9.financial Statement Analysis

FinancialandManagementAccounting
Unit9
Unit9
FinancialStatementAnalysis
Structure
9.1
Introduction
Objectives
SelfAssessmentQuestions1
9.2
MeaningofRatio
9.3
Meaningofratioanalysis
9.4
Scope
9.5
Advantages
9.6
Classification
9.7
Liquidity
SelfAssessmentQuestions6to8
9.8
Solvency
9.9
Profitability
9.10
Activity
9.11
Leverage
9.12
Limitation
9.13
Computation
TerminalQuestions
AnswertoSAQsandTQs
9.1Introduction
Every factthatislearned becomesa keytootherfacts E.Y. Youmans. Basedonthis, this
Unitdealswithanalysisoffinancialstatements,thefunctionsofwhichistoidentifyandhighlight
SikkimManipalUniversity
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the firms strengths and weaknesses. The objective of ratio analysis is to provide with the
financialinformationnecessarytomakefinancialdecisions.
LearningObjectives:
Afterstudyingthisunit,youshouldbeabletounderstandthefollowing
1. Understandtheconceptofratioanalysisanditsroleincomparativeanalysis
2. Explain the fundamental relationship between the gross profit ratio, the expenses to sales
ratioandthenetprofitmarginratio.
3. Defineandcalculatethethreeprimaryratioswhichexplainhowwellabusinessisutilizing
theresourcestogeneraterevenueandprofit.
Ratioanalysiscanprovideyouwiththisinformationinthreesteps:
1. Calculate the firms ratios for the current or recent period . Ratiosare calculated from the
firmsincomestatementorbalancesheetItishelpfulandsometimesnecessarytohavethe
financialstatementindependentlyaudited.
2. Compare these ratios to those calculated in past records. The purpose of this
comparisonistoidentifytendenciesinthefirmsratios.Thisisknownastrendanalysis.
3. Comparetheratiostoindustryaveragestoshowhowthecompanycomparestofirmsofthe
samesizeinitsindustry.ThisprocessisknownasCrosssectionalanalysis.
Aftercompletingtheanalysis,onecanhaveagreatdealofinformationonhowthecompanyis
doingbothoveraperiodoftimeandcomparedtootherfirmsinitsindustry.
SelfAssessmentQuestions1:
1. Ratiosarecalculatedfrom_____________Statementand_____________.
2. Identifyingtendenciesinthefirmsratioisknownas___________analysis.
3. Comparingfirmsratiowithindustryratiosisknownas__________analysis.
4. Ratiosenableacompanytohave_______________data.
9.2MeaningofRatio
Absolutenumberstellverylittle.AssumethattwocompaniesAandB,operatingwithinthesame
industrysupplytheinformation:
Company
AB
NETPROFITinRs.10,0001,00,000
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One can easily say that Company B makes the most profit. But which company is most
profitable?Theanswerforthiswillnaturallycallforfurtheradditionalinformationrelatingtoprofit
suchassizeofthecompany,thetotalsalesitgeneratesortohowmuchcapitalisinvestedinit.
Hence, an assessment or a judgment is made based on making some sort of comparison.
Extendingtheexample,
AB
NetProfit10,0001,00,000
Sales2,00,0005,00,000
Networth(CapitalandReserves)1,00,0002,00,000
IfnetprofitiscomparedwithSales,anassessmentcanbemadeonwhichcompanygenerates
themostnetprofitperRe.1receivedfromcustomers.CompanyA:NetProfit/sales*100i.e.5
percentandCompanyBitis20percent.Ifthenetprofitisexpressedintermsofinvestments
made by theowners in each company, itis NetProfit/ Net worth *100. For Company A,itis
10%andforitis25%.ItisalsoknownasReturnonCapitalEmployed.ROCE.Ratiosareuseful
intwoways:
1. Tomakeinterbusinesscomparisons
2. Tomakecomparisonsacrossfinancialperiods
A ratio is simply one number expressed in terms of another. It is a means of highlighting in
arithmetical terms the relationship between figures drawn from various financial statements.
Therefore,itreferstothenumericalorquantitativerelationshipbetweentwovariablesoritems.A
ratio expresses simply in one number the result of comparison between two figures. It is
calculatedbydividingonefigurebytheother.Thequotientsoobtainedistheratioofthefigures.
Ratiocanbeexpressedinthefollowingthreeforms:
1. Asproportion
2. Aspercentage
3. Asturnoverorrate
TheDictionarymeaningofAnalysisisseparationorbreakingupofanythingintoitselementsor
component parts. Ratio Analysis is, therefore, a technique of analysis and interpretation of
financialstatements.Ratioanalysisistheprocessofestablishingandinterpretingvariousratios
for helping in making certain decisions. It involves the methods of calculating and interpreting
financialratiostoassessthefirmsperformanceandstatus.
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SelfAssessmentQuestions 2:
1. a)Ratiosareusefultomake____________and_________________.
2. Ratiois__________________________________________.
3. Ratiorefersto________________________________relationship.
4. Theanswerforadivisionisknownas_______________________.
5. Ratiocanbeexpressedinthreeways_________,_______,___________.
6. Ratioanalysisis____________________________________.
9.3MeaningOfRatioAnalysis
TheDictionarymeaningofAnalysisisseparationorbreakingupofanythingintoitselementsor
component parts. Ratio analysisis therefore a technique of analysis and interpreting various
ratios for helping in making certain decisions. It involves the methods of calculating and
interpretingfinancialratiostoassessthefirmsperformanceandstatus
9.4Scope
Theratioanalysisisoneofthemostpowerfultoolsoffinancialanalysis.Thefirmisanswerable
to the owners, the creditors andemployees. Thefirm canreacha numberof parties. On the
other hand, parties interested in the business can compute ratios based on the financial
statementsofthefirm.Theanalysisisnotrestrictedtoanyoneaspectbuttakesintoaccountall
aspectssuchasearningcapacityofthefirm,financialobligation,liquidityandsolvencyaspects,
liquidityandprofitabilityconcepts.
1. Ratioanalysisispowertool_______________________.
2. ratiosarebasedon_______________________.
3. Ratioindicates___________________________.
9.5Advantages
Thevariousadvantagesofratioanalysisareasfollows:
a)FinancialForecastingandPlanning
Ratioanalysishelpsinthefinancialforecastingandplanningactivities.Ratiosbasedonthepast
salesareusefulinplanningthefinancialposition.Basedonthis,futuretrendsareset.
b)DecisionMaking
Ratioanalysisthrowslightonthedegreeofefficiency.Itisalsoconcernedwiththemanagement
andutilizationoftheassets.Thus,itenablesformakingstrategicdecisions.
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c)Comparison
Withthehelpofratioanalysis,idealratioscanbecomposed.Thesecanbeusedforcomparison
inrespectofthefirmsprogressandperformance,interfirmcomparisonwithindustryaverage.
d)FinancialSolvency
Ratiosare useful tools. Itindicates thetrendsin thefinancialsolvency of thefirm. Long term
solvency refers to the financial liability of a firm. It can also evaluate the short term liquidity
positionofthefirm..
e)Communication
The financial strength and weaknesses of a firm are communicated in a more easy and
understandable manner by the use of ratios. The information contained in the financial
statements is conveyed in a meaningful manner. It, thus, helps in the communication and
enhancethevalueofthefinancialstatements.
f)EfficiencyEvaluation
Itevaluatestheoverallefficiencyofthebusinessentity.Ratioanalysisisaneffectiveinstrument
which, when properly used, is useful to assess important characteristics of business liquidity,
solvency, profitability. A critical study of these aspects may enable conclusions relating to
capabilitiesofbusiness.
g)Control
It helps in making effective control of the business. Actual results can be compared with the
establishedstandardandtotakecorrectiveactionattherighttime.
h)Otheruses
Financialratiosareveryhelpfulintheearlyandproperdiagnosisandfinancialhealthofthefirm.
