International financial and management accounting lesson 05

82 International Financial and Management Accounting LESSON RATIO ANALYSIS CONTENTS 5.0 5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9 5.10 5.11 Aims and Objectives Introduction Purposes of the Ratio Analysis Utility of the Ratio Analysis Classification of Ratios 5.4.1 On the Basis of Financial Statements 5.4.2 On the Basis of Functions 5.4.3 Short-term Solvency Ratios 5.4.4 Leverage Ratios/Capital Structure Ratios 5.4.5 Debt -Equity Ratio 5.4.6 Proprietary Ratio 5.4.7 Fixed Assets Ratio 5.4.8 Coverage Ratios 5.4.9 Interest Coverage Ratio 5.4.10 Return on Assets 5.4.11 Turnover Ratio Limitations of the Ratio Analysis Dupont Analysis Let us Sum up Lesson End Activity Keywords Questions for Discussion Suggested Readings 5.0 AIMS AND OBJECTIVES In this lesson we shall discuss about various types of ratio analysis After going through this lesson you will be able to: Apply the accounting ratios to extract the financial performance of the firm from the financial statements Study not only the quantitative results of the firm but also qualitative factors viz solvency, liquidity and so on 5.1 INTRODUCTION The ratio analysis is one of the important tools of financial statement analysis to study the financial stature of the business fleeces, corporate houses and so on How the ratios are able to facilitate to study the financial status of the enterprise? What is meant by ratio? The ratio illustrates the relationship in between the two related variables What is meant by the accounting ratio? The accounting ratios are computed on the basis available accounting information extracted from the financial statements which are not in a position to reveal the status of the enterprise The accounting ratios are applied to study the relationship in between the quantitative information available and to take decision on the financial performance of the firm Definition According to J Betty, “The term accounting is used to describe relationships significantly which exist in between figures shown in a balance sheet, Profit & Loss A/c, Trading A/c, Budgetary control system or in any part of the accounting organization.” According to Myers “Study of relationship among the various financial factors of the enterprise.” How the Accounting Ratios are expressed? To understand the methodology of expressing the ratios, the expression of ratios should highlighted in the following discussion: Expression Quotient Current Ratio /Leverage Ratio Percentage Net Profit Ratio Time Stock Turnover Ratio Fraction Fixed assets to capital employed Figure 5.1: Methodology of Expressing the Ratios 5.2 PURPOSES OF THE RATIO ANALYSIS To study the short-term solvency of the firm - liquidity of the firm To study the long-term solvency of the firm - leverage position of the firm To interpret the profitability of the firm - profit earning capacity of the firm To identify the operating efficiency of the firm - turnover of the ratios 5.3 UTILITY OF THE RATIO ANALYSIS Easy to understand the financial position of the firm: The ratio analysis facilitates the parties to read the changes taken place in the financial performance of the firm from one time period to another Measure of expressing the financial performance and position: It acts as a measure of financial position through Liquidity ratios and Leverage ratios and also a measure of financial performance through Profitability ratios and Turnover ratios 83 Ratio Analysis Intra firm analysis on the financial information over many number of years: The financial performance and position of the firm can be analysed and interpreted within the firm in between the available financial information of many number of years; which portrays either increase or decrease in the financial performance 84 International Financial and Management Accounting Inter firm analysis on the financial information within the industry: The financial performance of the firm is studied and interpreted along with the similar firms in the industry to identify the presence and status of the respective firm among others Possibility for financial planning and control: It not only guides the firm to earn in accordance with the financial forecasting but also facilitates the firm to identify the major source of expense, which drastically has greater influence on the earnings Check Your Progress 1 Ratio is an expression of: (a) Quotient (b) Time (c) Percentage (d) Fraction (e) (a), (b), (c) & (d) Accounting ratios are to study: (a) Accounting relationship among the variables (b) The relationship in between the variables of financial statements (c) The relationship in between the variables of financial statements for analysis and interpretations (d) None of the above Accounting ratios are of: (a) Income statement ratios (b) Positional statement ratios (c) Both (a) & (b) (d) None of the above 5.4 CLASSIFICATION OF RATIOS The accounting ratios are classified into various categories viz.: On the basis of financial statements On the basis of functions 5.4.1 On the Basis of Financial Statements Income Statement Ratios: These ratios are computed from the statements of Trading, Profit & Loss account of the enterprise Some of the major ratios are as following GP ratio, NP ratio, Expenses Ratio and so on Balance Sheet or Positional Statement Ratios: These types of ratios are