1. COST & MANAGEMENT ACCOUNTING UNIT NO.IV Ratio Analysis: MBA 1

2. SYLLABUS 1.1 Introduction, Meaning of Ratio 1.2 Mode of Expression; Steps in Ratio Analysis 1.3 Importance of Ratio Analysis 1.4 Nature of Ratio Analysis 2

3. SYLLABUS 1.5 Limitations of Ratio Analysis 1.6 Classification of Ratios 1.7 Balance Sheet Ratios; Revenue Statement Ratios; Activity of Turnover Ratios; 1.8 Profit Cover Ratios; Du pont Chart 1.9 Miscellaneous Practical Problems. 3

4. LEARNING OBJECTIVES 1.1 Introduction, Meaning of Ratio 1.2 Mode of Expression; Steps in Ratio Analysis 1.3 Importance of Ratio Analysis 1.4 Nature of Ratio Analysis 4

5. LEARNING OBJECTIVES 1.5 Limitations of Ratio Analysis 1.6 Classification of Ratios 1.7 Balance Sheet Ratios; Revenue Statement Ratios; Activity of Turnover Ratios; 1.8 Profit Cover Ratios; Du pont Chart 1.9 Miscellaneous Practical Problems. 5

6. Classification of Ratios 6 Balance Sheet RatiosRevenue /Income Statement Ratios Activity/Turnover ratio & mixed ratios Current RatioProfitability RatiosCapital Turnover Ratio Liquid Ratio (Acid Test Ratio)Gross Profit RatioFixed Assets Turnover Ratio Absolute Liquidity RatioNet Profit RatioCurrent Assets Turnover Ratio Absolute Cash RatioOperating Profit RatioNet working capital Turnover Ratio Debt to Equity RatioOperating RatioStock Turn over Ratio Proprietary RatioExpense RatioDebtors Turnover Ratio Capital Gearing RatioInterest Coverage Ratio Creditors Turnover Ratio Pref Dividend Coverage RatioCash Profit Ratio Debt Service Coverage Ratio

7. Classification of Ratios Some other ratios 7 In Relation to InvestmentIn Relation to Equity Shareholder’s Fund Return on Total AssetReturn on Equity Shareholder’s Funds Return on Capital EmployedEarning Per share Return on Shareholder’s FundsDividend Per share Return on Equity Shareholder’s FundsPrice-Earning Ratio Dividend Payout Ratio Earning Yield Dividend Yield

8. Liquidity Ratio: Current Ratio Quick Ratio Absolute Cash Ratio 8

9. Current Ratio Meaning : The ratio establish relationship between current assets and current liabilities Formula Current Ratio = Current Assets Current Liabilities 9

10. Objective: 1.To measure the ability of the firm to meet is short-term obligation 2. To reflect the short-term financial strength/solvency of a firm 3. To measures the safety margin available for creditors. 10

11. Components of Current Ratio Current Assets ( converted into cash in a year) Current Liabilities ( To be paid within an accounting year) Cash BalanceCreditors for goods Bank BalanceBills payable Debtors ( after deducting provisions)Creditors for expenses Bills ReceivableBank Overdraft Marketable SecuritiesProvision for Tax Stock of Raw -MaterialsShort-term Loans & Advances Stock of Work-in-ProgressUnclaimed dividend Stock of Finished GoodsIncomes received-in-advance Prepaid Expenses Short-term Loans & Advances Outstanding income Income accrued but not due Advance payment of tax & TDS 11

12. Q1. Current Assets Rs. 2,00,000, Stock Rs. 1,00,000, Working capital Rs. 1,20,000. Calculate Current Ratio. Q2. Creditors Rs. 20,000. Working Capital Rs. 3,60,000, Other current Liabilities Rs. 1,00,000. 12

13. The Balance Sheet of T Ltd. as at 31 st March 2013 are as under: 13 LiabiitiesAmt (Rs)AssetsAmt (Rs) Equity Share Capital1,00,000Land & Building6,00,000 18% Pref. Share Capital1,00,000Plant & Machinery5,00,000 General Reserve60,000Furniture & Fixture1,00,000 Profit & Losss A/c2,40,00012,00,000 15% Debentures8,00,000(-) Depreciation(200,000) Trade Creditors40,00010,00,000 Bills Payable30,000Trade Investment (LT)1,00,000 Outstanding Expenses20,000Stock 95,000 Bank Overdraft10,000Debtors 3,40,000 Provision for Tax2,40,000(-) Provisions 30,0003,10,000 Marketable Securities10,000 Cash10,000 Bills Receivables10,000 Prepaid Expenses 5,000

14. Preliminary Expenses60,000 Underwriting Commission40,000 16,40,000 14 Net Sales for the year 2011-2012 amounted to Rs. 20,00,000. Net Profit after tax 2,40,000, tax @ 50%. Calculate Current Ratio as at 31.3.2012.

