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Chapter(8): Financial Ratios Analysis

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Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

CHAPTER (8)

FINANCIAL RATIOS ANALYSIS

‫تحليل النسب المالية‬

LEARNING OBJECTIVES …..

:‫األهداف التعليمية‬
After reading this chapter, you can certainly be able to
understand the following subjects :

 Liquidity Ratio

 Activity Ratio

 Profitability Ratio

 Solvency Ratio

 Project Evaluation

 Investment Policies

1
Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

CHAPTER (8)
FINANCIAL RATIOS ANALYSIS

‫تحليل النسب المالية‬

(Classification and Interpretation of Ratios )

A ratio analysis is a quantitative analysis of information contained in a

company’s financial statements. Ratio analysis is used to evaluate various aspects
of a company’s operating and financial performance such as its efficiency, liquidity,
profitability and solvency.
 Classification/Types of Ratios ‫ أنواع النسب‬/‫تصنيف‬
 Liquidity Ratios/Solvency Ratios ‫ نسب المالءة‬/‫نسب السيولة‬
 Liquidity ratios refers to the ability of a firm to meet its obligations in short-run,
usually, one year.
 Liquidity ratios are generally based on relationship between current assets
and current liabilities.
 The important liquidity ratios are :
(i) Current ratio, ‫نسبة التداول‬
(ii) Acid Test Ratio, and ‫نسبة السيولة السريعة‬
(iii) Fund Flow Ratio. ‫نسبة التدفق النقدي‬
 Activity Ratios (Turnover Ratios) )‫نسب النشاط ( نسب الدوران‬
 Turnover ratios measure how effectively the assets are employed by the firm.
 These ratios are based on the relationship between level of activity
represented by sales or cost of goods sold and levels of various assets.
 The important turnover ratios are :
1. Inventory Turnover Ratio, ‫نسبة دوران المخزون‬
2. Receivables Turnover Ratio, ‫نسبة دوران الذمم المدينة‬
3. Fixed Assets Turnover Ratio, ‫نسبة دوران الموجودات الثابتة‬

2
Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

4. Average Collection Period Ratio, and ‫معدل فترة التحصيل‬

5. Total Assets Turnover Ratio. ‫نسبة دوران مجموع الموجودات‬
 Profitability Ratios ‫نسب الربحية‬
 Profitability ratios reflects the final result of business operations.
 There are two types of profitability ratios, i.e.
(i) Profit Margin Ratios, and ‫نسب هامش الربح‬
(ii) Rate of Return Ratios. ‫معدل نسب العائد‬
 Profit margin ratios show the relationship between profit and sales.
 The two popular profit margin ratios are gross profit margin ratio, and net
profit margin ratio.
 Solvency Ratios ‫نسب المالءة المالية‬
Solvency ratios are also known as "Liquidity Ratios".
 Miscellaneous Group Ratios ‫نسب المجموعة المتنوعة‬
(1) Balance Sheet Ratios ‫نسب الميزانية العمومية‬
These ratios are classified into the following categories, viz. :
i. Current Ratio ‫نسبة التداول‬
Current ratio indicates the solvency of the business, i.e. abilities to meet the
liabilities of the business as and when they fall due.
Current Assets (CA)
Formula : current ratio =
Current Liabilities (CL)

ii. Proprietary Ratio : ‫نسبة الملكية‬

It is primarily the ratio between proprietor's funds and total assets. It indicates
the strength of the funding of the company.

Proprietor’s Funds
Formula: Proprietary Ratio =
Total Assets

iii. Debt Equity Ratio ‫نسبة حق المديونية‬

 This ratio is calculated to measure the comparative proportions of outsiders
funds and shareholders' funds invested in the company.
 The Debt-Equity Ratio indicates how many Dinars have come from
borrowings for every Dinar of shareholders' funds.

Long−term Debts
Formula: Debt Equity Ratio = Shareholders Funds

3
 Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

 A low debt equity ratio indicates that the management of the firm is following a
very conservative policy which is quite satisfactory from creditors angle.
 A very high debt equity ratio indicates a risky situation as proportion of
borrowed funds is quite high.
(2) Profit and Loss Account Ratios ‫نسب حساب األرباح والخسائر‬
These ratios are classified into the following categories, viz.:
i. Net Profit Ratio ‫نسبة صافي الربح‬
 This ratio shows the earnings left for shareholders (equity and preference) as
a percentage of net sales.
 This ratio measures overall efficiency of all the functions of a business firm
like production, administration, selling, financing, pricing, tax management etc.
 This ratio is very useful for prospective investors as it reveals the overall
profitability of the firm.
 Higher the ratio, the better it is because it gives an idea of overall efficiency of
the firm.
 This ratio is calculated as follows :

Formula :
Net Profit
Net Profit Ratio =Net sales ×100

Example :
Net Profit : 600,000
Net Sales: 6,000,000
600,000
Net Profit Ratio= 6,000,000 =10%

ii. Operating Ratio ‫نسبة التشغيل‬

 Operating Ratio is the relationship between cost of activities and net sales.
 Operating Ratio show at what percentage the operating expenses are
comprised in net sales.
 This Ratio is expressed as a percentage.

