Professional Documents
Culture Documents
Chapter 10
Chapter 10
Ratio Analysis
1. Meaning of Ratio
Accounting ratio is an expression relating to two figures or two accounts or two set
accounting heads or group of items stated in financial statement.
2. Objectives of Ratios
The accounting ratios are very useful in assessing the performance of business enterprise i.e.
financial position and profitability. This is possible to achiever by comparison of ratios of the
year or with the previous year.
The ratios are worked out to analyse the following aspect or areas of business organization.
1. Solvency: -
a. Long-term solvency
b. Short-term solvency
c. Immediate solvency
2. Stability
3. Profitability
4. Operational efficiency
5. Credit standing
6. Structural analysis.
7. Utilization of resources and
8. Leverage or external financing.
3. Classification of Ratios
The ratios are used for different purposes, for different users and for different analysis.
Traditional Classification:
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As per this classification, the ratios readily suggest through their names, their respective
resources. From this point of view, the ratios are classified as follows.
a) Balance Sheet Ratio: This ratio is also known as financial ratios. The ratios which express
relationships between two items or group of items mentioned in the balance sheet at the end
of the year.
Example: Current ratio, Liquid ratio, Stock to Working Capital ratio, Capital Gearing ratio,
Proprietary ratio, etc.
b) Revenue Statement Ratio:- This ratio is also known as income statement ratio which
expresses the relationship between two items or two groups of items which are found in the
income statement of the year.
Example: Gross Profit ratio, Operating ratio, Expenses Ratio, Net Profit ratio, Stock Turnover
ratio, Operating Profit ratio.
c) Combined Ratio:-This ratio shows the relationship between two items or two groups of
items, of which one is from balance sheet and another from income statement (Trading A/c
and Profit & Loss A/c and Balance Sheet).
Example: Return on Capital Employed, Return on Proprietors' Fund ratio, Return on Equity
Capital ratio, Earning per Share ratio, Debtors' Turnover ratio, Creditors Turnover ratio.
The accounting ratios can also be classified according their functions as follows.
a) Liquidity Ratios:- These ratios show relationship between current assets and current
liabilities of the business enterprise.
b) Leverage Ratios:- These ratios show relationship between proprietor's fund and debts used
in financing the assets of the business organization.
This ratio measures the relationship between proprietors fund and borrowed funds.
c) Activity Ratio: - This ratio is also known as turnover ratio or productivity ratio or
efficiency and performance ratio. These ratios show relationship between the sales and the
assets. These are designed to indicate the effectiveness of the firm in using funds, degree of
efficiency, and its standard of performance of the organization.
Example : Stock Turnover Ratio, Debtors' Turnover Ratio, Turnover Assets Ratio, Stock
working capital Ratio, working capital Turnover Ratio, Fixed Assets Turnover Ratio.
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Example: i) Profits and Sales: Operating Ratio, Gross Profit Ratio, Operating Net Profit
Ratio, Expenses Ratio etc.
ii) Profits and Investments: Return on Investments, Return on Equity Capital etc.
e) Coverage Ratios:- These ratios show relationship between profit in hand and claims of
outsiders to be paid out of profits.
Example: Dividend Payout Ratio, Debt Service Ratio and Debt Service Coverage Ratio.
d) Profitability Ratio: - These ratios show relationship between profits and sales and profit &
investments. It reflects overall efficiency of the organizations, its ability to earn reasonable
return on capital employed and effectiveness of investment policies.
b) Long term creditors: - Normally leverage ratios provide useful information to the long
term creditors which include debenture holders, vendors of fixed assets, etc. The creditors
interested to know the ability of repayment of principal sum and periodical interest payments
as and when they become due.
c) Short term creditors: - The short-term creditors of the company are basically interested to
know the ability of repayment of short-term liabilities as and when they become due.
Therefore, the creditors has important place on the liquidity aspects of the company's assets.
Example: Return on capital employed, Turnover Ratio, Operating Ratio, and Expenses Ratio.
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i) Debt-Equity ratio.
