RATIO ANALYSIS:
Ratio analysis is the tool of Finance. With ratio analysis, we can check our financial position and revenue position. It is very helpful to analyze financial statement. It is also easy to understand and explain interpretations through these ratios.
Before discussing different ratios, you should understand the meaning of Ratio. Ratio is the relationship between two or more items of balance sheet or profit and loss account or both statements. For knowing short term position’s strength or liquidity, we can find current ratio, liquid ratio. These ratios tell us what is the amount of current assets, which is in the business if we take the burden of current liabilities. If amount of current assets will more the amount of current liabilities, then our liquidity position will strong. We can also calculate mixed ratios like inventory turnover ratio, debtor turnover ratio, creditorturnover ratio.
These ratios are very helpful to find following period
1. With inventory turnover ratio, we can calculate inventory conversion period. If this period is very short then it means we have power to sell our product fastly.
2. With debtor turnover ratio, we can calculate debtor conversion period, if this period is short then it means that we can convert over credit sale fastly into cash.
3. With creditor turnover ratio, we can calculate creditor conversion period, if this period is short, then it means we are ready fastly to reduce our current liabilities. This is plus point if our debtor conversion period will also short. if debtor conversion period is long, then shortness of creditor conversion period is our negative point.
We can analyze of profitability by making gross profit ratio, operating ratio, net profit ratio and ROI ratio.We can also check our long term financial position’s strength or weakness by calculating debt-equity ratio, fixed asset and equity ratio, current asset and capital employed ratio.
ACCOUNTING RATIOS PPT ON YOU TUBE SLIDE SHARE
Hamilton Grammar, user of Slideshare has made beautiful presentation of Accounting Ratios in which he also has explained it .In these ratios , he has included Profitability Ratios , Gross Profit as a Percentage of Net Sales, Rate of Stock Turnover, Net Profit as a Percentage of Net Sales , Balance Sheet Ratios , Working (Current) Capital Ratio
ADVANTAGES OF RATIO ANALYSIS:
Ratio analysis is very useful tool of management accounting. With this, we can analyze business's financial position. We also check company's short term and long term solvency with ratio analysis. Following are the main advantages of ratio analysis.
1. Helpful in Decision Making
All our financial statements are made for providing information. But this information is not helpful for decision making because financial statements provide only raw information. When we calculate different ratios in ratio analysis, at that time, we get useful information. I can explain it with simple example. Suppose, we calculate our interest coverage ratio which is 10times but our competitor company's interest coverage ratio is 15 times. It means capacity of the profit of our competitor company is more than us. By seeing this, we can take decisions for increasing our profitability.
2. Helpful in Financial Forecasting and Planning
Every year we calculate lots of accounting ratios. When we make trend of all these ratios, we can get useful information for our future forecasting and planning. For example, we can tell five year collection period with following way
2007 = 90 days
2008 = 70 days
2009 = 60 days
2010 = 50 days
2011 = 30 days
From this trend, we know that we are decreasing the days for collection money from our debtors. With this information, we can make two plans. One is effective use of money which we are getting from our debtors more fastly and second we can also check the behavior of our debtors by comparing this with sales trend. Like this, there are lots of ratios which are also useful for better planning.
3. Helpful in Communication
Ratio analysis are more important from communication point of view. Suppose, we have to appoint new sales agents for our company. At that time, we can communicate them by using our company's sales and profit related ratios. There is no need of hi-tech for understanding the meaning of any specific ratio. For example, our gross profit in 2010 is 26.6% and in 2011, it is 28.55%. By just telling this ratio, we can understand whether our company is growing or falling.
4. Helpful in Co-ordination
No company has all the strength points. Company's financial results shows some strength points and some weak points. Ratio analysis can create co-ordination between strength points and weak points.
5. Helps in Control
Ratio analysis can also use for controlling our business. We can easily create the standard of each financial item of our balance sheet and profit and loss account. On this basis, we can also calculate standard ratios. By comparing standard ratios with actual accounting ratios, we can find variance. These variance may be favorable and unfavorable. On this basis, we can control our business from financial point of view.
6. Helpful for Shareholder's decisions
For example, I am a shareholder. I want to invest in any company's shares. Before buying any company's shares, I will be interested to know company's long term solvency. So, I have to calculate long term solvency ratios. In which, I have to calculate fixed assets to net worth ratio, fixed assets to long term debt ratio. On this basis, I can know the level of fixed assets and its main resource. After checking my money's security, I will be interested to know my return on this investment. ROI, EPS and DPS are most useful ratios which I can calculate for knowing this.
7. Helpful for Creditors' decisions
Creditors are those persons who provide goods on credit to company or provides short period loan to company. All the creditors are interested to know whether company will repay their debt or not. For this, they calculate current ratio and quick liquid ratio and average payment period. On this basis, they take decisions.
8. Helpful for employees' decisions
Every employee wants to increase his salary. He also wants to get more and more incentives from company. For this, he takes help from company's profitability ratios. Profitability ratios will be helpful for employees to pressure on the company for increasing their salary.
9. Helpful for Govt. decisions
Different companies analyze their accounting ratios and publish on the net and print newspapers. Govt. collects all these information. On this basis, Govt. makes policies. If ratios will wrong, Govt. policies will become wrong. For example, Govt. collects income data of all companies in different industries for calculation the national income.
HOW TO CALCULATE:
To calculate of accounting ratio, you need to remember and use of accounting ratio formula. These formulae are made by the persons who have both the knowledge of accounting and mathematics because ratio is the part of mathematics science and if you same ratio for financial statement analysis, then, it will be helpful also for those who are interested in business and its analyzed results. Every person is interested in business for knowing its profitability, liquidity and solvency position. Accounting ratio is easy way to explain complex and big financial statement in % form. We are calculating following Accounting ratios with given information. I think example is better than writing any detail of concept.
You are required to calculate :
i) Dividend yield on equity share
ii) Cover for the preference dividend
iii) Cover for the equity dividend
iv) Earning per share
v) the price earning ratio
vi) Net cash flow
Given information
The capital of star co. ltd. is as follows :
80000 equity share of Rs. 10 each = Rs. 800000
9% 30000 preference shares of Rs. 10 each = 300000
The following information has been obtained from the books of the company:
Profit after tax at 60% = Rs. 270000
depreciation = Rs. 60000
equity dividend paid = 20%
market price of equity share = Rs. 40
Solution
i ) DYES = DPS/ MPPS = 10 X 20% / 0 = 5%
ii ) CPD = Profit after tax / pref. dividend = 270000/ 300000 X 9% = 10 times
iii) CED = Profit after tax and pref. dividend/ equity dividend = 270000 -27000/ 800000 X 20% = 1.52 times
iv) EPS = Profit after tax and pref. dividend/ no. of equity shares = 270000 -27000/ 80000 = Rs. 3.04
v) PER = Market price per share / earning per share = 40/ 3.04 = 13.1 : 1
vi) Net Cash flow = net profit after tax + depreciation - total dividend = 270000 + 60000 - 27000 -160000 = Rs. 143000
( Note : because depreciation is not paid in cash, so it is operating loss but not cash, so it will include in net profit, if we are interested to calculate cash profit of business. )
Definition of current ratio
This ratio is a relationship of current asset and current liabilities . It states the business current position to pay the current liabilities in time as when due .
There are two components of this ratio
current assets
Ratio analysis is the tool of Finance. With ratio analysis, we can check our financial position and revenue position. It is very helpful to analyze financial statement. It is also easy to understand and explain interpretations through these ratios.
Before discussing different ratios, you should understand the meaning of Ratio. Ratio is the relationship between two or more items of balance sheet or profit and loss account or both statements. For knowing short term position’s strength or liquidity, we can find current ratio, liquid ratio. These ratios tell us what is the amount of current assets, which is in the business if we take the burden of current liabilities. If amount of current assets will more the amount of current liabilities, then our liquidity position will strong. We can also calculate mixed ratios like inventory turnover ratio, debtor turnover ratio, creditorturnover ratio.
These ratios are very helpful to find following period
1. With inventory turnover ratio, we can calculate inventory conversion period. If this period is very short then it means we have power to sell our product fastly.
2. With debtor turnover ratio, we can calculate debtor conversion period, if this period is short then it means that we can convert over credit sale fastly into cash.
3. With creditor turnover ratio, we can calculate creditor conversion period, if this period is short, then it means we are ready fastly to reduce our current liabilities. This is plus point if our debtor conversion period will also short. if debtor conversion period is long, then shortness of creditor conversion period is our negative point.
We can analyze of profitability by making gross profit ratio, operating ratio, net profit ratio and ROI ratio.We can also check our long term financial position’s strength or weakness by calculating debt-equity ratio, fixed asset and equity ratio, current asset and capital employed ratio.
ACCOUNTING RATIOS PPT ON YOU TUBE SLIDE SHARE
Hamilton Grammar, user of Slideshare has made beautiful presentation of Accounting Ratios in which he also has explained it .In these ratios , he has included Profitability Ratios , Gross Profit as a Percentage of Net Sales, Rate of Stock Turnover, Net Profit as a Percentage of Net Sales , Balance Sheet Ratios , Working (Current) Capital Ratio
ADVANTAGES OF RATIO ANALYSIS:
Ratio analysis is very useful tool of management accounting. With this, we can analyze business's financial position. We also check company's short term and long term solvency with ratio analysis. Following are the main advantages of ratio analysis.