4
Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

Formula :
Operating cost
Operating Ratio = ×100
Net sales

(3) Composite Ratios ‫النسب المركبة‬

These ratios are classified into the following categories, viz. :
i. Return on Capital Employed Ratio : ‫نسبة العائد على راس المال المستخدم‬
This ratio indicates the percentage of net profits before interest and tax to total
capital employed.
The capital employed is calculated as follows :
Formula : Capital Employed = Equity Capital (+) Preference Capita! (+) Reserves
and Surplus (+) Long-term Borrowings (-) Fictitious Assets.
This ratio is calculated as follows :
Formula :
Net Profit before Dividend
interest and Finance Charges
Return on Capital Employed Ratio = ×100
Capital Employed

 This ratio is considered to be a very important because it reflects the overall

efficiency with which capital is used.
 This ratio of a particular business should be compared with other business
firms in the same industry to find out the exact position of the business.
ii. Return on Equity Ratio ‫نسبة العائد على حق الملكية‬
 This ratio is also known as Return on shareholders' funds or Return on
proprietor's funds or Return on net worth.
 This ratio indicates the percentage of net profit available for equity
shareholders. In other words, this ratio measures the return only on equity
shareholders' funds and not on total capital employed.
Formula :
Net Profit after Interest
Income Tax and Prefrence Dividend (if any)
Return of Equity = ×100
Equity Shareholders Funds

[Note : Equity Shareholders' Funds = Equity Capital (+) Reserves, retained earnings
and Surplus].

5
Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

This ratio indicates the productivity of the owned funds employed in the firm.
However, in judging the profitability of a firm, it should not be overlooked that during
inflationary periods, the ratio may show an upward trend because the numerator of
the ratio represents current values whereas, the denominator represents historical
values.
iii. Price Earnings Ratio ‫نسبة عوائد (أرباح ) السهم‬
This ratio is calculated with the help of the following formula :

Market Price Per Equity Share

Formula : Price Earnings Ratio = EPS

Example :
If the share price of a company is 240 and EPS is 40, the P/E ratio will be
240
= 6 times. It indicates that the market value of every Dinar of earnings is six times,
40

iv. Dividend Payout Ratio : ‫نسبة توزيع األرباح‬

Dividend payout ratio indicates the percentage of profit distributed as
dividends to the shareholders.
 A higher ratio indicates that the organization is following a liberal policy
regarding the dividend, while a lower ratio indicates a conservative approach
of the management towards the dividend.
 The ratio is calculated as shown below :
Formula :
Dividend Per Equity Share
Dividend Payout Ratio = x 100
EPS

 Project Evaluation ‫تقييم المشروع‬

The following points highlight the top four methods of project evaluation in a
firm. The methods are:
1. Return of Investment (ROI) ‫العائد على االستثمار‬
2. Payback Period Method ‫طريقة فترة االسترداد‬
3. Net Present Value (NPV) ‫صافي القيمة الحالية‬
4. The Internal Rate of Return (IRR). ‫معدل العائد الداخلي‬

6
Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

We will address the method of return on investment as one of the methods

of financial analysis. Other methods are the study of financial management.
‫سوف نتطرق الى طريقة العائد على االستثمار باعتبارها من طرائق التحليل المالي أما الطرائق األخرى فهي‬
. ‫من اختصاص دراسة اإلدارة المالية‬
1. Return of Investment (ROI)
The ratio of profit expected from an investment project and the proposed
investment for the project is called Return on Investment (ROI).

This ROI ratio is used as a criterion for the evaluation of an investment

project. The greater the ROI of a project, the greater is its acceptability. There are
three concepts about the amount of investment on a project. The amount of
investment may mean the amount of assets, amount of capital invested, or the
amount of equity capital. We may obtain three types of ROI on the basis of these
three concepts.
These are:
(i) Return on Assets (ROA) ‫العائد على الموجودات‬
By definition, ROA is the ratio between net profit and the assets. We may
write, therefore,

ROA = net profit excluding taxes ÷ total assets

Here net profit does not include the interest to be paid to the lenders. But,
since interest is included in the real return on total assets, an improved form of ROA
is:

(ii) Return on Capital Employed (ROCE) ‫العائد على راس المال المستخدم‬
ROA = (net profit excluding taxes+ interest paid) ÷ total assets
ROCE is the second type of ROI. Here net profit, excluding tax, is expressed
as a ratio of the total amount of invested capital. The total amount of capital provided
by the owner of the firm and the lenders is the total invested capital in this case.

7
Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

We may have this estimate of capital in two ways

 First, the total amount of invested capital is the sum total of long-term
liabilities and equity of the shareholders.
 Second, invested capital is the summation of the net circulating capital and
fixed assets. Therefore, we may write here:-

𝐧𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭 𝐦𝐢𝐧𝐮𝐬 𝐭𝐚𝐱

ROCE= 𝐭𝐨𝐭𝐚𝐥 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐜𝐚𝐩𝐢𝐭𝐚𝐥

Add the interest paid in net profit and write:

𝐧𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭 𝐦𝐢𝐧𝐮𝐬 𝐭𝐚𝐱+𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐩𝐚𝐢𝐝

ROCE = 𝐭𝐨𝐭𝐚𝐥 𝐢𝐧𝐯𝐞𝐬𝐭𝐞𝐝 𝐜𝐚𝐩𝐢𝐭𝐚𝐥

(iii) Return on Shareholders’ Equity (ROSE) ‫العائد على حقوق المساهمين‬

By definition, a general estimate of ROSE is:

𝐧𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭 𝐦𝐢𝐧𝐮𝐬 𝐭𝐚𝐱

ROSE = 𝐭𝐨𝐭𝐚𝐥 𝐞𝐪𝐮𝐢𝐭𝐲 𝐨𝐟 𝐭𝐡𝐞 𝐬𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬

Now the shares of a company may be of two types: preference shares and
ordinary shares. Here, if the shares are ordinary shares, then we may write:

