Module III:

Analyzing Financial
Position
 Snapshot
Financial Analysis
Purpose of Financial Analysis
Limitations of Financial Analysis
Tools for Financial Analysis
Ratio Analysis
Advantages & Limitations of Ratio Analysis
Classification of Ratios
 Liquidity Ratios
 Solvency Ratios
 Profitability Ratios
 Turnover Ratios
 Financial Analysis
“A systematic process of critical
examination of the financial information
contained in the financial statements in
order to understand and make decisions
regarding the operations of the firm”
Process of dissection, establishing
relationships and interpretation thereof
to understand the working and financial
position of a firm
 Objects of
Financial Analysis
To present complex data contained in
financial statements in simple &
understandable form
To classify items contained in financial
statements in convenient & rational
groups
To make comparisons between various
groups to draw various conclusions
 Purpose of Financial
Analysis
 Earning capacity or profitability
 Short-term and long-term solvency
 Financial strength
 Inter-firm comparison
 Capability of payment of interest &
dividend
 Trend of the business
 Managerial efficiency
 Making forecasts and preparing budgets
Limitations of Financial
Analysis
Historical analysis
Limitations of Financial Statements
Affected by Window-dressing
Do not reflect price level changes
Variation in accounting practices
Effect of personal ability & bias of the analyst
Difficulty in forecasting
Qualitative aspect ignored
Limited use of single year’s analysis of financial
statements
Tools for Financial Analysis
Comparative Statements
Common Size Statements
Trend Analysis
Accounting Ratios
Cash Flow Statements
Funds Flow Statements
 Comparative Statements
Two or more Balance Sheets and/or Income
Statements are presented simultaneously in
columnar form to facilitate periodic comparison
Exhibits the magnitude and direction of changes
Prepared to show:
 Absolute amount of different items in
monetary terms
 Amount of periodic changes in monetary
terms- thereby indicating trend
 Percentage of periodic changes
Format of Comparative Balance
Sheet
 Absolute % incr/decr
Particulars 2006 2007 incr/decr in relation
over 2006 to 2006
Fixed Assets (A)
Investments (B)
Net Fixed Assets
Working Capital:
Current assets (i)
Current Liabilities (ii)
Working Capital (C)(i) – (ii)
Capital Employed (A+B+C)
Less: Long-term debts
Shareholder’s Funds
(OR)
Shareholder’s Funds =
Preference Share Capital
+ Equity Share Capital
+ Reserves & Surplus
Comparative Income Statement
Shows the increase or decrease in income and
expenditure for two or more years in terms of
rupees and percentage
Shows changes in sales, cost of goods sold, gross
profit, operating profit, operating expenses, non-
operating expenses & net profit
Format of Comparative Income
Statement
 Particulars 2006 2007 Absolute % incr/ decr
incr/decr in relation to
over 2006 2006
Net Sales
(-) Cost of goods sold
Gross Profit
(-) Operating exps:
Office & admin. exps
Selling & distribn exps
Net Operating Profits
(+) Non-operating incomes
Total income
(-) Non-Operating expenses
Profit before interest& tax(PBIT)
(-) Interest
Profit before Tax (PBT)
(-) Tax
Profit after tax (PAT)
 Operating expenses
Office & Administration expenses (e.g. salary,
postage, telephone, depreciation of office assets)
Selling & distribution expenses (i.e.
advertisement, carriage & freight outward, salary
& commission to sales staff)
Cash discounts allowed to customers
Bad debts
Provision for doubtful debts, provision for
discount on debtors.
Interest on short term debts
Non-operating incomes
Interest & dividend on long term investments
Profit on sale of fixed assets & investments
Rent received
Compensation on acquisition of land
Non-operating expenses
Interest on long term debts
Loss on sale of fixed assets & investments
Intangible assets amortized (e.g. goodwill,
patents, copyrights amortized)
Fictitious assets written off (e.g. preliminary
expenses, underwriting commission, discount or
brokerage on issue of shares/debentures written
off)
 Common Size Statements