calculated from the balance sheet of the enterprise which normally reveals the financial status of the position i.e short-term, long-term financial position, Share of the owners on the total assets of the enterprise and so on Inter Statement or Composite Mixture of Ratios: Theses ratios are calculated by extracting the accounting information from the both financial statements, in order to identify stock turnover ratios, debtor turnover ratio, return on capital employed and so on 85 5.4.2 On the Basis of Functions On the basis of Solvency position of the firms: Short-term and Long-term solvency position of the firms On the basis of Profitability of the firms: The profitability of the firms are studied on the basis of the total capital employed, total asset employed and so on On the basis of Effectiveness of the firms: The effectiveness is studied through the turnover ratios - Stock turnover ratio, Debtor turnover ratio and so on Capital Structure ratios: The capital structure positions are analysed through leverage ratios as well as coverage ratios 5.4.3 Short-term Solvency Ratios To study the short-term solvency or liquidity of the firm, the following are various ratios: Current Assets Ratio Acid Test Ratio or Quick Assets Ratio Super Quick Assets Ratio Defensive Interval Ratio Current Assets Ratio: It is one of the important accounting ratios to find out the ability of the business fleeces to meet out the short financial commitment This is the ratio establishes the relationship in between the current assets and current liabilities What is meant by current assets? Current assets are nothing but available in the form of cash, equivalent to cash or easily convertible into cash What is meant by the current liabilities? Current liabilities are nothing but short-term financial resources or payable in short span of time within a year Current Ratio = Current Assets Current Liabilities Current Ratio Current Assets Current Liabilities Marketable Securities Trade creditors Inventory Bank overdraft Debtors Bills Payable Bills Receivable Provision for taxation Prepaid expenses Outstanding expenses Outstanding Incomes Pre-received incomes Cash at Bank Cash in Hand Figure 5.2: Current Assets Ratio Ratio Analysis 86 Standard norm of the current ratio: International Financial and Management Accounting Implication of High ratio of current assets over the current liabilities: High ratio leads to greater the volume of current assets more than the specified norm denotes that the firm possess excessive current assets than the requirement portrays idle funds invested in the current assets Limitation of the current ratio: Under this ratio, the current assets are equally weighed each other to match the current liabilities Under the current ratio, one rupee of cash is equally weighed at par with the one rupee of closing stock, but the closing stock and prepaid expenses cannot be immediately realized like cash and marketable securities Acid Test Ratio: It is a ratio expresses the relationship in between the quick assets and current liabilities This ratio is to replace the bottleneck associated with the current ratio It considers only the liquid assets, which can be easily translated into cash to meet out the financial commitments Acid Test Ratio (Quick Assets Ratio) = Liquid Assets Current Liabilities Liquid Asset = Current Assets - (Closing Stock + Prepaid expenses) Quick /Liquid Assets Ratio Quick Assets Marketable Securities Debtors Bills Receivable Cash at Bank Cash in Hand Current liabilities Trade creditors Bank overdraft Bills Payable Provision for taxation Outstanding expenses Pre-received incomes Figure 5.3: Liquid Assets Ratio Standard norm of the ratio: The ideal norm is that 1:1 means: One rupee of current liabilities is matched with one rupee of quick assets Super Quick Assets Ratio: It is the ratio, which establishes the relationship in between the super quick assets and quick liabilities of the firm The super quick assets are nothing but the current assets, which can be more easily converted into cash to meet out the quick liabilities The super quick liabilities are the current liabilities should have to be met out at faster pace within shorter span in duration Super Quick Assets = Cash + Marketable Securities Super Quick Liabilities = Current Liabilities - Bank Over Draft Super Quick Assets Ratio = Super Quick Assets Super Quick Liabilities Standard norm of the ratio: 87 Ratio Analysis Higher the ratio is the better the position of the firm Illustration From the following calculate current ratio Current Assets: Rs Cash in hand 4,00,000 Sundry Debtors 1,60,000 Stock 2,40,000 Current Liabilities: Sundry creditors 3,00,000 Bills Payable 1,00,000 Current Ratio = Current Assets Rs 8,00 ,000 = =2 Current Liabilities Rs.4,00 ,000 Illustration The firm satisfies the standard norm of the Current assets ratio and Liquid assets ratio: M/s Shanmuga & Co Balance sheet as on dated 31st Mar, 2005 Particulars Rs Particulars Share capital 42,000 Fixed Assets Net Reserve 3,000 Stock Annual profit 5,000 Debtors Bank overdraft 4,000 Cash Sundry creditors 34,000 12,400 6,400 13,200 12,000 Total Current Ratio = Rs 66,000 Total 66,000 Rs.32,000 Current Assets = =2 Rs.16,000 Current Liabilities It satisfies the standard norm of the current asset ratio Liquid assets ratio = = Current Assets – Closing Stock Quick Assets = Current Liabilities Current Liabilities Rs.19,600 = 1.225 Rs.16,000 The firm financial position satisfies the standard norm of the Liquid assets ratio 88 International Financial and Management Accounting Illustration Liquid Assets Rs.65,000; Stock Rs.20,000; Prepaid expenses Rs.5,000;Working capital Rs.60,000 Calculate current assets ratio and liquid assets ratio For the computation of current assets ratio, current assets volume must be known It is not available in our problem, instead the liquid assets and prepaid expenses are given together which will facilitate to find the total volume of current assets Current Assets = Liquid Asset + Prepaid expenses + closing stock = Rs.65,000 + Rs.5,000 + 20,000 = Rs.90,000 The next step is to find out the current liabilities The volume of current liabilities could be found out through the available information of working capital Net working capital = Current Assets – Current Liabilities Rs.60,000 = Rs.70,000 – Current liabilities Current liabilities = Rs.90,000 – Rs.60,000 = Rs.30,000 From the above, the current ratio could be found out Current Ratio = Rs.90,000 =3>2 Rs.60,000 The firm satisfies the more than the norm of the current ratio It means that the firm keeps excessive current assets more than that of requirement Quick Assets Ratio = Rs.65,000 = 2.17 Rs.30,000 The firm keeps more liquid assets than that of the specified norm means that excessive liquid assets are held by the firm than the requirement in the form of idle not productive in utility Illustration The current ratio of Bicon Ltd is 4.5: and liquidity ratio is 3:1 stock is Rs.6,00,000 Find out the current liabilities To find out the volume of current liabilities, initially the share of closing stock should be found out in the total of current assets Share of stock = Current Assets Ratio – Liquid Assets Ratio = 4.5 – 3.0 = 1.5 Share of the stock = 1.5 If the share of the stock is 1.5 which amounted Rs.6,00,000 What is the volume of current liabilities for the ratio of 1? Current liabilities = Rs.6,00,000 = Rs.4,00,000 1.5 89 5.4.4 Leverage Ratios/Capital Structure Ratios Ratio Analysis The capital structure ratios are classified into two categories: Leverage Ratios: Long-term solvency position of the firm - Principal repayment Coverage Ratios: Fixed commitment charge solvency of the firm - Dividend coverage and Interest coverage Capital Structure Ratio Leverage Ratios Coverage Ratios Debt–Equity Ratio Total Debt–Equity Ratio Proprietary Ratio Fixed Assets Ratio Interest Coverage Ratio Dividend Coverage Ratio Figure 5.4: Capital Structure Raio Under the capital structure ratios, the composition of the capital structure is analysed only in the angle of long-term solvency of the firm 5.4.5 Debt-Equity Ratio It is the ratio expresses the relationship between the ownership funds and the outsiders' funds It is more specifically highlighted that an expression of relationship in between the debt and Shareholders' funds The debt-equity ratio can be obviously understood into two different forms Long term debt–equity ratio Total debt–equity ratio Long-term debt-equity ratio: It is a ratio expresses the relationship in between the outsiders' contribution through debt financial resource and Shareholders' contribution through equity share capital, preference share capital and past-accumulated profits It reveals the cover or cushion enjoyed by the firm due to the owners' contribution over the outsiders' contribution Debt-Equity Ratio = Debt (Long-term debt – Debentures/Term Loans) Net worth/Equity (Shareholder's fund) Higher ratio indicates the riskier financial status of the firm, which means that the firm has been financed by the greater outsiders' fund rather than that of the owners' fund contribution and vice versa Standard norm of the Debt-Equity Ratio: The ideal norm is that 1:2 which means that every one rupee of debt finance is covered by the rupees of shareholders' fund The firm should have a minimum of 50% margin of safety in meeting the long-term financial commitments If the ratio exceeds the specification, the interest of the firm will be ruined by the outsiders' during the moment at when they are unable to make the 90 International Financial and Management Accounting payment of interest in time as per the terms of agreement reached earlier During the moment of liquidation, the greater ratio may facilitate the creditors to recover the amount due lesser holding held by the owners Total Debt-Equity Ratio: The ultimate purpose of the ratio is to express the relationship total volume of debt irrespective of nature and shareholders' funds If the owners' contribution is lesser in volume in general irrespective of its nature leads to worse situation in recovering the amount of outsiders' contribution during the moment of liquidation Total Debt-Equity Ratio = Short-term debt + Long-term debt Equity (Shareholder's fund) 5.4.6 Proprietary Ratio The ratio illustrates the relationship in between the owners' contribution and the total volume of assets In simple words, how much funds are contributed by the owners in financing the assets of the firm Greater the ratio means that greater contribution made by the owners' in financing the assets Proprietary Ratio = Owners' Funds or Equity or Shareholders' funds Total Assets Standard norm of the ratio: Higher the ratio is better the position Higher ratio