CHAPTER 3

RATIO ANALYSIS

and weaknesses underlying the

performance of an enterprise. In order
LEARNING OBJECTIVES
to calculate a ratio, a relevant
relationship between two numbers of
After studying this chapter, you will
be able to :
financial statements is established and
the result of the same is interpreted in
l Appreciate the concept of ratio
analysis ; order to derive meaningful conclusions.
l Understand cross-sectional and Two numbers are needed to
time-series analyses ; calculate a ratio. One number is put as
l Analyse liquidity, solvency, the numerator and the other as the
activity and profitability of a denominator. For example, if we want
business enterprise by using
to know the relative market share of a
relevant ratios.
brand of toothpaste (say X), we will
calculate a ratio. This ratio will have the
In the previous chapter you studied
number of units sold of Brand X in the
about the various tools of financial
numerator and the total size of the
analysis and interpretation, viz.,
market for toothpaste in the
comparative statements, common-size
denominator. Let us assume that these
statements and ratio analysis etc. This
numbers are 200 and 1000
chapter is devoted to the concept and
respectively. So the ratio turns out to
use of ratio analysis in the interpretation
200
of financial statements. be 20%, i.e. × 100 . It implies that the
1000

3.1 Concept of Ratio Analysis market share of Brand X is 20%.

A very important aspect of this
Ratio analysis involves the method of process is that the numerator and
calculating and interpreting financial denominator must be logically related
ratios in order to assess the strengths to each other. Otherwise, the ratio will
RATIO ANALYSIS 107

not provide information needed for decision-making. For example, in the previous
example, if we put 200 (number of units sold of Brand X) in the numerator and
2000 (number of users of washing machines) in the denominator, we get a ratio
of 10%. Though it is a ratio,but it does not lead us anywhere as no meaningful
conclusion could be drawn out of it. This is so because the numbers in the
numerator and denominator were not logically related since two members belong
to different product categories. So, whenever a ratio is to be calculated, analyst
must ensure that a logical relationship exists between the two numbers. As a
corollary to this, we can design any number of ratios, to analyse the performance
of a business enterprise, depending on the purpose at hand, so long as we observe
the condition of logical relationship.
Ratio can be expressed as :
i) percentage say, gross profit ratio is 25% of sales [calculated by dividing
gross profit (Rs. 10,000) by sales (Rs. 40,000) and multiplying by 100];
ii) proportion say, current ratio is 2:1 [calculated by dividing current assets
(Rs. 20,000) by current liabilities (Rs.10,000)];
iii) fraction say, net profit is one-tenth of sales [calculated by dividing net profit
(Rs.4,000) by sales (Rs.40,000)];
iv) times say, inventory turnover ratio is 5 times [calculated by dividing sales
(Rs.40,000) by average inventory (Rs.8,000)].

3.2 Cross-sectional and Time-series Analyses

We began the discussion on ratio analysis by calculating market share of a brand

of toothpaste, and this ratio turned out to be 20%. The purpose was to know the
relative market share of the brand. In order to interpret the ratio one have to
answer a question as : Is the market share of Brand X high or low? To respond to
this question, we have to compare this ratio with that of other brands or same
brand over a period of time.

3.2.1. Cross-sectional Analysis

This comparison could be made with other brands of toothpaste. We will calculate
similar ratio for other brands and then compare the same with Brand X ratio of
20%. The data is presented here :
 108 ACCOUNTANCY

Relative Market Share of different Brands of Toothpaste (2002)

Brand Y Brand Z Brand X

45% 35% 20%

On the basis of the information given above, one can infer that the market
share of Brand X is the lowest one. This type of an analysis is called 'cross-
sectional analysis'. Cross-sectional analysis involves comparison with competitors
or industry averages at the same point of time. This type of analysis helps in
identifying the problems that exists. This will enable us to enquire into the reasons
underlying the problems and which, in turn, will help to initiate corrective actions.
However, care has to be exercised regarding the selection of the constituents of
the cross-section. There must be a common variable of similarity. This similarity
may be of end product (all providing similar product), capital market attribute
(all having similar equity price), production process or raw material consumption).
In the above example, brand X is comparable to brand Y and Z only if the two
products are of similar type and cater to the same market.

3.2.2 Time-series Analysis

Yet another way of examining the relative market share of Brand X is to compare
its market share over a period of time. This period has to be chosen carefully so
as to permit comparison across the period of time. This analysis requires similar
data quality over a period of time in order to derive meaningful conclusions. So
care must be exercised regarding change in accounting policy, or any structural
change arising out of change in government policy, technological development
and competition, over the period of analysis. For example, a company may have
changed its depreciation policy from straight line to written down value. In this
case, the effect of change has to be ironed-out to make cross-sectional comparison
possible. Similar will be the case when accounting year is changed from usual
12 months to another period, say 15 months then 15 months period is to be
divided so as to make it a period of 12 months, otherwise data for two years
would be incomparable.
Let us assume that this analysis is being carried out for five years and the
market share of brand X for these years is shown here :
RATIO ANALYSIS 109

Market Share of Brand X (1997-2002)

1997 1998 1999 2000 2001 2002

40% 37% 30% 27% 25% 20%

The table above clearly indicates that the ratio is declining. It implies that
the market share of Brand X is shrinking over a period of time. We could give this
clear judgement because we observed the behavior of the same ratio over a period
of time. This type of an analysis is called 'time-series analysis'. Time-series
analysis evaluates the performance of the same business enterprise over a period
of time and helps in identifying problem areas requiring corrective measures. We
can also use both cross-sectional and time-series analysis together in order to
better understand a situation.
As discussed earlier, depending on the purpose at hand, a ratio can be
calculated. So it becomes necessary that we understand the expectations of
different users of financial statements. Creditors, shareholders and management
have interest in the analysis of financial statements using ratio analysis. Creditors
could be short-term creditors and long-term creditors. Short-term creditors are
primarily interested in liquidity of the enterprise, as their claims are to be met in
the short-run. Liquidity analysis means an analysis of the ability of the enterprise
to make payments in the short-run. The interests of the long-term creditors are
different. They are more interested in the ability of an enterprise to pay interest
and the principal. So such creditors are more interested in long-run profitability,
cash-flow generating ability and the quantum and growth of long-term debt to
understand the solvency position. The shareholders, both present and prospective,
are interested in share price and income in the form of dividend. Management is
concerned with all aspects of working of an enterprises. Therefore, management
may be interested in the analysis of entire enterprise encompassing liquidity,
solvency, activity and profitability.

3.3 Benchmarks

As discussed earlier, we calculate ratios because in this way that we get a

comparison that may prove more useful. In order to comment on the quality of a
ratio one has to make a comparison with some standard or benchmark. These
benchmarks could be :
 110 ACCOUNTANCY

i) Past ratio : A ratio could be benchmarked with the last year’s ratio. This
type of process was discussed under time-series analysis;
ii) Ratio of similar firms or industry average : A ratio could be compared with
the ratio of firms in the same industry or by industry average at the same
point of time. This type of process has already been discussed under cross-
sectional analysis; and
iii) Rule of thumb : 'Rule of thumb' have evolved over a period of time. For
example, rule of thumb for current ratio is 2:1, meaning thereby current
assets should be two times the current liabilities. However, these rule of
thumb are to be cautiously used.

3.4 Types of Ratio

Financial ratios can be grouped into four types:

(i) liquidity ratios,
(ii) solvency ratios,
(iii) activity ratios,
(iv) profitability ratios.
Once we go ahead with detailed discussion on different ratios which fall
under each group, it will be realized that liquidity, solvency and activity ratios
measure risks whereas profitability ratios measure return. Further, some of these
ratios focus short-run while others focus long-run. The solvency ratios have
long-term perspective while other category ratios are primarily focussed to the
short-run.
An important aspect of ratio analysis is that it is similar to performing art
endowed with lot of creativity and imagination. The choice of a set of ratios though
conditioned by the objective and purpose of analysis yet the interpretation
depends on the ingenuity of the financial analyst. Though we have certain set of
given ratios yet there is enough fertile ground for designing unique ratios to suit
the needs of financial analysis keeping in view the ever changing complexities
and dimensions of business.
Now we discuss different ratios under each of the four groups. We will be using
the data of Punjab Tractors Limited (PTL) whose annual accounts are listed in
the previous chapter.
RATIO ANALYSIS 111

3.4.1 Liquidity Ratios

The liquidity means ability to meet short-term obligations as they become due.
We honour our obligations through liquid assets. A liquid asset is one that can
be easily converted into cash. If our liquid assets are of poor quality, meaning
thereby that we find it difficult to convert them into cash when needed. Or if the
investment in liquid assets is less as compared to our short-term obligations,
then our ability to honour our short-term liabilities will be impaired.
Short-term lenders are primarily interested in this type of analysis. They
want to evaluate the liquidity of the enterprise with an intention to ascertain
whether their short-term credit will be safe. Also the management is interested to
know whether it will be able to honour its commitments.
PTL has current obligations to tune of Rs.18,231.40 lacs (2001) to be paid
in an accounting cycle. Will PTL be in a position to satisfy these obligations? The
following liquidity ratios help answer this question.