Individual figures are converted into percentages to

some common base
Percentage of each individual item shows its
relation to respective total
Utility:
To present changes in various items in
relation to net sales, total assets or total
liabilities
To establish a relationship
To provide a common base for comparison
Format of Common Size
Income Statement
 Particulars 2006 2007 % of % of
net sales net sales
2006 2007
Net Sales 100 100
(-) Cost of goods sold
Gross Profit
(-) Operating exps:
Office & admin. exps
Selling & distribn exps
Net Operating Profits
(+) Non-operating incomes
Total income
(-) Non-Operating expenses
Net Profit before interest & tax
(-) Interest
Net Profit before Tax
(-) Tax
Net Profit after tax
Format of Common Size
Balance Sheet
 2009 2010 % of total assets % of total assets
(2009) (2010)
Fixed Assets:
Land & Building
Plant & machinery

Total Fixed Assets

Current assets:
Stock
Debtors
Cash & bank
Total current assets
Total assets 100 100
Share Capital & Reserves:
Preference Share Capital
Equity Share Capital
Reserves & Surplus
Total Capital & Reserves
Long term loans
Current Liabilities:
Creditors
Outstanding expenses
Total current liabilities
Total liabilities 100 100
Kavitha Menon
 Trend Analysis

Helps in making comparative study of financial

statements for several years.
Based on the idea that what has happened in the
past is what will happen in the future
Method involves calculation of percentage
relationship that each items bears to the same
item in the base year.
Any year may be taken as the base year (usually
the earliest year). It should be a normal year
Each item of base year is taken as 100
 Calculate trend percentages taking 2001 as base
year:
2001 2002 2003 2004
Net sales 200000 190000 240000 260000
Less: Cogs 120000 117800 139200 145600
Gross Profit
Less: Expenses 80000 72200 100800 114400
Net Profit 20000 19400 22000 24000
60000 52800 78800 90400
 Solution to previous sum…

2001 2002 2003 2004

Net sales 100 95 120 130
Less: Cogs 100 98.2 115.8 121.3
Gross Profit 100 90.3 126 143
Less: Expenses 100 97 110 120
Net Profit
100 88 131.3 150.6
 What is a Ratio?
A ratio is an arithmetical and logical
relationship between two figures
4 types:
Pure ratio or Simple ratio – e.g. 2:1
Rate or ‘So many times’ – e.g. 5 times
Percentage – e.g. 20%
Fraction – one-tenth
 Ratio Analysis
A method of calculating and interpreting
financial ratios in order to assess the strengths and
weaknesses underlying the performance of an
enterprise
Objective: To judge
 Earning capacity
 Financial soundness
 Operating efficiency
Advantages of Ratio Analysis
Helpful in analysis of financial statements
Simplification of Accounting figures
Helpful in Comparative Study – inter & intra-firm
Helpful in locating weaknesses
Useful in forecasting
Estimate about trend of the business
Fixation of ideal standards
Effective control
Study of Financial Soundness
 Limitations of Ratio Analysis
False accounting data gives false ratios
Comparison not possible if different firms adopt
different accounting policies
Less effective when there are price level changes
May be misleading in the absence of absolute
data
Window- dressing
Lack of proper standards
Ratios alone not adequate for proper conclusions
Effect of personal ability & bias of the analyst
Ignores qualitative factors
 Benchmarks
To comment on the quality of a ratio
one has to make a comparison with
some standard or benchmark.
Types:
 Past ratio
 Ratio of similar firms or industry
average
 Rule of thumb : e.g. current ratio is
2:1, meaning current assets should be
twice the current liabilities.
 Classification of Ratios

Solvency/ Profitability
Liquidity Activity/
Capital Ratios
Ratios Turnover/
Structure/
Leverage Efficiency
Ratios Ratios
 Liquidity Ratios
 The ability of a firm to satisfy its short-term
obligations as they become due for payment
 Helps users in knowing the extent of short-term
debt paying ability of a firm.
 Proper balance between liquidity and profitability
is required for efficient financial management.
 Types of
Liquidity
Ratios
Quick
Net ratio/ Absolute
Current
Working Acid Liquidity
Ratio
Capital Test Ratio
Ratio/
Liquid
Ratio
 Net Working Capital
Excess of current assets over current
liabilities i.e.
Working Capital =
Current Assets – Current Liabilities
Not really a ratio but frequently used as a measure
of company’s liquidity position.
An enterprise should have sufficient net working
capital to meet the claims of creditors and the
day-to-day need of the business.
Inadequate working capital is the first sign of
financial problems for a firm.
 Cash

