Financial Statement Analysis - 2 | Management Optional Notes for UPSC PDF Download

Long-term Solvency Ratios 

The long-term solvency ratios are calculated to assess the long-term financial position of the business. These ratios are also called leverage, ratios.
The following ratios generally come under this category:

1. Debt-Equity Ratio
2. Proprietory Ratio
3. Debt Ratio Debt-Equity Ratio

It shows the relationship between borrowed funds and owners' funds, or external funds (debt) and internal funds (equity). The purpose of this ratio is to show the extent of the firmJs dependence on external liabilities or external sources of funds.
In order to calculate this ratio, the required components are external liabilities and owners' equity or networth. 'external liabilities, include both long-term as well as shortterm borrowings. The term 'owners equity' includes paid-up share capital, reserves and surplus undistributed profits, but excludes past accumulated losses and deferred expenditure. Since there are two approaches to work out this ratio, there are two formulas as shown below:

The first formula includes only long-term debts in the numerator and excludes short-term obligations or current liabilities. This exclusion is justified for the following reasons:
(a) Nature of Current Liabilities: Current liabilities are of a short-term nature, and liquidity ratios aim to assess the firm's ability to meet these immediate obligations.
(b) Variability of Current Liabilities: Current liabilities fluctuate throughout the year, and the interest on short-term obligations does not have a consistent relationship with the book value of current liabilities.
In contrast, the second formula considers both short-term and long-term debts in the numerator. The rationale behind this inclusion is as follows:
(a) Comprehensive Obligation Assessment: When a firm has an obligation, whether short-term or long-term, it should be taken into account to thoroughly evaluate the risk associated with the firm.
(b) Cost Consideration: Both long-term and short-term loans incur costs, and including both in the numerator provides a more comprehensive understanding of the firm's financial obligations.
(c) Pressure from Creditors: Short-term creditors often exert more immediate pressure compared to long-term loans, making it important to consider the obligations from both categories.

Illustration 3: From the following Balance Sheet of Kavitha Ltd., calculate Debt-Equity Ratio:
Ans:

For analysing the capital structure, debt-equity ratio gives an idea about the relative share of 'funds of outsiders and owners invested in the business. The ratio of long-term debt to equity is generally regarded as safe if it is 2 : 1. A higher ratio may, put the JBhm in difficulty in meeting the obligation to outsiders. The higher the ratio, the greater would be the risk as the firm has to pay interest irrespective of profits. On the other hand, a smaller ratio is less risky and creditors will have greater margin of safety.What ratia is ideal will depend on the nature of the enterprise and the economic conditions prevailing at that time. During business prosperity a high ratio may be favourable and in a reverse situation a low ratio is preferred. The Controller of Capital Issues in India suggests 2: 1 as the norm for this ratio.

Proprietory Ratio 

• This ratio, alternatively known as the Equity Ratio or Net Worth to Total Assets Ratio, represents a variation of the debt-equity ratio. It reveals the relationship between owners' equity and the total assets of the firm. The primary objective of this ratio is to signify the extent of owners' contribution to the overall value of assets, providing insights into the ownership structure of the firm.
• To compute this ratio, proprietors' funds and total assets are the essential components. Proprietors' funds encompass equity capital, preference capital, reserves, and undistributed profits. In case there are accumulated losses, they are subtracted from the owners' funds. 'Total assets' comprise both fixed and current assets but exclude fictitious assets like preliminary expenses, the debit balance of the profit and loss account, etc. If there are intangible assets such as goodwill, patents, and copyrights, they are considered at the amount at which they can be realized.
• The formula for this ratio is expressed as follows:
  

Illustration 4: Taking the information from Illustration 3, calculate the Proprietory Ratio as follows:
Ans: 
 
There is no definite norm for this ratio. Some financial experts hold the view that proprietors' funds should be 33% to 50% of the total capital employed and outsiders' funds (debt funds) should be from 67% to 50% of the total assets. The higher the ratio, the lesser would be the reliance on debt funds. A high proprietory ratio implies that the firm is not using debt funds as much as would maximise the rate of return on the proprietor's funds. For instance, if a fhm earns 20% return on investment and the rate of interest on such funds is 10%, the proprietors would be able to gain to the extent cf 10% on the debt funds. This increases the earnings of the shareholders,

It shows the relationship between debt and total assets of the fdm The purpose cf this ratio is to indicate the extent af creditors' contribution to the total assets of the firm. Like debt-equity ratic, this ratio'can also be worked out in two tvays: (1) long-term debt to total assets (debt-ratio), and (2) total debt to total assets (total debt ratio).

