(ii) Use of Financial Ratio by Company‘s own Management:

The management of the company is concerned with all aspects of its operations and its relation with creditors, investors, and other concerned. The management makes use of all types of ratio i.e. profitability, liquidity, leverage, activity and structural ratios. It makes use of profitability ratios to evaluate its ability to pay reasonable return to investors; liquidity and leverage ratios are used to ascertain companies ability to honour commitments to creditors whereas activity ratios are used to minimise cost order to determine whether the organisation will meet ultimate objectives of providing shareholders with a maximum return. Ratios are useful tools in the hands of management to compare the performance of the organisation in various areas over a period of time and also against the established standard in the industry.

 

FACTORS AFFECTING THE EFFICACY OF RATIOS:

Ratio is one of the important tools of financial analysis to various end users such as management executives, investors, creditors and banks to assess the performance of company in terms of liquidity position, long term solvency, operating efficiency and profitability.

 

The efficacy of a company is affected by several factors. Some of these factors are discussed as under:-

1. Type of Business: Type of Business under consideration affects the ratios and conclusions drawn from them. For example, a high ratio of debt to net worth can be expected of a public utility company operating with large fixed assets with social benefit considerations 61 of a corporate entity applying trading on equity. Inventory turnover ratios vary considerably among industries. For example, grocery store chains may have a turnover of 10 to 12 times. In contrast, jewelry stores may have an average turnover of 1 to 1.6 times.

2. Seasonal Character: Seasonal character of the business affects ratio for a particular type of industry or business enterprise. For example, inventory to sales ratio for a woolen clothes merchant during the winter season has a different meaning and is supposed to be much higher than during other periods of the same year.

3. Quality of Assets: Quality of assets also affects the ratio analysis and gives different interpretation to business enterprises. Current assets to current liabilities ratio mostly 2:1 is considered more satisfactory for a liquid position of the company but if the same proportion of assets acid test ratio is calculated, it may give a different result and may depict the unsatisfactory position of availability of liquid finds with the company to meet its most urgent and pressing obligations.

4. Adequacy of Data: Adequacy of data is another consideration for comparison of particular factors with each

other. For example, average collection period for bill receivables for a particular month may differ to those with other months or the average of the year. Another consideration would be whether bill receivables have been properly valued for a particular period as over valuation may render the ratio incomparable.

5. Modification of Ratios: Modification of ratios reflects only the past performance and must be modified by future trends of business. 

6. Change in Accounting Policies & Accounting Estimates: With the change in accounting policies & accounting estimates their may be vast changes in financial position of a Company in comparison to the previous years which makes ratio‘s of these years incomparable.

7. Interpretation of Ratios: Interpretation of ratios should not be relied upon in isolation and should be considered with accounting documents for interpretations.

8. Accuracy: Having the wrong information can be far worse than having no information at all. It does not mean that ratios have to be calculated to four decimal places, but anyone using the figures should be able to rely on the fact that the numbers given tell a true story.

9. Relevance: This means using the appropriate ratios for objective in hand. A potential supplier does not need to know, and will not be interested in, the dividend per share, dividend cover, PE ratio, and so on. There is no point in swamping the interested party with a great deal of unwanted information. That would be a waste of time and effort on both sides.

10. Timelines: The receiver of the information wants it in order to be able to make a decision. The sooner the information is received, the swifter that decision can be reached. Indeed, if the information is too slow in arriving, the time to make the decision may have passed. This is one area where ratio analysis is open to criticism, since the numbers are based on accounts relating to a period which finished months ago.

11. Non-financial Data: Ratios based on financial data of firms should be considered with non-financial data to

supplement the financial ratios and give better interpretation.

 

Efficacy of ratios in a company can be increased by adopting following principles:

1. Using a uniform accounting system and accounting procedures including a uniform classification of accounts and similar depreciation methods.

2. Following a uniform accounting period preferably on a natural business year basis.

3. Following similar asset valuation and amortization policies.

4. Represent a homogenous group.

5. Adopt and maintain somewhat uniform managerial policies.

 

SOURCES OF INFORMATION FOR DECISION MAKING:

Relying upon Ratios:

The accounts have been analysed, the ratios calculated and interpreted. A decision now has to be made, and a Solution suggests itself. But can you rely sufficiently on the ratios to be sure that your solution is correct? The answer is no. Ratio analysis is useful, but not omniscient. Ratios form part and a substantial part of research into a company, but not all of the research that should take place.

 

Where else to look;

There are other sources of information, some of it not financial, as follows:

Financial Media: There are news stories, analysis of performance, forecasts, tips & hints galore in the financial press.

Local Media: Stories about planned expansion or closure of sites may influence a decision about the company whether the stories are accurate or not.

Employees: They will always have their own opinions.

Company newspaper/journals: This journal will give the official view.

Customers and Suppliers: They can report on their trading experiences.

Trade Exhibitions: These events can provide general information about the company (and its competitors will probably by there too).

Stockbrokers: They will always have views on the merits or otherwise of individual companies.

 

The better the quality of the research carried out and information discovered, the more likely it is that a good decision will be made.

 

 

LIMITATIONS OF RATIO ANALYSIS:

Ratio analysis is very important in revealing the financial position and soundness of the business. But, in spite of its advantages, it has some limitations which restrict its use. These limitations should be kept in mind while making use of ratio analysis for interpreting the financial statements. The following are the main limitations of accounting ratios:

 

1. Out of date: A limited company has a maximum of nine months after the end of its financial year to file its

accounts with the ROC, thus making their results publicity available. Many companies, and particularly private companies, will delay submission until the last few days, even if the accounts were audited and approved within weeks of the year end. Public Companies accounts take longer to prepare and audit because of the sheer size of some of them. 

For whatever reason, however, several months will generally elapse between the end of the company's financial year and the availability of the accounts. That does not mean that the numbers stated are of no use the next year's performance can reasonably be expected to be close to last year's other circumstances permitting. Nevertheless, external influences do change, especially for companies operating globally; customers go into liquidation or suppliers fail, raw material prices change dramatically, foreign currencies move up and down, and so on. There is no guarantee that the future will be the some or better than the past as portrayed in the accounts. Therefore, one must accept the accounts for what they are a report on last year's activities and look around for more current information to add to that derived from the accounts,

2. It communicates only a relative picture: Every organisation in one way or the other is unique and comparison may not be valid. For example, company A may be working in manufacture of heavy electrical goods as a Government Company in India. It is subject to numerous audits and management may not enjoy the full freedom of decision-making due to accountability to Parliament. Its comparison with Siemens, a German Company, may not be 100% valid, because Siemens is an international giant with a different type of management. Ratios do not depict the circumstances, in which the organisations are working.

3. Ratios are only a tool: Ratios are simply tools of analysing and interpretating the financial position of a concern, still a great deal of investigation is needed to be done. Hence more importance must be given to those items which require investigation. Their ultimate use depends on the craftsmen who use it. The background and understanding level of the interpreter is very important in making inferences. For this reason, it is said that they are not an end in themselves. Rather they are means to an end. They only pass guiding signals, 

4. False results if based on incorrect accounting data: Accounting ratios can be correct only if the data (on which they are based) are correct. Sometimes, the information given in the financial statements is affected by window dressing, i.e. showing position better than what actually is. For example, if inventory values are inflated or deprecation is not charged on fixed assets, not only will one have an optimistic view of profitability of the concern but also of its financial position. So the analyst must always be on the look-out signs of window dressing, if any. 

5. Affected by Window Dressing: Sometimes, attempts are made to window dress the accounts, i.e., efforts are made to manipulate the accounts in a manner that the picture being presented is better than what actually it is. Hence an analyst must pay attention towards window dressing. For example, a company may be having a lot of capital locked in inventory. Company might have allowed unwarranted price reduction to dispose of the inventory. This particular step may have far reaching consequences, but this fact will not be revealed by ratio analysis. Another example is disposal of investments at the end of the year to pay off creditors.

6. Inflation distorts financial ratio analysis: No attention is paid in financial statements on changes in price level. Hence the ratios based on these financial statements are misleading. Changes in the reported performance of a company may be entirely due to inflation and not due to management. For this reason company may have to use replacement cost method or other suitable device used to differentiate the impact of inflation.

