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Ratio Analysis Ratio Analysis: A ‘Ratio: is defined as an arithmetical/quantitative/numerical relationship between two numbers. Ratio analysis is a very important and age old technique of financial analysis.

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Ratio Analysis 1 Uses of Ratio Analysis: There are various uses of Ratio analysis, some of which are as follows: 1. It helps in managerial decision making 2. It helps in financial forecasting and planning 3. It helps in communicating the financial strength of a concern 4. It helps in control 5. It is an essential part of budgetary control and Standard costing 6. It helps an investor/prospective investor in decision making 7. It provides information to the creditors about the solvency of the firm 8. It helps the employees by providing information about the profitability of the concern 9. It helps the government in policy making by providing financial information about the industry/firm etc 10. It facilitates inter-firm; intra-firm; and firm-industry comparison

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**Ratio Analysis RESERVES & SURPLUSES Capital reserves**

Capital redemption reserve Share premium account Proposed additions to reserves P & L account balance etc.

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**Ratio Analysis LIST OF CURRENT ASSETS: Cash in hand Cash at bank**

Bills receivable or notes receivable Book debts or sundry debtors or receivables or accounts receivables Stock or raw material, work-in-progress or finished goods Marketable securities Advance payments ( prepaid expenses etc) Stores & spare parts Preliminary expenses etc

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**Ratio Analysis LIST OF CURRENT LIABILITIES**

Trade creditors or accounts payable Bills payable or notes payable Outstanding accruals or expenses Short term loans Bank overdraft Provision for taxes/ contingencies/ insurance etc Unclaimed dividends Advance payments & un expired discounts etc

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**Ratio Analysis LIST OF FIXED ASSETS Land & buildings Plant & machinery**

Furniture & fixtures Lease hold land Patents or trade marks Copy rights, formulas, license etc Good will Loose tools

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**Ratio Analysis LIST OF LONG TERM LIABILITIES Loan on mortgage**

Debentures or bonds Bank loan Loans from financial institutes etc CAPITAL Preference share capital Equity share capital

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Ratio Analysis 1. Liquidity Ratios (Short Term Solvency Ratios): These Ratios measure the ability of the firm to meet its current obligations. They indicate whether the firm has sufficient liquid resources to meet its short term liabilities. The various liquidity ratios are :- (i) Current Ratio: This Ratio measures the ability of the firm to pay debts in the short term Current Ratio = Current Assets (Ideal Ratio is 2:1) Current Liabilities

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Ratio Analysis (ii) Quick / Liquid / Acid-Test Ratio: This Ratio measures the short term debt paying ability of the firm Quick / Liquid /Acid Test Ratio = Quick Assets (Ideal Raito = 1:1) Current Liabilities Absolute Liquid Ratio / Cash position Ratio = Cash in hand & at Bank + Short term Marketable securities (Ideal Ratio = 0.75:1, or even 0.50:1)

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Ratio Analysis (iv) Debtor’s Turnover Ratio: This Ratio is a measure of quality of Debtors and of the effectiveness of the collection efforts. Debtor’s Turnover Ratio = Debtors + Bills Receivable X No. of working days Credit sales in a year (v) Average Debt Collection Period: This Ratio measures the time taken to collect from Debtors Average Debt Collection Period = Average Debtors Net Sales / 360 days (vi) Stock / Inventory Turnover Ratio: This Ratio measures the time taken to turn inventory into sales. Stock / Inventory Turnover Ratio = Cost of Goods sold Average stock (Where Average Stock = Opening stock + Closing Stock ) 2

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Ratio Analysis 2. Solvency Ratios (Long Term): These Ratios measure the long term financial condition of the firm. Bankers and creditors are most interested in liquidity. But shareholders, debenture holders and financial institutions are concerned with the long-term financial prospects. The various Solvency Ratios are: (i) Debt-Equity Ratio: This Ratio measures the relationship between borrowed Capital to own Capital. There are many variations to this Ratio. But, the most popular ones’ are : Debt (or) Outsider’s funds (Ideal Ratio = 1:1) Equity Share holders’ funds (ii) Proprietary Ratio: Share holders’ Funds Total Assets