1. Therearemajor______________________advantages.
2. Financialforecastingisusefulfor___________________.
3. Decisionmakingconcernedwith______________________.
4. Comparisonisfor________________________________.
5. Financialsolvencyincludes________________________.
6. Communicationenhances_________________statements.
7. Evaluationdonefor______________________________.
8. Throughcontrol,________________________________.
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9.6ClassificationsOfRatios
Thediagrammaticrepresentationofratiosareasfollows:
TYPEOFRATIO
LIQUIDITY
SOLVENCY
PROFITABLITY
Current
liquid
Debt
Equity
GrossProfit
NetProfit
Operating
ACTIVITY
STO
DTO
CTO
LEVERAGE
Gearing
TItoLT
1. Typesofratiosare_____________________________________.
2. Liquidityratiosconsistof______________________________.
3. Solvencyratioconsistsof______________________________.
4. Profitabilityratioconsistsof____________________________.
5. Activityratioconsistsof_______________________________.
9.7LiquidityRatio
Itmeanstheliquidityofthefirm.Liquidityistheabilityofthefirmtomeetitscurrentliabilitiesas
theyfalldue.Sincetheliquidityisbasictocontinuousoperationsofthefirm,itisnecessaryto
determinethedegreeofliquidityofthefirm.Theseareimportantbecauseliquidityisclosetothe
heartofthefirm.Afirmmayhaveahighleveloflongtermassetsandsubstantialnetincome,
butiftheydonothaveenoughcashonhandorassetsthatcanbeturnedintocashfairlyquickly,
theywillnotbeabletooperatedaytoday.Theliquidityratiosexaminethecurrentportionofthe
balance sheet : current assets and current liabilities. The implicit assumption is that current
assetswillbeusedtopayoffcurrentliabilities.Thismakessenseduetothematchingprinciple
(matchthematurityofthedebtwiththedurationoftheneed)e.g.onewouldnottakeafiveyear
bankloantopayoffanaccountpayabledueinthirtydays.
Therearetworatiosthatdeterminehowliquidafirmis:thecurrentratioandquickratio.
1. Liquidityistheability________________________.
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2. Liquidityratiosdealwith______________________.
3. Liquidityratiosplaceimportanceon_____________.
4. Tworatiosthatdetermineliquidity_______________.
CurrentRatio
It is one of the popular financial ratios. It measures the firms ability to meet its short term
obligations. This is achieved by comparing the current assets of a business with its current
liabilities..Theformulaforcurrentratiois:
CurrentRatio=CurrentAssets/CurrentLiabilities
Example:
CurrentAssets
Stock
Debtors
Cash
Rs.
Rs.
3,000
60,000
16,000
Nil
5,000
Nil
24,000
Nil
Nil
10,000
CurrentLiabilities
Creditors
BankOverdraft
The liquidity of the firms are determined by the amount of working capital available to the
business. This is defined as current assets minus current liabilities. The current ratio is not
expressedasapercentagebutasaproportion.Thecurrentratiooftheabovetwofirmsare:1for
A and 5 for B. The ratio reveals a considerable difference between the two companies.
Company B is five times more liquid than company A. Company A can only just cover its
obligationstocreditorsintheshortterm,yetCompanyBcancoveritsobligationtothebankfive
timesover.
AlthoughcompanyAwouldbelessvulnerableifitsratiowashigher,itcanbearguedthattohave
aratiothatistoohighindicatesinefficiency,inthattoomuchworkingcapitalisavailable,which
mightbebetterinvestedinfixedassets.However,itisimportanttoidentifythespecifictypesof
currentassetsthatareexcessivesuchas
1. Excessivestocklevels,indicatingpoorstockcontroloradeclineinsalesvolume
2. Excessivedebtors,indicatingpoorcreditcontrolandanincreasingriskofbaddebts
3. Excessive cash or near cash equivalents, indicating a lack of suitable investment
opportunitiesincapitalprojects.
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Aruleofthumbisthataratioof2:1(Rs.2incurrentassetsforeveryRe.1ofcurrentliabilities)is
acceptable. However, the current ratio may vary from less than oneinsuch industriesasfast
foodsto morethan two inthe telephone apparatus manufacturingindustry. Consequently,itis
importanttooutilizetheindustryaverages.
Aratiothatismuchhigherthantheindustryaverageindicatesthatthefirmmayhaveexcessive
currentassets.Furtherinvestigationmaydemonstratethecauseoftheexcess.Onereasonmay
be that thefirm ishaving troublein the collection ofits debtors or has high inventory, both of
which willbe identified throughtheuse ofotherratios. Another reason maybe that thefirm is
holding too much cash or short term investments which could be earning more money if they
wereinvestedinlongterminstruments.Stillanotherreasonforahighratioisthatthefirmmay
beataspecificpointinitsbusinesscycle.Thecompanythatsellswoolengoodsinwinteris
expectedtohavehighinventoryinNovember,December,JanuaryandhighdebtorsinFebruary.
A ratio which ismuchlower thantheindustry average indicates that thefirm is havingliquidity
problems, meaning thatit may not be able to meet its short term obligations. Accordingly, an
extremelylowcurrentratioshouldbearedflagtothecompanybeinganalyzed.
Thecomponentsofcurrentassetsandcurrentliabilitiesare:
Current Assets: Cash in hand, cash at bank, trade debtors, bills receivable, stock, prepaid
expenses,tradeinvestments,marketablesecurities
Current Liabilities: Trade creditors, bills payable, bank overdraft, outstanding or accrued
expenses,taxpayable,provisionfortax,dividendspayable.
Example: Given:CurrentRatiois2.5andworkingcapitalisRs.1,80,000.CalculatetheCurrent
Assetsandcurrentliabilities.
Solution: Givendataisworkingcapital,hence:
Workingcapital=Currentassetsminuscurrentliabilities
CurrentRatio=CA/CL
Intheabsenceofanyvalue,thecurrentliabilityisalwaystakenas1unit
2.5=CA/1andcrossmultiplying,CAis2.5
Workingcapitalratiois2.5,thensubstitutingthevalues,
2.5=2.5minus1orWC=1.5
For1.5WCR=WorkingcapitalvalueisRs1,80,000
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For2.5CAR,thecurrentassetisRs.1,80,000 x2.5/1.5=Rs.3,00,000
For1CLR,thecurrentliabilityis1,80,000x2.5/1=Rs.1,20,000
1. CurrentRatiois___________________________________ratio.
2. Currentratiomeasures____________________________.
3. Currentratiocompares___________________________.
4. Theformulaforcurrentratiois_____________________.
5. Currentratioisexpressedin_______________________.
6. TheruleofthumbinCurrentratiois___________________.
7. Workingcapitalistheresultof_______________________.
8. TheworkingcapitalisRs.80,000anditscurrentratiois5.Whatarethe
9. currentassetsandcurrentliabilities.
LiquidRatio
It is also known as Quick Ratio or Acid test Ratio. It is similar to current ratio except that it
excludesinventory whichis generallytheleastliquid currentasset. The reasonfor eliminating
inventorymaybeduetotwoprimaryfactors
a. Many types ofinventory cannot beeasily sold because they are partially completeditems,
obsoleteitems,specialpurposeitems.
b. Theitemsaretypicallysoldoncredit.Thisresultsinthecreationof
tradedebtorsorbillsreceivablesbeforebeingconvertedintocash.
