Using Ratios and Cash Flow to Judge Profitability, Activity, and Liquidity
From the books of a trading company for the year ended 31 March 2024: revenue from operations ₹24,00,000; cost of revenue from operations ₹16,80,000; operating expenses ₹2,40,000; other income ₹60,000; interest on 12% debentures ₹1,20,000; tax rate 30%. Inventory was ₹1,80,000 at the beginning and ₹2,40,000 at the end; trade receivables ₹2,40,000 and ₹3,60,000; trade payables ₹1,50,000 and ₹2,10,000. Cash and cash equivalents are ₹1,20,000. Equity share capital is ₹10,00,000, 10% preference share capital ₹2,00,000, surplus ₹6,00,000, and 12% debentures ₹10,00,000. Depreciation for the year was ₹1,50,000 and income tax paid was ₹1,00,000. The finance manager wants a short report on profitability, activity, and liquidity ratios, plus cash flow from operating activities. He is particularly unsure whether interest paid should be deducted in arriving at cash flow from operating activities and whether the increase in trade payables should be added or subtracted.
1. Compute the gross profit ratio, operating ratio, operating profit ratio, net profit ratio and return on capital employed. Explain the treatment of interest and other income in each ratio.
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Gross profit = ₹24,00,000 − ₹16,80,000 = ₹7,20,000; gross profit ratio = 7,20,000/24,00,000 = 30%. Operating ratio = (cost of revenue + operating expenses)/revenue = (16,80,000 + 2,40,000)/24,00,000 = 80%. Operating profit = 7,20,000 − 2,40,000 = ₹4,80,000; operating profit ratio = 20%. Net profit before tax = 4,80,000 + 60,000 − 1,20,000 = ₹4,20,000; tax = ₹1,26,000; PAT = ₹2,94,000. Net profit ratio on PAT = 2,94,000/24,00,000 = 12.25%. If preference dividend of ₹20,000 is deducted, profit for equity is ₹2,74,000 and the ratio is 11.42%; the basis must be disclosed. ROCE = EBIT/capital employed. EBIT = 4,80,000 + 60,000 = ₹5,40,000. Capital employed = equity 10,00,000 + preference 2,00,000 + surplus 6,00,000 + debentures 10,00,000 = ₹28,00,000. ROCE = 19.29%. If other income is treated as non-operating, ROCE on operating profit is 4,80,000/28,00,000 = 17.14%.
Interest is added back for ROCE because it is a financing cost, not an operating expense. Other income is included in EBIT because it is a return on the capital employed, but it is excluded from the operating profit ratio because it does not arise from operations.
2. Compute inventory turnover, trade receivables turnover, average collection period, trade payables turnover, and current ratio. State the assumptions you had to make.
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Average inventory = (1,80,000 + 2,40,000)/2 = ₹2,10,000. Inventory turnover = 16,80,000/2,10,000 = 8 times. Average receivables = (2,40,000 + 3,60,000)/2 = ₹3,00,000. Receivables turnover = 24,00,000/3,00,000 = 8 times. Average collection period = 365/8 = 45.6 days. Average payables = (1,50,000 + 2,10,000)/2 = ₹1,80,000. Payables turnover = 16,80,000/1,80,000 = 9.33 times. Average payment period = 365/9.33 = 39.1 days. Current assets = inventory 2,40,000 + receivables 3,60,000 + cash 1,20,000 = ₹7,20,000. Current liabilities = payables 2,10,000 + tax payable 26,000 = ₹2,36,000. Current ratio = 7,20,000/2,36,000 = 3.05. If tax payable is excluded, the ratio is 3.43.
Assumptions: purchases are not given, so cost of revenue is used as a proxy for credit purchases in the payables turnover; this overstates the ratio if a large part of purchases is cash. Year-end figures may be seasonal, so averages of monthly balances would be better. The receivables turnover assumes all sales are credit sales.
3. Compute cash flow from operating activities using the indirect method. Explain why interest paid is not deducted in operating activities and why an increase in payables is added.
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Profit before tax ₹4,20,000 Add: depreciation ₹1,50,000 Add: interest on debentures ₹1,20,000 Less: other income ₹60,000 Operating profit before working capital changes = ₹6,30,000 Less: increase in receivables ₹1,20,000 Less: increase in inventory ₹60,000 Add: increase in payables ₹60,000 Cash generated from operations = ₹5,10,000 Less: income tax paid ₹1,00,000 Cash flow from operating activities = ₹4,10,000.
Interest paid of ₹1,20,000 is not deducted here. Under AS 3, for a non-financial enterprise, interest paid on borrowings is a financing cash outflow. It was added back to PBT precisely so that it can be shown under financing activities. If the company chose the operating classification, cash flow from operating activities would be ₹2,90,000; the classification must be consistent and disclosed.
An increase in payables is added because expenses have been incurred but not yet paid, so profit is lower than cash generated. An increase in receivables is deducted because sales have been recognised but cash has not been collected. Tax is adjusted at the amount actually paid, not the tax expense, because the unpaid ₹26,000 remains a liability.