consumable Spares Deferred Receivables Advance for Capital Expenditure Intangible Assets [ Goodwill, Patent, Trade Mark] Preliminary & Pre-operative Expenses Major Components of balance sheet

  19. Lenders’ need it for carrying out :- Technical Appraisal Commercial Appraisal Financial Appraisal Economic Appraisal Management Appraisal FINANCIAL Statements are studied to know • Does the firm has liquidity to meet its short term obligations? • Would the firm be able to meet its long term commitments? • Is the firm using its assets efficiently? • How profitable are the operations of the firm?

  20. It is the process of identifying the financial strengths & weaknesses of a firm by properly establishing relationships between the items of the Balance Sheet and Profit & Loss A/c. This is done by – (1) The Firm’s Management (2) Owners (3) Creditors (4) Investors (5) Bankers & Others What is Financial analysis?

  21. TRADE CREDITORS : They do it to know the firm’s ability to meet their claim. [Liquidity] SUUPLIERS OF LONG TERM DEBT : They need to know the firm’s long term solvency. [Profitability over a long period of time] INVESTORS : They are concerned about the firm’s earnings. BANKERS : They need to understand the soundness of the Business so as to take a good Credit Decision. Why Financial analysis?

  22. It’s 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 Ratio Analysis

  23. Ratio is the indicated quotient of two mathematical expressions i.e. the relationship between two or more things. Ratio Analysis involves comparison for useful interpretation of the financial statement. A single ratio does not indicate favourable or unfavourable condition. It should be compared with some sort of standard. Standard of comparison may consist of : Ratios calculated from the past financial statements of the same firm. Ratios developed using the projected financial statements of the same firm. Ratios of some selected firms, especially the most progressive and successful at the same point of time; and Ratios of the industry level to which the firm belongs. Ratio Analysis

  24. 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. How a Ratio is expressed?

  25. Format of balance sheet for ratio analysis

  26. Classification of Ratios

  27. Liabilities have Credit balances and Assets have Debit balances 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 Some important notes

  28. 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. But with Rights Issue, change takes place in Net Worth and Current Ratio. Some important notes

  29. 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 Current Assets : Cash & those assets which can be converted into cash within 1 year. For example, Marketable securities, Debtors, Inventories, Prepaid Expenses. Current Liabilities : Creditors, Bills Payable, Accrued Expenses, Short Term Bank Loans, Income Tax Liabilities and long Term Liabilities maturing in the current year.

  30. Current Ratio measures the firm’s short term solvency. A ratio greater than 1 means that the firm has more current assets than current claims against them. As a conventional rule a Current Ratio of 2 is considered most satisfactory. This rule is based on the logic that in a worse situation, even if the value of current assets become half, the firm will be able to meet its current obligations. It represents the “Margin of Safety’ i.e. a cushion of protection for creditors. Higher the ratio greater the margin of safety.

  31. Net Working Capital : This is worked out as surplus of Long Term Sources over Long Term Uses, alternatively it is the difference of Current Assets and Current Liabilities. It measures the firm’s potential reservoir of funds. NWC = Current Assets – Current Liabilities

  32. 3. ACID TEST or QUICK RATIO : It is the ratio between Quick Current Assets and Current Liabilities. Quick Current Assets : Quick assets are those which can be immediately converted into cash without a loss of value. Cash & Bank balances are the most liquid assets. Examples of quick Assets are : Cash/Bank Balances, Receivables upto 6 months, Quickly realizable securities such as Govt. Securities or quickly marketable/quoted shares and Bank Fixed Deposits. Inventories are less liquid hence the same is deducted from the Current Assets to arrive at Quick Assets. 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 = > 3,00,000/1,00,000 = 3 : 1 Quick Ratio = > 1,50,000/1,00,000 = 1.5 : 1

  33. DEBT EQUITY RATIO : It is the relationship between borrower’s fund (Debt) and Owner’s Capital (Equity). It represents the lender’s contribution for each Rupee of owner’s contribution. • 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 => 800/500 = 1.6 : 1

  34. 5. PROPRIETARY RATIO : This ratio indicates the extent to which Tangible Assets are financed by Owner’s 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.

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

  36. 9. STOCK/INVENTORY TURNOVER RATIO :It indicates the efficiency of the firm in selling its products. It is calculated by dividing the Cost of Goods Sold by Average Inventory. To arrive at the number of days, weeks or months turnover the following formulas may be applied. (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, i.e. how rapidly the inventory is turning into receivables through sales. Generally a high inventory turnover is indicative of good inventory management and vice versa.

  37. 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)

  38. 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.

  39. 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

  40. 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)

  41. LIQUIDITY RATIOS : • CURRENT RATIO = C.A / C.L • QUICK RATIO = (C.A – INVENTORY)/C.L • ACTIVITY RATIOS : • INVENTORY TURNOVER RATIO = (COST OF GOODS SOLD OR SALES)/INVENTORY • DEBTORS TURNOVER RATIO = (CREDIT SALES OR SALES)/AVERAGE DEBTORS • INVENTORY PERIOD = 360/INVENTORY TURNOVER • COLLECTION PERIOD = 360/DEBTORS TURNOVER • ASSETS TURNOVER = SALES/NET ASSETS OR CAPITAL EMPLOYED • WORKING CAPITAL TURNOVER = SALES/NET WORKING CAPITAL • PROFITABILITY RATIOS : • GROSS MARGIN = GROSS PROFIT/SALES • NET MARGIN = PAT/SALES, EBIT/SALES • PAT TO EBIT RATIO = PAT/EBIT • RETRUN ON INVESTMENT RATIO = EBIT/NET ASSETS OR CAPITAL EMPLOYED • RETRUN ON EQUITY = PAT/NET WROTH • LEVERAGE RATIOS : • TOTAL DEBT RATIO = TOTAL DEBT/CAPITAL EMPLOYED • DEBT EQUITY RATIO = NET WORTH/TOTAL DEBT • CAPITAL EQUITY RATIO = C.E OR NET ASSETS / NET WORTH • INTEREST COVERAGE RATIO = (EBIT+Depr.)/INTEREST

  42. EXERCISE 1 • 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

  43. EXERCISE 2 1. Tangible Net Worth for 1st Year : ( 300 + 140) - 50 = 390 2. Current Ratio for 2nd Year : (170 + 30 +170+20+ 240 + 190 ) / (580+70+80+70) 820 /800 = 1.02 3. Debt Equity Ratio for 1st Year : 320+150 / 390 = 1.21

  44. Exercise 3. 1. Debt Equity Ratio will be : 600 / (200+100) = 2 : 1 2. Tangible Net Worth : Only equity Capital i.e. = 200 3. Total Outside Liabilities / Total Tangible Net Worth : (600+400+100) / 200 = 11 : 2 4. Current Ratio will be : (300 + 150 + 50 ) / (400 + 100 ) = 1 : 1

  45. Exercise 4. • What is the Current Ratio ? Ans : (1+125 +128+1) / (38+26+9+15) • : 255/88 = 2.89 : 1 • Q What is the Quick Ratio ? Ans : (125+1)/ 88 = 1.43 : 11 • Q. What is the Debt Equity Ratio ? Ans : LTL / Tangible NW • = 100 / ( 362 – 30) • = 100 / 332 = 0.30 : 1

  46. Exercise 4. contd… Q . What is the Proprietary Ratio ? Ans : (TNW / 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

  47. Exercise 4. contd… • 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

  48. 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

  49. 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

  50. 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 )

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