Intermediate (IPC)Course Paper 3 Part 2 Financial Management Chapter 3 CA. N Raja Natarajan, B.Com, PGDBA, ACA

Intermediate (IPC)Course Paper 3 Part 2 Financial Management Chapter 3 CA. N Raja Natarajan, B.Com, PGDBA, ACA

Classification of Ratios Liquidity Ratios Capital Structure / Leverage Ratios Activity Ratios Profitability Ratios

Liquidity Ratios Current Ratio Quick Ratio Cash Ratio / Absolute Liquidity Ratio Basic Defense Interval Ratio

LIABILITIES ASSETS CURRENT LIABILITIES CURRENT ASSETS

Current Ratio 700 600 500 400 300 Current Liability Current Asset 200 100 0 Working Capital

Current Ratio 350 300 250 200 150 DANGER ZONE Current Liability Current Asset 100 50 0 Working Capital

Scenario I II III Current Asset 600 300 200 Current Liability 300 300 300 Net Working Capital 300 - -100 Current Ratio 2:1 1:1 0.67:1

350 Quick Ratio / Acid Test Ratio 300 250 200 150 100 50 Current Liability Current Assets Liquid Assets 0 Working Capital

CURRENT ASSET 300 QUICK ASSETS 200 CURRENT LIABILITY 300 QUICK RATIO = QUICK ASSETS / CURRENT LIABILITY = 200/300 = 0.67:1

360 Preferable Liquidity Position 350 340 330 320 310 300 Current Liability Current Assets Liquid Assets 290 280 270 Working Capital

Absolute Liquid Ratio 350 300 250 200 150 100 50 Current Liability Absolute Liquid Assets 0 Working Capital

CURRENT ASSET 350 LIQUID ASSETS 250 ABSOLUTE LIQUID ASSET 150 CURRENT LIABILITY 300 ABSOLUTE LIQUID RATIO = ABSOLUTE LIQUID ASSETS / CURRENT LIABILITY = 150/300 = 0.50:1

CASH EXPENSES P.A. --------------------------- 365 DAYS = CASH EXPENSE PER DAY CASH RESOURCES AVAILABLE ------------------------------------------ CASH EXPENSE PER DAY NO. OF DAYS BASIC DEFENSE INTERVAL

Capital Structure Ratios Equity Ratio Debt Ratio Debt to Equity Ratio

Share Holders Funds 100 Total Capital Employed 400 EQUITY RATIO = Share holder Funds ---------------------------- Total Capital Employed = 100/400 = 25%

DEBT (OUTSIDE LIABILITIES) 400 TOTAL CAPITAL EMPLOYED 500 DEBT RATIO =DEBT (OUTSIDE LIABILITIES) ---------------------------------------- TOTAL CAPITAL EMPLOYED = 400/500 = 80%

DEBT (OUTSIDE LIABILITIES) 400 EQUITY 100 DEBT-EQUITY RATIO =DEBT (OUTSIDE LIABILITIES) ---------------------------------------- EQUITY (SHARE HOLDERS FUNDS) = 400/100

DEBT EQUITY RATIO TIMES PERCENTAGE% 400/100 400/100 x 100 4:1 DEBT 4 TIMES OF EQUITY 400% DEBT 400% OF EQUITY

Coverage Ratio Debt service coverage Ratio (DSCR) Interest Coverage Ratio Preference Dividend Coverage Ratio Capital Gearing Ratio

Interest on Loan = 100 Installment = 100 ------------------------------------- Total Debt Obligation = 200 PBDIT = 400 DSCR = Profit Before Depreciation and Interest Interest + Installment = 400/200 = 2 times

Profit before depn ; Interest and Tax (PBDI T) = 400 Interest on Loan =100 Interest coverage ratio = PBDIT Interest on loan = 400/100 = 4 times

PAT = 100 Preference Dividend Liability = 25 Preference Dividend Coverage Ratio = Profit After Tax Pref. Dividend Liability = 100/25 = 4 times

Calculation : Share holders funds = 200 Interest Bearing Funds = 700 Capital Gearing Ratio = Interest Bearing Funds Share holders funds = 700/200 = 3.5 times

Activity Ratios Capital Turnover Ratio Fixed Asset Ratio Total Asset Turnover Ratio Working capital Turnover Ratio

Calculation I II III Sales 1000 2000 500 Capital Employed 1000 1000 1000 Capital Turnover Ratio 1 Time 2 Times 0.5 Times

Fixed Asset Turnover Ratio = Sales ------------------------------ Average Fixed Assets

