Ratio Analysis || 243

Practical Questions
hired as an analyst for Mayers Bank and your team is working on
fou have beenD an independent
assessment of DDF Enterprises Ltd. DDF Enterprises is afirm that
specializes in the production of
freshlyimported farm products from Sri Lanka. Your assistant has provided you with the following
data and along with the industry averages:
Ratio 2013 2012 2011 2013
Industry Average
Long-termmdebt 0.45 0.40 0.35 0.35
|Inventory Turnover 62.65 42.42 32.25 53.25
Depreciation / Total Assets 0.25 0.014 0.018 0.015
Days' sales in receivables 113 98 94 130.25
Debt to Equity 0.75 0.85 0.90 0.88
Profit Margin 0.082 0.07 0.06 0.075
Total Asset Turnover 0.54 0.65 0.70 0.40
Quick Ratio 1.028 1.03 1.029 1.031
Current Ratio 1.33 1.21 1.15 1.25

(a) You are required to comment on the liquidity portion of the firm with reference to the
information given in the table.
(b) What can you say about the firmis asset management? Be as complete as possible given the
above information.
(c) You are asked to provide the shareholders with an assessment of the firm's solvency and
leverage.
Solution:
(a) The liquidity position will be assessed using current ratio and quick ratio. The current ratio
has steadily increased over the three years. Quick ratio has increased from 2011 to 2012
but decreased in the current year. The quick ratio is very close to the industry level whereas
the current ratio is higher. This difference seems to have come from inventories which has
increased the liquidity.
(D) Firm asset management will be analysed using Inventory turnover, days sales in receivables, and
the total asset turnover ratio. Inventory turnover has increased over time and is now above the
industry average. This is good - especially given the fresh food nature of the firms industry. In
2013, it means for example that every 365/62.65 =5.9 days the firm is able to sellits inventories
as opposed to the industry average of 6.9 days. Days' sales in receivables has gone down over
time, but is stillbetter than the industry average. So, while they are able to turn inventories
around quickly, they seem to have more trouble collecting on these sales, although they are
doing better than the industry. Finally, total asset turnover has went down over time, but it is
Stl higher than the industry average. It does tell us something about apotential problem in the
firm's long term investments, but again, they are still doing better than the industry.
 244 || Financial Reporting and Analysis

(c) Solvency and leverageis captured by an analysis of thecapitalstructure ofthe firm and thesfirm's
ability to payinterest. Capital structure: Both the equity multiplier and the
debt-to-equity
ratio
tell us that the firm has become les levered. To get a better idea about the proportion ofdat
in the firm, we can turn the D/E ratio into the D/V ratio: 2013: 43%, 2012: 46%, 2011:47%. anA
the industry-average is 47%. So based on this, we would like to know why this is
happening
and whether this is good or bad. From the numbers it is hard to give a qualitative judgement
beyond observing the drop in leverage. However, the number of times interest earned uses
EBIT as a proxy for the ability to pay for interest, while we know that we should probabb
consider cash flow instead of earnings.
Acompany has aprofit margin of 20% and asset turnover of 3times. What is the company's return
on investment? How will this return on investment vary if? (i) Profit margin is increased by 5%?
(ii) Asset turnover is decreased to 2 times? (iii) Profit margin is decreased by 5% and asset turnover
is increase to 4 times?
Solution:
Net profit ratio = 20% (given)
Assets turnover ratio = 3 times (given)
N
A
Return on Investment = Net Profit after investment and tax/Total Assets
Net profit ratio = Net profit (after interest and taxes) /Turnover
Asset turnover = Turnover/Total assets
Return on Investment (ROI) = Net profit ratio x Assets turnover ratio = 20% x3 times = 60%
(i) If net profit ratio is increased by 5%. Then Revised Net Profit
Ratio = 20 + 5 = 25% Asset
Turnover Ratio (as before) = 3 times. .. ROI= 25 % x 3 times = 75%.
(ii) If assets turnover ratio is decreased to 2 times: NP Ratio (as
before) = 20% Revised Asset
Turnover Ratio = 2 times. .. ROI = 20% >x 2 times = 40%.
(iii) Ifnet profit ratio falls by 5% and assets turnover ratio
= 20 - 5 = 15% Revised Asset Turnover Ratio = 4
raises to 4 times: Then Revised NP Ratio
times. .. ROI = 15% x 4= 60%
ABC Company sells plumbing fixtures on terms of 2/10, net
the firm, it means that 30 days credit period is being offered to 30. (This reflects the credit policy ot
able to make the payment within ten days of sales, he would bethe customers; and if any customer is
statements over the last 3 years are as follows: offered a 2% discount). Its financial
2011 2012 2013
() )
Cash )
30,000
20,000 5,000
Accounts receivable 2,00,000 2,60,000 2,90,000
Inventory 4,00,000 4,80,000
Net fixed assets 6,00,000
8,00,000 8,00,000 8,00,000
14,30,000 15,60.000 16.95,000
 Ratio Analysis || 245
2011
2012 2013
() ()
Accounts payable 2,30,000 3,00,000 3,80,000
Accruals 2,00,000 2,10,000 2,25,000
Bank loan, short-term 1,00,000 1,00,000 1,40,000
Long-ternm debt 3,00,000 3,00,000 3,00,000
Common stock 1,00,000 1,00,000 1,00,000
Retained earnings 5,00,000 5,50,000 5.50,000
14,30,000 15,60,000 16,95,000
Sales 40,00,000 43,00,000 38,00,000
Cost of Goods sold 32,00,000 36,00,000 33,00,000
Net Profit\ 3,00,000 2,00,000 1,00,000
Analyse the company's financial condition and performance over the last 3 years. Are there any
problems?
Solution:
2/10 net 30 means a discount for payment within 10days. The purpose of this is to shorten accounts
receivable cycles for those who provide credit terms. This is essential when vendors have accounts
receivable turnover cycles which exist longer than preferred. Abusiness that offers a 2/10 net 30
discount is expressing that it is more important to have cash as quickly as possible than it is to have
the full amount of their payable.
2011 2012 2013

