ratio analysis

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RATIO ANALYSIS Profitability Ratio Liquidity Ratio Turnover Ratio Solvency Ratio Investor’s Ratio Profitability Ratio i. Return-on-Investment (ROI) = Operating Profit Capital Employed x 100

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x 100 x Op. Profit Ratio = Op. Profit Cap. Employed Sales Turnover = Sales Cap. Employed Operating Profit Sales Op. Profit Capital Employed Cap. Employed Cap. Employed x 100 = x 100 ROI =

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Capital Employed = Fixed Assets + Net Current Assets Net Current Assets = CA – CL Or Cap. Emp. = Equity Shares + Pref. Shares + Reserves + Retained Earnings + Loans – Non-Operating Assets

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DuPort Chart Divided by ROI Net Profit as Percentage of Sales Sales Turnover Net Profit Sales Sales Divided by Total Assets FA + CA

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Profit & Loss A/c of Alpha Ltd. For the year ending 31-3-99 Sales Rs. 11,00,000 Less cost of goods sold 8,20,000 Gross Profit 2,80,000 Less Operating Expenses 1,30,000 Depreciation 40,000 Operating Profit (EBIT) 1,10,000 = (IBIT) Less Interest on Loan 16,200 = (PBIT) Income Tax Provision 40,300 Net Income (Net Profit) 53,500

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Balance Sheet of Alpha Ltd.as at 31-3-1999 Source of Funds 1998-99 Shareholder’s funds Ordinary Shares Rs. 1,50,000 Preference Shares 60,000 Reserves 70,000 Retained earnings 1,70,000 Long Term Loans Govt. Loan 2,70,000 Current Liabilities 2,50,000 Total Liabilities 9,70,000

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Application of funds Fixed Assets 3,90,000 Depreciation 40,000 3,50,000 Current Assets 6,10,000 Debtors 200000 Stock 2,70,000 Marketable Securities 90,000 Cash 40,000 Prepayments 10,000 Goodwill 10,000 Total Assets 9,70,000

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4. Gross Profit Ratio Sales – COGS Sales GP Sales Shows efficiency of operations. Also average mark-up or Margin on Product Sold. x 100 x 100 II. LIQUIDITY RATIOS 1. Current Ratio = Current Asset Current Liabilities 2. Quick Ratio (Acid Test Ratio) = Liquid Assets CL

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III. TURNOVER RATIOS 1. SALES TURNOVER OR CAPITAL TURNOVER RATIO SALES Cap. Employed 2. WORKING CAP. TURNOVER RATIO Net Sales Net Working Cap 3. INVENTORY TURNOVER RATIO Cost of goods sold Average Inventory Opening + Closing Inv. 2 = = = Av. Inv =

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4. AVERAGE COLLECTION PERIOD RECEIVABLES SALES PER DAY OR RECEIVABLES SALES This ratio indicates the efficiency of collection of CASH from debtors as also the Credit Policy. Credit Sales figure, if known, should be taken instead of sales. Figures for receivables should be average: Av. Rec. B + cl. B 2 = = x 365 =

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IV. SOLVENCY RATIOS A firm’s ability to meet interest charges and repayment dues on long term obligations is referred to as its solvency. DEBT. EQUITY RATIO (Long Term Debit to owner’s equity ratio) Long Term Debit Share Cap.+ Reserves + Retained earnings If Indicates the firm’s financial policy regarding the balancing of debit and equity. It is also an index of the degree of protection the firm’s creditors have. =

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2. Interest Coverage Ratio The no. of items the fixed interest charges are covered by operating Profit (IBIT), indicates the margin of safety of the Long term creditors. Op. Profit Interest (Interest on Long term Loans) It measures the Level to which profits can decline without impairing the firm’s ability to meet its interest liability It is also known as Debit Service Coverage Ratio. =

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EPS = Net Profit available to Equity holders No. of ordy. Shares outstanding DPS = Net Profit after interest and Pref. Dividend No. of ordy. Shares outstanding PE Ratio = Market Price of a share EPS

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V. INVESTORS’ RATIOS Earnings Per Share (EPS) = Net income (after interest and tax No. of outstanding Equity Shares 2. Price- Earnings Ratio (P/E Ratio) = Market Price per share EPS

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Exercise The Current Assets and Current Liabilities of a Co. are Rs. 15,00,000 and Rs. 10,00,000 respectively on 31-3-98. What is the effect of following transactions on current Ratios? i) Purchase of machinery for Rs. 1,00,000 on cash ii) Purchase of a building for Rs. 2,00,000 on a medium term loan from the bank with 20% margin. iii) Payment of creditors through a cheque Rs. 50,000. iv) Payment of dividend Rs. 50,000 after deducting tax @20%. Dividend payable is included in cl.

