Ratios

1Chapter 9
Financial Statement Analysis - Accounting Ratios
2
CHAPTER 9
1
2
FINANCIAL STATEMENT ANALYSIS- ACCOUNTING RATIOS
4
5
Sunlight Industries, the FMCG major, was preparing itself for a public issue. The
7accounting department was getting ready to highlight the companys financial performance. Two
8members of the issue team, Hari and Arjun, were in a big argument. Arjun felt they need to
9highlight the current asset position and the turnover position, whereas Hari said, it was very
10important to highlight the profitability position and the capital structure of the business to attract
11the first time investors.
12
13How relevant are these ratios for a public issue?
14Does an investor examine the profits or assets of a business?
15How does one evaluate the performance of a firm from its financial statements?
16
17LEARNING OBJECTIVES
18
After studying this chapter you should be able to:
19
1. Understand the usefulness of financial statements as external reports.
20
2. Analyse financial statements by preparing ratios.
21
3. Interpret ratios and make managerial decisions.
22
23FINANCIAL STATEMENTS
24
25
Financial information about a firm is communicated through its financial statements. The
26stakeholders of an entity, for example the investors or the management, are interested in the
27performance of the entity. Their interests are wide and varied.
28
29
The process of identifying the financial strengths and weaknesses of a firm by
30establishing proper relationships between the items of the financial statements is known as
31financial analysis. Ratio analysis is a powerful tool of financial analysis.
32
33CONSTITUTION OF THE FIRM
34
35
The kind of analysis selected would depend on the constitution of the firm, viz.,
36proprietary, partnership or joint-stock company.

37
38ANALYZING A PROFIT AND LOSS ACCOUNT
39
40
Expressing the relationship between the figures of a profit and loss account needs a
41thorough analysis of a profit and loss account.

42
3PSG Institute of Management
15
1Chapter 9
2
The Companies Act does not prescribe specific format according to which a company
2has to prepare its profit and loss account. The company can prepare the account in any format it
3prefers. It has to prepare:
4
i.
A Profit and Loss Account to arrive at the net profit for the year ;and
6
7
ii.
A Profit and Loss Appropriation Account to show how the net profit has been disposed
of.
The profit and loss appropriation account will appear as under:
10
11
PROFIT AND LOSS APPROPRIATION ACCOUNT
12
Rs.
To
To
To
To
Shortage in provision made

Transfer to Reserves
Dividends
Bonus to Shareholders
To
(Issue of bonus shares)

Balance carried forward to
Rs.
By
By
By
By
Balance from last year

Net Profit for current year
Surplus in provisions
Reserves withdrawn
Balance Sheet
13
14UNDERSTANDING A BALANCE SHEET
15
16
Expressing the relationship between the numbers in a balance sheet needs a thorough
17understanding of the balance sheet itself. Hence the format of the balance sheet is presented
18below. The vertical form of a balance sheet is presented on the next page. This is the popular
19form used by companies at present.
20
21
The balance sheet is split into liabilities and assets, with equal balance at any point of
22time due to the dual aspect of accounting principles.

23
24
25
26
Liabilities
Share Capital
Authorised Capital
Issued Capital
Subscribed Capital
Reserves and Surplus
Capital Reserves
Capital Redemption Reserve
Share Premium Account
Other Reserve
Balance in Profit and Loss
Sinking Funds
Secured Loan
Debentures
27
Loans and Advances from Banks
BALANCE SHEET
.Co. Ltd.,
BALANCE SHEET as on ..
Rs.
Assets
Fixed Assets
Goodwill
Land
Buildings
Leaseholds
Plant and Machinery
Furniture and Fittings
Development of property
Patents, Trademark and Design
Live stock
Vehicles
Investments
Investment in Government or
Securities
Investment in Shares and Bonds
Rs.
16
1Chapter 9
2
Loan and Advances from
Subsidiaries
Immovable Properties
Unsecured Loan
Investment in the Capital of

partnership firms
Current Assets, Loans and
Advances
A. Current Assets
Fixed Deposits
Loan and Advances from
Subsidiaries
Short-term Loans and Advances
(a) From Banks
(b) From Others
Other Loans and Advances
(a) From Banks
(b) From Others
Current Liabilities and
Provisions
A. Current Liabilities
Acceptances
Sundry Creditors
Subsidiary Companies
Advance Payments
Unclaimed Dividends
Other Liabilities
Interest Accrued but not due
B. Provisions
Provision for Taxation
Proposed Dividends
For Contingencies
For Provident Fund Scheme
For Insurance, Pension, etc.,
For Staff
Other Provision
Rs.
Interest Accrued on Investments

Stores and Spares Parts
Loose Tools
Stock-in-Trade
Work-in-progress
Sundry Debtors
Cash and Bank Balances
B. Loans and Advances
Advances and Loans to
Subsidiaries
Bills of Exchange
Advances recoverable in cash in
Balances with Customs, Port
Miscellaneous Expenditure
Preliminary Expenses
Share Issue Expenses
Development Expenditure
Profit and Loss Account
Rs.
2Source: C. Jeevanadam, (2002) Management Accounting & Financial Management, Sultan Chand & Sons, New Delhi.
1
3
4
5BALANCE SHEET IN VERTICAL FORM
6
The condensed balance sheet shows only one side instead of the usual two sides for
8 debit and credit. This is known as the vertical form of the balance sheet. The format prescribed
9 under the Companies Act for a vertical form of balance sheet is given below. It may be
10 observed that the contents of the balance sheet are the same under both the formats. The
11 details of the contents are presented in separate schedules.
12
17
1Chapter 9
2
VERTICAL FORM OF BALANCE SHEET
.Co. Ltd.,
1
2
3
Schedule No.
Rs.
SOURCES OF FUNDS
1. Shareholders funds :
(a) Capital
(b) Reserves and Surplus
2. Loan Funds :
(a) Secured Loans
(b) Unsecured Loans
Total
APPLICATION OF FUNDS
1. Fixed Assets
(a) Gross Block
(b) Less Depreciation
(c) Net Block
(d) Capital work-in-progress
2. Investments
3. Current Assets, Loans and Advances
(a) Inventories
(b) Sundry Debtors
(c) Cash and Bank Balance
(d) Loans and Advances
Less : Current Liabilities and Provisions
(a) Liabilities
(b) Provisions
4. Net Current Assets
(a) Miscellaneous Expenditure to the extent not written off or adjusted
(b) Profit and Loss Account
Total
6
7
8Liabilities side of a Balance Sheet: The liabilities side of a balance sheet consists of the following
9items.
10
11
Share Capital
12
13
Secured Loans
14
Unsecured Loans
15
Current Liabilities and Provisions
16
17 Assets side of a Balance Sheet: The assets side of a balance sheet consists of the following
18 items.
19
20
o Fixed Assets
21
Investments
22
Current Assets, Loans and Advances
23
Miscellaneous Expenditure
18
1Chapter 9
2
1
o Profit and Loss Account

2
3 Analysis of Balance Sheet: The balance sheet can be analyzed by the following methods.
4
5
o Ratio Analysis
Trend Analysis
Inter-Firm Comparison
Synthesis of Different Methods
9
10
This text focuses on the first method, namely, ratio analysis. To carry out ratio analysis
11 the balance sheet is restructured as under:

12
13The liabilities are classified into
14
15
o Current Liabilities
16
Term Liabilities
17
Equity or Net Worth
18
19
20The assets are classified into
21
22
o Current Assets
23
Fixed Assets
24
Intangible Assets
25
Miscellaneous Assets
26
27
28
RESTRUCTURED BALANCE SHEET
29
.Co. Ltd.,
30
BALANCE SHEET SPREAD ..
31
Liabilities
Current Liabilities
Short-term borrowings from
Short-term borrowings from
Deposits maturing within one
Sundry Creditors
Unsecured Loans
Advances from Customers,
Deposits from dealers, etc.
Interest accrued but not due
payment
Dividend payable
Other Statutory liabilities
(due within one year)
Installments of term loans /
payment credits / debentures /
Rs.
Assets
Current Assets
Cash and Bank Balance
Investments (Quoted) other Longterm investments
Receivables (other than deferred
Receivables
Installments of deferred receivables
Rs.
Inventory
(i) Raw materials
(ii) Stock-in-progress
(iii) Finished goods
(iv) Other consumable goods
Advances to suppliers of Tax
Advance payment of Tax
Other Current Assets
19
1Chapter 9
2
redeemable preference shares
Other current liabilities and
provisions (due within one)
Total
Term Liabilities
Debentures (not maturing one
year)
Redeemable preference shares
(not maturing within one year of
maturity not exceeding 12 years)
Total
Net Worth
Ordinary share capital
Preference share capital (maturing
after 12 months)
General Reserves
Investment allowances reserve
Other Reserves
Balance in Profit and Loss
Total
Total Liabilities
Total
Fixed Assets
Gross Block
Less : Depreciation to date
Net Block
Miscellaneous Assets
Investments / Book deposits which
are not current assets.
Non-consumable stores and
Other Miscellaneous Assets
Total
Intangible Assets
Goodwill, Patents, Preliminary
Expenses etc.
Total
*****
Total Assets
*****
3
4RATIO ANALYSIS
5
6
The relationships between numbers which are connected with each other in a
7meaningful way are called accounting ratios. (There is no purpose served by comparing figures
8which are not connected with each other.)
9
10The ratios can be classified into:
11
Liquidity Ratios
12
Profitability Ratios
13
Turnover Ratios
14
Financial Ratios
15
16
17LIQUIDITY RATIOS
18
19
Liquidity Ratios indicate the short-term financial position of a firm. It is a sound principle
20of finance that long-term requirements should be met out of long-term funds, and short-term
21requirements should be met out of short-term funds.
22
231. Current Ratio: This ratio is an indicator of the firms commitment to meet its short-term
24liabilities. It is expressed as follows:

25
26
27
28
Current Assets
Current Liabilities
20
1Chapter 9
2
1
2
Current assets mean assets that will either be used up, or converted into cash within a
3years time or within the normal operating cycle of the business, whichever is longer. Current
4liabilities mean liabilities that are payable within a year, or during the operating cycle of the
5business, whichever is longer, out of the existing current assets or by creation of other current
6liabilities.
7
8
Book debts outstanding for more than 6 months, and loose tools, should not be included
9in current assets. Prepaid expenses should be taken into current assets.
10
11Illustration 9.1 From the following data of Sridevi Textiles, compute the Current Ratio.
12
Particulars
Sundry Debtors
Prepaid Expenses
Short-term Investments
Loose Tools
Bills Payable
13
Rs.
40,000
20,000
10,000
5,000
10,000
Particulars
Sundry Creditors
Debentures
Inventories
Outstanding Expenses
Rs.
20,000
1,00,000
20,000
20,000
14Solution
15
16
17
18
Current Assets
Current Ratio
Rs. 90,000
=
Current Liabilities
= 1.8
50,000
19
20
The ideal current ratio is 2. The ratio of 2 is considered as a safe margin of solvency:
21even if Current Assets are reduced to half, i.e., 1 instead of 2, the creditors will still be able to get
22their payments in full. However, a business that has seasonal trading activity may show a lower
23current ratio at a certain time of year. On the other hand, a very high Current Ratio is also not
24desirable, since it means less efficient use of funds; this is because a high Current Ratio means
25excessive dependence on long-term sources of raising funds. Long-term liabilities are costlier
26than current liabilities and, therefore, this results in a considerable lowering of the concerns
27profitability.
28
29
Note that the mere fact that a Current Ratio is quite high does not mean that the
30company will be in position to meet its short-term liabilities adequately. In fact the Current Ratio
31should be seen in relation to the component of the companys current assets and their liquidity. If
32a large portion of the current assets are comprised of obsolete stocks, or debtors outstanding for
33a long time, the company may fail even if the Current Ratio is higher than 2.
34
35
The Current Ratio can also be easily manipulated.
This may be done either by
36postponing certain pressing payments, by postponing the purchase of inventories, or by making

37payment of certain current liabilities. Consider the following data of Sridevi Textiles Ltd. (STL).
38
Rs.
21
1Chapter 9
2
1Example 1:
Current Assets:
Sundry Debtors
Inventories
Cash in hand
Current Liabilities:
4
5
40,000
60,000
1,00,000
Sundry Creditors
80,000
Bills Payable
20,000
2,00,000
7
8
9
10
Current Ratio =
= 2
1,00,000
In case the creditors are paid to the extent of Rs. 50,000 out of cash in hand, the Current
11
12Ratio will be as follows :

13
Rs. 1,50,000
14
15
16
17
Current Ratio
= 3
1,00,000
18Example 2 : STL has current assets of Rs. 30,000 including stock of goods of Rs. 5,000. Its
19current liabilities are of Rs. 15,000. The Current Ratio is 2. However, if the business had
20maintained a stock of Rs. 15,000, the Current Ratio would have been as follows :
30,000 + 10,000
21
22
23
40,000
=
15,000 + 10,000*
= 1.6
25,000
24
25* presuming that the goods are purchased on credit.

26Significance : The Current Ratio is an index of the concerns financial stability, since it shows the
27extent of the working capital, which is the amount by which the current assets exceed the current
28liabilities. As stated earlier a higher Current Ratio would indicate inadequate employment of
29funds while a poor Current Ratio is a danger signal to the management. It shows that business
30is trading beyond its resources.
31
32Change in the Current Ratio : The relationship between current assets and current liabilities is
33disturbed on account of a number of factors some of which are mentioned below :

34
35
i)
36
37
38
Seasonal changes in the business. Certain concerns purchase their raw materials at
harvest time, others manufacture in advance those goods which have a seasonal
market.
ii)
39
Over-trading. Accumulation of stocks and mounting up of debtors and creditors

balances.
40
iii)
Repayment of a long-term liability.
41
iv)
A change made in the terms of trade, e.g., goods are being sold on one months
42
credit, instead of selling them for cash or on hire-purchase basis.
43
22
1Chapter 9
2
12. Liquidity Ratio: This ratio is also termed the acid test ratio, or the quick ratio.
It is
2ascertained by comparing the liquid assets (i.e., assets which are immediately convertible into
3cash without much loss) to current liabilities. Prepared expenses and stock are not considered to
4be liquid assets. The ratio may be expressed as:
Liquid Assets
5
6
Current Liabilities
7
8
9
On the basis of the numbers given in illustration 9.1, the Liquidity Ratio will be computed
10as under :
11
12
Liquid Assets
=
13
14
Rs. 90,000 Rs. 40,000
Current Liabilities
Rs. 50,000
=
Rs. 50,000
=1
Rs. 50,000
15
16
Some accountants prefer the term Liquid Liabilities for Current Liabilities for the
17purpose of ascertaining this ratio. Liquid or quick liabilities mean liabilities which are payable
18within a short period. Bank over-draft (if it becomes a permanent mode of financing) and cash
19credit facilities would be excluded from current liabilities in such a case:
20
The Liquidity Ration in this case may be expressed as:

Liquid Assets
21
22
Liquid Liabilities
23
24
25
The ideal ratio is 1. The ratio is also an indicator of short-term solvency of the company.
26
27
A comparison of the Current Ratio to Quick Ratio indicates inventory hold-ups. For
28example, if two units have the same Current Ratios but different Liquidity Ratios, it indicates
29over-stocking by the concern having the low Liquidity Ratio as compared to the concern which
30has a higher Liquidity Ratio.
31
32
33PROFITABILITY RATIOS
34
35
Profitability is an indication of the efficiency with which the operations of the business are
36conducted. Poor operational performance indicates poor sales, and hence poor profits. Lower
37profitability may arise due to a lack of control over expenses. Bankers, financial institutions and
38other creditors look at the profitability ratios as an indicator whether or not the firm earns
39substantially more than the interest it pays on borrowed funds, and whether the ultimate
40repayment of its debt appears reasonably certain. Owners are interested to know about
41profitability, since it indicates the return which they can get on their investment.
42
23
1Chapter 9
2
11. Overall Profitability Ratio : This is also called the Return on Investments (ROI), or Return
2on Capital Employed (ROCE). It indicates the percent return on the capital employed in the
3business. It is calculated according to the following formula :
4
The term capital employed has been given different meanings. Some of the popular
6meanings are as follows :

7
i.
Sum total of all assets whether fixed or current.
ii.
Sum-total of fixed assets
iii.
Sum-total of long-term funds employed in the business, i.e.,

Share Capital + Reserves and surplus + Long-term Loans - Non-business Assets
10
11
+ Fictitious Assets
12
The management accounting Information System generally uses the term capital
13employed given in point iii above.

14
15
The term Operating Profit means (or) Earnings before Interest and Tax. The term
16Interest means Interest on long-term Borrowings. Interest on short-term borrowings will be

17deducted for computing operating profit. Non-trading incomes such as interest on Government
18securities or non-trading losses or expenses such as loss on account of fire, etc., will also be
19executed.
20
21Illustration 9.2 Calculate the ROI in order to figure out the return on capital employed by Raaha
22Garments Pvt. Ltd., a retail (textile) showroom in Coimbatore based on the following particulars:
23
Particulars
Fixed Assets
Current Assets
Investment in Govt. Securities
Sales
Cost of goods sold
Share Capital :
10% Preference
Amount
(Rs.)
4,50,000
1,50,000
1,00,000
5,00,000
3,00,000
Particulars
Reserves
Debentures
Income from Investments
Interest on Debentures at 10%
Provision for Tax at 50% of Net
Profits
Amount
(Rs.)
1,00,000
1,00,000
10,000
1,00,000
24
25Solution
26
Prepare the Profit and Loss Account and the Balance Sheet of the company before
27computation of the return on capital employed.