1. Helpful in Decision Making
All our financial statements are made for providing information. But this information is not helpful for decision making because financial statements provide only raw information. When we calculate different ratios in ratio analysis, at that time, we get useful information. I can explain it with simple example. Suppose, we calculate our interest coverage ratio which is 10times but our competitor company's interest coverage ratio is 15 times. It means capacity of the profit of our competitor company is more than us. By seeing this, we can take decisions for increasing our profitability.
2. Helpful in Financial Forecasting and Planning
Every year we calculate lots of accounting ratios. When we make trend of all these ratios, we can get useful information for our future forecasting and planning. For example, we can tell five year collection period with following way
2007 = 90 days
2008 = 70 days
2009 = 60 days
2010 = 50 days
2011 = 30 days
From this trend, we know that we are decreasing the days for collection money from our debtors. With this information, we can make two plans. One is effective use of money which we are getting from our debtors more fastly and second we can also check the behavior of our debtors by comparing this with sales trend. Like this, there are lots of ratios which are also useful for better planning.
3. Helpful in Communication
Ratio analysis are more important from communication point of view. Suppose, we have to appoint new sales agents for our company. At that time, we can communicate them by using our company's sales and profit related ratios. There is no need of hi-tech for understanding the meaning of any specific ratio. For example, our gross profit in 2010 is 26.6% and in 2011, it is 28.55%. By just telling this ratio, we can understand whether our company is growing or falling.
4. Helpful in Co-ordination
No company has all the strength points. Company's financial results shows some strength points and some weak points. Ratio analysis can create co-ordination between strength points and weak points.
5. Helps in Control
Ratio analysis can also use for controlling our business. We can easily create the standard of each financial item of our balance sheet and profit and loss account. On this basis, we can also calculate standard ratios. By comparing standard ratios with actual accounting ratios, we can find variance. These variance may be favorable and unfavorable. On this basis, we can control our business from financial point of view.
6. Helpful for Shareholder's decisions
For example, I am a shareholder. I want to invest in any company's shares. Before buying any company's shares, I will be interested to know company's long term solvency. So, I have to calculate long term solvency ratios. In which, I have to calculate fixed assets to net worth ratio, fixed assets to long term debt ratio. On this basis, I can know the level of fixed assets and its main resource. After checking my money's security, I will be interested to know my return on this investment. ROI, EPS and DPS are most useful ratios which I can calculate for knowing this.
7. Helpful for Creditors' decisions
Creditors are those persons who provide goods on credit to company or provides short period loan to company. All the creditors are interested to know whether company will repay their debt or not. For this, they calculate current ratio and quick liquid ratio and average payment period. On this basis, they take decisions.
8. Helpful for employees' decisions
Every employee wants to increase his salary. He also wants to get more and more incentives from company. For this, he takes help from company's profitability ratios. Profitability ratios will be helpful for employees to pressure on the company for increasing their salary.
9. Helpful for Govt. decisions
Different companies analyze their accounting ratios and publish on the net and print newspapers. Govt. collects all these information. On this basis, Govt. makes policies. If ratios will wrong, Govt. policies will become wrong. For example, Govt. collects income data of all companies in different industries for calculation the national income.
HOW TO CALCULATE:
To calculate of accounting ratio, you need to remember and use of accounting ratio formula. These formulae are made by the persons who have both the knowledge of accounting and mathematics because ratio is the part of mathematics science and if you same ratio for financial statement analysis, then, it will be helpful also for those who are interested in business and its analyzed results. Every person is interested in business for knowing its profitability, liquidity and solvency position. Accounting ratio is easy way to explain complex and big financial statement in % form. We are calculating following Accounting ratios with given information. I think example is better than writing any detail of concept.
You are required to calculate :
i) Dividend yield on equity share
ii) Cover for the preference dividend
iii) Cover for the equity dividend
iv) Earning per share
v) the price earning ratio
vi) Net cash flow
Given information
The capital of star co. ltd. is as follows :
80000 equity share of Rs. 10 each = Rs. 800000
9% 30000 preference shares of Rs. 10 each = 300000
The following information has been obtained from the books of the company:
Profit after tax at 60% = Rs. 270000
depreciation = Rs. 60000
equity dividend paid = 20%
market price of equity share = Rs. 40
Solution
i ) DYES = DPS/ MPPS = 10 X 20% / 0 = 5%
ii ) CPD = Profit after tax / pref. dividend = 270000/ 300000 X 9% = 10 times
iii) CED = Profit after tax and pref. dividend/ equity dividend = 270000 -27000/ 800000 X 20% = 1.52 times
iv) EPS = Profit after tax and pref. dividend/ no. of equity shares = 270000 -27000/ 80000 = Rs. 3.04
v) PER = Market price per share / earning per share = 40/ 3.04 = 13.1 : 1
vi) Net Cash flow = net profit after tax + depreciation - total dividend = 270000 + 60000 - 27000 -160000 = Rs. 143000
( Note : because depreciation is not paid in cash, so it is operating loss but not cash, so it will include in net profit, if we are interested to calculate cash profit of business. )
Definition of current ratio
This ratio is a relationship of current asset and current liabilities . It states the business current position to pay the current liabilities in time as when due .
There are two components of this ratio
current assets
- cash in hand
- cash at bank
- marketable securities
- sundry debtors
- bills receivable
- stock in trade
- prepaid exp.
current liabilities
- sundry creditors
- bill payable
- outstanding bill
- bank overdraft
current ratio = current assets /current liabilities
QUICK RATIO: ACID TEST RATIO:
Acid test ratio is strict test of liquidity. When check the quality of stone, we drop some acid on the stone. If stone will be of original marble, it will be shine. Like this, we also test company's short term position with acid test ratio. This ratio is just more deep analysis after calculating current ratio. This ratio tells the relationship between liquid assets and current liabilities. Liquid assets are different from current assets. Any asset will be liquid if it can be easily converted into cash without any loss of money within minimum time period. For calculating liquid assets, we deduct inventories and prepaid expenses from current assets.
Following is the formula of Acid Test Ratio
= Liquid Assets / Current Liabilities
For example : Quick assets are 200000 and current liabilities are Rs. 150000
Quick ratio or acid test ratio = 200000/ 150000
Components of Quick or Liquid Ratio
Liquid Assets
a) Cash in Hand
b) Cash at Bank
c) Sundry Debtors
d) Marketable Securities
e) Temporary Investments
Current Liabilities
Outstanding or Accrued Expenses
Bill payable
Sundry Creditors
Short term advances
Income Tax payables
Dividends payables
Bank overdraft
Point of Analysis of Acid Test or Quick or Liquid Ratio
1. When Acid Test Ratio is equal to Rule of Thumb
Rule of Thumb of acid test ratio is 1:1. If our acid test ratio is 1:1. It is good because at that time, our liquid assets are capable to pay current liabilities.
2. When Acid Test Ratio is less than Rule of Thumb
If acid ratio is 04 : 1 or less than this, this is not good because with this few amount of liquid assets, we will unable to pay our liabilities. But if our acid test ratio is little low, then there is no problem, because sometime, our stock may be liquid and we can easily sell it.
3. When Acid Test Ratio is more than Rule of Thumb
If acid test ratio is more than rule of thumb, then this is good but we should not ignore the position of our sundry debtors in this. Sometime high ratio than rule of thumb will not good, if major part of debtor is not available for quickly convertible in liquid amount.
Following is the formula of Acid Test Ratio
= Liquid Assets / Current Liabilities
For example : Quick assets are 200000 and current liabilities are Rs. 150000
Quick ratio or acid test ratio = 200000/ 150000
Components of Quick or Liquid Ratio
Liquid Assets
a) Cash in Hand
b) Cash at Bank
c) Sundry Debtors
d) Marketable Securities
e) Temporary Investments
Current Liabilities
Outstanding or Accrued Expenses
Bill payable
Sundry Creditors
Short term advances
Income Tax payables
Dividends payables
Bank overdraft
Point of Analysis of Acid Test or Quick or Liquid Ratio
1. When Acid Test Ratio is equal to Rule of Thumb
Rule of Thumb of acid test ratio is 1:1. If our acid test ratio is 1:1. It is good because at that time, our liquid assets are capable to pay current liabilities.
2. When Acid Test Ratio is less than Rule of Thumb
If acid ratio is 04 : 1 or less than this, this is not good because with this few amount of liquid assets, we will unable to pay our liabilities. But if our acid test ratio is little low, then there is no problem, because sometime, our stock may be liquid and we can easily sell it.
3. When Acid Test Ratio is more than Rule of Thumb
If acid test ratio is more than rule of thumb, then this is good but we should not ignore the position of our sundry debtors in this. Sometime high ratio than rule of thumb will not good, if major part of debtor is not available for quickly convertible in liquid amount.
Some accounting experts recommend to calculate absolute liquid or acid test ratio because this ratio will give us correct idea whether our short term financial position is good or not.
