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# The principal tools of analysis are Ratio analysis i.e.

.e. to determine the relationship between any set of two parameters and compare it with the past trend. In the statements of accounts, there are several such pairs of parameters and hence ratio analysis assumes great significance. The most important thing to remember in the case of ratio analysis is that you can compare two units in the same industry only and other factors like the relative ages of the units, the scales of operation etc. come into play. Funds flow analysis this is to understand the movement of funds (please note the difference between cash and fund cash means only physical cash while funds include cash and credit) during any given period and mostly this period is 1 year. This means that during the course of the year, we study the sources and uses of funds, starting from the funds generated from activity during the period under review. Let us see some of the important types of ratios and their significance: Liquidity ratios; Turnover ratios; Profitability ratios; Investment on capital/return ratios; Leverage ratios and Coverage ratios. Liquidity ratios: o Current ratio: Formula = Current assets/Current liabilities. Min. Expected even for a new unit in India = 1.33:1. Significance = Net working capital should always be positive. In short, the higher the net working capital, the greater is the degree of overall short-term liquidity. Means current ratio does indicate liquidity of the enterprise. Too much liquidity is also not good, as opportunity cost is very high of holding such liquidity. This means that we are carrying either cash in large quantities or inventory in large quantities or receivables are getting delayed. All these indicate higher costs. Hence, if you are too liquid, you compromise with profits and if your liquidity is very thin, you run the risk of inadequacy of working capital. Range No fixed range is possible. Unless the activity is very profitable and there are no immediate means of reinvesting the excess profits in fixed assets, any current ratio above 2.5:1 calls for an examination of the profitability of the operations and the need for high level of current assets. Reason = net working capital could mean that external borrowing is involved in this and hence cost goes up in maintaining the net working capital. It is only a broad indication of the liquidity of the company, as all assets cannot be exchanged for cash easily and hence for a more accurate measure of liquidity, we see quick asset ratio or acid test ratio. o Acid test ratio or quick asset ratio: Quick assets = Current assets (-) Inventories which cannot be easily converted into cash. This assumes that all other current assets like receivables can be converted into cash easily. This ratio examines whether the quick assets are sufficient to cover all the current liabilities. Some of the authors indicate that the entire current liabilities should not be considered for this purpose and only quick liabilities should be considered by deducting from the current

liabilities the short-term bank borrowing, as usually for an on going company, there is no need to pay back this amount, unlike the other current liabilities. Significance = coverage of current liabilities by quick assets. As quick assets are a part of current assets, this ratio would obviously be less than current ratio. This directly indicates the degree of excess liquidity or absence of liquidity in the system and hence for proper measure of liquidity, this ratio is preferred. The minimum should be 1:1. This should not be too high as the opportunity cost associated with high level of liquidity could also be high. What is working capital gap? The difference between all the current assets known as Gross working capital and all the current liabilities other than bank borrowing. This gap is met from one of the two sources, namely, net working capital and bank borrowing. Net working capital is hence defined as medium and long-term funds invested in current assets. Turn over ratios: Generally, turn over ratios indicate the operating efficiency. The higher the ratio, the higher the degree of efficiency and hence these assume significance. Further, depending upon the type of turn over ratio, indication would either be about liquidity or profitability also. For example, inventory or stocks turn over would give us a measure of the profitability of the operations, while receivables turn over ratio would indicate the liquidity in the system. o Debtors turn over ratio this indicates the efficiency of collection of receivables and contributes to the liquidity of the system. Formula = Total credit sales/Average debtors outstanding during the year. Hence the minimum would be 3 to 4 times, but this depends upon so many factors such as, type of industry like capital goods, consumer goods capital goods, this would be less and consumer goods, this would be significantly higher; Conditions of the market monopolistic or competitive monopolistic, this would be higher and competitive it would be less as you are forced to give credit; Whether new enterprise or established new enterprise would be required to give higher credit in the initial stages while an existing business would have a more fixed credit policy evolved over the years of business; Hence any deterioration over a period of time assumes significance for an existing business this indicates change in the market conditions to the business and this could happen due to general recession in the economy or the industry specifically due to very high capacity or could be this unit employs outmoded technology, which is forcing them to dump stocks on its distributors and hence realisation is coming in late etc. o Average collection period = inversely related to debtors turn over ratio. For example debtors turn over ratio is 4. Then considering 360 days in a year, the average collection period would be 90 days. In case the debtors turn over ratio increases, the average collection period would reduce, indicating improvement in liquidity. Formula for average collection period = 360/receivables turn over ratio. The above points for debtors turn over ratio hold good for this also. Any significant deviation from the past trend is of greater significance here than the absolute numbers. No minimum and no maximum.

