CU-SEM-VI-Financial Analysis and Business Valuation

allows us to calculate liquidity ratios, which assess a company's capacity to satisfy debt obligations as well as its margin of safety. A crucial group of financial indicators known as liquidity ratios is used to assess a debtor's capacity to settle current debt commitments without the need for outside funding. The quick ratio, current ratio, and days sales outstanding are common liquidity ratios. While solvency ratios are focused on a longer-term ability to pay off ongoing debts, liquidity ratios assess a company's capacity to meet short-term obligations and cash flows. The capacity to quickly and affordably turn assets into cash is known as liquidity. The best application of liquidity ratios is in comparison form. Both internal and external analyses may be used. For instance, employing numerous accounting periods that are reported using the same accounting standards is necessary for internal study of liquidity ratios. Analysts can follow changes in the firm by comparing historical periods to current operations. A higher liquidity ratio, in general, indicates that a business is more liquid and has better coverage of its outstanding debts. As an alternative, external analysis compares the liquidity ratios of various businesses or an entire sector. When setting benchmark targets, it is helpful to compare the company's strategic orientation to that of its rivals. Since different firms require different funding structures, liquidity ratio research may not be as useful when comparing industries. Comparing businesses of various sizes and locations using liquidity ratio analysis is less effective. A financial statistic called a liquidity ratio is used to assess a company's capacity to settle its short-term loan obligations. The statistic aids in figuring out if a business can use its liquid, or current, assets to pay its current liabilities. The current ratio, quick ratio, and cash ratio are the three liquidity ratios that are most frequently utilized. For each of the liquidity ratios, the numerator of the equation is the quantity of liquid assets, and the denominator is the amount of current liabilities. Ratios above 1.0 are desired due to the ratio's structure, which places assets on top and liabilities at the bottom. With a ratio of 1, a business may fully cover all of its current liabilities with its cash on hand. A ratio of less than 1 (for example, 0.75), would indicate that a business is unable to pay its present obligations. 101 CU IDOL SELF LEARNING MATERIAL (SLM)

A ratio higher than 1 (for example, 2.0) would indicate that a business can pay its present obligations. A corporation may actually cover its present liabilities twice over with a ratio of 2.0. If they had a ratio of 3, they could pay their existing liabilities off three times, and so on. The company's credibility and credit rating are both impacted by the liquidity ratio. Bankruptcy will result from ongoing failures to make short-term obligation repayments. Therefore, this ratio is crucial to the credit ratings and financial health of any organization. Types of Liquidity Ratio  Current Ratio  Quick Ratio or Acid test Ratio  Cash Ratio or Absolute Liquidity Ratio  Net Working Capital Ratio Solvency Ratios vs. Liquidity Ratios In contrast to liquidity ratios, solvency ratios evaluate a company's ability to pay off all of its debts, including long-term liabilities. While solvency refers to a company's total ability to meet debt obligations and maintain operations, liquidity concentrates on current or short-term financial accounts. A company must have more overall assets than total liabilities in order to be solvent; similarly, a company must have more current assets than current liabilities in order to be liquid. Despite the fact that solvency and liquidity are not directly related, liquidity ratios offer an early evaluation of a company's solvency. Divide a company's net income and depreciation by its short- and long-term obligations to get the solvency ratio. This determines if a company's net income is sufficient to cover all of its liabilities. A corporation with a greater solvency ratio is generally thought to be a better investment 5.2 CURRENT RATIO It is one of the most popular ratios for gauging a company's short-term liquidity or solvency. It represents the proportion of current assets to current liabilities. To put it another way, it assesses if there are sufficient liquid assets to cover present liabilities with a margin of safety for possible losses during the liquidation of the assets. 102 CU IDOL SELF LEARNING MATERIAL (SLM)

Usually, the ideal current ratio is 2:1. However, the ideal ratio depends on the nature of the business and the characteristics of its current assets and current liabilities. Thus, Where, Current Assets = Sundry Debtors + Inventories + Cash-in-hand + Cash-at-Bank + Receivables + Loans and Advances + Disposable Investments + Advance Tax Current Liabilities = Creditors + Short-term Loans + Bank Overdraft + Cash Credit + Outstanding expenses + Provision for Taxation + Dividend payable The easiest liquidity ratio to calculate and understand is the current ratio. On a company's balance sheet, the line items for current assets and current liabilities are simple to locate. The current ratio is calculated by dividing current assets by current liabilities. 5.3 QUICK RATIO The Acid-test Ratio is another name for it. The Quick Ratio calculates the difference between current liabilities and quick assets. It assesses if there are adequate readily convertible short - term cash available to pay the present liabilities. It is therefore superior to the Current Ratio. Cash and assets close to cash are the only quick assets. Since inventories cannot easily be converted into cash, they are not included. Also, it does not include prepaid expenses as these are paid in advance and cannot be converted into cash. The ideal Quick Ratio or Acid-test Ratio is 1:1. Thus, Where, 103 Quick Assets = Current Assets – Inventories – Prepaid Expenses CU IDOL SELF LEARNING MATERIAL (SLM)

5.4 CASH RATIO OR ABSOLUTE LIQUIDITY RATIO It gauges the firm's overall liquidity. It determines if a company can settle its present liabilities entirely with its cash, bank accounts, and marketable securities. Because there is no assurance that inventory will be realized or debts will be paid, we do not list them. Thus, This ratio measures the total liquidity available to the company. This ratio only considers marketable securities and cash available to the company. This ratio only tests short-term liquidity in terms of cash, marketable securities, and current investment. A cash ratio of one indicates that the company's cash and cash equivalents are exactly equal to its current liabilities. It can use this money to settle its short-term financial obligations. On the other side, a cash ratio of less than one indicates that the business does not have enough cash on hand to cover its present obligations. Due to the companies' lengthy payment cycles and quick collections, this might not be a problem. It also includes businesses who effectively manage their inventories. Last but not least, a cash ratio greater than one shows that the business has more than enough cash to pay off its current debts. This indicates that even after paying off its short-term debt obligations, the corporation still has some cash on hand. A high cash ratio, on the other hand, is not a positive sign because it suggests that the company's financial strategy was inadequate. It would be preferable to invest the extra money sitting around in high-yield ventures. 5.5 NET WORKING CAPITAL RATIO It is a measure of cash flow. The answer to this ratio should be positive. Usually, the bankers keep an eye on this ratio to see whether there is a financial crisis or not. Thus, Net Working Capital Ratio = Current Assets – Current Liabilities (exclude short-term bank borrowing) 104 CU IDOL SELF LEARNING MATERIAL (SLM)

5.6 PRACTICAL PROBLEMS ON LIQUIDITY RATIOS Liquidity Ratio Analysis Example The financial performance of two electric industry juggernauts, ABB and Rockwell, was the subject of a study. Ratio analysis was the main method employed to carry out this financial statement analysis. Therefore, current ratio was utilized to examine these multinational electric companies' short- term solvency during the time period in question. This ratio is distinct from the other group of determined ratios. Solvency ratios, asset turnover ratios, and return on capital employed were some of the other ratios. Analysis The research came to the conclusion that ABB had an average current ratio of 1.49 from 2013 to 2016. Rockwell, on the other hand, had an average current ratio of 2.69 over that time. A corporation often has insufficient assets to satisfy its short-term obligations if its current ratio is less than 2, according to standard accounting theory. In other words, a business's sales are increasing more quickly than it can finance them. The business might go bankrupt as a result of this circumstance. It's because the business is striving to balance the number of clients who are willing to buy its goods with its ability to pay for them. As a result, ABB's low current ratio for the time period portends a short-term liquidity difficulty for the business. As a result, ABB must invest in current assets in order to fulfill its immediate financial obligations. Likewise, Rockwell's financial management is subpar if its current ratio is higher than 2. This suggests that Rockwell's current assets, which could include slow-paying debtors or unsold products, are of poor quality. 1. From the following particulars calculate the liquidity ratios: Particulars Amount Inventory 140000 105 CU IDOL SELF LEARNING MATERIAL (SLM)

