Accounting

Rajveer Rawlin
Senior Lecturer, Finance,
MBA (VTU)
Dayananda Sagar Institute
 Ratio Analysis

Why look at ratio analysis?

How can we make sense out of ratios?

What are the groups of ratios?

What are the limitations of ratio

analysis?

How can we use this to evaluate
profitability, risk, and growth?

2
 Why Look at Ratios?

compare a company’s performance with

itself overtime or a company versus
competitors within its industry

a basis for evaluating suppliers and
customers

Useful in historical analysis as well as
projecting performance
 End Users of Ratios

Lenders – judge a company’s ability to

repay loans

Managers – look at gross margins to keep
costs under control

Investors can compare their company
against the competition and the rest of the
industry
 Making Sense out of Ratios

Trend Analysis

How a company does over time

Peer Group Analysis

The company vs other competitors

Industry Comparison

Company vs the Industry
 Categories of Ratios

Liquidity

Look at the ability of a company to meet
its short term obligations

How cash rich a company is will determine
its liquidity

Can required payments be met?

2 Ratios

Current Ratio

Quick Ratio
 Categories of Ratios

Asset Management

How effective is the firm in managing it’s
assets?

How effective is the firm in using its assets
to generate sales?

3 Ratios

Total Asset Turnover

Fixed Asset Turnover

Inventory Turnover
 Categories of Ratios

Debt Management Ratios

How is the company financed?

What is the mix of debt and equity?

Does it generate enough cash flow to
cover interest payments?

3 Ratios

Debt Ratio

Tie Ratio

Debt to Equity Ratio
 Categories of Ratios

Profitability

How profitable is the company?

Is the company generating the right
returns on the assets deployed and
capital invested?

Are sales high enough to maintain
profitability?
 Categories of Ratios

2 Ratios focusing on profit margins

Gross Profit Margin

Net Profit Margin

2 Ratios focusing on returns

Return on Assets

Return on Equity
 Categories of Ratios

Market Value Ratios

How is the company’s value reflected in
the stock market?

Is the company under or over-valued vis a
vis it’s peers

2 Ratios

Price / Earnings

Price / Book Value

 Income Statement
2007 2008

Sales 5,834,400 7,035,600

COGS 4,980,000 5,800,000
Other expenses 720,000 612,960
Depreciation 116,960 120,000
Tot. op. costs 5,816,960 6,532,960
EBIT 17,440 502,640
Int. expense 176,000 80,000
EBT (158,560) 422,640
Taxes (40%) (63,424) 169,056
Net income (95,136) 253,584
 Balance Sheets: Assets

2007 2008

Cash 7,282 14,000

S-T invest. 20,000 71,632

AR 632,160 878,000

Inventories 1,287,360 1,716,480

Total CA 1,946,802 2,680,112

Net FA 939,790 836,840

Total assets 2,886,592 3,516,952
 Balance Sheets: Liabilities &
Equity

2007 2008

Accts. payable 324,000 359,800

Notes payable 720,000 300,000

Accruals 284,960 380,000

Total CL 1,328,960 1,039,800

Long-term debt 1,000,000 500,000

Common stock 460,000 1,680,936

Ret. earnings 97,632 296,216

Total equity 557,632 1,977,152

Total L&E 2,886,592 3,516,952
 Other Data

2007 2008

Stock price Rs 6.00 Rs 12.17

# of shares 100,000 250,000

DPS Rs 0.11 Rs 0.22

Lease payments 40,000 40,000

Tax rate 0.4 0.4
 Liquidity Ratios

Current Ratio (CR) = Current Assets (CA)
----------------------------------------

Current Liabilities (CL)

CR08 = 2680112/1039800 = 2.58

Quick Ratio (QR) = CA - Inventory
-------------------------------

CL
QR08 = (2680112-1716480)/1039800
= 0.93
 Analysis of CR and QR
2008 2007 2006 Ind.
CR 2.58x 1.46x 2.3x 2.7x
QR 0.93x 0.5x 0.8x 1.0x

 Signs of improvement from 2007 but still

below the industry average
 Liquidity position is weak as the quick
ratio is < 1 and lower than that of the
industry
 Analysis

