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A
study of top Indian companies with high return on capital employed (ROCE) shows that
many of these companies have operated on negative working capital management. These
companies are known to give good returns to their shareholders, both in terms of
dividends and capital gains. Interestingly, most of these companies belong to the FMCG
or the auto sector.
Of the 30 stocks in the Sensex, seven stocks have negative working capital and ROCEs in
the range of 20-80%. The total market capitalisation of these companies has moved up by
94% as against the entire Sensex, which moved up by 67% over the last one year.
Industries like steel and cement, which are working capital-intensive, may not show high
ROCEs on account of high capital costs. But some companies have begun to show
negative working capital. A better credit management system will help these companies
generate higher ROCEs in the long run.
Today, cement companies carry a feedstock ranging from 5-6 days; it was earlier around
15-30 days.
Overall, the cement industry's inventory turnover ratio is in the range of 10-12. Piling
cement stocks in the warehouses of the companies is no longer a phenomenon. When the
cement dispatches from the warehouses are growing at more than 20-30%, Indian cement
companies are able to move cement from factories in less than a day.
As a result of this, top cement companies such as ACC, Gujarat Ambuja, UltraTech
Cement and Madras Cement have negative working capital. The same companies have
given high returns to their shareholders in terms of dividends, bonuses as well as capital
gains.
Negative is positive
HLL, Nestle and Godrej Consumers Products Ltd have ROCE in excess of 40%. The
same goes for two-wheeler companies like Bajaj Auto, TVS and Hero Honda, which have
given high returns on their investment. The success of this high return is associated with
the way these companies have managed their working capital management cycles.
These are the companies that first sell their goods and later on pay their raw material
suppliers. This is possible only when the companies are huge in size and account for the
bulk of turnover for their suppliers. In such a situation, they are always in a position to
arm-twist the suppliers by taking more credit.
Says Jigar Shah of broking firm KR Choksey: “Companies operating in industries like
FMCG and automobiles have been able to manage working capital efficiently and, thus,
create value for shareholders by way of high ROCE.”
Says Sunil Sapre, vice-president, finance, Godrej Consumer Products (GCPL): “Effective
use of ERP systems, involving trade partners in planning and monitoring working capital
items, following win-win policies, efficient operations at all levels enable GCPL to
manage working capital efficiently. It has given us an advantage of higher sales and better
ROCE.”
The strong distribution and dominant position in the FMCG industry has made these
companies to bargain with the debtors and creditors to expand the payment cycle in
favour of the company.
The FMCG companies have been able to keep their creditors almost equal to debtors and
inventory, which have resulted in a lot of cash generation for these companies, which is
again invested in the business. These companies also make investment in short-term
papers and call money, which allows them to earn good returns.
“Traditionally, the FMCG companies are known for maintaining negative working capital
which is leveraged on strong supply chain management. Since this industry accounts for
very negligible amount of debtors, the whole trade is financed by creditors from the
production side and vendors and dealers from the supply side,” says an FMCG analyst.
For the automobile industry, the most critical factor of the working capital is inventory
management. In the two-wheeler segment, Hero Honda and Bajaj Auto have negative
working capital of Rs 1047 crore and Rs 344 crore and generate RoCE of 81% and
21.6%, respectively. The Indian automobile industry has come a long way in terms of
managing inventory. The inventory-turnover ratio in the last five years has improved
more than two times.
Companies have been able to produce fast and sell in the market and realise the cash.
Hero Honda, which had an inventory turnover ratio of as low as 18.50 in FY01 has
improved significantly to 47.59 and Bajaj Auto notched it from 17.14 for FY01 to 32.37
in FY05.
Says Ravi Sud, CFO, Hero Honda, “Hero Honda has asked its major suppliers to have
their warehouses around its manufacturing locations to reduce the inventory at our end.
The concept of direct on line has been implemented for about 100 vendors where the
material is supplied directly on the assembly line without being stored.”
Hero Honda has managed its working capital very efficiently and has been having
negative working capital for the last six years. The inventory number of days has come
down from 29 days in 1999 to 10 days in 2005 due to indigenous production. Imported
inventory has reduced to about 30 days stock in the factory and similar stock is kept in
transit due to long transportation time.
It is evident that the companies have significantly reduced the level of inventory. In the
four-wheeler and commercial vehicle segment, Tata Motors has a negative working
capital of Rs19.92 crore and a ROCE of 32.76%. The companies with good brand image
have been the major beneficiaries of the country's booming automobiles market.
On the one hand, these companies have been giving bulk orders to auto ancillaries
companies while sourcing the auto parts with the condition of extended credit cycles. On
the other hand, the dealers have been pushed to pay upfront or in advance.
Companies like Hero Honda, Bajaj Auto and TVS Motors enjoy a significant gap of
number of days between the payment to creditors and their receivables. Receivables are
managed through implementing a credit policy, which rewards efficient dealers and
penalises inefficient ones.
The dealers are required to keep 15 days paid-up stock and then enjoy 15 days credit for
stock beyond 15 days. If the payment is not received within 15 days, the interest is
charged from day one. This does not mean that companies with high working capital do
not generate returns to their shareholders. It is in the nature of some businesses to sustain
efficiency in managing their working capital, while some industries are simply working
capital-intensive.
But even for industries that have high working capital, they need to generate higher
revenues to maintain a healthy operating ratio. But negative working capital is one
important parameter that no successful investor has ever missed.
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Successful investors have always given a lot of thrust on working capital management. A
study of top Indian companies with high return on capital employed (ROCE) shows that
many of these companies have operated on negative working capital management. These
companies are known to give good returns to their shareholders, both in terms of
dividends and capital gains. Interestingly, most of these companies belong to the FMCG
or the auto sector.
