LITERATURE REVIEW TYPES OF RATIOS

The ratios can be classified, for the purpose of exposition into four broad groups:-

1.LIQUIDITY RATIOS 2.CAPITAL STRUCTURE /LEVERAGE RATIOS 3. PROFITABILITY RATIOS 4.ACTIVITY RATIOS.

LIQUIDITY RATIOS.
The liquidity ratios measure the ability of a firm to meet its short term obligations and reflect the short tern financial strength/solvency of a firm. The ratios which indicate the liquidity of a firm are: Net working capital. Current ratio. Acid test/quick ratio Super quick ratio. Turnover ratio.

Net working capital.

Net working capital represents the excess of current assets over current liabilities. It is frequently employed as a measure of a companys liquidity position. An enterprise should have sufficient NWC to meet the claims of the creditors and meeting the day to day needs of

the business. The greater the amount of NWC, the greater the liquidity of a firm. Accordingly, NWC is the measure of liquidity.

Interpretation of Net Working Capital

Positive working capital means that the business is able to pay off its short-term liabilities. Also, a high working capital can be a signal that the company might be able to expand its operations. Negative working capital means that the business currently is unable to meet its shortterm liabilities with its current assets. Therefore, an immediate increase in sales or additional capital into the company is necessary in order to continue its operations. Working capital also gives an idea of company's efficiency. Money tied up in inventory or accounts receivable cannot pay off any of the company's short term financial obligations. Therefore, working capital analysis is very important, but very complex too. For example, an increase in working capital can be explained by sales increase, but can also be explained by slow collection or inadequate increase in inventory.

CURRENT RATIO.
The current ratio is the ratio of total current assets to total current liabilities.. It is calculated by dividing the total current assets by the total current liabilities. Current ratio = current assets/ current liabilities.

Interpretation of Current Ratio.

The current ratio of a firm measures its short term solvency, i.e, its ability to meet its short/ term obligations. As a measure of short term current financial liquidity, it indicates the rupees of current assets available for each rupee of current liability/ obligation.

The higher the current ratio, the larger the amount of rupees available per rupee of current liability, the more the firms ability to meet current obligations and greater the safety of funds of short term creditors. It is very important to note that a very high ratio of current assets to current liabilities may be indicative of slack management practices, as it might signal excessive inventories for the current requirements and poor credit management in terms of over extended accounts

receivable. At the same time, the firm may not be making full use of its current borrowing capacity. Thus, a firm should have reasonable current ratio.

3. Acid test or Quick Ratio.

The acid test ratio is the ratio between quick current assets and current liabilities and is calculated by dividing the quick assets by the current liabilities. Acid Test Ratio = Quick Assets/ Current Liabilities.

Interpretation of Acid Test Ratio

It is a rigorous measure of a firms ability to service short term liabilities. The usefulness of the ratio lies in the fact that it is widely accepted as the best available test of the liquidity position of the company. The acid test ratio is superior to the current ratio. Generally speaking, an acid test ratio of 1:1 is considered satisfactory as a firm easily meet all current claims. The acid test ratio provides in a sense a check on the liquidity position of the firm as shown by its current ratio. The quick ratio is more rigorous and penetrating test of the liquidity position of the firm. Both the acid test ratio and the current ratios should be considered in

relation to the industry average to infer whether the firms short term financial position is satisfactory or not.

4. Super Quick Ratio.

This ratio is calculated by dividing the super quick current assets by the current liabilities of the firm. Super Quick Ratio= super quick current assets/current liabilities. The super quick current assets are cash and marketable securities. This ratio is the most rigorous and conservative test of a firms liability position. Further it is suggested that it would be useful for the management if the liquidity measure also takes into account reserve borrowing power as the firms real debt paying ability depends not only on cash resources available with it but also on its capacity to borrow from the market short notice.

5. TURNOVER RATIO.
Another way of examining the liquidity is to determine how quickly certain current assets are converted into cash. The three turnover ratios that are relevant are:1. Inventory Turnover Ratio. 2. Debtors Turnover Ratio 3. Creditors Turnover Ratio.

1. Inventory Turnover Ratio.

It is computed by dividing the cost of goods sold by the average inventory. Thus, Inventory Turnover Ratio= cost of goods sold/ average inventory.

The cost of goods sold means sale minus gross profit. The average inventory refers to the simple average of the opening and the closing inventory. The ratio indicates how fast inventory is sold. A high ratio is good from the viewpoint of the liquidity and vice versa. A low ratio would signify that the inventory does not sell and stays on the shelf in the warehouse for a long time.

