Ratio Analysis and Financial Planning — Practice

Question 1

A company has a current ratio of 2.5 and a quick ratio of 0.8. What does the gap between these two ratios suggest about the composition of its current assets?

Accepted Answer

The large gap between a current ratio of 2.5 and a quick ratio of 0.8 suggests that a substantial proportion of the company's current assets is tied up in inventory and possibly prepaid expenses, since these are the items excluded when moving from the current ratio to the quick ratio. A current ratio well above 2 looks comfortable on its face, but a quick ratio below 1 means that, excluding inventory, the company's more liquid current assets, cash, marketable securities and receivables, are insufficient to cover current liabilities, indicating that the company's apparent liquidity cushion depends heavily on successfully converting inventory into cash, which is not guaranteed and takes time, making the company potentially less liquid in the near term than the current ratio alone would suggest.

Question 2

Company A has EBIT of ₹40 lakh and interest expense of ₹50 lakh. Compute its interest coverage ratio and explain what this figure means for the company's immediate financial position.

Accepted Answer

Interest coverage ratio = EBIT ÷ Interest expense = 40 ÷ 50 = 0.8 times. A ratio below 1 means the company's operating earnings, EBIT, are insufficient to cover its interest obligation for the period from operations alone; there is a shortfall of ₹10 lakh that must be met from some other source, such as existing cash reserves, asset sales, or fresh borrowing, none of which is sustainable indefinitely. This signals a serious immediate financial position: the company is not generating enough from its core operations even to service its existing debt, before any consideration of principal repayment or dividend, and a ratio this low would typically be treated as a significant red flag for solvency risk.

Question 3

Two companies each report a return on equity of 18%. Company X has a net profit margin of 12%, total assets turnover of 0.5 times, and an equity multiplier of 3. Company Y has a net profit margin of 6%, total assets turnover of 1 time, and an equity multiplier of 3. Verify both figures using DuPont analysis and explain which company's return on equity is achieved through a riskier combination of drivers.

Accepted Answer

For Company X: ROE = 12% × 0.5 × 3 = 18%. For Company Y: ROE = 6% × 1 × 3 = 18%. Both companies indeed report an identical 18% return on equity, confirming the figures. However, the two arrive at this identical headline number through different underlying combinations: Company X achieves it through a relatively high net profit margin combined with low asset turnover, meaning it earns strong profitability per unit of sales but generates relatively little sales per unit of assets, while Company Y achieves the same overall return through a much lower net profit margin compensated by double the asset turnover, meaning it earns thin margins but generates sales more efficiently from its asset base. Neither company here relies more heavily on the leverage component specifically, since both share the same equity multiplier of 3; the risk distinction instead lies in operating model: Company Y's thinner margin business is typically more vulnerable to cost increases or price competition eroding its already-slim margin, since it has less cushion, whereas Company X's higher-margin, slower-turnover model has more margin cushion to absorb cost pressure, though it depends more on maintaining that pricing power or cost advantage to sustain its ROE.

Question 4

A firm's return on capital employed is 15%, and it borrows at an after-tax cost of 9%. Explain, without doing a full numerical computation, why its return on equity would be expected to exceed 15%, and name the ratio pair whose gap reflects this effect.

Accepted Answer

Since the firm earns 15% on the total capital it employs, debt and equity together, but pays only 9% after tax on the portion of that capital funded by debt, the surplus, the difference between the 15% earned and the 9% paid on borrowed funds, accrues entirely to the equity shareholders on the capital funded by debt, over and above what the equity shareholders earn on their own directly invested capital. This means the return earned specifically on the equity portion is boosted above the overall 15% return on capital employed, because equity is, in effect, benefiting from the spread earned on borrowed money as well as its own. This is precisely the effect of favourable financial leverage, and the ratio pair whose gap reflects it is return on capital employed compared against return on equity — whenever return on equity exceeds return on capital employed, it signals that the firm is using debt profitably, earning more on that borrowed capital than its after-tax cost.

Question 5

A company's inventory turnover ratio has fallen from 8 times last year to 5 times this year, while its current ratio has risen from 1.8 to 2.3 over the same period. Explain why the rising current ratio should not, by itself, be read as an improvement in the company's financial health.