Sundry Debtors 280000 Cash 50000 Bills receivable 20000 Creditors 300000 Bank Overdraft 50000 Table 5.1 Particulars Calculate The Liquidity Ratios Ans; Current Assets = Sundry Debtors + Inventories + Cash-in-hand + Bills Receivable = 280000 + 140000 + 50000 + 20000 = 490000 Current Liabilities = Creditors + Bank Overdraft = 300000 + 50000 = 350000 106 CU IDOL SELF LEARNING MATERIAL (SLM)

Quick Assets = Current Assets – Inventories = 490000 – 140000 = 350000 4. Net Working Capital Ratio = Current Assets – Current Liabilities (exclude short- term bank borrowing) = 490000 – 300000 = 190000 2. Calculate the different liquidity ratios from the following particulars 107 CU IDOL SELF LEARNING MATERIAL (SLM)

Table 5.2 Calculate the different liquidity ratios from the following particulars a. Current Ratio= Current Assets/ Current Liabilities Current Assets = Sundry Debtors + Inventories + Cash-in-hand + Bills Receivable Current Liabilities = Creditors + Bank Overdraft Current Assets= 300,000 + 150,000+ 50,000+ 30,000= 530,000 Current Liabilities = 350,000+ 30,000= 380,000 Current Ratio= 530,000 / 400,000= 1.3 :1 b. Quick Ratio or Acid Test Ratio= Quick Assets / Current Liabilities Quick Assets = Current Assets – Inventories Quick Assets= 530,000 - 150,000= 380,000 Quick Ratio or Acid Test Ratio= 380,000 / 380,000 = 1:1 c. Cash Ratio = Cash Balance / Current Liabilities Cash Ratio = 50,000 / 380,000= 0.13:1 108 CU IDOL SELF LEARNING MATERIAL (SLM)

d. Net Working Capital Ratio = Current Assets – Current Liabilities (exclude short- term bank borrowing) Net Working Capital Ratio = 530,000- 350,000= 180,000 5.7 SUMMARY  A crucial group of financial indicators known as liquidity ratios is used to assess a debtor's capacity to settle current debt commitments without the need for outside funding.  The quick ratio, current ratio, and days sales outstanding are common liquidity ratios.  While solvency ratios are focused on a longer-term ability to pay off ongoing debts, liquidity ratios assess a company's capacity to meet short-term obligations and cash flows.  The capacity to quickly and affordably turn assets into cash is known as liquidity. The best application of liquidity ratios is in comparison form. Both internal and external analyses may be used.  For instance, employing numerous accounting periods that are reported using the same accounting standards is necessary for internal study of liquidity ratios. Analysts can follow changes in the firm by comparing historical periods to current operations. A higher liquidity ratio, in general, indicates that a business is more liquid and has better coverage of its outstanding debts.  As an alternative, external analysis compares the liquidity ratios of various businesses or an entire sector. When setting benchmark targets, it is helpful to compare the company's strategic orientation to that of its rivals. Since different firms require different funding structures, liquidity ratio research may not be as useful when comparing industries. Comparing businesses of various sizes and locations using liquidity ratio analysis is less effective.  A financial statistic called a liquidity ratio is used to assess a company's capacity to settle its short-term loan obligations. The statistic aids in figuring out if a business can use its liquid, or current, assets to pay its current liabilities. 109 CU IDOL SELF LEARNING MATERIAL (SLM)

 The current ratio, quick ratio, and cash ratio are the three liquidity ratios that are most frequently utilized. For each liquidity ratio, the equation's numerator is the quantity of liquid assets, and the denominator is the amount of current liabilities. 5.8 KEYWORD  Liquidity: Liquidity is defined as how quickly an asset can be converted into cash – so assets that can be sold and turned into cash in a short amount of time are considered to be highly liquid (and vice versa for assets with low liquidity).  Quick Ratio The quick ratio is a more stringent variation of the current ratio, including only the most liquid assets – or more specifically, assets that can be converted into cash within 90 days with a high degree of certainty.  Current ratio The current ratio is a measure of a company’s ability to pay off the obligations within the next twelve months. This ratio is used by creditors to evaluate whether a company can be offered short term debts. It also provides information about the company’s operating cycle. 5.9 LEARNING ACTIVITY 1. Define Current ratio ___________________________________________________________________________ ___________________________________________________________________________ 2. State the meaning of Quick ratio. ___________________________________________________________________________ ___________________________________________________________________________ 3. State the meaning of cash ratio. ___________________________________________________________________________ ___________________________________________________________________________ 4. State the meaning of Net working capital ratios. ___________________________________________________________________________ ___________________________________________________________________________ 110 CU IDOL SELF LEARNING MATERIAL (SLM)

5.10 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Explain Liquidity ratios. 2. List the liquidity ratios formula 3. Explain in detail about the cash ratio 4. What is net working capital ratio? Long Questions 1. What is acid test ratio? Explain with illustration 2. What is Absolute liquidity ratio? 3. Explain Liquidity Ratio Analysis with Example. 4. What is Current ratio? B. Multiple Choice Questions 1. Quick ratio is also known as _________ a. Acid test ratio b. Current ratio c. Cash ratio d. None of the above. 2. ________ is a measure of cash flow. a. Net working capital ratio b. Cash ratio c. Quick ratio d. None of the above 3. __________ is a measure of a company’s liquidity in which it is measured whether the company has the ability to clear off debts only using the liquid assets 111 CU IDOL SELF LEARNING MATERIAL (SLM)

a. Cash ratio b. Net working capital ratio c. Quick ratio d. Current ratio 4. ________ ratios are a measure of the ability of a company to pay off its short-term liabilities. a. Liquid b. Liquidity c. Quick d. Current Answers 1-a, 2-a, 3-a. 4-b 5.11 REFERENCES References book  Financial Statement Analysis - Martin Fridson. ...  International Financial Statement Analysis - Thomas Robinson. ...  The Finance Book - Stuart Warner & Si Hussain. ...  Financial Statements: Step by Step - Thomas Ittelson. Website  https://byjus.com/commerce/liquidity-ratio/#:~:text=Liquidity%20ratios  https://corporatefinanceinstitute.com/resources/knowledge/finance/liquidity-ratio/  https://investopedia.com/terms/l/liquidityratios.asp 112 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT – 6 SOLVENCY RATIO STRUCTURE 6.0 Learning Objectives 6.1 Introduction 6.2 Debt-assets ratio 6.3 Debt to equity ratio 6.4 Proprietory ratio 6.5 Practical sums 6.6 Summary 6.7 Keywords 6.8 Learning Activity 6.9 Unit End Questions 6.10 References 6.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Describe interest coverage ratio  Difference between debt to equity and debt to asset ratio  Practical problems on solvency ratio 6.1 INTRODUCTION Prospective business lenders frequently utilize a solvency ratio as a significant indicator of a company's capacity to repay its long-term debt. A company's financial health can be assessed by looking at its solvency ratio, which determines if its cash flow is sufficient to cover its long-term obligations. An unfavorable ratio can suggest a chance that a corporation would fail to pay its debts. A solvency ratio looks at a company's capacity to pay off its long-term debts and commitments. The debt-to-assets ratio, the interest coverage ratio, the equity ratio, and the debt-to-equity (D/E) ratio are the four primary measures of solvency. Both potential bond 113 CU IDOL SELF LEARNING MATERIAL (SLM)

investors and prospective lenders frequently utilize solvency measures to assess a company's creditworthiness. Both solvency ratios and liquidity ratios assess a company's financial standing, but solvency ratios offer a more long-term perspective. One of the many criteria used to assess a company's long-term viability is the solvency ratio. In order to analyze a company's ability to stay afloat, a solvency ratio adds back depreciation and other non-cash expenses to measure a firm's actual cash flow rather than net income. This cash flow capacity is evaluated in relation to all liabilities, not only short-term debt. The ability of a corporation to pay off its long-term debt and the interest on that debt is assessed by looking at its solvency ratio. Solvency ratios differ between industries. Therefore, rather than being assessed in isolation, a company's solvency ratio should be evaluated in comparison to that of its counterparts in the same industry. When comparing the size of an insurance company's capital to the premiums earned and measuring the risk an insurer faces from uninsurable claims, the phrase \"solvency ratio\" is also Solvency The ratios used to assess an organization's financial status from the perspective of long-term solvency are called ratios. These ratios gauge the company's capacity to meet its long-term commitments. Investors keep a careful eye on them to determine whether the company can meet its long-term obligations and to assist them in making decisions about the long-term investment of their money in the company. Solvency Ratios vs. Liquidity Ratios While liquidity ratios demonstrate a company's capacity to pay short-term obligations, solvency ratios demonstrate a company's capacity to pay long-term debt obligations. Even though a company appears to have a lot of short-term liquidity, it may not be able to pay its long-term debts. As a result, a company may seem to have a lot of liquid assets but ultimately turn out to be bankrupt. This circumstance can occur when a company has recently received a sizable payment from a client, but its sales backlog is so weak that it will be unable to sustain long-term positive cash flow. A situation where a business is not particularly liquid over the short term can also occur and yet is highly solvent when viewed over a longer period of time. Types of Solvency Ratios:  Interest Coverage Ratio 114 CU IDOL SELF LEARNING MATERIAL (SLM)