Interpretation of Inventory Turnover Ratio

A low inventory turnover ratio is a signal of inefficiency, since inventory usually has a rate of return of zero. It also implies either poor sales or excess inventory. A low turnover rate can indicate poor liquidity, possible overstocking, and obsolescence, but it may also reflect a planned inventory build up in the case of material shortages or in anticipation of rapidly rising prices. A high inventory turnover ratio implies either strong sales or ineffective buying (the company buys too often in small quantities, therefore the buying price is higher).A high inventory turnover ratio can indicate better liquidity, but it can also indicate a shortage or inadequate inventory levels, which may lead to a loss in business.

2. Debtors Turnover Ratio.

It is determined by dividing the net credit sales by the average debtors outstanding during the year. Debtors Turnover Ratio= net credit sales/ average debtors. Net credit sales consists of gross credit sales minus returns, if any, from customers. Average debtors is the simple average of debtors at the beginning and at the end of the year.

Interpretation of Debtors Turnover Ratio.

The analysis of the Debtors turnover ratio supplements the information regarding the liquidity of one item of current assets of the firm. The ratio measures how rapidly debts are collected. A high ratio is indicative of shorter time lag between credit sales and cash collection. A low ratio shows that debts are not being collected rapidly.

3. Creditors Turnover Ratio.

It is the ratio between net credit purchase and average amount of creditors outstanding during the year. Thus, Creditors Turnover Ratio= net credit purchase/ average creditors. Net Credit Purchase= Gross credit purchase less returns to suppliers. Average Creditors= Average of creditors outstanding during the beginning and at the end of the year.

Interpretation of Creditors Turnover Ratio.

A low turnover ratio reflects the liberal credit terms granted by the suppliers, while a high ratio shows that accounts are to settled rapidly. The Creditors Turnover Ratio is an important tool of analysis a firm can reduce its requirement of current assets by relying on the suppliers credit. The extent to which trade creditors are willing to wait for payment can be approximated by the Creditors turnover ratio.

2. CAPITAL STRUCTURE /LEVERAGE RATIOS

The capital structure ratio shows the percent of long term financing represented by long term debt. A capital structure ratio over 50% indicates that a company may be near their borrowing limit (often 65%). Formula to calculate capital structure ratio:

Capital Structure Ratio = long term debt / (shareholders equity + long term debt).

TYPES OF CAPITAL STRUCTURE RATIOS 1. DEBT EQUITY RATIO

A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets.
Debt/Equity Ratio = Total Liabilities/ Shareholders Equity.

Sometimes only interest-bearing, long-term debt is used instead of total liabilities in the calculation.

Also known as the Personal Debt/Equity Ratio, this ratio can be applied to personal financial statements as well as corporate ones.

Interpretation of Debt Equity Ratio

The debt equity ratio is an important tool of financial analysis to appraise the financial structure of a firm. It has important implications from the point of view of creditors, owners and the firm itself. The ratio reflects the relative contribution of creditors and the owners of business in its financing. A high ratio shows a large share of financing by the creditors relative to the owner and therefore a larger claim against the assets of the firm. A low ratio implies a smaller claim of creditors. The ratio indicates the margin of safety to the creditors.

DEBT TO TOTAL CAPITAL RATIO

A measurement of a company's leverage, calculated as the company's debt divided by its total capital. Debt includes all short-term and long-term obligations. Total capital includes the company's debt and shareholders' equity, which includes common stock, preferred stock, minority interest and net debt.

Interpretation of Debt to Total Capital Ratio

As this ratio is like D/E equity, it gives results similar to the D/E ratio. A firm with a very high ratio would expose the creditors to higher risk. The implications of the ratio to the equity capital to the total assets are exactly opposite to that of the debt to the total assets. A firm should have neither a very high ratio nor too very low ratio.

PROFITABILITY RATIOS
A class of financial metrics that are used to assess a business's ability to generate earnings as compared to its expenses and other relevant costs incurred during a specific period of time. For most of these ratios, having a higher value relative to a competitor's ratio or the same ratio from a previous period is indicative that the company is doing well. Profitability ratios measure the firm's use of its assets and control of its expenses to generate an acceptable rate of return. Profitability ratios measure how well a company is performing by analyzing how profit was earned relative to sales, total assets and net worth.

(a)Based on Sales. 1.Gross Profit Ratio.

Gross profit ratio expresses relationship between gross profit and net sales. It is obtained by dividing gross profit by net sales and expressing this relationship as a percentage. Gross profit is obtained by deducting cost of goods sold from net sales. Net sales are basically determined by deducting sales returns from sales. Gross profit ratio evaluates the effectiveness of business. It indicates the efficiency of firm in terms of its production and how much it has gained profit. Gross profit reflects the profit firm has made on cost of goods sold. If firm has higher gross profit margin then it is a sign of success because all operating expenses, interest charges and dividends would have to be taken off from GP. If company increase selling price of goods sold and decrease cost of goods sold then this ratio increases. However If company decrease selling price of goods sold and increase cost of goods sold then this ratio decreases.
[Gross Profit Ratio = (Gross profit / Net sales) 100]

Interpretation of Gross Profit Ratio

It should be observed that an increase in the GP ratio may be due to the following factors.

