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Friends, Updating here the recollected questions from June 2016 Exams. Wish you all the very best for your exam.
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Ratio Analysis
Financial ratios are mathematical comparisons of financial statement accounts or categories. These relationships between the financial statement accounts help investors, creditors, and internal company management understand how well a business is performing and areas of needing improvement.
Financial ratios are the most common and widespread tools used to analyze a business' financial standing. Ratios are easy to understand and simple to compute. They can also be used to compare different companies in different industries.
Ratios allow us to compare companies across industries, big and small, to identify their strengths and weaknesses. Financial ratios are often divided up into seven main categories: liquidity, solvency, efficiency, profitability, market prospect, investment leverage, and coverage.
Liquidity Ratios
Solvency Ratios
Efficiency Ratios
Profitability Ratios
Market Prospect Ratios
Financial Leverage Ratios
Coverage Ratios
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Liquidity Ratios
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Liquidity ratios analyze the ability of a company to pay off both its current liabilities as they become due as well as their long-term liabilities as they become current. In other words, these ratios show the cash levels of a company and the ability to turn other assets into cash to pay off liabilities and other current obligations.
Most common liquidity ratios are :
Quick Ratio or Acid Test Ratio
Current Ratio or Working Capital Ratio
Times Interest Earned Ratio
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Quick Ratio or Acid Test Ratio
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The quick ratio or acid test ratio is a liquidity ratio that measures the ability of a company to pay its current liabilities when they come due with only quick assets. Quick assets are current assets that can be converted to cash within 90 days or in the short-term. Cash, cash equivalents, short-term investments or marketable securities, and current accounts receivable are considered quick assets.
Short-term investments or marketable securities include trading securities and available for sale securities that can easily be converted into cash within the next 90 days. Marketable securities are traded on an open market with a known price and readily available buyers.
Formula
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Quick Ratio or Acid Test Ratio =
(Cash + Cash Equivalents + Short Term Investments + Marketable Securities + Accounts Receivable) / Current Liabilities
or
Quick Ratio = (Current assets – Inventory - Advances - Prepayments Current Liabilities) / Current Liabilities
Example 1 :
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M/s Raj&co's balance sheet included the following accounts:
Cash: 10,000
Accounts Receivable: 5,000
Inventory: 5,000
Stock Investments: 1,000
Prepaid taxes: 500
Current Liabilities: 15,000
Find the Quick Ratio
Quick Ratio = Cash + Cash Equivalents + Short Term Investments + Marketable Securities + Accounts Receivable) / Current Liabilities
= (10000+5000+1000) / 15000
= 16000 / 15000
= 1.07
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Example 2 :
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M/s Raj&co's balance sheet included the following accounts:
Inventory : 5,000
Prepaid taxes : 500
Total Current Assets : 21,500
Current Liabilities : 15,000
Find the Quick Ratio
Quick Ratio = (Current assets – Inventory - Advances - Prepayments Current Liabilities) / Current Liabilities
= (21500 - 5000 - 500) / 15000
= 16000 / 15000
= 1.07
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Example 3 :
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XYZ Pvt Ltd has the following assets and liabilities as on 31st March 2015 (in Lakhs) :
Non Current Assets
Goodwill 75
Fixed Assets 75
Current Assets
Cash in hand 25
Cash in bank 50
Short term investments 45
Inventory 25
Receivable 100
Current Liabilities
Trade payables 100
Income tax payables 60
Non Current Liabilities
Bank Loan 50
Deferred tax payable 25
Find the Quick Ratio
Quick Ratio = (Cash in hand + Cash at Bank + Receivables + Marketable Securities) / Current Liabilities
= (25+50+45+100) / 160
= 220 / 160
= 1.375
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Current Ratio or Working Capital Ratio
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The current ratio is a liquidity and efficiency ratio that measures a firm's ability to pay off its short-term liabilities with its current assets. The current ratio is an important measure of liquidity because short-term liabilities are due within the next year.
This means that a company has a limited amount of time in order to raise the funds to pay for these liabilities. Current assets like cash, cash equivalents, and marketable securities can easily be converted into cash in the short term. This means that companies with larger amounts of current assets will more easily be able to pay off current liabilities when they become due without having to sell off long-term, revenue generating assets.
The current ratio is calculated by dividing current assets by current liabilities.
The current ratio helps investors and creditors understand the liquidity of a company and how easily that company will be able to pay off its current liabilities. This ratio expresses a firm's current debt in terms of current assets. So a current ratio of 4 would mean that the company has 4 times more current assets than current liabilities.