Of the 30 stocks in the Sensex, seven stocks have negative working capital and ROCEs in
the range of 20-80%. The total market capitalisation of these companies has moved up by
94% as against the entire Sensex, which moved up by 67% over the last one year.
Industries like steel and cement, which are working capital-intensive, may not show high
ROCEs on account of high capital costs. But some companies have begun to show
negative working capital. A better credit management system will help these companies
generate higher ROCEs in the long run.
Today, cement companies carry a feedstock ranging from 5-6 days; it was earlier around
15-30 days.
Overall, the cement industry's inventory turnover ratio is in the range of 10-12. Piling
cement stocks in the warehouses of the companies is no longer a phenomenon. When the
cement dispatches from the warehouses are growing at more than 20-30%, Indian cement
companies are able to move cement from factories in less than a day.
As a result of this, top cement companies such as ACC, Gujarat Ambuja, UltraTech
Cement and Madras Cement have negative working capital. The same companies have
given high returns to their shareholders in terms of dividends, bonuses as well as capital
gains.
Negative is positive
HLL, Nestle and Godrej Consumers Products Ltd have ROCE in excess of 40%. The
same goes for two-wheeler companies like Bajaj Auto, TVS and Hero Honda, which have
given high returns on their investment. The success of this high return is associated with
the way these companies have managed their working capital management cycles.
These are the companies that first sell their goods and later on pay their raw material
suppliers. This is possible only when the companies are huge in size and account for the
bulk of turnover for their suppliers. In such a situation, they are always in a position to
arm-twist the suppliers by taking more credit.
Says Jigar Shah of broking firm KR Choksey: “Companies operating in industries like
FMCG and automobiles have been able to manage working capital efficiently and, thus,
create value for shareholders by way of high ROCE.”
HLL, which had a net negative working capital of Rs 183.3 crore in FY05, has been able
to maintain its creditor days at 64 as compared to receivable days at 16. The company has
generated a ROCE at 44.1%. On the other hand, Godrej Consumer Products (GCPL) is
another company with negative working capital of Rs 45.48 crore and creditor days at 53,
compared to average debtors of six days only. The company has earned an ROCE at
almost 158%.
Says Sunil Sapre, vice-president, finance, Godrej Consumer Products (GCPL): “Effective
use of ERP systems, involving trade partners in planning and monitoring working capital
items, following win-win policies, efficient operations at all levels enable GCPL to
manage working capital efficiently. It has given us an advantage of higher sales and better
ROCE.”
The strong distribution and dominant position in the FMCG industry has made these
companies to bargain with the debtors and creditors to expand the payment cycle in
favour of the company.
The FMCG companies have been able to keep their creditors almost equal to debtors and
inventory, which have resulted in a lot of cash generation for these companies, which is
again invested in the business. These companies also make investment in short-term
papers and call money, which allows them to earn good returns.
“Traditionally, the FMCG companies are known for maintaining negative working capital
which is leveraged on strong supply chain management. Since this industry accounts for
very negligible amount of debtors, the whole trade is financed by creditors from the
production side and vendors and dealers from the supply side,” says an FMCG analyst.
For the automobile industry, the most critical factor of the working capital is inventory
management. In the two-wheeler segment, Hero Honda and Bajaj Auto have negative
working capital of Rs 1047 crore and Rs 344 crore and generate RoCE of 81% and
21.6%, respectively. The Indian automobile industry has come a long way in terms of
managing inventory. The inventory-turnover ratio in the last five years has improved
more than two times.
Companies have been able to produce fast and sell in the market and realise the cash.
Hero Honda, which had an inventory turnover ratio of as low as 18.50 in FY01 has
improved significantly to 47.59 and Bajaj Auto notched it from 17.14 for FY01 to 32.37
in FY05.
Says Ravi Sud, CFO, Hero Honda, “Hero Honda has asked its major suppliers to have
their warehouses around its manufacturing locations to reduce the inventory at our end.
The concept of direct on line has been implemented for about 100 vendors where the
material is supplied directly on the assembly line without being stored.”
Hero Honda has managed its working capital very efficiently and has been having
negative working capital for the last six years. The inventory number of days has come
down from 29 days in 1999 to 10 days in 2005 due to indigenous production. Imported
inventory has reduced to about 30 days stock in the factory and similar stock is kept in
transit due to long transportation time.
It is evident that the companies have significantly reduced the level of inventory. In the
four-wheeler and commercial vehicle segment, Tata Motors has a negative working
capital of Rs19.92 crore and a ROCE of 32.76%. The companies with good brand image
have been the major beneficiaries of the country's booming automobiles market.
On the one hand, these companies have been giving bulk orders to auto ancillaries
companies while sourcing the auto parts with the condition of extended credit cycles. On
the other hand, the dealers have been pushed to pay upfront or in advance.
Companies like Hero Honda, Bajaj Auto and TVS Motors enjoy a significant gap of
number of days between the payment to creditors and their receivables. Receivables are
managed through implementing a credit policy, which rewards efficient dealers and
penalises inefficient ones.
The dealers are required to keep 15 days paid-up stock and then enjoy 15 days credit for
stock beyond 15 days. If the payment is not received within 15 days, the interest is
charged from day one. This does not mean that companies with high working capital do
not generate returns to their shareholders. It is in the nature of some businesses to sustain
efficiency in managing their working capital, while some industries are simply working
capital-intensive.
But even for industries that have high working capital, they need to generate higher
revenues to maintain a healthy operating ratio. But negative working capital is one
important parameter that no successful investor has ever missed.