7. No idea of probable happenings in future: Ratios are an attempt to make an analysis of the past financial statements; so they are historical documents. Now-a-days keeping in view the complexities of the business, it is important to have an idea of the probable happenings in future.

8. Variation in Accounting Methods: The two firm's results are comparable with the help of accounting ratios only if they follow the same accounting methods and policies. Comparison will become difficult if the two concerns follow the different methods of providing depreciation or valuing stock. Similarly, if the two firms are following two different standards and methods, an analysis by reference to the ratios would be misleading. Moreover, utilisation of inbuilt facilities, availability of facilities and scale of operation would affect financial statements of different firms. Comparison of financial statements of such firms by means of ratios is bound to be misleading.

9. Only one method of analysis: Ratio analysis is only a beginning and gives just a fraction of information needed for decision-making. So, to have a comprehensive analysis of financial statements, ratios should be used along with other methods of analysis.

10. No Common Standards: It is very difficult to lay down a common standard for comparison because circumstances differ from concern to concern and the nature of each industry is different. For example, a business with current ratio of more than 2: 1 might not be in a position to pay current liabilities in time because of an unfavourable distribution of current assets in relation to liquidity. On the other hand, another business with a current ratio of even less than 2:1 might not be experiencing any difficulty in making the payment of current liabilities in time because of its favourable distribution of current assets in relation to liquidity.

11. Ignores Qualification Factors: During ratio analysis no attention is paid towards the qualitative analysis because the ratios are calculated from the figures which can be expressed in monetary terms. Accounting ratios are tools of quantitative analysis only. But sometimes qualification factors may surmount the quantitative aspects. The calculations derived from the ratio analysis under such circumstances may get distorted. For example, though credit may be granted to a customer on the basis of information regarding his financial position, yet the grant of credit ultimately depends on debtor's character, honesty, past record and his managerial ability.

12. Effect of Personal Ability and Bias of the Analyst: Accounting ratios are affected by personal ability and

of the analyst. Hence they must be used with due care and skill. Ratios are based on accounting figures given in the financial statements. However, accounting figures are themselves subject to deficiencies, approximations, diversity practice of even manipulation to some extent. Therefore, ratios are not very helpful in drawing reliable conclusions.

 

CLASSIFICATION OF RATIOS:

The ratios can be classified on the basis of requirements of various uses, e.g., creditors, bankers, investors, management, government etc.

 

The ratios may be classified as follows:

(1) Profitability Ratios: These ratios measure how efficiently a company management has generated profit on sales and investment, e.g., operating ratio, gross profit ratio, Net Profit ratio, Return on Capital Employed, Net Profit to Net Worth ratio, etc.

(2) Activity Ratios: These ratios show how efficiently a company is using its assets to generate sales, e.g., Fixer

Assets turnover ratio, Working Capital turnover ratio, Inventory turnover ratio, debtor turnover ratio etc.

(3) coverage Ratios: The soundness of a firm, from the view-point of long-term creditors & Preference shares, lies in its ability to service their claims. This ability is indicated by the coverage ratios.

(4) Market Test Ratios: The market test ratios are especially important for investors while analysing information about a company. This analysis helps the investors to decide about a company as an investment opportunity at a point of time. These ratios are also known as stock market ratios, investment ratios or market test ratios.

(5) Liquidity Ratios: These ratios show a company's ability to meet its short-term financial obligations like current ratio and quick ratio.

(6) Long Term solvency Ratios: These ratios measure the extent to which a company has been financed by long-term debt obligations like debt-equity ratio. It measures the ability of an enterprise to survive over a long period of time.

 

The ratio analysis necessarily proceeds on the following assumptions:

(1) That the financial statements show a reasonable picture of the condition of a company.

(2) That the financial statements from which the ratios are calculated present a typical and up-to-date picture.

(3) That the figures in the financial statements of a company are comparative with the data of other company’s financial statements.

 

PROFITABILITY RATIOS:

The main objective of a company is to earn profits because profits are necessary to survive and grow over a long period of time. The long-term survival of a business enterprise depends on satisfactory income earned by it. Profit is the ultimate output of a company, and it will have no future if it fails to make sufficient profits. It may be noted that profit is an absolute term while profitability is a relative term. The word profitability, a composite of two words ‘profit’ and ‘ability’, signifies the ability of a business to earn profits on its investments & sales. The word 'profit" can be defined as the excess of total revenues over the expenses for a given period. The word 'ability' shows the power of concern to earn profits. An evaluation of a company's past profits may give the investors, creditors and others a better understanding for decision-making. The profitability position also affects the liquidity position which is vital to creditors as well. Profitability ratios try to establish relationship among profit, turnover, capital employed etc. Profitability ratios measure the income or operating success of an enterprise for a given period of time. These ratios are:

 

(A) Profitability Ratios Based on Sales (Income Statement Profitability Ratios)

 

1. Cost of Goods Sold Ratio (COGS Ratio): This ratio indicates the proportion that the cost of goods sold bears sales and is expressed in percentage terms. Cost of goods sold includes the carrying amount of inventory sold. It is calculated as under:

 

Cost of Goods Sold or COGS Ratio = (Cost of Goods Sold or COGS)/(Net Sales )×100

 

Where, COGS = Opening Stock + Net Purchases + Direct Expenses – Closing Stock

Net Sales = total Sales – Sales Return

 

Lower the ratio, the better it is. Higher the ratio, the less favourable it is because it would have a smaller margin of Gross profit for covering other operating expenses, such as office 6: administration expenses, selling & distribution expenses, payment of interest & dividends and the creation of reserves.

2. Gross Profit Ratio (GP Ratio) or Gross Margin Percentage: This ratio establishes a relationship between

oss profit earned by a business organisation against its Net Sales, and is expressed as a percentage. It is computed as follows:

 

Gross Profit Ratio or GP Ratio = (Gross Profit or GP)/(Net Sales )×100

 

Where, COGS = Opening Stock + Net Purchases + Direct Expenses – Closing Stock

Net Sales = total Sales – Sales Return

 

This ratio is calculated to find the profitability of business. A high ratio of gross profit to sales is a sign of good management. It may also be indicative of a higher sales price without a corresponding increase in the cost of goods sold. It is also likely that cost of goods sold might have declined without a corresponding decline in sales price. If the Gross Profit ratio is lower than expectation, then it provides that profit in the business is not sufficient comparison to sales. This situation is not healthy for the business. Hence, a low Gross Profit ratio should be carefully investigated. A low ratio indicates unfavourable trends in the form of reduction in selling prices not accompanied by proportionate decrease in cost of goods sold or increase in cost of goods sold or reduction in sales volume with or without reduction in selling price. Gross profits should be adequate to cover expenses, dividends and building up of reserves.

 

Relationship between COGS ratio & GP ratio

COGS Ratio = 100 5 GP Ratio A

GP Ratio = 1oo - COGS Ratio

 

3. Expenses Ratio: Another profitability ratio related to sales is the expenses ratio. It is computed by dividing

expenses by sales. The term 'expenses' includes (i) cost of goods sold, (ii) administrative expenses, (iii) selling and distribution expenses. Another classification is: (i) Fixed expenses, (ii) Variable expenses.

 

(1) COGS Ratio has been discussed above

(2) Office & Administration Expenses Ratio = Office & Administration Expenses x 100

Net Sales

(3) Selling A Distribution Expenses Ratio = Selling & Distribution Expenses x 100

Net Sales

(4) Fixed Expenses Ratio = Fixed Expenses x 100

     Net Sales

(5) Variable Expenses Ratio = Variable Expenses x 100

Net Sales

 

The Expenses Ratio is closely related to the profit margin, gross as well as net. The expenses ratio shows what percentage share of sales is consumed by each expense. The expenses ratio is very important for analysing the profitability of a firm. It should be compared over a period of time with the industry average as well as firms of similar type. As a working proposition, a low ratio is favourable, while a high one is unfavourable. The implication of a high expenses ratio is that only a relatively small percentage share of sales is available for financial liabilities like interest, and dividends.