 Debt to Assets Ratio  Equity Ratio  Debt to Equity (D/E) Ratio 6.2 INTEREST COVERAGE RATIO The interest coverage ratio calculates how many times a company's available earnings can cover its existing interest payments. It is an indicator of the company's safety margin for paying off its debt's interest during a specific time frame. Calculation of Interest Coverage Ratio: Interest Coverage Ratio= EBIT/ Interest Expenses Where EBIT = Earnings before interest and taxes For the corporation, a higher interest coverage ratio is preferable. A corporation may have trouble making the interest payments on its obligations if the interest coverage ratio is 1.5 or less. The amount of times a company's profits can be used to pay interest on its obligations can be calculated using the interest coverage ratio. Divide the company's profits (before any interest or tax deductions) by the amount of interest paid to arrive at the figure. The company is more financially stable the larger the valuation. In other words, it indicates that regular business operations are generating sufficient revenue to cover its interest expenses. 6.3 DEBT-TO-ASSETS RATIO A company's entire debt is compared to its total assets to get its debt to assets ratio. It reveals how much of the company is financed by debt and measures the company's leverage. It assesses the business's capacity to settle its debt using its available resources. Calculation of Debt to Asset Ratio: Debt to Assets Ratio= Debt/ Assets A higher debt to asset ratio, above 1.0, indicates that a significant amount of the company’s funding is through debt which may make it difficult to meet its obligations. 115 CU IDOL SELF LEARNING MATERIAL (SLM)

A company's debt-to-assets ratio can provide insight into the leverage of the business and its capital structure. A company's dependence on its lenders increases as its level of leverage increases. When interest rates increase, a firm with a lot of debt may suffer because it will have to use more of its income to pay back loans rather than making payroll or investing in new equipment. A corporation has more financial flexibility when its assets are greater than its overall debt. A small business that has less debt can pay better wages and expand more quickly since it won't have to spend as much money paying off the loan. On the other hand, a business can profit from having some debt. Loans provide immediate cash flow, and cash can be spent on expanding a business. 6.4 DEBT TO EQUITY (D/E) RATIO The debt to equity ratio and the debt to assets ratio both assess a company's funding structure. This ratio indicates how much of the company's funding comes from stock in this scenario. Calculation of the Debt-to-Equity (D/E) ratio: Debt to Equity Ratio (DE)= Debt Outstanding / Equity A higher debt to equity ratio means that the company has more debt on its books, which indicates higher chances of default. The ratio assesses how much of the company’s debt can be covered by the equity in case of liquidation. 6.5 PROPRIETARY RATIO A type of solvency ratio called a proprietary ratio is helpful for figuring out how much shareholders or business owners contribute to the total assets of the company. It is sometimes referred to as the net worth ratio, shareholder equity ratio, or equity ratio. This ratio's main goal is to quantify how much of a company's total assets are contributed by the owners. A proprietary ratio can be used to assess the stability of a firm's capital structure and to demonstrate how a company builds its assets by issuing a large number of equity shares as opposed to borrowing money from outside sources. Additionally, it shows how much will be paid to shareholders in the event of a corporate collapse. 116 CU IDOL SELF LEARNING MATERIAL (SLM)

The shareholders equity is divided by the total assets of the company to arrive at the proprietary ratio, which is expressed as a percentage It is implied that no external debt was required to finance the company in a situation where the shareholders' equity contributes 100% or the entire company's assets are financed by shareholders. Additionally, stock capital is more costly than loan capital. A high proprietary ratio demonstrates a company's strength and offers relief to creditors, whereas a low proprietary ratio demonstrates the company's reliance on debt funding to operate. It also suggests that lenders will become less interested in financing such a business. The chance of bankruptcy will increase, and interest rates will rise. Proprietary Ratio or equity ratio can be calculated with the help of the following formula. It is represented as Proprietary Ratio = Proprietors Funds / Total Assets Where, Proprietors funds refers to the funds provided by equity shareholders and total assets refer to the combined funds of both debt (financing obtained from outside) and equity (shareholder or proprietors funds). 6.6 PRACTICAL PROBLEMS ON SOLVENCY RATIOS 117 Illustration 1: Using Current Ratio Working Capital: 150,000 Total debt of the company: 400,000 Long term debt: 200,000 Current ratio (CR) = Current assets (CA) / Current liabilities (CL) CR = 350,000/ 200,000= 1.75: 1 Here working capital= Current assets – Current liabilities 150,000= CA- 200,000 CA= 350,000 CU IDOL SELF LEARNING MATERIAL (SLM)

Current liabilities= Total debt- Long term debt CL= 400,000- 200,000 CL= 200,000 Illustration 2: Using Interest Coverage ratio NPA: 78,000 Tax Rate: 35% Debentures: 5,00,000 at 10% Net Profit before tax = (78,000 × 100) ÷ 65 Net Profit Before tax = 1,20,000 Debentures Interest = 5,00,000 × 10% = 50,000 Interest Coverage Ratio = Net Profit before Interest and Tax / Interest on Long-Term Debt = 1, 20,000 / 50,000 Interest Coverage Ratio = 2.4:1 So the firm can cover the interest cost 2.4 times. Illustration 3: 118 Using Debt Equity Ratio Short term debt or liabilities: 50000 Long Term liabilities: 70000 Shareholder’s equity: 2,00,000 Total Liabilities = Short term debt + Long term debt = 50000 +70000 =1,20,000 Shareholder’s equity = 2,00,000 CU IDOL SELF LEARNING MATERIAL (SLM)

Debt to Equity Ratio = Debt to Equity Ratio (DE)= Outstanding Debt / Equity =1,20,000 / 2,00,000 = 0.6 So, the debt consists of 60% of shareholder’s equity. Illustration 4: Let’s look at the case of SaleSmarts Co.: SaleSmarts Net Income 45,000 Depreciation 15,000 Short-term Liabilities 83,000 Long-term Liabilities 160,000 Table 6.1 Illustration Solvency Ratio = (45,000 + 15,000) / (83,000 + 160,000 Solvency Ratio = 0.246 * 100 = 24.6% Important to note is that a company is considered financially strong if it achieves a solvency ratio exceeding 20%. So, from our example above, it is clear that if SalesSmarts keeps up with the trend each year, it can repay all its debts within four years (100% / 24.6% = Approximately four years). 6.7 SUMMARY  A solvency ratio looks at a company's capacity to pay off its long-term debts and commitments. The debt-to-assets ratio, the interest coverage ratio, the equity ratio, and the debt-to-equity (D/E) ratio are the four primary measures of solvency. Both potential bond investors and prospective lenders frequently utilize solvency measures to assess a company's creditworthiness.  Both solvency ratios and liquidity ratios assess a company's financial standing, but solvency ratios offer a more long-term perspective. 119 CU IDOL SELF LEARNING MATERIAL (SLM)

