1. UNIT – 3 RATIO ANALYSIS

2. Contents Meaning of ratio Classification of ratios
Profitability ratios
Turnover ratios
Financial ratios
Du Pent control chart
Practical problems

3. Comparative Analysis
There are three types of comparisons to provide decision usefulness of financial information:
Intra-company basis
Inter-company basis
Industry averages

4. Comparative Analysis
Intra-company basis – comparisons within the company.
Inter-company basis – comparisons with other companies.
Industry averages – comparisons with other companies in the same industry.

5. Financial Statement Analysis
Three basic tools are used in financial statement analysis :
Horizontal analysis - It is a technique for evaluating a series of financial statement data over a period of time.
Did an increase or decrease take place?
Vertical analysis - Expresses each item in a financial statement as a percent of a base amount.
Income statement
Balance Sheet
Ratio analysis (for cross sectional analysis)

6. Ratio Analysis
‘A mathematical yardstick that measures the relationship between two figures or groups of figures which are related to each other and are mutually inter- dependent’.
It can be expressed as a pure ratio, percentage, or as a rate percentage, or as a rate

7. Words of caution
A ratio is not an end in itself. They are only a means to get to know the financial position of an enterprise.
Computing ratios does not add any information to the available figures.
It only reveals the relationship in a more meaningful way so as to enable us to draw conclusions there from.

8. Utility of ratios Comparison may be in any one of the following forms:
For the same enterprise over a number of years
For two enterprises in the same industry
For one enterprise against the industry as a whole
For one enterprise against a pre-determined standards
For inter-segment comparison within the same organisation

9. Profitability ratio
These ratios measure the operating efficiency of the firm and its ability to ensure adequate returns to its shareholders.
WHY? A company’s income affects:
its ability to obtain debt and equity financing
its liquidity position
its ability to grow
Further the profitability ratios can be determined
(i) in relation to sales and (ii) in relation to investments

10. Profitability in relation to sales
Gross Profit Ratio – It measures the relationship between gross profit & sales.
GPR = Gross Profit/ Net Sales × 100
Gross Profit = Sales – Cost of goods sold
Net Profit Ratio - This ratio is indicative of the firm’s ability to leave a margin of reasonable compensation to the owners for providing capital, after meeting the cost of production, operating charges and the cost of borrowed funds.
It measures the relationship b/w net profit & sales of a firm.
NPR = Profit after tax / Net sales × 100

11. Operating profit ratio – It establishes the relationship between total operating expenses & net sales.
Operating profit ratio = Operating expenses × 100
Net sales
Operating expenses include = cost of goods sold, general & administrative expenses, selling & distribution expenses.
Operating profit = Net sales – Cost of goods sold – administrative expenses – selling & distribution expenses
Operating Ratio = COGS + Operating expenses

12. Expenses Ratio – While some of the expenses may be increasing & other may be declining. To know the behavior of specific items of expenses the ratio of each individual operating expenses to net sales should be calculated.
Cost of goods sold = COGS/ Net sales × 100
Admini. Expenses Ratio = Admin. Exp. × 100
Net sales
Selling & distribution = Selling & distrib. Exp. × 100
expense ratio Net sales

13. Profitability in relation to investments
Return on gross investment or gross capital employed – This ratio establishes the relationship between net profit & the gross capital employed. The term gross capital employed refers to the total investment made in the business.
ROCE = Earnings After Tax (EAT) × 100
Gross capital employed
Return on Net capital employed
RNCE = EBIT/ Net capital employed × 100
Net capital = Gross capital – current liabilities

14. Return on share capital employed – This ratio establishes the relationship b/w earnings after taxes & the shareholder investments in the business.
This ratio revels how profitability the owners’ funds have been utilized by the firm.
RSCE = EAT/ Shareholders capital employed × 100
Return on equity share capital employed – This ratio establishes the relationship b/w earning after tax & preference dividend & equity shareholder investment or capital employed or net worth.
RESCE = EAT- preference dividends × 100
Equity share capital employed

15. Earning per share (EPS) – It measures the profit available to the equity shareholders on a per share basis.
EPS = Earnings after tax – preference dividends
Equity shares outstanding
Dividend per share – the dividends paid to the shareholders on a per share basis is called as DPS.
DPS = Earnings paid to ordinary shareholders
No. of ordinary shares outstanding
Dividend payout ratio (pay out ratio) – It measures the relationship b/w the earnings belonging to the equity shareholders & the dividend paid to them
DPR = Dividend per share / Earnings per share

16. Pay out ratio shows what percentage shares of the earnings are available for the ordinary shareholders are paid out as dividends to the ordinary shareholders.
Price Earning ratio – The reciprocal of the earnings yield is called P/ER.
P/E Ratio = Market Price of shares
Earning per share

17. 2) Turnover Ratios
Turnover ratios are also known as activity ratios or efficiency ratios with which a firm manages its current assets. The various turnover ratios are as follows:-
Inventory Turnover Ratio
Debtor Turnover Ratio
Creditors Turnover Ratio
Assets Turnover Ratio

18. Inventory Turnover Ratio
This ratio indicates the number of times the inventory has been converted into sales during the period.
Inventory/stock Turnover Ratio = Cost of goods Sold
Average Inventory
COGS = Opening stock+ purchases+ wages – Closing stock
Average Inventory = Opening Inventory + Closing inventory 2
Debtor Turnover Ratio
This indicates the number of times average debtor have been converted into cash during a year.
Debtor Turnover Ratio = Net credit sales
Average Trade Debtors
Average Trade debtor = Operating Trade Dr. + Closing Trade Dr.
or DTR = Total Sales
Trade Debtors