B) To test the Profitability: (Percentage)
i) Gross Profit Ratio;
ii) Net Profit ratio;
iii) Return on Capital Employed/Overall profitability;
iv) Return on Net worth;
C) To test the Managerial Efficiency/ Turnover Ratio/Activity Ratio: (Times)
i) Inventory Turnover ratio;
ii) Accounts Receivable/Debtors Turnover Ratio
iii) Average Collection Period
iv) Assets Turnover Ratio;
v) Accounts Payable/Creditors Turnover ratio
D) Market ratio: (Tk.)
i) Earnings per Share (EPS);
ii) Price earnings Ratio (P/E)
iii) Dividend Payout Ratio
A. Solvency Ratios
Current Ratio:
This ratio is also known as working capital ratio. This expresses the relationship between
current assets and current liabilities. This ratio is calculated by dividing current assets by
current liabilities. It is expressed as pure ratio standard current ratio is 2:1. Means current
assets should be double the current liabilities.
Current Assets
Current Ratio =
Current Liabilitie s
Significance: This ratio tests the credit strength and solvency of an organization. It shows
strength of working capital, it indicates ability to discharge short term liabilities.
This ratio expresses the relationship between liquid assets and liquid liabilities. This ratio is
also known as quick ratio or acid test ratio. This ratio is calculated by dividing liquid assets
by liquid liabilities. Standard quick ratio is 1:1.
Quick Assets
Liquid Ratio =
Current/Qu ick Liabilitie s
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a) Liquid assets = Current assets less (Inventory, prepaid expenses and advance tax etc)
b) Liquid liabilities = Current liabilities less (Bank overdraft and cash credit etc)
Significance:-
This ratio express the relationship between external equities and external equities i.e. owners'
capital and borrowed capital.
Components:-
1) Debts include all liabilities including short term & long term i.e. mortgage loan and
debentures.
2) Shareholders' funds consist of Preference share capital, Equity share capital, Capital
and Revenue Reserves, Surplus, etc.
Significance:
1) It shares favorable or non favorable capital structure of the company.
2) It shows long term capital structure.
3) It reveals high margin of safety to creditors.
4) It makes us understand the dependence on long terms debts.
A. Profitability Ratio
Profitability refers to the expression of profits in relation to sales, investment and equity of a
firm. Whenever profits are related to any one of these parameters; then we get profitability
ratio. These ratios are calculated to enlighten the end results of business activities which are
the sole criterion of the overall efficiency of a business concern. Some important profitability
ratios that are used in the study are as follows:
Gross Profit Ratio: This ratio tells gross margin on trading and is calculated as under:
Gross Profit
Gross Profit Ratio = X 100
Net Sales
Significance:
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Operating Profit Margin: This ratio establishes the relationship between operating profit
and sales and is calculated as follows:
Operating Profit
Operating Profit Margin = x 100
Net Sales
Significance:-
1) It is used to test operational efficiency of business.
2) This ratio is the yardstick which measures the efficiency of all operational activities of
business i.e. production, management, administration, sales, etc.
Net Profit Ratio: This ratio is measured by dividing profit after tax by net sales.
Net Profit
Net Profit Ratio = x 100
Net Sales
Significance:-
1) It measures overall profitability of business.
2) It is very useful in judging return on investments.
3) It provides useful inferences as to the efficiency and profitability of business.
4) It indicates the portion of net sales is available for proprietors.
5) It is clear index of cost control, managerial efficiency, sales promotion, etc.
Return on Capital Employed: This ratio is an indicator of the earning capacity of the capital
employed in the business. This ratio is calculated as follows:
Net Profit
Return on Capital Employed = x100
Capital Employed
Capital employed =
i) Equity share capital
ii) Add. Preference share capital reserve & surplus
iii) Add. Long term borrowings (Term loan + Debentures)
iv) Less: Fictitious assets like miscellaneous expenses not written off.
Less profit & loss A/c Dr. Balance (loss)
Return on Total Assets: This ratio is calculated to measure the profit after tax against the
amount invested in total assets to ascertain whether assets are being utilized properly or not.
It is calculated as under:
Net profiit
Return on Total Assets = x 100
Total Assets
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Significance: -
1) This ratio is effective tools to measure overall managerial efficiency of business.
2) Comparison of this ratio with other company and this information can be obtained for
determining future course of action.
3) This ratio indicates the productivity of capital employed and measure the operating
efficiency of the business.
Earnings per share are calculated to find out overall profitability of the organization. It
represents earnings of the company whether or not dividends are declared. Earnings per
share are determined by dividing net profit by the number of equity shares.
Components:-
1) Net profit after tax & interest - less preference dividend.
2) No. of equity shares.
Purpose:
Purpose of this ratio is to calculate the amount of profits available on each equity share to
take care of equity dividend, transfer to reserves, etc.
