Ratio Analysis

Working Capital or
 SOLVENCY RATIO ANALYSIS

Solvent:
having assets in excess of
liabilities; able to pay one's
debts.
 SOLVENCY RATIO ANALYSIS
Liquidity Ratios

Liquidity ratio analysis measure how liquid the company’s assets are (how easily can
the assets be converted into cash) as compared to its current liabilities. There are three
common liquidity ratio.

1. Current ratio analysis

2. Acid test (or quick asset) ratio analysis
3. Cash Ratio analysis

Current Ratio Analysis

Current ratio is the most frequently used ratio to measure company’s liquidity as it is
quick, intuitive and easy measure to understand the relationship between the current
assets and current liabilities. It basically answers this question

“How many rupee in current assets does the company have to cover each rupee of
current liabilities”
 SOLVENCY RATIO ANALYSIS
Current Ratio Formula = Current Assets / Current Liabilities

Current Assets = Rs.200 Current Liabilities = Rs.100

Current Ratio = Rs.200 / Rs.100 = 2.0x
This implies that the company has two dollar of current assets for every one dollar of
current liabilities.

INTERPRETATION
• Current ratio analysis provides us with a rough estimate that whether the company would be
able to “survive” for one year or not. If Current Assets is greater than Current Liabilities, we
interpret that the company can liquidate its current assets and pay off its current liabilities and
survive at least for one operating cycle.
• Current Ratio analysis in itself does not provide us with full details of the quality of current
assets and whether they are fully realizable.
• If the current assets consists primarily of receivables, we should investigate the collectability of
such receivables.
• If current assets consists of large Inventories, then we should be mindful of the fact that
inventories will take longer to convert into cash as they cannot be readily sold. Inventories are
much less liquid assets than receivables.
• Average maturities of current assets and current liabilities should also be looked into. If current
liabilities mature in the next one month, then current assets providing liquidity in 180 days may
not be of much use.
 SOLVENCY RATIO ANALYSIS

Quick Ratio Analysis

• Sometimes current assets may contain huge amounts of inventory, prepaid expenses
etc. This may skew the current ratio interpretations as these are not very liquid.
• To address this issue, if we consider the only most liquid assets like Cash and Cash
equivalents and Receivables, then it should provide us with a better picture on the
coverage of short term obligations.
• This ratio is know as Quick Ratio or the Acid Test.

Quick Ratio = (Cash and Cash Equivalents + Acc. Receivables)/Current Liabilities

Cash and Cash Equivalents = Rs.100

Accounts Receivables = Rs.500
Current Liabilities = Rs.1000
Then Quick Ratio = (Rs.100 + Rs.500) / Rs.1000 = 0.6x
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INTERPRETATION

• Accounts Receivables are more liquid than the inventories.

• This is because Receivables directly convert into cash after the credit period, however,
Inventories are first converted to Receivables which in turn take further time to
convert into cash.
• In addition, there can be uncertainty related to the true value of the inventory
realized as some of it may become obsolete, prices may change or it may become
damaged.
• It should be noted that a low quick ratio may not always mean liquidity issues for the
company. You may find low quick ratios in businesses that sell on cash basis (for
example, restaurants, supermarkets etc). In these businesses there are no receivables,
however, there maybe a huge pile of inventory.
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Cash Ratio analysis

Cash Ratio considers only the Cash and Cash Equivalents (there are the most liquid assets
within the Current Assets). If the company has a higher cash ratio, it is more likely to be
able to pay its short term liabilities.

Cash Ratio Formula = Cash & Cash equivalents / Current Liabilities

Cash and Cash Equivalents = Rs.500

Current Liabilities = Rs.1000
Then Quick Ratio = Rs.500 / Rs.1000 = 0.5x

INTERPRETATION
• All three ratios – Current Ratios, Quick Ratios, and Cash Ratios should be looked at for
understanding the complete picture on Company’s liquidity position.
• Cash Ratio analysis is the ultimate liquidity test. If this number is large, we can
obviously assume that the company has enough cash in its bank to pay off its short
term liabilities.
 SOLVENCY RATIO ANALYSIS
Turnover Ratio Analysis/Activity Ratio/ Efficiency ratio

We saw from the above three liquidity ratios (Current, Quick and Cash Ratios) that it
answer the question “Whether the company has enough liquid assets to square off its
current liabilities”. So this ratio is all about the rupee amounts.

However, when we look at Turnover ratio analysis, we try to analyze the liquidity from
“how long it will take for the firm to convert inventory and receivables into cash or time
taken to pay its suppliers”.

The commonly used turnover ratios include:

4) Receivables turnover
5) Accounts receivables days
6) Inventory turnover
7) Inventory days
8) Payables turnover
9) Payable days
10) Cash Conversion Cycle
 SOLVENCY RATIO ANALYSIS
Receivables Turnover Ratio analysis/Debtor’s Turnover ratio

• Accounts Receivables Turnover Ratio can be calculated by dividing Credit Sales by Avg.
Accounts Receivables.
• Intuitively. it provides us the number of times Accounts Receivables (Credit Sales) is
converted into Cash Sales
• Accounts Receivables can be calculated for the full year or for a specific quarter.
• For calculating accounts receivables for a quarter, one should take annualized sales in
the numerator.