3.4.1.1 Current Ratio

Current ratio is the relationship between current assets and current liabilities.
Current assets are assets held on a short-term basis. These assets include cash
and bank balances, prepaid expenses, debtors, bills receivables, inventory (finished
goods, work-in-progress and raw material), short term investment in treasury
accounts and accrued income. Normally short-term refers to an accounting period.
Current liabilities are obligations that are payable within an accounting period.
Current liabilities include, creditors, bills payable, cash credit and overdraft from
a bank for a short period and liability for expenses, income recorded in advance,
and any other liability due for payment during the current accounting period.
Current ratio is calculated by dividing current assets by current liabilities.

Current Assets
Current Ratio =
Current Liabilities
 112 ACCOUNTANCY

Punjab Tractors Limited

Extract from the Balance Sheet as at March 31, 2001
(Rs. in lacs)
Current Assets, Loans 2001 2000
and Advances Rs. Rs. Rs. Rs.
Inventories 9,687.87 11,968.50
Sundry Debtors 29,828.64 8,827.90
Cash and Bank 419.64 1,839.79
Balances
Loan and Advances 5,955.51 7,109.68
45,891.66 29,745.87
Less:
Current Liabilities
and Provisions 18,231.40 8462.47
Net Current Assets 27,660.26 21,283.40

For PTL, this ratio is :

2001 2000

Rs.45,891.66 Rs.29,745.87
= = 2.5 = = 3.5
Rs.18,231.40 Rs.8,462.47

How to interpret this ratio? A current ratio of 2:1 is generally considered to

be acceptable. However, this rule of the thumb varies from industry to industry.
Higher the current ratio better it is as it signifies higher liquidity. Another way of
interpretation is to observe the behaviour of this ratio over a period of time. As
discussed earlier, it is called time-series analysis. We have current ratios of PTL
for the year 2000 and 2001. A comparison of the two ratios signifies that ratio
has gone down. It means that the liquidity position of PTL has deteriorated over
a period of time. However, as discussed earlier that the rule of thumb for this
ratio is 2:1, then one can infer that PTL is trying to reduce excessive investment
in current assets and bringing this ratio down.
One can also interpret a ratio by comparing it with a competitor or industry
average. As discussed earlier, this process of comparison is called cross-sectional
analysis. For example, the major competitor of PTL happens to Mahindra and
Mahindra (M & M). The current ratio of M & M for the year 2001 is 1.4:1. If we
compare current ratio of PTL of 2001 with M & M, one is led to the conclusion
that the current ratio of PTL is higher. It is roughly double the M & M current
ratio. So steps are required to be taken by PTL to bring its current ratio in line
RATIO ANALYSIS 113

with M & M, if PTL is benchmarking in liquidity management with that of M & M.

One can look to industry average also for comparison. The tractor industry
current ratio average was 1.4:1 in 2001. The firms included in the industry
group are: Mahindra and Mahindra Ltd., Eicher Ltd., Punjab Tractors Ltd., Escorts
Ltd. and HMT Ltd. A comparison with this ratio also results in same observations
as given for the M & M benchmark ratio since industry average and M & M
current ratio come out to be same, i.e., 1.4:1. However, a too high current ratio is
not good as excessive money blocked in current assets reduces profitability. If
the organization carries huge inventory, it means the organization has blocked
massive funds in inventory and the profitability arising out of faster rotation is
affected. Similar is the case with all other current assets. Instead of this, if the
funds are invested in fixed assets, higher return is generated. So one should
keep in mind that there is an inverse relationship between liquidity and
profitability. Higher liquidity means lower profitability and vice versa. So one
has to strike a balance between the two.
The above discussion makes us understand that one can interpret a ratio in
relation to the rule of thumb, or observation of the phenomenon over a period of
time (time-series analysis), or industry average or competitor benchmark (cross-
sectional analysis).
Ratio analysis is a tool and like every tool it has to be handled with care by
the analyst. The sophistication in the use is dependent upon the personal skills,
experience and judgemental power of the analyst. The subtleties have to be born
in mind while interpreting the ratio in line with the composition of the ratio.

3.4.1.2 Liquid Ratio

This ratio is also referred to as 'acid-test ratio' or 'quick-ratio'. The ratio seeks to
ascertain the liquidity position of a business enterprise. Liquidity implies the
ability to convert current assets into cash. Liquid ratio is expressed as follows :
Liquid Assets
Liquid Ratio = Current Liabilities

The term 'liquid assets' implies current assets minus inventory. The current
liabilities have already been explained in the context of current ratio.
 114 ACCOUNTANCY

Liquid assets include only those current assets which are capable of being
converted into cash according to the needs of the organization arising out of
payments. Therefore, some assets such as inventory, prepaid expenses, non-
realizable portion of receivables and non-saleable portion of marketable securities,
will be excluded from current assets to obtain the value of liquid assets. However,
in the absence of any information to the contrary, debtors and marketable
securities are assumed to be realizable at their stated book values.
For PTL, following is the amount of liquid assets (current assets-inventories).
(Rs. in lacs)

2001 2000
= Rs. 45,891.66 – Rs. 9,687.87 = Rs. 29,745.87 – Rs. 11,968.50
= Rs. 36,203.79 = Rs. 17,777.37

Rs. 36,203.79 Rs. 36,203.79

Liquid Ratio = = 1.98 = = 1.98
Rs. 18,231.40 Rs. 18,231.40

Generally, a quick ratio of 1:1 or more is considered to be good for the reason
that it indicates availability of funds to meet the liabilities 100%. However, this
rule of thumb varies from industry to industry as in case of current ratio and
other ratios.
In case of PTL this ratio is 1.98 for 2001. It means that the level of liquidity
of PTL is too high. As discussed in the interpretation of current ratio, higher
liquidity means less profitability. So PTL should use some benchmark level, or
industry average, to further its liquidity position. The ratio has slightly gone
down when compared with last year implying thereby that management has
already initiated corrective actions to maintain liquidity in the optimum range.
Having understood two measures of liquidity and the justification and
process behind their calculation, we can appreciate that while calculating liquid
ratio, more important is the quality of current assets. If a business enterprise
has a highly liquid block of inventory but slow moving debtors, then we will
reduce debtors (and not inventory) from the current assets. So all those current
assets which as per our judgement are less liquid are to be reduced from the
current assets. Inventory being traditionally the most liquid asset it has been
reduced for the calculation of liquid (quick) ratio.
From the view point of management, the above method of calculation and
interpretation is valid for the analysis of balance sheet, which is static in nature,
RATIO ANALYSIS 115

as it is carried at a point in time. It is of not much use to management if the focus

of managerial decision-making is operations of the enterprise. At operations level,
liquidity has to be managed on daily basis and within the period of credit made
available by the suppliers. Therefore, the cash generating potential of the
enterprise has to be matched with the obligations that are due for payment within
the payment cycle.

3.4.2 Solvency Ratios

The term solvency implies the ability of the enterprise to meet its obligations on
the due date. Some payments have short-term maturity and some have long-
term maturity. The firm has to plan for both short-term and long-term obligations.
We have analyzed short-term liquidity of a business enterprise in the previous
section. Now we extend an analysis to long-term liquidity. Long-term liquidity
means ability to meet long-term commitments or obligation. Long-term lenders
are primarily interested in this type of analysis.
A long-term lender of funds is basically interested in two things. The safety
of principal which is to be given by way of a loan, and regular servicing of the
loan, in the form of payment of interest commitments and repayment of installment
of loan. For example, a loan is extended for Rs. 1 crore for 5 year period with
10% interest to be paid annually. One would like to be sure that the principal
amount of Rs.1 crore is safe for the duration of loan and the lender will regularly
get Rs.10 lacs as interest every year.
To capture these two aspects of long-term liquidity two ratios are calculated,
debt to equity ratio and interest coverage ratio. Interest coverage ratio deals with
the ability of the enterprise to honour its interest payment out of the cash
generated by it. It is expressed as number of times the operating net cash inflows
are to the interest payments. In other words, interest coverage ratio = net cash
inflows from operations, interest charges. Computation of net cash inflows from
operations will be discussed in the chapter on cash flow statement.

