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UNIT V

CHAPTER 13:FINANCIAL RATIOS

LESSON 34:FINANCIAL RATIOS

Learning Objectives• To understand what ratio means and the significance of

ratios to different categories of people• To learn various classifications of ratios and computation of

the same.

IntroductionFinancial Analysis can be undertaken by the management orowners of the firm, or by external people viz., creditors,investors and others. The nature of analysis and ratios useddepend upon the perspective / need of the person computingthe ratios.

Sl. No.

Analysed by Area of Interest

Area of Finance

1 Trade Creditors Firm’s ability to meet short term claims

Liquidity Position

2 Lenders of the Long term debt

-Firm’s ability to pay

interest and repay

principal amount

-Relationship between

various sources of funds -Future

Solvency and Profitability

-Long-term Solvency

-Consistency in Profitability

-Capital Structure

Relationships -Projected Financial

Statements

3 Investors Steady growth in earnings

-Present & future

profitability -Influence of

financial structure

on earning ability

and risk

4 Management Most effective & efficient use

of the resources and

sound financial condition

Every aspect of financial analysis

Meaning of RatioThe term Ratio refers to the numerical or quantitative relation-ship between two related items / variables / accounting figures.

Ratios help to make qualitative judgement. Ratios may beexpress asi. Proportion of numbers e.g. 2:1; orii. A ‘Rate’ or ‘Time’ e.g. 2 times; oriii. Percentages e.g. 200%; oriv. Fraction or Quotient / decimal e.g. 2/3 or 0.667Ratio analysis makes related information comparable. Ratios arehelpful in ascertaining the financial condition of the firm,strengths and weaknesses of the firm.A single ratio like an absolute figure is not of much use. Ratiosneed to be compared –a. Over a period of time i.e. trend or time series analysisb. With competitors, industry standards, selected firms of the

industry (Cross-sectional analysis)c. Rule of thumbFollowing are the steps involved in Ratio Analysis:i. Determination of the objective of the analysisii. Selection of relevant data from the financial statementsiii. Comparison of ratios computed for different points of time

or comparison with firms of the same industry (inter-firmcomparison) etc.

iv. Interpretation of the ratios

Types / Classification of RatiosTraditionally ratios are classified based on statement/s usedi. Balance Sheet Ratiosii. Profit & Loss a/c Ratiosiii. Composite or Mixed or Inter-statement ratiosHowever, Functional Classification leads to a more meaningfuldiscussion, understanding and analysisi. Liquidity Ratiosii. Activity or Efficiency or Performance or Turnover Ratiosiii. Profitability Ratiosiv. Leverage or Solvency / Capital Structure Ratios

i. Liquidity RatiosLiquidity Ratios measure the ability of the firm to meet current/ short-term obligations. They establish a relationship betweencash and other current assets to current obligations. A firmshould strike a proper balance between high liquidity with morecash balance (which means less profitability) and low liquidity(with problems of failure to meet obligations etc.)Liquidity Ratios include (i) Current Ratio, (ii) Liquid or AcidTest Ratio or Quick Ratio, (iii) Cash Ratio or Absolute LiquidRatio, (iv) Defensive-interval Ratio

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a. Current Ratio: Current Ratio establishes relationshipbetween the current assets and current liabilities andmeasures the ability of the firm to meet current liabilities.

Current Ratio = Current AssetsCurrent Liabilities

This ratio indicates the rupees of current assets available foreach rupee of current liability / obligation. The higher theratio, larger is the ability to meet current obligations andgreater is the safety of funds of short-term creditors.Depending upon the industry the ratio may vary between 1.5to 3.5 though the rule of thumb is 2.

b. Liquid Ratio or Acid Test Ratio or Quick Ratio: Liquid Ratiomeasures the ability to meet the current liabilities from thecurrent assets which are readily or quickly convertible intocash (Current Assets less Inventory & Pre-paid expenses).Inventory is not readily convertible into cash and hence to beexcluded.

Liquid Ratio = Liquid or Quick AssetsCurrent Liabilities

It is called Acid Test Ratio since it is more severe andstringent test. Rule of thumb is 1.

c. Cash Ratio / Absolute Liquid Ratio: Absolute LiquidAssets are considered here. Receivables have doubts abouttheir realisability in time and hence they are excluded here.

Cash & Bank Balances + Marketable SecuritiesCash Ratio= ——————————————————————

Current Liabilities

d. Defensive-internal RatioThis ratio measures the ability to meet projected dailyoperating expenditure

Liquid Assets Defensive-internal Ratio= ----------------------------------------- Projected daily cash requirements

Where,

Projected Cash Operating Expenditure Projected Daily Cash Requirement= ----------------------------------------------------- Number of days in the year

Projected Cash Operating Expenditure may be ascertained byadding Cost of goods sold + Selling & administrative andother cash expenses less depreciation & other non-cash expendi-ture. The resultant figure will be in number of days.

ii. Leverage / Capital Structure RatiosThe process of magnifying the shareholders’ return through theemployment of debt is called “Financial Leverage” or “Tradingon Equity”. These ratios are called as financial ratios also.Leverage Ratios which are used to ascertain long-term solvencyof a firm have two aspects:A. Debt Repaying capacity measured through Structural RatiosB. Interest paying capacity measured through Coverage Ratios

A. Structural RatiosThese ratios examine the soundness of the capital structure

a. Debt-Equity Ratio

This ratio indicates the relative proportions of debt and equityin financing & claims against the assets of the firm.

