Summary of "CA Inter | Financial Management | Ratio Analysis | Full Chapter Revision |CS Aditya"
Concise summary — main ideas, methods, formulas, exam tips
Purpose and context
- This is a full‑chapter revision of Ratio Analysis for CA Intermediate / Financial Management — a high‑scoring, commonly‑tested topic.
- Ratio analysis = analysis of financial statements (Profit & Loss and Balance Sheet) by forming ratios from two items to evaluate liquidity, solvency, efficiency, profitability and market performance.
- Two common exam/problem models:
- You are given a Balance Sheet and P&L and asked to compute specified ratios.
- You are given one item (or partial statements) plus a set of ratios; you use those ratios step‑by‑step (a “treasure hunt” or reconstruction) to fill in the statements and prepare projected financials.
Key conventions and exam reminders
- “Equity” for ratio‑analysis purposes = Equity share capital + Reserves & surplus + Preference share capital (unless question explicitly says “equity share capital” only).
- “Capital employed” = Equity (as above) + long‑term borrowings. Equivalent: Fixed assets + Working capital.
- Use average balances for inventories, debtors, creditors where appropriate (e.g., average stock, average debtors).
- Many solvency/turnover ratios are expressed as “times”; profitability ratios are percentages of sales.
- Common benchmark rules:
- Ideal current ratio ≈ 2:1 (general convention).
- Ideal debt:equity ≈ 2:1 (general guideline — not mandatory).
- Practice many problems — this chapter is scoring and frequently asked.
Classification of ratios, formulas and interpretation
For each ratio the formula, what it measures, and a quick interpretive note are given.
1) Short‑term solvency / Liquidity ratios
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Current ratio = Current assets / Current liabilities Measures short‑term liquidity. Conventionally ≈ 2:1 is ideal.
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Quick (liquid) ratio = Quick assets / Current liabilities Quick assets = Cash (cash‑in‑hand + bank) + Marketable securities + Bills receivable. Excludes inventory and prepaid expenses.
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Cash (absolute) ratio = (Cash + Marketable securities) / Current liabilities Strictest liquidity test.
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Basic defense interval (days) = (Cash + Marketable securities + Bills receivable) / (Operating expenses per day) Number of days company can run on liquid funds if operations stop.
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Working capital = Current assets − Current liabilities Absolute short‑term financing cushion.
2) Long‑term solvency: Leverage / Capital structure ratios
Important note: In this section “debt” refers to long‑term borrowings unless otherwise specified.
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Equity ratio = Equity / (Debt + Equity) = Equity / Capital employed Percentage of capital provided by owners.
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Debt ratio = Debt / (Debt + Equity) = Debt / Capital employed Percentage of capital provided by lenders (long‑term borrowings).
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Debt‑to‑equity ratio = Debt / Equity Degree of leverage; higher implies more financial risk.
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Capital gearing ratio = Fixed cost bearing funds / Non‑fixed cost bearing funds Fixed cost bearing funds = Long‑term debt + Preference share capital. Non‑fixed = Equity share capital + Reserves & surplus. Note: preference capital combines with debt here because both carry fixed charges.
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Proprietary (owners’) ratio = Net worth / Total assets Net worth = equity share capital + preference share capital + reserves & surplus. Measures proportion of assets financed by owners’ funds.
3) Coverage ratios (ability to meet fixed obligations)
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Debt service coverage ratio (DSCR) = Funds available for debt service / (Interest + Principal installments) Funds available = Net profit + Non‑cash expenses (e.g., depreciation) + appropriate add‑backs (e.g., interest if excluded) + non‑operating losses added back. Measures ability to meet scheduled debt repayments.
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Interest coverage ratio = EBIT / Interest Shows how many times operating earnings can cover interest.
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Preference dividend coverage ratio = Earnings available after interest and tax / Preference dividend Tells how many times preference dividend can be paid from available profits.
4) Turnover / Activity / Efficiency / Frequency ratios
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Capital turnover = Sales / Capital employed Sales generated per unit of capital employed.
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Fixed assets turnover = Sales / Fixed assets Useful for manufacturing — how effectively fixed assets generate sales.
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Working capital turnover = Sales / Working capital
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Inventory (stock) turnover = Cost of goods sold / Average inventory Frequency of converting inventory into COGS (higher usually better).
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Debtors (receivables) turnover = Credit sales / Average debtors Frequency of receivables collection. Convert to days: Collection period = 365 / Debtors turnover (or = Average debtors × 365 / Credit sales).