3.4.2.1 Debt-equity Ratio

Debt-equity ratio refers to the relationship of the long-term debt and the equity
of the enterprise. The degree of indebtedness of an enterprise is captured by this
ratio. Long-term lender wants to know about the status of outsiders’ long- term
funds being used by a business enterprise vis-a-vis owner’s funds. By
establishing this relationship one will come to know that at a point of time how
 116 ACCOUNTANCY

much is the stake of owner’s as compared to those who have given long- term
loans.
Debts are long-term liabilities having maturity after one year. It includes
debenture, long-term loans from banks and financial institutions and public
deposits. Equity (also called shareholder’s funds) includes equity share capital,
preference share capital, general reserves, capital reserves, securities premium
account balance and all other reserves and surplus available for equity share
holders. For the computation of equity, miscellaneous expenses and debit balance
of profit and loss account, if any, are to be deducted.
Debt
Debt-Equity Ratio is expressed as
Equity

Punjab Tractors Limited

Extract from the Balance Sheet as at March 31, 2001

(Rs. in lacs)
Shareholders’ Funds 2001 2000
Capital 6,075.57 2,025.19
Reserves and Surplus 37,356.31 43,431.68 35,176.32 37,201.51
Loan Funds
Secured Loan 4.58 –
Unsecured Loans 1,310.00 1,314.58 1,275.32
44,746.46 38,476.83

2001 2000
Debt 1314.58 1275.32
= = 0.030 = 0.034
Equity 43431.88 37201.51
As already discussed, this ratio measures the degree of indebtedness of a
business enterprise. So it gives an idea to a long-term lender regarding the safety
of the principal. If this ratio is high, then risk is more in extending a loan. Rule of
the thumb for this ratio is 2 : 1. It means debt could be twice the equity. However,
this ratio, like other ratios, varies from industry to industry. Industries which
have inherent stability of earnings like oil companies, have debt-equity standard
far higher than 2:1 Industries like heavy equipment and machinery manufac-
turing, whose earnings and cash flows are less stable, this ratio has to be low.
PTL's debt-equity ratio is too low and it has remained same when compared
RATIO ANALYSIS 117

with 2000. It means that PTL has massive long-term debt raising capacity if it
ever plans to expand its operations in future. PTL management has a very
conservative approach to financing as it finances its growth primarily from the
sources which are related to the owners.
Another way of looking at this ratio is from the perspective of owners. In
general, greater the use of debt in relation to equity, the greater its financial
leverage. Financial leverage results from the use of fixed charge bearing securities
like debentures. It has a bearing on owners' return and risk. An increase in
financial leverage results in higher potential return and greater risk.
From this perspective, PTL is not reaping the benefits of financial leverage
for owners as its financial leverage is quite low. PTL can magnify the owners'
earnings by increasing debt-equity ratio.

3.4.2.2 Total Assets to Debt Ratio

This ratio attempts to measure the proportion of total assets funded by long-
term debt. The lower the ratio, the role of loaned funds in financing the assets
engaged in profit generating activities of the organization.
Total Assets
The ratio is calculated as : =
Debt
118 ACCOUNTANCY

Punjab Tractors Limited

Extract from the Balance Sheet as at March 31, 2001

(Rs. in lacs)
2001 2000
SOURCES OF FUNDS
Shareholders' Funds :
Capital 6,075.57 2,025.19
Reserves and Surplus 37,356.31 43,431.88 35,176.32 37,201.51
Loan Funds :
Secured Loans 4.58 -
Unsecured Loans 1,310.00 1,314.58 1,275.32
Total 44,746.46 38,476.83

APPLICATION OF FUNDS
Fixed Assets :
Gross Block 26,214.84 24,413.58
Less: Depreciation 10,726.89 9,054.04
Net Block 15,487.95 15,359.54
Capital Work-in-Progress 758.26 664.59
/Advance and Construction
Capital Spares 66.53 16,312.74 84.38 16,108.51
Investments 773.46 1,084.92
Current Assets,
Loans and Advances :
Inventories 9,687.87 11,968.50
Sundry Debtors 29,828.64 8,827.90
Cash and Bank Balances 419.64 1,839.79
Loan and Advances 5,955.51 7,109.68
45,891.66 29,745.87

Total Assets 62,977.86 46,939.30

Less: Current Liabilities and 18,231.40 8,462.47
Provisions 44,746.46 38,476.83
RATIO ANALYSIS 119

The ratio for PTL has been calculated below :

Rs. in lacs

2001 2000

Rs. 62,977.86 Rs. 46,939.30

= 47.9 = 36.8
Rs.1,314.58 Rs.1,275.32

The behaviour of this ratio signifies that the role of outsiders' fund in financing of
the total asset base of PTL is going down. One can calculate the percentage of
total assets funded by long-term lenders also. These percentages for PTL will be
:
Rs. in lacs
2001 2000

Rs. 1,314.58 Rs. 1,275.32

×100 = 2.1% ×100 = 2.7%
Rs. 62,977.86 Rs. 46,939.30

This also reinforces the conclusion drawn earlier that in 2001 total assets of PTL
were funded to the tune of 2.1% only by the long-term lenders as compared to
2.7% in 2000.

3.4.2.3 Proprietary Ratio

The proprietary ratio is a variant of debt-equity ratio. It captures relationship
between equity and total assets. It attempts to indicate the part of total assets
funded through equity. The following is the formula:
Equity
Proprietary Ratio =
Total Assets

Calculation of this ratio for PTL

(Rs. in lacs)
2001 2000

Rs. 43,431.88 Rs. 37,201.51

= = 0.69 or 69% = 0.79 or 79%
Rs. 62,977.86 Rs. 46,939.30

Total assets block of PTL is funded to the tune of 69% by equity. This
percentage stood at 79% in 2000. It means that during one year 34.17%
 120 ACCOUNTANCY

 62977.86 − 46939.30 × 100 

  growth in total assets has been funded by equity to
 4693.30 

 43431.88 − 37201.51 × 100

the tune of only 16.75%   only. Rest of the growth has
 37201.51
been funded primarily by current liabilities which have grown over the period by
18231.40 − 8462.47 × 100
115.44%.   . The share of long-term debt in the funding
 8462.47
of total assets is meager. This is clear from the previous ratio (Total assets to Debt
ratio) also.

3.4.3 Activity Ratios

These ratios help in commenting on the efficiency of the firm in managing its
assets. The speed with which assets are converted into sales is captured by activity
ratios. The activity of any business enterprise is reflected by the volume of sales
it is able to generate. All assets are used by the business in the quest of generating
sales. So, one can comment on the efficiency of different assets in relation to sales
generated during a defined period. Let us take a simple example in order to
explain this.

Co. A Co. B
(Rs.) (Rs.)
Fixed Assets 1,000 2,000
Sales 10,000 18,000

On the basis of these figures, one can opine that Co. A is relatively efficient
because for every Re.1 investment in fixed assets it is able to generate sale of
Rs.10 as compared to Rs.9 in case of co.B. This leads one to infer that faster the
rotation, greater is the efficiency. Following are select activity ratios discussed in
this section.

3.4.3.1 Inventory Turnover Ratio

Inventory is an element of current assets. Inventory is needed for smooth flow of
production and sales. Inventory is of three types, i.e., raw material, work-in-
progress and finished goods. Raw material and work-in-progress inventory is
maintained for the uninterrupted flow of production. Finished goods inventory
RATIO ANALYSIS 121

is kept for meeting the demands of customers. Due to uncertain nature of demand
fluctuations as also the likelihood of creeping of logistics bottlenecks for
unforeseen reasons. We usually maintain finished goods inventory. Inventory
turnover ratio measures the efficiency with which inventory has been converted
into sales. The ratio could be put like this:

Sales
Inventory Turnover Ratio =
Average Inventory

Inventory is generally valued at cost. In order to have a logical relationship

with the denominator, the numerator should also be a cost variable. Sales include
an element of profit. By eliminating this element, cost of goods sold is calculated
and then inventory turnover ratio will be :

Cost of Goods Sold

Inventory Turnover Ratio = Average Inventory

Opening Stock + Closing Stock

Average Inventory =
2

The figure of cost of goods sold is not separately available in the published
accounts of Indian companies. The external analysts do not have an access to
cost of goods sold data. So, they use sales in the numerator. However, management
should use cost of goods sold data in order to calculate this ratio. Further, the
numerator should be net of excise duty. So, sales are always to be used net of
excise duty while calculating different ratios. However, if these balances are not
available, one can use the end-of-year balance also.

Punjab Tractors Limited

Extract from the Balance Sheet and Profit and Loss Account
For the year ended March 31, 2001

(Rs. in lacs)
2001 2000
Revenue from operations 1,11,946.37 1,17,020.86
Excise Duty 15,499.10 15,336.46
Revenue from operations 96,447.27 1,01,684.40
(Net of excise duty)
Inventories 9,687.87 11,968.50
 122 ACCOUNTANCY

Inventory turnover ratio of PTL for the year 2001 has been calculated below.
Ratio for 2000 can not be calculated as we need to have the closing value of
inventory for 1999 (This amount is not available in this annual report).