is better position for the firm as well as safety to the creditors 5.4.7 Fixed Assets Ratio The ratio establishes the relationship in between the fixed assets and long-term source of funds Whatever the source of long-term funds raised should be used for the acquisition of long-term assets; it means that the total volume of fixed assets should be equivalent to the volume of long-term funds i.e the ratio should be equal to Fixed Assets Ratio = Shareholders' funds + Outsiders' funds Net Fixed Assets If the ratio is lesser than one means that the firm made use of the short-term fund for the acquisition of long-term assets If the ratio is greater than one means that the acquired fixed assets are lesser in quantum than that of the long-term funds raised for the purpose In other words, the firm makes use of the excessive funds for the built of current assets Standard norm of the ratio: The ideal norm of the ratio is 1:1 which means that the long-term funds raised only utilised for the acquisition of long-term assets of the enterprise It facilitates to understand obviously about the over capitalization or under capitalization of the assets of the enterprise 5.4.8 Coverage Ratios These ratios are computed to know the solvency of the firm in making the periodical payment of interest and preference dividends The interest and preference dividends are to be paid irrespective of the earnings available in the hands of the firm In other words, these are known as fixed commitment charge of the firm 91 5.4.9 Interest Coverage Ratio Ratio Analysis The firms are expected to make the payment of interest on the amount of borrowings without fail This ratio facilitates the prospective lender to study the strength of the enterprise in making the payment of interest regularly out of the total income To study the capacity in making the payment of interest is known as interest coverage ratio or debt service coverage ratio The ability or capacity is analysed only on the basis of Earnings before interest and taxes (EBIT) available in the hands of the firms Greater the ratio means that better the capacity of the firm in making the payment of interest as well as greater the safety and vice versa Interest coverage ratio = Earnings before interest and taxes Interest Lesser the times the ratio means that meager the cushion of the firm which may lead to affect the solvency position of the firm in making payment of interest regularly Dividend coverage ratio: It illustrates the firms' ability in making the payment of preference dividend out of the earnings available in the hands of the firm after the payment of taxation If the size of the Profits after taxation is greater means that greater the cushion for the payment of preference dividend and vice versa The preference dividends are to be paid without fail irrespective of the profits available in the hands of the firm after the taxation Dividend coverage ratio = Earnings after taxation Preference Dividend Standard norm of the ratio: Higher the ratio means that the firm has greater cushion in meeting the needs of preference dividend payment against Earnings after taxation (EAT) and vice versa Profitability Ratios: The ratios are measuring the profitability of the firms in various angles viz On sales On investments On capital employed and so on While discussing the measure of profitability of the firm, the profits are normally classified into various categories: Gross Profit Net Profit Earnings before interest and taxes Earnings after taxation and so on All profitability ratios are normally expressed only in terms of (%) The return is normally expressed only in terms of percentage, which warrant the expression of this ratio to be also in percentage 94 International Financial and Management Accounting Debtors velocity: This is an extension of the earlier ratio to denote the effectiveness of the collection department in terms of duration Debtors velocity = 365 days/52 weeks/12 months Debtors turnover ratio Standard norm of the ratio: Lesser the duration shows greater the effectiveness in collecting the dues which means that the collection department takes only minimum period for collection and vice versa Creditors turnover ratio: It shows effectiveness of the firm in making use of credit period allowed by the creditors during the moment of credit purchase Creditors Turnover ratio = Credit Purchase Credit Purchase or Bills Payable Sundry Creditors Average Creditors Standard norm of the ratio: Lesser the ratio is better the position of the firm in liquidity management means enjoying the more credit period from the creditors and vice versa Creditors velocity = 365 days/52 weeks/12 months Creditors Turnover Ratio Standard norm of the ratio: Greater the duration is better the liquidity management of the firm in availing the credit period of the creditors and vice versa Check Your Progress 2 Solvency position of the firm studied and interpreted through: (a) Short-term solvency ratios (b) Long-term solvency ratios (c) Coverage ratios (d) (a), (b) & (c) Efficiency and effectiveness of the firm is studied through: (a) Liquidity ratios (b) Leverage ratios (c) Turnover ratios (d) Profitability ratios Profitability ratios to study the potential to earn profits on: (a) On Assets (b) On Capital employed (c) On Sales (d) (a), (b) & (c) Illustration Sundaram & Co sells goods on cash as well