 

4. Profit/Volume Ratio (P/V Ratio): P/V ratio expresses the relationship between contribution and sales. Better H P/V ratio is an index of Sound 'financial health' of a company's product. One important characteristic of P/V ratio is  that it remains the same at all levels of output. The other terms being used to refer to P/V ratio are: (a) Marginal Income Ratio, (b) Contribution to Sales Ratio, and (c) Variable Profit Ratio. P/V ratio may be expressed as:

 

P/V Ratio =  Contribution/(Net Sales)×100

 

Contribution = Sales - Variable Cost

Or = Fixed Cost + Profit

 

A change in fixed cost does not result in change in P/V ratio since P/V ratio expresses relationship between contribution and sales. P/V ratio helps in determining the break-even point. It helps in determining profit at various sales levels. It helps to find out the sales volume to earn a desired quantum of profit.

5. Operating Ratio: This ratio establishes a relationship between the Operating Costs and the Net Sales. Operating Costs includes Cost of Goods Sold as well as other operating expenses, i.e. administration, selling and distribution expenses which have matching relationship with sales. It excludes non operating expenses which have no bearing on production, administration and sales, such as: interest paid on long-term loans and debentures, penalties, donations, loss by fire, etc. It also excludes non-operating incomes such as: interest and dividend received on investment, profit on sale of fixed assets or long term investments, etc. It is calculated as under:

 

Operational Ratio =  (Operations Costs)/(Net Sales)×100

 

=  (Cost of Goods Sold+Other Operating Expenses)/(Net Sales)×100

 

Where, Other Operating Expenses = Office & Administration expenses + Selling & Distribution Expenses

 

Lower the ratio, the better it is. A high ratio is unfavourable since it will leave only a small amount of operating income to meet interest, dividends etc. The Operating ratios of a firm should be compared with the ratios of the similar firms and the industry average. This will reveal the true picture. Operating ratios are related with cost structure of a firm.

6. Net Operating Profit Ratio (NOP Ratio): This ratio establishes the relationship between Net Operating profit or Earnings Before Interest <& Tax (EBIT) and sales and is computed as follows:

 

Net Operating Profit Ratio =  (Net Operating Profits or EBIT)/(Net Sales)×100

 

Where EBIT = GP – Other Operating Expenses

 

This ratio indicates the portion remaining out of every rupee worth of sales after all operating costs and expenses have been met. Higher the ratio the better it is.

 

Relationship between Net Operating Profit Ratio & Operating Ratio:

Net Operating Profit Ratio = (100 - Operating Ratio)

Operating Ratio = (100 - Net Operating Profit Ratio)

 

7. Net Profit Ratio (NP Ratio) or Net Margin Percentage: This ratio is very useful to the proprietors and prospective investors because it reveals the overall profitability of the concern. This ratio measures the relationship between net profits and sales of a firm. This is the ratio of Net Profit after taxes to net sales and is calculated as follows:

 

Net Profit Ratio =  (Net Profit )/(Net Sales)×100

 

Where, Net Profit = Profit after Tax (PAT)

 

The NP ratio is indicative of managements ability to operate the business with sufficient success not only to recover from revenues of the period, the cost of merchandise or services, the expenses of operating the business (including depreciation) and the cost of the borrowed funds, but also to leave a margin of reasonable compensation to the owners for providing their capital at risk. This ratio is a Symbol of profitability and efficiency of the business. Higher the ratio the more favourable for the business as it denotes Sound management and efficiency. Lower ratio reveals decline in profits and mismanagement.

The ratio differs from the Net Operating Profit ratio in as much as it is calculated after deducting non-operating expenses, such as interest expense, income tax liability, loss on sale of fixed assets etc, from operating profit and adding non-operating income like interest or dividends on investments, tax refunds, profit on sale of investments or fixed assets, etc. to net operating profit. Higher the ratio, the better it is because it gives an idea of improved efficiency of the concern.

To conclude, the profitability ratios based on sales are an important indicator of the operational efficiency of a trading & a manufacturing enterprise. However, they suffer from a serious limitation in that they are not useful from the viewpoint of the owners of the firm.

 

(B) Profitability Ratios Based on Capital & Investment:

 

8. Return on Capital Employed or Return on Investment: This ratio measures the relationship between Net profit before interest and tax and average capital employed. This ratio is an indicator of the earnings capacity on the capital employed in the business. The objective of computing this ratio is to determine how efficiently the long term funds supplied by the creditors and shareholders have been used. It is calculated as under:

Return on Capital Employed =  (Operating Net Profit before Interest adn Tax or EBIT )/(Capital Employed)×100

 

Where, EBIT = Gross Profits - Other Operating Expenses

Or EBIT = NP + Provision for Tax + Interest on Long Term Debts + Other Non Operating Expenses A Losses (but not accrual adjustments for amortisation of Preliminary Expenses, Goodwill, Patents right, Copyright, Trademarks etc.) - Non Operating Incomes A Gains (such as: Interest/Dividend from Non-Trade Investments, Prof it on sale of Fixed Assets A Investments)

Capital Employed = Equity Share Capital + Reserves A Surplus + Preference Share Capital + Long term debt - Fictitious Assets A Losses - Non Trade Assets

Or Capital Employed = Net Fixed Assets (including intangible Fixed Assets like Goodwill, Patents, Copyrights and trademarks) + Net Working Capital + Trade Investments (if any)

 

This ratio measures profitability of total capital employed in the business. This ratio helps in determining as to what extent the management has been successful in increasing the income of the shareholders through the use of borrowed capital. This ratio is an important tool for making investment decisions: a project yielding higher return is favourable as it reveals more profit. This ratio is considered to be the most important ratio because it reflects the overall efficiency with which capital is issued. 

9. Return on Equity (ROE): Return on Equity has been analysed by various authors in two manners, namely:

(a) Return on Total Shareholder's Funds

(b) Return on Equity Shareholder's Funds

 

(a) Return on Shareholder's Funds Ratio: This ratio, also called Return on Proprietor’s Funds/Return on Net Worth is a measure of the percentage of net profit to average shareholder's funds. The ratio is expressed as follows:

 

Return on Shareholder^' s Funds Ratio =  (Net Profit After Tax )/(Shareholder^' sFunds)×100

 

Where, Shareholder's Funds/Net Worth/Proprietor's Funds/Owner's Equity =

Equity Share Capital + Paid-up Preference Share Capital + Reserves A Surplus (preferably excluding Revaluation Reserve) - Fictitious Assets A Losses

 

The ratio of Net profit to Shareholders' Funds shows the extent to which profitability objective is being achieved for the shareholders of the Company. Higher the ratio, the better it is.

(b) Return on Equity Shareholder's Funds: Another widely used profitability ratio is return on common stockholder equity. It measures profitability from the common stockholders' (equity shareholders) viewpoint. This ratio is calculated to find out how efficiently the funds supplied by the equity shareholders have been used. It is computed by dividing net income available for equity shareholders by average equity shareholders funds. When preference shareholders are present, preferred dividend requirements are deducted from net income to compute income available for equity stockholders. It is calculated as under:

 

Return on Equity Shareholder s Funds Ratio =  (Net Profit After Tax & Preference Dividends )/(Equity Shareholder' sFunds)×100

 

 

Where Equity Shareholder's Funds Where, Equity Shareholder's Funds = Equity Share Capital + Reserves & Surplus (preferably excluding revaluation reserve) - fictitious Assets & Losses

 

Higher the ratio the more efficient the management and utilisation of equity shareholder's funds. The Return on Equity may be substantially higher than its Return on Total Assets. The reason for this is effective use of leverage or trading on the equity at a gain. Trading on the equity at a gain means that the company has borrowed money at a lower rate of interest than it is able to earn by using the borrowed money. 

 

10. Return on Operating Assets: This ratio measures a relationship between net operating profits after tax and average Operating assets. The objective of determining this ratio is to find out how efficiently the assets invested in the business have been used by the management in order to earn operating profits after tax. This ratio is expressed as follows:

 

Return on Operating Assets =  (Net Operating Profits After Tax & NOPAT)/(Operating Assets)×100

 

Where, NOPAT = EBIT (1 - Income Tax Rate)

Operating Assets = Total Assets (Excluding Fictitious Assets) - Non Trade Assets

 

This ratio reveals the profitability of operating assets. Higher the ratio, the more beneficent is for the concern.