Absolute acid means pure acid. Its effect will be very high on marble stone than diluted acid. If marble stone will tolerate the effect of absolute acid, it means that marble is of high quality. We can take the example of Taj Mahal Agra. This Taj Mahal of Agree is tolerating of acid raining from many years but still exists which show the purity and high quality of the marble of Taj Mahal. Like this, company wants to know the capacity of its cash and bank balance for paying its current liabilities. For this purpose, company calculate absolute acid test ratio or absolute liquid ratio. It is just relationship between absolute acid assets and current liabilities.
Formula of Absolute acid test ratio
= Absolute liquid assets / current liabilities
Absolute liquid or acid assets = marketable securities + cash + bank
Main point of analysis
1. If absolute acid test ratio is equal to rule of thumb
Rule of thumb of absolute acid test ratio is 0.5 :1 or 50% of total current liabilities are absolute acid assets. In simple words, if we have 1$ for paying 2$ liabilities it is good because every our creditor will feel good if he will get minimum 50% of cash at any time.
2. If absolute acid test ratio is more than rule of thumb
If absolute acid test ratio is much higher than the rule of thumb, at that time, we analyze our absolute liquid assets. More free cash fund than need will reduce our return on investment. So, we can take some cash fund for investment projects. Upto 1:1 absolute acid test ratio is quit satisfactory.
3. If absolute acid ratio is less than rule of thumb
If absolute acid test ratio is 0.25 which is less than rule of thumb and current and liquid ratio are much more than rule of thumb, at that time, we have to improve cash liquidity by changing the policy of credit sales and advance payments.
Absolute acid means pure acid. Its effect will be very high on marble stone than diluted acid. If marble stone will tolerate the effect of absolute acid, it means that marble is of high quality. We can take the example of Taj Mahal Agra. This Taj Mahal of Agree is tolerating of acid raining from many years but still exists which show the purity and high quality of the marble of Taj Mahal. Like this, company wants to know the capacity of its cash and bank balance for paying its current liabilities. For this purpose, company calculate absolute acid test ratio or absolute liquid ratio. It is just relationship between absolute acid assets and current liabilities.
Formula of Absolute acid test ratio
= Absolute liquid assets / current liabilities
Absolute liquid or acid assets = marketable securities + cash + bank
Main point of analysis
1. If absolute acid test ratio is equal to rule of thumb
Rule of thumb of absolute acid test ratio is 0.5 :1 or 50% of total current liabilities are absolute acid assets. In simple words, if we have 1$ for paying 2$ liabilities it is good because every our creditor will feel good if he will get minimum 50% of cash at any time.
2. If absolute acid test ratio is more than rule of thumb
If absolute acid test ratio is much higher than the rule of thumb, at that time, we analyze our absolute liquid assets. More free cash fund than need will reduce our return on investment. So, we can take some cash fund for investment projects. Upto 1:1 absolute acid test ratio is quit satisfactory.
3. If absolute acid ratio is less than rule of thumb
If absolute acid test ratio is 0.25 which is less than rule of thumb and current and liquid ratio are much more than rule of thumb, at that time, we have to improve cash liquidity by changing the policy of credit sales and advance payments.
INVENTORY TURNOVER RATIO:
Inventory turnover ratio is useful for checking the efficiency of stock. It is also improvement of current ratio. Sometime current ratio may mislead use when there is slow movement of stock in to sale. But inventory turnover ratio will give more idea about, how should we keep our stock in store.
Inventory turnover ratio is relationship between cost of goods sold or net sales and average inventory. This ratio is also known as stock velocity. This ratio tells us whether we use of stock efficiently or not. This ratio will be in times. It tells us the times of sales of every time of stock bought.
Formula
or
ITR = Net Sales / Average Inventory at Cost
Inventory Turnover Ratio = 300000 / 30000 = 10 times
Analysis on the Basis of Inventory Turnover Ratio
1. There is no rule of thumb of inventory turnover ratio but inventory turnover ratio should be optimum. It should not be very higher or very lower.
2. A lower inventory turnover ratio is not good. Because at this level, we are increasing inventory but our sale is not increasing. Due to not converting inventory into sale, we have to keep our stock in our store and we have to face its cost which may be main cause of decreasing our profit. So, we earnestly say you, if you see lower inventory turnover ratio, you should decrease inventory and take good steps to increase your sale. For example, you net sales is just $ 50000 and your average inventory is $ 100000. It means ITR is just 0.5 times. So, this is not good. Try to improve it.
3. A higher inventory turnover ratio is good because higher ITR tells us that our number of time of total sales is more than number of times inventory has been bought. A higher ITR means low investment in inventory and higher return on this investment. But very higher ITR is not good because at this time our inventory may be too low. Due to shortage of low inventory, we may face the problem of loss of new sales orders or our supply may delay of sending us the stock. So, remember this point also.
Inventory turnover ratio is relationship between cost of goods sold or net sales and average inventory. This ratio is also known as stock velocity. This ratio tells us whether we use of stock efficiently or not. This ratio will be in times. It tells us the times of sales of every time of stock bought.
Formula
or
ITR = Net Sales / Average Inventory at Cost
Inventory Turnover Ratio = 300000 / 30000 = 10 times
Analysis on the Basis of Inventory Turnover Ratio
1. There is no rule of thumb of inventory turnover ratio but inventory turnover ratio should be optimum. It should not be very higher or very lower.
2. A lower inventory turnover ratio is not good. Because at this level, we are increasing inventory but our sale is not increasing. Due to not converting inventory into sale, we have to keep our stock in our store and we have to face its cost which may be main cause of decreasing our profit. So, we earnestly say you, if you see lower inventory turnover ratio, you should decrease inventory and take good steps to increase your sale. For example, you net sales is just $ 50000 and your average inventory is $ 100000. It means ITR is just 0.5 times. So, this is not good. Try to improve it.
3. A higher inventory turnover ratio is good because higher ITR tells us that our number of time of total sales is more than number of times inventory has been bought. A higher ITR means low investment in inventory and higher return on this investment. But very higher ITR is not good because at this time our inventory may be too low. Due to shortage of low inventory, we may face the problem of loss of new sales orders or our supply may delay of sending us the stock. So, remember this point also.
Inventory conversion period reports us about the average time to convert our total inventory into sales. It is relationship between total days in year and inventory turnover ratio. In other words, it measures the length of time on average between the acquisition and sale of merchandise. We can calculate it with following formula.
Actually cash conversion period is nothing but it is the part of whole cycle which is created with inventory, debtor and creditor conversion cycle.
Both days payable outstanding and days sales outstanding will tell you the exact position of cash conversion period. Our aim of studying cash conversion cycle and its calculation is to change the policies relating to credit purchase and credit sales. We can change our standard of payment of credit purchase or getting cash from our debtors on the basis of reports of cash conversion cycle. If it tells good cash liquidity position, we can maintain our past credit policies. Its also aim is to study cash flow of business. Cash flow statement and cash conversion cycle study will be helpful for cash flow analysis.
For example, inventory turnover ratio is 10 times of average stock at cost. Its inventory conversion period will be
= 365/ 10 = 37 days. It means, the inventory has been disposed off or sold on an average in 37 days.
Interpretation of Inventory Conversion Period
1. Less inventory conversion period is better because more fastly, we will convert our inventory into sales, there will be less chance of obsolescence and paying of over-stocking cost.
2. Inventory conversion period is the part of cash conversion cycle. If this period is very high, it will increase the time to complete the cash conversion cycle. It means, there will be more liquidity risk in that level of inventory.
3. After adding average collection period and deducting average payment period, we can take good decision relating to inventory level. Following example will explain its importance in simple way.
Meaning Debtor Turnover ratio
Debtor turnover ratio is the relationship between net sales and average debtors. It is also called account receivable turnover ratio because we debtor and bill receivables' total is used for following formula
= Net Credit Sales / Average Debtors ( sundry debtors + bill receivables)
Average Debtors = Opening balance of debtors + closing balance of debtors / 2
Net Credit Sales = Total sales - sales return - cash sales
If net credit sales is $50000 and average debtors are $ 10000, then debtor turnover ratio is 5 times. It means, net sales is 5 times of total debtors. We issue new stock for sale which is 5 times of its debtors. It means, our average debtors 5 times are converted into cash. We collected cash from our debtors and then we sell the more goods.
Interpretation of Debtor Turnover Ratio
1. Higher debtor turnover ratio is good because more higher debtor turnover ratio means, more fastly, we are collecting money. Suppose, in above example, we have only one debtor Mr. Alfred. We sold $ 50000 goods 5 times. It means, we are collecting money from Alfred 5 times. More times, we collect money from Mr. Alfred, our liquidity position will become more strong.
2. Lower debtor turnover ratio is not good because it tells us that we have not manage debtors better ways. Money from debtors are not collected fastly.
If we calculate average collection period on the basis of debtor turnover ratio, we can analyze our debtors more deeply.
