ASNC L A S S E S

CHAPTER 5 FINANCIAL ANALYSES

MEANING

Analysis of financial statements is the systematic calculation of relationship between one fact
with another, to measure the position and performance.

OBJECTIVES

1. To measures the long term and short term solvency position of the enterprise.
2. To analyze the financial position of the business.
3. To measure the operating efficiency and profitability of the company.
4. Judging operational efficiency by matching the amount of selling, manufacturing, distribution
& financial expenses of current year with corresponding expenses of previous year.
5. To make a comparative study of financial statements with other companies.
6. Inter firm & intra firm comparison.
7. Spot (point out) weaknesses in the company’s operations and take corrective action.
8. Analysis of financial statements is done to know the progress being made and the present
position of industry.

Objectives
to Know

Ownership

Profitability
Trends
Solvency

Financial
Strength

Gearing &
cover
STEPS OR PROCESS

There are three steps in financial analysis:

1. Selection of information: relevant to decision from the total information in the financial
statements ( P & L A/C & B/S)
2. Establishment of relationship by choosing the information in such a way that relationship
can be known.
3. Evaluation: By studying these relationships, conclusions and interpretations are made.

TYPES OF FINANCIAL ANALYSIS

There are 4 types of Financial Analysis:

1. Horizontal or dynamic
• Analysis for a number of years.
• Analysis of different firms.
• Techniques used: comparative balance sheet and P & L A/c, trend analysis.

These notes are prepared by MS. SHUCHI SINGHAL 1

85 Shree Gopal Nagar, Gopal Pura bypass, 5177216, 3241216
 2. Vertical Or Static
• Study relationship between different components for a fixed period of time
(single year)
• Techniques Used: Common size P & L and Balance Sheet, Ratio Analysis.
3. Internal Financial analysis: When analysis is made by internal persons like executives,
employees, etc.
4. External Financial Analysis: When analysis is made by external users like banks,
creditors, government etc.

IMPORTANCE OF FINANCIAL STATEMENT ANALYSIS

1. Disclosure of facts: With the help of financial analysis all facts related to profitability,
liquidity, solvency are made available. Thus, as a result of analysis, all undisclosed facts
come to light for the benefit of all concerned parties.

2. Effective planning & control: The analysis and interpretation of financial statements
provides adequate information for planning and controlling the affairs of the business.

3. Measures operational efficiency: The management and the owners are interested in
knowing about the operational efficiency of different activities of the concern. This can
be judged by calculating different activity and profitability ratios.

4. Comparative study: With the help of financial analysis, business information and facts
can be presented comparatively. Such presentation is made either in the form of last
few year’s position of the business or comparison of operating activities with other
business units engaged in the same industry.

5. Serving the needs of interested parties: Financial analysis provides necessary

information on timely basis to the various parties.

LIMITATIONS

1. Suffers from limitation of financial statements.

2. Ignores qualitative aspect.
3. Ignores price- level changes.
4. Ignores time-value of money.
5. Absence of universally accepted standard terminology.
6. Spots the symptoms but not diagnose.

TECHNIQUES OF FINANCIAL ANALYSIS

There are seven techniques used in financial analysis, they are:-

1. Comparative financial statements
2. Common size financial statements
3. Trend analysis
4. Ratio analysis
5. Fund flow analysis
6. Cash flow analysis
7. Break even analysis

1. Comparative Financial Statements

There are two things included in comparative financial statements
(i) Comparative Balance Sheet
(ii) Comparative Profit & Loss A/c

(ii) Comparative Balance Sheet: It is the study of the trend of the same items in two or
more balance sheets of different years of the same company.

These notes are prepared by MS. SHUCHI SINGHAL 2

85 Shree Gopal Nagar, Gopal Pura bypass, 5177216, 3241216
 Advantages:
1. Emphasis on changes: Comparative balance sheet not only discloses balance of
accounts of different dates but also discloses changes in such balances between the
two different dates.

2. Effect of activities: Comparative balance sheet serves as a link between the balance
sheet & profit & loss A/c

3. Future Forecasts: With the help of comparative balance sheet future forecasts about
business activities can be made, provided there are no hurdles in future.

Comparative Balance Sheet

As at Increase (+) or
Particulars 31st December decrease (-) in 2007
2006 2007 Amount %
Assets Rs. Rs. Rs.
Fixed Assets 40,000 52,000 + 12,000 + 30%
Current Assets 15,000 13,000 - 2,000 - 13.3%
Other Assets 5,000 5,000
Total 60,000 70,000 + 10,000 + 16.7%
Liabilities
Share Capital 25,000 25,000
Reserves 15,000 25,000 + 10,000 + 67%
Long term loans 12,000 10,000 - 2,000 - 16.7%
Current Liabilities 8,000 10,000 + 2,000 + 25%
Total 60,000 70,000 + 10,000 + 16.7%

(iii) Comparative Profit & Loss A/c: It shows the operational results of the business for a
number of accounting periods. So that changes in absolute figures from one period
to another may be stated in terms of money value & percentages.

Comparative Profit & Loss Account

Amount year ended Increase (+) or
Particulars 31st December Decrease (-)
2006 2007 Amount %
Rs. Rs. Rs.
Sales (net) 1,20,000 1,44,080 24,080 20%
Less: Cost of goods sold 72,800 81,000 8,200 11.3%
Gross Profit (1) 47,200 63,080 15,880 33.6%
Operating Expenses:
Selling Expenses 24,000 26,400 2,400 10%
Administration Expenses 12,000 13,600 1,600 13.3%
Total Expenses (2) 36,000 40,000 4,000 11.1%
Net Operating Profit (1-2) 11,200 23,080 11,880 106.1%
Other Incomes 1,200 1,600 400 33.3%
12,400 24,680 12,800 99%
Less: Other expenses 1,600 2,400 800 50.5%
Net Profit Before Tax 10,800 22,280 11,480 106.3%

2. Common - Size Financial Statements: In such statements, all figures are converted to a
common unit by expressing them as a percentage of a key figure in the statement.
Common- size statement includes:
i) Common Size Balance Sheet:
ii) Common size Profit & Loss Account.

