PART 2 LESSON 2 FINANCIAL RATIOS

LESSON 2 FINANCIAL RATIOS

Ratio analysis is a tool used in financial statements. It is used to identify the means of process in computing and determining relationship between the various items in the financial statements. Ratio analysis interprets and asses the performance of assets in the business. It is a quantitative investment technique used to compare company on a relative basis with the market share. It is used as a yard stick to evaluate the financial condition and performance of an organization. Relationship between two items over the other is expressed in mathematical term called as ratios. Ratio is not only expressed to show the relationship between two numbers it also shows the strengths or weakness of the concern. It measures the past and future trends of the organization.

Objectives of Ratio Analysis

1. 2. 3. It helps the management in taking a valuable decision It helps to gauge profitability and efficiency of an enterprise. Ascertain the rate and direction of future potentiality.

Ratios of a concern have been divided into four categories such as 1. 2. 3. 4. Liquidity ratio Turnover ratio Profitability ratio Leverage ratio

Types of Ratio I Liquidity ratio

It measures the ability to meet its short-term obligations of the organization. Easy conversion of assets into cash is called liquidity. When a firm is in a sound liquidity

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PART 2 LESSON 2 FINANCIAL RATIOS position, it will be useful to the management to have a strong and sound financial position. Liquidity of the concern mainly depends on the firms current assets. If a firm is not in a liquid position, it will be easily insolvent. Liquidity ratios may be 1. 2. 3. 4. Current ratio. Acid test ratio. Cash to current assets ratio. Cash to working capital ratio.

1.

Current ratio
It is the most widely used ratio in the business concern. Current ratio is calculated as

Current ratio =

Current assets Current liabilities

It is measured to meet the companys short term obligations. Current assets They are the assets of the organization that are expected to convert into cash easily as and when needed. Current assets do include cash, inventory, accounts receivable, cash in hand, cash at bank, debtors and prepaid expenses. Current liabilities They are the amount due by the organization in a short span of period. They do include. 1. 2. 3. 4. 5. 6. Accounts payable Accrued expenses Sundry creditors Short term debts Dividends Outstanding expenses

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PART 2 LESSON 2 FINANCIAL RATIOS The ideal ratio for current assets and liabilities is 2:1. If the ratio is more than 2 then there is no difficulty in the business operations to make payments in order to meet its current liabilities. If the current ratio is less than 2 then the firm faces difficulty in conducting the business. Therefore high current ratio is essential for a business organization in order to meet its short term funds and also to run a successful business.

2.

Quick or acid test ratio

It is more or less same as the current ratio. It excludes inventory as they are

very slow to get converted into cash and also more uncertain to conversion price.

Quick or acid test ratio =

Current assets Inventory Current liabilities

As the name indicates, it refers to the current assets that can be easily converted in to cash within a short period. Current assets can be easily converted into cash and also it is much useful for the creditors who lend money to the organization. More the current assets of the organization easy for them to get loan form the creditors. In case of any bankruptcy money can be easily got by converting these current assets into cash. The ideal ratio for the acid test is 1:1. Organization is wise if they keep the current equal to the liabilities of the concern. Low acid test ratio brings in more problem to the concern as there are chances of insolvency if they are not able to meet the short term obligations. It is much useful for a solvent firm.

3.

Cash to current assets ratio

It has a direct proportion of the cash maintained to that of the current assets.

It maintains the level of cash in a concern. Lower ratio indicates greater profitability to a concern. If the ratio is high it reveals a stock control over cash available. Cash given in respect of the current assets can be had from the past experience.

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PART 2 LESSON 2 FINANCIAL RATIOS Cash to current assets ratio = (Cash / Current Assets) * 100

4.

Cash to Working Capital Ratio

Working Capital is the difference between current assets and current liabilities.

Cash inflow and outflow is a major concern over the business operations. If the working capital is high then it indicates that the company is in sound financial position and able to pay its short term obligations at times when needed. Cash to Working Capital = Cash Working Capital Cash is an essential concern for the business. Cash is necessary to meet the day to day expenses of the organization. Proportion of the cash is apportioned to the total working capital to calculate the necessary cash balances available to the concern. If the cash is low then it will not be useful for the concern to meet its current needs. Higher cash to working capital ratio leads to shrinkage of profits.

