Telecommunication Accounts and Finance -7

 

 

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Chapter-6

Ratio Analysis

 

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Financial Analysis is the process of identifying the financial strengths and weakness

of the firm by properly establishing relationships between the items of the balance

sheet and the profit and loss account. Ratio Analysis is a powerful tool of financial

analysis. The relationship between two accounting figures, expressed mathematically,

is known as a financial ratio. Ratios help to summarise the large quantities of financial

data and to make qualitative judgement about the firm’s financial performance.

Standards of comparison: A single ratio in itself does not indicate favourable or

unfavorable conditions. It should be compared with some standard. Standards of

comparison may consist of:

1. Ratios calculated from the past financial statements of the same firm;

2. Ratios developed using the projected, or pro forma, financial statements of

the same firm;

3. Ratios of some selected firms, especially the most progressive and

successful, at the same point of time, and

4. Ratios of the industry to which the firm belongs.

Advantages of Ratio Analysis:

i. Simplifies, Summarizes and Systematizes accounting figures for easy

understanding;

ii. Ratios helps the management in measuring things like Long-term Solvency,

Operational Efficiency, etc. of the firm

iii. Facilitates the understanding of financial statements showing the whole story

of changes in financial conditions of business;

iv. Facilitates inter-firm comparison showing relative performance of enterprise

in the industry;

v. Facilitates intra-firm comparison showing the improvement/degradation in the

performance of the enterprise;

vi. Facilitates the Planning of Operations;

vii. Facilitates in Establishing Standards;

 

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viii. Facilitates Management by Exception higher management can concentrate the

area where its intervention is required; thereby making the best use of time &

available resources.

Limitations of Ratio Analysis:

1) Ratios has little meaning by itself; unless there exists a comparison;

2) Ratios are arithmetical expressions, so, qualitative aspects cannot be presented

through ratios directly;

3) Ratios are calculated from accounting records which are subject to their own

limitations. Hence, ratios are also considerably affected by limitations of

accounting records;

4) Ratios are only a tool, whose best use ultimately depends upon the craftsman

who uses it. So, “they are only means & not end in themselves”.

5) Strongly affected by manipulations of financial statements [like window

dressing]; & this fact is not revealed by Ratio Analysis.

6) Factors like Inflation also strongly distort the Ratio Analysis.

Classification of Ratios:

Structural Classification of Ratios: This is the Conventional mode of classifying

ratios where the ratios are classified on the basis of information given in the financial

statements. The classification is as follows:

S.

No:

Type What it is Examples

1. Balance Sheet

Ratios

These are the ratios for which the

components for computation are

drawn from the Balance Sheet.

These are called Financial

Ratios.

* Current Ratio

* Liquid Ratio

* Debt Equity Ratio

* Proprietary Ratio

* Capital Gearing Ratio

* Fixed Assets Ratio

 

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2. Profit and

Loss Account

Ratios

These are the ratios for which the

components for computation are

drawn from the Profit & Loss

Account.

These are called Income

Statement Ratios or Operating

Ratios.

* Gross Profit Ratio

* Net Profit Ratio

* Operating Ratio

* Stock Turnover Ratio

* Expenses Ratio

3. Interstatement

Ratios or

Combined

Ratios

These are the ratios for which the

components for computation are

drawn both from the Balance

Sheet and Profit & Loss Account.

These are called Financial

Ratios.

* Return on Capital

Employed [ROCE]

* Return on Investments

ROI]

* Debtors Turnover Ratio

* Creditors Turnover

Ratio

* Fixed Assets Turnover

Ratio

* Working Capital

Turnover Ratio

_ Functional Classification Of Ratios:

 

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RATIOS

LIQUIDITY

RATIOS

CAPITAL

STRUCTU

RE

RATIOS

COVERAGE

RATIOS

TURNOVER

RATIOS

PROFITABILITY

RATIOS

* Current

Ratio

* Acid Test

Ratio or Quick

Ratio

* Absolute

Cash Ratio

* Interval

Measure

* Equity to

Funds Ratio

* Debt Equity

Ratio

* Capital

Gearing Ratio

* Fixed Assets

to Long- term

Funds

* Proprietary

Ratio

* Debt Service

Coverage

Ratio

* Interest

Coverage Ratio

* Preference

Dividend

Coverage Ratio

* Capital

Turnover

Ratio

* Fixed Asset

Turnover

Ratio

* Working

Capital

Turnover

Ratio

* Raw

Materials

Turnover

Ratio

* FG/Stock

Turnover

Ratio

* Creditors

Turnover

Ratio

* Debtors

Turnover

Ratio

Based on

Sale

Based on

Capital

* Gross Profit

Ratio

* Operating Profit

Ratio

* Net Profit Ratio

* Return on Investment [ROI] or

Return on Capital Employed

[ROCE]

