Unit 5: Ratio Analysis - Subjective Questions

Ratio Analysis is the systematic process of establishing and interpreting relationships between items appearing in financial statements. A ratio expresses one accounting figure in relation to another.

Nature of Ratio Analysis:

• It is a quantitative technique for analysing financial statements.
• It establishes relationships between logically connected accounting figures.
• Ratios may be expressed as a proportion, percentage, rate, or number of times.
• A ratio becomes meaningful only when it is compared with a standard, past ratio, industry average, or competitor's ratio.
• It is an analytical tool and not a substitute for professional judgement.

Principal Uses:

• Evaluating short-term liquidity and working capital management.
• Measuring operational efficiency and asset utilisation.
• Assessing profitability and return on investment.
• Examining long-term solvency and financial risk.
• Comparing performance across periods and firms.
• Assisting management, investors, lenders, and other stakeholders in decision-making.

Advantages of Ratio Analysis:

• Simplifies financial statements: Ratios convert large amounts of accounting data into understandable indicators.
• Facilitates comparison: They support comparison over time, with competitors, and against industry standards.
• Measures efficiency: Activity and profitability ratios reveal how effectively resources are being used.
• Assists planning and control: Management can establish standards, prepare budgets, and identify deviations.
• Evaluates liquidity: Creditors can assess the firm's ability to meet short-term obligations.
• Evaluates solvency: Long-term lenders can assess debt-servicing capacity and financial stability.
• Supports investment decisions: Investors can evaluate earnings, dividends, market valuation, and financial risk.
• Identifies trends: Trend analysis highlights improvements or deterioration in financial performance.
• Enables inter-firm comparison: Ratios provide a common basis for comparing firms of different sizes.

However, the benefits depend on reliable financial statements and the use of appropriate comparison standards.

Limitations of Ratio Analysis:

• Ratios are based on historical financial statements and may not reflect current conditions.
• Different accounting policies for depreciation, inventory valuation, or revenue recognition reduce comparability.
• Inflation and changes in price levels may distort accounting figures.
• Window dressing can temporarily improve ratios near the reporting date.
• Ratios ignore qualitative factors such as management quality, employee relations, and customer satisfaction.
• Seasonal businesses may show misleading year-end ratios.
• There is no universally accepted ideal ratio for every industry.
• A single ratio may provide an incomplete or incorrect impression.
• Errors in financial statements are carried into the calculated ratios.
• Ratios identify symptoms but do not necessarily explain their causes.

Ratios should not be interpreted in isolation because their significance depends on comparisons with past performance, budgets, industry averages, competitors, and related ratios. For example, a high current ratio may suggest strong liquidity, but it may also indicate excessive inventory or idle cash.

Liquidity Ratios measure an enterprise's ability to meet its short-term financial obligations as they become due.

1. Current Ratio

It measures the extent to which current assets cover current liabilities. A ratio of has traditionally been treated as a general benchmark, although the appropriate level varies by industry.

2. Quick Ratio

where:

The Quick Ratio applies a stricter liquidity test because inventory and prepaid expenses are excluded. A ratio of is commonly used as a general benchmark.

Interpretation:

• A very low ratio may indicate difficulty in paying short-term liabilities.
• A very high ratio may indicate idle cash, excessive receivables, or inefficient inventory management.
• Both ratios should be examined together with cash flows, collection periods, and industry norms.

Step 1: Calculate Current Assets

Current Ratio:

Step 2: Calculate Quick Assets

Quick Ratio:

Step 3: Calculate Cash Ratio

Interpretation:

• The Current Ratio of indicates adequate current asset coverage.
• The Quick Ratio of suggests that short-term liabilities can be covered without selling inventory.
• The Cash Ratio of means immediately available funds cover of current liabilities.
• Overall liquidity appears satisfactory, subject to the quality and collectability of receivables.

Activity Ratios, also known as turnover or efficiency ratios, measure how effectively a business uses its assets and working capital to generate sales or revenue.