A higher current ratio is always more favorable than a lower current ratio because it shows the company can more easily make current debt payments.
Formula
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Current Ratio or Working Capital Ratio = Current Assets / Current Liabilities
Example 1:
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XYZ shoes sells shoes. It is applying for loans to help fund to increase the inventory. The bank asks for its balance sheet so they can analysis the current debt levels. According to XYZ shoes's balance sheet it reported 10,00,000 of current liabilities and only 2,50,000 of current assets. Will the loan get approved?
Current Ratio = Current Assets / Current Liabilities
= 250000 / 1000000
= 0.25
XYZ shoes only has enough current assets to pay off 25 percent of his current liabilities. This shows that XYZ shoes is highly leveraged and highly risky. Banks would prefer a current ratio of at least 1 or 2, so that all the current liabilities would be covered by the current assets. Since XYZ shoes's ratio is so low, it is unlikely that it will get approved for his loan.
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Example 2:
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Ms. Ankita Agency has several loans from banks for equipment they purchased in the last five years. All of these loans are coming due which is decreasing their working capital. At the end of the year, they had 1,00,000 of current assets and 1,25,000 of current liabilities. Find out its Working Capital Ratio.
The working capital ratio is calculated by dividing current assets by current liabilities.
Formula
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WC Ratio = CA/CL
= 100000 / 125000
= 0.80
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Times Interest Earned Ratio or Interest Coverage Ratio
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The times interest earned ratio, sometimes called the interest coverage ratio, is a coverage ratio that measures the proportionate amount of income that can be used to cover interest expenses in the future.
In some respects the times interest ratio is considered a solvency ratio because it measures a firm's ability to make interest and debt service payments. Since these interest payments are usually made on a long-term basis, they are often treated as an ongoing, fixed expense. As with most fixed expenses, if the company can't make the payments, it could go bankrupt and cease to exist. Thus, this ratio could be considered a solvency ratio.
The times interest earned ratio is calculated by dividing income before interest and income taxes by the interest expense.
Formula
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Times Interest Earned Ratio or Interest Coverage Ratio = Income before interest and taxes / Interest Expense
Example 2:
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Ravi's income statement shows that he made 5,00,000 of income before interest expense and income taxes. Ravi's overall interest expense for the year was only 50,000. Ravi's time interest earned ratio would be ......
Times Interest Earned Ratio or Interest Coverage Ratio = Income before interest and taxes / Interest Expense
= 500000 / 50000
= 10 Times
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Solvency Ratios
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Solvency ratios, also called leverage ratios, measure a company's ability to sustain operations indefinitely by comparing debt levels with equity, assets, and earnings. In other words, solvency ratios identify going concern issues and a firm's ability to pay its bills in the long term. Many people confuse solvency ratios with liquidity ratios. Although they both measure the ability of a company to pay off its obligations, solvency ratios focus more on the long-term sustainability of a company instead of the current liability payments.
Solvency ratios show a company's ability to make payments and pay off its long-term obligations to creditors, bondholders, and banks. Better solvency ratios indicate a more creditworthy and financially sound company in the long-term.
The most common solvency ratios include:
Debt to Equity Ratio
Equity Ratio
Debt Ratio
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Debt to Equity Ratio
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The debt to equity ratio shows the percentage of company financing that comes from creditors and investors. A higher debt to equity ratio indicates that more creditor financing (bank loans) is used than investor financing (shareholders).
The debt to equity ratio is calculated by dividing total liabilities by total equity
Formula
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Debt to Equity Ratio = Total Liabilities / Total Equity
Example 2:
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A company has 1,00,000 of bank lines of credit and a 5,00,000 mortgage on its property. The shareholders of the company have invested 12,00,000. Calculate the debt to equity ratio.
DER = TL / Total Equity
= (100000+500000) / 1200000
= 600000 / 1200000
= 0.5
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Equity Ratio
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The equity ratio is an investment leverage or solvency ratio that measures the amount of assets that are financed by owners' investments by comparing the total equity in the company to the total assets.
The equity ratio highlights two important financial concepts of a solvent and sustainable business. The first component shows how much of the total company assets are owned outright by the investors. In other words, after all of the liabilities are paid off, the investors will end up with the remaining assets.
