Ratio analysis ii
- 1. ACCOUNTANCY MODULE - 6A Notes Accounting Ratios – II Analysis of Financial Statements 42 You have learnt in the previous lesson that accounting ratios can be classified into five major groups viz. liquidity ratios, activity ratios, solvency ratios, profitability ratios and leverage ratio. You have already learnt the meaning, computations and significance of liquidity and activity ratios. In this lesson, you will learn about the various solvency ratios, profitability ratios and leverage ratio and their significance. OBJECTIVES After studying this lesson you will be able to : explain various types of accounting ratios i.e. solvency, profitability and leverage ratios; calculate the various ratios on the basis of given information; describe the limitations of accounting ratios. 29.1 SOLVENCY RATIOS The term ‘solvency’ refers to the ability of a concern to meet its long term obligations. The long-term liability of a firm is towards debenture holders, financial institutions providing medium and long term loans and other creditors selling goods on credit. These ratios indicate firm’s ability to meet the fixed interest and its costs and repayment schedules associated with its long term borrowings. The following ratios serve the purpose of determining the solvency of the business firm. Debt equity ratio Proprietary ratio 29 ACCOUNTING RATIOS – II
- 2. MODULE - 6A Analysis of Financial Statements Notes 43 Accounting Ratios – II ACCOUNTANCY Debt-equity ratio It is also otherwise known as external to internal equity ratio. It is calculated to know the relative claims of outsiders and the owners against the firm’s assets. This ratio establishes the relationship between the outsiders funds and the shareholders fund. Thus, Debt-equity ratio = Outsiders' funds Share holders' funds The two basic components of the ratio are outsiders’ funds and shareholders’ funds. The outsiders’ funds include all debts/liabilities to outsiders i.e. debentures, long term loans from financial institutions, etc. Shareholders’ funds mean preference share capital, equity share capital, reserves and surplus and fictitious assets like preliminary expenses. This ratio indicates the proportion between shareholders’ funds and the long-term borrowed funds. In India, this ratio may be taken as acceptable if it is 2 : 1. If the debt-equity ratio is more than that, it shows a rather risky financial position from the long term point of view. Significance The purpose of debt equity ratio is to derive an idea of the amount of capital supplied to the concern by the proprietors. This ratio is very useful to assess the soundness of long term financial position of the firm. It also indicates the extent to which the firm depends upon outsiders for its existence. A low debt equity ratio implies the use of more equity than debt. Illustration 1 From the following, calculate the debt-equity ratio Rs. Equity Shares Capital 1,00,000 General Reserve 45,000 Accumulated Profits 30,000 Debentures 75,000 Sundry trade creditors 40,000 Outstanding expenses 10,000 Solution : Debt-equity ratio = Debt (Total long- term loans) Equity (Shareholders Funds) = Rs 75,000 Rs 1,75,000 = 3 : 7
- 3. ACCOUNTANCY MODULE - 6A Notes Accounting Ratios – II Analysis of Financial Statements 44 Working Notes : Shareholders’ fund = Equity share capital + Reserves + Accumulated profits (i) Rs100000 + Rs45000 + Rs30000 = Rs175000 (ii) Long term debt = Debentures = Rs75000 Illustration 2 Calculate the debt-equity ratio from the following data : Total Assets Rs1,20,000. Total debt Rs1,00,000 current liabilities Rs 60,000. Solution : Calculation of debt-equity ratio Long term debt = Total debt – current liabilities = Rs 1,00,000 – Rs 60,000 = Rs 40,000 Shareholders’ fund = Total Assets – total debt = 1,20,000 – Rs 1,00,000 = Rs 20,000 Debt equity ratio = Debt Equity = Rs 40,000 Rs 20,000 = 2 Proprietory ratio It is also known as equity ratio. This ratio establishes the relationship between shareholders’ funds to total assets of the firm. The shareholders’ fund is the sum of equity share capital, preference share capital, reserves and surpluses. Out of this amount, accumulated losses should be deducted. On the other hand, the total assets mean total resources of the concern. The ratio can be calculated as under : Proprietory ratio = Shareholders' funds Total assets
- 4. MODULE - 6A Analysis of Financial Statements Notes 45 Accounting Ratios – II ACCOUNTANCY Significance Proprietary ratio throws light on the general financial position of the enterprise. This ratio is of particular importance to the creditors who can ascertain the proportion of shareholders’ funds in the total assets employed in the firm. A high ratio shows that there is safety for creditors of all types. Higher the ratio, the better it is for concerned. A ratio below 50% may be alarming for the creditors since they may have to lose heavily in the event of company’s liquidation on account of heavy losses. Illustration 3 From the following calculate the proprietary ratio : Rs Equity share capital 1,00,000 Preference share capital 50,000 Reserves and surpluses 25,000 Debentures 60,000 Creditors 15,000 Total 2,50,000 Fixed assets 1,25,000 Current Assets 50,000 Investment 75,000 Total 2,50,000 Solution : Proprietary ratio = Shareholders' funds Total assets = Rs 1,75,000 Rs 2,50,000 = 0.7 or 70% INTEXT QUESTION 29.1 Fill in the blanks with suitable word/words/figures : (i) Debt equity ratio = ........................ (i) ........................ ratio measures the long term obligation of a firm.