11. Return on Total Assets: The Return on Total Assets measures the prof itability of the total investments of a company. The ratio is computed by dividing net income after tax by average total assets. This ratio is calculated to measure the profit after tax against the amount invested in total assets to ascertain whether assets are being utilised properly or not. It is calculated as under:

 

Return on Total Assets =  (Net Profit After Tax or PAT )/(Total Assets (Excluding Fictitious Assets))×100

 

Where, Total Assets = Total Assets side of Balance sheet (excluding Fictitious Assets)

 

The higher the ratio, the better it is for the concern. This ratio reveals the profitability of total assets; hence it throws light on how efficiently the assets (whether business assets or non trade assets) are used by the management to earn profits for the company. If, however, throws no light on the profitability of the different sources of funds which finance the total assets.

 

ACTIVITY OR PERFORMANCE OR TURNOVER RATIOS:

Investment of the funds of creditors and owners in various kinds of assets is done to generate sales and profit. The effective management of Assets & Capital Employed will increase the amount of sales. Activity ratios are computed to evaluate the efficiency with which the firm manages and utilises its assets & Capital. These ratios are very important for a concern to judge how well facilities at the disposal of the concern are being used or to measure the effectiveness with which a concern uses its resources at its disposal. These ratios are usually calculated on the basis of sales or cost of sales and are expressed in times rather than as a percentage. Higher the turnover ratio, the better the use of capital or resources will be. Some of the important ratios are discussed below:

 

1. Fixed Assets Turnover Ratio: This ratio expresses the relationship between the Sales & Average Net Fixed Assets. The way to ascertain the ratio is:

 

Fixed Assets Turnover Ratio =  (Net Sales )/(Net Fixed Assets)

 

Where, Net Fixed Assets = 6ross Fixed Assets - Accumulated Depreciation

 

This ratio is most useful for manufacturing concern since sales are produced not only by the use of working capital but also by the capital invested in fixed assets. This ratio indicates how effectively and profitably the fixed assets of a business are used. The higher is the ratio, the better is the performance. On the other hand a low ratio indicates that Fixed Assets are not being efficiently utilised.

 

2. Total Assets Turnover Ratio: This ratio is also known as Total Investment /Resources Turnover Ratio establishes a relationship between Average Total Assets & Sales. Asset Turnover measures how efficiently a company uses its assets to generate sales.

 

Total Assets Turnover Ratio =  (Net Sales )/(Total Assets )

 

This ratio indicates how effectively and profitably the total assets of a business are used. Total Assets mean Current Assets plus Net Fixed Assets. Total assets do not include Fictitious Assets but some authors do not include intangible fixed assets like goodwill, patents, copyright etc also. A high ratio is an indicator of overtrading of total assets while a low ratio reveals idle capacity.

3. Current Assets Turnover Ratio: This ratio establishes a relationship between Average Current Assets à & sales. This ratio indicates how effectively current assets are being utilised by the concern. The way to ascertain the ratio is:

 

Current Assets Turnover Ratio =  (Net Sales )/(Current Assets )

 

This ratio is most useful for non-manufacturing concern since the sales are produced mainly by Current Assets as compared to Fixed Assets. This ratio indicates the effective use of Current Assets.

4. Capital Turnover Ratio: This ratio establishes a relationship between Average Capital Employed in business and Sales. This ratio shows the efficiency of Capital Employed in the business. The way to ascertain the ratio is as follows:

 

Current Turnover Ratio =  (Net Sales )/(Capital Employed )

 

Higher ratio indicates effective management and proper utilisation of Capital Employed. A low Capital Turnover Ratio should be taken to mean that sufficient sales are not being made and profits are lower.

5. Net Working Capital Turnover Ratio: This ratio establishes a relationship between Average Net Working Capital & Sales. This ratio indicates how effectively working capital is being utilised by the concern. Net Working Capital means Current Assets minus Current Liabilities. The way to ascertain the ratio is:

 

Net Working Capital Turnover Ratio =  (Net Sales )/(Net Working Capital )

Where, Net Working Capital - Current Assets - Current Liabilities

 

The higher the ratio, the lesser is the investment in Working Capital and the greater are the profits. A very high ratio is a sign of overtrading and a low ratio indicates undertrading, i.e. working capital is not effectively used.

6. Debtors Turnover Ratio or Receivables Turnover Ratio: It measures the number of times, on Average, Accounts Receivables (Trade Debtors and Bills Receivables) are collected during the period. Receivables Turnover is computed by dividing Net Credit Sales (Net Sales less Cash Sales) by the Average Net Receivables. The way to ascertain the ratio is:

 

Debtors Turnover Ratio =  (Net Credit Sales )/(Accounts Receivable (Debtors+Bills Receivables))

 

Where Net Credit Sales, = Net Total Sales - Cash Sales

 

Receivables or Debtors Turnover Ratio determines the liquidity of one item of current assets and finds out how faster debts are being collected. The Debtors Turnover Ratio throws light on the collection and credit policies of the firm. The firm can compare what credit period it receives from the suppliers and what it offers to the customers. Also it can compare the Average Credit Period offered to the customers in the industry to which it belongs. In case, credit sales figure is not separately given, total sales figure can be assumed to be credit sales.

7. Stock or Inventory Turnover Ratio: Inventory Turnover Ratio measures the number of times on an average the inventory is sold during the period. Its purpose is to measure the liquidity of the inventory. The Inventory Turnover ratio is computed by dividing Cost of Goods Sold by the Average Inventory. The way to ascertain the ratio is:

 

Inventory Turnover Ratio =  (Cost of Goods Sold/Cost of Sales or COGS)/(Stocks in trade/Finished Goods Inventory)

 

COGS = (a) Opening Stock + Net Purchases + Direct Expenses - Closing Stock (b) Manufacturer = Opening Finished Goods Inventory + Net Factory Cost of Goods Produced - Closing Finished Goods Inventory

This ratio is computed for traders in regard to their Stock in trade and for manufacturer in regard to their inventory of finished goods. Generally, the faster the Inventory Turnover, the lesser the cash is tied up in inventory and the lesser the chances of inventory obsolescence. A smaller, faster-moving inventory means that the company has less cash tied up in inventory. On the contrary a low ratio would signify that inventory does not sell fast and stays on the shelf or in the warehouse for a long time. A build up in inventory means that a recession or some other factor is preventing sales from keeping pace with purchasing and production. Inventory Turnover Ratios vary considerably among industries. Even within a company there may be significant differences in Inventory Turnover among different products. Higher the ratio, the better it is because it shows that finished stock is rapidly turned-over. On the other hand, a low Stock Turnover Ratio is not desirable because it reveals the accumulation of obsolete stock, or the carrying of too much stock. Due to lack of information regarding Cost of Goods Sold, Inventory Turnover may be computed with reference to Sales Value instead of Cost of Sales or Cost of Goods Sold.

8. Raw Materials Turnover Ratio: For manufacturers this ratio is computed to measure the movement of row material from storeroom to consumption stage. Raw Materials Turnover Ratio states the number of times on an Average the inventory of raw material is converted into consumption during the period. The Raw Materials Turnover ratio is computed by dividing Raw Materials Consumed by the average inventory of raw materials. This ratio can be computed as follows:

 

Raw Materials Turnover Ratio =  (Raw Materials Consumed )/(Inventory of Raw Materials)

 

Where, Raw Materials Consumed = Opening Stock of Raw Material + Net Purchases of Raw Materials - Closing Stock of Raw Materials

 

A higher ratio shows that the raw material inventory is fast moving and a lower ratio implies that the inventory of raw material is slow moving. Perishable raw materials and raw materials having risk of change in technology and fashion h®* a high Raw Material Turnover ratio and durable raw materials have a low Raw Material Turnover ratio.

9. Work in Progress (WIP) Turnover Ratio: For manufacturers this ratio is computed to measure the rate conversion of WIP inventory to production stage. Work in progress Turnover Ratio states the number of times on are average the inventory of Work in progress is converted into Production during the period. The Work in progress Turnover ratio is computed by dividing Net Factory Cost by the Average Inventory of Work in progress. This ratio can be computed as follows:

 

Work in Progress Turnover Ratio =  (Net Factory Cost of Goods Produced )/(Inventory of WIP)

 

Where, Net Factory Cost of Goods produced = Raw Materials Consumed + Conversion Costs Opening stock of Work in Progress - Closing Stock of Work in Progress

 

A higher ratio shows that the Work in progress inventory is fast moving and a lower ratio implies that the inventory of Work in progress is slow moving.

