LESSON 6 RATIO ANALYSIS CONTENTS

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1 LESSON 6 RATIO ANALYSIS CONTENTS 6.0 Aims and Objectives 6.1 Introduction 6.2 Definition 6.3 How the Accounting Ratios are Expressed? 6.4 Purpose, Utility & Limitations of Ratio Analysis 6.5 Classification of Ratios 6.6 Short-term Solvency Ratios Current Assets Ratio 6.7 Standard Norm of the Current Ratio Implication of High Ratio of Current Assets over the Current Liabilities Limitation of the Current Ratio Acid Test Ratio Super Quick Assets Ratio 6.8 Capital Structure Ratios 6.9 Debt equity Ratio Long-Term Debt-equity Ratio Standard Norm of the Debt-equity Ratio Total Debt equity Ratio 6.10 Proprietary Ratio 6.11 Fixed Assets Ratio 6.12 Standard Norm of the Ratio 6.13 Coverage Ratios Interest Coverage Ratio Dividend Coverage Ratio 6.14 Return on Capital Employed 6.15 Stock Turnover Ratio 6.16 Debtors Turnover Ratio Debtors Velocity Creditors Turnover Ratio 6.17 Dupont Analysis 6.18 Let us Sum up 6.19 Lesson-end Activity 6.20 Keywords 6.21 Questions for Discussion 6.22 Suggested Readings

2 Accounting and Finance for Managers 6.0 AIMS AND OBJECTIVES In this lesson we shall discuss about ratio analysis. After going through this lesson you will be able to: (i) understand purpose, utility and limitations of ratio analysis (ii) analyse classifications of ratios and Du pont analysis 6.1 INTRODUCTION The ratio analysis is an one of the important tools of financial statement analysis to study the financial stature of the business fleeces, corporate houses and so on. How the ratios are able to facilitate to study the financial status of the enterprise? What is meant by ratio? The ratio illustrates the relationship between the two related variables What is meant by the accounting ratio? The accounting ratios are computed on the basis available accounting information extracted from the financial statements which are not in a position to reveal the status of the enterprise. The accounting ratios are applied to study the relationship between the quantitative information available and to take decision on the financial performance of the firm. 6.2 DEFINITION According to J. Betty, The term accounting is used to describe relationships significantly which exist in between figures ratio shown in a balance sheet, Profit & Loss A/c, Trading A/c, Budgetary control system or in any part of the accounting organization. According to Myers Study of relationship among the various financial factors of the enterprise 6.3 HOW THE ACCOUNTING RATIOS ARE EXPRESSED? To understand the methodology of expressing the ratios, the expression of ratios are highlighted in the following discussion Expression Quotient Percentage Time Fraction Current Ratio /Leverage Ratio Net Profit Ratio Stock Turnover Ratio Fixed assets to capital 6.4 PURPOSE, UTILITY & LIMITATIONS OF RATIO ANALYSIS 96 Purposes of the Ratio Analysis are: l To study the short term solvency of the firm liquidity of the firm l To study the long term solvency of the firm leverage position of the firm l To interpret the profitability of the firm Profit earning capacity of the firm l To identify the operating efficiency of the firm. turnover of the ratios

3 Utility of the Ratio Analysis are: i. Easy to understand the financial position of the firm: The ratio analysis facilitates the parties to read the changes taken place in the financial performance of the firm from one time period to another. ii. Measure of expressing the financial performance and position: It acts as a measure of financial position through Liquidity ratios and Leverage ratios and also a measure of financial performance through Profitability ratios and Turnover Ratios. iii. Intra-firm analysis on the financial information over many number of years: The financial performance and position of the firm can be analysed and interpreted with in the firm in between the available financial information of many number of years; which portrays either increase or decrease in the financial performance. iv. Inter-firm analysis on the financial information within the industry: The financial performance of the firm is studied and interpreted along with the similar firms in the industry to identify the presence and status of the respective firm among others. v. Possibility for Financial planning and control: It not only guides the firm to earn in accordance with the financial forecasting but also facilitates the firm to identify the major source of expense which drastically has greater influence on the earnings. Limitations of the Ratio Analysis are: i. It is dependant tool of analysis: The perfection and effectiveness of the analysis mainly depends upon the preparation of accurate and effectiveness of the financial statements. It is subject to the availability of fair presentation of data in the financial statements. ii. Ambiguity in the handling of terms: If the tool of analysis taken for the study of inter firm analysis on the profitability of the firms lead to various complications. To study the profitability among the firms, most required financial information are profits of the enterprise. The profit of one enterprise is taken for analysis is Profit After Taxes (PAT) and another is considering Profit Before Interest and Taxes (PBIT) and third one is taking Net profit for study consideration. The term profit among the firms for the inter firm analysis is getting complicated due to ambiguity or poor clarity on the terminology. iii. Qualitative factors are not considered: Under the ratio analysis, the quantitative factors only taken into consideration rather than qualitative factors of the enterprise. The qualitative aspects of the customers and consumers are not considered at the moment of preparing the financial statements but while granting credit on sales is normally considered. iv. Not ideal for the future forecasts: Ratio analysis is an outcome of analysis of historical transactions known as Postmortem Analysis. The analysis is mainly based on the yester performance which influences directly on the future planning and forecasting ; it means that the analysis is mainly constructed on the past information which will also resemble the same during the future analysis. v. Time value of money is not considered: It does not give any room for time value of money for future planning or forecasting of financial performance ; the main reason is that the fundamental base for forecasting is taken from the yester periods which never denominate the timing of the benefits. Ratio Analysis Check Your Progress (1) Ratio is an expression of (a) Quotient (b) Time (c) Percentage (d) Fraction (e) (a), (b), (c) & (d) (2) Accounting ratios are to study (a) Accounting relationship among the variables Contd... 97