as credit basis The following particulars are extracted from the books of accounts for the calendar 2005: Particulars Rs Total Gross sales 2,00,000 Contd Cash sales (included in above) 40,000 Sales returns 14,000 Total Debtors 18,000 Bills receivable 4,000 Provision for doubtful debts 2,000 Total creditors 20,000 Calculate average collection period To find out the average collection period, first Debtors turnover ratio has to computed Net credit sales Bills receivable Debtors Debtors turnover ratio = Net credit sales = Gross sales – cash sales – sales return = Rs.2,00,000 – Rs.40,000 – Rs.14,000 = Rs.1,46,000 Debtor turnover ratio = Rs.1,46,000 Rs.4,000 + Rs.18,000 = 6.64 times 365 days 365 days = = 55 days Debtors turnover ratio 6.64 times Debtors velocity = Illustration Find out the value of creditors from the following: Sales Rs.1,00,000 Opening stock Rs10,000 Gross profit on Sales 10% Closing stock Rs.20,000 Creditors velocity 73 days Bills payable Rs.16,000 Note: All purchases are credit purchases: To find out the volume of purchases, the formula of cost of goods sold should taken into consideration Cost of goods sold = Opening stock + Purchases - Closing stock X = Rs.10,000 + Y - Rs.20,000 Cost of goods sold = Sales – Gross profit = Rs.1,00,000 –10% on Rs.1,00,000 = Rs.90,000 The next step is to apply the found value in the early equation Purchases = Rs 90,000 – Rs.10,000 + Rs.20,000 = Rs.1,00,000 To find out the value creditors, the creditor velocity and creditors turnover ratio Creditors velocity = 365 days Creditors turnover ratio 95 Ratio Analysis 96 International Financial and Management Accounting Creditors turnover ratio = Credit purchases Bills payable Sundry creditors = Rs.1,00,000 Rs.16,000 + Sundry Creditors The next step is to find out the sundry creditors, the reversal process to be adopted 73 days = 365 days Creditors turnover ratio The next step is to substitute the found value in the equation of creditors turnover ratio Rs.16,000 + Sundry creditors = Rs.1,00,000 Sundry creditors = Rs.20,000 – Rs.16,000 = Rs.4,000 Illustration From the following information, prepare a balance sheet show the workings: Rs Working capital 75,000 Reserves and surplus Bank overdraft Current ratio 1.75 Liquid Ratio 1.15 Fixed assets to proprietors' fund 75 Long-term liabilities Nil 1,00,000 60,000 (B.Com Madras, April 1980) First step is to find out the current liabilities Current ratio = Current Assets 1.75 = Current Liabilities Working capital = Rs.75,000 = 1.75-1 = 75 If 75 is the share of working capital, what would be the share of current assets? Current assets = Rs.75,000 × 1.75 = Rs 1,75,000 75 Working capital = Current assets – Current liabilities Current liabilities = Current Assets – Working Capital CL = Rs.1,75,000 – Rs.75,000 = Rs.1,00,000 Quick assets ratio = 1.15 = Quick Assets Quick Liabilities 97 Quick Assets = Current Liabilities – BOD Ratio Analysis 1.15 (Rs.1,00,000 – Rs.60,000) = Quick Assets 1.15 (Rs.40,000) = Quick assets Rs 46,000 = Quick assets The next step is to find out the amount of the closing stock This can be found out through finding out the difference in between the current assets and quick assets Closing stock = Current assets – Quick assets = Rs.1,75,000 – Rs.46,000 = Rs.1,29,000 The next one is to find out the proprietors' fund The fixed assets to proprietors' fund is 75 This has to be found out on the basis of Double Entry Accounting Concept Total liabilities = Total Assets (1) Long-term funds + Short-term financial resources = Total liabilities In the long-term funds, there is no long-term liabilities, which means the structure of long-term funds consist of the shareholders' funds The shareholder funds are known as proprietors' fund Short-term financial resources are known as current liabilities Proprietors' fund + Current liabilities = Total liabilities Current assets + Fixed assets = Total assets To substitute the values in the equation (1) Proprietors' fund + Current liabilities = Current assets + Fixed assets Proprietors' fund – Fixed assets= Current assets - Current liabilities 1– 0.75 = Rs.1,75,000 – Rs.1,00,000 0.25 = Rs.75,000 If 0.25 is bearing the volume of Rs 75,000; what would be the volume of investment of fixed assets for 75 and proprietor's fund for Proprietor's fund = Rs.75,000 = Rs 3,00,000 25 75 portion of the owners' funds are contributed to fixed assets i.e 75 on Rs.3,00,000 = Rs.2,25,000 To find out the exact share of the equity share capital, the following formula has to be used: Shareholder's funds = Equity share capital + Reserves and surpluses In this problem, reserves and surpluses is given Rs.3,00,000 = Equity share capital + Rs 1,00,000 Equity share capital = Rs.2,00,000 98 The Balance sheet of the company Ltd as on dated International Financial and Management Accounting Liabilities Rs Assets Rs Share capital 2,00,000 Fixed assets 2,25,000 Reserves and surpluses 1,00,000 Stock 1,29,000 Bank overdraft 60,000 Quick assets Quick liabilities 40,000 46,000 4,00,000 4,00,000 Check Your Progress 3 Standard norm of the current ratio is (a) 2:1 (b) 1:.5 (c) 1:2 (d) 3:1 Super quick assets not include: (a) Closing stock (b) Prepaid expenses (c) Sundry debtors (d) Both (a) & (b) Standard norm of the Debt to Capital: (a) 1:2 (b) 1:1 (c) 2:1 (d) 1:5 Illustration Debtors velocity Creditors velocity Stock velocity Capital turnover ratio