Working Capital Turnover Ratio:

Definition:

Working capital turnover ratio indicates the velocity of the utilization of net working capital.
This ratio represents the number of times the working capital is turned over in the course of year and is calculated as follows:

Formula of Working Capital Turnover Ratio:

Following formula is used to calculate working capital turnover ratio

Working Capital Turnover Ratio = Cost of Sales / Net Working Capital

The two components of the ratio are cost of sales and the net working capital. If the information about cost of sales is not available the figure of sales may be taken as the numerator. Net working capital is found by deduction from the total of the current assets the total of the current liabilities.

Example:

Cash Bills Receivables Sundry Debtors Stock Sundry Creditors Cost of sales

10,000 5,000 25,000 20,000 30,000 150,000

Calculate working capital turnover ratio

Calculation:

Working Capital Turnover Ratio = Cost of Sales / Net Working Capital

Current Assets = $10,000 + $5,000 + $25,000 + $20,000 = $60,000

Current Liabilities = $30,000

Net Working Capital = Current assets – Current liabilities

= $60,000 − $30,000

= $30,000

So the working Capital Turnover Ratio = 150,000 / 30,000

= 5 times

Significance:

The working capital turnover ratio measure the efficiency with which the working capital is being used by a firm. A high ratio indicates efficient utilization of working capital and a low ratio indicates otherwise. But a very high working capital turnover ratio may also mean lack of sufficient working capital which is not a good situation.

Creditors / Accounts Payable Turnover Ratio:

Definition and Explanation:

This ratio is similar to the debtors turnover ratio. It compares creditors with the total credit purchases.
It signifies the credit period enjoyed by the firm in paying creditors. Accounts payable include both sundry creditors and bills payable. Same as debtors turnover ratio, creditors turnover ratio can be calculated in two forms, creditors turnover ratio and average payment period.

Formula:

Following formula is used to calculate creditors turnover ratio:

Creditors Turnover Ratio = Credit Purchase / Average Trade Creditors

Average Payment Period:

Average payment period ratio gives the average credit period enjoyed from the creditors. It can be calculated using the following formula:

Average Payment Period = Trade Creditors / Average Daily Credit Purchase

Average Daily Credit Purchase= Credit Purchase / No. of working days in a year

Or

Average Payment Period = (Trade Creditors × No. of Working Days) / Net Credit Purchase

(In case information about credit purchase is not available total purchases may be assumed to be credit purchase.)

Significance of the Ratio:

The average payment period ratio represents the number of days by the firm to pay its creditors. A high creditors turnover ratio or a lower credit period ratio signifies that the creditors are being paid promptly. This situation enhances the credit worthiness of the company. However a very favorable ratio to this effect also shows that the business is not taking the full advantage of credit facilities allowed by the creditors.

Debtors Turnover Ratio | Accounts Receivable Turnover Ratio:

A concern may sell goods on cash as well as on credit. Credit is one of the important elements of sales promotion. The volume of sales can be increased by following a liberal credit policy.
The effect of a liberal credit policy may result in tying up substantial funds of a firm in the form of trade debtors (or receivables). Trade debtors are expected to be converted into cash within a short period of time and are included in current assets. Hence, the liquidity position of concern to pay its short term obligations in time depends upon the quality of its trade debtors.

Definition:

Debtors turnover ratio or accounts receivable turnover ratio  indicates the velocity of debt collection of a firm. In simple words it indicates the number of times average debtors (receivable) are turned over during a year.

Formula of Debtors Turnover Ratio:

Debtors Turnover Ratio = Net Credit Sales / Average Trade Debtors

The two basic components of accounts receivable turnover ratio are net credit annual sales and average trade debtors. The trade debtors for the purpose of this ratio include the amount of Trade Debtors & Bills Receivables. The average receivables are found by adding the opening receivables and closing balance of receivables and dividing the total by two. It should be noted that provision for bad and doubtful debts should not be deducted since this may give an impression that some amount of receivables has been collected. But when the information about opening and closing balances of trade debtors and credit sales is not available, then the debtors turnover ratio can be calculated by dividing the total sales by the balance of debtors (inclusive of bills receivables) given. and formula can be written as follows.

Debtors Turnover Ratio = Total Sales / Debtors

Example:

Credit sales $25,000; Return inwards $1,000; Debtors $3,000; Bills Receivables $1,000.