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Solution The CR on 31-3-98 is 15,00,000 10,00,000 ii) Purchase of machinery on medium term loan will not affect ch. But 20% margin money will reduce CA & Rs. 4,000 (20% of Rs. 20,000) 14,60,000 10,00,000 iii) Payment of S.Crs. thru. Cheque will reduce both CA and Cl. & Rs.50,000 each. Hence new 14,50,000 9,50,000 = 1.5 Rs. = 1.46 CR now = 1.526 CR =

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iv) Payment of Dividend Rs. 50,000 will reduce CA & this amount. The deduction of tax will out make any difference because it will be hand to Govt. while balance will be paid to share holders. The total amount payable & the co. will remain the same i.e.; Rs. 50,000. Cl. 14,50,000 9,50,000 Purchase of ----- for Rs. 100000 will reduce CA & this amount. 14,00,000 10,00,000 New CR = = 1.526 CR = = 1.4

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Exercise Given : CR = 1.5 QR = 1 Cl = Rs. 50,000 Calculate: CA Quick Assets Inventory

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II Comment on the Liquidity position of the co. Liability 1998 1999 Assets 1998 1999 Creditors 5,00,000 6,00,000 Inventory 2,00,000 5,00,000 Bills Payable 3,00,000 2,40,000 Sundry Debtors 6,00,000 6,00,000 Bank Over draft - 1,00,000 Prepayments 40,000 - Cash 4,00,000 2,00,000 Sales = Rs. 70,00,000 1998 Rs. 60,00,000 1999

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Solution CR = CA CA CL 50,000 CA = 50,000 x 1.5 = 75,000 Quick Assets = 50,000 x 1.0 = 50,000 Inventory = CA – QA = 75,000 – 50,000 = Rs. 25,000 CR = (1998) = 12,40,000 CR unsatisfactory & 8,00,000 deteriorated in 1989 1989 = 13,00,000 9,40,000 1.5 = = 1.55 = 1.38

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QR = (1988) = 10,00,000 QR ok but gone down in 1989 8,00,000 1989 = 8,00,000 9,40,000 Average Age of Drs. = 6,00,000 Drs 70,00,000 Sales {1988) = 31.3 days (ACP increased from 31.3 to 36.5. Not good. = 6,00,000 Inventory increased from 2 6,00,000 lakhs & & 5 lakhs resulting = 36.5 days in stock filing and poor sales = 1.25 = 0.85 x 365 x 365 x 365

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EXERCISE ABC Ltd. has a liquid ratio of 1.5. Its net working capital is Rs. 1,20,000 & its inventory is Rs. 80,000. Calculate CA. Liquid Ratio = Liquid Assets CL or = CA – Stock CL or CA- Rs. 80,000 = 1.5 CL or CA – 1.5 CL = Rs. 80,000 EQ. 1 Net WC = CA – CL or CA – CL = Rs. 1,20,000 EQ. 2 = 1.5 = 1.5

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Subtracting EQ.2 from EQ. 1 0.5 CL = Rs. 40,000 CL = RS. 40,000 0.5 CA = Rs. 80,000 + Rs. 1,20,000 = Rs. 2,00,000 = Rs. 80,000

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CAPITAL GEARING RATIO Equity Deb. 6% Pref. Shareholders. % 10,00,000 - - 4,00,000 6,00,000 - 4,00,000 4,00,000 2,00,000 CAP Emp. IBIT Interest 10,00,000 2,00,000 - 10,00,000 2,00,000 36,000 10,00,000 2,00,000 24,000 PBT Tax 50% 2,00,000 1,00,000 1,64,000 82,000 1,76,000 88,000 PAT Pref. Dividend 1,00,000 - 82,000 - 88,000 14,000 74,000 A B C

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RO Eq 1,00,000 82,000 74,000 10,00,000 4,00,000 4,00,000 = 10% = 20.5% = 18.5% x 100 x 100 x 100

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DEBT-EQUITY RATIO Equity Deb. 10% Op. Profit Inst. 5,00,000 - 1,00,000 - 2,00,000 3,00,000 1,00,000 30,000 1,00,000 4,00,000 1,00,000 40,000 PBT Tax 50% 1,00,000 50,000 70,000 35,000 60,000 30,000 PAT 50,000 35,000 30,000 A B C RO Eq 50,000 35,000 30,000 5,00,000 2,00,000 1,00,000 = 10% = 17.5% = 30% x 100 x 100 x 100

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CAPITAL STRUCTURE – CHARACTERISTICS Characteristics Debentures Pref. Shares Equity Shares Owner Ship Rights Repayment Claim on Assets Claim to Profits Increasing Owners Profit None Must be Repaid First Claim None only Interest All Profits above interest go to owners None Must be Redeemed Second Claim First Claim-up to a point All Profits above fixed dividend go to owners Full Rights None Last Claim Full Claim on residual Profits All profits (residual)

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Limitations of Financial Ratio Accounting figures, used for ratios, are themselves subject to deficiencies, approximations, diversity in practice or even manipulation to some extent. Companies may use different accounting methods. In inventory valuation some may use FIFO, others may use LIFO. Depreciation methods may vary; amortization of intangibles and preliminary expenses – all these may create problems in comparability. Due to inflation, historical cost – based financial statements and accounting figures do not reflect current value figures, especially in the case of assets purchased at different dates. Since data are not adjusted for price level changes, ratios get distorted. Due weightage should be given to general economic conditions industry situation, position of a firm within the industry, size of a firm, technology, diversity of product etc. which can make the firms totally dissimilar. Different concepts used for determining numerator and denominator will make ratios dissimilar. Ratios should be supplemented by other tools.

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ANALYSIS OF FINANCIAL STATEMENTS COMPARATIVE BALANCE SHEET: The effect changes in ASSETS & LIABILITIES, EQUITY or CAPITAL can be studied by a comparison of the balance sheets at the beginning and end of a period. The emphasis is on CHANGE, & not STATUS Information regarding TRENDS is more important than the book values. Say, if CA increase from Rs. 100,000 & 1,10,000 increase is 10%. CL increase from Rs. 30,000 to Rs. 39,000, the increase is 30% Absolute changes are not so imp. as Trends are

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