Taking the information from illustration 3, the long-term debt, the total debt and the total assets of Kavitha Ltd., as calculated earlier, are Rs. 2,00,000; and Rs. 2,95,00; and Rs. 4,65,000. The two debt ratios will be worked out as follows:

Thus we observe that in case of Kavitha Ltd., the total capital employed has been funded 43% by debt. If we use the total debt concept, it will be 63% by debt and 37% by proprietor's funds, proprietary ratio being 0.3656.

Ratios to Assess Efficiency (Turnover Ratios) 

These ratios are referred to as velocity ratios, activity ratios, performance ratios, efficiency ratios, or turnover ratios. Both owners' and creditors' funds are utilized to finance various assets within a firm. The effectiveness of the firm hinges on how swiftly these assets are turned over or generate sales. The activity turnover ratios reflect the relationships between different assets and sales. Given the various types of assets, there are corresponding activity ratios, with some of the more significant ones being:

1. Stock/Inventory Turnover Ratio
2. Debtors' Turnover Ratio
3. Creditors' Turnover Ratio
4. Total Assets Turnover Ratio (Investment Turnover Rate)
5. Net Assets Turnover Ratio

Stock Turnover Ratio

This ratio establishes a connection between the cost of goods sold and the average value of inventory or stock. It provides insight into the efficiency of inventory management, indicating how many times the inventory of a firm is rotated in a year. To calculate this ratio, the necessary information includes the cost of goods sold and the average inventory. The cost of goods sold can be determined by deducting the gross profit from sales or subtracting the closing stock from the sum of opening stock, purchases, and manufacturing expenses (direct expenses). The average stock is determined by dividing the sum of opening and closing stock by two.
The formula for this ratio is as follows:

Where the details of cost of goods sold and average stock are not available, this ratio can be computed by dividing the sales by stock at the end of the year.
Of the two versions stated above, the first one is more realistic as the two components of the ratios are dependent on cost price. In the second version one component is based on the selling price (i.e., sales) and the other one usually on cost price (closing stock).

Illustration 6: From the following particulars of Sanjeev & Co., calculate Stock Turnover Ratio
i) Net Sales Rs. 2,00,000
ii) Margin of Gross Profit 25%
iii) Opening Stock Rs. 5,000
iv) Closing Stock Rs. 15,000
Ans:  

A high inventory/stock turnover ratio is an index of efficient inventory management and a low ratio stands for inefficient inventory management. A low ratio also implies that the finn has excess stock in relation to production and sales. Further, it may be an indication of the presence of non-moving or slow moving or obsolete stock. A very high ratio is also not a healthy sign as it may be the result of low level of stocks. This may lead to frequent stock-out situations. Hence, this ratio should he neither too high nor too low.

Debtors' Turnover Ratio 

This ratio, also known as the 'Receivables Turnover Ratio,' illustrates the connection between sales and debtors. Typically, businesses extend credit to boost sales, resulting in the creation of debtors and bills receivables. Both debtors and bills receivables are categorized as current assets, as they are expected to be converted into cash within a year. The firm's liquidity position significantly relies on how quickly these items are converted into cash.
To assess the quality of debtors and bills receivables, this ratio can be calculated in two ways:
(i) Debtors Turnover Ratio, and
(ii) Average Collection Period.
The Debtors Turnover Ratio indicates the average number of times debtors are turned over in a year, providing insight into the speed of debt collection. The Average Collection Period reveals the average number of days the firm has to wait for collecting money after selling goods on credit. The average debtors are obtained by dividing the sum of opening and closing balances of debtors (including bills receivable) by two.
The formula for this ratio is as follows:
The second version of tl~isra tio is known as Average Collection Period. As a matter of fact, it is dependent on the first version.
The formula is as follows:

Creditors Turnover Ratio 

This ratio, often referred to as the 'Creditors Turnover Ratio,' establishes the correlation between credit purchases and average creditors, which includes bills payable. The primary objective of this ratio is to determine the speed at which payments are made to creditors for credit purchases.
Similar to other turnover ratios, there are two variations for this ratio:

1. Creditors Turnover Ratio
2. Average Payment Period

The Creditors Turnover Ratio indicates the average frequency with which the firm settles its payments to creditors. On the other hand, the Average Payment Period offers insights into the average number of days the firm can defer its payments to creditors on credit purchases. Calculating the average creditors involves adding the opening and closing balances of creditors and dividing the sum by two.
The formulas for these ratios are as follows:

