RATIOS

Introduction:

Ratios are presentation technique, which helps the reader to get idea about the performances & Position of a firm with least efforts. He can get overall view of the firm from the ratios presented to him. He can compare such ratios with the ratios of the past & also with ratios other firm in industry. For getting insight we must know how such ratios are calculated.

Types of Ratios

Liquidity Ratios: Short term solvency ratios. (Pure Ratio shown in 1: 1 form)

Current Ratio Liquid Ratio Quick Ratio

1. Current Ratio Current Assets

Current Liabilities

Objective:

The objective is to measure the ability of the firm to meet its short – term obligations and to reflect the short – term financial strength/ solvency of a firm. It suggests whether firm can meet its short term obligation from short – term Assets.

Current Assets refer to those assets which are held for their conversion into cash normally within a year.

Current Liabilities refer to those liabilities which are expected to be matured normally within a year.

Interpretation:

It indicates rupees of current assets available for each rupee of current liability. Higher the ratio, greater is the margin of safety for short–term creditors and vice versa. However, too high/too low ratio calls for further investigation since the too high ratio may indicate the presence of idle funds with the firm or the absence of investment opportunities with the firm and too low ratio may indicate problem of short-term insolvency. Traditionally, a current ratio of 2:1 is considered to be a satisfactory ratio.

2 Liquid Ratio or Acid Test Ratio = Liquid Assets

Liquid Liabilities.

Liquid Assets = Current Assets – StockLiquid Liability = Current liabilities – Bank O/D – cash credit

Objective:

The objective is to measure the ability of the firm to meet its short – term obligations as and when due without relying upon the realization of stock.

Interpretation:

It indicates rupees of quick assets available for each rupee of liability due on short term notice. Traditionally, a quick ratio of 1:1 is considered to be a satisfactory ratio. However, this traditional rule should not be used blindly since a firm having a quick ratio of more than 1, may not be meeting its short–term obligations in time if its current assets consist of doubtful and slow paying debtors while a firm having a quick ratio of less than 1, may be meeting its short–term obligations in time because of its very efficient debtors management.

3. Quick Ratio Quick Assets

Liquid Liabilities

Quick Assets = Current ratio less stock and debtor. This ratio suggests whether available cash & cash equivalent (which can quickly convertible in cash) are sufficient to meet its short term liabilities.

Profitability Ratios (Always is percentage except EPS)

In relation to Sales In relation to Investmenta) Gross profit ratio a) Return on Cap. Employedb) Net profit Ratio b) Return on Equityc) Operating Ratio c) Return on equity shareholder Fund

d) Return on equity share capitale) Earning per sharef) Return on total assets

Income Statement

Net SalesLess: Cost Of Goods Sold= Gross ProfitLess: Operating Exp (Administrative & Selling Expense)Add : Operating income (commission, discount received.)= Operating Profit (PBIT)Less: Non operating Expenses:

Liquidity Ratios

Solvency Ratios

Profitability Ratios

Activity Ratios

Equity Profit Equity shareholder fund

100

Int. on DebenturesLoss on Sale of assets or loss due to fire

Add: Non-operating Income:Interest & Dividend on InvestmentProfit on sale of Assets & Investment

= Net Profit before taxLess: Tax= Net Profit after taxLess: Preference dividend= Equity Profit

1. Gross Profit Ratio Gross Profit

Net Sales 100

Gross Profit = Sales – Cost of goods sold. Cost of goods sold = Opening stock + Net purchase + Purchase Exp +wages – closing stock

Objective:

The objective is to determine the efficiency with which production and/or purchase operations are carried on.

Interpretation:

This ratio indicates (a) an average gross margin earned on a sale of Rs. 100, (b) the limit beyond which the fall in sales prices will definitely result in losses. And (c) what portion of sales is left to cover operating expenses and non – operating expenses like to pay dividend and to create reserves. Higher the ratio, the more efficient the production and /or purchase management. This ratio may increase due to one of the following factors:

Higher Sales Prices with constant Cost of Goods Sold; Lower Cost of Goods Sold with constant Sales Prices; A combination of aforesaid two factors.

2. Net Profit Ratio Net Profit After Tax

Net Sales 100

Objective:

The objective is to determine the overall profitability due to various factors such as operational efficiency.

Interpretation:

This ratio indicates (a) an average net margin earned on a sale of Rs. 100 (b) what portion of sales is left to pay dividend and to create reserves, and (c) firm’s capacity to withstand adverse economic conditions when selling price is declining.

3 Operating Ratio = .

Cost of Goods sold + Administrative/Selling/ Distribution /Financial Expenses Net Sales

100

Objective:

The objective is to determine the operational efficiency with which production and /or purchases and selling operations are carried on.

Interpretation:

This ratio indicates an average operating cost incurred on sales of goods worth Rs. 100. Lower the ratio, greater is the operating profit to cover the non – operating expenses, to pay dividend and to create reserves and vice–versa. 1. Return on Capital Employed =

P.B.I.TCapital Employed

100

Capital employed = total investment=long term fund

Objective:The objective is to find out how efficiently the long – term funds supplied by the Debenture holder and shareholders have been used.

Interpretation:

Higher the ratio, the more is the efficient the management and utilization of Capital Employed.

2. Return on Equity =

Equity = shareholder Fund = Owners fund = Proprietors Fund

Objective:-

The objective is to find out how efficiently the funds belonging to the shareholders (equity and preference) have been used.

