COST & MANAGEMENT
ACCOUNTING
UNIT NO.IV
Ratio Analysis:
MBA
1
SYLLABUS
1.1Introduction, Meaning of Ratio
1.2 Mode of Expression; Steps in Ratio Analysis
1.3 Importance of Ratio Analysis
1.4 Nature of Ratio Analysis
2
SYLLABUS
1.5 Limitations of Ratio Analysis
1.6 Classification of Ratios
1.7 Balance Sheet Ratios; Revenue Statement Ratios;
Activity of Turnover Ratios;
1.8 Profit Cover Ratios; Du pont Chart
1.9 Miscellaneous Practical Problems.
•
3
LEARNING OBJECTIVES
1.1Introduction, Meaning of Ratio
1.2 Mode of Expression; Steps in Ratio Analysis
1.3 Importance of Ratio Analysis
1.4 Nature of Ratio Analysis
4
LEARNING OBJECTIVES
1.5 Limitations of Ratio Analysis
1.6 Classification of Ratios
1.7 Balance Sheet Ratios; Revenue Statement
Ratios; Activity of Turnover Ratios;
1.8 Profit Cover Ratios; Du pont Chart
•
1.9 Miscellaneous Practical Problems.
5
Classification of Ratios
•
Classification of Ratios
Balance Sheet Ratios
Revenue /Income
Statement Ratios
Activity/Turnover ratio &
mixed ratios
Current Ratio
Profitability Ratios
Capital Turnover Ratio
Liquid Ratio (Acid Test Ratio)
Gross Profit Ratio
Fixed Assets Turnover Ratio
Absolute Liquidity Ratio
Net Profit Ratio
Current Assets Turnover Ratio
Absolute Cash Ratio
Operating Profit Ratio
Net working capital Turnover
Ratio
Debt to Equity Ratio
Operating Ratio
Stock Turn over Ratio
Proprietary Ratio
Expense Ratio
Debtors Turnover Ratio
Capital Gearing Ratio
Interest Coverage
Ratio
Creditors Turnover Ratio
Pref Dividend Coverage Ratio Cash Profit Ratio
Debt Service Coverage Ratio
6
Classification of Ratios
• Some other ratios
In Relation to Investment
In Relation to Equity Shareholder’s Fund
Return on Total Asset
Return on Equity Shareholder’s Funds
Return on Capital Employed
Earning Per share
Return on Shareholder’s Funds
Dividend Per share
Return on Equity Shareholder’s Funds
Price-Earning Ratio
Dividend Payout Ratio
Earning Yield
Dividend Yield
7
Liquidity Ratio:
• Current Ratio
• Quick Ratio
• Absolute Cash Ratio
8
Current Ratio
• Meaning : The ratio establish relationship
between current assets and current liabilities
• Formula
• Current Ratio = Current Assets
•
Current Liabilities
9
• Objective:
1.To measure the ability of the firm to meet is
short-term obligation
2. To reflect the short-term financial
strength/solvency of a firm
3. To measures the safety margin available for
creditors.
10
Components of Current Ratio
Current Assets ( converted into cash
in a year)
Current Liabilities ( To be paid within
an accounting year)
Cash Balance
Creditors for goods
Bank Balance
Bills payable
Debtors ( after deducting provisions)
Creditors for expenses
Bills Receivable
Bank Overdraft
Marketable Securities
Provision for Tax
Stock of Raw -Materials
Short-term Loans & Advances
Stock of Work-in-Progress
Unclaimed dividend
Stock of Finished Goods
Incomes received-in-advance
Prepaid Expenses
Short-term Loans & Advances
Outstanding income
Income accrued but not due
Advance payment of tax & TDS
11
Q1. Current Assets Rs. 2,00,000, Stock Rs. 1,00,000,
Working capital Rs. 1,20,000. Calculate Current
Ratio.
Q2. Creditors Rs. 20,000. Working Capital
Rs. 3,60,000, Other current Liabilities Rs. 1,00,000.