Citingtheexample,inthecaseofcompanyB,theonlycurrentassetthatitcarriesisstock.The
question must be asked : is this level of stock too high or might it be essential to this type of
business?
Asstockistheleastliquidofthecurrentassets,prudencerequiresthatliquiditybelookedatin
another way. If current assets excluding stock are compared with current liabilities, a more
cautious assessmentof theliquidityof thetwo companies is given.. This ratiois calculated as
follows:
AcidTestRatio=CurrentassetslessStock/currentliabilities
ThequickratiosforcompaniesAandBareasfollows:
A=24,0003,000/24,000=0.875
B=50,00050,000/10,000=0
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This time the quick ratio indicates that company A has a considerably better liquidity from this
point ofviewandcompanyBisdangerouslyinsolvent.
Illustration:
GiventhatCurrentratiois3.5,acidtestratiois1.5andworkingcapitalisRs.6,50,000.Compute
currentassets,currentliabilities,liquidassets
Solution:
Givendata,Workingcapital
=CurrentAssetsminuscurrentliabilities
Wherecurrentliabilityistakenas1
CR=CA/.CL=3.5=CA/CL
Crossmultiply=3.5x1=CurrentAssets
WorkingCapitalRatioistherefore:CARCLRor3.5minus1or2.5
For2.5WCR,theamountisRs.6,50,000
For3.5,CAR,thecurrentassetis6,50,000x3.5/2.5orRs.9,10,000
For1,CLR,thecurrentliabilityis6,50,000x1/2.5orRs.2,60,000
LiquidassetisbasedonAcidTestRatiowhere,1.5=LA/CL
Liquidasset,therefore,are=2,60,000x1.5orRs.3,90,000
Problem:GivenCurrentratio1.5:1Quickratio1:1andCurrentliabilitiesRs.50,000.Calculate
currentassets,quickassetsandinventory.
Solution: GivenCurrentratio:1.5:1andvalueofcurrentliabilitiesRs.50,000
Currentassets:CR=CA/e1.5=CA/50,000orCA=Rs.75,000
QuickAsset:QR=QA/1or1=QA/50,000orRs.50,000
Inventory=CAQAor75,00050,000orRs.25,000
Problem: AssumingtheCurrentratioofDRLtdis2,stateineachofthefollowingcaseswhether
theratiowillimproveordeclineorwillhavenochange.
(a) paymentofcurrentliability(b)purchaseoffixedassets(c)cashcollectedfromcustomers
(d)Billsreceivabledishonoredand(e)issueofnewshares.
Solution: CR=CA/CLwhere2=CA/1orCA=2andCL=1
a) Paymentofcurrentliability:Currentratiowillimprove.Thereasonisthatwhencurrentratio
is 2:1, payment of current liability will reduce the same amount in the numerator and
denominator.Hence,theratiowillimprove.
b) Purchaseoffixedassets:here,thecurrentratiowilldecline.
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c) Cashcollection:Currentratiowillnotbechangedbecausecashwillincreaseand debtors
willdecrease
d) BRdishonored:Currentratiowillnotchange.ReasonisthatBRwilldecreaseanddebtors
willincrease
e) Issueofnewshares:Currentratiowillimprovebecausecashbalancewillincrease.
1. LiquidRatioisalsoknownas________________________.
2. Liquidratioexcludes_______________________________.
3. Thereasonforexclusionis__________________________.
4. Theformulatocalculatetheliquidratiois______________.
5. Paymenttocurrentliabilitywillimprove_______________.
6. ForBillsdishonored,Currentratio_____________________.
7. Forissueofnewshare,currentratio____________________.
8. Forpurchaseoffixedassets___________________________.
9. Forcashcollection,__________________________________.
10. Given CR is 1.75. Liquid ratio is 1.25.. Net working capital is Rs.1,50,000. Calculate (a)
currentassets(b)currentliabilitiesand(c)liquidassetsandstock.
11. DRscurrentratiois5.5:1.Quickratiois4to1.InventoryisRs.30,000.findoutthecurrent
liabilities.
12. Given CR is 2.5. Liquid ratio 1.5 working capital Rs.6,00,000, Bank overdraft Rs.10,000.
CalculateCurrentassets,currentliabilities.Stockandliquidassets.
9.8SolvencyRatios
Theratiosareanalyzedonthebasisoflongtermfinancialpositionofafirm.Itisalsoknownas
testofsolvencyoranalyzingthedebt.Manyfinancialanalystsareinterestedintherelativeuse
ofdebtandequityinthefirm.Debtreferstooutsideborrowingsbythefirm.
The debt position of a firm indicates the amount of other peoples money being used in
attemptingtogenerateprofits.Thelongtermdebtsareofmuchimportancetothefirmsincea
firm is expected to commit the payment of periodic interest over the long run. In addition,
repaymentofloanaftertheexpiryofmaturitydatehastobeplanned.
Sincethecreditorsclaimsmustbesatisfiedbeforethedistributionofearningstoshareholders,
present and prospective shareholders pay close attention to the degree of indebtedness and
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abilitytorepaythedebts.Lendersarealsoequallyconcernedabouttheindebtednessand the
repaymentmodes.Hence,thesolvencyofthefirminparticularneedsconsideration.
1. Solvencyratioareanalyzedon__________________________basis.
2. Solvencyratioisalsoknownas______________________.
3. Solvencyratioiscombinationof____________________.
4. Debtrefersto____________________________________.
5. Lendersareconcernedabout________and____________.
DebtRatio
Debtratiosareimportantbecausedebtiswidelyconsideredtobeameasureofthehealthofthe
firmandtheriskassociatedwithit.Ifafirmhashighdebt,theyhavefixedpaymentswhichmust
be made. This means that limited funds may be directed to debt payment (either principal or
interestorboth)insteadofinvestments..
Thedebtratiois:
TotalLiabilities/totalassets
This ratio tells you how much of the firms assets are financed with debt. A high debt ratio
indicatesthatthefirmmaybecarryingtoomuchdebt.Thisisofconcerntothefirmbecauseit
maynotbeabletorepaythedebtnortoborrowadditionalfundstheyareneeded.Accordingly,a
firmin this situationisconsidered risky becauseshort termfinancingislimited and may not be
availableinanemergency.
Alowdebtmeansthatthefirmhasalowlevelofliabilitiescomparedtoitstotalassets.Sucha
ratio indicates that the firm is not risky because it has plenty of financing available when
comparedtoitsneed.However,alowratiomayalsoindicatethatthefirmshouldtakeonmore
debt.Thereasonforthisisthattheabilitytoborrowisconsideredaresourceandafirmwithlow
debtmaynotbetakingadvantageofthisresource.
1. Debtisconsideredas_________Ofthefirmand________Associated________.
2. Theformulais__________________________.
3. Highdebtratioindicates__________________.
4. Theresultofhighdebt___________________.
5. Shorttermfinancingis____________________.
6. Alowdebtratioindicates__________________.
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Debt:EquityRatio
Thedebt:equityratiois:
LongtermDebt/Shareholdersequity
Thedebtequityratiodealswiththelongtermliabilitiesandequityportionofthebalancesheet.
Note that shareholders equity includes retained earning (Equity may also be known as net
worth). Thedebtequityratioprovidesinformationonthecapitalstructure(relationshipbetween
debtandequity)ofthefirm. Suchinformationisimportantbecauseitaffectsthevalueofthefirm.