Sales(Net of Excise Duty)

Inventory Turnover Ratio = Opening Inventory + Closing Inventory
2

Rs. 96,447.27
= 11,968.50 + 9,687.87
2

Rs. 96,447.27
= 11,968.50 + 9,687.87
= 8.9
2

This ratio of 8.9 signifies that inventory of PTL is getting rotated over 8.9
times in a year. As we do not have sufficient data to calculate this ratio of PTL for
earlier years, so time-series analysis cannot be carried out. However, going by
the basic nature of this ratio, higher the ratio, better it is. If this ratio improves
and reaches the level of 18 over time, then it implies that with the same level of
inventory. PTL could generate double the existing level of sales or by reducing
the investment in inventory to a level which commensurate to change in the level
of sales and this is good for the organization. Therefore, higher the ratio, the
better it is. This is subject to one condition that the inventory turnover ratio
should not turn so high that it results into a situation of stock out. It means that
the inventory being carried is so less that we might have to refuse the supply of
goods to the customer, i.e reduction in the level of inventory without sacrificing
the smooth flow of goods to customers. Carrying high inventory, costs the
organization and reduces its profits. On the other hand, carrying insufficient
inventory saves the costs and creates opportunity cost for lost sales because of
stock out.
Inventory turnover ratio can also be converted into number of days, in the
following manner.

Days in a year
Average Age of Inventory =
Inventory Turnover Ratio

365
= = 41days
8.8
RATIO ANALYSIS 123

In this case inventory age of 41 days implies working captial investement for
that period.
So, on an average, the money blocked in inventory gets converted into sales
in 41 days. If the inventory turnover ratio goes up, the average age of inventory
will go down and vice versa.

3.4.4.2 Debtors Turnover Ratio

Debtors turnover ratio measures the efficiency with which the debtors are
converted into cash. This ratio indicates both the quality of debtors and the
collection efforts of the business enterprise. This ratio is calculated as follows:
Sales
Debtors Turnover Ratio = Average Debtors

Opening Debtors + Closing Debtors

Average Debtors =
2
The numerator of this ratio should preferably be credit sales. This is so
because the denominator is logically related to credit sales as it arises from credit
sales only. Cash sales do not generate debtors. However, as the information related
to credit sales is not separately available in corporate accounts, so total sales
could be taken in the numerator. Average debtors are calculated by dividing the
sum of beginning-of-year and end-of-year balance of debtors by 2.

Punjab Tractors Limited

Extract from the Balance Sheet and Profit and Loss Account
for the year ended March 31, 2001

(Rs. in lacs)

2001 2000
Revenue from operations 1,11,946.37 1,17,020.86
Excise Duty 15,499.10 15,336.46
Revenue from operations (Net of excise duty) 96,447.27 1,01,684.40
Sundry Debtors 29,828.68 8,827.90

The calculation of this ratio for PTL for the year 2001 is as follows :
 124 ACCOUNTANCY

Sales
Debtors Turnover Ratio =
Opening Debtors + Closing Debtors
2

Rs. 96,447.27
=
Rs. 29,828.64 + Rs. 8,827.90
2

Rs. 96,447.27
= = 5.0
Rs. 19,328.27

It means that debtors of PTL are getting turned over on an average 5.0 times
in a year. As discussed in 3.4.3.1, higher a turnover ratio, better it is. However, a
too high debtor's turnover ratio generally means tight credit policy and hence
denial of opportunity to increase sales by offering liberal credit facility to the
customers.Conversally the nature of product and industing customers may
warrantee no credit, or very limited credit.
This ratio can also be converted into the number of days it takes to get cash
collected from the debtors in the following manner:

Days in a year
Average Collection Period = Debtors Turnover Ratio

365
= = 73 days
5.0
It means that the debtors of PTL normally take 73 days to get converted into
cash. A better insight into the quality of this ratio could be had by observing the
behaviour of this ratio over a period of time and also by comparing this ratio with
the best company in the industry or with industry-average.

3.4.3.3 Payable Turnover Ratio

This ratio reflects the efficiency in making payment to the creditors. Prudence
demands that one should not make payment to creditors at a pace which is
faster than the pace of receiving payments from debtors. So, normally we compare
this ratio with debtors turnover ratio to observe our pace of discharging payable,
apart from observing this ratio over a period of time and in relation to our
competitors.
RATIO ANALYSIS 125

Purchases
Payable Turnover Ratio = Average Creditors

Opening Creditors + Closing Creditors

Average Creditors =
2
The numerator of the ratio carries the amount of purchases made during
the year and the denominator carries the average creditors which have emerged
from the numerator.

Punjab Tractors Limited

Extract from the Balance Sheet and Profit and Loss Account
for the year ended March 31, 2001
(Rs. in lacs)
2001 2000
Raw Materials & Components Purchased (Schedule I) 63,645.56 69,589.05
Sundry Creditors (Schedule H) 11,356.56 2,714.60

Purchases
Payable Turnover Ratio = Opening Creditors + Closing Creditors
2

Rs. 63,645.56
= = 9.05
Rs. 7,035.58
Payable turnover ratio could be converted into number of days by dividing
the days in a year by this ratio.
Days in a year
Average Payment Period = 365
Creditors Turnover Ratio = 9.05 = 40.3 days

PTL is making payment to its creditors as on average after 41 days.It is to be

noted that any fraction of day would, in practice, mean next day. Hence, in the
present care arithmetical ratio of 40.3 days would imply 41 days. Average
collection period of PTL, as calculated earlier, is 73 days. It implies that PTL is
making payments to its creditors more quickly than the payment.
 126 ACCOUNTANCY

This ratio for PTL for two years is :

2001 2000

Rs. 1,11,946.37 Rs. 1,17,020.86

= = 4.0 = = 5.5
Rs. 27,660.26 Rs. 21,283.40

The ratio of two years leads one to the conclusion that the turnover of working
capital has gone down in 2001. PTL could generate lesser sales revenue in 2001
with the same amount of investment made in working capital as compared to
2000. This requires attention of the management.

3.4.3.4 Working Capital Turnover

Working capital refers to investment in current assets. This is also known as
gross concept of working capital. There is another concept of working capital
known as net working capital. Net working capital is the difference between cur-
rent assets and current liabilities.
Analysts intend to establish a relationship between working capital and sales
as the two are closely related. Through this ratio we are attempting to see that
one rupee blocked by the organization in net working capital is generating how
much sales. Higher the ratio the better it is.

Sales
Working Capital Turnover =
Net Working Capital
RATIO ANALYSIS 127

Punjab Tractors Limited

Extract from the Balance Sheet and Profit and Loss Account
for the year ended March 31, 2001

(Rs. in lacs)
2001 2000
Revenue from operations 1,11,946.37 1,17,020.86
Excise Duty 15,499.10 15,336.46
Revenue from operations (Net 96,447.27
of excise duty) 1,01,684.40
Current Assets, Loans &
Advances :
Inventories 9,687.87 11,968.50
Sundry Debtors 29,828.68 8,827.90
Cash and Bank Balances 419.64 1,839.79
Loan and Advances 5,955.51 7,109.68
45,891.66 29,745.87
Less : Current Liabilities and 18,231.40 8,462.47
Provisions
Net Current Assets 27,660.26 21,283.40
(Net Working Capital

This ratio for PTL for two years is :

2001 2000

96,447.27 1,01,684.40
= = 3.5 = = 4.8
27,660 21,283.40

The ratio of two years leads one to the conclusion that the turnover of working
capital has gone down in 2001. PTL could generate lesser sales revenue in 2001
with the same amount of investment made in working capital as compared to
2000. This requires attention of the management.

3.4.4 Profitability Ratios

Profit is important for every business enterprise. It is so because without profits
a business will find it difficult to attract capital, and assure its creditors and
owners regarding the safety of their funds. Further, profit acts as a touchstone to
comment on the soundness (or otherwise) of the policies and decisions of the
 128 ACCOUNTANCY

management. There exists very many measures of profitability. However, we will

deliberate on gross profit ratio and operating ratio only.

3.4.4.1 Gross Profit Ratio

Gross profit is the difference between sales and cost of goods sold. Gross profit
ratio is the ratio of gross profit to sales. The gross profit ratio represents (in
percentage terms) the excess of what the concern is able to charge as sale price
over the cost of purchasing/manufacturing the goods. This excess is available to
meet other operating expenses (administrative, selling and distribution expenses),
interest on borrowings and income tax. The amount remaining after meeting
these expenses represents net profit which belongs to the shareholders.
The gross profit ratio represents the efficiency of the concern in respect of
selling and purchasing/manufacturing operations as well as the market
conditions in which it is operating. Thus, a concern can raise the gross profit
ratio by reducing the cost of purchase of goods (in the case of a trading concern)/
the cost of purchase of raw materials and other manufacturing costs like wages
(in the case of a manufacturing concern), or by increasing the sale prices, or by a
combination of both.