12
• The Balance Sheet of T Ltd. as at 31st March
2013 are as under:
Liabiities
Amt (Rs)
Assets
Amt (Rs)
Equity Share Capital
1,00,000
Land & Building
6,00,000
18% Pref. Share Capital
1,00,000
Plant & Machinery
5,00,000
General Reserve
60,000
Furniture & Fixture
1,00,000
Profit & Losss A/c
2,40,000
15% Debentures
8,00,000
Trade Creditors
40,000
Bills Payable
30,000
Trade Investment (LT)
Outstanding Expenses
20,000
Stock
Bank Overdraft
10,000
Debtors
Provision for Tax
2,40,000
(-) Provisions
12,00,000
(-) Depreciation
(200,000)
10,00,000
1,00,000
95,000
3,40,000
30,000
Marketable Securities
3,10,000
10,000
13
16,40,000
Preliminary Expenses
60,000
Underwriting Commission
40,000
16,40,000
Net Sales for the year 2011-2012 amounted to Rs. 20,00,000. Net Profit after tax
2,40,000, tax @ 50%. Calculate Current Ratio as at 31.3.2012.
14
Liquid Ratio/Quick Ratio
• Meaning: This ratio establishes a relationship
between Quick Assets & Current Liabilities
or Quick Assets & Quick Liabilities
• Objective:
• To measure the ability of the firm to meet its
short-term obligations as and when due
without relying upon the realization of stock
15
COMPONENTS
• 1. Quick Assets: Refer to those assets which can be
converted into cash immediately or at a short
notice. ( Current Assets –Stock –Prepaid Expenses)
• 2. Quick Liabilities = ( Current Liabilities- Bank OD –
Cash Credit)
16
• F
• Formula:
• Quick Ratio = Quick Assets/Current Liabilities
•
or
• Quick Ratio = Quick Assets/Quick Liabilities
17
• Calculate Quick Ratio
• 1. Current Assets Rs. 4,40,000, Stock Rs. 95,000,
Prepaid expenses Rs. 5,000, Current Liabilities Rs.
3,40,000
• 2. Current Assets Rs. 2,00,000, Inventory Rs. 40,000,
Working Capital Rs. 1,20,000.
• 3. Current Liabilities Rs. 1,20,000. Working Capital
Rs. 3,60,000, Creditors Rs. 20,000, Inventory Rs.
1,20,000, Calculate Quick Ratio.
18
Absolute Cash Ratio
• Meaning:
• This ratio measures a relationship between
cash & marketable securities & Current
Liabilities.
• Formula
• Absolute Cash Ratio
• = Cash & Marketable Securities/ C L
19
• From the following Calculate, Absolute Cash
Ratio;
Inventory
Rs. 4,00,000 Marketable Securities
Rs. 1,00,000
Debtors
Rs. 3,50,000 Current Liabilities
Rs. 5,00,000
Cash
Rs. 2,00,000 Provision for Doubtful
Debts
Rs. 50,000
20
Debt to Equity Ratio
• Meaning:
• The Ratio establishes the relationship
between long term debt and share holders
fund.
• Objective:
• To measure the relative proportion of debt
and equity in financing the assets of a firm.
21
• Components:
• 1. Long-term Debts: Which means long term loans
( whether secured or un secured) ( e.g.
debentures, bonds, loans from financial
institutions).
• 2. Share holders’ fund: Which means Equity share
capital + Preference share capital Plus reserves and
surplus (-) fictitious assets (e.g. preliminary
expenses)
22
• Computation: This ratio is computed by the
following formula:
• Debt to equity ratio= Long Term Debt
Shareholders’ Fund
23
Proprietory Ratio
• Meaning:
• This ratio measures the relationship between
equity or Shareholders’ fund and total assets.
• Objective:
• To measure the proportion of total assets
financed by Equity or Shareholders’ Fund or
Proprietors’ Fund.
24
Computation: It is computed by the following formula:
Proprietory Ratio = Proprietors’ Fund/Total Assets*100
The ratio indicates the extent to which the assets of
the enterprise have been financed out of
proprietors’ funds.