II Turnover ratio
They are also called as activity ratio and useful for efficiency in the management. Greater the turnover higher is the efficiency of the management. It defines the relationship between the sales and the assets of a firm. Turnover ratios are. 1. 2. 3. 4. 5. Current assets turnover ratio. Fixed assets turnover ratio. Debtors turnover ratio. Creditors turnover ratio. Inventory ratio.

1.

Current assets turnover ratio

They rely on the utilization of current assets to ascertain a reasonable turnover.

If the ratio is high it indicator that the current assets are circulated more and of higher liquidity lower current ratio indicates stagnation of current assets.

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PART 2 LESSON 2 FINANCIAL RATIOS Current assets turnover ratio = Sales Current Assets

2.

Fixed asset turnover ratio

It measures the efficiency of the organization with effect of utilization of funds

by the management in fixed assets such as land, building and machinery. If the fixed assets turnover ratio is high, it indicates higher utilization of funds by the management there by creating greater efficiency. Lower ratio indicates inefficiency of management thereby leading to idle utilization of funds.

Fixed assets turnover ratio =

Sales Net fixed assets

3.

Debtors turnover ratio

It measures the time needed to convert the debtors into cash. It is the test for the

liquidity of the firm. Debtors turnover ratio is measured by Net credit sales Average debtors The debtors turnover ratio uses the sales available only on credit. Credit sales are the sales of the firm minus the return of sale available if any. Debtors are the total numbers of debtor available to the concern within a year. Debtors turnover ratio helps to measures the financial strength of the concern, which is must useful for the investors. It shows the average amount of payment available to the debtors. While calculating the debtors turnover ratio it will be much useful for the organization to easily point out the customers who are facing any financial issues.

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PART 2 LESSON 2 FINANCIAL RATIOS

Average collection period

The average collection period with respect to the Debtors Turn over ratio is calculated as Average collection period = Days in a year Debtors turnover ratio The days in a year are the 365 days available for the organization. It indicates the number of days available to collect the receivables from the debtors. It helps to evaluate the companys credit and collection receivables. Higher the debtors turnover ratio and lower the collection period indicates effective credit management. Lower the debtors turnover ratio and higher the average collection period indicates ineffective cash credit management and delay in repayment of debtors. Therefore for an organization shorter the collection period is better for an effective management in respect of average debtors receivables.

4.

Creditors Turnover Ratio

Creditors Turnover Ratio are related with the average purchase made to the

creditors Creditors turnover ratio = Net credit purchases Average accounts payable Accounts payable is trade creditors and bills payable. This ratio is done to calculate the credit terms offered by the suppliers of the organization. Higher creditors turnover ratio indicates that payments are not made to the creditors where a lower creditors turnover ratio indicates the creditors are not taking full advantage over the credit period. Creditors turnover ratios do also calculate the average collection period required for the payment of the purchase to the creditors.

Average collection period

It is measured to calculate the average payment period for the credit purchase to the creditors. It is calculated as

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PART 2 LESSON 2 FINANCIAL RATIOS

Average collection period =

Days in a year Creditors turnover ratio

If the creditor turnover ratio is high and the average collection period for the purchase is low it indicates that the creditors are being paid promptly and there is no delayed payment in paying their credit purchases. Lower the creditor turnover ratio and higher the average collection period indicates that the creditors payment is not paid in time. An organization should calculate both debtors and creditors turnover ratio to know about the prompt payment both for credit purchase and credit sales.

5.

Inventory turnover ratio

It measures how fast the inventory can be easily convertible into cash. Because

chances are more for inventory, to convert to receivables. Inventory establishes the relationship between the cost of goods sold and inventory.

Inventory turnover ratio =

Cost of goods sold Average inventory

The average inventory is calculated by Opening inventory + closing inventory 2 If the inventory turnover ratio is high it indicates a greater operating efficiency and impels a higher inventory management. The inventory ratio being high indicates that the firm incurs high stock out costs. If the inventory ratio is low it is really dangerous. Lower inventory ratio is the result of lower inferior quality and obsolete goods.

III.

Profitability ratio
It indicates the efficiency and the effectiveness of an investment for

organization profitability is the most important concern. It is a measure for the liquidity

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PART 2 LESSON 2 FINANCIAL RATIOS and solvency for a firm. Profitability indicates the growth and the rate of return on the investment made. Profitability ratios are: 1. Gross profit ratio. 2. Net profit ratio. 3. Operating profit ratio. 4. Operating ratio. 5. Return on owners equity. 6. Earnings per share. 7. Return on capital employed. 8. Return on assets.