1. Increase in the selling price of goods sold without any corresponding increase in the cost of goods sold. 2. Decrease in cost of goods sold without corresponding decrease in selling price. 3. Omission of purchase invoices from accounts. 4. Under valuation of opening stock or overvaluation of closing stock.

On the other hand, the decrease in the gross profit ratio may be due to the following factors.

1. Decrease in the selling price of goods, without corresponding decrease in the cost of goods sold. 2. Increase in the cost of goods sold without any increase in selling price. 3. Unfavourable purchasing or mark up policies. 4. Inability of management to improve sales volume, or omission of sales.

5. Over valuation of opening stock or under valuation of closing stock

Hence, an analysis of gross profit margin should be carried out in the light of the information relating to purchasing, mark-ups and markdowns, credit and collections as well as merchandising policies.

NET PROFIT RATIO

Net profit ratio is the ratio of net profit (after taxes) to net sales. It is expressed as percentage. The two basic components of the net profit ratio are the net profit and sales. The net profits are obtained after deducting income-tax and, generally, non-operating expenses and incomes are excluded from the net profits for calculating this ratio. Thus, incomes such as interest on investments outside the business, profit on sales of fixed assets and losses on sales of fixed assets, etc are excluded. Formula:- Net Profit Ratio=Net Profit/Net Sales*100

Interpretation of Net Profit Ratio

NP ratio is used to measure the overall profitability and hence it is very useful to proprietors. The ratio is very useful as if the net profit is not sufficient, the firm shall not be able to achieve a satisfactory return on its investment.

This ratio also indicates the firm's capacity to face adverse economic conditions such as price competition, low demand, etc. Obviously, higher the ratio the better is the profitability. But while interpreting the ratio it should be kept in mind that the performance of profits also be seen in relation to investments or capital of the firm and not only in relation to sales.

PRICE EARNING RATIO

A valuation ratio of a company's current share price compared to its per-share earnings. Formula:- Market value per share/ Earning Per Share.

Interpretation of Price Earning Ratio

The price-to-earnings ratio is a financial ratio used for valuation: a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with a lower P/E ratio. The P/E ratio can be seen as being expressed in years, in the sense that it shows the number of years of earnings which would be required to pay back purchase price, ignoring inflation. The P/E ratio also shows current investor demand for a company share. The reciprocal of the P/E ratio is known as the earnings yield.

(b) Based on Capital:RETURN ON CAPITAL EMPLOYED

The return on capital employed (ROCE) ratio, expressed as a percentage, complements the return on equity (ROE) ratio by adding a company's debt liabilities, or funded debt, to equity to reflect a company's total "capital employed". This measure narrows the focus to gain a better understanding of a company's ability to generate returns from its available capital base.

Interpretation of return on capital employed

The return on capital employed is an important measure of a company's profitability. Many investment analysts think that factoring debt into a company's total capital provides a more comprehensive evaluation of how well management is using the debt and equity it has at its disposal. Investors would be well served by focusing on ROCE as a key, if not the key, factor to gauge a company's profitability. An ROCE ratio, as a very general rule of thumb, should be at or above a company's average borrowing rate.

RETURN ON ASSETS
An indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's annual earnings by its total assets, ". ROA is displayed as a percentage. Sometimes this is referred to as "return on investment

The formula for return on assets is:- Net Income/ Total Assets.

Interpretation of return on assets

ROA tells you what earnings were generated from invested capital (assets). ROA for public companies can vary substantially and will be highly dependent on the industry. This is why when using ROA as a comparative measure, it is best to compare it against a company's previous ROA numbers or the ROA of a similar company.

RETURN ON EQUITY CAPITAL

Return on equity capital which is the relationship between profits of a company and its equity, can be calculated as follows: Return on Equity Capital= N.P after tax, interest and pref. dividend/Equity Share Capital*100

Interpretation of return on equity capital

This ratio is more meaningful to the equity shareholders who are interested to know profits earned by the company and those profits which can be made available to pay dividends to them. Interpretation of the ratio is similar to the interpretation of return on shareholder's investments and higher the ratio better is. OPERATING RATIO Operating ratio is the ratio of cost of goods sold plus operating expenses to net sales. It is generally expressed in percentage.

Operating ratio measures the cost of operations per dollar of sales. This is closely related to the ratio of operating profit to net sales.

