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Financial Statements Analysis

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FINANCIAL STATEMENTS
ANALYSIS
Ratio Analysis
Common Size Statements
Importance and Limitations of
Ratio Analysis
Mini Case
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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.

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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.

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Types of Ratios
Liquidity Ratios
Capital Structure Ratios
Profitability Ratios
Efficiency ratios
Integrated Analysis Ratios
Growth Ratios

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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
Total current assets
Total current liabilities
NWC

Company A
Rs 1,80,000
1,20,000
60,000

Company B
Rs 30,000
10,000
20,000

Table 2: Change in Net Working Capital


Particulars
Current assets
Current liabilities
NWC

Company A
Rs 1,00,000
25,000
75,000

Company B
Rs 2,00,000
1,00,000
1,00,000

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Liquidity Ratios

Liquidity ratios measure the ability of a firm to


meet its short-term obligations.

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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
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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
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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

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Supplementary Ratios for


Liquidity
Inventory Turnover Ratio
Debtors Turnover Ratio
Creditors Turnover Ratio

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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.

Inventory turnover ratio =

Cost of goods sold


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.
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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)
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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.
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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
=

Debtors
collection period

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

8 (times per
year)

12 Months
=

Debtors turnover ratio, (8)

1.5
Months
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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.
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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

4 (times
per year)

12 months
=

Creditors turnover ratio, (4)

= 3 months

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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.
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DEFENSIVE INTERVAL RATIO


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

Defensiveinterval ratio

Projected daily
cash requirement

Liquid assets
=

Projected daily cash requirement

Projected cash operating expenditure


=

Number of days in a year (365)

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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.

Projected daily cash requirement =


Defensive-interval ratio =

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

= Rs 500

= 80 days
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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

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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

Second type: These ratios are


computed from the Income
Statement

(a) Debt-equity ratio

(a) Interest coverage ratio

(b) Debt-assets ratio

(b) Dividend coverage ratio

(c) Equity-assets ratio


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

Debt-equity ratio measures


ratio of long-term debt + Other Current
Totalthe
Debt
Debt-equity
ratiode3bt
= to shareholders equity Liabilities = Total external
term or total
Shareholders equity
Obligations
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.
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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.

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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
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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 =

Permanent

Capital

Total debt
Permanent capital

Shareholders equity
Long-term debt.

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III. Debt to total assets ratio


Debt to total assets ratio =

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

Capital Gearing Ratio


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.
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Coverage Ratio
Interest Coverage Ratio
Interest Coverage Ratio measures the firms ability to make
contractual interest payments.
Interest coverage ratio =

EBIT (Earning before interest and taxes)


Interest

Dividend Coverage Ratio


Dividend Coverage Ratio measures the firms ability to pay dividend
on preference share which carry a stated rate of return.

Dividend coverage ratio =

EAT (Earning after taxes)


Preference dividend
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Total fixed charge coverage ratio


Total fixed charge coverage ratio measures the firms ability to meet all fixed
payment obligations.
Total fixed charge
=
coverage ratio

EBIT + Lease Payment


Interest + Lease payments + (Preference dividend
+ Instalment of Principal)/(1-t)

Total Cashflow Coverage Ratio


However, coverage ratios mentioned above, suffer from one major
limitation, that is, they relate the firms ability to meet its various
financial obligations to its earnings. Accordingly, it would be
more appropriate to relate cash resources of a firm to its
various fixed financial obligations.

Total cashflow
=
coverage ratio

EBIT + Lease Payments + Depreciation + Non-cash expenses


Lease payment
+
+ Interest

(Principal repayment)
(1 t)

(Preference dividend)
(1 - t)
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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.
n

DSCR

t=1

EATt

Interestt
n

t=1

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.
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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

Net profit for the


year

Interest on term loan


during the year

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

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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

Average DSCR (DSCR 8)

1.83

Tata McGraw-Hill Publishing Company Limited, Financial Management


Tata McGraw-Hill Publishing Company Limited, Financial Management

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

Profitability Ratios
Related to Investments

(i) Profit Margin

(i) Return on Investments

(ii) Expenses Ratio

(ii) Return on Shareholders


Equity

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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

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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

i. Operating Profit Ratio =

ii. Pre-tax Profit Ratio =

iii. Net Profit Ratio =

Earning before interest and taxes


Net sales
Earnings before taxes
Net sales

Earning after interest and taxes


Net sales
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Example 7: From the following information of a firm,


determine (i) Gross profit margin and (ii) Net profit
margin.
1. Sales
2. Cost of goods sold
3. Other operating expenses
(1) Gross profit margin =

(2) Net profit margin =

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

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Expenses Ratio
i. Cost of goods sold =
ii. Operating expenses =

Cost of goods sold


X 100
Net sales
Administrative exp. + Selling exp.
Net sales

iii. Administrative expenses =

Administrative expenses
Net sales

iv. Selling expenses ratio =

Selling expenses
Net sales

v. Operating ratio =

X 100

X 100

X 100

Cost of goods sold + Operating expenses


X 100
Net sales

vi. Financial expenses =

Financial expenses
Net sales

X 100
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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
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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
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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
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Debtors Turnover Ratio


Liquidity of a firms receivables can be examined
in two ways.
Credit sales
i. Debtors
Inventoryturnover
Turnover
i.
= measures the activity/liquidity of inventory of
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
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Assets Turnover Ratio


Assets turnover indicates the efficiency with which firm
uses all its assets to generate sales.
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
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1)

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

2)

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)

Earnings yield = EPS/Market price per share.

6)

Dividend Yield = DPS/Market price per share.

7)

Dividend payment/payout (D/P) ratio = DPS/EPS.

8)

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

9)

Book value per share = Ordinary shareholders equity/Number of equity


shares outstanding.
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Integrated Analysis Ratio


Integrated ratios provide better insight about financial and
economic analysis of a firm.
(1) Rate of return on assets (ROA) can be decomposed in to
(i) Net profit margin (EAT/Sales)
(ii) Assets turnover (Sales/Total assets)
(2) Return on Equity (ROE) can be decomposed in to
(i) (EAT/Sales) x (Sales/Assets) x (Assets/Equity)
(ii) (EAT/EBT) x (EBT/EBIT) x (EBIT/Sales) x (Sales/Assets) x
(Assets/Equity)
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Rate of Return on Assets


EAT as percentage of
sales
EAT

Divided by

Gross profit = Sales less


cost of goods sold

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
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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

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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

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
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Return on Equity (ROE)


ROE is the product of the following three ratios: Net profit ratio (x)
Assets turnover (x) Financial leverage/Equity multiplier
Three-component model of ROE can be broadened further to
consider the effect of interest and tax payments.

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
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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
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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.
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