15. Liquid Ratio/Quick Ratio Meaning: This ratio establishes a relationship between Quick Assets & Current Liabilities or Quick Assets & Quick Liabilities Objective: To measure the ability of the firm to meet its short-term obligations as and when due without relying upon the realization of stock 15

16. COMPONENTS 1. Quick Assets: Refer to those assets which can be converted into cash immediately or at a short notice. ( Current Assets –Stock –Prepaid Expenses) 2. Quick Liabilities = ( Current Liabilities- Bank OD – Cash Credit) 16

17. F Formula: Quick Ratio = Quick Assets/Current Liabilities or Quick Ratio = Quick Assets/Quick Liabilities 17

18. Calculate Quick Ratio 1. Current Assets Rs. 4,40,000, Stock Rs. 95,000, Prepaid expenses Rs. 5,000, Current Liabilities Rs. 3,40,000 2. Current Assets Rs. 2,00,000, Inventory Rs. 40,000, Working Capital Rs. 1,20,000. 3. Current Liabilities Rs. 1,20,000. Working Capital Rs. 3,60,000, Creditors Rs. 20,000, Inventory Rs. 1,20,000, Calculate Quick Ratio. 18

19. Absolute Cash Ratio Meaning: This ratio measures a relationship between cash & marketable securities & Current Liabilities. Formula Absolute Cash Ratio = Cash & Marketable Securities/ C L 19

20. From the following Calculate, Absolute Cash Ratio; 20 InventoryRs. 4,00,000Marketable SecuritiesRs. 1,00,000 DebtorsRs. 3,50,000Current LiabilitiesRs. 5,00,000 CashRs. 2,00,000Provision for Doubtful Debts Rs. 50,000

21. Debt to Equity Ratio Meaning: The Ratio establishes the relationship between long term debt and share holders fund. Objective: To measure the relative proportion of debt and equity in financing the assets of a firm. 21

22. Components: 1. Long-term Debts: Which means long term loans ( whether secured or un secured) ( e.g. debentures, bonds, loans from financial institutions). 2. Share holders’ fund: Which means Equity share capital + Preference share capital Plus reserves and surplus (-) fictitious assets (e.g. preliminary expenses) 22

23. Computation: This ratio is computed by the following formula: Debt to equity ratio= Long Term Debt Shareholders’ Fund 23

24. Proprietory Ratio Meaning: This ratio measures the relationship between equity or Shareholders’ fund and total assets. Objective: To measure the proportion of total assets financed by Equity or Shareholders’ Fund or Proprietors’ Fund. 24

25. Computation: It is computed by the following formula: Proprietory Ratio = Proprietors’ Fund/Total Assets*100 The ratio indicates the extent to which the assets of the enterprise have been financed out of proprietors’ funds. Traditionally, a proprietory ratio of 1:4 is considered satisfactory, which means 25% of the total assets are financed out of equity.

26. Computation of Shareholders’ Fund or Equity Liabilities Side ApproachAMTAsset Side ApproachAMT Equity share CapitalNet Fixed Asset (+) Resrves & Surplus(+) Trade investment (Less) Misc Exp(+) Current Assets Equity Sharholder’s FundTotal Assets (Add) Pref Share Capt(-) Current Liabilities Shareholders’ Fund or Proprietors’ Fund Capital Employed (-) Long term Debt Shareholders’ Fund /Proprietors’ Fund 26

27. Capital Gearing Ratio Meaning: This ratio establishes a relationship between funds bearing fixed financial payment and Equity Shareholders’ Fund Objective: To measure the relative proportion of funds bearing Fixed financial payments to Equity Shareholders’ Fund. 27

28. Components: 1. Funds bearing fixed financial payment: Debentures, bonds, loans from financial institutions, preference share capital. 2. Equity Shareholders’ Fund: Equity share capital + Reserves & Surplus (-) Fictitious assets. 28

29. Debt to Equity Ratio: Taking the same example of Q3. In Current Ratio Calculate Debt to Equity Ratio. Proprietory Ratio: Net Fixed Assets Rs. 10,00,000, Long Term Trade Investments Rs. 1,00,000, Current Assets Rs. 4,40,000, Preliminary Expenses Rs. 60,000, Underwriting Commission Rs. 40,000, Equity Share Capital ( Rs. 10 Each) Rs. 1,00,000, 18% Pref. Share Capital Rs. 1,00,000, Reserves Rs. 1,00,000, P & L A/c ( Opening Balance) Rs. 2,00,000, 15% Debentures Rs. 8,00,000, Current Liabilities Rs. 3,40,000. 29

