PR ACADEMY

Financial Management (FM)

Chapter 3: Financial Analysis and Planning (Ratio Analysis) (10%)
Introduction:

Ratio Analysis is the basic tool for a Financial Manager to carry out Financial Analysis of
the organisation.

Ratio analysis:

Ratio analysis is a quantitative method of gaining insight into a company's liquidity,

operational efficiency, and profitability by comparing information contained in its financial
statements. Ratio analysis is a cornerstone of financial analysis.

Types of Ratios:

 Profitability ratios measure the firm’s use of its assets and control of its expenses
to generate an acceptable rate of return.
 Liquidity ratios measure the availability of cash to pay debt.
 Activity ratios, also called efficiency ratios, measure the effectiveness of a firm’s
use of resources, or assets.
 Debt, or leverage, ratios measure the firm’s ability to repay long-term debt.
 Market ratios are concerned with shareholder audiences. They measure the cost
of issuing stock and the relationship between return and the value of an investment
in company’s shares.

Liquidity Ratios:

Current Ratio: The current ratio measures a company's ability to pay off its current
liabilities (payable within one year) with its current assets such as cash, accounts
receivable and inventories. A ratio of 2:1 is considered respectable, nevertheless, it varies
from industry to industry.

Current Ratio = Current Assets/ Current Liabilities

Where, Current Assets = Inventories + Sundry Debtors + Cash and Bank Balances +
Receivables/ Accruals + Loans and Advances + Disposable Investments + Any other
current assets.

Current Liabilities = Creditors for goods and services + Short-term Loans + Bank
Overdraft + Cash Credit + Outstanding Expenses + Provision for Taxation + Proposed
Dividend + Unclaimed Dividend + Any other current liabilities.

Quick Ratio or Acid Test Ratio: A measurement of the liquidity position of the business.
The quick ratio compares the cash plus cash equivalents and accounts receivable to the
current liabilities. The primary difference between the current ratio and the quick ratio is
the quick ratio does not include inventory. A ratio of 1:1 is considered acceptable.
Consequently, a business's quick ratio will be lower than its current ratio.
1
MADESH KUPPUSWAMY
 PR ACADEMY

Quick Ratio = Quick Assets (CA – Inventories)/ Current Liabilities

Cash Ratio: The cash ratio is a measurement of a company's liquidity, specifically the
ratio of a company's total cash and cash equivalents to its current liabilities. The measure
calculates a company's ability to repay its short-term debt with cash or near-cash
resources, such as easily marketable securities. This information is useful to creditors
when they decide how much money, if any, they would be willing to loan a company.

Cash Ratio = Cash Equivalents + Marketable Securities /Current Liabilities

Note: Current Investments can be used as well in place of marketable securities

Interval Ratio: The defence interval ratio (DIR), also called the defensive interval period
(DIP) or basic defence interval (BDI), is a financial measure that indicates the number of
days that a company can operate without needing to access noncurrent assets, long-term
assets whose full value cannot be obtained within the current accounting year, or
additional outside financial resources.

DIR (expressed as number of days) = Current Assets / Daily operational expenses

Current assets = Cash + Marketable securities

Operating Expenses = Cost of Goods Sold + Selling Administration and other General
expenses – Depreciation and other non-cash expenditure.

Daily operational expenses = Operating Expenses/No. of Days in a Year (360 Days)

Net Working Capital: It compares current assets to current liabilities, and serves as the
liquid reserve available to satisfy contingencies and uncertainties. A high working capital
balance is instructed if the entity is unable to borrow on short notice.

Net Working Capital = Current Assets – Current Liabilities

Leverage Ratios: A leverage ratio is any kind of financial ratio that indicates the level of
debt incurred by a business entity against several other accounts in its balance sheet,
income statement, or cash flow statement. These ratios provide an indication of how the
company’s assets and business operations are financed (using debt or equity).

There are 2 types of Ratios: 1. Capital Structure and 2. Coverage Ratios

Capital Structure Ratios: Capital structure refers to the degree of long-term financing
of a business concern as in the form of debentures, preference share capital and equity
share capital including reserves and surplus. There should be a proper mix between debt
capital and equity capital. Capital structure is otherwise called as leverage.

Equity Ratio: The shareholder equity ratio shows how much of the company's assets are
funded by equity shares. The lower the ratio result, the more debt a company has used to
pay for its assets.

Equity Ratio = Shareholders’ Equity/Capital Employed

2
MADESH KUPPUSWAMY
 PR ACADEMY

Shareholders’ Equity include Retained Earnings

Debt Ratio: It can be interpreted as the proportion of a company’s assets that are financed
by debt.

Debt Ratio = Total outside liabilities/Total Debt + Net worth (Capital Employed)

Debt Ratio = Total Debt/Net Assets

Total debt or total outside liabilities includes short- and long-term borrowings from
financial institutions, debentures/bonds, deferred payment arrangements for buying
capital equipment, bank borrowings, public deposits and any other interest-bearing loan.