𝐧𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭 𝐦𝐢𝐧𝐮𝐬 𝐭𝐚𝐱−𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐩𝐚𝐢𝐝 𝐭𝐨 𝐩𝐞𝐫𝐟𝐞𝐫𝐞𝐧𝐜𝐞 𝐬𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬

ROSE = 𝐞𝐪𝐮𝐢𝐭𝐲 𝐨𝐟 𝐭𝐡𝐞 𝐨𝐫𝐝𝐢𝐧𝐚𝐫𝐲 𝐬𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬

We may mention here two more measures of the rate at which the owners of
ordinary shares may obtain return from their company. These two rates of return
are “earning per share” (EPS) and “dividend per share” (DPS).
By definition, we have:-

𝐧𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭 𝐦𝐢𝐧𝐮𝐬 𝐭𝐚𝐱−𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐩𝐚𝐢𝐝 𝐭𝐨 𝐩𝐞𝐫𝐟𝐞𝐫𝐞𝐧𝐜𝐞 𝐬𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬

EPS =
𝐧𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐨𝐫𝐝𝐢𝐧𝐚𝐫𝐲 𝐬𝐡𝐚𝐫𝐞𝐬

𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐩𝐚𝐢𝐝 𝐭𝐨 𝐭𝐡𝐞 𝐨𝐰𝐧𝐞𝐫𝐬 𝐨𝐟 𝐨𝐫𝐝𝐢𝐧𝐚𝐫𝐲 𝐬𝐡𝐚𝐫𝐞𝐬

DPS = 𝐧𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐨𝐫𝐝𝐢𝐧𝐚𝐫𝐲 𝐬𝐡𝐚𝐫𝐞𝐬

8
Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

It may be noted here that the share owners may earn at the rate of EPS only
when the company actually distributes all the money equal to the numerator of the
formula for EPS among the shareholders.

 Investment Policy ‫سياسة االستثمار‬

The investment decisions are to choose the assets on which the money is
being spent. The assets are divided into two parts:
1. Long-term assets: which have an impact over many years.
2. Short-term assets: All assets that can be converted into cash or cash
equivalents during the period and are highly liquid.
Accordingly, asset selection has two aspects:
 The first aspect relates to capital investments.
 The second aspect relates to the management of working capital.
For the capital investments, there are key elements that are involved in
making capital decisions, including the group of assets in the entity and its
composition, the risks related to the entity's business in general, as well as the
theory of measuring the cost of capital.
Working capital management is one of the main tasks of financial
management. It must create a an equilibrium between profitability and liquidity
because of a conflict between the two.
Working capital means the difference between current assets and current
liabilities as in the following equation:
Working capital = Current assets - Current liabilities
If this difference is significant, there is a large amount of money frozen in
current assets that could have been invested in other areas effectively. If the
difference is small or negative, it means that the company is suffering from financial
difficulties, poor financial situation or financial failure. In this case, the entity must
increase its working capital so that it can meet its outstanding obligations during the
financial period. The company will resort to this in a number of ways, including the
introduction of new shares in the market, the increase in current assets or the sale of
part of the fixed assets.

9
‫‪Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis‬‬

‫‪ ‬سياسة االستثمار ‪Investment Policy‬‬

‫تتمثل القرارات االستثمارية في اختيار الموجودات التي يتم إنفاق األموال عليها وتقسم الموجودات إلى‬
‫قسمين ‪:‬‬
‫‪ .1‬موجودات طويلة األجل‪ :‬والتي يكون تأثيرها على مدى سنوات طويلة ‪.‬‬
‫‪ .2‬موجودات قصيرة األجل‪ :‬هي كل الموجودات التي يمكن تحويلها إلى نقدية أو سيولة خالل السنة المالية‬
‫وتتصف بدرجة عالية من السيولة ‪.‬‬
‫وبناءا ً على ذلك فان اختيار الموجودات يكون ذو جانبين ‪:‬‬
‫الجانب األول ‪ :‬يتعلق باالستثمارات الرأسمالية ‪.‬‬
‫الجانب الثاني ‪ :‬يتعلق بإدارة رأس المال العامل ‪.‬‬
‫فيما يتعلق االستثمارات الرأسمالية فإن هنالك عناصر أساسية تدخل في اتخاذ القرارات الرأسمالية ومنها‬
‫مجموعة الموجودات في المنشأة وتكوينها والمخاطر المتعلقة بأعمال المنشأة بشكك عام‪ ،‬كذلك نظرية قياس كلفة‬
‫رأس المال‪.‬‬
‫أما إدارة رأس المال العامل فإنها من المهام الرئيسية لإلدارة المالية‪ ،‬إذ يتعين عليها خلق حالة التوازن بين‬
‫الربحية والسيولة بسب وجود تعارض بين االثنين‪.‬‬
‫يقصد برأس المال العامل الفرق بين الموجودات المتداولة والمطلوبات المتداولة وكما في المعادلة اآلتية ‪:‬‬
‫رأس المال العامل = الموجودات المتداولة ‪ -‬المطلوبات المتداولة‬
‫إذا كان هذا الفرق كبيرا يعني إن هنالك أمواالً كبيرة جمدت في الموجودات المتداولة كان يمكن أن تستثمر‬
‫في مجاالت أخرى بشكل فعال ‪ ،‬أما إذا كان الفرق قليال أو سالبا فأن ذلك يعني إن المنشأة تعاني من العسر المالي أو‬
‫من رداءة الوضع ا لمالي أو الفشل المالي ‪ .‬ويجب على المنشاة في هذه الحالة أن تزيد من رأس المال العامل لكي‬
‫تستطيع تسديد التزاماتها المستحقة خالل الفترة المالية‪ ،‬وتلجأ المنشأة إلى ذلك بإتباع أساليب متعددة ‪ ،‬من ابرزها‬
‫طرح أسهم جديدة في السوق أو زيادة الموجودات المتداولة أو بيع جزء من الموجودات الثابتة وتحويلها إلى سيولة ‪.‬‬