1.

Gross Profit Ratio

It is the relationship between the gross profit and sales. Gross profit is arrived

after considering the sales and cost of goods sold. Net sales are the sales minus the return of goods. Gross Profit is calculated after deducting sales from the cost of goods sold. Gross profit is the profit earned before considering office and other administrative expenses. Gross profit ratio = (Gross Profit / Sales) * 100 If the gross profit ratio is high, it indicates much sales and an efficient cash management. Lower gross profit ratio indicates that the organization is not able to have more sales leading to an inefficient management

2.

Net Profit Ratio

Net profit is assigned considering all the incomes and expenses. Gross profit,

which considers the cost of goods sold and sales, is also considered in Net Profit. Net profit considers office, administrative, selling and factory expenses and also the commission and dividend received. Net profit Ratio = (Net Profit / Sales) * 100

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PART 2 LESSON 2 FINANCIAL RATIOS Net profit ratio indicates the overall profitability of a business concern. If the Net Profit ratio is high it indicates that the firm is in a better high position. It is much useful for the proprietors to know about the level of profitability

3.

Operating Profit Ratio

Operating Profit Ratio = (Net Operating Profit / Sales) * 100 It measures the efficiency of the management with which the organization is managed. Operating profit mainly measures the operating efficiency of the management considering the gross profit ratio. Operating profit is calculated excluding the sale of the fixed assets and other non operating expenses.

4.

Operating Ratio
Operating expenses are the expenses included in operating a product a service.

The operating ratio establishes the relationship between operating expenses and sales. Operating ratio is calculated as (Cost of Goods Sold + Operating Expenses) / Sales * 100 If the operating ratio is high it indicates that the operating expenses are high there by the profit margin is low therefore lower operating ratio is much essential for a business.

5.

Return on Owners Equity

The owners equity or shareholders fund is the amount invested by the share

holders in the organization. Shareholders have to be repaid from the investments made in by them. Return on investments in respect of profits is known to the shareholders. Profitability of the organization is judged using the return on shareholders equity. Return on shareholders equity is calculated as: Net Profit after interest and tax / Shareholders or Owners Equity * 100 All shareholders who invested in the concern will be much keen on knowing the return on their investment made. This ratio helps to calculate it.

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PART 2 LESSON 2 FINANCIAL RATIOS This ratio helps to measure whether the firm has made a reasonable profit in order to repay their return on investment. If the shareholders equity ratio is high it indicates that the company is efficient in management and having more profit for the better utilization of the shareholders funds and the organization productivity. Even the shareholders are much satisfied because they are assured of a favorable dividend. Lower shareholders equity ratio indicates poor profitability, productivity, and inefficiency in management.

6.

Earnings per share

It is the profit earned form the shareholders point of view. It is the profit earned

by the shareholders in each and every share held by the shareholders after deducting tax and preference dividend from the net profit. Earnings per share = Net profit after tax Preference dividend Number of equity share. It indicates the wealth of each and every shareholder on the basis of the shares held by them. Earnings per share have a direct indication over the performance and prospects of the firm. If the earnings per share is high it indicates higher profit to the concern thereby enabling the firm to issue more bonus shares to the shareholders. It also affects the market price of the firm.

7.

Return on capital employed

It is the maximum return expected on the capital invested. It is also known as

the return on investments. The firms total profitability is indicated through this ratio. Return on capital employed = (Operating Profit / Capital Employed) * 100 Capital employed is calculated as (Share capital + Reserves + Long-term loans) - (Nonbusiness and Fictitious assets). Operating profit is the profit before calculating interest and tax. If the return on capital employed ratio is high it indicates that the funds are properly invested and thereby the overall operating efficiency of the concern improves.

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8.

Return on Assets

Return on Assets is calculated = (Net Earnings/Total Assets) * 100 It is one of the most widely used ratios in the business concern. Since this ratio determines how the assets are widely used in an organization it is used to analyze the profitability of the concern. The earning power of the assets is also calculated using this ratio thereby measuring the overall efficiency of the firm. The overall financial position of the concern is incomplete without assessing the profitability of the concern. If the profitability of the concern is measured then the overall efficiency of the concern is also determined.

III Leverage Ratios

Company/organization strength is determined mainly on the financial strength and soundness of the organization. They are invested to determine the financial strength of the organization. They are. 1. 2. 3. 4. 5. 6. Debt equity ratio. Debt to net worth Capital gearing ratio. Proprietary ratio. Interest coverage ratio. Financial leverage.

1.Debt equity ratio

Debt is a loan by the organization to third parties. Equity is the amount that the organization own through its shareholders. The amount the company owes and owns is compared to estimate this ratio. It measures the financial concern of the organization. This ratio is quite satisfactory if the shareholders funds are equal to the borrowed funds by the concern.

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PART 2 LESSON 2 FINANCIAL RATIOS Debt Equity ratio is calculated as Debt Equity Equity includes share capital and reserves where as the debt include both short and long term funds. Shareholders usually prefer a higher debt equity ratio because it would give them a higher return of investment on each and every share held by them. Lower debt equity ratio is preferred by the creditors as they are much worried about the security of their investments. Companies with high debt equity ratio are riskier to invest due to the fluctuation in the interest rates. If it is high they have to pay more interest for the debt to be paid. Lower the debt equity ratio indicates a layer claim for the equity of funds.

2.Debt to Net Worth

It is calculated as (Debt / Total Funds) * 100 It calculates the percentage of the total funds. Higher ratio is safe for the concern.

3.Capital Gearing Ratio

It measures the relationship between the interest bearing securities and the shareholders fund. It is calculated as Capital Gearing Ratio = Fixed Interest Bearing Securities Shareholders Funds Interest bearing securities are securities, which have a fixed rate of dividend and include debentures and preference dividend. The ratio is interpreted as follows. Capital gearing ratio more than one indicates that the firm is in a very good position and having a strong share capital. If it is less than one, it indicates that the firm is in a low gearing with respect to securities and funds. If it is equal to one, it indicates that the ratio is

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PART 2 LESSON 2 FINANCIAL RATIOS even to all levels of the funds and securities. This ratio affects the firms capacity to maintain a uniform dividend policy.

4.Proprietary ratio
The proportion of the assets towards the shareholders funds is identified through this ratio. It is much useful to the creditors for whom it will be easy to find out the proportion of the shareholders wealth on each asset. It is calculated as Proprietary ratio = Net worth Total assets If the ratio is high it indicates the organization is financially sound to meet its obligations and do not depend on the outside source funds. Lower ratio indicates a smaller amount of owners funds over the capital and they entirely depend on the outside organization for want of funds.

5.Interest coverage ratio

The interest coverage ratio is determined by Interest coverage = EBIT Interest EBIT Earnings before interest and taxes. It determines the interest on the long term loan as concerned. As the interest is tax deductible it uses the operating profit. The EBIT is determined to find out the ability to service the debts which is not easily affected. If the interest coverage is more it indicates the ability to manage the liabilities and the payment of interest is made and assured by the organization. If the interest coverage ratio is too low it indicates that the firm is using too much of debt capacity to run its business and the payment of interest towards the creditors is not assured.

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6.Financial leverage ratio

It determines the financial charges that are fixed in the finance stream. They are not varied in respect of EBIT and operating profits. Irrespective of the earnings before interest and taxes, these financial charges should be met to manage the effect of financial changes on the earnings per share available to the shareholders. Financial leverage is calculated as EBIT EBT Even if the financial leverage is high or low it indicates that the firm is in a very sound position. Leverage maintains relationship between the debt and equity financing. The funds of the shareholders are invested in assets and these assets may be used as collateral to obtain debt from outside source.

Other types of ratios

Fixed assets ratio
Fixed assets are used in the operations of a business. Fixed assets do include Land and Building, Plant and machinery, Furniture etc .Investments in the fixed assets are done by shareholders and are of permanent in nature. The types of fixed assets ratios are: 1. Fixed assets to net worth. 2. Fixed assets to long-term funds.

1. Fixed assets to net worth

It establishes the relationship between the shareholders funds and the fixed assets of the concern. Fixed assets to net worth = Net fixed assets Net worth. If the fixed assets ratio is high it indicates that creditors would have a lesser protection towards them. Lesser the ratio indicates that the shareholders funds are mostly financed by them.

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2. Fixed assets to long term funds

This ratio establishes the relationship between fixed assets and long-term funds. It is calculated as. Fixed assets to long term funds = Fixed assets Long-term funds A lower ratio is preferable because it indicates the working capital is funded through long-term funds. If it is high it is a dangerous position. Liability is more in such assets therefore, it is not reliable. Fixed assets do include Investments, Land and Building, Plant and Machinery. Long-term funds do include share capital reserves and other borrowings.

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