Fixed assets turnover ratio Gross profit turnover ratio months months times 2.5 times times 25% Gross profit in a year amounts to Rs.1,60,000 There is no long-term loan or overdraft Reserves and surplus amount to Rs 56,000 Liquid assets are Rs.1,94,666 Closing stock of the year is Rs 4,000 more than the opening stock Bill receivable amount to Rs 10,000 and bills payable to Rs.4,000 Find out: Sales Closing stock Sundry debtors Fixed assets Sundry creditors Proprietors' fund Draft the balance sheet with as many as details possible The first step is to find out the sales Gross profit ratio = 25% The total volume of gross profit is given = Rs.1,60,000 Gross Profit GP ratio = × 100 Sales 25% = Sales = Rs.1,60,000 × 100 Sales Rs.1,60,000 = Rs 6,40,000 25% The next step is to find out the closing stock value In our problem, two important informations given are stock velocity and details about the closing stock in terms of opening stock Stock velocity = times Closing stock is Rs.4,000 excess of opening stock The information stock velocity given denotes that the stock turnover ratio Stock turnover ratio = Cost of goods sold Average stock Now the volume of cost of goods sold has to be found out from the early available information i.e sales and gross profit Cost of goods sold = Sales – Gross profit = Rs.6,40,000 – Rs.1,60,000 = Rs.4,80,000 The next step is to find out the volume of average stock through the earlier formula times = Rs 4,80,000 Average Stock Average stock = Rs.60,000 The next step is to apply the conditionality with regards to closing stock Opening Stock Closing Stock = Rs 60,00 Opening Stock 4,000 = Rs 60,000 Opening stock +Rs.4,000= Rs.1,20,000 Opening stock = Rs.1,20,000-Rs.4,000 Opening stock = Rs.58,000 Closing stock = Opening stock + Rs.10,000 = Rs.58,000 + Rs.10,000=Rs.68,000 The next fact is to be found that sundry debtors To find out the debtors, the most information given debtors velocity and bills receivable have to be made use of 99 Ratio Analysis 100 International Financial and Management Accounting Debtors velocity = 12 months Debtors turnover ratio Debtors turnover ratio = times = 12 months = times months Credit Sales Bills Receivable Sundry Debtors Rs.10,000 + Sundry debtors = Rs 6,40,000 Sundry debtors = Rs.1,60,000 – Rs.10,000 = Rs.1,50,000 The next important stage is to find out the sundry creditors To find out the sundry creditors, the creditors velocity has to be applied in the formula In addition to the earlier, one missing information has to be found out i.e Credit purchases The volume of purchase to be found out through the formula of cost of goods sold Cost of goods sold = Opening stock + Purchases – Closing stock Rs.4,80,000 = Rs.58,000 + Purchases – Rs.68,000 Purchases = Rs.4,80,000 – Rs.58,000 +Rs.68,000 = Rs.4,80,000 + Rs.10,000 = Rs.4,90,000 Creditors velocity = 12 months Creditors turnover ratio Creditors turnover ratio = 6times = 12 months = times months Rs 4,90,000 Rs 4,000 Sundry Creditors Rs.4,000 + Sundry creditors = Rs.81,667 Sundry creditors = Rs 77,667 The next step is to find out the volume of fixed assets This could be found out with the help of fixed assets turnover ratio = times Fixed assets turnover ratio = times = Fixed assets = Sales Fixed Assets Rs.6, 40,000 times = Rs.1,28,000 101 Proprietors' fund Ratio Analysis Proprietor's fund = Fixed assets + Current Assets – Current liabilities The above equation is coined on the basis of Double accounting concept Fixed assets + Current assets = Total assets = Total Liabilities Total Assets – Current liabilities = Total Liabilities – Current liabilities Current assets volume is not known In such cases the stock volume should be added with the Liquid assets to derive the early mentioned Current assets = Closing stock + Liquid Assets = Rs.68,000+ Rs.1,94,666=Rs2,62,666 Proprietor's fund = Rs.1,28,000 + Rs.2,62,666 - Rs.81,667 = Rs.3,08,999 Share capital = Proprietor's fund - Reserves and surpluses = Rs.3,08,999- Rs.56,000= Rs.2,52,999 Cash and Bank Balances to be found out in the next stage Liquid Asset = Rs.1,94,666 Less : Debtors Rs.1,50,000 Bills receivable 10,000 Rs 1,60,000 Rs 34,666 From the above found information the detailed balance sheet with as many as information possible to portray Balance sheet as on dated Liabilities Share capital Reserves and surpluses Bills receivable Sundry creditors R s Assets 2,52,999 Fixed assets 56.000 Stock 4,000 Debtors 77,667 Bills receivable Cash and Bank Balance 3,90,666 Rs 1,28,000 68,000 1,50,000 10,000 34,666 3,90,666 Illustration From the following particulars, prepare trading, profit and loss account and a balance sheet Current ratio Liquid ratio 1.8 Bank overdraft Rs.20,000 Working capital Rs.2,40,000 102 Debtors velocity month International Financial and Management Accounting Gross profit ratio 20% Proprietary ratio (Fixed assets / shareholders' fund) Reserves and surpluses 25 of share capital Opening stock Rs.1,20,000 8% Debentures Rs 3,60,000 Long-term investments Rs.2,00,000 Stock turnover ratio 10 times Creditors velocity 1/2 month Net profit to share capital 20% (B.Com Bharathidasan, April 1989) First step is to find out the current assets and current liabilities through current ratio Current ratio = Current Assets =3 Current Liabilities Current Assets – Current Liabilities = Working capital – = = Rs.2,40,000 The volume of working capital Rs 