First, the total assets, liabilities, capital and net sales are assumed to be equal to 100.
Second, the ratio that each item bears to the total is ascertained by dividing the
individual money amount by the total amount as contained in the statement &
multiplying the quotient by 100.

These notes are prepared by MS. SHUCHI SINGHAL 3

85 Shree Gopal Nagar, Gopal Pura bypass, 5177216, 3241216
 1. Common size Balance–Sheet: The balance sheet converted into percentage form is
called common size Balance Sheet.

Common size Balance Sheet

Particulars Amount Percent to
Total
Net Assets Rs.
Current Assets
Cash 49,000 9.24
Debtors 1,00,000 18.87
Stock 1,60,000 30.19
Bills Receivable 30,000 5.66
Total Current Assets 3,39,000 63.96
Less: Current Liabilities 2,33,280 44.01
Net Working Capital 1,05,720 19.95
Fixed Assets (net) 4,24,280 80.05
5,30,000 100.0
Shareholder’s Fund
Equity Share Capital 2,50,000 47.17
Preference Share Capital 1,00,000 18.87
Reserves 1,10,000 20.75
Profit & Loss Account 70,000 13.21
5,30,000 100.0

2. Common size Profit & Loss Account: Common size profit & loss account shows the
percentages of net sales that have been absorbed by each individual item
representing cost in profit & loss account.

Common Size Profit & Loss Account

Amount Percentage
Item of net
Rs. sales (%)
Net Sales 2,53,800 100.0
Less: Cost of goods sold 1,42,200 56.0
Gross Profit (1) 1,11,600 44.0
Operating Expenses:
Selling expenses 72,000 28.4
Administrative expenses 18,400 7.2
Total Expenses (2) 90,400 35.6
Operating Profit (1-2) 21,200 8.4
Add: Other Income: Dividend on Investments 2,600 1.0
23,800 9.4
Less: Other expenses: Interest on Debentures 4,000 1.6
Net Profit Before Tax 19,800 7.8
Income Tax 6,800 2.7
Net Profit After Tax 13,000 5.1

3. Trend Analysis: Trend analysis is the method of analyzing financial position of a business
on the basis of changes in the items of financial statements of successive years in
comparison to a specific date or period of commencement of study.

Trend Analysis Includes:

1. Trend percentages
2. Trend ratios
3. Graphic Presentations

1. Trend Percentages: In this method first of all, information contained in financial

statements of several years is tabulated. Then the % increases or decreases in each
item for all years are calculated by taking the earliest year or any one year as base.
These percentages are called trend percentage.

These notes are prepared by MS. SHUCHI SINGHAL 4

85 Shree Gopal Nagar, Gopal Pura bypass, 5177216, 3241216
 Example:

31st Dec. Sales(Rs.) Increase/Decrease Increase/Decrease

compared to base compared to base year (%)
year (2002) (Rs.) ( Inc. /Dec. x 100)
Base Year Sales
2002 50,000 - -
2003 60,000 + 10,000 + 20%
2004 43,500 - 6,500 - 13%
2005 55,000 + 5,000 + 10%
2006 62,500 + 12,500 + 25%

2. Trend Ratios: While calculating trend ratios, current year’s value is divided by base
year’s value and is multiplied by 100. Example:

Year 2004 2005 2006 2007 2008

Sales (Rs.) 50,000 60,000 43,500 55,000 62,500
Trend Ratios 100 120 87 110 125

4. Ratio Analysis: Ratio Analysis is a technique of presenting internal and external events
affecting the business transactions relating to its operation, operating results and
attainment of predetermined goals and objectives of a business in brief and summary form.
Ratio analysis is the process of determining and presenting the relationship of items or
group of items in the financial statements.

5. Fund Flow Analysis: Fund flow statement is summary report of financial operations of a
business enterprise, in which it is explained, how business activities are financed and how
the financial resources of the business are being used. “A statement of sources and
application of funds is a technical device designed to analyze the changes in the financial
conditions of business enterprise between two dates.”

6. Cash Flow Analysis: To know about the flows of cash during an accounting period, a
separate statement known as cash flow statement is prepared. Thus, cash flow statement is
a statement setting out the flow of cash under different heads of sources and their
utilization to determine the requirements of cash during the given period and to prepare for
its adequate provision.

7. Break even analysis: - Profit is a function and resultant of the interplay of costs, profit and
volume. Break Even Analysis refers to the study of relationship between cost, volume &
profit at different levels of sales or production. It is also called Cost-Volume-Profit Analysis
(CVP Analysis).

These notes are prepared by MS. SHUCHI SINGHAL 5

85 Shree Gopal Nagar, Gopal Pura bypass, 5177216, 3241216
 NOTES

These notes are prepared by MS. SHUCHI SINGHAL 6

85 Shree Gopal Nagar, Gopal Pura bypass, 5177216, 3241216
 ASNC L A S S E S
CHAPTER 6 RATIO ANALYSES
MEANING OF RATIO

It refers to numerical or quantitative relationship between two variables. It is used to describe

significant relationship which exists between figures shown in a B/S or P & L A/c in a budgetary
control system.

EXPRESSION OF RATIOS

1) As Ratio or Proportion e.g. 2:1.

2) As turnover or rate e.g. 4 times.
3) As percentage e.g. G.P 18%.

CLASSIFICATION OF RATIOS

1) Liquidity Ratios:

Liquidity refers to the ability of a firm to meet its obligations in the short run, usually
one year. These ratios are generally based on the relationship b/w current assets &
current liabilities. It includes:
c) Current ratio. b. Acid test ratio. c. Absolute liquidity ratio.

2) Leverage Ratios or Capital Structure Ratios:

It throws light on the long-term solvency of a firm. It is based on the principle of finance
that long term debts should be met out of long-term funds & short-term debts should be
met out of short-term funds. It includes:
a) Debt- Equity ratio. b) Proprietary ratio. c) Solvency ratio.
d) Fixed assets ratio. e) Capital gearing ratio. f) Debt service
ratio.