Total Assets Turnover Ratio 
This ratio, known as the 'Total Assets Turnover Ratio' or 'Investment Turnover Rate,' establishes the connection between sales and total assets. The main objective is to assess whether the firm is generating sufficient sales relative to the total assets employed. Additionally, it helps in evaluating whether there is an appropriate level of investment, potential over-investment, or under-investment in the firm's assets.
The formula for this ratio is as follows:

Net Assets Turnover Ratio 

The 'Net Assets Turnover Ratio' establishes a relationship between net assets (total assets - current liabilities) and sales. This ratio reflects the overall efficiency with which the firm's assets are employed to generate sales revenue. Since net assets are equivalent to capital employed (shareholders' funds + debt funds), this ratio is also referred to as the Capital Employed Turnover Ratio or Investment Turnover Rate.
The formula for calculating this ratio is as follows:

Ratios to Assess Profitability 

The operational efficiency of a firm and its capacity to provide satisfactory returns to its shareholders are evident in the profits it generates. Consequently, a firm must earn reasonable profits to sustain itself and facilitate growth. Firms that are unable to achieve reasonable profits face an uncertain future. Profitability ratios are specifically formulated to gauge the earning capacity and profitability performance of the firm. These ratios can be calculated either in relation to sales or in relation to investment.

Profitability in relation to Sales 

Profits earned in relation to sales provide insights into the firm's ability to cover operating expenses and generate a surplus. To assess the management's efficiency in terms of production and sales, profitability ratios are computed in relation to sales.
These ratios include:

1. Gross Profit Margin
2. Net Profit Margin
3. Operating Profit Margin
4. Operating Ratio

Gross Profit Margin
The 'Gross Profit Margin,' also referred to as the 'Gross Profit Ratio' or 'Gross Profit to Sales Ratio,' is particularly valuable for wholesale and retail trading firms. This ratio establishes the connection between gross profit and net sales. Its purpose is to illustrate the amount of gross profit generated for each rupee of sales.
The formula for calculating the Gross Profit Margin is as follows:

The amount of gross profit is the difference between net sales income and the cost of goods sold which includes direct expenses. 

Net Profit Margin

The 'Net Profit Margin,' also known as the 'Net Profit to Sales Ratio,' illustrates the relationship between net profit after taxes and net sales. The objective of this ratio is to disclose the portion of sales income remaining for shareholders after covering all costs and expenses of the business.
The formula for calculating the Net Profit Margin is as follows:

Operating Profit Margin
The 'Operating Profit Margin,' also recognized as 'Profit Before Interest and Taxes (PBIT) to Sales Ratio,' is a modified version of the Net Profit Margin. This ratio examines the relationship between operating profit (PBIT - Before Interest and Taxes) and sales. The objective of calculating this ratio is to determine the amount of operating profit generated for each rupee of sale. When computing operating profit, non-operating expenses (e.g., interest, loss on sale of assets, etc.) and non-operating income (e.g., profit on sale of assets, income on investment, etc.) are excluded.
The formula for the Operating Profit Margin is as follows:

Operating Ratio 
The 'Operating Ratio' establishes the relationship between total costs incurred and sales. It can be calculated using the following formula:

Profitability in relation to Capital Employed (Investment)

As mentioned earlier, profitability ratios can also be computed by relating profits to capital or investment. This ratio is commonly known as the rate of Return on Investment (ROI). The term "investment" may refer to capital employed or owners' equity.
Two ratios are generally calculated:

1. Return on Capital Employed (ROCE)
2. Return on Shareholders’ Equity (ROE)
3. Earnings Per Share (EPS)

Return on Capital Employed (ROCE)
This ratio establishes the relationship between total capital and profit before interest and tax. The objective is to determine whether the return on capital employed is reasonable or not. This ratio is also referred to as Return on Investment (ROI). The term capital employed includes long-term funds, comprising owners' capital and borrowed capital.
The ratio may be calculated using the following formula:

Return on Shareholders' Equity
This ratio demonstrates the relationship between net profit after taxes (PAT) and shareholders' equity. It unveils the rate of return on owners'/shareholders' funds. Shareholders' equity, also referred to as 'net worth,' encompasses equity capital, preference capital, share premium, reserves, and surplus. This ratio is also known as Return on Net Worth (RONW).
The formula for this ratio is as follows:

Earnings Per Share (EPS)
Earnings per share (EPS) is a crucial ratio from the perspective of equity shareholders as it influences the market price of shares and the amount of dividend distributed to equity shareholders.
The earnings per share are calculated using the following formula:

 Standards for Comparison

Ratios provide valuable insights into the financial health of a business by showcasing the relationship between different values. However, a single ratio lacks significance without a comparative context. Meaningful interpretation of ratios involves comparing them against certain benchmarks. There are three main types of comparisons: (1) Intra-firm comparison, (2) Inter-firm comparison, and (3) Comparison against set standards or targets.