Gross Profit
Gross Profit Ratio = ×100
Sales

In case of a trading concern

Cost of Goods Sold = Opening Stock + Purchases + Expenses
directly related to Purchases* – Closing Stock

In case of a manufacturing concern

Cost of Goods Sold = Opening Stock of Finished Goods + Cost
of Goods Manufactured – Closing Stock of
Finished Goods
It is to be noted that gross profit ratio cannot be calculated from the publicly
available from published accounts because of its high sensitivity competitiveness
of the firm. Hence, it is calculated by management for internal decision-making,
sales pricing, etc.
In case of a public limited companies like PTL, the annual accounts do not
provide information for Manufacturing Account or Trading Account. So, in order
RATIO ANALYSIS 129

to calculate gross profit, additional information is required to be obtained from

the books of accounts of PTL. In the light of this, gross profit ratio is not being
calculated for PTL. However, to make the concept clear, the following data can be
used.

R. and Bros. Rs.

Opening Stock as on April 1, 2000 2,00,000
Purchases made during the year 15,00,000
Sales made during the year 20,00,000
Freight Inward* 25,375
Wages (Loading/Unloading Charges)* 2,585
Closing Stock as on March 31, 2001 2,25,000

Note : These are the expenses which are incurred in connection while making purchases such
as carriage inward, loading and unloading expenses, octroi etc.
Gross Profit = Sales – Cost of Goods Sold
= Sales – [Opening Stock + Purchases + Freight Inward
+ Wages – Closing Stock]
= Rs. 20,00,000 – [2,00,000 + 15,00,000 + 25,375 + 2,585
– 2,25,000]
= 20,00,000 – [15,02,960]
Gross Profit = Rs. 4,97,040

Gross Profit
Gross Profit Ratio = × 100
Sales

Rs. 4,97,040
= ×100 = 24.9%
Rs. 20,00,000

Gross profit ratio (24.9%) signifies that out of Rs.100 sales revenue, Rs.75.10
have been spent on cost of goods sold. The balance of Rs. 24.90 is available to
meet the incidence of operating expenses, viz., administrative, selling and
distribution expenses, and for payment of interest charges and income tax. The
amount remaining after meeting these expenses represents the earnings belonging
to the owners.
 130 ACCOUNTANCY

3.4.4.2 Operating Ratio

It is the ratio of operating expenses to sales. Operating expenses include cost of
raw material, finished and semi-finished goods, manufacturing expenses,
administrative, selling and distribution expenses (including depreciation).
Operating expenses do not include interest charges and income tax. In other
words, operating expenses include all those expenses which relate to operations
of a business enterprise but do not include any expenses or charges related to
finance and non-operating activities. If a manufacturing or trading concern has
invested some of its funds outside (which would be disclosed under 'investments'
in the balance sheet), any income arising therefrom is also not included in revenue
from operations. Similarly, any cost relating to the same, including diminution
in value, is not included in operating expenses.
Operating Expenses
Operating Ratio = × 100
Sales

Punjab Tractors Limited

Extract from the Profit and Loss Account
for the year ended March 31, 2001
(Rs. in lacs)
2001 2000
Raw Material, Finished and Semi-finished
Products 65,126.87 69,643.81
Operating and Administrative Expenses 13,047.32 12,508.45
(Schedule J)
Depreciation 1,691.90 1,598.17
Provision for Diminution in Value of
Investments (Schedule J) 311.46 0
Revenue from operations 1,11,946.37 1,17,020.86
Excise Duty 15499.10 15,336.46
Revenue from operations
(Net of excise duty) 96,447.27 1,01,684.40

Schedule J (listed in the previous chapter) which carries the details of

operating, administrative and other expenses, makes it clear that all expenses in
the schedule, except 'Provision for Diminution in Value of Investments', are
operating expenses. 'Provision for Diminution in Value of Investments' is not an
operating charge. It does not relate to operations of PTL. So, the amount this
finance variable, Rs.311.46 lacs, has been deducted while calculating operating
RATIO ANALYSIS 131

expenses for 2001. Hence, operating expenses of PTL for the two years happen
to be :
Operating Expenses = Cost of Raw Material, Finished Goods and
Semi-finished Goods + operating, administrative,
selling and distribution expenses - Finance
charges + Depreciation
2001 = 65,126.87+(10,347.32 - 311.46)+691.90
= 75,854.63
2000 = 69,643.81 + (12508.45 - 0) +1,598.17
= 83,750.43

2001 2000

Rs. 75,854.63 Rs. 83,750.43

Operating Ratio = Rs. 96,447.27 × 100 = ×100
Rs. 101,684.40

= 78.6% = 82.4%
The operating ratio of PTL has shown a decline in 2001. It is 78.6% in 2001.
This ratio signifies that roughly 80% of sales have been consumed by cost of
goods sold and other operating expenses. The remainder (20%) is available to
cover interest charges, taxes and earnings available to shareholders.
The lower the ratio, better it is. As a higher operating ratio will leave a small
amount of operating income to meet interest, tax and dividends. This ratio should
be studied over a period of time in order to have a better understanding of the
behaviour of this ratio.It is to be noted that in case of same enterprises such as
Xerox companies, computer hardware companies, internet service provider
initially earn their revenues by selling the machines forming part of their care
services activities but later on due to saturation of the market, such companies
desire larger components of their revenues from the annual maintain contracts
and sale of spares. In such a case, the revenue from such activities will from part
of revenue from operations. However, while making product segment analysis
classifications between service and products provide deeper insight into the
changing character and focus about the operations of the enterprise. Sometimes
the firm experiences the initial core business becoming non-profitable and chance
may take recourse to hiring of strategy.
 132 ACCOUNTANCY

Illustration
a) If current ratio is 2.5 times and current liabilities are Rs. 27,000. Calculate
current assets.
b) Calculate current liabilities, if current assets are Rs.1,05,000 and current
ratio is 3 times.
c) If current liabilities are Rs. 35,000, current ratio is 3.25 times and liquid
ratio is 2.75 times, calculate the amount of current assets, liquid assets and
inventory.

Solution
Current Assets
a) Current Ratio = Current Liabilities

Current Assets
2.5 (Given) = Rs. 27,000(Given)

Current Assets = Rs. 27,000 × 2.5

= Rs. 67,500

Current Assets
b) Current ratio = Current Liabilities

Rs. 1,05,000(Given)
3 (Given) =
Current Liabilities

Rs. 1,05,000
Current Liabilities =
3
= Rs. 35,000

Current Assets
c) Current Ratio = Current Liabilities

Current Assets
3.25 (Given) = Rs. 35,000

Current Assets = Rs. 35,000 × 3.25

= Rs. 1,13,750
RATIO ANALYSIS 133

Liquid Assets
Liquid Ratio =
Current Liabilities

Liquid Assets
2.75 (Given) =
Rs. 35,000

Liquid Assets = Rs. 35,000 × 2.75

= Rs. 96,250
Inventory = Current Assets – Liquid Assets
= Rs. 1,13,750 – Rs.96,250
= Rs.17,500

Illustration 2
Calculate (i) Debt-Equity Ratio and (ii) Proprietary Ratio from the following data
:
Rs.
Equity Share Capital 75,000
Reserves and Surplus 20,000
Debentures 40,000
Loan from ICICI 30,000
Current Liabilities 15,000
Fixed Assets 82,000
Goodwill 48,000
Current Assets 50,000

Solution

Debt
i) Debt-Equity Ratio =
Equity

Debentures+ Loan from ICICI

=
Equity Share Capital + Reserve & Surplus

Rs. 7,000
=
Rs. 95,000
= 0.74 times
 134 ACCOUNTANCY

Equity
ii) Proprietary Ratio =
Total Assets

Total Assets = Fixed Assets + Goodwill + Current Assets

= Rs. 82,000 + 48,000 + 50,000
= Rs.1,80,000

Rs. 95,000
Proprietary Ratio =
Rs. 1,80,000

= 0.53 times
Illustration 3
Inventory turnover ratio is 3 times. Sales is Rs. 75,000. Opening balance of
inventory is Rs. 7,000 more than the closing balance of inventory. Calculate
opening and closing balances of inventory.

Solution
Sales
Inventory Turnover Ratio =
Average Inventory

Rs. 75,000
3 (Given) =
Average Inventory

Rs. 75,000
Average Inventory = = Rs. 25,000
3
Total Inventory = Rs. 25,000 × 2 = Rs. 50,000
Let the Inventory in the = X
beginning
Inventory at the end = X – Rs. 7,000
Total inventory = X + (X – Rs. 7,000)
Rs. 50,000 = X + (X – Rs. 7,000)
2X = Rs. 57,000
X = Rs. 28,500
Therefore, Inventory in the beginning = Rs. 28,500
Inventory in the end = Rs. 28,500 – Rs. 7,000
= Rs. 21,500
RATIO ANALYSIS 135

Illustration 4
Calculate Working Capital Turnover Ratio from the following information.

