ELEMENTARY FINANCE
- 0N LINE
Chapter 3 Lesson A - More on Accounting Ratios
Introduction of the Host
Mrs.Geetha Dasaraty is a commerce graduate with a Masters in Business Administration specialising in finance. Her stint with a Coimbatore based company and later with a consulting firm in Chennai has provided her with a decade of experience in project finance and appraisals, accounting and tax laws. She is a freelance writer and money matters are her forte. She is currently pursuing her final course in Company Secretaryship and is doing a course on Vaishnavism. She has a passion for literature and Carnatic music. She is also a violinist.
About the Class
We bring you an online class titled 'Elementary Finance'. This will have 12 lessons - one a month. Each lesson is further subdivided into 4 chapters. And we will give you one new chapter every week.
Chapter 3 Lesson A - More on Accounting Ratios
Lenders to any business like financial institutions and other individuals or lending houses would require information on whether the business house will be able to repay the loan instalments, as well as, the interest on the loans. The debt-service coverage ratios help these institutions get such information from the financial statements.
Debt servicing is the ability of the business house to pay the lender the interest and the loan instalments out of the profit.
The profit here means the profit available for debt servicing, which is -
Net profit after tax provision + Depreciation and other non-cash charges + Interest on debts.
Profit available for debt servicing
Debt Service Coverage Ratio = ---------------------------------
Loan instalments + Interest
The higher the coverage ratio, the better is the position of the business house to service its debt.
Turnover Ratios
The turnover ratios or performance ratios show how well the assets of the concern are being utilised. They generally indicate the relationship between assets and liabilities with sales or cost of goods sold.
The various turnover ratios are the following
Assets Turnover
Sales
Assets Turnover ratio = ------------
Total assets
The major components of the Asset Turnover Ratio are :
Sales
Fixed Assets Turnover = -------------
Fixed Assets
This ratio shows how well the fixed assets are being used.
Sales
Working Capital Turnover Ratio = -----------------
Working Capital
This ratio shows the number of times a unit invested in working capital produces sales.
Returns
Return on Capital Employed = ------------------ x 100
Capital Employed
If the assets turnover is more than one, the profitability based on the capital employed is more than the profitability based on sales.
Inventory Turnover or Stock Turnover Ratio
The inventory turnover ratio helps the concern maintain an optimum balance between running out of goods to sell and investing in a huge inventory.
This ratio is calculated for finished goods, work-in-progress and for raw material.
Cost of goods sold
Inventory turnover for Finished Goods = --------------------
Average Inventory
Where the average inventory is the average of the opening and closing inventories.
Cost of production
Inventory turnover for work-in-progress = --------------------
Average inventory
Where cost of production = Opening Work in progress + Raw materials consumed + Direct wages + production expenses - closing work in progress.
Raw materials consumed
Inventory turnover for raw materials = --------------------------
Average inventory
Where raw material consumed = Opening stock of raw materials + Purchases - Closing stock of raw materials.
A high inventory turnover ratio shows that the inventory is managed efficiently, but this also depends on the type of industry.
Debtors Turnover Ratio
This ratio establishes the relationship between credit sales and accounts receivable. The debtors turnover ratio is a comparison of the size of the firm'' sales and the size of its uncollected bills from the customers.
Credit sales
Debtors Turnover = -----------------
Average debtors
The higher the debtors' turnover, the lower is the credit period offered to customers.
If the firm is having difficulty collecting its money it has a large receivables balance and a low ratio. If the concern has a strict credit policy and an aggressive collection procedure, it has a low receivables balance and a high ratio.
Average Collection Period
365
Average collection period = ------------------
Debtors Turnover
Creditors Turnover Ratio
This ratio indicates the credit period enjoyed by the firm from its suppliers.
Credit Purchases
Creditors Turnover Ratio = ------------------
Average Creditors
365
Average Payment Period = ------------------
Creditors Turnover
Or Average Creditors
-----------------------
Daily Credit Purchases
The higher the turnover the lower the credit period offered by the suppliers.
Operating and Financial Leverages
Operating Leverage is the tendency of the net income to vary disproportionately with sales.
Contribution
Operating Leverage = -------------
Net Income
Where contribution is sales less variable costs.
A low operating leverage implies greater safety.
Financial Leverage
Financial leverage is the tendency of residual net income to vary disproportionately with net income. This depends upon the proportion of fixed charges namely interest to net income.
Earnings before tax
Financial Leverage = --------------------------------
Earnings before interest and tax
The higher the proportion of fixed charges to net income, the higher the financial leverage. A higher financial leverage implies more profit for equity funds.
An ideal combination is a low operating leverage together with a high financial leverage.
Determining Financial Norms
Financial analysis depends on the determination of norms against which an individual business concern can be judged. A few guidelines for the determination of norms are given below:
Industry norms: A business house may be compared against the financial ratios of other firms in the same industry. This will only give a partially satisfactory view because industry norms vary widely from the strongest to the weakest firm in the industry.
Similar Firms: Comparing a firm with similar firms in other industries gives a better insight of the financial condition.
Historical Trends: A firm can be compared with its own performance over a period of time. An increasing trend in profits is a healthy sign and a drop in liquidity is a bad sign.
Future Expectations: The forecasts by economists and analysts can be used for comparison of firms.
Subjective judgement: In addition to the above, an analyst should use subjective judgement.
Usage of profitability, liquidity and ownership ratios together will help give a better financial picture of the business concern. In addition, norms should be established using a combination of the above guidelines.
Financial ratios are an important tool in the interpretation of financial statements and are widely used by shareholders, prospective investors, lenders and the management for decision making. These ratios are an effective tool in budgeting.
Questions on Lesson 2 (d)
1. From the following figures calculate the current ratio of the concern.
Debtors 20,000 Creditors 6,000
Stock 15,000 Outstanding Expenses 1,500
Cash 4,000 Proposed dividend 3,000
Prepaid expenses 1,000 Provision for taxation 2,000
2. From the following calculate the debt -equity ratio.
Preference share capital 4,00,000
12% debentures 2,00,000
Equity share capital 2,00,000
General reserve 40,000
Profit and loss a/c 50,000
Preliminary expenses 30,000