Financial Analysis Planning & Control

B. Pharm + MBA Semester 9

SVKM’s NMIMS Deemed-to-be University

Unit 1
Ratio Analysis

Dr. Ashique Ali K A

Assistant Professor (Finance)
School of Law
SVKM’s NMIMS Deemed-to-be University
Hyderabad
Accounting Ratios
• A mathematical expression of the relationship between two accounting figures.
Forms of Ratios
• Proportion – 2:1 etc.
• Percentage – 20% of Net sale
• Times – Sales are 3 times the fixed assets
• Fraction – 3/5 etc.
Classification according to nature of functions
• Liquidity ratios – Current ratio, Quick ratio, Absolute quick ratio
• Leverage ratios – Debt-equity ratio, Capital gearing ratio, proprietary ratio
• Activity ratios – Stock turnover ratio, Fixed assets turnover ratio, Debtors turnover ratio
• Profitability ratios – Gross profit ratios, Operating profit ratio, Return on investment
• Market test ratios – EPS, DPS, DPO ratio, P/E ratio
 Operating Statement
Gross sales
Less: Sales returns
Net sales
Less: Cost of goods sold (CGS):
Opening stock
Add: Purchase
Less: Closing stock CGS = Opening stock + Purchase + Wages
Gross Profit (Net sales – CGS) and other Direct expenses – Closing stock
Less: Operating Expenses:
Administrative expenses
Selling and distribution expenses
Operating Net Profit (EBIT)
Add: Non-operating income
Less: Non-operating expenses
Net profit before tax (EBT)
Less: Provision for taxation
Net profit after tax (EAT)
Less: Preference Dividend
Earnings available to Equity Shareholders (EATPD)
 1. Liquidity Ratios
• Short term solvency ratios. It refers to the firm’s ability to pay Current Current
its current liabilities out of its current assets. These ratios assets liabilities (C L)
measure the liquidity position of a firm. (C A)
Sundry
1. Current Ratio = Current Assets / Current Liabilities Cash in hand creditors
also called Working capital ratio. The standard is 2:1 and at bank
Bills payables
2. Quick Ratio = Quick Assets / Current Liabilities Marketable
Quick assets or Liquid assets = C A – (stock + prepaid securities Outstanding
expenses) expenses
also called Acid test ratio. The ideal ratio is 1:1 Short term
investments Short term
3. Absolute liquid ratio = Absolute liquid assets / C L advances
Absolute liquid assets = Cash and Cash equivalents Bills
(Marketable securities) receivables
Provision for
also called Cash ratio. The ideal ratio = 0.5:1 Sundry debtors taxation
Stock Dividends
Work in payable
Debtors less provision for doubtful debts are considered progress Bank overdraft
Prepaid
expenses Cash credit
Problem 1
• From the Following information, calculate the liquidity ratios
Machinery – 250,000
Prepaid expenses – 2000
Sundry debtors – 167,500
Cash balance – 15,500
Short term investments – 20,000
Sundry creditors – 150,000
Stock – 145,000
Bills payable – 38,000
Expenses outstanding – 12,000
Long term loans – 75,000
Problem 2
• From the Following information, calculate the liquidity ratios
Debtors – 200,000
Prepaid expenses – 20,000
Bills receivables – 50,000
Cash balance – 10,000
Marketable securities – 100,000
Sundry creditors – 230,000
Stock – 180,000
Bills payable – 75,000
Bank overdraft – 175,000
Problem 3

• Current Ratio = 1.75:1

• Working capital = 150,000.
• Calculate current assets?
Problem 4

• Current Ratio = 1.6:1

• Quick Ratio = 1.1:1
• Stock = 50,000.
• Calculate current assets, current liabilities, liquid
assets and working capital
Problem 5

• Current Ratio = 2.5:1

• Quick Ratio = 1.5:1
• Working Capital = 60,000.
• Calculate current assets, current liabilities, liquid
assets and stock
Problem 6

• Total Assets = Rs.11,00,000

• Fixed Assets = Rs. 5,00,000
• Capital Employed = Rs. 10,00,000
• Long Term Investment = Nil

Calculate Current Ratio

 2. Leverage Ratios
• Long term solvency ratios. It refers to the firm’s ability to repay Structural Ratios
its long term liabilities along with interest due on them
Debt-Equity ratio
regularly. These ratios are of two types.
Long-term
Structural ratios
Total debt
• It is based on the relationship between owned capital and
borrowed capital. It is calculated from balance sheet items to Proprietary ratio
know the ability of the firm to repay the principal amount when
due. Also known as Capital structure ratios because it Debt to Total Assets Ratio
measures the extent of debt financing in a firm. Capital gearing ratio
Coverage ratios Coverage ratios
• These are computed from the statement of P & L. It is to Interest coverage ratio
ascertain the firm’s capacity to pay interests and dividend
regularly Dividend coverage ratio

