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Ratio Analysis 107 Part – II Management & Cost Accounting This page intentionally left blank Ratio Analysis 109 Chapter–4 Ratio Analysis LEARNING OBJECTIVES In this chapter we will study: Introduction Concept of Ratio Types of Ratios Measurement and Interpretation of Ratios Application of Ratios Methodology for Ratio Analysis Du-pont Chart for Ratio Analysis Advantages of Ratio Analysis Limitations of Ratio Analysis 110 Accounting and Financial Management for I.T. Professionals 4.1 INTRODUCTION Ratio analysis is a technique used to evaluate the financial health of the concerned organisation from interested groups’ point of view using different ratios as a tool. It comprises of two terms viz. ratio and analysis and therefore both the terms should be dealt separately while studying ratio analysis. Ratio Analysis Ratio l l l l Analysis1 + Concept of Ratio Types of Ratios Measurement of Ratios Interpretation of Ratios l l l l Trend Analysis Inter-firm Comparison Comparison with Industrial Average Horizontal/Vertical Analysis 4.2 CONCEPT OF RATIOS Absolute financial data of an organization does not provide useful information but whenever it is compared with another financial data of the same organization it provides useful information and constitutes a ratio. Illustration Suppose following is the data related to Company A. Profit — Rs.10,000 Sales — Rs.1,00,000 Data dealt separately is not useful. [(Profit/Sales)*100/Sales = 10%] is useful information as it represents profit margin ratio. 4.3 TYPES OF RATIOS There are various groups, which are interested in financial health of the organization. These groups are Owners/Shareholders, Short-term creditors (suppliers, suppliers of short-term loans), Long-term creditors (Debenture holders, Banks and Financial Institutions providing term loans), Management and government. Furthermore, the risk and return perceived by abovesaid groups are varying in nature and since risk–return trade off is the objective of any group, this leads to basis for classification of financial health. Thus financial health of the organization can viewed as follows: 1. Financial health from owner’s point of view. 2. Financial health from short-term creditor’s point of view. 3. Financial health from long-term creditor’s point of view. 4. Financial health from management’s point of view. 5. Financial health from government’s point of view. Here Financial health means ability to serve the concerned group. The classification of ratios is done on the basis of the purpose of different groups mentioned above having direct interest in the organization concerned. 1. Analysis refers to application of ratios in different ways (mentioned above) for the purpose of planning financial decisions and in solving decision-making problems. This portion is beyond the scope of this book. Ratio Analysis 111 There are five broad categories of ratios on the basis of its nature: 1. Liquidity ratios 2. Profitability ratios 3. Solvency ratios 4. Turnover ratios 5. Market ratios l Liquidity ratios measure liquidity position of the organization. Liquidity means ability to meet short-term obligations. Short-term obligation includes bills payables, outstanding expenses, bank overdraft etc. l Profitability ratios measure profitability position i.e. ability to earn profit. Higher the ratio better it is. l Solvency ratios measure solvency position of the organization. Solvency means ability to meet long-term obligations. Long-term obligation includes loan repayments, debt servicing i.e. interest payments etc. l Turnover ratios measure position of resources utilization. A higher turnover ratio indicates better utilization of resources. Resources include fixed assets, current assets, working capital etc. l Market ratios reflect performance of the organization within industry concerned/economy. Market ratios are useful to secondary market (stock market) investors. Table 1 and Table 2 stated below, describe the summary of ratios with groups having direct interest. Table 1 Groups having direct interest Relevant ratios Owners/shareholders - Profitability ratios - Market ratios Short-term creditors - Liquidity ratios - Turnover ratios Long-term creditors - Solvency ratios Management - Turnover ratios - Market ratios Government. - Profitability ratios - Market ratios Table 2 (Summary of ratios) Type of ratios Name of the ratios Liquidity ratios 1. Current Ratio (CR) 2. Quick Ratio (QR) 3. Cash Ratio 1. Gross Profit Margin (GPM) 2. Operating Profit Margin (OPM) 3. Net Profit Margin (NPM) Profitability ratios Contd... 