* Return on Equity [ROE]

* Return on Assets [ROA]

* Earnings per Share [EPS]

* Dividend per Share [DPS]

* Dividend Yield Ratio [DYR]

* Price – Earnings [P/E Ratio]

* Dividend Pay – out Ratio [D/P

Ratio]

* Reserves to Capital Ratio

 

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Types of Ratios

Liquidity Ratios: Liquidity ratios measure the ability of the firm to meet its

current obligations.

1. Current ratio = Current assets

Current Liabilities

Current assets include cash and those assets which can be converted into cash within a

year, such as marketable securities, debtors and inventories. Prepaid expenses also

included in current assets as they represent the payments that will have not to be made

by the firm in the near future. All obligations maturing within a year are included in

current liabilities. Thus current liabilities include creditors, bills payable, accrued

expenses, short-term bank loan, income-tax liability and long-term debt maturing in

the current year. The current ratio is a measure of the firm’s short-term solvency. A

ratio of greater than one means that the firm has more current assets than current

claims against them. As a conventional rule, a current ratio of 2 to 1 or more is

considered satisfactory. Too much reliance should not be placed on the current ratio.

Further investigations about the quality of current assets should be carried.

2. Quick ratio = Current Assets-Inventories

Current liabilities

This ratio establishes a relationship between quick or liquid, assets and current

liabilities. Generally a quick ratio of 1 to 1 is considered to represent a satisfactory

current financial condition.

3. Cash ratio = Cash + Marketable securities

Current liabilities

4. Interval measure =Current assets-Inventory

Average daily operating expenses

This ratio assesses a firm’s ability to meet its regular cash outgoings. The daily

operating expenses will be equal to cost of goods sold plus selling, administrative and

general expenses less depreciation(and other non-cash expenditure) divided by

number of days in the year (say 360)

 

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5. Net working capital ratio =Net working capital

Net assets

The difference between current assets and current liabilities is called net working

capital. NWC is sometimes used as a measure of a firm’s liquidity. It can be related to

net assets (or capital employed). It is considered that, between two firms, the one

having the larger NWC has the greater ability to meet its current obligations.

Leverage Ratios:

Leverage ratios are calculated to measure the financial risk and the firm’s ability of

using debt for the benefit of shareholders. Leverage ratios may be calculated from the

balance sheet items to determine the proportion of debt in total financing. Leverage

ratios are also computed from the income statement items by determining the extent to

which operating profits are sufficient to cover the fixed charges.

1. Total Debt ratio = Total Debt = TD

Total debt + Net worth TD + NW

OR = Total debt = TD

Capital employed CE

Total debt (TD) will include short and long-term borrowing financial institutions,

debentures/bonds, deferred payment arrangements for buying capital equipments, and

bank borrowing, public deposits and nay other interest- bearing loan.

Capital employed (CE) will include total debt and net worth (NW)

Capital employed (CE) equals net assets (NA) which consist of net fixed assets (NFA)

and net current assets (NCA).

Net current assets (NCA) are equal to current assets (CA) minus current liabilities

(CL) excluding interest- bearing debt.

 

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2. Debt-Equity ratio =Total Debt

Net Worth

Relationship describing the lenders’ contribution for each rupee of the owners’

contribution is called debt-equity ratio.

3. Total liabilities to total assets ratio = Total liabilities

Total assets

THIS RATIO assesses the proportion of total funds-short-term and long-term

provided by outsiders to finance total assets.