Debt to Equity Ratio: The ratio is used to evaluate a company's financial leverage. It is
a measure of the degree to which a company is financing its operations through debt versus
wholly-owned funds. More specifically, it reflects the ability of shareholder equity to cover
all outstanding debts in the event of a business downturn.

Debt to Equity Ratio = Total Outside Liabilities/Shareholders' Equity

D/E Ratio = Total Debt/Shareholders’ Equity

Long Term Debt/Equity Ratio = Long-term/Debt Shareholders' equity

The shareholders’ equity is equity and preference share capital + post accumulated profits
(excluding fictitious assets etc).

Total Debts to Assets: Total-debt-to-total-assets is a leverage ratio that defines the total
amount of debt relative to assets. The higher the ratio, the higher the degree of leverage
(DoL) and, consequently, financial risk.

Total Debt to Assets = Total Outside Liabilities or Debt/Total Assets

Capital Gearing Ratio: Companies with high capital gearing will have a large amount
of debt relative to their equity. The gearing ratio is a measure of financial risk and
expresses the amount of a company's debt in terms of its equity. A company with a gearing
ratio of 2.0 would have twice as much debt as equity. Common Stockholders’ Equity is
taken as equity less preferred stock. Fixed Cost Bearing Funds include long-term loans,
bonds, debentures and preferred stock.

Capital Gearing = Preference Shares + Debentures + Other borrowed Funds/Equity

Share Capital + Reserves & Surplus - Losses

Proprietary ratio: It is the proportion of shareholders' equity to total assets. If the ratio
is high, this indicates that a company has enough equity to support the functions of the
business, and probably has room in its financial structure to take on additional debt, if
necessary. Conversely, a low ratio indicates that a business may be making use of too much
debt or trade payables, rather than equity, to support operations (which may place the
company at risk of bankruptcy).

Proprietary Ratio = Proprietary Fund/Total Assets

3
MADESH KUPPUSWAMY
 PR ACADEMY

Proprietary fund includes Equity Share Capital + Preference Share Capital + Reserve &
Surplus. Total assets exclude fictitious assets and losses.

Fictitious assets include Discount on issue of Debenture/Equity or Preference shares,

Preliminary Expenses, Business promotion Expenses (If it has huge value), Any loss on
issue of Debenture/Equity or Preference shares.

Coverage Ratios: A coverage ratio, broadly, is a group of measures of a company's ability

to service its debt and meet its financial obligations such as interest payments or
dividends. The higher the coverage ratio, the easier it should be to make interest payments
on its debt or pay dividends.

Debt Service Coverage Ratio (DSCR): It measures how well a company can pay its
entire debt service. A ratio of 1.5 to 2 is acceptable.

DSCR Ratio = Earnings available for debt services/Interest + Instalments

Earning for debt service = Net profit (Earning after taxes) + Non-cash operating
expenses like depreciation and other amortizations + Interest +other adjustments like loss
on sale of Fixed Asset etc.

Interest Coverage Ratio: The interest coverage ratio measures the ability of a company
to pay the interest expense on its debt.

Interest Coverage Ratio = EBIT/Interest Expense

Preferred dividend coverage ratio is a coverage ratio that measures a company's ability
to pay off its required preferred dividend payments.

Preference Dividend Coverage = Net Profit/Earning after taxes (EAT)/Preference

dividend liability

Equity Dividend coverage ratio can also be calculated taking (EAT – Pref. Dividend)
and equity fund figures into consideration.

Fixed-charge coverage ratio: It measures a firm's ability to cover its fixed charges, such
as debt payments, interest expense and equipment lease expense. It shows how well a
company's earnings can cover its fixed expenses. Banks often look at this ratio when
evaluating whether to lend money to a business. Ratio of 1 is acceptable.

Fixed Charges Coverage = EBIT +Depreciation/Interest+ (Repayment of loan1-tax rate)

Activity or Efficiency Ratios: Activity ratios measure the relative efficiency of a firm
based on its use of its assets, leverage, or other similar balance sheet items and are
important in determining whether a company's management is good at generating
revenues and cash from its resources.

Asset Turnover Ratios: Based on Assets utilisation

4
MADESH KUPPUSWAMY
 PR ACADEMY

Total Asset Turnover Ratio: The total assets turnover ratio measures how efficiently
an entity uses its assets to make a sale. Smaller ratios may indicate that the company is
holding higher levels of inventory instead of generating sales.

Total Asset Turnover = Sale/Cost of Goods Sold/Total Assets

Fixed Asset Turnover: Measures the efficiency of a firm using its fixed assets.

Fixed Asset Turnover = Sale/Cost of Goods Sold/Fixed Assets

Capital Turnover Ratio: Capital turnover ratio shows the relationship between net
sales and capital employed. It is used to measure the efficiency of management to
generate revenue from companies’ capital. The higher degree of this ratio is better for a
company in sense that capital is being used in effective way.

Capital Turnover = Sales or Cost of goods Sold/Net Assets or Capital Employed

Current Asset Turnover Ratio: Measures the efficiency of using Current Assets.