Thevalueofthefirmisimportantbecauseithasanimpactontheabilitytoraisefunds.,either
throughincreasedborrowingorthesaleofsharesorboth.
A high debtequity ratioindicates a poor capital structure because it signifies that the firm has
highdebtincomparisontoitslevelofshareholdersequity.Thismeansthatthefirmscreditors
maybeconcernedabouttherepaymentofdebt,whichinturnleadstohighinterestrates,which
inturnleadstohigherrequiredreturnsonthefirmspotentialinvestments..
Alowdebtequityratioisanindicationthatthefirmisinsoundfinancialpositionandthereforeis
notconsideredrisky.Normally,thedebtequityratiovarytremendouslyfromindustrytoindustry.
Problem: TheBalanceSheetofDRLtdisasfollows:
Assets: FixedAssets10,00,000
CurrentAssets5,00,000
Representedby:
CurrentLiabilities1,00,000
Reservesandsurplus1,00,000
10%Debentures2,00,000
6%PreferenceSharecapital3,00,000
EquitySharecapital
8,00,000
CalculatetheDebtRatioandDebtequityratio.
Solution: DebtRatio:TotalLiabilitiestooutsiders/totalassets
:Debentures+Tradecreditors/Fixed+currentassets
3,00,000/15,00,000or 1:5
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Debtequityratio:Outsidersfunds/shareholdersequity
Outsidersfunds10%Debenturesonly+SundryCreditors
ShareholdersfundsEquitySharecapital+Preferencesharecapital+Reserves
3,00,000/12,00,000or 1:4
1. Debtequitydealswith____________________________.
2. Shareholdersequityis____________________________.
3. Theformulais__________________________________.
4. Debtequityprovidesinformationon_________________.
5. Capitalstructurerefersto_________________________.
6. Capitalstructureaffects___________________________.
7. valueisimportanttoraise_________________________.
8. Raisingoffundsisdonethrough____________________.
9. Highdebtindicates_______________________________.
10. Creditorsmaygetupsetover_______________________.
11. Lowdebtindicates______________________________
12. Lowdebtisnot__________________________________.
13. Debtequityratio_____________fromindustrytoindustry.
9.9ProfitabilityRatios
A firms profitability can be assessed relative to sales, assets, equity or share value. The
profitabilityratiosareimportantbecausetheyindicatewhetherthefirmisdoingwhatitsetoutto
do:makeaprofitandprovideareturntoitsinvestors.Therearemanymeasuresofprofitability.
Eachrelatesthereturnsofthefirmwithregardtothesales,assets,equityorsharevalue.Asa
group,thesemeasuresenabletoevaluatethefirmsearnings.Thecriteriaforearningscanbe
relatedtoagivenlevelofsales,.Acertainlevelofassets,theownersinvestmentorsharevalue.
Earningsresultinprofits.Withoutprofits,afirmmaybehandicappedtoattractoutsidecapital.
Theincomestatementofthefirmshowsthetotalprofitsearnedbythefirmduringthepreceding
fiscalperiod.Theimportantratioswhichhighlighttheprofitabilityofafirmwouldbeasfollows:
1.
Profitabilityratioisimportantas______________________.
2.
Profitabilitycanbeassedto___________________________.
3.
Profitabilityratioevaluatesfirms_____________________.
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4.
Earningsresultin___________________________________.
5.
Withoutprofit,______________________Cannotbeattracted.
GrossProfitRatio
Itmeasuresthepercentageofeachsalesvalueremainingafterthefirmhaspaidforitsgoods.
The higher the gross profit margin, the better and lower the relative cost of merchandise sold.
Thus,itservesanimportanttoolinshapingthepricingpolicyofthefirm.Theformulais:
GrossProfit= (GrossProfit/Sales)x100
WhereGrossprofit=SalesminusCostofgoodssold(COGS)
NetSales= CashSales+CreditSalesminusSalesReturns
Itisnormallyexpressedasa percentage.Ifwedeductgrossprofitratiofrom 100,theratioof
COGSisobtained..
Problem
DRLtdprovidesthefollowinginformation.
Cash Sales Rs.8,00,000 Credit Sales Rs.10,000 COGS Rs.15,80,000 and Return Inwards
Rs.20,000.CalculateGrossProfitRatioandratioofCOGS.
Solution
GPR:GP/NetSalesx100:GrossProfit:NetSalesminusCOGS
NetSales:GrossSalesminusReturnInwards
GrossSales:Cash+CreditSales
8,00,000+10,00,000minus20,000orRs.17,80,000
GrossProfit:17,80,000minus15,80,000orRs.2,00,000
GPR2,00,000/17,80,000x100or
11.2%
RatioofCOGS:100GPRatioor10011.2or 88.76%
1. Grossprofitmeasures__________________ofeachsalesvalue.
2. Grossprofitmeasures__________________.
3. Theformulais_________________________.
4. Grossprofitis_________________________.
5. Netsalesis____________________________.
6. GrossProfitratioisexpressedas___________.
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ExpensesRatio
Theseratiosindicatetherelationshipofvariousexpensestonetsales.Individualexpensesare
calculatedbasedonthenetsalesandindicatedasapercentagetonetsales.
1. Expenseratioindicate____________________ofexpensestonetsales.
2. Individualexpensesarecalculatedon___________________.
NetProfitRatio
ItisalsoknownasNetProfitMargin.Itmeasuresthepercentageofeachsalesinrupeeafterall
expensesincludingtaxeshavebeendeductedThisratioprovidesconsiderableinsightintothe
overall efficiency of the business. A higher ratio speaks about the overall efficiency of the
business. It also focuses the attention of the better utilization of total resources. A lower ratio
wouldmeanapoorfinancialplanningandlowefficiency.Anetprofitmarginof1percentorless
wouldbeunusualforagrocerystorewhichanetprofitmarginof10percentwouldbelowfora
retailstores.Itisdividedbynetincomebynetsales.Theformulais:
NetProfitRatio=(NetProfitaftertaxes/NetSales)x100
The net profits are calculated after excluding the income tax, the nonoperating incomes and
nonoperatingexpenses.Itisexpressedasapercentageonnetsales..
Example: TheincomestatementofDRLtdisasfollows:
ToOpeningStock2,00,000BySales12,00,000
Purchases8,00,000ClosingStock1,00,000
DirectExpenses1,00,000
GrossProfit2,00,000
13,00,00013,00,000
ToAdmnExpenses1,00,000ByGrossProfit2,00,000
SellingExpenses80,000Profitonsaleof
Investments60,000
NonOperatingexp40,000Dividendsreceived40,000
NetProfit80,000
3,00,000
3,00,000
Calculate the Gross Profit Ratio, Net Profit Ratio, Operating Ratio, Operating Profit Ratio and
ExpenseRatio.