CR and QR > 1 are a sign of good financial
health

However very high CR and or low QR
could mean

Cash build up

Under utilization of the firms resources

Build up in inventory

Inability to generate sales from it’s inventory

Slow collection of receivables
 Asset Management Ratios

Fixed Asset Turnover Ratio = Sales
----------------
Net Fixed Assets

Fixed Asset TO08 = 7035600/836840 = 8.41

Total Asset Turnover Ratio = Sales
----------------
Total Assets

Total Asset TO08 = 7035600/ 3516952 = 2.00
 Analysis
2008 2007 2006 Ind.
FA TO 8.4x 6.2x 10.0x 7.0x
TA TO 2.0x 2.0x 2.3x 2.5x
 FA turnover exceeds industry average.
Good sign
 TA turnover not up to industry average.
Caused by poor A/R collection and
inventory build up
 These ratios tell us how effectively the
firm is deploying it asset base and long
term fixed assets to generate sales
 Inventory Turnover

Inventory Turnover Ratio = Sales
----------------
Inventories

Inventory TO08 = 7035600/1716480 =4.1

Another Inv Ratio is calculated as cost of

goods sold / Inventory

2008 2007 2006 Ind.

Inv. T. 4.1x 4.5x 4.8x 6.1x
 Analysis

The inventory turnover declined from the
last year and is also below industry
average

Firms Inventory may be becoming
obsolete

Need better inventory control measures

Have to translate accumulated inventory

to sales, by reducing turnover time

Reduce shelf-life for perishable items
 Days Sales Outstanding (DSO)

It is a measure of how fast a company

collects money due in sales from its
customers

How fast customers pay their bills

In short, does the firm have a good credit

policy

High DSO’s are warning signs that a firm
is unable to collect its bills on time
 DSO

DSO = Receivables / (Average Sales/day)

DSO = Receivables / (Sales/365)

DSO = 878000 / (7035600/365) = 45.5

Debtor’s TO Ratio = Sales / (Receivables +
Debtors)

DSO has been deteriorating and is far below
industry norms

Poor credit and collection policy, need
improvement

2008 2007 2006 Ind.

DSO 45.5 39.5 37.4 32.0
 Creditor and Debtor Turnover

Debtors Turnover Ratio = Credit Sales

-------------------------
(Debtors + Receivables)

Creditors Turnover Ratio = Credit

Purchases
-------------------------
(Creditors + Payables)
Debt Management or Leverage Ratios

Tells you the proportion of debt financing

used

Right balance must be struck through a
mix of debt and equity

Too much equity can result in dilution
issues, lower EPS

Too much debt can pose challenges
stemming from financial risk
Debt Management or Leverage Ratios

Debt Ratio = Total Liabilities

----------------
Total Assets

Debt Ratio 08

= (1039800+500000)/3516952 = 0.44

TIE = EBIT
-----------------
Int. Exp

TIE 08 = 502640/80000 =6.3
Debt Management or Leverage Ratios

Debt to Equity Ratio (D/E) = Total Liab.

-----------------
Sh. Holders EQ

D/E 08 = (1039800+500000)/1977152
= 0.78

Debt to equity ratio is < 1
 Analysis

2008 2007 2006 Ind.

D/A 0.44 0.81 0.55 0.5

TIE 6.3x 0.1x 3.3x 6.2x

D/E 0.78 4.18 0.85 0.85

The company's debt reduction measures

seem to be working

All debt ratios better than industry levels

The company seems to have emerged

from serious financial risk it was exposed
to in 2007
 Profitability Ratios

Measure the ability of the firm to generate

profits effectively

Gross Margin (GM)

Gross Margin = (Sales – COG)X100/Sales

Tells you how profitable the firm is after
covering the cost of making the product

Key measure of a firms financial health

Negative Gross Margins can mean

Pricing pressures from competitors are
reducing sales, resulting in discounting
 Profitability Ratios

Variable cost such as material and labour

costs could be rising

Negative GM’s are a sign of trouble ahead

Net Profit Margin (NPM)

The profit remaining after all expenses are
paid

A bottom-line ratio

A very important ratio to assess
profitability and compare against the
available competition
 Profitability Ratios

Gross Margin = (Sales – COG)X100/Sales

GM08 = (7035600-5800000) /7035600 %

GM08 = 28%

NPM = Net Income X 100 / Sales

NPM08 = 253584/7035600 % = 3.6%

These two ratios can be increased by

Increasing Sales

Reducing costs
 Profitability Ratios

2008 2007 2006 Ind.

