

2 :

WHY FINANCIAL ANALYSIS Lenders’ need it for carrying out the following
Technical Appraisal
Commercial Appraisal
Financial Appraisal
Economic Appraisal
Management Appraisal 

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Ratio Analysis It’s a tool which enables the banker or lender to arrive at the following factors :
Liquidity position
Profitability
Solvency
Financial Stability
Quality of the Management
Safety & Security of the loans & advances to be or already been provided 

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Meaning of Ratio Analysis Ratio is a mathematical relationship between two financial data having cause and effect relationship. 

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Essential of Ratio Analysis At least two data
Financial Data
Mathematical Relationship
Cause and Effect relationship 

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How a Ratio is expressed? As Percentage  such as 25% or 50% . For example if net profit is Rs.25,000/ and the sales is Rs.1,00,000/ then the net profit can be said to be 25% of the sales.
As Proportion  The above figures may be expressed in terms of the relationship between net profit to sales as 1 : 4.
As Pure Number /Times  The same can also be expressed in an alternatively way such as the sale is 4 times of the net profit or profit is 1/4th of the sales. 

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Classification of Ratios 

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Format of balance sheet for ratio analysis 

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Some important notes Liabilities have Credit balance and Assets have Debit balance
Current Liabilities are those which have either become due for payment or shall fall due for payment within 12 months from the date of Balance Sheet
Current Assets are those which undergo change in their shape/form within 12 months. These are also called Working Capital or Gross Working Capital 

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Net Worth & Long Term Liabilities are also called Long Term Sources of Funds
Current Liabilities are known as Short Term Sources of Funds
Long Term Liabilities & Short Term Liabilities are also called Outside Liabilities
Current Assets are Short Term Use of Funds


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Some important notes Assets other than Current Assets are Long Term Use of Funds
Installments of Term Loan Payable in 12 months are to be taken as Current Liability only for Calculation of Current Ratio & Quick Ratio.
If there is profit it shall become part of Net Worth under the head Reserves and if there is loss it will become part of Intangible Assets 

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Investments in Govt. Securities to be treated current only if these are marketable and due. Investments in other firms/financial institute/market/banks for longterm to be treated as Noncurrent. 

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Classification of Ratios Liquidity Ratio
Profitability Ratio
Working Efficiency Ratio
Solvency Ratio
Debt Service Ratio
Investment Analysis Ratio 


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LIQUIDITY RATIO It is essential for a business entity to maintain sufficient liquidity
For smooth functioning
To satisfy credit provider
To meet with current obligation
To know about firm’s short term financial position 

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Current Ratio
Net Working Capital
Acid Test or Quick ratio
Absolute Liquidity Ratio


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Current Ratio : It is the relationship between the current assets and current liabilities of a concern.
Current Ratio = Current Assets/Current Liabilities
If the Current Assets and Current Liabilities of a concern are Rs.4,00,000 and Rs.2,00,000 respectively, then the Current Ratio will be : Rs.4,00,000/Rs.2,00,000 = 2 : 1
The ideal Current Ratio preferred by Banks is 1.33 : 1


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Interpretation This ratio is an indicator of the firm’s commitment to meet its shortterm liabilities.
If the ratio is more than 1 it suggest that suggest the current assets are adequate to pay off all current liabilities.
If the ratio is 1, they are just sufficient.
If the ratio is less than 1, a company shall be unable to pay current dues when asked 

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Net Working Capital : This is worked out as surplus of Long Term Sources over Long Tern Uses, alternatively it is the difference of Current Assets and Current Liabilities.
NWC = Current Assets – Current Liabilities


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Interpretation From the financial management point of view the amount of net working capital is the most reliable measure to judge the sound liquidity position of a firm. 

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3. ACID TEST or QUICK RATIO : It is the ratio between Quick Current Assets and Current Liabilities.
Quick Current Assets : Cash/Bank Balances + Receivables upto 6 months + Quickly realizable securities such as Govt. Securities or quickly marketable securities and Bank Fixed Deposits
Like – Treasury bills


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Interpretation This ratio shows that a firm must have at least as much liquid assets as its current obligations so that it will have no difficulty in paying those obligations. 

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Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities
Example :
Cash 50,000
Debtors 1,00,000
Inventories 1,50,000 Current Liabilities 1,00,000
Total Current Assets 3,00,000
Current Ratio = > 3,00,000/1,00,000 = 3 : 1
Quick Ratio = > 1,50,000/1,00,000 = 1.5 : 1


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4. Absolute Liquidity Ratio
This ratio is used to know the instant solvency.
Cash in hand, cash at bank, short term marketable securities
Super Quick Asset
Absolute Liquidity Ratio=
current liabilities 

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Interpretation This ratio is used to know whether the company will be or will not be capable of paying them instantly. 

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SOLVENCY RATIO/
CAPITAL STRUCTURE RATIO 

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Debtequity Ratio
Proprietor Ratio
Solvency ratio
Capital Gearing Ratio 

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Objective Whether the borrower business entity will be in a position of to repay loans on or before their due dates of payment or not.
Whether the borrower business entity will be able to timely pay the loan instalments including interest on loan. 