Accounts
Purchases
Receivable

Working
Raw
Sales Capital Materials
Cycle

Finished Accounts
Stock Payable

Production
 Limitations
Size of Net Working Capital is not an appropriate measure
of the liquidity position
Analyzing the size of the working capital, Company A has a
better liquidity position
Company A Company B
Total Current Assets 180,000 30,000
Total Current liabilities 120,000 10,000
NWC 60,000 20,000
CA are 1.5 CA are 3
Actual Analysis times CL times CL

Better Liquidity
 Limitations
Change in NWC does not necessarily reflect
change in liquidity position
Year 1 Year 2
Total Current Assets 100,000 200,000 Change
Total Current liabilities 25,000 100,000 in W/C is
Rs.
NWC 75,000 100,000 25,000
Actual Analysis increase
CA 4 CA 2
times CL times CL
NWC not a satisfactory measure of the liquidity
of a firm for inter-firm comparison or trend
analysis
 Current Ratio
Current Assets
Current Ratio 
Current Liabilitie s
Indicates the relationship between current
assets and current liabilities
Indicates a firm’s ability to meet its short-
term liabilities promptly
 Rationale
Measure of safety margin to creditors
Higher the Current Ratio, larger is the amount
of rupees available per rupee of current
liability, the more is the firm’s ability to meet
current obligations and greater is the safety of
funds of short-term creditors.
 Need…
Need arises due to inevitable unevenness in the flow
of funds through current assets and liabilities.
If the flows were absolutely smooth and uniform each day
so that inflows exactly equalled absolutely maturing
obligations, the requirement of a safety margin would be
small.
Because of uneven flows, the size of CA should be
sufficiently larger than CL so that the firm would be
assured of being able to pay its current maturing debts as &
when it becomes due.
Also CA are liable to shrinkage due to bad debts,
inventories becoming obsolete or unsaleable etc.
 Interpretation
Co. A Co. B
Current Assets 180,000 30,000
= 120,000 =
Current liabilities 10,000
Current Ratio = = 1.5:1 = 3:1
 The liquidity position of Co. B is better as
compared to Co. A as it has a higher current ratio
 Very high ratio may indicate slack management
practices - Excessive inventories, idle cash, poor
credit management, not making full use of its
current borrowing capacity
 Interpretation
Ideal ratio – 2:1 – but no hard & fast rule
Higher ratio considered adverse
- stock piling up because of poor sales
- obsolete stock
- large amount locked up in debtors due to
inefficient collection policy
- defaulting debtors
- cash or bank balances lying idle , no proper
investment opportunities are available
What is satisfactory depends on development of the
capital market and the availability of long-term
funds to finance current assets, the nature of the
industry
 Limitations
 It is a quantitative index rather than a qualitative
one.
 Does not tell us how liquid the receivables and
inventory are.
 What effect does the omission of inventory and
prepaid expenses have on the liquidity ?
Quick Ratio/Acid Test Ratio/Liquid Ratio
Liquid Assets
Quick Ratio 
Liquid Liabilitie s
Measures the firm’s ability to convert its current
assets quickly into cash in order to meet its current
liabilities.
Liquid Assets = Current Liquid Liabilities =
Assets – Stock – Prepaid Current Liabilities – Bank
Expenses Overdraft – Cash Credit
 Interpretation
Best available test of the liquidity position
Cash 2000
Debtors 2000
Inventory 12000
Total Current Assets 16000
Total Current Liabilities 8000
(i) Current Ratio 2:1
(ii) Acid-Test Ratio 0.5:1
 Absolute Liquidity Ratio
Also known as Super Quick Ratio or Cash Ratio or
Cash Reservoir Ratio
Cash in hand &at bank  Marketable Securities