CA Turnover Ratio = Sales or Cost of goods sold/Current Assets

Working Capital Turnover Ratio: Measures the productivity of Working Capital.

WC Turnover Ratio = Sales or Cost of goods sold/WC

Working Capital turnover ratios are further classified Inventory Turnover, Debtors and
Creditors Turnover Ratios. It also aides in examining the liquidity management of the
company.

Inventory or Stock turnover Ratio: It shows how good the inventories are managed by
the firm. A high ratio indicates the company is managing its inventories efficiently.

Inventory Turnover Ratio = Cost of Goods Sold or Sales/Average Inventory

Inventory Turnover = Avg. Inventory/COGS or Sales * 360 Days / 52 Weeks /12 months

Raw Material Turnover Ratio = Raw Material Consumed/Average RM Stock

Receivable Turnover Ratio: The accounts receivable turnover ratio is an accounting

measure used to quantify a company's effectiveness in collecting its receivables or money
owed by clients. A low receivables turnover ratio might be due to a company having a
poor collection process, bad credit policies, or customers that are not financially viable or
creditworthy and vice-versa.

Accounts Receivable Turnover=Credit Sales/Average Accounts Receivable

Accounts Receivable Turnover = Average Accounts Receivable/ Credit Sales * 360 Days
Receivable Velocity =Average Accounts Receivables/Average Daily Credit Sales

Accounts payable turnover ratio is a short-term liquidity measure used to quantify

the rate at which a company pays off its suppliers. A decreasing turnover ratio indicates

5
MADESH KUPPUSWAMY
 PR ACADEMY

that a company is taking longer to pay off its suppliers than in previous periods and vice-
versa.

Payables Turnover Ratio = Annual Net Credit Purchases/Average Accounts Payables

Payables Turnover = Average AP/Annual Net Credit Purchases * 360 Days

Payables Velocity = Average Accounts Payable/Average Daily Credit Purchases

Points to Note:

 Only selling & distribution expenses differentiate Cost of Goods Sold (COGS) and
Cost of Sales (COS) in absence of it, COGS will be equal to sales.
 We should keep in mind that investment may be Total Assets or Net Assets. Further
funds employed in net assets are also known as capital employed which is nothing
but Net worth plus Debt. Where Net worth is equity shareholders’ fund. Similarly,
the concept of returns/ earnings/ profits may vary as per the requirement and
availability of information.
 In the absence of preference dividend PAT can be taken as earnings available to
equity shareholders.
 When average figures of total assets, net assets, capital employed, shareholders’
fund etc. are available, it may be preferred to calculate ratios by using this
information. To find out average figures, average the opening and closings items.
 Ratios are most informative and useful when used to compare a subject company to
other, similar companies, the company's own history, or average ratios for the
company's industry.
 Ratios shall be calculated based on requirement and availability of data and may
deviate from original formulae

Profitability Ratios:

These ratios are categorised into four types as follow:

 Related to Sales
 Related to overall Return on Investment
 Required for Analysis from Owner’s Point of View
 Profitability Ratios related to Market/ Valuation/ Investors.

Profitability Ratios based on Sales

Except for Expenses ratios, having a higher Profitability ratio relative to a competitor's
ratio or relative to the same ratio from a previous period indicates that the company is
doing well.

 Gross Profit Ratio = GP/Sales x 100

 Net Profit Margin = EAT or Net Profit/Sales x 100
 Pre-Tax Profit Ratio = EBT/Sales x 100
 Operating Profit Ratio = EBIT/Sales x 100

6
MADESH KUPPUSWAMY
 PR ACADEMY

Expenses Ratios:
 The operating ratio shows how efficient a company's management is at keeping
costs low while generating revenue or sales. The smaller the ratio, the more
efficient the company is at generating revenue versus total expenses.
 Operating Ratio = (COGS + Operating Expenses)/Sales x 100
 Operating Expenses Ratio = (Admin Exp + Selling + OH Exp)/Sales x 100
 COGS Ratio = COGS/Sales x 100
 Financial Expenses Ratio = Financial Expenses/Sales x 100
Financial expense excludes taxes, loss due to death and goods destroyed by
fire

Profitability Ratios related to Overall Return on Assets/ Investments

Return on Investment (ROI): It is a performance measure used to evaluate the

efficiency of an investment or compare the efficiency of several different investments.
ROI tries to directly measure the amount of return on a particular investment, relative
to the investment’s cost.
ROI = (Profit / Investment) x 100
ROI = Profit/Sales x Sales/Investment

The above formula is based on Dupont Analysis, which we will cover later. Therefore,
ROI = Profitability Ratio x Investment turnover ratio.
The investment ratios are further classified into three types.
Return on Assets: ROA gives a manager, investor, or analyst an idea as to how efficient
a company's management is at using its assets to generate earnings.

The above formula is without interest, for calculating ROA for Debtors, see below:

ROA = NP + Taxes/Average Total Assets or Fixed Assets or Tangible Assets

Or Return on Total Assets = EBIT(1-T)/ Average Total Assets

Or, Return on Net Assets = EBIT (1-T)/ Net Assets

Return on capital employed (ROCE) is a financial ratio that measures a company's

profitability and the efficiency with which its capital is used. In other words, the ratio
measures how well a company is generating profits from its capital.