Current ratio 1.19 1.25 1.20

Acid-test ratio 0.43 0.46 0.40

Average collection period 18 22 27

Inventory turnover NA* 8.2 6.1

Total debt to net worth 1.38 1.40 1.61

0.32
Long-term debt to total 0.33 0.32
capitalization
0.132
Gross profit margin 0.200 0.163

Net proft margin 0.075 0.047 0.026

2.24
Asset turnover 2.80 2.76
0.13 0.06
Return on assetS 0.21
should refer to the
(All the ratios calculated in the table are discussed in the chapter. Students
formulae while computing).
Analysis:
The company's profitability has declined steadily over the period. As only 50,000 is added to
retained earnings.
 246 || Financial Reporting and Analysis

period is still
Receivables are growing slower, although the average collection very
relative to the terms given. reasonable
Inventory turnover is slowing as well, indicating a relative buildup in inventories.
The current and acid-test ratios have fluctuated, but the current. The lack of deterioration in
these ratios is clouded by the relative build up in both receivables and inventories,
deterioration in the liquidity of these two assets. evidenci
The relationship betwe
ng
Both the gross profit and net profit margins have declined substantially.
the two suggests that the company has reduced relative expenses in 2012 in particular.
The build-up in inventories and receivables has resulted in a decline in the asset turnover ratio,
and this, coupled with the decline in profitability, has resulted in asharp decrease in the return on
assets ratio.

Interpretation:
The current ratio calculated above indicates a low current ratio. This suggests that the business is
not well placed to pay its debts. It might be required to raise extra finance or extend the time it
takes to pay creditors. However, one should not conclude the final position only the basis of asingle
ratio. Another point to be highlighted here is that we are considering only the quantity and not the
quality of assets to interpret the liquidity position of XLtd. We shall be discussing the various other
ratios in detail in further course.

Q4/ ABC Ltd has made the following estimations for the next year:
Total assets employed 10,00,000
Borrowed capital 4,00,000
Interest rate on borrowed capital 10% p.a.
Gross profit ratio 25% on sales
Direct cost ?1,00,000
Other operating expenses 50,000
Sales revenue 350% on direct cost
Tax rate 30%
Compute:
(i) Net profit margin
(ii) Return on assets
(iii) Asset turnover ratio
(iv) ROE
Solution:
Statement of profit
Particulars
Sales (350% on direct cost)
3,50,000
Less: Direct cost
1,00,000
Gross profit 2,50,000
 Ratio Analysis || 247