- 5. ACCOUNTANCY MODULE - 6A Notes Accounting Ratios – II Analysis of Financial Statements 46 (iii) ........................ = Shareholders' fund Total Assets (iv) Debt equity ratio = 2 00 000 3 00 000 , , , , 29.2 PROFITABILITY RATIOS The main aim of an enterprise is to earn profit which is necessary for the survival and growth of the business enterprise. It is earned with the help of amount invested in business. It is necessary to know how much profit has been earned with the help of the amount invested in the business. This is possible through profitability ratio. These ratios examine the current operating performance and efficiency of the business concern. These ratios are helpful for the management to take remedial measures if there is a declining trend. The important profitability ratios are : (i) Gross profit ratio (ii) Net profit ratio (iii) Operating profit ratio (iv) Return on investment ratio (i) Gross profit ratio It expresses the relationship of gross profit to net sales. It is expressed in percentage. It is computed as Gross profit ratio = Gross profit Net sales ×100 where Net sales = Total sales – (sales returns + excise duty) Gross profit = Net sales – Cost of goods sold. Significance Gross profit ratio shows the margin of profit. A high gross profit ratio is a great satisfaction to the management. It represents the low cost of goods sold. Higher the rate of gross profit, lower the cost of goods sold.
- 6. MODULE - 6A Analysis of Financial Statements Notes 47 Accounting Ratios – II ACCOUNTANCY Illustration 4 From the following detail of a business concern ascertain the gross profit ratio : Details 2005 2006 (Rs) (Rs) Sales 120,000 160,000 Gross profit 40,000 60,000 Solution : 2005 Gross profit ratio = Rs 40,000 Rs 120,000 × =100 2667%. 2006 Gross profit ratio = Rs 60,000 Rs 160,000 × =100 37 1 2 % Illustration 5 Calculate the gross profit ratio from the following data : Sales Rs.3,25,000 sales returns Rs.25,000 and cost of goods sold 2,40,000 Solution. Gross Profit Ratio = Gross Profit Net Sales ×100 Gross Profit = Net sales – cost of goods sold = 300,000 – 2,40,000 = 60,000 Gross Profit Ratio = 60,000 3,00,000 ×100 = 20% (ii) Net profit ratio Aratio of net profit to sales is called Net profit ratio. It indicates sales margin on sales. This is expressed as a percentage. The main objective of calculating this ratio is to determine the overall profitability. The ratio is calculated as :
- 7. ACCOUNTANCY MODULE - 6A Notes Accounting Ratios – II Analysis of Financial Statements 48 Net profit ratio = Net profit Net sales 100× Significance Net profit ratio determines overall efficiency of the business. It indicates the extent to which management has been effective in reducing the operational expenses. Higher the net profit ratio, better it is for the business. Illustration 6 Calculate Net profit ratio from the following : Net profit Rs 45,000 Sales Rs 640,000 Sales Returns Rs 40,000 Solution : Net profit ratio = Net profit Net sales ×100 Net sales = Sales – Sales returns = Rs 640,000 – Rs 40,000 = Rs 600,000 Net profit ratio = Rs 45,000 Rs 600,000 ×100 = 7.5% Illustration 7 Calculate gross profit ratio and net profit ratio from the following figures. Sales Rs 150,000 Cost of goods sold Rs 120,000 Operating expenses Rs 12,000 Solution : Gross profit ratio = Gross profit Net sales ×100 Gross profit = Sales – Cost of goods sold = Rs 150,000 – Rs 120,000 = Rs 30,000