‫‪‬‬ ‫‪Procedures of Investment Policy‬‬ ‫إجراءات سياسة االستثمار‬

‫‪You can increase the value of your business and increase your income by‬‬
‫‪investing the profits from your company. This policy will help you control how profits‬‬
‫‪are invested.‬‬
‫‪‬‬ ‫‪Establishing an Investment Clearing Process‬‬
‫إنشاء عملية توضيح االستثمار‬
‫‪You can set up a procedure for reviewing and approving investments. This‬‬
‫‪procedure should designate who can present investment ideas, who will approve‬‬
‫‪them and who will monitor the profits and losses from investments.‬‬

‫‪10‬‬
Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

 Listing Prudent Investments ‫وضع قائمة باالستثمارات الحكيمة‬

You can avoid making emotional investments by creating a list of the types of
investments you will consider. The "prudent man rule,"( ‫) قاعدة الرجل الحكيم‬which comes
from common law but is endorsed by the Federal Deposit Insurance Corporation,
dictates that each investment must be considered on its own merits.
 Setting Objectives ‫تحديد األهداف‬
Your investment policy should include investment objectives. For example,
you may seek to create income by investing in dividend-paying stocks or interest-
paying bonds.
 Choosing a Strategy ‫اختيار االستراتيجية‬
Your investment policy should lay out a strategy for investing. That means
explaining exactly how and when you will invest.

 Exercises Solved
Exercise No. 1
The following are the summarized Profit and Loss A/c and Balance Sheet of
Zane Ltd. for
Dr. Profit and Loss Account Cr.
Particulars IQD Particulars IQD
To Opening Stock 99,000 By Sales 950,000
To Purchases 545,000 By Closing Stock 150,000
To Freight Inward 16,000
To Gross Profit 440,000
1,100,000 1,100,000
To Operating Expenses 200,000 By Gross Profit 440,000
To Loss on Sale of Asset 40,000. By Non-operating income 60,000
To Net Profit 260,000
500,000 500,000

Balance Sheet
Liabilities IQD Assets IQD
Share Capital 200,000 Land and Building 150,000
Reserve and Surplus 260,000 Plant and Machinery 180,000
Bill Payable 40,000 Stocks 150,000
Other Current Liabilities 90,000 Debtors 45,000
Bills Receivable 5,000
Cash & Bank 60,000
590,000 590,000

11
Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

Requirement: Calculate the following:

1. Gross Profit Ratio.
2. Operating Profit Ratio.
3. Return on Capital Employed.
4. Stock Turnover Ratio.
5. Debtors Turnover Ratio.
6. Current Ratio.
7. Sales to Fixed Assets Ratio.
8. Net Profit to Fixed Assets Ratio.
9. Sales to Capital Employed Ratio.
10. Turnover to Total Assets Ratio.

Solution :
G.P
(1) Gross Profit Ratio = Sales ×100
440,000
= 950,000 ×100

= 46.32 %
Operating Profit
(2) Operating Profit Ratio = ×100
Sales
240,000
= ×100
990,000

= 24.24%
Net Profit
(3) Return on Capital Employed = Capital Employed×100
260,000
= 460,000 (200,000 + 260,000) ×100

= 56.52%
Cost of Goods Sold
(4) Stock Turnover Ratio = Average Stock

510,000
= 124,750

= 4.088
Credit Sales
(5) Debtors Turnover Ratio =Average Debtors (+) Average Bills Receivable
950,000
= 45,000 + 5,000
950.00
= 50,000
= 19
Current Assets
(6) Current Ratio = Current Liabilities
260,000 (150,000 + 45,000 + 5,000 + 60,000)
= 130,000(40,000 + 90,000)
= 2:1
Sales
(7) Sale to Fixed Assets Ratio = Fixed Assets
950,00
= 330,000

12
Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

= 2.88 Times

N.P
(8) Net Profit to Fixed Assets Ratio = Fixed Assets × 𝟏𝟎𝟎
260,000
= 330,000 ×100

= 78.79%
Sales
(9) Sales to Capital Employed Ratio = Capital Employed
950,000
= 460,000
= 2.06
Sales
(10) Turnover to Total Assets Ratio = Total Assets
950,000
= 590,000
= 1.61 Times


Exercise No.2
Betal Manufacturing company submits the following Profit and Loss Account
for the year ended 31st March, 2019.

Dr. Profit and Loss A/c Cr.

