noc18-ce39 Lec 38-Ratio Analysis

[Music] Namaskar welcome back to this course once again accounting and finance for civil engineers and this is lecture 38 and what we'll be talking of today after we've discussed concepts relating to working capital financial statements and concepts is a discussion on ratio analysis so basically we'll spend time understanding what is called ratio analysis in the parlance of construction management now before we get started with ratio analysis let's try to look at this illustrative example this table here gives the data for sales and profits for organizations a and B the B will be added shortly if we look at organization a we have the numbers given here for year 1 and year 2 we see that the sales from 2 lakhs have gone to 3 lakhs the profits have increased from 50,000 to one lakh now there is one way of looking at it that is in terms of these absolute numbers now if we add corresponding figures for another organization let's say organization B please note that they began together that is their sales in year 1 were the same 2 lakhs now this guy grew to 3 lakhs this guy grew to 250 thousand this guy had 50,000 but his profit was only 20 thousand he grew from 50 thousand to one lakh and this guy grew from 20,000 to 50,000 now given this information or given this data there are just so many ways in which these eight numbers can be looked at and before we go to the next slide I would like you to spend some time and try to interpret and make notes as to what you can conclude from this information which is given some of the points we can discuss here one is that the sales for both a and B were identical in the first year that's what I pointed out to you however they grew at different levels the sales of a grew by 50% that is 2 lakh became 3 lakh that is the 50% growth in the case of B this growth is only 25% then we can say that in the first year the profits of a and B are 25 percent and 10 percent and these numbers become 33 percent and 20 percent of the next year so what does this 25 percent refer to if we try to take the ratio of the profit with respect to the sales this is 25 percent here it was 10 percent but this became 33 percent and this becomes 20 percent similarly the profits of a doubled in the second year that is the 50,000 became one lakh whereas in the case of B there is a jump of two hundred and fifty percent so what these four points B is two here and the two that we talked about in the previous slide what do they tell us they tell us that apart from the absolute numbers themselves there's a lot of story which the ratios tell us they also tell us that different ratios can be taken you can take the ratio of profit to sales you can take the ratio of the growth of profit from one year to another year you can compare one organization versus another organization but you should do it on a level playing field that is you should have comparable data all the time but in ratio analysis one should also remember always that ratios are essentially a representation of one quantity say X as a proportion of another quantity say Y and it is expressed as X upon Y what it means is that both x and y should be known to you therefore the ratio X upon y in a manner of speaking does not give you any new information what it however does is to put the information of X&Y in some perspective that's something which we'll talk about again later on to calculate the ratio X divided by Y and the quotient which is said if it's multiplied by hundred we express it in terms of percentages that's elementary and ratio analysis is a powerful tool as it makes information comparable so for example in the previous example that we took deliberately we started with the sales to be identical they need not be identical of course if you can take two different companies their sales could be quite different and then the only way you can really compare them would be to talk in terms of how much they have grown what is the market share and so on and so forth so that's why ratio analysis as I said is a tool which helps you organize the information that you have it does not really add new information it only gives you a different perspective so that's what's written here ratios as such do not add a new dimension for example if it says that company XYZ dispensed 1% of its revenue your R&D this does not convey anything so what we need in this case is what is the revenue and that will give us an idea as to what is the spending on R and B thus ratios and absolute values are actually complementary to each other when we want to make evaluations and decisions they are useful for comparisons as well and what we have to understand and keep in mind is that when we are taking ratios we should also remember that by taking a ratio making a comparison and so on we are also making certain simplifying assumptions and one has to be careful what ratio to use at what point in time for what kind of comparison is that valid invalid what is the limitations of taking that ratio and so on so that's something which you should be always always careful about so as far as the industry is concerned there are three types of comparisons which are made trend ratios inter firm comparisons and comparisons with standards or plans now let's try to examine them a little bit more as far as trend ratios are concerned they involve a comparison of ratios of a form over time that is present ratios are compared with the past ratios how has a given company performed over time so that's what we were trying to do when we were trying to see how has the ratio changed for a company a or a company B from year one to year two it could be here - to year five and so on so that is what is a trend for example a comparison of the profitability of a firm over a period say 1981 to 1985 is an illustration of the trend ratio then there is inter firm comparison represents a comparison of ratios of a form with another form which may be in a similar business at the same time you can compare two construction companies you can compare two automobile manufacturers you can compare