o Inventory turn over ratio as said earlier, this directly contributes to the profitability of the organisation. Formula = Cost of goods sold/Average inventory held during the year. The inventory should turn over at least 4 times in a year, even for a capital goods industry. But there are capital goods industries with a very long production cycle and in such cases, the ratio would be low. While receivables turn over contributes to liquidity,

this contributes to profitability due to higher turn over. The production cycle and the corporate policy of keeping high stocks affect this ratio. The less the production cycle, the better the ratio and vice-versa. The higher the level of stocks, the lower would be the ratio and vice-versa. Cost of goods sold = Sales profit Interest charges. o Current assets turn over ratio not much of significance as the entire current assets are involved. However, this could indicate deterioration or improvement over a period of time. Indicates operating efficiency. Formula = Cost of goods sold/Average current assets held in business during the year. There is no min. Or maximum. Again this depends upon the type of industry, market conditions, managements policy towards working capital etc. o Fixed assets turn over ratio Not much of significance as fixed assets cannot contribute directly either to liquidity or profitability. This is used as a very broad parameter to compare two units in the same industry and especially when the scales of operations are quite significant. Formula = Cost of goods sold/Average value of fixed assets in the period (book value). Profitability ratios -Profit in relation to sales and profit in relation to assets: o Profit in relation to sales this indicates the margin available on sales; o Profit in relation to assets this indicates the degree of return on the capital employed in business that means the earning efficiency. Please appreciate that these two are totally different. For example, we will study the following; Units A and B are in the same type of business and operate at the same levels of capacities. Unit A employs capital of 250 lacs and unit B employs capital of 200lacs. The sales and profits are as under: Parameter Unit A Unit B Sales 1000lacs 1000lacs Profits 100lacs 90lacs Profit margin on sales 10% 9% Return on capital employed 40% 45% While Unit A has higher profit margins, Unit B has better returns on capital employed. o Profit margin on sales: Gross profit margin on sales and net profit margin ratio Gross profit margin = Formula = Gross profit/net sales. Gross profit = Net sales (-) Cost of production before selling, general, administrative expenses and interest charges. Net sales = Gross sales (-) Excise duty. This indicates the efficiency of production and serves well to compare with another unit in the same industry or in the same unit for comparing it with past trend. For example in Unit A and Unit B let us assume that the sales are same at Rs.100lacs. Parameter Unit A Unit B Sales Cost of production Gross profit Deduct: Selling general, Administrative expenses and interest Net profit 100lacs 60lacs 40lacs 35lacs 5lacs 100lacs 65lacs 35lacs 30lacs 5lacs

While both the units have the same net profit to sales ratio, the significant difference lies in the fact that while Unit A has less cost of production and more office and selling expenses, Unit B has more cost of production and less of office and selling expenses. This ratio helps