Liabilities (Rs.)
Share Capital 2,00,000
12% Debenture 1,60,000
Reserves and Surplus 40,000
Current Liabilities 1,40,000
Total 5,40,000

Assets
Fixed Assets 3,40,000
Current Assets 2,00,000
Total 5,40,000
Net sales during the year are Rs. 2,70,000

Solution

Net Sales
Working Capital Turnover Ratio =
Working Captial

Working Capital = Current Assets – Current Liabilities

= Rs. 2,00,000 – Rs. 1,40,000
= Rs. 60,000

Rs. 2,70,000
Working Capital Turnover Ratio =
Rs. 60,000

= 4.5 times

Illustration 5
Calculate : (i) Payable Turnover Ratio
(ii) Average Payment Period
 136 ACCOUNTANCY

2000 2001
Rs. Rs.
Annual Purchases 25,840 28,500
Opening Creditors 3,040 2,800
Closing Creditors 2,680 4,200

Solution

Purchases
(i) Payable Turnover Ratio = Average Creditors

2000 2001

25,840 28,500
(3,040 + 2,680) (2,800 + 4,200)
2 2
= 9.03 = 8.14

Days in a year
(ii) Average Payment Period =
Payables Turnover Ratio

2000 2001

365 365
= = = 45 days
9.03 8.14
= 40.42 days = 44.80 days
i.e. 41 days i.e. 45 days

Illustration 6
From the following information, calculate
i) Debtors Turnover Ratio
ii) Average Collection Period
iii) Payable Turnover Ratio
iv) Average Payment Period

Given :
(Rs.)
Sales 8,75,000
Creditors 90,000
Bills Receivable 48,000
RATIO ANALYSIS 137

Bills Payable 52,000

Purchases 4,20,000
Debtors 59,000

Solution

365
i) Debtors Turnover Ratio = = 45 days
8.14

8,75,000
=
59,000 + 48,000
= 8.18 times
*This figure has not been divided by 2, in order to calculate an average, as the figures of
debtors and bills receivables in the beginning of the year are not available. So when only
year-end figures are available use the same as it is.
365
(ii) Average Collection Period =
Debtors Turnover Ratio

365
=
8.18
= 45 days
Purchases
(iii) Payable Turnover Ratio = Average Creditors

Purchases
=
Creditors+ Bills payable

4,20,000
=
90,000 + 52,000

4,20,000
=
1,42,000
= 3 times
365
(iv) Average Payment Period =
Payables TurnoverRatio

365
=
3
= 122 days
 138 ACCOUNTANCY

Illustration 7
Given the following information
(Rs.)
Sales 3,40,000
Cost of goods sold 1,20,000
Selling expenses 80,000
Administrative Expenses 40,000

Calculate Gross Profit Ratio and Operating Ratio.

Solution
Gross Profit = Sales – Cost of goods sold
= Rs. 3,40,000 – Rs. 1,20,000
= Rs. 2,20,000

Gross Profit
Gross Profit Ratio = × 100
Sales

Rs. 2,20,000
= ×100
Rs. 3,40,000

= 64.71%
Operating Expenses = Cost of goods sold + Selling Expenses +
Administrative Expenses
= Rs. 1,20,000 + 80,000 + 40,000
= Rs. 2,40,000

Operating Expenses
Operating Ratio = ×100
Net Sales

2,40,000
= × 100
3,20,000

= 75%

Illustration 8
The Profit and Loss Accounts and Balance Sheets of Arnold Co. Ltd. for two
years are given below :
RATIO ANALYSIS 139

Profit and Loss Account of Arnold Co. Ltd.

for the years ending March 31, 2000 and 2001

(Rs. in lacs)
2000 2001
Net Sales 3,75,000 4,20,000
Less:Cost of Goods Sold 1,08,500 1,13,000
Administrative
Expenses 42,000 65,500
Selling Expenses 47,500 1,98,000 56,500 2,35,000
Profit before Interest 1,77,000 1,85,000
and Tax
Less: Interest 35,000 42,000
Profit before Tax 142,000 1,43,000
Less: Provision for Tax 76,000 89,000
Profit after Tax 66,000 54,000

Balance Sheets of Arnold Co. Ltd.

as at March 31, 2000 and 2001
(Rs. in lacs)
2000 2001

LIABILITIES Rs. Rs.

Capital 8,00,000 8,00,000

Reserves and Surplus 3,50,000 3,00,000

Long-term Loan 8,20,000 98,000

Creditors 54,000 46,000

Bills Payable 23,500 26,000

Total 13,09,500 12,70,000

ASSETS

Fixed Assets (Net) 4,62,000 5,04,000

Investments 2,42,500 1,33,000
Debtors 72,000 64,000
Inventories 2,18,000 2,84,000
Cash and Bank Balance 3,15,000 2,85,000

Total 13,09,500 12,70,000

 140 ACCOUNTANCY

Calculate the following ratios for both the years and comment on the solvency
position and analyse the efficiency of operations management of the firm.
1. Debt-Equity Ratio
2. Proprietary Ratio
3. Inventory Turnover Ratio
4. Debtors Turnover Ratio
5. Working Capital Turnover Ratio
6. Total Asset to Debt Ratio

Solution
Debt Debt
=
1. Debt-Equity Ratio = Equity Captial + Reserves and Surplus

2000 2001
82,000 98,000
= =
80,000 + 350,000 8,00,000 + 3,00,000

82,000 98,000
= =
11,50,000 11,00,000
= 0.07 times = 0.09 times

Equity
2. Proprietary Ratio =
Total Assets

2000 2001

11,50,000 11,00,000
= =
13,09,500 12,70,000
= 0.878 or 87.8% = 0.866 or 86.6%
Sales
3. Inventory Turnover Ratio = Average Inventory*

* Year-end figure of inventory has been used in the denominator.

2000 2001

3,75,000 4,20,000
= =
2,18,000 2,84,000
= 1.72 times = 1.47 times
RATIO ANALYSIS 141

Sales
4. Debtors Turnover Ratio =
AverageDebtors*

* Year-end figure of debtors has been used in the denominator.

2000 2001

3,75,000 4,20,000
= =
72,000 64,000
= 5.21 times = 6.56 times

Sales
5. Working Capital Turnover Ratio =
Net Working Captial

Net Working Capital = [Debtors+Inventories+Cash and Bank

Balance - (Creditors+Bill Payable)]
Net Working Capital
For the year 2000
3,75,000
=
72,000+ 2,18,000+ 3,15,000− (54,000+ 23,500)

3,75,000
=
5,27,500
= 0.71 times
Net Working Capital
For the year 2001
4,20,000
=
64,000+ 2,84,000+ 2,85,000− (46,000+ 26,000)
= 0.75 times

Interpretation
Debt-Equity ratio and Proprietary ratio relate to solvency position of an enterprise.
Debt-Equity ratio of Arnold Co. Ltd. is too low. Further, it has not changed much
in 2001 as compared to last year. Slight increase in ratio signifies a small increase
in long-term loans. It means that the company is not reaping the benefits of
financial leverage. By increasing the use of long-term loans and hence increasing
financial leverage, Arnold Co. Ltd. can attempt to magnify the earnings of owners.
Proprietary ratio makes one understand about the part of total assets funded
through equity. The ratio stands at 86.6% in 2001 meaning thereby that the
total assets of Arnold Co. Ltd. are funded to the tune of 86.6% by equity. This
 142 ACCOUNTANCY

ratio stood at 87.8% in 2000. This ratio reinforces the comments made earlier
regarding the use of low financial leverage. It means that the assets of this
enterprise are primarily funded through equity.
Inventory turnover ratio, Debtors turnover ratio and Working capital turnover
ratio belong to 'activity ratios' category. These ratios help in commenting on the
efficiency of different assets in relation to sales generated. Inventory Turnover
Ratio of the company has got reduced to 1.47 times in 2001 as compared to
1.72 times in 2000. It means that the efficiency with regard to use of inventory to
generate sales has deteriorated over the period. Further, Inventory turnover ratio
is quite low. Low Inventory turnover ratio, and that too deteriorating over a period
of time, should be interpreted as a signal of forthcoming problems. Low Inventory
turnover ratio will result in slow-moving and finally non-moving inventory
resulting in permanent blockade of funds. Debtors turnover ratio has improved
from 5.21 times in 2000 to 6.56 times in 2001. This is reflective of better handling
of debtors and their faster rotation. Working capital turnover ratio has also slightly
improved in 2001.
On the whole, Arnold Co. Ltd. is advised to use more of long-term debt and
also rotate its working capital at a faster pace.

Summary

1. Ratio Analysis
Ratio Analysis is a process of identifying the financial strengths and weaknesses
of the firm by logically establishing relationships between the numbers given
in the balance sheet and profit and loss account, and interpreting the results
thereof in order to derive meaningful conclusions.

2. Cross-sectional and Time-series Analysis

Cross-sectional analysis involves comparison of the firm's ratios with the
competitors or industry averages at the same point of time.
Time-series analysis evaluates the performance of the same business enterprise
over a period of time.
Both these analysis help in identifying problem areas requiring corrective
actions.

