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Financial Management Made Easy
Financial Analysis
A banker advances to many clients including individuals, traders, firms and
corporate. Before a loan is granted the banker needs to do an evaluation of
the firms/companys financial position by applying different parameters. One important parameter is to do a financial analysis.
The advantages of financial analysis are:
To understand the financial position of the firm/company
(prospective/existing)
To assess the repayment capacity of the firms (the loan amount +
interest + other fees)
To evaluate the managerial skills of the management team, with
special reference to the financial management.
The Tools used in financial Analysis:
Balance Sheet (BS)-
A BS is statement indicates the financial position as on a particular date
(ex: as on 31st March,2010)
A BS has two sides Assets & Liabilities
Assets- What the firm Owns and its Receivable
Financials
Balance SheetProfit & Loss
AccountsFlow Statements
Cash Flow Funds Flow
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Liabilities What the firm Owes and its Payables
Shows Sources of Funds and Uses of funds
To have a fair idea/view about the financial position of a firm/company, the
interested persons /Institutions (investors,analysts,bankers,credit ratingagencies) need to analyse the financials for a period of three to five years.
The study/analysis helps to understand the trend about the various aspects.
The analysis need to cover the entire period of 12 months. The study
should be based on different set of figures to arrive at a meaningful decision.
Ratio Analysis: (RA) is used by the analysts to compare and understand
the financial position of a firm/company. Ratios are used as tools for this type
of analysis. Ratio analysis is a process of establishing a significant
relationship between the items of financial statements to provide a
meaningful understanding of the performance and financial position of afirm.
Classification of ratios I-(Expression/Degree of
Importance
Types of
Ratios
Mode of
expression
Degree of
Importance
Simple/Pure
Percentage Rate
Primary
tertiary
Secondary
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Classification of ratios II-Users
Manageme
nt
Credit
Analysts-
Credit
Rating Cos
Investors/S
hareholder
s
Long term
creditors-
Banks/Fin
Institutions
Short tem
creditors-
Banks
Auditors
Users
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Classification of ratios III Important Parameters
Profitabili
ty
Ratio
Activityratio
Solvency
ratio
Liquidity
Ratio
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Classification of ratios IV Financial Statements:
Briefly we try to understand the following:
Traditional Classification: On the basis of financials. They are classified as
Balanc
e
Sheet
P&L
Accou
nt
Cash
Flow
Funds
Flow
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P&L a/c ratios: i.e., ratios calculated on the basis of p/l a/c only
Balance sheet ratio: ratios on the basis of figures of balance sheet only
Composite or inter statement ratios: on the basis of the figures of P&L as well
as Balance sheet
ratios can be classified into:
Financial or Solvency Ratio
Turnover or Activity Ratio
Profitability or Income Ratio
Financial Ratios may be classified into
Short term solvency ratios: This discloses the financial position or solvency of
the firm in the short term. This is also called as Liquidity Ratio
Long term solvency ratios : This discloses the financial position or solvency
of the firm in the long term. This is also called as Solvency Ratios
Advantages of Ratios as a tool for financial analysis:
It simplifies the reading of the financial statements
Helps in Inter firm comparison
Highlights the factors associated with successful/unsuccessful firms.
Reveals different positions of the firm/s such as
strong/weak/overvalued and undervalued
Helps in Planning and forecasting
Recap:
Ratios can assist the user (lender, management) in the basic functions
of forecasting, planning, coordination, control and communication.
Limitations of Ratios:
+ Comparative study required
+ Non financial changes, an important factor is not covered
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+ Different accounting policies in the same industry may distort the results
+ Ratios alone are not adequate: Ratios are only indicators. Other things are
also needed for taking decision.
Example: (i) a high current ratio does not necessarily mean that the concernhas a good liquidity position ( in case the current assets consists of outdated
stocks) (ii) debtors beyond a reasonable period if not excluded from the
current assets would not reveal the correct position
Ratios tells the analyst/user to stop, look and decide
Window dressing:
} Window dressing is manipulation of accounts, i.e., concealment of facts
and figures
} Does not reveal the factual position, but reflects a better position that what
actually is,
Example : A high stock turnover ratio is generally considered as an
indication to operational efficiency. This may be achieved by unwarranted
price reduction or failure to maintain proper stock of goods This might result
in a favorable ratio/s.