/Particulars 3)
Les: Operatingexpenses
60,000
Profit/Earningsbefore interest and taxes (PBIT/EBIT)
1,90,000
Interest(10%
Less:.
on 74,00,000) 40,000 1,50,000
Proft/Earning before taxes (PBT/EBT) 1,00,000
40%
Less: Tax @ 40,000
(PAT/EAT)
Profit/ Earnings after tax 60,000

(0) Net profit margin

PAT 760,000
= 0.1714 or 17.19%
Sales 3,50,000

(iü) Return on assets

(EBIT (1 -T)) R1,90,000 (1 -0.40)]
= 0.3257 or 32.57%
Sales {3,50,000
(iiü) Asset turnover ratio
Sales 3,50,000
= 0.35 or 35%
Assets }10,00, 000
(iv) ROE
PAT R60,000
=0.10 or 10%
6,00,000
Owners'equity
(V) Owner's equity = Total assets - Borrowed fund
-10,00,000 -74,00,000
=6,00,000
yntexLLP financial statements contain the following information:
31.03.2012 31.03.2013
2,00,000 1,60,000
Cash
3,20,000 4,00,000
Sundry debtors 3,20,000
2,00,000
Investments 18,40,000 21,60,000
Stock 12,000
28,000
Prepaid expenses
Total Current Assets 25,88,000 30,52,000
8,00,000
Current Liabilities 6,40,000
15,00,000
10% debentures 15,00,000
20,00,000
Equity Share Capital 20,00,000
8,12,000
Retained Earnings 4,68,000
 248 || Financial Reporting and Analysis

Statement of Profit and Loss for the year ended 31.03.2013

Sales 40,00,000
Les: cost of goods sold 28,00,000
Less: interest 1,60,000
Net profit 10,40,000
Less: taxes 5,20,000
Profit after taxes 5,20,000
Dividend declared on equity shares 2,20,000

From the albove appraise the financial position in terms of :

1. Liquidity
2. Profitability
Solution:
(i) Liquidity:
2011-12 2012-13
Current Ratio = Current Assets /Current 25,88,000 /6,40,000 30,52,000 /8,00,000
Liabilities
4.04 3.81
Acid Test Ratio =Quick assets / Current
7,20,000/6,40,000 8,80,000/8,00,000
Liabilities
1.13 1.10
(iü) Profitability
(a) Gross Profit Ratio
Gross Profit
x100 = 12,00,000 x 100 = 30%
Sales 40,00,000
(b) Net Profit Ratio
Net Profit 5,20,000
x 100 = x100 = 13%
Sales 40, 00, 000
(c) Return on capital employed
Net profit before interest and taxes
x100
Capital employed
12,00,000
15,00,000 + 20,00,000 + 8, 12, 000
12,00,000
= 27.82%
43,12,000
 Ratio Analysis || 249

Analysis: exhibits.sound position in terms of liquidity and profitability. There is a

company decrease in
Theoverallliquidly position when compared to last year, it still remains in a positive position.
the
has made plans
for the next
year. It is estimated that the company will employ total assets
x Co. per cent of the being financed borrowed capital at an interest of 8
asets by cost
of 8, 00,000; 50
Percent peryear. The direct costs for the year are estimated at 4, 80,000 and all other operating
expenses are estimated at 80,000. The goods will be sold to customers at 150 per cent of the direct
assumed to be 50 per cent.
COsts. Tax rateis
s are required to calculate: (1) net proht margin; (ii) return on assets; (iii) assets turnover and
equity.
(iv) return on owners'
Solution:
follows:
The net profit is calculated as
Particulars
7,20,000
Sales (150% of 74, 80,000)
Less: Direct costs
4,80,000
2,40,000
Gross profit
80,000
Less: Operating expenses
32,000
Less: Interest charges (8% of 4, 00,000)
1,28,000
Profit before taxes
64,000
Less: Taxes (@ 50%) 64,000
Net profit after taxes
(i) Net Profit Margin
Profit after taxes 64,000 x 100 = 0.089 or 8.9%
x 100 =
Sales 77,20,000
(ii) Return on Assets
EBIT (1-T) 1,60,000(1-0.5) =0.10 or 10%
Assets 8,00,000
(ii) Assets Turnover
Sales 7,20,000 = 0.9 times
Assets 78,00,000
(iv) Return on Equity
Net profit after taxes
Owner's equity
64,000 (64,000 = 0.16 or 16%
50% of 8,00,000 74,00,000
 250 || Financial Reporting and Analysis
Q7. From the following information you are asked to prepare a Balance sheet:
Particulars (in )
1. Current liabilities
1,00,000
2. Reserves and surplus 50,000
3. Bills payable 40,000
4. Debtors 35,000
5. Current ratio 1.75
6. Acid test ratio 1.15
7. Fixed assets to proprietors fund 0.75
8. Ratio of fixed assets to current assets

