ANALYSIS OF

FINANCIAL
STATEMENTS
CHAPTER II
RATIO ANALYSIS
- ROHIT SHARMA

QUALITATIVE

FINANCIAL ANALYSIS

Evaluating

intangible factors that seem likely to

influence future performance of the company, such as
the integrity and experience of a company's management
the positioning of its products and services
labour relations
industry cycles
strength of R&D
appeal of its marketing campaign

More subjective than quantitative analysis, which looks

at statistical data
Advocates of this approach believe that success or
failure in the corporate world is often driven as much by
qualitative factors as by financial data

QUANTITATIVE FINANCIAL ANALYSIS

A mathematical analysis of the financial data of

acompany to project potential future performance

This type of analysis does not include a subjective
assessment of the quality of management
This methodology involves looking at
profit-and-loss statements
sales and earnings histories
and the statistical state of the economy rather than at

more subjective factors

While some people feel that quantitative analysis by

itself gives an incomplete picture of a company's

prospects, advocates tend to believe that numbers
tell the whole story

A business or financial analysis technique that is used to

understand market behavior by employing complex mathematical

and statistical modeling, measurement, and research. By
assigning a numerical value to variables, quantitative analysts try
to replicate reality in mathematical terms. Quantitative analysis
helps measure performance evaluation or valuation of a financial
instrument. It also can be used to predict real-world events such
as changes in a share's price.
In broad terms, quantitative analysis is a way of measuring

things. Examples of quantitative analysis include everything from

simple financial ratio calculations such as earnings per share to
more complicated analyses such as discounted cash flow or
option pricing. Although quantitative analysis is a powerful tool
for evaluating investments, it only tells half the story; the other
half is qualitative analysis. In financial circles, quantitative
analysts are referred to as quants, quant jockeys, and rocket
scientists.

ACCOUNTING RATIOS
Accounting ratios
describe a significant relationship
between figures from a Balance Sheet, Profit &
Loss Account or any other part of the Financial
Statements of a Company
Quantitative relationship between accounting
data, which can be used for analysis & decision
making
Relevant / Effective only when compared with
Industry Ratios (Interfirm Comparison) or
Base Period Ratios (Trend Analysis)

Useless on a standalone basis

ADVANTAGES
Simplifies comprehension of financial statements
Facilitates inter-firm comparison: Ratios highlight the factors

associated with successful and unsuccessful firm. They also reveal

strong firms and weak firms, overvalued and undervalued firms.
Helps in planning & forecasting: Ratios can assist
management, in its basic functions of forecasting. Planning, coordination, control and communications.
Makes intra-firm comparison possible: Ratios analysis also
makes possible comparison of the performance of different
divisions of the firm.
Helps in investment decisions in the case of investors and
lending decisions in the case of bankers etc.
The ratios are helpful in deciding about their efficiency or
otherwise in the past and likely performance in the future.
Ratios tell the whole story of changes in the financial
condition of the business

LIMITATIONS
Limitations of Financial Statements: Ratios are based only on

the information which has been recorded in the financial statements.

Financial statements are affected to a very great extent by accounting

conventions and concepts.

Personal judgment plays a great part in determining the figures for
financial statements.
Financial statements themselves are subject to several limitations.

Thus ratios derived, there from, are also subject to those limitations.
Comparative study required: Ratios are useful in judging the
efficiency of the business only when they are compared with past
results of the business. However, such a comparison only provide
glimpse of the past performance and forecasts for future may not
prove correct since several other factors like market conditions,
management policies, etc. may affect the future operations.
Ratios alone are not adequate: Ratios are only indicators, they
cannot be taken as final regarding good or bad financial position of
the business. Other things have also to be seen.

Lack of adequate standard: No fixed standard can be laid

down for ideal ratios. There are no well accepted standards

or rule of thumb for all ratios which can be accepted as
norm. It renders interpretation of the ratios difficult.
Limited use of single ratios: A single ratio, usually, does
not convey much of a sense. To make a better interpretation,
a number of ratios have to be calculated which is likely to
confuse the analyst than help him in making any good
decision.
Personal bias: Ratios are only means of financial analysis
and not an end in itself. Ratios have to interpreted and
different people may interpret the same ratio in different
way.
Incomparable: Not only industries differ in their nature, but
even firms in the same industry widely differ in their size and
accounting procedures etc. It makes comparison of ratios
difficult and misleading.