Changes in Price levels: Two firms depreciate the machinery based on their
date of purchase then the deprecation would be lower for the older
company than the new company. Hence mere comparative study does not
convey purposeful meaning.
A) Profitability Ratios:
1)Overall Profitability Ratio:
Known as Return on Investment It indicates the % of return on the total
capital employed in the business. Formula : Operating Profit/Capital
employed x 100
Capital employed: (i) Sum Total of all assets (fixed+current) (ii)Sum total of
fixed assets
(iii) Sum total of long term funds employed in business.,
Share Capital + Reserves and surplus + Long Term loans (Non-business
assets + fictitious assets)
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Operating Profit is the profit before interest and tax. Interest means Interest
on long term borrowings. Interest on short term borrowings is deducted for
computing operating profit.
Non trading income such as interest on GOI Sec or non trading losses or
expenses such as loss on a/c of fire will be excluded
2) Return on Investment(ROI): The ROI is a concept which is also stated
as YOC (Yield on Capital). ROI indicates the efficiencies/deficiencies of the
firms performance. The profit being the net result of all operations, the
return on Capital is an important indicator to measure the performance of a
firm.
Suppose a firm borrow funds @ 8% and the ROI is 7 %, it is better not to
borrow (unless absolutely necessary). Further, it shows that the firm has not
been employing the funds efficiently
3) Earning per Share (EPS): This indicates the overall profitability of a
firm. ROI comparison would be effective only when two firms are of the
same age, same size. To avoid this mismatch, evaluation based on EPS is a
better option.
EPS tells the earning per equity share. EPS= Net Profit after tax and pre
dividend/Number of equity share.EPS helps in determining the market price
of the equity share of the company. A comparison of EPs of two firms shows,
whether the equity share capital is being effectively used or not.
4) Price Earning (P/E) Ratio:
The number of times the EPS is covered by the market price. P/E
ratio=Market Price per equity share/EPS. P/E ratio helps investor/s to decide
to buy or not to buy the shares of a company
5)Gross Profit Ratio: Gross Profit/Net Sales x100. This ratio indicate the
degree to which the selling price of goods per unit may decline without
resulting in losses from operations.
6) Net Profit Ratio: This indicates the net margin earned on a sale of
Rs.100.Net Operating Profit/Net Sales x100
This shows the efficiency of the firm. An increase in the ratio over the
previous period shows improvement in the operational efficiency of the
business provided the gross profit ratio is constant. An effective measure to
check profitability of business
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B) Solvency Ratios:
A firm is said to be solvent or financially sound, if it is in a position to carry
on its business smoothly and meet all its obligations, both long and short
term without strain/any issue.
1) Long term Solvency Ratios:
(a) Fixed assets Ratio: Fixed assets/long term funds. This ratio should not
be more than 1. {Fixed assets include net fixed assets (original cost
depreciation to date) and trade investments including shares in subsidiaries.
Long term funds include share capital reserves, and long term loans}If it is
less than 1, it shows that a part of the working capital has been financed
through the long term funds. This is possible to some extent because, a part
of the working capital termed as core working capital is more or less of a
fixed nature. The ideal ratio =0.67
(b) Debt Equity Ratio: This is calculated to find out the soundness of the
long term financial policies of the firm/company. It is also known as
External-Internal equity ratio. Debt equity ratio- External equities/Internal
equities
External equities : Total outside liabilities and Internal equities : Share holder
funds or the tangible net worth. If the ratio is 1 :ie., outsiders funds are
equal to share holders funds it is considered quite satisfactory
Debt equity ratio can also be calculated as: (i) Debt equity ratio- Total longterm debt/Total long term funds
(ii) Debt equity ratio- Total long term debt/Shareholders funds, method,
which more popular
(ii) includes the proportion of the long term debt to the share holders
funds(i.e., tangible net worth) the ideal ratio is 1.
This ratio indicates the proportion of owners stake in the business. The ratio
indicates the extent to which the firm depends upon outsiders for its
existence. The ratio tells its owners the extent to which they can borrow to
increase the profits with limited investment.
2) Short term Solvency Ratios:
(i) Current Ratio: The firms commitment to meet its short term liabilities.
