Importance of Ratio Analysis in Financial Performance Evaluation

RATIOANALYSIS

Topics to be Enlightened: Introduction and Meaning Interpretation of Ratio Usefulness of Ratio Analysis Limitations of Ratio Analysis Classification of Ratio Analysis + Traditional Classification + Functional Classification ProfitabilityRatio TurnoverRatio LiquidityRatio Ownership/SolvencyRatio + Classification byUsers

Introduction and Meaning It is one of the tools of measuring financial performance of the organization It is a comparative analysis between two factors Business performance can be measured by the use of ratios It must be interpreted against some standards Apart from the absolute profit figures, the management might find a need of relative data/information about the variables, thus, at this time, ratio analysis assists the management. It evaluates the financial conditions and the purpose of a firm through various yardsticks This tool is useful for all the various stakeholders of the company like, shareholders, bankers, creditors, lenders, investors, government, etc. The following are four ways to analyzeratio:

Four Ways to Analyse Ratio It helps you analyse the movementof the variables compared across years This helps to make comparisons of two companiesof the same industry It helps you look intothe persistent record of a particular variable for detailed analysis It helps the firm to determine the groupof ratios of a variable in various forms, e.g. gross profit, net profit, operating profit,etc.

Usefulness of Ratio Analysis Simplification of data Helps in disclosing operational efficiency Benchmark for comparison Planning Managerial tool Analyzing financial statement Scanning Device

Limitatio ns of Ratio Analysis It depends on the past data which in itself serves as a limiting factor. It may not represent the correct picture of thebusiness. Only accounting information is used while analyzingand interpreting the results of ratioanalysis. In taking corrective actions, the management mightconcentrate more on improving the ratio over the years rather than solving the major reason behind such an adversecondition. At times, when the two items are compared, it isnot necessary that due to the items in questions leads to the changes in the output. There could be other reasons as well which lead to the adverseratio.

Classifications of Ratio Analysis Classification Traditional Functional

Traditional Classification Traditional Revenue Statement Ratios Composite Ratio Balance Sheet Ratios

Functional Classification

Classification by Users

Profitability Ratio In relation to sales + Gross profitratio + Operatingratio + Expenseratio + Operating profitratio + Net profitratio In relation to investment + Return on capital employed + Return on shareholders fund + Return on equity shareholders fund

InTe rms o f Sales Gross profit ratio It measures the gross margin of profit over the total sales of a unit: Gross profit Sales Gross Profit Margin= X 100 Operating ratio Operating ratio is measured to find out proportion of cost of goods sold and operating expenses tosales: Cost of goods sold + Operatingexpenses Net Sales X 100 Operating ratio =

Cont Expense Ratio + Operating expenseratio + Material costratio + Labor cost ratio + Conversion costratio + Administration costratio + Selling & distribution costratio

Cont Operating Profit Ratio - It is calculated by reducing administration, selling and distribution expenses from GrossProfits: Operating Profit Net Sales 100 Operating Profit ratio = X Net Profit Ratio - It measures the margin of revenues available to the owners satisfying all costs, expense, and losses: of the business after Net Profit Net Sales 100 Net Profit Margin = X

In Terms ofInvestments Return on Capital Employed - The return on the investment is measured by dividing the net profit or the income bytotalcapital invested: Net Profit (EBIT) Capital Employed 100 ROI = X Return on Shareholders Fund -This ratio indicates the margin available for the shareholders after satisfying all other obligations and taxes aswell: Net Profit (PAT) Shareholders FundX 100 ROSF =

Cont Return on Equity Shareholders Fund -This measures returns available for equity shareholders, but it excludes preferenceshare capital: Net Profit (PAT) preference Dividend Equity ShareholdersFund 100 ROESF = X

Du-Pont Chart Return on investment (%) Totalassets Net profit margin Netprofit Net Sales Net Sales TotalAssets Net Sales + Non operatingsurplus Net Fixed Assets TotalCosts CurrentAssets Cost of GoodsSold Cash & BankBalances Operating Expenses Receivables Interest Inventories Tax Other Currentassets