Multi Page
Format
Working Capital Dubai Real Estate Leading Edge SCM
Q&A Luxury Apartments in Dubai Learn how supply chain
Get Working Capital Advice From and UAE management
Finance.Toolbox.com www.TheFirstGroup.com www.scm-institute.org
Ads by Google
Discuss this story on expressindia forums
WHILE the profit and loss (P&L) account of a company essentially contains revenue
items, appropriation and provisions, the balance-sheet lists out the assets and
liabilities.
While it is useful to understand the absolute quantum of each asset, liability and
revenue item in isolation, far greater understanding of its implication with respect to
the trend and performance of the company can be achieved by a `relationship' study.
For instance, if one studies profits in relation to sales for the current year and
compares it with the same relationship for a series of years, a greater understanding
of the trend and performance can be had.
The `relationship' study referred has two facets: i) the relationship of one item to
another for the current or previous years, but in respect of the same company, and
ii) the relationship of these parameters with industry figures or representative figur
es of competitors or of firms of similar size and operations. The first set enables one
to understand the performance of the company in isolation, while the second gives
an insight as to where the company stands vis-a-vis the industry or competition.
The liquidity ratios give a clear indication of the extent to which a company is liquid.
Liquidity and profitability are two separate yardsticks to gauge a company's
performance. The current ratio gives an indication of the number of times by which
the c urrent assets multiply the current liabilities. In a healthy industry, the current
ratio should be upwards of 1.75. A figure of less than 1.25 would indicate that the
company's working capital management has to be pretty rigid to keep the liquidity
afloa t. The quick or acid test ratio is a modification of the current ratio in that only
the `quick' assets are considered in the numerator, and inventory, which is the
slowest of the current assets, is ignored. The measure gives the extent of fast
liquidity enjoyed by the company.
The debt ratio can ascertain the extent of reliance of external financing. The debt-
equity ratio gives the proportion of debt to equity. In capital-intensive industries, this
ratio can be as high as four -- that is, debt can be up to four times the equit y
portion. Normally, a debt-equity ratio of two is considered acceptable. The `times
interest earned ratio' is a matter or reassurance to the lenders that their interest
dues are protected. If the company is doing well in terms of having a high times int
erest earned ratio, it means that the interest liability is only a relatively small portion
of the company's net surplus. However, if the ratio is small, there is cause for
concern for the lender.
Only the most essential and fundamental ratios are considered here. Depending on
the specific needs of the user, more ratios can be utilised.
By comparing the various ratios with those of the previous year or years, the areas
where the company has improved can be identified; as also the spheres where
finances display a fall in the performance. This will act as a good planning tool.
Ratios have far greater utility if compared with those of the industry as a whole and
those of the competitors. Specific areas which need improvement can be identified
and corrective action initiated.
Concept check
* A high profit-to-sales ratio means that the return on assets is also high. Do you
agree?
* Suppose you are viewing key ratios of a company from the angle of a term-lending
institution, and find that the quick ratio is less than one but the current ratio and the
times interest earned ratio are 1.2 and 2 respectively, what will be your assessm ent
about the interest and principal repayment capacity of the company?
Parvatha Vardhini C
A quicker way to understand a company’s performance, rather than poring over pages of accounts, notes and
schedules in the annual report is through ‘ratio analysis’. Ratios can be classified into profitability ratios, coverage,
turnover and financial ratios. We’ll take a look at a few ratios, their relevance and significance.
We start with profitability rations, as profit is the foremost objective of any business. Are the operations efficient
enough to generate profits? This is what banks/financial institutions and creditors are worried about. After all, their
money can be repaid only when the company is able to generate income from its operations, is it not?
Shareholders, too, are equally concerned about profitability, as it broadly indicates the likely return they can earn
on their investments.
The profitability ratio is calculated as: Operating profit/capital employed x 100. Operating profit is the profit before
interest and taxes (PBIT). Capital employed is share capital + reserve and surplus + long-term liabilities - (non-
business assets + fictitious assets).
Suppose the return is 8 per cent, how will you know whether this is good or bad? As a thumb rule, if the company
has borrowed funds at, say, 7 per cent, the ROI should be greater than 7 per cent for the business to be profitable.
Coverage ratios
The ROI will show if the company is profitable alright; but will the profits be enough to pay interest on loan or repay
the amount? This is where the ‘fixed interest cover’ and ‘debt service coverage’ (DSCR) ratios come in. Calculated
as PBIT/ Interest charges, the higher the fixed interest cover, the better. A comfortable interest cover would be at
least two-three times.
To find out whether a company can repay the principal portion of its loan on time, the DSCR is calculated — the
formula being, PBIT/interest + (principal payment instalment / (1 – tax rate)). A DSCR of over 1 is considered
appropriate. But here again, the higher the coverage, the better.
Turnover ratios
While the ROI is one indicator of profitability, the speed at which capital employed in the business rotates or is
unlocked, is another. The higher the rotation, the greater the profitability. The ‘fixed assets turnover’ ratio (net
sales/ net fixed assets) shows how much of the investment in fixed assets contribute towards sales. Ditto with the
working capital ratios. High volume of sales with a relatively low working capital is an indicator of efficiency.
Credit sales/average accounts receivable will give the debtors turnover ratio. Say the turnover is three times, using
this, we can calculate the collection period (months in a year/debtor’s turnover) as 12 / 3 = 4 months. This
collection period indicates the promptness or the lack of it in money collection. Generally, the receivables should
not exceed three-four months of credit sales. Such calculations can also be made for creditors. Similarly, a high
inventory turnover (cost of goods sold/average inventory) ratio indicates good sales. A low ratio, in turn, indicates
that money is locked up in stocks. The working capital ratios are useful in determining the company’s ability to
generate future cash flows from operations.