Pre-Tax, ROCE = EBIT/Capital Employed x 100

Post Tax, ROCE = EBIT(1-T)/Capital Employed x 100

ROCE = PAT + Interest/Capital Employed x 100

Where, Capital Employed = Total Assets – Current Liabilities or Net Worth + Debt or
Fixed Assets + Working Capital
7
MADESH KUPPUSWAMY
 PR ACADEMY

Important Points

❖ ROCE should always be higher than the rate at which the company borrows.
❖ Intangible assets (assets which have no physical existence like goodwill, patents
and trade-marks) should be included in the capital employed.
❖ Fictitious asset should not be included within capital employed.

Return on equity (ROE) is a ratio that provides investors with insight into how
efficiently a company (or more specifically, its management team) is handling the money
that equity shareholders have contributed to it. In other words, it measures the
profitability of a corporation in relation to stockholders’ equity. The higher the ROE, the
more efficient a company's management is at generating income and growth from its
equity financing.

ROE = (EAT – Preference Dividend)/Equity Shareholders’ Fund x100

Or, ROE = EAT/Total Shareholders’ Fund or Net worth x100

ROE using Du Pont Model:

DuPont analysis is a useful technique used to decompose the different drivers of return
on equity (ROE). Breakdown of ROE allows investors to focus on the key metrics of
financial performance individually to identify strengths and weaknesses.

The Dupont analysis is an expanded return on equity formula, calculated by

multiplying the net profit margin by the asset turnover by the equity multiplier.

ROE = Net Profit Margin × Asset Turnover × Equity Multiplier

Where, Net Profit Margin = Revenue/Net Income
Asset turnover, measures how efficiently a company uses its assets to generate revenue.
Asset Turnover = Sales/Average Total Assets

Equity multiplier or Financial leverage, is an indirect analysis of a company's use of

debt to finance its assets. If the company borrows more to purchase assets, the ratio will
continue to rise.
The equity multiplier is a ratio used to analyse a company’s debt and equity financing
strategy. A higher ratio means that more assets were funding by debt than by equity. In
other words, investors funded fewer assets than by creditors.
Equity Multiplier = Average Total Assets/Average Shareholders’ Equity
Illustration:

Return on Equity of Companies- A and B. Both the companies are into the electronics
industry and have the same ROE of 45%. The ratios of the two companies are as follows-

8
MADESH KUPPUSWAMY
 PR ACADEMY

Ratios Company A Company B

Profit Margin 30% 15%

Asset Turnover 0.5 6

Financial Leverage 3 0.5

Analysis:
Even though both companies have the same ROE, however, the operations of the
companies are totally different. Company A can generate higher sales while maintaining
a lower cost of goods which can be seen from its high-profit margin.
On the other hand, company B is selling its products at a lower margin but having very
high Asset Turnover Ratio indicating that the company is making a large number of sales.
Besides, company B seems less risky since its Financial Leverage is very low. Thus,
DuPont Analysis will help investors to measure the risk associated with the business
model of each company.

Profitability Ratios Required for Analysis from Owner’s Point of View

Earnings per share (EPS) is calculated as a company's profit divided by the

outstanding shares of its common stock. The resulting number serves as an indicator of
a company's profitability. The higher a company's EPS, the more profitable it is
considered.

Dividend per share (DPS) is the sum of declared dividends issued by a company for
every ordinary share outstanding. Clearly, a higher ratio makes the company attractive.

The dividend pay-out ratio is the ratio of the total amount of dividends paid out to
shareholders relative to the net income of the company. It is the percentage of earnings
paid to shareholders in dividends.

Dividend Pay-out Ratio = DPS/EPS

Profitability Ratios related to market/ valuation/ Investors

The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that
measures its current share price relative to its per-share earnings (EPS).

P/E ratios are used by investors and analysts to determine the relative value of a
company's shares in an apples-to-apples comparison. It can also be used to compare a
company against its own historical record or to compare aggregate markets against one
another or over time. It also gives the payback period for the investment.
9
MADESH KUPPUSWAMY
 PR ACADEMY

The dividend yield is the ratio of a company's dividend compared to its share price.

Dividend Yield = Dividend ± Change in Share Price/MPS

The earnings yield refers to the earnings per share for the most recent year divided by
the current market price per share. The earnings yield (which is the inverse of the P/E
ratio) shows the percentage of how much a company earned per share.

EP Ratio = EPS/MPS

Market to Book Value Ratio: Companies use the price-to-book ratio to compare a firm's
market to book value. Generally, a higher ratio is good, nevertheless, it needs proper
analysis as the company may be over valued or under valued.

