Financial Statements Analysis

6-1

FINANCIAL STATEMENTS ANALYSIS

Ratio Analysis

Common Size Statements

Importance and Limitations of Ratio Analysis Mini Case
6-2

Ratio Analysis
Ratio analysis is a widely used tool of financial analysis. It is defined as the systematic use of ratio to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical performance and current financial condition can be determined.

6-3

Basis of Comparison
1) Trend Analysis involves comparison of a firm over a period of time, that is, present ratios are compared with past ratios for the same firm. It indicates the direction of change in the performance improvement, deterioration or constancy over the years.
2) Interfirm Comparison involves comparing the ratios of a firm with those of others in the same lines of business or for the industry as a whole. It reflects the firms performance in relation to its competitors. 3) Comparison with standards or industry average.

6-4

Types of Ratios
Liquidity Ratios Capital Structure Ratios

Profitability Ratios
Efficiency ratios Integrated Analysis Ratios Growth Ratios
6-5

Net Working Capital

Net working capital is a measure of liquidity calculated by subtracting current liabilities from current assets.
Table 1: Net Working Capital Particulars Company A Company B

Total current assets Total current liabilities NWC

Table 2: Change in Net Working Capital Particulars

Rs 1,80,000 1,20,000 60,000

Rs 30,000 10,000 20,000

Company A

Company B

Current assets Current liabilities NWC

Rs 1,00,000 25,000 75,000

Rs 2,00,000 1,00,000 1,00,000

6-6

Liquidity Ratios

Liquidity ratios measure the ability of a firm to

meet its short-term obligations.

6-7

Current Ratio
Current Ratio is a measure of liquidity calculated dividing the current assets by the current liabilities

Current Ratio =

Current Assets

Current Liabilities
Firm B Rs 30,000

Particulars Current Assets

Firm A Rs 1,80,000

Current Liabilities
Current Ratio

Rs 1,20,000
= 3:2 (1.5:1)

Rs 10,000
3:1
6-8

Acid-Test Ratio
The quick or acid test ratio takes into consideration the differences in the liquidity of the components of current assets.

Acid-test Ratio =

Quick Assets
Current Liabilities

Quick Assets = Current assets Stock Pre-paid expenses

6-9

Example 1: Acid-Test Ratio

Cash Debtors Inventory Total current assets Total current liabilities (1) Current Ratio (2) Acid-test Ratio Rs 2,000 2,000 12,000 16,000 8,000 2:1 0.5 : 1

6 - 10

Supplementary Ratios for Liquidity

Inventory Turnover Ratio Debtors Turnover Ratio Creditors Turnover Ratio

6 - 11

Inventory Turnover Ratio

The ratio indicates how fast inventory is sold. A high ratio is good from the viewpoint of liquidity and vice versa. A low ratio would signify that inventory does not sell fast and stays on the shelf or in the warehouse for a long time.

Cost of goods sold

Inventory turnover ratio = Average inventory

The cost of goods sold means sales minus gross profit. The average inventory refers to the simple average of the opening and closing inventory.
6 - 12

Example 2: Inventory Turnover Ratio

A firm has sold goods worth Rs 3,00,000 with a gross profit margin of 20 per cent. The stock at the beginning and the end of the year was Rs 35,000 and Rs 45,000 respectively. What is the inventory turnover ratio?

Inventory turnover ratio

(Rs 3,00,000 Rs 60,000) (Rs 35,000 + Rs 45,000) 2

6 (times per year)

12 months Inventory = = 2 months holding period Inventory turnover ratio, (6)

6 - 13

Debtors Turnover Ratio

The ratio measures how rapidly receivables are collected. A high ratio is indicative of shorter time-lag between credit sales and cash collection. A low ratio shows that debts are not being collected rapidly.