19. Creditor Turnover Ratio
It indicates number of times sundry creditors have been paid during a year.
CTR = Net Credit Purchases
Aveg. Trade Creditor
Net Credit purchase = Gross Credit Purchase
Purchase Return
or CTR = Total Purchases
Total Trade Creditors

20. Assets Turnover Ratio
The relationship between assets & sales is known as assets turnover ratio. It includes following ratios:-
Total assets turnover
Net assets turnover
Fixed assets turnover
Current assets turnover
Net working capital turnover ratio
i) Total Assets Turnover – This ratio shows the firms ability to generate sales from all financial resources committed to total assets.
Total Assets Turnover = Total sales
Total Assets

21. ii) Net Assets Turnover = Total Sales Net Assets Net Assets = Total Assets - Current Liabilities iii) Fixed Assets Turnover = Total sales Net Fixed Assets Net Fixed assets = Cost of fixed assets – depreciation iv) Current Assets Turnover = Total sales Current Assets

22. v) Net working capital Turnover Ratio A higher ratio is an indicator of better utilization of current assets & working capital & vice-versa. NWCTR = Total Sales Working capital Working capital = Current Assets – current Liabilities

23. From the following P&L account of Brilliant Products Ltd
From the following P&L account of Brilliant Products Ltd. For the year ending 31st march 1990 & balance sheet as on 31st march 2009:
Particulars (Dr.)
Amt.
Particulars (Cr.)
To opening stock
To purchases
To incidental charges
To Gross profit
To operating expenses:
Selling & Distib.
Administration
Finance
To non-operating expenses
Loss on sale of assets
To Net profit
1,99,000
10,90,500
28,500
6,80,000
19,98,000
60,000
3,00,000
30,000
3,90,000
8,000
6,98,000
By sales
By Closing Stock
By Gross Profit
Non-operating
income
By profit on sale of shares
17,00,000
2,98,000
6,000
12,000

24. Balance sheet as on 31st March 2009
Liabilities
Amt.
Assets
Issued Capital
4,000 equity shares of Rs.100/- each
Reserves & surplus
Current Liabilities
P& L A/c
4,00,000
1,80,800
2,60,000
1,20,000
9,60,000
Land & Buildings
Plant & Machinery
Stock in trade
Sundry Debtors
Cash & bank
3,00,000
1,60,000
2,98,000
1,42,000
60,000
Calculate
Current Assets turnover ratio
Operating ratio
Stock turnover ratio
Fixed assets turnover ratio
Gross profit ratio
Net profit ratio
Return on equity share capital

25. Current Assets Turnover Ratio
= Total Sales/ Current assets
=17,00,000/ ( )
=17,00,000/ = 3.4:1
Operating Ratio
= COGS + Operating expenses/ net sales
= 10,20, /17,00,000 = 0.83:1
COGS = OS + Purchases+ incidental charges – CS
Stock Turnover ratio
= COGS/ Average Inventory
= 10,20,000/ = 4.1:1
Average Inventory = OS + CS/ 2

26. Fixed Assets Turnover Ratio
= Total sales/ Net fixed assets
= 17,00,000/ 4,60,000 = 3.7:1
Gross Profit Ratio
= Gross profit/ Net sales × 100
= 6,80,000/ 17,00,000 × 100
= 40%
Net Profit Ratio
= Net profit/ Net sales × 100
= 3,00,000/ 17,00,000 × 100
=17.7%
Return on equity share capital
= EAT – Preference dividend/ Eqty. Share capital× 100
= 3,00,000/ 4,00,000 × 100 = 75%

27. Financial Ratios
These ratios analyse the short-term financial position of a firm and indicate the ability of the firm to meet its short-term commitments (current liabilities) out of its short-term resources (current assets).
These are also known as ‘solvency ratios’. The ratios which indicate the liquidity of a firm are:
Current ratio
Liquidity ratio or Quick ratio or acid test ratio
Absolute liquid Ratio

28. 1) Current ratio
It is calculated by dividing current assets by current liabilities.
Current ratio = Current assets Current liabilities
Where,
Conventionally a current ratio of 2:1 is considered satisfactory

29. Current Assets Includes:-
Inventories of raw material, WIP, finished goods,
stores and spares,
sundry debtors/receivables,
short term loans deposits and advances,
cash in hand and bank,
prepaid expenses,
incomes receivables and
marketable investments and short term securities.

30. sundry creditors/bills payable, outstanding expenses,
Current Liabilities:-
sundry creditors/bills payable,
outstanding expenses,
unclaimed dividend,
advances received,
incomes received in advance,
provision for taxation,
proposed dividend,
instalments of loans payable within 12 months,
bank overdraft and cash credit

31. 2) Quick Ratio or Acid Test ratio
This ratio measures the immediate ability of the company to pay off its current obligations.
Quick Ratio = Quick Assets
Quick or current liabilities
QUICK ASSETS are current assets (as stated earlier)
less prepaid expenses and inventories.
QUICK/ CURRENT LIABILITIES are current liabilities (as stated earlier)
less bank overdraft and incomes received in advance.

32. 3) Absolute liquid ratio
It measures the absolute liquidity of the firm.
Absolute liquid Ratio = Cash in hand + Cash at bank
Quick/Current Liabilities

33. 4) Du-Pont control chart
It is the system of management control designed by an American company named Du-Pont company is popularly called Du-pont control chart.
This system uses the ratio inter-relationship to provide charts for managerial attention. The standard ratios of the company are compared to present ratios & changes in performance are judged.
ROI = Net Profit × 100
Capital Employed

34. Net profit includes both net profit before interest, tax & dividends & net profit after tax (PAT).
Capital Employed includes any of these:-
Net fixed assets + working capital
Net fixed assets + current assets
Gross fixed assets + current assets
Gross fixed assets + working capital