Accepted Answer

A falling inventory turnover ratio, from 8 times to 5 times, indicates that inventory is being sold and replaced less frequently, which typically means inventory is building up relative to the rate at which it is being sold, whether due to slowing demand, overproduction, or purchasing decisions not being adjusted to actual sales. If this excess, slower-moving inventory is what is driving the rise in current assets, then the current ratio's rise from 1.8 to 2.3 is not evidence of genuine improvement in liquidity or operational health but rather a symptom of the same underlying problem the falling turnover ratio has already flagged: cash is increasingly tied up in unsold stock rather than being generated through sales. Reading the current ratio in isolation would mask this, since the ratio mechanically rises whenever current assets rise relative to current liabilities regardless of what is driving that rise, which is exactly why ratios need to be read together rather than individually, as this chapter emphasises — the falling inventory turnover ratio here directly explains and undercuts the apparently favourable movement in the current ratio.

Question 6

A firm's current year sales are ₹200 lakh, and the following balance sheet items vary proportionately with sales: inventory ₹30 lakh, debtors ₹20 lakh, trade creditors ₹15 lakh. Fixed assets of ₹80 lakh and long-term debt of ₹60 lakh are expected to remain unchanged. The firm projects sales to grow to ₹250 lakh next year, expects a net profit margin of 8% on sales, and a dividend payout ratio of 40%. Compute the external funds requirement.

Accepted Answer

Step 1: express spontaneously varying items as a percentage of current sales of ₹200 lakh — inventory 30/200 = 15%, debtors 20/200 = 10%, trade creditors 15/200 = 7.5%. Step 2: apply these percentages to projected sales of ₹250 lakh — projected inventory = 15% × 250 = ₹37.5 lakh, projected debtors = 10% × 250 = ₹25 lakh, projected trade creditors = 7.5% × 250 = ₹18.75 lakh. Step 3: projected total assets = fixed assets (unchanged) ₹80 lakh + projected inventory ₹37.5 lakh + projected debtors ₹25 lakh = ₹142.5 lakh. Step 4: projected increase in retained earnings = projected net profit × (1 − payout ratio) = (8% × 250) × (1 − 0.40) = ₹20 lakh × 0.60 = ₹12 lakh, added to whatever the firm's existing equity base is assumed to be, but for the funds requirement calculation what matters is the increase available to fund the asset growth. Step 5: total financing automatically available = unchanged long-term debt ₹60 lakh + projected trade creditors ₹18.75 lakh + increase in retained earnings ₹12 lakh (plus existing equity base, which is unchanged and therefore does not itself close the funding gap for the incremental assets) = spontaneous liabilities and internally generated funds together total ₹18.75 lakh + ₹12 lakh = ₹30.75 lakh available to fund the increase in assets. Step 6: increase in assets required = projected total current and fixed assets ₹142.5 lakh − current year's ₹130 lakh (₹80 + ₹30 + ₹20) = ₹12.5 lakh increase in assets needed. External funds requirement = increase in assets required ₹12.5 lakh − increase in spontaneous liabilities (trade creditors) ₹3.75 lakh − increase in retained earnings ₹12 lakh = ₹12.5 lakh − ₹3.75 lakh − ₹12 lakh, which computes to a negative figure of −₹3.25 lakh, meaning the firm's internally generated funds and spontaneous liability growth together are actually more than sufficient to fund the projected asset growth, leaving a surplus of ₹3.25 lakh rather than a financing gap, so no external funds need be raised.

Question 7

State the effect on a firm's external funds requirement, projected using the percentage of sales method, of each of the following changes considered independently: a higher projected sales growth rate; a higher net profit margin; a higher dividend payout ratio.

Accepted Answer

A higher projected sales growth rate increases the external funds requirement, because faster growth in sales means a correspondingly larger projected increase in the spontaneously varying assets, such as inventory and debtors, needed to support that higher level of sales, requiring more financing to fund that larger asset base. A higher net profit margin decreases the external funds requirement, because a higher margin means more profit, and therefore, for a given payout ratio, more retained earnings generated internally to help fund the growth in assets, reducing how much must be raised from external sources. A higher dividend payout ratio increases the external funds requirement, because paying out a larger share of profit as dividend leaves a smaller share retained within the business to help fund asset growth, meaning a larger gap must be filled by external financing, all else being equal.