Debtor turnover ratio is the relationship between net sales and average debtors. It is also called account receivable turnover ratio because we debtor and bill receivables' total is used for following formula
= Net Credit Sales / Average Debtors ( sundry debtors + bill receivables)
Average Debtors = Opening balance of debtors + closing balance of debtors / 2
Net Credit Sales = Total sales - sales return - cash sales
If net credit sales is $50000 and average debtors are $ 10000, then debtor turnover ratio is 5 times. It means, net sales is 5 times of total debtors. We issue new stock for sale which is 5 times of its debtors. It means, our average debtors 5 times are converted into cash. We collected cash from our debtors and then we sell the more goods.
Interpretation of Debtor Turnover Ratio
1. Higher debtor turnover ratio is good because more higher debtor turnover ratio means, more fastly, we are collecting money. Suppose, in above example, we have only one debtor Mr. Alfred. We sold $ 50000 goods 5 times. It means, we are collecting money from Alfred 5 times. More times, we collect money from Mr. Alfred, our liquidity position will become more strong.
2. Lower debtor turnover ratio is not good because it tells us that we have not manage debtors better ways. Money from debtors are not collected fastly.
If we calculate average collection period on the basis of debtor turnover ratio, we can analyze our debtors more deeply.
WC TURNOVER RATIO
There is direct relation of working capital of company with its sales. We have more control over working capital because we can change current asset or current liability according to our need. But, there is no full control over our sales because external business environment affects our level of sales. Working capital turnover ratio is good tool to take decision to manage sales. It shows the use of working capital for sales. Both high and low working capital turnover ratio is not good. Because low WCTR means low inefficient use of working capital in operation and very high working capital turnover ratio does not show good position of company because its shows company is operating with high short-term debt obligations. Only optimum working capital turnover ratio is the best. Formula of Working capital turnover ratio.
= Cost of sale or sales / average working capital
This ratio also shows the return in volume on our net invested current assets. We can also compare it with Asset turnover ratio which shows the relationship of sales and total assets
= Cost of Sales or Sales / Total Assets
If we write earning asset instead of writing cost of sales or sales, it will be the Earning assets to total assets ratio. It is also better way to check the position of company.
= Cost of sale or sales / average working capital
This ratio also shows the return in volume on our net invested current assets. We can also compare it with Asset turnover ratio which shows the relationship of sales and total assets
= Cost of Sales or Sales / Total Assets
If we write earning asset instead of writing cost of sales or sales, it will be the Earning assets to total assets ratio. It is also better way to check the position of company.
Average collection period and and Average payment period is basic test of the business's good or bad activity or operation . This is the main part of financial analysis to calculate these type of ratio . Even a small business man want to time in which he gets his debt from his debtors in whole year . He also wants to know at what period he pays his creditors .
2. Average Payment Period12 months or 365 days
= __________________
Creditors Turnover ratio
Because it is based on Creditors turnover ratio . So we should also know Creditors turnover ratio
- These two ratios are the good symbol for calculating the efficiency and capacityof any type of organisation
- These two ratios are the good symbol for making good planning for increase or decrease working capital efficiently . Because working capital is more effected from sundry debtors and sundry creditors.
☼ Lets start for calculating these two ratios
- Average Collection Period
12 months or 365 days
= __________________
Debtors Turnover ratio
Because it is based on debtors turnover ratio . So we should also know debtor turnover ratio
Net Credit Sale
= _______________
Average Debtors amount
Average debtors amount is equal to sum of opening and closing debtors and after divide 2 , we can calculate the average debtors amount.
2. Average Payment Period12 months or 365 days
= __________________
Creditors Turnover ratio
Because it is based on Creditors turnover ratio . So we should also know Creditors turnover ratio
Net credit Purchase
= _______________
Average Creditors amount
Average Creditors amount is equal to sum of opening and closing Creditors and after divide 2 , we can calculate the average Creditors amount.
= _______________
Average Creditors amount
Average Creditors amount is equal to sum of opening and closing Creditors and after divide 2 , we can calculate the average Creditors amount.
CREDITOR TURNOVER RATIO:
A business organisation has to pay creditors if it buys goods on credit. Any new creditor will give us the goods on credit if he knows that we pay our creditors' bill within short period of time. So, for knowing this time period, both parties calculate creditor turnover ratio. We will calculate this because if our time period is more than normally standard period, we will try to decrease it. On the other side, new creditor will take the decision on this ratio whether goods on credit will be given to us or not.
We calculate creditor turnover ratio just like calculating of debtor turnover ratio but we show net credit annual purchase and average trade creditors instead of net credit annual sales and average trade debtors. If we have not the information of net credit purchase, we can take total purchase as numerator. Like this, if we have no information of opening balance of creditors, we can take closing balance of creditors. We can calculate average trade creditors by taking the average of opening balance and closing balance of creditors. Following is the formula
Creditor or Payable Turnover Ratio
= Net Credit Annual Purchase / Average Trade Creditors
This ratio can be used for calculating Average Payment period.
Example
Total purchases = Rs. 400,000
Cash purchases = Rs. 50000
purchase return = Rs. 20000
Creditors at end = Rs. 60000
Bills payable at end = Rs. 20000
Reserve for discount on creditors = Rs. 5000
Creditor Turnover Ratio = Annual Net Credit Purchase / Average Trade Creditors
= 400000 - 50000 - 20000 / 60000+20000 = 330000 / 80000 = 4.13 times
Interpretation of Creditor Turnover Ratio
We calculate creditor turnover ratio just like calculating of debtor turnover ratio but we show net credit annual purchase and average trade creditors instead of net credit annual sales and average trade debtors. If we have not the information of net credit purchase, we can take total purchase as numerator. Like this, if we have no information of opening balance of creditors, we can take closing balance of creditors. We can calculate average trade creditors by taking the average of opening balance and closing balance of creditors. Following is the formula
Creditor or Payable Turnover Ratio
= Net Credit Annual Purchase / Average Trade Creditors
This ratio can be used for calculating Average Payment period.
Example
Total purchases = Rs. 400,000
Cash purchases = Rs. 50000
purchase return = Rs. 20000
Creditors at end = Rs. 60000
Bills payable at end = Rs. 20000
Reserve for discount on creditors = Rs. 5000
Creditor Turnover Ratio = Annual Net Credit Purchase / Average Trade Creditors
= 400000 - 50000 - 20000 / 60000+20000 = 330000 / 80000 = 4.13 times
Interpretation of Creditor Turnover Ratio
Higher creditor turnover ratio is good because it will decrease the average payment period.
In the question, if we have given the information of creditor turnover ratio and other information, we can calculate one missing information. For example, in following video, we can find opening balance of creditors, if all other information is given.
AVERAGE PAYMENT PERIOD:
This ratio will tell us the numbers of days or months for making the payments of trade payable. It is propinquity between no. of working days and creditor turnover ratio. Its formula is given below:
= No. of Working Days or Months / Creditor Turnover Ratio
or Account payable / Net Credit Purchase / 365 or 360
For example, if creditor turnover ratio is 60 times of net credit purchase, then average payment period will be
= 365 / 60 = 6 days
For this instance, we can understand that company will take 6 days to pay its creditors and account payable.
Interpretation of Average Payment Period
= No. of Working Days or Months / Creditor Turnover Ratio
or Account payable / Net Credit Purchase / 365 or 360
For example, if creditor turnover ratio is 60 times of net credit purchase, then average payment period will be
= 365 / 60 = 6 days
For this instance, we can understand that company will take 6 days to pay its creditors and account payable.
Interpretation of Average Payment Period
If this period will be low, it will be good for our liquidity because more smartly, we will pay our creditors, more amount of credit purchase, we can get.
If this period will be high, it will create the risk for our liquidity position because some creditor can demand and in long period, we can forget to pay. One month or two month is best time period of our creditors. So, our average payment period should be between 30 to 60 days.
We can also use this ratio in cash conversion cycle. Cash conversion cycle ratio is
inventory conversion period + average collection period - average payment period. Only calculate this period, we can adjust average payment period for minimum affecting the balance of normal flow of our cash
If this period will be high, it will create the risk for our liquidity position because some creditor can demand and in long period, we can forget to pay. One month or two month is best time period of our creditors. So, our average payment period should be between 30 to 60 days.
We can also use this ratio in cash conversion cycle. Cash conversion cycle ratio is
inventory conversion period + average collection period - average payment period. Only calculate this period, we can adjust average payment period for minimum affecting the balance of normal flow of our cash
Cash conversion cycle tells the period in which we collect our cash if we invest our money in inventory and then we sell it on credit. If cash conversion cycle is positive, it means, we have more time for collecting money from inventory and credit sales than payment tocreditors. At that time, we have to maintain other sources of cash for our operation of business. If cash conversion cycle is negative, it means, we can collect money more quickly from our inventory and credit sales than payment to our creditors. At that time, we can take decision to invest this money in other projects.
Following is the simple formula for calculation of cash conversion cycle or period
= Inventory conversion period + Receivables conversion period – Payables conversion period
or
= 365 / inventory turnover ratio + 365 / debtors turnover ratio - 365/ creditors turnover ratio
Following is example which explain this concept
Following is the simple formula for calculation of cash conversion cycle or period
= Inventory conversion period + Receivables conversion period – Payables conversion period
or
= 365 / inventory turnover ratio + 365 / debtors turnover ratio - 365/ creditors turnover ratio
Following is example which explain this concept
Actually cash conversion period is nothing but it is the part of whole cycle which is created with inventory, debtor and creditor conversion cycle.