Receivables Turnover = Credit Sales / Avg. Accounts Receivables

Sales = Rs.1000
Credit given is 80%
Avg. Accounts Receivables = Rs.200
Credit Sales = 80% of Rs.1000 = Rs.800
Accounts Receivables Turnover = Rs.800 / Rs.200 = 4.0x
Net credit sales are sales where the cash is collected at a later date. The formula for net credit sales is = Sales on
credit – Sales returns – Sales allowances.
Average accounts receivable is the sum of beginning and ending accounts receivable over a time period (such as
monthly or quarterly), divided by 2.
 SOLVENCY RATIO ANALYSIS
Bill’s Ski Shop is a retail store that sells outdoor skiing equipment. Bill offers accounts to
all of his main customers. At the end of the year, Bill’s balance sheet shows $20,000 in
accounts receivable, $75,000 of gross credit sales, and $25,000 of returns. Last year’s
balance sheet showed $10,000 of accounts receivable.

The first thing we need to do in order to calculate Bill’s turnover is to calculate net credit
sales and average accounts receivable. Net credit sales equals gross credit sales minus
returns (75,000 – 25,000 = 50,000). Average accounts receivable can be calculated by
averaging beginning and ending accounts receivable balances ((10,000 + 20,000) / 2 =
15,000).

Finally, Bill’s accounts receivable turnover ratio for the year can be like this.

As you can see, Bill’s turnover is 3.33. This means that Bill collects his receivables about
3.3 times a year or once every 110 days. In other words, when Bill makes a credit sale, it
will take him 110 days to collect the cash from that sale.
 SOLVENCY RATIO ANALYSIS
INTERPRETATION

• Please note that the Total Sales include Cash Sales + Credit Sales. Only Credit Sales
convert to Accounts Receivables, hence, we should only take Credit Sales.
• If a company sells most of its items on Cash Basis, then there will be No Credit Sales.
• Credit Sales figures may not be directly available in the annual report. You may have
to dig into the Management discussions to understand this number.
• A high ratio implies either that a company operates on a cash basis or that its
extension of credit and collection of accounts receivable is efficient. While a low ratio
implies the company is not making the timely collection of credit.
• Due to the time value of money principle, the longer a company takes to collect on its
credit sales, the more money a company loses, or the less valuable the company’s
sales. Therefore, a low or declining accounts receivable turnover ratio is detrimental
to a company.
 SOLVENCY RATIO ANALYSIS
Days Receivables

Days receivables is directly linked with the Accounts Receivables Turnover. Days
receivables expresses the same information but in terms of number of days in a year.
This provides with a intuitive measure of Receivables Collection Days
You may calculate Account Receivable days based on the year end balance sheet
numbers.
Many, however, prefer to use the average balance sheet receivables number to calculate
the average collection period. (right way is to use the average balance sheet)

Accounts Receivables Days = Number of Days in Year / Accounts Receivables Turnover

Accounts Receivables Turnover = 4.0x

Number of days in a year = 365
Days Receivables = 365 / 4.0x = 91.25 days ~ 91 days
This implies that it takes 91 days for the company to convert Receivables into Cash.
 SOLVENCY RATIO ANALYSIS
INTERPRETATION

• Number of days taken by most analysts is 365, however, some analyst also use 360 as
the number of days in the year. This is normally done to simplify the calculations.
• Accounts receivable days should be compared with the average credit period offered
by the company. For example in the above case, if the Credit Period offered by the
company is 120 days and they are receiving cash in just 91 days, this implies that the
company is doing well to collect its receivables.
• However, if the credit period offered is say 60 days, then you may find significant
amount of previous accounts receivables on the balance sheet, which obviously is not
good from company’s point of view.
 SOLVENCY RATIO ANALYSIS
Inventory Turnover Ratio analysis

Inventory Ratio means how many times the inventories are restored during the year. It
can be calculated by taking Cost of Goods Sold and dividing by Inventory.

Inventory Turnover Formula = Cost of Goods Sold / Inventory

Cost of Goods Sold = Rs.500

Avg. Inventory = Rs.100
Inventory Turnover Ratio = Rs.500 / Rs.100 = 5.0x
This implies that during the year, inventory is used up 5 times and is restored to its
original levels.

INTERPRETATION

You may note that when we calculate receivables turnover, we took Sales (Credit Sales),
however, in inventory turnover ratio, we took Cost of Goods Sold. Why?

The reason is that when we think about receivables, it directly comes from Sales made
on the credit basis. However, Cost of Goods sold is directly related to inventory and is
carried on the balance sheet at cost.
 SOLVENCY RATIO ANALYSIS
To get an intuitive understanding of this, you may see the BASE equation.