Debtors turnover ratio

Net credit sales

Average debtors

Net credit sales consist of gross credit sales minus returns, if any, from customers. Average debtors is the simple average of debtors (including bills receivable) at the beginning and at the end of year.
6 - 14

Example 3: Debtors Turnover Ratio

A firm has made credit sales of Rs 2,40,000 during the year. The outstanding amount of debtors at the beginning and at the end of the year respectively was Rs 27,500 and Rs 32,500. Determine the debtors turnover ratio. Debtors turnover ratio Rs 2,40,000 8 (times per year) 1.5 Months
6 - 15

(Rs 27,500 + Rs 32,500) 2

= 12 Months Debtors turnover ratio, (8)

Debtors collection period

Creditors Turnover Ratio

A low turnover ratio reflects liberal credit terms granted by suppliers, while a high ratio shows that accounts are to be settled rapidly. The creditors turnover ratio is an important tool of analysis as a firm can reduce its requirement of current assets by relying on suppliers credit.

Creditors turnover ratio

Net credit purchases Average creditors

Net credit purchases = Gross credit purchases - Returns to suppliers. Average creditors = Average of creditors (including bills payable) outstanding at the beginning and at the end of the year.
6 - 16

Example 4: Creditors Turnover Ratio

The firm in previous Examples has made credit purchases of Rs

1,80,000. The amount payable to the creditors at the beginning

and at the end of the year is Rs 42,500 and Rs 47,500 respectively. Find out the creditors turnover ratio.

Creditors turnover ratio Creditors payment period

(Rs 1,80,000) (Rs 42,500 Rs 47,500) 2 12 months

4 (times per year)

Creditors turnover ratio, (4)

= 3 months

6 - 17

The summing up of the three turnover ratios (known as a cash cycle) has a bearing on the liquidity of a firm. The cash cycle captures the interrelationship of sales, collections from debtors and payment to creditors.

The combined effect of the three turnover ratios is summarised below:

Inventory holding period Add: Debtors collection period Less: Creditors payment period 2 months + 1.5 months 3 months 0.5 months

As a rule, the shorter is the cash cycle, the better are the liquidity ratios as measured above and vice versa.
6 - 18

DEFENSIVE INTERVAL RATIO

Defensive interval ratio is the ratio between quick assets and projected daily cash requirement.

Defensiveinterval ratio

Liquid assets = Projected daily cash requirement

Projected daily cash requirement

Projected cash operating expenditure Number of days in a year (365)

6 - 19

Example 5: Defensive Interval Ratio

The projected cash operating expenditure of a firm from the
next year is Rs 1,82,500. It has liquid current assets amounting to Rs 40,000. Determine the defensive-interval

ratio.
Rs 1,82,500 365 Rs 40,000 Rs 500

Projected daily cash requirement = Defensive-interval ratio =

= Rs 500

= 80 days
6 - 20

Cash-flow From Operations Ratio

Cash-flow from operation ratio measures liquidity of a firm by comparing actual cash flows from operations (in lieu of current and potential cash inflows from current assets such as inventory and debtors) with current liability. Cash-flow from operations ratio Cash-flow from operations Current liabilities

6 - 21

Leverage Capital Structure Ratio

There are two aspects of the long-term solvency of a firm: (i) Ability to repay the principal when due, and

(ii) Regular payment of the interest . Capital structure or leverage ratios throw light on the long-term solvency of a firm. Accordingly, there are two different types of leverage ratios.
First type: These ratios are computed from the balance sheet (a) Debt-equity ratio (b) Debt-assets ratio (c) Equity-assets ratio
6 - 22

Second type: These ratios are computed from the Income Statement (a) Interest coverage ratio (b) Dividend coverage ratio

I. Debt-equity ratio
Debt-equity ratio measures the ratio of long-term or total debt to shareholders equity.

Debt-equity ratio measures the ratio of long-term debt = Total external Total Debt Obligations Debt-equity ratio = to shareholders equity term or total de3bt Shareholders equity
If the D/E ratio is high, the owners are putting up relatively less money of their own. It is danger signal for the lenders and creditors. If the project should fail financially, the creditors would lose heavily. A low D/E ratio has just the opposite implications. To the creditors, a relatively high stake of the owners implies sufficient safety margin and substantial protection against shrinkage in assets.
6 - 23

Long-term Debt + Short

For the company also, the servicing of debt is less burdensome and consequently its credit standing is not adversely affected, its operational flexibility is not jeopardised and it will be able to raise additional funds. The disadvantage of low debt-equity ratio is that the shareholders of the firm are deprived of the benefits of trading on equity or leverage.