Particulars IQD Particulars IQD
By Sales 320,000
By Closing Stock 76,000
To Opening Stock 52,000
To Purchase 160,000

To Wages 48.000
To Manufacturing Expenses 32,000
To Gross Profit c/d 104,000
396,000 396,000
To Selling & Distribute
8,000 By Gross Profit b/d 104,000
Expenses
By Profit on Sale of
To Administrative Expenses 45,600 Shares 9,600
To Loss by Fire 2,400
To Loss on Sale of Furniture 1,600
To Net Profit 56,000
113,600 113,600
Calculate :
1. Gross profit ratio,
2. Net profit ratio,
3. Operating profit ratio,

13
Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

4. Operating net profit ratio.

Solution :
Gross profit
(i) Gross Profit Ratio = × 𝟏𝟎𝟎
Sales
104,000
= 320,000 × 100

= 32.5%
Net Profit
(ii) Net Profit Ratio = × 𝟏𝟎𝟎
Sales
56,000
= 320,000 × 100

= 17.5%
Cost of Goods Sold (+)Operating Expenes
(iii) Operating Ratio = × 𝟏𝟎𝟎
Sales
216,000 (+)53,600
= 320,000
× 100
= 84.25%
Operating Net Profit
(iv) Operating Profit Ratio = ×100
Sales

56,000 (+) 1,600 (−) 9,600

= ×100
320,000

48,000
=320,000 × 100

= 15%

Exercise No.3
From the following Balance-sheet of XYZ Ltd., calculate the following ratios:
1. Current ratio,
2. Liquid ratio,
3. Absolute liquidity ratio,
4. Current assets to Fixed assets ratio,
5. Debt to equity ratio,
6. Proprietary ratio,
7. Capital gearing ratio,
8. Fixed assets ratio.

14
Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

Balance Sheet as on 31st March, 2019

Liabilities IQD Assets IQD
Equity Capital 1,000,000 Goodwill (At cost) 500,000
6% Preference Capital 500,000 Plant and Machinery 600,000
General Reserve 100,000 Land and Building 700,000
Profit and Loss A/c 400,000 Furniture 100,000
Provision for Taxation 176,000 Inventories 600,000
Bills Payable 124,000 Bills Receivable 30,000
Bank Overdraft 20,000 Debtors 150,000
Creditors 80,000 Bank 200,000
12% Debentures 500,000 investments (Short-term) 20,000
2,900,000 2,900,000

Solution :
Current Assets
I. Current Ratio = Current Liabilities
1,000,000
= 400,000

= 2.5:1
Note : Current assets include inventories, debtors, bills receivable, bank
balance and short-term investments.
Current liabilities include creditors, bills payable, bank overdraft, taxation
provision.
Current Assets
II. Liquid Ratio = Liquid Liabilities
1,000,000 (−) 600,000
= 400,000 (−) 20,000
Liquid Assets= Current Assets (-) Stock
Liquid Liabilities = Current Liabilities (-) Bank Overdraft
400,000
Overheads = 380,000
= 1.05:1
Cash at Bank (+) Short−term Investments
III. Absolute Liquidity Ratio = Current Liabilities
220,000
= 400,000
= 0.55:1
Current Assets
IV. Current assets to fixed assets = Fixed Assets
1,000,000
=
1,900,000
= 0.526:1
Note : Fixed assets include Goodwill, Plant and Machinery, Furniture and
Land and Building.

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 Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

V. Debt to Equity Ratio

Long−term Debt 500,000

a. = 1,000,000
Shareholders Funds 500,000 100,000 400,000
Equity Capital (+) Preference Capital (+) General
Reserve (+) Profit and Loss A/c
500,000
= 2,000,000
=0.25:1
Long−term Debt 500,000
b. Long−term Debt = 500,000+2,000,000
+
Shareholders Funds
500,000
a. = 2,500,000
b. = 0.20:1
Shareholders Funds
VI. Proprietary Ratio = Total Assets
2,000,000
= 2,900,000
= 0.69 : 1
Fixed Interest Bearing Securities
VII. Capital Gearing Ratio = Equity Capital+Reserves and Surplus
1,000,000 {500,000 Preference + 500,000 Debt}
= 1,000,000 + 500,000
1,000,000
= 1,500,000
= 0.66:1
Fixed Assets
VIII. (viii) Fixed Assets Ratio = Capital Employed
1,900,000
=
2,500,000
(Shareholders' Funds + Long-term debt)
= 0.76:1


Exercise No. 4
From the following details prepare the balance sheet of ABC Ltd.

Stock Turnover 6
Capital Turnover Ratio 2
Fixed Assets Turnover Ratio 4
Gross Profit 2%
Debt Collection Period 2 months
Creditors Payment Period 73 days

The Gross Profit IQD 6,00,000. Closing Stock IQD 5,000 in excess of
Opening Stock.

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Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

Solution :
Balance Sheet of ABC Ltd,
Liabilities IQD Assets IQD
Capital 120,000 Closing Stock 42,500
Creditors 49,000 Debtors 50,000
Fixed Assets 60,000
Cash 16,500
169,000 169,000

Working Notes:
Gross Profit
1. Gross Profit Ratio × 100
Sales
600,000
2%= × 100
Sales
600,000
2= Sales

Sales = 300,000 IQD

Cost of Goods Sold = Sales - Gross Profit
= 300,000 - 60,000
= 240,000 IQD
Cost of Goods Sold
2. Stock Turnover = Average Stock

240,000
6 = Average Stock

Average Stock = 40,000 IQD

Opening Stock + Closing Stock
But. Average Stock = 2
Opening Stock + Closing Stock
40,000 IQD = …….(1)
2

5,000 IQD = Opening Stock + Closing Stock …….(2)

Solving the above two equations.