Current assets/Current liabilities. It includes cash and other assets
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convertible or meant to be converted into cash during the operating cycle of
business (which is not more than a year) Current liabilities mean liabilities
payable within a years time either out of existing current assets or by
creation of new current assets. Book debts outstanding for more than 6
months and loose tools should not be included in the current assets. Prepaid
expenses should be included in the current assets.
An ideal ratio is 2:1. A very high current ratio is also not desirable, since it
means less efficient use of funds. Current ratio is an index of a firms
financial stability. A higher current ratio indicates inadequate employment of
funds, while a poor current ratio indicates that the business is trading
beyond its resources (capacity).
(ii) Liquidity Ratio: Known as quick ratio or Acid Test Ratio. This ratio
is worked out by comparing the liquid assets (ie., assets which are
immediately convertible into cash). Prepaid expenses and stocks are nottaken as liquid assets. Liquid assets/Current liabilities and the ideal ratio is
1. This is also an indicator of short term Solvency of the firm.
A comparison of current ratio to quick ratio indicate the inventory
management.
Ex:If two concerns have the same current ratio but a different liquidity ratio,
it indicates over stocking by the concern having low liquidity ratio as
compared to the concern which has a higher liquidity ratio
C) Turn Over Ratios:
1) Stock Turnover Ratio: The ratio indicates whether the investments in
inventories is efficiently used or not. This is arrived at by using the cost of
goods sold and average inventory
Cost of goods sold during the year/Average inventory .Average inventory is
calculated by taking stock levels of raw materials, work in progress, finished
goods at the end of each month adding them up an dividing by 12.
The inventory turn over ratio signifies the liquidity of inventory management.
A high inventory ratio shows good sales. A low inventory turn over ratio
results in the blocking of funds in inventory, which might result in losses due
to inventory becoming obsolete or decreasing in quality
This ratio is calculated as : inventory x 365/cost of goods sold
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2) Debtors Turnover Ratio: Debtors are important components of current
assets, therefore the quality of debtors determines a firms good liquidity
management. The Two important ratios are (i) Debtors turnover ratio and (ii)
Debt collection period ratio
(i)Debtors turnover ratio = Credit sales/Average account receivables.The term Account Receivable includes Trade Debtors and Bills Receivable.
Credit Sales to Account Receivable Ratio indicates the firms efficiency in
collection of receivables.. The higher the ratio , it is better, as it indicates
that debts are being collected more promptly.
(ii) Debt collection Period Ratio: This ratio indicates the extent to which
the debts have been collected in time. It gives an average debt collection
period. The ratio is very helpful to the lenders because it explains to them
whether their borrowers are collecting money within a reasonable time. An
increase in the period will result in greater blockage of funds in debtors. Theratio can be calculated by any of the following methods
(a) Months (or days) in a year/Debtors turnover
(b) {Average account receivables(months or days) in a year}/Credit sales for
the year
(c) Account receivables/Average monthly or daily credit sales
For example, if sales during the year is Rs.365,000 or Rs.1,000 per day, and
if the outstanding or amount receivable is Rs.100,000, the debt collection
period is 100 days i.e., Rs 100,000/1000. Assuming if the firm has allowed a
credit term of 60 days, this ratio indicates that the credit collection needs to
be geared up.
Debtors collection period measures the quality of debtors. It measures the
turnover time i.e., quick or slow turnaround in respect of collection of money.
A short collection period means prompt payment by the debtors, and shows
the efficiency of fund collection. Whereas, a longer collection periodindicates an inefficient credit collection performance by the firm. The
management should have a flexible policy to have a better result. A
restrictive policy may result in slower sales and would result in low profits. A
too liberal policy could result in delay in collection of dues and affect the
liquidity management.
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Let us try to understand by some examples:
A firms current ratio is 2. If so, identify in which of the following cases the
current ratio will Improve/decline or will have no change.