28
24
1Chapter 9
2
1
Raaha Garments Pvt. Limited
PROFIT AND LOSS ACCOUNT

Particulars
To
To
To
To
Amount
Rs.
3,00,000
10,000
1,00,000
1,00,000
5,10,000
Cost of goods sold

Interest on Debentures
Net Profit after Tax
Particulars
By
By
Sales
Amount
Rs.
5,00,000
10,000
5,10,000
BALANCE SHEET As on
Particulars
Amount
(Rs.)
Share Capital
10% Preference
Equity
Reserves
10% Debentures
Profit and Loss Account
Particulars
Fixed Assets
Investment in Govt. Securities
Current Assets
1,00,000
2,00,000
1,00,000
1,00,000
1,00,000
1,00,000
7,00,000
Amount
(Rs.)
4,50,000
1,00,000
1,50,000
7,00,000
Net Operating Profit before Interest and Tax
6
7Return on total capital employed
8
9
10
11
12
=
Total Capital Employed
2,00,000
=
x 100 = 40%
5,00,000
13
14Net Operating Profit
Net Profit + Provision for Tax Income from

Investments + Interest on Debentures
15
17
16
Rs. 1,00,000 + Rs. 1,00,000 Rs. 10,000 + Rs. 10,000
19
Rs. 2,00,000
20
21Capital employed
Fixed Assets + Current Assets Provision for Tax
22
Rs. 4,50,000 + Rs. 1,50,000 Rs. 1,00,000
23
Rs. 5,00,000
24
Share Capital + Reserves + Debentures + Profit and
18
Loss Account Balance Investment in Govt. Securities
25
26
Rs. 1,00,000 Rs. 1,00,000
27
28
Rs. 3,00,000 + Rs. 1,00,000 + Rs. 1,00,000 +
Rs. 5,00,000.
25
1Chapter 9
2
1
Return on Investment (ROI) can be computed for different purposes. Some of the ratios
3are calculated as follows:

4
5
(i)
6
7
Return on Shareholders Funds : If the profitability of the company from the

shareholders point of view is to be determined, the return should be computed as
follows:
Net Profit after Interest and Tax
x 100
10
Shareholders Funds
11
12
13
The term Net Profit here means Net Income after Interest and Tax. It is different from
14
15
16
Net Operating Profit which is used for computing the Return on Total Capital Employed in
the business. This is because the shareholders are interested in Total income after including
Net Non-operating income (i.e., Non-operating IncomeNonoperating expenses).
17
For Raaha Garments Pvt. Ltd., the Return on Shareholders Funds would be:
18
19
Rs. 1,00,000
20
21
22
x 100 = 20%
Rs. 5,00,000
23
24
(ii)
25
26
27
Return on Equity Shareholders Funds.
From the point of view of the equity
shareholders, profitability is judged after taking into account the amount of dividend
payable to the Preference Share Holders.
The formula for Return on Equity
Shareholders Funds is
28
29
30
Net Profit after Interest, Tax and Preference Dividend
31
Equity Shareholders Funds
x 100
32
33
For Raaha Garments Pvt. Ltd., the Return on Equity Shareholders Funds would be:
34
Rs. 90,000
35
36
37
x 100 = 23%
Rs. 3,90,000
38
39
40
(iii)
Return on Total Assets. In order to determine the Productivity of the Total Assets.
three methods are used to calculate the returns on total assets:
26
1Chapter 9
2
1
Net Profit after Tax
2
3
4
(a)
x 100
Total Assets
Thus, using the figures for Raaha Garment, the ratio would be:
7
1,00,000
8
9
10
x 100 = 14.29%
7,00,000
11
12
13
14
15
Net Profit after tax + Interest

(b)
x 100
Total Assets
Thus, using the figures of Raaha Garment the ratio would be
16
17
18
19
20
1,00,000 + 10,000
=
x 100 = 15.71%
7,00,000
21
22
The inclusion of interest here is conceptually sound, because total assets have been
23financed from the pool of funds supplied by the creditors and the owners. The objective of
24computing the Return on Total Assets is to determine how effectively the funds pooled together
25have been used. Hence, it is proper to include the interest in computing the Return on Total
26Assets.
27
28
A further modification of this formula excludes Intangible Assets from the Total Assets.
29However, it is proper to exclude only fictitious assets, and not all intangible assets. The term
30fictitious assets includes assets such as Preliminary expenses, Debit balance in the Profit and
31Loss Account, etc. The Return on Assets, according to this method, may, therefore, be
32calculated as follows:
Net Profit after Tax + Interest
33
34
35
36
(c)
x 100
Total Assets excluding Fictitious Assets
37(iv) [Needs a transitional sentence here] a)
Return on Gross Capital employed : The term
38Gross Capital means the total of Fixed Assets and Current Assets that are employed in the
39business. The formula for its computation can be stated as follows:
40
41
Net Profit before Interest (on long as well as short-term borrowings) and Tax
x 100
42Gross Capital employed (i.e., Net Fixed Assets + Current Assets employed in the Business)
43
44
45
46
27
1Chapter 9
2
1Tutorial Note: Students are advised to give their assumptions regarding computation of
2Net Profit as well as Capital employed while calculating the Return on Investment (ROI).
28
1Chapter 9
2
1
On the basis of the figure for Raaha Garment, the Return on Gross Capital Employed
2can be computed as follows:

3
2,00,000
4
5
6
7
x 100 = 33.3%
6,00,000
8b) Average Capital employed: Some people prefer to use Average Capital employed (or Total
9average total assets, as the case may be) in place of only Capital employed (or Total Assets).
10Average Capital employed is the average of the capital employed at the beginning and at the end
11of the accounting period. For example, if in the example of Raaha Garment given above, the
12capital employed at the beginning of the accounting period was Rs. 4,50,000, and so the ROI
13would be calculated as follows:
14
15
16
17
18
19
20
Net Profit before Interest and Tax

ROI
x 100
Average Capital employed
2,00,000
x 100
1/2 (5,00,000 + 4,50,000)
21
22
23
24
25
26
27
2,00,000
=
x 100 = 42.11%
4,75,000
It should be noted that while computing the ROI according any of the above methods
28Abnormal Gains or Losses should always be excluded from Net Profit.

29
302. Earning per Share (E.P.S) In order to avoid confusion on account of the varied meanings of
31the term capital employed, the overall profitability can also be judged by calculating earning per
32share with the help of the following formula:
33
34
35Earning per equity share =
36
37
Net Profit after Tax and Preference Dividend *

Number of Equity Shares
38Illustration 9.3 Net Solutions Ltd., Bangalore wants to know its position in the stock market.
39They have provided us the following data:

40
41
Net profit before tax Rs. 1,00,000
42
Taxation at 50% of Net Profit
43
10% preference share capital (Rs. 10 each) Rs. 1,00,000
44
Equity Share capital (Rs. 10 share) Rs. 1,00,000
45
46
Let us calculate their earnings.
47
29
1Chapter 9
2
1Solution
Net Profit after Tax and Pref. Dividend
2
3Earning per equity share =
4
Number of Equity Shares
Rs. 40,000
=
= Rs. 4 per share

10,000
7
8
9Significance: The earning per share helps in determining the market price of the equity shares of
10the company. A comparison of earning-per-share of one company with another also helps in
11deciding whether or not the equity share capital is being effectively used,, and in estimating the
12companys capacity to pay dividend to its equity shareholders.
13
143. Price Earning Ratio (P/ER): This ratio indicates the number of times the earning per share
15is covered by its market price. This is calculated according to the following formula:
16
17
Market Price per Equity Share
18
19
Earning per Share
20
21
For example, the market price of a share is Rs. 30 and earning per share is Rs. 5, the
22price earning ratio would be 6 (i.e. 30 5). This means that the market value is 6 times every one
23rupee of earnings. The P/ER ratio is useful in financial forecasting. It also helps in determining
24whether the shares of a company are under or over-valued. For example, if the earning per
25share of Net Solutions Limited is Rs. 20 and its market price is Rs. 140, and the earning ratio of
26similar companies is 8, it means that the market value of a share of Net Solutions Limited should
27be Rs. 160 (i.e. 8 x 20). The shares of Net Solutions Limited are, therefore, undervalued in the
28market by Rs. 20. If the price earning ratio of similar companies is only 6, the value of a share of
29Net Solutions Limited should have been Rs. 120 (i.e. 6 x 20); thus the company shares are
30overvalued by Rs. 20.
31
32Significance: Price-earning ratios help the investor in deciding whether or not to buy the shares
33of a company at a particular market price.

34
354. Gross Profit Ratio: This ratio expresses the relationship between gross profit and net sales.
36The formula to calculate this ratio is:

37
38
Gross Profit
x 100
39
40
Net Sales
30
1Chapter 9
2
1
2Illustration 9.4 Palamudhir Nilayam, Peelamedu had the following data retrieved from its
3accounting records for the year end March 2004.