LiquidityRatio Current Ratio -This ratio measures the liquidity position of the concern for a short period: Current Assets CurrentLiabilities Current Ratio= Quick Ratio - It is designed to show how the amount of cash is made available to meet immediatepayments: Liquid Assets Liquid Liabilities Quick Ratio= Acid Test Ratio -The actual liquidity is measured by comparing the cash and bank balance as well asthe marketable securities with liquid liabilities: Quick Assets Liquid Liabilities Acid-test Ratio=

TurnoverRatio Inventory turnover ratio Cost of goods sold Average inventory Inventory turnover Ratio = Debtors turnover ratio Debtors + Bills Receivable Average Daily Credit Sales Debtors Ratio = CreditSales 365 / 360 days Credit Sales =

Cont Creditors turnover ratio Creditors + Bills Payable Average Credit Purchase per day Creditor Turnover Ratio = Credit Purchases 365 / 360days Credit Purchase Per day = Fixed assets turnover ratio Net Sales FixedAssets Fixed AssetsTurnover Ratio = Total assets turnover ratio Net Sales TotalAssets TotalAssetsTurnover Ratio =

Ownership Ratio Debt EquityRatio Long TermLiabilities Shareholders'funds Debt-equity Ratio = Shareholders equity ratio Shareholders Funds Total assets(tangible) Shareholders Equity Ratio = Capital gearing ratio Fixed Int. or DividendSecurities Eq. S. H. Fund/ Networth Capital Gearing Ratio = Long term funds to fixed assets ratio Long termFunds FixedAssets FixedAssets Ratio =

Practical Problems Problem I Revenue Ratios Problem II Balance Sheet Ratios Problem III Composite Ratios

Problem I The following T rad ing an dProfit and Loss Account of Fantasy Ltd. for the year 31-3-2000 is given b el ow .Calculate:Gr oss Profit Ratio, Expenses Ratio, Operating Ratio, Net Profit Ratio, Operating Ratio, Stock Turnover Ratio. Particular Rs. 76,250 BySales 3,15,250 2,000 5,000 2,00,000 5,98,500 Particular Rs. To Opening Stock Purchases Carriage and Freight Wages Gross Profit b/d 5,00,000 98,500 Closingstock 5,98,500 To Administration expenses Selling and Dist.expenses Non-operatingexpenses FinancialExpenses Net Profit c/d 1,01,000 By Gross Profitb/d 12,000 Non-operatingincomes: 2,000 Interest on Securities 7,000 Dividend onshares 84,000 Profit on sale ofshares 2,00,000 1,500 3,750 750 2,06,000 2,06,000

SOLUTION I Op. ExpensesX Net Sales Grossprofit Sales 2. Expenses Ratio = 100 1. Gross Profit Margin = X 100 2,00,000 5,00,000 1,13,000 5,00,000 X 100 X 100 = 22.60% = 40% Cost of goods sold + Op. ExpensesX Net Sales 3,00,000 + 1,13,000 5,00,000 = 82.60% 3. Operating Ratio= 100 X 100 Cost of Goods Sold = Op. stock + purchases + carriage and Freight + wages Closing Stock = 76250 + 315250 + 2000 + 5000 + -98500 = 3,00,000 Rs.

Cont Net Profit Net Sales 84,000 5,00,000 = 16.8% 4. Net Profit Ratio X 100 = X 100 Op. Profit Net Sales 5. Operating Profit Ratio= X 100 Operating Profit = Sales ( COGS + Op.Exp.) 87,000 5,00,000 = 17.40% X 100 Cost of goodssold Avg. Stock 3,00,000 87,375 = 3.43 times 6. Stock Turnover Ratio =