Current Liabilitie s
Cash + bank balance + marketable securities
considered as highly liquid assets
Measures the immediate amount of cash available
to satisfy short term debt.
 Limitations of Liquidity
Ratios
Current assets can be manipulated by changing
the accounting policies e.g. method of valuation
of inventories or marketable securities
Current liabilities manipulated by postponing
payment by a few days
Static in nature
Ratios show the position on the balance sheet date
 Exercise - 1
Current liabilities Rs.120,000, working capital Rs.
360,000, creditors Rs. 20,000, inventory Rs.
120,000.
Calculate quick ratio.
 Exercise - 2
X Ltd. has a current ratio of 2:1 and a liquid ratio
of 1.5:1. Its current liabilities are Rs. 80,000.
Calculate the value of stock.
 Exercise -3
Assuming that current ratio is 2, state giving reasons whether
this ratio will improve or decline or will have no change, in each
case below:
(i) Payment of outstanding salary
(ii) Payment on bank loan
(iii) Purchase of stock for cash
(iv) Purchase of stock on credit
(v) Purchase of fixed asset on a credit of 2 months
(vi) Cash paid to creditors
(vii) Issue of new shares for cash
(viii)Sale of stock in trade at loss on credit
(ix) Issue of new shares against the purchase of fixed assets
(x) Sale of stock in trade at par on credit
 Try out these sums….
1) X Ltd. has a CR of 3:1. Its net working capital is
Rs. 200,000 and its inventory is Rs. 220,000.
Calculate liquid assets
2) X Ltd. has a CR of 3:1 & liquid ratio is 1:1. its
working capital is Rs. 200,000. calculate value of
stock.
3) X Ltd. has a CR of 4.5:1 and quick ratio of 3:1. If
its inventory is Rs. 36,000, find out its total CA,
total CL and quick assets
 Try out these sums….
4) A firm had CA of Rs. 150,000. It then paid a current
liability of Rs. 30,000. After this payment, the CR was 2:1.
Determine the size of CL and WC after and before the
payment.
5) A firm had CL of Rs. 90,000. it then acquired stock in
trade at a cost of Rs. 10,000 on credit. After this
acquisition, the CR was 2:1. Determine the size of the CA
and WC after & before stock was acquired.
6) The ratio of CA (Rs.300,000) & CL (Rs. 200,000)is 1.5:1.
The accountant of this firm is interested in maintaining a
CR of 2:1 by paying some part of current liabilities.
Suggest him the amount of CL which must be paid for this
purpose.
 Turnover/Activity Ratios
Helps to determine how quickly certain current
assets are converted into cash.
The liquidity ratios should be examined in
conjunction with the relevant turnover ratios
affecting liquidity.
Types of Turnover Ratio
Debtors’/
Inventory Average age of
Receivables
Turnover Ratio Inventory
Turnover ratio

Average Creditors’/
Collection Payables Age of Payables
Period Turnover Ratio

Working
Fixed Assets
Capital
Turnover Ratio
Turnover Ratio
 Inventory/
Stock Turnover Ratio
Cost of goods sold
Inventory Turnover Ratio 
Average Inventory
Average Inventory = Opening Stock + Closing Stock
2
Or
Average inventory = Closing Stock
Cost of goods sold = Net Sales – Gross Profit
Or
Cost of goods sold = Opening Stock + Purchases +
Carriage Inward + Wages + other direct charges –
Closing Stock
 Interpretation
Establishes the relationship between cost
of goods sold during the year and average
inventory held during the year
High ratio – good from the point of
liquidity
Low ratio – inventory does not sell fast
and stays on the shelf or in the warehouse
for a long time.
Average age of Inventory
Also known as Days of Inventory Holding (DIH)
Days or Months in a year
DIH 
Inventory Turnover Ratio
Indicates number of days that inventory is held
prior to being sold.
Increasing age indicates a risk in the company's
inability to sell its products (lack of demand).
Low ratio - company is not keeping enough stock
on hand to meet demands.  
 Debtors Turnover Ratio
Net Credit Sales
DTR 
Average Accounts Receivable
Accounts receivable = Trade debtors + Bills
Receivable
Net Credit Sales = Gross credit sales – Sales returns.
Provision for Bad and Doubtful debts is not
deducted from debtors
If amount of credit sales is not given total sales to be
taken
 Interpretation
Measures how rapidly receivables are collected
High ratio indicates shorter collection period –
prompt payment by debtors
Low ratio indicates a longer collection period –
delayed payments by debtors i.e. debts are not
being collected rapidly.
To be compared with past ratios or ratios of
similar firms or industry average
 Average Collection Period
Represents the average number of days for
which a firm has to wait before its
receivables are converted into cash
Average Accounts Receivable
  No. of days / months in a year
Net Credit Sales
Or
Days or Months in a year
Average Collection Period 
DTR
• Shorter collection period- prompt
payment by debtors
Creditors/Payable Turnover Ratio
Net Credit Purchases
CTR 
Average Accounts Payable