Traditionally, a proprietory ratio of 1:4 is considered
satisfactory , which means 25% of the total assets
are financed out of equity.
Computation of Shareholders’
Fund or Equity
Liabilities Side Approach
AMT
Asset Side Approach
Equity share Capital
Net Fixed Asset
(+) Resrves & Surplus
(+) Trade investment
(Less) Misc Exp
(+) Current Assets
Equity Sharholder’s Fund
Total Assets
(Add) Pref Share Capt
(-) Current Liabilities
Shareholders’ Fund or
Proprietors’ Fund
Capital Employed
AMT
(-) Long term Debt
Shareholders’ Fund
/Proprietors’ Fund
26
Capital Gearing Ratio
• Meaning:
• This ratio establishes a relationship between
funds bearing fixed financial payment and
Equity Shareholders’ Fund
• Objective:
• To measure the relative proportion of funds
bearing Fixed financial payments to Equity
Shareholders’ Fund.
27
• Components:
• 1. Funds bearing fixed financial payment:
• Debentures, bonds, loans from financial
institutions, preference share capital.
• 2. Equity Shareholders’ Fund: Equity share
capital + Reserves & Surplus (-) Fictitious
assets.
28
• Debt to Equity Ratio:
• Taking the same example of Q3. In Current Ratio
Calculate Debt to Equity Ratio.
•
• Proprietory Ratio:
•
• Net Fixed Assets Rs. 10,00,000, Long Term Trade
Investments Rs. 1,00,000, Current Assets Rs. 4,40,000,
Preliminary Expenses Rs. 60,000, Underwriting
Commission Rs. 40,000, Equity Share Capital ( Rs. 10
Each) Rs. 1,00,000, 18% Pref. Share Capital Rs.
1,00,000, Reserves Rs. 1,00,000, P & L A/c ( Opening
Balance) Rs. 2,00,000, 15% Debentures Rs. 8,00,000,
Current Liabilities Rs. 3,40,000.
29
• Capital Gearing Ratio:
• Calculate the Capital Gearing Ratio from the
following:
• 15% Long-Term Debt Rs. 8,00,000, 18%
Preference Share Capital Rs. 1,00,000, Equity
Share Capital Rs. 2,00,000. Reserves & Surplus
Rs. 1,50,000, Preliminary Expenses Rs. 50,000.
30
Preference Dividend Coverage Ratio
• Meaning:
• This ratio establishes a relationship between Net
profits after interest and taxes and Preference
dividend on preference share.
• Objective:
• To measure the Preference shares servicing
capacity of a firm so far as Fixed Dividend on
Preference Share is concerned.
31
• Components:
• 1. Net profits after interest and taxes;
• 2. Preference Dividend on Preference Shares.
• Computation: By the following formula:
• Preference Dividend Coverage Ratio
• = Net profits after interest and taxes
•
Pref Dividend on Pref. Shares
32
• Interpretation:
• This ratio shows the number of times the
amount of Preference Dividend is covered by
the profits out of which Pref. Dividend will be
paid.
It indicates the limit beyond which the ability of
the firm to service its preference shares capital
would be adversely affected.
33
Debt service Coverage Ratio:
• Meaning:
This ratio measures the relationship between
Net profit before Interest &Tax and interest +
Principal portion of installment.
• Objective:
To determine the firm’s capacity to pay off
both the interest and principal portion of
installment.
34
• Components:
• 1. Net Profit before interest & Tax
• 2. Interest and principal portion of installment
• Debt-service Ratio
•
= Net Profit before Interest & Tax
= times.
Interest + Principal portion of installment
1-Tax Rate
It indicates the limit beyond which the ability of the firm to
service its debt would be adversely affected.
35
Interest Coverage Ratio
• Meaning:
• The ratio establishes a relationship between Net
profits before interest and taxes on long-term
debt.
• Objective:
• To measure the debt servicing capacity of the
firm so far as fixed interest on long-term debt is
concerned.
36
• Components:
• 1. Net Profit before interest & Tax
• 2. Interest on long term debt
• Computation: By the following formula
Interest coverage Ratio
= Net Profit before interest & Tax
Interest on long term debt
37
Capital Turn-Over Ratio
• Meaning:
• The ratio establishes a relationship between
net sales and capital employed.