• It measures the firm’s ability to service the fixed liabilities. Debt Service Coverage ratio
Total coverage ratio
 2A. Structural Ratios
Debt-Equity ratio
• Indicates the relative proportion of debts and equity in financing the assets. It expresses the
relationship between external equity and internal equity
Long term debt to equity ratio = Long term debt / Shareholders Fund
Total debt to equity ratio = Total debt / Shareholders Fund
• Long term debt refers to the funds invested by outsiders including debentures, mortgages and long
term loans.
• Shareholders Fund or Net worth means funds invested by the shareholders including Equity share
capital, Preference share capital, reserves and surplus.
• Shareholders Fund = Equity Share capital + Preference Share Capital + Reserves and surplus
– (Accumulated losses + Fictitious assets)
also called Networth
• Total debt = Long term debt + Short term debt or Current Liabilities
• A higher ratio indicates higher debt and less protection for creditors. A low ratio indicates a wider
safety cushion. This ratio indicated a firm’s financial leverage also
 2A. Structural Ratios
Proprietary ratio
Indicates the relationship between shareholders’ fund and total assets. It expresses how
much funds have been contributed by the shareholders in the total assets. Standard ratio is
50% or 0.5:1
Proprietary ratio = Shareholder’s fund / Total assets
• Total assets include all current assets and non-current assets. The realisable value of
intangible assets is also included. Total assets shall not include fictitious assets and
accumulated losses.
• The ratio indicated the proportion of total assets financed by shareholders fund.
• Higher the ratio, less risky the scenario it shall be.
 2A. Structural Ratios
Capital Gearing Ratio
Capital gearing or leverage means the proportion between fixed income bearing funds and
equity shareholders’ funds.
Ratio = Fixed income bearing funds / Equity shareholders’ funds
Fixed income bearing funds include debentures, long term loans and preference share
capital.
Equity Shareholders Fund = Equity Share capital + Reserves and surplus –
(Accumulated losses + Fictitious assets)
Ratio of more than 1 indicates a high geared firm, i.e., more risk
 2A. Structural Ratios
Debt to Total Assets Ratio
Also known as Debt to Total Fund Ratio
It measures the proportion of total assets financed with debt.
Debt to Total Assets Ratio = Total Debt / Total assets
A higher ratio indicates that assets are less backed up by equity and hence higher financial
leverage
 2B. Coverage Ratios
Interest coverage ratio
• It measures the capacity of a firm to pay
interests on debentures and loans regularly
• It establishes the relationship between
operating profit and interest charges.
Interest coverage ratio = EBIT / Interest Debt Service Coverage Ratio
• Higher ratio is favourable. The standard is 6 Ability of the firm to pay off current interest and
to 7 times. instalments
Preference Dividend coverage ratio Interest coverage ratio = EBIT / Interest +
• Indicates the ability of a company to pay Installments
dividend on preference shares carrying a fixed 1.5 to 2 is satisfactory.
rate of dividend.
Dividend coverage ratio = EAT / Preference
dividend
• The standard ratio is generally taken to be 2
times.
 3. Activity Ratios
Turnover ratios indicate the efficiency in asset management.
Also called Efficiency ratios, performance ratios, and asset utilisation
ratios.
It show the speed with which the resources are converted into cash.
Higher turnover ratio means better use of resources.
Always expressed in times
Ratios
• Total Assets Turnover ratio
• Fixed assets turnover ratio
• Capital Turnover ratio
• Working capital turnover ratio
• Inventory or stock turnover ratio
• Debtors turnover ratio
• Creditors turnover ratio
 Activity Ratios
Total assets turnover ratio
• It measures the efficiency with which a firm is utilising its total assets in
generating sales. It is expressed in times.
• Ratio = Net sales / Total assets
• Net fixed assets = Current Assets + Non-current Assets
• Investments should not be included in fixed assets
• Higher ratio is better
• If Net Sales are not given, Cost of Goods sold may be used.
 Activity Ratios
• Fixed assets turnover ratio
• It measures the efficiency with which a firm is utilising its fixed assets in
generating sales. It is expressed in times.
• Ratio = Net sales / Net fixed assets
• Net fixed assets = Fixed assets - Depreciation
• Investments should not be included in fixed assets