30. Capital Gearing Ratio: Calculate the Capital Gearing Ratio from the following: 15% Long-Term Debt Rs. 8,00,000, 18% Preference Share Capital Rs. 1,00,000, Equity Share Capital Rs. 2,00,000. Reserves & Surplus Rs. 1,50,000, Preliminary Expenses Rs. 50,000. 30

31. Preference Dividend Coverage Ratio Meaning: This ratio establishes a relationship between Net profits after interest and taxes and Preference dividend on preference share. Objective: To measure the Preference shares servicing capacity of a firm so far as Fixed Dividend on Preference Share is concerned. 31

32. Components: 1. Net profits after interest and taxes; 2. Preference Dividend on Preference Shares. Computation: By the following formula: Preference Dividend Coverage Ratio = Net profits after interest and taxes Pref Dividend on Pref. Shares 32

33. Interpretation: This ratio shows the number of times the amount of Preference Dividend is covered by the profits out of which Pref. Dividend will be paid. It indicates the limit beyond which the ability of the firm to service its preference shares capital would be adversely affected. 33

34. Debt service Coverage Ratio: Meaning: This ratio measures the relationship between Net profit before Interest &Tax and interest + Principal portion of installment. Objective: To determine the firm’s capacity to pay off both the interest and principal portion of installment. 34

35. Components: 1. Net Profit before interest & Tax 2. Interest and principal portion of installment Debt-service Ratio = Net Profit before Interest & Tax = times. Interest + Principal portion of installment 1-Tax Rate It indicates the limit beyond which the ability of the firm to service its debt would be adversely affected. 35

36. Interest Coverage Ratio Meaning: The ratio establishes a relationship between Net profits before interest and taxes on long-term debt. Objective: To measure the debt servicing capacity of the firm so far as fixed interest on long-term debt is concerned. 36

37. Components: 1. Net Profit before interest & Tax 2. Interest on long term debt Computation: By the following formula Interest coverage Ratio = Net Profit before interest & Tax Interest on long term debt 37

38. Capital Turn-Over Ratio Meaning: The ratio establishes a relationship between net sales and capital employed. Objective: To determine the efficiency with which the capital employed is utilized. 38

39. Components: 1. Net sales (Gross sales – sales return) 2. Capital Employed. Computation: By the following formula Capital Turn over ratio = Net sales/Capital Employed 39

40. Calculation of capital employed Liabilities Side ApproachRs.Assets Side ApproachRs. Equity Share CapitalxxxxxxxNet Fixed Assetsxxxxxxx (+) Reserves & Surplusxxxxxxx(+) Trade Investmentxxxxxxx (-) Miscellaneous Expenditurexxxxxxx(+) Current Assetsxxxxxxx Equity Share holders’ FundxxxxxxxTotal Assetsxxxxxxx (+) Preference Share Capitalxxxxxxx(-) Current Liabilitiesxxxxxxx Shareholders’ FundxxxxxxxCapital Employedxxxxxxx (+) Long –term Debtsxxxxxxx( Non –Trading Assets should not be included while calculating Total Assets) xxxxxxx (-) NonTrading Assetsxxxxxxx( Advance purchase of fixed assets,xxxxxxx Capital EmployedxxxxxxxCapital W.I.P., Non Trade Investment s) xxxxxxx 40

41. Preference Dividend Coverage Ratio: 1. Calculate Preference Dividend Coverage Ratio from the following information: 15% Debentures Rs. 8,00,000, Net Profit before Interest & Tax Rs. 6,00,000, Tax 50%, 16% Rs. 100,000 Pref Shares of Rs. 100 each. Debt-Service Coverage Ratio: 2. Net Profit before interest & Tax Rs. 8,50,000, 10% Debentures ( payable in 10 installments) Rs. 7,00,000. Tax Rate 30%, Calculate Debt-Service coverage Ratio. 41

42. Fixed Asset & current Asset Turnover Ratio Meaning: Establishes relationship between Net Sales & Fixed Assets. Objective: To determine the efficiency with which the fixed assets are utilized Components: 1. Net Sales: which means gross sales – sales return 2. Net Fixed Operating assets - Depreciation 42

43. Computation: By the following formula Fixed Assets Turnover Ratio = Net Sales / Net Fixed Operating Assets. Current Assets Turnover Ratio = Net Sales / Current Assets. 43