(i) purchase of fixed assets
(ii) cash collected from Customers
(iii) payment of a current liability
(iv) Bill receivable dishonored
Answers: If the current ratio is 2:1, then our assumption is current assets =
Rs1,00,000 and current liabilities = Rs.50,000
(i) Purchase of fixed assets: On purchase of fixed assets in cash, current
assets will decrease without any change in current liabilities. Hence he
transaction will result in decline of current ratio from 2:1
(ii) Cash collected from customers: Collection of debtors (receivables) would
result in the conversion of one current asset., viz., debtors into another
current asset viz., debtors to cash. Hence amount of current assets and
current liabilities remain unchanged the current ratio will therefore remain
2:1
(iii) Payment of a current liability: On payment of a current liability out of
current assets Working capital will remain unchanged. However current ratiowill improve. For example, if out of above current liabilities Rs20,000 is paid
resultant current assets will be Rs.120,,000 and current liabilities Rs30,000,
this will give the current ratio 3:1
(iv) Bill receivable dishonored: When a bill receivable is dishonored, if the
customer is solvent, then the amount of bills receivable will get deducted
and the amount due from debtors will increase, There will be no change in
the amount of current liabilities Hence on this assumption the current ratio
will remain 2:1
Fund Flow Analysis
Another method of financial analysis is fund flow analysis. The fund flow
analysis indicates the inflow and outflow of cash. This statement is also
known as sources and application of funds
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Sources of funds:
(a) Cash inflow from operations (b) Income from investments (c) sale of
investments (d) sale of fixed assets (e) decrease in working capital (f)
increase in liabilities (g) short and long term loans
Application of funds:
(a) Operating expenses (b) Repayment of loans/debentures(c)Payment of
dividend (d)acquisition of fixed assets (e) increase in working capital (f)
Securities bought for investments
A review of the balance sheet from the funds flow angle is an important
factor in financial analysis.
Fund flow analysis Advantages:
: Cash inflow from operations is better a tool to measure whether cash is
generated from the business or otherwise.
: Since funds flow statements are prepared based on estimates, these
estimated figures help in planning and can also be used to monitor the
progress.
: It helps in comparison of the pervious years budgeted estimates against
the actual to find out whether and to what extent the resources of the firm
were used as per the plan.
: From the point of view of the lending banker, the comparison of 3 to 5
years statements indicate the diversion of funds from working capital to long
term application viz., purchase of fixed assets.
Contingent Liabilities or Off Balance Sheet Items: These items appear
outside the balance sheet as a foot note, hence called as off balance sheet
items. While on the date of the balance sheet these figures may not have
any impact, by default there are risks associated with these items. If,on the
date of crystallization,(due date) these non fund based liabilities can be
converted into the funds based items, there by can affect the currentliabilities. In view of this, due importance and weight age needs to be given
for these off balance sheet items
Some examples are (a) Tax liability on account of cases pending with
tribunals (b) Bankers letter of credit issued (c) Bankers guarantees issued
(d) Derivatives of banks
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Working Capital Finance:
Features: (a) Short term finance (maximum for a period of one year) (b)
Called as circulating capital.(c) Ganted against inventories and/or receivables(d)
A bank which grants a working capital finance should ensure that the finance
is granted to a borrower, should be, on a time bound basis based on the
concept of operating cycle method..
For a manufacturing company, the term working capital means, the
requirement of funds for its day to day operations viz.,ensure that sufficientcash is available to meet day to day cash flow needs.
Cash is needed for
(a) purchase of raw materials, spares (b) payment of wages to employees (c)
payment of administrative expenses including expenses towards water, fuel
energy consumption, payment of statutory dues like taxes, transportation
expenses etc.,(d)all other expenses on account of production, sales,marketing, recoveries etc.,
What is an operating cycle: A bank gives working capital finance in the form
of fund based finance against inventories and or receivables. Depending
upon the industry the finance can be granted for a period of 120 days to 180
Working Capital Finance
Inventory finance Receivables finance
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days. This means, the finance availed by the client needs to be repaid at the
end of the period. This can be shown in a diagram. This is also called as the
working capital cycle
Each component of working capital has two dimensions TIME and
MONEY.
As shown above the main feature of working capital is the cash getting
converted into cash after different stages of the production of goods.
Hence the entire process is reflected in the form of a cycle, which is
called as operating cycle or working capital cycle.
Cash
Credit
sales
Bills
receivable
s
Raw
materials
Finished
goods
Semi
finished
goods
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The shorter the period of operating cycle, the larger will be the
turnover of the funds invested in various purposes.
