Financial Analysis

Two limitations of financial ratio analysis:

1. Ignores qualitative factors — ratios are based only on figures from the financial statements and ignore non-financial aspects such as management quality, employee morale, brand value and market conditions.

2. Affected by window dressing and differing accounting policies — figures can be manipulated (window dressing) to show a better position, and different firms following different accounting methods make comparison misleading.

Working notes

• Current assets = 1,00,000 + 2,00,000 + 40,000 + 60,000 = Rs 4,00,000
• Current liabilities = 50,000 + 30,000 + 20,000 = Rs 1,00,000
• Quick assets = 4,00,000 − 1,00,000 (stock) = Rs 3,00,000
• Shareholders' equity = 4,00,000 + 3,00,000 = Rs 7,00,000
• Capital employed = Total assets − Current liabilities = 9,00,000 − 1,00,000 = Rs 8,00,000

(a) Current ratio

$\frac{\text{Current assets}}{\text{Current liabilities}} = \frac{4{,}00{,}000}{1{,}00{,}000} = 4:1$

(b) Quick ratio

$\frac{\text{Quick assets}}{\text{Current liabilities}} = \frac{3{,}00{,}000}{1{,}00{,}000} = 3:1$

(c) Debt-equity ratio (long-term debt = loan)

$\frac{\text{Long-term debt}}{\text{Shareholders' equity}} = \frac{1{,}00{,}000}{7{,}00{,}000} = 0.143:1 \;(1:7)$

(d) Net profit ratio

$\frac{\text{Net profit}}{\text{Sales}} \times 100 = \frac{2{,}40{,}000}{6{,}00{,}000} \times 100 = 40\%$

(e) Return on total assets

$\frac{\text{Net profit}}{\text{Total assets}} \times 100 = \frac{2{,}40{,}000}{9{,}00{,}000} \times 100 = 26.67\%$

(f) Return on total capital (capital employed)

$\frac{\text{Net profit}}{\text{Capital employed}} \times 100 = \frac{2{,}40{,}000}{8{,}00{,}000} \times 100 = 30\%$

(g) Debtors turnover ratio (all sales taken as credit sales, closing debtors as average)

$\frac{\text{Credit sales}}{\text{Debtors}} = \frac{6{,}00{,}000}{2{,}00{,}000} = 3 \text{ times}$

(h) Days sales outstanding

$\frac{360}{3} = 120 \text{ days}$

Fixed assets turnover ratio is a turnover (activity) ratio that measures the efficiency with which a firm uses its fixed assets to generate sales. It is computed as:

$\text{Fixed Assets Turnover Ratio} = \frac{\text{Net Sales}}{\text{Net Fixed Assets}}$

A higher ratio indicates better utilisation of fixed assets in generating sales revenue.

Working Notes:

• Current Assets = Cash + Debtors + Stock
  = Rs. 1,00,000 + Rs. 2,00,000 + Rs. 50,000 = Rs. 3,50,000

• Current Liabilities = Creditors + Overdraft
  = Rs. 80,000 + Rs. 1,20,000 = Rs. 2,00,000

• Liquid Assets = Current Assets – Stock
  = Rs. 3,50,000 – Rs. 50,000 = Rs. 3,00,000

• Shareholders’ Fund = Capital + Retained Earnings
  = Rs. 3,00,000 + Rs. 1,50,000 = Rs. 4,50,000

• Capital Employed = Total Assets – Current Liabilities
  = Rs. 7,50,000 – Rs. 2,00,000 = Rs. 5,50,000
  (or Shareholders’ Fund + Debenture = Rs. 4,50,000 + Rs. 1,00,000 = Rs. 5,50,000)

Computation of Ratios:

Note: Inventory Turnover Ratio has been computed using Sales in place of Cost of Goods Sold, as COGS is not given in the question.

Current ratio is determined to measure a firm's short-term liquidity (solvency) position — that is, to know whether its current assets are sufficient to pay off its current liabilities as and when they fall due.

Given: Current assets Rs 4,50,000 (inventory Rs 80,000, cash Rs 20,000); creditors (current liabilities) Rs 1,00,000; bank loan (long-term debt) Rs 2,00,000; equity = 5,00,000 + 2,50,000 = Rs 7,50,000; total assets Rs 10,50,000; net profit Rs 1,20,000; sales Rs 18,00,000.

(a) Liquid ratio

Liquid assets = 4,50,000 − 80,000 = Rs 3,70,000

$\frac{3{,}70{,}000}{1{,}00{,}000} = 3.7:1$

(b) Debt-equity ratio

$\frac{2{,}00{,}000}{7{,}50{,}000} = 0.27:1$

(h) Gross profit (margin 40%, needed for part c)

$40\% \times 18{,}00{,}000 = \text{Rs } 7{,}20{,}000$

(c) Inventory turnover ratio

Cost of goods sold = 18,00,000 − 7,20,000 = Rs 10,80,000 (closing inventory taken as average)

$\frac{10{,}80{,}000}{80{,}000} = 13.5 \text{ times}$

(d) Fixed assets turnover ratio

$\frac{18{,}00{,}000}{6{,}00{,}000} = 3 \text{ times}$

(e) Return on total assets

$\frac{1{,}20{,}000}{10{,}50{,}000} \times 100 = 11.43\%$

(f) Return on equity

$\frac{1{,}20{,}000}{7{,}50{,}000} \times 100 = 16\%$

(g) Net profit ratio

$\frac{1{,}20{,}000}{18{,}00{,}000} \times 100 = 6.67\%$

(h) Gross profit = Rs 7,20,000

Ratio analysis is the technique of calculating and interpreting various financial ratios from the financial statements to evaluate a firm's profitability, liquidity, solvency and efficiency.

(a) Closing stock

$\text{Current assets} = 2.5 \times 80{,}000 = \text{Rs } 2{,}00{,}000$

$\text{Closing stock} = 2{,}00{,}000 - 60{,}000 - 40{,}000 = \textbf{Rs } 1{,}00{,}000$

(b) Quick ratio

$\frac{2{,}00{,}000 - 1{,}00{,}000}{80{,}000} = \mathbf{1.25:1}$

(c) Sales

$\text{Sales} = \frac{80{,}000}{20\%} = \textbf{Rs } 4{,}00{,}000$

(d) Fixed assets turnover ratio

$\frac{4{,}00{,}000}{2{,}00{,}000} = \mathbf{2 \text{ times}}$

(e) Return on fixed assets

$\frac{80{,}000}{2{,}00{,}000} \times 100 = \mathbf{40\%}$

(f) Return on equity

Debt-equity ratio = 50% = 0.5 with debt = debenture Rs 1,00,000, so equity = 1,00,000 ÷ 0.5 = Rs 2,00,000.

$\frac{80{,}000}{2{,}00{,}000} \times 100 = \mathbf{40\%}$

(g) Inventory turnover ratio (cost of goods sold not given, so sales is used)

$\frac{4{,}00{,}000}{1{,}00{,}000} = \mathbf{4 \text{ times}}$

(h) Days sales outstanding

$\frac{40{,}000}{4{,}00{,}000} \times 360 = \mathbf{36 \text{ days}}$