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Creditors turnover = Credit purchases / Average creditors Frequency of payables. Lower turnover (longer payment days) can be preferable for firm cash position; convert to days: Payment period = 365 / Creditors turnover (or = Average creditors × 365 / Credit purchases).
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Interpretation rule: For most turnover ratios, higher is better (faster turnover). Exception: creditors turnover — lower turnover (longer payment period) eases cash outflow but may affect supplier relations.
5) Profitability ratios
Profitability ratios are expressed as percentages of sales.
- Gross profit margin = Gross profit / Sales × 100
- Operating profit margin = Operating profit (EBIT) / Sales × 100
- Net profit margin = Net profit (PAT) / Sales × 100
Returns (usually post‑tax unless specified):
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Return on Capital Employed (ROCE) = (EBIT × (1 − tax rate)) / Capital employed × 100 Use EBIT adjusted for tax because capital employed includes debt.
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Return on Total Assets (ROTA) = Net profit / Total assets × 100
- Return on Equity (ROE) = Net profit / Net worth × 100 Net worth = Equity share capital + Preference share capital + Reserves & surplus (unless question restricts to equity share capital only).
DuPont (decomposition) theory
- ROE can be decomposed to show drivers: ROE = (Net profit / Sales) × (Sales / Total assets) × (Total assets / Net worth) Or ROE = Net profit margin × Asset turnover × Equity multiplier Equity multiplier = Total assets / Net worth = (Debt + Equity) / Equity Implication: Leverage (debt) can magnify ROE when return on assets exceeds cost of debt — but it increases risk.
6) Market test ratios (market performance indicators)
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Earnings per share (EPS) = Earnings available to equity shareholders / No. of equity shares Earnings available = Net profit − Preference dividend (if any).
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Payout ratio (%) = Dividend per share (DPS) / EPS × 100
- DPS = EPS × Payout ratio
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Price‑earnings (P/E) ratio = Market price per share (MPS) / EPS Higher P/E implies higher market valuation relative to earnings.
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Earnings yield (%) = EPS / MPS × 100 (inverse of P/E)
- Dividend yield (%) = DPS / MPS × 100
- Market‑to‑book (M/B) ratio = Market price per share / Book value per share Book value per share = (Equity share capital + Reserves & surplus − any debit balance in P&L) / No. of equity shares
Quick methodological checklist for solving ratio problems (exam technique)
- Read definitions carefully: check whether “equity” or “equity share capital” is specified.
- Identify which items are given and which ratios are provided.
- Use the classification approach (start with liquidity/leverage/turnover as required).
- Use average balances where formula requires averages (inventory, debtors, creditors).
- Convert turnover ratios to days when asked (365 / turnover or Average item × 365 / flow measure).
- For reconstruction problems: start from the given item, apply a ratio to find the next item, iteratively fill in statements (treasure‑hunt approach).
- Be mindful of tax adjustments where required (ROCE uses after‑tax EBIT).
- Remember conventions: times vs percentage, which items include preference capital, which ratios include interest/add‑backs.
- Practice many numeric problems — this chapter is scoring and frequently asked.
Examples / clarifying notes
- Debt collection period example: Debtors turnover = 4 → collection period = 12 months / 4 = 3 months.
- DuPont numerical example: If ROA = 8% and Equity multiplier = 3 (total assets 30, equity 10), then ROE = 8% × 3 = 24% (shows leverage effect).
Recap of ratio groups (short list)
- Short‑term solvency: Current, Quick, Cash, Basic defense interval, Working capital
- Long‑term solvency (leverage): Equity ratio, Debt ratio, Debt‑Equity, Capital gearing, Proprietary/net worth ratio
- Coverage: Debt service coverage, Interest coverage, Preference dividend coverage
- Turnover: Capital, Fixed assets, Working capital, Inventory, Debtors, Creditors (and conversion‑to‑days formulas)
- Profitability: Gross/Operating/Net margins; ROCE, ROTA, ROE (post‑tax convention)
- Market test: EPS, Payout, DPS, P/E, Earnings yield, Dividend yield, Market/Book
Speakers / sources featured
- CS Aditya — presenter / instructor (main speaker)
- Indigo Learn — educational channel/platform (referenced at start; app “One Fin” mentioned)
- DuPont (DuPont) — referenced as the economist behind the DuPont analysis/theory
Note: Background music was present in the video; subtitles were auto‑generated and edited for clarity.
Category
Educational
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