10. Creditors (or Accounts Payable) Turnover Ratio. This ratio is used to establish a relationship between Net Credit Purchases and Average Trade Creditors. The objective of calculating this ratio is to determine the efficiency with which the creditors are managed. This ratio gives the average credit period enjoyed from the creditors and is calculated as under:

 

Creditors Turnover Ratio =  (Net Credit Purchases )/(Accounts Payable (Creditors+Bills Payable))

 

Where, Net Credit Purchases = Net Total Purchases - Cash Purchases

 

A low turnover ratio reflect liberal credit terms granted by suppliers, while a high ratio shows that accounts are to De

 

settled rapidly. A high ratio indicates that creditors are not paid in time while a low ratio gives an idea that the business is not taking full advantages of credit period allowed by the creditors. The Creditors Turnover Ratio is an important tool of analysis as a firm can reduce its requirement of Current Assets by relying on suppliers credit.

11. Average Collection Period: A popular variant of the Receivables Turnover Ratio is to convert it to an Average Collection Period in terms of days/ weeks/ months. This is done by dividing the Receivables Turnover Ratio into days/ weeks/ months in a year. The Average Collection Period is frequently used to assess the effectiveness of a company s credit and collection policies. The general rule is that the collection period should not greatly exceed the credit term period (the time allowed for payment). The Collection Period is calculated as under:

 

Average Collection Period =  (360/12/52)/(Debtors Turnover Ratio)  Or  (Average Debtors & Bills Receiable)/(Net Credit Sales)×360/12/52

 

This period indicates an average period for which the credit sales remain outstanding and measures the quality of debtors. It indicates the speed with which the money is collected from debtors. This ratio is a measure of the collectability of accounts receivables and tells about how the credit policy of the company is being enforced. The shorter the average collection period the better the quality of debtors as short collection period indicates prompt payments by debtors. A long collection period implies a too liberal and ineffective credit and collection performance by the management. This increases the chances of bad debts.

12. Average Inventory Conversion/Holding Period: A popular variant of inventory turnover is the average days to sell the inventory. It is calculated by dividing the Inventory Turnover into days/ weeks/ months in a year. The average conversion period is frequently used to assess the effectiveness of a company's ability to convert its inventory into sales. The Conversion Period is calculated as under:

Average Finished Good Conversion Period/Average Stock in Trade Holding Period =  (360/12/52)/(Stock Turnover Ratio)

OR

 

(Average Stock in trade/finished Goods)/(Cost of Goods Sold)×360/12/52

This period indicates the speed with which the stock gets turned over into sales. Inventory conversion period vary considerably among industries.

13. Raw Materials Inventory Conversion Period: This period is used to assess the capability of manufacturer's ability to convert its Raw Materials into Consumption. The Conversion Period is calculated as under:

 

Raw Materials Conversion Period=(360/12/52)/(Raw Materials Turnover Ratio)×360/12/52

 

OR

 

(Average Stock of Raw Materials)/(Raw Materails Consumed)×360/12/52

 

This period indicates the speed with which the stock of raw materials gets used. Raw materials inventory conversion period vary considerably from industry to industry.

14. Work in Progress Inventory Conversion Period: This period is used to assess the capability of a manufacturer's ability to convert its Work in progress into production. The Conversion Period is calculated as under:

Work in Progress Conversio nPeriod= (360/12/52)/(Work in Progress Turnover Ratio)×360/12/52

 

OR

 

(Average Stock of Work in Progress)/(Net Factory Cost)×360/12/52

 

This period indicates the speed with which the stock of Work in progress gets turned over into goods produced. Work in progress Inventory conversion period vary depending upon the nature of finished goods.

15. Average Payment Period: A popular variant of the Creditors Turnover Ratio is to convert it to an Average Payment Period terms of days/weeks/months in a year. This is done by dividing the Creditors Turnover Ratio into days weeks/ months in a year. The Average Payment Period (or Average Age of Payables or Creditors Payment Period enjoyed) is used to indicate the speed with which payments for credit purchases are made to creditors. The payment period is calculated as under:

 

Average Payment Period=(360/12/52)/(Creditorts  Turnover Ratio)

 

OR

 

(Average Creditors & Bills Payable)/(Net Credit Purchases)×360/12/52

A high payment period reflects liberal credit terms granted by suppliers, while a low period shows that accounts are t» be settled rapidly.

 

COVERAGE RATIOS:

These ratios are computed from information available in the profit and loss account. For a normal firm, in the ordinary course of business, the claims of creditors are not met out of the sale proceeds of the permanent assets of the firm. The obligations of a firm are normally met out of the earnings or profits. The coverage ratios measure the firm’s ability to service the fixed liabilities. These ratios establish the relationship between fixed claims and what is normally available out of which these claims are to be paid. The fixed claims consist of:

(i) Interest on loans

(ii) Preference dividend

(iii) Amortisation of principal or repayment of the installment of loans or redemption of preference capital on maturity. 

 

The soundness of a firm, from the view-point of long-term creditors, lies in its ability to service their claims. This ability is indicated by the coverage ratios. The coverage ratios measure the relationship between what is normally available from operations of the firms and the claims of the outsiders. The important coverage ratios are:

1. Interest Coverage Ratio: It is also known as 'Time-Interest-Earned Ratio’. This ratio indicates the relationship between net profits before interest and taxes <& interest on long-term debts. Interest Coverage Ratio determines the debt servicing capacity of a business enterprise keeping in view fixed interest on long-term debt. The way to ascertain the ratio is:

 

Interest Coverage Ratio= (Earnings Before Interest and Taxes (EBIT))/(Interest on Long-Term Dbts)

 

Interest Coverage Ratio shows the number of times the interest charges are covered by the income out of which they will be paid. Higher the ratio, the more beneficial it is for the lenders, because this ratio measures the margin of safety for the lenders. The Interest Coverage Ratio measures the degree of protection; creditors have from default on the payment of interest by the company. It provides an indication of the company’s ability to meet interest payments as they become due. A high Interest Coverage Ratio means that an enterprise can easily meet its interest obligations even if earnings before interest and taxes suffer a considerable decline. A lower ratio indicates excessive use of debt or inefficient operations.

2. Preference Dividends Coverage Ratio: It is also known as Cover For Preference Dividends. Preference Dividend Coverage ratio determines the capacity & ability of a business enterprise to service its preference shares. Preference dividend is treated as appropriation of profit. To calculate this ratio the Net Income After Interest and Tax is divided by preference shares dividend, it can be written as:

Prefernce Dividends Coverage Ratio= (Earnings After Tax)/(Preference Dividends)

 

Preference Dividend Coverage Ratio shows the number of times the Preference Dividend charges are covered by the income out of "which they will be paid. The ratio, like the Interest Coverage Ratio, reveals the safety margin available to the Preference shareholders. As a result, the higher the coverage, the better it is from their point of view.

3. Equity Dividends Coverage Ratio: It is also known as Cover for Equity Dividend. It denotes the number of Dividend Per Share is covered by Earnings Per Share or total equity dividends are covered by earnings available for equity shareholders.

 

Equity Dividends Cover= (Earnings Per Share)/(Dividends Per Share)  or  (Earning Available for Equity shareholders)/(Dividends to Equity Shareholders)

 

Dividend cover helps in assessing the prospects for dividend increases. Or, alternatively, the possibility of a dividend art, should profits decline. For the purpose of dividend cover full distribution earnings per share is normally taken into account. In other words, it is assumed that ail profits are distributable as dividends.

4. Total Dividends Coverage Ratio: Total Dividend Coverage Ratio determines the capacity à ability of a business enterprise to service its preference shareholders and equity shareholders together. To calculate this ratio the net income after interest and tax is divided by total dividend, it can be written as:

 

Total Dividends Coverage Ratio= (Earnings After Tax)/(Total Dividend)

 

This ratio indicates that after paying the interest and tax the profits are sufficient to cover and payoff the total dividends. As a rule, the higher the coverage, the better it is from the point of view of both shareholders.