Accounts payable = Trade creditors + Bills

Payable
Net Credit Purchases = Gross credit purchases
– purchase returns.
 Interpretation
 High Ratio indicates creditors are being paid
promptly, thus enhancing credit worthiness
 Low ratio indicates creditors are not paid on time
 Average Age of Payables
Days or Months in a year
Average age of payables 
CTR
Indicates speed with which payments for credit
purchases are made to creditors
To be compared with credit period allowed by
suppliers – should be approximately equal
 Working Capital
Turnover Ratio
Cost of goods sold
WC Turnover Ratio 
Net Workin g Capital
Used to analyze the relationship between the
money used to fund operations and the sales
generated from these operations. 
Measures efficiency with which the working capital
is used by the firm
High ratio indicates efficient utilization
 Fixed Asset Turnover Ratio
Sales
FA Turnover Ratio 
Net Fixed Assets
Measures the efficiency in the utilization of fixed
assets
Higher the better – efficient use of assets will
generate greater sales
 Low ratio indicates idle capacity and excessive
investment in fixed assets
 Sum: XYZ Co. financial statement contain the foll. info:
Liabilities Rs. Assets Rs.
Creditors 700000 Cash 200000
Bank Overdraft 40000 Sundry debtors 320000
5 % debentures 1500000 Marketable 200000
Loan from ICICI 800000 securities
Equity Share Capital 2000000 Stock 1840000
Retained Earnings 460000 Prepaid expenses 20000
Land & Building 2200000
Furniture & 720000
fixtures

5500000 5500000
 Statement of Profit for the current year
Sales 4000000
Less: Cost of goods sold 2200000
Less: office expenses 200000
Less: S & D expenses 400000
Less: Interest 160000
Net Profit 1040000
Less: Tax @ 30 % 312000
Profit after taxes
728000
Profit distributed
220000

Calculate (i) Liquidity (ii) Turnover ratios

 Solvency/Leverage/Capital
Structure Ratios
■ Measure long term solvency of a firm.
■ The long term lenders/creditors measure
soundness by the firm’s ability to
»Pay interest on loan regularly and
»Repay the instalment of the principal
on due dates or in one lumpsum.
 BASED ON RELATIONSHIP
Types of Leverage Ratios BETWEEN BORROWED
FUNDS & OWNER’S
COVERAGE RATIOS
CAPITAL

» Debt-Equity Ratio » Interest Coverage

» Proprietary Ratio ratio
» Total Assets to » Dividend
Debt Ratio Coverage ratio
» Capital Gearing » Debt Service
Ratio Coverage Ratio

Note: Computed from

the Balance Sheet
 Based on relationship between
borrowed funds & owner’s capital

Debt-Equity Proprietary
Ratio Ratio

Capital
Total Assets
Gearing
to Debt Ratio
Ratio
 Debt-Equity Ratio
Long term debts
D/E Ratio 
Shareholde rs' Funds
Debt does not include current liabilities

Total debts
D/E Ratio 
Shareholde rs' Funds

Debt does includes current liabilities

 Composition
Long term debts – Debentures, bonds, bank loan,
loans from financial institutions
Shareholder’s Funds
includes Equity Share Capital, Preference Share
Capital, General Reserve, Securities Premium
and P & L a/c credit balance) and
excludes accumulated losses (P & L a/c debit
balance) & fictitious assets (preliminary
expenses, underwriting commission, share issue
expenses, discount on issue of shares/debentures
 Why two formulas?
The first one excludes current liabilities while the
latter one includes them in the numerator.