- 8. MODULE - 6A Analysis of Financial Statements Notes 49 Accounting Ratios – II ACCOUNTANCY Gross profit ratio = Rs 30,000 Rs 150,000 ×100 = 20% Net profit ratio = Net profit Net sales ×100 Net profit = Gross profit – operating expenses = Rs 30,000 – Rs 12,000 = Rs 18,000 Net profit ratio = Rs 18,000 Rs 150,000 ×100 = 12% (iii) Operating profit ratio Operating profit is an indicator of operational efficiencies. It reveals only overall efficiency. It establishes relationship between operating profit and net sales. This ratio is expressed as a percentage. It is calculated as : Operating profit = Operating profit Net sales ×100 Operationg Profit = Gross Profit – (Administration expenses + selling expenses) Significance It helps in examining the overall efficiency of the business. It measures profitability and soundness of the business. Higher the ratio, the better is the profitability of the business. This ratio is also helpful in controlling cash. Illustration 8 From the following details of a business concern ascertain the operating profit ratio Details 2005 2006 Rs Rs Sales 60,000 80,000 Interest on debentures 1,000 2,000 Net profit 3,800 6,000
- 9. ACCOUNTANCY MODULE - 6A Notes Accounting Ratios – II Analysis of Financial Statements 50 Solution : 2005 Net profit before interest = Net profit + Interest = Rs 3,800 + Rs 1,000 = Rs 4,800 Operating profit ratio = Rs 4,800 Rs 60,000 ×100 = 8% 2006 Net profit before interest = Rs 6,000 + Rs 2,000 = Rs 8000 Operating profit ratio = Rs 8,000 Rs 80,000 ×100 = 10% Some firms take profit before tax but usually companies take profit after tax. Illustration 9 Calculate operating profit ratio from the following data : Rs Sales 3,00,000 Gross profit 1,20,000 Administration expenses 35,000 Selling and distribution expenses 25,000 Income on investment 15,000 Loss by fire 9,000 Solution : Operating profit Ratio = Net operating profit Net sales ×100
- 10. MODULE - 6A Analysis of Financial Statements Notes 51 Accounting Ratios – II ACCOUNTANCY = Rs60,000 Rs 3,00,000 ×100 = 20% Note : Operating profit = Gross profit – (Administration expenses + Selling expenses) = 1,20,000 – (35,000 + 25,000) = 1,20,000 – 60,000 = 60,000 (iv) Return on investment ratio (ROI) ROI is the basic profitability ratio. This ratio establishes relationship between net profit (before interest, tax and dividend) and capital employed. It is expressed as a percentage on investment. The term investment here refers to long-term funds invested in business. This investment is called capital employed. where Capital employed = Equity share capital + preference share capital + Reserve and surplus + long term liabilities – fictitious assets – Non trading investment or Capital employed = (Fixed asset – depreciation) + (Current Asset – Current liabilities) or Capital employed = (Fixed Assets – Depreciation) + (Working capital) This ratio is also known as Return on capital employed ratio. It is calculated as under ROI = Net profit before interest, tax and dividend Capital employed ×100 Note : If net profit after interest, tax and dividend is given, the amount of interest, tax and dividend should be added back to calculate the net profit before interest, tax and dividend. Significance ROI ratio judges the overall performance of the concern. It measures how efficiently the sources of the business are being used. In other words, it tells what is the earning capacity of the net assets of the business. Higher the ratio the more efficient is the management and utilisation of capital employed.
