Financial Analysis:

ou have learnt about the financial statements

Y (Income Statement and Balance Sheet) of
companies. Basically, these are summarized
financial reports which provide the operating results
and financial position of companies, and the detailed
information contained therein is useful for assessing
the operational efficiency and financial soundness of
a company. This requires proper analysis and
interpretation of such information for which a
number of techniques (tools) have been developed by
financial experts. In this chapter we will have an
overview of these techniques.

4.1 Meaning of Analysis of Financial

LEARNING OBJECTIVES
Statements
After studying this
chapter, you will be able The process of critical evaluation of the financial
to : information contained in the financial statements in
• explain the nature and order to understand and make decisions regarding
significance of financial the operations of the firm is called ‘Financial
analysis; Statement Analysis’. It is basically a study of
• identify the objectives of
financial analysis; relationship among various financial facts and
• describe the various tools figures as given in a set of financial statements, and
of financial analysis; the interpretation thereof to gain an insight into the
• state the limitations of profitability and operational efficiency of the firm to
financial analysis;
• prepare comparative and
assess its financial health and future prospects.
common size statements The term ‘financial analysis’ includes both
and interpret the data ‘analysis and interpretation’. The term analysis
given therein; and means simplification of financial data by methodical
• calculate the trend
classification given in the financial statements.
percentages and interpret
Interpretation means explaining the meaning and
significance of the data. These two are
complimentary to each other. Analysis is useless
without interpretation, and interpretation without analysis is difficult or even
impossible.

Financial statement analysis is a judgmental process which aims to estimate current

and past financial positions and the results of the operation of an enterprise,
with primary objective of determining the best possible estimates and predictions
about the future conditions. It essentially involves regrouping and analysis of
information provided by financial statements to establish relationships and
throw light on the points of strengths and weaknesses of a business enterprise,
which can be useful in decision-making involving comparison with other firms (cross
sectional analysis) and with firms own performance, over a time period (time
series analysis).

4.2 Significance of Analysis of Financial Statements

Financial analysis is the process of identifying the financial strengths and
weaknesses of the firm by properly establishing relationships between the various
items of the balance sheet and the statement of profit and loss. Financial analysis
can be undertaken by management of the firm, or by parties outside the firm,
viz., owners, trade creditors, lenders, investors, labour unions, analysts and
others. The nature of analysis will differ depending on the purpose of the analyst.
A technique frequently used by an analyst need not necessarily serve the purpose
of other analysts because of the difference in the interests of the analysts.
Financial analysis is useful and significant to different users in the following
ways:
(a) Finance manager: Financial analysis focusses on the facts and
relationships related to managerial performance, corporate efficiency,
financial strengths and weaknesses and creditworthiness of the company.
A finance manager must be well-equipped with the different tools of
analysis to make rational decisions for the firm. The tools for analysis
help in studying accounting data so as to determine the continuity of the
operating policies, investment value of the business, credit ratings and
testing the efficiency of operations. The techniques are equally important in
the area of financial control, enabling the finance manager to make
constant reviews of the actual financial operations of the firm to analyses the
causes of major deviations, which may help in corrective action wherever
indicated.
(b) Top management: The importance of financial analysis is not limited to the
finance manager alone. It has a broad scope which includes top
management in general and other functional managers. Management of the
firm would be interested in every aspect of the financial analysis. It is
 their overall responsibility to see that the resources of the firm are used
most efficiently and that the firm’s financial condition is sound. Financial
analysis helps the management in measuring the success of the
company’s operations, appraising the individual’s performance and
evaluating the system of internal control.
(c) Trade payables: Trade payables, through an analysis of financial
statements, appraises not only the ability of the company to meet its
short-term obligations, but also judges the probability of its continued
ability to meet all its financial obligations in future. Trade payables are
particularly interested in the firm’s ability to meet their claims over a
very short period of time. Their analysis will, therefore, evaluate the firm’s
liquidity position.
(d) Lenders: Suppliers of long-term debt are concerned with the firm’s long-
term solvency and survival. They analyses the firm’s profitability over a
period of time, its ability to generate cash, to be able to pay interest and
repay the principal and the relationship between various sources of funds
(capital structure relationships). Long-term lenders analyses the historical
financial statements to assess its future solvency and profitability.
(e) Investors: Investors, who have invested their money in the firm’s shares, are
interested about the firm’s earnings. As such, they concentrate on the
analysis of the firm’s present and future profitability. They are also
interested in the firm’s capital structure to ascertain its influences on
firm’s earning and risk. They also evaluate the efficiency of the
management and determine whether a change is needed or not. However, in
some large companies, the shareholders’ interest is limited to decide
whether to buy, sell or hold the shares.
(f) Labour unions: Labour unions analyses the financial statements to assess
whether it can presently afford a wage increase and whether it can absorb a
wage increase through increased productivity or by raising the prices.
(g) Others: The economists, researchers, etc., analyses the financial statements
to study the present business and economic conditions. The government
agencies need it for price regulations, taxation and other similar purposes.

4.3 Objectives of Analysis of Financial Statements

Analysis of financial statements reveals important facts concerning managerial
performance and the efficiency of the firm. Broadly speaking, the objectives of the
analysis are to apprehend the information contained in financial statements with a
view to know the weaknesses and strengths of the firm and to make a forecast
about the future prospects of the firm thereby, enabling the analysts to take
decisions regarding the operation of, and further investment in the firm. To
be more specific, the analysis is undertaken to serve the following purposes
(objectives):
• to assess the current profitability and operational efficiency of the firm as
a whole as well as its different departments so as to judge the financial
health of the firm.
• to ascertain the relative importance of different components of the
financial position of the firm.
• to identify the reasons for change in the profitability/financial position
of the firm.
• to judge the ability of the firm to repay its debt and assessing the
short-term as well as the long-term liquidity position of the firm.
Through the analysis of financial statements of various firms, an economist can
judge the extent of concentration of economic power and pitfalls in the financial
policies pursued. The analysis also provides the basis for many governmental
actions relating to licensing, controls, fixing of prices, ceiling on profits, dividend
freeze, tax subsidy and other concessions to the corporate sector.