4
Rs.
10,00,000
1,00,000
2,00,000
Sales
Sales Returns
Opening Stock
Purchases
Purchases Returns
Closing Stock
Rs.
6,00,000
1,50,000
50,000
5
6
They have requested for help in calculating their profitability.
Let us see what we can do with the given figures.
8
9Solution
Gross Profit
10
11
Gross Profit Ratio
x 100
Net Sales
12
13
Net Sales Cost of Goods sold
14
15
x 100
Net sales
16
17
Rs. 9,00,000 - Rs. 6,00,000
18
19
x 100
Rs. 9,00,000
20
21
Rs. 3,00,000
22
23
x 100 = 33.33%
Rs. 9,00,000
24
25
26Significance: This ratio indicates the degree to which the selling price of goods per unit may
27decline without resulting in losses from operations to the firm. It also helps in ascertaining
28whether the average percentage mark up on the goods is maintained.
29
305. Net Profit Ratio: This ratio indicates the net margin earned on a sale of Rs. 100. It is
31calculated as follows.
32
33
34
35
36
Net Operating Profit

x 100
Net Sales
The Net Operating profit is arrived at by deducting operating expenses from Gross Profit.
37
31
1Chapter 9
2
1Illustration 9.5 By probing further into the records of Palamudir we could retrieve the following
2data:
Sales Less Returns
Gross Profit
Administration Expenses
Rs.
10,00,000
4,00,000
1,00,000
Selling Expenses
Loss on account of fire
Rs.
1,00,000
50,000
30,000
3
4
Let us explore what we can do with this.
6
7Solution: Net Profit Ratio
x 100
Net Sales
8
9
Rs. 2,00,000
10
11
12
x 100 = 100 = 20%

Rs. 10,00,000
13
14Significance: This ratio helps in determining the efficiency with which the business affairs are
15being managed. An increase in this ratio over the previous period indicates an improvement in
16the operational efficiency of the business, provided the gross profit ratio is constant. The ratio is
17thus an effective measure to check the profitability of business.
18
19
An investor has to judge the adequacy, or otherwise, of this ratio by taking into account
20the cost of capital, the return in the industry as a whole, and market conditions such as boom
21periods or depression period periods. No norms can be laid down. However, a constant
22increase in the above ratio year after year is a definite indication of improving conditions at the
23business.
24
256. Operating Ratio: This ratio is complementary to the net profit ratio. In case the net profit ratio
26is 20%, it means that the operating ratio is 80%. It is calculated as follows:
27
Operating costs
28
x 100
29
Net Sales
30
31
32
The operating costs include the cost of direct materials, direct labour and other
33overheads, viz., factory, office or selling. Finance charges such as interest, provision for taxation,
34etc., are generally excluded from operating costs.
35
32
1Chapter 9
2
1The ratio for each element of the operating cost can be calculated as,
2
3
(i)
Direct material cost to sales = Direct Material Cost

x 100
Net Sales
(ii)
Direct labour cost to Sales = Direct Labour Cost

x 100
Net Sales
(iii)
Factory Overheads to Sales = Factory Overhead expenses

x 100
10
Net Sales
11
12
13The operating ratio tests the operational efficiency of the business. It should be low to in order for
14investors to get a fair return.

15
167. Fixed Charges Cover:
This ratio is very important from the lenders point of view. It
17indicates whether the business would earn sufficient profits to pay periodically the interest
18charges. The higher the number, the more secure the lender is with respect to his periodical
19interest income. It is calculated as follows:
20
21
Income before Interest and Tax
22
Interest charges
23
24
25
The standard for this ratio for an industrial company is that interest charges should be
26covered six to seven times.

27
288. Debt Service Coverage Ratio: The interest coverage ratio, as explained above, does not tell
29us anything about the ability of a company to make payment of principal amounts also on time.
30For this purpose, the debt service coverage ratio is calculated as follows:
31
32
33Debt Service Coverage Ratio =
Interest + Principal Payment Installment
34
1 Tax Rate
35
36
37
The principal payment installment is adjusted for tax effects, since such payment is not
38deducted from the profit for tax purposes.

39
33
1Chapter 9
2
1Illustration 9.6 Net Solutions Limited assumes that their net profit before Interest and Tax
2reduces to Rs. 5,00,000. They require us to find out what will be the impact of this on their ability
3to service debt, if 10% Debentures (payable 10 years in equal installments) Rs. 10,00,000 is
4issued to redeem the preference capital tax rate remains the same 50%.
5
6
7Solution: Debt Service Coverage Ratio =
1 Tax Rate
9
10
5,00,000
11
12
=
1,00,000 + 1,00,000
13
5,00,000
= 1.67
3,00,000
.5
14
15
16
The ratio comes to 1.67, meaning that net profit, before interest and tax, covers both
17interest and principal repayment installments adequately.

18
19
Debt Service Coverage Ratio can also be computed as under:
20
21
Cash Profit available for Debt Service
22
23
24
25
The Cash Profit available for debt service is computed by adding items like depreciation
26interest on debt, amortization of items like goodwill preliminary expenses, etc. to Net Profit
27
28
However, the former seems to be a better method, since by giving the tax effect, it puts
29the two items, interest and principal payment installments, on the same footing.
30
31
The higher the ratio, the better it is.
32
339. Pay out Ratio: This ratio indicates the proportion of earning per share is used for paying
34dividend. The ratio can be calculated as follows:

35
36
Dividend per Equity Share
37
38
Earning per Equity Share
39
40The complement of this ratio is the Retained Earning Ratio. It is calculated as follows.
34
1Chapter 9
2
1
Retained Earning per Equity Share
2
3
4
5
Retained Earnings
x 100
Total Earnings
8
9
10Illustration 9.7 Palamudhir Nilayam further provides following data:
Rs.
10,000
5,000
2,000
Net Profit
Provision for Tax
Preference Dividend
Rs.
3,000
0.40
No. of Equity Shares

11
12They would like to know their dividend payout ratio, and their retained earnings ratio.
13
14Solution:
15
PAT
= Net profit (provision for tax + Pref. dividend)
PAT
= 10,000 7,000
16
17
18
19
= 3,000
PAT
20
21
EPS
22
3,000
=
No. of equity shares
23
= 1
3,000
25Dividend Pay out Ratio =
40
x 100 =
26
x 100 = 40%
1
27
28
29
30Total Dividends
Total Earnings x Dividend Payout Ratio
31
3,000 x 40%
32
1,200
34Retained Earnings
Total Earnings Total Dividends
35
3,000 1,200
36
1,800
33
37
38
Retained Earnings
Rs. 1,800
35
1Chapter 9
2
1Retained Earning ratio =
x 100
x 100 = 60%
Total Earning
Rs. 3,000
or
4
5
6
Retained Earning per share

x 100 =
7
8
Re.60
Total Earning per share
x 100 = 60%
Re. 1
9
10Significance: The pay-out ratio and the retained earnings ratio are indicators of the amount of
11earning that have been ploughed back in the business. The lower the pay-out ratio, the higher
12will be the amount of earnings ploughed back in the business, and vice versa. Similarly, the
13lower the retained earnings ratio, the lower will be the amount of earnings ploughed back into the
14business, and vice versa. A lower pay-out ratio or a higher retained earning ratio means a
15stronger financial position of the company.
16
1710. Dividend Yield Ratio: This ratio is particularly useful for investors who are interested only
18in dividend income. It is calculated by comparing the dividend per share with its market value.
19Its formula can be put as follows:
20
21
Dividend per Share

x 100
22
23
Market Price per share
24
25For example, if Net Solutions declares dividend at 20% on its shares, each share paying a value
26of Rs. 8, and the market price being Rs. 25, the dividend yield ratio will be calculated as follows:
20
27
28
Dividend per Share
x 8 = Rs. 1.60
100
29
30
Dividend per Share
31
32
Dividend Yield Ratio
x 100
Market Price per Share
33
34
1.6
35
36
37
x 100 = 6.4%
25
38
39Significance: The ratio helps an interested investor to know the effective return he is going to get
40on the proposed investment. For example in the above case, although the company is paying a
36
1Chapter 9
2
1dividend of 20% on its shares, a person who purchases the shares of the company from the
2market will get only an effective return of 6.4%. He, therefore, can decide whether he should
3make this investment or not.
4
5TURNOVER RATIOS
6
7
Turnover ratios indicate the efficiency with which the capital employed is rotated in the
8business. They are also known as Activity Ratios. The overall profitability of the business
9depends on two factors: (i) The rate of return on the capital employed; and (ii) the turnover, i.e.,
10the speed at which the capital employed in the business rotates. The higher the rate of rotation,
11the greater will be the profitability. Thus, the overall profitability ratio can be classified into:
12
1. The Net Profit Ratio, and
13
2. The Turnover Ratio
14
15
As already explained the Net Profit Ratio is calculated as follows:
16
17
18
19
20
21
22
23
24

x 100
Sales
The Turnover Ratio is calculated as follows:
Sales
Capital employed
25
26
The Turnover Ratio indicates the number of times the capital has been rotated in the
27process of doing business.

28
29
When these two ratios are put together, we get the overall profitability ratio.
30
31
Overall Profitability Ratio = Net Profit Ratio x Turnover Ratio

Net Profit
32
33
= 100 x
Sales
x
Sales
34
Capital Employed
35
36
37
38
39
Net Profit
=
x 100
Capital Employed
40Illustration 9.8 Net Solutions Ltd., wonders why the market price of Global Net is higher than
41theirs despite Global Net having a lower net profit ratio.

42
43Let us help them understand this. The financial statements reveal:
37
1Chapter 9
2
1
Global Net
Net Solutions
Net Profit Ratio
5%
8%
Turnover Ratio
6 times
3 times
5
6Solution:
7
In the above case, when only the net profit ratio is seen, Net Solutions seems to be more
8profitable, but in reality, Global Net is more profitable because it has a higher turnover ratio,
9which gives it a higher return on the capital employed: 30% compared to 24% in the case of Net
10Solutions.
11
12
In order to find out which portion of the capital is efficiently employed, and which portion
13is not, different turnover ratios are calculated. These ratios are as follows:
14
151. Fixed Assets Turnover Ratio: This ratio indicates the extent to which the investment in fixed
16assets contributes towards sales. When compared with a previous period, it indicates whether
17the investment in fixed assets has been judicious or not. The ratio is calculated as follows:
18
Net Sales
19
20
Fixed Assets (net)
21
22
23Illustration 9.9 The General Manager of Arjun Textiles has a nagging doubt that the firms fixed
24assets are not performing well. He has provided us the following information:
25
2003
26
27Fixed assets at written down value
2004
Rs. 1,50,000
Rs. 3,00,000
6,00,000
8,00,000
28Sales less Returns

29
30Let us try to help him resolve his doubts

31
32Solution: Fixed Assets Turnover Ratio =
33
Sales
Fixed Assets
34
2003
35
36
6,00,000
37
38
39
40
41
2004
8,00,000
= 4 times
1,50,000
= 2.67 times
3,00,000
There has been a decline in the Fixed Assets Turnover Ratio, even though the absolute
42sales numbers have gone up. This means that an increase in the investment in Fixed Assets has
43not brought about a commensurate gain. However, the results for next two or three years must
38
1Chapter 9
2
1also be examined before commenting on the judiciousness, or otherwise, of an increase in the
2investments in fixed assets.