2,40,000 is equated to share What is the volume of current liabilities for the share of Current liabilities = Rs.2,40,000 = Rs.1,20,000 The volume of current assets = Rs.1,20,000 × = Rs.3,60,000 The next step is to find out the volume of liquid assets Liquid assets ratio = 1.8 = Liquid assets Liquid liabilities When the Bank overdraft is given, the liquid liabilities should be computed Liquid liabilities = Current liabilities - Bank overdraft = Rs.1,20,000 - Rs.20,000= Rs.1,00,000 Liquid assets is 1.8 times greater than the Liquid liabilities Liquid assets = 1.8 × Rs.1,00,000 = Rs.1,80,000 To find out the volume of the stock Stock = Current assets – Liquid assets = Rs.3,60,000 – Rs.1,80,000 = Rs.1,80,000 The next step is to find out the cost of goods sold 103 Ratio Analysis To find out the cost of goods sold, the stock turnover ratio has to be found out 10 times = Cost of goods sold Average stcok Average stock = Opening Stock Closing Stock Rs.1,20,000 Rs.1,80,000 = 2 = Rs.1,50,000 Cost of goods sold = Rs.1,50,000 × 10= Rs.15,00,000 Next step is to find out the volume of sales in order to find out the volume of debtors The volume of sales could be found out through Gross profit ratio Sales – Profit = Cost of goods sold 100 – 20 = 80 The Rs 15,00,000 worth of cost of goods sold is equated to share of 80 What would be the volume of sales? Rs.15,00,000 80 = Sales 100 = Sales = Rs.15,00,000 100 × = Rs.18,75,000 80 Gross profit = Rs.18,75,000-Rs.15,00,000= Rs.3,75,000 The next step is to find out the volume of debtors The debtors could be found out with the help of debtors turnover ratio and collection period Debtors velocity or collection period = Debtors turnover ratio = 12 times = 12 months Debtors turnover ratio 12 months = 12 times month Credit sales Average debtors Average Debtors = Rs.18,75,000 = Rs.1,56,250 12 The next step is to find out the creditors The volume of creditors; to find out the volume of the creditors, the creditors turnover ratio and creditors average payment period should have to be applied Creditors average payment period = 12months Creditors turnover ratio 104 International Financial and Management Accounting Creditors turnover ratio = 12months = 24 times month Creditors turnover ratio = Credit Purchase Average Creditors Average creditors = Credit Purchase 24 times Now the volume of credit purchase to be found out with the help of cost of goods sold formula Cost of goods sold = Opening stock+ Purchases - Closing stock Rs.15,00,000 – Rs.1,20,000+Rs.1,80,000 = Purchases Rs 15,60,000 = Purchases Average creditors = Rs.65,000 The next step is to find out the proprietary fund; this could be found out by using the ratio proprietary fund to fixed assets ratio Total Assets= Total Liabilities Long term liabilities + Short term liabilities = Fixed assets + Current assets + Investments Share holders' fund - Fixed assets = Current assets + Investment - Current liabilitiesDebenture 1–.9= Rs.2,00,000 + Rs.3,60,000 – Rs.1,20,000 – Rs.3,60,000 1–.9 = Rs.80,000 1=Rs.80,000 If share is the volume of Rs.80,000 what is the volume of proprietary fund for the share of 1? The volume of proprietary fund = Rs.8,00,000 The volume of fixed assets = Rs.8,00,000 × 9= Rs.7,20,000 The next step is to find out the volume of the share capital This could be found out only with the help of the ratio given Reserves and surpluses to share capital Reserves and surpluses = 25% of share capital It means that % is Share capital Share capital + Reserves and surpluses = Shareholders' fund 100+25 = 125 To find out the share of share capital from the shareholders' fund, the following is the computation Rs 8,00,000 × 100 = Rs.6,40,000 = Share capital 125 Reserves and surpluses = 25% on the Share capital = 25% on Rs.6,40,000 =Rs.1,60,000 The last step is to find out the Net profit, which could be found out through the Net profit to share capital 105 Net profit is 20% on share capital Ratio Analysis Net profit = 20% on Rs.6,40,000= Rs.1,28,000 Next stage is to prepare the Trading, Profit & Loss A/c for the year ended and Balance sheet as on dated Trading Profit & Loss Account for the year ended Dr Cr Particulars Rs Particulars To opening stock To purchases To Gross profit c/d Rs 1,20,000 By sales 15,60,000 By closing stock 3,75,000 20,55,000 28,800 By Gross profit B/d To Debenture Interest 8% 3,60,000 To Balancing figure other expenses To Net profit c/d* 18,75.000 1,80,000 20,55,000 3,75,000 2,18,200 1,28,000 3,75,000 3,75,000 Balance sheet as on dated Liabilities Share capital Reserves and Surpluses Profit during the year 8% Debentures Current liabilities Overdraft Creditors Others Rs Rs Assets 6,40,000 Fixed assets Investments 1,60,000 3,60,000 Current Assets 20,000 Stock 65,000 Debtors 35,000 1,20,000 Other current asset 12,80,000 Rs Rs 7,20,000 2,00,000 32,000 1,28,000 1,80,000 1,56,250 23,750 3,60,000 12,80,000 5.5 LIMITATIONS OF THE RATIO ANALYSIS It is dependant tool of analysis: The perfection and effectiveness of the analysis mainly depends upon the preparation of accurate and effectiveness of the financial statements It is subject to the availability of fair presentation of data in the financial statements Ambiguity in the handling of terms: If the tool of analysis taken for the study of inter firm analysis on the profitability of the firms lead to various complications To study the profitability among