112 Accounting and Financial Management for I.T. Professionals Type of ratios Name of the ratios 4. Return on Investment (ROI):l Return on Net worth (RO Net worth) Solvency ratios l Return on Capital Employed (ROCE) l Return on Total Asset (ROTA) 1. Debt-equity ratio 2. Fixed charge coverage ratio Turnover ratios 1. Fixed Asset Turnover Ratio (FATOR) 2. Current Asset Turnover Ratio (CATOR) 3. Total Asset Turnover Ratio (TATOR) 4. Debtors Turnover Ratio (Drs TOR)/Average Collection Period (ACP). 5. Creditors Turnover Ratio (Crs TOR)/Average Payable Period (APP) 6. Working Capital Turnover Ratio (WCTOR) 7. Stock Turnover Ratio (a) Raw material turnover ratio (b) Work in progress turnover ratio (c) Finished goods turnover ratio Market ratios 1. Dividend Payout Ratio (D/P ratio) 2. Price-Earning Ratio (P/E Ratio) 3. Dividend Yield 4. Earnings Yield 4.4 MEASUREMENT AND INTERPRETATION OF RATIOS Liquidity Ratio Liquidity ratio measures liquidity position of the organization. Liquidity means ability to meet short-term obligations i.e. current liabilities (bank overdraft, bills payable, outstanding expenses etc.). Remark Liquidity of asset is different from liquidity of organization stated above. Liquidity of asset means ease of convertibility of that asset into cash. The extent of liquidity depends upon the level of current assets. (Current assets are those, which convert into cash within one year e.g. cash, debtors, stock, marketable securities, prepaid expenses, loans and advances (given) etc.). Types of Liquidity Ratios The different types of liquidity ratios are as follows: 1. Current ratio 2. Quick ratio or acid test ratio Ratio Analysis 113 3. Cash ratio or super quick ratio. l Higher the liquidity ratios, higher will be the liquidity position. l Higher the liquidity ratios, higher will be the amount of Working Capital (WC). l Working capital means excess of Current Assets (CA) over Current Liabilities (CL). Current Ratio (CR) = l l l A very high Current Ratio indicates inadequate employment of funds. A very low Current Ratio indicates that business is trading beyond its resources and is signal of danger for management. CR is a measure of margin of safety to short-term creditors i.e. higher the CR, greater the safety of funds of short-term creditors. Quick Ratio = l l Note: Current Assets – Inventory (Stock) Current Liability Quick ratio is used to measure the liquidity position, when stock (inventory) is doubtful. Cash Ratio = l Current Assets (CA) Current Liability (CL) (Cash + Marketable Securities) Current Liability Cash ratio is the most penetrating test regarding the liquidity position and is used when debtors are also doubtful. A very high cash ratio is not desirable because it indicates the organization has an idle cash balance leading to decrease in profitability. The ideal current ratio is 2:1 The ideal quick ratio is 1:1 The ideal cash ratio is 0.5:1 Profitability Ratios Profitability Ratios measures the profitability position of the organization. Profitability means ability to earn more profit. Following are the different types of profitability ratios: 1. Gross Profit Margin (GPM) 2. Operating Project Margin (OPM) and Operating Ratio (OR) 3. Net Profit Margin (NPM) 4. Return on investment (i) Return on Net Worth (ii) Return on Capital Employed (ROCE) (iii) Return on Total Assets (ROTA) Gross Profit Margin = Gross Profit ×100 Sales Operating Profit Margin = Operating Profit ×100 Sales 114 Accounting and Financial Management for I.T. Professionals Operating Ratio = Operating Expenses ×100 Sales Net Profit ×100 Sales Higher the profitability ratios (GPM, OPM, NPM), higher will be the profitability position of the concerned organization. Lower the operating ratio (OR = OE/Sales), the better it is. In case gross profit margin is satisfactory but the operating profit margin is not satisfactory then it indicates that the organization is incurring huge operating expenses. Again if operating profit margin is satisfactory but net profit margin is not satisfactory then it indicates that the organization has heavy debt burden. In this situation, to improve the net profit margin, the organization should try to reduce debt burden in order to reduce the interest payment obligation leading to improvement of net profit and hence net profit margin. Net Profit Ratio = l l l Note Income Statement for the Year ——— Particulars Less Less Add Less Less Less Less Less Amount (Rs.) Sales Cost of Goods Sold (COGS) Trading A/c Gross Profit (GP)/(Gross Loss) Operating Expenses (OE) Operating Profit (OP) Non operating income/less non operating losses Earning Before