FINANCIAL PERFORMANCE ACCOUNTING RATIOS

Accounting Ratio Analysis Information contained in financial statements is of major significant to internal and external stakeholders if it is interpreted properly Accounting ratios are relative measures that provides an aid to interpret the information provided by financial statements. Analysis of accounting ratios involves calculating and interpreting financial ratios to assess the firm’s performance and status. Basic inputs are balance sheet and income statements.

4 Main Categories of Accounting Ratios Liquidity Ratio Profitability Ratio Working capital/ Efficiency Ratio Investment Ratio

Liquidity Ratio Net working Capital Current assets – Current liabilities NWC is useful for internal control. Used as a measure of a firm’s liquidity position. Firms should have sufficient NWC in order to be able to meet the claims of the creditors and meeting the day-to-day needs of business. NWC is a measure of firms liquidity but not an appropriate measure Inadequate NWC is the first sign of financial problems for a firm.

Liquidity Ratio Contd.. Current Ratio Current assets / current liabilities It measure the firm’s ability to meet its short-term obligations (short term solvency). Higher this ratio, more is the firm’s ability to meet current obligations and the greater safety of funds of short-term creditors. But a very high ratio maybe indicative of slack management practices: it may signal excessive inventories for the current requirement and poor credit management of over extended accounts receivable. Or firm is not making full use of its current borrowing capacity.

Liquidity Ratio Contd.. Quick Ratio (Acid-test ratio) (Current assets – inventories) / Current liabilities Similar to current ration except that it excludes inventory and prepaid expenses (which are the least liquid asset). Is a better measure of overall liquidity only when firm’s inventory cannot easily be converted into cash.

Profitability Ratio Gross profit margin Gross profit / Sales x 100 High ratio is a sign of good management, as it implies that cost of production is low. It may show higher sales without corresponding increase in the cost of goods sold. A relatively low ratio is a danger signal, which may be due to High cost of production A low selling price

Profitability Ratio Contd.. Net Profit margin Net profit / Sales x 100 It measures the percentage of each sales rupee remaining after all expenses have been deducted. It measures firm’s success with respect to earnings on the sales

Profitability Ratio Contd.. Return on Assets EBIT / Total assets Return on investment Net profit / Total asset x 100 It measures the overall effectiveness of management in generating profits with its available assets.

Profitability Ratio Contd.. Return on capital employed (EBIT / Fixed assets + NWC) x 100 It provides a test of profitability related to the sources of long term assets. It tells how efficiently the long term funds of owners and creditors is being used. Higher the ratio more efficient is the use.

Profitability Ratio Contd.. Return on equity (shareholder fund) Net profit / Ordinary share capital + Reserves (R.E)

Efficiency Ratio Inventory turnover Cost of goods sold / Average inventory In general a high inventory turnover ratio is better. It shows good inventory management. A very high ratio calls for careful analysis, as it may mean very low level of inventory A very low ratio signifies excessive inventory. Firms should have neither too high nor too low inventory turnover.

Efficiency Ratio Contd.. Avg. No. of days inventory is sold (Stock held / cost of sales) x 365 Debtors/ Receivables turnover Sales / Avg. Receivables Debtors settlement period (Receivables / Sales) x 365 Higher the turnover ratio and shorter the settlement period, the better the trade credit management.

Efficiency Ratio Contd.. Creditors Turnover Cost of sales / Avg. Creditors ( accounts payable ) Creditors Settlement period (Avg. Creditors / Cost of sales ) x 365 Sales on capital employed Sales / Capital employed Total Asset Turnover Sales / Total assets

Investment Ratio Dividends payout ratio (div announced/ earnings for the year) or DPS / EPS Dividend yield (Div per share / Market price per share) x 100 Earnings per share Net profit / no. of ordinary shares

Investment Ratio Contd.. Price/Earning ratio Market price per share / EPS It indicates the degree of confidence that investors have in the firms future performance. Higher is the ratio, better it is for the owners

A case study of ratio analysis Profitability Ratio: Gross profit Margin: Net profit margin: ROCE: ROE

A case study of ratio analysis Liquidity Ratio: Current Ratio Acid test Ratio

A case study of ratio analysis Efficiency Ratio: Inventory turnover (in days): Debtors settlement period: Creditors settlement period:

A case study of ratio analysis Investment Ratio: % Dividend payout ratio: Dividend yield: Earnings per share: Price/Earning ratio: