RATIO ANALYSIS
Financial analysis is used primarily to gain insights into:
(a) Operating problems
(b) Financial problems confronting the firm
One of the major tools of financial analysis is Ratio analysis
A ratio expresses the relationship between two related
variables, which is not obvious from the raw data
Liquidity ratios examine the adequacy of funds and are based
as the relationship between current assets and current
liabilities
Current assets
Current Ratio=-----------> 1.33: 1
Current liabilities
1
RATIO ANALYSIS
Contd….
A low ratio may indicate that a firm may not be able to pay its
obligations on time. A high ratio may possibly a failure to
properly utilise the firm’s resources.
Current assets – Inventories
Acid Test ratio =
---------------------------------Current liabilities – Bank borrowings
This ratio concentrates on the immediately arising liabilities
and the highly liquid assets that will be used to meet these
obligations
A high quick ratio indicates that cash and / or receivables are
excessive, both possible signs of lax management
A low quick ratio indicates the possibility of difficulties in
prompt payment of bills in the near future.
2
RATIO ANALYSIS
Contd
Sales
Account receivables Turnover = ----------------------Accounts Receivables
A high ratio indicates a strict credit policy and aggressive
collection procedures.
A lower ratio indicates a large quantity of receivables and that
perhaps the firm is experiencing difficulties in collecting its
unpaid bills.
Accounts Receivables
Average Collection period = ---------------------------- x 365
Sales
This ratio indicates how many days it took to accumulate the
account receivables.
3
RATIO ANALYSIS
Contd
ROFITABILITY RATIOS :
Operating Profit(EBIT)
Profit margin ratio
=
-------------------------Sales
This ratio indicates the overall operational efficiency of the
firm to withstand adverse conditions, which may arise from
several sources such as, falling prices, rising costs, and
declining sales.
Goss Profit
Gross profit margin ratio = ----------------Sales
(Gross profit = Sales – cost of Sales)
It indicates the relation between production costs and selling
price.
4
RATIO ANALYSIS
Contd
Sales
Asset turn over Ratio =
-------------Total Assets
High ratio indicates, Increasing profits
Operating profit (EBIT)
Return on Investment =
---------------------------Assets
A high ratio indicates efficient use of the assets and
management’s skill
Leverage Ratios:
These are also called capital structure
ratios, indicate the long-term financial position of the firm and
the relative position of debt and equity in the financial
structure of the firm
5
RATIO ANALYSIS
Contd
Debt Equity Ratio: Two version of the ratio are:
Term Liabilities
Total outside liabilities
Debt Equity Ratio =(i) ------------------ (ii)------------------------Tangible Net worth
Tangible Net worth
Should be 3:1 upto 10 lakh & 2:1 above 10 lakh
Total outside liabilities
Debt Assets Ratio
= ---------------------------------Total Assets
A high ratio represents a great risk to creditors.
A low ratio represents security to creditors.
6
RATIO ANALYSIS
Contd
Coverage Ratios indicate the relationship between debt
servicing commitments and the sources for meeting task
burdens
Operating income (EBIT)
Interest coverage Ratio=----------------------------Debt interest
This ratio measures the margin of safety between the earning
of the firm and its interest liability. A high ratio means the
firm can easily meet its interest burden .
A low ratio may result in financial embarrassment, when
earnings decline
7
RATIO ANALYSIS
Contd
Cash flow coverage ratio:
This ratio is a wider measure of the debt servicing ability as it
considers both the interest and the principal repayment
obligations
Cash flow coverage ratio =
=
Earning before Interest & tax + Depreciation
Debt interest
+ Repayment of loan
1 - Tax rate
The ratio can be calculated including other fixed changes like
base payments and preference dividend.
8
RATIO ANALYSIS
Production costs
High/ Low
Assets
How many
Idle ?
affect
Contd……
Sales
Adequate
Interest
is it excessive
affect
explains
Selling price
Asset Turnover
Gross Profit
Margin
explains
explains
Profit
Margin
Return on
explains Investment
Return of
Equity
explains
Earning
Power
9
RATIO ANALYSIS
Contd….
Measures ability of Management to earn:
Return on Investment – a return on resources
Return on equity
- to cover operating profits to after tax returns for
shareholder
Earning power
- to achieve an after tax return on resources.
Uses and limitations of Ratio Analysis:
These ratios might help in answering the following questions:
a)
Is the firm in a position to meet its current obligations ?
b)
What sources of long-term fund do the firm and what is the
relationship between them ?
c)
Is there any danger to the solvency of the firm due to excessive-debt ?
d)
How effectively does the firm adequate ?
e)
Are the earnings of the firm adequate ?
f)
Do the investors consider the firm profitable enough, for the purpose
of investing in the share of the firm ?
10
RATIO ANALYSIS
Contd….
COMMON WINDOW DRESSING PRACTICES
Balance sheet:
i)
Date of Balance sheet coinciding with end of season
ii)
Indicating Current expenses as Capital in Balance Sheet
iii)
Capitalisation of interest on term loans – leading to equated
annual liability
iv)
Preparing Balance sheet on different dates for associate
concerns.(lead to manipulation of accounts by paper entries-leads
to non-detection of interlocking of funds / stocks)
v)
Temporary reduction in CL ( for a day or so). Setting off current
liabilities against Current Assets. Issuing cheques in payment of
current liabilities but not dispatching them( decrease in sundry
creditors)
vi)
Maximising collection of receivables on balance sheet date
thus showing a large cash balance ( including cheques yet to be
realised)
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RATIO ANALYSIS
Contd….
vii) Withdrawal of intercorporate investments on Balance
sheet date
viii) Delaying declaration of commencement of production
ix) Revaluation of fixed assts-leading to inflating the fixed assets
value and improvement in Net worth position
Profit & Loss Account:
i) Restoring to heavy billing of sales on date of Balance sheet –
leading to increase in sales, decrease in closing inventory and
increases in profit
ii) Changing the method of valuation of stocks
iii)
Changing the method of Depreciation – particularly with
retrospective effect
iv) Booking unrealised income (e.g. Export incentives) as
revenue
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