4 Accounting and Finance for Managers (b) the relationship in between the variables of financial statements (c) The relationship in between the variables of financial statements for analysis and interpretations (d) None of the above (3) Accounting ratios are (a) Income statement ratios (b) Positional statement ratios (c) Both (a) & (b) (d) None of the above 6.5 CLASSIFICATION OF RATIOS The accounting ratios are classified into various categories on the basis of 1. Financial statements 2. Functions On the basis of Financial Statements: I. Income statement Ratios: These ratios are computed from the statements of Trading, Profit & Loss account of the enterprise. Some of the major ratios are: GP ratio, NP ratio, Expenses Ratio, and so on. II. Balance sheet or Positional Statement Ratios: These type of ratios are calculated from the balance sheet of the enterprise which normally reveals the financial status of the position i.e. short term, Long term financial position, Share of the owners on the total assets of the enterprise and so on. III. Inter statement or Composite Mixture of Ratios: Theses ratios are calculated by extracting the accounting information from the both financial statements, in order to identify stock turnover ration, debtor turnover ratio, return on capital employed and so on. On the basis of Functions: I. On the basis of Solvency position of the firms: Short term and Long term solvency position of the firms. II. On the basis of Profitability of the firms: The profitability of the firms are studied on the basis of the total capital employed, total asset employed and so on. III. On the basis of Effectiveness of the firms: The effectiveness is studied through the turnover ratios Stock turnover ratio, Debtor turnover ratio and so on. IV. Capital Structure ratios: The capital structure position are analysed through leverage ratios as well as coverage ratios. 6.6 SHORT-TERM SOLVENCY RATIOS To study the short term solvency or liquidity of the firm, the following are various ratios l Current Assets Ratio l Acid Test Ratio or Quick Assets Ratio l Super Quick Assets Ratio l Defensive Interval Ratio Current Assets Ratio 98 It is one of the important accounting ratios to find out the ability of the business fleeces to meet out the short financial commitment This is the ratio establishes the relationship

5 in between the current assets and current liabilities. Ratio Analysis What is meant by current assets /Current assets are nothing but available in the form of cash, equivalent to cash or easily convertible in to cash. What is meant by the current liabilities? Current liabilities are nothing but short term financial resources or payable in short span of time within a year. Current Current Assets Current Liabilities Current Ratio Current Assets Current Liabilities Marketable Secuities Inventory Debtors Bill Receivable Pre paid expenses Outstanding Incomes Trade creditors Bank overdraft Bills Payable Provision for taxation Outstanding expenses Pre received incomes Cash at Bank : Cash in Hand 6.7 STANDARD NORM OF THE CURRENT RATIO The ideal norm is that 2:1; which means that every one rupee of current liability is appropriately covered by Two rupees of current assets Implication of High Ratio of Current Assets over the Current Liabilities High ratio leads to greater the volume of current assets more than the specified norm denotes that the firm possess excessive current assets than the requirement portrays idle funds invested in the current assets Limitation of the Current Ratio Under this ratio, the current assets are equally weighed each other to match the current liabilities. Under the current ratio, One rupee of cash is equally weighed at par with the one rupee of closing stock, but the closing stock and prepaid expenses cannot be immediately realized like cash and marketable securities Acid Test Ratio It is a ratio expresses the relationship in between the quick assets and current liabilities. This ratio is to replace the bottleneck associated with the current ratio. It considers only the liquid assets which can be easily translated into cash to meet out the financial commitments. 99

6 Accounting and Finance for Managers Liquid Assets Acid Test Ratio ( Quick Assets Ratio) Current Liabilities Liquid Asset Current Assets ( Closing Stock +Pre paid expenses) Quick Liquid Assets Ratio Quick Assets Current liabilities Marketable Securities Debtors Bill Receivable Cash at Bank Cash in Hand Trade creditors Bank overdraft Bills Payable Provision for taxation Outstanding expenses Pre received incomes Standard norm of the ratio; The ideal norm is that 1:1 means; One rupee of current liabilities is matched with one rupee of quick assets Super Quick Assets Ratio It is the ratio which establishes the relationship in between the super quick assets and quick liabilities of the firm. The super quick assets are nothing but the current assets which can be more easily converted into cash to meet out the quick liabilities. The super quick liabilities are the current liabilities should have to be met out at faster pace within shorter span in duration. Super Quick Assets Cash + Marketable Securities. Super Quick Liabilities Current Liabilities Bank Over Draft Super Quick Assets Super Quick Assets Ratio Super Quick Liabilities Standard norm of the ratio Higher the ratio is the better the position of the firm Illustration 1 From the following calculate current ratio Current Assets: 100 Rs Cash in hand 4,00,000 Sundry Debtors 1,60,000