- Closing Stock + Opening Stock = 80,000 IQD
- Closing Stock - Opening Stock = 5,000 IQD …..(3)
Subtracting equation (2) from equation(3) , we get
2 (Opening Stock) = 75,000 IQD
Opening Stock =37,000 IQD
But, Closing Stock + Opening Stock = 80,000 IQD
Closing Stock + IQD 37,500 = 80,000 IQD
Closing Stock =42,500(80,000- 37,500)
Cost of Sales
3. Capital Turnover Ratio = Capital

17
Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

240,000
2= Capital

Capital = 120,000 IQD

Cost of Sales
4. Fixed Assets Turnover Ratio = Fixed Assets
240,000
4= Fixed Assets

Fixed Assets = 60,000 IQD

5. Debt Collection Period = 2 Months
12 Months
Debtor Turnover Ratio = Debt Collection Period
12
= 2

=6
Credit Sales
OR Debtors Turnover Ratio = Average Debtors
Assuming Sales as Credit Sales and Debtors Turnover Ratio is based on
year-end figures, we have,

300,000
Debtors = 6

= 50,000 IQD
6. Creditors Payment Period = 73 Days

365 Days
Creditors Turnover Ratio = Creditors Payment Period

365 days
= 73 days

= 5 days
Assuming all purchases to be credit purchases, the amount of purchase is
determined as follows :
Cost of Goods Sold= Opening Stock (+) Purchases (-) Closing Stock
240,000 = 37,500 (+) Purchases (-) 42,500
240,000 (+) 42,500 (-) 37,500= Purchases
Purchases = 245,000 IQD

Credit Purchases
Now. Creditors Turnover Ratio = Closing Stock

245,000
5= Closing Stock

Closing Stock = 49,000 IQD



18
Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

Exercise No. 5
Following are the ratios relating to the trading activities of an organization.
- Debtors Velocity = 3 months
- Stock Velocity = 4 months
- Creditors Velocity = 2month
- G. P. Ratio = 25%
- Capital Turnover Ratio =3
- Fixed Assets Turnover Ratio =4
Gross Profit for 2018-19 IQD 750,000. Stock as on 31-3-2019 was 30,000
IQD more than it was on 1-4-2018. At the end of the year Bills Payable and Bills
Receivable were 45,000 IQD and 50,000 IQD and Bank Overdraft was 110,000
IQD.
Requirement: Prepare a statement of Proprietary Fund for the year ended 31-3-
2019.

Solution :
Statement Showing Proprietary Fund as on 31-3-2019
Particulars IQD IQD
Fixed Assets 750,000
Add : Current Assets (CA):
Closing Stock 765,000
Debtors 750,000
Bills Receivable 50,000 1,565,000
Less : Current Liabilities (CL): 2,315,000
Creditors 380,000
Bills Payable 45,000
Overdraft 110,000 535,000
Proprietary Fund 1,780,000

Working Notes :
Debtors
1- Debtors Velocity = Sales × 12
Debtors
OR 3 = 3,000,000 × 12
3,000,000
Debtors = 4

= 750,000 IQD
G.P.
2- G.P. Ratio = Sales × 100
G.P
25= Sales × 100
750,000
= ×100
Sales

Sales = 750,000 ×4
= 3,000,000 IQD

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Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

Cost of Goods Sold

3- Stock Velocity= Average Stock

Here, Stock Velocity = 4 months

12
= months
4

= 3 times
Now, Cost of Goods Sold = Sales – G.P.
Cost of Goods Sold = 3,000,000 – 750,000
= 2,250,000 IQD
Let the Opening Stock be y.
Closing Stock = y + 30,000
y + y + 30,000
Average Stock = 2
2y + 30,000
= 2

2 (y + 15,000)
=
2
= y + 15,000
Cost of Goods Sold
Now. Stock Velocity = Average Stock

2,250,000
i.e., 3= y+15,000

3y+45,000 = 2,250,000
3y = 2,205,000
2,205,000
y= 3

= 735,000 IQD
Opening Stock = 735,000 (y)
Now. Closing Stock = y+ 30,000
Closing Stock = 735,000 + 30,000
= 765,000 IQD
Turnover
4- Capital Turnover Ratio = Capital

3,000,000
3= Capital

Capital = 1,000,000 IQD

20
Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

Turnover
5- Fixed Asset Turnover Ratio = Fixed Assets
3,000,000
4= Fixed Assets

Fixed Assets = 750,000 IQD

Creditors
6- Creditors Velocity = × 12
Purchase
Creditors
2= 2,280,000 × 12

2,280,000
Creditors =
6
= 380,000 IQD
()The Purchase figure of 2,280,000 IQD can be found by Opening Trading A/c.

Trading A/c (31-3-2019)

Particulars IQD Particulars IQD
To Opening Stock 735,000 By Sales 3,000,000
To Purchase (Balancing Figure) 2,280,000 By Closing Stock 765,000
To Gross Profit 750,000
3,765,000 3,765,000


Exercise No. 6
With the help of the following ratios regarding Kachin Ltd. draw the balance
sheet for the year ended 31 March, 2019.
 Current ratio 2.5 Liquid ratio 1.5
 Net working capital 300,000 IQD.
 Stock turnover ratio (cost of sales/closing stock) 6 times Gross profit ratio
20%
 Fixed assets turnover ratio (on cost of sales) 2 times Debt collection period 2
months Fixed assets to shareholders net worth 0.80
 Reserve and surplus to capital 0.50.
Solution :
Working Notes:

(1) Working Capital = CA-CL

CA
= 𝐶𝐿
𝐶𝐴
2.5 = 𝐶𝐿

CA= 2.5 CL

21
Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

Working Capital = 2.5 CL – CL

300,000 = 1.5 CL
CL = 200,000
CA = 2.5 × 200,000
CA= 500,000 IQD
Quick Assets
(2) Liquid Ratio = Quick Liabilities
𝐶𝐴−𝑆𝑡𝑜𝑐𝑘
1.5= 200,000