6 - 24

Trading on Equity
Trading on equity (leverage) is the use of borrowed funds in expectation of higher return to equity-holders. Trading on Equity Particular (a) Total assets Financing pattern: Equity capital 15% Debt (b)Operating profit (EBIT) Less: Interest Earnings before taxes Less: Taxes (0.35) Earnings after taxes Return on equity (per cent) A 1,000 1,000 300 300 105 195 19.5 (Amount in Rs thousand) B 1,000 800 200 300 30 270 94.5 175.5 21.9 C 1,000 600 400 300 60 240 84 156 26 D 1,000 200 800 300 120 180 63 117 58.5
6 - 25

II. Debt to Total Capital

The relationship between creditors funds and owners capital can also be expressed using Debt to total capital ratio. Debt to total capital ratio =

Total debt Permanent capital

Permanent

Capital

Shareholders equity Long-term debt.

6 - 26

III. Debt to total assets ratio

Debt to total assets ratio =
Proprietary Ratio Proprietary ratio indicates the are financed by owners funds. extent to which assets

Total debt Total assets

Proprietary ratio =
Capital Gearing Ratio

Proprietary funds X 100 Total assets

Capital gearing ratio is used to know the relationship between equity funds (net worth) and fixed income bearing funds (Preference shares, debentures and other borrowed funds.
6 - 27

Coverage Ratio
Interest Coverage Ratio Interest Coverage Ratio measures the firms ability to make contractual interest payments. Interest coverage ratio = Dividend Coverage Ratio
Dividend Coverage Ratio measures the firms ability to pay dividend on preference share which carry a stated rate of return.

EBIT (Earning before interest and taxes) Interest

Dividend coverage ratio =

EAT (Earning after taxes) Preference dividend

6 - 28

Debt Service Coverage Ratio

Debt-service coverage ratio (DSCR) is considered a more comprehensive and apt measure to compute debt service capacity of a business firm.

DSCR

t=1

EATt

Interestt

t=1 n

Depreciationt

OAt

Instalmentt

DEBT SERVICE CAPACITY

Debt service capacity is the ability of a firm to make the contractual payments required on a scheduled basis over the life of the debt.
6 - 29

Example 6: Debt-Service Coverage Ratio

Agro Industries Ltd has submitted the following projections. You are required to work out yearly debt service coverage ratio (DSCR) and the average DSCR.
(Figures in Rs lakh) Year 1 2 3 4 5 6 7 8 Net profit for the year 21.67 34.77 36.01 19.20 18.61 18.40 18.33 16.41 Interest on term loan during the year 19.14 17.64 15.12 12.60 10.08 7.56 5.04 Nil Repayment of term loan in the year 10.70 18.00 18.00 18.00 18.00 18.00 18.00 18.00

The net profit has been arrived after charging depreciation of Rs 17.68 lakh every year.
Tata McGraw-Hill Publishing Company Limited, Financial Management

6 - 30

Solution
Table 3: Determination of Debt Service Coverage Ratio (Amount in lakh of rupees)
Ye ar Net profit Depreciation Interest Cash available (col. 2+3+4) 5 58.49 70.09 68.81 49.48 46.37 43.64 41.05 34.09 Principal instalment Debt obligation (col. 4 + col. 6) 7 29.84 35.64 33.12 30.60 28.08 25.56 23.04 18.00 DSCR [col. 5 col. 7 (No. of times)] 8 1.96 1.97 2.08 1.62 1.65 1.71 1.78 1.89