the firms, most required financial information are profits of the enterprise The profit of one enterprise is taken for analysis is Profit After Taxes (PAT) and another is considering Profit Before Interest and Taxes (PBIT) and third one is taking Net profit for study consideration The term profit among the firms for the inter firm analysis is getting complicated due to ambiguity or poor clarity on the terminology 106 International Financial and Management Accounting Qualitative factors are not considered: Under the ratio analysis, the quantitative factors only taken into consideration rather than qualitative factors of the enterprise The qualitative aspects of the customers and consumers are not considered at the moment of preparing the financial statements but while granting credit on sales is normally considered Not ideal for the future forecasts: Ratio analysis is an outcome of analysis of historical transactions known as Postmortem Analysis The analysis is mainly based on the yester performance which influences directly on the future planning and forecasting; it means that the analysis is mainly constructed on the past information which will also resemble the same during the future analysis Time value of money is not considered: It does not give any room for time value of money for future planning or forecasting of financial performance; the main reason is that the fundamental base for forecasting is taken from the yester periods, which never denominate the timing of the benefits 5.6 DUPONT ANALYSIS This was an analysis established by the DUPONT INC., USA to study the Return on investment It was the first company developed the chart which depicted the influences of Return on Investment The company underwent for the consideration two important ratios for the return on investment is Net profit ratio and Capital turnover ratio A change in the any one of the two ratios that will immediately reflect on the Return on investment The various associated factors are considered to study the impact of the profitability of the firm This type of analysis to correct the problems not only to identify the specific cause which drastically affects the profitability but also to find the possible ways and means to improve the profitability Having developed the chart for analysis was called as DUPONT Chart Net profit Sales Net profit ratio Cost of goods sold Sales Expenses Return on capital employed Administrative, Selling and distribtution expense Re Working capital Current assets Fixed asset Current liabilities Sales Capital turnover ratio Capital employed Figure 5.5: DUPONT Chart 5.7 LET US SUM UP Ratio analysis is one of the important tools of financial statement analysis to study the financial structure of the business fleeces Ratios are classified as follows: Liquidity, leverage, profitability, activity, integrated and growth ratio We have dealt all these in detail We have also studied limitations of the ratio analysis and Dupont analysis 5.8 LESSON END ACTIVITY Discuss the similarities and differences between acid test ratio and current ratio What are the usefulness of these ratios? 5.9 KEYWORDS Income Statement Ratios: These ratios are computed from the statements of Trading, Profit & Loss account of the enterprise Balance Sheet or Positional Statement Ratios: These type of ratios are calculated from the balance sheet of the enterprise which normally reveals the financial status of the position i.e short-term, long-term financial position, Share of the owners on the total assets of the enterprise and so on Capital Structure Ratios: The capital structure position are analysed through leverage ratios as well as coverage ratios Current Assets: Current assets are in the form of cash, equivalent to cash or easily convertible into cash Current Liabilities: Current liabilities are short-term financial resources or payable in short span of time within a year 5.10 QUESTIONS FOR DISCUSSION Define ratio Define Accounting ratio What is meant by Accounting ratio analysis? Elucidate the importance of the ratio analysis Explain the Liquidity ratios Highlight the Leverage ratios Discuss in detail about the Profitability ratios Illustrate the various kinds of Turnover ratios List out the limitations of the ratio analysis Check Your Progress: Model Answers CYP 1 (a), (c), (c) (d), (c) (d), (c) CYP (d), CYP (a), 107 Ratio Analysis 108 International Financial and Management Accounting 5.11 SUGGESTED READINGS M P Pandikumar, Management Accounting, Excel Books M N Arora, "Cost and Management Accounting", 8th Edition, Vikas Publishing House (P) Ltd Hilton, Maher and Selto, "Cost Management", 2nd Edition, Tata McGraw-Hill Publishing Company Ltd B.M Lall Nigam and I.C Jain, "Cost Accounting", Prentice-Hall of India (P) Ltd ... Ratio Analysis 108 International Financial and Management Accounting 5.11 SUGGESTED READINGS M P Pandikumar, Management Accounting, Excel Books M N Arora, "Cost and Management Accounting" , 8th... profit and loss account and a balance sheet Current ratio Liquid ratio 1.8 Bank overdraft Rs.20,000 Working capital Rs.2,40,000 102 Debtors velocity month International Financial and Management Accounting. .. between the available financial information of many number of years; which portrays either increase or decrease in the financial performance 84 International Financial and Management Accounting Inter