B+A=S+E

B = Beginning Inventory

A = Addition to Inventory (purchases during the year)

S = Cost of Goods sold

E = Ending Inventory

S =B+A–E

As we note from the above equation, Inventory is directly related to Cost of Goods Sold.
 SOLVENCY RATIO ANALYSIS
Days Inventory

We calculated Inventory Turnover Ratio earlier. However, most analyst prefer calculating
inventory days. This is obviously the same information but more intuitive. Think of
Inventory Days as the approximate number of days it takes for inventory to convert into
finished product.

Inventory Days Formula = Number of days in a year / Inventory Turnover

Cost of Goods Sold = Rs.500

Inventory = Rs.100
Inventory Turnover Ratio = Rs.500 / Rs.100 = 5.0x
Inventory Days = 365/5 = 73 days.
This implies that Inventory is used up every 73 days on an average and is restored to its original
levels.

INTERPRETATION
• You may also think of inventory days as the number of days a company can continue with
production without replenishing its inventory.
• One should also look at the seasonality patter in how inventory is consumed depending on the
demand. It is rare that inventory is consumed constantly throughout the year.
 SOLVENCY RATIO ANALYSIS
Accounts Payable Turnover

Payables turnover indicates the number of times that payables are rotated during the
period. It is best measured against purchases, since purchases generate accounts
payable.

Payables Turnover Formula = Purchases / Avg. Accounts Payables

Ending Inventory = Rs.500
Beginning Inventory = Rs.200
Cost of Goods Sold = Rs.500
Avg. Accounts Payable = Rs.200
In this example, we need to first find out Purchases during the year. If you remember the
BASE equation that we used earlier, we can easily find purchases.
B+A=S+E
B = Beginning Inventory
A = Additions or Purchases during the year
S = COGS
E = Ending Inventory
we get, A = S + E – B
Purchases or A = Rs.500 + Rs.500 – Rs.200 = Rs.800
Payables Turnover = Rs.800 / Rs.200 = 4.0x
 SOLVENCY RATIO ANALYSIS
INTERPRETATION

• Mistake of taking Cost of Goods Sold in the numerator of this accounts payable
turnover formula.
• It is important to note here that Purchase is the one that leads to Payables.
• We earlier saw Sales can be Cash Sales and Credit sales. Likewise, Purchases can be
Cash Purchases as well Credit Purchases. Cash Purchases does not results in payables,
it is only the Credit Purchases that leads to Accounts payables.
• Ideally, we should seek for Credit Purchases information from the annual report.
 SOLVENCY RATIO ANALYSIS
Days Payable Ratio Analysis

Like with all the other turnover ratios, most analyst prefer to calculate much intuitive
Days payable. Payable days represent the average number of days a company takes to
make the payment to its suppliers.

Payables Days Formula = Number of Days in a year / Payables Turnover

We earlier calculated Accounts Payable Turnover as 4.0x

Payable Days = 365 / 4 = 91.25 ~ 91 days
This implies that the company pays its clients every 91 days.

INTERPRETATION

• Higher the accounts payable days, better it is for the company from liquidity point of
view.
• Payable days can be affected by seasonality in the business. Sometimes business may
stock inventories due to upcoming business cycle. This may distort the interpretations
that we make on payable days if we are not aware of seasonality.
 SOLVENCY RATIO ANALYSIS
Cash Conversion Cycle

Cash conversion cycle is the total time taken by the firm to convert its cash outflows into
cash inflows (returns). Think of Cash Conversion Cycle as time taken by a company to
purchase the raw materials, then convert inventory into finished product and sell the
product and receive cash and then make the necessary payout for the purchases.
 SOLVENCY RATIO ANALYSIS
Cash Conversion cycle depends primarily on three variables – Receivable Days, Inventory
Days and Payable Days.

Cash Conversion Cycle Formula = Receivable Days + Inventory Days – Payable Days

Receivable Days = 100 days

Inventory Days = 60 days
Payable Days = 30 days
Cash conversion cycle = 100 + 60 – 30 = 130 days.

INTERPRETATION

• It signifies the number of days firm’s cash is stuck in the operations of the business.
• Higher cash conversion cycle means that it takes longer time for the firm to generate
cash returns.
• However, a lower cash conversion cycle may be viewed as a healthy company.
• Also, one should compare the cash conversion cycle with the industry averages so
that we are in a better position to comment on higher/lower side of cash conversion
cycle.
OPERATING PERFORMANCE RATIO ANALYSIS
Asset Turnover Ratio analysis
The asset turnover ratio is a comparison of sales to total assets. This ratio provides with
an indication on how efficiently the assets are being utilized to generate sales.
Asset Turnover ratio Formula = Total Sales / Assets

Sales of Company A = $900 million

Total Assets = $1.8 billion
Asset Turnover = $900/$1800 = 0.5x
This implies that for every $1 of assets, the company is generating $0.5

INTERPRETATION
• Asset turnovers can be extremely low or very high depending on the Industry they
operate in.
• Asset turnover of Manufacturing firm will be on the lower side due to large asset
base as compared to a companies that operates in the services sector (lower assets).
• If the firm has seen considerable growth in assets during the year or the growth has
been seasonal, then the analyst should find additional information to interpret such
numbers.
Growth