5. Fixed Charges Coverage Ratio: This ratio indicates the relationship between net profits before interest and taxes & total fixed financial charges. This ratio can be computed as follows:

 

Fixed Charges Coverage Ratio= (Earning Before Interest and Taxes (EBIT))/(Interest on Long-Term Debt+ (Preference Dividends)/(1- +))

 

Financial Charges Coverage Ratio shows the number of times the financial charges are covered by the income -out of which they will be paid. Higher the ratio, the more beneficial it is for the fixed finance providers, because this ratio measures the margin of safety for them. It provides an indication of the company's ability to meet the fixed financial charges as they become due.

6. Debt Service Coverage Ratio: This ratio is important from lender’s point of view and indicates whether the business can earn sufficient profits to pay periodically the interest charges & principal installments on long-term loans or debentures. It is considered a more comprehensive and apt measure to compute debt service capacity of a firm. It provides the value in terms of the number of times the total debt service obligations consisting of interest and repayment of principal in installments are covered by the total operating funds available after the payment of taxes. It is calculated as follows:

 

Debt Service Coverage Ratio= (Eat+Interst+Depreciation+Other Non-Cash Expenditures  like Amortisation)/(Interest on Long-Term Liabilities+Installment of Principal)

 

Amortisation includes Intangible Fixed Assets written off, Fictitious assets written off, Loss on Sale of Fixed assets or investments, etc. The higher the ratio, the better it is, the more is the margin of safety for the lenders. A ratio of less than one may be taken as a sign of long-term solvency problem as it indicates that the firm does not generate enough cash internally to service debt If the ratio is one (i.e. profits are just equal to interest), it will show a bad position of the company as nothing will be left for shareholders and will be unsafe for the lenders also.

Debt Service Coverage Ratio indicates the capacity of a firm to service a particular level of debt i.e. repayment of principal and interest. High credit rating firms target Debt Service Coverage Ratio to be greater than 2 in its entire loan life. High DSCR facilitates the firm to borrow at the most competitive rates.

 

MARKET TEST OR MARKET STRENGTH ANALYSIS OR INVESTOR ANALYSIS RATIOS:

The market test ratios are especially important for investors (equity shareholders) while analysing information about stock market performance of a company. This analysis helps the investors to decide about a company as an investment opportunity at a point of time. These ratios are also known as stock market ratios. The ratios under this category area as follows:

1. Dividends per share or DPS: This ratio is calculated by dividing the Dividends payable to Equity Shareholders by Number of Equity Shares. Hence —

 

Dividends Per Share= (Dividend Payable to Equity Shareholders)/(Number of Euiqty shares Outstanding)

 

Higher the ratio, the more favourable it is, because this ratio shows that how much income as profit will be received by the investors. Generally no company distributes entire profits as dividend among shareholders. Some part of the profits is kept as reserves for the purpose of future necessity.

2. Earnings per share (EPS): Earnings per share (EPS) is a measure of the net income earned on each share of common stock. The objective of determining this ratio is to measure the profitability of the firm on equity shares. It is computed by dividing net income by the number of weighted average common shares outstanding during the year. A measure of net income earned on a per share basis provides a useful perspective for determining profitability.

 

Earning Per Share= (Earnings Available for Equity Shareholders (EAE))/(Number of Equity Shares Outstanding)

 

Where, EAE = EAT - Preference Dividends and CDT on Preference Dividends (if any)

 

The terms "earnings per share" and "net income per share" refer to the amount of net income applicable to each share of common stock. If there are both preference and equity share capital, then out of net income first of all, preference dividends should be deducted in order to fund out the net income available for equity shareholders. Higher the earnings per share, better is the performance and prospects of the company. The increasing trend of E.P.S. increases the possibility of more dividend and bonus shares which finally has a favourable effect on the market value of share. This ratio assists in evaluating the prevailing market price of share in the light of earning capacity of the firm.

3. Book value per Share/ Net Asset Value per Share: This ratio is also known as the Theoretical Market Value per share. Net Asset Value per share is the value of net assets attributable to one ordinary share. In simple words, Net asset value is the equity shareholders funds. Net asset value or book value has nothing to do with the market value as shares usually sell in the stock market at several times to its net asset or book value.

 

Net Asset Value Per Share= (Equity Shareholders Funds)/(Number of Equity Shares)

 

Net assets or book value can be considered only as the theoretical value of ordinary shares if the assets unusual for a share price to be very different from the net asset value per share, even where assets in the balance sheet have recently been revalued. In general, the market price of a share price will be influenced by earnings and the dividend- paying potential.

4. Dividends Yield in Equity shares: This ratio is also known as Dividend - Price ratio. The dividend yield indicates the current level of income from a share. This ratio is important for those investors who are interested in the dividend income. The dividend yield is the dividend per share divided by the market price of equity share, expressed as a percentage.

 

Dividends Yield Ratio= (Dividend per share)/(Market Price per share)×100

 

Where, MPS = Avg. Market Price per Equity Share or Closing MPS

 

This ratio indicates return on investment; this may be on average investment or closing investment. Dividend (%) indicates return on paid up value of shares. But yield (%) is the indicator of true return in which share capital is taken at its market value. This ratio shows that how much dividend can be received by an investor if he buys the shares from open market.

 

5. Earnings Yield Ratio: This ratio is also known as Earnings - Price ratio. This ratio shows the relationship between the Earnings Per Share & Market Price Per Share. The earnings yield ratio is the earnings per share divided by the market price of equity share, expressed as a percentage.

 

Earnings Yield Ratio= (Earning Per Share)/(Market Price Per Share)×100

 

The basic view of this ratio is that each investor in equity shares expects a certain amount of earnings, whether distributed or not from the company in whose shares he invests.

6. Dividends Payout Ratio: This ratio is calculated by dividing Dividend Per Share by Earning Per Share. This ratio reveals that how much profits are distributed as cash dividend. Hence it can be written as:

 

Dividends Payout Ratio= (Dividends Per Share)/(Earnings Per Share)×100

 

The payout ratio measures the percentage of earnings distributed in the form of cash dividends. It is computed by dividing cash dividends by net income. Companies that have high growth rates generally have low payout ratios because they reinvest most of their net income into the business.

7. Retention Ratio: This ratio indicates as to what proportion of earning per share has been kept as retained earnings for ploughing bock.

 

Retention Ratio= (Earning Retained)/(Retained Available)×100

 

This ratio is very important from shareholder's point of view as it tells him that that the company has used whole or substantially the whole of its earnings for future growth and expansion purposes, then there are very bright chances of capital appreciation in the price of shares of such company. In other words, an investor who is more interested in capital appreciation must look for a company having high retention ratio.

8. Price-Earning Ratio or P/E Ratio: At any time, the P/E ratio is an indication of how highly the market “rates" & “values" à business. A P/E ratio is best viewed in the context of a sector or market average to get a feel for relative value and stock market pricing. This ratio is helpful in predicting the market price of equity share at some future date and in determining whether the share of a particular firm is undervalued/overvalued. This ratio is determined as:

 

P/E Ratio= (Market Price per Equity Share)/(Earning Per Share) or  MPS/EPS

Where, MPS = Average Market Price per Equity Share or Closing MPS

 

Many investors consider P/E Ratio as the best indicator of the ongoing performance of a company. High growth shares high P/E ratios as investors are willing to pay à greater multiple of current earnings to achieve a higher future growth. If high risk is found in a share, it reduces its market price and hence automatically reduces its P/E ratio. This c helps the shareholders to decide whether shares should be purchased or not in a company. If the shares are to be purchased then it indicates the possibility of capital appreciation. It indicates the payback period to the investors or prospective investors.

9. Market Value to Book Value per Share: This ratio indicates market response of the shareholders' investment. This ratio is determined as:

 

Market value to Book Value Ratio= (Market Value per share)/(Book Value per share)

 

A low ratio would mean that the share has potential of growth in value and that it is underpriced unless there is some mismanagement on account of which this ratio is less. Undoubtedly, higher the ratios better is the shareholders' position in terms of return and capital gains.