3) Activity or Turnover Ratios:

They measure how efficiently the assets are being used by the business. They are also
called turnover ratios because they indicate the speed with which assets are being
converted or turned over into sales. The better the management of assets, the larger
the amount of sales. It includes:
a) Inventory Turnover Ratio b) Debtors Turnover Ratio
c) Creditors Turnover Ratio d) Total assets Turnover Ratio
e) Fixed assets Turnover Ratio f) Current Assets Turnover Ratio
g) Working capital Turnover Ratio h) Capital Turnover Ratio
i) Net worth Turnover Ratio

4) Profitability Ratios:

Profitability refers to profit earning capacity of the business. These ratios indicate overall
efficiency of the management.
a) On the basis of sales
i) Gross Profit ratio ii) Operating ratio. iii) Operating Profit ratio.
iv) Expenses ratio. v) Net profit ratio.
b) On the basis of investment
i) Return on capital Employed. ii) Return on shareholders funds.
iii) Return on Eq. shareholders funds.
iv) Return on Eq. Share Capital. V) Return on total assets.
c) On the basis of shares
i) Earning Per Share (EPS) ii) Dividend Per Share (DPS) iii) Dividend payout & yield
ratio.
iv) Price Earning ratio. v) Ratio of revenue reserve to Equity Share Capital.
These notes are prepared by MS. SHUCHI SINGHAL 7
85 Shree Gopal Nagar, Gopal Pura bypass, 5177216, 3241216
LIQUIDITY RATIOS

Current Ratio
It is also called working capital ratio. It establishes a relationship b/w current assets &
Current Liabilities.
Current ratio = Current Assets
Current Liabilities
Ideal Ratio: 2:1 because if half the amount is realized from the current assets on time,
the firm can still meet its current liabilities.
Significance:
a) It is a test of short –term solvency of business.
b) More Ratio: greater safety of funds to short–term creditors. Idle investment in assets
earns nothing.
c) Low Ratio: Not able to meet current obligations.

Liquid Ratio
It is also called Quick ratio or acid test ratio.
Liquid ratio = Liquid assets (C.A. – Stock & Prepaid Exp.)
Current Liabilities
Ideal Ratio: 1:1
Significance: Better test of short term solvency than current ratio.

Absolute Liquidity ratio

It is also called super quick ratio & cash position ratio.
Absolute Liquidity ratio = Cash in hand or bank + Marketable Securities
C.L. - Bank O/D
Ideal Ratio: 0.5:1
Significance:
a) More meaningful than current & liquid ratio.
b) High Ratio: good from creditors point of view, but show poor investment policy of
management.

LEVERAGE RATIOS

Debt equity Ratio

It relates the long –term debts to shareholder’s funds to indicate the degree of
protection enjoyed by long –term creditors. It indicates the proposition of funds, which
are provided by outsider creditors in comparison to shareholder’s funds.
Debt Equity ratio = External Equities
Internal Equities
Ideal Ratio: 1:1
Significance:
a) Indicate the proportion of owner’s stake in business.
c) Extent to which firm depends on outside funds for its existence.
d) Provides margin of safety to creditors.
d) High Ratio shows a risky financial position from the long-term creditor’s point of
view.

Proprietary Ratio
It is also called ‘Equity ratio’ or net worth to total assets ratio.

Proprietary ratio = Proprietor’s fund or shareholder’s fund

Total Assets
Significance:
a) Shows general financial position of business.
b) Important for the long term creditors.
c) High Ratio: More safety to creditors.
d) Low Ratio: Greater risk to creditors since in the event of loss a part of their money
may be lost.

These notes are prepared by MS. SHUCHI SINGHAL 8

85 Shree Gopal Nagar, Gopal Pura bypass, 5177216, 3241216
 Classification:
a) Ratio of fixed assets to proprietor’s fund: Indicate how much owner’s funds are
invested in fixed assets.
b) Ratio of current assets to proprietor’s fund: Indicate how much owner’s funds are
invested in current assets.

Solvency Ratio or Debt to Total Assets Ratio

Solvency means the ability of the business to repay its outside liabilities.

Solvency ratio = Total outside debts

Total Assets
Note: Higher ratio is unfavorable.

Fixed Assets Ratio

It shows the proportion of long term funds invested in fixed assets.

Fixed Assets ratio = Long Term funds

Fixed Assets (Net)
Ideal Ratio: 1.5:1

Significance:
a) Highlights the principle that fixed assets should be financed by long term funds only.
b) Helps to know whether fixed assets are purchased by raising long term funds or
short-term funds.
c) More than 1: Indicates that long-term funds are employed to finance working capital
also besides fixed assets.
d) Less than 1: Along with long-term funds, short-term funds are also employed to
finance fixed assets & indicate poor liquidity position.

Capital Gearing Ratio

Capital gearing ratio = Fixed cost bearing capital
Variable cost bearing capital
Significance:
a) Helps in making analysis of capital structure of firm.
b) Important to prospective (future) investors & the company also.
High Gearing: Variable cost< Fixed cost bearing capital.
Low Gearing: Variable cost > fixed cost bearing capital.

Interest Coverage Ratio or Debt Service Ratio

It is also called fixed charges coverage ratio. It measures the capacity of business to
earn sufficient profit to pay periodically the interest charges. It measures the debt
servicing capacity.

Interest coverage ratio = Net Income before int. & tax

Fixed Int. charges
Significance:
a) Indicate how many times the profit covers fixed interest.
b) High Ratio: Indicates margin of safety for long term lenders. Assurance of regular
interest payment.
c) Low Ratio: It is a danger signal that the firm is using excessive debt & does not have
the ability to offer assured payment of interest to creditors.