The question is –

Should current liabilities be included in the

amount of debt to calculate D/E?
 Rationale
Though individual items of current liabilities are short
term and fluctuate widely, a fixed amount of them are
always in use as that they available on a long-term
footing.
Some current liabilities like bank credit, though they
are short term, are renewed year after year and hence
they remain permanently in the business
Current liabilities create a charge on the assets and
they are paid along with the long-term lenders at the
time of liquidation
Short-term creditors do exercise pressure on the
management
OMISSION OF CURRENT LIABILITIES IN CALCULATING THE
D/E RATIO WOULD LEAD TO MISLEADING RESULTS
How should preference share
capital be treated?
The question is –
Should it be included in debt or equity?
INCLUDE in INCLUDE in
Equity Debt

Object – to examine Object – to show the

the financial solvency effect of use of fixed-
of a firm in terms of interest /dividend
its ability to avoid sources of funds on the
financial risk earning available to
ordinary shareholders.
 Trading of Equity
Also known as Leverage
Meaning - The use of borrowed funds carrying
a fixed charge in expectation of obtaining
higher returns to equity-holders
Benefit will occur only if the firm is able to earn
on the borrowed funds at a rate higher than
the fixed charge loans
 Trading of Equity
Situations A B C D
Total Assets 1000 1000 1000 1000
Financing Pattern:
Equity Capital 1000 800 600 200
15% Debt - 200 400 800
Operating Profit 300 300 300 300
Less: Interest - 30 60 120
Earnings before taxes 300 270 240 180
Less: taxes (30%) 90 81 72 54
Earnings after taxes 210 189 168 126
Return on equity (%) 21 23.6 28 63

Rs. in ’000
 Interpretation
Computed to ascertain the soundness of the long-
term financial policies of the firm
Indicates the proportion of funds which are
acquired by long-term borrowings in comparison
to shareholders funds i.e. extent to which the firm
depends upon outsiders for its existence
 Interpretation
High ratio –
Owners putting up less money of theirs - danger signal
for long-term lenders
If project should fail financially – creditors would lose
heavily
Owners may indulge in speculative activities
Restrictions on borrowings – debt servicing
burdensome
Pressure and interference of creditors in the
management
Heavy burden of interest payment specially in adverse
conditions
 Benefits of “Trading on Equity” to shareholders
 Interpretation
Low ratio –
 Easy availability of credit
Deprived of the benefits of “Trading on Equity”
 Sufficient safety margin and protection
Debt servicing less burdensome.
Less pressure & interference of creditors in
management.
 Ideal D/E Ratio
No ideal ratio
Depends upon the type and size of the business,
nature of industry and degree of risk involved
 Exercise
Explain the effect of the following transactions on the
debt-equity ratio:
(i) Purchase of fixed assets for cash
(ii) New debentures issued
(iii) Equity shares issued at a premium
(iv) Purchase of fixed assets on credit by taking a short
term loan from bank
(v) Sale of fixed assets in cash for a profit.
(vi) Equity shares issued at par.
(vii) Debentures redeemed.
(viii)Sale of fixed assets in cash at a loss
 Total Assets to Debt Ratio
Total assets
Total Assets to Debt Ratio 
Long term debts

Total Assets = Fixed assets + Current Assets

No debit balance of P & L a/c and fictitious assets
Measures extent to which debt is covered by assets
High ratio – higher security to lenders, no benefits of
Trading on Equity
Low ratio – risky financial position ; business
depends heavily on outside loans for its existence
 Proprietary Ratio
Indicates proportion of total assets funded by
owners or shareholders.
Shareholde rs' Funds
Proprietar y Ratio 
Total tangible assets
Total Assets exclude fictitious assets
High ratio – indicator of financial soundness
Low ratio – danger signal for long-term lenders as
they are less secured
 Capital Gearing Ratio
Equity Share Capital
Capital Gearing Ratio 
Fixed interest bearing funds