MVBV = Average Share Price/Book Value Per Share

Book Value Per share = Networth/Number of Equity Shares

Q Ratio: The Tobin's Q ratio equals the market value of a company divided by its assets'
replacement cost. For example, a low Q (between 0 and 1) means that the cost to replace
a firm's assets is greater than the value of its stock. This implies that the stock is
undervalued. Conversely, a high Q (greater than 1) implies that a firm's stock is more
expensive than the replacement cost of its assets, which implies that the stock is
overvalued.

Limitations of Ratio Analysis:

➢ Diversified Product Lines

➢ Inflation effect on Financial Statements
➢ Seasonal Factors
➢ Year-end adjustments
➢ Difference in accounting policies and period
➢ No standard set of ratios
➢ Ratios are interrelated and not independent

Financial Analysis:

Horizontal Analysis: Comparing over the years i.e. Year on Year Analysis.
Vertical Analysis: Analysing single year’s performance using the ratios.
Conclusion
Financial ratios offer signs but not conclusions. These are tools only in the hands of
experts because there is lot of professional judgement and experience required to assess
a company using the ratios. It can be a starting point for financial analysis.

10
MADESH KUPPUSWAMY
 PR ACADEMY

Illustrations:
Problem 1
XYZ & Co. has Rs.10,00,000 as capital comprised of Rs 4,00,000 debt and Rs. 6,00,000
equity. The company’s earnings before interest and taxes (EBIT) are Rs.1,20,000. It has
accounted for depreciation and amortization in its financial statements in the current
financial year for Rs.20,000. Interest Expenses include Rs. 40,000. The assets of the
company amount to Rs 10,00,000. EAT is Rs, 50,000.
Calculate 1. Debt to Equity Ratio 2. Equity Ratio 3. Debt to total assets Ratio 4. DSCR 5.
Interest Coverage.
1. Debt to Equity Ratio = Total Debt/Total Equity = 4,00,000/6,00,000 = 0.67
2. Equity Ratio = Shareholders’ Equity/Capital employed
= 6,00,000/10,00,000 = .6
3. Debt to Total Assets Ratio = Total Debt/Total Assets = 400000/100000 = .4
4. DSCR = Earnings available for Debt Servicing/ Interest/Instalments
= 50000+20000/40000 = 1.75 times
5.Interest Coverage Ratio = EBIT/Interest = 1,20,000/40000 = 3 times

Problem 2
The balance sheet of TN Auto Limited as on 31-03-2015 was as follows:

From the above compute 1. The current ratio 2. Quick ratio 3. Debt-equity ratio 4.
Proprietary ratio.
Solution: -
1.Current Ratio = (Current Assets/Current liabilities)
Current Assets = Stock + debtors + Investments (short term) + Cash In hand
Current Liabilities = Creditors + bank overdraft + Provision for Taxation (current &
Future)
CA = 12000 + 12000 + 4000 + 12000= 40,000
CL = 16000 + 4000 + 4000 + 4000= 28,000
CA/ CL = 40,000/ 28,000 = 1.43: 1
2. Quick Ratio = (Quick Assets/ Current Liabilities)
11
MADESH KUPPUSWAMY
 PR ACADEMY

Quick Assets = Current Assets ‐ Stock

QA = 40,000 – 12,000= 28,000 CL = 28,000
QA /CL = 28,000/ 28,000 = 1: 1
3. Debt – Equity Ratio = Long Term Debt (Liabilities)/ Shareholders Equity
Only long-term debt alone considered, therefore, LTL = 32,000
SHE = Eq. Sh. Cap. + Reserves & Surplus + Preference Sh. Cap. – Fictitious Assets
SHE = 40,000 + 8,000 + 12,000 = 60,000
Debt-equity ratio = 32,000/ 60,000 = 0.53: 1
4. Proprietary Ratio = Propriety’ Funds / Total Assets
PF = Eq. Sh. Cap. + Reserves & Surplus + Pref. Sh. Cap. – Fictitious Assets & Losses
PF= 40,000 + 8,000 + 12,000 = 60,000
Total Assets = Total Assets – Fictitious Assets TA = 1,20,000
Proprietary ratio = 60,000/ 1,20,000 = 0.5: 1

Problem 3
The following Trading and Profit& Loss Account of Fantasy Ltd. for the year 31‐3‐2018
is given below:

Calculate:
1. Gross Profit Ratio 2. Operating Expenses Ratio 3. Operating Ratio.
4.Net Profit Ratio 5. Operating Profit Ratio 6. Stock Turnover Ratio.
Solution
1. Gross Profit Margin = (Gross profit / Sales) X 100 = 2,00,000 / 5,00,000 X 100 = 40%
2. Operating Expenses Ratio = (Op. Expenses / Sales) X 100
= 1,01,000 +12,000 / 5,00,000 x 100 = 22.60%
3. Operating Ratio = (COGS + Op. Expenses) / Sales)) X 100
= (300000 + 113000) /500000 X 100 = 82.60%
12
MADESH KUPPUSWAMY
 PR ACADEMY