ACTIVITY OR TURNOVER RATIOS

Stock Turnover Ratio

It shows the speed with which the stock is rotated into sales or the no. of times the
stock is turned into sales during a year.
Stock turnover ratio = Cost of goods sold
Av. Stock

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 Significance:
a) It reflects the efficiency of inventory management.
b) High Ratio: More sales being produced by a rupee of investment in stock. Low
inventory level, frequent stock outs & incur high stock–out costs.
c) Low Ratio: Blocking of funds in inventory. High inventory level, slow movement of
inventory & incur high carrying costs.

Debtors or Receivable Turnover Ratio

Debtors Turnover Ratio = Net credit sales
Average Receivables
Significance:
a) Indicate the efficiency of the staff entrusted with collection of book debts.
b) High Ratio: Indicate that debts are collected more promptly.
c) Low Ratio: Longer collection period which implies delayed payments by debtors.

Creditors Turnover Ratio

It indicates the speed with which the payments for credit purchases are made to the
creditors.

Creditors Turnover ratio = Net Credit purchases

Avg. Account payable
Significance:
a) Indicates efficient payment capacity of management.
b) High Ratio: Indicates shorter payment period, which implies either the availability of
less credit or earlier payments.
c) Low Ratio: Indicates a larger payment period which implies either the availability of
more credit or delayed payments.

Total Assets Turnover Ratio

It shows the firm’s ability in generating sales from all financial resources committed to
total assets.

Total assets turnover ratio = Net Sales or Cost of Goods Sold

Total Assets
Significance:
a) High Ratio: shows managerial efficiency & speedy utilization of investment in assets.
b) Low Ratio: Implies over investment in assets & under utilization of financial
resources committed to total assets.

Fixed Assets Turnover Ratio

It indicates the extent to which investment in fixed assets contributes in generation of sales.

Fixed assets turnover ratio = Net sales or cost of goods sold

Net fixed Assets
Significance:
a) High Ratio: Indicates efficient utilization of fixed assets in generating sales.
b) Low Ratio: Indicates inefficient management & utilization of fixed assets.

Current Assets Turnover Ratio

Current assets turnover ratio = Net Sales or Cost of goods sold
Total current Assets
Significance:
a) Important for non-manufacturing concerns using lesser amount of fixed assets.
b) Measures the utilization & effectiveness of the use of current assets.
c) Highlights over investment & under investment in current assets which may
indirectly affect the solvency position of the concern.

Working Capital Turnover Ratio

Working Capital Turnover Ratio = Net sales or cost of goods sold
Working Capital

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85 Shree Gopal Nagar, Gopal Pura bypass, 5177216, 3241216
 Significance:
a) It reveals how efficiently working capital has been utilized in making sales.
b) High Ratio: Shows efficient use of working capital & also indicate over trading i.e.
doing business with too little working capital.
c) Low Ratio: Indicates under utilization of working capital.

Capital Turnover Ratio

It is calculated to determine the efficiency with which the capital employed is utilized.

Capital turnover ratio = Net Sales or cost of goods sold

Capital Employed (Net)
Significance:
a) Measures the effectiveness with which a concern is using capital at its disposal.
b) It indicates how many times the capital is turned over into sales.
c) High Ratio: Indicates quicker rotation of capital to generate higher sales which leads
to higher profitability.
d) Low Ratio: Indicates that either the capital is lying idle or the capital is not being
used efficiently to generate enough sales.

Net Worth Turnover Ratio

It measures how efficiently the net worth or shareholders funds is utilized.

Net Worth Turnover = Net Sales or Cost of goods sold

Net Worth
Significance:
a) It indicates number of times the net worth is converted into sales.
b) High Ratio: Reflects the efficiency in the management of shareholders fund or net
worth.

PROFITABILITY RATIOS
A) IN RELATION TO SALES:

Gross Profit Ratio

G.P ratio = Gross Profit x 100
Net Sales
Significance:
a) It reveals profit making capacity of the business with reference to its sales.
b) This ratio should be adequate to cover non operating & operating expenses.
c) High Ratio: Sign of good management.

Operating Ratio
Operating ratio = Total operating cost x 100
Net Sales
Significance:
a) It is a yardstick of operational efficiency.
b) High Ratio: It is unfavorable since it will leave a small amount of operating income to
meet interest, dividend etc.
c) Low Ratio: Indicates operational efficiency.

Operating Profit Ratio

Operating Profit Ratio = Operating Profit x 100
Net sales
Significance:
a) Measures operational efficiency & implies profitability from operations & provide
information for cost control.
b) High ratio: Better profitability.
c) Low ratio: Shows managerial inefficiency & excessive operating expenses.

These notes are prepared by MS. SHUCHI SINGHAL 11

85 Shree Gopal Nagar, Gopal Pura bypass, 5177216, 3241216
Expenses Ratio
It represents a summation of changes in net sales and in the expense items. These
ratios are useful in comparing two similar businesses or operating data from year to
year of the same business.
Expense ratio = Particular Exp. x 100
Net Sales
Significance:
a) Indicates whether these expenses in relation to sales are increasing, decreasing or
stationary which in turn reflect the profit earning capacity of the concern.
b) Low ratio: Lower the ratio, greater is profitability.

Net Profit Ratio

Net Profit Ratio = Net profit after or before tax x 100
Net Sales
Significance:
a) Indicates the efficiency of management in administrating, manufacturing & selling
products.
b) It is an overall measure of a company’s ability to turn each rupee of sales into net
profit.
c) High ratio: Shows advantageous position in the phase of falling sale price, rising
cost or declining demand for product.
d) Low ratio: Vice-versa.

B) IN RELATION TO INVESTMENT

Return on Capital Employed

It is a good measure of profitability = Net Profit before Tax & Int. x 100
Capital Employed
Significance:
a) Indicates how the management has used the funds supplied by creditors & owners.
b) Used in comparison of even dissimilar business.
c) High ratio: More efficient use of capital employed.
d) Decision of management concerning further investment depends on this ratio.
e) Useful for prospective investors.

Return On Shareholder’s Funds or Equity

It is also called return on proprietor’s fund or return on net worth.
Return on Shareholder’s Funds = Net profit after tax x 100
Shareholder’s Fund
Significance:
a) Indicates how well the company has used the resources of owners.
b) Important for present & prospective shareholders.

