Read this essay to learn about:- 1. Meaning of Financial Ratios 2. Liquidity Ratios 3. Solvency Ratios 4. Profitability Ratios 5. Turnover Ratios 6. Ratios for Shareholders and Potential Investors 7. Coverage Ratios 8. Debt-Service Ratios 9. Cost Ratios 10. Calculation of Different Ratios.

**Essay # 1. Meaning of Financial Ratios:**

Financial ratios express relationship between two financial variables. For example, sales is one element of profit and loss account and profit after tax (PAT) is another element.

Financial ratio are either expressed in number or in percentage.

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Various elements of profit and loss account and balance sheet are expressed in absolute terms. They are classified as required by the Company Law or any other relevant law under which they are prepared. For the purpose of understanding the financial characteristics like, liquidity, profitability, solvency, turnover, cost, etc. it becomes necessary to analyse the financial statements. The basic analytical tool is analysis of financial ratios.

There are many financial ratios.

However, we shall concentrate only on some standard ratios.

**As per the financial characteristics five important categories are: **

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a) Liquidity ratios,

b) Solvency ratios,

c) Profitability ratios,

d) Turnover ratios, and

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e) Cost ratios.

These are general purpose ratios.

Financial ratios may be calculated taking profit and loss account elements, which are called profit and loss ratios. They may be calculated involving two balance sheet elements, which are called balance sheet ratios or they may be calculated taking one profit and loss element and another balance sheet element, which are called mixed ratios. For example, PAT is a profit and loss account element and Net Worth is a balance sheet element. PAT/Net Worth is a mixed ratio. This is calculated to indicate return on shareholders’ funds.

**User-Specific Ratios:**

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**A specific user-group needs some special ratios. A list of such user-specific ratios is given below: **

In addition, financial ratios are used for specific purpose. One such specific use is prediction of industrial sickness. Auditors also use ratios to form an opinion about the reliability of the financial statements elements.

The different types of ratios are explained below:

**Essay # 2. Liquidity Ratios: **

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‘Liquidity’ means ability of the reporting entity to pay its liabilities in the short run. This is also called “short-term solvency”.

**The popularly used liquidity ratios are: **

i. Current Ratio

ii. Quick Ratio.

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**i. Current ratio – Current ratio is given by: **

Current assets are either cash and cash equivalents or those which can be converted into cash in the short run, say one year. Current liabilities are those which are payable in the short run, say one year.

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At this stage let us take a Balance Sheet for illustrative discussion.

**Note: **

Contingent liability arising out of default in agreement Rs.100 lakhs, but not provided for.

For the purpose of computing current ratio it is necessary to re-classify current assets and current liabilities.

Current Assets mean inventories, debtors prepayments, cash and bank balances, current investments (which are held for a short period, say not more than one year, and which are readily encashable), short-term loans and advances and advance tax.

Current Liabilities mean sundry creditors, outstanding expenses and wages, short-term secured and unsecured loans, bank overdrafts, instalments of long-term loans which are due or will be due within one year, tax provision and proposed dividend.

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**Now let us use the balance sheet given above. Let us further consider certain other information: **

(1) 20% of the secured loans and 40% of the unsecured loans are short- term

(2) Out of the long-term unsecured loan, 20% will fall due within 3 months

(3) Loans to subsidiaries is a short-term loan

(4) 40% of investments may be taken as current investments.

Let us reclassify the balance sheet elements for determining current assets and current liabilities.

Generally, current ratio of 1.33 is taken as the target ratio. Current ratio of the company was 1.13 in 2001-02. It has further declined to 0.87 in 2002-03. A current ratio of 0.87 indicates that it will be difficult for the company to match payment of current liabilities as per schedule.

**ii. Quick ratio:**

This is also called acid test ratio. This is so because the ratio is calculated to eliminate all possible illiquid elements from current assets as their conversion into cash in the short run is not decisive. Similarly, it excludes all current liabilities which need not be paid in the short run by financial arrangement. For example, bank overdraft limit is fixed. It may not be necessary to pay for the overdraft in the short run. Similarly, if long-term fund is arranged for repayment of short-term loan or instalment of long term-loan (which has fallen due), such portion is eliminated from current liabilities.