two electronics manufacturers and so on the concept may also be used for the industry as a whole and it reflects the performance in relation to its competitors when it comes to ratios there are different ratios that are defined liquidity capital structure profitability activity or efficiency so we will see how there are different ratios that we take and all of them have their own relevance as far as accounting finance is concerned which is a part of construction management coming to the liquidity ratio we have the current ratio or the asset test or the specific turnover ratio in this lecture I will not really spend too much time in defining each of these ratios we will define some of them and try to upload some basic definitions on the forum and the idea will be that you should be aware of how to calculate these numbers if it comes to that and the fact that these numbers are important from the point of your financing accounts I don't think we will be able to do justice to all these numbers at the same time in this short span that we have at our disposal today so now coming to current ratios there is a standard that normally as far as construction companies is concerned we would like a company to have the current assets to current liabilities ratio to be greater than one point three is to 1 that is their current assets should be at least thirty percent more than their current liabilities what is current assets and current liabilities that's something which we talked about in the first lecture which we did for this module and there we had talked about that at the end of it the current liabilities are supposed to be met from current assets and therefore the ability of a construction company or any company for that matter to be able to make its day-to-day expenses is largely dependent on the current assets and those day-to-day expenses are their current liabilities so in order to be financially sound or adjudged to be financially sound the current assets should be 30% more than your current liabilities similarly when you come to acid test there is a concept of quick assets and current liabilities so here we are talking of current assets here we are talking of quick assets we will try to take an illustrative example and try to see how they are different and here we find that the norm is your quick asset should be at least 10% more than the current liabilities without going into the details of this specific turnover ratio let's try to look at an illustrative example this shows the description of assets for a particular company cash is let's say 2000 letters are 2000 the inventory is 12,000 so now the total current assets is a plus B plus C which is all these three and that totals 16,000 the quick assets which does not include the inventory is 4,000 and now let's say it's given the current liabilities are 8,000 so with this information we can calculate the current ratio which is basically D upon G that is the total current assets - the total current liabilities which is 16,000 upon 8,000 which is 2 is to 1 similarly we can calculate the asset test ratio which is e upon G which is the quick assets part of it the quick assets - the same current liabilities and that we find is 0.5 is to 1 so now if you want to go back and compare with the norms what is expected this here is greater than 1.3 but this here is less than 1.1 which is expected from a sound company so you can see that actually that if your total assets are 16,000 most of them are actually blocked as far as the inventory is concerned so you have very little quick assets so that's the kind of information now that's the kind of discussion that somebody has to keep in mind that if I'm increasing my inventory at the cost of cash and debtors my asset test ratio will go down that is we will not be able to immediately make our payments will not be able to honor our immediate commitments and that commitment is coming from current liabilities so that's how we use these ratios in this case the current ratio and the asset test ratio now we come to the capital structure ratio which indicates the long-term solvency or soundness of a company when a firm makes a long term borrowing it commits to paying the interest regularly and to repay the principal when it is due in installments are due dates or in a single payment at the time of maturity so the company commits to that when it makes a long term borrowing as far as the different types of capital structure ratios are concerned there is the leverage ratio and the coverage ratio debt equity debt asset equity resset and so on and so forth again debt to worth should be less than 2 is to 1 these are the kind of standards these are the kind of norms in the industry then there are profitability ratios profitability is a key word for a commercial company and is also a measure of the efficiency and indicates the public acceptance of the product profits also provide funds for repaying debts incurred while financing the project and mobilizing resources and profitability ratios have been defined to establish quantitative measures of the profitability of a company and are of interest to owners management creditors and regulatory bodies profitability ratios can be determined based either on sales or on investment and in the former class that is those based on sales the ratio is commonly used or gross or net profit margin and the expenses or operating ratio and on the other hand such ratios as those defined in terms of return on assets or the total capital employed and equity shareholders are based on investment so if we have the sales based numbers and we have investment based numbers so this is sometimes referred to as ROA and this is big called ROC e that is the return on capital employed this is the return on assets so this chart actually gives you the kind of description of the different types of profitability ratios then there is something called an activity ratio this set of ratios are concerned with the measurement of efficiency in asset management activity ratios are also called efficiency ratios and measure the efficient