TEST YOUR UNDERSTANDING I• State which of the following statements are True or False. (b) Analyses of data provided in the financial statements a is termed as financial analysis. (c) Long term creditors are concerned about the ability of a firm to discharge its obligations to pay interest and repay the principal amount of term. (d) A ratio is always expressed as a quotient of one number divided by another. (e) Ratios help in comparisons of a firm’s results over a number of accounting periods as well as with other business enterprises. (f) One ratios reflect both quantitative and qualitative aspects. DO IT YOURSELF IQuestion 1. Current ratio =4.5:1,quick ratio =3:1, Inventory is Rs.36,000. Calculate the current assets and current liabilities. Question 2. Current liabilities of a company are ? 5,60,000 current ratio is 5 : 2 and quick ratio is 2 : 1. Find the value of the stock. Question 3. Current assets of a company are Rs. 5,00,000. Current ratio is 2.5 : 1 and quick ratio is 1 : 1. Calculate the value of current liabilities, liquid assets and stock. TEST YOUR UNDERSTANDING II(i) The following groups of ratios primarily measure risk (ii) The————ratios are primarily measures of return. (iii) The…………….of a business firm is measured by its ability to satisfy (iv) ……………….ratios are a measure of the speed with which various (v) The two basic measure of liquidity are (vi) The……………is a measure of liquidity which excludes………………….., generally the least liquid asset. DO IT YOURSELF IIQuestion 1. Calculate the amount of gross profit Question 2. Calculate stock Turnover Ratio TEST YOUR UNDERSTANDING III(i) The………..is useful in evaluating credit and collection policies. (ii) The………measures the activity of a firm’s inventory. (iii) The………..ratio may indicate the firm is experiencing stock outs and lost sales. (iv) ABC Co extends credit terms of 45 days to its customer, its credit collection would be considered poor if its average collection period was (v) …………… are especially interested in the average payment period, since it provides them with a sense of the billpaying patterns of the firm. (vi) The……………….. ratios provide the information critical to the longrun operation of the firm SHORT ANSWER TYPE QUESTIONSQuestion 1. What do you mean by Ratio Analysis? Question 2. What are various types of ratios? Question 3. What relationships will be established to study? (b)Debtor Turnover Ratio :Debtor turnover ratio or accounts receivable turnover ratio indicates the velocity of debt collection of a firm. In simple words it indicates the number of times average debtors (receivable) are turned over during a year. The formula for calculating Debtors turnover ratio is as follows (c)Creditors/Payables Turnover Ratio :It compares creditors with the total credit purchases. It signifies the credit period enjoyed by the firm in paying creditors. Accounts payable include both sundry creditors and bills payable. Same as debtor’s turnover ratio, creditor’s turnover ratio can be calculated in two forms, creditors’ turnover ratio and average payment period. The following formula is used to calculate the creditors Turnover Ratio (d)Working Capital Turnover Ratio Working capital turnover ratio indicates the velocity of the utilization of net working capital. This ratio represents the number of times the working capital is turned over in a year and is calculated as follows Question 4. Why would the inventory turnover ratio be more important when analysing a grocery store than an insurance company? Question 5. The liquidity of a business firm is measured by its ability to satisfy its long term obligations as they become due? Comment. Debt Equity Ratio: Debt equity ratio indicates the relationship between the external equities or outsiders funds and the internal equities or shareholders funds. It is also known as external internal equity ratio. It is determined to ascertain soundness of the long term financial policies of the company. Following formula is used to calculate debt to equity ratio Proprietory Ratio/Total Assets to Debt Ratio: Total assets to Debt Ratio or Proprietory Ratio are a variant of the debt equity ratio. It is also known as equity ratio or net worth to total assets ratio. This ratio relates the shareholder’s funds to total assets. Proprietory / Equity ratio indicates the longterm or future solvency position of the business. Formula of Proprietory/Equity Ratio Fixed Assets to Proprietor’s Fund Ratio: Fixed assets to proprietor’s fund ratio establish a relationship between fixed assets and shareholders’ funds. The purpose of this ratio is to indicate the percentage of the owner’s funds invested in fixed assets. The formula for calculating this ratio is as follows Interest Coverage Ratio: This ratio deals only with servicing of return on loan as interest. This ratio depicts the relationship between amount of profit utilise for paying interest and amount of interest payable. A high Interest Coverage Ratio implies that the company can easily meet all its interest obligations out of its profit. Question 6. The average age of inventory is viewed as the average length of time inventory is held by the firm or as the average number of day’s sales in inventory. Explain. LONG ANSWER TYPE QUESTIONSQuestion 1. Who are the users of financial ratio analysis? Explain the significance of ratio analysis to them. Question 2. What are liquidity ratios? Discuss the importance of current and liquid ratio. Current Ratio/Working Capital Ratio: This ratio establish relationship between current assets and current liabilities. The standard for this ratio is 2 : 1. It means a ratio 2 : 1 is considered favourable. It is calculated by dividing the total of the current assets by total of the current liabilities. The formula for the current ratio is as follows Importance of Current Ratio: Current Ratio Provides a measure of degree to which current assets cover current liabilities. The excess of current assets over current liabilities provides a measure of safety margin available against uncertainty in realisation of current assets and flow of funds. However, it must be interpreted carefully because windowdressing is possible by manipulating the components of current assets and current liabilities, e.g., it can be manipulated by making payment to creditors. A very high current ratio is not a good sign as it reflects under utilisation or improper utilisation of resources. Importance of Quick Ratio :It helps in determining whether a firm has sufficient funds if it has to pay all its current liabilities immediately. Because of exclusion of nonliquid current assets, it is considered