**Let us now continue with the example making some further assumptions: **

1. 20% of the inventories are slow moving

2. 30% of the sundry debtors are long overdue

3. The subsidiary is in a financial crisis. It may not be able to pay the loan amount.

4. The new bank loan has been arranged to cover the installment of unsecured long-term loan.

With these assumptions, let us now classify quick assets.

Quick ratio is considered as a true indicator of liquidity. In this case, quick ratio of the company has declined. It becomes difficult to maintain the payment schedule with very low quick ratio. The target quick ratio is 1.00. The company may not be able to manage its short term payment as when fall due.

**Essay # 3****. Solvency Ratios: **

‘Solvency’ means long-term solvency. It indicates whether the entity will be able to continue in the long run.

**Three important solvency ratios are: **

a) Debt-equity ratio

b) Proprietary funds ratio

c) Long-term funds to total assets ratio.

**a. Debt-equity ratio:**

It is the most popular solvency ratio. Inclusion of debt funds on the capital structure (Le. sources) means committing for fixed return by way of interest. This adds to financial risk. Business profit does not always show increasing upward trend nor does it remain stable. There are ups and downs. In times of poor business profit, high interest liability poses a problem. The entity may suffer loss because of high interest liability. So the reasonableness of debt-equity ratio is always viewed from the angle of volatility in business profit.

Debt means long-term loan funds; both secured and unsecured. Equity means share capital and free reserves net of any loss and preliminary expenses and other fictitious assets.

While computing debt we should eliminate current liabilities. Let us now compute debt, equity and debt-equity ratio.

The debt-equity ratio of the company is well below 1.00. A large section of big Indian companies operate with more than 1.00 debt-equity ratio. Of course, the choice of debt-equity ratio depends on relative cost of debt as compared to equity. If cost of debt is lower than the rate of return the company earns, it will increase returns to the equity shareholders.

**b. Proprietary funds ratio:**

‘Proprietary Funds’ means equity, i.e. share capital and free reserves net of losses and fictitious assets like preliminary expenses.

**Proprietary funds ratio is given by:**

Total assets, of course, exclude fictitious assets. This ratio explains the proportion of total assets financed out of proprietary funds. Higher the ratio, lower is the dependence on outside funds — and more stable is the position of the company in the long run.

Let us continue with the balance sheet and the assumptions we have made so far for computing proprietary funds ratio.

Since this ratio considers total assets and financing thereof out of proprietary funds, it is considered a guide to long-term solvency.

**c. Long-term funds to total assets ratio:**

This ratio shows how much of the total assets are financed out long-term funds. Higher the ratio lower is the dependence on short-term funds and so better is the long- term solvency.

Continuing with the example, we may now compute long-term funds to total assets ratio.

Sharp decline in the ratio is indicative of more dependence on short-term funds and current liabilities.

**Essay # 4****. Profitability Ratios: **

The term ‘profitability’ implies rate of profit.

**Profitability is measured with reference to different bases: **

1. Sales

2. Net worth

3. Long-term capital employed

4. Total assets.

Depending upon the base, meaning of the term ‘profit’ also changes.

**1. Sales based profitability ratios: **

**Some important profitability ratios with sales as base are: **

**i. Gross profit ratio: **

**ii. Operating profit ratio: **

**iii. Net profit ratio: **

Gross profit = Sales ± Stock Adjustment

Direct expenses like raw material consumption, direct wages and direct expenses

Operating profit = Sales + Stock Adjustment

All operating expenses.

This means Profit Before Interest and Tax (PBIT)

Non-operating expenses + Non-operating income

Net Profit = Profit After Tax (PAT)

At this stage, we should expand our example by adding a profit and loss account for the year ended 31-3-2003.

**Assume that: **

(i) 60% of salaries are direct wages.