4.4 Tools of Analysis of Financial Statements

The most commonly used techniques of financial analysis are as follows:
1. Comparative Statements: These are the statements showing the
profitability and financial position of a firm for different periods of time in a
comparative form to give an idea about the position of two or more periods. It
usually applies to the two important financial statements, namely,
balance sheet and statement of profit and loss prepared in a comparative
form. The financial data will be comparative only when same accounting
principles are used in preparing these statements. If this is not the case, the
deviation in the use of accounting principles should be mentioned as a
footnote. Comparative figures indicate the trend and direction of financial
position and operating results. This analysis is also known as ‘horizontal
analysis’.
2. Common Size Statements: These are the statements which indicate the
relationship of different items of a financial statement with a common item by
expressing each item as a percentage of that common item. The
percentage thus calculated can be easily compared with the results of
corresponding percentages of the previous year or of some other firms, as the
numbers are brought to common base. Such statements also allow an analyst
to compare the operating and financing characteristics of two companies
of different sizes in the same industry. Thus, common size statements are
useful, both, in intra-firm comparisons over different years and also in making
inter-firm comparisons for the same year or for several years. This analysis is
also known as ‘Vertical analysis’.
3. Trend Analysis: It is a technique of studying the operational results and
financial position over a series of years. Using the previous years’ data of a
business enterprise, trend analysis can be done to observe the percentage
changes over time in the selected data. The trend percentage is the
percentage relationship, in which each item of different years bears to the
same item in the base year. Trend analysis is important because, with its long
run view, it may point to basic changes in the nature of the business. By
looking at a trend in a particular ratio, one may find whether the ratio is
falling, rising or remaining relatively constant. From this observation, a
problem is detected or the sign of good or poor management is detected.
4. Ratio Analysis: It describes the significant relationship which exists
between various items of a balance sheet and a statement of profit and loss
of a firm. As a technique of financial analysis, accounting ratios measure the
comparative significance of the individual items of the income and position
statements. It is possible to assess the profitability, solvency and efficiency of
an enterprise through the technique of ratio analysis.
5. Cash Flow Analysis: It refers to the analysis of actual movement of cash into
and out of an organization. The flow of cash into the business is called as cash
inflow or positive cash flow and the flow of cash out of the firm is called as
cash outflow or a negative cash flow. The difference between the inflow and
outflow of cash is the net cash flow. Cash flow statement is prepared to
project the manner in which the cash has been received and has been
utilized during an accounting year as it shows the sources of cash receipts
and also the purposes for which payments are made. Thus, it summarizes the
causes for the changes in cash position of a business enterprise between
dates of two balance sheets.
In this chapter, we shall have a brief idea about the first three techniques, viz.,
comparative statements, common size statements and trend analysis. The ratio
analysis and cash flow analysis is covered in detail in Chapters 5 and 6 respectively.
 4.5 Comparative Statements
As stated earlier, these statements refer to the statement of profit and loss and the balance sheet
prepared by providing columns for the figures for both the current year as well as for the previous
year and for the changes during the year, both in absolute and relative terms. As a result, it is possible
to find out not only the balances of accounts as on different dates and summaries of different
operational activities of different periods, but also the extent of their increase or decrease between
these dates. The figures in the comparative statements can be used for identifying the direction of
changes and also the trends in different indicators of performance of an organization.
The following steps may be followed to prepare the comparative statements: Step 1: List out
absolute figures in rupees relating to two points of time (as shown in columns 2 and 3 of Exhibit 4.1).
Step 2: Find out change in absolute figures by subtracting the first year (Col.2) from the second year
(Col.3) and indicate the change as increase (+) or decrease (–) and put it in column 4.
Step 3: Preferably, also calculate the percentage change as follows and put it in column 5.

Particulars First Year Second Year Absolute Percentage

Increase (+) or Increase (+)
Decrease (–) or Decrease (–)
1 2 3 4 5
Rs. Rs. Rs. %.

.
 Particulars Note No. Previ Current Absolute Percentage
ous Year Increase/ Increase/
Yea Decrease Decrease
1 2 3 4 5 6
A B C=A-B D= C /A x 1yy
I.Equity and Liabilities: -
1. Shareholder’s
Funds : ----- ----- ----- -----
(a) Share Capital ----- ----- ----- -----
(b) Reserve &
Surplus 2. Non-Current ----- ----- ----- -----
Liabilities: ----- ----- ----- -----
(a) Long Term Borrowings ----- ----- ----- -----
(b) Long Term Provisions
(c) Other Long Term ----- ----- ----- -----
Liabilities 3. Current ----- ----- ----- -----
Liabilities: ----- ----- ----- -----
(a) Short Term Borrowings ----- ----- ----- -----
Total ……………………………. ----- ----- ----- -----
II. Assets: -
1.Non-Current Assets:
(a) Fixed Assets:
i] Tangible ----- ----- ----- -----
Assets ii] ----- ----- ----- -----
Intangible Assets ----- ----- ----- -----
iii] Capital work in progress ----- ----- ----- -----
(b) Non-Current Investments ----- ----- ----- -----
(c) Long Term Loans & Advances ----- ----- ----- -----
(d) Other Non-Current Assets
2. Current Assets: ----- ----- ----- -----
(a) Current Investments ----- ----- ----- -----
(b) Inventories ----- ----- ----- -----
(c) Trade Receivables ----- ----- ----- -----
(d) Cash & Cash Equivalents ----- ----- ----- -----
(e) Short Term Loans & Advances ----- ----- ----- -----
(f) Other Current Assets
Total …………………………. ----- ----- ----- -----
Convert the following statement of profit and loss into the comparative statement of
profit and loss of BCR Co. Ltd.:

Particulars Note 2013-14 2014-15

No. Rs. Rs.
(i) Revenue from operations 60,00,000 75,00,000
(ii) Other incomes 1,50,000 1,20,000
(iii) Expenses 44,00,000 50,60,000
(iv) Income tax 35% 40%

Comparative statement of profit and loss for the year ended March 31, 2014 and
2015:

Particulars 2013-14 2014-15 Absolute Percentage

Increase (+) or Increase (+)
Decrease (–) or Decrease (–)
Rs. Rs. Rs. %
I. Revenue from operations 60,00,000 75,00,000 15,00,000 25.00
II. Add: Other incomes 1,50,000 1,20,000 (30,000) (20.00)

III. Total Revenue I+II 61,50,000 76,20,000 14,70,000 23.90

IV Less: Expenses 44,00,000 50,60,000 6,60,000 15.00

Profit before tax 17,50,000 25,60,000 8,10,000 46.29

6,12,500 10,24,000 4,11,500 67.18
V Less: Tax
11,37,500 15,36,000 3,98,500 35.03
Profit after tax
From the following statement of profit and loss of thermax Co. Ltd., prepare
comparative statement of profit and loss for the year ended March 31, 2014 and
2015:

Particulars Note 2013-14 2014-15

No. Rs. Rs.

Revenue from operations 16,00,000 20,00,000

Employee benefit expenses 8,00,000 10,00,000
Other expenses 2,00,000 1,00,000
Tax rate 40 %

Comparative statement of profit and loss of Thermax Co. Limited for the
year ended March 31, 2014 and 2015:

Particulars 2013-14 2014-15 Absolute Percentage

Increase (+) or Increase (+) or
Decrease (–) Decrease (–)
Rs. Rs. Rs. %
I. Revenue from operations 16,00,000 20,00,000 4,00,000 25
II. Less: Expenses
a) Employee benefit expenses 8,00,000 10,00,000 2,00,000 25

b) Other expenses 2,00,000 1,00,000 (1,00,000) (50)

Profit before tax 6,00,000 9,00,000 3,00,000 50

2,40,000 3,60,000 1,20,000 50
III. Less tax @ 40%
3,60,000 5,40,000 1,80,000 50
Profit after tax
Limitation of financial analysis:
Though financial analysis is quite helpful in determining financial strengths and
weaknesses of a firm, it is based on the information available in financial
statements. As such, the financial analysis also suffers from various limitations of
financial statements. Hence, the analyst must be conscious of the impact of price
level changes, window dressing of financial statements, changes in accounting
policies of a firm, accounting concepts and conventions, personal judgement, etc.
Some other limitations of financial analysis are:
1. Financial analysis does not consider price level changes.
2. Financial analysis may be misleading without the knowledge of the
changes in accounting procedure followed by a firm.
3. Financial analysis is just a study of reports of the company.
4. Monetary information alone is considered in financial analysis while non-
monetary aspects are ignored
 5. The financial statements are prepared on the basis of accounting concept, as
such, it does not reflect the current position.

Introduction of Ratio Analysis-

The goal of the financial manager is to maximize shareholder’s wealth, which occurs when the
firm’s share price is maximized. We want to get more pragmatic. The stakeholders look at the
firm’s financial statements for answers to all the questions. Firm managers use accounting
information to help them manage the firm. Investors and creditors use accounting information
to evaluate the firm. This focuses on the interpretation and analysis of financial statements. To
perform financial analysis, you will need to know how to use common-sized financial
statements, financial ratios, and the Du Pont ratio method and we can learn market-based
ratios that provide insight about what the market for shares and bonds believes about future
prospects of the firm. Financial analysis is the process of using financial information to assist in
investment and financial decision making. Financial analysis helps managers with efficiency
analysis and identification of problem areas within the fi rm. Also, it helps managers identify
strengths on which the firm should build. Externally, financial analysis is useful for credit
managers evaluating loan requests and investors considering security purchases.

The balance sheet is a financial snapshot of the firm, usually prepared at the end of the fiscal
year. That is, it provides information about the condition of the firm at one particular point in
time. By reviewing a series of balance sheets from different years, the analyst can identify
changes in the firm over time.
Meaning & definition:
 The idea of ratio analysis was introduced by Alexander wall for the first time in 1919.

 Ratio analysis is defined as, “The systematic use of ratio to interpret the financial
statement so that the strength and weakness of the firm as well as its historical
performance and current financial condition can be determined. In the financial statements
we can find many items are co-related with each other For example current assets and
current liabilities, capital and long term debt, gross profit and net profit purchase and sales etc.

 To take managerial decision the ratio of such items reveals the soundness of financial
position. Such information will be useful for creditors, shareholder’s management and
all other people who deal with company.

 Ratio analysis is one of the powerful techniques which is widely used for interpreting
financial statements.

 This technique serves as a tool for assessing the financial soundness of the business.

 Ratios are quantitative relationship between two or more variables taken from financial
statements.

 Ratio analysis is the process of determining and interpreting numerical relationship

between figures of financial statements.

 In a simple word, ratio is a quotient of two numerical variables, which shows the
relationship between the two figures. Accordingly, accounting ratio is a relationship
between two numerical variables obtained from financial statements such as income
statements and balance sheet.