Significance:
1) This ratio helps the investors or shareholders to take decision while purchasing or
selling shares.
2) This ratio shows the possibilities of issue of bonus shares.
3) Higher ratio indicates overall profitability.
a) Formula: -
Market price per Equity
Price Earnings Ratio =
Earning per Equity shares
b) Components:
1. Market price per equity share = quoted price of a listed equity share.
2. Earnings per equity share
c) Purpose: -
1) Purpose of this ratio is to show the effect of the earning on the market price of
the share.
2) It helps the investors while deciding whether to purchase, keep or sell the equity
shares.
3) It helps to ascertain the value of equity share.
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Dividend payout Ratio:
This ratio shows relationship between dividends paid to equity shareholders out of profit
available to the equity share holders.
a) Formula: -
This ratio is calculated as follows.
Dividend per equity shares
Dividend payout ratio =
Earning per shares
b) Components: -
1) Dividend per equity shares means total dividend paid to equity shareholder dividend
by number of equity shares.
2) Earning per shares
c) Purpose: - Purpose of this ratio is to measure the dividend paying capacity of the
company.
d) Significance: -
1) Higher ratio signifies that the company has utilized the larger portion of its earning for
payment of dividend to equity shareholders.
2) It says lesser amount of earning has been retained.
Problem:-01
Balance Sheet
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Cash ****
Total **** Total ****
Based on the above information you are required to prepare the Balance sheet of the company
as on 31.12.2010.
Solution:
Gross profit
1. Gross profit ratio = x 100
Net Sales
Gross profit
Net sales = x 100
Gross Profit Ratio
1,00,000
Net sales = x 100 = 4, 00,000
25
Credit sales
4. Debtors Turnover ratio =
Debtors
Credit sales
Debtors =
Debtors Turnover Ratio
3,00,000
=
360/36
= 30,000
Long - term Debt
5. Long-term Debt to Equity =
Equity
Long - term Debt
→
0.40= 1,20,000
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So, Current Liabilities = Total Liabilities – Shareholders Equity – Long term Debt
= 2, 00,000 – 1, 20,000 – 48,000
= 32,000
Current Assets 3
6. Current Ratio =
Current Liabilitie s 1
Problem:-02
Mariland Ltd. gives you the following information. Prepare Income Statement for the year
ended 31st March 2017 and Balance Sheet as on that date:
Credit period allowed by suppliers one month. Average debt collection period two months.
On 31st March 2017 current assets consists of stock, debtors and cash only. There was no
bank overdraft. All purchases are made on credit. Cash sales were 1/3 rd of credit sales.
Problem:-03
Following is the abridged Balance Sheet of the Consolidated Co. Ltd. As at 31 st March, 2014.
Balance Sheet
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75,000
1,75,000
Stock 1,05,000
Debtors 1,00,000
Bank 5,000
7,85,000 7,85,000
From the following information you are required to prepare Profit and Loss Account and
Balance Sheet as at 31st March, 2015:
a) The composition of the total of liabilities side of the company’s Balance sheet as at
31st March 2015 (the paid-up capital remaining the same as at 31st March, 2014) was:
The debentures were issued on 1st April, 2014, interest being paid on 30th September
2014 and 31st March 2015;
b) During the year ended on 31st March 2015, additional Plant and Machinery had been
bought and a further Tk. 25,000 depreciation written off. Freehold property remained
unchanged. The total fixed assets then constituted 60 percent of total fixed and current
assets.
c) The current ratio was 1.6:1. The quick assets ratio was 1:1.
d) The debtors (four-fifths of the quick assets) to sales ratio revealed a credit period of
two months.
e) Gross profit was at the rate of 15 percent of selling price and return on net worth as at
31st March 2015 was 10 percent.
f) Ignore taxation.
Problem:-04
The comparative statements of two companies belonging to the same industry are
presented below:
Income Statement
For the Year ended December-31
Particulars A Co. B Co.
Net Sales 28,00,000 41,00,000
Cost of goods sold 21,00,000 34,00,000
Other expenses 5,40,000 4,30,000
Interest expenses 20,000 30,000
Income tax 70,000 1,20,000
Dividends 50,000 80,000
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Balance Sheet
December-31
A Co. B Co.