(ii) 20% of expenses are direct expenses.

Let us calculate sales based ratios.

Although the company enjoys high gross profit ratio, its operating profit ratio is very low because of high depreciation and other indirect expenses. Operating performance is slightly better as shown by operating profit ratio because of lower indirect expenses and comparatively lower administrative cost ratio. Gross profit ratio is down by 2.5496 which are eventually reflected in the downfall of net profit ratio by 0.24%. Overall profitability of the company has not been affected much because of improved operating profit ratio and higher level of other income.

**2. Capital based profitability ratios:**

Return on total capital is an indicator of the efficiency of funds use. Every company should earn above the risk-free rate. Of course, a company’s ultimate financial performance is indicated by return on net worth.

Capital Employed means long-term funds consisting of both debt and equity. So return on capital employed means PAT + Interest. Net worth means equity or shareholders’ funds net of losses and fictitious assets. Return on net worth means PAT.

Let us now take data from the example to compute return on capital employed and return on net worth.

Return of the company has improved in 2002-03. But it pays higher interest than its return. So despite a 20.08% return on capital employed, shareholders get only 12.9%. In this case debt has proved to be a costly financing option.

**Asset based profitability ratio – Return on total asset (ROTA) is given by: **

However, a better indicator of operational profitability is given by return on operating assets.

Operating Assets exclude non-trade investments.

Using data generated in the continuing Example,

Outside investments could not generate comparable return. ROTA is very low whereas return on operating asset is much higher. This big gap in the earning capacity of the outside investments suggest that such investments might of strategic importance which the management want to continue despite poor return. Of course return on operating asset remains more or less stable.

**Essay # 5****. Turnover Ratios: **

Turnover ratios indicate efficiency in asset use.

**Some popularly used turnover ratios are: **

a) Assets turnover

b) Working capital turnover

c) Inventories turnover

d) Debtors’ turnover.

**a) Assets turnover ratio:**

This ratio explains sales generating capacity of trading assets or operating assets.

**It is calculated as:**

Let us continue with the example once more

There is serious decline in the asset turnover ratio meaning that sales per rupee of asset has been declined. So return on operating asset would have declined unless there was decline in expense ratios.

**b) Working capital turnover ratio:**

This ratio explains how quickly working capital (i.e. gross current assets) rotates. Higher the turnover better is the working capital utilization. The ratio is given by

Let us compute the ratio using the data given in the example.

It shows that utilization of working capital has slowed down. As a whole efficiency of asset use has deteriorated.

**c) Inventories turnover ratios:**

Inventory turnover ratio explains movement of inventories in relation to sales. Lower ratio indicates slow movement of inventories.

**This ratio is given by: **

Let us compute the ratio using the data given in the example.

Inventory turnover has slowed down which implies slowing down of sales.

This ratio is also calculated with reference to average inventories. Sometimes inventories turnover ratio is broken down into components.

**i. Finished goods inventories turnover: **

This is computed with reference to cost of goods sold.

**ii. W.I.P. inventories turnover: **

This is computed with reference to cost of production.

**iii. Raw material inventories turnover: **

This is computed with reference to cost of purchases.

**d) Debtors turnover ratio:**

This ratio indicates movement of debtors. It is calculated with reference to credit sales.

**The ratio is given by: **

Receivable means debtors and bills receivable.

Let us continue with the example. Assume all sales are credit sales.

**Debtors turnover ratios are given below: **

Higher turnover implies better collection. This also indicates that average collection period has been reduced.

**Collection period: **

Closely related to the idea of debtor’s turnover is average collection period.

**This is given by:**

Average Debtors/Average Daily Credit Sales

In fact there is no major improvement in the collection period.

**Creditors’ turnover and payment period: **

In the same manner, you may look into average payment period to the creditors. Let us assume that all purchases are credit purchases.

**Computation of payment period will be as follows: **

Average payment period remained increased implying liberal credit is available in the market which helped to reduce the current ratio and enjoy better liquidity.