 Ratio analysis is a process of determining and presenting the quantitative relationship

between two accounting figures to evaluate the strengths and weakness of a business. It
is important from the point of view of investors, creditors and management for analysis
and interpretation of a firm's financial health.

 Ratio analysis uses financial report and data and summarizes the key relationship in
order to appraise financial performance. The effectiveness will be greatly improved
when trends are identified, comparative ratios are available and inter-related ratios are
prepared.
  Ratio analysis is the most popularly and widely used technique of financial statement
analysis.

Importance and Advantages of Ratio Analysis

1. Analyzing Financial Statements

Ratio analysis is an important technique of financial statement analysis. Accounting ratios are
useful for understanding the financial position of the company. Different users such as
investors, management. bankers and creditors use the ratio to analyze the financial situation of
the company for their decision making purpose.

2. Judging Efficiency
Accounting ratios are important for judging the company's efficiency in terms of its operations
and management. They help judge how well the company has been able to utilize its assets and
earn profits.

3. Locating Weakness
Accounting ratios can also be used in locating weakness of the company's operations even
though its overall performance may be quite good. Management can then pay attention to the
weakness and take remedial measures to overcome them.

4. Formulating Plans
Although accounting ratios are used to analyze the company's past financial performance, they
can also be used to establish future trends of its financial performance. As a result, they help
formulate the company's future plans.

5. Comparing Performance
It is essential for a company to know how well it is performing over the years and as compared
to the other firms of the similar nature. Besides, it is also important to know how well its
different divisions are performing among themselves in different years. Ratio
analysis facilitates such comparison.

Limitations of Ratio Analysis:

1. Ratios are tools of quantitative analysis, which ignore qualitative points of view.

2. Ratios are generally distorted by inflation.

3. Ratios give false result, if they are calculated from incorrect accounting data.

4. Ratios are calculated on the basis of past data. Therefore, they do not provide complete
information for future forecasting.

5. Ratios may be misleading, if they are based on false or window-dressed accounting

information.

Pro Forma Analysis:

 Summary
• Financial ratio analysis and common-size analysis help gauge the financial performance
and condition of a company through an examination of relationships among these many
financial items.
• A thorough financial analysis of a company requires examining its efficiency in putting its
assets to work, its liquidity position, its solvency, and its profitability.
• We can use the tools of common-size analysis and financial ratio analysis, including the
DuPont model, to help understand where a company has been.
• We then use relationships among financial statement accounts in pro forma analysis,
forecasting the company’s income statements and balance sheets for future periods, to
see how the company’s performance is likely to evolve.

 Effective Use of Ratio Analysis

• In addition to ratios, an analyst should describe the company (e.g., line of business,
major products, major suppliers), industry information, and major factors or influences.
• Effective use of ratios requires looking at ratios
- Over time.
- Compared with other companies in the same line of business.
- In the context of major events in the company (for example, mergers or
divestitures), accounting changes, and changes in the company’s product mix.

 CLASSIFICATION OF RATIOS:

1) LIQUIDITY RATIO

 Current Ratio
  Quick Acid Ratio

2) CAPITAL STRUCTURE RATIO

 Debt-equity Ratio

 Proprietary Ratio.

 Capital Gearing Ratio

 Interest coverage ratio

3) ACTIVITY RATIO:

 Fixed Assets Turnover Ratio

 Stock Turnover Ratio

 Debtors Turnover Ratio

 Creditors Turnover Ratio

4) PROFITABILITY RATIO:

 Gross Profit Ratio

 Net Profit Ratio

 Operating Profit Ratio

 Operating Expenses Ratio or Operating Ratio

 Return on Investment Ratio

 Returns on shareholders’ funds

 Earnings per share

  Operating ratio

1) Liquidity Ratios:
 These ratios are also termed as ‘working capital’ or ‘short term solvency ratio’. The
importance of adequate liquidity in the sense of the ability of a firm to meet
current/short term obligations when they become due for payment can hardly be
overstressed. In fact, liquidity is a prerequisite for the very survival of a firm.
 The short term creditors of the firm are interested in the short term solvency or
liquidity of a firm. But liquidity implies, from the viewpoint of utilization of the funds of
the firm that funds are idle or they earn very little.
 A proper balance between the two contradictory requirements, that is, liquidity and
profitability is required for efficient financial management. The liquidity ratios measure
the ability of firm to meet its short term obligations and reflect the short term financial
solvency of a firm.

a) Current Ratio
 Meaning: - This ratio is called ‘working capital ratio’. It is used to assess the short-term
Financial position of the business concern. In other words, it is an indicator of the
company’s ability to meet its short-term obligation. It matches the total current assets
Of the company against its current liabilities.

Computation: It is calculated on the basis of the following:

Current Ratio= Current Assets

Current Liabilities

b) Quick Acid Ratio:

 Meaning: - Quick ratio is also an indicator of short-term solvency of a company quick
ratio is an improvement over current ratio. Quick ratio is a ratio which expresses
relationship between quick assets and current liabilities.

The quick ratio is very useful in measuring the liquidity position of a firm.it measures the
firm’s capacity to pay off obligation immediately and is a rigorous test of liquidity than
the current ratio. It is used as a complementary ratio to the current ratio.
 Computation: Quick ratio can be calculated by dividing quick assets current liabilities.
Thus,

Quick Ratio= Quick Assets or Quick Assets

Quick liabilities Quick Assets

 Quick Assets= Current Assets – (stock- prepaid expenses)

 Quick liabilities= Current liabilities - (Outstanding expenses + Bank overdraft)

2) Capital Structure Ratio:

 These ratios provide an insight into the financial techniques used by a firm
and focus, as a consequence, on the long term solvency position with
regard to, periodic payment of interest during the period of loan,
repayment of principal on maturity or in predetermined instalments n due
dates.

a) Debt-Equity Ratio:
 Meaning: This ratio is also called ‘External-internal Equity Ratio’. It is mainly calculated
to assess the soundness of long-term financial policies and to determine the relatives
stakes of outsiders and owners (shareholders). It determines the relationship between
debt and equity (shareholder funds).