Solution: Balance Sheet

Liabilities Amount () Assets Amount ()
Share capital 65,0000 Fixed assets 5,25,000
Reserves and surplus 50,000 Current assets
Current liabilities Stock 60,000
Sundry creditors 60,000 Debtors 35,000
Bills payable 40,000 Cash 8,00,000
Miscellaneous
Expenditure (bal. figl 1,00,000
8,00,000 8,00,000
1. Current Assets
Current Assets
Current Ratio = -=1.75
Current Liabilities
Current assets = 1.75 x Current Liabilities = 1.75 x 100000 = 175000
2. Liquid Assets
Acid Test Ratio = Liquid Assets
=1.15
Current Liabilities
Liquid Assets = 1.15 x Current Liabilities = 1.15 x 100000 = 115000
3. Stock
Stock = Current assets - Liquid Assets
= 175000- 115000 = 60000
4. Cash balance Current assets - (Stock +
Debtors]
= 1750000 - (60000 + 35000] = 80000
5. Fixed Assets
Ratio of fixed assets to current assets = Fixed Assets
=3
Fixed assets = 3 x Current assets =3x Current Assets
175000 = 525000
 Ratio Analysis || 251l
AProprietorsFunds
Fixed ASsets
proprietorsfunds =0.75
Fixedassetsto Proprietors Funds
Fixed assets 5,25,000
ProprietorsFunds= =7,00,000
0.75 0.75
ShareCapital
Prop.Fund= Share
Capital + Reserves and Surplus
Funds - Reserves and Surplus = 700000 - 50000 =650000
Sharecapital = Prop.
Sundry creditors = Current liabilities - Bills payable
= 60000
=100000- 40000
9. Miscellaneous Expenditure
Ralance on the asset side of balance sheet may be treated as miscellaneous expenditure.
From the following Balance Sheet and Income Statement, compute and analyse different ratios for
the current year.
Balance Sheet
Current year Previous year
Assets
105 195
Cash and marketable securities
205 195
Receivables
310 290
Inventories
620 580
Total current assets
51,700
Gross property, plant, and equipment 1,800
360 340
Accumulated depreciation
2060 1,940
Total assets
Liabilities
90
110
Payables 140
160
Short-term debt 45
55
Current portion of long-term debt 275
325
Current liabilities 690
610
Long-term debt 105
95
Deferred debt 300
300
Common stock at per 400
400
Additional paid in capital 320
180
Retain earnings 1,020
880
Common shareholders equity 2,060 1,940
Total liabilities and
equity
 252 || Financial Reporting and Analysis

Example Income Statement

Particular Current year
Sale 4,000
Cost of goods sold 3,000
Gross profit 1,000
Operating expenses 650
Operating profit 350
Interest expanse 50
Earnings before taxes 300
Taxes 100
Net income 200
Common dividends 60

Financial Ratio Template

Current Year Last Year Industry
Current ratio 2.1 1.5
Quick ratio 1.1 0.9
Days of sales outstanding 18.9 18.0
Inventory turnover 10.7 12.0
Total asset turnover
2.3 2.4
Working capital turnover 27.4% 29.3%
Gross Profit margin 5.8% 6.5%
Net Profit margin 21.1% 22.4%
Return on total capital
24.1% 19.8%
Debt-to-equity 99.4% 35.7%
Interest coverage 5.9 9.2
Solution:
" Current ratio= Current assets
Current liabilities
620
Current ratio = =1.9
325
The current rationindicates lower liquidity levels when compared to last year
than the industry average. and more liquidity
" Quick ratio = Cash + Receivables + Marketable securities
Current liabilities
 Ratio Analysis || 253
(105+ 205)
=0.95
(Uik
ratio
= 325