LIQUIDITY RATIOS
Attempt to measure a company's ability to pay off its

short-term debt obligations

comparing a company's short-term assets with its shortterm liabilities.
greater the coverage of liquid assets to short-term
liabilities the better as it is a clear signal that a company
can
pay its debts that are coming due in the near future
still fund its ongoing operations

company with low coverage should raise a red flag for

investors as it may be a sign that the company will have

difficulty
running its operations
meeting its obligations

CURRENT RATIO (CR)

LEVEL I
Tests a company'sLiquidityby determining the

proportion of CA available to cover CL

The concept behind this ratio is to ascertain
whether a company's short-term assets are
readily available to pay off its short-term liabilities
Highlights a firmsWorking Capital position
Theoretically, the higher the current ratio, the
better
Threshold limit for CR is 1

CR = CA/ CL

LEVEL II
CR>1

Good sign for creditors Payments

Not necessarily for owners Inefficiency
CR<1 -> Bad sign for creditors Payments
For owners efficiency
->

Check Creditors, Debtors, Inventory & Line of

Credit
High CR -> Debtors 6m, Inventory 4m, Creditors

2m,
Low CR -> Debtors 2m, Inventory 4m, Creditors
6m

LEVEL III
Trend Analysis

Compare Ratios with Past Years

Higher CR Why?Lower CR Why?
Less STD
More STD
More Inefficient More Efficient
Both
Both

Interfirm Comparison

With others in the same industry

Higher CR Why?Lower CR Why?
Less STD
More STD
More Inefficient More Efficient
Both
Both

QUICK RATIO (QR)

Quick Assets (QA) Ratio
Liquid Ratio
Acid-Test Ratio
LEVEL I

QR is more conservative than CR because it

includes only the most liquid CAs

QA excludes Inventory, Prepaid Expenses and
other CA, which are more difficult to turn into cash
Therefore it measures the proportion by which,
the most liquidCA cover CL

Liquidity Indicator, derived from CR

A higher ratio means a more liquid current

position
QR = QA/ CL
QA = CA Stock Prepaid Expenses

LEVEL II
QR>1 -> Good sign for creditors Payments

Not necessarily for owners Inefficiency

QR<1 ->
Bad sign for creditors Payments
For owners efficiency
Check Creditors, Debtor & Line of Credit
High QR -> Debtors 6m, Creditors 2m
Low QR -> Debtors 2m, Creditors 6m

LEVEL III
Trend Ratios

Compare Ratios with Past Years

Higher QR Why?
Lower QR Why?
Less STD
More STD
More Inefficient More Efficient
Both
Both

Interfirm Comparison

With others in the same industry

Higher QR Why?
Lower QR Why?
Less STD
More STD
More Inefficient More Efficient
Both
Both

CURRENT & QUICK RATIO

COMPARITIVE
CR significantly higher than QR

means High Inventory

E.g. Car Showroom

CR barely higher than QR

means Low Inventory

E.g. McDonalds

CASH RATIO
LEVEL I

Measures the amount of cash, cash equivalents or

invested funds there are in CA to cover CL

This Ratio is relevant as this amount is certainly
realizable today itself

Cash Ratio (CR) =

Cash & Cash Equivalents / Current Liabilities

(CL)
Cash & Cash Equivalents = Cash + Bank +

Marketable Securities / Short-Term Investments

LEVEL II
High CaR -> Good sign for creditors Payments
Not necessarily for owners Inefficiency
Low CaR -> Bad sign for creditors Payments

For owners efficiency

Check Loans & Line of Credit
High CaR -> Loans & Interest, may not have enough
money to pay LTD
Salaries Payable may be high, not part of STD
Low CaR -> Could mean funds being invested well
Line of Credit

LEVEL III
Trend Ratios

Compare Ratios with Past Years

Higher CaR Why?
Lower CaR Why?
Less STD More STD
More Inefficient More Efficient
Both
Both

Interfirm Comparison

With others in the same industry

Higher CaR Why?
Lower CaR Why?
Less STD More STD
More Inefficient More Efficient
Both
Both