Computation: Debt-Equity Ratio can be calculated as below formula.

Debt-Equity Ratio= External Equities or = long-term Debt

Internal Equities Shareholders fund

 Long-term Debt = Debentures + Term loans + Loan on mortgage + Loans from financial
institutions + Others Long-term loans +redeemable preference share capital.
 Shareholders fund =Equity capital share + Irredeemable preferences share capital +
Capital reserves + Retained earning + Any Earmarked surplus like provision for
contingences, etc. – fictitious Assets.

b) Proprietary Ratio:
 Meaning: This ratio measures the relationship between proprietors’ funds and the total
assets. The objectives of computing this ratio is to find out how the proprietors have
financed the assets.

 There are two components of this ratio which are as under:

1) Proprietors’ Funds
2) Total Assets

Computation: This ratio is computed by dividing the proprietors’ funds by total assets.
The ratio can be calculated as under.

Proprietors’ Ratio = Proprietors’ Funds

Total Assets

c) Capital Gearing Ratio:

 Meaning: The term ‘capital gearing’ is used to describe the relationship between equity
share capital including reserves and surplus to preference share capital and other fixed
interest-bearing loans.

Computation: This ratio can be calculated as under:

Capita Gearing Ratio = Equity Share capital + Reserve & Surplus

Preference Capital + Long-term debt bearing fixed interest
 3)Activity Ratio:
 Meaning: Funds are invested in various assets in business to make sales and earn
profits. The efficiency with which assets are managed directly affects the volume of
sales. The better the management of assets are managed directly affects the volume of
sales. The better the management of assets, the largely is amount of sales and the
profits. Activity ratios measures the efficiency or effectiveness with which a firm’s
managers its resources or assets. These ratios are also called turnover ratios because
they indicate the speed with which assets are converted or turned over into sales. Its
includes the following ratios.

a) Fixed Assets Turnover Ratio:

 Meaning: Fixed assets turnover ratio compares the sales revenue a company to its fixed
assets. This ratio tells us how effectively and efficiently a company is using its fixed
assets to greater revenues. This ratio indicates the productivity of fixed assets in
generating revenues. If company has a high fixed assets turnover ratio, its shows that
company is efficient at managing its fixed assets. Fixed assets are important because
they usually represent the largest component of total assets.

Computation: The formula for calculation of fixed assets turnover ratio is given below.

Fixed Assets Turnover ratio= Net Sales

Net Fixed Assets
 Net Sales = Gross Sales – Sales Returns
 Net fixed Assets = Gross fixed Assets – Depreciation

 The fixed assets usually include property, plant and equipment. The value of goodwill,
long-term deferred tax and others fixed that do not belong property, plant and
equipment is usually subtracted from the total fixed assets to presents more meaningful
fixed assets turnover ratio.

b) Stock Turnover Ratio:

 Meaning: The ratio is also known as “inventory turnover ratio” or “stock velocity ratio”.
Its establishes relationship between average stock at cost and cost of good sold.

Computation: It is calculated by applying the following formula:

 Stock Turnover Ratio = Cost Of Goods sold
Average Inventory

 Cost of Goods sold = Sales- Gross Profit

 Cost of Goods sold = Opening Stock+ Purchases +Direct Expenses – Closing stock
 Average Stock = Opening stock + Closing Stock
2

c)Debtors Turnover Ratio:

 Meaning: This ratio is also known as “Ratio of Net Sales to Gross receivable” or
“Receivable Turnover” or “Debtors velocity”. It expresses the relationship between net
credit sales and average accounts receivable. It measures the number of times the
receivable. Its measure the number of times the receivable is rotated in a year in terms
of sales. It also indicates the number times the receivable is rotated in a year in terms of
sales. It also indicates the efficiency of credit collection and efficiency of credit collection
and efficiency of credits policy.

Computation: - It is calculated by applying the following formula:

Debtors Turnover Ratio = Net Credits Sales

Average Accounts Receivable or Average Trade Debtors

Where, Accounts Receivable = Debtors + Bills Receivable

d)Creditors Turnover Ratio:

 Meaning: This ratio establishes a relationship between net credit purchases and average
trade creditors. The objective of computing this is to determine efficiency with which
the creditors are managed.

Computation: It may be calculated as under.

Creditors Turnover Ratio = Net Credit Purchases

Avg. Trade Creditors
 Net Credit Purchases = Gross Credit Purchases - Purchases Returns

 Average Trade Creditors = Opening Trade Creditors + Closing Trade Creditors

 2
 In case, the details regarding credit purchases, opening and closing creditors are not
given, the ratio may be calculated as follows:

Creditors Turnover Ratio = Total Purchases

Closing Creditors

4)Profitability ratio:
 Meaning: The primary objective of a business undertaking is to earn profits. Profits
earning is considered essential for the business. A business needs profits not only for its
existence but also for expansion and diversification. “Profits are thus, a useful measure
of overall efficiency of a business. Profits to the management are the test of efficiency
and a management of control; to owners, a measure of worth of their investment; to
the creditors, the margin of safety; to employees, a source of fringe benefits; to
government , a measure of tax-paying capacity and the basic of legislative action; to
customers, a hint to demand for better quality and price cuts; to an enterprises, less
cumbersome source of finance for growth and existence and finally to the country,
profits are an index of economic progress.

a) Gross Profit Ratio:

 Meaning: This ratio is also known as “Gross Marginal Ratio” or “Trading Marginal Ratio”.
It shows the relationship between the gross profits to nets sales and generating
expressed in percentages. In other words, it expresses the gross margin as a percentage
of sales.