Return On Equity Shareholder’s Funds:

Return on Equity Shareholder’s Funds =

Net Profit after Tax – Pref. Share dividend x 100

Equity shareholder’s fund
Significance:
a) This ratio helps the Eq. Shareholders in having an idea of the rate of return on their
investment.
b) High ratio: Better from Eq. Shareholder’s point of view.

Return on Equity Share Capital

Return on Equity Share Capital =
Net Profit after Tax – Pref. Share Dividend x 100
Eq. Share Capital (Paid up)
Significance:
a) Helps to know the capacity of the company to declare dividends.
b) It serves as better measures of profitability for inter firm comparisons.

These notes are prepared by MS. SHUCHI SINGHAL 12

85 Shree Gopal Nagar, Gopal Pura bypass, 5177216, 3241216
Return on Total Assets
Return on Total Assets = Net Profit after Tax + Interest x 100
Total Assets
Significance:
a) It shows how far the management has exploited the funds furnished by the owners
as well as creditors, to produce sales & profits.
b) This ratio can be very well used for inter firm comparisons.

C) RATIOS SHOWING PROFITABILITY ON SHARES

Earning Per Share

Earning per share = Net Profit after Tax – Pref. Share Dividend x 100
No. of Eq. Shares
Significance:
a) It helps in determining the market price of equity shares.
b) It reflects upon the capacity of the company to pay dividend to its equity
shareholders.
Demerits:
a) Does not reflect how much is paid & how much is retained in the business.

Dividend Per Share

Dividend Per Share = Dividend paid to Eq. Shareholders
No. of Eq. Shares
Significance:
a) DPS is better than EPS because it shows what exactly is received by the owners.

Dividend Payout Ratio

Dividend Payout Ratio = Dividend Per Share x 100 or DPS x 100
Earning Per Share EPS
Significance:
a) It measures to what extent the company believes in distributing its earning to
shareholders.
b) Low ratio: Investor interested in capital appreciation should invest in shares of
company having low payout ratio. Retention Ratio = 100 – Payout Ratio.

Dividend Yield Ratio

Dividend Yield Ratio = Dividend per share (DPS) x 100
Market Price per Eq. share (MPS)
Significance:
a) The rate of dividend is compared to the market price of a share so as to know the
effective rate of return on investment.
b) High ratio: Preferred by prospective investors.
Price Earning Ratio
Price Earning Ratio = Market Price per Eq. share (MPS)
Earning per Eq. Share (EPS)
Significance:
a) Helps in estimation of future market price.
b) Helps in evaluation of company’s performance.
c) High ratio: Indicates investor’s confidence in the stability & growth of company’s
income.

Ratio of Revenue Reserves to Eq. Share Capital

= Revenue Reserves x 100
Paid up Eq. Share Capital
Significance:
a) It highlights upon the dividend policy of company.
b) High ratio: Shows conservative dividend policy.
c) Low ratio: Preferred by investors interested in current income instead of capital
appreciation.

These notes are prepared by MS. SHUCHI SINGHAL 13

85 Shree Gopal Nagar, Gopal Pura bypass, 5177216, 3241216
NOTES:
Coverage Ratio
They are included in leverage ratio. They help in assessing the risk arising from the use
of debt capital. They also show the relationship b/w debt servicing commitments & the
sources for meeting these burdens.

External Equity
They includes all the long-term & short-term debt such as debenture, Bank loan etc.

Internal Equity
(Or net worth Or Proprietor’s funds.) It refers to shareholders funds.

Fixed Cost Bearing: Variable Cost Bearing:

Pre. Share capital Eq. Share Capital
Debenture Reserves & surplus.
Bonds
Bank Loan.

Stock Velocity
It indicates the period for which sales can be generated with the help of an average
stock maintained & is usually expressed in days or months.
Stock Velocity = Av. Stock x 365 or 12 months
Cost of goods Sold.

Average Collection Period or Debtor’s Velocity

= 365 or 12 months
Debtors Turnover Ratio
This period shows an average period for which the credit sales remain outstanding &
measures the quality of debtors.
Short Period: Better quality of debtors, prompt payments.
Long Period: Blockage of funds, chances of bad debts, shows inefficiency & negligence
on part of management.

Average Payment Period or Creditor’s Velocity

= 365 or 12 months
Creditors Turnover Ratio
It shows average period for which the credit purchases remain outstanding.
High Ratio: Means lower payment period.

Factors Responsible For Increase in Gross Profit Ratio

a) Under valuation of op. stock & over valuation of closing stock.
b) Decreases in cost of production with corresponding decrease in sale price.
c) Higher sale prices with constant cost of goods sold.
d) Decrease in direct expenses.

Factors Responsible For Decline in Gross Profit Ratio

a) Inefficient utilization of plant & machinery.
b) Purchasing of goods at higher price.
c) Increase in direct Exp. & manufacturing Exp. without corresponding increase in sale
prices.
d) Reduction in selling price.
e) Wastages & losses etc.

These notes are prepared by MS. SHUCHI SINGHAL 14

85 Shree Gopal Nagar, Gopal Pura bypass, 5177216, 3241216
 RATIO ANALYSIS
RATIO ANALYSIS (Formulas)

LIQUIDITY RATIOS OR SHORT TERM RATIOS

1) Current ratio
Current Assets 3) Absolute Liquidity ratio
Current Liabilities Cash in hand or bank+ Marketable
Securities
2) Liquid ratio C.L - Bank O/D

= Liquid Assets
Current Liab.

= C.A – Stock & Prepaid Exp.

