A NOTE ON FINANCIAL RATIO ANALYSIS
LEVERAGE/CAPITAL STRUCTURE RATIO
These ratios measure the long-term
solvency of a firm. Financial leverage refers to the use of debt finance. While
debt capital is a cheaper source of finance, it is also a risky source. Leverage
ratios help us assess the risk arising from the use of debt capital. Two types
of ratios are commonly used to analyze financial leverage - structural ratios
and coverage ratios. Structural ratios are based on the proportions of debt and
equity in the financial structure of a firm. Coverage ratios show the
relationship between the debt commitments and the sources for meeting them.
The long-term creditors of a firm evaluate its financial strength on
the basis of its ability to pay the interest on the loan regularly during the
period of the loan and its ability to pay the principal on maturity.
RATIOS COMPUTED FROM BALANCE SHEET
Debt-Equity: This ratio shows
the relative proportions of debt and equity in financing the assets of a firm.
The debt includes short-term and long-term borrowings. The equity includes the
networth (paid-up equity capital and reserves and surplus) and preference
capital. It can be calculated as:
Debt / Equity
Debt-Asset Ratio: The debt-asset ratio measures the extent to which the
borrowed funds support the firm's assets. It can be calculated as:
Debt / Assets
The numerator of the ratio includes all debt, short-term as well as long-term,
and the denominator of the ratio includes all the assets (the balance sheet
AVERAGE COLLECTION PERIOD (ACP)
ACP is calculated by dividing the days
in a year by the debtors' turnover. The average collection period represents the
number of day's worth of credit sales that is blocked with the debtors (accounts
receivable). It is computed as follows:
Average Collection Ratio = Months (days) in a Year / Debtors Turnover
The ACP and the accounts receivables turnover are related as:
ACP = 365 / Accounts Receivable Turnover
The ACP can be compared with the firm's credit terms to judge the efficiency of
credit management. For example, if the credit terms are 2/10, net 45, an ACP of
85 days means that the collection is slow and an ACP of 40 days means that the
collection is prompt.
INVENTORY OR STOCK TURNOVER RATIO (ITR)
ITR refers to the number of times the inventory is sold and replaced during
the accounting period. It is calculated as follows:
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
ITR reflects the efficiency of inventory management. The higher the ratio, the
more efficient is the management of inventories, and vice versa. However, a high
inventory turnover may also result from a low level of inventory which may lead
to frequent stock outs and loss of sales and customer goodwill. For calculating ITR, the average of inventories at the beginning and the end of the year is
taken. In general, averages may be used when a flow figure (in this case, cost
of goods sold) is related to a stock figure (inventories).
The FAT ratio measures the net sales per rupee of investment in fixed assets. It
can be computed as follows:
FAT = Net sales / Average net fixed assets
This ratio measures the efficiency with which fixed assets are employed. A high
ratio indicates a high degree of efficiency in asset utilization while a low
ratio reflects an inefficient use of assets. However, this ratio should be used
with caution because when the fixed assets of a firm are old and substantially
depreciated, the fixed assets turnover ratio tends to be high (because the
denominator of the ratio is very low).
TOTAL ASSETS TURNOVER (TAT)
TAT is the ratio between the net sales and the average total assets. It can be
computed as follows:
TAT = Net sales / Average total assets
This ratio measures how efficiently an organization is utilizing its assets.
CALCULATING FINANCIAL RATIOS OF HLL
COMMON SIZE INCOME STATEMENT OF HLL
2010, ICMR (IBS Center for Management Research).All rights reserved. No part of this publication may be
reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted
in any form or by any means - electronic or mechanical, without permission.
To order copies, call +91- 8417- 236667 or write to ICMR,
Survey No. 156/157, Dontanapalli Village, Shankerpalli Mandal,
Ranga Reddy District,
Andhra Pradesh, INDIA.
Mob: +91- 9640901313, Ph: +91- 8417- 236667,
Fax: +91- 8417- 236668