ratioislower than
last year and is in line with the industry average.
quick
Ihe 365
(days ofsales outstanding) = Revenue/ Average receivables
DSO
365 -=18.25
DSO= 4,000/((205 + 195)/2]

a bit lower relative to the company's past performance but slightly higher than the
The DSOis
industryaverage.
Cost of goods sold
Inventoryturnover
Average inventories
3,000
Inventory turnover = =10.0
(310+ 290)/2
Inventory turnover is much lower than last year and the industry average. This suggests that the
stock.
company is not managing inventory efficiently and may have obsolete
Revenue
Total asset turnover=
Average assets
4,000
Total asset turnover = =2.0
(2,060 +1,940)/2
lotal asset turnover is slightly lower than last year and the industry average.
Revenue
" Working capital turnover =
Average working capital
Seginning working capital =580 - 275 =305
Ending working capital = 620 - 325 = 295
Working capital turnover = 4,000 =13.3
(305 + 295)/2
average.
turnover is lower than last year, but still above the industry
"
WorGrosskingCapital Gross profit
profit margin=
Revenue
Gross profit 1,000
margin =
4,000
-=25.0%
The gross profit margin is lower than last year and much lower than the industry average.

Net profit margin Net income

Revenue
 254 | Financial Reporting and Analysis

200
Net profit margin = 4,000 =5.0%

Ten net profit margin is lower than last year and much lower than the industry averans
EBIT
" Return on total capital =
Short and long-term debt + Equity
Beginning total capital = 140 + 45 + 690 880 = 1,755
Ending total capital = 160 + 55 + 610 1,020 = 1,845
350
Return on total capital =
(1,755 + 1,845)/2 -=19.4%
The return on total capital is below last year and
below the industry average. This suggests a problem
stemming from the low asset turnover and low profit margin.
" Net income - Preferred dividends
Return on common equity =
Average common equity
200
Return on common equity = =21.1%
(1,020+ 880)/2
The return on equity is lower than last year but
better than the industry average. The reason it is
higher than the industry average is probably because of greater use of leverage.
Total debt
Debt-to-equity ratio =
Total equity
610+160 +55
Debt-to-equity ratio= 1,020
=80.9%

Note that preferred equity would be included in the

have included short-term debt and the current denominator if there were any, and that we
(interest-bearing) debt. portion of long-term debt in calculating total
The debt-to-equity ration is lower than last
This suggests the company is trying to get its year but still much higher than the
industry averag
debt level more in line with the industry.
" Interest coverage = EBIT
Interest payments
350
Interestcoverage= 50
=7.0

The interest coverage is better than

with the slip in profit margin and last year but still worse than the industry average. This, a
return on assets, might cause
some concern.
Receivable
turnoverAcid-test
(times)
Working ratio
Current of
P.6.6
the
Particulars
company'sFrom
capital ratio
the
(per
turnover
cent) financialratios
and
(times)
condition: other

data

set
foh

below

for
the
302 Year 3
99
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ACCessones

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110 278 Year 2
8.41 3.00 indcate

your
interpetatxn
Year 1
(Contd) 155 265
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he otonciusion, debts average of ner 7 other profit expenses
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d
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ngths
any'sand shares. in
consistent to 2 (Rs) to worthshare
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indicated The year the protitability net in the (per salesnetcent)the net
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trend of they EPS ratio sales yearprotit (per yearsales
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fo r gone the (c) from cent)
for in is in of in inferences:
position inincreased realise that due of fromfinancial
the the unlikely year year company, decrease 30
the
the (ii)in th e ratio up increase
excessive for by
Supreme
esses Supreme
as expenses
The company 3 from inthe
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asfrom year condition
has extending payment. Though, to following:
in
commendable
in and excessive from
in policy the
encounter
compared another in
working not as than 22 70 sales rate to1
Plastic fixed
shown
ratioratio. 37
from appears to to
become the 50 73 of 27
credit days50 to 25 110
and relevant from
return per
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shown investment in per to 2.0 3 2.5 5.41
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ompany. consistent
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so in serious be cent. on Accessories
nalysis.
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particularly bad likelyto
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current customers collection of
1difficulty is worth
and that as inventory There has 1 3,
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clear 7.2 declined year from (b) Ltd. 100 43
its it have a increase expenses 5.09 18.0 3
71 16 23 4.05 6.01
8.5
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also period. decrease as
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in has 1 the has
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is in in