- 11. ACCOUNTANCY MODULE - 6A Notes Accounting Ratios – II Analysis of Financial Statements 52 Illustration 10 Following is the Balance sheet of X Ltd. as on 31st December 2006. Liabilities Amount Assets Amount Rs Rs Share capital 20,00,000 Fixed Assets net 29,00,000 Reserves 6,00,000 Current Assets 25,00,000 10% loan 10,00,000 Underwriting commission 100,000 Current liabilities 14,00,000 Profit for the year 5,00,000 55,00,000 55,00,0000 Find out the return on investment for the year 2006. Solution : Rs Profit before interest : Profit as given 500,000 Add : Interest 100,000 NPBI tax & Dividend 600,000 Capital employed : Net Fixed Assets 29,00,0000 Working capital 11,00,000 Current Assets – Current liabilities (i.e. 25,00,000 – 14,00,000) ROI = Net Profit before Interest and Dividend Capital employed ×100 = 60 00 000 40 00 000 100 15% , , , , × = Alternatively Share capital 20,00,000 Reserves 11,00,000 Loans 10,000000 Less : Under writing commission 1,00,000 Capital employed 40,00,000 ROI = Net Profit before interest and dividend Capital employed ×100 = 6,00,000 40,00,000 ×100 = 15%
- 12. MODULE - 6A Analysis of Financial Statements Notes 53 Accounting Ratios – II ACCOUNTANCY Illustration 11 From the following data, calculate the return on capital employed : Net fixed assets Rs 100,000 current assets Rs 50,000, current liabilities Rs 25,000, Gross profit Rs 32,500, Interest on long-term debt Rs 7500 tax Rs 8750, office and administrative expenses Rs 2500, selling and distribution expenses Rs 5000. There were no long term investments. Solution : Calculation of return on capital employed : Net profit before interest = Gross profit – office and Administrative and tax expenses – selling and distribution expenses = Rs 32,500 – Rs 2500 – Rs 5000 = Rs 25000 Capital employed = Net fixed Assets + Current Assets – Current liabilities = Rs 100,000 + 50,000 – 25,000 = 1,25,000 Return on capital employed = Net profit before interest and tax Capital empolyed ×100 = Rs 25,000 Rs 125,000 ×100 = 20% Illustration 12 Given below is the Balance Sheet of M/s ABC Ltd, calculate return on investment (ROI). Liabilities Amont Assets Amount Rs Rs Equity share capital 10,00,000 Net fixed assets 15,00,000 Reserves 2,50,000 Current Assets 12,50,000 Profit for the year 2,50,000 Discount on issue of Debentures 50,000 10% debentures 5,00,000 Current liabilities 8,00,000 28,00,000 28,00,000
- 13. ACCOUNTANCY MODULE - 6A Notes Accounting Ratios – II Analysis of Financial Statements 54 Solution : Return on investment = Net Profit before Interest, Tax and Dividend Capital Employed 100× Net profit before interest, tax and dividend = Profit + Interest on debentures = Rs 2,50,000 + Rs 50,000 = Rs 3,00,000 Capital employed = Equity share capital + Reserves and surplus + Debentures – Discount on debentures = Rs 10,00,000 + Rs 2,50,000 + Rs 2,50,000 + 5,00,000 – 50,000 = 19,50,000 or Capital employed = Net fixedAssets + (current assets – current liabilities) = Rs15,00,000 + (Rs12,50,000 – Rs8,00,000) = Rs15,00,000 + Rs4,50,000 = Rs19,50,000 Return on investment = Rs 300 000 100 , Rs 19,50,000 × = 15.4% Illustration 13 From the following information, calculate return on investments Information Amount (Rs) Share capital 1,60,000 General reserve 60,000 Profit and Loss A/c 1,00,000 Loan @ 15% Interest 2,00,000 Sales for the year 5,60,000 Tax paid during the year 40,000 Profit for the current year after interest and tax 80,000
- 14. MODULE - 6A Analysis of Financial Statements Notes 55 Accounting Ratios – II ACCOUNTANCY Solution : Return on investment = Profit before interest and tax Capital employed ×100 (80,000 + 40,000 + 30,000) = Rs 1,50,000 Rs 5,20,000 ×100 (160,000 + 60,000 + 2,00,000) = 28.84% INTEXT QUESTIONS 29.2 Fill in the blank with suitable word/words : (i) Return on investment is a ..................... ratio. (ii) Gross profit ratio = ..................... × 100 (iii) Capital employed = ..................... (iv) ..................... = Operating Profit Net Sales ×100 (v) Name the ratios that relate to the profitability of a business concern ..................... 