7 Stock 2,40,000 Current Liabilities: Sundry creditors 3,00,000 Bills Payable 1,00,000 Ratio Analysis Current Assets Rs.8,00,000 Current Ratio 2 Current Liabilities Rs. 4,00,000 Illustration 2 The firm satisfies the standard norm of the current asset ratio and Liquid assets ratio M/s Shanmuga &Co Balance sheet as on dated 31 st Mar, 2005 Particulars Rs. Particulars Rs. Share capital 42,000 Fixed Assets Net 34,000 Reserve 3,000 Stock 12,400 Annual Profit 5,000 Debtors 6,400 Bank overdraft 4,000 Cash 13,200 Sundry creditors 12,000 Total 66,000 Total 66,000 Current Ratio Current Assets Current Liabilities Rs. 32,000 Rs.16,000 2 It satisfies the standard norm of the current asset ratio Quick assets Current Assets - Closing Stock Liquid assets ratio Current Liabilities Current Liabilities Rs.19, Rs.16,000 The firm financial position satisfies the standard norm of the Liquid assets ratio. Illustration 3 Liquid Assets Rs. 65,000; Stock Rs. 20,000; Pre paid expenses Rs. 5,000; Working capital Rs. 60, 000 Calculate current assets ratio and liquid assets ratio For the computation of current assets ratio, current assets volume must be known. It is not available in our problem, instead the liquid assets and prepaid expenses are given together which will facilitate to find the total volume of current assets. Current Assets Liquid Asset + Prepaid expenses + closing stock Rs. 65,000 + Rs. 5,000+20,000 Rs. 90,000 The next step is to find out the current liabilities. The volume of current liabilities could be found out through the available information of working capital. Net working capital Current Assets- Current Liabilities 101

8 Accounting and Finance for Managers Rs. 60,000 Rs. 70,000 - Current liabilities Current liabilities Rs. 90,000 - Rs. 60,000 Rs. 30,000 From the above, the current ratio could be found out Rs.90,000 Current Ratio 3 > 2 Rs.30,000 The firm satisfies the more than the norm of the current ratio. It means that the firm keeps excessive current assets more than that of requirement. Rs. 65,000 Quick Assets Ratio 2.17 Rs.30, 000 The firm keeps more liquid assets than that of the specified norm means that excessive liquid assets are held by the firm than the requirement in the form of idle not productive in utility. Illustration 4 The current ratio of Bicon Ltd. is 4.5 :1 and liquidity ratio is 3:1 stock is Rs. 6,00,000 Find out the current liabilities. To find out the volume of current liabilities, initially the share of closing stock should be found out in the total of current assets. Share of stock Current Assets Ratio Liquid Assets Ratio Share of the stock1.5 If the share of the stock is 1.5 which amounted Rs. 6,00,000 What is the volume of current liabilities for the ration of 1? Rs. 6,00,000 Current Liabilities 4, 00, CAPITAL STRUCTURE RATIOS The capital structure ratios are classified into two categories l l Leverage Ratios Long term solvency position of the firm Principal repayment Coverage Ratios Fixed commitment charge solvency of the firm Dividend coverage and Interest coverage Capital Structure Leverage Ratios Coverage Ratios 102 Debt Equity Ratio Total Debt Equity Ratio Proprietary Ratio Fixed assets Ratio Interest Coverage Ratio Dividend Coverage

9 Under the capital structure ratios, the composition of the capital structure is analysed only in the angle of long term solvency of the firm. Ratio Analysis 6.9 DEBT-EQUITY RATIO It is the ratio expresses the relationship between the ownership funds and the outsiders funds. It is more specifically highlighted that an expression of relationship in between the debt and Shareholders funds. The debt equity ratio can be obviously understood into two different forms l l Long term debt equity ratio Total debt equity ratio Long-term Debt-equity Ratio It is a ratio expresses the relationship in between the outsiders contribution through debt financial resource and Share holders contribution through equity share capital, preference share capital and past accumulated profits. It reveals the cover or cushion enjoyed by the firm due to the owners contribution over the outsiders contribution. Debt (Long term debt Debentures/Term Loans) Debt - Equity Ratio Net worth/equity (Shareholders' fund) Higher ratio indicates the riskier financial status of the firm which means that the firm has been financed by the greater outsiders fund rather than that of the owners fund contribution and vice versa Standard Norm of the Debt-equity Ratio The ideal norm is that 1:2 which means that every one rupee of debt finance is covered by the 2 rupees of shareholders fund The firm should have a minimum of 50% margin of safety in meeting the long term financial commitments. If the ratio exceeds the specification, the interest of the firm will be ruined by the outsiders during the moment at when they are unable to make the payment of interest in time as per the terms of agreement reached earlier. During the moment of liquidation, the greater ratio may facilitate the creditors to recover the amount due lesser holding held by the owners Total Debt-equity Ratio The ultimate purpose of the ratio is to express the relationship total volume of debt irrespective of nature and shareholders funds. If the owners contribution is lesser in volume in general irrespective of its nature leads to worse situation in recovering the amount of outsiders contribution during the moment of liquidation. Short term debt + Long term debt Total Debt Equity Ratio Equity (Shareholders' fund) 6.10 PROPRIETARY RATIO The ratio illustrates the relationship in between the owners contribution and the total volume of assets. In simple words, how much funds are contributed by the owners in financing the assets of the firm. Greater the ratio means that greater contribution made by the owners in financing the assets. 103