• Intra-firm comparison: This involves assessing the current performance of a business against its own past performance. By comparing present figures with historical data or conducting trend analyses over several years, it becomes possible to identify rising, declining, or stable trends. Average ratios over specific periods can also be calculated for a more comprehensive evaluation.
• Inter-firm comparison: This type of comparison entails evaluating the performance of one firm against that of another, especially similar businesses or industry leaders. Benchmarking against industry averages is a common approach, providing insights into how a particular firm stacks up against its peers or competitors.
• Comparison against set standards: In instances where predetermined standards or targets exist, businesses can compare their current performance against these benchmarks. Standards might be established by regulatory bodies, government entities, or industry conventions. Such external standards serve as ideal references for assessing a firm's performance.

Whether standards are internal or external, they play a crucial role in contextualizing and interpreting financial ratios, providing a basis for evaluating a business's financial standing and progress.

Usefulness of Ratio Analysis 

Ratio analysis holds significant importance in financial assessment due to its diverse utilities, outlined as follows:

• Clarity in Financial State and Efficiency: Ratios offer a clear depiction of the interrelationship between various items in the Balance Sheet and Profit and Loss Account. Unlike absolute accounting figures, ratios provide a more nuanced understanding of the financial state and operational efficiency. For instance, a large net profit of Rs. 5 lakh might seem satisfactory, but when related to the total investment (capital of Rs. 2 crore), the profit percentage is only 2.5%. Ratios help in assessing performance relative to the scale of investment.
• Revealing Management Efficiency: Financial ratios reveal the efficiency of management and the overall financial position, offering insights not readily apparent from raw accounting figures. These ratios serve as an index of efficiency, providing a basis for management control. Monitoring the trend of ratios over time aids in planning and forecasting.
• Assessing Creditworthiness and Investment Decisions: Ratio analysis provides crucial information about a firm's creditworthiness, earning capacity, debt repayment ability, growth prospects, and more. Creditors, financiers, investors, and shareholders rely on these insights. Comparing a firm's ratios with those of competitors or industry averages helps stakeholders make informed investment decisions.

Limitations of Ratio Analysis

While ratio analysis is a valuable tool for evaluating operational efficiency, its utility depends heavily on the interpretation of ratios.
The practical relevance of financial ratios is constrained by certain limitations:

• Limitations of Accounting Figures: Ratios rely on figures derived from accounting records, making them susceptible to the limitations of accounting practices. Management has significant discretion in recognizing income, handling expenses, and valuing assets. Accounting concepts and conventions allow room for managerial judgment, which may result in financial statements not accurately reflecting the true state of affairs. Consequently, ratios may not provide an accurate depiction.
• Exclusion of Non-Monetary Aspects: Financial ratios focus solely on the monetary aspects of organizational functions. While they offer insights into a business's operational efficiency and health based on financial data, non-financial elements such as employee morale, quality of supervision, and human relations are not captured by financial ratios.
• Indicators of Management Performance: Specific ratios or even a set of ratios should not be viewed as definitive indicators of good or bad management performance. Ratios offer clues that require careful examination to understand the underlying conditions influencing them. Favorable ratios may, upon closer inspection, stem from factors that could lead to adverse consequences over time. For example, high earnings ratios may be influenced by aggressive management practices at the cost of low employee morale.
• Challenges in Establishing Standards for Comparison: Ratios for a particular period lack significance unless compared with ratios from previous periods, corresponding ratios of other firms, or conventional standard ratios. Comparing present ratios with past ratios indicates improvement or deterioration, but it doesn't assess whether past ratios were satisfactory. Comparing ratios between firms is challenging due to varying characteristics, making it hard to establish comparability. Standards set by the government or financial institutions are specific to certain ratios and conditions.
• Impact of Varying Accounting Practices: Changes in ratios over successive years may result from the adoption of different accounting practices by a firm. Understanding changes in accounting treatment of items is crucial for reliable interpretation. Inter-firm comparison of ratios becomes less useful unless differences in accounting practices between firms are taken into account.