in controlling either production costs if cost of production is high or selling and administration costs, in case these are high. Net profit/sales ratio net profit means profit after tax but before distribution in any form = Formula = Net profit/net sales. Tax rate being the same, this ratio indicates operating efficiency directly in the sense that a unit having higher net profitability percentage means that it has a higher operating efficiency. In case there are tax concessions due to location in a backward area, export activity etc. available to one unit and not available to another unit, then this comparison would not hold well. Investment on capital ratios/Earnings ratios: o Return on net worth Profit After Tax (PAT) / Net worth. This is the return on the shareholders funds including Preference Share capital. Hence Preference Share capital is not deducted. There is no standard range for this ratio. If it reduces it indicates less return on the net worth. o Return on equity Profit After Tax (PAT) Dividend on Preference Share Capital / Net worth Preference share capital. Although reference is equity here, all equity shareholders funds are taken in the denominator. Hence Preference dividend and Preference share capital are excluded. There is no standard range for this ratio. If it comes down over a period it means that the profitability of the organisation is suffering a setback. o Return on capital employed (pre-tax) Earnings Before Interest and Tax (EBIT) / Net worth + Medium and long-term liabilities. This gives return on long-term funds employed in business in pre-tax terms. Again there is no standard range for this ratio. If it reduces, it is a cause for concern. o Earning per share (EPS) Dividend per share (DPS) + Retained earnings per share (REPS). Here the share refers to equity share and not preference share. The formula is = Profit after tax (-) Preference dividend (-) Dividend tax both on preference and equity dividend / number of equity shares. This is an important indicator about the return to equity shareholder. In fact P/E ratio is related to this, as P/E ratio is the relationship between Market value of the share and the EPS. The higher the PE the stronger is the recommendation to sell the share and the lower the PE, the stronger is the recommendation to buy the share. This is only indicative and by and large followed. There is something known as industry average EPS. If the P/E ratio of the unit whose shares we contemplate to purchase is less than industry average and growth prospects are quite good, it is the time for buying the shares, unless we know for certain that the price is going to come down further. If on the other hand, the P/E ratio of the unit is more than industry average P/E, it is time for us to sell unless we expect further increase in the near future. Leverage ratios Leverages are of two kinds, operating leverage and financial leverage. However, we are concerned more with financial leverage. Financial leverage is the advantage of debt over equity in a capital structure. Capital structure indicates the relationship between medium and long-term debt on the one hand and equity on the other hand. Equity in the beginning is the equity share capital. Over a period of time it is net worth (-) redeemable preference share capital. It is well known that EPS increases with increased dose of debt capital within the same capital structure. Given the advantage of debt also, as even risk of default, i.e., nonpayment of interest and non-repayment of principal amount increases with increase in

debt capital component, the market accepts a maximum of 2:1 at present. It can be less. Formula for debt/equity ratio = Medium and long-term loans + redeemable preference share capital / Net worth (-) Redeemable preference share capital. From the working capital lending banks point of view, all liabilities are to be included in debt. Hence all external liabilities including current liabilities are taken into account for this ratio. We have to add redeemable preference share capital and reduce from the net worth the same as in the previous formula. Coverage ratios o Interest coverage ratio This indicates the number of times interest is covered by EBIT. Formula = EBIT / Interest payment on all loans including short-term liabilities. Minimum acceptable is 2 to 2.5:1. Less than that is not desirable, as after paying interest, tax has to be paid and afterwards dividend and dividend tax. o Asset coverage ratio This indicates the number of times the medium and long-term liabilities are covered by the book value of fixed assets. Formula = Book value of Fixed assets / Outstanding medium and long-term liabilities. Accepted ratio is minimum 1.5:1. Less than that indicates inadequate coverage of the liabilities. o Debt Service coverage ratio This indicates the ability of the business enterprise to service its borrowing, especially medium and long-term. Servicing consists of two aspects namely, payment of interest and repayment of principal amount. As interest is paid out of income and booked as an expense, in the formula it gets added back to profit after tax. The assumption here is that dividend is ignored. In case dividend is paid out, the formula gets amended to deduct from PAT dividend paid and dividend tax. Formula is: (Numerator) Profit After Tax (+) Depreciation (+) Deferred Revenue Expenditure written off (+) Interest on medium and long-term borrowing (Denominator) Interest on medium and long-term borrowing (+) Installment on medium and long-term borrowing. This is assuming that dividend is not paid. In the case of an existing company dividend will have to be paid and hence in the numerator, instead of PAT, retained earnings would appear. The above ratio is calculated for the entire period of the loan with the bank/financial institution. The minimum acceptable average for the entire period is 1.75:1. This means that in one year this could be less but it has to be made up in the other years to get an average of 1.75:1.