Objectives: Gross Profit Ratio is calculated to know:

1) Whether the business is in a position to meet operating expenses or not, and
2) How much the shares holders can get after meeting such expenses?

Computation: It is calculated as under.

Gross Profit Ratio = Gross Profit x 100

Net Sale
Where,
 Gross Profit = Net Sale – Cost of Goods Sold, and
 Cost of Goods Sold = Opening Stock + Purchases(Net) + Direct Expenses- Closing
Stock
 Net Sales = Total Sales – Sales Returns

b) Net Profit Ratio:

 Meaning: This ratio is also known as “the net to sales ratio” or “net profit margin”. It
measures the rate of the net profit per unit of sales.

Computation: It is determined by dividing the net profit to the net sales for the period.
Its formula is as follow:

Net Profit Ratio = Net Profit x 100

Net Sales

 Net profit may be net profit before tax or net profit after tax. Accordingly, this period
may have two approaches:

Net Profit before Tax x 100 or PBT x 100

Net Sales Net Sales

c) Operating Profit Ratio:

 Meaning: This ratio is the variation of net profit ratio. It measures the relationship
between operating profits and sales.

Computation: It may be calculated as under:

Operating profit ratio = Operating Profits x 100

Net Sales

 Operating ratio is calculated by subtracting the operating expenses, that include cost of
goods sold, office and administration expenses, and selling and distribution expenses
 relating to the business, from the operating revenues. It, therefore, does not take into
account non-operating expenses and non-operating incomes.
 Financial expenses like interest, taxes and dividend, provision for taxation, losses such as
losses due to theft or fire or extraordinary revenues or capital receipt are excluded from
its ambit. Thus, operating net profits ascertained as under:

Operating Profit = Sales- (cost of Goods sold + Administrative Office expenses + Selling
& distribution Expenses)

Operating Net Profit = Gross Profit + Operating Incomes - Operating Expenses

d) Operating Ratio:
 Meaning: This ratio measures the extent of cost incurred for making the sales. In other
words, this ratio matches cost of goods sold plus other operating expenses, on the one
hands, with net sales, on the other.

Computation: It is calculated as follows:

Operating Ratio = Cost of Goods sold + Operating Expenses x 100

Net Sales

 Operating expenses consist of those which are a charge against profits. These includes
selling and distribution expenses, administration expenses, e.g., salary of sales staff and
office staff, rent, advertisement expenses director’s fees, electricity bills and legal
expenses. Financial expenses like interest and provision for taxation are generally not
included in operating expenses.

e) Return on investment: -

 Meaning: Return on capital employed ratio is computed by dividing the net income or
profit before interest and tax by capital employed. It measures the success of a business
in generating satisfactory profit on invested. The ratio is expressed in percentage.
 Computation: It is calculated as:
The basic components of the formula of the return on capital employed ratio are net
income before interest and tax and capital employed.

Returns on Capital Employed = Net Income Before Interest and tax x 100
Capital Employed

e) Returns on shareholders’ funds:

 Meaning: This ratio establishes the profitability from the shareholder’s point of view.
Computation: It is calculated by dividing the net profits after interest and tax by the
shareholder’s funds. Thus:

Returns on shareholders’ funds = Net profit after interest and tax

Shareholders fund
Here,
Shareholders’ fund = Equity share capital + Preference share capital + share premium+
Revenue Reserve + capital Reserve + Retained Earning –
Accumulated losses

Or
Shareholders’ fund = Fixed assets + current assets – current and long term liabilities

f) Operating expenses ratio: -

 Meaning: Expenses ratio indicates the relationship of various expenses to net sales. The
objective of computing this ratio is to provide information about increase or decrease in
expenses ratio is considered better for the business.

Computation: this can be calculated by using the following formula.

 Expenses Ratio = Amount of Expenses x 100
Net Sale

 We can also calculate separate expense ratio, such as ratio of administrative Expenses
to Net Sales, Ratio of selling and distribution Expenses to Sales etc. The above ratio can
be calculated as below:

For Administrative Expenses to Net Sales Ratio

= Administrative & Office Expenses x 100
Net Sales

For Selling and Distribution Expenses to Net Sales Ratio

= Selling & Distribution Expenses x 100
Ney Sales

For financial Expenses to Net Sales Ratio

= Financial Expenses and Interest x 100
Net Sales

g) Earnings Per Share (EPS): -

 Meaning: This ratio is calculated to assess the availability of total profits per share.

Computation: It is calculated by dividing the net profit after tax and preference dividend
by number of equity shares. Thus:

Earnings per Shares = Net Profit after Tax, Interest and Preference Dividend
Number of Equity Share

h) Price Earnings Ratio: -

 Meaning: This ratio indicates the number of times the earning per shares is covered by
its market price.
 Computation: - The Formula is:

Price Earnings Ratio = Market Price per Share

Earnings per equity share

 Thermax Key Financial Ratios, Thermax Financial

Statement & Accounts

Mar 16 Mar 15 Mar 14 Mar 13 Mar 12

Per Share Ratios

Basic EPS ( Rs.) 25.64 28.19 21.23 29.37 34.15
Diluted EPS (Rs.) 25.64 28.19 21.23 29.37 34.15
Cash EPS (Rs.) 30.75 33.58 26.08 33.98 38.09
Book Value [Excel Reval 208.74 190.25 169.95 156.88 134.38
Reserve]/Share (Rs.)

Book Value 208.74 190.25 169.95 156.88 134.38

[InclRevalReserve]/Share (Rs.)