Debt Total Debt or Outsiders Funds or External Equities D/E Ratio = ---------- or -------------------------------------------------------------------

Equity Shareholders’ Equity or Net Worth or Internal Equities The Debt Equity Ratio may relate only Long-term debt, inwhich case the formula is as below:

Long-term DebtD/E Ratio = —————————

Shareholders’ Equityb. Debt to Total AssetsThe Proportion of the assets that are financed with debt isindicated by this ratio

Debt———————

Total Assetsc. Debt to Capitalization RatioThis is a link between the outsiders long-term debt andlong-term funds in the firm.

Debt Total Debt --------------------------------- or ---------------- Capital Employed Net Assets

(Total Debt + Net Worth) (Total Assets – Current Liabilities)

d. Proprietary RatioThe Proportion of Total Assets financed by owners isindicated by this ratio.

Net Worth——————

Total Assetse. Capital Gearing Ratio

Net Worth——————————————

Fixed income bearing funds(debentures, preference capital, loans)

B. Coverage RatiosThese Ratios measure the ability of the firm to cover or meetthe obligations of paying interest on its debt. They reflectthe ability of the firm to service the claims of long-termcreditors.a. Interest Coverage Ratio / Debt Service Ratio

It measures the debt servicing capacity of the firm.Earnings Before Interest & Taxes (EBIT)

Interest Coverage = ————————————————Interest

Since taxes are calculated after interest, the earnings beforetaxes is taken. Since the resultant figure gives the number oftimes interest covered by the EBIT, it is also known as‘Times interest earned ratio’.From the point of view of creditors, the larger the ratio,more assured is the payment of interest. For the firm a toohigh ratio means that the firm is too conservative in using

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debt and not using credit to the best advantage ofshareholders. On the contrary, low ratio is a dangerousindication of excessive debt and not able to assure paymentof interest to creditors.b. Total Cash Flow CoverageTotal Cash Flow Coverage Ratio is used for relating cashResources to the fixed financial obligations.

EBIT + Lease Payments + Depreciation + Non Cash Expenses—————————————————————————

Preference Dividend + Loan RepaymentInterest + Lease Payments + —————————————

1 – Tax Rate

Since only the after-tax earnings is available to repay principal,the principal repayment is converted to a before-tax basis bydividing it by 1 – Tax Rate.

iii. Activity or Efficiency or Turnover Ratios

The efficiency with which the assets are utilized or convertedinto sales, is evaluated with these ratios. The speed at whichassets are converted into sales, is reflected in these ratios.a. Inventory or Stock Turnover RatioInventory Turnover Ratio measures the velocity of the move-ment of goods. It measures the relationship between the Costof Goods Sold and the Inventory level.

Cost of Goods SoldInventory Turnover = —————————————

Average InventoryCost of goods sold = Opening stock + Purchases and Manu-facturing Cost - Closing Stock

Opening Stock + Closing StockAverage Inventory = ——————————————

2The average time taken for clearing the stocks is calculated asfollows:

Number of days in a yearInventory conversion period = ——————————

Inventory Turnover RatioGenerally, high inventory ratio implies good inventory manage-ment. But it may indicate under-investment which means lossof business opportunities. Similarly, a low inventory turnovermay be indicative of over-investment which is still worse evil.Hence what is required is the optimum inventory level.The Inventory Turnover Ratio can be extended to the compo-nents of inventory: (i) Raw materials and (ii) Work-in-progress.This may examine the efficiency with which the raw materials areconverted into work-in-progress and work-in-progress tofinished goods. Raw Materials inventory is related to MaterialsConsumed and work-in-progress to the Cost of GoodsManufactured.b. Debtors or (Accounts) Receivables Turnover Ratio and

Average Collection PeriodDebtors Turnover Ratio measures the efficiency at which thesales are converted into cash

Credit Sales Total SalesDebtors Turnover = —————— or ——————

Average Trade Debtors Debtors

Average Collection Period:

Average Collection Period represents the average number ofdays for which a firm has to wait for converting a receivable intocash.