 A higher debt to equity ratio means that the company has more debt on its books, which indicates higher chances of default. The ratio assesses how much of the company’s debt can be covered by the equity in case of liquidation.  A company's debt-to-assets ratio can provide insight into the leverage of the business and its capital structure. A company's dependence on its lenders increases as its level of leverage increases. When interest rates increase, a firm with a lot of debt may suffer because it will have to use more of its income to pay back loans rather than making payroll or investing in new equipment.  A corporation has more financial flexibility when its assets are greater than its overall debt. A small business that has less debt can pay better wages and expand more quickly since it won't have to spend as much money paying off the loan. On the other hand, a business can profit from having some debt. Loans provide immediate cash flow, and cash can be spent on expanding a business. 6.8 KEYWORDS  Interest coverage ratio The interest coverage ratio calculates how many times a company's available earnings can cover its existing interest payments. It is an indicator of the company's safety margin for paying off its debt's interest during a specific time frame.  Proprietary ratio A type of solvency ratio called a proprietary ratio is helpful for figuring out how much shareholders or business owners contribute to the total assets of the company.  Debt to asset ratioA company's entire debt is compared to its total assets to get its debt to assets ratio. It reveals how much of the company is financed by debt and measures the company's leverage. It assesses the business's capacity to settle its debt using its available resources  Debt to Equity ratioThe debt to equity ratio and the debt to assets ratio both assess a company's funding structure. This ratio indicates how much of the company's funding comes from stock in this scenario. 6.9LEARNING ACTIVITY 1. Define Solvency ratios 120 CU IDOL SELF LEARNING MATERIAL (SLM)

__________________________________________________________________ _________ ___________________________________________________________________________ 2. State the various solvency ratios ___________________________________________________________________________ ___________________________________________________________________________ 3. What is debt to equity ratio? ___________________________________________________________________________ ___________________________________________________________________________ 4. What is Debt to asset ratio? ___________________________________________________________________________ ___________________________________________________________________________ 6.10 UNIT END QUESTIONS A. Descriptive Questions Short Questions: 1. Define interest coverage ratio. 2. Explain what is solvency ratio? 3. Describe briefly about propritory ratio. Long Questions: 1. What is a solvency ratio? Explain the various types of solvency ratios? 2. Describe in detail about the debt to assets ratio 3. What is use of proprietary ratio? B.Multiple Choice Questions 1. A type of solvency ratio called a ________ ratio is helpful for figuring out how much shareholders or business owners contribute to the total assets of the company. a. Proprietary 121 CU IDOL SELF LEARNING MATERIAL (SLM)

b. Liquid c. Quick d. Debt equity 2. The __________ ratio calculates how many times a company's available earnings can cover its existing interest payments. a. interest coverage b. debt- asset ratio c. Debr-equity d. Cash ratio 3. ____________ is referred to as the net worth ratio a. Proprietary b. Liquid c. Quick d. Debt equity 4. A company's entire debt is compared to its total assets to get its _________ ratio. a. debt to assets b. Liquid c. Quick d. Debt equity Answers 1-a, 2-a, 3-a, 4-a 6.11 REFERENCES References book  Financial Statement Analysis - Martin Fridson. ...  International Financial Statement Analysis - Thomas Robinson. ...  The Finance Book - Stuart Warner & Si Hussain. ...  Financial Statements: Step by Step - Thomas Ittelson. 122 CU IDOL SELF LEARNING MATERIAL (SLM)

Website  https://www.investopedia.com/terms/s/solvencyratio.asp#:~  https://www.investopedia.com/articles/investing/100313/financial-analysis-solvency- vs-liquidity-ratios.asp  https://byjus.com/commerce/solvency-ratio/ 123 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT – 7 PROFITABILITY RATIOS STRUCTURE 7.0 Learning Objectives 7.1 Introduction 7.2 Gross profit ratio 7.3 Net profit ratio 7.4 Return on assets ratio 7.5 Return on capital employed 7.6 Operating ratio 7.7 Operating profit ratio 7.8 Summary 7.9 Keywords 7.10 Learning Activity 7.11 Unit End Questions 7.12 References 7.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Describe nature of profitability ratios  Identify scope of gross profit and net profit ratios  State the various ratios such as return on asset ratio 7.1 INTRODUCTION Using information at a single point in time, profitability ratios are a class of financial measurements that are used to evaluate a company's capacity to generate profits in relation to its revenue, operating costs, balance sheet assets, or shareholders' equity over time. Profitability ratio,which evaluate how effectively a company uses its resources internally to generate income, can be compared to profitability ratios (as opposed to after-cost profits). A company's capacity to generate profits from sales or activities, balance sheet assets, or shareholders' equity is evaluated by profitability ratios. 124 CU IDOL SELF LEARNING MATERIAL (SLM)

Profitability ratios show how effectively a business makes money and adds value for shareholders. However, when compared to results of other companies, the company's past performance, or the industry average, higher ratio results often provide much more information. For the majority of profitability ratios, a greater number in comparison to a competitor's ratio or to the same ratio from a prior period denotes the company's success. When compared to similar businesses, the business's own past, or typical ratios for its sector, profitability ratios are most helpful. One of the most popular profitability or margin ratios is gross profit margin. Gross profit, also known as cost of products sold, is the difference between revenue and manufacturing expenses (COGS). Some industries have operations that are seasonal. For instance, during the year-end holiday season, shops often see much greater revenues and earnings. Therefore, since they are not directly comparable, it would be useless to compare a retailer's fourth-quarter gross profit margin to its first-quarter gross profit margin. It would be significantly more instructive to compare a retailer's fourth-quarter profit margin to its fourth-quarter profit margin from the prior year. One of the most widely used measures in financial research is the profitability ratio, which may be divided into two groups: return ratios and margin ratios. Margin ratios shed light on a company's capacity to convert revenues into profits from a variety of perspectives. Return ratios give numerous different ways to analyze how successfully a company creates a return for its shareholders. One of the most widely used measures in financial research is the profitability ratio, which may be divided into two groups: return ratios and margin ratios. Margin ratios shed light on a company's capacity to convert revenues into profits from a variety of perspectives. Return ratios give numerous different ways to analyze how successfully a company creates a return for its shareholders. 7.2 GROSS PROFIT RATIO A sort of profitability ratio is the gross profit margin ratio, often known as the gross margin. It is useful to calculate the profit generated by a company's sales of goods and services after 125 CU IDOL SELF LEARNING MATERIAL (SLM)

direct costs are subtracted. Simply put, it is a straightforward metric to assess the profitability of the business. It is also beneficial to assess how well the business uses its labor force and raw materials during the production process. The cost of products sold is subtracted from the total sales to determine the gross profit in a company's income statement. Only the direct costs of the business are taken into account when calculating the cost of goods sold. The direct expenses are erratic because they fluctuate according to the volume of production. Examples of direct expenses include direct labour and direct materials. The gross profit margin ratio may change depending on the business and sector. The larger the profit margin signifies more efficiency of the company. Also, this ratio gives owners a picture of how production costs affect their revenue. If the gross margin declines, the company may review its strategy, alter its cash flow forecasts, alter its price, reduce costs, use less expensive raw materials, etc. The gross profit margin is the percentage of revenue that remains after the cost of goods sold. The following is the formula to calculate – Gross Profit Margin = (Net Sales – Cost of Goods Sold)/ Net Sales Net Sales – is deducting any sales returns, discounts or allowances from the total sales. Net sales give more accurate information than total sales. Cost of Goods Sold (COGS) – is the direct costs during the production process like the direct materials and direct labour. These costs may vary depending on the company and industry. Also, indirect costs and other fixed costs like administrative expenses, marketing expenses are not a part of in the COGS. Example: Let’s assume that a company ABC has Rs. 75 lakhs net sales and the cost of goods sold per the income statement is Rs. 35 lakhs. What is the gross profit margin? Gross Profit Ratio = (75,00,000 – 35,00,000)/ 75,00,000 = 0.5333 or 53.33% Therefore, the company earned 53% gross profit from its total sales before. This is further used to cover the operating expenses and other costs. Importance of Gross Profit Margin Ratio 126 CU IDOL SELF LEARNING MATERIAL (SLM)