10 Accounting and Finance for Managers Owners' Funds or Equity or Shareholders' funds Pr oprietary Ratio Total assets Standard Norm of the ratio Higher ratio is better position for the firm as well as safety to the creditors FIXED ASSETS RATIO The ratio establishes the relationship in between the fixed assets and long term source of funds. Whatever the source of long term funds raised should be used for the acquisition of long term assets; it means that the total volume of fixed assets should be equivalent to the volume of long term funds i.e., the ratio should be equal to 1 Fixed Assets Ratio share holders'funds + Outsiders'funds Net Fixed Assets If the ratio is lesser than one means that the firm made use of the short term fund for the acquisition of long term assets. If the ratio is greater than one means that the acquired fixed assets are lesser in quantum than that of the long term funds raised for the purpose. In other words, the firm makes use of the excessive funds for the built of current assets STANDARD NORM OF THE RATIO The ideal norm of the ratio is 1:1 which means that the long term funds raised only utilised for the acquisition of long term assets of the enterprise It facilitates to understand obviously about the over capitalization or under capitalization of the assets of the enterprise COVERAGE RATIOS These ratios are computed to know the solvency of the firm in making the periodical payment of interest and preference dividends. The interest and preference dividends are to be paid irrespective of the earnings available in the hands of the firm. In other words, these are known as fixed commitment charge of the firm Interest Coverage Ratio The firms are expected to make the payment of interest on the amount of borrowings without fail This ratio facilitates the prospective lender to study the strength of the enterprise in making the payment of interest regularly out of the total income. To study the capacity in making the payment of interest is known as interest coverage ratio or debt service coverage ratio. The ability or capacity is analysed only on the basis of Earnings before interest and taxes (EBIT) available in the hands of the firms. Greater the ratio means that better the capacity of the firm in making the payment of interest as well as greater the safety and vice versa Earning before interest and taxes Interest coverage ratio Interest Lesser the times the ratio means that meager the cushion of the firm which may lead to affect the solvency position of the firm in making payment of interest regularly. 104

11 Dividend Coverage Ratio Ratio Analysis It illustrates the firms ability in making the payment of preference dividend out of the earnings available in the hands of the firm after the payment of taxation. If the size of the Profits after taxation is greater means that greater the cushion for the payment of preference dividend and vice versa. The preference dividends are to be paid without fail irrespective of the profits available in the hands of the firm after the taxation. Dividend coverage ratio Earnings after taxatation Preference Dividend Standard norm of the ratio Higher the ratio means that the firm has greater cushion in meeting the needs of preference dividend payment against Earnings after taxation(eat) and vice versa Profitability Ratios The ratios are measuring the profitability of the firms in various angles viz l l l On sales On investments On capital employed and so on While discussing the measure of profitability of the firm, the profits are normally classified into various categories l l l l Gross Profit Net Profit Earnings before interest and taxes Earnings after taxation and so on All profitability ratios are normally expressed only in terms of (%). The return is normally expressed only in terms of percentage which warrant the expression of this ratio to be also in percentage. GP Ratio: The ratio elucidates the relationship in between the Gross profit and sales volume. It facilitates to study the profit earning capacity of the firm out of the manufacturing or Trading operations. Gross Profit 100 Gross Profit Ratio Sales Standard Norm of the ratio: Higher the ratio is better the position of the firm which means that the firm earns greater profits out of the sales and vice versa. NP Ratio: The ratio expresses the relationship in between the Net profit and sales volume. It facilitates to portray the overall operating efficiency of the firm. The net profit ratio is an indicator of over all earning capacity of the firm in terms of return out of sales volume. Net Profit 100 Net Profit Ratio Sales 105

12 Accounting and Finance for Managers Standard Norm of the Ratio: Higher the ratio is better the operating efficiency of the firm which means that the firms earns greater volume of both operating as well as non operating profit out of sales and Vice versa. Operating profit ratio: The operating ratio is establishing the relationship in between the cost of goods sold and operating expenses with the total sales volume. Cost of goods sold + Operating expenses 100 Operating ratio Net sales Standard norm of the ratio Lower the ratio is better as well as favourable position for the firm, which highlights % of absorption cost of goods sold and operating expenses out of sales and vice versa. The lower ratio leads to have the higher margin of operating profit. Return on Assets: This ratio portrays the relationship in between the earnings and total assets employed in the business enterprise. It highlights the effective utilization of the assets of the firm through the determination of return on total assets employed. Return on Assets Net Profit After Taxes 100 Average Total Assets Standard norm of the ration Higher the ratio illustrates that the firm has greater effectiveness in the utilization of assets, means greater profits reaped by the total assets and vice versa RETURN ON CAPITAL EMPLOYED The ratio illustrates that how much return is earned in the form of Net profit after taxes out of the total capital employed. The capital employed is nothing but the combination of both non current liabilities and owners equity. The ratio expresses the relationship in between the total earnings after taxation and the total volume of capital employed. Return on total capital employed Standard norm of the ratio Net profit after taxes 100 Total capital employed Higher the ratio is better the utilization of the long term funds raised under the capital structure means that greater profits are earned out of the total capital employed. Activity turnover ratio: It highlights the relationship in between the sales and various assets. The ratio indicates that the rate of speed which is taken by the firm for converting the assets into sales STOCK TURNOVER RATIO The ratio expresses the speed of converting the stock into sales. In other words, how fast the stock is being converted into sales in a year? The greater the ratio of conversion leads to lesser the number of days /weeks /months required to convert the stock into sales. 106 Cost of Goods Sold Sales Stock turnover ratio Or Average stock Closing stock