Trade DebtorsAverage Collection Period = ——————————

Average Sales per day

SalesAverage Sales per day= —————————————

No. of days in a yearHence,

Trade Debtors————————— x No. of days in a year

SalesOR

No. of days in a year No. of days in a year Average Collection Period = -------------------------- or --------------------- Debtors Turnover Sales ------------------ Trade Debtors

To supplement the information, Ageing Schedule may be useto ascertain the quality of the trade debtors to identify the areasof problems in debtors.c. Assets Turnover RatiosAssets Turnover Ratios measure the efficiency of the assets ingenerating salsi. Total Assets TurnoverTo ascertain the ability to generate sales from all financialresources

Cost of Goods Sold or Sales———————————

Total Assetsii. Fixed and Current Assets Turnover RatioTo ascertain the adequacy of investment in fixed and currentassets

Cost of Goods Sold or SalesFixed Assets Turnover Ratio = ———————————

Fixed Assets

Cost of Goods Sold or SalesCurrent Assets Turnover Ratio = ——————————

Current Assetsiii. Working Capital Turnover Ratio

To ascertain the efficiency with which working capital isutilized in the business

Cost of Goods Sold or SalesWorking Capital Turnover Ratio = ——————————

Net Working Capital

iv. Profitability RatiosAll the stakeholders are interested in assessing theprofitability of a firm, more interested are the owners and

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the management. Profit is the final measure of performanceof a firm. Profit is the basic thing for survival and growth ofa business.Profitability Ratios can be related to sales as well asinvestments.

A. Profitability in relation to Sales

Profitability ratios can be related to Sales in respect of GrossProfit Margin, Net Profit Margin and Expenses.a. Gross Profit Margin to Sales ratio

Gross Profit Sales – Cost of Goods Sold Gross Profit Margin = ----------------- X 100 or --------------------------------- Sales Sales

High G/P ratio is a sign of good management and low G/Pratio is a cause of worry to unless there is improvement inmanaging.b. Net Profit Margin to Sales ratioNet Profit Margin ratio is calculated as below:

Net Profit after tax Net Profit Ratio = ----------------------- X 100 Sales

c. Expenses RatiosThese ratios establish relationship between various expensesand sales:i. Cost of Goods Sold Ratio

Cost of Goods Sold———————— X 100

Net Salesii. Administrative Expenses Ratio

Administrative Expenses————————— X 100

Net Salesiii. Selling & Distribution Expenses Ratio

Selling & Distribution Expenses———————————— X 100

Net Salesiv. Operating Ratio

Operating Cost Cost of Goods Sold + Operating Expenses ------------------- X 100 or --------------------------------------------------X 100

Net Sales Net Sales

B. Profitability in relation to InvestmentsThese ratios relate Profit to Investments. Return On Invest-ments (ROI) is related to three categories of Assets,Shareholders’ Equity / Funds and Capital Employed:a. Return on Assets

Net Profit After Taxes + Interest EBIT (1 – T) ROA = ----------------------------------------- or ---------------- Total Assets Total Assets

b. Return on Capital Employed (ROCE)

Net Profit after taxes ROCE = --------------------------------------------------- Capital Employed (Non Current Liabilities + Owners’ Equity)

c. Return to Shareholdersi. Return on Total Shareholders’ Equity

Net Profit after Tax——————————

Shareholders’ FundsShareholders’ Funds = Equity Share Capital + Preference ShareCapital + Reserves & Surplus – Accumulated losses, if any)ii. Return on Equity Capital (ROE)

Profit after tax – Preference DividendROE = —————————————————

Shareholders’ Equity or Net Worthiii. Earnings Per Share (EPS)EPS is the amount equity holders can get on every share held

Net Profit available to equity holders(Net Profit after tax – Preference Dividend)

EPS = ————————————————————Number of Equity Shares

iv. Dividend Per Share (DPS)The earnings distributed to the shareholders as cash dividends

Earnings paid to shareholdersDPS = ——————————————————

Number of Equity Sharesv. Dividend Payout Ratio

Dividend Per Share DPS Payout Ratio = ------------------------- or ------ Earnings Per Share EPS

Or

Total Dividend to Equity holders (Cash Dividend) ------------------------------------------------------ Total Net Profit belonging to Equity holders

vi. Earnings Yield and Dividend YieldThe yield is expressed in terms of the market value per share

EPS Earnings Yield = ----------------------------- (Earnings-Price Ratio) Market Value Per Share

DPS Dividend Yield = ------------------------------ Market Value Per Share

vii.Price-Earnings (P/E) RatioP/E Ratio assesses a firm/s performance as expected by theinvestors. It is the reciprocal of Earnings Yield or EarningsPrice Ratio.

Market Price Per ShareP/E Ratio = —————————————

Earnings Per Share

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viii. Market to Book Value RatioMarket Price Per Share————————Book Value Per Share

Points to Ponder• Du Pont analysis helps in understanding how the return on

total assets is influenced by the net profit margin and thetotal assets turnover ratio.

• Several ratios and indicators have been used in some kind ofa multivariate model in order to assess corporate excellence.

Review questions1. Discuss briefly how ratios help different people in making

financial decisions.2. What are the major classification of ratios? How these ratios

help in improving the financial performance of theorganization?

3. Determine sales of a firm with the following data:Current ratio = 1.8Acid-test ratio = 1.5Current liabilities = 7,50,000Inventory turnover ratio = 6 times

4. A firm’s current assets and current liabilities are 1,800 and1,250 respectively. How much can it borrow on a short termbasis without reducing the current ratio below 1.30.

Note