The working capital management needs to address the following aspects,
before taking a decision:
(i) How much inventory is to be held (ii) How much cash and bank balance is
to be maintained (iii) How much the company should provide credit to its
clients, also what should be the credit terms? (iv) Similarly to what extent
the company can enjoy or avail of the credit facilities and the credit terms
thereof (v) What should be the composition of current assets and liabilities.
What is working capital?
A working capital is the excess of current assets over current liabilities. Cash
which is one of the important component of the current assets, plays a
significant role in working capital management. As far as possible the
company should maintain adequate working capital as much as requited by
the company. It should neither be excessive nor inadequate.
Working Capital - Definition
1.According to Guttmann & Dougall -
Excess of current assets over current liabilities.
2. According to Park & Gladson -
The excess of current assets of a business over current items owned to
employees and others.
Types of Working Capital:
One of the important role of a finance manager is to ensure proper flow of
funds. In this connection arrangement of cash flow through proper working
capital management is very important. Depending upon the business
models the working capital can be classified into different types, as shown in
the diagram:
PERMANENT, FIXED OR REGULAR WORKING CAPITAL : The
requirement of minimum cash/funds required to run the firm, company. This
is also called as hard core Working Capital. If this quantity of Working capital
is not maintained, it would affect the business.
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FLEXIBLE OR TEMPORARY WORKING CAPITAL: During the course of
production activities a firm may need more funds on a temporary basis to
meet the short term requirements. The fund requirement may be over and
above the overall fixed working capital limits. The lender (banker) should
based on the merits of the case, may grant the temporary working capital.
SEASONAL WORKING CAPITAL OR SPECIAL WORKING CAPITAL : The
need for the funds vary from a company to another and/or from industry to
industry. Sometimes, there may be situations where the firms may need
additional working capital on certain special seasons. As already indicated
any additional or temporary requirements for funds needs to decided based
on the merit of the case/s.
Negative
BalanceSheet
Seasonal
Flexible /
Temporar
y/
Variable
Permanen
t, Fixed
or Regular
Types ofWorking
Capital
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NEGATIVE WORKING CAPITAL : Negative Working Capital is when current
liabilities exceed current assets
BALANCE SHEET WORKING CAPITAL: It is that Working Capital which iscalculated from the items appearing in the balance sheet of a firm.
Working Capital Classification based on concepts:
Net
Working
Capital
Gross Working Capital
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Working Capital means the funds available for day to day operation of an
enterprise. There are two concepts of Working Capital viz., (a) Gross Working
Capital and (b) Net Working Capital
(a) Gross Working Capital:
Gross concept of Working Capital is quantitative in nature. It represents the
total of all current assets. It is also known as circulating capital or current
capital. The word current assets means, those assets which can be converted
into cash within an accounting period or operating cycle like;
Inventory Trade debtors Bills
receivables
Loans and advances Investments
Cash and Bank Balance Marketable securities
The gross concept of Working Capital is a going concern concept, because
current assets are necessary for the proper utilization of fixed assets.
(b) Net Working Capital: Net Working Capital represents the excess ofcurrent assets over current liabilities or the portion of current assets which is
financed by long term funds..It is known as net working capital.
Current liabilities are those usually repaid within an accounting year like;
Account Payable / sundry creditors Bills Payable
Trade Advances Outstanding Expenses
Short Term Bonus Bank Overdraft
The net concept of Working Capital shows the financial soundness and
liquidity of a firm. This concept creates the confidence to the creditors about
the security of their funds.