3
4
The fixed assets turnover ratio can further be divided into the turnover of each item of
5assets to calculate the extent to which each asset has been properly used. For example:
6
Net sales
7
8Plant and Machinery to Turnover
=
Planted Machinery (Net)
9
10
Net sales
11
12Land and Buildings to Turnover
=
Land and Buildings (net)
13
14
152. Working Capital Turnover Ratio: This ratio indicates whether or not the working capital has
16been effectively utilized in making sales. The ratio is calculated as follows:

17
Net Sales
18
19
Working Capital
20
21
22
The Working Capital Turnover Ratio may take different forms for different purposes.
23Some of these are explained below:

24
25(i) Debtors Turnover Ratio (Debtors Velocity). Debtors are an important constituent of current
26assets, and therefore the quality of debtors to a great extent determines a firms liquidity. In
27financial analysis, two ratios are used to judge the liquidity of a firm. They are (i) Debtors
28Turnover Ratio and (ii) Debt collection period ratio.
29
The Debtors Turnover Ratio is calculated as below:
30
Credit Sales
31
32
Average Accounts Receivable
33
34
35
The term Accounts Receivable includes Trade Debtors and Bills Receivable.
36
39
1Chapter 9
2
1Illustration 9.10 Arjun Textiles further provides the following figures.
Rs.
2
3Total Sales for the year 2003
1,00,000
4Cash Sales for the year 2003
20,000
5Debtors as on 01.01. 2003
10,000
6Debtors as on 31.12. 2003
15,000
7Bills Receivable as on 01.01.2003
7,500
8Bills Receivable as on 31.12. 2003
12,500
9
10Let us find the Debtors Turnover Ratio for Arjun Textiles.
11
12Solution:
13
14
Credit Sales
15Debtors Turnover Ratio =
16
Average Accounts Receivable
17
80,000
=
= 3.5 times
22,000*
18* 1/2 of (Rs. 17,500 + 27,500)

19
20
In case the details regarding opening and closing receivable and credit sales are not
21available, the ratio may be calculated as follows:

22
Total Sales
23
24
Accounts Receivable
25
26
27Significance: The Ratio of Sales to Accounts Receivable indicates the efficiency of the staff
28entrusted with the collection of book debts. The higher the ratio, the greater is the efficiency,
29since it would indicate that debts are being collected more promptly. For measuring efficiency, it
30is necessary to set up a standard figure; a ratio lower than the standard will indicate inefficiency.
31
32
The ratio helps in Cash Budgeting, since the flow of cash from customers can be worked
33out on the basis of sales.

34
35(i) Debt Collection Period Ratio: This ratio indicates the extent to which the debts have been
36collected in time. It gives the average debt collection period. The ratio is very helpful to lenders
37because it indicates to them whether their borrowers are collecting money within a reasonable
38time. An increase in the period will result in greater blockage of funds in debtors. The ratio may
39be calculated by using any of the following three methods:
40
41
40
1Chapter 9
2
1
Months (or Days) in a Year
2(a)
3
Debtors Turnover
4
5
Average Accounts Receivable x Months (or Days) in a Year
6(b)
Credit Sales for the Year
7
8
9
Accounts Receivable
10(c)
11
Average Monthly or Daily Credit Sales
12
13Illustration 9.11 Further data dug out from Palamudhir Nilayam records:
14
15Credit Sales for the Year
Rs. 12,000
16Debtors
Bills receivable
Rs. 1,000
1,000
17
18Let us calculate the Debtors Turnover Ratio and Debt Collection Period.
19
20Solution: Debtors Turnover Ratio
Credit Sales
21
12,000
22
=
Accounts Receivable
23
= 6 times
2,000
24
25Debt Collection Period (or Average Age of Receivables)
Months in a Year
26
27
12
=
Debtors Turnover
28
= 2 Months
Or
29
Accounts Receivable x Months in a Year
30
31
2,000 x 12
=
Credit Sales in the year
32
= 2 Months
12,000
33
34
Or
Accounts Receivable
35
36
37
2,000
=
Monthly Credit Sales
= 2 Months
1,000
38
39
In fact, the two ratios are interrelated. Debtors Turnover can be obtained by dividing the
40months (or days) in a year by the average collection period (e.g. 12/6 = 2 months). Similarly,
41
1Chapter 9
2
1when the number of months (or days) in a year are divided by the debtors turnover, the average
2debt collection period is obtained (i.e. 12/6 = 2 months)

3
4Significance: Debtors collection period measures the quality of the debtors, since it measures
5the rapidity or slowness with which money is collected from them. A shorter collection period
6implies prompt payment by debtors. It reduces the changes of bad debts. A longer collection
7period implies a liberal and inefficient credit collection performance. However, in order to
8measure a firms credit and collection efficiency, its average collection period should be
9compared with the average period for the industry. It should be neither too liberal nor too
10restrictive. A restrictive policy will result in lower sales, which will reduce profits.
11
12
It is difficult to provide a standard collection period of debtors. It depends upon the
13nature of the industry, seasonal character of the business, and on the credit policies of the firm.
14In general, the amount of Receivables should not exceed 3-4 months credit sales.
15
16(iii) Creditors Turnover Ratio (Creditors Velocity): This is similar to the Debtors Turnover Ratio.
17It indicates the speed with which the payments for credit purchases are made to the creditors.
18The ratio can be computed as follows:
19
Credit Purchases
20
21
Average Accounts Payable
22
23
24The term Accounts Payable includes Trade Creditors and Bills Payable.
25
26
In case the details regarding credit purchases, opening and closing accounts payable
27are not provided, the ratio may be calculated as follows:

28
Total Purchase
29
30
Accounts Payable
31
32
33(iv) Debt Payment Period enjoyed Ratio (Average Age of Payables): This ratio gives the average
34credit period enjoyed from the creditors. It can be computed by any one of the following three
35methods:
36
37
Months (or Days) in a year
38(a)
39
Creditors Turnover
42
1Chapter 9
2
1
2
Average Accounts Payable x Months (or Days) in a year
3(b)
4
Credit Purchases in the year
5
6
7(c)
8
Average Monthly (or Daily) Credit Purchases
9
10
11Illustration 9.12 Use the following figures from Arjun Textiles to calculate the Creditors Turnover
12Ratio and the Average Age of Accounts Payable:

13
Rs.
Rs.
Credit purchase during 1988
1,00,000
Bills Payable on 1.1.1988
4,000
Creditors on 1.1.1988
20,000
Bills Payable on 31.12.1988
6,000
Creditors on 31.12.1988
2,000
14
15Solution:
16
17
Credit Purchases
Rs. 1,00,000
18Creditors Turnover Ratio =
=
= 6.25 times
19
Rs. 16,000
20
21Average Age of Accounts Payable (or Credit Period enjoyed)
22
23
Months (or Days) in a year
12
24
=
=
= 1.92 months
25
Creditors Turnover
6.25
26
27
Or
28
29
Average Accounts Payable x Months (or Days) in a Year
16,000 x 12
30=
=
= 1.92 months
31
Credit Purchases in the Year
1,00,000
32
33
34
16,000
35=
=
= 1.92 months
36
Average Monthly (or Days) Credit Purchases
8,333,33
37
38
39Significance: Both the Creditors Turnover Ratio and the Debt Payment Period enjoyed Ratio
40indicate the promptness or otherwise in making payment of credit purchases. A higher Creditors
41Turnover Ratio or a lower Credit Period enjoyed Ratio signifies that the creditors are being paid
42promptly, thus enhancing the credit-worthiness of the company. However, a very favourable ratio
43to this effect also shows that the business is not taking full advantage of the credit facilities which
44may be allowed by the creditors.
45
43
1Chapter 9
2
1(v)
Stock Turnover Ratio:
This ratio indicates whether or not the investment inventory is
2efficiently used. It explains whether investment in inventories is within proper limits. The ratio is
3calculated as follows.
4
Cost of Goods Sold During the Year
5
6
Average Inventory
7
8
9
Average inventory is calculated by adding up levels or raw materials, work-in-progress,
10and finished goods at the end of each month, and dividing by twelve.
11
12
The Inventory Ratio can be calculated with regard to each constituent of inventory. It
13may thus be calculated with regard to raw materials, work-in-progress or finished goods:
14
Cost of Goods Sold
15
161.
*
Average Stock of Finished Goods
17
18
Materials Consumed
19
202.
21
22
23
24
253.
26
27
28
29
**
Average Stock of Raw Materials
Cost of Completed Work
***
Average Work-in-process
As a mater of fact, the method discussed above is the best one for computing the Stock
30Turnover Ratio. However, in the absence of complete information, the Inventory Turnover Ratio
31may also be computed, on the following basis:
32
33
34
35
36
37
Net Sales
Average Inventory at Selling Price
The average of inventory may also be calculated on the basis of the average of the
38inventory at the beginning, and at of the end, of the accounting period.