Calculate debtors turnover ratio

Calculation:

Debtors Turnover Ratio = Net Credit Sales / Average Trade Debtors

= 24,000* / 4,000**

= 6 Times

*25000 less 1000 return inwards, **3000 plus 1000 B/R

Significance of the Ratio:

Accounts receivable turnover ratio or debtors turnover ratio indicates the number of times the debtors are turned over a year. The higher the value of debtors turnover the more efficient is the management of debtors or more liquid the debtors are. Similarly, low debtors turnover ratio implies inefficient management of debtors or less liquid debtors. It is the reliable measure of the time of cash flow from credit sales. There is no rule of thumb which may be used as a norm to interpret the ratio as it may be different from firm to firm.

Earnings Per Share (EPS) Ratio:

Definition:

Earnings per share ratio (EPS Ratio) is a small variation of return on equity capital ratio and is calculated by dividing the net profit after taxes and preference dividend by the total number of equity shares.

Formula of Earnings Per Share Ratio:

The formula of earnings per share is:

Earnings per share (EPS) Ratio = (Net profit after tax − Preference dividend) / No. of equity shares (common shares)

Example:

Equity share capital ($1): $1,000,000; 9% Preference share capital: $500,000; Taxation rate: 50% of net profit; Net profit before tax: $400,000.

Calculate earnings per share ratio.

Calculation:

EPS = 1,55,000 / 10,000

= $15.50 per share.

Significance:

The earnings per share is a good measure of profitability and when compared with EPS of similar companies, it gives a view of the comparative earnings or earnings power of the firm. EPS ratio calculated for a number of years indicates whether or not the earning power of the company has increased.

Dividend Payout Ratio:

Dividend payout ratio is calculated to find the extent to which earnings per share have been used for paying dividend and to know what portion of earnings has been retained in the business. It is an important ratio because ploughing back of profits enables a company to grow and pay more dividends in future.

Formula of Dividend Payout Ratio:

Following formula is used for the calculation of dividend payout ratio

Dividend Payout Ratio = Dividend per Equity Share / Earnings per Share

A complementary of this ratio is retained earnings ratio. Retained earning ratio is calculated by using the following formula:

Retained Earning Ratio = Retained Earning Per Equity Share / Earning Per Equity Share

Example:

Calculate dividend payout ratio and retained earnings from the following data:

Net Profit Provision for taxation Preference dividend

10,000 5,000 2,000

No. of equity shares Dividend per equity share

3,000 $0.40

Payout Ratio = ($0.40 / $1) × 100

= 40%

Retained Earnings Ratio = ($0.60 /$1) × 100

= 60%

Significance of the Ratio:

The payout ratio and the retained earning ratio are the indicators of the amount of earnings that have been ploughed back in the business. The lower the payout ratio, the higher will be the amount of earnings ploughed back in the business and vice versa. A lower payout ratio or higher retained earnings ratio means a stronger financial position of the company.

Dividend Yield Ratio:

Definition:

Dividend yield ratio is the relationship between dividends per share and the market value of the shares.
Share holders are real owners of a company and they are interested in real sense in the earnings distributed and paid to them as dividend. Therefore, dividend yield ratio is calculated to evaluate the relationship between dividends per share paid and the market value of the shares.

Formula of Dividend Yield Ratio:

Following formula is used for the calculation of dividend yield ratio:

Dividend Yield Ratio = Dividend Per Share / Market Value Per Share

Example:

For example, if a company declares dividend at 20% on its shares, each having a paid up value of $8.00 and market value of $25.00.

Calculate dividend yield ratio:

Calculation:

Dividend Per Share = (20 / 100) × 8

= $1.60

Dividend Yield Ratio = (1.60 / 25) × 100

= 6.4%

Significance of the Ratio:

This ratio helps as intending investor is knowing the effective return he is going to get on the proposed investment.

Return on Capital Employed Ratio (ROCE Ratio):

The prime objective of making investments in any business is to obtain satisfactory return on capital invested. Hence, the return on capital employed is used as a measure of success of a business in realizing  this objective.
Return on capital employed establishes the relationship between the profit and the capital employed. It indicates the percentage of return on capital employed in the business and it can be used to show the overall profitability and efficiency of the business.

