Professional Documents
Culture Documents
6-1
6-1
FINANCIAL STATEMENTS
ANALYSIS
Ratio Analysis
Common Size Statements
Importance and Limitations of
Ratio Analysis
Mini Case
6-2
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
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
6-4
Types of Ratios
Liquidity Ratios
Capital Structure Ratios
Profitability Ratios
Efficiency ratios
Integrated Analysis Ratios
Growth Ratios
6-5
6-5
Company A
Rs 1,80,000
1,20,000
60,000
Company B
Rs 30,000
10,000
20,000
Company A
Rs 1,00,000
25,000
75,000
Company B
Rs 2,00,000
1,00,000
1,00,000
6-6
6-6
Liquidity Ratios
6-7
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
Particulars
Firm A
Firm B
Current Assets
Rs 1,80,000
Rs 30,000
Current Liabilities
Rs 1,20,000
Rs 10,000
Current Ratio
= 3:2 (1.5:1)
3:1
6-8
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
Rs 2,000
2,000
12,000
16,000
8,000
2:1
0.5 : 1
6 - 10
6 - 10
6 - 11
6 - 11
Inventory
turnover ratio
6 (times per
year)
12 months
Inventory
=
= 2 months
holding period
Inventory turnover ratio, (6)
6 - 13
6 - 13
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
6 - 14
Debtors
turnover ratio
Rs 2,40,000
=
Debtors
collection period
8 (times per
year)
12 Months
=
1.5
Months
6 - 15
6 - 15
Creditors turnover
ratio
Average creditors
Creditors
turnover ratio
Creditors
payment period
(Rs 1,80,000)
=
4 (times
per year)
12 months
=
= 3 months
6 - 17
6 - 17
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
6 - 18
Defensiveinterval ratio
Projected daily
cash requirement
Liquid assets
=
6 - 19
6 - 19
Rs 1,82,500
365
Rs 40,000
Rs 500
= Rs 500
= 80 days
6 - 20
6 - 20
Cash-flow from
operations ratio
Current liabilities
6 - 21
6 - 21
I. Debt-equity ratio
Debt-equity ratio measures the ratio of long-term or total
debt to shareholders equity.
Long-term Debt + Short
6 - 24
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)
(Amount in Rs thousand)
A
1,000
1,000
1,000
1,000
1,000
300
300
105
195
19.5
800
200
300
30
270
94.5
175.5
21.9
600
400
300
60
240
84
156
26
200
800
300
120
180
63
117
58.5
6 - 25
6 - 25
Permanent
Capital
Total debt
Permanent capital
Shareholders equity
Long-term debt.
6 - 26
6 - 26
Total debt
Total assets
Proprietary Ratio
Proprietary ratio indicates the
are financed by owners funds.
Proprietary ratio =
extent
to
which
assets
Proprietary funds
X 100
Total assets
Coverage Ratio
Interest Coverage Ratio
Interest Coverage Ratio measures the firms ability to make
contractual interest payments.
Interest coverage ratio =
Total cashflow
=
coverage ratio
(Principal repayment)
(1 t)
(Preference dividend)
(1 - t)
6 - 29
6 - 29
DSCR
t=1
EATt
Interestt
n
t=1
Depreciationt
OAt
Instalmentt
Repayment of term
loan in the year
1
2
3
4
5
6
7
8
21.67
34.77
36.01
19.20
18.61
18.40
18.33
16.41
19.14
17.64
15.12
12.60
10.08
7.56
5.04
Nil
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
Tata McGraw-Hill Publishing Company Limited, Financial Management
6 - 31
6 - 31
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)
Principal
instalment
Debt
obligation
(col. 4 + col. 6)
DSCR [col. 5
col. 7
(No. of times)]
1
2
3
4
5
6
7
8
21.67
34.77
36.01
19.20
18.61
18.40
18.33
16.41
17.68
17.68
17.68
17.68
17.68
17.68
17.68
17.68
19.14
17.64
15.12
12.60
10.08
7.56
5.04
Nil
58.49
70.09
68.81
49.48
46.37
43.64
41.05
34.09
10.70
18.00
18.00
18.00
18.00
18.00
18.00
18.00
29.84
35.64
33.12
30.60
28.08
25.56
23.04
18.00
1.96
1.97
2.08
1.62
1.65
1.71
1.78
1.89
1.83
6 - 32
6 - 32
Profitability Ratio
Profitability ratios can be computed either from
sales or investment.