Both days payable outstanding and days sales outstanding will tell you the exact position of cash conversion period. Our aim of studying cash conversion cycle and its calculation is to change the policies relating to credit purchase and credit sales. We can change our standard of payment of credit purchase or getting cash from our debtors on the basis of reports of cash conversion cycle. If it tells good cash liquidity position, we can maintain our past credit policies. Its also aim is to study cash flow of business. Cash flow statement and cash conversion cycle study will be helpful for cash flow analysis.
IMMEDIATE SOLVENCY RATIO:
Do, you know immediate solvency ratio? No, but if I tell you some clues about this, I think, you can tell me what does this solvency ratio show?
1st Clue
This ratio is calculated for knowing the Short Term Financial Position.
2nd Clue
This ratio is calculated from Balance Sheet's Information.
Above two clues are enough to know about immediate solvency ratio. If you are not wrong, you are thinking about liquid ratio or quick ratio.
Yes, immediate solvency ratio is liquid ratio or quick ratio which is calculated for knowing the short term financial position and it is also calculate from liquid assets and current liabilities. Both information can only be found through making of balance sheet.
Immediate Solvency Ratio = Liquid assets / Current liabilities
{*} Note
Liquid assets
Current Liabilities
As a convention, generally, immediate solvency ratio or quick ratio of "one to one" (1:1) is considered to be satisfactory.
Yes, immediate solvency ratio is liquid ratio or quick ratio which is calculated for knowing the short term financial position and it is also calculate from liquid assets and current liabilities. Both information can only be found through making of balance sheet.
{*} Note
Liquid assets
- Cash
- Bank
- Sundry debtors
- Short term investments
Current Liabilities
- Sundry creditors
- Bills payable
- Outstanding expenses
- Short term advances
- Income tax payable
- Dividends payable
- Bank overdraft
As a convention, generally, immediate solvency ratio or quick ratio of "one to one" (1:1) is considered to be satisfactory.
CASH FLOW RATIOS:
In Management Accounting, there are 5 ratios which shows the relationship of cash flow and other items of financial statements. InYouTube video, Accounting teacher Susan has explained following 4 cash flow ratio. One cash flow ratio, I have found in Wikipedia's contentwhich has written by Wikipedia's writer. So, I have collected all these for your understanding.
1st Cash Flow Ratio
Cash Flow Yield Ratio
This ratio shows the relationship between cash flow from operations and Net Profit of Company. Cash flow operations is calculated by making cash flow statement and net profit is calculated by making profit and loss account.
Cash Flow Yield Ratio = Cash flow from operations / Net Profits
CFYR = CFFO/ NP
2nd Cash Flow Ratio
Cash flow to Sales Ratio
This ratio shows the relationship between cash flow from operations and total sales of company.
Cash Flow to Sales Ratio = Cash flow from operations / Sales
3rd Cash Flow Ratio
Cash flow to Assets
This ratio shows the relationship between cash flow from operations and average value of assets of companies. We can calculate average assets by adding opening and closing balance of total assets and after this we divide it by 2.
Cash Flow to Assets Ratio = Cash flow from operations / opening assets + closing assets / 2
4th Cash Flow Ratio
This ratio shows how much money is free after paying dividend and future assets purchasing.
Free Cash Flow Ratio = Cash from operations - dividend paid - ( Purchase value of planned Assets - Sale value of Planned Assets.
5th Cash Flow Ratio
Price to Cash Flow Ratio
This ratio shows the relationship between market price of company's capital and cash flow from operations.
Price to Cash Flow Ratio = Market price of Company's equity share capital / Cash from operations
Wait for next content relating to cash flow ratio analysis in which you will read soon how can these ratios are helpful for manager for managing and budgeting of cash and working capital.
1st Cash Flow Ratio
Cash Flow Yield Ratio
This ratio shows the relationship between cash flow from operations and Net Profit of Company. Cash flow operations is calculated by making cash flow statement and net profit is calculated by making profit and loss account.
Cash Flow Yield Ratio = Cash flow from operations / Net Profits
CFYR = CFFO/ NP
2nd Cash Flow Ratio
Cash flow to Sales Ratio
This ratio shows the relationship between cash flow from operations and total sales of company.
Cash Flow to Sales Ratio = Cash flow from operations / Sales
3rd Cash Flow Ratio
Cash flow to Assets
This ratio shows the relationship between cash flow from operations and average value of assets of companies. We can calculate average assets by adding opening and closing balance of total assets and after this we divide it by 2.
Cash Flow to Assets Ratio = Cash flow from operations / opening assets + closing assets / 2
4th Cash Flow Ratio
This ratio shows how much money is free after paying dividend and future assets purchasing.
Free Cash Flow Ratio = Cash from operations - dividend paid - ( Purchase value of planned Assets - Sale value of Planned Assets.
5th Cash Flow Ratio
Price to Cash Flow Ratio
This ratio shows the relationship between market price of company's capital and cash flow from operations.
Price to Cash Flow Ratio = Market price of Company's equity share capital / Cash from operations
Wait for next content relating to cash flow ratio analysis in which you will read soon how can these ratios are helpful for manager for managing and budgeting of cash and working capital.
LONG TERM SOLVENCY:
Like analysis of short term solvency, we also analyze our long term solvency. Solvency's dictionary meaning is the power to repay the loan. If we have sufficient amount in our pocket, we can repay loan at any time. But long term solvency meaning is very large. Some loan of $ 10 million which we have to pay after 5 years and other other loan is of $ 20 million which we have to pay after 10 years. All these loans are long term which are the main part of our long term liabilities. Analysis of long term solvency will tell us our power to repay all these long term liabilities through our long term assets. Suppose, we have $ 20 Million's trucks whose value will be $ 10 million, it means, we have capacity to repay $ 10 million after 5 years by selling our trucks of same amount. This is a simple analyze which you are doing of your single man transport business. Now, this a big MNC or any other company who has billions of assets and liabilities. But these companies also face the losses because these companies do not care on long term solvency.
If your all long term assets have no capacity to pay your all long term liabilities, it means there is big need to take big decisions. We all know our long period converts in to short period. So, if we see any default relating to long term solvency, we should not ignore it.
There are lots of accounting ratios which can be used for analysis of long term solvency but here we are discussing two important ratios.
1. Fixed Assets to Long Term Debt Ratio
2. Fixed Assets to Share Capital Fund Ratio
This ratio is relationship between fixed assets and share capital fund. This ratio is also called fixed assets to net worth ratio. Following is its formula:
= Fixed Assets / Share capital fund
For example, if fixed asset is 400,000 just like in above example, before calculating fixed asset ratio, we will calculate fixed assets to net worth ratio. Suppose, our share capital is Rs. 400,000, at that time this ratio will be
= 400000 /400000 X 100 = 100%.
It means all these fixed assets are bought from our share capital. But if fixed assets are Rs. 500,000, at that time, we have to demand RS. 1,00,000 from more debt which will increase our cost.
Why do We Calculate Assets ratio with Assets to Net Worth Ratio?
Suppose, our Rs. 400,000 becomes Rs. 0 due to high decrease of share market prices. At same time, if our total fixed assets are just 50% of total long term debt. How will we manage balance of 50%? So, it is very necessary to calculate all type of long term solvency ratio and be secure.
If your all long term assets have no capacity to pay your all long term liabilities, it means there is big need to take big decisions. We all know our long period converts in to short period. So, if we see any default relating to long term solvency, we should not ignore it.
There are lots of accounting ratios which can be used for analysis of long term solvency but here we are discussing two important ratios.
1. Fixed Assets to Long Term Debt Ratio
(a) From above ratio, we can estimate that these fixed assets are bought from long term debt. We have current 80% repayment capacity through these fixed assets.
(b) If fixed assets ratio is 100%, then it is good because we have capacity to clear our 100% long term debts.
(c) If fixed assets ratio is 130%, it means we have fixed assets of 30% which we bought from our short term fund, this long term solvency is not good because at that time we are using our short term funds for long term assets. At that time, our short term financial position may be affected from this.
2. Fixed Assets to Share Capital Fund Ratio
This ratio is relationship between fixed assets and share capital fund. This ratio is also called fixed assets to net worth ratio. Following is its formula:
= Fixed Assets / Share capital fund
For example, if fixed asset is 400,000 just like in above example, before calculating fixed asset ratio, we will calculate fixed assets to net worth ratio. Suppose, our share capital is Rs. 400,000, at that time this ratio will be
= 400000 /400000 X 100 = 100%.
It means all these fixed assets are bought from our share capital. But if fixed assets are Rs. 500,000, at that time, we have to demand RS. 1,00,000 from more debt which will increase our cost.
Why do We Calculate Assets ratio with Assets to Net Worth Ratio?
Suppose, our Rs. 400,000 becomes Rs. 0 due to high decrease of share market prices. At same time, if our total fixed assets are just 50% of total long term debt. How will we manage balance of 50%? So, it is very necessary to calculate all type of long term solvency ratio and be secure.