Calculation I II III Sales Opening Assets Closing Assets Average Assets 1000 2000 500 500 2000 Nil 1000 3000 1000 750 500 2500 Total Assets Turnover Ratio 1.33 Times 0.80 Times 1 Times

Working Capital Ratio Inventory Turnover Ratio Debtors Turnover Ratio Creditors Turnover Ratio

Calculation I II III Cost of Sales Opening Inventory Closing Inventory Average Inventory Inventory T/O 1000 1000 1000 500 500 500 500 250 750 500 375 625 2 Times 2.67 Times 1.60 Times Profit Good Best Reasonable

Cost of Goods Sold = Cost of Goods Sold per No. of. Days in a Year Day ------------------------------ No. of. Days of Inventory = Average Inventory -------------------------------------- Cost of Goods Sold per day

Calculation I II III Sales 1000 1000 1000 Cash Sales 400 400 400 Credit Sales 600 600 600 Opening Debtors 100 200 200 Closing Debtors 200 400 600 Average 150 300 400 Debtors Debtors T/O 4 Times 2 Times 1.5 Times Recovery Speed Good Better Should Improve

Credit Sales ------------------------------ 365 = Average Daily Credit Sales Opening Debtors + Closing Debtors ----------------------------------------------------- 2 = Average Debtors Average Debtors ----------------------------------- = Average Collection Period Average Daily Credit Sales

Sales-3,65,000 Open Debtors 15000 Cash Sales 182500 Credit Sales 182500 Credit Sales per Day (/ 365 Days) Closing Debtors 20000 Average Debtors 17500 500 Average Collection Period Avg. Drs =----------------- =35 Avg. Credit Days Sales per Day

Calculation I II III Purchases Credit Purchases(60)% Opening Creditors 1000 1000 1000 600 600 600 100 200 300 Closing Creditors 200 400 500 Average Creditors 150 Creditors Turnover 4 Times 2 Times 1.5 Times 300 400 Interpretation Rapid Settlement Average Rotation Liberal/Stre ss

Annual Credit Purchases --------------------------------- 365 Days = Credit Purchases per Day Opening Creditors + Closing Creditors ----------------------------------------------------- = Average Creditors 2 Average Payment Period = Average Creditors ----------------------------------- Credit Purchases per Day

Cash Purchases 182500 Purchases-3,65,000 Credit Purchases 182500 Opening Crs- 15000 Closing Crs- 20000 Credit Purchases per Day (/ 365 Days) Average Creditors- 17500 500 Average Crs Average =----------------- Payment Period Avg. Credit Purchase per Day 17500 = ------------ 500 =35 Days

General Profitability Ratio Gross Profit Ratio Operating Ratio Operating Profit Ratio Expenses Ratio Net Profit Ratio

Calculation: Gross Profit 20 Net Sales 100 x 100 = 20% Gross Sales Sales Return

Operating Ratio = Operating Cost Net Sales x 100

Sales 100 Sales return 10 Raw material Consumed 60 Manufacturing Expenses 10 Admin Expenses 5 Cost of goods sold Other operating expenses Net Sales 90 Operating cost 75 Operating Ratio = Operating Cost Net Sales x100 = 75/90 x 100 = 83 %

Net Sales 100 Operating Cost 80 Operating Profit - 20 Operating Profit ratio = Operating Profit 20 Net Sales 100 x 100 = 20/100 x100 20%

Cost Goods Sold Cost of goods sold x 100 Net sales Expenses Admin Expenses Admin expenses x 100 Net Sales Selling & Distribution Expenses Factory Cost Factory Cost x 100 Net Sales Specific Expenses Specific expenses x100 Net Sales S & D Expenses x 100 Net Sales

Calculation : Net Profit After Tax 20 x 100 Net Sales 100 Net Profit Ratio = 20/100 x 100 = 20 %

Return on Investment Ratio Return On Asset Return on Capital Employed Return on Shareholders Equity

Sales 100 Less: Operating Expenses 50 Profit before Interest 50 Less: Interest (10) ROA = TOTAL ASSETS - 100 PBIT Total Assets = 50/100 = 50% = 35/100 = 35 % Profit before Tax 40 Less: Tax @ 30% (12) ROA = PAT Total Assets = 28/100 = 28% Profit After Tax 28 28+10-3 = 35 Profit After Tax Before Interest