Equity share capital - equity share capital and all

reserves and surplus – fictitious assets
Fixed interest bearing funds includes
 Debentures,
 Preference share capital and
 Other long-term loans
 Interpretation
When the Equity Share Capital is lower than the
Preference Share Capital and long term loans, the
company's capital is said to be highly geared. If the
equity capital is higher than the Preference Shares
and Loans, the company's capital is said to be lowly
geared.
High gearing ratio is not good for a new company or
a company of which future earnings are uncertain.
 Exercise
Liabilities Rs. Assets Rs.
Equity Share Capital 800,000 Fixed assets 15,00,000
10% Preference share Current assets 600,000
capital 400,000 Preliminary expenses 60,000
Reserves & surplus 260,000
12% Debentures 300,000
Current liabilities 340,000
21,60,000 21,60,000

 Calculate the following

(v) Working Capital
ratios: (vi) Current Ratio
(i) Debt equity ratio
(vii) Net Worth
(ii) Proprietary ratios
(viii) Capital Employed
(iii) Capital gearing ratios
(iv) Total assets to debt ratio
 Coverage Ratios
• Computed from information available in the
profit & loss account
• Measure firm’s ability to pay certain fixed
charges -
Interest on loans
Preference dividend
Amortization of principal
Repayment of instalment of loans
Redemption of preference share capital
 Coverage Ratios
Interest Dividend
Coverage Coverage
ratio ratio

Debt Service
Coverage
Ratio
Interest Coverage Ratios
EBIT
Interest coverage Ratio 
Interest
Measures firm’s ability to pay fixed interest on
long term loans
Expressed in number of times
Higher the better
Dividend Coverage Ratio
PAT
Dividend coverage Ratio 
Preference Dividend
Measures firm’s ability to pay dividend on
preference shares which carry a fixed rate of
return
Expressed in number of times
Higher the better
Debt-Service Coverage Ratio
PAT  depreciati on  Annual interest
on long term loans & liabilitie s
DSCR 
Annual interest on Long Term Loans
& Liabilitie s  Annual Instalment
Debt-Service Coverage Ratio
Cashflow available for making annual interest and
principal payment of debt.
A DSCR of less than 1 would mean a negative cash
flow.
A DSCR of less than 1, say .95,  would mean that
there is only enough net operating income to cover
95% of annual debt payments.
 Profitability Ratios
 For Management
To measure the profitability or
operating efficiency of the business
 For Shareholders
Adequacy of returns
 Types of
Profitability
Ratios

On the basis of On the basis of

sales investment

Kavitha Menon
 ON THE BASIS OF
ON THE BASIS OF SALES
INVESTMENT
Types of Profitability
 Gross Profit Ratio  Return on assets
 Net Profit Ratio  Return on Capital
 Cost of goods sold Employed
Ratios

ratio  Return on
 Operating expenses Shareholders’ Equity
ratio  Earnings Per Share
 Operating Ratio  Book value per Share
 Dividend per Share
 Dividend Pay-out
Ratio
 Price Earnings Ratio

Kavitha Menon
 On the basis of Sales

Operating
Gross Profit Net Profit
Expenses
Ratio Ratio
Ratio

Operating Cost of goods

Ratio sold ratio

Kavitha Menon
 Gross Profit Ratio
Gross Profit
Gross Profit Ratio   100
Net Sales

Gross Profit = Net sales – Cost of goods sold

Net Sales = Gross Sales (both cash and
credit) minus Sales Returns

Kavitha Menon
 Interpretation
Indicates efficiency ofthe concern in respect of
selling and purchasing/manufacturing operations as
well as the market conditions in which it is
operating.
Should be analyzed and studied as a time series
High Ratio – sign of good management – cost of
production low, indicative of higher sale price,
overvaluation/undervaluation of closing stock
Low ratio – danger signal – high cost of production,
low selling price because of severe competition or
poor quality
 Net Profit Ratio
Net Profit
Net Profit Ratio  100
Net Sales
Net profit = Earnings after tax and interest
Shows overall efficiency in manufacturing,
administrative, selling and distributing the product
Should be analyzed and studied as a time series
High ratio – ensures adequate returns to owners,
enables firm to face adverse economic conditions
 Expenses Ratio
COGS
COGS Ratio  100
Net Sales