better than current ratio as a measure of liquidity position of the business. Standard for liquid ratio is 1:1. Sometimes quick ratio is calculated on the basis of quick liability instead of current liabilities. Quick liabilities are calculated by ignoring bank overdraft, if any. It means to get the figure of quick liabilities from current liabilities; bank overdraft is deducted from current liabilities. Question 3. How would you study the solvency position of the firm? Debt Equity Ratio :Debt Equity Ratio indicates the relationship between the external equities or outsiders funds and the internal equities or shareholders funds. It is also known as external internal equity ratio. It is determined to ascertain soundness of the long term financial policies of the company. Proprietory Ratio/ Total Assets to Debt Ratio: Total assets to Debt Ratio or Proprietory Ratio are a variant of the debt equity ratio. It is also known as equity ratio or net worth to total assets ratio. This ratio relates the shareholder’s funds to total assets. Proprietory/Equity Ratio indicates the longterm or future solvency position of the business. Formula of Proprietary/Equity Ratio Fixed Assets to Proprietor’s Fund Ratio: Fixed Assets to Proprietor’s Fund Ratio establish a relationship between fixed assets and shareholders’ funds. The purpose of this ratio is to indicate the percentage of the owner’s funds invested in fixed assets. The formula for calculating this ratio is as follows Interest Coverage Ratio :This ratio deals only with servicing of return on loan as interest. This ratio depicts the relationship between amount of profit utilise for paying interest and amount of interest payable. A high Interest Coverage Ratio implies that the company can easily meet all its interest obligations out of its profit. Question 4. What are important profitability ratios? How are they worked out? ‘ Gross profit would be the difference between net sales and cost of goods sold. Cost of goods sold in the case of a trading concern would be equal to opening stock plus purchase, minus closing stock plus all direct expenses relating to purchases. In the case of manufacturing concern, it would be equal to the sum of the cost of raw materials, wages, direct expenses and all manufacturing expenses. In other words, generally the expenses charged to profit and loss account or operating expenses are excluded from the calculation of cost of goods sold. Net Profit Ratio :Net Profit Ratio is the ratio of net profit 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 incometax and, generally, nonoperating 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. Operating Profit Ratio :Operating Profit Ratio is the ratio of operating profit to net sales. There are many non operating expenses and incomes included in the profit and loss account which has nothing to do with the operations of the business such as loss by fire, loss by theft etc. On the other had in credit side of the P&L account, there are so many incomes 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. 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. The formula for calculating the operating ratio is as follows Question 5. Financial ratio analysis are conducted by four groups of analysts : managers, equity investors, long term creditors and short term creditors. What is the primary emphasis of each of these groups in evaluating ratios? Question 6. The current ratio provides a better measure of overall liquidity only when a firm’s inventory cannot easily be converted into cash. If inventory is liquid, the quick ratio is a preferred measure of overall liquidity. Explain. But on the other hand, in case of those firms where the stock can be easily realised or sold off consideration of stock should be avoided and to measure the liquidity of that firm Quick ratio should be calculated, e.g., the inventories of a service sector company are very liquid as there are no stocks kept for sale, so in that case liquid ratio must be followed for measuring the liquidity of the firm. NUMERICAL QUESTIONSQuestion 1. Following is the Balance Sheet of Rohit and Company as on March 31, 2006. Question 2. Following is the Balance Sheet of Title Machine Limited as on March 31, 2006. Question 3. Current Ratio is 3:5 Working Capital is Rs. 9,00,000. Calculate the amount of Current Assets and Current Liabilities. Question 4. Shine Limited has a current ratio 4.5:1 and quick ratio 3:1; if the stock is 36,000, calculate current liabilities and current assets. Question 5. Current liabilities of a company are Rs. 75,000. If Current ratio is 4 : 1 and liquid ratio is 1:1, calculate value of current assets, liquid assets and stock. Question 6. Handa Limited has stock of Rs. 20,000. Total liquid assets are Rs. 1,00,000 and quick ratio is 2:1 Calculate current ratio. Question 7. Calculate debt equity ratio from the following information Question 8. Calculate Current Ratio if Stock is ? 6,00,000; Liquid Assets Rs. 24,00,000; Quick Ratio 2:1. Question 9. Compute Stock Turnover Ratio from the following information Question 10. Calculate following ratios from the following information Question 11. From the following information calculate Question 12. Compute Gross Profit Ratio, Working Capitat Turnover Ratio, Dept Equity Ratio and Proprietory Ratio from the fottowing information Question 13. Calculate Stock Turnover Ratio if Opening Stock is Rs. 76,250, Closing Stock is 98,500, Sales is Rs. 5,20,000, Sales Return is Rs.20,000, Purchase is Rs. 3,22,250. Question 14. Calculate Stock Turnover Ratio from the data given below Question 15. A trading firm’s average stock is ? 20,000 (cost). If the stock turnover ratio is 8 times and the firm setts goods at a profit of 20% on sales, ascertain the profit of the firm. Question 16. You are able to collect the following information about a company for two years Question 17. The following Balance Sheet and other information, calculate following ratios Question 18. The following is the summarised Profit and Loss account and the Balance Sheet of Nigam Limited for the year ended March 31, 2007 Question 19. From the following, Question 20. Cost of Goods Sold is 1 1,50,000 Operating expenses are Rs. 60,000. Sales is Rs. 2,60,000 and Sales Return is Rs. 10,000. Calculate Operating Ratio. Question 21. The following is the summerised transactions and Profit and Loss Account for the year ending March 31, 2007 and the Balance Sheet as on that date. Question 22. From the fotlowing information calcutate Gross Profit Ratio, Stock Turnover Ratio and Debtors Turnover Ratio.
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