Cash 1,40,000 3,20,000
Accounts Receivable 2,20,000 6,30,000
Inventories 8,20,000 9,50,000
Plant assets 11,30,000 24,00,000
23,10,000 43,00,000
Current liabilities 6,70,000 10,50,000
Debentures 3,80,000 5,00,000
Ordinary share capital 11,00,000 22,50,000
Retained earnings 1,60,000 5,00,000
23,10,000 43,00,000
Required:
Answer each of the following questions by making a comparison of one or more ratios:
a) Which company is using the shareholders investment more profitably?
b) Which company is better able to meet its current obligations?
c) Which company collects its receivable faster?
d) Which company is earning the higher rate of return on its investment?
e) If you are going to buy the shares of one or more company, which one would you
choose? Why?
Solution:
Calculation of net income:
Income Statement
For the Year ended December-31
Required-a)
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The name of such ratio is Return on Shareholders Fund
Net Profit
We Know, Return on Shareholders Fund = X 100
Net worth
A. Co. B. Co.
1,40,000 2,40,000
X 100 X 100
Share Capital Retained Earnings Share Capital Retained Earnings
1,40,000 2,40,000
= X 100 = X 100
11,00,000 1,60,000 22,50,000 5,00,000
= 11.11% = 8.73%
Required-b)
Current Assets
We Know, Current Ratio =
Current Liabilitie s
A. Co. B. Co.
1,40,000 2,20,000 8,20,000 3,20,000 6,30,000 9,50,000
6,70,000 10,50,000
= 1.76 : 1 = 1.81: 1
Comments: B co. is better able to meet its current obligation.
Required- c)
The name of such ratio is Average Collection Period
Accounts Receivable
We Know, Average Collection Period = X 360
Credit Sales
A. Co. B. Co.
2,20,000 6,30,000
X 360 X 360
28,00,000 41,00,000
= 28 day’s = 55 day’s
Required- d)
The name of such ratio is Return on Investment
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Net Profit
We Know, Return on Investment = X 360
Total Assets
A. Co. B. Co.
1,40,000 2,40,000
X 100 X 100
23,10,000 43,00,000
= 6.06% = 5.58%
Comments: A co. is earning the higher rate of return on its total assets investment.
Required- e)
The name of such ratio is Return on Equity Shareholders’ Investment
A. Co. B. Co.
1,40,000 - 70,000 2,40,000 - 1,20,000
X 100 X 100
12,60,000 27,50,000
= 5.55% = 4.44%
Comments: If we are going to buy the share of one company, I would choose the share
of A co., as the rate of return on equity shareholders’ fund of A co. is higher than that of
B co.
Problem:-05
Given below are the summarized income statement and Statement of Financial Position of
PQR Ltd.
PQR Ltd.
Income Statement
PQR Ltd.
Statement of Financial Position
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Particulars Taka (‘000) Taka (‘000)
ASSETS
Non-current Assets 800
Current Assets:
Inventory 400
Accounts Receivable 175
Marketable Securities 75
Cash 50 700
Total Assets 1500
CAPITAL AND LIABILITIES
Paid up capital (40,000 shares @ Tk. 10) 400
Retained earnings 120
Debentures 700
Accounts Payable 180
Bills Payable 20
Other current liabilities 80
Total capital and liabilities 1500
Instructions:
a) PQR ltd. would like to borrow Tk. 5, 00,000 from a bank for less than a year.
Evaluate the firms current financial position by calculating ratios that you feel would
be useful for the banks evaluation?
b) What problem areas are suggested by your ratio analysis? What are the possible
reasons for them?
c) Do you think the bank should grant the loan?
Solution:
Requirement-a)
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Bank, as a short-term lender, would be interested in evaluating the liquidity position of the
company. Such a position can be evaluated by current ratio, quick ratio, average collection
period and inventory turnover ratios. Besides these ratios, net income before interest and
taxes/ interest ratio and debts to total assets ratio may have some bearing on the decision of
the bank. Other profitability ratios are not as significant from the point of view of the bank, as
the time period involved is less than one year.
Following is a list of the relevant ratios of the company along with those industries:
Requirement-b)
Company’s position both in terms of liquidity ratios [(a) to (d)] and solvency ratio (e) are
almost at par with industry average. Apart from industry’s comparison, the company’s ratio
are also very satisfactory in as much as current ratio is more than the desired norm of 2:1;
quick ratio is also slightly more than the desired norm of 1:1. More than half of the total
assets are financed out of owned funds; signify satisfactory level of debt amount.
The problem area suggested by the ratio analysis is low inventory turnover ratio. It is
reflected in the stock turnover ratio, which is 4 times only compared to 8 times that of the
industry. There is accumulation of stocks with the company. It may be due to holding of
damaged or obsolete goods (now not in demand).