DEBT EQUITY RATIO:
Debt equity ratio shows the relationship between company's debt resources and capital resources. It is calculated for getting idea of solvency of company. If company's overall equity is more than overall debt, it means the position of solvency of company is good because company has internal equity to pay outside equity and external debt need not to worry. I have made an introduction video tutorial for more clearing the concept of debt equity ratio ON YOU TUBE.
Captions or Transcript are given below:
Welcome dear student, we will introduce debt equity ratio. What is this? Actually, this is relationship between debt and equity. Means, total debt is divided by total equity. With this, we see the solvency of company. Suppose total debt is 4 and total equity is 8. It means 1 : 2, we have capital 2 times of our total taken debt. We will include total debt. One is long term debt or debenture. Second is current liabilities which we can calculate from our balance sheet. Second element which we need for calculating debt equity ratio is total equity. It is net worth of business, means in this, we will add equity share capital plus pref. share capital plus reserves. If profit and loss account's balance will show in asset side, it will be loss and it will be deducted. We can a simple example. Suppose we have debenture of Rs. 100,000. Our current liabilities of Rs. 100000 and if we divide it with equity share capital of Rs. 200000 , pref. share capital of Rs. 100,000 and reserves of Rs. 100000
Debt Equity Ratio = 100,000 + 1,00,000 / 200000 +100000 +100000 = 200000/400000 = 2 : 4 = 1 : 2
Welcome dear student, we will introduce debt equity ratio. What is this? Actually, this is relationship between debt and equity. Means, total debt is divided by total equity. With this, we see the solvency of company. Suppose total debt is 4 and total equity is 8. It means 1 : 2, we have capital 2 times of our total taken debt. We will include total debt. One is long term debt or debenture. Second is current liabilities which we can calculate from our balance sheet. Second element which we need for calculating debt equity ratio is total equity. It is net worth of business, means in this, we will add equity share capital plus pref. share capital plus reserves. If profit and loss account's balance will show in asset side, it will be loss and it will be deducted. We can a simple example. Suppose we have debenture of Rs. 100,000. Our current liabilities of Rs. 100000 and if we divide it with equity share capital of Rs. 200000 , pref. share capital of Rs. 100,000 and reserves of Rs. 100000
Debt Equity Ratio = 100,000 + 1,00,000 / 200000 +100000 +100000 = 200000/400000 = 2 : 4 = 1 : 2
If any body say to me, " How can we simplify the debt to equity ratio?", I will answer that debt equity ratio is just a simple technique which a bank will check when it will approve or reject any bank loan.
Suppose company want to get $ 10,00,000 loan from XYZ bank. Bank is so smart. Bank manager will check previous year balance sheet and then finds the value of his already taken debt and equity share capital value and then calculates this ratio by debt divided by equity capital.
Suppose that company's debt equity ratio is 5 : 1, it means company has only 1$ equity capital for paying every $ 5. (*Always remember equity share capital is just like a person's own capital. Because equity shareholders are the real owner of company.) It is most risky position, bank will reject this loan to that company after calculating and seeing the overall financial position with this small ratio. So, it is Brahma Astra in the hand of bank manager.
Suppose company want to get $ 10,00,000 loan from XYZ bank. Bank is so smart. Bank manager will check previous year balance sheet and then finds the value of his already taken debt and equity share capital value and then calculates this ratio by debt divided by equity capital.
Suppose that company's debt equity ratio is 5 : 1, it means company has only 1$ equity capital for paying every $ 5. (*Always remember equity share capital is just like a person's own capital. Because equity shareholders are the real owner of company.) It is most risky position, bank will reject this loan to that company after calculating and seeing the overall financial position with this small ratio. So, it is Brahma Astra in the hand of bank manager.
PROPRIETARY SOLVENCY RATIO:
Proprietory ratio is the relationship between shareholders' fund and total assets of company. It is also called equity ratio or Shareholders' Funds to Total Assets Ratio or Net Worth to Total Assets Ratio. This ratio tells the percentage of Shareholders' which has been invested money in total assets.
Formula of Proprietary Ratio
If this ratio is 100%. It means whole money which was invested in the total assets, is of shareholders' invested capital. It this Ratio is just 10%, it means, company has just taken 10% of total purchased assets from shareholders. Other 90% money is from debt.
For Example
Total shareholders' fund is Rs. 4,00,000
Total Assets are Rs. 6,00,000
Proprietory Ratio is = 4,00,000/ 6,00,000 = 66.67 %
Interpretation of Proprietory Ratio
In above example, we find 66.67% as Proprietory ratio. It means Rs. 66.67 in total asset of Rs. 100 is of shareholders. Other money in total assets is of creditors.
Formula of Proprietary Ratio
If this ratio is 100%. It means whole money which was invested in the total assets, is of shareholders' invested capital. It this Ratio is just 10%, it means, company has just taken 10% of total purchased assets from shareholders. Other 90% money is from debt.
For Example
Total shareholders' fund is Rs. 4,00,000
Total Assets are Rs. 6,00,000
Proprietory Ratio is = 4,00,000/ 6,00,000 = 66.67 %
Interpretation of Proprietory Ratio
In above example, we find 66.67% as Proprietory ratio. It means Rs. 66.67 in total asset of Rs. 100 is of shareholders. Other money in total assets is of creditors.
INTEREST COVERAGE RATIO:
Interest coverage ratio is the part of analysis of long term solvency. This ratio is the relationship between net profit before tax and interest and total fixed interest charges. This ratio's second name is net profit to debt service ratio or debt service ratio because with this ratio, we check our net profit's capacity for paying interest on our long term debts. Creditors are interested that company may give interest on their loan or not. If our net profit is very high than our interest payment, at that time, we can say that we have capacity to pay our all interest payment liabilities.
Following is the formula of interest coverage ratio:
= Net profit before interest and tax / total interest charges
Example
For example, we have net profit after tax is Rs. 10000 and our tax is 50% on net profit and our payment of interest is Rs. 10000.
In this question, we have given net profit after tax, it means we have to calculate net profit before interest and tax first.
EBIT = Net profit after tax + Tax + interest = 10000 + 10000 + 10000 = 30000
Interest = 10000
ICR = 30000 / 10000 = 3 times
It means, we have 3 times capacity to pay interest on debt. But this is not sufficient because it should be high. Suppose, if we increase our net profit upto Rs. 50000, at that time our EBIT will be Rs. 110,000. So, our ICR will be = 110000 / 10000 = 11 times
It means, we can pay Rs. 10,000 even times without taking any short term loan, if we have Rs. 50000 net profit after tax. Now, we understood that all creditors are money minded. So, we have to secure ourselves by increasing our profit, otherwise, our creditors will take benefit of our this weak point.
How can they take benefit, if our profit is very low?
Simple answer : In future, they will give us loan at high rate of interest because they feel more risk of their money. With this, our fixed cost will increase. This fixed cost will decrease total profitability of shareholder. Less EPS will decrease the value of share in the market. Next, you can understand the future of that company.
= Net profit before interest and tax / total interest charges
Example
For example, we have net profit after tax is Rs. 10000 and our tax is 50% on net profit and our payment of interest is Rs. 10000.
In this question, we have given net profit after tax, it means we have to calculate net profit before interest and tax first.
EBIT = Net profit after tax + Tax + interest = 10000 + 10000 + 10000 = 30000
Interest = 10000
ICR = 30000 / 10000 = 3 times
It means, we have 3 times capacity to pay interest on debt. But this is not sufficient because it should be high. Suppose, if we increase our net profit upto Rs. 50000, at that time our EBIT will be Rs. 110,000. So, our ICR will be = 110000 / 10000 = 11 times
It means, we can pay Rs. 10,000 even times without taking any short term loan, if we have Rs. 50000 net profit after tax. Now, we understood that all creditors are money minded. So, we have to secure ourselves by increasing our profit, otherwise, our creditors will take benefit of our this weak point.
How can they take benefit, if our profit is very low?
Simple answer : In future, they will give us loan at high rate of interest because they feel more risk of their money. With this, our fixed cost will increase. This fixed cost will decrease total profitability of shareholder. Less EPS will decrease the value of share in the market. Next, you can understand the future of that company.
CASH FLOW TO DEBT SERVICE COVER RATIO:
Cash flow to debt service ratio is the improvement in interest coverage ratio. In interest coverage ratio, we create relationship between net profit and total interest payment but we all know that interest payment will always in cash form. So, it will be better if we create relationship between cash flow from operation instead of net profit and total interest payment. Following is the formula of cash flow to debt service ratio.
In this formula, we are seeing that there is relationship between cash inflow from operation and total interest payment. More high will our cash flow before interest, depreciation and taxes, more we can easily pay our interest without any problem.
What is sinking fund Appropriation on Debt?
Sinking fund is just like a reserve fund which is used for repayment of loan. So, this fund is also created from our profit for repayment of loan. This fund will be specific rate on our taken debt. So, we will add this total interest payment when we calculate cash flow to debt service ratio.