 

LIQUIDITY/ SHORT TERM SOLVENCY RATIOS

The term ’liquidity' and ’short-term solvency' are used synonymously. Liquidity analysis aims to measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash. Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity. The aim of liquidity analysis is for a company to have adequate funds on hand to pay bills when they are due. The ability of a firm to meet current/short-term obligations when they become due for payment can hardly be overstressed. In fact, liquidity is a prerequisite for the very survival of a firm. The short-term creditors of the firm are interested in the short-term solvency or liquidity! of a firm. The liquidity ratios measure the ability of a firm to meet its short-term obligations and reflect the short-1 term financial strength/solvency of a firm. Inadequate liquidity is a big financial problem for a firm. If a business! enterprise cannot maintain its short-term debt paying ability, obviously, it cannot maintain a long-term debt-paying ability or long-term solvency.

 

1. Current Ratio: The Current Ratio is a widely used measure for evaluating a company's liquidity and short-term] debt-paying ability. This ratio reveals the relationship between current assets and current liabilities. This ratio is] computed as follows:

 

Current Ratio= (Current Assets)/(Current Liabilities)

 

Where, Current Assets = Inventories + Sundry Debtors + Cash and Bank Balances + Receivables + Accrued Incomes + Loans and Advances + Short Term Marketable Investments

Current Liabilities = Creditors for Goods and Services + Short-term Loans + Bank Overdraft + Cash Credit + Outstanding Expenses + Accrued expenses + Provision for Taxation + Proposed Dividends +  Unclaimed Dividends

 

The Current Assets of a firm, represent those assets which can be converted into cash within a short period of time, normally not exceeding one year and include cash and bank balances, short term marketable securities, inventory of raw Materials, Semi-Finished (Work-In-Progress) and Finished Goods, Loans and Advances, Debtors net of Provision for Bad and Doubtful Debts, Bills Receivable and Prepaid Expenses. The current liabilities defined as liabilities which are short-term maturing obligations to be met, as originally contemplated, within a year, consist of Trade Creditors, Bills Payable, Provision for Taxation, Outstanding Expenses, Bank Overdraft, Cash Credits, Proposed Dividends a Unclaimed Dividends.

The main question answered by this ratio is: "Does the business under consideration have sufficient Current Assets to meet the payment schedule of its Current Liabilities with a margin of safety for a possible reduction in value of current assets?"

A Current Ratio of 2:1 is considered as ideal, i.e. if Current Ratio is 2 or more it means that the concern has the ability to meet its current obligations but if this ratio is less than 2 it indicates that the concern has difficulty in meeting its current obligations. But whether or not a specific ratio is satisfactory depends on the nature of the business and the characteristics of its Current Assets and Liabilities. While calculating and using the current ratio it must be seen, that:

(i) The quality of both receivables (debtors and bills receivables) and inventory, has been kept in mind; and

(ii) All Current Assets and Current Liabilities have been properly taken into account and correct valuation of them have been done.

The Current Ratio is only one measure of liquidity. It does not take into account the composition of the current assets. For example, a satisfactory current ratio does not disclose the fact that a portion of the Current Assets may be tied up in slow-moving inventory. A rupee of cash would be more readily available to pay the bills than a rupee of slow- moving inventory. Thus, the Current Ratio is not a conclusive index of the real liquidity of a firm.

A Company’s Current Ratio can be compared with the Company's past Current Ratios and with Industry Averages as well. Such comparisons can help in determining if the current ratio is high or low at this period in time. However, these comparisons do not indicate why the current ratio is high or low. Possible reasons for unsatisfactory current ratio can be found from an analysis of the individual accounts and items which make up the current assets and current liability.

2. Acid-Test/Quick/Liquid Ratio: The acid-test (quick) ratio is a measure of a company's immediate short-term liquidity. It is computed by dividing the Liquid assets by Current liabilities. Thus, it is an important compliment to the current ratio. The liquid assets exclude inventory and prepaid expenses. The inventory may not be readily saleable, and the prepaid expenses may not be transferable to others. Thus, the acid-test ratio measures immediate liquidity. This ratio is computed as follows:

 

Liquid Ratio= (Liquid Assets)/(Current Liabilities)

 

Where, Liquid Assets = Current Assets - Stock - Prepaid Expenses

 

The term quick assets refer to current assets which can be converted into cash immediately or a short notice without diminution of value. Included in the category or current assets are (i) cash and bank balances; (ii) short-term marketable securities and (iii) debtors/ receivables. Thus, the current assets which are excluded are: prepaid expenses and inventory. The exclusion of inventory is based on the reasoning that there is uncertainty about its selling price & it is not easily and readily convertible into cash. But in seller's market or specific inventories readily saleable inventories are also near cash assets. Hence their realisable value is liquid assets. Moreover, if there is a lag in collection of debtors, slow moving debtors are also not quick assets. Prepaid expenses by their very nature are not available to pay off current debts.

The main question answered by this ratio is: “If new sales revenues disappear, could the business under consideration -set its current obligations with the readily convertible ’quick' funds on hand?“ The usual guideline for the acid test rotio is 1:1. However, some industries may find that a ratio less than 1:1 is adequate, while others need a ratio greater than 1:1.

Sometimes for the purpose of Quick Ratio, bank overdraft & cash credits are not included in the in the calculation of quick liabilities for the simple reason that bank overdraft & cash credits facility is not withdrawn by the banks ail of a sudden à these can be used as a source of finance as and when required. If it is accepted, the quick ratio should be calculated as Quick Assets divided by Quick Liabilities. In such a case, 

 

Quick Ratio= (Quick Assets)/(Quick Liabilities)

 

Where, Quick Liabilities = Current Liabilities - Bank Overdraft - Cash Credit

3. Absolute Liquidity/Cash Ratio: A subsequent innovation in ratio analysis, the absolute liquidity ratio eliminates any unknowns surrounding receivables. The absolute liquidity ratio only tests short-term liquidity in term of cash and marketable securities (absolute liquidity available with the firm). This ratio establishes a relationship between absolute Squid assets and current liabilities. There are two components of this ratio which are as under:

(i) Absolute liquid Assets which mean marketable securities, cash in hand and bank balance.

(ii) Current liabilities will be as per mentioned in the current ratio. Some authors do not include bank overdraft. Absolute liquidity ratio is calculated as follows:

 

Absolute Liquidity Ratio= (Cash Reservoir)/(Current Liabilities)

 

Where, Cash Reservoir = Cash in hand and at bank + Short-term Marketable Securities

 

Liquidity of a firm can be viewed from an extremely conservative point of view. This may be the case when severe liquidity problems with inventory and receivables are likely to happen. In this situation, the short-term liquidity of a company may be measured through cash ratio. Cash ratio is not given much importance unless a firm is in deep financial trouble. The desirable norms for this ratio is 1 : 2 i.e. Rs.1 worth of absolute liquid assets are sufficient for Rs.2 worth of current liabilities. Even though the ratio gives a more meaningful measure of liquidity, it is not in much use because the idea of keeping a large cash balance or near cash items has long since been disproved. Cash balance yields no return and as such is barren.

4. Defensive Interval/Cash Interval Ratio: The liquidity ratios of a firm outlined in the preceding discussions throw light on the ability of a firm to pay its current liabilities. Apart from paying current liabilities, the liquidity position of a firm should also be examined in relation to its ability to meet projected daily expenditure from operations. The defensive-interval ratio provides such a measure of liquidity. If for some reason ail the company's revenues were to suddenly cease, the basic defense interval would help determine the number of days the company can cover its cash expenses without the aid of additional financing. It is a ratio between the Absolute liquid assets and the projected daily cash requirements and is calculated as follows:

 

Defensive-Internal Ratio= (Cash Reservoir+Receivables)/(Projected Daily Cash Requirement)

 

The projected cash operation expenditure is based on past expenditure and future plans. The defensive-interval ratio measures the time span a firm can operate on present liquid assets (comprising cash & marketable securities).

6. Ratio of Inventory to Working Capital: In order to ascertain that there is no overstocking, the ratio of inventory to working capital should be calculated. It is worked out as follows:

 

Inventory to Working Capital Ratio= Inventory/(Working Capital)

 

Working Capital is the excess of Current Assets over Current Liabilities. Increase in volume of sales required increase in size of inventory, but from a Sound financial point of view, inventory should not exceed amount of working capital. The desirable ratio is 1:1.