Question 8

Explain two specific limitations of ratio analysis that arise from the fact that ratios are computed from historical financial statements.

Accepted Answer

First, ratios are backward-looking: they are computed from statements reflecting a period that has already ended, and applying them to judge a firm's likely future performance assumes that the relationships and conditions reflected in that historical period will continue to hold, an assumption that can fail if the firm's operating environment, competitive position, or internal efficiency is genuinely changing rather than remaining stable. Second, ratios computed at a single balance sheet date can be distorted by seasonality or by conditions specific to that particular date, so a current ratio computed at a point in the firm's operating cycle when inventory happens to be unusually high or low ahead of a seasonal peak may not represent the firm's typical liquidity position across the rest of the year, meaning a ratio snapshot from one date can mislead if treated as representative of the firm's ongoing financial condition.

Question 9

Two companies in the same industry report different current ratios, but one values inventory using FIFO and the other using weighted average cost, and one capitalises certain development costs while the other expenses them immediately. Explain why comparing their ratios directly could be misleading.

Accepted Answer

Ratio analysis assumes that the figures being compared are computed on a broadly comparable basis, and differences in accounting policy directly undermine this assumption. A company using FIFO during a period of rising prices will report a higher closing inventory value than an otherwise identical company using weighted average cost, since FIFO leaves more recently, and therefore more expensively, purchased inventory in the closing balance, which inflates that company's current assets and therefore its current ratio relative to the weighted average company, purely as an artefact of accounting policy rather than any genuine difference in liquidity or operating performance. Similarly, a company capitalising development costs carries those costs as an asset on its balance sheet and spreads the charge to profit over time, while a company expensing them immediately recognises the full cost at once, which affects both reported assets and reported profit, and therefore affects both solvency ratios reliant on total assets and profitability ratios reliant on net profit, in ways that reflect the accounting choice rather than the underlying economics of the business. Comparing the two companies' ratios without adjusting for these policy differences risks attributing what is really an accounting artefact to a genuine difference in liquidity, solvency or profitability, which is precisely the kind of comparability limitation ratio analysis is vulnerable to.

Question 10

A company has total debt of ₹90 lakh and shareholders' equity of ₹60 lakh. Compute its debt-equity ratio and state what this figure indicates about its financial risk relative to a company with a ratio of 0.5.

Accepted Answer

Debt-equity ratio = Total debt ÷ Shareholders' equity = 90 ÷ 60 = 1.5. This means the company has ₹1.50 of debt for every ₹1 of equity, indicating a capital structure more heavily weighted toward borrowed funds than a company with a ratio of 0.5, which has only ₹0.50 of debt for every ₹1 of equity. The company with the 1.5 ratio carries materially higher financial risk, since a larger proportion of its capital structure consists of fixed obligations, interest and principal repayment, that must be met regardless of how the business performs, whereas the company with the lower ratio has a larger equity cushion and correspondingly lower fixed financial commitment relative to its size.

Question 11

A company's gross profit margin has remained stable at 35% for three years, but its net profit margin has fallen from 12% to 7% over the same period. Where should the analysis focus to explain this divergence?

Accepted Answer

Since gross profit margin measures the proportion of sales remaining after direct cost of goods sold, and this has stayed stable at 35%, the company's core production or trading economics — its pricing relative to its direct costs — have not deteriorated. The falling net profit margin, from 12% to 7%, despite stable gross margin, means the erosion is occurring below the gross profit line, in the region between gross profit and net profit, which includes operating expenses such as selling, administrative and distribution costs, interest expense, and tax. The analysis should therefore focus on this middle section of the income statement rather than on production or pricing, examining whether operating expenses have risen disproportionately to sales, whether the company has taken on more debt increasing its interest burden, or whether some other non-operating factor is consuming a growing share of what would otherwise flow through to net profit.

Question 12

A company's credit sales for the year are ₹180 lakh and its average debtors balance is ₹30 lakh. Compute the debtors turnover ratio and the average collection period, and explain what a collection period longer than the company's stated credit terms of 45 days would suggest.