The following are reasons why the gross profit margin ratio is significant:  Using sales revenues, organizations can be compared using a gross profit margin ratio.  It is an easy-to-understand financial statistic for analyzing sales revenue because it subtracts other business costs.  This ratio may provide insight into how effectively the business is run.  This ratio allows businesses to price their items at a level that is both competitive and profitable.  It offers a standard by which to assess how well a business is doing in relation to rivals. A highly competitive market with a minimal distinction between competing goods and services can be identified by a consistent decline in profit margins. An organization may have fewer competitors or be better able to set itself apart from the competition if its profit margins are consistently growing, on the other hand.  Finally, this ratio can be useful for emphasizing areas that need work. For instance, the management may decide to lower COGS or change the sales strategy for other items if one product has a greater gross profit margin.  As a result, a company's gross profit margin is crucial to understanding its management and demonstrates how much more it must spend on operating expenses, financing, and other expenses. Additionally, maintaining this ratio must be a priority, and any large changes call for prompt action. 7.3 NET PROFIT RATIO The amount of net income or profit generated as a percentage of revenue is expressed as the net profit margin, or simply net margin. It is the proportion of a company's or business segment's net profits to revenues. Although it can also be given in decimal form, the net profit margin is frequently expressed as a percentage. A company's net profit margin shows how much of every dollar in revenue it receives is converted into profit. One of the most crucial measures of a company's financial health is its net profit margin. A business can determine whether its existing procedures are effective and estimate earnings based on revenues by monitoring growth and reductions in its net profit margin. 127 CU IDOL SELF LEARNING MATERIAL (SLM)

It is easy to compare the profitability of two or more firms regardless of size since organizations represent net profit margin as a percentage rather than a monetary value. This metric includes all factors in a company's operations, including:  Total revenue  Additional income streams  COGS and other operational expenses  Interest expense on debt obligations  Investment income and income from secondary operations  One-time payments for unusual events such as lawsuits and taxes Investors can determine whether the management of a firm is making a sufficient profit from sales and whether operational costs and overhead expenditures are being controlled. For instance, a business may experience rising sales, but if operational expenses are rising more quickly than sales, the company's net profit margin would decrease. Investors prefer to observe a history of expanding margins, which indicates that the net profit margin is escalating with time. The majority of publicly traded corporations publish their net profit margins in both their financial statements and quarterly earnings announcements. Since share price growth is normally highly correlated with profit growth, companies that can increase their net margins over time are typically rewarded with stock price growth. Formula and calculation for Net Profit Margin 128 CU IDOL SELF LEARNING MATERIAL (SLM)

1. On the income statement, subtract the cost of goods sold (COGS), operating expenses, other expenses, interest (on debt), and taxes payable. 2. Divide the result by revenue. 3. Convert the figure to a percentage by multiplying it by 100. 4. Alternatively, locate net income from the bottom line of the income statement and divide the figure by revenue. Convert the figure to a percentage by multiplying it by 100 7.4 RETURN ON ASSETS RATIO Return on net assets (RONA) is a measure of financial performance calculated as net profit divided by the sum of fixed assets and net working capital. Net profit is also called net income. A high ratio result means that management is getting more money out of each dollar invested in assets. The RONA ratio determines how effectively a company and its management are using assets in economically productive ways. RONA is also used to evaluate a company's performance in relation to competitors in its sector. The following is the formula to calculate 129 CU IDOL SELF LEARNING MATERIAL (SLM)

Net income, fixed assets, and net working capital are the three parts of RONA. The income statement's net income is computed as revenue less costs related to producing or marketing the company's goods, running costs such as management salaries and utilities, debt-related interest costs, and all other costs. Fixed assets do not include goodwill or other intangible assets that are carried on the balance sheet, but rather tangible assets that are used in production, such as real estate and machinery. The company's current obligations are subtracted from its current assets to determine net working capital. The denominator of the working capital calculation does not include long- term liabilities, which is a crucial distinction to make. To smooth or normalize data, especially when compared to other companies, analysts make a few changes to the inputs of the ratio algorithm. Consider how certain types of accelerated depreciation, which allow up to 40% of an asset's value to be lost in the first full year of use, can have an impact on the fixed assets balance. Additionally, any important events, especially if they are one-time occurrences, that resulted in a sizable loss or unusual income should be subtracted from net income. Goodwill is another intangible asset that analysts occasionally leave out of the equation because it frequently results from an acquisition rather than being an asset bought to be used in the production of goods, like new equipment. Investors can assess how effectively a company is turning a profit from its assets by looking at the return on net assets (RONA) ratio, which compares a company's net income with its assets. A company is using its assets more efficiently when its earnings as a percentage of its assets are higher. RONA is a crucial statistic for capital-intensive businesses because fixed assets make up the majority of their assets. In the capital-intensive manufacturing sector, RONA can also be calculated as: 130 CU IDOL SELF LEARNING MATERIAL (SLM)

Interpretation of Return on net assets (RONA): The higher the return on net assets, the better the profit performance of the company A greater RONA suggests the company is utilizing its assets and working capital efficiently and effectively, yet no one figure reveals the complete picture of a company's performance. One of the measures used to assess a company's financial health is the return on net assets. Extraordinary expenses may be brought back into the net income calculation if the goal is to provide a longer-term perspective on the company's capacity to produce value. 7.5 RETURN ON CAPITAL EMPLOYED Return on capital employed (ROCE) is a financial measure that may be used to evaluate the profitability and capital efficiency of an organization. In other words, this ratio can be used to determine how effectively a business is turning a profit from the capital it uses. When evaluating a company for investment, financial managers, stakeholders, and potential investors may utilize a number of profitability ratios, including ROCE. When evaluating the performance of businesses in capital-intensive industries like utilities and telecommunications, return on capital employed can be very helpful. This is so that ROCE may take into account both debt and equity, unlike other fundamentals like return on equity (ROE), which solely assesses profitability connected to a company's shareholders' equity. Financial performance analysis for businesses with high debt levels may be mitigated by doing this.’ ROCE is a statistic for examining profitability and comparing capital-based profitability levels across different organizations. Calculating ROCE requires two elements. These are capital employed and earnings before interest and taxes (EBIT). EBIT, also referred to as operational income, reveals the amount of money a business makes from its operations alone, excluding taxes and debt interest. It is computed by deducting operational costs and cost of goods sold (COGS) from revenues. Comparable to invested capital, which is used to calculate ROIC, is capital employed. By deducting current obligations from total assets, you may calculate capital utilized, which 131 CU IDOL SELF LEARNING MATERIAL (SLM)

results in shareholders' equity plus long-term debts. Some analysts and investors may opt to calculate ROCE based on average capital employed, which averages opening and closing capital utilized over the time period under consideration, as opposed to capital employed at a predetermined moment in time. The return on capital employed ratio demonstrates the amount of profit produced by each dollar of capital invested. Naturally, a greater ratio would be preferable because it indicates that more profits are made from every dollar invested in capital. For instance, a return of.2 means that the business gained 20 cents in profits for every dollar invested in capital employed. Investors are curious about a company's long-term financing plans and its ratio to determine how effectively it spends its capital employed. Always make sure that a company's returns are higher than the rate at which it is borrowing money to fund its assets. Companies lose money if they borrow money at a rate of 10% but only receive a 5% return. The number of assets a firm has can, like the return on assets ratio, either hinder or assist it in generating a high return. In other words, a company that has less assets overall but greater earnings will have a larger return than a company with fewer assets overall but higher profits. 7.6 OPERATING RATIO By comparing a company's total operating expenses to its net sales, the operating ratio is a metric used by businesses to assess how well management manages to keep operating costs low while also generating revenues or sales. The cost of products sold plus operational expenses make up the overall operating expenses. 132 CU IDOL SELF LEARNING MATERIAL (SLM)

Operating expenses generally include accounting and legal fees, bank charges, sales and marketing costs, office supply costs, salary and wages, repair and maintenance costs, and non-capitalized R&D expenses. The cost of goods sold includes direct material costs, plant rent, direct labor, repair costs, etc. A number of tools are used by investment analysts to assess an organization's performance. The operational ratio is a great instrument to explain the performance and level of efficiency of the company because it emphasizes the organization's primary business activities. The operational ratio aids analysts in gauging productivity along with return on firm sales and return on equity. The ratio aids in trend analysis and performance monitoring over a predetermined time frame. The organization is not operating as effectively if the ratio is rising. In this scenario, operating expenses are increasing in relation to earnings or sales. On the other side, if the ratio is falling, it suggests that the business is successfully reducing its costs while increasing revenues. An organization may be forced to implement cost control measures to improve its margins if it experiences a persistently increasing operating ratio. Decreasing operating cost relative to sales revenue is noted as a positive sign. Components of the Operating Ratio All costs, with the exception of taxes and interest, are considered operating expenses. Non- operating costs, including exchange rate charges, are not taken into account by organizations when calculating the operating ratio because they are extra costs unrelated to the company's primary operations. Overheads like general sales or administrative charges are considered operating expenses. The costs incurred by owning a corporate office are an example of overhead since, despite being required, they are unrelated to the production process. Operating costs consist of:  Legal and accounting fees 133  Banking charges  Marketing or sales costs  Office costs CU IDOL SELF LEARNING MATERIAL (SLM)