Example
Calculate cash to debt service ratio :
Net profit after tax = 22500
Fixed interest charges = 2000
Depreciation charged = 3000
Tax rate = 50%
Sinking fund appropriation = 7.5% of outstanding debentures
10% debentures = 20000
Debt cash flow coverage ratio or cash flow to debt service ratio =
CF/ 1 + SFD / 1 - T
= 22500 + 22500 ( tax ) + 2000 ( interest ) + 3000 ( Depreciation ) / 2000 + 1500 / 1- 50%
= 50000 / 2000 + 1500 / 0.5
= 50000 /5000 = 10 times
It means we have 10 times cash from our profit which is available for paying interest. In other words, we have cash profit for paying interest on the debt of 200,000.
Importance of Cash Flow to Debt Service Ratio
To calculate this ratio is very important for creditor because our creditor will think 100 times before giving us loan. If he see, we have 10 times cash profit for paying his interest on loan, he will ready to give us more loan. If this cash flow to debt service ratio will be 20 times, other creditors will also be ready to give us loan. If our cash flow to debt service is just 1 or 2 times, our creditors can say us good bye, when we will ask for loan.
CURRENT ASSETS TO SHARE HOLDER FUNDS RATIO:
Ratio of current assets to shareholders funds is the relationship between all current assets and shareholder's funds. For example, our total current assets are $ 1,00,000 and our total shareholder funds are $ 4,00,000. At that time, this ratio will be
= Current assets / shareholders' funds X 100
= 1,00,000/ 4,00,000 X 100 = 25%
This ratio tells us, how much money of shareholders did company's management invest in current assets. Shareholder can get both items from current balance sheet. It is not wrong to invest shareholders money in current assets. But after a limit, it is not good to invest in short term or current assets because
(A) Current assets provides use short term profit but our commitment for shareholders are to provide earning long period.
(b) If we keep current assets in cash in hand, at that time, this cash will not generate any profit. At that time, it will be risky for company to suffer cost of equity capital.
(c) Some current assets are debtors and bill receivables. More investment of shareholder fund in these assets are risky because there is not any security of these assets. So, if any account manager sees current assets to shareholders funds ratio at very high rate, he or she should go to deep by calculating sundry debtors to shareholders fund ratio to know the exact % of shareholders funds which has been invested in debtors. Debtors who will not pay us, may easily becomes bad debtors and this loss will not company but this loss will be of shareholders. With this, money of shareholders will decrease. Result you can see in the share market. Rate of share market will decrease.
= Current assets / shareholders' funds X 100
= 1,00,000/ 4,00,000 X 100 = 25%
This ratio tells us, how much money of shareholders did company's management invest in current assets. Shareholder can get both items from current balance sheet. It is not wrong to invest shareholders money in current assets. But after a limit, it is not good to invest in short term or current assets because
(A) Current assets provides use short term profit but our commitment for shareholders are to provide earning long period.
(b) If we keep current assets in cash in hand, at that time, this cash will not generate any profit. At that time, it will be risky for company to suffer cost of equity capital.
(c) Some current assets are debtors and bill receivables. More investment of shareholder fund in these assets are risky because there is not any security of these assets. So, if any account manager sees current assets to shareholders funds ratio at very high rate, he or she should go to deep by calculating sundry debtors to shareholders fund ratio to know the exact % of shareholders funds which has been invested in debtors. Debtors who will not pay us, may easily becomes bad debtors and this loss will not company but this loss will be of shareholders. With this, money of shareholders will decrease. Result you can see in the share market. Rate of share market will decrease.
LIMITATIONS OF RATIO ANALYSIS:
Ratio analysis is used by almost all the accounts managers for strategic planning and decision making. It also very helpful tool to know the effect of each item of financial statements by creating relationship with other items. There is big list of benefits of ratio analysis but it has also some limitations. So, account managers and other parties who use ratio and its analysis should remember these limitations when they take any decision.
Following are main drawbacks or limitations of ratio analysis:
Limited Use of Single Ratio
Sometime, we can not compare our ratios with others. For example, we have started new business and our financial results are not still normal. At that time, our profitability ratio will have limited use because there is not any past data of profitability ratios.
Lack of Adequate Standards
We could not make standards of all ratios. For example, we can not tell what is rule of them of our net profit ratio because there are lots of factors affect it. In the lack of adequate standards of ratios, we can not give exact comment on the basis of ratio analysis.
Inherent Limitation of Financial Accounting
Ratio analysis is just like simplification of financial accounting data. But there are lots of limitations of financial accounting which you can read at here. All these limitation will be absorbed by ratios. This is the one of the important limitation of ratio. I can say if base is not good, everything will be wrong. If there is small portion of poison in milk, its effect will be in everything what you will make.
Changes of Accounting Procedures
If accounting procedures will change, our accounting ratio will be changed. At that time, we can not compare our current year ratios with our past year ratios. For example, in past year, we had used LIFO but current year, we are using FIFO for inventory valuation. Due to this, figures of closing stock will be different. On this basis, if we have calculated current ratio, it will not be comparable with past current ratio.
Window Dressing
Because we have shown our financial data through window dressing. Our ratios will also be affected from it.
Personal Bias
This is reality, I saw many CAs who waste their time to optimize different ratios by changing the project financial statements figures for making attractive projects. All these activities are done for getting loan. So, this will make the drawback of ratio analysis.
Matchless
Different companies uses different accounting policies, so, we can not compare their ratios.
Price Level Changes
Inflation effect is ignored in calculation of ratios. So, ratio will not give perfect answer in changing of price level.
Ratios are not Substitute of Financial Statements
Ratio analysis is important part of financial statements analysis. It can never become a substitute of financial statements. We just use it with cash flow analysis, fund flow analysis and other analysis.
Wrong Interpretation
We can interpretate wrongly. For explaining the effect on company's position with ratios, there is big need of experience. Wrong interpretation will be helpful for wrong decisions. So, it is limitation of ratio analysis that it does not explain all the facts, it has to explain. For a new accounts manager, it may be difficult.
Following are main drawbacks or limitations of ratio analysis:
Limited Use of Single RatioSometime, we can not compare our ratios with others. For example, we have started new business and our financial results are not still normal. At that time, our profitability ratio will have limited use because there is not any past data of profitability ratios.
Lack of Adequate Standards We could not make standards of all ratios. For example, we can not tell what is rule of them of our net profit ratio because there are lots of factors affect it. In the lack of adequate standards of ratios, we can not give exact comment on the basis of ratio analysis.
Inherent Limitation of Financial Accounting Ratio analysis is just like simplification of financial accounting data. But there are lots of limitations of financial accounting which you can read at here. All these limitation will be absorbed by ratios. This is the one of the important limitation of ratio. I can say if base is not good, everything will be wrong. If there is small portion of poison in milk, its effect will be in everything what you will make.
Changes of Accounting Procedures If accounting procedures will change, our accounting ratio will be changed. At that time, we can not compare our current year ratios with our past year ratios. For example, in past year, we had used LIFO but current year, we are using FIFO for inventory valuation. Due to this, figures of closing stock will be different. On this basis, if we have calculated current ratio, it will not be comparable with past current ratio.
Window DressingBecause we have shown our financial data through window dressing. Our ratios will also be affected from it.
Personal Bias This is reality, I saw many CAs who waste their time to optimize different ratios by changing the project financial statements figures for making attractive projects. All these activities are done for getting loan. So, this will make the drawback of ratio analysis.
MatchlessDifferent companies uses different accounting policies, so, we can not compare their ratios.
Price Level Changes Inflation effect is ignored in calculation of ratios. So, ratio will not give perfect answer in changing of price level.
Ratios are not Substitute of Financial Statements Ratio analysis is important part of financial statements analysis. It can never become a substitute of financial statements. We just use it with cash flow analysis, fund flow analysis and other analysis.
Wrong Interpretation We can interpretate wrongly. For explaining the effect on company's position with ratios, there is big need of experience. Wrong interpretation will be helpful for wrong decisions. So, it is limitation of ratio analysis that it does not explain all the facts, it has to explain. For a new accounts manager, it may be difficult.
DUPONT CONTROL CHART:
In ratio analysis, Du-Pont Control Chart shows the relationship of net profit margin ratioand total investment turnover ratio for calculating return on total investment ratio (ROI). If company wants to increase return on investment (ROI), it has to concentrate to increase net profit margin and total investment turnover ratio.
Following is its screenshoot :
Following is its screenshoot :
Gross margin is most used term in accounting area for showing the growth of companies. It is gross profit ratio. In simple words, it is gross profit divided by net sales. Gross profit is excess of net sales over cost of goods sold. More gross margin means more capacity to cover our all indirect cost.
Gross margin also tells, how much sale price do you expect for covering your operating expenses and getting profit on it?
For example, your cost of goods sold is 10$ and your expect 20% gross margin. With this margin, you can expect your sale price also.
Sale price = 10 + 10 X 20/80 = 12.5 $
Cost of Goods Sold = Opening stock of material + purchase + Direct Expenses – Closing stock
Showing of Gross Margin in Financial Reports
Following is the example for showing of Gross margin in financial reports
Gross margin of third quarter of 2011 of XYZ Company increased 62.4%. In previous accounting year 2010’s third quarter, gross margin increased just 61.6%.
Reason of Decreasing of Gross profit margin
There are many reasons of decreasing gross profit margin of any company. Some of them, we can include in following list.