13 Standard norm of the ratio: Ratio Analysis Higher the ratio is better the firm in converting the stock into sales and vice versa The next step is to find out the number of days or weeks or months taken or consumed by the firm to convert the stock into sales volume. 365 days/52 weeks/12 months Stock velocity Creditors Turnover Ratio Standard norm of the ratio Lower the duration is better the position of the firm in converting the stock into sales and vice versa DEBTORS TURNOVER RATIO This ratio exhibits the speed of the collection process of the firm in collecting the overdues amount from the debtors and against Bills receivables. The speediness is being computed through debtors velocity from the ratio of Debtors turnover ratio. Debtors turnover ration Net Credit Sales Net Credit Sales Or Average Debtors Debtor + Bills Receivable Standard norm of the ratio Higher the ratio is better the position of the firm in collecting the overdue means the effectiveness of the collection department and vice versa Debtors Velocity This is an extension of the earlier ratio to denote the effectiveness of the collection department in terms of duration. Debtors velocity 365days/52weeks/12months Debtor turnover ratio Standard norm of the ratio Lesser the duration shows greater the effectiveness in collecting the dues which means that the collection department takes only minimum period for collection and vice versa Creditors Turnover Ratio It shows effectiveness of the firm in making use of credit period allowed by the creditors during the moment of credit purchase. Creditors Turnover ratio Credit Purchase Credit Purchase Or Average creditors Bills payable + Sundry Standard norm of the ratio Lesser the ratio is better the position of the firm in liquidity management means enjoying the more credit period from the creditors and vice versa. Creditors velocity 365 days/52 weeks/12 months Creditors Turnover Ratio 107

14 Accounting and Finance for Managers Standard norm of the ratio Greater the duration is better the liquidity management of the firm in availing the credit period of the creditors and vice versa. Check Your Progress (1) Solvency position of the firm studied and interpreted through (a) Short-term solvency ratios (b) Long-term solvency ratios (c) Coverage ratios (d) (a) (b) & (c) (2) Efficiency and effectiveness of the firm is studied through (a) Liquidity ratios (b) Leverage ratios (c) Turnover ratios (d) Profitability ratios (3) Profitability ratios to study the potential to earn profits on (a) On Assets (b) On Capital employed (c) On Sales (d) (a) (b) & (c) Illustration 5 Sundaram &co sells goods on cash as well as credit basis. The following particulars are extracted from the books of accounts for the calendar 2005 Particulars Rs Total Gross sales 2,00,000 Cash sales ( included in above) 40,000 Sales returns 14,000 Total Debtors 18,000 Bills receivable 4,000 Provision for doubtful debts 2,000 Total creditors 20,000 Calculate average collection period To find out the average collection period, first Debtors turnover ratio has to computed Net Credit sales Debtors turnover ratio Bills receivable + Debtors Net credit sales Gross sales cash sales sales return Rs. 2, 00, 000 Rs. 40, 000 Rs. 14, 000Rs. 1, 46, 000 Debtor turnover ratio Rs. 1, 46, 000 Rs. 4,000 + Rs. 18, times 108 Debtors velocity 365 days 365 days Debtors turnover ratio 6.64 times 55 days

15 Illustration 6 Find out the value of creditors from the following Sales Rs. 1,00,000 Opening stock Rs10,000 Gross profit on Sales 10% Closing stock Rs. 20,000 Creditors velocity 73 days Bills payable Rs. 16,000 Note: All purchases are credit purchases To find out the volume of purchases, the formula of cost of goods sold should taken into consideration Cost of goods sold Opening stock +Purchases- Closing stock X Rs. 10,000 + Y Rs. 20,000 Cost of goods sold Sales Gross profit Rs. 1,00,000 10% on Rs 1,00,000 Rs. 90,000 The next step is to apply the found value in the early equation Purchases Rs. 90,000 Rs. 10,000 +Rs. 20,000 Rs. 1,00,000 To find out the value creditors, the creditor velocity and creditors turnover ratio Ratio Analysis Creditors velocity 365 days Creditors turnover ratio Credit purchases Creditors turnover ratio Bills payable + Sundry creditors Rs.1,00,000 Rs.16,000 + Sundry creditors The next step is to find out the sundry creditors, the reversal process to be adopted 73 days 365 days Creditors turnover ratio 365 days Creditors turnover ratio 5 times 73 days The next step is to substitute the found value in the equation of creditors turnover ratio Rs. 1,00,000 Rs. 16,000 + Sundry creditors 5 Sundry creditors Rs. 20,000 Rs. 16, 000 Rs. 4,000 Illustration 7 From the following information, prepare a balance sheet show the workings 1. working capital Rs. 75, Reserves and surplus 1,00, Bank overdraft 60,