COGS = Op. stock + purchases + carriage and Freight + wages – Closing Stock
Or, COGS = Sales - GP
= 76250 + 315250 + 2000 + 5000 ‐ 98500 = Rs.3,00,000
4. Net Profit Ratio = (Net Profit/ Sales) X 100 = (84000/ 500000) X 100 = 16.8%
5. Operating Profit Ratio = (Op. Profit / Sales) X 100
[Operating Profit = Sales – (Op. Exp. + Admin Exp.)]
= (87,000 / 5,00,000) X 100 = 17.40%
6. Stock Turnover Ratio = Cost of goods sold/Avg. Stock = 3,00,000 / 87,375 = 3.43 times
Problem 4
The details of Sri Company are as under:
Sales (40% cash sales) 15,00,000
Less: Cost of sales 7,50,000
Gross Profit: 7,50,000
Less: Office Exp. (including int. on debentures) 1,25,000
Selling Exp. 1,25,000 2,50,000
Profit before Taxes: 5,00,000
Less: Taxes 2,50,000
Net Profit: 2,50,000

Besides the details mentioned above, the opening stock was of Rs. 3,25,000. Taking 360
days of the year, calculate the following ratios; also discuss the position of the company:
(1) Gross profit ratio. (2) Stock turnover ratio. (3) Operating ratio. (4) Current ratio. (5)
Liquid ratio. (6) Debtors ratio. (7) Creditors ratio. (8) Proprietary ratio. (9) Rate of return
on net capital employed. (10) Rate of return on equity shares.
Solution
1. Gross Profit Margin = (Gross profit / Sales) X 100
= (7,50,000 /15,00,000) X 100 = 50%
2. Stock Turnover Ratio = Cost of goods sold/ Avg. Stock
Avg. stock = (Opening Stock + Closing Stock) /2

13
MADESH KUPPUSWAMY
 PR ACADEMY

= (3,25,000 + 1,75,000)/ 2 AS = 2,50,000

COGS = Sales – GP
COGS = 15,00,000 – 7,50,000= 7,50,000
Stock turnover ratio = (7,50,000/ 2,50,000) = 3 times
3. Operating Profit Ratio = (Op. Profit/ Net Sales) X 100
Operating Profit = Sales – (Op. Exp. + COGS)
OP = 15,00,000 – (7,50,000 + 1,25,000 + 25,000) = 6,00,000
(excluding Interest on Debentures)
Operating profit ratio = (6,00,000 /15,00,000) X 100 = 40%
4. Current Ratio = Current Assets/ Current liabilities
Current Assets = Stock + debtors + Bills receivable + Cash
CA = 1,75,000 + 3,50,000 + 50,000 + 2,25,000 = 8,00,000
Current Liabilities = Creditors + bank overdraft + Bills payable + Outstanding
expenses
CL = 1,00,000 + 1,50,000 + 45,000 + 5,000 = 3,00,000
CA/ CL = 8,00,000/ 3,00,000 = 2.67: 1
5. Quick Ratio / Liquid Ratio = Liquid Assets /Liquid Liabilities
(Liquid) Quick Assets = Current Assets ‐ Stock
QA = 8,00,000 – 1,75,000 = 6,25,000 CL = 3,00,000
QA / CL = 6,25,000/ 3,00,000 = 2.08: 1
(Debtors + Bills receivable)
6. Debtors Ratio = X 360 days
Credit sales

= ((3,50,000 + 50,000)/ 9,00,000) X 360 days (60% of 15,00,000)

= 0.444 X 360 days = 160 days
Creditors + Bills payable
7. Creditors Ratio = X 360 days
credit purchase

= (1,00,000 + 45,000)/ 7,50,000 X 360 days

Notes: If credit purchase could not find out at that point Cost of Goods sold consider
Credit purchase
= 0.193 X 360 days = 69 days
8. Proprietary Ratio =Shareholders’ Funds/Total Assets
SHF = Eq. Sh. Cap. + Reserves & Surplus + Preference Sh. Cap. – Fictitious Assets
SHF = 20,00,000 + 20,00,000 + 11,00,000 – 1,00,000 = 50,00,000
Total Assets = Total Assets – Fictitious Assets