Dividend / Share(Rs.) 6.00 7.00 6.00 7.00 7.00

Revenue from Operations/Share 365.24 394.24 361.07 393.69 445.16
(Rs.)

PBDIT/Share (Rs.) 41.83 48.75 39.74 48.69 54.92

PBIT/Share (Rs.) 36.72 43.37 34.89 44.09 50.98
PBT/Share (Rs.) 36.67 41.72 34.15 43.28 50.43
Net Profit/Share (Rs.) 25.64 28.19 21.23 29.37 34.15
Profitability Ratios
PBDIT Margin (%) 11.45 12.36 11.00 12.36 12.33
PBIT Margin (%) 10.05 11.00 9.66 11.19 11.45
PBT Margin (%) 10.03 10.58 9.45 10.99 11.32
Net Profit Margin (%) 7.02 7.15 5.88 7.46 7.67
Return on Net worth/ Equity (%) 12.28 14.81 12.49 18.72 25.41
Return on Capital Employed (%) 11.96 14.51 11.50 18.07 24.71
Return on Assets (%) 6.16 6.92 5.21 8.52 10.24
Total Debt/Equity (X) 0.04 0.01 0.09 0.01 0.10
Asset Turnover Ratio (%) 87.75 96.80 88.63 114.29 133.61
Liquidity Ratios
Current Ratio (X) 1.38 1.38 1.33 1.31 1.25
Quick Ratio (X) 1.28 1.29 1.24 1.21 1.13
Inventory Turnover Ratio (X) 19.36 20.76 17.01 22.30 19.00
 Dividend Payout Ratio (NP) (%) 23.39 24.82 28.26 23.83 20.50
Dividend Payout Ratio (CP) (%) 19.51 20.84 23.00 20.60 18.37
Earnings Retention Ratio (%) 76.61 75.18 71.74 76.17 79.50
Cash Earnings Retention Ratio 80.49 79.16 77.00 79.40 81.63
(%)
Valuation Ratios
Enterprise Value (Cr.) 8,891.49 12,489.45 8,776.23 6,565.78 5,129.42
EV/Net Operating Revenue (X) 2.04 2.66 2.04 1.40 0.97
EV/EBITDA (X) 17.84 21.50 18.53 11.32 7.84
Market Cap/Net Operating 2.06 2.70 2.07 1.44 1.04
Revenue (X)

Retention Ratios (%) 76.60 75.17 71.73 76.16 79.49

Price/BV (X) 3.61 5.59 4.40 3.62 3.46
Price/Net Operating Revenue 2.06 2.70 2.07 1.44 1.04
Earnings Yield 0.03 0.03 0.03 0.05 0.07

PROB LEMS AND SOLUTIONS :

Type 1: Final Account to Ratio

Problem 1. From the data calculate:
(i) Gross Profit Ratio (ii) Net Profit Ratio (iii) Return on Total Assets
(iv) Inventory Turnover (v) Working Capital Turnover (vi) Net worth to Debt
Sales 25,20,000 Other Current Assets 7,60,000
Cost of sale 19,20,000 Fixed Assets 14, 40,000
Net profit 3,60,000 Net worth 15,00,000
Inventory 8,00,000 Debt. 9,00,000
Current Liabilities 6,00,000
Solution:
1. Gross Profit Ratio = (GP/ Sales) * 100 = 6
Sales – Cost of Sales Gross Profit
25,20,000 – 19,20,000 = 6,00,000
2. Net Profit Ratio = (NP / Sales) * 100 = 3
3. Inventory Turnover Ratio = Turnover / Total Assets) * 100= 1920000/800000= 2.4 times
Turnover Refers Cost of Sales
4. Return on Total Assets = NP/ Total Assets = (360000/3000000) *100 = 12%
FA+ CA +inventory [14,40,000 + 7,60,000 + 8,00,000] = 30,00,000
5. Net worth to Debt = Net worth/ Debt= (1500000/900000) * 100 = 1.66 times
6. Working Capital Turnover = Turnover/Working capital
Working Capital = Current Assets – Current Liabilities
= 8,00,000 + 7,60,000 – 6,00,000
15,60,000 – 6,00,000= 9,60,000
Working Capital Turnover Ratio = 19,20,000 = 2 times.

Problem 2. Perfect Ltd. gives the following Balance sheet. You are required to compute the following
ratios.
(a) Liquid Ratio
(b) Solvency Ratio
(c) Debt-Equity Ratio
(d) Stock of Working Capital Ratio
Balance Sheet $ $
Equity share capital 1500000 Fixed Assets 1400000
Reserve fund 100000 Stock 500000
6% Debentures 300000 Debtors 200000
Overdraft 100000 Cash 100000
Creditors 2200000 2200000
Solution :
(a) Liquid Ratio= Liquid Assets / Liquid Liabilities
(or)
Liquid Assets / Current Liabilities
LA Debtors = 2,00,000 i.e., 3,00,000 / 200000 = 1.5
Cash = 1,00,000
= 3,00,000
Liquid Liabilities: Creditors = 2,00,000
(b) Debt – Equity Ratio = External Equities / Internal Equities
External Equities:
All outsiders loan Including current liabilities
3,00,000 + 1,00,000 + 2,00,000 = 6,00,000
Internal Equities:
It Includes shareholders fund + Reserves
15,00,000 + 1,00,000 = 16,00,000
Debt – Equity Ratio = 600000/ 1600000 = 0 · 375
© Solvency Ratio = Outside Liabilities / Total Assets
Outside Liabilities = Debenture + Overdraft + Creditors
= 3,00,000 + 1,00,000 + 2,00,000 = 6,00,000
Solvency Ratio = (600000 / 2200000) * 100
= 27.27%
(d) Stock of Working Capital Ratio = Stock / Working Capital
Working Capital = Current Assets – Current Liabilities
= 8,00,000 – 3,00,000 = 5,00,000
Stock of Working Capital Ratio =* 100 = 100%