1 1 2 3 4 5 6 7 8

2 21.67 34.77 36.01 19.20 18.61 18.40 18.33 16.41

3 17.68 17.68 17.68 17.68 17.68 17.68 17.68 17.68

4 19.14 17.64 15.12 12.60 10.08 7.56 5.04 Nil

6 10.70 18.00 18.00 18.00 18.00 18.00 18.00 18.00

Average DSCR (DSCR 8)

1.83
6 - 31

Tata McGraw-Hill Publishing Company Limited, Financial Management

Profitability Ratio
Profitability ratios can be computed either from sales or investment. Profitability Ratios Profitability Ratios

Related to Sales
(i) Profit Margin (ii) Expenses Ratio

Related to Investments
(i) Return on Investments (ii) Return on Shareholders Equity
6 - 32

Profit Margin
Gross Profit Margin
Gross profit margin measures the percentage of each sales rupee remaining after the firm has paid for its goods.

Gross profit margin =

Gross Profit X 100 Sales

6 - 33

Net Profit Margin

Net profit margin measures the percentage of each sales rupee remaining after all costs and expense including interest and taxes have been deducted. Net profit margin can be computed in three ways Earning before interest and taxes Net sales Earnings before taxes Net sales

i. Operating Profit Ratio =

ii. Pre-tax Profit Ratio =

iii. Net Profit Ratio =

Earning after interest and taxes Net sales

6 - 34

Example 7: From the following information of a firm, determine (i) Gross profit margin and (ii) Net profit margin. 1. Sales Rs 2,00,000 2. Cost of goods sold 1,00,000 3. Other operating expenses 50,000
(1) Gross profit margin = Rs 1,00,000 Rs 2,00,000 Rs 50,000 Rs 2,00,000 = 50 per cent

(2) Net profit margin =

= 25 per cent

6 - 35

Expenses Ratio
i. Cost of goods sold = ii. Operating expenses = Cost of goods sold X 100 Net sales Administrative exp. + Selling exp. Net sales Administrative expenses iii. Administrative expenses = Net sales iv. Selling expenses ratio = Selling expenses Net sales X 100 X 100

X 100

Cost of goods sold + Operating expenses v. Operating ratio = X 100 Net sales vi. Financial expenses = Financial expenses Net sales X 100
6 - 36

Return on Investment
Return on Investments measures the overall effectiveness of management in generating profits with its available assets.
i. Return on Assets (ROA) ROA = EAT + (Interest Tax advantage on interest) Average total assets

ii. Return on Capital Employed (ROCE)

ROCE = EAT + (Interest Tax advantage on interest) Average total capital employed
6 - 37

Return on Shareholders Equity

Return on shareholders equity measures the return on the owners (both preference and equity shareholders) investment in the firm. Return on total shareholders equity = Net profit after taxes X 100 Average total shareholders equity

Return on ordinary shareholders equity (Net worth) =

Net profit after taxes Preference dividend X 100 Average ordinary shareholders equity
6 - 38

Efficiency Ratio
Activity ratios measure the speed with which various accounts/assets are converted into sales or cash.
Inventory turnover measures the efficiency of various types of inventories.

Cost goods sold i. Inventory Turnover measures theof activity/liquidity of Inventory Turnover Ratio = Average inventory inventory of a firm; the speed with which inventory is sold
Cost of raw materials used i. Inventory Turnover measures the activity/liquidity of Raw materials turnover = inventory of a firm; the speed with which inventory is sold Average raw material inventory
of goods manufactured i. Inventory Turnover measuresCost the activity/liquidity of Work-in-progress turnover = Average work-in-progress inventory inventory of a firm; the speed with which inventory is sold
6 - 39

Debtors Turnover Ratio

Liquidity of a firms receivables can be examined in two ways.
Credit sales i. Inventory Turnover measures the activity/liquidity of inventory of i. Debtors turnover = a firm; the speed with Average whichdebtors inventory + Average is sold bills receivable (B/R)