44. Working Capital Turnover Ratio Meaning: This ratio establishes a relationship between net sales and working capital. Objective: To determine the efficiency with which working capital is utilised. 44

45. Components: 1. Net Sales: Which means Gross sales (–)Sales return 2. Working Capital: Current Assets (-) Current Liabilities Computation: By the following formula Working Capital Turnover Ratio = Net Sales/ Working Capital 45

46. Stock Turnover Ratio Meaning: This ratio establishes relationship between cost of goods sold and average inventory of finished goods. Objective: To determine the efficiency with which inventory is converted into sales. 46

47. Components: 1. Cost of goods sold = Opening Inventory + Net Purchases + Direct Expenses (-) Closing inventory or Net Sales – Gross Profit. 2. Average Inventory: Opening Inventory + Closing inventory /2 Computation: By the following formula Stock Turnover Ratio = Net Sales/Average Stock Or : = COGS / Average stock at cost 47

48. Stock Velocity: The velocity indicates the period for which sales can be generated with the help of an average stock maintained and is expressed in terms of period. Computation: By the following formula Stock Velocity = Average Stock /Average cost of goods sold per day = ……Days Or 12months/52 weeks/365 days = Months/Weeks/Days Stock Turnover Ratio Average Cost of Goods sold per day = Cost of Goods Sold/ No of working days in the year.

49. Debtors Turnover Ratio Meaning: It establishes a relationship between credit sales and average trade debtors. Objective: To determine the efficiency with which trade debtors are converted into cash. 49

50. Components: 1. Net Credit Sales: Gross Credit Sales (-) Returns 2. Average Debtors (or Receivables): = Opening Debtors + Opening B/R (+) Cl Debtors + Cl B/R 2 Computation: By the following formula Debtors Turnover Ratio= Net Credit Sales/Average Debtors It indicates the speed with which debtors are converted into cash. It also indicates both the quality of debtors and the credit collection efforts of the enterprise.

51. Average Collection Period/Debtors’ Velocity Meaning: This period shows the average period for which the credit sales remain outstanding or the average credit period actually enjoyed by the debtors. It indicates the rapidity or slowness with which the money is collected from debtors. 51

52. Calculated by the following formula: Debt Collection Period = Average Debtors /Average Net Cr sales per day or = 12 months/52 weeks/365 days = Months /weeks/days Debtors Turnover Ratio Note: Avg Credit sales per day = Net credit sales for the year/ No. of working days in the year 52

53. Creditors Turnover Ratio or Payable Turnover Ratio Meaning: The ratio establishes a relationship between net credit purchases and average creditors or payables. Objective: To determine the efficiency with which creditors are managed and paid.

54. Components: 1. Net Credit Purchase: Gross credit purchase (- )Returns 2. Average Creditors(or Payables) Opening Creditors + Opening B/P + Cl Creditors + Cl B/P 2 Computation: By the following formula Creditors Turnover Ratio = Net Credit Purchase/Average Creditors It indicates the speed with which the creditors turn over on an average each year. In general a high ratio indicates the shorter payment period and a low ratio indicates high payment period. 54

55. Debt Payment Period (or Creditors’ Velocity ) This shows an average period for which the credit purchases remain outstanding or the average credit period actually availed of. Calculated by the following formula: Avg Debt Payment Period = Avg Creditors/ Avg Net Credit purchase per day = …days Or = 12 months/52 weeks/365 days = Months /weeks/days Creditors Turnover Ratio Note: Avg Credit Purchases per day = Net credit Purchases for the year/ No. of working days in the year 55

56. Return on Total Asset Meaning: It measures the relationship between Net profit before interest and tax, and total assets Objective : To find out how efficiently the total assets have been used by the management. 56

57. Components: 1. Net profit before interest & tax 2. Total Assets: ( excluding fictitious assets e.g. preliminary expenses) Components: By the following formula Return on Total Assets = Net profit before interest & Tax * 100 = ……% Total Assets 57

58. Return on Capital Employed/Return on Investment (ROI) Meaning: This ratio measures a relationship between net profit before interest and tax and capital employed. Objective: To find out how efficiently the long-term funds supplied by the creditors and shareholders have been used. 58

59. Computation: By the following formula Return on capital employed = Net profit before interest & Tax* 100 = …..% Capital Employed This ratio indicates the firm’s ability of generating profit per rupee of capital employed. Higher the ratio more efficient the management and utilization of capital employed 59

