Submitted to: AAA, DDDDD Ratio Analysis

TERM PAPER II

PURPOSES AND CONSIDERATIONS OF RATIOS

AND RATIO ANALYSIS

Submitted to: The ***** Academy

Submitted by: ABC, ABCDE -000.
Date: February 24, 2010.

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Submitted to: AAA, DDDDD Ratio Analysis

Part I

Ratios are highly important profit tools in financial analysis that help financial
analysts implement plans that improve profitability, liquidity, financial structure,
reordering, leverage, and interest coverage. Although ratios report mostly on past
performances, they can be predictive too, and provide lead indications of
potential problem areas.

Ratio analysis is primarily used to compare a company's financial figures over a

period of time, a method sometimes called trend analysis. Through trend analysis,
you can identify trends, good and bad, and adjust your business practices
accordingly. You can also see how your ratios stack up against other businesses,
both in and out of your industry.

There are several considerations you must be aware of when comparing ratios
from one financial period to another or when comparing the financial ratios of
two or more companies.

 If you are making a comparative analysis of a company's financial

statements over a certain period of time, make an appropriate allowance
for any changes in accounting policies that occurred during the same time
span.

 When comparing your business with others in your industry, allow for any
material differences in accounting policies between your company and
industry norms.

 When comparing ratios from various fiscal periods or companies, inquire

about the types of accounting policies used. Different accounting methods
can result in a wide variety of reported figures.

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 Determine whether ratios were calculated before or after adjustments

were made to the balance sheet or income statement, such as non-
recurring items and inventory or pro forma adjustments. In many cases,
these adjustments can significantly affect the ratios.

 Carefully examine any departures from industry norms.

We will look at some of the prominently used ratios

PART II

Liquid or Short Term Analysis

While liquidity ratios are most helpful for short-term creditors/suppliers and
bankers, they are also important to financial managers who must meet
obligations to suppliers of credit and various government agencies. A complete
liquidity ratio analysis can help uncover weaknesses in the financial position of
your business.

Net working capital (NWC) is usually defined as Current Assets (CA) – Current
Liability (CL)

NWC = CA- CL

Current Ratio

CR = CA / CL which is nothing but 1+ (NWC/CL)

Keeping above equations in mind we can comment as under

1. If CR is Positive ( >1) then NWC is Positive (>1)

2. If CR is Negative (<1) then NWC is also Negative (<1)

3. Is CR=1 the NWC =1

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The current ratio will disclose balance sheet changes that net working
capital will not.

Current Assets = net of contingent liabilities on notes receivable

Current Liabilities = all debt due within one year of statement data

Current ratio is very basic & important ratio for a company. It basically
measures the no. of times the current liabilities are covered by its current
assets. Current Assets, as the definition goes, are the assets which are
convertible into cash in a span of 1 year from the date of reporting of
balance sheet and Current Liabilities are the liabilities to be paid off within
one year of time from the date of balance sheet.

Ideally Current Assets should never be less than Current Liabilities

otherwise in situation such as where in Current Assets are less than Current
Liabilities would put company in a cash crunch or liquidity crisis. To put it
other way round, NWC- net working capital of a company should never be
negative or current ration of company should never be less than 1.

Quick or Acid Ratio

Quick / Acid Ratio = (Current Assets – Inventory) / Current Liability

Here Current Assets include Cash, Marketable Securities & Receivables / Debtors

This ratio specifies whether your current assets that could be quickly converted
into cash are sufficient to cover current liabilities. Until recently, a Current Ratio
of 2:1 was considered standard. A firm that had additional sufficient quick assets
available to creditors was believed to be in sound financial condition.

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The Quick Ratio assumes that all assets are of equal liquidity. Receivables are one
step closer to liquidity than inventory. However, sales are not complete until the
money is in hand.

Cash Ratio

Cash Ratio = (Cash + Marketable Securities) / Current Liability

This ratio is alternatively known as Absolute Liquidity Ratio. This ratio eliminates
any unknowns surrounding receivables.

The Absolute Liquidity Ratio only tests short-term liquidity in terms of cash and
marketable securities.

Receivable Turnover Ratio

Receivable Turnover Ratio = Credit Sales / Avg. Accounts Receivables

Ratio is another indicator of liquidity. Receivables Turnover Ratio can also indicate
management's efficiency in employing those funds invested in receivables. Net
credit sales, while preferable, may be replaced in the formula with net total sales
for an industry-wide comparison.