16 Accounting and Finance for Managers 4. Current ratio Liquid Ratio 1,15 6. Fixed assets to proprietors fund Long term liabilities Nil (B.Com. Madras, April 1980) First step is to find out the current liabilities Current assets 1.75 Current ratio Current liabilities 1 Working capital Rs. 75, If 0.75 is the share of working capital, what would be the share of current assets? Current assets Rs. 75, Rs.1,75, Working capital Current assets current liabilities Current liabilities Current assets working capital CL Rs. 1, 75, 000 Rs. 75, 000Rs. 1, 00, 000 Quick assets ratio Quick assets Quick liabilities Quick assets Current liabilities BOD (Rs. 1,00,000 Rs. 60,000) Quick assets 1.15(Rs. 40,000) Quick assets Rs 46, 000 Quick assets The next step is to find out the amount of the closing stock. This can be found out through finding out the difference in between the current assets and quick assets. Closing stock Current assets Quick assets Rs. 1,75,000 Rs. 46,000 Rs. 1,29,000 The next one is to find out the proprietors fund The fixed assets to proprietors fund is 0.75 This has to be found out on the basis of Double Entry Accounting Concept Total liabilities Total Assets...(1) Long term funds + Short term financial resources Total liabilities In the long term funds, there is no long term liabilities, which means the structure of long term funds consist of the share holders funds The share holder funds are known as proprietors fund Short term financial resources are known as current liabilities Proprietors fund + Current liabilities Total liabilities Current assets + Fixed assets Total assets To substitute the values in the equation (1)

17 Proprietors fund + Current liabilities Current assets + Fixed assets Proprietors fund Fixed assets Current assets Current liabilities Rs. 1,75,000 Rs. 1,00, Rs. 75,000 If is bearing the volume of Rs 75, 000; what would be the volume of investment of fixed assets for and proprietor s fund for 1 Ratio Analysis Rs.75, 000 proprietor 's fund 0.25 Rs.3,00, portion of the owners funds are contributed to fixed assets i.e on Rs. 3,00,000 Rs. 2,25,000 To find out the exact share of the equity share capital, the following formula has to be used. Share holder s funds Equity share capital + Reserves and surpluses In this problem, reserves and surpluses is given Rs. 3,00,000Equity share capital +Rs 1,00,000 Equity share capital Rs. 2,00,000 The balance sheet of the company as on dated Liabilities Rs Assets Rs Share capital 2,00,000 Fixed assets 2,25,000 Reserves and surpluses 1,00,000 Stock 1,29,000 Bank overdraft 60,000 Quick assets 46,000 Quick liabilities 40,000 4,00,000 4,00,000 Check Your Progress (1) Standard norm of the current ratio is (a) 2:1 (b) 1:. 5 (c) 1:2 (d) 3:1 (2) Super quick assets do not include (a) Closing stock (b) Prepaid expenses (c) Sundry debtors (d) Both (a) & (b) (3) Standard norm of the Debt to Capital (a) 1:2 (b) 1:1 (c) 2:1 (d) 1:5 111

18 Accounting and Finance for Managers Illustration 8 Debtors velocity 3 months Creditors velocity 2 months Stock velocity 8 times Capital turnover ratio 2. 5 times Fixed assets turnover ratio 8 times Gross profit turnover ratio 25% Gross profit in a year amounts to Rs. 1, 60, 000. There is no long term loan or overdraft. Reserves and surplus amount to Rs. 56, 000. Liquid assets are Rs. 1, 94, 666. Closing stock of the year is Rs. 4, 000 more than the opening stock Bill receivable amount to Rs. 10, 000 and bills payable to Rs. 4, 000 Find out Sales Closing stock Sundry debtors Fixed assets Sundry creditors Proprietors fund Draft the balance sheet with as many as details possible. The first step is to find out the sales Gross profit ratio 25% The total volume of gross profit is given Rs. 1,60,000 Gros Profit GP ratio 100 Sales Rs.1,60,000 25% 100 Sales Rs.1,60,000 Saels Rs. 6,40,000 25% The next step is to find out the closing stock value In our problem, two important information given are stock velocity and details about the closing stock in terms of opening stock Stock velocity 8 times Closing stock is Rs. 4, 000 excess of opening stock The information stock velocity given denotes that the stock turnover ratio. cost of goods sold Stock trunover ratio AverageStock Now the volume of cost of goods sold has to be found out from the early available information i.e., sales and gross profit Cost of goods sold Sales Gross profit Rs. 6,40,000 Rs. 1,60,000 Rs. 4,80,000 The next step is to find out the volume of average stock through the earlier formula times Rs. 4,80,000 Average stock

19 Average stock Rs. 60,000 The next step is to apply the conditionality with regards to closing stock Ratio Analysis Opening Stock + Closing Stock Rs. 60,000 2 Opening stock + Opening stock + Rs. 4, 000 Rs. 60, Opening stock +Rs. 4, 000 Rs. 1, 20, Opening stock Rs. 1, 20, 000 Rs. 4, 000 Opening stock Rs. 58, 000 Closing stock Opening stock + Rs. 10, 000 Rs. 58, 000+ Rs. 10, 000Rs. 68, 000 The next fact is to be found that sundry debtors To find out the debtors, the most information given debtors velocity and bills receivable have to be made use of 12 months Debtors Velocity Debtors turnover ratio 12 months Debtors turnover ratio 4times 3 months Credit sales 4 times Bills receivable+ Sundry debrors Rs. 6,40,000 Rs.10,000 + Sundry debtors 4 Sundry debtors Rs. 1, 60, 000 Rs. 10, 000 Rs. 1, 50, 000 The next important stage is to find out the sundry creditors To find out the sundry creditors, the creditors velocity has to be applied in the formula In addition to the earlier, one missing information has to be found out i-e Credit purchases The volume of purchase to be found out through the formula of cost of goods sold Cost of goods sold Opening stock +Purchases Closing stock Rs. 4,80,000 Rs. 58,000+Purchases Rs. 68,000 Purchases Rs. 4,80,000 Rs. 58,000+Rs. 68,000 Rs. 4,80,000+Rs. 10,000 Rs. 4,90,000 Creditors velocity 12 months Creditors turnover ratio 12 months Creditors turnover ratio 6 times 2 months Rs. 4,90,000 6 times + Sundry creditors Rs. 4,000 Rs. 4,000+ Sundry creditors Rs. 81,667 Sundry creditors Rs 77,