3. Users of Ratio Analysis

The three main parties interested in the ratio analysis of an enterprise are:
creditors, shareholders and management.
RATIO ANALYSIS 143

4. Types of Ratios
Financial ratios can be classified into four important categories :
l Liquidity Ratios : Liquidity ratios help the users in knowing the extent of short-
term debt paying ability of a firm.
l Solvency Ratios: Solvency ratios analyse the long-term debt paying capacity
of the firm.
l Activity Ratios: Activity ratios help in commenting on the efficiency of the firm
in managing it assets. The speed with which assets are converted into sales is
captured by activity ratios.
l Profitability Ratios: Profitability ratios are calculated to measure the profitability
of a business enterprise.

Exercises

1. Objective type Questions

I. Multiple Choice Questions
(i) Ratio provide a _______ measure of a company's performance and condition.
A. Definitive
B. Gross
C. Relative
D. Qualitative
(ii) ______ analysis involves the comparison of different firms' financial ratio at
the same point in time.
A. Time-series
B. Cross-sectional
C. Marginal
D. Quantitative
(iii) ______ analysis involves comparison of current to past performance and the
evaluation of developing trends.
A. Time-series
B. Cross-sectional
C. Marginal
D. Quantitative
(iv) The primary concern of creditors when assessing the strength of a firm is
the firm's
A. Profitability
B. Leverage
144 ACCOUNTANCY

C. Short-term liquidity
D. Share price
(v) Time-series analysis is often used to
A. assess developing trends
B. correct errors of judgement
C. reflect performance relative to some norms
D. standardize results
(vi) In ratio analysis, a comparison to a standard industry ratio is made to
isolate_____ deviations from the norm.
A. positive
B. negative
C. standard
D. any
(vii) An analysis in which the firm's ratio values are compared to those of a key
competitor or group of competitors, primarily to identify areas for improvement
is called
A. time-series analysis
B. benchmarking
C. combined analysis
D. none of the above
(viii) Cross-sectional ratio analysis is used to
A. correct expected problems in operations
B. isolate the causes of problems
C. provide conclusive evidence of the existence of a problem
D. reflect the symptoms of a possible problem
(ix) _____ evidence of the existence of a problem or outstanding
management performance is provided by ratio analysis.
A. Conclusive
B. Inconclusive
C. Complete
D. Definitive
(x) In the near term, the important ratios that provide the information critical to
the short-run operation of the firm are
A. liquidity, activity, and profitability
B. liquidity, activity, and common stock
C. liquidity, activity, and debt
D. activity, debt, and profitability
RATIO ANALYSIS 145

(xi) The following groups of ratios primarily measure risk

A. liquidity, activity, and profitability
B. liquidity, activity, and common stock
C. liquidity, activity, and debt
D. activity, debt, and profitability
(xii) The _____ ratios are primarily measures of return.
A. liquidity
B. activity
C. debt
D. profitability
(xiii) The _____ of a business firm is measured by its ability to satisfy its short-term
obligations as they come due.
A. activity
B. liquidity
C. debt
D. profitability
(xiv) _____ ratios are a measure of the speed with which various accounts are
converted into sales or cash.
A. Activity
B. Liquidity
C. Debt
D. Profitability
(xv) The _____ is useful in evaluating credit and collection policies.
A. average payment period
B. current ratio
C. average collection period
D. current asset turnover
(xvi) Net working capital is defined as
A. total assets less current assets
B. the excess of current assets over current liabilities
C. current liabilities less current assets
D. marketable securities and cash
(xvii)The _____ measures the activity of a firm's inventory.
A. average collection period
B. inventory turnover
146 ACCOUNTANCY

C. liquid ratio
D. current ratio
(xviii) The two basic measures of liquidity are
A. inventory turnover and current ratio
B. current ratio and liquid ratio
C. gross profit margin and operating ratio
D. current ratio and average collection period
(xix) The _____ is a measure of liquidity which excludes _____, generally the least
liquid asset.
A. current ratio, accounts receivable
B. liquid ratio, accounts receivable
C. current ration, inventory
D. liquid ratio, inventory
(xx) The ____ ratio may indicate the firm is experiencing stock outs and lost
sales.
A. average payment period
B. inventory turnover
C. average collection period
D. quick
(xxi) The ____ ratio may indicate poor collection procedures or a tax credit policy.
A. average payment period
B. inventory turnover
C. average collection period
D. quick
(xxii) ABC Co. extends credit terms of 45 days to its customers. Its credit collection
would be considered poor if its average collection period was
A. 30 days
B. 36 days
C. 47 days
D. 57 days
(xxiii) _____ are especially interested in the average payment period, since it provides
them with a sense of the bill-paying patterns of the firm.
A. Customers
B. Stockholders
C. Lenders and suppliers
D. Borrowers and buyers
RATIO ANALYSIS 147

(xxiv) If the inventory turnover is divided into 365, it becomes a measure of

A. sales efficiency
B. the average age of the inventory
C. sales turnover
D. the average collection period
(xxv) The _____ is useful in evaluating credit and collection policies.
A. average payment period
B. current ratio
C. average collection period
D. current asset turnover
(xxvi) The two categories of ratios that should be utilized to assess a firm's true
liquidity are the
A. current and liquid ratios
B. liquidity and profitability ratios
C. liquidity and debt ratios
D. liquidity and activity ratios
(xxvii) The _____ ratios provide the information critical to the long-run operation
of the firm
A. liquidity
B. activity
C. solvency
D. profitability
(xxviii) The _____ indicates the percentage of each sales rupee remaining a f t e r
the firm has paid for its goods
B. net profit margin
C. operating profit margin
D. gross profit margin
E. earnings available to common shareholders

2. Short Answer Type Questions

(i) What do you mean by Ratio Analysis?
(ii) Distinguish between cross-sectional and time-series analysis.
(iii) Who are the users of financial ratio analysis and explain the significance of
ratio analysis to them.
(iv) What are the various types of ratios?
(v) What are liquidity ratios? Discuss briefly the importance of current and
liquid ratio.
148 ACCOUNTANCY

(vi) How would you study the solvency position of a firm?

(vii) What relationships will be established to study
a) Inventory Turnover
b) Debtors Turnover
c) Payable Turnover
d) Working Capital Turnover
(viii) What are the important profitability ratios? How are they worked out?
(ix) Financial ratio analysis is conducted by four groups of analysts :
managers, equity investors, long-term creditors, and short- term creditors.
What is the primary emphasis of each of these groups in evaluating ratios?
(x) Why would the inventory turnover ratio be more important when analyzing a
grocery store than an insurance company?

3. Comment on the following statements with reason thereon:

(i) Time-series analysis is the evaluation of the firm's financial performance in
comparison to other firm(s) at the same point in time.
(ii) As a rule, the necessary inputs to an effective financial analysis include, at
minimum the income statement and the statement of cash flow.
(iii) The cross-sectional ratio analysis involves comparing the firm's ratios to
those of firms in other industries at the same point in time.
(iv) Benchmarking is a type of cross-sectional analysis in which the firm's
ratio values are compared to those of firms in other industries, primarily to
identify areas for improvement.
(v) The time-series analysis evaluates performance of firms at the same point in
time using financial ratios.
(vi) The firm's creditors are primarily interested in the short-term liquidity of the
company and its ability to make interest and principal payments.
(vii) Ratio analysis merely directs the analyst to potential areas of concern; it
does not provide conclusive evidence as to the existence of a problem.
(viii) Net working capital is useful only in comparing the liquidity of the same
firm over time and should not be used to compare the liquidity of different
firms; the current ratio should be used, instead, for that purpose.
(ix) The liquidity of a business firm is measured by its ability to satisfy its long-
term obligations as they come due.
(x) The current ratio provides a better measure of overall liquidity only when a
firm's inventory cannot easily be converted into cash. If inventory is liquid,
the quick (liquid) ratio is a preferred measure of overall liquidity.
RATIO ANALYSIS 149

(xi) Since the differences in the composition of a firm's current assets and liabilities
can significantly affect the firm's "true" liquidity, it is important to look beyond
measures of overall liquidity to assess the liquidity of specific current assets.
(xii) The average age of inventory is viewed as the average length of time inventory is
held by the firm or as the average number of days' sales in inventory.
(xiii) The gross profit margin measures the percentage of each sales rupee left after
the firm has paid for its goods and operating expenses.