60. Return on Shareholders’ Fund or Return on Equity Meaning: It measures the relationship between net profit after Interest & Tax, and shareholders’ funds. Objective: To find out how efficiently the funds supplied by al the shareholders ( Equity and preference) have been used. 60

61. Components: 1. Net Profit after Interest & Tax 2. Shareholders’ funds Computation: By the following formula Return on Shareholders’ Fund = Net Profit after Interest & Tax * 100 = …..% Shareholders’ funds 61

62. Return on Equity Shareholders’ Funds Meaning: This ratio measures the relationship between Net Profit After Interest & Tax – Preference Dividend & Equity Shareholders’ Fund. Objective: To find out how efficiently the funds supplied by the equity shareholders have been used. 62

63. Components: 1. Net Profit after interest & tax –Pref Dividend 2. Equity Shareholders’ Funds: Equity share capital + Reserves & Surplus (-) Fictitious Assets. Computation: By the following formula Return on Equity Shareholders’ Funds = Net Profit after interest & tax –Pref Dividend*100 Equity shareholders’ Fund 63

64. Earning Per Share(EPS) Meaning: It measures the earnings available to the equity shareholder on a per share basis. Objective: To measure the profitability of the firm on per equity share basis. 64

65. Components: 1. Net profit after interest & Tax (-) Pref Div 2. No. of Equity Share Outstanding. Computation: BY the following formula EPS = Net profit after interest & Tax (-) Pref Div No. of Equity Share Outstanding. 65

66. Price Earning Ratio (PER) Meaning: It measures the relationship between the market price per share and earning per share. Objective: To Find out the expectations of the shareholders about the earnings of the firm. 66

67. Components: 1. Market Price Per share 2. Earning Per share Computation: BY the following formula Price Earning Ratio = Market Price Per share Earning Per share 67

68. Interpretation: It indicates the no of times of EPS, the share is being quoted in the market. In other words, it indicates the payback period within which the prospective investor can recover his investment in a single share by way of Earning Per Share. 68

69. Earning Yield Ratio (EY) Meaning: The ratio measures the relationship between Earning Per Share (EPS) & Market Price Per Share. Objective: To measure the performance of earnings in relation to market price per share.

70. Components: 1. Earning Per Share 2. Market Price Per Share Computation: By the following formula Earning Yield = Earning Per Share (EPS)* 100 Market Price Per Share 70

71. Dividend Per Share Meaning: It measures the dividend distributed per equity share. Objective: The objective is to measure the dividend distributed per equity share. 71

72. Components: 1. Profit distributed as Equity dividend 2. Number of Equity Shares Computation: By the following formula Dividend Per Share (DPS) = Profit distributed as Equity dividend = Rs. …… Number of Equity Shares 72

73. Dividend Payout Ratio: Meaning: It measures the proportion of earning per share distributed as dividend. Objective: TO measure the portion of EPS distributed as dividend.

74. Components: 1. Earning Per Share (EPS) 2. Dividend Per Share (DPS) Computation: By the following formula Dividend Payout Ratio = Dividend Per Share (DPS) *100 Earning Per Share (EPS) 74

75. Dividend Yield Ratio Meaning: It measures the relationship between Dividend Per Share (DPS) & Market Price Per Share. Objective: To measure the performance of dividend in relation to market price per share. 75

76. Components: 1. Dividend Per Share (DPS) 2. Market Price Per Share Computation: By the following formula Dividend Yield = Dividend Per Share (DPS)* 100 Market Price Per Share 76

77. Return on Total Assets Net profit after interest & tax Rs. 2,40,000, Tax rate 50%, Net Fixed Assets Rs. 10,00,000, Long Term Trade Investments Rs. 1,00,000, Current Assets Rs. 4,40,000, Preliminary Expenses Rs. 60,000, Underwriting Commission Rs. 40,000, Equity Share Capital ( Rs. 10 Each) Rs. 1,00,000, 18% Pref. Share Capital Rs. 1,00,000, Reserves Rs. 1,00,000, P & L A/c ( Opening Balance) Rs. 2,00,000, 15% Debentures Rs. 8,00,000, Current Liabilities Rs. 3,40,000. Return on Capital Employed/Return on Investment (ROI): Taking the same illustration of Return on Total Assets Calculate the Return of Capital Employed. 77

78. Return on Shareholders’ Fund or Return on Equity (ROI) Taking the same illustration of Return on Total Assets Calculate the Return of Shareholders’ Fund or Return on Equity. Return on Equity Shareholders’ Fund Taking the same illustration of Return on Total Assets Calculate the Return of Equity Shareholders’ Fund. 78