 Wages or salaries In some instances, operating costs include the cost of goods sold (COGS). Such expenses are directly related to the production process. That said, some companies prefer to keep operating costs and direct production costs separately. The direct product costs can include:  Material costs  Labor cost  Wages and benefits for production workers  Machine repair and maintenance costs Total sales or revenue usually appears at the top of an income statement as the sum total that an organization generates. The selected data from the records of Good Luck Company limited is given below: Net sales: 400,000 Cost of goods sold: 160,000 Administrative expenses: 35,000 Selling expense: 25,000 Solution Interest charges: = (220,000* / 400,000) × 100 = 55% The operating profit ratio is 55%. It means 55% of the sales revenue would be used to cover cost of goods sold and other operating expenses of Good Luck Company Limited. 10,000 134 CU IDOL SELF LEARNING MATERIAL (SLM)

Computation of operating expenses: Cost of goods sold + Administrative expenses + Selling expenses = 160,000 + 35,000 + 25,000 = 220,000 Notice that the interest charges of 10,000 have not been included because they are categorized as financial expenses, not operating expenses. Significance and interpretation: An organization's management's operational effectiveness is gauged using the operating ratio. It displays whether the cost portion of the sales number falls within the acceptable range. A high net profit ratio results from a low operating ratio (i.e., more operating profit). On the other hand, a high operational ratio denotes a low net profit ratio (i.e., less operating profit). The ratio should be compared to I the ratio from the company's prior years and (ii) the ratio from other companies that are similar to it. An rise in the ratio needs to be looked into and brought to management's attention right away so that corrective action can be taken. The operational ratio differs from sector to sector; as a result, the companies chosen for performance comparison must all be from the same sector. 7.7 OPERATING PROFIT RATIO The amount of money a business makes from its operations is represented by the operating profit ratio. It illustrates the financial viability of a business's core operations before any negative financial or tax consequences. As a result, it is among the more accurate measures of a management team's effectiveness in running a business. How much profit a company makes every rupee of sales is determined by the operating margin ratio. Operating profit margin ratios that are higher are viewed favorably. because they show how well a business manages its operations and its ability to turn sales into profits. the formula for the operating profit margin is as follows – Operating Profit Ratio = Operating Profit / Net Sales Where, 135 CU IDOL SELF LEARNING MATERIAL (SLM)

Operating Income: This income is the profit left after daily expenses and cost of goods have been deducted from net sales. It considers only those factors that are relevant to the company’s operations and excludes any irrelevant variables. Operating Expense: It includes salaries, wages, consultant fees, raw material costs, processing and manufacturing expenses, administrative costs, advertising and marketing costs, rent, utilities, insurance, depreciation, etc. It does not include such expenses that are not directly related to the main operation or business operations of the company. Hence, expenses such as tax, interest on loans, loss or profit from investments, etc are not included in this computation. Revenue or Net Sales: Revenue or net sales is the gross sales earned from the main and related income-generating activities of the company. To arrive at net sales, analysts must exclude discounts and returns from gross sales. A company's operating margin ratio will vary depending on its past performance, the industry it operates in, and its competitors' industries. A company is said to have a competitive advantage if its operational profit ratio exceeds the industry average, indicating that it is more successful than enterprises of a comparable nature. Although the usual margin varies by industry, organizations can often gain a competitive edge by increasing sales or reducing costs, or even doing both A smaller operating margin is ideal for businesses with lots of operations, like aviation and transportation On the other hand, software development, a service-intensive industry, generates a higher operating margin than the aviation sector. Therefore, it is essential to first comprehend the operating margin of a company before analyzing it. By increasing revenue or sales and cutting costs, the operating margin can be raised. The cost of goods sold and other operating expenses make up the expenses. Therefore, reducing these costs would result in an increase in operational profit and margin. The operating margin ratio reveals the efficiency with which a business can turn a profit from its revenues. This ratio demonstrates how easily available revenues are and how they can be 136 CU IDOL SELF LEARNING MATERIAL (SLM)

used to cover non-operating expenses like interest payments. Because of this, the operating margin measure is given special attention by both lenders and investors. Operating margins that fluctuate wildly point to potential company hazards. The simplest approach to tell if a company's performance has improved over time is to look at its prior operating profit ratio. Operating margins can be increased by improved administrative controls, more effective resource management, better pricing, and more methodical marketing. The operating profit ratio demonstrates the amount of profit generated by a company's core operations in comparison to overall sales. This metric can be used by investors to determine whether a firm derives the majority of its revenue from its core business or from other sources, such as investments. 7.8 SUMMARY  Profitability ratio, which evaluate how effectively a company uses its resources internally to generate income, can be compared to profitability ratios (as opposed to after-cost profits).  A company's capacity to generate profits from sales or activities, balance sheet assets, or shareholders' equity is evaluated by profitability ratios.  Profitability ratios show how effectively a business makes money and adds value for shareholders.  However, when compared to results of other companies, the company's past performance, or the industry average, higher ratio results often provide much more information.  The gross profit margin ratio may change depending on the business and sector. The larger the profit margin signifies more efficiency of the company. Also, this ratio gives owners a picture of how production costs affect their revenue. If the gross margin declines, the company may review its strategy, alter its cash flow forecasts, alter its price, reduce costs, use less expensive raw materials, etc.  Return on capital employed (ROCE) is a financial measure that may be used to evaluate the profitability and capital efficiency of an organization. In other words, this ratio can be used to determine how effectively a business is turning a profit from the 137 CU IDOL SELF LEARNING MATERIAL (SLM)

capital it uses. When evaluating a company for investment, financial managers, stakeholders, and potential investors may utilize a number of profitability ratios, including ROCE.  EBIT, also referred to as operational income, reveals the amount of money a business makes from its operations alone, excluding taxes and debt interest. It is computed by deducting operational costs and cost of goods sold (COGS) from revenues. 7.8 KEYWORDS  Operating Income: This income is the profit left after daily expenses and cost of goods have been deducted from net sales. It considers only those factors that are relevant to the company’s operations and excludes any irrelevant variables  Operating Expense: It includes salaries, wages, consultant fees, raw material costs, processing and manufacturing expenses, administrative costs, advertising and marketing costs, rent, utilities, insurance, depreciation, etc. It does not include such expenses that are not directly related to the main operation or business operations of the company. Hence, expenses such as tax, interest on loans, loss or profit from investments, etc are not included in this computation.  Revenue or Net Sales: Revenue or net sales is the gross sales earned from the main and related income-generating activities of the company. To arrive at net sales, analysts must exclude discounts and returns from gross sales  ROCE It is a statistic for examining profitability and comparing capital-based profitability levels across different organizations. Calculating ROCE requires two elements. These are capital employed and earnings before interest and taxes (EBIT). 7.9LEARNING ACTIVITY 1. Define profitability ratios ___________________________________________________________________________ ______________________________________________________________________ _____ 2. State various profitability ratios ___________________________________________________________________________ ___________________________________________________________________________ 138 CU IDOL SELF LEARNING MATERIAL (SLM)

3. What is Net profit ratio? ___________________________________________________________________________ ___________________________________________________________________________ 4. What is Operating ratio? ___________________________________________________________________________ __________________________________________________________________________ 7.10 UNIT END QUESTIONS A. Descriptive Questions Short Questions: 1. Define Gross profit ratio? 2. Explain what is Net profit ratio? 3. Describe briefly about Return on capital employed? 4. What do you understand by Operating ratio? Long Questions: 1. What is a profitability ratio ? Explain the various types of profitability ratios? 2. Describe the Return on assets ratio. 3. What are the various profitability ratios? B. Multiple Choice Questions 1. The amount of net income or profit generated as a percentage of revenue is expressed as the ________ a. net profit margin b. Return on assets ratio c. return on capital employed d. Operating profit 139 CU IDOL SELF LEARNING MATERIAL (SLM)