4. Debt ratio = Total debt + Value of lease

Total debt + Value of lease + Net worth

Coverage Ratios:

1. Interest coverage = EBIT + Depreciation

Interest

EBIT = Earnings before interest and taxes

2. Fixed coverage = EBIT + depreciation

Interest + Loan repayment

1-tax rate

Activity Ratios:

Activity ratios are employed to evaluate the efficiency with which the firm manages

and utilizes its assets. These ratios are also called turnover ratios because they indicate

the speed with which assets are being converted or turned over into sales.

1. Inventory turnover =Cost of goods sold

Average inventory

This ratio indicates the efficiency of the firm in selling its product. The average

inventory is the average of opening and closing balances of inventory.

 

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2. Days of inventory holdings (DIH) = Number of days in a year (say 360)

Inventory turnover

3. Raw material inventory turnover = Material consumed

Average raw material inventory

4. Work in process inventory turnover= Cost of production

Average work in process inventory

5. Debtors turn over = Credit Sales

Average debtors

6. Average collection period (ACP) = 360

Debtors turnover

Debtors turnover ratio and average collection period ratio judge the quality or

liquidity of debtors.

Asset Turnover

Assets are used to generate sales. Therefore, a firm should manage its assets

efficiently to maximize sales. The relationship between sales and assets is called

assets turnover.

7. Net assets turnover = Sales

Net assets

8. Total assets turnover = Sales

Total assets

9. Fixed assets turnover = Sales

Net fixed assets

10. Current assets turnover = Sales

Current assets

11. Net currents assets turnover= Sales

Net current assets

 

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Profitability Ratios:

The profitability ratios are calculated to measure the operating efficiency of the

company.

1. Gross profit margin = Gross profit

Sales

Gross profit= Sales-cost of goods sold

2. Net profit margin =Profit after tax or EBIT

Sales sales

EBIT = Earnings before interest and tax

3. Operating expense ratio =Operating expenses

Sales

4. Return on Investment = EBDIT

GFA+NCA

EBDIT=Earnings before depreciation, interest and Tax

GFA=Gross fixed Assets

CFA=Net current assets

5. Return on equity = Profit after tax

Net worth

6. Earnings per share (EPS) = Profit after tax

Number of common shares outstanding

7. Dividends per share (DPS) = Earnings paid to shareholders

Number of common shares outstanding

8. Dividend payout ratio = DPS

EPS

9. Price-earnings ratio = Market value per share (MVPS)

Earnings per share (EPS)

10. Market value-book value ratio = Market value of the share

Book value of the share

 

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Illustration:

The ABC company’s financial statements contain the following information:

31st March 2007

Rs.

31st March 2006

Rs.

Cash 200000 160000

Sundry debtors 320000 400000

Temporary investments 200000 320000

Stock 1840000 2160000

Prepaid expenses 28000 12000

Total current assets 2588000 3052000

Total assets 5600000 6400000

Current liabilities 640000 800000

10% debentures 1600000 1600000

Equity share capital 2000000 2000000

Retained earnings 468000 812000

Statement of Profit for the year ended 31st March,2007 Rs.

Sales 4000000

Less: cost of goods sold

Less: Interest

2800000

160000

2960000

Net profit for 2001 1040000

Less: taxes @ 50% 520000

520000

Dividend declared on equity shares = Rs.220000

(i) Liquidity Ratios

(a) Current ratio = Current assets

Current liabilities

 

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2000=2588000=4.04

640000

2001= 3052000=3.82

800000

(b) Acid Test Ratio =Liquid assets

Current liabilities

2000=720000=1.13

640000

2001=880000=1.1

800000

(ii) Solvency Ratios

(a) Debt equity ratio: Long term debts

shareholders’funds

2000=1600000=0.65(approx.)

2468000

2001=1600000=0.57(approx.)

2812000

b) Interest coverage ratio: Profit before interest and taxes

Interest charges

2001=1200000=7.5 times

160000

(iii) Profitability ratios

(a) Net Profit ratio = Net profit x 100

Sales

2001=520000 x 100= 13%

4000000

(b) Returns on capital employed : Net profit before interest and taxes x 100

Total capital employed

2001=1200000 x 100=27.2%

4412000

 

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(iv) Activity ratios

(a) Stock turnover ratio: Cost of goods sold

Average stock

2001=2800000=1.4 times

2000000

(b) Total assets turnover ratio: sales

Total assets

2001= 4000000=0.625 times

6400000