ANALYTICAL REVIEW
The two main functions of analytical review are:
To provide the client with supplementary useful information in addition to the annual accounts
Ø To identify critical audit areas in audit planning
For the purpose of a fundamental analysis of the economic status of an enterprise we need information about its development in the past and in the future.
As we are not able to forecast the future, we have to use reliable instruments to describe the actual and future opportunities as well as risks for the company’s development. Therefore, it is necessary to select a large amount of economic data.
Managers often know the significance of such ratios. Therefore the want to achieve optional ratios by using ‘window dressing’. Some of the ratios can be manipulated more than other ratios. For this reason, ratios that can easily be influenced should be used carefully.
In the following presentation of different types of ratios we focus on the aggregation of fundamental balance sheet data as well as on the profit and loss account.
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Sr. No.
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Name of the Ratio
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Formula
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Test
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Industry Norms
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1.
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Current Ratio
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Current Assets
Current Liabilities |
Liquidity and solvency
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2:1
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2.
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Liquid/quick/acid test Ratio
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Current assets - Stock – Prepaid Expenses
Current Liabilities - Bank Overdraft – Pre-received Income |
Liquidity and solvency
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1:1
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3.
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Absolute Liquid Ratio
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Cash + Marketable securities
Quick Liabilities |
Liquidity and solvency
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1:1
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4.
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Proprietary Ratio
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Proprietor’s Fund
Total Assets [Proprietor’s funds = Equity Capital + Preference Capital + Reserves and Surplus + Accumulated funds – Debit balances of P & L A/c and Miscellaneous Expenses]
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Liquidity and solvency
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60-75%
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|
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5.
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Debt Equity Ratio
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Debt
Equity [Debt = Long/Short-term loans, debentures, bills, etc, Equity = Proprietor’s funds]
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Capitalisation
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2:1
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|
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6.
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Capital Gearing Ratio
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Fixed cost funds
Funds not carrying fixed cost [Fixed cost funds = Preference share capital, Debentures, Loans from banks, financial institutions, other unsecured loans]
[Funds not carrying fixed cost = Equity share capital + undistributed profit – P & L A/c (Dr. Bal.) - Misc. exp.]
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Capitalisation
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2:1
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|
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7.
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Gross Profit Ratio
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Gross Profit x 100
Net sales |
Profitability
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20-30%
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|
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8.
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Net Profit Ratio
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Net Profit x 100
Net sales [Net profit may be either Operating Net profit, Profit before tax or Profit after tax]
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Profitability
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5-10%
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|
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9.
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Return on Capital Employed (ROCE)
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Net profit x 100
Capital employed [Capital employed = Fixed Assets + Current Assets - Current Liabilities]
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Profitability
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-
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|
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10.
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Return on Proprietors fund
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Profit after tax
Proprietor’s funds |
Profitability
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-
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|
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11.
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Return on Capital
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Profit after tax less pref. Dividend x 100
Equity Share Capital |
Profitability
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-
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|
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12.
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Earnings per share [EPS]
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Profit after tax less pref. Dividend
Total No. of Equity Shares |
Profitability
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-
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13.
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Dividend per share [DPS]
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Total Dividend paid to ordinary shareholders
Number of ordinary shares |
Profitability
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-
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14.
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Stock Turnover
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Cost of goods sold
Average Stock |
Management efficiency
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5-6 times
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|
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15.
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Debtors Turnover Ratio
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Debtors + Bills receivable x 365
Net Credit sales |
Management efficiency
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45-60 days
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|
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16.
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Debtor’s Turnover Rate
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Credit sales
Avg. Debtors + Bills receivable Management |
Management efficiency
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|
|
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17.
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Creditor’s Turnover Ratio
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Creditors + Bills payable x 365
Credit purchases |
Management efficiency
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60-90 days
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|
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18.
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Creditor’s Turnover Rate
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Credit purchases
Average Creditors |
Management efficiency
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|
|
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19.
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Operating Ratio
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Operating Costs x 100
Net sales [Operating Cost = Cost of goods sold + Operating expenses (viz. Administrative, selling & finance expenses)]
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Management efficiency
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|
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20.
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Preference shareholders’ coverage ratio
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Net profit (after Interest & Tax but before equity dividend)
Preference Dividend |
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21.
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Equity shareholder’s coverage ratio
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Net profit (after interest, tax & Pref. Dividend)
Equity Dividend |
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22.
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Interest coverage ratio
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Net profit (before Tax & Interest) (PBIT)
Fixed interests & charges |
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23.
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Total coverage ratio
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Net profit (before Interest & Tax) (PBIT)
Total fixed charges |
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24.
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Fixed expenses to total cost ratio
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Fixed expenses
Total cost |
Idle capacity
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|
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25.
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Material consumption to sales ratio
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Material consumption
Sales |
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26.
