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Chapter: 1 Definition of Financial Statement Analysis:
Definition and Explanation of Financial Statement Analysis:
Financial statement analysis is defined as the process of identifying financial strengths
and weaknesses of the firm by properly establishing relationship between the items of the
balance sheet and the profit and loss account.
There are various methods or techniques that are used in analyzing financial statements,
such as comparative statements, schedule of changes in working capital, common size
percentages, funds analysis, trend analysis, and ratios analysis.
Financial statements are prepared to meet external reporting obligations and also for
decision making purposes. They play a dominant role in setting the framework of
managerial decisions. But the information provided in the financial statements is not an end
in itself as no meaningful conclusions can be drawn from these statements alone. However,
the information provided in the financial statements is of immense use in making decisions
through analysis and interpretation of financial statements.
Limitations of Financial Statement Analysis:
Although financial statement analysis is highly useful tool, it has two limitations.
These two limitations involve the comparability of financial data between
companies and the need to look beyond ratios.
Comparison of Financial Data:
Comparison of one company with another can provide valuable clues about the financial
health of an organization. Unfortunately, differences in accounting methods between
companies sometimes make it difficult to compare the companies' financial data. For
example if one firm values its inventories by LIFO method and another firm by the average
cost method, then direct comparison of financial data such as inventory valuations and cost
of goods sold between the two firms may be misleading. Sometimes enough data are
presented in foot notes to the financial statements to restate data to a comparable basis.
Otherwise, the analyst should keep in mind the lack of comparability of the data before
drawing any definite conclusion. Nevertheless, even with this limitation in mind,
comparisons of key ratios with other companies and with industry average often suggest
avenues for further investigation.
The Need to Look Beyond Ratios:
An inexperienced analyst may assume that ratios are sufficient in themselves as a basis for
judgment about the future. Nothing could be further from the truth. Conclusions based on
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ratios analysis must be regarded as tentative. Ratios should not be viewed as an end, but
rather they should be viewed as starting point, as indicators of what to pursue in greater
depth. they raise many questions, but they rarely answer any question by themselves.
In addition to ratios, other sources of data should be analyzed in order to make judgment
about the future of an organization. The analyst should look, for example, at industry
trends, technological changes, changes in consumer tastes, changes in broad economic
factors, and changes within the firm itself. A recent change in a key management position,
for example, might provide a basis for optimization about the future, even though the past
performance of the firm (as shown by its ratios) may have been mediocre.
Advantages of Financial Statement Analysis:
There are various advantages of financial statements analysis. The major benefit is that
the investors get enough idea to decide about the investments of their funds in the specific
company. Secondly, regulatory authorities like International Accounting Standards Board
can ensure whether the company is following accounting standards or not. Thirdly, financial
statements analysis can help the government agencies to analyze the taxation due to the
company. Moreover, company can analyze its own performance over the period of time
through financial statements analysis.
Chapter 2: Techniques of Financial Statement Analysis:
Tools and Techniques of Financial Statement Analysis:
Following are the most important tools and techniques of financial statement analysis
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1. Horizontal and Vertical Analysis:
Horizontal Analysis or Trend Analysis:
Horizontal Analysis or Trend Analysis:
Definition and Explanation of Horizontal or Trend Analysis:
Comparison of two or more year's financial data is known as horizontal analysis, or trend
analysis.
Horizontal analysis is facilitated by showing changes between years in both dollar and
percentage form as has been done in the example below. Showing changes in dollar form
helps the analyst focus on key factors t hat have affected profitability or financial position.
Observe in the example that sales for 2002 were up $4 million over 2001, but that this
increase in sales was more than negated by a $4.5million increase in cost of goods sold.
Showing changes between years in percentage form helps the analyst to gain perspective
and to gain a feel for the significance of the changes that are taking place. For example a $1
million increase in sales is much more significant if the prior year's sales were $2 million
than if the prior year's sales were $20 million. In the first situation, the increase would be
50% that is undoubtedly a significant increase for any firm. In the second situation, the
increase would be 5% that is just a reflection of normal progress.
Example of Horizontal or Trend Analysis:
Balance Sheet:
Comparative Balance Sheet
December 31, 2002, and 2001
(dollars in thousands)
Increase (Decrease)
2002
2001
Amount
Percent
Cash
$1,200
$2,350
$(1,150)*
(48.9)%
Accounts receivable
6,000
4,000
2000
50%
Inventory
8,000
10,000
(2000)
(20.0)%
300
120
180
150.0%
----------
-----------
----------
----------
Assets
Current Assets:
Prepaid Expenses
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$15,500
$16,470
(970)
(5.9)%
-----------
-----------
----------
---------
Land
4,000
4,000
0
0%
Building
12,000
8,500
3,500
41.2%
-----------
-----------
----------
16,000
12,500
3,500
28%
----------
-----------
----------
---------
31,500
28,970
2,530
8.7%
======
======
======
======
Accounts payables
$5,800
$4,000
1800
45%
Accrued payables
900
400
500
125%
Notes payables
300
600
(300)
(50%)
----------
----------
-----------
---------
7,000
5,000
2,000
40%
----------
----------
-----------
8,000
(500)
(6.3)%
----------
----------
----------
8,000
(500)
6.3%
----------
----------
----------
13,000
1,500
(11.5)%
Total current assets
Property and equipment:
Total property and equipment
Total assets
Liabilities and Stockholders' Equity
Current liabilities:
Total current liabilities
---------Long term liabilities:
Bonds payable 8%
7,500
----------
Total long term liabilities
7,500
----------
Total Liabilities
$14,500
Stock holders equity:
Preferred stock, 100 par, 6%, $100 liquidation value
$2,000
$2,000
0
0%
Common stock, $12 par
6,000
6,000
0
0%
Additional paid in capital
1,000
1,000
0
0%
----------
----------
---------
--------
Total paid in capital
9,000
9,000
0
0%
Retained earnings
8,000
6,970
1,030
14.8%
----------
----------
----------
----------
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Total stockholders' equity
Total liabilities and stockholders' equity
17,000
15,970
1,030
6.4%
----------
----------
----------
---------
$31,500
$28,970
$2,530
8.7%
=====
======
======
======
*Since we are measuring the change between 2001 and 2002, the dollar amounts for 2001
become the base figure for expressing these changes in percentage form. For example, cash
decreased by figures $1,150 between 2001 and 2002. This decrease expressed in
percentage form is computed as follows:
$1,150 ÷ $2,350 = 48.9%
Other percentage figures in this example are computed by the same formula.
Income Statement:
Comparative income statement and reconciliation of retained earnings
For the year ended December 31, 2002, and 2001
(dollars in thousands)
Increase (Decrease)
2002
2001
Amount
Percent
Sales
$52,000
$48,000
$4,000
8.3%
Cost of goods sold
36,000
31,500
4,500
14.3%
------------
------------
------------
-----------
16,000
16,500
(500)
(3.0)%
------------
------------
------------
------------
Selling expenses
7,000
6,500
500
7.7%
Administrative expense
5,860
6,100
(240)
(3.9)%
------------
------------
------------
------------
12,860
12,600
260
2.1%
------------
------------
------------
------------
3,140
3,900
(760)
(19.5)%
640
700
(60)
(8.6)%
------------
------------
------------
------------
Net income before taxes
2,500
3,200
(700)
(21.9)%
Less income taxes (30%)
750
960
(210)
(21.9)%
------------
------------
------------
------------
Gross margin
Operating expenses:
Total operating expenses
Net operating income
Interest expense
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Net income
1,750
2,240
$ (490)
21.9%
======
Dividends to preferred stockholders, $6 per share (see balance
sheet above)
120
120
------------
------------
1,630
2,120
600
600
------------
------------
Net income added to retained earnings
1,030
1,520
Retained earnings, beginning of year
6,970
5,450
------------
------------
$ 8,000
$ 6,970
=======
=======
Net income remaining for common stockholders
Dividend to common stockholders, $1.20 per share
Retained earnings, end of year
Trend Percentage:
Definition and Explanation:
Horizontal analysis of financial statements can also be carried out by computing trend
percentages. Trend percentage states several years' financial data in terms of a base
year. The base year equals 100%, with all other years stated in some percentage of this
base.
Example:
Consider McDonald's Corporation, the largest global food service retailer, with more than
26,000 restaurants worldwide. McDonalds enjoyed tremendous growth during the 1990s, as
evidenced by the following data:
2000
1999
Sales(millions) $14,243 $13,259
Income(millions) $1,977
$1,948
1998
1997
1996
1995
1994
1993
1992
1991
1990
$12,421
$11,409
$10687
$9,795
$8,321
$7,408
$7,133
$6,695
$6,640
$1,550
$1,642
$1,573
$1,427
$1,224
$1,083
$959
$860
$802
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By simply looking at these data, one can see that sales increased every year. But how
rapidly sales have been increasing, and have the increases in net income kept pace with the
increase in sales? It is difficult to answer these questions by looking at the raw data alone.
The increases in sales and the increases in net income can be put into better perspective by
stating them in terms of trend percentages, with 1990 as the base year. These percentages
(all rounded) appear as follows:
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
Sales
215%
200%
187%
172%
161%
148%
125%
112%
107%
101%
100%
Income
247%
243%
193%
205%
196%
178%
153%
135%
120%
107%
100%
The trend analysis is particularly striking when the data are plotted as above. McDonald's
growth was impressive through the entire 11-year period, but it was out paced by even
higher growth in the company's net income. A review of the company's income statement
reveals that the dip in net income growth in 1998 was attributable, in part, to the $161.6
million that McDonalds spent to implement its "Made for you" program and a special charge
of $160 million that related to a home office productivity initiative.
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Chapter 3
Vertical Analysis and Common Size Statements:
Definition and Explanation of Vertical Analysis and
Common Size Statements:
Vertical analysis is the procedure of preparing and presenting common size statements.
Common size statement is one that shows the items appearing on it in percentage form
as well as in dollar form.
Each item is stated as a percentage of some total of which that item is a part. Key financial
changes and trends can be highlighted by the use of common size statements.
Common size statements are particularly useful when comparing data from different
companies. For example, in one year, Wendy's net income was about $110 million, whereas
McDonald's was $1,427 million. This comparison is somewhat misleading because of the
dramatically different size of the two companies. To put this in better perspective, the net
income figures can be expressed as a percentage of the sales revenues of each company,
Since Wendy's sales revenue were $1,746 million and McDonald's were $9,794 million,
Wendy's net income as a percentage of sales was about 6.3% and McDonald's was about
14.6%.
Example:
Balance Sheet:
One application of the vertical analysis idea is to state the separate assets of a company as
percentages of total sales. A common type statement of an electronic company is shown
below:
Common Size Comparative Balance Sheet
December 31, 2002, and 2001
(dollars in thousands)
Common-Size Percentages
2002
2001
2002
2001
$ 1,200
$ 2,350
3.8%
8.1%
Assets
Current assets:
Cash
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Accounts receivable, net
6,000
4,000
19.0%
13.8%
Inventory
8,000
10,000
25.4%
34.5%
300
120
1.0%
0.4%
------------
------------
-----------
------------
15,500
16,470
49.2%
56.9%
------------
------------
------------
------------
Land
4,000
4,000
12.7%
13.8%
Building and equipment
12,000
8,5000
38.1%
29.3%
------------
------------
------------
------------
16,000
12,500
50.8%
43.1%
------------
------------
------------
------------
$ 31,500
$ 28,970
100.0%
100.0%
======
======
======
======
Accounts payable
$ 5,800
$ 4,000
18.4%
13.8%
Accrued payable
900
400
2.9%
1.4%
Notes payable, short term
300
600
1.0%
2.1%
------------
------------
------------
------------
7,000
5,000
22.2%
17.3%
------------
------------
------------
------------
7,500
8,000
23.8%
27.6%
------------
------------
------------
------------
14,500
13,000
46.0%
44.9%
------------
------------
------------
------------
Preferred stock, $100, 6%, $100 liquidation value
2,000
2,000
6.3%
6.9%
Common stock, $12 par
6,000
6,000
19.0%
20.7%
Additional paid in capital
1,000
1,000
3.2%
3.5%
------------
------------
------------
------------
Prepaid expenses
Total current assets
Property and equipment:
Total property and equipment
Total assets
Liabilities and Stockholders' Equity
Current liabilities:
Total current liabilities
Long term liabilities:
Bonds payable, 8%
Total liabilities
Stockholders' equity:
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Total paid in capital
9,000
9,000
28.6%
31.1%
Retained earnings
8,000
6,970
25.4%
24.1%
------------
------------
------------
------------
17,000
15,970
54.0%
55.1%
------------
------------
------------
------------
$ 31,500
$ 28,970
100.0%
100.%
======
======
======
======
Total stockholders equity
*Each asset in common size statement is expressed in terms of total assets, and each liability and equity account is
expressed in terms of total liabilities and stockholders' equity. For example, the percentage figure above for cash in 2002
is computed as follows:
[$1,200 / $31,500 = 3.8%]
Notice from the above example that placing all assets in common size form clearly shows
the relative importance of the current assets as compared to the non-current assets. It also
shows that the significant changes have taken place in the composition of the current assets
over the last year. Notice, for example, that the receivables have increased in relative
importance and that both cash and inventory have declined in relative importance. Judging
from the sharp increase in receivables, the deterioration in cash position may be a result of
inability to collect from customers.
The main advantages of analyzing a balance sheet in this manner is that the balance sheets
of businesses of all sizes can easily be compared. It also makes it easy to see relative
annual changes in one business.
Income Statement:
Another application of the vertical analysis idea is to place all items on the income
statement in percentage form in terms of sales. A common size statement of this type of an
electronics company is shown below:
Common-Size Comparative income statement
For the year ended December 31, 2002, and 2001
(dollars in thousands)
Common-Size Percentage
2002
2001
2002
2001
Sales
$52,000
$48,000
100.0%
100.0%
Cost of goods sold
36,000
31,500
69.2%
65.6%
------------
------------
------------
------------
16,000
16,500
30.8%
34.4%
------------
------------
------------
------------
Gross margin
Operating expenses:
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Selling expenses
7,000
6,500
13.5%
13.5%
Administrative expense
5,860
6,100
11.3%
12.7%
------------
------------
------------
------------
12,860
12,600
24.7%
26.2%
------------
------------
------------
------------
3,140
3,900
6%
8.1%
640
700
1.2%
1.5%
------------
------------
------------
------------
2,500
3,200
4.8%
6.7%
750
960
1.4%
2.0%
------------
------------
------------
------------
$ 1,750
$2,240
3.4%
4.7%
======
======
======
======
Total operating expenses
Net operating income
Interest expense
Net income before taxes
Income tax (30%)
Net income
*Note that the percentage figures for each year are expressed in terms of total sales for the year. For example, the
percentage figure for cost of goods sold in 2002 is computed as follows:
[($36,000 / $52,000) × 100 = 69.2%]
By placing all items on the income statement in common size in terms of sales, it is possible
to see at a glance how each dollar of sales is distributed among the various costs, expenses,
and profits. And by placing successive years' statements side by side, it is easy to spot
interesting trends. For example, as shown above, the cost of goods sold as a percentage of
sales increased from 65.6% in 2001 to 69.2% in 2002. Or looking at this form a different
view point , the gross margin percentage declined from 34.4% in 2001 to 30.8% in 2002.
Managers and investment analysis often pay close attention to the gross margin percentage
since it is considered a broad gauge of profitability. The gross margin percentage is
computed by the following formula:
Gross margin percentage = Gross margin / Sales
The gross margin percentage tends to be more stable for retailing companies than for
other service companies and for manufacturers. Since the cost of goods sold in retailing
exclude fixed costs. When fixed costs are included in the cost of goods sold figure, the gross
margin percentage tends to increase of decrease with sales volume. The fixed costs are
spread across more units and the gross margin percentage improves.
While a higher gross margin percentage is considered to be better than a lower gross
margin percentage, there are exceptions. Some companies purposely choose a strategy
emphasizing low prices and (hence low gross margin). An increasing gross margin in such a
company might be a sign that the company's strategy is not being effectively implemented.
Common size statements are also very helpful in pointing out efficiencies and inefficiencies
that might other wise go unnoticed. To illustrate, selling expenses, in the above example of
electronics company , increased by $500,000 over 2001. A glance at the common-size
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income statement shows, however, that on a relative basis, selling expenses were no higher
in 2002 than in 2001. In each year they represented 13.5% of sales.
Chapter 4: Ratios Analysis:
Accounting Ratios | Financial Ratios:
Learning Objectives:
1. Define and explain the term accounting ratios.
2. What are advantages and limitations of using accounting or financial ratios.
3. How financial ratios are classified.
Ratios simply means one number expressed in terms of another. A ratio is a statistical
yardstick by means of which relationship between two or various figures can be compared
or measured.
Definition of Accounting Ratios:
The term "accounting ratios" is used to describe significant relationship between figures
shown on a balance sheet, in a profit and loss account, in a budgetary control system or in
any other part of accounting organization. Accounting ratios thus shows the relationship
between accounting data.
Ratios can be found out by dividing one number by another number. Ratios show how one
number is related to another. It may be expressed in the form of co-efficient, percentage,
proportion, or rate. For example the current assets and current liabilities of a business on a
particular date are $200,000 and $100,000 respectively. The ratio of current assets and
current liabilities could be expressed as 2 (i.e. 200,000 / 100,000) or 200 percent or it can
be expressed as 2:1 i.e., the current assets are two times the current liabilities. Ratio
sometimes is expressed in the form of rate. For instance, the ratio between two numerical
facts, usually over a period of time, e.g. stock turnover is three times a year.
Advantages of Ratios Analysis:
Ratio analysis is an important and age-old technique of financial analysis. The following are
some of the advantages / Benefits of ratio analysis:
1. Simplifies financial statements: It simplifies the comprehension of financial
statements. Ratios tell the whole story of changes in the financial condition of the
business
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2. Facilitates inter-firm comparison: It provides data for inter-firm comparison.
Ratios highlight the factors associated with with successful and unsuccessful firm.
They also reveal strong firms and weak firms, overvalued and undervalued firms.
3. Helps in planning: It helps in planning and forecasting. Ratios can assist
management, in its basic functions of forecasting. Planning, co-ordination, control
and communications.
4. Makes inter-firm comparison possible: Ratios analysis also makes possible
comparison of the performance of different divisions of the firm. The ratios are
helpful in deciding about their efficiency or otherwise in the past and likely
performance in the future.
5. Help in investment decisions: It helps in investment decisions in the case of
investors and lending decisions in the case of bankers etc.
Limitations of Ratios Analysis:
The ratios analysis is one of the most powerful tools of financial management. Though ratios
are simple to calculate and easy to understand, they suffer from serious limitations.
1. Limitations of financial statements: Ratios are based only on the information
2.
3.
4.
5.
6.
7.
8.
which has been recorded in the financial statements. Financial statements
themselves are subject to several limitations. Thus ratios derived, there from, are
also subject to those limitations. For example, non-financial changes though
important for the business are not relevant by the financial statements. Financial
statements are affected to a very great extent by accounting conventions and
concepts. Personal judgment plays a great part in determining the figures for
financial statements.
Comparative study required: Ratios are useful in judging the efficiency of the
business only when they are compared with past results of the business. However,
such a comparison only provide glimpse of the past performance and forecasts for
future may not prove correct since several other factors like market conditions,
management policies, etc. may affect the future operations.
Ratios alone are not adequate: Ratios are only indicators, they cannot be taken as
final regarding good or bad financial position of the business. Other things have also
to be seen.
Problems of price level changes: A change in price level can affect the validity of
ratios calculated for different time periods. In such a case the ratio analysis may not
clearly indicate the trend in solvency and profitability of the company. The financial
statements, therefore, be adjusted keeping in view the price level changes if a
meaningful comparison is to be made through accounting ratios.
Lack of adequate standard: No fixed standard can be laid down for ideal ratios. There
are no well accepted standards or rule of thumb for all ratios which can be accepted
as norm. It renders interpretation of the ratios difficult.
Limited use of single ratios: A single ratio, usually, does not convey much of a
sense. To make a better interpretation, a number of ratios have to be calculated
which is likely to confuse the analyst than help him in making any good decision.
Personal bias: Ratios are only means of financial analysis and not an end in itself.
Ratios have to interpreted and different people may interpret the same ratio in
different way.
Incomparable: Not only industries differ in their nature, but also the firms of the
similar business widely differ in their size and accounting procedures etc. It makes
comparison of ratios difficult and misleading.
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Classification of Accounting Ratios:
Ratios may be classified in a number of ways to suit any particular purpose. Different kinds
of ratios are selected for different types of situations. Mostly, the purpose for which the
ratios are used and the kind of data available determine the nature of analysis. The various
accounting ratios can be classified as follows:
Classification of Accounting Ratios / Financial Ratios
(A)
Traditional Classification or
Statement Ratios
(B)
Functional Classification or
Classification According to
Tests
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(C)
Significance Ratios or Ratios
According to Importance
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