1. Increase the cost of raw material.
2. High labour turnover ratio.
3. Adverse worker’s compensation problem.
4. Increase the rate of direct expenses.
5. Decreasing the sale prices due to hard competition.
6. Decreasing the quantity of sale.
Gross Margin Vs Markup
For example
If a product costs the company $200 to make and they wish to make a 50% profit on the sale of the product (sale dollars) they would have to use a markup of 100%. To calculate the price to the customer, you simply take the product cost of $200 and multiply it by (1 + the markup), e.g.: 1+1=2, arriving at the selling price of $400.
Gross margin also tells, how much sale price do you expect for covering your operating expenses and getting profit on it?
For example, your cost of goods sold is 10$ and your expect 20% gross margin. With this margin, you can expect your sale price also.
Sale price = 10 + 10 X 20/80 = 12.5 $
Formula of Gross margin = Sales – Cost of Goods sold / Sales
Gross margin % on Sales = (Sales – Cost of Goods Sold) / Sales X 100
Gross margin % on Cost = (Sales – Cost of Goods Sold) / COGS X 100
Cost of Goods Sold = Opening stock of material + purchase + Direct Expenses – Closing stock
Showing of Gross Margin in Financial Reports
Following is the example for showing of Gross margin in financial reports
Gross margin of third quarter of 2011 of XYZ Company increased 62.4%. In previous accounting year 2010’s third quarter, gross margin increased just 61.6%.
Reason of Decreasing of Gross profit margin
There are many reasons of decreasing gross profit margin of any company. Some of them, we can include in following list.
1. Increase the cost of raw material.
2. High labour turnover ratio.
3. Adverse worker’s compensation problem.
4. Increase the rate of direct expenses.
5. Decreasing the sale prices due to hard competition.
6. Decreasing the quantity of sale.
Gross Margin Vs Markup
Gross margin = Markup / (1 + Markup)
Markup = Gross margin (1- gross margin)
For example
If a product costs the company $200 to make and they wish to make a 50% profit on the sale of the product (sale dollars) they would have to use a markup of 100%. To calculate the price to the customer, you simply take the product cost of $200 and multiply it by (1 + the markup), e.g.: 1+1=2, arriving at the selling price of $400.
NP RATIO
Net profit margin may be defined as net profit ratio. It tells us, the amount of net profit out of every $ 100 sales. It may be 10% or 20% or any. It is different from gross margin because in net profit margin, we take only net profit instead of gross profit. After calculating net profit margin, we compare it with gross margin for checking whether our all indirect expenses are under control or not.
Following is the formula of Net Profit Margin :
= Net Profit / Sales or Revenue from Services X 100
For example, if sales is $ 1000 and cost of goods sold is $ 100 and other operating expenses are $ 600. Calculate Net Profit margin.
= Net Profit / Sales X 100
= Sales - Cost of goods sold - operating expenses / sales X 100
= 1000 - 100 - 600 / 1000 X 100 = 30%
Benefits of Calculating Net Profit Margin
1. We calculate net profit margin for making future price policy. We can decrease this margin for reducing our product prices. With this, we can increase our sales.
2. After calculating our net profit margin, we can compare it with our competitors. With this, we can defeat our competitors in pricing war.
3. Net profit margin is also useful for study the performance of company. After calculating net profit margin with past accounting figures, we analyze whether it is OK for surviving our business or not.
4. Sometime net profit margin is used for marketing purpose also. If we sell 5 products who have different prices. We can change each product's price but keeping same overall net profit margin as per our marketing strategy.
Net Profit Margin Vs Markup
Net profit margin is not markup. Markup is just way to calculate selling price on the basis of product cost. In markup, we can include both gross profit, net profit and other indirect expenses. But in net profit margin, we use just net profit and net sales.
Following is the formula of Net Profit Margin :
= Net Profit / Sales or Revenue from Services X 100
For example, if sales is $ 1000 and cost of goods sold is $ 100 and other operating expenses are $ 600. Calculate Net Profit margin.
= Net Profit / Sales X 100
= Sales - Cost of goods sold - operating expenses / sales X 100
= 1000 - 100 - 600 / 1000 X 100 = 30%
Benefits of Calculating Net Profit Margin
1. We calculate net profit margin for making future price policy. We can decrease this margin for reducing our product prices. With this, we can increase our sales.
2. After calculating our net profit margin, we can compare it with our competitors. With this, we can defeat our competitors in pricing war.
3. Net profit margin is also useful for study the performance of company. After calculating net profit margin with past accounting figures, we analyze whether it is OK for surviving our business or not.
4. Sometime net profit margin is used for marketing purpose also. If we sell 5 products who have different prices. We can change each product's price but keeping same overall net profit margin as per our marketing strategy.
Net Profit Margin Vs Markup
Net profit margin is not markup. Markup is just way to calculate selling price on the basis of product cost. In markup, we can include both gross profit, net profit and other indirect expenses. But in net profit margin, we use just net profit and net sales.
Profits and losses are two things which affect any small business more deeply. So, as a small businessman, if you are starting any new business or trading any goods, you should know what are the various losses and what are their reasons? According to accounting terminology, " Loss means reduction of businessman's capital. Suppose, Mr. Rahim started his business with $ 754. His business is operated by his unemployed brother and his wife. He made a box for keeping money safe. When Mr. Rahim came to his shop after one week and counted money, it was was $ 320. Last week, he counted box money and it was $ 230. He wondered that he got just $ 90 by his from sale during week. Mr. Rahim was very intelligent. He totalled all purchased goods which he purchased in last week and it was $ 175. Now, all last week's goods were sold. He calculated and found that his business got loss of $ 85. But, he was very sad that when the margin of profit was 20%, then how can he get loss? Moreover, key of box's lock was in his pocket from last week. Now, he learned accounting seriously and find following reasons of his loss.
1st Reason : Utilize of Product for personal Use
Due to lack of accounting knowledge, Rahim's brother and his wife used product of Rahim's shop for their personal use without Rahim's permission. With this some of $ 85 loss was from this cause. Mr. Rahim told that all goods which will be taken by him or his wife must be recorded for finding drawing.
2nd Reason : Shortage of Purchase of Goods
Mr. Rahim also thinks that it may be possible that vendor gave him less goods when he bough last week. It is one of reason of his loss. For future, he thinks to return all such goods which be short quantity.
3rd Reason : Not to Taken Money from Customers
Due to not knowing accounting, Mr. Rahim's brother and his wife did not record of name of customers whether they gave money or not. It may be possible that some customers may cheat Mr. Rahim's brother and his wife during last week.
4th Reason : Goods Taken by Thieves
Due to lack of inventory management, Mr. Rahim's brother thinks that some of goods may be theft by thieves. So, in future, he ordered his brother to supervise the goods more seriously.
5th Reason : Keeping Money in Other Place
After deep inquiry, Mr. Rahim's brother told that he has remembered that $ 40 are in his pocket.
It means now $ 45 are the net loss of one week trading to Mr. Rahim. Now Mr. Rahim sent brother and his wife to Accounting Education for learning accounting first for operating business.
If you are also like Rahim's brother, you should learn financial accounting first from here before operating any small business.
Above is very simple and true example of a very small business. Without knowledge of proper accounting, a big corporate may face the losses. So, knowledge of accounting will be your weapon to get safety from losses.
1st Reason : Utilize of Product for personal Use
Due to lack of accounting knowledge, Rahim's brother and his wife used product of Rahim's shop for their personal use without Rahim's permission. With this some of $ 85 loss was from this cause. Mr. Rahim told that all goods which will be taken by him or his wife must be recorded for finding drawing.
2nd Reason : Shortage of Purchase of Goods
Mr. Rahim also thinks that it may be possible that vendor gave him less goods when he bough last week. It is one of reason of his loss. For future, he thinks to return all such goods which be short quantity.
3rd Reason : Not to Taken Money from Customers
Due to not knowing accounting, Mr. Rahim's brother and his wife did not record of name of customers whether they gave money or not. It may be possible that some customers may cheat Mr. Rahim's brother and his wife during last week.
4th Reason : Goods Taken by Thieves
Due to lack of inventory management, Mr. Rahim's brother thinks that some of goods may be theft by thieves. So, in future, he ordered his brother to supervise the goods more seriously.
5th Reason : Keeping Money in Other Place
After deep inquiry, Mr. Rahim's brother told that he has remembered that $ 40 are in his pocket.
It means now $ 45 are the net loss of one week trading to Mr. Rahim. Now Mr. Rahim sent brother and his wife to Accounting Education for learning accounting first for operating business.
If you are also like Rahim's brother, you should learn financial accounting first from here before operating any small business.
Above is very simple and true example of a very small business. Without knowledge of proper accounting, a big corporate may face the losses. So, knowledge of accounting will be your weapon to get safety from losses.
Your post on Ratio analysis is very informative dear!! You have provided simple tips for Ratio analysis. My professor Dr. Aloke Ghosh has also provided guidelines for Ratio analysis. Well dear thanks for sharing these tips!!
ReplyDeleteThanks for sharing this post. To know more about accounting ratios method please reach vakilsearch : Accounting Ratios
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