29.3 LEVERAGE RATIO Leverage ratio is otherwise known as capital structure ratio. The term capital structure refers to the relationship between various long term forms of financing such as debentures (long term), preference share capital and equity share capital including reserves and surpluses. Financing the firm’s assets is a very crucial problem in every business and as a rule there should be a proper mix of debt and equity capital in financing the firm’s assets. Leverage or capital structure ratios are calculated to test the long term financial position of a firm. Generally capital gearing ratio is mainly calculated to analyse the leverage or capital structure of the firm Capital gearing ratio The capital gearing ratio is described as the relationship between equity share capital including reserves and surpluses to preference share capital and
- 15. ACCOUNTANCY MODULE - 6A Notes Accounting Ratios – II Analysis of Financial Statements 56 other fixed interest bearing loans. If preference share capital and other fixed interest bearing loans exceed the equity share capital including reserves, the firm is said to be highly geared. The firm is said to be low geared if preference share capital and other fixed interest bearing loans are less than equity capital and reserves. Capital gearing ratio = Equity share capital reserves and surpluses Preference share capital + long term debt bearing fixed interest + Significance Capital gearing ratio is very important ratio. Gearing should be kept in such a way that the company is able to maintain a steady rate of dividend. High gearing ratio is not good for a new company or a company of which future earnings are uncertain. Illustration 14 From the following information find out capital gearing ratio. Source 2005 2006 Amount (Rs) Amount (Rs) Equity share capital 500,000 400,000 Reserves & surplus 300,000 200,000 8% preference share capital 250,000 300,000 6% Debentures 250,000 400,000 Solution : Capital gearing ratio = Equity share capital Reserves and surplus Preference share capital + Long term debt bearing fixed interes + For the year 2005 = 500,000 300,000 250,000 250,000 8 : 5 + + = (Low geared) For the year 2006 = 400,000 200,000 300,000 400,000 8 : 7 + + = (High geared)
- 16. MODULE - 6A Analysis of Financial Statements Notes 57 Accounting Ratios – II ACCOUNTANCY INTEXT QUESTION 29.3 Fill in the blanks with suitable word/words : (i) Leverage ratio is also known as ........................... ratio. (ii) ........................... ratio is calculated to test the long term financial position of a firm. (iii) ................ = Equity share capital + Reserve and Surpluses Preference share capital + Long term debt bearing fixed interest (iv) To study capital structure of the firm ........................... ratio is used. 29.4 LIMITATION OF ACCOUNTING RATIOS Accounting ratios are very significant in analysing the financial statements. Through accounting ratios, it will be easy to know the true financial position and financial soundness of a business concern. However, despite the advantages of ratio analysis, it suffers from a number of disadvantages. The following are the main limitations of accounting ratios. Ignorance of qualitative aspect The ratio analysis is based on quantitative aspect. It totally ignores qualitative aspect which is sometimes more important than quantitative aspect. Ignorance of price level changes Price level changes make the comparison of figures difficult over a period of time. Before any comparison is made, proper adjustments for price level changes must be made. No single concept In order to calculate any ratio, different firms may take different concepts for different purposes. Some firms take profit before charging interest and tax or profit before tax but after interest tax. This may lead to different results. Misleading results if based on incorrect accounting data Ratios are based on accounting data. They can be useful only when they are based on reliable data. If the data are not reliable, the ratio will be unreliable.