𝐶𝐴 − 𝑆𝑡𝑜𝑐𝑘= 300,000
𝑆𝑡𝑜𝑐𝑘 =500,000 – 300,000
𝑆𝑡𝑜𝑐𝑘 = 200,000 IQD
Cost of Sales
(3) Stock Turnover Ratio =Closing Stock
Cost of Sales
6= 200,000
Cost of Sales = 1,200,000 IQD

(4) Sales = Cost of Sales (+) Gross Profit

= 1,200,000 (+)300,000
= 1,500,000 IQD
Sales Cost of Sales G.P.
100 80 20
1,200,000 ?
20
1,200,000 x 80
= 300,000 - (Gross Profit)

𝟏,𝟓𝟎𝟎,𝟎𝟎𝟎
(5) Debtors = ×2
𝟏𝟐
= 250,000
(6) Fixed Assets = 2 x 12,00,000
= 2,400,000 IQD
Fixed Assets
(7) Fixed Assets to Net worth = Net Worth
2,400,000
0.80 = Net Worth
Net Worth = 3,000,000 IQD
(8) Reserves and Surplus to Share Capital
Reserves and Surplus
= Equity Share Capital
= 0.50
1
Reserves and Surplus = 2 of Equity Share Capital
But, Net Worth = Capital (+) Reserve
= 3,000,000 IQD

22
Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

1
3,000,000 = [Equity Share Capital (+)2 Equity Share Capital]
2
Share Capital = 3,000,000x3
= 2,000,000
Reserves and Surplus = 0.50 of 2,000,000
= 1,000,000 IQD

Balance Sheet of Kachin Ltd. for the year ended 31-3-2019

Liabilities IQD Assets IQD
Share Capital 2,000,000 Fixed Assets 2,400,000
Reserves and Surplus 1,000,000 Current Assets:
Current Liabilities 200,000 Stock 200,000
Debtors 250,000
Cash 50,000 500,000

Investment (Balancing
Figure) 300,000
3,200,000 3,200,000


Exercise No. 7
Following information is given for two companies A Ltd. and B Ltd.
Particulars A Ltd. B Ltd.
Current Ratio 1.25 1.01
Liquid Ratio 0.96 0.69
Gross Profit Ratio 26.7% 33.3%
Debt Equity Ratio 0 0.33
Net Profit Ratio 15% 10%

Requirement: Analyze the financial position of the two companies.

Solution :
(a) Current Ratio of A. Ltd is 1.25 which is not favorable. Hence, the short-term
financial position of the company is not strong.
Current Ratio of B. Ltd. is 1.01 which is not favorable. Hence, the short-term
financial position of the company is not strong.
(b) Liquid Ratio of A. Ltd. is 0.96, which shows that the solvency position of A.
Ltd. is not strong.
satisfactory. (0.96 < 1)
Liquid Ratio of B. Ltd. is 0.69, which shows that the solvency position of B.
Ltd. is not satisfactory.(0.69 < 1)
(c) Gross Profit Ratio of A. Ltd. is 26.7% and B. Ltd is 33.3% which shows
that the profitability of both the companies seems to be satisfactory. However,
whether there is an improvement in the profitability or not depends on the
comparative study of figures of the previous accounting periods.
(d) Debt Equity Ratio of A. Ltd is 0 and B. Ltd is 0.33. Banking Companies
consider debt equity ratio upto 2 : 1 as normal. Debt equity ratio in both our

23
Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

cases was lower than the normal debt equity ratio. This shows that there was
a greater margin of safety available to loan creditors. Both the companies was
eligible for long-term financial assistance.
(e) The Net Profit Ratio of A. Ltd is 15%, which shows that the profitability of
the company seems to be quite satisfactory.
The Net Profit Ratio of B. Ltd. is 10% which is quite low. This shows that the
profitability position of the company is quite unsatisfactory. The management
is not efficient in controlling cost.

Exercise No. 8
The Current Ratio is twice than Quick Ratio. Calculate value of stock, if working
capital is 40,000/- IQD , & bank overdraft is 10,000/- IQD .
Solution :
Here, Current Ratio = 2
Current Assets (CA)
Now, Current Ratio = Current Liabilities (CL)
CA-CL= Working Capital
40,000+CL
2= Ca – cl = 40.000 IQD
𝐶𝐿

2CL = 40,000 + CL CA =40.000 + CL

CL = 40,000 IQD
and CA= 80,000 IQD
now Quick Ratio = 1
CA − Stock
Quick Ratio =
𝐶𝐿−BOD

80,000− Stock
1 = 40,000− 10,000

80,000− Stock
1= 30,000

30,000= 80,000 − Stock

Stock = 50,000 IQD



24
Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

Questions and Exercise

 Questions
1. Describe the Classification and Types of Ratios.
2. What is the Liquidity Ratios and Solvency Ratios?
3. What are The important liquidity ratios?
4. What are The important turnover ratios ?
5. What are types of profitability ratios?
6. Indicate the Balance Sheet Ratios.
7. Indicate the Profit and Loss Account Ratios.
8. Explain the Composite Ratios.
9. Indicate the methods of project evaluation in a firm.
10. Explain the Investment Policy.
11. What is the meaning of Working capital?
12. Explain the Procedures of Investment Policies.