2. The amount of money a business makes from its operations is represented by the _______ a. net profit margin b. Return on assets ratio c. return on capital employed d. Operating profit 3. The ______ ratio determines how effectively a company and its management are using assets in economically productive ways a. net profit margin b. Return on assets ratio c. return on capital employed d. Rona Answers 1-a, 2-d, 3-d 7.11 REFERENCES References book  Financial Statement Analysis - Martin Fridson. ...  International Financial Statement Analysis - Thomas Robinson. ...  The Finance Book - Stuart Warner & Si Hussain. ...  Financial Statements: Step by Step - Thomas Ittelson. Website  https://www.investopedia.com/terms/p/profitabilityratios.asp#  https://byjus.com/commerce/profitability-ratios/  https://scripbox.com/mf/profitability-ratios/ 140 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT - 8 TURNOVER RATIO STRUCTURE 8.0 Learning Objectives 8.1 Introduction 8.2 Working capital turnover ratio 8.3 Inventory turnover ratio 8.4 Receivables &payables turnover ratio 8.5 Average collection period & Average4 payment period 8.6 Summary 8.7 Keywords 8.8 Learning Activity 8.9 Unit End Questions 8.10 References 8.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Describe turnover ratios  Identify working capital turnover ratio  State the various turnover ratios importance  Difference between receivables and average collection period 8.1 INTRODUCTION The percentage of investments in a mutual fund or other portfolio that have been replaced over the course of a year (either the calendar year or the 12-month period that corresponds to the fund's fiscal year) is known as the turnover ratio or turnover rate. The turnover ratio, for instance, is 50% for a mutual fund that holds 100 equities and replaces 50 of them in a given year. Some funds have turnover ratios that are higher than 100% because they keep their stock positions for fewer than 12 months. 141 CU IDOL SELF LEARNING MATERIAL (SLM)

However, just because a portfolio's turnover percentage is higher than 100% doesn't mean that every holding has been replaced. The ratio aims to represent the percentage of stocks that have changed over the course of a year. The turnover ratio varies depending on the type of mutual fund, its investment goal, and/or the investing approach used by the portfolio manager. For instance, a stock market index fund often has a low turnover rate because it replicates a specific index and index component businesses don't change all that frequently. On the other hand, as bond investments are characterized by vigorous trading, a bond fund will frequently see substantial turnover. Buy-and-hold investing is reflected in actively managed mutual funds with low turnover ratios, whereas market timing is attempted in those with high turnover ratios. Compared to a large-cap value stock fund, an aggressive small-cap growth stock fund typically has higher turnover. The turnover ratio is the formula used to determine how many units of any asset are used by a company to produce revenue from sales. It is the relationship between a company's assets and the income produced by them. To be more specific, it is an efficiency ratio to determine how well the business uses various assets to derive profits from them (individually and as a whole). A larger ratio is thought to be preferable because it would show that the business is making the best use of its resources to generate income. The funds invested are used the least, thus a better ROI would be implied. 8.2 WORKING CAPITAL TURNOVER RATIO The working capital turnover ratio, which is derived by dividing the company's net sales during the period by the average working capital during the same period, aids in assessing how effectively the company uses its working capital (current assets minus current liabilities) in the business. The efficiency with which a company uses its working capital to support a particular level of sales is gauged by the working capital turnover ratio. Current assets minus Current Liabilities equals Working Capital. A high turnover ratio shows that management is utilising a company's short-term assets and liabilities to drive sales very effectively. A low ratio, on the other hand, suggests that a company is investing in too many inventory and accounts receivable assets to support its sales, which may ultimately result in an excessive number of bad debts and obsolete inventory write-offs. 142 CU IDOL SELF LEARNING MATERIAL (SLM)

Any firm needs a working capital turnover, but small businesses can often benefit the most from it. This equation provides a firm with an accurate notion of the funds it will have available to use for operations once all commitments have been fulfilled (debts, bills, etc.). Businesses are more effective at conducting their operations and making sales when they have higher working capital turnover percentages. Lower working capital turnover is a sign of inefficient operation management. To evaluate a company's overall operations and gauge its financial success, a working capital turnover ratio is frequently utilized. It can also be used to determine whether a business will be able to pay off debt within a predetermined time frame and prevent running out of money due to higher production demands. The formula for calculating working capital turnover ratio is: Working capital turnover = Net annual sales / Working capital. In this formula, the working capital is calculated by subtracting a company's current liabilities from its current assets. It is important to note that certain factors can affect a company's working capital turnover, including changes to either liabilities or assets. For example, if a business owner invests 20,000 into their business, this would increase the company's current assets by 20,000. This means that the overall working capital for the business would be increased and affect the working capital turnover ratio calculation. The calendar year is commonly used to determine working capital turnover ratios. However, a business may decide to use the net sales and working capital from a specific period to construct this formula. Advantages of working capital turnover ratio A business might benefit from a working capital turnover ratio in a number of ways. The following are the main advantages of keeping track of your business's working capital turnover ratio: 1. Guarantees liquidity A corporation may run out of money for ongoing operations and short-term debts if it does not keep an eye on its working capital turnover ratio. You may keep track of the state of your company's debt and stock management, as well as accounts payable and accounts receivable, by include working capital management in your business plan. This guarantees that you are 143 CU IDOL SELF LEARNING MATERIAL (SLM)

aware of where your money is going and how to allocate it effectively for the best management and efficiency. 2. Increases overall financial health You can more effectively control your cash outflow and evaluate your cash influx by using a working capital turnover ratio in your company. The overall financial health of your business might improve if you can effectively decide how to use cash profitably. Additionally, it helps to avoid running out of working capital and having to borrow money from other sources as a result. An increased return on capital employed due to an overall greater working capital turnover ratio might draw investors and raise the likelihood that your business will grow. 3. Enhances a company's value A high working capital turnover ratio can increase a company's total worth within its industry, much like improved overall financial health. This can make your firm stand out from the competition and earn it respect and added value. 4. Prevents operation interruptions By giving managers knowledge that enables them to use money most effectively, staying informed about your company's working capital turnover ratio will assist prevent any interruptions in your organization's daily operations. In order to continue operations and keep your business as profitable as possible, it is important to use working capital effectively. 5. Increasing profitability Over time, controlling your business' working capital turnover may lead to overall greater profitability. Your company can save money and make the most use of the cash it has available by minimizing or eliminating operational disruptions and maximizing the utilization of working capital. 8.3 INVENTORY TURNOVER RATIO The stock turnover ratio, sometimes referred to as the inventory turnover ratio, is a productivity ratio that assesses the effectiveness of inventory management. To determine how frequently inventory is \"turned\" or sold over the course of a period, the inventory turnover ratio formula is equal to the cost of products sold divided by total or average inventory. The ratio can be used to assess whether inventory levels are out of proportion to sales. Because overall turnover depends on two key performance factors, this ratio is significant. The first element is stock acquisition. In order to increase turnover, the company will need to 144 CU IDOL SELF LEARNING MATERIAL (SLM)

sell more inventory if it makes larger year-over-year purchases. If the business is unable to sell these larger quantities of inventory, it will have to pay for storage and other holding expenses. The sales element is the second. Sales must equal inventory purchases in order for the inventory to churn efficiently. Because of this, coordination between the purchasing and sales teams is essential.  Cost of goods sold is the cost attributed to the production of the goods that are sold by a company over a certain period. The cost of goods sold by a company can found on the company’s income statement.  Average inventory is the mean value of inventory throughout a certain period. Note: an analyst may use either average or end-of-period inventory values. Inventory turnover is a gauge of how effectively a business can manage its stock, hence a high turn is desirable. This demonstrates that the business does not squander resources by keeping unsalable inventory or overspend by purchasing an excessive amount of inventory. It also demonstrates the company's ability to successfully sell the inventory it purchases. Investors can also see from this statistic how liquid a company's inventory is. Consider this. One of the largest assets a company lists on its balance sheet is inventory. This inventory has no value to the business if it cannot be sold. This metric demonstrates how quickly a business can convert its inventory into cash. Inventory is frequently used as loan collateral, thus creditors are very interested in this. The ease of sale of this inventory is important information for banks. Industry-specific inventory turns vary. For instance, the fashion sector will experience higher turn rates than the exotic automobile sector. 8.4 RECEIVABLES & PAYABLES TURNOVER RATIO Receivables turnover ratio Business owners need to understand their accounts receivable turnover percentage in order to work toward and achieve financial security. The state of an organization's cash flow is 145 CU IDOL SELF LEARNING MATERIAL (SLM)