Current Liabilities

LEVERAGE RATIOS
1)Debt Equity ratio 4) Fixed Assets ratio
External Equities/ Total Debts Long Term funds
Internal Equities/ Shareholder’s fund Fixed Assets (Net)

2) Proprietors Ratio 5) Capital gearing ratio

Proprietor’s fund or shareholder’s fund Fixed cost bearing capital
Total Assets Variable cost bearing capital
(Reverse is also correct)
3) Solvency ratio
Total outside debts/ Total debts 6) Interest coverage ratio
Total Assets Net Income before int. & tax
Fixed Int. charges

ACTIVITY OR TURNOVER RATIOS

1) Stock turnover ratio
Cost of goods sold 5) Fixed assets turnover ratio
Average Stock Net sales or cost of goods sold
Net fixed Assets (Less dep.)

2) Debtors turnover Ratio

Net Credit Sales 6) Current assets turnover
Average Receivables Net Sales or Cost of goods sold
Total current Assets.
*Average Collection Period
365
Debtors Turnover Ratio 7) Working Capital Turnover Ratio
Net sales or cost of goods sold
3) Creditors Turnover ratio Working Capital
Net Credit purchases
Avg. Accounts payable period
8) Capital turnover ratio
*Average Payment period Net Sales or cost of goods sold
365 Capital Employed (Net)
Creditors Turnover Ratio

4) Total assets turnover ratio 9) Net Worth Turnover

Net Sales or Cost of Goods Sold Net Sales or Cost of goods sold
Total Assets Net Worth

These notes are prepared by MS. SHUCHI SINGHAL 15

85 Shree Gopal Nagar, Gopal Pura bypass, 5177216, 3241216
 PROFITABILITY RATIO

In relation to sales In relation to investment

1) G.P. ratio 1) Return On Capital Employed

Gross Profit x 100 Net Profit before Tax & Int. x 100
Net Sales Capital Employed

2) Operating ratio 2) Return on Shareholder’s Funds

Total operating cost x100 Net profit after tax x 100
Net Sales Shareholder’s Fund

3) Operating Profit Ratio 3) Return on Equity Shareholder’s Funds

Operating Profit x 100 Net Profit after Tax – Pref. Share div. x 100
Net sales Shareholder’s fund – pref. Sh. capital

4) Expense ratio 4) Return on Equity Share Capital

Particular Exp. X 100 Net Profit after Tax – Pref. Share Div. x 100
Net Sales Paid up Eq. Share Capital

5) N. P. Ratio 5) Return on Total Assets

Net profit after or before tax x 100 Net Profit after Tax + Interest x 100
Net Sales Total Assets

RATIO SHOWING PROFITABILITY ON SHARES:

1) Earning per share 4) Dividend Yield Ratio

Net Profit after Tax – Pref. Share Dividend Dividend per share (DPS) x 100
No of Eq. Shares Market Price per Eq. share (MPS)

2) Dividend Per Share 5) Price Earning Ratio:

Dividend paid to Eq. Shareholders Market Price per Eq. share (MPS)
No. of Eq. Shares Earning per Eq. Share (EPS)

3) Dividend Payout Ratio 6) Rate Of Revenue Reserves To Eq.

Dividend per share x100 or DPS x 100 Share Capital:
Earning per share Revenue Reserves x 100
Paid up Equity Share Capital

How to Calculate?

1) Current Assets: - Stock, Debtors, Prepaid Expenses, Cash in hand, Cash at Bank, bills
Receivables, Investment (Short term), Marketable Securities.
2) Current Liabilities:- Creditors, Bills payables, Bank overdraft, Outstanding expenses,
Short term loans, Income tax payable, Unclaimed dividend, Provision for tax, proposed
dividend.
3) Intangible Assets: - Goodwill, patent, copyright, Trade mark.
4) Fictitious Assets: - Preliminary Expenses, Deferred Revenue Expenses, Miscellaneous
Expenditure, Discount & loss on issue of shares and debentures and Dr. Balance of P& L a/c.
5) Liquid Assets: - Current assets – Stock & prepaid Expenses.

These notes are prepared by MS. SHUCHI SINGHAL 16

85 Shree Gopal Nagar, Gopal Pura bypass, 5177216, 3241216
6) External Equities/ Total Debt/Outsiders funds: - Debentures+ Current liabilities+
Short term & long Term Loans.
7) Internal Equities/ Share holders fund / Proprietors fund /Net worth: - Equity
Share
Capital+ Preference Share Capital + Reserve And Surplus + P & L (Cr.Balance) – Fictitious
Assets (Preliminary Expenses etc.)
8) Total Assets: - Current Assets + Fixed Assets+ Intangible Assets (If there is Realisable value)
9) Long term fund / Capital employed: - Equity Share Capital+ Preference Share
Capital + Reserve And Surplus + long term loans.
10) Fixed Cost bearing capital: - Preference share capital and Debentures.
11) Variable cost bearing capital: - Equity capital + Reserve & surplus + P&L a/c.
12) Cost of Good sold: = Opening stock + purchases + Direct Expenses – Closing Stock
= Sales – G.P.
13) Average Stock: - Opening stock + Closing Stock / 2
14) Stock velocity: - No. of days or month in a year/ Stock turnover Ratio.
15) Average receivables: - Average of Debtors & B/R (Op. + Closing /2)
16) Average Payables- Average of Creditors & B.P.
17) Working Capital: - Current Assets- Current Liabilities.
18) Capital Employed: = Total Assets – Current Liabilities
(Total assets: Include Unquoted investments, Patents, Trademarks
Exclude Quoted investments, Preliminary expenses, Discount on
Issue of shares & debentures)
= Current Assets + Fixed Assets (after Dep.) – Current Liabilities
= Fixed Assets + Working Capital
= Share Capital (Eq.+ Pref.) + Deb. + Res. & Surplus + P&L
A/C(Cr.)
+ Loans + Capital Reserve + General Reserve - Quoted
investments,
Preliminary expenses, Discount on issue of shares & debentures
19) Gross profit: - Net sales – Cost of good sold.
20) Operating Cost: - Cost of good sold + operating Expenses.
Operating Expenses = Office & Administration expenses (salary, rent, dep., director’s
fees, electricity, insurance etc.) + Selling & Distribution expenses

Not included in Operating Expenses

Financial expenses like interest, discount, provision for bad debts, provision for taxation &
abnormal expenses like preliminary expenses, donations, shares & debentures issue
expenses

Note: Operating Ratio between 75% & 85% is standard for manufacturing firms.