Profit and loss account
ratios or
revenue/income
statement ratios
Balance sheet ratios or
position statement
ratios
Composite/mixed
ratios or inter
statement ratios




Profitability ratios
Liquidity ratios
Activity ratios
Leverage ratios or long
term solvency ratios


Primary ratios
Secondary ratios
Chapter:5 Profitability Ratios:
Profitability Ratios:
Profitability ratios measure the results of business operations or overall performance and
effectiveness of the firm. Some of the most popular profitability ratios are as under:
General profitability:
Gross Profit Ratio (GP Ratio):
Definition of gross profit ratio:
Gross profit ratio (GP ratio) is the ratio of gross profit to net sales expressed as a
percentage. It expresses the relationship between gross profit and sales.
Components:
The basic components for the calculation of gross profit ratio are gross profit and net
sales. Net sales means that sales minus sales returns. Gross profit would be the difference
between net sales and cost of goods sold. Cost of goods sold in the case of a trading
concern would be equal to opening stock plus purchases, minus closing stock plus all direct
expenses relating to purchases. In the case of manufacturing concern, it would be equal to
the sum of the cost of raw materials, wages, direct expenses and all manufacturing
expenses. In other words, generally the expenses charged to profit and loss account or
operating expenses are excluded from the calculation of cost of goods sold.
Formula:
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Following formula is used to calculate gross profit ratios:
[Gross Profit Ratio = (Gross profit / Net sales) × 100]
Example:
Total sales = $520,000; Sales returns = $ 20,000; Cost of goods sold $400,000
Required: Calculate gross profit ratio.
Calculation:
Gross profit = [(520,000 – 20,000) – 400,000]
= 100,000
Gross Profit Ratio = (100,000 / 500,000) × 100
= 20%
Significance:
Gross profit ratio may be indicated to what extent the selling prices of goods per unit may
be reduced without incurring losses on operations. It reflects efficiency with which a firm
produces its products. As the gross profit is found by deducting cost of goods sold from net
sales, higher the gross profit better it is. There is no standard GP ratio for evaluation. It
may vary from business to business. However, the gross profit earned should be sufficient
to recover all operating expenses and to build up reserves after paying all fixed interest
charges and dividends.
Causes/reasons of increase or decrease in gross profit ratio:
It should be observed that an increase in the GP ratio may be due to the following factors.
1. Increase in the selling price of goods sold without any corresponding increase in the
cost of goods sold.
2. Decrease in cost of goods sold without corresponding decrease in selling price.
3. Omission of purchase invoices from accounts.
4. Under valuation of opening stock or overvaluation of closing stock.
On the other hand, the decrease in the gross profit ratio may be due to the following
factors.
1. Decrease in the selling price of goods, without corresponding decrease in the cost of
goods sold.
2. Increase in the cost of goods sold without any increase in selling price.
3. Unfavorable purchasing or markup policies.
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4. Inability of management to improve sales volume, or omission of sales.
5. Over valuation of opening stock or under valuation of closing stock
Hence, an analysis of gross profit margin should be carried out in the light of the
information relating to purchasing, mark-ups and markdowns, credit and collections as well
as merchandising policies.
Net Profit Ratio (NP Ratio):
Definition of net profit ratio:
Net profit ratio is the ratio of net profit (after taxes) to net sales. It is expressed as
percentage.
Components of net profit ratio:
The two basic components of the net profit ratio are the net profit and sales. The net
profits are obtained after deducting income-tax and, generally, non-operating expenses and
incomes are excluded from the net profits for calculating this ratio. Thus, incomes such as
interest on investments outside the business, profit on sales of fixed assets and losses on
sales of fixed assets, etc are excluded.
Formula:
Net Profit Ratio = (Net profit / Net sales) × 100
Example:
Total sales = $520,000; Sales returns = $ 20,000; Net profit $40,000
Calculate net profit ratio.
Calculation:
Net sales = (520,000 – 20,000) = 500,000
Net Profit Ratio = [(40,000 / 500,000) × 100]
= 8%
Significance:
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NP ratio is used to measure the overall profitability and hence it is very useful to
proprietors. The ratio is very useful as if the net profit is not sufficient, the firm shall not be
able to achieve a satisfactory return on its investment.
This ratio also indicates the firm's capacity to face adverse economic conditions such as
price competition, low demand, etc. Obviously, higher the ratio the better is the profitability.
But while interpreting the ratio it should be kept in mind that the performance of profits also
be seen in relation to investments or capital of the firm and not only in relation to sales
Operating Ratio:
Definition:
Operating ratio is the ratio of cost of goods sold plus operating expenses to net sales. It is
generally expressed in percentage.
Operating ratio measures the cost of operations per dollar of sales. This is closely related to
the ratio of operating profit to net sales.
Components:
The two basic components for the calculation of operating ratio are operating cost (cost of
goods sold plus operating expenses) and net sales. Operating expenses normally include (a)
administrative and office expenses and (b) selling and distribution expenses. Financial
charges such as interest, provision for taxation etc. are generally excluded from operating
expenses.
Formula of operating ratio:
Operating Ratio = [(Cost of goods sold + Operating expenses) / Net sales] × 100
Example:
Cost of goods sold is $180,000 and other operating expenses are $30,000 and net sales is
$300,000.
Calculate operating ratio.
Calculation:
Operating ratio = [(180,000 + 30,000) / 300,000] × 100
= [210,000 / 300,000] × 100
= 70%
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Significance:
Operating ratio shows the operational efficiency of the business. Lower operating ratio
shows higher operating profit and vice versa. An operating ratio ranging between 75% and
80% is generally considered as standard for manufacturing concerns. This ratio is
considered to be a yardstick of operating efficiency but it should be used cautiously because
it may be affected by a number of uncontrollable factors beyond the control of the firm.
Moreover, in some firms, non-operating expenses from a substantial part of the total
expenses and in such cases operating ratio may give misleading results.
Expense Ratio:
Definition:
Expense ratios indicate the relationship of various expenses to net sales. The operating
ratio reveals the average total variations in expenses. But some of the expenses may be
increasing while some may be falling. Hence, expense ratios are calculated by dividing each
item of expenses or group of expense with the net sales to analyze the cause of variation of
the operating ratio.
The ratio can be calculated for individual items of expense or a group of items of a particular
type of expense like cost of sales ratio, administrative expense ratio, selling expense ratio,
materials consumed ratio, etc. The lower the operating ratio, the larger is the profitability
and higher the operating ratio, lower is the profitability.
While interpreting expense ratio, it must be remembered that for a fixed expense like
rent, the ratio will fall if the sales increase and for a variable expense, the ratio in proportion
to sales shall remain nearly the same.
Formula of Expense Ratio:
Following formula is used for the calculation of expense ratio:
Particular Expense = (Particular expense / Net sales) × 100
Example:
Administrative expenses are $2,500, selling expenses are $3,200 and sales are $25,00,000.
Calculate expense ratio.
Calculation:
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Administrative expenses ratio = (2,500 / 25,00,000) × 100
= 0.1%
Selling expense ratio = (3,200 / 25,00,000) × 100
= 0.128%
Overall profitability:
Return on Shareholders Investment or Net Worth Ratio:
Definition:
It is the ratio of net profit to share holder's investment. It is the relationship between net
profit (after interest and tax) and share holder's/proprietor's fund.
This ratio establishes the profitability from the share holders' point of view. The ratio is
generally calculated in percentage.
Components:
The two basic components of this ratio are net profits and shareholder's funds.
Shareholder's funds include equity share capital, (preference share capital) and all reserves
and surplus belonging to shareholders. Net profit means net income after payment of
interest and income tax because those will be the only profits available for share holders.
Formula of return on shareholder's investment or net worth
Ratio:
[Return on share holder's investment = {Net profit (after interest and tax) / Share holder's fund} × 100]
Example:
Suppose net income in an organization is $60,000 where as shareholder's investments or
funds are $400,000.
Calculate return on shareholders investment or net worth
Return on share holders investment = (60,000 / 400,000) × 100
= 15%
This means that the return on shareholders funds is 15 cents per dollar.
Significance:
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This ratio is one of the most important ratios used for measuring the overall efficiency of a
firm. As the primary objective of business is to maximize its earnings, this ratio indicates
the extent to which this primary objective of businesses being achieved. This ratio is of
great importance to the present and prospective shareholders as well as the management of
the company. As the ratio reveals how well the resources of the firm are being used, higher
the ratio, better are the results. The inter firm comparison of this ratio determines whether
the investments in the firm are attractive or not as the investors would like to invest only
where the return is higher.
Return on Equity Capital (ROEC) Ratio:
In real sense, ordinary shareholders are the real owners of the company. They assume the
highest risk in the company. (Preference share holders have a preference over ordinary
shareholders in the payment of dividend as well as capital.
Preference share holders get a fixed rate of dividend irrespective of the quantum of profits
of the company). The rate of dividends varies with the availability of profits in case of
ordinary shares only. Thus ordinary shareholders are more interested in the profitability of a
company and the performance of a company should be judged on the basis of return on
equity capital of the company. Return on equity capital which is the relationship between
profits of a company and its equity, can be calculated as follows:
Formula of return on equity capital or common stock:
Formula of return on equity capital ratio is:
Return on Equity Capital = [(Net profit after tax − Preference dividend) / Equity share
capital] × 100
Components:
Equity share capital should be the total called-up value of equity shares. As the profit used
for the calculations are the final profits available to equity shareholders as dividend,
therefore the preference dividend and taxes are deducted in order to arrive at such profits.
Example:
Calculate return on equity share capital from the following information:
Equity share capital ($1): $1,000,000; 9% Preference share capital: $500,000; Taxation
rate: 50% of net profit; Net profit before tax: $400,000.
Calculation:
Return on Equity Capital (ROEC) ratio = [(400,000 − 200,000 − 45,000) / 1000,000 )×
100]
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= 15.5%
Significance:
This ratio is more meaningful to the equity shareholders who are interested to know profits
earned by the company and those profits which can be made available to pay dividends to
them. Interpretation of the ratio is similar to the interpretation of return on shareholder's
investments and higher the ratio better is.
Return on Capital Employed Ratio (ROCE Ratio):
The prime objective of making investments in any business is to obtain satisfactory return
on capital invested. Hence, the return on capital employed is used as a measure of success
of a business in realizing this objective.
Return on capital employed establishes the relationship between the profit and the capital
employed. It indicates the percentage of return on capital employed in the business and it
can be used to show the overall profitability and efficiency of the business.
Definition of Capital Employed:
Capital employed and operating profits are the main items. Capital employed may be
defined in a number of ways. However, two widely accepted definitions are "gross capital
employed" and "net capital employed". Gross capital employed usually means the total
assets, fixed as well as current, used in business, while net capital employed refers to total
assets minus liabilities. On the other hand, it refers to total of capital, capital reserves,
revenue reserves (including profit and loss account balance), debentures and long term
loans.
Calculation of Capital Employed:
Method--1. If it is calculated from the assets side, It can be worked out by adding the
following:
1. The fixed assets should be included at their net values, either at original cost or at
replacement cost after deducting depreciation. In days of inflation, it is better to
include fixed assets at replacement cost which is the current market value of the
assets.
2. Investments inside the business
3. All current assets such as cash in hand, cash at bank, sundry debtors, bills
receivable, stock, etc.
4. To find out net capital employed, current liabilities are deducted from the total of the
assets as calculated above.
Gross capital employed = Fixed assets + Investments + Current assets
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Net capital employed = Fixed assets + Investments + Working capital*.
*Working capital = current assets − current liabilities.
Precautions For Calculating Capital Employed:
While capital employed is calculated from the asset side, the following precautions should be
taken:
1. Regarding the valuation of fixed assets, nowadays it is considered necessary to value
2.
3.
4.
5.
6.
the assets at their replacement cost. This is with a view to providing for the
continuing problem of inflations during the current years. Under replacement cost
methods the fixed assets are to be revalued on the basis of their current market
prices either by reference to reliable published index numbers, or on valuation of
experts. When replacement cost method is used, the provision for depreciation
should be recalculated since depreciation charged might have been calculated on
original cost of assets.
Idle assets―assets which cannot be used in the business should be excluded from
capital employed. However, standby plant and machinery essential to the normal
running of the business should be included.
Intangible assets, like goodwill, patents, trade marks, rights, etc. should be
excluded. However, if they have sale value or if they have been purchased they may
be included. Investments made outside the business should be excluded.
All current assets should be properly valued. Any excess balance of cash or bank
than required for the smooth running of the business should be excluded.
Fictitious assets, like preliminary expenses, accumulated losses, discount on issue of
shares or debentures, advertisement, suspense account, etc. should be excluded.
Obsolete assets which cannot be used in the business or obsolete stock which cannot
be sold should be excluded.
Method--2. Alternatively, capital employed can be calculated from the liabilities side of a
balance sheet. If it is calculated from the liabilities side, it will include the following items:
Share capital:
Issued share capital (Equity + Preference)
Reserves and Surplus:
General reserve
Capital reserve
Profit and Loss account
Debentures
Other long term loans
Some people suggest that average capital employed should be used in order to give effect
of the capital investment throughout the year. It is argued that the profit earned remain in
the business throughout the year and are distributed by way of dividends only at the end of
the year. Average capital may be calculated by dividing the opening and closing capital
employed by two. It can also be worked out by deducting half of the profit from capital
employed.
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Computation of profit for return on capital employed:
The profits for the purpose of calculating return on capital employed should be computed
according to the concept of "capital employed used". The profits taken must be the profits
earned on the capital employed in the business. Thus, net profit has to be adjusted for the
following:






Net profit should be taken before the payment of tax or provision for taxation
because tax is paid after the profits have been earned and has no relation to the
earning capacity of the business.
If the capital employed is gross capital employed then net profit should be
considered before payment of interest on long-term as well as short-term
borrowings.
If the capital employed is used in the sense of net capital employed than only
interest on long term borrowings should be added back to the net profits and not
interest on short term borrowings as current liabilities are deducted while calculating
net capital employed.
If any asset has been excluded while computing capital employed, any income
arising from these assets should also be excluded while calculating net profits. For
example, interest on investments outside business should be excluded.
Net profits should be adjusted for any abnormal, non recurring, non operating gains
or losses such as profits and losses on sales of fixed assets.
Net profits should be adjusted for depreciation based on replacement cost, if assets
have been added at replacement cost.
Formula of return on capital employed ratio:
Return on Capital Employed=(Adjusted net profits*/Capital employed)×100
*Net profit before interest and tax minus income from investments.
Significance of Return on Capital Employed Ratio:
Return on capital employed ratio is considered to be the best measure of profitability in
order to assess the overall performance of the business. It indicates how well the
management has used the investment made by owners and creditors into the business. It is
commonly used as a basis for various managerial decisions. As the primary objective of
business is to earn profit, higher the return on capital employed, the more efficient the firm
is in using its funds. The ratio can be found for a number of years so as to find a trend as to
whether the profitability of the company is improving or otherwise.
Dividend Yield Ratio:
Definition:
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Dividend yield ratio is the relationship between dividends per share and the market value
of the shares.
Share holders are real owners of a company and they are interested in real sense in the
earnings distributed and paid to them as dividend. Therefore, dividend yield ratio is
calculated to evaluate the relationship between dividends per share paid and the market
value of the shares.
Formula of Dividend Yield Ratio:
Following formula is used for the calculation of dividend yield ratio:
Dividend Yield Ratio = Dividend Per Share / Market Value Per Share
Example:
For example, if a company declares dividend at 20% on its shares, each having a paid up
value of $8.00 and market value of $25.00.
Calculate dividend yield ratio:
Calculation:
Dividend Per Share = (20 / 100) × 8
= $1.60
Dividend Yield Ratio = (1.60 / 25) × 100
= 6.4%
Significance of the Ratio:
This ratio helps as intending investor is knowing the effective return he is going to get on
the proposed investment.
Dividend Payout Ratio:
Dividend payout ratio is calculated to find the extent to which earnings per share have
been used for paying dividend and to know what portion of earnings has been retained in
the business. It is an important ratio because ploughing back of profits enables a company
to grow and pay more dividends in future.
Formula of Dividend Payout Ratio:
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Following formula is used for the calculation of dividend payout ratio
Dividend Payout Ratio = Dividend per Equity Share / Earnings per Share
A complementary of this ratio is retained earnings ratio. Retained earning ratio is
calculated by using the following formula:
Retained Earning Ratio = Retained Earning Per Equity Share / Earning Per Equity Share
Example:
Calculate dividend payout ratio and retained earnings from the following data:
Net Profit
Provision for taxation
Preference dividend
10,000
5,000
2,000
No. of equity shares
Dividend per equity share
3,000
$0.40
Payout Ratio = ($0.40 / $1) × 100
= 40%
Retained Earnings Ratio = ($0.60 /$1) × 100
= 60%
Significance of the Ratio:
The payout ratio and the retained earning ratio are the indicators of the amount of earnings
that have been ploughed back in the business. The lower the payout ratio, the higher will be
the amount of earnings ploughed back in the business and vice versa. A lower payout ratio
or higher retained earnings ratio means a stronger financial position of the company.
Earnings Per Share (EPS) Ratio:
Definition:
Earnings per share ratio (EPS Ratio) is a small variation of return on equity capital ratio
and is calculated by dividing the net profit after taxes and preference dividend by the total
number of equity shares.
Formula of Earnings Per Share Ratio:
The formula of earnings per share is:
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Earnings per share (EPS) Ratio = (Net profit after tax − Preference dividend) / No. of equity
shares (common shares)
Example:
Equity share capital ($1): $1,000,000; 9% Preference share capital: $500,000; Taxation
rate: 50% of net profit; Net profit before tax: $400,000.
Calculate earnings per share ratio.
Calculation:
EPS = 1,55,000 / 10,000
= $15.50 per share.
Significance:
The earnings per share is a good measure of profitability and when compared with EPS of
similar companies, it gives a view of the comparative earnings or earnings power of the
firm. EPS ratio calculated for a number of years indicates whether or not the earning power
of the company has increased.
Price Earnings Ratio (PE Ratio):
Definition:
Price earnings ratio (P/E ratio) is the ratio between market price per equity share and
earning per share.
The ratio is calculated to make an estimate of appreciation in the value of a share of a
company and is widely used by investors to decide whether or not to buy shares in a
particular company.
Formula of Price Earnings Ratio:
Following formula is used to calculate price earnings ratio:
Price Earnings Ratio = Market price per equity share / Earnings per share
Example:
The market price of a share is $30 and earning per share is $5.
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Calculate price earnings ratio.
Calculation:
Price earnings ratio = 30 / 5
=6
The market value of every one dollar of earning is six times or $6. The ratio is useful in
financial forecasting. It also helps in knowing whether the share of a company are under or
over valued. For example, if the earning per share of AB limited is $20, its market price
$140 and earning ratio of similar companies is 8, it means that the market value of a share
of AB Limited should be $160 (i.e., 8 × 20). The share of AB Limited is, therefore,
undervalued in the market by $20. In case the price earnings ratio of similar companies is
only 6, the value of the share of AB Limited should have been $120 (i.e., 6 × 20), thus the
share is overvalued by $20.
Significance of Price Earning Ratio:
Price earnings ratio helps the investor in deciding whether to buy or not to buy the shares
of a particular company at a particular market price.
Generally, higher the price earning ratio the better it is. If the P/E ratio falls, the
management should look into the causes that have resulted into the fall of this ratio.
Chapter 6 Short Term Financial Position or Test of
Solvency:
Current Ratio:
It is a measure of general liquidity and is most widely used to make the analysis for short
term financial position or liquidity of a firm. It is calculated by dividing the total of the
current assets by total of the current liabilities.
Contents:
1.
2.
3.
4.
5.
6.
Definition of current ratio
Formula
Components
Example
Significance
Limitations of current ratio
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Definition:
Current ratio may be defined as the relationship between current assets and current
liabilities. This ratio is also known as "working capital ratio". It is a measure of general
liquidity and is most widely used to make the analysis for short term financial position or
liquidity of a firm. It is calculated by dividing the total of the current assets by total of the
current liabilities.
Formula:
Following formula is used to calculate current ratio:
Current Ratio = Current Assets / Current Liabilities
Or
Current Assets : Current Liabilities
Components:
The two basic components of this ratio are current assets and current liabilities. Current
assets include cash and those assets which can be easily converted into cash within a short
period of time, generally, one year, such as marketable securities or readily realizable
investments, bills receivables, sundry debtors, (excluding bad debts or provisions),
inventories, work in progress, etc. Prepaid expenses should also be included in current
assets because they represent payments made in advance which will not have to be paid in
near future.
Current liabilities are those obligations which are payable within a short period of tie
generally one year and include outstanding expenses, bills payable, sundry creditors, bank
overdraft, accrued expenses, short term advances, income tax payable, dividend payable,
etc. However, some times a controversy arises that whether overdraft should be regarded
as current liability or not. Often an arrangement with a bank may be regarded as permanent
and therefore, it may be treated as long term liability. At the same time the fact remains
that the overdraft facility may be cancelled at any time. Accordingly, because of this reason
and the need for conversion in interpreting a situation, it seems advisable to include
overdrafts in current liabilities.
Example:
Current assets are $1,200,000 and total current liabilities are $600,000.
Calculate current ratio.
Calculation:
Current Ratio = 1,200,000 / 600,000
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=2
or
1200,000 : 600,000
2:1
Significance:
This ratio is a general and quick measure of liquidity of a firm. It represents the margin of
safety or cushion available to the creditors. It is an index of the firms financial stability. It is
also an index of technical solvency and an index of the strength of working capital.
A relatively high current ratio is an indication that the firm is liquid and has the ability to
pay its current obligations in time and when they become due. On the other hand, a
relatively low current ratio represents that the liquidity position of the firm is not good and
the firm shall not be able to pay its current liabilities in time without facing difficulties. An
increase in the current ratio represents improvement in the liquidity position of the firm
while a decrease in the current ratio represents that there has been a deterioration in the
liquidity position of the firm. A ratio equal to or near 2 : 1 is considered as a standard or
normal or satisfactory. The idea of having double the current assets as compared to current
liabilities is to provide for the delays and losses in the realization of current assets.
However, the rule of 2 :1 should not be blindly used while making interpretation of the
ratio. Firms having less than 2 : 1 ratio may be having a better liquidity than even firms
having more than 2 : 1 ratio. This is because of the reason that current ratio measures the
quantity of the current assets and not the quality of the current assets. If a firm's current
assets include debtors which are not recoverable or stocks which are slow-moving or
obsolete, the current ratio may be high but it does not represent a good liquidity position.
Limitations of Current Ratio:
This ratio is measure of liquidity and should be used very carefully because it suffers from
many limitations. It is, therefore, suggested that it should not be used as the sole index of
short term solvency.
1. It is crude ratio because it measure only the quantity and not the quality of the
current assets.
2. Even if the ratio is favorable, the firm may be in financial trouble, because of more
stock and work in process which is not easily convertible into cash, and, therefore
firm may have less cash to pay off current liabilities.
3. Valuation of current assets and window dressing is another problem. This ratio can
be very easily manipulated by overvaluing the current assets. An equal increase in
both current assets and current liabilities would decrease the ratio and similarly
equal decrease in current assets and current liabilities would increase current ratio.
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Liquid or Liquidity or Acid Test or Quick Ratio:
Definition:
Liquid ratio is also termed as "Liquidity Ratio", "Acid Test Ratio" or "Quick Ratio". It is
the ratio of liquid assets to current liabilities. The true liquidity refers to the ability of a firm
to pay its short term obligations as and when they become due.
Components:
The two components of liquid ratio (acid test ratio or quick ratio) are liquid assets and
liquid liabilities. Liquid assets normally include cash, bank, sundry debtors, bills receivable
and marketable securities or temporary investments. In other words they are current assets
minus inventories (stock) and prepaid expenses. Inventories cannot be termed as liquid
assets because it cannot be converted into cash immediately without a loss of value. In the
same manner, prepaid expenses are also excluded from the list of liquid assets because
they are not expected to be converted into cash. Similarly, Liquid liabilities means current
liabilities i.e., sundry creditors, bills payable, outstanding expenses, short term advances,
income tax payable, dividends payable, and bank overdraft (only if payable on demand).
Some time bank overdraft is not included in current liabilities, on the argument that bank
overdraft is generally permanent way of financing and is not subject to be called on
demand. In such cases overdraft will be excluded from current liabilities.
Formula of Liquidity Ratio / Acid Test Ratio:
[Liquid Ratio = Liquid Assets / Current Liabilities]
Example:
From the following information of a company, calculate liquid ratio. Cash $180; Debtors
$1,420; inventory $1,800; Bills payable $270; Creditors $500 Accrued expenses $150; Tax
payable $750.
Liquid Assets = 180 + 1,420 = 1.600
Current Liabilities = 270 + 500 + 150 + 750 = 1,670
Liquid Ratio = 1,600 / 1,670
= 0.958 : 1
Significance:
The quick ratio/acid test ratio is very useful in measuring the liquidity position of a firm. It
measures the firm's capacity to pay off current obligations immediately and is more rigorous
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test of liquidity than the current ratio. It is used as a complementary ratio to the current