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Solution
GrossProfitRatio=GP/NewSalesx100or2,00,000/12,00,000x100or16.61%
NetProfitratio= NPaftertax/NetSalesx100or80,000/12,00,000x100or 6.67%
OperatingRatio=COGS+operatingexpenses/NetSalesx100
SalesminusGrossprofit=COGS
10,00,000+1,00,000+80,000/12,00,000x100or98.33%
OperatingProfit=10098.33or16.67%Ratio
AdmnExpensesRatio=AdmnExpenses/Netsalesx100or1,00,000/12,00,000x1008.33%
SellingExpenseRatio=SellingExpenses/NetSalesx100or80,000/12,00,000x100or6.67%
1. Netprofitisknownas__________________________.
2. Netprofitmeasurespercentageofeach_________________after___________.
3. Netprofitprovides_________________________ofbusiness.
4. Netprofitfocuseson________________________.
5. Lowratiorefersto__________________________.
6. Theformulais_____________________________.
7. Calculationisbasedon______________________.
9.10ActivityRatios
Theseareusedtomeasurethespeedwithwhichvariousaccountsareconvertedintosalesor
cash.Measuresofliquidityaregenerallyinadequateduetothecompositionofthefirmscurrent
assetsandcurrentliabilities.Theactivityratiosarealsoknownasturnoverratios.Someofthe
turnoverratiosareasfollows:
StockTurnoverRatio
:STO
DebtorsTurnoverRatio
:DTO
CreditorsTurnoverRatio
: CTO
1. Activityratiosmeasure__________________________________.
2. Measuresofliquidityisinadequatedueto__________________.
3. STO,DTO,CTOarealsoknownas________________________________.
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StockTurnoverRatio
I t commonly measuresthe activity or liquidity of thefirms stock.. The STOis also known as
stockvelocity. Velocity refers to speed with which an object travel. Here, it is the speed on
convertingthestockintosalesthentocash.Itindicatesthenumberoftimesthestockhasbeen
turnedoverascashduringagivenperiodoftime.Itevaluatestheefficiencywithwhichafirmis
abletomanageitsstock.
Ifthecostofgoodssold)COGS)isknown,theSTOcanbecalculatedasfollows:
STO=COGS/Averagestockatcost
WhereCOGS=NetSalesGrossProfit
AverageStock=Opening+ClosingStock/2
IfCOGSisnotknown,itcanbecomputedasfollows:
STO=NetSales/Stock
Example: DRLtdprovidesthefollowing
Stock: Opening Rs.75,000 Closing Rs.1,00,000. Credit Sales Rs.2,00,000. Cash sales
Rs.50,000.GrossProfit25%.CalculatetheStockTurnoverRatio
Solution:
STO=COGS/Averagestock
COGS=NetSalesGrossProfit
NetSales=CashSales+CreditSalesor2,00,000+50,000or2,50,000
Averagestock=Opening+closingstock/2or75,000+1,00,000/2or87,500
GrossProfit=25%onRs.2,50,000or 62,500
COGS=2,50,00062,500or1,87,500
STO=187,500/87,500or2.14times.
1. STRmeasures______________________________.
2. STRisalsoknownas_______________________.
3. Velocityrefersto___________________________.
4. STRcommonlyrefersto_____________________.
5. STRevaluatesthe___________________________.
6. TheformulaforSTRis______________________.
7. COGSis__________________________________.
8. AverageStockis____________________________.
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9. IfCOGSnotgiven,theformulais_______________.
DebtorsTurnoverRatio:DTO
ItisalsoknownasDebtorsvelocity.Thebirthofdebtorcomesfromcreditsales.Totaldebtors
include the Bills Receivable also. The Bills receivables are written promise of trade debtors.
Trade debtors are normally provided with 3 months credit time. After the expiry, they will pay
cash.Thus,debtorsareexpectedtobeconvertedintocashwithinashortperiod.Therefore,itis
includedinthecurrentassets.Itiscalculatedasfollows:
DTO=(Debtors+BR/Netcreditsales)xNumberofworkingdays
DTO indicates the velocity of debt collection of firm. It indicates the number of times average
debtorsconvertthemselvesoverintocashduringayear.Debtorscareshouldalwaysbetaken
ongrossvalue/Donotdeductthebaddebtsorprovisionfordoubtfuldebts.Itisexpressedasthe
numberoftimes.
IfDTOisgiveninmonths,convertitintoacommonbaseperiod.Ifitisgivenasanumber
oftimes,donotreduceittoabaseperiod.
Example: Total sales of a firm Rs.5,00,000, of which the credit sales are Rs.3,65,000.Sundry
DebtorsandBillsreceivableareRs.50,000andRs.2,000respectively
CalculatetheDTO.
Solution:
DTO=Debtors+BR/Netcreditsalesx365
50,000+2,000/3,65,000x365or 52days
1. DTOisalsoknownas___________________________.
2. Birthofdebtorsisfrom_________________________.
3. Debtorsarebasedon____________________________.
4. Debtorsinclude________________________________.
5. Totaldebtsinclude_____________________________.
6. Billsreceivableis_______________________________.
7. Tradedebtorsareprovidedwith___________________credittime.
8. Debtorsareincludedin___________________________.
9. FormulaforDTO________________________________.
10. Netcreditsalesinclude___________________________.
11. DTOinvolvesin_________________________________.
12. TotalsalesR.1,00,000.CashsalesRs.20,000.OpeningDebtorsRs.10,000,
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13. DebtorsatcloseRs.15,000.BRopeningRs.7,500andatcloseRs.12,500.
14. CalculateDTO.
15. TotalannualsalesRs.10,00,000andBRorRs.1,60,000.HowrapidlymustBR
16. becollectedifthemanagementwantstoreducetheBRtoRs.1,20,000?
CreditorsTurnoverRatio:CTO
Creditorscomeintobeingoutofcreditpurchases.Creditorsincludebothtradecreditorsandbills
payables. It is included in the current liability since the payment has to be made within three
monthsnormally.Theformulaisasfollows:
CTO=(Creditors+BillsPayable/Creditpurchases)x100
Wherecreditpurchases=Totalpurchasesminuscashpurchases
Example: Total purchases Rs.1,00,000. Cash purchases Rs.20,000. Discount Provision on
creditors Rs.1,000. Purchase returns Rs.2,000. Creditors at close Rs.30,000. Bills payable at
closeRs.25,000.CalculateCTO.
Solution:Creditpurchases=Totalpurchasecashpurchasepurchasereturn
1,00,00020,0002,000orRs.78,000
CTO=30,000+25,000/78,000x365or257days
The Reserve for discount on creditors should not be considered for calculating the net credit
sales.
1. Thebirthofcreditors__________________________.
2. Creditorsinclude___________________________.
3. Creditorsare______________________________.
4. Theformulais____________________________.
5. Creditpurchases____________________________.
9.11LeverageRatio
Afirmscapitalstructureistherelationofdebttoequityassourcesofthefirmsassets..Normally
both the owners and the creditors of the business will be interested in analyzing its capital
structure.Theratiosthatdealwiththeleverageareasfollows:
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1. Leverageratiorefersto_____________________________.
2. Itisbasedon____________________________________.
CapitalGearingRatio::
It denotes the extent of reliance of a company on the fixed cost bearing securities viz. the
preferencesharecapitalandthedebenturesasagainsttheequityfundsprovidedbytheequity
shareholders.Theratioiscalculatedas:
CapitalGearingRatio:Fixedcostbearingcapital/variablecostbearingcapital
Where fixed cost bearing capital = preference share capital, debentures , long term bank
borrowings.
Variablecostbearingcapital =equitysharecapital,reservesandsurplus.
Iffixedcostbearingcapitalismorethantheequitycapital,i.e.iftheratioismorethan1,thefirm
issaidtobehighlygeared.Onthereverse,itislowgeared.
Example:Thecapitalstructure oftwocompanies,NeverdowellandGoodfornothingLtdare
asfollows:
NDWGDF
EquityShareCapital(Rs.)10,00,0006,00,000
6%PreferenceShareCapital3,00,0004,00,000
7%Debentures
ReservesandSurplus
2,00,000
2,00,0002,00,000
Solution:
CapitalGearingRatio:NDW:3,00,000/12,00,000or0.25:1
GDF:6,00000/8,00,000or0.75:1
ThecapitalofNDWislowgearedwhencomparedtoGDF.