Definition of Capital Employed:

Capital employed and operating profits are the main items. Capital employed may be defined in a number of ways. However, two widely accepted definitions are "gross capital employed" and "net capital employed". Gross capital employed usually means the total assets, fixed as well as current, used in business, while net capital employed refers to total assets minus liabilities. On the other hand, it refers to total of capital, capital reserves, revenue reserves (including profit and loss account balance), debentures and long term loans.

Calculation of Capital Employed:

Method--1. If it is calculated from the assets side, It can be worked out by adding the following:

1. The fixed assets should be included at their net values, either at original cost or at replacement cost after deducting depreciation. In days of inflation, it is better to include fixed assets at replacement cost which is the current market value of the assets.
2. Investments inside the business
3. All current assets such as cash in hand, cash at bank, sundry debtors, bills receivable, stock, etc.
4. To find out net capital employed, current liabilities are deducted from the total of the assets as calculated above.

Gross capital employed = Fixed assets + Investments + Current assets

Net capital employed = Fixed assets + Investments + Working capital*.

*Working capital = current assets − current liabilities.

Precautions For Calculating Capital Employed:

While capital employed is calculated from the asset side, the following precautions should be taken:

1. Regarding the valuation of fixed assets, nowadays it is considered necessary to value the assets at their replacement cost. This is with a view to providing for the continuing problem of inflations during the current years. Under replacement cost methods the fixed assets are to be revalued on the basis of their current market prices either by reference to reliable published index numbers, or on valuation of experts. When replacement cost method is used, the provision for depreciation should be recalculated since depreciation charged might have been calculated on original cost of assets.
2. Idle assets―assets which cannot be used in the business should be excluded from capital employed. However, standby plant and machinery essential to the normal running of the business should be included.
3. Intangible assets, like goodwill, patents, trade marks, rights, etc. should be excluded. However, if they have sale value or if they have been purchased they may be included. Investments made outside the business should be excluded.
4. All current assets should be properly valued. Any excess balance of cash or bank than required for the smooth running of the business should be excluded.
5. Fictitious assets, like preliminary expenses, accumulated losses, discount on issue of shares or debentures, advertisement, suspense account, etc. should be excluded.
6. Obsolete assets which cannot be used in the business or obsolete stock which cannot be sold should be excluded.

Method--2. Alternatively, capital employed can be calculated from the liabilities side of a balance sheet. If it is calculated from the liabilities side, it will include the following items:
Share capital:
     Issued share capital (Equity + Preference)
Reserves and Surplus:
    General reserve
    Capital reserve
Profit and Loss account
Debentures
Other long term loans
Some people suggest that average capital employed should be used in order to give effect of the capital investment throughout the year. It is argued that the profit earned remain in the business throughout the year and are distributed by way of dividends only at the end of the year. Average capital may be calculated by dividing the opening and closing capital employed by two. It can also be worked out by deducting half of the profit from capital employed.

Computation of profit for return on capital employed:

The profits for the purpose of calculating return on capital employed should be computed according to the concept of  "capital employed used". The profits taken must be the profits earned on the capital employed in the business. Thus, net profit has to be adjusted for the following:

• Net profit should be taken before the payment of tax or provision for taxation because tax is paid after the profits have been earned and has no relation to the earning capacity of the business.
• If the capital employed is gross capital employed then net profit should be considered before payment of interest on long-term as well as short-term borrowings.
• If the capital employed is used in the sense of net capital employed than only interest on long term borrowings should be added back to the net profits and not interest on short term borrowings as current liabilities are deducted while calculating net capital employed.
• If any asset has been excluded while computing capital employed, any income arising from these assets should also be excluded while calculating net profits. For example, interest on investments outside business should be excluded.
• Net profits should be adjusted for any abnormal, non recurring, non operating gains or losses such as profits and losses on sales of fixed assets.
• Net profits should be adjusted for depreciation based on replacement cost, if assets have been added at replacement cost.

Formula of return on capital employed ratio:

Return on Capital Employed=(Adjusted net profits*/Capital employed)×100

*Net profit before interest and tax minus income from investments.

Significance of Return on Capital Employed Ratio:

Return on capital employed ratio is considered to be the best measure of profitability in order to assess the overall performance of the business. It indicates how well the management has used the investment made by owners and creditors into the business. It is commonly used as a basis for various managerial decisions. As the primary objective of business is to earn profit, higher the return on capital employed, the more efficient the firm is in using its funds. The ratio can be found for a number of years so as to find a trend as to whether the profitability of the company is improving or otherwise.