ratio. Liquid ratio is more rigorous test of liquidity than the current ratio because it
eliminates inventories and prepaid expenses as a part of current assets. Usually a high
liquid ratios an indication that the firm is liquid and has the ability to meet its current or
liquid liabilities in time and on the other hand a low liquidity ratio represents that the firm's
liquidity position is not good. As a convention, generally, a quick ratio of "one to one" (1:1)
is considered to be satisfactory.
Although liquidity ratio is more rigorous test of liquidity than the current ratio , yet it should
be used cautiously and 1:1 standard should not be used blindly. A liquid ratio of 1:1 does
not necessarily mean satisfactory liquidity position of the firm if all the debtors cannot be
realized and cash is needed immediately to meet the current obligations. In the same
manner, a low liquid ratio does not necessarily mean a bad liquidity position as inventories
are not absolutely non-liquid. Hence, a firm having a high liquidity ratio may not have a
satisfactory liquidity position if it has slow-paying debtors. On the other hand, A firm having
a low liquid ratio may have a good liquidity position if it has a fast moving inventories.
Though this ratio is definitely an improvement over current ratio, the interpretation of this
ratio also suffers from the same limitations as of current ratio.
Absolute Liquid Ratio:
Absolute liquidity is represented by cash and near cash items. It is a ratio of absolute
liquid assets to current liabilities. In the computation of this ratio only the absolute liquid
assets are compared with the liquid liabilities. The absolute liquid assets are cash, bank and
marketable securities. It is to be observed that receivables (debtors/accounts receivables
and bills receivables) are eliminated from the list of liquid assets in order to obtain
absolute4 liquid assets since there may be some doubt in their liquidity.
Formula of Absolute Liquid Ratio:
Absolute Liquid Ratio = Absolute Liquid Assets / Current Assets
This ratio gains much significance only when it is used in conjunction with the current and
liquid ratios. A standard of 0.5 : 1 absolute liquidity ratio is considered an acceptable norm.
That is, from the point of view of absolute liquidity, fifty cents worth of absolute liquid
assets are considered sufficient for one dollar worth of liquid liabilities. However, this ratio is
not in much use.
Chapter 7: Current Assets Movement, Efficiency or Activity
Ratios:
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Inventory Turnover Ratio or Stock Turnover Ratio (ITR):
Every firm has to maintain a certain level of inventory of finished goods so as to be able to
meet the requirements of the business. But the level of inventory should neither be too high
nor too low.
A too high inventory means higher carrying costs and higher risk of stocks becoming
obsolete whereas too low inventory may mean the loss of business opportunities. It is very
essential to keep sufficient stock in business.
Contents:
1.
2.
3.
4.
5.
Definition of Inventory Turnover Ratio (ITR)
Components of the Ratio
Formula of Stock Turnover or Inventory Turnover Ratio
Example
Significance of ITR
Definition:
Stock turn over ratio and inventory turn over ratio are the same. This ratio is a
relationship between the cost of goods sold during a particular period of time and the cost of
average inventory during a particular period. It is expressed in number of times. Stock turn
over ratio/Inventory turn over ratio indicates the number of time the stock has been turned
over during the period and evaluates the efficiency with which a firm is able to manage its
inventory. This ratio indicates whether investment in stock is within proper limit or not.
Components of the Ratio:
Average inventory and cost of goods sold are the two elements of this ratio. Average
inventory is calculated by adding the stock in the beginning and at the and of the period and
dividing it by two. In case of monthly balances of stock, all the monthly balances are added
and the total is divided by the number of months for which the average is calculated.
Formula of Stock Turnover/Inventory Turnover Ratio:
The ratio is calculated by dividing the cost of goods sold by the amount of average stock at
cost.
(a) [Inventory Turnover Ratio = Cost of goods sold / Average inventory at cost]
Generally, the cost of goods sold may not be known from the published financial
statements. In such circumstances, the inventory turnover ratio may be calculated by
dividing net sales by average inventory at cost. If average inventory at cost is not known
then inventory at selling price may be taken as the denominator and where the opening
inventory is also not known the closing inventory figure may be taken as the average
inventory.
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(b) [Inventory Turnover Ratio = Net Sales / Average Inventory at Cost]
(c) [Inventory Turnover Ratio = Net Sales / Average inventory at Selling Price]
(d) [Inventory Turnover Ratio = Net Sales / Inventory]
Example:
The cost of goods sold is $500,000. The opening stock is $40,000 and the closing stock is
$60,000 (at cost).
Calculate inventory turnover ratio
Calculation:
Inventory Turnover Ratio (ITR) = 500,000 / 50,000*
= 10 times
This means that an average one dollar invested in stock will turn into ten times in sales
*($40,000 + $60,000) / 2
= $50,000
Significance of ITR:
Inventory turnover ratio measures the velocity of conversion of stock into sales. Usually a
high inventory turnover/stock velocity indicates efficient management of inventory because
more frequently the stocks are sold, the lesser amount of money is required to finance the
inventory. A low inventory turnover ratio indicates an inefficient management of inventory.
A low inventory turnover implies over-investment in inventories, dull business, poor quality
of goods, stock accumulation, accumulation of obsolete and slow moving goods and low
profits as compared to total investment. The inventory turnover ratio is also an index of
profitability, where a high ratio signifies more profit, a low ratio signifies low profit.
Sometimes, a high inventory turnover ratio may not be accompanied by relatively a high
profits. Similarly a high turnover ratio may be due to under-investment in inventories.
It may also be mentioned here that there are no rule of thumb or standard for interpreting
the inventory turnover ratio. The norms may be different for different firms depending upon
the nature of industry and business conditions. However the study of the comparative or
trend analysis of inventory turnover is still useful for financial analysis.
Debtors Turnover Ratio | Accounts Receivable Turnover Ratio:
A concern may sell goods on cash as well as on credit. Credit is one of the important
elements of sales promotion. The volume of sales can be increased by following a liberal
credit policy.
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The effect of a liberal credit policy may result in tying up substantial funds of a firm in the
form of trade debtors (or receivables). Trade debtors are expected to be converted into
cash within a short period of time and are included in current assets. Hence, the liquidity
position of concern to pay its short term obligations in time depends upon the quality of its
trade debtors.
Definition:
Debtors turnover ratio or accounts receivable turnover ratio indicates the velocity of
debt collection of a firm. In simple words it indicates the number of times average debtors
(receivable) are turned over during a year.
Formula of Debtors Turnover Ratio:
Debtors Turnover Ratio = Net Credit Sales / Average Trade Debtors
The two basic components of accounts receivable turnover ratio are net credit annual sales
and average trade debtors. The trade debtors for the purpose of this ratio include the
amount of Trade Debtors & Bills Receivables. The average receivables are found by adding
the opening receivables and closing balance of receivables and dividing the total by two. It
should be noted that provision for bad and doubtful debts should not be deducted since this
may give an impression that some amount of receivables has been collected. But when the
information about opening and closing balances of trade debtors and credit sales is not
available, then the debtors turnover ratio can be calculated by dividing the total sales by the
balance of debtors (inclusive of bills receivables) given. and formula can be written as
follows.
Debtors Turnover Ratio = Total Sales / Debtors
Example:
Credit sales $25,000; Return inwards $1,000; Debtors $3,000; Bills Receivables $1,000.
Calculate debtors turnover ratio
Calculation:
Debtors Turnover Ratio = Net Credit Sales / Average Trade Debtors
= 24,000* / 4,000**
= 6 Times
*25000 less 1000 return inwards, **3000 plus 1000 B/R
Significance of the Ratio:
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Accounts receivable turnover ratio or debtors turnover ratio indicates the number of times
the debtors are turned over a year. The higher the value of debtors turnover the more
efficient is the management of debtors or more liquid the debtors are. Similarly, low debtors
turnover ratio implies inefficient management of debtors or less liquid debtors. It is the
reliable measure of the time of cash flow from credit sales. There is no rule of thumb which
may be used as a norm to interpret the ratio as it may be different from firm to firm.
Average Collection Period Ratio:
Definition:
The Debtors/Receivable Turnover ratio when calculated in terms of days is known as
Average Collection Period or Debtors Collection Period Ratio.
The average collection period ratio represents the average number of days for which a firm
has to wait before its debtors are converted into cash.
Formula of Average Collection Period:
Following formula is used to calculate average collection period:
(Trade Debtors × No. of Working Days) / Net Credit Sales
Example:
Credit sales $25,000; Return inwards $1,000; Debtors $3,000; Bills Receivables $1,000.
Calculate average collection period.
Calculation:
Average collection period can be calculated as follows:
Average Collection Period = (Trade Debtors × No. of Working Days) / Net Credit Sales
4,000* × 360** / 24,000
= 60 Days
* Debtors and bills receivables are added.
**For calculating this ratio usually the number of working days in a year are assumed to be 360.
Significance of the Ratio:
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This ratio measures the quality of debtors. A short collection period implies prompt payment
by debtors. It reduces the chances of bad debts. Similarly, a longer collection period implies
too liberal and inefficient credit collection performance. It is difficult to provide a standard
collection period of debtors.
Creditors / Accounts Payable Turnover Ratio:
Definition and Explanation:
This ratio is similar to the debtors turnover ratio. It compares creditors with the total credit
purchases.
It signifies the credit period enjoyed by the firm in paying creditors. Accounts payable
include both sundry creditors and bills payable. Same as debtors turnover ratio, creditors
turnover ratio can be calculated in two forms, creditors turnover ratio and average
payment period.
Formula:
Following formula is used to calculate creditors turnover ratio:
Creditors Turnover Ratio = Credit Purchase / Average Trade Creditors
Average Payment Period:
Average payment period ratio gives the average credit period enjoyed from the
creditors. It can be calculated using the following formula:
Average Payment Period = Trade Creditors / Average Daily Credit Purchase
Average Daily Credit Purchase= Credit Purchase / No. of working days in a year
Or
Average Payment Period = (Trade Creditors × No. of Working Days) / Net Credit Purchase
(In case information about credit purchase is not available total purchases may be assumed
to be credit purchase.)
Significance of the Ratio:
The average payment period ratio represents the number of days by the firm to pay its
creditors. A high creditors turnover ratio or a lower credit period ratio signifies that the
creditors are being paid promptly. This situation enhances the credit worthiness of the
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company. However a very favorable ratio to this effect also shows that the business is not
taking the full advantage of credit facilities allowed by the creditors.
Working Capital Turnover Ratio:
Definition:
Working capital turnover ratio indicates the velocity of the utilization of net working
capital.
This ratio represents the number of times the working capital is turned over in the course of
year and is calculated as follows:
Formula of Working Capital Turnover Ratio:
Following formula is used to calculate working capital turnover ratio
Working Capital Turnover Ratio = Cost of Sales / Net Working Capital
The two components of the ratio are cost of sales and the net working capital. If the
information about cost of sales is not available the figure of sales may be taken as the
numerator. Net working capital is found by deduction from the total of the current assets
the total of the current liabilities.
Example:
Cash
Bills Receivables
Sundry Debtors
Stock
Sundry Creditors
Cost of sales
10,000
5,000
25,000
20,000
30,000
150,000
Calculate working capital turnover ratio
Calculation:
Working Capital Turnover Ratio = Cost of Sales / Net Working Capital
Current Assets = $10,000 + $5,000 + $25,000 + $20,000 = $60,000
Current Liabilities = $30,000
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Net Working Capital = Current assets – Current liabilities
= $60,000 − $30,000
= $30,000
So the working Capital Turnover Ratio = 150,000 / 30,000
= 5 times
Significance:
The working capital turnover ratio measure the efficiency with which the working capital is
being used by a firm. A high ratio indicates efficient utilization of working capital and a low
ratio indicates otherwise. But a very high working capital turnover ratio may also mean lack
of sufficient working capital which is not a good situation.
Fixed Assets Turnover Ratio:
Definition:
Fixed assets turnover ratio is also known as sales to fixed assets ratio. This ratio measures
the efficiency and profit earning capacity of the concern.
Higher the ratio, greater is the intensive utilization of fixed assets. Lower ratio means
under-utilization of fixed assets. The ratio is calculated by using following formula:
Formula of Fixed Assets Turnover Ratio:
Fixed assets turnover ratio turnover ratio is calculated by the following formula:
Fixed Assets Turnover Ratio = Cost of Sales / Net Fixed Assets
Over and Under Trading:
Over Trading:
Over-trading and under-trading are facets of over and under-capitalization. Over
trading is a curse to the business.
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A company which is under-capitalized will try to do too much with the limited amount of
capital which it has. For example it may not maintain proper stock of stock. Also it may not
extend much credit to customers and may insist only on cash basis sales. It may also not
pay the creditors on time. One can detect cases of overtrading by computing the current
ratio and the various turnover ratios. The current ratio is likely to be very low and turn over
ratios are likely to be very higher than normally in the industry concerned.
Under Trading:
Under-trading is the reverse of over-trading. It means keeping funds idle and not using
them properly. This is due to the under employment of assets of the business, leading to
the fall of sales and results in financial crises. This makes the business unable to meet its
commitments and ultimately leads to forced liquidation. The symptoms in this case would be
a very high current ratio and very low turnover ratio. Under-trading is an aspect of overcapitalization and leads to low profit.
Chapter: 8 Analysis of Long Term Solvency:
Debt to Equity Ratio:
Definition:
Debt-to-Equity ratio indicates the relationship between the external equities or outsiders
funds and the internal equities or shareholders funds.
It is also known as external internal equity ratio. It is determined to ascertain soundness
of the long term financial policies of the company.
Formula of Debt to Equity Ratio:
Following formula is used to calculate debt to equity ratio
[Debt Equity Ratio = External Equities / Internal Equities]
Or
[Outsiders funds / Shareholders funds]
As a long term financial ratio it may be calculated as follows:
[Total Long Term Debts / Total Long Term Funds]
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Or
[Total Long Term Debts / Shareholders Funds]
Components:
The two basic components of debt to equity ratio are outsiders funds i.e. external equities
and share holders funds, i.e., internal equities. The outsiders funds include all debts /
liabilities to outsiders, whether long term or short term or whether in the form of
debentures, bonds, mortgages or bills. The shareholders funds consist of equity share
capital, preference share capital, capital reserves, revenue reserves, and reserves
representing accumulated profits and surpluses like reserves for contingencies, sinking
funds, etc. The accumulated losses and deferred expenses, if any, should be deducted from
the total to find out shareholder's funds
Some writers are of the view that current liabilities do not reflect long term commitments
and they should be excluded from outsider's funds. There are some other writers who
suggest that current liabilities should also be included in the outsider's funds to calculate
debt equity ratio for the reason that like long term borrowings, current liabilities also
represents firm's obligations to outsiders and they are an important determinant of risk.
However, we advise that to calculate debt equity ratio current liabilities should be included
in outsider's funds. The ratio calculated on the basis outsider's funds excluding liabilities
may be termed as ratio of long-term debt to share holders funds.
Example:
From the following figures calculate debt to equity ratio:
Equity share capital
Capital reserve
Profit and loss account
6% debentures
Sundry creditors
Bills payable
Provision for taxation
Outstanding creditors
1,100,000
500,000
200,000
500,000
240,000
120,000
180,000
160,000
Required: Calculate debt to equity ratio.
Calculation:
External Equities / Internal Equities
= 1,200,000 / 18,000,000
= 0.66 or 4 : 6
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It means that for every four dollars worth of the creditors investment the shareholders have
invested six dollars. That is external debts are equal to 0.66% of shareholders funds.
Significance of Debt to Equity Ratio:
Debt to equity ratio indicates the proportionate claims of owners and the outsiders against
the firms assets. The purpose is to get an idea of the cushion available to outsiders on the
liquidation of the firm. However, the interpretation of the ratio depends upon the financial
and business policy of the company. The owners want to do the business with maximum of
outsider's funds in order to take lesser risk of their investment and to increase their
earnings (per share) by paying a lower fixed rate of interest to outsiders. The outsiders
creditors) on the other hand, want that shareholders (owners) should invest and risk their
share of proportionate investments. A ratio of 1:1 is usually considered to be satisfactory
ratio although there cannot be rule of thumb or standard norm for all types of businesses.
Theoretically if the owners interests are greater than that of creditors, the financial position
is highly solvent. In analysis of the long-term financial position it enjoys the same
importance as the current ratio in the analysis of the short-term financial position.
Proprietary Ratio or Equity Ratio:
Definition:
This is a variant of the debt-to-equity ratio. It is also known as equity ratio or net worth to
total assets ratio.
This ratio relates the shareholder's funds to total assets. Proprietary / Equity ratio
indicates the long-term or future solvency position of the business.
Formula of Proprietary/Equity Ratio:
Proprietary or Equity Ratio = Shareholders funds / Total Assets
Components:
Shareholder's funds include equity share capital plus all reserves and surpluses items. Total
assets include all assets, including Goodwill. Some authors exclude goodwill from total
assets. In that case the total shareholder's funds are to be divided by total tangible assets.
As the total assets are always equal to total liabilities., the total liabilities, may also be used
as the denominator in the above formula.
Example:
Share holders funds are $1,800,000 and the total assets, which are equal to total liabilities
are $3,000,000.
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Calculate proprietary ratio or Equity ratio.
Calculation:
Proprietary or Equity Ratio = 1,800,000 / 3,000,000
This means that out of every $1 employed in the business, shareholders contribution is
about 60 cents. Accordingly, the creditors contribution would be the remaining 40 cents.
Significance:
This ratio throws light on the general financial strength of the company. It is also regarded
as a test of the soundness of the capital structure. Higher the ratio or the share of
shareholders in the total capital of the company, better is the long-term solvency position of
the company. A low proprietary ratio will include greater risk to the creditors.
This ratio may be further analyzed into the following two ratios:
1. Ratio of fixed assets to shareholders/proprietors' funds
2. Ratio of current assets to shareholders/proprietors' funds
Fixed Assets to Proprietor's Fund Ratio:
Definition:
Fixed assets to proprietor's fund ratio establishes the relationship between fixed assets
and shareholders funds.
The purpose of this ratio is to indicate the percentage of the owner's funds invested in fixed
assets.
Formula:
Fixed Assets to Proprietors Fund = Fixed Assets / Proprietors Fund
The fixed assets are considered at their book value and the proprietor's funds consist of the
same items as internal equities in the case of debt equity ratio.
Example:
Suppose the depreciated book value of fixed assets is $ 36,000 and proprietor's funds are
48,000 the relevant ratio would be calculated as follows:
Fixed assets to proprietor's fund = 36,000 / 48,000
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= 0.75 or 0.75 : 1
Significance:
The ratio of fixed assets to net worth indicates the extent to which shareholder's funds are
sunk into the fixed assets. Generally, the purchase of fixed assets should be financed by
shareholder's equity including reserves, surpluses and retained earnings. If the ratio is less
than 100%, it implies that owners funds are more than fixed assets and a part of the
working capital is provide by the shareholders. When the ratio is more than the 100%, it
implies that owners funds are not sufficient to finance the fixed assets and the firm has to
depend upon outsiders to finance the fixed assets. There is no rule of thumb to interpret
this ratio by 60 to 65 percent is considered to be a satisfactory ratio in case of industrial
undertakings
Current Assets to Proprietor's Fund Ratio:
Current Assets to Proprietors' Fund Ratio establishes the relationship between current
assets and shareholder's funds.
The purpose of this ratio is to calculate the percentage of shareholders funds invested in
current assets.
Formula:
Current Assets to Proprietors Funds = Current Assets / Proprietor's Funds
Example:
This may be expressed either as a percentage , or as a proportion. To illustrate, if the value
of current assets is $36,000 and the proprietors funds are $180,000 the relevant ratio
would be calculated as follows:
Current Assets to Proprietors Funds = 36,000 / 180,000
= 0.2
This may also be expressed as 20%. It means that 20% of the proprietors funds have been
invested in current assets.
Significance:
Different industries have different norms and therefore, this ratio should be studied carefully
taking the history of industrial concern into consideration before relying too much on this
ratio.
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Debt Service Ratio or Interest Coverage Ratio:
Definition:
Interest coverage ratio is also known as debt service ratio or debt service coverage
ratio.
This ratio relates the fixed interest charges to the income earned by the business. It
indicates whether the business has earned sufficient profits to pay periodically the interest
charges. It is calculated by using the following formula.
Formula of Debt Service Ratio or interest coverage ratio :
Interest Coverage Ratio = Net Profit Before Interest and Tax / Fixed Interest Charges
Example:
If the net profit (after taxes) of a firm is $75,000 and its fixed interest charges on long-term
borrowings are $10,000. The rate of income tax is 50%.
Calculate debt service ratio / interest coverage ratio
Calculation:
Interest Coverage Ratio = (75,000* + 75,000* + 10,000) / 10,000
= 16 times
*Income after interest is $7,5000 + income tax $75,000
Significance of debt service ratio:
The interest coverage ratio is very important from the lender's point of view. It indicates
the number of times interest is covered by the profits available to pay interest charges.
It is an index of the financial strength of an enterprise. A high debt service ratio or interest
coverage ratio assures the lenders a regular and periodical interest income. But the
weakness of the ratio may create some problems to the financial manager in raising funds
from debt sources.
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Capital Gearing Ratio:
Definition and Explanation:
Closely related to solvency ratio is the capital gearing ratio. Capital gearing ratio is mainly
used to analyze the capital structure of a company.
The term capital structure refers to the relationship between the various long-term form of
financing such as debentures, preference and equity share capital including reserves and
surpluses. Leverage of capital structure ratios are calculated to test the long-term financial
position of a firm.
The term "capital gearing" or "leverage" normally refers to the proportion of relationship
between equity share capital including reserves and surpluses to preference share capital
and other fixed interest bearing funds or loans. In other words it is the proportion between
the fixed interest or dividend bearing funds and non fixed interest or dividend bearing funds.
Equity share capital includes equity share capital and all reserves and surpluses items that
belong to shareholders. Fixed interest bearing funds includes debentures, preference share
capital and other long-term loans.
Formula of capital gearing ratio:
[Capital Gearing Ratio = Equity Share Capital / Fixed Interest Bearing Funds]
Example:
Calculate capital gearing ratio from the following data:
Equity Share Capital
Reserves & Surplus
Long Term Loans
6% Debentures
1991
1992
500,000
300,000
250,000
250,000
400,000
200,000
300,000
400,000
Calculation:
Capital Gearing Ratio 1992 = (500,000 + 300,000) / (250,000 + 250,000)
= 8 : 5 (Low Gear)
1993 = (400,000 + 200,000) / (300,000 + 400,000)
6 : 7 (High Gear)
It may be noted that gearing is an inverse ratio to the equity share capital.
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Highly Geared------------Low Equity Share Capital
Low Geared---------------High Equity Share Capital
Significance of the ratio:
Capital gearing ratio is important to the company and the prospective investors. It must be
carefully planned as it affects the company's capacity to maintain a uniform dividend policy
during difficult trading periods. It reveals the suitability of company's capitalization.
Over-capitalization and Under-capitalization:
The total amount of funds available to an undertaking should be neither too much nor too
low.
An important question, therefore is the question of capitalization of the company, i.e., the
determination of the amount which the company should have at least its disposal. The total
amount of long term funds available to the company, therefore, is the capitalization of the
company.
Under-Capitalization:
Definition and Explanation of Under Capitalization:
If the owned capital of the business is much less than the total borrowed capital than it is a
sign of under capitalization. This means that the owned capital of the company is
disproportionate to the scale of its operation and the business is dependent upon borrowed
money and trade creditors. Under-capitalization may be the result of over-trading. It must
be distinguished from high gearing. Incase of capital gearing there is a comparison between
equity capital and fixed interest bearing capital (which includes reference share capital also
and excludes trade creditors) whereas in the case of under capitalization, comparison is
made between total owned capital (both equity and preference share capital) and total
borrowed capital (which includes trade creditors also). Under capitalization is indicated by:



Low proprietary Ratio
Current Ratio
High Return on Equity Capital
The effects of under capitalization may be:
1. Payment of excessive interest on borrowed capital.
2. Use of old and out of date equipment because of inability to purchase new plant etc.
3. High cost of production because of the use of old machinery
Over-Capitalization:
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Definition and Explanation of Over Capitalization:
A concern is said to be over-capitalized if its earnings are not sufficient to justify a fair
return on the amount of share capital and debentures that have been issued. It is said to be
over capitalized when total of owned and borrowed capital exceeds its fixed and current
assets i.e. when it shows accumulated losses on the assets side of the balance sheet.
An over capitalized company can be like a very fat person who cannot carry his weight
properly. Such a person is prone to many diseases and is certainly not likely to be
sufficiently active. Unless the condition of overcapitalization is corrected, the company may
find itself in great difficulties.
Causes of Over Capitalization:
Some of the important reasons of over-capitalization are:
1. Idle funds: The company may have such an amount of funds that it cannot use them
properly. Money may be living idle in banks or in the form of low yield investments.
2. Over-valuation: The fixed assets, especially good will, may have been acquired at a
cost much higher than that warranted by the services which that asset could render.
3. Fall in value: Fixed assets may have been acquired at a time when prices were high.
with the passage of time prices may have been fallen so that the real value of the
asset may also have come down substantially even though in the balance sheet the
assets are being being shown at book value less depreciation written off. Then the
book values will be much more than the economic value.
4. Inadequate depreciation provision: Adequate provision may not have been provided
on the fixed assets with the result the profits shown by books may have been
distributed as dividend, leaving no funds with which to replace the assets at the
proper time.
Remedies:
Over-capitalization can be remedied by reducing its capital so as to obtain a satisfactory
relationship between proprietors funds and net profit. In case over-capitalization is the
result of over-valuation of assets then it can be remedied by bringing down the values of
assets to their proper values.
Financial-Accounting-Ratios Formulas:
This is a collection of financial ratio formulas which can help you calculate financial ratios in
a given problem.
Analysis of Profitability:
General profitability:

Gross profit ratio = (Gross profit / Net sales) × 100
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


Operating ratio = (Operating cost / Net sales) × 100
Expense ratio = (Particular expense / Net sales) × 100
Operating profit ratio = (Operating profit / Net sales) × 100
Overall profitability:







Return on shareholders' investment or net worth = Net profit after interest and tax /
Shareholders' funds
Return on equity capital = (Net profit after tax – Preference dividend) / Paid up
equity capital
Earnings per share (EPS) ratio = (Net profit after tax – Preference dividend) /
Number of equity shares
Return on gross capital employed = (Adjusted net profit / Gross capital employed) ×
100
Return on net capital employed = (Adjusted net profit / Net capital employed) × 100
Dividend yield ratio = Dividend per share / Market value per share
Dividend payout ratio or pay-out ratio = Dividend per equity share / Earnings per
share
Short Term Financial Position or Test of Solvency:



Current ratio = Current assets / Current liabilities
Quick or acid test of liquid ratio (for immediate solvency) = Liquid assets / Current
liabilities
Absolute liquid ratio = Absolute liquid assets / Current liabilities
Current Assets Movement, Efficiency or Activity Ratios:






Inventory / Stock turnover ratio = Cost of goods sold / Average inventory at cost
Debtors of receivables turnover ratios = Net credit sales / Average trade debtors
Average collection period = (Trade debtors No. of working days) / Net credit sales
Creditors or payables turnover ratio = Net credit purchase / Average trade creditors
Average payment period = (Trade creditors No. of working days) / Net credit
purchase
Working capital turnover ratio = Cost of sales / Net working capital
Analysis of Long Term Solvency:







Debt to equity ratio = Outsiders funds / Shareholders funds or External funds /
Internal funds
Ratio of long term debt to shareholders funds (Debt equity) = Long term debt /
Shareholders funds
Proprietary of equity ratio = Shareholders funds / Total assets
Fixed assets to net worth = Fixed assets after depreciation / Shareholders' funds
Fixed assets ratio or fixed assets to long term funds = Fixed assets after depreciation
/ Total long term funds
Ratio of current assets proprietors' funds = Current assets / Shareholders' funds
Debt service or interest coverage ratio = Net profit before interest and tax / Fixed
interest charges
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
Capital gearing ratio = Equity share capital / Fixed interest bearing funds
Limitations of Financial Statement Analysis:
Although financial statement analysis is highly useful tool, it has two limitations. These two
limitations involve the comparability of financial data between companies and the need to
look beyond ratios.
Financial-Accounting-Ratios Formulas:
This is a collection of financial ratio formulas which can help you calculate financial ratios in
a given problem.
Analysis of Profitability:
General profitability:




Gross profit ratio = (Gross profit / Net sales) × 100
Operating ratio = (Operating cost / Net sales) × 100
Expense ratio = (Particular expense / Net sales) × 100
Operating profit ratio = (Operating profit / Net sales) × 100
Overall profitability:







Return on shareholders' investment or net worth = Net profit after interest and tax /
Shareholders' funds
Return on equity capital = (Net profit after tax – Preference dividend) / Paid up
equity capital
Earnings per share (EPS) ratio = (Net profit after tax – Preference dividend) /
Number of equity shares
Return on gross capital employed = (Adjusted net profit / Gross capital employed) ×
100
Return on net capital employed = (Adjusted net profit / Net capital employed) × 100
Dividend yield ratio = Dividend per share / Market value per share
Dividend payout ratio or pay-out ratio = Dividend per equity share / Earnings per
share
Short Term Financial Position or Test of Solvency:


Current ratio = Current assets / Current liabilities
Quick or acid test of liquid ratio (for immediate solvency) = Liquid assets / Current
liabilities
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
Absolute liquid ratio = Absolute liquid assets / Current liabilities
Current Assets Movement, Efficiency or Activity Ratios:






Inventory / Stock turnover ratio = Cost of goods sold / Average inventory at cost
Debtors of receivables turnover ratios = Net credit sales / Average trade debtors
Average collection period = (Trade debtors No. of working days) / Net credit sales
Creditors or payables turnover ratio = Net credit purchase / Average trade creditors
Average payment period = (Trade creditors No. of working days) / Net credit
purchase
Working capital turnover ratio = Cost of sales / Net working capital
Analysis of Long Term Solvency:








Debt to equity ratio = Outsiders funds / Shareholders funds or External funds /
Internal funds
Ratio of long term debt to shareholders funds (Debt equity) = Long term debt /
Shareholders funds
Proprietary of equity ratio = Shareholders funds / Total assets
Fixed assets to net worth = Fixed assets after depreciation / Shareholders' funds
Fixed assets ratio or fixed assets to long term funds = Fixed assets after depreciation
/ Total long term funds
Ratio of current assets proprietors' funds = Current assets / Shareholders' funds
Debt service or interest coverage ratio = Net profit before interest and tax / Fixed
interest charges
Capital gearing ratio = Equity share capital / Fixed interest bearing funds
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