Financial ratios
Liquidity and debt-equity ratios are widely used financial ratios. Liquidity ratio, also called the ‘short-term solvency’
ratio shows the adequacy or otherwise of working capital for a company’s day-to-day operations. It is calculated as
current assets/current liabilities. An ideal current ratio would be 2, indicating that even if the current assets are to
be reduced by half, the creditors will be able to able to get their money in full.
But a lot depends on the composition of current assets. If a substantial portion of the current assets is made of
slow-moving/obsolete stocks or if the debtors comprise ageing debts, the company may not be able to pay the
creditors even if the current ratio is higher than 2.
The debt-equity ratio is calculated as total long-term debt/shareholders’ funds. It is considered ideal if the ratio is 1.
This ratio shows the extent of owners’ stake in the business as also the extent to which firm depends upon
outsiders for existence.
Ratio Analysis
Ratio Analysis is the most commonly used analysis to judge the financial strength of
a company. A lot of entities like research houses, investment bankers, financial
institutions and investors make use of this analysis to judge the financial strength of
any company.
This analysis makes use of certain ratios to achieve the above-mentioned purpose.
There are certain benchmarks fixed for each ratio and the actual ones are compared
with these benchmarks to judge as to how sound the company is. The ratios are
divided into various categories, which are mentioned below:
Profitability ratios
Profitability ratios speak about the profitability of the company. The various
profitability ratios used in the analysis are, operating margin (operating profit divided
by net sales), gross margin (gross profit divided by net sales) net profit margin (net
profit divided by net sales), return on equity (net profit divided by net worth of the
company) and return on investment (operating profit divided by total assets). As
obvious from the name, the higher these ratios the better for the company.
Solvency ratios
These ratios are used to judge the long-term solvency of a firm. The most commonly
used ratios are – Debt Equity ratio (total debt divided by total equity), Long term
debt to equity ratio (long term debt divided by equity). While the accepted norm for
debt equity ratio differs from industry to industry, the usual accepted norm for D/E is
2:1. It should not be more than this. For certain industries, a higher D/E is accepted,
e.g., in banking industry, a debt equity ratio of 12:1 is acceptable.
Liquidity ratios
These ratios are used to judge the short-term solvency of a firm. These ratios give
an indication as to how liquid a firm is. The most commonly used ratios are – Current
ratio (all current assets divided by current liabilities) and quick ratio (current assets
except inventory divided by current liabilities). The accepted norm for current ratio is
1.5:1. It should not be less than this.
Turnover ratios
These ratios give an indication as to how efficiently a company is utilizing its assets.
The most commonly ratios are sales turnover ratio, inventory turnover ratio (average
inventory divided by net sales) and asset turnover ratio (net sales divided by total
assets). The higher these ratios, the better for the company.
Valuation Ratios
While a lower PBV usually means a lower valuation, there can be a case where a low
PBV can be because of a very huge capital base of the company. In such a case, the
stock might be overvalued but the PBV will indicate that the stock is undervalued. On
the other extreme, a higher PBV usually means overvalued stock but that can also be
because the company has a very small capital base. So care has to taken while
interpreting these ratios.
Coverage ratios
These ratios give an indication about the repayment capabilities of a company. The
most commonly used coverage ratios are Interest coverage ratio (Interest
outstanding divided by earnings before interest and taxes) and debt service coverage
ratio (earnings before interest and taxes plus all non cash charges divided by interest
outstanding plus the term loan repayment installment). The acceptable norm for
DSCR is 2:1.
Ratio Analysis
Not all corporates can raise capital from the market. Capital
market is an information driven arena. The availability of
market capital to an existing corporate depends solely on its
perceived performance. The market watchers have, at their
disposal, various tools to make this value judgement. Ratio
analysis is one such oft used (or abused) tool. The trends in
management, financial viability and other factors relevant
from the point of view of the market can be studied from the
various financial ratios such as:
RATIO ANALYSIS
Mere statistics/data presented in the different financial statements do not reveal the true picture of a financial
position of a firm. Properly analyzed and interpreted financial statements can provide valuable insights into a
firm’s performance. To extract the information from the financial statements, a number of tools are used to
analyse such statements. The most popular tool is the Ratio Analysis. Financial ratios can be broadly
classified into three groups: (I) Liquidity ratios, (II) Leverage/Capital structure ratio, and (III) Profitability
ratios.
(I) Liquidity ratios:
Liquidity refers to the ability of a firm to meet its financial obligations in the short-term which is less than a
year. Certain ratios, which indicate the liquidity of a firm, are (i) Current Ratio, (ii) Acid Test Ratio, (iii)
Turnover Ratios. It is based upon the relationship between current assets and current liabilities.
(i) Current ratio = Current Assets/ Current Liabilities
The current ratio measures the ability of the firm to meet its current liabilities from the current assets. Higher
the current ratio, greater the short-term solvency (i.e. larger is the amount of rupees available per rupee of
liability).
(ii) Acid-test Ratio = Quick Assets/ Current Liabilities
Quick assets are defined as current assets excluding inventories and prepaid expenses. The acid-test ratio
is a measurement of firm’s ability to convert its current assets quickly into cash in order to meet its current
liabilities. Generally speaking 1:1 ratio is considered to be satisfactory.
(iii) Turnover Ratios:
Turnover ratios measure how quickly certain current assets are converted into cash or how efficiently the
assets are employed by a firm. The important turnover ratios are: Inventory Turnover Ratio, Debtors
Turnover Ratio, Average Collection
Period, Fixed Assets Turnover and Total Assets Turnover
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Where, the cost of goods sold means sales minus gross profit. ‘Average Inventory’ refers to simple average
of opening and closing inventory. The inventory turnover ratio tells the efficiency of inventory management.
