Ratio Analysis (Part - 2) - Analysis and interpretation of Financial statements, Cost Accounting | Cost Accounting - B Com PDF Download

3.1.2 Return on Shareholders’ Funds

It is also referred to as return on net worth. In this case it is desired to work out the profitability of the company from the shareholders’ point of view and it is computed as follows:

Modifications of the ‘return on capital employed’ can be made to adopt it to various circumstances. Thus if it is required to work out the profitability from the shareholders’ point of view, then the profit figure should be after interest and taxation and the capital employed should be after deducting the long-term loans. This ratio would reflect the profitability for the shareholders. To extend the idea further, the profitability from equity shareholders’ point of view can also be worked out by taking the profits after preference dividend and comparing against capital employed after deducting both long-term loans and preference capital.

3.1.3 Return on Assets

Here the profitability is measured in terms of the relationship between net profits and assets. It shows whether the assets are being properly utilised or not. It is calculated as:

This ratio is a measure of the profitability of the total funds or investment of the organisation.

3.1.4 Profit Ratios

3.1.4.1 Gross Profit Ratio or Gross Margin

Gross profit ratio expresses the relationship of gross profit to net sales or turnover. Gross profit is the excess of the proceeds of goods sold and services rendered during a period over their cost, before taking into account administration, selling and distribution and financing charges. Gross profit ratio is expressed as follows:

This ratio is important to determine general profitability since it is expected that the ratio would be quite high so as to cover not only the remaining costs but also to allow proper returns to owners.

Any fluctuation in the gross profit ratio is the result of a change either in ‘sales’ or the ‘cost of goods sold’ or both. The rise or fall in the selling price may be an external factor over which the management may have little control, specially when prices are controlled. The management, however, must try to keep the other end of the margin (i.e., cost) at least steady, if not reduce it. If the gross profit ratio is lower than what it was previously, when the selling price has remained steady, it can be reasonably concluded that there is an increase in the manufacturing cost. Since manufacturing overheads include a fixed element as well, a fall in the volume of sales will also lower the rate of gross profit and vice-versa.

3.1.4.2 Net Profit Ratio

One of the components of return on capital employed is the net profit ratio (or the margin on sales) calculated as:

It indicates the net margin earned in a sale of Rs100. Net profit is arrived at from gross profit after deducting administration, selling and distribution expenses; non-operating incomes, such as dividends received and non-operating expenses are ignored, since they do not affect efficiency of operations.

3.1.4.3 Operating Ratio

The ratio of all operating expenses (i.e., materials used, labour, factory overheads, office and selling expenses) to sales is the operating ratio. A comparison of the operating ratio would indicate whether the cost content is high or low in the figure of sales. If the annual comparison shows that the sales has increased, the management would be naturally interested and concerned to know as to which element of the cost has gone up. It is not necessary that the management should be concerned only when the operating ratio goes up.

If the operating ratio has fallen, though the unit selling price has remained the same, still the position needs analysis as it may be the sum total of efficiency in certain departments and inefficiency in others. A dynamic management should be interested in making a fuller analysis. It is, therefore, necessary to break up the operating ratio into various cost ratios. The major components of cost are: material, labour and overheads. Therefore, it is worthwhile to classify the cost ratio as:

Generally all these ratios are expressed in terms of percentage. They total upto the Operating Ratio. This, deducted from 100 will be equal to the Net Profit Ratio.

If possible, the total expenditure for effecting sales should be divided into two categories, viz., fixed and variable-and then ratios should be worked out. The ratio of variable expenses to sales will be generally constant; that of fixed expenses should fall if sales increase; it will increase if sales fall.

3.2 Activity Ratios or Turnover Ratios

The ratios used to measure the effectiveness of the employment of resources are termed as activity ratios. Since these ratios relate to the use of assets for generation of income through turnover they are also known as turnover ratios, as we have seen already, the overall profitability of the business depends on two factors i.e. (i) the rate of return on sales and (ii) the rate of return on capital employed i.e. the speed at which the capital employed in the business relates. More efficient the operations of an undertaking, the quicker and more number of times the rotation is. Thus the overall profitability ratio is calculated as - Net Profit Ratio x Turnover Ratio. The net profit ratio has already been discussed. Now the important turnover ratios as regards capital employed and assets are discussed below:

3.2.1 Capital Turnover (Sales to Capital Employed) Ratio

This ratio shows the efficiency of capital employed in the business and is calculated as follows:

The higher the ratio the greater are the profits.