Problem II THE BALANCE SH EET OF P UNJAB AUT O LIMITED AS ON 31- 1 2-2002 WAS AS FOLLOWS: FROM THE BELOW, COMPUTE (A) THE CURRENT RATIO, (B) QUICK RATIO, (C) DEBT-EQUITY RA TIO , AND ( D ) PRO PRIE TARY RATIO Particular Rs. Particular Rs. Equity Share Capital Capital Reserve 8% Loan on Mortgage Creditors Bank overdraft Taxation: Current Future Profit and LossA/c 40,000 Plant and Machinery 8,000 Land and Buildings 32,000 Furniture & Fixtures 16,000 Stock 4,000 Debtors Investments(Short-term) 4,000 Cash in hand 4,000 12,000 24,000 40,000 16,000 12,000 12,000 4,000 12,000 1,20,000 1,20,000

SOLUTION II Current Assets Currentliabilities 1.Current Ratio = Current Assets = Stock + debtors + Investments (short term) + Cash In hand CurrentLiabilities = Creditors+ bankoverdraft+ ProvisionforTaxation(current & Future) CA= 12000 +12000 +4000 +12000 =40,000 CL=16000 +4000 +4000 +4000 =28,000 = 40,000 28,000 = 1.43 :1 QuickAssets QuickLiabilities 2. QuickRatio = QuickAssets=CurrentAssets-Stock Quick Liabilities = Current Liabilities (BOD + PFT future) QA=40,000 12,000 =28,000 QL=28,000 (4,000+4,000) =20,000 = 28,000 20,000 = 1.40 :1

CONTINUE Long T erm Debt(Liabilities) Shareholders Fund L TL = Debentures + long termloans SHF= Eq.Sh.Cap.+ Reserves &Surplus+ PreferenceSh.Cap. FictitiousAssets L TL = 32,000 SHF= 40,000 +8,000 +12,000 3. Debt Equity Ratio = =60,000 = 32,000 60,000 = 0.53 :1 Shareholders Funds T otalAssets 4. ProprietaryRatio = SHF= Eq.Sh.Cap.+ Reserves &Surplus+ PreferenceSh.Cap. FictitiousAssets T otalAssets=T otalAssets FictitiousAssets SHF= 40,000 +8,000 +12,000 =60,000 TA =1,20,000 = 60,000 1,20,000 = 0.5 :1

PROBLEM III ThedetailsofShreenath companyare as under: Beside the details mentioned above, the opening stock was of Rs. 3,25,000. Taking 360 days of the year , calculate the following ratios; also discuss the position of the company: (1) Gross profit ratio. (2) Stock turnoverratio.(3) Operatingratio.(4) Current ratio. (5) Liquid ratio.(6) Debtorsratio. (7) Creditors ratio.(8) Proprietaryratio. (9) Rate ofreturnon netcapitalemployed.(10) Rate ofreturn on equityshares. Particular Rs. Particular Rs. 55,00,000 1,75,000 3,50,000 50,000 2,25,000 1,00,000 Equity share capital 10% Preference sharecapital Reserves 10% Debentures Creditors Bank-overdraft Bills payable Outstanding expenses 20,00,000 FixedAssets 20,00,000 Stock 11,00,000 Debtors 10,00,000 Bills receivable 1,00,000 Cash 1,50,000 FictitiousAssets 45,000 5,000 64,00,000 64,00,000 Sales (40% cash sales) Less: Cost ofsales 15,00,000 7,50,000 7,50,000 Gross Profit: Less: Office Exp. (including int. ondebentures) Selling Exp. 1,25,000 1,25,000 2,50,000 Profit beforeTaxes: 5,00,000 2,50,000 2,50,000 Less: Taxes NetProfit:

SOLUTION III 1. Margin = GrossProfit Gross profitX 100 Sales 7,50,000 15,00,000 X 100 = 50% Cost of goodssold Avg.Stock Avg.stock=OpeningStock+Closing Stock 2. Stock Turnover Ratio = 2 COGS=Sales GP 3,25,000 +1,75,000 2 AS =2,50,000 COGS = 15,00,000 7,50,000 7,50,000 =7,50,000 2,50,000 = 3times