- 17. ACCOUNTANCY MODULE - 6A Notes Accounting Ratios – II Analysis of Financial Statements 58 No single standard ratio for comparison There is no single standard ratio which is universally accepted and against which a comparison can be made. Standards may differ from Industry to industry. Difficulties in forecasting Ratios are worked out on the basis of past results. As such they do not reflect the present and future position. It may not be desirable to use them for forecasting future events. WHAT YOU HAVE LEARNT The term solvency ratio means ability of a concern to meet its long-term obligations. The solvency ratios are : Debt-equity ratio Proprietary ratio The purpose of debt equity ratio is to derive an idea of the amount of capital supplied to the concern by the proprietary. Debt equity ratio = Outsiders' fund Shareholders' fund Proprietary ratio establishes relationship between shareholders’ funds to total assets of the firm Proprietary ratio Shareholders' fund Total assets = Profitability ratio assesses the overall efficiency of the business concern. Important profitability ratios are : Gross profit ratio = Gross profit Net sales ×100 Net profit ratio = Net Proift Net sales ×100 Operating profit ratio = Operating proift Net sales ×100 Return on investment ratio = Net profit before interest,tax and dividend capital employed ×100
- 18. MODULE - 6A Analysis of Financial Statements Notes 59 Accounting Ratios – II ACCOUNTANCY Leverage ratio establishes the relationship between various long term forms of financing such as debentures, preference share capital and equity share capital including reserves and surpluses. Capital gearing ratio establishes relationship between equity share capital including reserves and surpluses to preference share capital and other fixed interest bearing loans. Capital gearing ratio = Equity share capital + reserve and surplus Preference share capital + Long term bearing fixed interest Limitations of accounting ratios are – ignorance of price level charges – ignorance of qualitative factors – no single concept – misleading result if based on incorrect accounting data – difficulties in forecasting TERMINAL QUESTIONS 1. Explain solvency ratios in brief. 2. What are profitability ratios? Explain the ratios in brief. 3. What are the limitations of ratio analysis? 4. What is meant by gross profit and net profit? 5. Explain capital gearing ratio. 6. From the following data, calculate (a) Gross profit ratio (b) Net profit ratio. Rs Sales 25,20,000 Cost of sales 19,20,000 Net profit 3,60,000 7. Total assets Rs 12,50,000, Total debt Rs 10,00,000 current labilities Rs500,000. Calculate debt-equity ratio.
- 19. ACCOUNTANCY MODULE - 6A Notes Accounting Ratios – II Analysis of Financial Statements 60 8. Following is the Profit and Loss account of M/s Bunu Ltd for the year 31st December, 2006. Opening stock 100000 Sales 560000 Purchases 350000 Closing stock 100000 Wages 9000 Gross profit c/d 201000 660,000 660,000 Administrative expenses 20000 Gross profit b/d 201,000 Salary and administrative 89000 Interest on investment 10000 expense Non-operating expenses 30000 Profit on sale of investment 8000 Net Profit 80000 219000 219000 You are required to calculate (a) Gross profit ratio (b) Net profit ratio (c) Operating profit ratio. 9. Following particulars pertaining to assets and liabilities of a XYZ Ltd. are given : Liabilities Amount Assets Amount (Rs) (Rs) Equity share capital 250000 Land and Building 450000 Preference share capital 200000 Plant 400000 Reserves 200000 Stock 150000 Debentures 300000 Sundry debtors 100000 Current liabilities 200000 Cash 45000 Prepaid expenses 5000 1150000 1150000 Calculate (a) debt equity ratio (b) proprietory ratio. ANSWERS TO INTEXT QUESTIONS Intext Questions 29.1 I. (i) Outsiders' funds Shareholders' funds (ii) Solvency (iii) Proprietary ratio (iv) 2 : 3
- 20. MODULE - 6A Analysis of Financial Statements Notes 61 Accounting Ratios – II ACCOUNTANCY Intext Questions 29.2 (i) Profitability ratio (ii) Gross profit Net sales (iii) Fixed assets – Depreciation + current asset – current liabilities (iv) Operating profit ratio (v) Gross profit ratio, Net profit ratio, Return on investments, operating profit ratio Intext Questions 29.3 (i) Capital structure (ii) Leverage (iii) Capital gearing ratio (iv) Capital gearing Answers to Terminal Questions 6. (a) 23.8% (b) 14.29% 7. 2 : 1 8. (a) 35.9%, (b) 14.3% (c) 16.4% 9. (a) 1 : 1.3, (b) 1 : 1.77 Activity Visit the office of a stock broker in the nearby market and ask annual report of two joint stock companies. Study the Banace Sheets of the two companies and compute the following ratios : (a) Debt Equity Ratio (b) Gross Profit Ratio (c) Net Profit Ratio (d) Return on investment Compare and comment on the profitability and solvency efficiency of the two companies.