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DEBT EQUITY RATIO : It is the relationship between borrower’s fund (Debt) and Owner’s Capital (Equity).
Long Term Outside Liabilities / Tangible Net Worth
Liabilities of Long Term Nature
Total of Capital and Reserves & Surplus Less Intangible Assets


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For instance, if the Firm is having the following :
Capital = Rs. 200 Lacs
Free Reserves & Surplus = Rs. 300 Lacs
Long Term Loans/Liabilities = Rs. 800 Lacs
Debt Equity Ratio will be => 800/500
i.e. 1.6 : 1


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It determines the extend of assets on which the charge is in the hand of lenders. 

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PROPRIETARY RATIO This ratio indicates the extent to which Tangible Assets are financed by Owner’s Fund.
Proprietary Ratio = (Tangible Net Worth/Total Tangible Assets) x 100
The ratio will be 100% when there is no Borrowing for purchasing of Assets.


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The higher proprietors ratio indicates the high cushion for longterm solvency. On the other hand low ratio indicates that the problem may be faced by the level of management to satisfy the obligation of interest and principals payable to longterm lenders due to low solvency cashion. 

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Capital Gearing Ratio variable cost bearing
capital
Capital gearing ratio=
fixed cost bearing
capital


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Higher capital gearing ratio indicates the better chance for higher dividend on equity shares, as it keeps the financial risk limited and hence wins the confidence of investors and vice –versa. 

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Solvency Ratio This ratio is a measure of solvency to infer about the chances of legal bankruptcy of business entity.
total liabilities
Solvency ratio=
Total Assets 

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Less than 1 solvency ratio indicates the good position of solvency of business entity. 

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PROFITABILITIES RATIO 

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GROSS PROFIT RATIO
NET PROFIT RATIO
OPERATING PROFIT RATIO


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6. GROSS PROFIT RATIO : By comparing Gross Profit percentage to Net Sales we can arrive at the Gross Profit Ratio which indicates the manufacturing efficiency as well as the pricing policy of the concern.
Gross Profit Ratio = (Gross Profit / Net Sales ) x 100


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This ratio shows the profit that remains after the manufacturing costs have been met. It measures the efficiency of production as well as pricing. 

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7. OPERATING PROFIT RATIO :
It is expressed as => (Operating Profit / Net Sales ) x 100
Higher the ratio indicates operational efficiency


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The operating efficiency of an industrial or a trading entity can be determined on the basis of this ratio. 

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NET PROFIT RATIO :
It is expressed as => ( Net Profit / Net Sales ) x 100
It measures overall profitability.


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This ratio is calculated for the measurement of managerial performance. 

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PROFITABILITY RATIO ( BASED ON CAPITAL EMPLOYED) 

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RETRUN ON ASSETS
RETRUN ON CAPITAL EMPLOYED
RETRUN ON EQUITY CAPITAL (ROE)


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It measures the overall efficiency of production, administration, selling, financing, pricing and tax management. Jointly considered, the gross and net profit margin ratios provide an understanding of the cost and profit structure of a firm. 

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15. RETRUN ON ASSETS : Net Profit after Taxes/Total Assets


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16. RETRUN ON CAPITAL EMPLOYED ( Net Profit before Interest & Tax / Average Capital Employed) x 100
Average Capital Employed is the average of the equity share capital and long term funds provided by the owners and the creditors of the firm at the beginning and end of the accounting period.


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ROCE is calculated to ascertain various points
Measurement of Managerial Efficiency
Comparison of profitability of two business entity
The measurement of Overall Profitability
Decision for New Investment
Decision of Raising Longterm Loans
Effective Technique of Management Control 

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17. RETRUN ON EQUITY CAPITAL (ROE) :
Net Profit after Taxes / Tangible Net Worth


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This ratio indicates the return for true owners of the company after satisfying the claims all other parties against the company. 

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Activity / Efficiency Ratio 

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Activity / Efficiency Ratio To know or to ascertain the efficiency of resources used efficiency ratios are calculated. With these ratios the number of cycle or turnover of respective resources can be obtained. 

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EARNING PER SHARE
PRICE EARNING RATIO
CREDITORS TURNOVER RATIO
ASSET TRUNOVER RATIO
FIXED ASSET TURNOVER RATIO
CURRENT ASSET TURNOVER RATIO


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. STOCK/INVENTORY TURNOVER RATIO : (Average Inventory/Sales) x 365 for days
(Average Inventory/Sales) x 52 for weeks
(Average Inventory/Sales) x 12 for months
Average Inventory or Stocks = (Opening Stock + Closing Stock)

2


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This ratio indicates the number of times the inventory is rotated during the relevant accounting period


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10. DEBTORS TURNOVER RATIO : This is also called Debtors Velocity or Average Collection Period or Period of Credit given .
(Average Debtors/Sales ) x 365 for days
(52 for weeks & 12 for months)


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With the help of debtors turnover ratio, it is determined that number of times in a year the money is being received from the debtors and whether the period of collection from debtors is within the permitted credit policy. 

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11. ASSET TRUNOVER RATIO : Net Sales/Tangible Assets
12. FIXED ASSET TURNOVER RATIO : Net Sales /Fixed Assets
13. CURRENT ASSET TURNOVER RATIO : Net Sales / Current Assets


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These ratios are a measure to determine the managerial efficiency of the concerned business entity. 