• Higher ratio is better
• If Net Sales are not given, Cost of Goods sold may be used.
 Activity Ratios
Capital turnover ratio
• It shows how many times the working capital is turned over to generate
sales.
• Ratio = Net sales / Capital Employed
• Net sales = Total Sales – Sales returns
• Capital Employed = Net Assets = Fixed Assets + Current Assets – Current
Liabilities
• Capital Employed = Shareholders Fund + Borrowed Fund
• Higher ratio shows efficiency
 Activity Ratios
• Working capital turnover ratio
• It shows how many times the working capital is turned over to generate
sales.
• Ratio = Net sales / Working capital
• Net sales = Total Sales – Sales returns
• Working capital = C A – C L
• Higher ratio shows efficiency. 7 to 8 times may be good
• Working capital turnover ratio is further segregated into Stock turnover ratio,
Debtors turnover ratio, and Creditors turnover ratio.
 Activity Ratios
Stock turnover ratio
• It shows the relationship between cost of goods sold and average stock. Also called Merchandise turnover
ratio.
• It indicates the number of times stock is converted into sales.
• Stock turnover ratio = Cost of goods sold / Average stock
• CGS = Opening stock + Purchase + Direct expenses – Closing stock
• CGS = Sales – Gross profit = Sales + Gross loss
• Average stock = (Opening stock + closing stock) / 2
• If CGS can’t be calculated, use Net Sales
• If average stock can’t be calculated, use Closing stock
• Standard = 8 times
• Stock velocity
• Also called inventory turnover period.
• Stock velocity = 365 or 12 or 52 / Stock turnover ratio
• Stock velocity = (average stock x 12 or 365 or 52) / Cost of goods sold
 Activity Ratios
Debtors turnover ratio
It shows the relationship between net credit sales and average debtors including bills receivables.
It indicates how quickly debtors are realised into cash. Also called Receivables turnover ratio.
Debtors turnover ratio = Net credit sales / Average receivables
• Net credit sales = Gross credit sales – Sales returns
• Gross credit sales = Total sales – Cash sales
• Average receivables = Average debtors + Average bills receivables
• Provision for bad and doubtful debts should not be deducted.
• Higher ratio is better
Average collection period
Also called debtors velocity or average age of debtors.
Debtors velocity = 365 or 12 or 52 / Debtors turnover ratio
Debtors velocity = (average receivables x 12 or 365 or 52) / Net credit sales
 Activity Ratios
Creditors turnover ratio
It shows the relationship between net credit purchase and average creditors including bills payables.
It indicates the number of times the creditors are paid. Also called Payables turnover ratio.
Creditors turnover ratio = Net credit purchase / Average payables
• Net credit purchase = Gross credit purchase – purchase returns
• Gross credit purchase = Total purchase – Cash purchase
• Average payables = Average creditors + Average bills payables
• Provision for discount on creditors should not be deducted.
• Lower ratio is better
Average payment period
Also called creditors velocity or average age of creditors.
Creditors velocity = 365 or 12 or 52 / Creditors turnover ratio
Creditors velocity = (average payables x 12 or 365 or 52) / Net credit purchase
Problem 7
From the following particulars extracted from the financial statements of Company X, calculate
a) Current Ratio b) Acid Test Ratio c)Stock Turnover Ratio d) Debtors Turnover Ratio e) Creditors Turnover Ratio
Calculate the ratios for two years – 2022 and 2023 independently and comment on the liquidity position of the company
Amount – 2022 Amount - 2023
Opening Stock 47,000 53,000
Closing Stock 53,000 67,000
Sales less Returns 252,000 365,000
Provision for bad debts 2,000 3,000
Sundry Creditors 32,000 35,000
Purchases 180,000 190,000
Sundry Debtors 42,000 63,000
Cash 10,000 15,000
Bank 8,000 10,000
Bills Receivables 15,000 20,000
Bills Payables 29,000 30,000
Marketable Securities 8,000 8,000
 4. Profitability Ratios
• Profitability refers to the ability of a firm to earn income. It indicates the operational efficiency
Profitability Ratios based on Sales
• Gross profit ratio
• Operating ratio
• Operating profit ratio
• Net profit ratio
• Expense Ratio
Profitability Ratios based on Investment
• Return on Investment or Return on Capital Employed
• Return on Shareholder’s fund
• Return on Equity Capital
Profitability Ratios based on Owners’ point of view
• Earnings per share
• Dividend per share
• Dividend Payout ratio
 4A. Profitability Ratios based on
Sales