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**Ratio Analysis iii) Assets to Proprietary Ratios:**

(a) Fixed Assets to Proprietor’s Fund Ratio = Fixed Assets after Depreciation (Ideal Ratio = 60% to 65) Shareholders’ Funds (b) Current Assets to Proprietor’s Fund Ratio = Current Assets Shareholders’ Funds (iv) Interest Coverage Ratio : This Ratio measures the ability of the firm in meeting its interest charges and thus gives the measure of protection to creditors for payment of interest. Interest coverage ratio less than 2.0 suggest a risky situation Interest Coverage Ratio = Profit before interest and Taxes Interest Expense

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Ratio Analysis 3. Profitability Ratios: These Ratios measure the profitability of a firm’s business operations. They may be related to sales (ex- Gross Profit Ratio) or investments (ex – Return on Assets or Return on Capital Employed) (i) Gross Profit Ratio = Gross Profit X 100 Sales (ii) Net Profit Ratio = Net Profit X 100 Sales Operating Ratio = Cost of Goods Sold + Operating Expenses X 100

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Ratio Analysis (iv) Return on Capital Employed (ROCE) : This Ratio measures the overall profitability and efficiency of the business. ROCE = Net Profit + Interest + Taxes X 100 Average Capital Employed Where Capital Employed = Fixed Assets + Current Assets – Current Liabilities (or) Shareholders’ Funds + Long Term Liabilities. (v) Profit Margin : This Ratio gives the amount of Net Profit earned by each rupee of revenue. Profit Margin = Profit after Tax Net Sales

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Ratio Analysis Asset Turnover: This Ratio measures the efficiency with which Assets are utilized Asset Turnover = Net Sales Average Total Assets Return on Assets (ROA): This Ratio measures the profitability from a given level of investment Return on Assets (ROA) = Profit after Tax

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Ratio Analysis Return on Equity (ROE) : This Ratio measures the profitability on Shareholders’ Funds. Return on Equity (ROE) = Profit after Tax Average Shareholders’ Equity Earnings Per Share (EPS) : This Ratio measures the earnings on each equity share Earnings Per Share (EPS) = Profit after Tax No of Equity Shares

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Ratio Analysis 4. Activity Ratios: These Ratios indicate the number of times stock is replaced during a year. A high Ratio indicates quick movement of stock and vice-versa. i.e, Activity Ratios measure the efficiency of asset management. The efficient utilization of assets would be reflected by the speed with which they are converted into sales. (i) Stock / Inventory Turnover Ratio = Cost of Goods sold Average stock (Where Average Stock = Opening stock + Closing Stock ) 2 (ii) Debtor’s Turnover Ratio = Debtors + Bills Receivable X No. of working days Credit sales in a year This Ratio shows the speed with which Debtors / Accounts Receivable are collected.

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Ratio Analysis (iii) Creditor’s Turnover Ratio : This Ratio shows the no. of days taken by the firms to pay its creditors. Creditor’s Turnover Ratio = Creditors + Bill Payable X No of working days in a Credit Purchases year (iv) Fixed Assets Turnover Ratio: This Ratio indicates the sales generated by every rupee invested in Fixed Assets Fixed Assets Turnover Ratio = Sales Net Fixed Assets

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Ratio Analysis 6. Capital Market Ratios : These Ratios are usually related to the Stock Market and are highly useful to the investors / potential investors. Price Earnings Ratio (P/E Ratio): This Ratio measures the amount investors are willing to pay for a rupee of earnings. Price Earnings Ratio (P/E Ratio) = Market Price per share (MPS) Earnings per Share (EPS) Dividend Yield : This Ratio measures the current return to investors Dividend Yield = Dividend per Share (DPS) Market Price per share (MPS)

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8 - 1 © 2005 Accounting 1/e, Terrell/Terrell Analyzing Financial Statements for Profitability, Liquidity, and Solvency Chapter 8.

8 - 1 © 2005 Accounting 1/e, Terrell/Terrell Analyzing Financial Statements for Profitability, Liquidity, and Solvency Chapter 8.

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