The second component inversely shows how leveraged the company is with debt. The equity ratio measures how much of a firm's assets were financed by investors. In other words, this is the investors' stake in the company. This is what they are on the hook for. The inverse of this calculation shows the amount of assets that were financed by debt. Companies with higher equity ratios show new investors and creditors that investors believe in the company and are willing to finance it with their investments.
The equity ratio is calculated by dividing total equity by total assets.
Formula
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Equity Ratio = Total Equity / Total Assets
Example :
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A company has total assets at 1,50,000 and its total liabilities are 50,000. Based on the accounting equation, we can assume the total equity is 1,00,000. Find the Equity Ratio.
ER = Total Equity / TA
= 100000 / 150000
= 0.67
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Debt Ratio
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Debt ratio is a solvency ratio that measures a firm's total liabilities as a percentage of its total assets. In a sense, the debt ratio shows a company's ability to pay off its liabilities with its assets. In other words, this shows how many assets the company must sell in order to pay off all of its liabilities.
This ratio measures the financial leverage of a company. Companies with higher levels of liabilities compared with assets are considered highly leveraged and more risky for lenders.
This helps investors and creditors analysis the overall debt burden on the company as well as the firm's ability to pay off the debt in future, uncertain economic times.
The debt ratio is calculated by dividing total liabilities by total assets.
Formula
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Debt Ratio = Total Liabilities / Total Assets
Example 2:
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A company has total assets at 1,50,000 and its total liabilities are 50,000. Based on the accounting equation, we can assume the total equity is 1,00,000. Find the Debt Ratio.
DR = TL / TA
= 50000 / 150000
= 0.33
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Efficiency Ratios
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Efficiency ratios also called activity ratios measure how well companies utilize their assets to generate income. Efficiency ratios often look at the time it takes companies to collect cash from customer or the time it takes companies to convert inventory into cash—in other words, make sales. These ratios are used by management to help improve the company as well as outside investors and creditors looking at the operations of profitability of the company.
Efficiency ratios go hand in hand with profitability ratios. Most often when companies are efficient with their resources, they become profitable. Wal-Mart is a good example. Wal-Mart is extremely good at selling low margin products at high volumes. In other words, they are efficient at turning their assets. Even though they don't make much profit per sale, they make a ton of sales. Each little sale adds up.
Here are the most common efficiency ratios are :
Accounts Receivable Turnover Ratio
Working Capital Ratio
Asset Turnover Ratio or Total Asset Turnover Ratio
Inventory Turnover Ratio
Days' sales in Inventory Ratio
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Accounts Receivable Turnover Ratio
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It's an efficiency ratio or activity ratio that measures how many times a business can turn its accounts receivable into cash during a period. In other words, the accounts receivable turnover ratio measures how many times a business can collect its average accounts receivable during the year. A turn refers to each time a company collects its average receivables.
This ratio shows how efficient a company is at collecting its credit sales from customers. Some companies collect their receivables from customers in 90 days while other take up to 6 months to collect from customers.
In some ways the receivables turnover ratio can be viewed as a liquidity ratio as well. Companies are more liquid the faster they can covert their receivables into cash.
Accounts receivable turnover is calculated by dividing net credit sales by the average accounts receivable for that period.
Formula
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Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
The reason net credit sales are used instead of net sales is that cash sales don't create receivables. Only credit sales establish a receivable, so the cash sales are left out of the calculation.
Average receivables is calculated by adding the beginning and ending receivables for the year and dividing by two. In a sense, this is a rough calculation of the average receivables for the year.
Example
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Babu's Ski Shop is a retail store that sells outdoor skiing equipment. Babu offers accounts to all of his main customers. At the end of the year, Babu's balance sheet shows 20,000 in accounts receivable, 75,000 of gross credit sales, and 25,000 of returns. Last year's balance sheet showed 10,000 of accounts receivable. Find the Accounts Receivable Turnover Ratio.
The first thing we need to do in order to calculate Babu's turnover is to calculate net credit sales and average accounts receivable. Net credit sales equals gross credit sales minus returns (75,000 – 25,000 = 50,000). Average accounts receivable can be calculated by averaging beginning and ending accounts receivable balances ((10,000 + 20,000) / 2 = 15,000).
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
= 50000 / 15000
= 3.33
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Asset Turnover Ratio or Total Asset Turnover Ratio
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The asset turnover ratio is an efficiency ratio that measures a company's ability to generate sales from its assets by comparing net sales with average total assets. In other words, this ratio shows how efficiently a company can use its assets to generate sales.