Net Working Capital = Current Assets Current Liabilities
How to calculate the working capital requirements:
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ESTIMATING WORKING CAPITAL REQUIREMENT
For this purpose the length of cash to cash cycle is measured:
The duration of the working capital cycle can be mentioned as follows:
O = R+W+F+D-C
O = Duration of operating cycle
R = Raw materials storage period
W= Work in progress period
F = Finished goods storage period
D= Debtors collection period
C=Creditors collection period
Gross operating cycle = inventory Conversion period + Debtors
conversion Period
Determinants of Working Capital
WC is determined on the basis of certain factors, like :
(i) Nature of Industry (ii) Size of Business (iii) Manufacturing Cycle (iv)Firms Production Policy (v) Terms of purchase & Sales (vi) Volume of Sales
(vii) Capital base of the firm (viii)Business Cycle (ix)Management of
Inventory an d receivables (x) changes in economy inflation (xi)
Government policies (xii) Profit margin
Importance or Advantages of Adequate Working Capital (WC):
Adequate WC helps to
(a) maintain solvency of business (b) create & maintaining goodwill (c)
arrange loans from banks & others on easy and favorable terms (d) avail
cash discount/s and hence reduction in cost of production (e) get regular
supply of raw materials (f) adhere to payment schedules for salary & wages
and other dues taxes (g) negotiate the terms more comfortably (i) manage
the liquidity
Position of excess WC:
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Excessive WC - disadvantages
Disadvantages of redundant or excessive WC;
(i) Excessive WC means idle funds which earn no income for the business (ii)
Since funds are not invested business cannot earn a proper rate of return(iii)Improper inventory management leads to a situation of redundant WC
and increases the cost of inventory management (iv) Similarly excessive
debtors & defective receivable management policy may create higher
levels of bad-debts.
Thus the factors can reflect the inefficiency of the firm and it does not speak
well of the role of the financial manager
Sources of Working Capital:
Sources of Funds
Long Term Funds Short Term Funds
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Issue of Shares: This is popularly known as Equity Financing. The
main source of long term funds is raised through the issuance of
different types of equity shares. The share holders are part owners of
the companies depending upon the type of shares.
Debentures: This is called as Debt Financing. The investors in the
debentures are creditors of the company. They are entitled for the
dividend as return and also charge over the assets of the company.
Hybrid Financing: The combination of equity and debt is called hybrid
financing. The Finance manager needs to decide the proportion of the
equity and debt funds.
Retained Earning: One of the important component of the long term
funds is the profits retained in business. It creates no charge on the
future of the firm
Long
Term
Borrowin
gs
Retained
Earnings
Hybrid
Financin
g
Debentur
es
Equity
Shares
Long
Term
Funds
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Long Term Borrowings: Acceptance of public deposits, debts from
financial institutions and banks, etc., Other sources are security
deposits accepted from the customers (depending on the business
models)
Short Term Financing: The short term financing mainly arranged through
the working capital finance, also consist of other sources.
Working Capital Ratios;
Working Capital Ratios;
Short Term
Financing
Working Capital
FinancePublic Deposits Other Credits
Overdraft
Cash Credit
Six Months
Three Years Commercial
Paper
Trade CreditsSecurity
Deposits
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Working Capital Ratios;
Liquidity Ratios:
Current Ratio = Current Assets/ Current Liability
Quick Ratio = Current Assets Inventory/ Current Liability Bank Overdraft
Efficiency Ratios:
Working Capital to sales ratios= Sales/Working Capital
Inventory Turnover ratio = Sales/Inventory
Current assets turnover ratio: Sales/Current Assets
Other Ratios:
Debtors Turnover Ratio = Credit Sales/Debtors
Bad debts to sales ratio = Bad Debts/Sales
Debtor Collection period = Debtors x 365/credit sales
Creditor Payment Period= Creditorsx365/credit purchase
Working
Capital
Ratios
Liquidity
Ratios
Efficienc
y Ratios
Other
Ratios
Current
Ratio
Turnover
Ratio
Debtors
Turnover
Ratio
Quick Ratio
Inventory
Turnover
Ratio
Debtor
collection
period
period
CreditorsPayment
Period
Current
Assets
Turnover
Ratio
Bad debts
to sales
ratio
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Working Capital Turnover Ratio:
Meaning: This ratio establishes a relationship between net sales and
working capital.
Objective: The objective of computing this ratio is to determine the
efficiency with which the working capital is utilized.
Components: There are two components of this ratio which are as under:
Net Sales which mean gross sales minus sales returns
Working Capital which means current assets minus current liabilities.
Computation: This ratio is computed by dividing the net sales by the
working capital. This ratio is usually expressed as x number of times.
Working Capital Turnover Ratio = Net Sales/ Working Capital
Interpretation: It indicates the firms ability to generate sales per rupee of
working capital. In general, higher the ratio, the more efficient the
management and utilization of working capital and vice versa.