GM 28% 15% 25% 27%

NPM 3.6% -1.6% 2.6% 3.6%

The company’s Gross and Profit margins
recovered from 2007 to reach Industry
levels in 2008

The company seems to have grown sales
faster than the rise in costs experienced
 Return on Assets (ROA)

Tells you what % of money invested in the

business was returned as profit

If this ratio is too high, the company may
be sitting on cash and not investing for
the future

Too low a ratio implies under utilization of
its assets

ROA = NI / TA = 253584 / 3516952

ROA08 =7.2%
 Return on Equity (ROE)

Key Ratio

Serves as a useful comparison parameter
vs the competition and industry

Tells you how much of the equity invested
is returned as profit

ROE = NI / Common Equity

ROE08 = 253584 / (1680936+296216)

ROE08 = 12.8%
 Return on Capital Employed (ROCE)

Measures the returns generated on the

capital employed by the firm

Capital Employed = Total Assets – Current
Liabilities

ROCE = EBIT / Capital Employed

ROCE08 = 502640 / (3516952-1039800)

ROCE08 = 20%
 Analysis of ROA, ROE & ROCE

2008 2007 2006 Ind.

ROA 7.2% -3.3% 6.0% 9.0%

ROE 12.8% -17.1% 13.3% 18.0%

ROCE 20% 1% 18% 22%

Definite Improvement from 2007 but below

industry average

Reduction in debt has helped the recovery from
2007

Further debt reductions and cost cutting can help
achieve industry levels
 Capital Structure Ratios

Proprietary Ratio = Share holders Funds /

Total Assets

Proprietary Ratio08 = (1680936 + 296,216) /
3,516,952

Proprietary Ratio08 = 0.56 =56%

Fixed Assets to Net Worth Ratio

= Fixed Assets / Share Holders Funds

FANW08 = 836840 / (1680936 + 296,216)

FANW08 = 0.42 = 42%

 Market Related Ratios

These ratios factor in the current stock

price

We will look at 3 ratios

Price / Earnings (P/E)

Price / Cash Flow (P/CF)

Price / Book Value (P/BV)

These tell you how the company is valued
in the market

Important comparison metrics with the
competition
 P/E Ratio

Price08 = $12.17

EPS = Net Income / Out. Shares

EPS08 = Rs 253584/250000 = Rs 1.01

P/E = Price per share
EPS

P/E08= 12.17/1.01 = 12

Higher the growth rate higher the P/E
ratio

Reference comparison with industry
necessary
 P/CF Ratio

CF per share = (Net Income +Deprec.)

/ Out. Shares

CF per share08 = (253584 + 120000) /
250000

CF per share08 = Rs 1.49

P/CF = Price per share

CF per share

P/CF08= 12.17/1.49 = 8.14
 Price to Book Ratio

Tells you what a firm is trading relative to

its net worth

Book Value / Sh = Shareholders Funds /
Out Shares

BVPS08 = (1680936 + 296,216) / 250000

BVPS 08 = 7.91

P/BV = (Price / Sh) / BVPS

P/BV08 = 12.17/7.91 = 1.54

 Analysis

2008 2007 2006 Ind.

P/E 12.0x -6.3x 9.7x 14.2x

P/CF 8.2x 27.5x 8.0x 7.6x

P/BV 1.5x 1.1x 1.3x 2.9x

General improvement in ratios from 2007

Near Industry levels

Market seems to have recognized the

company's turn around
 Dividend Ratios

Dividend Per Share = Dividends / Shares

(DPS) Outstanding

DPS 08 = 55000/250000 = 0.22 Rs

Dividend Payout Ratio (DPR) = DPS/EPS

DPR 08 = 0.22/1.01 = 0.22 = 22%

Dividend Yield (DY) = DPS / (MP/Sh)

DY 08 = 0.22/12.17 = 2%
So Mr Analyst What is your View?