The total asset turnover ratio calculates net sales as a percentage of assets to show how many sales are generated from each dollar of company assets. For instance, a ratio of .5 means that each dollar of assets generates 50 cents of sales.
The asset turnover ratio is calculated by dividing net sales by average total assets.
Formula
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Asset Turnover Ratio or Total Asset Turnover Ratio = Net Sales / Average Total Assets
Example
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Seela's Tech Company is a tech start up company that manufactures a new tablet computer. Seela is currently looking for new investors and has a meeting with an angel investor. The investor wants to know how well Seela uses her assets to produce sales, so he asks for her financial statements.
Here is what the financial statements reported:
Beginning Assets: 50,000
Ending Assets: 1,00,000
Net Sales: 25,000
The total asset turnover ratio is ......
Asset Turnover Ratio or Total Asset Turnover Ratio = Net Sales / Average Total Assets
= 25000 / ((50000+100000)/2)
= 25000 / (150000/2)
= 25000 / 75000
= 0.33
As you can see, Seela's ratio is only 0.33. This means that for every Rupee in assets, Sally only generates 33 Paisa. In other words, Seela's start up is not very efficient with its use of assets.
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Inventory Turnover Ratio
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The inventory turnover ratio is an efficiency ratio that shows how effectively inventory is managed by comparing cost of goods sold with average inventory for a period. This measures how many times average inventory is "turned" or sold during a period. In other words, it measures how many times a company sold its total average inventory dollar amount during the year.
This ratio is important because total turnover depends on two main components of performance. The first component is stock purchasing. If larger amounts of inventory are purchased during the year, the company will have to sell greater amounts of inventory to improve its turnover. If the company can't sell these greater amounts of inventory, it will incur storage costs and other holding costs.
The second component is sales. Sales have to match inventory purchases otherwise the inventory will not turn effectively. That's why the purchasing and sales departments must be in tune with each other.
The inventory turnover ratio is calculated by dividing the cost of goods sold for a period by the average inventory for that period.
Formula
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Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Example
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Govind's Furniture Company sells industrial furniture for office buildings. During the current year, Govind reported cost of goods sold on its income statement of 10,00,000. Govind's beginning inventory was 30,00,000 and its ending inventory was 40,00,000. Govind's turnover is ......
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
= 1000000 / ((3000000+4000000)/2)
= 1000000 / (7000000/2)
= 1000000 / 3500000
= 0.29 Times
This means that Govind only sold roughly a third of its inventory during the year. It also implies that it would take Govind approximately 3 years to sell his entire inventory or complete one turn. In other words, Govind does not have very good inventory control.
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Days' sales in Inventory Ratio
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The days sales in inventory calculation, also called days inventory outstanding or simply days in inventory, measures the number of days it will take a company to sell all of its inventory. In other words, the days sales in inventory ratio shows how many days a company's current stock of inventory will last.
This is an important to creditors and investors for three main reasons. It measures value, liquidity, and cash flows. Both investors and creditors want to know how valuable a company's inventory is. Older, more obsolete inventory is always worth less than current, fresh inventory. The days sales in inventory shows how fast the company is moving its inventory. In other words, it shows how fresh the inventory is.
This calculation also shows the liquidity of inventory. Shorter days inventory outstanding means the company can convert its inventory into cash sooner. In other words, the inventory is extremely liquid.
Along the same line, more liquid inventory means the company's cash flows will be better.
The days sales inventory is calculated by dividing the ending inventory by the cost of goods sold for the period and multiplying it by 365.
Formula
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Days' sales in Inventory Ratio = (Ending Inventory / Cost of Goods Sold) * 365
Example
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Ambica's Furniture Company's management have been extremely happy with their sales staff because they have been moving more inventory this year than in any previous year. At the end of the year, Ambica's financial statements show an ending inventory of 50,000 and a cost of good sold of 1,50,000. Ambica's days sales in inventory is ......
Days' sales in Inventory Ratio = (Ending Inventory / Cost of Goods Sold) * 365
= (50000/150000) * 365
= 122
This means Ambica has enough inventories to last the next 122 days or Ambica will turn his inventory into cash in the next 122 days.
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Profitability Ratios
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Profitability ratios compare income statement accounts and categories to show a company's ability to generate profits from its operations. Profitability ratios focus on a company's return on investment in inventory and other assets. These ratios basically show how well companies can achieve profits from their operations.