Excess Cash lying idle is a bad sign

Less Cash is also a bad sign, if there is no Line of Credit

CASH CONVERSION CYCLE (CCC)

This liquidity metric expresses the length of time

(in days) that a company uses to sell inventory,

collect receivables and pay its accounts payable
CCC measures the number of days a company's
cash is tied up in the production and sales
process of its operations
& the benefit it gets from payment terms from its
creditors
The shorter this cycle, the more liquid the
company'sworking capital positionis
The CCC is also known as the "cash" or
"operating" cycle

CCC =

ACP
+ IHP
- PPP

TURNOVER RATIOS
Activity Ratios
Asset Management Ratios
Operational Efficiency Ratios

Measure how efficiently the assets are employed

by a firm
Measures how quickly certain assets are
converted to cash
Relationship between Level of Activity & Levels
of certain Assets

FIXED ASSETS TURNOVER

Measures the productivity of a company'sFA wrt Sales

Generation
For most companies, their investment in fixed assets
represents the single largest component of their total
assets
This annual turnover ratio is designed to reflect a
company's efficiency in managing these significant
assets
Simply put, the higher the yearly turnover rate, the
better

Fixed Assets Turnover = Net Sales

/ Avg. Net Fixed Assets

INVENTORY TURNOVER
Stock Turnover
Measures how fast the inventory is moving through the

firm
Reflects the efficiency of inventory management
Higher the ratio the more efficient the inventory
management & vice-versa (Not always true)
High Inventory Turnover may be because of low level
of inventory which would result in Stockouts & Loss of
Sales & Customer GW
{Avg. Inventory, as we are comparing a flow
figure(COGS) to a stock figure(Inventory)}

Inventory Turnover = COGS / Avg. Inventory

RECEIVABLES TURNOVER
Debtors Turnover
Shows how many times Debtors turn over during

the year
Measures how quickly receivables are collected
A higher ratio indicates a short time lag between
credit sales & cash collection
The higher the ratio, the higher the efficiency of
credit management

Receivables Turnover = Net Sales

/ Avg. Receivables

PAYABLES TURNOVER
Creditors Turnover
Shows how many times Creditors turn over

during the year

Measures how quickly payables are paid
A higher ratio indicates a short time lag
between credit purchases & cash payment

Payables Turnover = Net Purchases

/ Avg. Payables

INVENTORY HOLDING PERIOD

Represents number of days of sales locked in

Receivables

IHP = Avg. Inventory / Daily Cost of Goods Sold

(COGS)
Daily Cost of Goods Sold = COGS / 365
Avg. Inventory = (Opening + Closing Inventory) / 2

IHP = 365 / Inventory Turnover

AVERAGE COLLECTION PERIOD

(ACP)
Debtors Collection Period - Represents

number of
Receivables

days of sales locked in

ACP = Avg. Receivables / Daily Net Sales

Daily Net Sales = Net Sales / 365
Avg. Receivables = (Opening + Closing

Receivables) / 2

PAYABLES PAYMENT PERIOD

Represents number of days of available to pay

Payables

PPP = Avg. Payables / Daily Net Purchases

Daily Net Purchases = Net Purchases / 365
Avg. Payables = (Opening + Closing Payables)

/2

PPP = 365 / Payables Turnover

LEVERAGE RATIOS
Leverage = theactionofa lever
Lever = arigidbarthatpivotsaboutonepoint

andthatisusedtomoveanobjectatasecond
pointbya forceappliedatathird
Give users a general idea of the company's overall

debt load as well as its mix of equity and debt

Debt ratios can be used to determine the overall
level of FINANCIAL RISK of a company
Generally, the greater the amount of debt held by
a company the greater the financial risk of
bankruptcy*

Why?
Owners Perspective
1) Lenders may interfere in the running of the business
2) Strict Debt Covenants for further borrowing
3) Further borrowing automatically becomes tougher
4) High Debt payments