Problem 3. Calculate the following ratios from the balance sheet given below:
(i) Debt – Equity Ratio (ii) Liquidity Ratio
(iii) Fixed Assets to Current Assets (iv) Fixed Assets Turnover
Balance Sheet
Liabilities $ Assets $
Equity shares of $ 10 each 1,00,000 Goodwill 60000
Reserves 20,000 Fixed Assets 140000
P.L. A/c 30,000 Stock 30000
Secured loan 80,000 Sundry Debtors 30000
Sundry creditors 50,000 Advances 10000
Provision for taxation 20,000 Cash Balance 10000
3,00,000 300000
The sales for the year were $ 5,60,000.
Solution:
Debt – Equity = Long – Term Debt / Shareholders Fund
Ratio = Secured loan $. 80,000
Shareholder’s Fund= Equity Share Capital + Reserves + P.L.A/c
= 1,00,000 + 20,000 + 30,000 = 1,50,000
Debt-Equity Ratio = 80,000 / 1,50,000=.53
Liquidity Ratio = Liquid Assets / Liquid Liabilities
Liquid Assets = Sundry Debtors + Advances + Cash Balance
30,000 + 10,000 + 30,000 = 70,000
Liquid Liabilities = Provision for Taxation + sundry creditors
= 20,000 + 50,000 = 70,000
Liquid Ratio = 70,000 / 70,000= 1
Fixed Assets to Current Assets
= Fixed Assets / Current Assets= 1,40,000/ 100000
= 1.4
Fixed Assets Turnover =Turnover / Fixed Assets= 5,60,000/1,40,000
=4

Problem 4. The Balance sheet of Harnath & Co. as on 31.12.2000 shows as follows:
Liabilities $ Assets $
Equity capital 1,00,000 Fixed Assets 1,80,000
15% Preference shares 50,000 Stores 25,000
12% Debentures 50,000 Debtors 55,000
Retained Earnings 20,000 Bills Receivable 3,000
Creditors 45,000 Bank 2,000
2,65,000 2,65,000
Comment on the financial position of the Company i. e., Debt – Equity Ratio, Fixed Assets Ratio, Current
Ratio, and Liquidity.
Solution:
Debt – Equity Ratio = Debt – Equity Ratio / Long – Term Debt
Long-term Debt = Debentures
= 50,000
Shareholder’s Fund = Equity + Preference + Retained Earnings
= 1,00,000 + 50,000 + 20,000
= 50,000
= 1,70,000
= ·29
Fixed Assets Ratio= Fixed Assets / Proprietor’s Fund= -1,80,000
Proprietor’s Fund=Equity Share Capital + Preference Share Capital+ Retained Earnings
=1,00,000 + 50,000 + 20,000 = 1,70,000
Fixed Assets Ratio = 1,80,000 / 1,70,000= 1.05
Current Ratio = Current Assets / Current Liabilities
Current Assets = Stores + Debtors + BR + Bank= 25,000 + 55,000 + 3,000 + 2,000 = 85,000
Liquid Ratio=45,000 / 85,000= 1.88
Liquid Assets = 45,000
Liquid Liabilities = Debtors + Bill Receivable + Cash=55,000 + 3,000 + 2,000 = 60,000
Liquid Ratio = 60,000 / 45,000 = 1.33

Problem 5: From the following particulars pertaining to Assets and Liabilities of a company calculate:
(a) Current Ratio (b) Liquidity Ratio (c) Proprietary Ratio
(d) Debt-equity Ratio (e) Capital Gearing Ratio
Liabilities $ Assets $
5000 equity shares $ 10
each 500000 Land & Building 500000
8% 2000 pre shares $ 100 Plant & Machinery 600000
Each 200000 Debtors 200000
9% 4000 Debentures of Stock 240000
$ 100 each 400000 Cash and Bank 55000
Reserves 300000 Prepaid expenses 5000
Creditors 150000
Bank overdraft 50000
1600000 1600000

Solution:
Current Ratio = Current Assets / Current Liabilities
Current Assets = Stock + Cash + Prepaid Expenses + Debtors
= 2,40,000 + 55,000 + 5,000 + 2,00,000 = 5,00,000

Current Liabilities = Creditors + Bank Overdraft

=1,50,000 + 50,000 = 2,00,000
=5,00,000 / 2,00,000
= 2.5: 1

Liquid Ratio = Liquid Assets / Liquid Liabilities

Liquid Assets = Cash and Bank + Debtors

=55,000 + 2,00,000 = 2,55,000
Liquid Liabilities: Creditors = 1,50,000

Liquid Ratio = 2,55,000 / 1,50,000

= 1.7: 1

Proprietor’s Ratio = Proprietor’s Fund / Total Tangible Assets

Proprietor’s Fund = Equity Share Capital + Preference

Share Capital + Reserves and Surplus

=5,00,000 + 2,00,000 + 3,00,000

Proprietary Ratio=10,00,000 / 16,00,000

= 0.625: 1

Debt – Equity Ratio = External Equities / Internal Equities

External Equities = Long-term Liabilities + Short-term Liabilities
= 4,00,000 + 2,00,000 = 6,00,000

Internal Equities = Proprietor’s funds

= 6,00,000 / 10,00,000

= 0.6: 1

Capital Gearing Ratio = Fixed Interest Bearing Securities / Equity Share Capital + Reserves

Fixed Interest Bearing Securities = Preference Shares 2,00,000

Debentures 4,00,000
6,00,000

= 6,00,000 / 8,00,000

= 0.75: 1