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Wages to sales ratio
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Wages
Sales |
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27.
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Price earning ratio
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Market price of a share (MPS)
Earnings per share (EPS) |
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|
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28.
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Dividend per share
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Dividend paid to ordinary shareholders
Number of ordinary shares |
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1. Liquidity ratios:
1.1 CURRENT RATIO
The ratio is a measure of current liquidity and indicates a company’s ability to meet its current obligations. A ratio of less than1.0 (negative net working capital) may be a danger signal. A high ratio, although desirable, could indicate that surplus funds are tied up inefficiently in stocks and debtors, instead of being made to work for the business.
1.2 QUICK RATIO
The quick ratio gives an indication of a company’s immediate liquidity portion. A satisfactory current ratio may fail to reveal that there are slow moving items in stock that cannot be converted quickly into cash.
Working Capital = Current Assets – Current liabilities
When using liquidity ratios the problems are as follows:
Generally current liabilities are due later than current assets.
The amounts do not indicate temporary variations in the liquidity structure
Overdraft facilities on bank accounts, which are not fully utilised, are not included in the balance sheet.
Notwithstanding the problems mentioned above, it is useful to show the variance of Working Capital during a certain period of activity. Declines or improvements in liquidity can be reviewed.
Cash-Flow = net income for the year + depreciation of fixed assets
This represents the surplus of money paid in over the money paid out. It indicates the company’s ability to raise finance e.g. to meet repayments of loans and investments.
Sometimes there are other components (i.e. provision for liabilities and charges) to be added. This is due to the fact that some figures in the profit and loss represent only expenditure for which there are no payments in the same year.
The cash flow has a double function. It shows the profitability and the internal financing of the company. In particular the relationship between cash flow and sales is used to indicate the financial strength of the company.
2. Funds management ratios:
Funds management ratios concentrate on the elements of working capital and provide a measure of financial control of a business.
2.1 DEBTOR TURNOVER RATIO
This ratio indicates the average credit given to trade debtors and can be compared with the stated credit terms. As with all ratios it is important to ensure that there is a logical relationship between the elements makin up the ratio. This means, for debtor days, excluding VAT, prepayments and other debtors.
Fluctuations in the number of debtor days may be caused by :
Ø business changes affecting turnover, such as changes in mix or volume
Ø deterioration or improvement in credit control or debt collection procedures doubtful debts
2.2 CREDITORS’ TURNOVER RATIO
This ratio is a measure of credit period taken before settling with suppliers. This can be a difficult ratio to calculate and misleading results will arise if the cost of sales figure is not compatible with the trade creditors figure.
Fluctuations in the credit period may indicate
Ø deliberate change in the payments policy
Ø going concern problems
Ø a breakdown in the payment system
2.3 STOCK TURNOVER RATIO
The stock days ratio is a measure of the saleability of a company’s and the efficiency of stock management. It measures the rate at which stock is sold and replaced during a financial period.
Fluctuations in stock days might be attributable to:
Ø business changes such as sales volume or mix
Ø too much or to little stock through failure to match requirements to the business cycle
Ø changes in stock control procedures
Ø over-valuation of stock
3. Capital structure and solvency:
These ratios illustrate the relationship between the various sources of finance used by a business. The two broad categories of finance available are equity capital and loan capital. The latter carries a fixed charge against profits while equity capital is rewarded by dividends paid out of profits after charging interest. There are several relevant ratios and two examples are given.
3.1 CAPITAL GEARING RATIO
If a company is highly geared, that is has a high debt to equity ratio, it is generally more difficult for it to raise additional loan capital. A highly geared company is more sensitive to adverse fluctuations in profits because of the effect of fixed interest charges.
3.2 INTEREST COVERAGE RATIO
The ratio indicates the number of times that the interest payments are covered by profits. It the ratio is low or falling, a company’s ability to raise additional finance is likely to be impaired.
4. Profitability:
4.1 RETURN ON CAPITAL
This is a very common indicator of economic performance and over a period of years, can show if a business is improving or declining.
4.2 GROSS PROFIT PERCENTAGE
This is probably the most commonly used indicator of performance. It can be used to make comparisons with previous periods for the same business and with the gross profit achieved by other companies in the same industry.
An increasing ratio during some periods of activity might reflect an improvement in production costs and could be interpreted as increasing productivity.
A change in the ratio could also indicate stock cut-off problems.
4.3 EXPENSE RATIOS
Expense ratios are used to compare the level of an expense with some measure of activity, frequently either sales or total overheads. Typical examples are:
Ø sales per square foot of selling area
Ø sales per employee
Ø wages per employee
Ø head office costs to total overheads
Experience shows that ratios exist for the main areas of business activity. By comparing these ratios with the ratio of the audited company the profitability of this company can be judged.
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