1. CGRrelieson______________________________.
2. Fixedcostsecuritiesinclude_________________.
3. Theratiois_______________________________.
4. Variablecostbearingcapitalinclude___________.
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DebtequityRatio:
Theratiocomparesthedebtwithequity.Debtreferstolongtermloansandliabilities.
RedeemablePreferencesharesarealsoconsideredasdebt.Thismeasureishelpfultoassess
thesoundnessofthelongtermfinancialpolicies.Itdeterminestherelativestakeofoutsidersand
shareholdersinthecompany.Lowertheratio,itisconsideredmorecomfortableforthecreditors
financialposition.2:1istakenasasatisfactorydebtequityratio.However,itisnotavery
satisfactorymeasure.sincethenominalvaluesmaybearverylittlerelationshiptotheircurrent
marketvalues.Thecalculationisasfollows:
DebtequityRatio=Longtermdebts/Shareholdersfunds+Longtermdebts
1. DERcompares______________with_____________________.
2. Debtrefersto_______________________________________.
3. RedeemablePreferencesharesaretakenas_______________.
4. DERdetermines________________________________stake.
5. Lowerratioindicates__________________________________.
6. ________________________________________Ruleofthumb.
7. Formula_____________________________________________.
Example: ThecapitalstructureofDRLtdisasfollows:
EquityShareCapital:10,00,000
RedeemablePreferenceCapital5,00,000
6%Debentures3,00,000
Longtermliabilities2,00,000
Reservesandsurplus2,00,000
CalculatetheCapitalGearingRatioandRatioofTotalInvestmenttoLongtermliabilities
Solution:
CGR:FixedCostbearingcapital/variablecostbearingcapital
10,00,000/12,00,000or0.83:1
TItoLTL:EquitySharecapital+Reservesandsurplus+Longterm
Liabilities/Longtermliabilities
22,00,000/10,00,000or2.2:1
9.12 LimitationsOfRatioAnalysis
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Undoubtedly, ratios are precious tools in the hands of the analyst. But its significance comes
fromproperuseoftheseratios.Misuseormishandlingoftheseratiosandusingthemwithout
propercontextmayleadtheanalystormanagementtoawrongdirection.Thepersonwhouses
theseratiosshouldbewellversedandshouldpossessexpertiseknowledgeaboutmakingproper
useoftheseratios.Likealltools,ratiosalsosufferfromseveralifsandbutsandforathorough
understandingofproperuseoftheseratios.Therearecertainlimitingfactorsinthecaseofratio
analysis.Theselimitingfactorsare:
1. The user should possess the practical knowledge about the concerns and the industry in
general.
2. Ratiosarenotanend.Theyareonlymeanstoanend.
3. A single ratio in itself is not important. The trend is more significant in the analysis.
Comparisonofratiosshouldbemade.
4. For comparativepurposes, there should bea standard ratio. Thereisno such standards
prescribedfortheratios.
5. Theaccuracyandcorrectnessofratiosaretotallydependentuponthereliabilityofthedata
containedinthefinancialstatementonthebasisofwhichratiosarecalculated.
6. Touseratios,firstofallthereshouldbeuniformityintheaccountingplanusedbyboththe
firms.Inaddition.Theremustbeconsistencyinthepreparationoffinancialstatementand
recordingthetransactionsfromyeartoyearwithinthatconcern.
7. Ratiosbecomemeaninglessifdetachedfromthedetailsfrom whichtheyarederived.The
shouldbeusedassupplementaryandnotsubstitutionoftheoriginalabsolutefigures.
8. Time lag in calculation and communicating the same should not be unnecessarily too
much.
9. Themethodofpresentationshouldbepreciseandwithoutanyambiguity.
10. Pricelevelchangesmaketheratioanalysismeaningless.
11. Interfirm comparison should never beundertaken iin the case ofconcerns which are not
associatedorcomparable.
12. Alltechniquesconcerningtheratioanalysisshouldbetakenintoaccount.
1. Oneshouldpossess___________________abouttheconcern.
2. Ratiosarenot_______________But______________________.
3. Ratioshouldbestudied________________________________.
4. Comparisonofratiosisdonewiththehelpof_______________.
5. _________________________Makeratioanalysismeaningless.
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9.13ComputationofRatios
Problem1:
ExtractsfromfinancialaccountofDRltdaregivenbelow
Year2006Year2007
Assets
Stock
10,00020,000
Debtors30,00030,000
Paymentinadvance
2,000
Cashinhand20,00015,000
Liabilities
Sundrycreditors25,000
30,000
Billspayable15,00012,000
BankOverdraft
5,000
SalesamountedtoRs.3,50,0002006anRs.3,00,000in2008.Computethesolvencypositionof
DR.
Solution: Shorttermsolvencyanalysis
CurrentRatio:CA/CLorYear2006:62,000/40,000or1.55:1
2007
:65,000/47,000or1.38:1
LiquidRatio:LA/Liquidliabilities
For2006:52,000/40,000or1.30:1
2007:45,000/42,000or1.07:1
Bankoverdraftisnotincludedinliquidliabilitiesasittendstobecomesomesortofapermanent
modeoffinancing.
Inventoryturnoverratio:Netsales/averageinventory
For2006:3,50,000/10,000or35:1
2007
:3,00,000/15,000or20:1
Theliquidpositionisnotsound.ThecurrentratioItheyear2006doesnotappeartobegood
enough as it is below the rule of thumb i.e. 2 : 1 . In the year 2007, the position has further
deterioratedto1.38:1.Thelaterratioshowsadefiniteweakeninginthesolvencypositionofthe
company.Asregardstheacidtestratio,itissatisfactoryintheyear2006andnotalarminginthe
year2007.However,thefallinthecashbalanceandappearanceofbankoverdraftintheyear
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showsadefinitedeteriorationinthefinancialposition.Moreover,becauseoffactorsconcerning
sales,stockanddebtors,thequickratioislikelytosoondeteriorate.
As regardsinventory turnover ratio,itindicatesan alarmingdeteriorationin the year 2007. The
disproportionateriseinthepercentageofstocktototalcurrentassetsfrom16%intheyear2006
to31%in the year2007 is alsoa matterof concern. Thisshows over purchaseof materials
whichneedsthroughinvestigation.
Acomparisonofdebtorsturnoverratiosofthetwo yearsindicates worseningofthecompanys
liquidposition. Therewillbemuchcauseofworryifthesalesisonlytoafewcustomers.
LONGTERMRATIOS
Debttoequityratio:Externalequities/Internalequities
For2006:40,000/22,000or1.82:1
2007:47,000/18,000or2.61:1
ProprietaryRatio:ShareholdersEquities/TotalEquities
For2006:22,000/62,000or0.35:1
2007:18,000/65,000or0.28:1
Fromthelongtermpointofview,thefinancialpositionofDRisveryunsatisfactoryasthedebtto
equityratioandproprietaryratioarefaroffthenorminbothyears.Thesituationhasworsened
intheyear2007resultinginaseriousdeclineintheshareholdersequity.Thecompanyseems
tobeheavilybankinguponthecreditorsfunds.
The overall conclusion of the above analysis is that the solvency position of DR is not
satisfactoryandneedscarefulplanning.
Problem1
Amanufacturerofstovessellstoretailersonterms2.5%discountin30days,60daysnet.The
debtorsand receivablesattheend ofDecemberofpastthreeyearsand netsalesforallthese
threeyearsareasunder.
Year
200520062007
Debtors
54,84233,93285,582
BillsReceivable4,2123,6869,242
NetSales
2,68,4663,47,3924,43,126
Determinetheaveragecollectionperiodforeachofthesethreeyearsandcomment.