Admin Exps  S & D Exps

Operating Exp Ratio   100
Net Sales

COGS  Operating Exp

Operating Ratio   100
Net Sales
 Interpretation
Should be analyzed and studied as a time series
Should be compared over a period of time with
the industry average as well as firm’s of similar
type
Lower the ratio, better it is.
Higher ratio - small amount of operating income
to meet interest, tax and dividends
 On the basis of Investment
Return on Return on
Return on
Capital Shareholders’
assets
Employed Equity

Earnings Per Book value Dividend per

Share per Share Share

Price
Dividend
Earnings
Pay-out Ratio
Ratio
Also called “Return on Investments” (ROI)
 Return on Assets
PAT  Interest
ROA   100
Average Total Assets

Indicates what return a company is generating on

the firm's investments/assets.
Helps management to know how efficient it is at
using its assets to generate earnings. 
 Return on Capital Employed (ROCE)

EBIT
ROCE  100
Capital Employed

Capital Employed = Equity Share Capital +

Preference Share Capital + Undistributed Profits +
Reserves & Surplus + Long-term Liabilities –
Fictitious Assets
Or
Fixed assets + Current assets – Current liabilities
Return on Shareholders’ Equity
PAT - Preference Dividend
ROE   100
Net Worth

Net Worth = Equity share capital + reserves &

surplus – accumulated losses – Fictitious assets
From the owner’s point – very crucial ratio
Helps to judge whether the firm has earned a
satisfactory return for its equity shareholders who
bear all the risk and participate in the management
Earnings per share (EPS)
PAT - Preference Dividend
EPS 
Number of Equity Shares
Measures profit available to equity shareholders
on a per share basis
Limitation
 Does not reveal amount paid to owners as
dividend
Does not reveal amount retained in the
business
 Book value per share
Net Worth
Book Value per share 
No. of equity shares
Represents the claim of the equity shareholders
on a per share basis
Limitation
►Cannot be used as valuation tool as it is based on the
historical cost of assets of a firm. There may be significant
difference between market value and book value
 Dividend per share
Dividend paid to equity shareholde rs
DPS 
No. of equity shares
Indicates dividend paid to the equity shareholders
on a per share basis
Better indicator than EPS – shows what exactly is
received
 Dividend Pay-out ratio
DPS
D/P Ratio  100
EPS
Shows what percentage share of the net profits after
taxed and preference dividend is paid out as
dividend to the equity shareholders
Retention ratio = 100 – D/P ratio
which indicates what percentage of the net profits
are retained in the business (Ploughing back of
profits)
 Price Earning (PE) ratio
Market Price per equity share
P/E Ratio 
Earnings per share(EPS)

Measures the amount investors are willing to pay for

each rupee of earnings
Higher the ratio, larger is the investors’ confidence
in the firm’s future
Sum: XYZ Co. financial statement contain the foll. info:
Liabilities Rs. Assets Rs.
Creditors 700000 Cash 200000
Bank Overdraft 40000 Sundry debtors 320000
5 % debentures 1500000 Marketable 200000
Loan from ICICI 800000 securities
Equity Share Capital 2000000 Stock 1840000
Retained Earnings 460000 Prepaid expenses 20000
Land & Building 2200000
Furniture & 720000
fixtures

5500000 5500000
 Statement of Profit for the current year
Sales 4000000
Less: Cost of goods sold 2200000
Less: office expenses 200000
Less: S & D expenses 400000
Less: Interest 160000
Net Profit 1040000
Less: Tax @ 30 % 312000
Profit after taxes
728000
Profit distributed
220000
Appraise the financial position by calculating (i)
Liquidity (ii) Profitability ratios (iii) Solvency
ratios (iv) Turnover ratios
Prepare a statement of comparative ratios showing liquidity,
profitability, activity and financial position of two companies.
Particulars Peerless Ltd Perfect Ltd
Sales Rs 32,00,000 Rs 30,00,000
Net profit after tax 1,23,000 1,58,000
Equity capital (Rs 10 per 10,00,000 8,00,000
share fully paid)
General reserves 2,32,000 6,42,000
Long term debt 8,00,000 5,60,000
Creditors 3,82,000 5,49,000
Bank credit (short-term) 60,000 2,00,000
Fixed assets 15,99,000 15,90,000
Inventories 3,31,000 8,09,000
Other current assets 5,44,000 5,42,000