21) Operating Profit: - Gross profit – Operating expenses.

22) Net Profit Ratio = Net Profit (after or before) Tax x 100
Net Sales

N.P. = Operating Profit + Non-Operating Income (Interest or Dividend on investment) –

Non–Operating Expenses (e.g. Loss on sale of fixed assets, Provision for legal
damages)
N.P.Before Tax is used to measure managerial efficiency
N.P.After Tax is used for owner’s purpose or for comparing two firms.

23) Return on Capital Employed

ROI = Total Assets Turnover Ratio x N.P. Ratio

= Sales x N.P. x 100
Total Assets Sales

These notes are prepared by MS. SHUCHI SINGHAL 17

85 Shree Gopal Nagar, Gopal Pura bypass, 5177216, 3241216
 RATIO ANALYSIS (QUESTIONS)

Q.1. Find current ratio of the firm from the following balance sheet: -
Balance Sheet of Mohan & Company
As on 31st March, 2007
Liabilities Amount Assets Amount
Share Capital 1,00,000 Fixed Assets 1,00,000
Reserves 50,000 Stock 50,000
Profit & Loss a/c 50,000 Debtors 80,000
Bank overdraft 30,000 Bills Receivable 20,000
Bills Payable 25,000 Cash 30,000
Creditors 45,000 Bank 20,000
3,00,000 3,00,000

Q.2. From the following data, calculate current ratio: -

Working capital = Rs. 2, 00,000
Total debt = Rs. 4, 50,000
Long-term Debt = Rs. 2, 50,000

Q.3. Calculate current assets from the following:

Stock turnover = 5 times
Sales (all credit) = Rs.4, 00,000
Rate of Gross Profit = 25% on cost
Current liabilities = 1,20,000
Acid test ratio (quick ratio) = Rs. 0.75
Closing stock is Rs.10,000 more than the stock at the beginning.

Q.4. The current liabilities of Shyam Ltd. are Rs.1,50,000. Its Current Ratio is 3:1 and
liquidity ratio is 1:1.Calculate the value of current assets & Liquid assets & stock.

Q.5. Following is the balance sheet of N Ltd. as on 31st March 2007.

Liabilities Amount Assets Amount

Equity Share Capital 2,00,000 Plant & machinery 2,50,000
Profit & Loss A/c 20,000 Stock 40,000
Debentures 80,000 Sundry Debtors 30,000
Sundry Creditors 50,000 Cash in hand 25,000
Provision for Taxation 10,000 Cash at Bank 10,000
Prepaid Expenses 5,000
3,60,000 3,60,000

Calculate the following ratios:

1. Current Ratio
2. Quick Ratio
3. What conclusions do you draw about the company on the basis of these ratios?

Q.6. Rs.1,00,000 is net sales of a concern during 2001. If inventory turnover is 4 times,
calculate the inventory at the end of the year. Inventory at the end is 1.5 times of that in
the beginning.

Q.7. From the following statement, calculate:

1. Current Ratio
2. Quick Ratio
3. Debt Equity Ratio
4. Proprietary ratio
5. Solvency Ratio.

These notes are prepared by MS. SHUCHI SINGHAL 18

85 Shree Gopal Nagar, Gopal Pura bypass, 5177216, 3241216
 Condensed Balance Sheet
As on 31st March, 2007
Liabilities Amount Assets Amount
Share Capital 1,00,000 Fixed Assets(Net) 2,70,000
Reserves & Surplus 50,000 Cash at Bank 20,000
Debentures 2,00,000 Stock 80,000
Creditors 30,000 Debtors 30,000
Bills Payable 20,000
4,00,000 4,00,000

Q.8. Calculate debtors turnover ratio and average collection period from the information
given
below:-
Total Gross sales 5,00,000
Cash sales (included in the above) 1,80,000
Sales return 28,000
Debtors as on 31-3-2006 36,000
Debtors as on 31-3-2007 24,000
Bills receivable as on 31-3-2006 10,000
Bills receivable as on 31-3-2007 20,000
Provision for doubtful debts as on 31-3-2007 1,200

Q.9. From the information given below, calculate the following below:
1. Total Assets turnover ratio
2. Fixed assets turnover ratio
3. Current assets turnover ratio
4. Working capital turnover ratio
5. Net worth turnover ratio
Balance sheet
As on 31st March, 2007
Liabilities Amount Assets Rs.
Share capital 50,000 Land & Building 70,000
Reserves & Surplus 25,000 Plant & Machinery 40,000
Profit & loss a/c 15,000 Furniture 15,000
Debentures 40,000 Long-term Investment 10,000
Term Loan 25,000 Stock 15,000
Sundry creditors 10,000 Debtors 10,000
Bills payable 5,000 Bills receivable 4,000
Tax payable 4,000 Cash at bank 12,000
Proposed dividend 4,000 Cash in hand 4,000
Interest payable 2,000
1,80,000 1,80,000

Net sales during the year was Rs. 6,00,000

Q.10. The following information is given for a company whose accounting year ends on 31st
March
2007.
Equity share capital 2,00,000
8% preference share capital 1,00,000
Reserves & surplus 1,00,000
10% debentures 1,25,000
Current liabilities 1,75,000
Fixed Assets 4,00,000
Current Assets 3,00,000
Net Profit after tax 78,000
Income Tax 78,000
Calculate return on capital employed.

These notes are prepared by MS. SHUCHI SINGHAL 19

85 Shree Gopal Nagar, Gopal Pura bypass, 5177216, 3241216
Q.11. Following is the balance sheet of Shriram Mills Limited as on 31st Marc h 2007.