Higher the ratio, more the efficient of inventory management.
Debtors’ Turnover Ratio = Net Credit Sales / Average Accounts Receivable (Debtors)
The ratio shows how many times accounts receivable (debtors) turn over during the year. If the figure for net
credit sales is not available, then net sales figure is to be used. Higher the debtors turnover, the greater the
efficiency of credit management.
Average Collection Period = Average Debtors / Average Daily Credit Sales
Average Debtors
Average Collection Period represents the number of days’ worth credit sales that is locked in debtors
(accounts receivable).
Average Collection Period = 365 Days / Debtors Turnover
Fixed Assets turnover ratio measures sales per rupee of investment in fixed assets. In other words, how
efficiently fixed assets are employed. Higher ratio is preferred. It is calculated as follows:
Fixed Assets turnover ratio = Net. Sales / Net Fixed Assets
Total Assets turnover ratio measures how efficiently all types of assets are employed.
Total Assets turnover ratio = Net Sales / Average Total Assets
(II) Leverage/Capital structure Ratios:
Long term financial strength or soundness of a firm is measured in terms of its ability to pay interest regularly
or repay principal on due dates or at the time of maturity. Such long term solvency of a firm can be judged by
using leverage or capital structure ratios. Broadly there are two sets of ratios: First, the ratios based on the
relationship between borrowed funds and owner’s capital which are computed from the balance sheet.
Some such ratios are: Debt to Equity and Debt to Asset ratios. The second set of ratios which are calculated
from Profit and Loss Account are: The interest coverage ratio and debt service coverage ratio are coverage
ratio to leverage risk.
(i) Debt-Equity ratio reflects relative contributions of creditors and owners to
finance the business.
Debt-Equity ratio = Total Debt / Total Equity
The desirable/ideal proportion of the two components (high or low ratio) varies from industry to industry.
(ii) Debt-Asset Ratio: Total debt comprises of long term debt plus current liabilities. The total assets comprise
of permanent capital plus current liabilities.
Debt-Asset Ratio = Total Debt / Total Assets
The second set or the coverage ratios measure the relationship between proceeds from the operations of
the firm and the claims of outsiders.
(iii) Interest Coverage ratio = Earnings Before Interest and Taxes /Interest
Higher the interest coverage ratio better is the firm’s ability to meet its interest burden. The lenders use this
ratio to assess debt servicing capacity of a firm.
(iv) Debt Service Coverage Ratio (DSCR) is a more comprehensive and apt to compute debt service
capacity of a firm. Financial institutions calculate the average DSCR for the period during which the term
loan for the project is repayable. The Debt Service Coverage Ratio is defined as follows:
DSCR - Profit after tax Depreciation Other Non-cash Expenditure Interest on term loan / Interest on Term
loan Repayment of term loan
(III) Profitability ratios:
Profitability and operating/management efficiency of a firm is judged mainly by the following profitability
ratios:
(i) Gross Profit Ratio (%) = Gross Profit / Net Sales * 100
(ii) Net Profit Ratio (%) = Net Profit / Net Sales * 100
Some of the profitability ratios related to investments are:
(iii) Return on Total Assets = Profit Before Interest And Tax / (Fixed Assets Current Assets)
(iv) Return on Capital Employed = Net Profit After Tax / Total Capital Employed (Here, Total Capital
Employed = Total Fixed Assets + Current Assets - Current Liabilities)
(v) Return on Shareholders’ Equity = Net profit After-Tax / Average Total Shareholders Equity or Net Worth
(Net worth includes Shareholders’ equity capital plus reserves and surplus) A common (equity) shareholder
has only a residual claim on profits and assets of a firm, i.e., only after claims of creditors and preference
shareholders are fully met, the equity shareholders receive a distribution of profits or assets on liquidation. A
measure of his well being is reflected by return on equity.
There are several other measures to calculate return on shareholders’ equity of which the following are the
stock market related ratios:
(i) Earnings Per Share (EPS): EPS measures the profit available to the equity shareholders per share, that
is, the amount that they can get on every share held. It is calculated by dividing the profits available to the
shareholders by number of outstanding shares. The profits available to the ordinary shareholders are arrived
at as net profits after taxes minus preference dividend. It indicates the value of equity in the market.
EPS = Net profit AvailableToThe Shareholder / Number of Ordinary Shares Outstanding
(ii) Price-earnings ratios = P/E Ratio = Market Pr ice per Share / EPS
Abbreviations:NSE- National Stock Exchange of India Ltd.SEBI - Securities Exchange Board of IndiaNCFM -
NSE’s Certification in Financial MarketsNSDL - National Securities Depository LimitedCSDL - Central
Securities Depository LimitedNCDEX - National Commodity and Derivatives Exchange Ltd.NSCCL -
National Securities Clearing Corporation Ltd.FMC – Forward Markets CommissionNYSE- New York Stock
ExchangeAMEX - American Stock ExchangeOTC- Over-the-Counter MarketLM – Lead ManagerIPO- Initial
Public OfferDP - Depository ParticipantDRF - Demat Request FormRRF - Remat Request FormNAV – Net
Asset ValueEPS – Earnings Per ShareDSCR - Debt Service Coverage RatioS&P – Standard & PoorIISL -
India Index Services & Products LtdCRISIL- Credit Rating Information
Companies despatch their annual reports once every accounting year (normally 12
months). With these reports running into hundreds of pages, how do you quickly
understand a company's performance over this period? As accounts are prepared
using the double-entry system, every item is linked to at least one other item.