Solution: Collectionperiod:Tradereceivables/NetcreditsalesxNumberofworkingdays
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Year2005:59,054/2,68,466x365= 80days
200637,618/3,37,392x365= 41days
200794,824/4,43,126x365=
78days
Theaveragecollectionperiodinallthethreeyearshasbeenwithinstandardperiod80days,i.e.
60+1/3of60days.Hence,itisgood.
Problem2: DRpurchasesgoodsbothoncashandcreditterms.Thefollowingparticularsare
obtainedfromthebooks:
TotalpurchasesRs.2,00,000.CashpurchasesRs.20,000.PurchasereturnsRs.34,000.Creditors
at the end Rs.70,000. Bills payable at the end Rs.40,000. Reservefor discount on creditors
Rs.5,000.Calculateaveragepaymentperiod.
Solution:
Calculation of net credit purchases : Total purchases minus cash purchases minus purchase
returnsorRs.3,00,00020,00034,000orRs.1,46,000.
Averagepaymentperiod:Creditors+Billspayable/Netcreditpurchasesx365days
70,000+40,000/1,46,000x365daysor275days.
Problem3: FromthefollowingBalancesheet,computetheBalanceSheetratios
Assets: Plantand Machinery Rs.2,00,000. Land and BuildingRs.2,00,000. Stock Rs.1,50,000.
DebtorsRs.50,000andCashbalancesRs.1,00,000=Rs.7,00,000
Liabilities: Equity Share capital Rs.2,00,000. 6 % Preference Share capital Rs.1,00,000. 8 %
Debentures Rs.1,00,000. Reserves and surplus Rs.1,00,000. Long term loan Rs.50,000.
CreditorsRs.1,00,000.BankoverdraftRs.50,000=Rs.7,00,000.
Solution:
CurrentRatio:CA/CLor3,00,000/1,50,000or2:1
LiquidRatio:LA/CLor1,50,000/150,000or1:1
AbsoluteLiquidRatio:Absoluteliquidassets/currentliabilitiesor1,00,000/1,50,000
Or10.67
ProprietaryRatio:Proprietorsequity/currentliabilitiesor4,00,000/7,00,000or0.57:1
AssetsProprietaryRatio:Fixedassets/Proprietorsequityor4,00,000/4,00,000or1:1
Currentassetstoproprietorsequity:Currentassets/Proprietorsequityor4,00,000/4,00,000or
1:1
DebtEquityRatio:Totaldebts/Proprietorsequityor3,00,000/4,00,000or0.75:1
StocktoCurrentassetRatio:Stock/Currentassetsor1,50,000/3,00,000or0.50:1
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Stocktoworkingcapitalratio:Stock/workingcapitalor1,50,000/1,50,000or1:1
Currentassetstoworkingcapitalratio:CA/WCor3,00,000/1,50,000or2:1
CurrentassetstoLiquidassetsratio:CA/LAor3,00,000/1,50,000or2:1
Long term funds to working capital ratio: All long term funds / working capital or 2,50,000 /
1,50,000or1.67:1
Tangibleassetstoworkingcapitalratio:Tangibleassets/currentliabilitiesor4,00,000/1,50,000
or2.67:1
Tangible assets to current liabilities ratio: Tangible assets / current liabilitieisi or 4,00,000 /
1,50,000or2.67:1
Capital Gearing Ratio: Equity share capital / Preference shares + Debentures or 2,00,000 /
2,00,000or1:1
Problem4: Afactoryengagedinanindustrywhichiscapitalintensivehasbeeninoperationfor
ten years. The capital employed is Rs.17,00,000, out of which Rs.10,00,000 represent equity
capitalandreserves,Rs.5,00,,,longtermborrowingsonDebenturesandRs.2,00,000cashcredit
frombanks.TheworkingcapitalofthecompanyisRs.8,50,000madeupofstocksRs.3,00,000,
Stores Rs.1,40,000, Debtors Rs.3,50,000, Advances and deposits Rs.60,000. Annual Sales
Rs.8,00,000. Calculate current ratio, liquidity ratio, debt equity ratio, proprietary ratio, Fixed
assetstoproprietorsfunds,Fixedassetratio.
Solution:CurrentRatio:8,50,000/2,00,000or4.25:1
LiquidityRatio=4,10,000/2,00,000or2.05:1
Debtequityratio:7,00,000/10,00,000or0.7:1
Proprietaryratio:10,00,000/17,00,000or0.59:1
FAtoProprietorsfundor8,50,000/10,000or0.85:1
Fixedassetsratioor8,50,000/15,00,000or0.57:1
Problem5:TheratiosrelatingtoDRLtdaregivenbelow
Grossprofitratio15%.Stockvelocity:6months.Debtorsvelocity3months.Creditorsvelocity3
months.ThegrossprofitfortheyearamountsRs.60,000.Closingstockisequaltoopeningstock.
Findsales,closingstock,sundrydebtorsandsundrycreditors.
Solution:
Gross Profit Ratio = Gross Profit / sales and 100 or 15 % = 60,000 / sales x100 or Sales is
Rs.4,00,000.
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Closingstock=BasisstockvelocityorCostofgoodssold/averagestockwhere
COGS=SalesGrossprofitorRs.4,00,000Rs.60,000orRs.3,40,000
6months=3,40,000/AveragestockofAveragestockisRs.6,80,000.
Sinceopeningandclosingstocksarethesame,theclosingstockisRs.6,80,000
SundryDebtors:BasisDebtorsvelocity=Totaldebtors/salesxNumberofmonths
TotalDebtorsis4,00,000x3/12orRs.1,00,000
SundryCreditors:Totalcreditors/purchasesxNumberofmonths
WherePurchases=Openingstock+purchases closingstockorRs.3,40,000
Creditors=3,40,000x3/12orRs.85,000
Problem6: PrepareaBalancesheetfromthefollowing
CurrentRatio1.4.LiquidRatio1.StockturnoverRatio8.GPRatio20%.Debtcollectionperiod
1.5 months. Reservesand surplus tocapital0.6. Turnover tofixed assets1.6. Capital Gearing
Ratio0.5.Fixedassetstonetworth1.25.SalesRs.10,00,000.
Solution: CalculationofcostofSales:SalesGrossprofit10,00,000minus2,00,000(20%
of10,00,000) Rs.8,00,000.
ClosingStock:Costofsales/StockTurnoverRatioor8,00,000/8orRs.1,00,000
FixedAssets:CostSales/FAturnoveror8,00,000/1.6orRs.5,00,000
Debtors:TotalsalesxDebtcollectionperiodof10,00,000x1.5/12orRs.1,25,000
Current assets based on liquid ratio: Current Ratio is 1.4. Therefore Stock is Current Ratio
minusLiquidRatioof1.4minus1.0oro.4orValueofstockxcurrentratio/stockratioo1,00,000
x1.4/4orRs.3,50,000
Liquidassets=Currentassetsminusstockor2,50,000minus1.25,000orRs.1,25,000
Cashbalances:LiquidassetsminusDebtorsor2,50,000minus1,25,000orRs.1,25,000
CurrentLiabilities:CurrentRatiois1.4
Therefore,currentliabilitiesisCurrentassets/currentratioor3,50,000/1.4orRs.2,50,000
NetWorth:FixedAssets/FAtonetworthor5,00,000/1.25orRs.4,00,000
ReservesandSurplus:Ratio0.6
LettheCapitalbe1
Add:Reservesandsurpluswhichis0.6,henceitis1.6
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Reservesandsurpluswillbe:ShareholdersfundsxReserves/Totalratioor4,000x0.6/1.6or
Rs.1,50,000
ShareCapital:ShareholdersfundsminusReservesor4,00,000minus1,50,000orRs.2,50,000
LongtermLiabilities:CapitalGearingratiois0.5
SharecapitalxGearingratioor4,00,000x0.5orRs.2,00,000
BALANCESHEET
Liabilities
Assets
Sharecapital2,50,000FixedAssets5,00,000
ReservesandSurplus1,50,000Stock1,00,000
LongtermLiabilities2,00,000Debtors1,20,000
CurrentLiabilities2,50,000Cashbalances1,25,000
8,50,000
8,50,000
TerminalQuestions:
Problem1:
CalculateCurrentratio,acidtestratio.:CashinhandRs.3,000.CashatBankRs.65,000.Bills
receivable Rs.10,000. Stock Rs.1,20,000, Debtors Rs.80,000. Prepaid expenses Rs.2,000.