39
40
Inventory at the beginning of the Account Period
41
+ Inventory at the end of the accounting period
42
43Average Inventory
44
44
1Chapter 9
2
1
2Illustration 9.13 The following is the Trading Account of Raaha Garments. Calculate the Stock
3Turnover Ratio.
4
TRADING ACCOUNT
Particulars
To
To
To
To
Opening Stock
Purchases
Carriage
Gross Profit
Amount
Rs.
40,000
1,00,000
10,000
70,000
2,20,000
Particulars
By
By
Sales
Closing stock
Amount
Rs.
2,00,000
20,000
2,20,000
6
7Solution:
Cost of Sales
Stock Turnover Ratio =
Rs. 1,30,000
=
Average Stock
10
= 4.33 times
30,000
11
12Significance:
13
14
15
16
17
18
As already stated, the Inventory Turnover Ratio signifies the liquidity of the
inventory. A high Inventory Turnover Ratio indicates brisk sales. The ratio is, therefore, a
measure that reveals possible trouble in the form of overstocking or overvaluation. The
stock position is called the graveyard of the Balance Sheet. If sales are quick, such a
position would not arise unless the stocks consist of unsaleable items. A low Inventory
Turnover Ratio results in blocking funds in inventory, which may ultimately result in heavy
losses due to inventory becoming obsolete, or due to it deteriorating in quality.
19
It is difficult to establish a standard Ratio of Inventory, because it will differ from industry
20
21to industry. However, the following general guidelines can be offered:

22
i.
The raw material should not exceed 2 4 months consumption of the year.
23
ii.
The finished goods should not exceed 23 months cost of sales.
24
iii.
Work-in-progress should not exceed 1530 days cost of production.
25
26* It indicates the effectiveness of sales vis--vis finished goods stock
27** It indicates whether there is over-stocking of materials
28*** It indicates whether there is undue accumulation of work at different points.
29
30Precaution: When using the Inventory Ratio, care must be taken regarding the following factors:
31
32
33
34
35
i.
Seasonal conditions. If the Balance Sheet is prepared at the time of a slack season,
the average inventory will be much less (if calculated on the basis of inventory at the
beginning of the accounting period and inventory at the close of the accounting
period). This may give a very high Turnover Ratio.
45
1Chapter 9
2
ii.
Supply conditions. In case of conditions of scarcity, inventory may have to be kept in

high quantity in order to meet future requirements.
iii.
4
5
Price trends. In case of a possible increase in prices, a large inventory may be kept
by the business. The reverse would be the case if there were a possibility of a
decline in prices.
iv.
Trend of volume of business. In case there is a trend for sales being sufficiently
higher than in the past, a higher amount of inventory may be kept.
8
9FINANCIAL RATIOS
10
Financial Ratios indicate the financial position of the company. A company is deemed to
11
12be financially sound if it is in a position to carry on its business smoothly, and meet all its
13obligations both long-term as well as short-term without strain. Thus, its financial position
14has to be judged from two angles long-term as well as short term. It is a sound principle of
15finance that long-term requirements should be met out of long-term funds, and short-term
16requirements should be met out of short-term funds. For example, if fixed assets are purchased
17out of funds provided by a bank overdraft, the company will come to grief because such assets
18cannot be sold off when payment is demanded by the bank. Let us discuss some of the
19important ratios which are calculated, in order to judge the financial position:
20
211. Fixed Assets Ratio. The ratio is expressed as follows:
Fixed Assets
22
23
Long-term Funds
24
25
26
The ratio should not be more than 1. If it is less than 1, it shows that a part of the
27working capital has been financed through long-term funds. This is desirable to some extent,
28because a part of working capital termed as Core working capital is more or less of a fixed
29nature. The ideal ratio is 0.67.
30
31
Fixed assets include net fixed assets (i.e., original cost depreciation to date) and
32trade investments, including shares in subsidiaries. Long-term funds include share capital,
33reserves and long-term loans.
34
35Illustration 9.14 From the following data for Srihari Cloth Stores, compute the Fixed Assets
36Ratio.
37
Particulars
Share Capital
Reserves
14% Debentures
Rs.
1,00,000
50,000
1,00,000
Particulars
Furniture
Trade Debtors
Cash Balance
Rs.
25,000
50,000
30,000
46
1Chapter 9
2
Trade Creditors
Plant and Machinery
Land and Buildings
50,000
1,00,000
1,00,000
Bill Payable
Stock
10,000
40,000
1
2Solution:
Fixed Assets
2,25,000
4Fixed Assets Ratio =
=
Long-term Funds
= 0.9
2,50,000
6
7
84. Debt-Equity Ratio: The Debt-Equity Ratio is determined in order to ascertain the soundness
9of the long-term financial policies of the company. It is also known as the External Internal
10Equity Ratio. It may be calculated as follow :
11
External Equities
12
13
Debt Equity Ratio
=
Internal Equities
14
15
16
The term External Equities refers to total outside liabilities, and the term Equities refers
17to shareholders funds, or the tangible net worth (as used in the pro forma balance sheet given in
18the preceding chapter). In case the ratio is 1 (i.e. outsiders funds are equal to shareholders
19funds) it is considered to be quite satisfactory.
20
21
In case the Debt-Equity Ratio is to be calculated as a long-term financial ratio, it may be
22calculated as follows:
23
Total Long-term Debt
24
25(i) Debt-Equity Ratio
=
Total Long-term Funds
26
27
Shareholders Funds
28
29(ii) Debt-Equity Ratio
=
30
31
32
33(iii) Debt-Equity Ratio
34
Shareholders Funds
35
36Method (iii) is the most commonly used.
37
47
1Chapter 9
2
1
Ratios in (i) and (ii) give the proportion of long-term debt / shareholders funds in total
2long-term funds (including borrowed as well as owned funds). Ratio (iii) indicates the proportion
3between shareholders funds (i.e. tangible net worth), and the total long-term borrowed funds.
4
5
Ratios in (i) and (ii) may be taken as ideal if they are 0.5 each, while the ratio in (iii) may
6be taken as ideal if it is 1. In other words, the investor may take the Debt-Equity Ratio as being
7quite satisfactory if shareholders funds are equal to borrowed funds. However, a lower ratio, say
82/3rds borrowed funds and 1/3rd owned funds, may also not be considered as satisfactory if the
9business needs heavy investment in fixed assets and has an assured return on its investment,
10e.g., in case of public utility concerns.
11
12
Note that preference shares, that are redeemable within a period of 12 years from the
13date of their issue, should be taken as part of debt.

14
15Illustration 9.15 From the following figures of Srihari, calculate the Debt-Equity Ratio:
16
Particulars
Preference Share Capital
Equity Share Capital
Capital Reserves
Profit & Loss Account
12% Mortgage Debentures
17
Amount
Rs.
1,00,000
2,00,000
50,000
50,000
1,00,000
Particulars
Amount
Rs.
50,000
40,000
20,000
10,000
20,000
Unsecured Loans
Creditors
Bills Payable
Provision for Taxes
Provision for Dividends
18Solution: The Debt-Equity Ratio may be calculated according to any of the following methods,
19depending on the purpose for which the information is required:

20
External Equities
21
22(i) Debt-Equity Ratio =
23
2,40,000
=
Internal Equities
= 0.6
4,00,000
24
25
26(ii)
27
Total Long-term Debt*

=
1,50,000
=
Total Long-term Liabilities
= 0.27
5,50,000
28
29
30(iii)
31
Shareholders Funds
=
4,00,000
=
= 0.73
5,50,000
32
33
34(iv)
35

=
1,50,000
=
Shareholders Funds
= 0.375
4,00,000
36
48
1Chapter 9
2
1Significance: The ratio indicates the proportion of the owners stake in the business. Excessive
2liabilities tend to cause insolvency. The ratio indicates the extent to which the firm depends upon
3outsiders for its existence. The ratio provides a margin of safety to the creditors; it tells the
4owners the extent to which they can gain benefits or maintain control with a limited investment.
5
65. Proprietary Ratio: This is a variant of the Debt-Equity Ratio. It establishes a relationship
7between the proprietors or shareholders funds and the total tangible assets.
8expressed as:
It may be
Shareholders Funds
10
11
Total Tangible Assets
12
13
14Illustration 9.16 For Raahas figures, calculate the proprietary ratio:

15
Liabilities
Preference Share Capital
Equity Share Capital
Debentures
Creditors
Rs.
1,00,000
2,00,000
50,000
1,00,000
50,000
5,00,000
Assets
Fixed Assets
Current Assets
Goodwill
Investments
Rs.
2,00,000
1,00,000
50,000
1,50,000
5,00,000
16
17Solution
Shareholders Funds
18
19
Proprietary Ratio =
Rs. 3,00,000*
=
20
= 0.67 or 67%
Rs. 4,50,000
21
22* Rs. 1,00,000 + 2,00,000 + 50,000 50,000
23
24Significance:
This ratio focuses attention on the general financial strength of the business
25enterprise. The ratio is of particular importance to the creditors, who can determine what
26proportion of shareholders funds is in the total assets employed in the business. A high
27Proprietary Ratio indicates relatively little danger to the creditors, etc., in the event of forced
28reorganisation or winding up of the company. A low Proprietary Ratio indicates greater risk to
29the creditors since, in the event of loss, a part of their money may be lost in addition to the loss to
30the proprietors of the business. A higher ratio is better than a lower one: a ratio below 50% may
31be alarming for the creditors, since they may have to lose heavily in the event of the companys
32liquidation on account of heavy losses.
33
34
35
INTERPRETATION OF RATIOS
49
1Chapter 9
2
1
2Interpretation of ratios is a more important managerial exercise than the calculation of the ratios.
3As management accounting is not rule-driven, there are no set standards to concretely decide
4what an ideal ratio is. The best way to establish a standard is to look at what business the firm is
5into and conclude whether a ratio is good, bad or all right after comparing it with the industry
6averages. Say for example a ratio of 2:1 of current assets to current liabilities is generally
7considered good. Does this mean a current ratio of 4:1 is extremely good or very bad? There is
8no right answer to this question. It can be either way. For a firm that produces and sells industrial
9goods, it may be essential to have a higher current ratio because they are expected to receive
10their revenue at a slower pace compared with an FMCG. Whereas the same ratio for an FMCG
11may be ridiculous because it means they have not utilised their assets in a better way to perform
12for the shareholders. Therefore it is a matter of judgment to decide what is advantageous and
13what is disadvantageous to a company.
14
15Let us look into the following example and understand how to interpret various ratios:
16
Ratios
Current ratio
Working Capital Turnover
Total Assets Turnover
Debtors Turnover
Creditors Turnover
Debt-Equity
Gross Profit
Net Profit
Return on Investment
Earnings per Share
Dividends per Share
Operating Profit ratio
Proprietary ratio
Debt Service Coverage ratio
Companys Ratio
0.95
8 times
4 times
2 times
3 times
60:40
18%
15%
16%
Rs.5
Rs.3
18%
60%
1.27
Industry Average
2:1
5 times
6 times
4 times
5 times
50:50
20%
18%
15%
Rs.3
Rs.2
22%
50%
0.95
17
18
50
1Chapter 9
2
1The above ratios are extracted from the financial statement analysis of a company. Let us
2try to interpret them.

3
4The Current Ratio signifies that the company makes use of the current assets properly. It is
5better than the industry average if this company has the backup of suppliers and consumers. But
6if the same company does not have the backup of suppliers, who will supply on credit and wait
7for payment, and also customers, who will be ready to pay in advance to buy from the company,
8the company may fail badly in the long run.
9
10In the same way, Working Capital Turnover is very good when compared with the industry
11average. This also indicates that the company has properly utilised the current assets such that
12the business was able to turn over the working capital a number of times.
13
14The total assets turnover is much less than the industry average. This means that the company
15has not properly utilised the fixed assets. The company needs to concentrate on the same.
16
17The Debtors Turnover is less than the industry average. In one sense it may mean that the
18companys collection efforts are not good. But from another angle, the company might not have
19many Debtors, because the majority, or almost all, of the customers may pay in advance.
20
21The Creditors Turnover is less than the industry average. This indicates that the company pays
22the creditors at a slower pace. This might be because the company is very popular and the
23creditors know that their funds will be returned, and they are too willing to be vendors of the
24company. If all this is not true, then the position of the company may turn negative if the creditors
25start to demand a faster payment.
26
27The Debt-Equity Ratio of the company is better than the industry average in one sense. That is, if
28the profits are greater, then the company benefits more this is because debt requires only a
29fixed interest to be paid, and the extra profits earned on the investment belong to the equity
30holders.
31
32The Gross Profit Ratio is less than that of the industry average, and therefore we understand that
33the company does not operate efficiently and effectively. They need to figure out the reason for
34such poor performance, and correct it.
35
51
1Chapter 9
2
1The Net Profit Ratio is also less than the industry average, and this confirms that the organisation
2needs to concentrate on the operations.

3
4The Return on Investment Ratio is better than the industry average. Because the firm has a
5better Current Ratio, it is able to have a better return by utilising the current assets in an efficient
6manner.
7
8The Earnings Per Share is more than that of the industry average, because the return on
9investments is higher, and the company has a better Debt-Equity Ratio. A lower equity always
10gives a better Earnings per Share.
11
12The Dividend Per Share for the firm is better than that for the industry. This is also because of
13higher Earnings Per Share, and lower equity capital in the firm.
14
15The Operating Profit Ratio is lower than that of the industry average. This is a known factor
16because the firm already has a lower Gross Profit Ratio, and the fixed assets are not properly
17utilised.
18
19The Proprietary Ratio indicates the proportion of shareholders funds in the total assets
20employed. A ratio that is higher than the industry average indicates that the firm has a better
21position and the creditors can be relatively safe being in this firm.
22
23The ability of the firm to repay the interest and principal is higher than that of the industry. This is
24possible because the firm utilises the current assets properly.

25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
52
1Chapter 9
2
1
2The following is the summary of the most important ratios:
3
4Liquidity Ratios
5
6 1. Current Ratio
7
Current Assets
8
-----------------------------9
Current Liabilities
10
11 2. Acid Test Ratio
12
13
Quick Assets
14
------------------------------15
Current Liabilities
16
17
or
18
19
Quick Assets
20
-------------------------------21
Quick Liabilities
22
23 Activity Ratios
24
25 1. Debtors Velocity
26
27
Average Balance of Debtors * 365
28
-----------------------------------------------29
Credit Sales during the year
30
31
or
32
33
Average Balance of Debtors * 12
34
------------------------------------------------35
Credit Sales during the year
36
37
38 2. Creditors Velocity
39
40
Average Creditors * 365
41
--------------------------------------42
Credit Purchases
43
44
453. Inventory Velocity
46
47
Inventory Turnover
48
49
Cost of Goods sold
50
----------------------------------------------51
Average Level of Inventory
52
53
or
54
55
Sales
56
-------------------------57
Closing Stock
58
59
604. Working Capital Turnover
53
1Chapter 9
2
1
2
3
4
5
6
7
85. Current Assets Turnover Ratio
9
10
11
12
13
146. Fixed Assets Turnover Ratio
15
16
17
18
19
207. Capital Turnover
21
22
23
24
25
268. Total Assets Turnover
27
28
29
30
31
329. Stock Turnover
33
34
35
36
37
3810. B/R or Debtors Turnover
39
40
41
42
43
4411. Average Collection
45
46
47
48
49
5012. B/P or Creditors Turnover
51
52
53
54
55
56
Net Sales
-----------------------------Net Working Capital
Net Sales
-------------------------Current Assets
Net Sales
-------------------------Fixed Assets
Sales
-------------------------Capital Employed
Sales
-------------------------Total Assets
Cost of Goods Sold

----------------------------Average Inventory
Credit Sales
-------------------------Average Debtors
360
-------------------------Debtors Turnover
Credit Purchase
-------------------------Average Creditors
54
1Chapter 9
2
1
2Leverage Ratios
3
41. Debt-Equity Ratio
5
6
Long-Term Liabilities
7
---------------------------------8
Equity or Net Worth
9
102. Total Indebtedness Ratio
11
12
Term Liabilities + Current Liabilities
13
-----------------------------------------------------14
Equity
15
163. Preference Dividend Coverage Ratio
17
18
PAT
19
---------------------------------------------------20
Preference Dividend (1+ Dividend Rate of Tax)
21
23 Profitability Ratios
24
251. Gross Profit Ratio
26
27
Gross Profit
28
-------------------- x 100
29
Net Sales
30
31
322. Net Profit Ratio
33
34
Net Profit
35
----------------- x 100
36
Net Sales
37
383. Return on Investment
39
40
Operating Profits
41
-------------------------42
43
44
454. Return on Properties Fund
46
47
Net Profit
48
---------------------- x 100
49
Net Worth
50
515. Earnings per Share
52
53
PAT and Pref. Dividend
54
---------------------------------55
No. of Equity Shares
56
576. Dividends per Share
22
58
59
60
61
Dividend paid to Equity Shareholders

-------------------------------------------------------No. of Equity Shares
55
1Chapter 9
2
1
27. Dividend payout Ratio
3
Dividend per Share
4
------------------------------5
Earnings per Share
6
7
88. Price Earnings Ratio
9
10
----------------------------------11
Earnings per Share
12
139. Dividend Yield Ratio
14
Dividend per Share
15
-------------------------------16
17
1810. Earnings Yield Ratio
19
Earnings per Share
20
-------------------------------21
Market Value of Share
22
2311. Operating Ratio
24
Operating Costs
25
-------------------------26
Net Sales
27
2812. Expense Ratio
29
Particular Expense
30
-------------------------31
Net Sales
32
3313. Operating Profit Ratio
34
35
Operating Profit
36
-------------------------37
Net Sales
38
3914. Return on Investment
40
41
EBIT (1 T)
42
a) ROTA = -----------------43
TA
44
45
46
47
b)
RONA
EBIT (1 T)
= -----------------NA
48
49
PAT
50
c) ROE = ------------51
NW
52
53
54NOTE: RONA = ROCE
55
ROE = SHAREHOLDERS FUNDS
56
57
56
1Chapter 9
2
1
2 Stability Ratios
3
41.
Fixed Assets Ratio
5
6
Fixed Assets
7
----------------------8
Capital Employed
9
10
112.
Ratio of Current Assets to FA
12
13
Current Assets
14
----------------------15
Fixed Assets
16
17
183.
Proprietary Ratio
19
20
Shareholders Fund
21
--------------------------------22
23
24
254.
Capital Gearing Ratio
26
27
Fixed INT Bearing Securities
28
----------------------------------------------------------------------29
Equity Shareholders Funds or Total Capital Employed
30
31
32
33 Coverage Ratios
34
351.
36
37
38
39
40
41
422.
43
44
45
46
47
48
493.
50
51
52
53
54
55
56
Fixed Interest Cover