14
MADESH KUPPUSWAMY
 PR ACADEMY

TA = 64,00,000 – 1,00,000 = 63,00,000

SHF /TA = 50,00,000/ 63,00,000 = 0.79: 1
9. Rate of Return on Capital Employed = (EBIT /Capital employed) X 100
CE = Eq. Sh. Cap. + Pref. Sh. Cap. + Reserves & Surplus + Debenture + Long Term
Loan – Fictitious Assets
CE = 20,00,000 + 20,00,000 + 11,00,000 +10,00,000 – 1,00,000 = 60,00,000
Rate of return of capital employed = (6,00,000/60,00,000) X 100 = 10%
10. Rate of Return on Shareholders Fund = (PAT/SHF) X 100
SHF = Eq. Sh. Cap. + Pref. Sh. Cap. + Reserves & Surplus – Fictitious Assets
SHF = 20,00,000 + 20,00,000 11,00,000 – 1,00,000 = 50,00,000
Rate of Return on Shareholders Fund = (2,50,000/ 50,00,000) X 100= 5%
11. Rate of return on Equity Shareholders Fund = ((PAT – Pref. Div.)/ESHF) X 100
ESHF = Eq. Sh. Cap. + Reserves & Surplus – Fictitious Assets
ESHF = 20,00,000 + 11,00,000 – 1,00,000 = 30,00,000
Rate of return on Equity Shareholders Fund = (50,000/30,00,000) X 100 = 1.67 %
Problem 5
Following figures are available in the books Tirupati Ltd.
Fixed assets turnover ratio 8 times
Capital turnover ratio 2 times
Inventory Turnover 8 times
Receivable turnover 4 times
Payable turnover 6 times
GP Ratio 25%
Gross profit during the year amounts to Rs.8,00,000. There is no long-term loan or
overdraft. Reserve and surplus amount to Rs.2,00,000. Ending inventory of the
year is Rs. 20,000 above the beginning inventory.
Calculate various assets and liabilities and prepare a balance sheet of Tirupati Ltd.
Solution:
G.P. ratio = 25% = GP/Sales
a) Sales = Gross Profit/25 x 100 = 8, 00, 000/25 × 100 = Rs,32,00,000
b) Cost of Sales = Sales – Gross profit =Rs32,00,000 - Rs8,00,000 = Rs24,00,000
c) Receivables Turnover = Sales/Receivables = 4
Receivables = 32,00,000/4 =Rs. 8,00,000
15
MADESH KUPPUSWAMY
 PR ACADEMY

d)Fixed Asset Turnover = COS/FA = 8 Fixed Asset = 24,00,000/8 =3,00,000

e) Inventory Turnover = COS/Avg. Stock AS = 24,00,000/8 = 3,00,000
Avg Stock = Opening Stock + Closing Stock/2
We are given, Closing Stock is Rs. 20,000 above Opening Stock, therefore,
Avg Stock = Opening Stock + Opening Stock + 20000/2 = Opening Stock + 10000
Opening Stock = 300000 - 10000 and Closing Stock = 3,10,000
f) Payable Turnover = Purchases/Payables = 6
Purchases = COS + Increase in Stock = 24,00,000 + 20,000
Payables = 24,20,000/6 = 4,03,333
g) Capital Turnover = COS/Sales/Capital Employed = 2
Capital Employed = 24,00,000/2 = 12,00,000
h) Share Capital = Capital Employed – Reserves and Surplus = 10,00,000

Problem 6
Assuming the current ratio of a Company is 2, State in each of the following cases whether
the ratio will improve or decline or will have no change:
(I) Payment of current liability
(ii) Purchase of fixed assets by cash
(iii) Cash collected from Customers
(iv)Bills receivable dishonoured
(v) Issue of new shares
Solutions:
1) Payment of Current Liabilities, will improve the current ratio as payment of
current liability will reduce the balance of Current Liabilities.
2) Purchase of Fixed Asset by Cash, it will deteriorate the Current Ratio because it
will reduce the balance of Current Assets.
3) Cash Collected from Customer, will improve the Current asset balance, therefore,
it will improve current ratio

16
MADESH KUPPUSWAMY
 PR ACADEMY

4) Bills Receivable Dishonoured, will have no impact on the ratio as dishonouring

of bills will reduce the bills receivable balance and increase debtors balance.
5) Issue of New share, will inject funds into the company, thus, improving the ratio.
Problem 7
From the following table of financial ratios of XYZ Limited, comment on various ratios
given at the end:

Comment on the following aspect of XYZ Limited: (I) Liquidity (ii) Operating profits (iii)
Financing (iv) Return to the shareholders
Solution:
Liquidity: Current ratio has improved from last year and matching the industry average.
Quick ratio also better than last year and above the industry average. This may happen
due to reduction in receivable collection period and quick inventory turnover. Though, this
also indicates idleness of funds. Overall it is reasonably good. All the liquidity ratios are
either improved or same in both the year compare to the Industry Average.
Operating Profit: Operating Income-ROI reduced from last year but Operating
Profit Margin has been maintained. This may happen due to variability of cost on
turnover. Nevertheless, both the ratio is still higher than the industry average.
Financing: The company has reduced its debt capital by 1% and saved operating profit
for equity shareholders. It also signifies that dependency on debt compared to other
industry players (57%) is low.

17
MADESH KUPPUSWAMY
 PR ACADEMY

Return to the Shareholders: ROE is 24 per cent in 2017 and 25 per cent in 2018
compared to an industry average of 15 per cent. The ROE is above average and improved
over the last year.
Problem 8
Using the following information, Prepare and complete the Balance Sheet given below:
(i) Total debt to net worth is 1: 2
(ii) Total assets turnover is 2
(iii) Gross profit on sales is 30%
(iv) Average collection period is 40 days (Assume 360 days in a year)
(v) Inventory turnover ratio based on cost of goods sold and year-end inventory is3
(vi) Acid test ratio is 0.75