employment of assets by relating the assets to sales and/or the cost of the goods sold and therefore the activity ratios may therefore be defined as a test of the relationship between sales and the cost of the goods sold and the various assets of the firm so here we are talking about various assets of the that is cash land and so on and so forth we talked about the different assets and in relation to those assets the different assets how is the sales performing and depending on the different types of assets different types of activity ratios can be defined for example we can talk off the inventory or the stock turnover ratio which is the cost of goods sold to the average inventory we can talk in terms of the debtors turnover ratio or the receivables turnover ratio which is credit sales to the average debtors then we have the asset turnover ratios which is total assets to total turnover fixed assets to the total turnover current assets to the turnover and working capital to the turnover ratios so these here are basically as its turnover ratios coming to the last part of our discussion today we have the productivity ratios which is the turnover to the number of employees that turnover to the plants and equipment the profit to the number of employees and so on let me give you an illustrative example there was a news item recently a couple of months ago maybe a year or two that India wants to increase its investment or spending in the construction industry they want to pump in a trillion dollars equivalent into the creation of infrastructure now that's an absolute number somebody wants to pump in a trillion dollars or equivalent of that money into the construction industry construction of infrastructure now if we want to understand whether we will be actually able to consume that that is even if the money is available or made available to the construction industry how will it get distributed what do we need to do as a construction industry to be able to rise to the occasion and consume or deliver goods and services equivalent of that trillion dollars where do we start we could start with what is the total turnover of all our construction companies total that and find some number and see that okay if we are at number X we want to go to X - what is the percentage of increase in the turnover that we are looking at in terms of turnover if we want to reach or consume that trillion dollars additionally similarly let's look at the number of people which are employed in that industry and say that if we want to increase the amount of money being spent or consumed in that industry what should be the productivity see at the end of it if there is a company which has a turnover of 1 crore and has a thousand employees that company wants to grow from 1 crore to 10 crores how does it do that the only way to do it would be to increase its efficiency of the employees the efficiency of the employees is one crew divided by 1,000 so basically per employee they are having a certain amount of turnover if that has to grow 10 times so either the number of employees have to grow 10 times or the efficiency of those employees has to become 10 times or somewhere in between there will be some growth of employees some increase in efficiency in order to get that increase in efficiency what is the kind of measures that we need to take there can be a certain amount of mechanization that it can be a certain amount of automation and so on so that will increase the productivity of those employees as far as the number of employees is concerned it goes back to education more or less if we talk of construction do we have the right amount of engineers who want to work or who will be available to work in the construction industry in order that a certain target as far as productivity is concerned can be met so this is the larger picture of how ratio analysis how relating one number versus another would help us understand the facts on the ground so with this we come to an end of our discussion and of course there are some references which we have always been following some of them are probably added to this some of them up taken off from the previous lectures and so on that will help you understand some of the concepts better and now before we close the discussion in this course let me just go over very quickly about some of the key concepts that we have covered in this course we talked about an overview of the course where we primarily talked about different ways how civil engineers or all engineers is matter of fact should know about financing and accounts and we talked about the concept of time value of money then we had a lot of discussion on economic decision-making which had concepts like cash flow sensitivity analysis incremental rate of return break-even analysis depreciation methods of depreciation Book value and so on then we spend some time on risk analysis simulation bidding processes then we spent time on accounting balance sheets profit loss statements assets liabilities working capital and now today we'd spend time on ratio analysis so we will talk about this a little bit more in the forum with some examples which will be added and we'll try to finally go to the exam and as far as the exam is concerned of course I cannot tell you what the exam would be like but it will be very similar to the kind of questions that we've been asking you in the assignments so those of you have been trying to do the assignments regularly should not find it very difficult to do well in the exam only thing I would like to mention is that we will post a few notes and aids to you in the forum please watch out and follow so that you are better prepared like I've always insisted we don't expect you to memorize any formula which we have given we'll try to make sure that the either the formulae are available or some tables are available to you during the exam to be able to solve a certain problem I wish you all the best and has been a pleasure talking to you on behalf of my friend professor chai and myself thank you once again for being with us thank you [Music] [Music]