Net Profit Before INT & TAX
-------------------------------------------Interest Charges
Fixed Dividend Cover
Net Profit After INT & TAX
--------------------------------------Preference Dividend
Debt Service Coverage Ratio
Net Profit Before INT & TAX
-------------------------------------------------------------INT + Principal Payt Installment 1 Tax Rate
57Note: For a real time interpretation of ratios look into appendix I
57
1Chapter 9
2
1EXERCISES
2
31.
Sigma Limited, manufacturers of Steel pipes, ingots and billets, are planning an
4
5
expansion. They are on the look out for export opportunities to the Middle East, and
The following is their profit and loss account for the year ending 31 st March 2004, and
their balance sheet as on that date.
some African Countries.
Dr.
PROFIT AND LOSS ACCOUNT
Opening stock of finished goods
10,00,000
Opening stock of raw materials
5,00,000
Cr.
Sales
1,00,00,000
Closing stock of raw materials
15,00,000
10,00,000
Purchase of raw materials
30,00,000
Closing
goods
Direct wages
20,00,000
Profit on sale of shares
Manufacturing expenses
10,00,000
Administration expenses
5,00,000
Selling and distribution expenses
5,00,000
Loss on sale of plant
5,50,000
Interest on debentures
1,00,000
Not Profit
stock
of
finished
38,50,000
1,30,00,000
9
10
11
Liabilities
Share Capital :
Equity share capital
Preference share capital
Reserves
Debentures
Sundry creditors
5,00,000
1,30,00,000
BALANCE SHEET
Rs.
1,00,000
1,00,000
1,00,000
2,00,000
50,000
6,50,000
Assets
Fixed assets
Stock of raw materials
Stock of finished goods
Sundry debtors
Bank balance
Rs.
2,50,000
1,50,000
1,00,000
1,00,000
50,000
6,50,000
12
13As a winter intern at Sigma Limited, you are required to advise the top management on the
14proposal to expand. Comment on their liquidity, profitability and leverage position after redrafting
15the balance sheet and calculating the:
16(i)
Gross Profit Ratio
(ii)
Overall Profitability Ratio
17(iii)
Current Ratio
(iv)
Debt-Equity Ratio
18(v)
Stock Turnover Ratio
(vi)
Liquidity Ratio
19
58
1Chapter 9
2
1
22.
Ramu Hosiery Limited Tiruppur, supplier to a leading exporter Halo International, is
bothered about its operational position, since the non-quota days are fast approaching.
Your Professor, Management consultant to Ramu Hosiery, requires you to help him in
6
7
analyzing the companys operating position by calculating the following ratios, with
appropriate comments on the same.
8
9
(a)
Current ratio
(d)
Return on total resources
10
(b)
Operating ratio
(e)
Turnover of fixed assets
11
(c)
Stock turnover ratio
12
13
14
To
PROFIT AND LOSS ACCOUNT FOR RAMU HOSIERY

Opening Stock
To
Purchase
To
Incidental Expenses
To
Gross Profit c/d
9,950
By
Sales
85,000
54,525
By
Closing Stock
14,900
1,425
34,000
99,000
To
Opening Expenses
Selling & Distribution
Administration
Finance
3,000
99,900
By
Gross Profit b/d
By
Non-operating Income:
15,000
1,500
34,000
Interest
300
Profit on sale of shares
600
19,500
To
Non-operating Expenses:
Loss on sale of Assets
To
900
Net Profit
400
15,000
34,900
15
16
17
18
Liabilities
Issued Capital :
2,000 Equity Shares of Rs.10
each
Reserve
Current Liabilities
Profit & Loss A/c
34,900
BALANCE SHEET
Rs.
20,000
9,000
13,000
6,000
48,000
Assets
Land and Building
Plant & Machinery
Rs.
15,000
8,000
Stock-in-trade
Sundry Debtors
Cash & Bank Balance
14,900
7,100
3,000
48,000
19
20
21
59
1Chapter 9
2
13.
On New Years Eve of the year 2005, you appear before a panel for a summer
2
3
placement interview to select an FMCG International in their Finance Department. After a

few minutes introduction, the panel provides you with the following data:
4
5
(i)
Stock Velocity
(ii)
Capital Turnover Ratio (on Cost of Sales)
(iii)
Fixed Assets Turnover Ratio (on Cost of Sales) :
(iv)
Gross Profit Turnover Ratio
20 per cent
(v)
Debtors Velocity
2 months
10
(vi)
Creditors Velocity
73 days
11
12
The gross profit was Rs. 60,000. Reserves and Surplus amount to Rs. 20,000. Closing
13
Stock was Rs. 5,000 in excess of Opening Stock.
14
15
The panel requires you to prepare a Statement of Proprietary Funds with as many details
16
as possible.
17
184.
As a part of the Best Manager Contest at PSG IM, your senior requires you to prepare
19
the Balance Sheet for a company for the year 2003, with help of the following ratios:
20
21
Current Ratio
2.5
22
Liquidity Ratio
1.5
23
Net Working Capital
Rs. 3,00,000
24
Stock Turnover Ratio (cost of sales / closing stock)
6 times
25
Gross Profit Ratio
20%
26
Fixed Assets Turnover Ratio (on cost of sales)
2 times
27
Debt Collection Period
2 months
28
Fixed Assets to Shareholders Net Worth
0.80
29
Reserve and Surplus to Capital
0.50
30
31
325.
33
34
Ms. Anu, your senior, attended an interview for a final placement with LG Finance Ltd. in
Chennai. They provided her with the following information and asked her to prepare a
Balance Sheet. It was also needed to show the workings.
35
1.
Working Capital
2.
3.
Bank Overdraft
4.
Current Ratio
75,000
5.
Liquid Ratio
1.15
1,00,000
6.
Fixed Assets
Funds
60,000
7.
Long-term Liabilities
to
Proprietors
0.75
Nil
1.75
36
37
Ms. Anu wants to check her answer. She requires you to prepare a Balance Sheet on the
38same and compare it with hers.

39
60
1Chapter 9
2
16.
Using ratio analysis, analyze the Balance Sheets and the Profit and Loss Accounts of
HLL and L & T, given in the following pages.
61

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1Chapter 9

Financial Statement Analysis - Accounting Ratios

FINANCIAL STATEMENT ANALYSIS- ACCOUNTING RATIOS

After studying this chapter you should be able to:

1. Understand the usefulness of financial statements as external reports.

2. Analyse financial statements by preparing ratios.

3. Interpret ratios and make managerial decisions.

The process of identifying the financial strengths and weaknesses of a firm by

36proprietary, partnership or joint-stock company.

41thorough analysis of a profit and loss account.

3PSG Institute of Management

Financial Statement Analysis - Accounting Ratios

The profit and loss appropriation account will appear as under:

PROFIT AND LOSS APPROPRIATION ACCOUNT

Shortage in provision made

(Issue of bonus shares)

Balance from last year

22time due to the dual aspect of accounting principles.

Loans and Advances from Banks

3PSG Institute of Management

Financial Statement Analysis - Accounting Ratios

Investment in the Capital of

Interest Accrued on Investments

3PSG Institute of Management

Financial Statement Analysis - Accounting Ratios

Reserves and Surplus

Current Liabilities and Provisions

Current Assets, Loans and Advances

3PSG Institute of Management

Financial Statement Analysis - Accounting Ratios

o Profit and Loss Account

Synthesis of Different Methods

11 the balance sheet is restructured as under:

Equity or Net Worth

RESTRUCTURED BALANCE SHEET

BALANCE SHEET SPREAD ..

3PSG Institute of Management

Financial Statement Analysis - Accounting Ratios

24liabilities. It is expressed as follows:

3PSG Institute of Management

Financial Statement Analysis - Accounting Ratios

The Current Ratio can also be easily manipulated.

This may be done either by

36postponing certain pressing payments, by postponing the purchase of inventories, or by making

3PSG Institute of Management

Financial Statement Analysis - Accounting Ratios

12Ratio will be as follows :

25* presuming that the goods are purchased on credit.

33disturbed on account of a number of factors some of which are mentioned below :

Over-trading. Accumulation of stocks and mounting up of debtors and creditors

Repayment of a long-term liability.

credit, instead of selling them for cash or on hire-purchase basis.

3PSG Institute of Management

Financial Statement Analysis - Accounting Ratios

Rs. 90,000 Rs. 40,000

The Liquidity Ration in this case may be expressed as:

3PSG Institute of Management

Financial Statement Analysis - Accounting Ratios

6meanings are as follows :

Sum total of all assets whether fixed or current.

Sum-total of fixed assets

Sum-total of long-term funds employed in the business, i.e.,

13employed given in point iii above.

16Interest means Interest on long-term Borrowings. Interest on short-term borrowings will be