Cont Op.Profit NetSales Current Assets Currentliabilities 3. Operating Profit Ratio= X 100 4. CurrentRatio = Operating Profit =Sales (Op. Exp. + COGS.) OP =15,00,000 (7,50,000 + 1,25,000+ 25,000) CurrentAssets= Stock+debtors+ Billsreceivable +Cash CurrentLiabilities= Creditors+ bankoverdraft+ Bills payable + Outstandingexpenses CA=1,75,000 + 3,50,000 +50,000 + 2,25,000 =6,00,000 =8,00,000 CL =1,00,000 +1,50,000 +45,000+5,000 (excluding Interest on Debentures) = 6,00,000 15,00,000 =40% =3,00,000 = 8,00,000 3,00,000 X 100 = 2.67 :1

Cont 5. Quick Ratio / Liquid Ratio = Liquid Assets LiquidLiabilities 6. Debtors Ratio = Debtors+Billsreceivable Creditsales X 365 / 360 days = 3,50,000 +50,000 9,00,000 (60% of15,00,000) =0.444 = 160days (Liquid)QuickAssets = CurrentAssets - Stock (Liquid)QuickLiabilities=Current Liabilities BOD X 360 days X 360 days QA=8,00,000 1,75,000 =6,25,000 Creditors +Bills payable CreditPurchase 7. CreditorsRatio = X 365 / 360 days QL=3,00,000 1,50,000 = 1,00,000 +45,000 7,50,000 =1,50,000 Notes: If credit purchase could not find X 360 days outatthat point Cost ofGoods sold consider Creditpurchase = 6,25,000 1,50,000 = 4.17: 1 =0.193 X 360 days = 69days

Cont Shareholders Funds T otalAssets 8. ProprietaryRatio = SHF= Eq.Sh.Cap.+Reserves &Surplus+ PreferenceSh. Cap. Fictitious Assets T otal Assets = T otal Assets Fictitious Assets SHF= 20,00,000+ 20,00,000+ 11,00,000 1,00,000 =50,00,000 TA = 64,00,000 1,00,000 =63,00,000 = 50,00,000 63,00,000 = 0.79 :1

Cont RateofReturnonCapitalEmployed Rate of Return on Share holders Rate ShareholdersFund of return on Equity Fund = EBIT Capitalemployed = PAT Pref.Div. ESHF = PAT X100 X100 X100 SH F CE = Eq Sh. Cap. + Pref. Sh. Cap. + Reserves & Surplus + Debenture + Long TermLoan Fictitious Assets SHF = Eq. Sh. Cap. + Pref. Sh. Cap. + Reserves&Surplus FictitiousAssetsESHF= Eq.Sh.Cap.+ Reserves & Surplus Fictitious Assets 15,00,000 Sales Less: Cost of goodssold 7,50,000 7,50,000 1,50,000 6,00,000 1,00,000 5,00,000 2,50,000 2,50,000 2,00,000 50,000 Gross profit Less: Operating expenses (including Depreciation) Earnings before Interest & Tax(EBIT) Less: Interest Cost Earnings before Tax(EBT) Less: Taxliability Earnings after Tax (EAT/PAT) Less: Preference sharedividend DistributionalProfit

Cont 9. 10. 11. Rate of Return on Capital Employed Rate holders Fund of Return on Share Rate of return on Equity Shareholders Fund = Capitalemployed EBIT = PAT Pref. Div. ESHF = PA T SH F X100 X100 X100 CE = Eq Sh. Cap. + Pref. Sh. Cap. + Reserves & Surplus + Debenture + Long Term Loan FictitiousAssets SHF = Eq. Sh. Cap. + Pref. Sh. Cap. + Reserves & Surplus FictitiousAssets ESHF = Eq. Sh. Cap.+ Reserves & Surplus FictitiousAssets CE = 20,00,000 + 20,00,000 11,00,000 +10,00,000 1,00,000 = 60,00,000 SHF = 20,00,000 +20,00,000 11,00,000 1,00,000 =50,00,000 ESHF = 20,00,000 +11,00,000 1,00,000 =30,00,000 = 50,000 30,00,000 = 6,00,000 60,00,000 = 2,50,000 50,00,000 X100 X100 X100 = 1.67% =10% =5%