3.2.2 Total Assets Turnover Ratio

This ratio is ascertained by dividing the net sales by the value of total assets. Thus,

A high ratio is an indicator of overtrading of total assets while a low ratio reveals idle capacity. The total Assets Turnover Ratio can be segregated into:

3.2.2.1 Fixed Assets Turnover Ratio

This ratio indicates the number of times fixed assets are being turned over in a stated period. It is calculated as:

This ratio is an indicator of the extent to which investment in fixed assets contributes to generate sales. The fixed assets are to be taken net of depreciation. The higher is the ratio the better is the performance.

3.2.2.2 Working Capital Turnover Ratio

This ratio shows the number of times working capital is turned-over in a stated period. This ratio is calculated as:

It indicates to what extent the working capital funds have been employed in the business towards sales.

3.2.3 Stock Turnover Ratio (Inventory Turnover Ratio)

This ratio is an indicator of the efficiency of the use of investment in stock. It is calculated as:

Mostly opening and closing stock figures are given and these should be averaged. If monthly figures are available, then these figures should be averaged. In case stock level fluctuates violently, then monthly average should be calculated as under:

In this case stock turnover ratio should be as under:

Cost of goods sold / Average stock

Too large an inventory will depress the ratio; control over inventories and active sales promotion will increase the ratio. If desired this ratio may be split into two ratios, for raw materials and for finished goods:

This analysis will throw a better light on the inventory position.

Average inventory is calculated on the basis of the average inventory at the beginning and at the end of the accounting period.

3.2.4 Debtors Turnover Ratio (Debtors’ Velocity)

These days some amount of sales always locked up in the form of book debts. Efficient credit control and prompt collection of amounts due will mean lower investments in book debts. This ratio measures the net credit sales of a firm to the recorded trade debtors thereby indicating the rate at which cash is generated by turnover of receivable or debtors. This ratio is calculated as:

Average debtors refer to the average of opening and closing balance of debtors for the period. Debtors include bills receivables but exclude debts which arise on account of transactions other than sale of goods. While calculating debtors turnover, it is important to note that provision for bad and doubtful debts are not deducted from total debtors in order to avoid the impression that a larger amount of receivables have been collected.

Debt Collection Period: This ratio indicates the extent to which the debts have been collected in time. This ratio is infact, interrelated with and dependent upon the debtors turnover ratio. It is calculated by dividing the days in a year by the debtors turnover. This ratio can be computed as follows:

Debtors’ collection period shows the quality of debtors since it measures the speed with which money is collected from them. It is rather difficult to specify a standard collection period for debtors. It depends upon the nature of the industry, seasonal character of the business and credit policy of the firm etc.

Illustration 3

From the following information, calculate, debtors turnover ratio and average collection period.

Solution:

Total Debtors Account

Debtors Turnover Ratio = Credit Sales / Average Debtors

Average Debtors = (Opening Debtors + Closing Debtors) / 2

= (Rs 2,00,000 + Rs 3,00,000) / 2

= Rs 2,50,000

Debtors Turnover Ratio = Rs 10,00,000 / Rs 2,50,000 = 4 times

Average Collection Period = Days in the Year / Debtors Turnover Ratio

= 360 / 4 = 90 days.

3.2.5 Creditors Turnover Ratio (Creditors’ Velocity) 

Like debtors’ turnover ratio, this ratio indicates the speed at which the payments for credit purchases are made to creditors. This ratio is computed as follows:

The term ‘creditors’ include, trade creditors and bills payable. In case the details regarding credit purchases, opening and closing balances of creditors are not available, then instead of credit purchases, total purchases may be taken and in place of average creditors, the balance available may be substituted.

Debt Payment Period: This ratio gives the average credit period enjoyed from the creditors. It can be computed as under:

Both above ratios determine the average age of payables, on the basis of which it can be compensated as to how prompt or otherwise the company is making payments for credit purchases effected by it. A high creditors’ turnover ratio or a low debt payment period shows that creditors are being paid promptly, hence enhancing the credit worthiness of the company. However, a very favourable ratio to this effect also shows that the business is not taking full advantage of credit facilities allowed by the creditors.