 

LONG TERM SOLVENCY RATIOS:

Long term Solvency ratios measure the ability of the company to survive over a long period of time. Long-tem creditors, business managers, supplier A shareholders are particularly interested in a company's ability to pay interest as it comes due and to repay the face value of debt at maturity. The long-term solvency of a firm can be examined by using leverage or capital structure ratios. Leverage or Capital Structure ratios are calculated to judge the long-term financial position of the firm. These ratios reveal the funds provided by owners and outsiders. These ratios show how much amount is introduced by the owner in business, generally these ratios are beneficial to the long-term creditors like debenture holders, financial institutions etc. The process of magnifying the shareholders return through the employment of debt is called 'trading on equity'. The owner’s equity is treated as a margin of safety by creditors; of the equity base is thin, the creditors risk will be high. Thus, leverage ratios are calculated to measure the financial risk and the concern's ability of using debt for the benefit of shareholders. Usually the following ratios are calculated to judge the long term financial solvency of the Company:-

1. Debt-Equity Ratio: The relationship between borrowed funds and owner's capital is a popular measure of the long-term financial solvency of a firm. This ratio indicates the relationship between long term debts and shareholder's fund. Some people call it financial leverage ratio also. The objective of calculating this ratio is the measure the relative proportion of debt and equity in financing the assets of a firm.

This ratio can be expressed as:

 

Debt-Equity Ratio (D/E Ratio)= Debt/Equity or  (Outsider^' sFunds)/(Shareholder^' sor Proprietor^' sFunds or Net Worth)

 

 

Where, Outsiders Fund = Long Term Loan (whether secured or unsecured), e.g. debentures, bonds, loans from financial institutions

Shareholders Fund = Equity Share Capital + Preference Share Capital + Reserves and Surplus - Fictitious Assets and Losses

 

Whether a given debt to equity ratio shows a favourable or unfavourable financial position of the concern depends on the industry and the pattern of the concern depends on the industry and the pattern of earning. A low ratio is generally viewed as favourable from long-term creditors. A low ratio shows a greater claim of owners than creditors. From the creditors point of view it represents a larger margin of safety since owners equity is treated as margin of safety by creditors. During the periods of low profits the debt surviving will prove to be less burdensome for a firm with low debt-equity ratio. The same low ratio may be taken as quite unsatisfactory by the shareholders because they fine neglected opportunity for using low cost outsiders* funds to acquire fixed assets that could earn a high return.

A high D/E Ratio shows that the claims of creditors are greater than those of owners. A very high ratio is unfavourable from the owner's point of view. This causes hindrance in the firm's operations due to the increasing pressure and interference of creditor in management. A high debt company finds difficulty in raising additional debt. During the periods of low profits a highly debts company suffers great strain, it cannot earn sufficient profits even to pay the interest charges of creditors. In this case the firm enjoys the benefits of trading on equity when it earns a rate higher than the interest rate on borrowed funds. The desirable norms for this ratio is 2 : 1.

2. Debt to Total Funds Ratio/Debt ratio: The relationship between borrowed funds and total capital is another popular measure of the long-term financial solvency of a firm. This ratio indicates the relationship between long term debts and total long term funds.

This ratio can be expressed as:

 

Debt to Total Funds Ratio= Debt/(Debt+Equity)

 

Where, Outsiders Funds = Long Term Loan (whether secured or unsecured), e.g. debentures, bonds, loans from financial institutions

Total Funds = Shareholders Funds + Long Term Debts

The desirable norms for this ratio is 2 : 3.

 

3. Proprietors Funds to Total Funds Ratio/Equity Ratio: This ratio indicates proportion of owners' fund to total fund invested in the business. Traditionally, it is believed that higher the proportion of owners' fund lower is the degree of risk.

 

Equity Ratio= (Shareholder^' s Equity)/(Debt+Equity)

 

The desirable norms for this ratio is 1: 3.

5. Debt to Total Assets/ Debt to Value Ratio: It is also called debt to total resources ratio or only debt ratio. The Debt to Total Asset ratio measures the percentage of the total assets provided by creditors. It is computed by dividing debt (long-term liabilities) by total assets. This ratio indicates the company's degree of leverage. It also provides some indication of the company's ability to withstand losses without impairing the interests of creditors.

 

Debt to Total Assets Ratio= Debt/(Total Assets)

 

 

The higher the percentage of debt to total assets, the greater the risk that the company may be unable to meet its maturing obligations. The lower the ratio, the more equity "butter" there is available to the creditors. Thus, from the creditors' point of view, a low ratio of debt to total assets is usually desirable. The adequacy of this ratio is often judged in the light of the company's earnings: Generally, companies with relatively stable earnings (such as public utilities) have higher debt to total ratios than cyclical companies with widely fluctuating earnings (such as many high- tech companies).

5. Proprietary Ratio: This ratio is also known as Net Worth to Total Assets Ratio. The Proprietary Ratio shows the relationship between shareholder's funds and total assets. This ratio is worked out as follows:

 

Proprietary Ratio= (Shareholder^' sFunds/Net Worth/Proprietary Funds)/(Total Assets)

 

Where, Proprietary Funds = Equity Share Capital + Preference Share Capital + Reserve A Surplus - Fictitious Assets

 

Total assets = Assets side of Balance Sheet excluding Fictitious Assets and Losses

 

This ratio shows that how much capital is introduced by the owner in business. Higher ratio means a Sound position of business, because it shows that the organisation is not run through outside funds which mean less interference and pressure of outsiders. 

This ratio should be 1: 3 i.e. one-third, of the assets minus current liabilities should be acquired by shareholders' funds and the other two-thirds of the assets should be financed by outsiders' funds.

6. Gearing or Capital Gearing Ratio: This ratio establishes the relationship between the fixed interest A dividend bearing securities and equity shareholders funds of a company. It is calculated as follows:

 

Captial Gearomg Ratio= (Fixed Interest & Dividend bearing Securities)/(Equity Shareholder^' s Fund)

 

Where, Fixed Interest A dividend bearing Securities = Preference Share Capital + Debentures + Long Term Loan Equity Shareholder's Fund = Equity Share Capital + Reserves A Surplus - Losses

 

Fixed interest A dividend bearing securities carry with them the fixed rate of dividend or interests include preference Capital Gearing Ratio indicates the relationship between fixed cost bearing capital and variable cost bearing capital. Fixed cost bearing capital means the capital upon which rate of return is fixed, e.g. long-term loan (whose rate of interest is fixed) and preference share capital (rate of dividend is fixed). Variable cost capital means the capital upon which rate of return is not fixed because its rate of dividend keeps on changing. It includes equity share capital, reserves and undistributed profits. A highly geared capital is one which has a small proportion of equity capital, including any reserves or undistributed profits which may be regarded as being part of interest of ordinary shareholders. If the larger proportion of total capital is made up of equity capital, the capital is said to be low geared. The higher the ratio the more beneficial for the firm because at the time of prosperity the owners will enjoy the benefits of 'trading on equity1, while at time of depression they will have to suffer a lot because they will have to pay the interest whether they are in loss or profit. When the rate of interest is fixed higher gearing ratio is beneficial for shareholders.

 

4. Fixed Assets Ratio: This ratio gives an idea as to what part of the capital employed has been used in purchasing the fixed assets for the concern. This ratio is calculated as under:

 

Fixed Assets Ratio= (Fixed Assets)/(Capital Employed)

 

If the ratio is less than one it is good for the concern.

5. Ratio of Current Assets to Fixed Assets: This ratio states the relationship between current assets & fixed assets of the company. A decrease in the ratio may mean that trading is slack or more mechanisation has been put through. An increase in the ratio may reveal that inventories and debtors have unduly increased or fixed assets have been intensively used. An increase in the ratio, accompanied by increase in profit, indicates that business is expanding. 

This ratio is worked out as;

 

Current Assets to Fixed Assets Ratio= (Current Assets)/(Fixed Assets)

 

This ratio will differ from industry to industry and, therefore, no standard can be laid down.