2. Average collection period =

Months (days) in a year Debtors turnover

Months (days) in a year (x) (Average Debtors + Average (B/R) i. Inventory Turnover measures the activity/liquidity of inventory of a Alternatively = Total firm; the speed with which inventory is credit sold sales

Ageing Schedule enables slow paying debtors.

analysis

to

identify
6 - 40

Assets Turnover Ratio

Assets turnover indicates the efficiency uses all its assets to generate sales. with which firm

Cost of goods sold of inventory of i. Inventory Turnover measures the activity/liquidity i. Total assets turnover = a firm; the speed with which inventory Average total is sold assets ii. Fixed assets turnover = Cost of goods sold Average fixed assets

Cost of goods sold i. Inventory Turnover measures the activity/liquidity of inventory of iii. Capital turnover = Average is capital a firm; the speed with which inventory sold employed Cost of goods sold iv. Current assets turnover = Average current assets Cost of goods sold of inventory of i. Inventory Turnover measures the activity/liquidity v. Working capital turnover = Net working capital a firm; the speed with which inventory is sold
6 - 41

1)
2)

Return on shareholders equity = EAT/Average total shareholders equity.

Return on equity funds = (EAT Preference dividend)/Average ordinary shareholders equity (net worth).

3)

Earnings per share (EPS) = Net profit available to equity shareholders (EAT Dp)/Number of equity shares outstanding (N).

4)

Dividends

per

share

(DPS)

Dividend

paid

to

ordinary

shareholders/Number of ordinary shares outstanding (N).

5)
6) 7)

Earnings yield = EPS/Market price per share.

Dividend Yield = DPS/Market price per share. Dividend payment/payout (D/P) ratio = DPS/EPS.

8)
9)

Price-earnings (P/E) ratio = Market price of a share/EPS.

Book value per share = Ordinary shareholders equity/Number of equity shares outstanding.
6 - 42

Return on Assets
Earning Power
Earning power is the overall profitability of a firm; is computed by multiplying net profit margin and assets turnover.

Earning power = Net profit margin Assets turnover Where, Net profit margin = Earning after taxes/Sales Asset turnover = Sales/Total assets
Earning after taxes Sales of inventory EAT of i. Inventory Turnover measures the activity/liquidity x x Earning Power = a firm; the speed with which Salesinventory isTotal sold Assets Total assets

6 - 43

EXAMPLE: 8
Assume that there are two firms, A and B, each having total assets amounting to Rs 4,00,000, and average net profits after taxes of 10 per cent, that is, Rs 40,000, each.
Firm A has sales of Rs 4,00,000, whereas the sales of firm B aggregate Rs 40,00,000. Determine the ROA of firms A and B. Table 4 shows the ROA based on two components.

Table 4: Return on Assets (ROA) of Firms A and B

Particulars 1. Net sales 2. Net profit 3. Total assets 4. Profit margin (2 1) (per cent) 5. Assets turnover (1 3) (times) 6. ROA ratio (4 5) (per cent) Firm A Rs 4,00,000 40,000 4,00,000 10 1 10 Firm B Rs 40,00,000 40,000 4,00,000 1 10 10
6 - 44

Return on Equity (ROE)

ROE is the product of the following three ratios: Net profit ratio (x) Assets turnover (x) Financial leverage/Equity multiplier

EAT EBT

EBT EBIT

EBIT x Sales

Sales Assets

Assets Equity
6 - 45

Common Size Statements

Preparation of common-size financial statements is an extension of ratio analysis. These statements convert absolute sums into more easily understood percentages of some base amount. It is sales in the case of income statement and totals of assets and liabilities in the case of the balance sheet.

Limitations
Ratio analysis in view of its several limitations should be considered only as a tool for analysis rather than as an end in itself. The reliability and significance attached to ratios will largely hinge upon the quality of data on which they are based. They are as good or as bad as the data itself. Nevertheless, they are an important tool of financial analysis.
6 - 46