Solution:
Net worth = Capital + Reserves and surplus = 4,00,000 + 6,00,000 = Rs.10,00,000
Total Debt / Net worth = ½ Thus, Total Debt = Rs.5,00,000
Total Liabilities = 4,00,000 + 6,00,000 + 5,00,000 = 15,00,000 = Total Assets
Total Asset turnover = 2 = Sales/Total Assets, Therefore, Sales = 30,00,000
GP on Sales is 30% = Rs, 9,00,000; COGS = Sales – GP = Rs. 21,00,000
Inventory turnover = 3 = COGS/Inventory Thus, 21,00,000/3 = 7,00,000 = Inventory
Average Collection Period = Avg Debtors/Sales Per Day = 40
40 = (Debtors/30,00,00) x 360, Debtors = Rs, 3,33,333
Acid Test Ratio = Quick Assets/CL =.75
3,75,000=Current Assets – 7,00,000 = Rs. 10,75,000
Fixed Assets = TA-CA =Rs. 4,25,000
Cash and Bank Balances = Current Assets – Inventory – Debtors
= 10,75,000 – 7,00,000 – 3,33,333 =Rs. 41,667

18
MADESH KUPPUSWAMY
 PR ACADEMY

Problem 9
With the help of the following information Analyse and complete the Balance Sheet of
ABC Ltd.:
Equity share capital Rs. 1,00,000
The relevant ratios of the company are as follows:
Current debt to total debt 0.40
Total debt to Equity share capital 0.60
Fixed assets to Equity share capital 0.60
Total assets turnover 2 Times
Inventory turnover 8 Times
Solution:
Balance Sheet of ABC Ltd.

Total debt = 0.60 x Equity share capital = 0.60 Rs. 1,00,000 = Rs. 60,000
Current debt to total debt = 0.40. So, current debt = 0.40 × Rs.60,000 = Rs.24,000,
Long term debt = Rs.60,000 - Rs.24,000 = Rs. 36,0002.
Fixed assets = 0.60 × Equity share Capital = 0.60 × Rs. 1,00,000 = Rs. 60,000.
Total assets to turnover = 2 Times and Inventory turnover = 8 Times
Hence, Inventory /T total assets = 2/8 =1/4, Total assets = Rs. 1,60,000
Therefore Inventory = Rs. 1,60,000/4 = Rs. 40,000
Problem 10:
From the following Financial Statements find the missing items.

19
MADESH KUPPUSWAMY
 PR ACADEMY

1.Current Ratio was 2:1.

2.Closing Stock is 25% of Sales.
3.Proposed Dividend was 40% of paid up capital.
4.Gross profit Ratio was 60%.
5.Amount transfer to General Reserve is same as proposed Dividend.
6.Balance of P & L Account is calculated 10% of proposed dividend.
7.Commission income is 1/7 of Net profit.
8. Balance of General reserve is twice the current year transfer amount.
Solution:

20
MADESH KUPPUSWAMY
 PR ACADEMY

Sales = GP/GP Margin =718, 421/60 =11,97, 368

Closing Stock = Sales x 25% = 2,99, 342
Proposed Dividend = Paid Capital x 40% = 2,00,000
General Reserve = Proposed Dividend = 2,00,000
Commission = 1/7th of NP =3,50,000/7 = 50,000
P&L A/c = 10% of Dividend = 20,000
Debenture = 10% Interest on Debenture is 30,000, therefore, Debenture = Rs. 3,00,000
Current Ratio = 2 = Stock + debtors + Bank Balance/Current Liability
2 = 2,99,342 + debtors + 62,500/6,00,000; Debtors = Rs. 838,158
Opening Balance of General Reserve = 2 times Current year’s Proposed Dividend
Therefore, Opening GR = 4,00,000
Closing GR = Opening GR + Current Year’s Provision = Rs. 6,00,000.
Home Assignments:
Problems 11:
The following is the information of 3MLtd. relate to the year ended 31-03-2019:
Gross Profit 20% of Sales
Net Profit 10% of Sales
Inventory Holding period 3 months
Receivable collection period 3 months
Non-Current Assets to Sales 1: 4
Non-Current Assets to CA 1: 2
Current Ratio 2: 1
21
MADESH KUPPUSWAMY
 PR ACADEMY

Non-Current Liabilities to CL 1: 1
Share Capital to Reserve & Surplus 4: 1
Non-current Assets as on 31stMarch, 2017 is Rs. 50,00,000
Assume that:
(i) No change in Non-Current Assets during the year 2017-18
(ii) No depreciation charged on Non-Current Assets during the year 2017-18.
(iii) Ignoring Tax, you are required to Calculate cost of goods sold, Net profit,
Inventory, Receivables and Cash for the year ended on 31st March, 2018
Problem 12:
The accountant of Sun Ltd. has reported the following data:
GP Rs.60,000
GP Margin 20%
Total Asset Turnover 0.30:1
Net worth to Total Asset 0.90:1
Current Ratio 1.5 Times
Quick Ratio 1 Time
Credit Sales to Total Sales 0.80:1
Average Collection Period 60 Days.
Assume 360 Days
Complete the Below Balance Sheet of Sun Ltd below:

22
MADESH KUPPUSWAMY