)Lenders Perspective
1) If the company goes bankrupt, Lenders may suffer
2) Owners have a lesser share they would care less about

the company
3) Bearing the risk to let owners earn magnified returns

Why Not?
Owners Perspective
1) With a limited stake, retain control
2) Return would be magnified, as benefits go to

smaller number of shareholders (leverage or

trading on equity)
)Need for Balance
)Use MV of Debt & Equity
)PSC

DEBT-ASSET RATIO
DEBT RATIO
Used to gain a general idea as to the amount of

leverage being used by a company

A low percentage means that the company is less
dependent on leverage, i.e., money borrowed from
and/or owed to others
The lower the percentage, the less leverage a
company is using and the stronger its equity position
Generally, the higher the ratio, the more risky the
company
Debt Ratio = Total Debt / Total Assets

PROPRIETARY RATIO
Indicates the ratio of total assets financed by owners
Used to gain a general idea as to the amount of

leverage being used by a company

A high percentage means that the company is less
dependent on leverage
The higher the percentage, the less leverage a
company is using and the stronger its equity position
Generally, the higher the ratio, the less risky the
company
Proprietary Ratio = Equity / Total Assets

DEBT-EQUITY RATIO
This is a measurement of how much suppliers, lenders,

creditors and obligors have committed to the company

versus what the shareholders have committed.
To a large degree, the debt-equity ratio provides another
vantage point on a company's leverage position
A lower percentage means that a company is using less
leverage and has a stronger equity position.

Debt-Equity Ratio = Long-Term Debt / Equity

or
= Total Debt / Equity
Equity = Paid-Up Capital + Reserves & Surplus

CAPITALIZATION RATIO
DEBT to TOTAL CAPITAL RATIO
There is no right amount of debt
Leverage varies according to industries, a

company's line of business and its stage of

development
Common sense tells us that low debt and high
equity levels in the capitalization ratio indicate
investment quality

Capitalization Ratio = Long-Term Debt

/ (Equity + Long-Term Debt)

CAPITAL-GEARING RATIO
Provides the relationship between equity

funds and fixed-income bearing funds

Used to show the effect of the use of Fixed
Interest/Dividend vs the use of Dividend
based on Profits on the earnings available
to equity shareholders
Capital-Gearing Ratio = Equity

(Shareholders Funds)
Bearing Capital

/ Fixed-Income

COVERAGE RATIOS
Second category of Leverage Ratios
Computed from information available in the

P/L a/c
These ratios analyze the ability of the firm to
meet its fixed payments
Measures the extent to which profit covers
the fixed payment

INTEREST COVERAGE RATIO (ICR)

ICRis used to determine how easily a company

can pay interest expenses on outstanding debt

Tells us how many times the EBIT covers Interest
The lower the ratio, the more the company is
burdened by debt expense
Hence the higher the better
When a company's interest coverage ratio is
only 1.5 or lower, its ability to meet interest
expenses may be questionable

ICR = EBIT / Interest

DIVIDEND COVERAGE RATIO (DCR)

Measure the ability of the firm to pay

Preference Dividend
Tells us how many times the EAT covers
Preference Dividend
Preference Dividend is an Appropriation of
Profits
The higher the better for Preference
Shareholders
DCR = EAT / Preference Dividend

DEBT SERVICE COVERAGE RATIO (DSCR)

Comprehensive measure to compute Debt Service

Capacity
Debt Service Capacity is the ability of a firm to make
contractual payments required on a scheduled basis over
the life of the debt
Used by Financial Institutions in India
Number of times the total debt service obligations are
covered by total operating funds
2:1 satisfactory for lenders
DSCR = EAT + Dep + Other Non-Cash Charges +

Int on Loan + LR
/ Int on Loan + Repayment of Loan + LR

FIXED CHARGES COVERAGE RATIO

(FCCR)
FCCR shows us how many times the Profit before

Interest, Tax & Lease Payments covers all the Fixed

Financing Charges
takes into account all Fixed obligations
Debt Interest
Lease Payments
Loan Repayment Installment
Preference Dividend

FCCR = EBIT + LR

/ [Debt Int + LR +
{(Loan Repayment Inst + Pref Div)/ 1-T}]

PROFITABILITY RATIOS
Help us understand how well the company utilized its

resources in generating profit and shareholder value

The long-term profitability of a company is vital for both
the survival of the company
benefit received by shareholders