Investors and creditors can use profitability ratios to judge a company's return on investment based on its relative level of resources and assets. In other words, profitability ratios can be used to judge whether companies are making enough operational profit from their assets. In this sense, profitability ratios relate to efficiency ratios because they show how well companies are using thier assets to generate profits. Profitability is also important to the concept of solvency and going concern.
Here are some of the key ratios that investors and creditors consider when judging how profitable a company should be:
Gross Margin Ratio
Profit Margin
Return on Assets
Return on Capital Employed
Return on Equity
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Market Prospect Ratios
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Market Prospect ratios are used to compare publicly traded companies' stock prices with other financial measures like earnings and dividend rates. Investors use market prospect ratios to analyze stock price trends and help figure out a stock's current and future market value.
In other words, market prospect ratios show investors what they should expect to receive from their investment. They might receive future dividends, earnings, or just an appreciated stock value. These ratios are helpful for investors to predict how much stock prices will be in the future based on current earnings and dividend measurements. For instance, a downward trend in earnings per share and dividend yield point to profitability problems and could even raise going concern issues. All of these issues point to a lower stock evaluation.
Here are some of the basic market prospect ratios that investors tend to analyze.
Earnings Per Share
Price Earnings Ratio or P/E Ratio
Dividend Payout Ratio
Dividend Yield
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Financial Leverage Ratios
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Financial leverage ratios, sometimes called equity or debt ratios, measure the value of equity in a company by analyzing its overall debt picture. These ratios either compare debt or equity to assets as well as shares outstanding to measure the true value of the equity in a business.
In other words, the financial leverage ratios measure the overall debt load of a company and compare it with the assets or equity. This shows how much of the company assets belong to the shareholders rather than creditors. When shareholders own a majority of the assets, the company is said to be less leveraged. When creditors own a majority of the assets, the company is considered highly leveraged. All of these measurements are important for investors to understand how risky the capital structure of a company and if it is worth investing in.
Here are the most common financial leverage ratios.
Debt Ratio
Debt to Equity Ratio
Equity Ratio
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Coverage Ratios
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Coverage ratios are comparisons designed to measure a company's ability to pay its liabilities. On the surface, coverage ratios might sound a lot like liquidity and solvency ratios, but there is a distinct difference. Coverage ratios analyze a company's ability to service its debt and other obligations.
In other words, these ratios measure how well companies can afford to make the interest payments associated with their debt. Some ratios also include obligations that are not typical liabilities like regular dividend payments to stockholders.
Here are the main coverage ratios used to analyze companies.
Times Interest Earned Ratio
Fixed Charge Coverage Ratio
Debt Service Coverage Ratio
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Ratio Analysis - 1
LIABILITES
Capital 180
Reserves 20
Term Loan 300
Bank C/C 200
Trade Creditors 50
Provisions 50
Total - 800
ASSETS
Net Fixed Assets 400
Inventories 150
Cash 50
Receivables 150
Goodwill 50
Total - 800
a. Net Worth ......
b. Tangible Net Worth is ......
c. Outside Liabilities ......
d. Net Working Capital ......
e. Current Ratio ......
f. Quick Ratio ......
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Ratio Analysis - 2
LIABILITIES 2005-06 2006-07
Capital 300 350
Reserves 140 160
Bank Term Loan 320 280
Bank CC (Hyp) 490 580
Unsec.Long T L 150 170
Creditors (RM) 120 70
Bills Payable 40 80
Exps Payable 20 30
Provisions 20 40
Total 1600 1760
ASSETS 2005-06 2006-07
Net Fixed Assets 730 750
Security Elect 30 30
Investments 110 110
Raw Materials 150 170
S I P 20 30
Finished Goods 140 170
Cash 30 20
Receivables 310 240
Loans/Advances 30 190
Goodwill 50 50
Total 1600 1760
1. Tangible Net Worth for 1st Year ......
2. Current Ratio for 2nd Year ......
3. Debt Equity Ratio for 1st Year ......
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Ratio Analysis - 3
Raju's Furniture Company sells industrial furniture for office buildings. During the current year, Raju reported cost of goods sold on its income statement of 10,00,000. Raju's beginning inventory was 30,00,000 and its ending inventory was 40,00,000. Calculate Raju's Furniture Company's Inventory Turnover Ratio.
Inventory Turnover Ratio = Cost of goods sold / Average inventory for that period
= 1000000 / ((3000000 + 4000000)/2)
= 100000 / 3500000
= 0.29
Inventory Turnover Ratio
The inventory turnover ratio is calculated by dividing the cost of goods sold for a period by the average inventory for that period.
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