CreditorsRs.1,20,000.BillspayableRs.20,000.
Problem2:
Calculate : Debts to equity Ratio and Proprietary ratio : Equity share capital Rs.5,00,000.
PreferencesharecapitalRs.3,00,000.ReservesRs.2,00,000.CurrentliabilitiesRs.1,00,000.8%
DebenturesRs.3,00,000.FixedassetsRs.10,00,000.CurrentassetsRs.4,00,000
Problem3:
ThecurrentassetsandcurrentliabilitieswereRs.16,00,000andRs.8,00,000respectively.What
istheeffectofeachofthefollowingtransactionsindividuallyandtotallyonthecurrentratio:
1. PurchaseofnewmachineryforRs.5,00,000
2. PurchaseofnewmachineryforRs.10,00,000onamediumtermloanfromabankwith20%
margin.
3. PaymentofadividendofRs.2,00,000ofwhichRs.0.47lakhwastaxdeductedatsource.
4. MaterialspurchasedcostingRs.5,00,000inrespectofwhichbankfinancedRs.3,00,000.
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Problem4:
The current ratio is 2 : 1. Which of the following suggestions would improve the ratio, which
wouldreduceitandwhichwouldnotchangeit.
a) topayacurrentliability
b) tosellamotorcarforcashataslightloss
c) toborrowmoneyforshorttimeonaninterestbearingpromissorynote
d) topurchasestockforcash
e) togiveaninterestbearingpromissorynotetoacreditortowhommoneywastobepaid.
AnswerforSelfAssessmentQuestions
1. Incomeandbalancesheet
2. Trend
3. Crosssectional
4. Comparative
1. Interbusinesscomparisonandacrossfinancialperiod
2. Onenumberexpressedintermsofanother
3. Numericalorquantitative
4. Quotient
5. Proportion,percentageandturnover
6. Processofestablishingandinterpretingratiosfordecisionmaking
1. Financialanalysis
2. Financialstatements
3. Liquidity,solvencyandprofitabilityaspects
1. Eight
2. Forforecastingandplanningactivities
3. Managementandutilizationofasset
4. Firmsprogressandperformance
5. Shorttermandlongtermliquidityposition
6. Valueofthefinancialstatements
7. Overallefficiencyofthebusinessentity
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8. Actualresultscanbecomparedwithestablishedstandards
1. Currentandliquid
2. Debtandequity
3. GP,NP,andoperating
4. STO,DTOandCTO
5. Gearing.
1. Tomeetcurrentliability
2. Currentassetsandcurrentliabilities
3. Matchingprinciple
4. Currentratioandquickratio.
1. Financial
2. Shorttermobligations
3. Currentandcurrentliabilities
4. Currentassets:currentliabilitiesorcurrentassets/currentliabilities
5. Proportion
6. 2:1
7. Currentassetsminuscurrentliabilities.
8. CA1,00,000andCL20,000
1. Quick,acidtest
2. Stock
3. Stockcannotbesoldeasilyandstocktypicallysoldoncredit
4. Currentstockminusstock/currentliabilities
5. Willnotchange
6. Willimprove
7. CRwilldecline
8. CRwillnotchange.
9. 3,50,0002,00,000,2,50,000andRs.1,00,000.
10. Rs.20,000
11. CARs.1,00,000,CLRs.40,000,StockRs.40,000andLARs.60,000.
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1. Longtermfinancialposition
2. Testofsolvency
3. Debtandequity
4. Outsideborrowings
5. Indebtednessandrepayment
1. Healthandrisk
2. Totalliabilities/totalassets.
3. Toomuchofdebt
4. Inabilitytorepaydebt
5. Limited
6. Nonriskysituations.
1. LongtermliabilitiesandequityportioninBalancesheet
2. Equitysharecapital+Reservesandsurplus
3. Longtermdebt/shareholdersequity
4. Capitalstructure
5. Relationshipbetweendebtandequity
6. Valueofthefirm
7. Funds
8. Increasedborrowingsorsaleofsharesorboth
9. Poorcapitalstructure.
10. Repaymentofdebt
11. Soundfinancialposition
12. Risky
13. Vary
1. Tellsthestatus
2. Sales,assets,equityorsharevalue
3. Earnings
4. Profits
5. Capital.
180
Unit9
1. Percentage
2. Pricingpolicy
3. Grossprofit/salesx100
4. SalesminusCostofgoodssold
5. Cash+creditsalesminusreturns
6. Percentage.
1. Relationship
2. Netsales
1. NPmargin
2. Salesinrupee,expensesandtaxes
3. Overallefficiency
4. Overallefficiency
5. Poorfinancingplanningandlowefficiencies
6. f)Netprofitaftertaxes/netsalesx100
7. Incomestatement
1. Speed
2. CompositionofCurrentassetsandcurrentliabilities
3. Turnover.
1. Firmsstock
2. Inventoryturnover,stockvelocity
3. Speedofconvertingstockintosalestocash
4. Numberoftimesturnover
5. Efficiencytomanagestock
6. CostofGoodsSold(COGS)/Averagestock
7. Netsalesminusgrossprofit.
8. Opening+Closingstock/2
9. Netsales/Stock
181
Unit9
1. Debtorsvelocity
2. creditsales
3. Grossvalue
4. Baddebtsandreserveefordoubtfuldebts
5. TradedebtorsandBillreceivable
6. Written
7. Threemonths
8. Currentassets
9. Debtors+Billsreceivable/netcreditsalesxnumberofworkingdays.
10. Salesminusreturninwards
11. Velocityofdebtcollection
12. DTO3.56
13. Collectionperiod43days.
1. Creditpurchases
2. Tradecreditors+billspayable
3. Currentliabilities
4. Creditors+BP/creditpurchasesxNumberofdays.
5. Creditpurchasesminusreturnoutwards.
1. Relationofdebtandequity
2. Capitalstructure.
1. Fixedcostbearingsecurities.
2. Preferencesharecapital+debentures.
3. Fixedcostbearingsecurities/variablecostbearingcapital.
4. Equitysharecapital+reservesandsurplus.
1. debt,equity
2. Longtermloansandliabilities
3. Longtermdebt
4. relative
182
Unit9
5. comfortzone
6. 2:1
7. Longtermdebts/Shareholdersfunds+longtermdebt
1. Comprehensiveandpracticalknowledge
2. Endsbutmeans
3. Intotality
4. Standards
5. Pricelevelchanges
AnswerforTerminalQuestions:
1. Refertounits9.7
2. Refertounits9.8&9.13
3. (1)Decrease(2)decrease(3)decrease(4)increase
4. (a)increase(b)increase(c)decrease(d)nochange(e)nochange
183

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