**Essay # 6. ****Ratios for Shareholders and Potential Investors: **

**Shareholders and potential investors are interested in the fundamental strength of the shares which they are holding or interested to buy in terms of:**

a) Asset Backing

b) Profitability

c) Performance.

**Important ratios are: **

Let us assume that shares are of Rs.10 each and average market price for 2002-03 and 2001-02 as Rs.30 and Rs.40.

Capital market discounts high P/E ratio. Generally 10-15 P/E ratio is considered reasonable.

**Essay # 7****. Coverage Ratio:**

Sometimes adequacy of profit to cover dividend and interest is judged through coverage ratio.

**Continuing with the example, coverage ratio are shown below:**

Although dividend coverage improved, there was a decline in the interest coverage ratio e.g. which was not a happy signal to the lenders.

**Essay # 8. ****Debt-service coverage ratio: **

In fact, the lenders are more interested in debt-servicing as a whole rather than simply interest coverage. Available cash profit (after tax) should be sufficient to pay interest and instalments.

**Essay # 9****. Cost Ratios****: **

Cost ratios are calculated with reference to sales. They explain the element-wise cost variance and the resultant impact on profit.

Let us take data given in the example and move to illustrate cost ratios.

**Essay # 10. Calculation**** of Different Financial Ratios: **

**Illustration 1:**

Given below are the Extracts of Profit and Loss Accounts of Avishek dairy Products Ltd. and balance sheets.

Find out profitability, liquidity and solvency ratios. Treat loans to subsidiary as long term. Entire unsecured loans will due for repayment with three months and no financial arrangement has been made for refinancing. Investments are readily encashable.

**Solution:**

**Comment: **

The company is highly profitable. The profitability has improved further during the current year. Also there is proper leverage effect. But there is a tendency to finance through shareholders’ funds. This has been reflected in sharp fall in current ratio and debt equity ratio.

**Illustration 2:**

**Given below is the extracts of Profits and loss Accounts of Rajni Electronic Products Ltd. and Balance Sheets. **

The management wanted to know the key ratio like profitability, liquidity solvency and asset productivity.

**The Finance Manager has complied the following information: **

And he has derived the following ratios. He is confused with the poor performance reflected in ROCE, RONW and asset productivity although he is happy with the reasonable level of current ratio and stable state of leverage ratio.

Could you find reasons for fall in the profitability and efficiency of asset utilization?

**The finance manager provides the following further information: **

i. Investments are in group companies from which no income has accrued yet.

ii. Interest on new loan has not been charged to profit and loss account as this is incurred during the construction period.

**Solution: **

The poor profitability as shown in the ROCE and RONW computed above should be analyzed in the context of expansion which the company is undergoing. The capital work-in-progress of the company has increased implying the expansion and also its outside investment has increased. It is better to exclude the capital utilized in the expansion and outside investments. The company has raised new capital of Rs.1500 million (Share Capital Rs. 500 million, Secured Loans Rs. 500 million and Unsecured Loans Rs. 500 million).

**If these elements of new capital are eliminated debt, equity and capital employed data would appear as follows: **

There is no sharp fall in the profitability. But there is a declining symptom in ROCE. Sharp fall in the RONW is for increase in the equity without corresponding increase in the PAT. The management needs to plan for debt-equity ratio. Excluding the new capital raised, there was a fall in the debt-equity ratio that caused a sharp fall in the RONW.

Now let us look into operating efficiency issue. Increase in fixed assets has been considered as an element of expenditure incurred for maintaining the existing business. Also there is increase in current assets although it has been supported by rise in the current liability. Above 4% decline in return on operating assets reflect the decline in operating efficiency of the company. Also sales per rupee of operating assets have declined.

So there is evidence of decline in operating performance and efficiency of operating asset utilization. A major reason for this is increase in current assets. In fact, the finance manager should not be happy to increase the current assets and get it financed through current liabilities keeping the current ratio low. The important aspect which needs better attention is the impact of such increase in current assets on operating performance.