20 Accounting and Finance for Managers The next step is to find out the volume of fixed assets This could be found out with the help of fixed assets turnover ratio 5 times Fixed assets turnover ratio 5 times Sales Fixed Assets Rs.6,40,000 5 times Rs.1, 28, 000 Proprietors fund Proprietor s fund Fixed assets+ Current Assets Current liabilities The above equation is coined on the basis of Double accounting concept Fixed assets + Current assets Total assets Total Liabilities Total Assets Current liabilities Total Liabilities Current liabilities Current assets volume is not known, In such cases the stock volume should be added with the Liquid assets to derive the early mentioned. Current assets Closing stock + Liquid Assets Rs. 68,000+ Rs. 1,94,666 Rs2,62,666 Proprietor s fund Rs. 1,28,000+ Rs. 2,62,666 Rs. 81,667 Rs. 3,08,999 Share capital Proprietor s fund Reserves and surpluses Rs. 3,08,999 Rs. 56,000 Rs. 2,52,999 Cash and Bank Balances to be found out in the next stage Liquid Asset Rs. 1,94,666 Less : Debtors Rs. 1,50,000 Bills receivable 10,000 Rs. 1,60,000 Rs. 34, From the above found information the detailed balance sheet with as many as information possible to portray Balance sheet as on dated - Liabilities Rs Assets Rs Share capital 2,52,999 Fixed assets 1,28,000 Reserves and surpluses Stock 68,000 Bills receivable 4,000 Debtors 1,50,000 Sundry creditors 77,667 Bills receivable 10,000 Cash and Bank Balance 34,666 3,90,666 3,90,666 Illustration 9 From the following particulars, prepare trading, profit and loss account and a balance sheet Current ratio -3 Liquid ratio -1.8 Bank overdraft Rs. 20,000

21 Working capital Rs. 2,40,000 Debtors velocity -1 month ; Gross profit ratio -20% Proprietary ratio (Fixed assets / share holders fund) -.9 Reserves and surpluses of share capital Opening stock Rs. 1,20,000; 8% Debentures Rs. 3,60,000 Long term investments Rs. 2,00,000 Stock turnover ratio -10 times Creditors velocity -1/2 month Net profit to share capital -20% (B. Com Bharathidasan, April 1989) First step is to find out the current assets and current liabilities through current ratio Ratio Analysis Current Assets Current ratio 3 Current Liabilities Current Assets- Current Liabilities Working capital Rs. 2, 40, 000 The volume of working capital Rs 2,40,000 is equated to share 2 What is the volume of current liabilities for the share of 1 Current liabilities Rs. 2, 40, 000 Rs. 1,20,000 2 The volume of current assets Rs. 1,20,000 3 Rs. 3,60,000 The next step is to find out the volume of liquid assets Liquid assets ratio 1.8 Liquid assetss Liquid Liabilities When the Bank overdraft is given, the liquid liabilities should be computed. Liquid liabilities Current liabilities Bank overdraft Rs. 1,20,000 Rs. 20,000 Rs. 1,00,000 Liquid assets is 1.8 times greater than the Liquid liabilities Liquid assets 1.8 Rs. 1,00,000 Rs. 1,80,000 To find out the volume of the stok Stock Current assets Liquid assets Rs. 3,60,000 Rs. 1,80,000 Rs. 1,80,000 The next step is to find out the cost of goods sold To find out the cost of goods sold, the stock turnover ratio has to be found out cost of goods sold 10 times Average stock Opening stock + Closing stock Average stock 2 Rs.1,20,000 + Rs.1,80,000 Rs.1,50,

22 Accounting and Finance for Managers Cost of goods sold Rs. 1,50, Rs. 15,00,000 Next step is to find out the volume of sales in order to find out the volume of debtors The volume of sales could be found out through Gross profit ratio Sales Profit Cost of goods sold The Rs15, 00, 000 worth of cost of goods sold is equated to share of 80 What would be the volume of sales? Rs.15,00,000 Sales Rs.18,75, Gross profit Rs. 18, 75, 000 Rs. 15, 00, 000 Rs. 3,75,000 The next step is to find out the volume of debtors The debtors could be found out with the help of debtors turnover ratio and collection period Debtors velocity or collection period 12 months Debtors turnover ratio 12 times 1month Credit Sales 12 times Average debtors Rs.18,75,000 Average Debtors Rs.1,56, months Debtors turnover ratio The next step is to find out the creditors. The volume of creditors ; to find out the volume of the creditors, the creditors turnover ratio and creditors average payment period should have to be applied Creditors average payment period Creditors turnover ratio 12 months 24times months Creditors turnover ratio Creditors turnover ratio credit purchase Average creditors Average creditors credit purchase 24 times Now the volume of credit purchase to be found out with the help of cost of goods sold formula Cost of goods sold Opening stock+ Purchases- Closing stock Rs. 15,00,000 Rs. 1,20,000+Rs. 1,80,000 Purchases Rs. 15,60,000 Purchases 116 Average creditors Rs. 65,000