Closely monitoring this ratio on a monthly or quarterly basis can quickly

underscore any change in collections.

Debt Collection Period

Debt collection period = 12 months/ Receivable turnover ratio

The Debt Collection Period (DCP) is another litmus test for the quality of
receivables, giving the average length of the collection period. As a rule,
outstanding receivables should not exceed credit terms by 10-15 days.

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Inventory Turnover Ratio

Inventory Turnover Ratio = Cost of goods sold / Avg. Inventory

Multiply your inventory turnover by your gross margin percentage. If the result is
100 percent or greater, your average inventory is not too high.

Avg. Inventory Holding Period

Avg. Inventory holding period = 12 months/ Inventory Turnover Ratio

Benchmark rates by Tandon Committee

The Tandon Committee appointed by Reserve Bank of India after carrying out
detailed market survey has arrived at certain benchmark rates for some
industries. These are often referred to as Tandon Committee’s Inventory Norms.

If a company‘s receivable turnover ratio is 4 then it is on an avg. extending a

credit of 3 months or 90 days to its customers.

If Inventory turnover ratio of company is 2 then company is carrying an inventory

of avg.6 moths

Profitability Analysis

Below are some of the ratios related to Profitability analysis

Gross Profit Margin = Gross Profit / Sales

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Net Profit Margin = Net Profit / Sales

Return on Capital = Profit before Interest & tax / Total Capital Employed

Return on Equity = (PAT– Preference Dividend)/Ordinary Share holder’s fund)

PAT = Profit after tax

Return on Assets = Net Profit / Assets

Asset Turnover Ratio = Sales / Assets

Gross & net profit margin ratios indicate the efficiency of a company in carrying
out the operations. The benchmark rates of Gross & Net profit margins vary from
industry to industry.

It is essential that company should compare current ratios with its own current
ratios pertaining to previous year.

If company is able to generate profit that are consistently higher than the
benchmark for that industry then the additional or higher profit generated by the
company leads to what is known as EVA – Economic Value Addition

Capital Structure or Gearing Analysis

Debt/Equity Ratio = Total Liability / Tangible Net worth

Here, Tangible Net worth = (Net worth – Intangible assets)

Interest Coverage Ratio =EBIT / Annualized Interest Burden

Debt Service Coverage Ratio = (PAT+ Depreciation)/ (Annual Payment Obligation)

Debt-Equity ratio is very important from view point of lenders; as lenders would
always want certain portion of project cost or capital to be spin in by company
and lender is not financing the entire amount required by company. In other
words lenders would always look for reasonable debt-equity ratio. If this ratio is 1

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means the equity & debt stand at 50% each. If ratio is 1.5 then debt stands at 60%
& equity at 40%. The lenders while lending also look for ratios like Interest service
ratio & Debt service coverage ratio in order to understand the repayment
capability of the company.

KEY OPERATING RATIOS

Stated below are a few key ratios related to the SBU : Effect Pigment Division of
Sudarshan Chemical Industries Ltd.

Deviation
Budge
Effect Pigment Div. Actual from
t
Budget
R M % Sales 30% 30% 0%
Inventory Turnover Ratio (Annualised) 4.69 4.57 0.12
Avg Oustanding No of Days 75 60 15
Fixed Cost (Excl. interest & depreciation )
(Rs. lacs) 1,062 1,108 (45)
Interest (Rs. lacs) 95 200 (105)
PBDIT:Sales % 23% 25% -2%
Net Sales Per Perennial Employee (Rs. Lacs)
Annualised 45 48 -3
Working Capital ( Rs. Lacs) 1912 1824 89
Working Capital % Sales (Overall) Annualised 27% 24% 3%
3. 3.4
Turnover:Fixed Assets (Overall) Annualised
20 4 -25%
Net Capital Employed (Rs. Lacs) 4121 4002 120
Average Capital Employed 3850 3687  
PBIT/ Avg. Capital Employed (ROCE) 30% 29% 0%
MPBIT/ Avg. Capital Employed 38% 35% 2%
MPDBIT/ Avg. Capital Employed     0%
Free Cash Flow 753 585 169
Current Ratio 3 1 1
Average Working Capital 1798 1824 -26
Average Working Capital % Sales 25% 25% 0%
MPBDIT 1879 2020 -141

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MPBDIT/ Avg. Capital Employed (ROEC) 49% 55% -6%

MPBDIT (Modified Profit Before Depreciation Interest and Taxes) is calculated so
as to rule out the non controllable factor in evaluating the performance of any
SBU.

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