Gross Profit Ratio (Gross Profit Margin)
Ratio = (Gross profit / Net sales) x 100
• Gross Profit = Net sales – Cost of goods sold
• The ideal ratio is 20% to 25%. Higher ratio is better
Operating Profit Ratio
Ratio = (Operating profit / Net sales) x 100
• Operating profit means profit from normal business operations
• Operating Profit or EBIT = Gross profit – Operating expenses
• EBIT = Net Sales – Cost of Goods Sold – Operating Expenses
• EBIT = EBT + Non-operating expenses – Non-operating income
• Operating ratio + Operating Profit ratio = 100%
• Higher ratio is better.
 4A. Profitability Ratios based on
Sales
Operating Ratio
Ratio = (Operating cost / Net sales) x 100
It expresses the relationship between operating cost and sales. It indicates the
overall efficiency in operating the business.
Operating cost = Cost of goods sold + Operating expenses
Operating expenses include Office and administrative expenses, Selling and
distribution expenses, Financial expenses like Interest on short term loans, bad
debts, and discount allowed.
Financial expenses like Interest on long term funds will not be considered
Lower the ratio more is the operational efficiency. Ideal ratio of Manufacturing
concerns is 75% to 85%
Expense ratios
Break up of Operating ratio. It shows the relationship of various expenses to net
sales.
Ratio = (Concerned expenses / Net sales) x 100
 4A. Profitability Ratios based on
Sales
Example
Net profit ratio = 10%
Operating profit = 50000
Net Profit Ratio
Non – operating income = 20000
• It measures the overall profitability of a
business. Non – operating expenses = 5000
Ratio = (Net profit / Net sales) x 100 Sales returns = 10000
• Net Profit can be either before tax or after tax.
What is Net sales?
• Net Profit = EBIT+ Non operating income –
Non operating expenses
• The ideal ratio is 5% to 10% Net profit = 50000 + 20000 – 5000 = 65000
Net profit = 10% of Net sales = 65000
Net sales = 65000 x 100/10 = 650,000
 4B. Profitability Ratios based on
Investment
Return on Investment
ROI = (EBIT / Capital employed) x 100
ROI = Capital turnover ratio x Operating profit ratio
ROI = (Net sales/Capital employed) x (Operating profit/Net sales) x 100
• Also called Rate of return or Return on capital employed (ROCE)
• Capital employed can be either in Gross or Net terms
Gross capital employed = Fixed assets + Current assets
Net capital employed = Total assets – C L
Net Capital Employed = Fixed Assets + Working Capital
Net capital employed = Share capital + reserves and surplus + other long term funds – Fictitious assets –
Accumulated loss
• Net capital employed is preferred.
• If average capital employed is taken, it is the average of opening and closing capital employed.
EBIT or Earnings Before Interest and Tax = Operating profit = G P – Operating expenses
• Ideal ratio is 15%.
 4B. Profitability Ratios based on
Investment
• Return on Shareholder’s fund Return on Equity capital
• Ratio = (EAT before preference Ratio = (EAT and after preference
dividend / Shareholder’s fund) x 100 dividend / Equity Shareholder’s fund) x
100
• Shareholder’s fund includes both equity
and preference capital and all reserves • Equity Shareholder’s fund includes equity
and surplus belonging to shareholders share capital and all reserves and surplus
(Accumulated loss and fictitious assets belonging to equity shareholders
shall be deducted) (Accumulated loss and fictitious assets
shall be deducted)
• EAT means Earnings After Tax
 4C. Profitability Ratios based on
Owners’ point of View
• Earnings Per Share • Dividend Per Share
• EPS = EAT after preference dividend / • DPS = Dividend Paid to Equity
Number of Equity Shares Shareholders / Number of Equity
Shares

• Dividend Payout Ratio • Retention Ratio

• DP = Dividend Paid to Equity • RR = Retained Earnings / EATPD
Shareholders / EATPD
• RR = 1 – DP
• DP = DPS/EPS
Or
RR = 100 – DP (if expressed in %)
 5. Market Test Ratios
• Used for evaluating the shares and stocks which are traded in
the market. Also known as Investor’s ratios or Stock market
ratios or Market valuation ratios.
Ratios
• Price earning ratio (P/E)
• Dividend Yield Ratio
 Market Test Ratios
• Price Earning Ratio Dividend Yield Ratio
• Ratio = MPS / EPS Ratio = (DPS / MPS) * 100
• MPS = Market Price per share • It measures dividend paid based on
market price of shares
• It indicates the expectation of equity
investors about the earning of the firm.
• A higher ratio could either mean that a
company’s stock is overvalued or the
investors are expecting high growth rates
in future