5 Profit Margin Ratios display the amount of profit a

company generates on its sales

Profits are calculated at the different stages of anincome

statement
these are equated upon sales at each level

The Rate of Return Ratios reflect the relationship

between profit & investment

They detail how effective a company is at generating income
from its resources

ALL PROFITABILITY RATIOS are expressed as a %

PROFIT MARGINS
In theP/L A/C, there are 5 levels of profit or profit margins -
Gross Profit Margin
EBITDA Margin
Operating Profit Margin
Pretax Profit Margin
Net Profit Margin
Margin can apply to the absolute number for a given profit level

and/or the number as a percentage of net sales/revenues

Profit Margin Analysis uses amount of profit (at different levels)
generated by the company as a percent of the sales generated
Provides a comprehensive measure of a company's profitability on a
historical basis (3-5 years) and in comparison to peer companies and
industry benchmarks
The objective of margin analysis is to detect consistency or +ve / -ve
trends in a company's earnings
+ve profit margin analysis translates into +ve investment quality
To a large degree, it is the quality, and growth, of a company's
earnings that drive its stock price

FORMULAS
Gross ProfitMargin = Gross Profit / Net

Sales
EBITDA Margin = EBITDA / Net Sales
Operating Profit Margin = EBIT / Net Sales
Pretax Profit Margin = EBT / Net Sales
Net Profit Margin = EAT / Net Sales

RATE OF RETURN RATIOS

RETURN ON ASSETS (ROA)
This ratio indicates how profitable a company is relative

to its total assets.

TheROA ratio illustrates how well management is
employing the company's total assets to make a profit.
The higher the return, the more efficient management is
in utilizing its asset base.
The ROA ratio is calculated by comparing net income to
average total assets, and is expressed as a percentage

ROA = EAT / Avg. Total Assets

Avg. Total Assets = Opening + Closing Total Assets / 2

RETURN ON EQUITY (ROE)

This ratio indicates how profitable a company is by

comparing its PAT to its average shareholders equity

ROE measures how much the shareholders earned
for their investment in the company
The higher the percentage, the more efficient
management is in utilizing its equity base and the
better return is to investors

ROE = (EAT Preference Dividend)

/ Avg. Equity
Equity = Paid-Up Capital + Reserves & Surplus
Avg. Equity = Opening + Closing Equity / 2

RETURN ON CAPITAL EMPLOYED(ROCE)

ROCE complements theROE by adding a company's

Debt to Equity to reflect a company's total "capital

employed"
This measure narrows the focus to gain a better
understanding of a company's ability to generate
returns from its available capital base
By comparing net income to the sum of a
company's debt and equity capital, investors can
get a clear picture of how the use of leverage
impacts a company's profitability
ROCE is considered to be a more comprehensive
profitability indicator because it gauges
management's ability to generate earnings from a
company's total pool of capital

ROCE = NOPAT / Avg. Capital Employed

NOPAT / NOEAT = EBIT ( 1 T )
Capital Employed / Net Assets

= Total Assets Short-Term Liabilities

or
= Equity + Long-Term Debt
Avg. Capital Employed

= Opening + Closing Capital Employed / 2

EARNING POWER (EP)

Investors can get a clear picture of how

the use of leverage impacts a company's

profitability, ignoring taxation

EP = EBIT / Avg. Capital Employed

EFFECTIVE TAX RATE

This amount will often differ from the

company's stated Tax Rate due to many

accounting factors, including foreign exchange
provisions
Tax Profit = Accounting Profit?
This effective tax rate gives a good
understanding of the tax rate the company
actually faces
The purpose of this is to see the efficiency in
Tax Planning of the organization

Effective Tax Rate = Tax / EBT

DU-PONT ANALYSIS
It is also known as "DuPont identity"
A method of performance measurement that was started by the

DuPont Corporation in the 1920s

If ROE is unsatisfactory, the DuPontanalysis helps locatethe
part of the business thatis underperforming
3-Stage DuPont analysistells us that ROE is affected by3
things:
Operating efficiency, indicated by PROFIT MARGIN
Asset use efficiency, indicated by TOTAL ASSET TURNOVER
Financial leverage, indicated by the EQUITY MULTIPLIER or