• Objective:
To determine the efficiency with which the
capital employed is utilized.
38
• Components:
• 1. Net sales (Gross sales – sales return)
• 2. Capital Employed.
• Computation: By the following formula
Capital Turn over ratio
= Net sales/Capital Employed
39
Calculation of capital employed
Liabilities Side Approach
Rs.
Assets Side Approach
Rs.
Equity Share Capital
xxxxxxx
Net Fixed Assets
xxxxxxx
(+) Reserves & Surplus
xxxxxxx
(+) Trade Investment
xxxxxxx
(-) Miscellaneous Expenditure
xxxxxxx
(+) Current Assets
xxxxxxx
Equity Share holders’ Fund
xxxxxxx
Total Assets
xxxxxxx
(+) Preference Share Capital
xxxxxxx
(-) Current Liabilities
xxxxxxx
Shareholders’ Fund
xxxxxxx
Capital Employed
xxxxxxx
(+) Long –term Debts
xxxxxxx
( Non –Trading Assets should not
be included while calculating Total
Assets)
xxxxxxx
(-) NonTrading Assets
xxxxxxx
( Advance purchase of fixed assets,
xxxxxxx
Capital Employed
xxxxxxx
Capital W.I.P. , Non Trade
Investment s)
xxxxxxx
40
• Preference Dividend Coverage Ratio:
• 1. Calculate Preference Dividend Coverage Ratio from the
following information:
• 15% Debentures Rs. 8,00,000, Net Profit before Interest & Tax
Rs. 6,00,000, Tax 50%, 16% Rs. 100,000 Pref Shares of Rs. 100
each.
•
Debt-Service Coverage Ratio:
• 2. Net Profit before interest & Tax Rs. 8,50,000, 10%
Debentures ( payable in 10 installments) Rs. 7,00,000. Tax
Rate 30%, Calculate Debt-Service coverage Ratio.
•
41
Fixed Asset & current Asset
Turnover Ratio
Meaning:
Establishes relationship between Net Sales &
Fixed Assets.
Objective:
To determine the efficiency with which the fixed
assets are utilized
Components:
1. Net Sales: which means gross sales – sales
return
2. Net Fixed Operating assets - Depreciation
42
• Computation: By the following formula
• Fixed Assets Turnover Ratio
= Net Sales / Net Fixed Operating Assets.
Current Assets Turnover Ratio
= Net Sales / Current Assets.
43
Working Capital Turnover Ratio
• Meaning:
This ratio establishes a relationship between
net sales and working capital.
Objective:
To determine the efficiency with which working
capital is utilised.
44
• Components:
1. Net Sales: Which means Gross sales (–)Sales return
2. Working Capital: Current Assets (-) Current Liabilities
Computation: By the following formula
Working Capital Turnover Ratio = Net Sales/ Working Capital
45
Stock Turnover Ratio
• Meaning:
This ratio establishes relationship between cost of
goods sold and average inventory of finished
goods.
Objective:
To determine the efficiency with which inventory
is converted into sales.
46
• Components:
1. Cost of goods sold = Opening Inventory + Net
Purchases + Direct Expenses (-) Closing inventory
or Net Sales – Gross Profit.
2. Average Inventory:
Opening Inventory + Closing inventory /2
Computation: By the following formula
Stock Turnover Ratio = Net Sales/Average Stock
Or :
= COGS / Average stock at cost
47
• Stock Velocity: The velocity indicates the period for which
sales can be generated with the help of an average stock
maintained and is expressed in terms of period.
• Computation: By the following formula
• Stock Velocity
= Average Stock /Average cost of goods sold per day
= ……Days
Or 12months/52 weeks/365 days = Months/Weeks/Days
Stock Turnover Ratio
Average Cost of Goods sold per day
= Cost of Goods Sold/ No of working days in the year.
Debtors Turnover Ratio
• Meaning: It establishes a relationship
between credit sales and average trade
debtors.