Important Activity Ratios:

• Inventory Turnover Ratio.
• Trade Receivables Turnover Ratio.
• Trade Payables Turnover Ratio.
• Working Capital Turnover Ratio.
• Fixed Assets Turnover Ratio.
• Total Assets Turnover Ratio.

Role in evaluating efficiency:

• They indicate the speed with which inventory is sold.
• They measure how quickly credit sales are collected.
• They show the time taken to pay suppliers.
• They assess whether working capital is being used productively.
• They reveal the ability of fixed and total assets to generate revenue.
• They help identify idle assets, slow-moving inventory, and inefficient credit policies.

Generally, higher turnover indicates better utilisation, but an excessively high ratio may result from insufficient inventory, inadequate working capital, or overused assets. Therefore, each ratio must be interpreted in its business context.

Inventory Turnover Ratio measures the number of times average inventory is sold or consumed during an accounting period.

where:

Inventory Holding Period:

Alternatively:

Interpretation:

• A high turnover ratio and short holding period generally indicate efficient inventory management and rapid sales.
• An excessively high turnover may indicate understocking and the risk of lost sales.
• A low turnover ratio and long holding period may indicate overstocking, obsolete goods, weak demand, or poor purchasing decisions.
• The ratio should be compared with previous periods, industry standards, and the nature of the product.

Step 1: Calculate Average Inventory

Step 2: Calculate Inventory Turnover Ratio

Step 3: Calculate Inventory Holding Period

Thus, the inventory is turned over 6 times per year, and inventory remains in stock for approximately 61 days before being sold or consumed.

The result should be compared with the company's previous performance and industry norms. A 61-day holding period may be efficient for one industry but excessive for another.

Trade Receivables Turnover Ratio:

It measures how quickly the business collects amounts due from credit customers.

A high turnover and short collection period generally indicate efficient collection and a strict credit policy.

Trade Payables Turnover Ratio:

It measures the speed with which the business pays its suppliers.

A longer payment period may improve short-term cash flow but could damage supplier relationships or indicate financial difficulty.

Key Difference:

• Receivables turnover concerns the collection of money from customers.
• Payables turnover concerns the payment of money to suppliers.

The collection and payment periods should be coordinated to maintain a healthy operating cash cycle.

Step 1: Calculate Net Credit Sales

Step 2: Calculate Average Trade Receivables

Step 3: Calculate Receivables Turnover Ratio

Step 4: Calculate Average Collection Period

Therefore, trade receivables are collected approximately 6.67 times per year, and customers take about 55 days on average to pay.

If the normal credit period is substantially shorter than 55 days, the company may need to strengthen its collection procedures.

1. Working Capital Turnover Ratio

It measures the sales generated from each unit of working capital. A very high ratio may indicate efficient use or inadequate working capital, while a low ratio may indicate excessive working capital.

2. Fixed Assets Turnover Ratio

It shows how efficiently property, plant, and equipment are used to generate sales. A low ratio may indicate idle capacity or excessive investment in fixed assets.

3. Total Assets Turnover Ratio

It measures the overall efficiency with which the firm's assets generate revenue.

These ratios should be compared with previous years and similar firms because asset intensity differs considerably across industries.

Profitability Ratios measure the earning capacity of a business and its effectiveness in generating profit from sales, assets, capital, or shareholders' funds.

Profitability in relation to sales:

• Gross Profit Ratio.
• Operating Profit Ratio.
• Net Profit Ratio.
• Operating Ratio.

These ratios measure the portion of sales retained as profit at different stages. They help evaluate pricing, production cost, operating expenses, and overall margin control.

Profitability in relation to investment:

• Return on Capital Employed.
• Return on Equity.
• Return on Assets.

These ratios compare profit with the resources invested in the business. They show whether management is generating an adequate return on capital.

Distinction:

• Sales-based ratios focus on profit margins and cost control.
• Investment-based ratios focus on the productivity of capital and assets.

A company may have a low profit margin but a satisfactory return on investment if it generates a high volume of sales from its assets.

Gross Profit Ratio:

It reflects production, purchasing, and pricing efficiency. A rising ratio generally indicates improved margins.