Liabilities Amount Assets Amount

Equity share Capital 8,00,000 Fixed Assets 20,00,000
12%Preference Share capital 2,00,000 Less: Dep. 4,00,000 16,00,000
Reserve fund 5,00,000 Investment (short term) 2,00,000
14% debentures 7,00,000 Stock 4,00,000
Sundry Creditors 60,000 Book Debts 2,00,000
Bills Payable 1,00,000 Bank 1,00,000
Tax Provision 1,30,000
Outstanding Expenses 10,000
25,00,000 25,00,000

Other information is as follows:

1) Net Sales Rs.32,00,000
2) Cost of goods sold Rs.25,60,000
3) Net income after taxes Rs.1,60,000

Calculate: a) Liquidity Ratio b) Proprietary Ratio c) Current Ratio d) G.P. Ratio

e) N.P. Ratio

Q.12. From the following information prepare the balance sheet of AR & Co.

Sales to net worth 5 times

Current liabilitities to net worth 50%
Total Debt to net worth 60%
Fixed Asset to net Worth 60%
Current Ratio 2:1
Sales to stock 10 times
Debtor’s Turnover Ratio 9 times
Sales Rs. 15,00,000
40% of sales were made on cash.

Analysis:

Q.13. Following are the ratio’s abstracted from the annual report of ABC Ltd., being a
finance manager you have been asked to analyze the company performance.

(1) Current Ratio = 2.9 : 1

(2) Liquid Ratio = 0.65 : 1
(3) Proprietary Ratio = 0.75 : 1
(4) Fixed Assets proprietorship Ratio = 1.06 : 1
(5) Debt Equity Ratio = 0.34 : 1
(6) Capital Gearing Ratio = 1:1
(7) Gross Profit Ratio = 20%
(8) Net Profit Ratio = 5%
(9) Stock-Turnover Ratio = 3.6 Times
(10) Debtors’ Turnover Ratio = 96 Days
(11) Return on Proprietors’ Fund = 0.05 : 1
(12) Turnover to Fixed Assets Ratio = 0.92 : 1

Solution:
Comments:
1. Liquidity and Solvency Position: Current ratio is 2.9. It means current assets of Rs.
2.90 are available against each rupee of current liability. The position is satisfactory on the
basis of current ratio. However, the liquid ratio is 0.65 : 1. It means greater part of current
assets constitute stock; the stock is slow-moving. Therefore, the liquidity position is not
satisfactory.

These notes are prepared by MS. SHUCHI SINGHAL 20

85 Shree Gopal Nagar, Gopal Pura bypass, 5177216, 3241216
2. Credit Terms: The collection system is faulty because debtors enjoy a credit facility for
96 days, which is beyond normal period. The performance of debt collection department is
poor.
3. Profitability: Gross profit ratio is 20% which is a healthy sign. But net profit ratio is only
5%. It means operating expenses are higher.

4. Investment Structure: Debt equity ratio is 0.34 : 1. It means the firm is not dependent
on outside liabilities. The position is satisfactory. Capital gearing ratio is also satisfactory.
However, the fixed assets to proprietorship ratio reveals that the entire fixed assets were not
purchased by the proprietors’ equity. It means the firm depends on outside liabilities. It is
not desired.

5. Return on Proprietors’ Fund: 5% of the sales is net profit and are available for the
proprietors. The state of low return is not desirable.

6. Stock Turnover Ratio and Turnover to fixed assets indicate an unhealthy sign. Fixed assets
are not used properly. It is great sign of understanding. The economic condition of the firm is
not sound. The firm can increase the rate of return on investment by increasing productivity.

ASSIGNMENT

Q.A. Following is the balance sheet of Rakesh limited as on 31st March 2007

Liabilities Amount Assets Amount

Share Capital: Fixed Assets:
4,000 Equity shares of Buildings 1,70,000
Rs. 100/- each 4,00,000 Furniture 1,14,000
Reserves and Surplus: Machinery 1,10,000
General Reserve 20,000 Investments 20,000
Capital Reserve 8,000 Current Assets:
Current Liabilities: Stock 10,000
Creditors 6,000 Debtors 7,000
Bills payable 4,000 Bill Receivable 5,000
Outstanding Expenses 2,000 Cash & Bank Balance 2,000
Marketable Securities 2,000
4,40,000 4,40,000

Calculate the following ratios: -

1. Current Ratio
2. Quick Ratio
3. Absolute Liquidity Ratio.

Q.B. Sanchit limited has a current ratio of 4.5:1 and a quick ratio of 3:1. If its inventory is
Rs.72,000. Find out its total current assets & current liabilities.

Q.C. From the following information calculate

(i) Debt equity Ratio (ii) Interest Coverage ratio
(iii)Return on Investments (iv) Capital turnover Ratio
Share Capital 1,60,000
General reserve 60,000
Profit & Loss A/c 1,00,000
Loan @ 15% interest 2,00,000
Sales for the year 5,60,000
Tax Paid 40,000
Profit after Interest & Tax 80,000

Q.D. X Co. Ltd. has made plans for the next year. It is estimated that the company will
employ total assets of Rs.8,00,000; 50 % of the assets being financed by borrowed capital
at an interest cost of 8 % per year. The direct cost for the year is estimated at Rs.4,80,000

These notes are prepared by MS. SHUCHI SINGHAL 21

85 Shree Gopal Nagar, Gopal Pura bypass, 5177216, 3241216
& all other operating expenses are estimated at Rs.80,000. The goods will be sold to
customers at 150 % of the direct costs. Tax rate is assumed to be 50%.

You are required to calculate:

(i) Net profit margin,
(ii) return on assets
(iii) asset turnover
(iv) Return on owner’s equity.

Q.E. From the following information, prepare a balance sheet of Ashutosh Ltd.:

(i) Current Ratio 2.5

(ii) Liquid Ratio 1.5
(iii) Proprietary Ratio 0.75
(Fixed Assets / Proprietary Funds)
(iv) Working capital Rs.60,000
(v) Reserves & surplus Rs.40,000
(vi) Bank Overdraft Rs.10,000

These notes are prepared by MS. SHUCHI SINGHAL 22

85 Shree Gopal Nagar, Gopal Pura bypass, 5177216, 3241216