• Objective:
To determine the efficiency with which trade
debtors are converted into cash.
49
•
•
•
=
Components:
1. Net Credit Sales: Gross Credit Sales (-) Returns
2. Average Debtors (or Receivables):
Opening Debtors + Opening B/R (+) Cl Debtors + Cl B/R
2
Computation: By the following formula
Debtors Turnover Ratio= Net Credit Sales/Average Debtors
It indicates the speed with which debtors are converted
into cash. It also indicates both the quality of debtors and
the credit collection efforts of the enterprise.
Average Collection
Period/Debtors’ Velocity
• Meaning:
This period shows the average period for which
the credit sales remain outstanding or the
average credit period actually enjoyed by the
debtors.
It indicates the rapidity or slowness with
which the money is collected from debtors.
51
• Calculated by the following formula:
Debt Collection Period
= Average Debtors /Average Net Cr sales per day
or
= 12 months/52 weeks/365 days = Months /weeks/days
Debtors Turnover Ratio
Note: Avg Credit sales per day
= Net credit sales for the year/ No. of working days in the
year
52
Creditors Turnover Ratio or
Payable Turnover Ratio
• Meaning:
The ratio establishes a relationship between net
credit purchases and average creditors or
payables.
Objective:
To determine the efficiency with which creditors
are managed and paid.
• Components:
1. Net Credit Purchase: Gross credit purchase (- )Returns
2. Average Creditors(or Payables)
Opening Creditors + Opening B/P + Cl Creditors + Cl B/P
2
Computation: By the following formula
Creditors Turnover Ratio
= Net Credit Purchase/Average Creditors
It indicates the speed with which the creditors turn over on
an average each year. In general a high ratio indicates the
shorter payment period and a low ratio indicates high
payment period.
54
Debt Payment Period (or
Creditors’ Velocity)
• This shows an average period for which the credit
purchases remain outstanding or the average credit
period actually availed of.
• Calculated by the following formula:
• Avg Debt Payment Period = Avg Creditors/ Avg Net Credit
purchase per day = …days
Or = 12 months/52 weeks/365 days = Months /weeks/days
Creditors Turnover Ratio
Note: Avg Credit Purchases per day
= Net credit Purchases for the year/ No. of working days in
55
the year
Return on Total Asset
• Meaning: It measures the relationship between Net
profit before interest and tax, and total assets
• Objective :
To find out how efficiently the total assets have
been used by the management.
56
• Components:
1. Net profit before interest & tax
2. Total Assets: ( excluding fictitious assets e.g.
preliminary expenses)
Components: By the following formula
Return on Total Assets
= Net profit before interest & Tax * 100 = ……%
Total Assets
57
Return on Capital Employed/Return
on Investment (ROI)
• Meaning:
This ratio measures a relationship between net
profit before interest and tax and capital
employed.
Objective:
To find out how efficiently the long-term funds
supplied by the creditors and shareholders have
been used.
58
• Computation: By the following formula
Return on capital employed
= Net profit before interest & Tax* 100 = …..%
Capital Employed
This ratio indicates the firm’s ability of generating
profit per rupee of capital employed.
Higher the ratio more efficient the management
and utilization of capital employed
59
Return on Shareholders’ Fund
or Return on Equity
• Meaning: It measures the relationship between
net profit after Interest & Tax, and shareholders’
funds.
• Objective:
To find out how efficiently the funds supplied by
al the shareholders ( Equity and preference)
have been used.
60
• Components:
• 1. Net Profit after Interest & Tax
• 2. Shareholders’ funds
• Computation: By the following formula
• Return on Shareholders’ Fund
= Net Profit after Interest & Tax * 100 = …..%
Shareholders’ funds
61
Return on Equity
Shareholders’ Funds
• Meaning: This ratio measures the relationship
between Net Profit After Interest & Tax –
Preference Dividend & Equity Shareholders’
Fund.
• Objective:
To find out how efficiently the funds supplied by
the equity shareholders have been used.
