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Net worth
It means total of share capital and reserves and surplus. This includes preference share capital unlike in Accounts preference share capital is treated as a debt. For the purpose of debt to equity ratio, the necessary adjustment has to be done by reducing preference share capital from net worth and adding it to the debt in the numerator.
Secured loans
It represent loans taken from banks, financial institutions, debentures (either from public or through private placement), bonds etc. for which the company has mortgaged immovable fixed assets (land and building) and/or hypothecated movable fixed assets (at times even working capital assets with the explicit permission of the working capital banks)
Unsecured loans
It represent fixed deposits taken from public (if any) as per the provisions of Section 58 (A) of The Companies Act, 1956 and in accordance with the provisions of Acceptance of Deposit Rules, 1975 and loans, if any, from promoters, friends, relatives etc. for which no security has been offered. Such unsecured loans rank second and subsequent to secured loans for settlement of claims against the company. There are other unsecured creditors also, forming part of current liabilities, like, creditors for purchase of materials, provisions etc.
Investments
Investment made in shares/bonds/units of Unit Trust of India etc. This type of investment should be ideally from the profits of the organisation and not from any other funds, which are required either for working capital or capital expenditure.
Company incorporation expenses or public issue of share capital, debenture etc. together known as preliminary expenses written off over a period of 5 years as per provisions of Income Tax. Misc. expense could also be other deferred revenue expense like product launch expenses.
There is a significant difference between the way in which the statements of accounts are prepared as per Schedule VI of the Companies Act and the manner in which these statements, especially, balance sheet is analysed by a finance person or an analyst. For example, in the Schedule VI, the current liabilities are netted off against current assets and only net current assets are shown. This is not so in the case of financial statement analysis. Both are shown fully and separately without any netting off.
At the end of any financial year, there are certain adjustments to be made in the books of accounts to get the proper picture of profit or loss, as the case may be, for that particular period. For example, if stocks of raw materials are outstanding at the end of the period, the value of the same has to be deducted from the total of the opening stock (closing stock of the previous year) and the current years purchases. This alone would show the correct picture of materials consumed during the current year. Ratio analysis
It is to determine the relationship between any set of two parameters and compare it with the past trend. In the statements of accounts, there are several such pairs of parameters and hence ratio analysis assumes great significance. The most important thing to remember in the case of ratio analysis is that you can compare two units in the same industry only and other factors like the relative ages of the units, the scales of operation etc. come into play.
Types of Ratios
Liquidity ratios Turnover ratios Profitability ratios Investment on capital/return ratios
Liquidity Ratios
CURRENT RATIO
Significance = Net working capital should always be positive. In short, the higher the net working capital, the greater is the degree of overall short-term liquidity. Means current ratio does indicate liquidity of the enterprise. Too much liquidity is also not good, as opportunity cost is very high of holding such liquidity. This means that we are carrying either cash in large quantities or inventory in large quantities or receivables are getting delayed. All these indicate higher costs. Hence, if you are too liquid, you compromise with profits and if your liquidity is very thin, you run the risk of inadequacy of working capital.
Range No fixed range is possible. Unless the activity is very profitable and there are no
immediate means of reinvesting the excess profits in fixed assets, any current ratio above 2.5:1 calls for an examination of the profitability of the operations and the need for high level of current assets. Reason = net working capital could mean that external borrowing is involved in this and hence cost goes up in maintaining the net working capital. It is only a broad indication of the liquidity of the company, as all assets cannot be exchanged for cash easily and hence for a more accurate measure of liquidity, we see quick asset ratio or acid test ratio.
Turnover Ratios
Generally, Turn Over Ratios indicate the Operating Efficiency. The higher the ratio, the higher the degree of efficiency and hence these assume significance. Further, depending upon the type of turn over ratio, indication would either be about liquidity or profitability also. For example, inventory or stocks turn over would give us a measure of the profitability of the operations, while receivables turn over ratio would indicate the liquidity in the system.
Formula = Net Credit Purchase / Average Payables Net Credit Purchases = Gross Credit Purchases Purchase Return Average Payables = (Opening Creditors & B/P + Closing Creditors & B/P) / 2
Average Credit Period or Creditors Velocity It shows an average period for which the credit purchases remain outstanding.
Formula = Months or Days in a year / Credit Turnover
Profitability Ratios
Profitability Ratios
Profit Margin On Sales a) Gross profit margin on sales and net profit margin ratio Gross profit margin :Formula = Gross Profit / Net Sales. Gross Profit = Net sales (-) Cost of production before selling, general, administrative expenses and interest charges. Net Sales = Gross sales (-) Excise duty. This indicates the efficiency of production and serves well to compare with another unit in the same industry or in the same unit for comparing it with past trend. For example in Unit A and Unit B let us assume that the sales are same at Rs.100lacs. Parameter Unit A Unit B Sales 100 Lacs 100 Lacs Cost of production 60 Lacs 65 Lacs Gross profit 40 Lacs 35 Lacs Deduct: Selling General Administrative expenses and interest 35 Lacs 30lacs Net profit 5 Lacs 5 Lacs While both the units have the same net profit to sales ratio, The significant difference lies in the fact that while Unit A has less cost of production and more office and selling expenses, Unit B has more cost of production and less of office and selling expenses. This ratio helps in controlling either production costs if cost of production is high or selling and administration costs, in case these are high.
=> Net Profit To Sales Ratio Net profit means profit after tax but before distribution in any form. Formula = Net Profit / Net Sales. Tax rate being the same, this ratio indicates operating efficiency directly in the sense that a unit having higher net profitability percentage means that it has a higher operating efficiency. In case there are tax concessions due to location in a backward area, export activity etc. available to one unit and not available to another unit, then this comparison would not hold well. b) Investment on Capital Ratios or Earnings Ratios
Formula = Profit after tax (-) Preference dividend (-) Dividend tax both on preference and equity dividend / number of equity shares.
This is an important indicator about the return to equity shareholder.
In terms of percentage anything less than 40% to 50% of the face value of the shares would not go well with the market sentiments. In fact P/E ratio is related to this, as P/E ratio is the relationship between Market value of the share and the EPS. The higher the PE the stronger is the recommendation to sell the share and the lower the PE, the stronger is the recommendation to buy the share. This is only indicative and by and large followed. There is something known as industry average EPS. If the P/E ratio of the unit whose shares we contemplate to purchase is less than industry average and growth prospects are quite good, it is the time for buying the shares, unless we know for certain that the price is going to come down further. If on the other hand, the P/E ratio of the unit is more than industry average P/E, it is time for us to sell unless we expect further increase in the near future.
Relevant Indicator/Remarks
Percentage of profit before tax to total income including other income, like dividend or interest income. Operating profit, i.e., profit before tax (-) other income as above as a percentage of income from the main operations of the company, be it manufacturing, trading or services.
Formula = External liabilities + preference share capital /net worth of the company (-) preference share capital (redeemable kind).
From the lenders point of view, this should not exceed 3:1. Is there any sharp deterioration in this ratio? If so, please be on guard, as the financial risk for the company increases to that extent. For only medium and long-term debts, it cannot exceed 2:1.