Hence, understanding financial ratios would help profile a company. These ratios are
broadly classified as leverage, liquidity, efficiency and profitability ratios. We shall
first focus on the profitability ratios for, as investors, we are more concerned with the
company's earnings than with its operational efficiency, capital structure or its ability
to meet debt obligations.
Margin ratios
Margin ratios, one of the key measures of profitability, show the efficiency of the firm
in retaining revenues. These can be classified further into gross margin, operating
margin and net margin ratios.
The operating margin ratio is calculated by dividing the operating income (net sales
minus production, administration and selling and distribution costs) by net sales. In
other words, it is the percentage of revenue earned in excess of production,
administration and selling and distribution costs. Realisations or billing rates and
operating cost per unit are among the key factors that drive this ratio. Volumes,
though not as pivotal as the earlier mentioned factors, also play a role.
While high margins are desirable, as they provide a cushion against the risk of
adverse changes, investors need to look at the structure of the margins to determine
the sustainability and scope for improvement.
A significantly high margin needs to be treated with caution as threats from new
entrants and substitute products are higher. Tendency to hike capacities, leading to
overcapacity, is also more; the recent trend in the caustic soda industry is case in
point.
While the above two measures of profitability are derived from the income statement
(simply, the profit-and-loss account) the following two return ratios are derived from
both the income statement and the balance-sheet.
This ratio indicates the profitability of an entity's capital investments. Why does this
ratio matter to an investor? If this ratio is lower than the rate at which the company
borrows, any further rise in debt will lead to negative earnings growth.
This ratio indicates an entity's profitability and efficiency, and is arrived at by dividing
earnings after taxes by the shareholder's funds. This ratio, a combination of three
underlying factors, is related to profit margin, asset management, and leverage.
When an investor goes by the price-to-book value measure, he should consider this
ratio as it aids in measuring the rate at which a company improves its shareholder
funds.
Although a high RONW is desirable, the stability of this ratio plays a significant role.
A key reason for the steady run-up in the price of Infosys Technologies is the fact
that the company has recorded an average RONW of 40 per cent over the past five
years. This would indicate that the company has grown more than four-fold in this
period.
Ans.4 It is that statement in which net sales figure is taken as 100 and all other
figures are expressed as percentage of sales.
Ans.6 Cash flow statement is a statement which shows inflows and outflows of
cash and cash equivalence of an enterprise during a specified period of
time.
Ans.9 While preparing the cash flow statement according to AS-3 (Revised) the
activities are classified into three groups :
Current Ratio
Quick Ratio
Sales/Receivables
Days' Receivables
Cost of Sales/Inventory
Days' Inventory
Cost of Sales/Payables
Days Payables
Sales/Working Capital
Industry
LEVERAGE RATIOS 12-31-03 12-31-04 12-31-05 Average
Fixes/Worth
Debt/Worth
Total liabilities divided by tangible net worth. 3.5 3.2 6.0 2.3
Net sales divided by net fixed assets. 72.3 21.9 33.5 28.5
Sales/Total Assets
Net sales divided by net fixed asserts. 4.8 4.6 4.3 3.1
Industry
GOING-CONCERN EVALUATION 12-31-03 12-31-04 12-31-05 Average
Industry
FACTORS USED IN COMPUTATIONS 12-31-03 12-31-04 12-31-05 Average
Amortization expense 0 0 0
Unit 1
1. the success of a business entity depends on the combined effects of four factors –
land , labour ,managements and
a. capital
b. finance
c. share
d. assets
2. without accounting a business entity cannot communicate with
a. inside world
b. outside world
c. general
d. majors
3. certain ground rules were initially set for financial accounting also called
a. golden rules
b. accounting conventions or concepts
c. accounts results
d. ledgers
4. a corporate entity is a separate legal entity , entirely divorced from its ……..
a. company
b. customer
c. owners
d. none
5. a ……………… normally comes to an end with the expiry of the owners.
a. Partnership business
b. Corporate business
c. Sole proprietorship business
d. Enterprise business
6. a ………………….. entity is not distributed at all on the expiry of any equity
shareholders
a. corporate
b. sole proprietor
c. assets
d. liability
7. Human intervention normally ends with the preparation of necessary documents
called
a. Vouchers
b. Ledgers
c. Accounts
d. Balance sheets
8. the ………….. voucher is drawn to record all non-cash transaction and events.
a. Journal
b. Payment
c. Receipt
d. Memo
9. ……….. are end products of the accounting process.
a. Balance sheet
b. Profit and loss a/c
c. Financial statements
d. None
10. the three basic elements of balance sheets –
a. assets
b. liability
c. equity
d. cash
11. A…………. is a present obligation of the enterprises arising from past events
a. Assets
b. Liability
c. Cash
d. Profit
12. ………. Is the access of assets over liabilities
a. equity
b. Cash
c. Profit
d. None
13. fundamental accounting equation is
a. A=L+E
b. A=L-E
c. A=L/E
d. A=LxE
14. The amount at which equity is shown in the balance sheets is dependent on
measuring of ……….. and ………..
a. Assets , liabilities
b. Profit , loss
c. Capital , liabilities
d. Shares, debitors
15. the principle of the double entry accounting were first explained in print by ……
…….