62
• Components:
• 1. Net Profit after interest & tax –Pref Dividend
• 2. Equity Shareholders’ Funds: Equity share
capital + Reserves & Surplus (-) Fictitious Assets.
• Computation: By the following formula
Return on Equity Shareholders’ Funds
= Net Profit after interest & tax –Pref Dividend*100
Equity shareholders’ Fund
63
Earning Per Share(EPS)
• Meaning: It measures the earnings available to
the equity shareholder on a per share basis.
Objective:
To measure the profitability of the firm on per
equity share basis.
64
• Components:
1. Net profit after interest & Tax (-) Pref Div
2. No. of Equity Share Outstanding.
Computation: BY the following formula
EPS = Net profit after interest & Tax (-) Pref Div
No. of Equity Share Outstanding.
65
Price Earning Ratio (PER)
• Meaning: It measures the relationship between the
market price per share and earning per share.
• Objective:
• To Find out the expectations of the shareholders
about the earnings of the firm.
66
• Components:
• 1. Market Price Per share
• 2. Earning Per share
• Computation: BY the following formula
Price Earning Ratio = Market Price Per share
Earning Per share
67
• Interpretation:
• It indicates the no of times of EPS, the share is
being quoted in the market.
• In other words, it indicates the payback period
within which the prospective investor can
recover his investment in a single share by way
of Earning Per Share.
68
Earning Yield Ratio (EY)
• Meaning: The ratio measures the relationship
between Earning Per Share (EPS) & Market Price
Per Share.
• Objective:
To measure the performance of earnings in
relation to market price per share.
• Components:
1. Earning Per Share
2. Market Price Per Share
Computation: By the following formula
Earning Yield = Earning Per Share (EPS)* 100
Market Price Per Share
70
Dividend Per Share
• Meaning: It measures the dividend distributed per
equity share.
• Objective:
The objective is to measure the dividend
distributed per equity share.
71
• Components:
• 1. Profit distributed as Equity dividend
• 2. Number of Equity Shares
• Computation: By the following formula
• Dividend Per Share (DPS)
= Profit distributed as Equity dividend = Rs.
……
Number of Equity Shares
72
Dividend Payout Ratio:
• Meaning: It measures the proportion of earning
per share distributed as dividend.
• Objective:
• TO measure the portion of EPS distributed as
dividend.
• Components:
• 1. Earning Per Share (EPS)
• 2. Dividend Per Share (DPS)
Computation: By the following formula
Dividend Payout Ratio
= Dividend Per Share (DPS) *100
Earning Per Share (EPS)
74
Dividend Yield Ratio
• Meaning:
It measures the relationship between Dividend
Per Share (DPS) & Market Price Per Share.
Objective:
To measure the performance of dividend in
relation to market price per share.
75
• Components:
• 1. Dividend Per Share (DPS)
• 2. Market Price Per Share
• Computation: By the following formula
•
Dividend Yield = Dividend Per Share (DPS)* 100
Market Price Per Share
76
• Return on Total Assets
• Net profit after interest & tax Rs. 2,40,000, Tax rate 50%, Net
Fixed Assets Rs. 10,00,000, Long Term Trade Investments Rs.
1,00,000, Current Assets Rs. 4,40,000, Preliminary Expenses
Rs. 60,000, Underwriting Commission Rs. 40,000, Equity
Share Capital ( Rs. 10 Each) Rs. 1,00,000, 18% Pref. Share
Capital Rs. 1,00,000, Reserves Rs. 1,00,000, P & L A/c (
Opening Balance) Rs. 2,00,000, 15% Debentures Rs. 8,00,000,
Current Liabilities Rs. 3,40,000.
• Return on Capital Employed/Return on Investment (ROI):
• Taking the same illustration of Return on Total Assets
Calculate the Return of Capital Employed.
77
• Return on Shareholders’ Fund or Return on
Equity (ROI)
• Taking the same illustration of Return on Total
Assets Calculate the Return of Shareholders’
Fund or Return on Equity.
•
• Return on Equity Shareholders’ Fund
• Taking the same illustration of Return on Total
Assets Calculate the Return of Equity
Shareholders’ Fund.
•
78