Requirement-c)
The bank should grant the loan to the company for the following reasons:
i. Its current and quick ratios are very satisfactory;
ii. Its debt-equity ratio is not high. However, the bank should probe in-depth about the
causes of high investment inventory.
Problem:-06
The comparative statements of two companies belonging to the same industry are presented
below:
Income Statement
For the Year ended December-31
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Income tax expenses 18,000 14,000
Total expenses 5,61,600 4,88,800
Net Income 38,400 31,200
Balance Sheet
December-31
Additional Data:
The common stock recently sold at Tk. 19.50 per share.
Required:
Answer each of the following questions by making a comparison of one or more ratios:
a) Which company is using the shareholders investment more profitably?
b) Which company is better able to meet its current obligations?
c) Which company collects its receivable faster?
d) Which company is earning the higher rate of return on its investment?
e) Which company is efficient for its inventory turnover?
f) Which company is better regarding earnings per share?
g) If you are going to buy the shares of one or more company, which one would you choose?
Why?
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Problem:-07
Following is the Trading and Profit and Loss Account and Balance Sheet for the year ended 31 st
December 2014:
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Market price of equity share is Tk. 8.
a) You are required to calculate the following ratios:
i) Acid Test Ratio; ii) Stock Turnover Ratio; iii) Return on Capital Employed; iv)
Earnings Per Share; v) Price Earnings Ratio; vi) Debt equity Ratio; vii) Debtors
Collection Period; viii) Net Profit Ratio.
b) Draft a report to the top level management about the performance of the company’s of the
year 2014 on the basis of the above ratios.
Problem:-08
Presented below is an incomplete income statement and an incomplete comparative balance sheet
of Denis Corporation.
Denis Corporation
Income Statement
For the year ended December 31, 2015
Denis Corporation
Balance Sheet
December 31
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Common stock, Tk. 1 par 60,00,000 60,00,000
Retained earnings 8,00,000 7,50,000
Total stockholders’ equity 68,00,000 67,50,000
Total liabilities and stockholders’ equity ? 1,40,00,000
Additional Information:
i. The receivable turnover for 2015 is 10 times;
ii. All sales are on account;
iii. The profit margin for 2015 is 14.5%;
iv. Return on assets is 22% for 2015;
v. The current ratio on December 31, 2015, is 3.0;
vi. The inventory turnover for 2015 is 4.8 times.
Instructions:
Compute the missing information given the ratios above and complete the Income Statement and
Balance Sheet. Show computations.
Solution:
22,000,000
1. Receivable Turnover = 10 =
Average Receivable s
22,000,000
Average Receivables = = 22, 00,000
10
Net Receivable s (31.12.2015) 19,00,000
= 22, 00,000
2
Net Receivables (31.12.2015) = 25, 00,000
Net Income
2. Profit Margin = 14.5% = 0.145 = x100
Sales (22,000,000)
Net Income = 31, 90,000
Income before income taxes = 31, 90,000 + 11, 20,000 = 43, 10,000
31,90,000
3. Return on Assets = 22% = 0.22 =
Average Assets
Average Assets = 31, 90,000/0.22 = 1, 45, 00,000
Assets (31.12.2015) 1, 40, 00,000
= 1, 45, 00, 000
2
Assets (31.12.2015) = 1, 50, 00,000
Total Current Assets = 1, 50, 00,000 - 92, 40,000 = 57, 60,000
Inventory = 57, 60,000 - 25, 00,000- 9, 00,000 = 23, 60,000
Total Liabilities and Stockholders’ Equity = 1, 50, 00,000
Total Liabilities = 1, 50, 00,000 - 68, 00,000 = 82, 00,000
57,60,000
4. Current Ratio = 3.0 =
Current Liabilitie s
Current Liabilities = 57, 60,000/3 = 19, 20,000
Long-term notes payable = 82, 00,000 – 19, 20,000 = 62, 80,000
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Cost of goods sold
5. Inventory Turnover = 4.8 =
34,40,000 23,60,000
2
Cost of goods sold = 29, 00,000 x 4.8 = 1, 39, 20,000
Gross Profit = 2, 20, 00,000 - 1, 39, 20,000 = 80, 80,000
Income from operations = 80, 80,000 - 33, 30,000 = 47, 50,000
Interest Expense = 47, 50,000 - 43, 10,000 = 4, 40,000
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