23 The next step is to find out the proprietary fund ; this could be found out by using the ratio proprietary fund to fixed assets ratio Total Assets Total Liabilities Long term liabilities + Short term liabilities Fixed assets + Current assets + Investments Share holders fund Fixed assets Current assets + Investment Current liabilities Debenture Rs. 2,00,000+Rs. 3,60,000 Rs. 1,20,000 Rs. 3,60, Rs. 80, Rs. 80,000 If 0.1 share is the volume of Rs. 80,000 what is the volume of proprietary fund for the share of 1? The volume of proprietary fund Rs. 8,00,000 The volume of fixed assets Rs. 80, Rs. 7,20,000 The next step is to find out the volume of the share capital. This could be found out only with the help of the ratio given Reserves and surpluses to share capital Reserves and surpluses 25 % of share capital It means that % is Share capital. Share capital + Reserves and surpluses Shareholders fund To find out the share of share capital from the shareholders fund, the following is the computation Ratio Analysis Rs.8,00, Rs.6,40,000 share capital 125 Reserves and surpluses 25% on the Share capital 25% on Rs. 6,40,000 Rs. 1,60,000 The last step is to find out the Net profit, which could be found out through the Net profit to share capital Net profit is 20% on share capital Net profit 20% on Rs. 6,40,000 Rs. 1,28,000 Next stage is to prepare the Trading, Profit & Loss A/c for the year ended and Balance sheet as on dated Trading Profit & Loss Account for the year ended Dr Cr Particulars Rs Particulars Rs To opening stock 1,20,000 By sales 18, To purchases 15,60,000 By closing stock 1,80,000 To Gross profit c/d 3,75,000 20,55,000 20,55,000 To Debenture Interest 8% 28,800 By Gross profit B/d 3,75,000 Rs.3,60,000 To Balancing figure other 2,18,200 expenses To Net profit c/d* 1,28,000 3,75,000 3,75,

24 Accounting and Finance for Managers Balance sheet as on dated Liabilities Rs Rs Assets Rs Rs Share capital 6,40,000 Fixed assets 7,20,000 Reserves and 32,000 Investments 2,00,000 Surpluses Profit during the 1,28,000 1,60,000 year 8% Debentures 3,60,000 Current liabilities Current Assets Overdraft 20,000 Stock 1,80,000 Creditors 65,000 Debtors 1,56,250 Others 35,000 1,20,000 Other current asset 23,750 3,60,000 12,80,000 12,80, DUPONT ANALYSIS This was an analysis established by the DUPONT INC., USA to study the Return on investment. It was the first company developed the chart which depicted the influences of Return on Investment. The company underwent for the consideration two important ratios for the return on investment is Net profit ratio and Capital turnover ratio A change in the any one of the two ratios that will immediately reflect on the Return on investment. The various associated factors are considered to study the impact of the profitability of the firm. This type of analysis to correct the problems not only to identify the with specific cause which drastically affects the profitability but also to find the possible ways and means to improve the profitability. Having developed the chart for analysis was called as DUPONT Chart. Net profit ratio Net profit Sales Cost of goods sold Sales Expenses Roce Return on capital employed Administrative, Selling and distribtution expense sales Working capital Current assets Capital turnover ratio Capital employed Fixed asset Current liabilities 6.18 LET US SUM UP 118 The accounting ratios are applied to study the relationship in between the quantitative information available and to take decision on the financial performance of the firm. The financial performance and position of the firm can be analysed and interpreted with in the firm in between the available financial information of many number of years; which portrays either increase or decrease in the financial performance. The perfection and effectiveness of the analysis mainly depends upon the preparation of accurate and effectiveness of the financial statements. It is subject to the availability of fair presentation of data in the financial statements. Current liabilities are nothing but short term financial resources or payable in short span of time within a year. The super quick assets are nothing but the current assets which can be more easily converted into cash to meet out

25 the quick liabilities. Under the capital structure ratios, the composition of the capital structure is analysed only in the angle of long term solvency of the firm. All profitability ratios are normally expressed only in terms of (%). The return is normally expressed only in terms of percentage which warrant the expression of this ratio to be also in percentage. Ratio Analysis 6.19 LESSON-END ACTIVITY Identity four ratios or other analytical tools used to evaluate profitability. Explain briefly how each is computed KEYWORDS Ratio Stock term over ratio Acid Test ratio Fixed assets ratio Accounting ratio GP ratio Coverage ratio Stock velocity Du analysis 6.21 QUESTIONS FOR DISCUSSION 1. Define ratio. 2. Define Accounting ratio. 3. What is meant by Accounting ratio analysis? 4. Elucidate the importance of the ratio analysis. 5. Explain the Liquidity ratios. 6. Highlight the Leverage ratios. 7. Discuss in detail about the Profitability ratios. 8. Illustrate the various kinds of Turnover ratios. 9. List out the limitations of the ratio analysis SUGGESTED READINGS R. L. Gupta and Radhaswamy, Advanced Accountancy V. K. Goyal, Financial Accounting, Excel Books, New Delhi. Khan and Jain, Management Accounting S. N. Maheswari, Management Accounting S. Bhat, Financial Management, Excel Books, New Delhi. Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw Hill, New Delhi (1994). I. M. Pandey, Financial Management, Vikas Publishing, New Delhi. Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi. 119

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