FINANCIAL LEVERAGE

ROE = Profit Margin (Profit/Sales)

* Total Asset Turnover (Sales/Avg. Total Assets)

* Equity Multiplier (Avg. Total Assets/Avg. Equity)

If a company's ROE goes up

Due to an increase in the net profit margin or

asset turnover
Good Sign
Due to equity multiplier
company was already appropriately leveraged
Bad Sign as the company is now riskier
company was under-leveraged
Good Sign as it indicates better management

5-Stage DuPont analysistells us that ROE is affected

by5 things:
Asset use efficiency, measured by TOTAL ASSET

TURNOVER
Financial leverage, measured by the EQUITY MULTIPLIER or
FINANCIAL LEVERAGE
Profitability, indicated by EBIT Margin
The Change in Profit due to Tax indicated by Tax Burden
The Change in Profit due to Interest indicated by Interest
Burden

ROE = Tax Burden (EAT/EBT)

* Interest Burden
(EBT/EBIT) * EBIT Margin (EBIT/Sales) * Total
Asset Turnover (Sales/ Total Assets)
* Equity
Multiplier (Total Assets/Equity)

VALUATION RATIOS
Used to estimate the attractiveness of a potential or existing

investment and get an idea of its valuation

When looking at the financial statements of a company many
users can suffer from information overload as there are so
many different financial values
Investment valuation ratios attempt to simplify this
evaluation process by comparing relevant data that help
users gain an estimate of valuation
The most well-known investment valuation ratio is the P/E
ratio, which compares the current price of company's shares
to the amount of earnings it generates
The purpose of this ratio is to give users a quick idea of how
much they are paying for each Re. of earnings
With one simplified ratio, you can easily compare the P/E
ratio of one company to its competition and to the market

PRICE-TO-BOOK VALUE RATIO

A valuation ratio used by investors which compares a stock's

per-share price (Market Value) to its book value (Shareholders

Equity)
It is expressed as a multiple (i.e. how many times a company's
stock is trading per share compared to the company's book
value per share),
Indicates how much shareholders are paying for the net assets
of a company
The book value of a company is the value of a company's assets
expressed on the balance sheet
It is the difference between the B/SAssets & B/S Liabilities
Provides investors a way to compare the market value, or what
they are paying for each share, to a conservative measure of the
value of the firm

P/BV = MVPS / BVPS

PRICE/EARNINGS (P/E) RATIO

P/E is the best known of the investment valuation

indicators
P/E ratio has its imperfections, but it is
nevertheless the most widely reported and used
valuation by investment professionals and the
investing public
The financial reporting of both companies and
investment research services use a basic EPS
figure divided into the current stock price to
calculate the P/E multiple (i.e. how many times a
stock is trading (its price) per each Re. of EPS)

It's not surprising that estimated EPS figures are

often very optimistic during bull markets, while

reflecting pessimism during bear markets
As a matter of historical record, it's no secret that
the accuracy of stock analyst earnings estimates
should be looked at skeptically by investors
Nevertheless, analyst estimates and opinions
based on forward-looking projections of a
company's earnings do play a role in influencing
the MP
The ratio will vary widely among different
companies and industries
P/E Ratio = Market Price / EPS

PRICE-TO-SALES RATIO
Sales Revenue is not easy to manipulate as

Earnings & BV which depend on accounting

convention
High Sales do not indicate High Earnings

P/S = MVPS / Sales per share

= Market Value of Equity / Total Sales

EV/EBITDA RATIO
measures the value of a company
alternative to the P/E Ratio
advantage of this multiple is that it iscapital

structure-neutral
useful for transnational comparisons because
it ignores the distorting effects of individual
countries taxation policies

EV/EBITDA = EV / EBITDA

IMPORTANT TERMS
EPS = Earnings to ESH

/ No. of Equity Shares

Earnings to ESH = EAT Preference Dividend
REPS = Retained Earnings

/ No. of Equity Shares

Retained Earnings = EAT Preference Dividend

Equity Dividend

DPS = Dividend Distributed / No. of Equity

Shares
Earnings Yield = EPS / MVPS * 100
Dividend Yield = DPS / MVPS * 100
Dividend Payout Ratio = DPS / EPS
Retention Ratio = REPS / EPS