Accepted Answer

Debtors turnover ratio = Credit sales ÷ Average debtors = 180 ÷ 30 = 6 times. Average collection period = 365 ÷ Debtors turnover ratio = 365 ÷ 6 = approximately 61 days. Since the company's stated credit terms are 45 days but the actual average collection period works out to approximately 61 days, this suggests that, on average, the company is taking about 16 days longer to collect from its debtors than its own stated credit policy allows, indicating either weak enforcement of credit terms, a build-up of slow-paying or overdue accounts, or genuinely lenient informal practice diverging from the formal stated policy. This gap is worth investigating further, since debtors taking longer than agreed to pay ties up the company's working capital for longer than planned and can be an early indicator of collection or credit-quality problems building up among the customer base.

Question 13

Explain what a low total assets turnover ratio indicates about a firm, and why comparing this ratio across firms in different industries, such as a steel manufacturer and a software company, is generally not meaningful.

Accepted Answer

A low total assets turnover ratio indicates that the firm is generating relatively little sales revenue per rupee of assets employed, which can reflect either genuine underutilisation of assets, such as idle capacity or excess assets not contributing to sales, or simply that the firm's business is inherently asset-heavy relative to the sales it generates. Comparing this ratio across a steel manufacturer and a software company is generally not meaningful because the two industries have fundamentally different asset intensity by nature of their business models: a steel manufacturer requires enormous investment in plant, machinery and fixed infrastructure to generate a given level of sales, resulting in a structurally low asset turnover even when operating efficiently, whereas a software company can generate substantial sales from a comparatively tiny asset base of computers and office space, resulting in a structurally high asset turnover even without any special operating efficiency. A low turnover for the steel company is therefore normal for its industry, not evidence of poor performance, and the meaningful comparison is against other companies within the same or a similarly asset-intensive industry, not across industries with different underlying asset requirements.

Question 14

Explain what earnings per share and the price-earnings ratio each measure, and why a high price-earnings ratio is not, by itself, evidence that a share is overvalued.

Accepted Answer

Earnings per share, net profit available to equity shareholders divided by the number of equity shares outstanding, measures the profit attributable to each individual share, translating a firm's total profit into a per-share figure that is directly comparable across different points in time for the same company, though not directly comparable across companies with different numbers of shares outstanding. The price-earnings ratio, market price per share divided by earnings per share, measures how much investors are currently willing to pay for each rupee of the company's current earnings, and is widely used as a quick, if imperfect, indicator of how the market values a company relative to its current profitability. A high price-earnings ratio is not, by itself, evidence of overvaluation because it can equally reflect the market's genuine expectation of strong future earnings growth for that specific company; investors are often willing to pay more per rupee of current earnings for a company expected to grow its earnings rapidly than for a company with flat or declining prospects, so a high ratio may be a rational reflection of growth expectations rather than a mispricing, and distinguishing the two requires assessing whether those growth expectations are actually justified by the company's fundamentals, not reading the ratio in isolation.

Question 15

A firm has historically operated its fixed assets near full capacity, and its percentage of sales forecast assumes fixed assets remain unchanged even as sales are projected to grow by 30%. Explain why this specific assumption is likely to understate the firm's true external funds requirement, and what adjustment a more careful forecast should make.

Accepted Answer

The percentage of sales method's convention of holding fixed assets constant rests on the implicit assumption that the firm has spare capacity to absorb higher sales without needing additional fixed assets, an assumption that is reasonable only when a firm is genuinely operating below full capacity. If the firm has historically operated near full capacity, then a 30% increase in sales volume cannot realistically be produced from the existing fixed asset base at all, and holding fixed assets constant in the forecast would understate the true funds requirement by omitting the additional investment in plant, machinery or capacity that would actually be needed to physically support the higher sales level. A more careful forecast should explicitly estimate the additional fixed asset investment required to support the projected sales growth, given the firm's actual capacity utilisation, and add this amount to the asset side of the projection alongside the spontaneously varying current assets, rather than mechanically applying the blanket 'fixed assets constant' convention regardless of the firm's actual starting capacity position. This is precisely the kind of judgement the chapter flags as necessary when applying the technique — the convention is a simplifying default, not an assumption that holds automatically for every firm.

Practice — Ratio Analysis and Financial Planning

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