This
is where ratios come to our rescue. In this case, if we find a
relationship between the Net Profit and Sales, we can observe that Chinese
companies are earning a return of 13.89% [(40/288)*100] on their sales
whereas Indian companies are earning a return of 7.82% on their sales. So,
we can interpret that Chinese companies are earning Rs. 13.89 on every Rs.
100 of sales while the corresponding figure for the Indian companies is
only Rs. 7.82.
In other words, Chinese companies are incurring a cost
of Rs. 86.11 (100-13.89) for Rs. 100 of sales whereas the corresponding
figure for the Indian companies stands at Rs. 92.18. This cost has been
incurred with respect to the purchase of raw material, manufacturing,
wages and other operating costs. This also proves that Chinese companies
are relatively cost efficient as compared to their Indian counterparts
which has been substantiated by various reports mentioning about China's
emergence as an effective low cost destination for manufacturing and
services.
We have been able to get this insight because of the
use of ratios which establish relationship between two absolute numbers so
as to enable us to make meaningful analysis and comparison.
There are various other ratios which we can use for our
analysis, which are listed here along with their brief interpretation.
1. Liquidity ratios
a. Current ratio = Current Assets__
Current Liabilities
Indicates:
* Short term solvency of a firm
* Its ability to pay-off its Current Liabilities
* Rupee of Current Assets available for each rupee of Current
Liabilities
* Should not be very high, as that may indicate that the funds are
blocked in Current Assets which do not earn any return
b. Quick (Liquid) ratio = Current Assets-Inventories
Current Liabilities
Indicates:
* Short term solvency of a firm
* It is a comparatively rigorous test as huge amount may be blocked
in inventories which may have inflated the current ratio
* Inventories are considered as the least liquid among the current
assets
2. Profitability ratios
a. Gross Profit ratio = Gross Profit * 100
Sales
where,
Gross Profit = Sales – Cost of Goods Sold
* Higher Gross Profit ratio indicates lower Cost of Goods sold and
vice-versa
b. Net Profit ratio = Profit after Tax * 100
Sales
* Higher Net Profit ratio indicates lower Cost of Good Sold,
operating expenses like administrative, selling and distribution expenses
and financing expenses and vice-versa
c. Return on Investment = Operating Profit * 100
Total Assets
where,
Operating Profit = Gross Profit – Operating Expenses
Indicates:
* Profitability of investment made by creditors and shareholders
* Operating Profits are the profits available to pay interest,
taxes and dividends
d. Return on Equity = Profit after Tax – Preference Dividend
* 100
Net Worth
where,
Net Worth = Equity Share Capital + Reserves and Surplus
Indicates:
* Whether equity shareholders are earning satisfactory return on their
investment
3. Turnover ratios
a. Asset Turnover ratio = Sales * 100
Total Assets
Indicates:
* Sales earned per rupee of investment
* Higher the ratio, more efficient the company is in utilizing its
assets
b. Average Inventory Age (in months) = _____12________* Avg.
Inventory
Cost of Goods Sold
where,
Avg. Inventory = Opening Inventory + Closing Inventory
2
Indicates:
* How quickly inventory is disposed
* Lower the ratio, it is good as it indicates lesser amount of
funds blocked in the inventory
* Excessive lower ratio may indicate underinvestment in the
inventory which may result in not meeting customer demand
c. Average Collection Period (in months) = _____12______*
Avg. Debtors
Credit Sales
where,
Avg. Debtors = Opening Debtors + Closing Debtors
2
Indicates:
* How quickly cash is received from the debtors for the good sold
* Lower the ratio, better the collection efforts and quality of
debtors
d. Average Payment Period (in months) = _____12______*
Avg. Creditors
Credit Purchases
where,
Avg. Creditors = Opening Creditors + Closing Creditors
2
Indicates:
* How quickly cash is paid to the creditors for the raw material
purchased
* Lower the ratio, better the credit standing and reputation of the
firm
4. Solvency ratios
a. Debt-Equity ratio = Total Debt
Equity
Indicates:
* Higher the ratio, greater the dependence on the borrowed funds and
greater the interest payments
* Implies higher risk for the lenders as the amount contributed by
the equity shareholders is comparatively less
b. Interest Coverage ratio = Operating Profit
Interest
Indicates:
* Higher the ratio, more are the profits available to pay interest to
the lenders
* Excessive high ratio may indicate conservative approach of the
firm by using equity which results in higher cost of capital
5. Other ratios
a. Earning per Share = Profit after Tax - Preference Dividend
No. of Outstanding Equity Shares
Indicates:
* Profit available to the equity shareholders on each share
b. Price-Earning ratio = Market Price per Share
Earning per Share
Indicates:
* Price which investors are ready to pay for every rupee of earning
c. Dividend Payout ratio = Dividend per Share * 100
Earning per Share
Indicates:
* The percentage of earnings paid to the equity shareholders as
dividends
d. Price to Book Value ratio = Market Price per Share
Book Value per Share
where,
Book Value per Share = _________Net Worth________
No. of Outstanding Equity Shares
Indicates:
* Higher the ratio, better the growth prospects for the firm
All these ratios can help in carrying out an efficient analysis of a firm.
However, it is always prudent to this comparative analysis for a
particular firm for different years or for a particular year, with respect
to its competitors within the industry. It will not be wise to compare the
performance of two companies from different industries as there will be
variations in their composition of assets and liabilities and cost
structure because of the difference in their nature of business.