a. Luca Fra Pacioli
b. Newton
c. Summa de
d. None
16. anticipates no profits but provide for all possible losses
a. concept of prudence
b. the realization concept
c. accounting concept
d. none
1. Unit 2
17. ……….. is a book of first entry or prime entry
a. voucher
b. journal
c. primary book
d. secondary book
18. journalise means ……………
a. recording in primary book
b. positing in secondary book
c. preparation of vouchers
d. none
19. in ground rule of journalization increase in assets and decrease in liabilities is
called
a. debit
b. credit
c. profit
d. loss
20. in ground rule of journalization income and gains is also called
a. debit
b. credit
c. both
d. none
21. ………. Records bills raised by suppliers
a. bills payable
b. bills receivable
c. bill quoted
d. cash book
22. …………. Records all residual transaction
a. bills payable
b. bills receivable
c. bill quoted
d. journal proper
23. ……….. records credit sales of goods
a. purchase day book
b. sales day book
c. return onward book
d. return inward book
24. …………. Records goods returned to the suppliers
a. purchase day book
b. sales day book
c. return onward book
d. return inward book
25. if debit side of the bank column is greater than the credit side the balance is a …
……………… balance
a. favorable
b. un favorable
c. unit
d. gain
26. bank balance analysis is done with a document called ………. statements
a. bank reconciliation
b. bank conciliation
c. bank non reconciliation
d. de reconciliation
27. ……….. is a journal and ledger
a. cash book
b. sales day book
c. return onward book
d. return inward book
1. Unit 3
28. date wise transaction is done in
a. primary book
b. ledgers
c. balance sheets
d. secondary books
29. …………. Is a self sufficient secondary book in the sense that all entries in the
primary book will be posted in this ledgers
a. general ledgers
b. debtor ledgers
c. creditor ledgers
d. none
30. ………….. has separate accounts for each supplier
a. general ledgers
b. debtor ledgers
c. creditor ledgers
d. none
31. the motive behind having subsidiary ledgers is to reduce the burden on the ……
…..
a. main ledgers
b. general ledgers
c. debtor ledgers
d. none
32. the controls maintained under general ledger is called
a. mondry
b. sundry
c. controller
d. none
33. “To” is used to represent
a. credit
b. debit
c. both
d. none
34. balancing account is also known as
a. opening account
b. closing account
c. renaming account
d. re opening account
35. the suffix ‘c/d ‘ denotes
a. carried debit
b. carried down
c. carried debtors
d. none
36. due date is normally calculated after ……………… days grace from the date of
maturity.
a. 1
b. 2
c. 3
d. 4
37. ………….. is a formal record of a particular type of transaction
a. credit
b. balance
c. account
d. ledger
38. Sundry creditor means
a. Customer
b. Supplier
c. Organization
d. Entity
Unit 4
Unit 7
67. …………is a technical device designed to highlight the changes in the financial
conditions of a business enterprise between two balance sheets.
a. funds flow analysis
b. costs analysis
c. market analysis
d. management analysis
68. objectives of funds flow statement is to find out financial strength and weakness
of the business
a. a true
b. b false
69. first steps in preparation of funds flow statement is preparation of schedule
changes in working capital
a. a true
b. b false
70. funds flow statement includes
a. non trading incomes
b. b issue of shares
c. c non operating exp.
d. d all of the above
71. for the purpose of fund flow statement the term fund means…
a. net working capital
b. net assets
c. capital
d. net liability
72. FFO stands for
a. Fund form operation
b. Fund From operation
c. Funds For operation
d. None
73. the fund flow statement describes the sources from which additional funds were
derived and the uses to which these funds were put, is said by
a. newmen
b. Robert newman
c. Robert Anthony
d. None
Unit 8.
Short Answer
Pyramid Ltd.
BALANCE SHEET as on 31st March, 2008
Liabilities Rs. Assets Rs.
Share Capital Fixed Assets
Authorised Capital At Gross Value17,00,000
....Equaity shares of Rs. ....each.... Less : Depreciation2,40,000
14,60,000
Issued, Subscribed and Paid-up=======
--------------
....Equity share sof Rs. ...each Investments
....
Fully paid-up in Cash 12,00,000 Current Assets, Loans and
Reserves and Surplus Advances
General Reserve 3,00,000 Current Assets
11,40,000
Profit and Loss A/c 1,80,000 Miscellaneous Expenditure
Secured Loans .... Discount on issue of
Debentures 40,000
10% Debentures 4,00,000
Unsecured Loans
Current Liabilities Provisions
Current Liabilities 5,60,000
---------- ----------- ------------
26,40,000 26,40,000
======= =======
(iii) Not. Free from Bias: In many situations, the accountant has to
make a choice out of various alternatives available, e.g., choice in the
method of depreciation choice in the method of inventory valuation.
Since, the subjectivity is interest in personal judgment, the financial
statements are therefore not free from bias. As a result, financial
analysis also cannot be said to be free from bias.
Ans.9 Solution :
Particulars Absolute Figure Change (Base Year : 2006)
2006 2007 Absolute Percentage
Change Change
(Rs.) (Rs.) (Rs.) %
Sales 20,00,000 30,00,000 10,00,000 50%
Less : Cost of Goods Sold 12,00,000 21,00,000 9,00,000 75%
Gross Profit ,8,00,000 9,00,000 1,00,000 12.5%
Less : Indirect Taxes 4,00,000 3,60,000 (-40000) -10%
Net Profit before Tax 4,00,000 5,40,000 1,40,000 35%
Less : Tax 50% 2,00,000 2,70,000 70,000 35%
Net Profit after Tax 2,00,000 2,70,000 70,000 35%
Ans.11 Solution:
ii) Purchase of goods on cash will not change the ratio, neither the
total current assets nor the total currert liabilities are affected since
there is only a conversion of one current asset into another current
asset.
iii) Sale of office equipment will improve the ratio because current
asset (cash) will increase without any change in current liability.
iv) Sale of goods for Rs 11,000; cost being Rs 10,000 will improve the
current ratio because current asset will increase by Rs. 1,000.
v) Payment of dividend will reduce the total of current assets and total
of current liabilities by the same amount. Therefore, the current
ratio will improve.