Profitability Ratios
Related to Sales
Profitability Ratios
Related to Investments
6 - 33
6 - 33
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
X 100
Sales
6 - 34
6 - 34
Rs 1,00,000
Rs 2,00,000
Rs 50,000
Rs 2,00,000
Rs 2,00,000
1,00,000
50,000
= 50 per cent
= 25 per cent
6 - 36
6 - 36
Expenses Ratio
i. Cost of goods sold =
ii. Operating expenses =
Administrative expenses
Net sales
Selling expenses
Net sales
v. Operating ratio =
X 100
X 100
X 100
Financial expenses
Net sales
X 100
6 - 37
6 - 37
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 =
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 of
i. Inventory
Turnover
measures
the of
activity/liquidity
Inventory
Turnover
Ratio
=
Average
inventory of a firm; the speed with
whichinventory
inventory is sold
Cost
raw materials used
i. Inventory
Turnover
measures
theofactivity/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 of a firm; the speed
with which
inventory isinventory
sold
6 - 40
6 - 40
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
analysis
to
identify
6 - 41
6 - 41
1)
2)
3)
4)
Dividends
per
share
(DPS)
Dividend
paid
to
ordinary
6)
7)
8)
9)
Divided by
Assets
turnover
Sales
Sales
Fixed assets
Divided by
Total Assets
Plus
Current assets
Alternatively
Minus
Shareholder equity
Expenses: Selling
Administrative Interest
Plus
Minus
Long-term borrowed
funds
Income-tax
Plus
Current liabilities
6 - 45
6 - 45
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 - 46
6 - 46
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.
Firm A
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)
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 - 47
6 - 47
Net Profit
EBT the activity/liquidity
EBIT
EAT Turnover measures
i. Inventory
of
x
=
x
SalesinventorySales
Earnings
taxes
EBITwith which
inventory before
of a firm;
the speed
is sold
As a result of three sub-parts of net profit ratio, the ROE
is composed of the following 5 components.
EAT
EBT
EBT
EBIT
EBIT
x
Sales
Sales
Assets
Assets
Equity
6 - 48
6 - 48
A 5-way break-up of ROE enables the management of a firm to analyse the effect of interest
payments and tax payments separately from operating profitability. To illustrate further assume 8
per cent interest rate, 35 per cent tax rate and other operating expense of Rs 3,22,462 (Firm A) and
Rs 39,26,462 (Firm B) for the facts contained in Example 8. Table 5 shows the ROE (based on the
5 components) of Firms A and B.
Table 5: ROE (Five-way Basis) of Firms A and B
Particulars
Net sales
Less: Operating expenses
Earnings before interest and taxes (EBIT)
Less: Interest (8%)
Earnings before taxes (EBT)
Less: Taxes (35%)
Earnings after taxes (EAT)
Total assets
Debt
Equity
EAT/EBT (times)
EBT/EBIT (times)
EBIT/Sales (per cent)
Sales/Assets (times)
Assets/Equity (times)
ROE (per cent)
Firm A
Rs 4,00,000
3,22,462
77,538
16,000
61,538
21,538
40,000
4,00,000
2,00,000
2,00,000
0.65
0.79
19.4
1
2
20
Firm B
Rs 40,00,000
39,26,462
73,538
12,000
61,538
21,538
40,000
4,00,000
2,50,000
1,50,000
0.65
0.84
1.84
10
1.6
16
6 - 49
6 - 49
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 - 50
6 - 50