 Exercises
Exercise No.1:
The following is the balance sheet of Iraqi Rubber Industries Company
for the financial year ended 31/12/2019:
Liabilities IQD Assets IQD
capital 2,000,000 building 1,000,000
Net profit 302,000 equipment 1,200,000
long-term loans 320,000 inventory 31/12 at a sales 480,000
price
creditors 440,000 Financial investments 98,000

Provision for depreciation 280,000 Bills receivable 120,000

of machinery

Provision for doubtful 16,000 Debtors 336,000

debts
Accrued Salaries 20,000 cash 120,000

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Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

Rent prepaid 24,000

Total 3,378,000 Total 3,378,000

Additional Information:
1. The value of the beginning inventory at 1/1/2019 was 320,000 dinars at
cost.
2. The selling price is determined in accordance with the company's policy
plus 20% as the profit margin for the cost.
3. Total profit for the year amounted to 360,000 dinars.
4. Credit purchases represent two-thirds (2/3) of the cost of net sales.
5. The discount rate charged by the bank is 5%. The average maturity of
the notes receivable is 4 months.
6. Payment period average planned by the company is 3 months.
7. Storage period average planned by the company is 80 days.
8. Cash ratio (monetary standard) accepted by the company is 50%.
Required:
1. Rebalancing the balance sheet in accordance with accounting standards
and applying financial analysis.
2. Use the revised balance sheet data to extract the following ratios:
 Cash ratio (cash standard).
 Creditors Turnover.
 Payment period average
 Inventory turnover.
 Storage period average .
 Fixed asset turnover.
Exercise No.2

The net profit before interest and tax for an industrial company for the year
2019 is 520,000 dinars and the debit annual interest is 80,000 and the annual
installments due for the same year are 120,000.

Required : Determine the company's ability to service its debt for the year 2019 and
compare it with the year 2018 by 1.5 times.

26
Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

Exercise No.3
The following is the financial data extracted from the records of a company for
the years 2018 and 2019.
particular 2018 2019
Net profit before interest and taxes 500,000 1,800,000
Net operating assets 2,000,000 5,000,000
Net sales 2,500,000 7,500,000

Required:
A. Determine the profit margin, and turnover of operating assets.
B. Determine The company's earning power during the two years and comment
on it.
Exercise No.4
the following data abstracted from records of an industrial company for the
years 2018 and 2019
particular 2018 2019
Total assets (fixed and current) 480,000 520,000
Total long and short term debt 360,000 240,000

Require : find the ratio of debt (financial leverage) of the company for 2018 and
2019.

Exercise No.5
The following is the data of a company for the period ended 31/12/2019:
particular Amount particular Amount
Creditors ‫؟‬ Cash ‫؟‬
Accrued Expenses 875000 notes receivable ‫؟‬
Total current liabilities ‫؟‬ Debtors ‫؟‬
Long-term liabilities ‫؟‬ inventory ‫؟‬
Total liabilities ‫؟‬ Expenses paid in advance ‫؟‬
Equity ‫؟‬ Total Current Assets ‫؟‬
‫؟‬ machinery and equipment 550000
Total Liabilities and Equity ‫؟‬ Total assets ‫؟‬

27
Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

Additional Information:
1. Inventory turnover = 10 times
2. Quick Liquidity ratio = 2:1
3. Gross profit = 7,800,000
4. Net profit = 2,080,000
5. Total debt to the equity ratio = 1:4
6. Asset turnover rate = 2
7. Profit margin ratio = 8%
8. Debtors Turnover rate = 8 times
9. Balances of accounts receivable, inventory, equity and total assets as of
31/12/2019 are identical to their balances as at 31/12/2018.
10. Convertible quick assets to cash consist of the following:
 cash 27%
 notes receivable 8%
 debtors 65%
11. All sales and procurement results.
Required:
a. Find the values of the balances indicated by a question mark (?).
b. Find a rate of return on assets.
c. Find a rate of return on equity.

28
Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

Exercise No.6
The balance sheet of an industrial corporation for the year ended 31
December 2019 is as follows:
Liabilities Assets
equity fixed assets 770.000
capital 500.000 (-) 150.000
Depreciation of
Fixed assets
net profit for 40.000 Current assets:
the year

Total equity 540.000 ending Goods 116.000

long-term 50.000 notes receivable 20.000

loans

Short - term Debtors 43.600

liabilities
creditors 123.000 provision of 8.600 35.000
doubtful debts
Notes payable 97.000 Current 10.000
securities
Other credit Cash on hand 12.800
balances
10.000 Other debit
due salaries balances
Prepaid 6.200
expenses
Total Current 230.000 Total Current 200.000
Liabilities Assets
820.000 Total assets 820.000
Total liabilities

additional information
• Annual net sales of 1,260,000 dinars
• Annual net purchases of 600,000 dinars
• Cost of sales is 1,181,600 dinars
Required: Calculate the following financial ratios:
1. Current ratio
2. Quick liquidity ratio
3. Creditors turnover and notes payable

29
 Analysis of Financial Statements………..Chapter(8): Financial Ratios Analysis

4. Creditors payment period average and notes payable

5. Inventory turnover
6. Storage period average
7. Fixed asset turnover
8. Debtors collection period average and notes receivable and their comparison
with creditors payment period average and notes payable.
Exercise No. 7
The following elements of a balance sheet as on 31/12/2019:
o Assets: Cash? Inventory? Total current assets? fixed assets ?
o Liabilities : Loans? Current liabilities? Total liabilities? equity?
Information's additional:
1. Equity of stockholders = 500,000 IQD
2. Ratio of Current Liabilities to Total Debt = 40%
3. Total debt to equity = 60%
4. Ratio of fixed assets to equity = 60%
5. Asset turnover = 2 times
6. Inventory turnover = 8 times
Required: Complete the balance sheet using the information available above.



30

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