Ans.13 Solution :
Ans.14 Solution :
Cost of Goods Sold
Stock Turnover Ratio = Average Stock
Profit = Rs. 20
Ans.15 Solution :
Net Credit Sales
Debtors Turnover Ration = Average Debtors
3,50,000
= 43.750
Average Debtors = 8
2x = (43,750 x 2) + 14,000
x = 50,750
Closing Debtors = Rs. 50,750
Opening Debtors = 50,750 - 14,000 = 36,750
Ans.17 Solution :
Rs. 4,00,000
Cash Sales = 2 = Rs. 2,00,000
Ans.18 Cash Sales = 25% of total sales. It means that credit sales will be 75%
of total sales. If credit sales (75% of total sales) = Rs. 2,40,000
= Rs. 2,56,000
Note :
x 100 = 49.76%.
Solution:
Gross Profit
i) Gross Profit Ratio = Net Sales x 100
Rs.7,87,50 0 - Rs.3,95,60 0
= Rs.7,87,50 0 x 100 = 49.76%
Cost of Goods Sold Rs. 3,95,600
ii) Stock Turnover Ratio = Average Stock = Rs. 1,97,800 = 2 times
Debt (Long - term Loans)
iii) Debt-Equity Ratio = Shareholders' Funds
Ans.21 Solution
Current Assets
Current Ratio = Current Liabilitie s
Ans.22 Solutions :
Current Liabilities are Rs. 1,00,000 and Current Ratio is 2.5 : 1;
therefore, Current Assets = Rs. 1,00,000 x 2.5 = Rs. 2,50,000
After paying Rs. 25,000
Current Assets = Rs. 2,50,000 - Rs. 25,000 = Rs. 2,25,000
Current Liabilities = Rs. 1,00,000 - Rs. 25,000 = Rs. 75,000
Current Assets
Current Ratio = Current Liabilitie s = = 3 : 1
Ans.23 Solution :
Current Assets
Current Ratio = Current Liabilitie s
Ans.24 Solution :
Calculation of Quick Assets :
Quick Assets Quick Assets
Quick Ratio = Current Liabilitie s = Rs. 40,000 = 1.5
Quick Assets = Rs. 40,000 x 1.5 = Rs. 60,000
Calculation of Stock :
Stock = Current Assets - Quick Assets
= Rs. 1,00,000 - Rs. 60,000 = Rs. 40,000
Ans.25 Solution :
Calculation of Current Assets and Current Liabilities :
Current Assets - Current Liabilities = Working Capital
Current Assets - Current Liabilities = Rs. 60,000
Current Assets / Current Liabilities = 2.5
or, Current Assets - 2.5 Current Liabilities = 0
Subtracting Eqn. 2 from Eqn. 1,
1.5 Current Liabilities = Rs. 60,000
Current Liabilities = s. 60,000/1.5 = Rs. 40,000
Current Assets= Rs. 40,000 x 2.5 = Rs. 1,00,000
Ans.26 Solutions :
Current Assets
Current Ratio = Current Liabilitie s
Rs.17,00,000
2.5 = Current Liabilitie s
Rs.17,00,000
Current Liabilities = 2.5 = Rs. 6,80,000
Liquid Assets
Liquid Ratio = Current Liabilitie s
Liquid Assets
0.95 = Rs.6,80,00 0 ; Liquid Assets = Rs. 6,46,000
iii) To ascertain the net change in cash and cash equivalents (sources
minus uses of cash and cash equivalents) between the date of two
Balance Sheets.
b) Investing Activities
c) Operating Activities
d) Operating Activities
Ans.29 Solution :
82,000
Less : Profit on Sale of Machinery 5,000
Dividend Received 3,000 8,000
Operating Profit before Working Capital Changes 74,000
Less : Increase in Current Assets & Decrease in
Current Liabilities :
Commission Accrued 4,000
Cash Generated from Operations 70,000
Less : Tax Paid 15,000
Cash Flow from Operating Activities 55,000
Note :
Net Profit before Tax and Extraordinary items is calculated by adding
Provision for Tax and Proposed Dividend to the amount of Net Profit, i.e,,
Rs. 24,000 + Rs. 15,000 + Rs. 10,000.
Ans.30 Solution :
Particulars Rs.
Net Profit for the year 50,000
Add : Transfer to General Reserve 10,000
Net Profit before Tax 60,000
Add : Depreciation 20,000
Loss on Sale of Machine 10,000
Preliminary Expenses Written Off 10,000
1,00,000
Less : Profit on Sale of Furniture 5,000
Operating Profit before Working Capital Changes 95,000
Add : Decrease in Bills receivable 2,000
Increase in Bills Payable 10,000
Increase in Outstanding Expenses 1,000 13,000
1,08,000
Less: Increase in Debtors 5,000
Increase in Stock 3,000
Increase in Prepaid Expenses 1,000
Decrease in Creditors 2,000 11,000
Cash Flow from Operating Activities 97,000
Ans.31 Solution :
Particulars Rs.
Net Profit 1,00,000
Add : Transfer to General Reserve 30,000
Net Profit before Tax 1,30,000
Adjustment for non-cash and non-operation expenses :
Ans.32 Solution :
Rajan Ltd.
CASH FLOW STATEMENT for the year ended 31st December, 2002
Particualrs Rs. Rs.
A. Cash Flow from Operating Activities
Ans.33 Solution :