Problems

4. Calculate the following ratios from the details given below:

i) Current Ratio
ii) Liquid Ratio
iii) Operating Ratio
iv) Gross Profit Ratio
Details :
Current Assets = Rs. 70,000 Sales = Rs.1,40,000
Net working capital = Rs. 30,000 Cost of Goods Sold = Rs. 68,000
Inventories = Rs. 30,000
5. The current assets of Monarch Company are Rs.29745 and the current ratio is
1.5. The inventories stood at Rs.8827. Calculate the liquid ratio and comment
on the liquidity position of the company.
6. From the following information, calculate the shareholder's funds.
Current Ratio 2.5
Liquid Ratio 1.5
Proprietary Ratio 0.75
Working Capital Rs. 60,000
Reserves and Surplus Rs. 40,000
Loan Funds Rs. 10,000
7. From the following particulars, determine the amount of gross profit and
sales.
Average Inventory Rs. 95,000
Inventory Turnover Ratio 3 times
Gross Profit 25% of sales
150 ACCOUNTANCY

8. On the basis of the following ratios derived from the accounts of company,
comment on the efficiency of management of the company.
Years Inventory Payable Operating
Turnover Turnover Ratio
(Times) (Times) (%)
1999 9.4 5.1 83.15
2000 9 4.7 82.56
2001 7.3 4.5 81.34
2002 6.5 3.7 82.93
9. The following figures have been taken from the published accounts of G.
Associates for the two successive years.
2001 2002
Rs. Rs.
Revenue from Operations 2,10,000 4,20,000
Gross Profit 52,500 84,000
Comment on the profitability for the two years.
10. Bhatia Company had a liquid (quick) ratio of 1.4, a current ratio of 3.0, an
inventory turnover of 6 times, total current assets of Rs.810,000, and cash
and marketable securities of Rs.120,000 in 2002. What are annual sales?
11. On the basis of the following information calculate: (i) Gross Profit Ratio
(ii) Debt-Equity Ratio (iii) Working Capital Turnover Ratio.
(Rs.)
Net Sales 36,50,000
Cost of Goods Sold 23,60,000
Current Liabilities 7,80,000
Loan Funds 6,25,000
Current Assets 13,29,000
Equity Share Captial 17,80,000
Debentures 840,000
12. Calculate Operating Ratio from the following information.
(Rs.)
Net Sales 5,40,000
Net Purchases 3,10,000
Opening Stock 75,000
Direct Expenses 32,000
Closing Stock 50,000
Selling Expenses 25,000
Distribution Expenses 15,000
RATIO ANALYSIS 151

13.
Profit and Loss Accounts of D. Co. Ltd.
for the year ended March 31, 2001

(Rs. in lacs)
Rs.
Net sales 20,00,000
Less:Cost of Goods Sold
Opening Stock 2,50,000
Add : Purchases 13,00,000 15,50,000
Less : Closing Stock 5,50,000 10,00,000
Gross Profit 10,00,000
Less : Operating Expenses 3,70,000
Operating Profit 6,30,000
Less : Interest 2,10,000
Profit before Tax 4,20,000

Required : Calculate Operating Ratio and Gross Profit Ratio.

14. Indicate for each of the following ratios the formula for its calculation and
the kinds of problems, if any, the business enterprises is likely to have if these
ratios are too high relative to the industry average. What if they are too low
relative to the industry? Create a table similar to the one that follows and fill
in the empty blocks.
Ratio Too high Too low
Current ratio =
Inventory turnover =
Gross profit margin =
Debt-equity ratio =
15. Supreme Paper company's total current assets, net working capital,
and inventory for each of the past 4 years follow :

Item 1999 2000 2001 2002

Rs. Rs. Rs. Rs.
Total current assets 1,01,700 1,31,400 1,35,000 1,62,000
Net working capital 47,700 55,800 59,400 57,600
Inventory 36,000 41,400 41,400 43,200

a. Calculate the current and liquid (quick) ratios for each year. Compare the
resulting time series of each measure of liquidity (i.e., net working capital, the
current ratio, and the liquid (quick) ratio.
152 ACCOUNTANCY

b. Comment on the firm's liquidity over the 1999-2002 period.

c. If you were told that Supreme Paper Company's inventory turnover for each
year in the 1999-2002 period and the industry averages were as follows, would
this support or conflict with your evaluation in b? Why?

Inventory turnover 1999 2000 2001 2002

Supreme Paper 6.3 6.8 7.0 6.4
Industry average 10.6 11.2 10.8 11.0

16. Capital Manufacturing Co. has sales of Rs.1,60,00,000 and a gross profit
margin of 40% . Its end-of-quarter inventories are as follows :
Quarter Inventory
Rs.
1. 16,00,000
2. 32,00,000
3. 48,00,000
4. 8,00,000
a. Find the average quarterly inventory and use it to calculate inventory
turnover and the average age of inventory.
b. Assuming that the company is in an industry with an average inventory
turnover of 2.0, how would you evaluate the activity of Capital
Manufacturing Co's inventory?
17. The new owners of Natural Foods Co. have hired you to help them diagnose
and cure problems that the company has had in maintaining enough working
capital. As a first step, you perform a liquidity analysis. You then do an
analysis of the company's short-term activity ratios. Your calculations and
appropriate industry norms are listed.

Natural Foods Industry norm

Current ratio 4.5 4.0
Liquid ratio 2.0 3.1
Inventory turnover 6.0 10.4
Average collection period 73 days 52 days
Average payment period 31 days 40 days
a. What recommendations relative to the amount and the handling of
inventory could you make to the new owners?
b. What recommendations relative to amount and handling of accounts
receivable could you make to the new owners?
c. What recommendations relative to amount and handling of accounts
payable could you make to the new owners?
RATIO ANALYSIS 153

d. What results, overall, would you hope you recommendations would

achieve?
18. Industrial Finance Limited has been approached by two customers for a short-
term loan of Rs.175000. The following summarized financial information is
available from the latest financial statements
(Figures in Rs.)
Consolidated Stores Golden Stores
Net Sales 31,85,000 26,25,000
Gross Profit Margin 13,37,700 10,23,750
Interest Expense 70,000 28,700
Income Tax 2,62,500 1,75,000
Profit after Tax 2,87,000 1,96,875
Inventories 3,15,000 2,28,200
Debtors 2,45,000 1,96,000
Cash 21,000 63,000
Current Liabilities 6,39,100 4,06,000
Long-term Liabilities 5,60,000 4,55,000
Shareholders' Equity 6,30,000 4,90,000

Industrial Finance Ltd. intends to accept one of the two loan requests.
On the basis of your understanding of financial ratio analysis decide the loan
request which should be accepted by Industrial Finance Ltd.
19. Calculate stock turnover ratio if:
a. Opening stock is Rs. 58,000
b. Closing stock is Rs. 62,000
c. Sales Rs. 6,40,000
d. Gross profit 25% on sales
(Ans. 8 times)
20. Calculate inventories at the end of year if Rs. 2,00,000 is the cost of sales of a
concern during the year 2002-2003. If inventory is 8 times; inventories at the
end is 1.5 times more than that in the beginning.
(Ans. inventories : Rs. 30,000)
154 ACCOUNTANCY

21. A firm normally has accounts receivables equal to two months credit sale.
During the coming years it expects credit sales of Rs. 7,20,000 spread evenly
over the year (12 months). What is the estimated amount of account receivables
at the end of the year?
(Accounts receivables: Rs. 1,20,000)
22. From the following, calculate the debit equity ratio :
Rs.
a. 10,000 shares of Rs. 10 each 1,00,000
b. General reserve 45,000
c. Accumulated profits 30,000
d. Debentures 75,000
e. Accounts payable 40,000
f. out standing expenses 10,000
(Debit equity ratio 3:10)
23. The debt-equity ratio of a company is 1:2. Which of the following would
increase, decrease and not change it.
1. Issue of equity shares
2. Cash received from accounts receivables
3. Redemption of debentures
4. Purchased goods on credit.
(i) Decrease
(ii) No change
(iii) Decrease
(iv) No change
24. A Company’s Returns on Investment (ROI) in 25% before tax. Tax is paid by
the company is 60%. The company has a loan of Rs. 50 lakhs as part of the
capital employed on which interest is paid at 15 p.a. What is the amount by
which shareholders gain from there being the loan.
(Ans. Net gain to shareholders: Rs. 2,00,000)

Answers

1. Objective Type Questions

(i) C
(ii) B
(iii) A
RATIO ANALYSIS 155

(iv) A
(v) A
(vi) A
(vii) B
(viii) C
(ix) A
(x) C
(xi) D
(xii) B
(xiii) B
(xiv) A
(xv) C
(xvi) A
(xvii) B
(xviii) B
(xix) D
(xx) A
(xxi) C
(xxii) C
(xxiii) C
(xxiv) B
(xxv) A
(xxvi) A
(xxvii) C
(xxviii) D
4. (i) Current Ratio 7:4
(ii) Liquid Ratio 1:1
(iii) Operating Ratio 48.57%
(iv) Gross profit Ratio 51.42%
156 ACCOUNTANCY

5. Liquid Assets = Rs. 20,918

Current Liabities = Rs. 19,830
Liquid Ratio = 1.05:1
7. Sales Rs. 2,85,000;
Gross Profit Rs. 71,200
11. Gross Profit Ratio 35.3%
Debt-Equity Ratio .82
Working Capital Turnover Ratio 6.64 times
12. Operating Ratio 78.7%
13. Gross Profit Ratio 50%