Operating Profit Ratio:

It measures profit from core operations before interest and tax.

Net Profit Ratio:

The numerator may be taken before or after tax depending on the purpose, but the basis must be stated consistently. It reflects overall profitability after considering operating and non-operating items.

Operating Ratio:

A lower Operating Ratio generally indicates greater operating efficiency.

The Operating Profit Ratio and Operating Ratio are complementary when calculated consistently:

Step 1: Calculate Gross Profit

Step 2: Calculate Operating Cost

Step 3: Calculate Operating Profit

Step 4: Calculate Net Profit Ratio

Therefore, the company earns a gross margin of 40%, an operating margin of 15%, and a net margin of 12%. Operating costs consume 85% of net sales.

Return on Capital Employed (ROCE):

Capital employed may be calculated as:

ROCE measures the return generated from long-term funds supplied by both owners and long-term lenders.

Return on Equity (ROE):

ROE measures the return available specifically to equity shareholders.

Differences:

• ROCE uses profit before interest and tax, whereas ROE uses profit available to equity shareholders.
• ROCE considers both debt and equity capital; ROE considers equity shareholders' funds only.
• ROCE measures overall operating efficiency, while ROE measures owners' return.
• Financial leverage can cause ROE to exceed ROCE, but it also increases shareholders' risk.

Solvency Ratios measure the long-term financial stability of a business and its ability to meet interest, principal repayment, and other long-term obligations.

Debt-Equity Ratio:

It shows the relationship between borrowed long-term funds and owners' funds. A high ratio indicates greater financial leverage and risk.

Proprietary Ratio:

It indicates the proportion of total assets financed by owners. A higher ratio generally suggests a stronger long-term financial position.

Interest Coverage Ratio:

It measures how many times operating profit covers interest obligations. A low ratio indicates a limited margin of safety for lenders.

These ratios should be evaluated together because capital structure and debt-servicing capacity are related but distinct aspects of solvency.

Step 1: Calculate Shareholders' Funds

Step 2: Calculate Debt-Equity Ratio

This means the company uses of long-term debt for every of shareholders' funds.

Step 3: Calculate Interest Coverage Ratio

Comment:

• A Debt-Equity Ratio of indicates that owners' funds exceed long-term debt.
• Interest is covered four times by earnings before interest and tax, providing a reasonable margin of safety.
• On the available information, the company's long-term solvency appears satisfactory.
• A complete assessment would also consider cash flows, repayment schedules, industry norms, and the stability of earnings.

Market Test Ratios, also called market valuation ratios, relate accounting information to market prices and shareholder returns. They help investors evaluate the attractiveness and market valuation of equity shares.

Earnings per Share (EPS):

EPS shows the earnings attributable to each equity share.

Price-Earnings Ratio:

It shows how much investors are willing to pay for each unit of current earnings. A high ratio may reflect strong growth expectations, but it may also indicate overvaluation.

Book Value per Share:

It represents the accounting value of net assets attributable to each equity share. Book value may differ significantly from market value because it is based mainly on historical accounting figures.

Dividend per Share (DPS):

It shows the dividend distributed on each equity share.

Dividend Payout Ratio:

It indicates the proportion of earnings distributed as dividends. The remaining proportion is retained in the business.

Dividend Yield Ratio:

It measures the cash dividend return earned on the current market price of the share.

Usefulness to investors:

• Income-oriented investors use dividend yield to compare cash returns.
• The payout ratio helps assess the sustainability of dividend policy.
• Growth investors examine retained earnings available for reinvestment.
• DPS helps track the absolute dividend received per share.

A high payout is not automatically favourable because it may restrict future growth or prove unsustainable when earnings decline.

Step 1: Earnings available to equity shareholders

Earnings per Share:

Dividend per Share:

Price-Earnings Ratio:

Dividend Payout Ratio:

Dividend Yield:

Thus, the company earns ₹7 per share, distributes ₹2.80 per share, retains 60% of equity earnings, and provides a dividend yield of approximately 2.67% at the given market price.