Interest and Tax (EBIT) Interest Earning Before Tax (EBT) Tax Profit After Tax (PAT)/Net profit (NP) Provision for dividend Provision for tax Transfer to general reserves P & L (appropr.) A/c Profit & loss A/c —— —— ——@ —— ——@ —— ——@ —— ——@ —— ——@ —— P & L A/c —— ——@ Goes to Balance sheet liability side (under the head ‘Reserves and surplus’ as Profit & Loss A/c or Retained Earnings (RE)) l @ Stands for balancing figure. l OE includes general and administrative expenses plus selling and distribution expenses plus depreciation. l Gross Profit (G.P.) = Sales – Cost of Goods Sold (COGS) Ratio Analysis 115 l l l l Operating Profit (OP) = G.P. – Operating Expenses (O.E.) Earning Before Interest and Tax (EBIT) = OP + Non-Operating Profit (NOP)/Less Non-Operating Expenses (NOE) Net Profit (N.P.) = EBIT – (Interest + tax). Interest is tax-deductible item which means interest is charged before the tax is levied. Whereas dividend is not tax-deductible item which means dividend is paid after tax is paid. This is the reason why debt is cheaper source of finance as compared to equity. Return on Investment—There are three approaches regarding definition of investment.: Total Asset (TA) Investment Net worth or equity Capital Employed (CE) Net Profit ×100 Total Asset ROTA measures overall profitability of the organization because TA includes total resources of the organization. ROTA is the most popular measure of Return On Investment (ROI). ROTA = l l Return on net worth or equity = = l Net Profit (Equity Capital + Reserve & Surplus) Return on equity measures the productivity of the owner’s capital (i.e. risk capital) employed in the firm. ROCE = l NP Net worth of equity Net Profit Capital Employed (CE) CE = Total long-term fund = Total asset – Current liability Higher the return on investment (ROTA, RO net worth, ROCE) higher will be the profitability. Solvency Ratios Solvency ratios measure solvency position of the concerned organization. Solvency means ability to meet long-term obligations. There are two categories of liabilities arising out of long-term obligations i.e. longterm creditors viz. fixed charge/interest payment obligation and principal repayment. Thus there are two ratios to measure the solvency position. 1. Fixed Charge/Interest Coverage Ratio (for fixed charge obligation): Fixed Charge/Interest Coverage Ratio = l l EBIT ( Unit – Times ) Fixed Charges Higher the ratio, better it is. This ratio indicates the extent of EBIT towards fixed charge/interest payment obligation. 116 Accounting and Financial Management for I.T. Professionals 2. Debt Equity (D/E) ratio (for principal repayment obligation): D/E ratio = l l l l l Long - term Debt (Equity Capital + Reserve & Surplus) Lower the ratio, better it is. D/E ratio measures the margin of safety of principal amount invested by long-term creditors. More the equity, more safe will be principal of long-term creditors. Equity capital acts as cushion to long-term creditors. Leverage means making use of low cost debt capital in order to boost the earnings on equity i.e. return on equity. Low cost debt means, Rate of earnings > Interest rate of debt capital. Trading on equity is possible when leverage exits. Illustration (Trading on equity): (In Rs.) Particulars Company A Equity Long-term debt at 10% rate of interest Total capital employed Company B 1,00,000 40,000 - 60,000 1,00,000 1,00,000 15,000 15,000 EBIT (Earnings Before Interest and Tax)–15% (say) Less: Interest - 6,000 15,000 9,000 Less: Tax @ 40% (say) 7,500 3,600 EAT (Earnings After Tax)/PAT/NP 7,500 6,400 Return on equity = (NP/Equity) x 100 7.5% 10.6% EBT (Earning Before Tax) From above table it is clear that Company B is in better position as it gives more return to its shareholders in comparison to Company A. This is known as trading on equity. Thus trading on equity means maximizing shareholder’s wealth (measured in terms of return on equity) through use of low cost debt capital in total capital employed. Here we can trace out that trading on equity is possible because leverage exists. Company B has used low cost debt capital means Rate of earning (Rate of EBIT—15%) > Interest rate of debt capital—10%). This excess earning (15% – 10% = 5%) goes to equity as equity shareholders have residual claim on income. Turnover Ratios l l It measures the position of resources utilization. Resources include 5M (men, machine, material, money, method) + IT. Higher the turnover ratio, better it is. The unit of turnover ratio is ‘Times’. The different turnover ratios are as follows: ‘X’ Turnover Ratio (‘X’ T.O.R.) = Cost of Goods Sold (COGS) Average ‘X’