Components:
The two basic components for the calculation of operating ratio are operating cost (cost of goods sold plus operating expenses) and net sales. Operating expenses normally include (a) administrative and office expenses and (b) selling and distribution expenses. Financial charges such as interest, provision for taxation etc. are generally excluded from operating expenses.

Formula:- Operating Ratio= Operating Cost/ Net Sales*100

Interpretation of Operating Ratio

Operating ratio shows the operational efficiency of the business. Lower operating ratio shows higher operating profit and vice versa. An operating ratio ranging between 75% and 80% is generally considered as standard for manufacturing concerns. This ratio is considered to be a

yardstick of operating efficiency but it should be used cautiously because it may be affected by a number of uncontrollable factors beyond the control of the firm. Moreover, in some firms, non-operating expenses from a substantial part of the total expenses and in such cases operating ratio may give misleading results.

ACTIVITY RATIOS.
Activity ratios measure company sales per another asset accountthe most common asset accounts used are accounts receivable, inventory, and total assets. Activity ratios measure the efficiency of the company in using its resources. Since most companies invest heavily in accounts receivable or inventory, these accounts are used in the denominator of the most popular activity ratios. An indicator of how rapidly a firm converts various accounts into cash or sales. In general, the sooner management can convert assets into sales or cash, the more effectively the firm is being run.

TYPES OF ACTIVITY RATIOS. Accounts Receivables Turnover

Accounts receivable is the total amount of money due to a company for products or services sold on an open credit account. The accounts receivable turnover shows how quickly a company collects what is owed to it.
Accounts Receivables Turnover = Total Credit Sales/ Accounts Receivables.

Interpretation of Accounts Receivables Turnover

Accounts receivable represents the indirect interest free loans that the company is providing to its clients. Therefore, it is very important to know how "costly" these loans are for the company.

A high receivables turnover ratio implies either that the company operates on a cash basis or that its extension of credit and collection of accounts receivable are efficient. Also, a high ratio reflects a short lapse of time between sales and the collection of cash, while a low number means collection takes longer. The lower the ratio is the longer receivables are being held and the risk to not be collected increases. A low receivables turnover ratio implies that the company should re-assess its credit policies in order to ensure the timely collection of credit sales that is not earning interest for the firm.

Inventory Turnover Ratio

For a company to be profitable, it must be able to manage its inventory, because it is money invested that does not earn a return. The best measure of inventory utilization is the inventory turnover ratio ( inventory utilization ratio), which is the total annual sales or the cost of goods sold divided by the cost of inventory. Inventory Turnover= Total Annual Sales or Cost of Goods Sold/Inventory Cost. Using the cost of goods sold in the numerator is a more accurate indicator of inventory turnover, and allows a more direct comparison with other companies, since different companies would have different mark ups to the sale price, which would overstate the actual inventory turnover. In seasonal businesses, where the amount of inventory can vary widely throughout the year, the average inventory cost is used in the denominator.

Interpretation of Inventory Turnover Ratio

Inventory Turnover Ratio measures company's efficiency in turning its inventory into sales. Its purpose is to measure the liquidity of the inventory.

Inventory Turnover Ratio is figured as "turnover times". Average inventory should be used for inventory level to minimize the effect of seasonality. This ratio should be compared against industry averages. A low inventory turnover ratio is a signal of inefficiency, since inventory usually has a rate of return of zero. It also implies either poor sales or excess inventory. A low turnover rate can indicate poor liquidity, possible overstocking, and obsolescence, but it may also reflect a planned inventory build up in the case of material shortages or in anticipation of rapidly rising prices. A high inventory turnover ratio implies either strong sales or ineffective buying (the company buys too often in small quantities, therefore the buying price is higher).A high inventory turnover ratio can indicate better liquidity, but it can also indicate a shortage or inadequate inventory levels, which may lead to a loss in business

Total Asset Turnover

The total asset turnover measures the return on each dollar invested in assets and is equal to the net sales, which is total sales minus returns and allowances, divided by the average total assets.

Average Total Assets =

Assets at Beginning of Year + Assets at End of Year 2

Total Assets Turnover= Net Sales/Average Total Assets.

Interpretation of Total Assets Turnover Ratio

The lower the total asset turnover ratio, as compared to historical data for the firm and industry data, the more sluggish the firm's sales. This may indicate a problem with one or more of the asset categories composing total assets - inventory, receivables, or fixed assets. The small business owner should analyze the various asset classes to determine where the problem lies.

There could be a problem with inventory. The firm could be holding obsolete inventory and not selling inventory fast enough. With regard to accounts receivable, the firm's collection period could be too long and credit accounts may be on the books too long. Fixed assets, such as plant and equipment, could be sitting idle instead of being used to their full capacity. All of these issues could lower the total asset turnover ratio.

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