assessed using this efficiency ratio by taking into account its receivable balances and receivable accounts. Long-term unchecked and mismanaged receivables turnover may indicate a company's failure to accurately and consistently bill clients or to follow up with them over unpaid debts. This would put companies at danger of not getting their hard-earned money for the goods or services they delivered in a timely way, which might potentially cause significant financial problems. Two crucial business objectives are served by the accounts receivable ratio. In order for businesses to pay their own bills and effectively plan future investments, they can first understand how quickly payments are collected. Second, the ratio gives businesses the ability to assess whether or not their credit policies and procedures support strong cash flow and ongoing business growth. Accounts receivable ratios show how effectively a business is able to collect accounts receivable and how quickly its clients pay off their debts. Despite the fact that figures differ by industry, larger ratios are sometimes preferred because they imply a quicker turnover and a healthier cash flow. Businesses that receive payments more quickly typically have stronger financial standing. The average number of times a company collects its accounts receivable balance is measured by the accounts receivables turnover ratio. It is a measurement of how well a business manages its line of credit process and collects unpaid bills from customers. A company's accounts receivable turnover ratio is higher for an efficient business and lower for an inefficient one. This indicator is frequently used to compare businesses in the same sector in order to determine whether they are on par with their rivals. Accounts receivable, which businesses issue to their clients, are essentially short-term, interest-free loans. If a business makes a transaction to a customer, it may extend terms of 30 or 60 days, giving the customer between 30 and 60 days to pay for the item. The efficiency with which a business is able to collect on its receivables or the credit it gives to clients is measured by the receivables turnover ratio. The ratio also counts the number of times a company's receivables are turned into cash over a specific time period. It is possible to determine the receivables turnover ratio on an annual, quarterly, or monthly basis. 146 CU IDOL SELF LEARNING MATERIAL (SLM)

Accounts Receivables Turnover = Net Annual Credit Sales ÷ Average Accounts Receivables Net Credit Sales Net credit sales, or the amount of revenue made by a business paid on credit, is the numerator of the accounts receivable turnover ratio. Cash sales are included in this number because they do not result in accounts receivable activity. Net credit sales are computed as gross credit sales less any remaining reductions from customer returns or sales discounts. It's crucial that the calculation employs a constant time period. Consequently, only a certain time period should be included in the net credit sales (i.e. net credit sales for the second quarter only). This amount should be considered in the computation as it relates to the activity being examined, should returns occur in a subsequent period. Average Accounts Receivable The average balance of accounts receivable serves as the denominator of the accounts receivable turnover ratio. The average of a company's beginning and ending accounts receivable balances is typically used to calculate this. The average balance of accounts receivable at the conclusion of each day may be easily extracted by businesses with more complicated accounting information systems. The business can then take the average of these balances, but it needs to be careful because daily entries could modify the average. The average accounts receivable balance should only span a relatively limited time period, just like when computing net credit sales. High vs. Low Receivables Turnover Ratio High Ratios A high turnover rate for receivables can be a sign of effective receivables management and a high percentage of reliable clients that pay their obligations on time. A high turnover rate for accounts receivable may also be a sign that a business runs on a cash basis. A high ratio may also indicate that a business is cautious about giving its clients credit. Conservative credit practices can be advantageous since they may aid businesses in avoiding offering credit to clients who might be unable to make payments on time. On the other hand, a lending policy that is excessively restrictive may turn away potential clients. These clients might then transact business with rivals who can provide and extend 147 CU IDOL SELF LEARNING MATERIAL (SLM)

them the credit they require. Even though it might result in a lower accounts receivable turnover ratio, a company may be better suited easing its credit policy to increase sales if it experiences client loss or slow growth. Low Ratios It's bad to have a low turnover ratio of accounts receivable. That's because it can be the result of a weak credit policy, a lousy collection process, or clients who aren't financially stable or creditworthy. In order to secure the prompt collection of its receivables, the company should review its credit rules if it has a low turnover ratio. However, if a business with a low ratio enhances its collection procedure, it may result in a cash infusion from recovering previous debt or receivables. Low ratios, though, aren't always a bad thing. For instance, if the company's distribution division isn't doing well, it might not be able to give clients the right products in a timely manner. Customers may therefore postpone paying their receivables as a result, which would decrease the company’s receivables turnover ratio. Calculations for the accounts receivable turnover ratio will be very different among industries. Larger businesses may also be more willing to extend credit terms since they are less dependent on credit sales. Companies should aim for a ratio of at least 1.0 to ensure they collect the whole amount of average accounts receivable at least once during a period. In general, a greater accounts receivable turnover ratio is advantageous. Payables turnover ratio Accounts Payable Turnover Ratio, Creditors Turnover Ratio, and Trade Payables Turnover Ratio are other names for this metric. This ratio is used to calculate how frequently a company pays its suppliers or debtors within a certain accounting period A company's short-term obligations to its suppliers and creditors are known as accounts payable. Accounts payable turnover ratio or trade payable turnover ratio shows how effectively the company pays its debtors. An increase in the accounts payable turnover ratio is a sign that the company is paying its creditors on time and is in good standing with both its suppliers and creditors. 148 CU IDOL SELF LEARNING MATERIAL (SLM)

A business is taking longer to pay its creditors than in previous periods if the value of the accounts payable turnover ratio is declining. The business may be in financial trouble if payments are occurring less frequently. The formula for Trade payables turnover ratio or Accounts payable turnover ratio is represented as follows. Accounts Payable Turnover Ratio = Net Credit Purchases / Average Accounts Payable Net credit purchases can be obtained by subtracting the purchase returns from the total credit purchases made during the accounting period. Average accounts payable is obtained by adding the value of accounts payable at the beginning and ending of an accounting period and dividing by 2. New Horizon Pvt Ltd has reported annual credit purchases amounting to ₹250,000, while there were purchase returns of ₹40,000. The beginning balance of accounts payable was ₹20,000 and ending balance was ₹30,000. Find the trade payable turnover ratio Answer We know that, Accounts Payable Turnover Ratio = Net Credit Purchases / Average Accounts Payable Now, Net Credit Purchases = Total Credit Purchases – Purchase Returns = 250,000 – 40,000 = 210,000 Average Account Payable = (Beginning Account Payable + Ending Account Payable) / 2 = (20,000 + 30,000) / 2 = 50,000 /2 = 25,000 149 CU IDOL SELF LEARNING MATERIAL (SLM)

Now, Accounts Payable Turnover Ratio = Net Credit Purchases / Average Accounts Payable = 210,000 / 25,000 = 8.4 This implies that the suppliers were paid 8 times during the accounting period. The accounts payable turnover ratio helps suppliers and creditors determine whether or not to extend credit to a business since it shows how rapidly a company pays off its vendors. A larger ratio is virtually always preferable to a smaller ratio, as is the case with the majority of liquidity ratios. A greater ratio demonstrates to vendors and creditors that the business pays its invoices on time and frequently. Additionally, it implies that new vendors would be paid promptly. A high turnover rate may be used to your advantage in future credit negotiations. The accounts payable turnover varies by industry, just like all ratios. There are modest variations in standards between industries. The ideal usage of this ratio is to assess similar businesses in the same sector. High accounts receivable turnover ratios are more favorable than low ratios because this signifies a company is converting accounts receivables to cash faster. This allows for a company to have more cash quicker to strategically deploy for the use of its operations or growth. 8.5 AVERAGE COLLECTION PERIOD AND AVERAGE PAYMENT PERIOD. Average Collection Period Average collection time is a measurement of the number of days it typically takes a business to collect its receivables. It measures the effectiveness of the collecting process; the lower it is, the shorter the business's cash cycle is, which benefits its profitability. The length of a business's cash cycle must be determined by how long it takes it to recover the money it spends on inventory and raw materials. The cash cycle keeps track of how many 150 CU IDOL SELF LEARNING MATERIAL (SLM)