BALANCE SHEET LIABILITIES ASSET Share holders funds 100 Bank Loan 100 Sundry Creditors 100 300 Fixed Assets 150 Current Asset 150 300 Income Statement Total Capital Employed - 300 Sales 200 Less: Operating Expense (150) Operating Profit 50 Less: Interest (10) Profit before Tax 40 ROCE = Operating profit Capital employed = 50/300x 100 = 16.67 %

Return on Share holders Funds = Profit After Tax X 100 Share holders Funds

Return on Equity Share Holders Funds Earnings Per Share Cash Flow Earnings Per Share Dividend Per Equity Share Dividend Pay Out Ratio Dividend Yield Ratio

Comprehensive Illustration Depreciation 100 EP S = Profit after Tax and Pref. Dividend No. Of Equity Shares 100 Profit after Tax 1000 Preference Dividend 100 Profit after Tax and Preference Dividend 900 Equity Dividend 100 800 Div. Per Share Div. Payout Ratio = 900 / 100 => 9 Per Share = Equity Dividend No. Of Equity Shares = 100 / 100 => 1 Per Share = Dividend Per Share Earnings Per Share = 1 / 9 => 11.11% Cash Flow Earnings Per Share = (PAT & Pref Dividend + Depn/Amtisn + Non Cash Expense) No. Of Equity Shares = (1000+100)/100 = 11 Per Share Div. Yield Per Share = Div. Per Share Market Price per Share = 1/10 => 10% 10/Sh

Market Value Ratios Earnings Yield Ratio Price Earning Ratio Price to Cash Flow Ratio Market Value to Book Value Ratio

Earning Yield Ratio = Earning Per Share (E/P ratio) Market Price Per Share

Price Earnings Ratio (or) P/E Ratio = Market Price Per Share Earning Per Share

EPS 10 MPS 100 High P/E ratio SOLD Low EPS Low Profit 10 Times of Earnings High Expectation

High P/E ratio High Expectations Low profit Compare High Expectations Industry Average Other Shares High Risk Element

Cash Flow Earning Per Share = Cash Flow Earnings Market Price Per Share

Book Value of Share Market Value of Share

Equity Share Capital + Reserve & Surplus (-) Accumulated Loss Books Value No. Of Equity Shares = Books Value Per Share

BV = 10 MV = 30 BV to MV ratio = 30/ 10 = 3 Book Value Per Share Balance sheet Past Value Market Value Market Future

Long Term Sources of Funds Surplus Changes in WC Requirement Increase in WC Long Term Uses of Funds Deficit Changes in WC Decrease in WC

Balance Sheet Uses of Funds Decrease in WC Long Term Sources Long term Uses Inflow Outflow Inflow Outflow Short Term Sources Sources of Funds Short Term Uses (Increase in WC)

Sources of Funds Uses of Funds LONG TERM USES LONG TERM FUNDS WORKING CAPITAL

Sources of Funds Uses of Funds LONG TERM FUNDS LONG TERM USES -VE WORKING CAPITAL

Fund Flow Analysis Sources of Funds Use of Funds Working Capital aising Long Term Funds TLs Funds From Operations Disposing Long Term Assets Paying Long Term Funds Back Purchase of Long Term Assets Increase in WC Decrease in WC quity Debenture Profit before Depreciatio n and Tax Dividend & Tax

Current Year Income Statement Fund Flow Analysis Two Year Balance Sheet Funds Generated Operations Long Term Sources Long Term Uses Changes in WC

Fund From Operations Long Term Source Profit Before Tax (+) Depreciation/Amortization (+) Losses on the Sales of Assets/Investments (-) Profit on the Sales of Assets/Investments

INCOME STATEMENT BALANCE SHEET Sales Less: Operating Exp Less: Depreciation Less: Tax 100 (50) (20) PBT 30 (10) PAT 20 50 SOURCES OF FUNDS Liabilitie s Capital Reserves Term loan Current Liabilities PY 100 50 50 CY 110 70 60 40 50 240 290 FUND FLOW STATEMENT Assets Fixed Assets Current Assets USES OF FUNDS PY CY 150 90 170 120 240 290 Funds From Operations (30+20) 50 Fixed Assets (170-150)+20 40 Capital (110-100) Term Loan (60-50) 10 10 70 Working Capital CY[120-50] PY[90-40] =70 =50 Tax 10 20 + 10 70

Financial Soundness Despite Loss Liquidity Strain Indicators Despite Profits Diversion of Short Term Fund for Long Term Purpose Uses of Fund Flow Statement Where Funds Have Come From Funds Generated From Operations Long Term Fund Support for WC Purpose