Interpretation:

This ratio indicates the firm’s ability of generating profit per 100 rupees of shareholders’ funds. Higher the ratio, the more efficient the management and utilization of shareholders’ funds is.

3. Return on Equity shareholder fund =

Objective:

The objective is to find out how efficiently the funds supplied by the equity shareholders have been used.

Interpretation:

This ratio indicates the firm’s ability of generating profit per 100 rupees of equity shareholders’ funds. Higher the ratio, the more efficient the management and more is the utilization of equity shareholders’ funds.

4. Return on equity share capital =

Objective:

The objective is to find out how efficiently the funds supplied by the equity shareholders have been used.

Interpretation:

This ratio indicates the firm’s ability of generating profit per 100 rupees of equity share capital. Higher the ratio, the more efficient the management and utilization of equity shareholders’ Capital is.

5. Earning Per Share =

Objective:

The objective is to measure the profitability of the firm on per equity share basis.

Interpretation:

In, general, higher the EPS, better it is and vice versa. EPS helps in determining the market price of the equity shares of the company. It also helps in estimating the company’s capacity to pay dividend.

Solvency Ratios (Long term Solvency)

Debt – Equity Ratio Interest Coverage RatioCapital Gearing Ratio Debt Service Coverage RatioProprietary Ratio Long term fund to fixed Asset

1. Debt – Equity Ratio (Leverage Ratio) =

Objective:

The objective is to measure the relative proportion of debt and equity in financing the assets of a firm.

Interpretation:

It indicates the margin of safety to long – term Debt. A low debt equity ratio implies the use of more equity than debt which means a larger safety margin for Debt providers since owner’s equity is treated as a margin of safety by debenture holder and vice versa. The implications from the point of view of long term providers of loan and the firm may be seen as under.

Capital Gearing Ratio =

Objective:

The objective is to find proportion of fix return bearing security to not fix return bearing securities in total capital of firm.

Interpretation:

It indicate that for every 100 Rs. of equity capital what proportion of fix return bearing capital existing. More this ratio higher is the risk of fix commitment & more burdens for generating equity profit. However it may result in to benefit by effect on trading on equity.

Proprietary ratio =

Objective:

The objective is to find out how much the proprietors have financed for the purchases of assets.

Interpretation:

This ratio indicates the extent to which the assets of the firm have been financed out by proprietors’ fund.Total Assets = All Assets (Excluding Fictitious Assets like preliminary exp. underwriting exp, debenture discount.)

2. Interest Coverage Ratio =

Objective:

The objective is to measure the debt servicing capacity of a firm so far fixed interest on long – term debt and debenture is concerned.

Interpretation:

Interest coverage ratio shows the number of times the amount of interest on long – term debt is covered by the profits out of which that will be paid. It indicates the limit beyond which the ability of the firm to service its debt would be adversely

affected. Higher the ratio, greater the firm’s ability to pay interest but very high ratio may imply lesser use of debt and very efficient operations.

3. Debt Service Coverage Ratio =

Cash available for debt payment means P.A.T. +Depreciation & other non cash expenditure dr. to P & L account + Interest on debt

Long term Fund to Fixed Assets =

Interpretation:

Sound business technique it to Acquire major permanent assets from permanent capital & temporary capital should be invested in current assets. If temporary capital is invested in permanent assets than financial position may get disturb? This ratio suggests how much proportion of permanent assets is purchased from permanent capital. Higher the ratio more is the finance from long term sources.

Activity Ratios:

Capital Turnover Ratio (In times) =

Objective:

The objective is to determine the efficiency with which the capital employed is utilized.

Interpretation:

It indicates the firm’s ability to generate sales per rupee of capital employed. In general, higher the ratio, the more efficient the management and utilization of capital employed is.

Fixed Assets Turnover Ratio (in times) = Net Sales

(Avg.)Fixed Assets

Objective:

The objective is to determine the efficiency with which the fixed assets are utilized.

Interpretation:

It indicates the firm’s ability to generate sales per rupee of investment in fixed assets. In general, higher the ratio, the more efficient the management and utilization of fixed assets is and vice versa.

Stock Turnover Ratio (in times) =

Objective:

The objective is to determine the efficiency with which the inventory is utilized.

Interpretation:

It indicates the speed with which the inventory is converted into sales. In general, a high ratio indicates efficient performance. However, too high ratio and too low ratio should be called for further investigation. A too high ratio may be the result of a very low inventory levels which may result in frequent stock – outs and thus the firm may incur high stock – out costs. On the other hand, a too low ratio may be the result of excessive inventory levels, slow moving or obsolete inventory and thus, the firm may incur high carrying costs. Thus, a firm should have neither very high ratio nor low ratio. (Stock out means customer going out of shop due to unavailability of stock.)

Debtors Turnover Ratio (in times) =

Objective:

The objective is to determine the efficiency with which the trade debtors are managed.

Interpretations:

High Debtors T/O ratio =shorter debtors ratio = quick recovery of money.Low debtors T/O ratio = higher debtor ratio = delay in recovery of money.

Creditors Turnover Ratio (in times) =

Objective:

The objective is to determine the efficiency with which the creditors are managed.

Interpretation:

High creditor T/O ratio = low creditor ratio = quick payment to creditorLow creditor T/O ratio = high creditor ratio = delayed payment to creditor

Total Assets Turnover Ratio (in times) =

Objective:

How efficiently assets are employed in business.

Interpretation:

This ratio suggests how a rupee of asset contributes to earn sales more the ratio more efficiently assets are used in gainful operation.