Financial Statements Analysis

Ratios
Financial Statements Analysis

Ratio Analysis

Common Size Statements

Importance and Limitations of

Ratio Analysis
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.
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) lnterfirm 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 firm's performance in relation to its competitors

3) Comparison with standards or industry average.

Types of Ratios
Capital
Liquidity
Structure
Ratios
Ratios

Profitability Efficiency
Ratios Ratios

Integrated
Growth
Analysis
Ratios
Ratios
Net Working Capital (NWC)
Net Working Capital is a measure of liquidity calculated by subtracting Current
Liabilities (CL) from Current Assets (CA).

NWC = CA - CL

Particulars Company A Company B

Table1: Net Working Capital (NWC)
Total Current Assets (CA) Rs Lakh 180 30
Total Current Liabilities (CL) Rs Lakh 120 10
NWC (CA – CL) Rs Lakh 60 20

Table 2: Change in Net Working Capital

Current Assets (CA) Rs Lakh 150 300
Current Liabilities (CL) Rs Lakh 75 200
NWC (CA - CL) Rs Lakh 75 100
Liquidity Ratios
Liquidity Ratios

Liquidity ratios measure the ability of

a firm to meet its short-term
obligations
Current Ratio
Current Ratio is a measure of liquidity calculated dividing the Current Assets (CA) by the
Current Liabilities (CL).

Current Ratio = Current Assets (CA)

Current Liabilities (CL)

Particulars Company A Company B

Current Assets (CA) Rs Lakh 180 30
Current Liabilities (CL) Rs Lakh 120 10
Current Ratio (CA ÷ CL) =3:2 (1.5:1) =3:1
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 (QA)*

Current Liabilities

*Quick Assets = Current Assets – Stock – Prepaid Expenses

Particulars Amount Current Ratio (CA ÷ CL)

Cash Rs Lakh 20 = 160 ÷ 80 = 2:1
Debtors Rs Lakh 20
QA = 160 – 120 = 40
Inventory Rs Lakh 120
Total Current Assets Rs Lakh 160 Acid-Test Ratio (QA ÷ CL)
Total Current Liabilities Rs Lakh 80 = 40 ÷ 80 = 0.5:1
Supplementary Ratios for Liquidity

Inventory Debtors Turnover

Turnover Ratio Ratio

Creditors
Turnover Ratio
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 (COGS)*

Average Inventory**

* COGS = Sales – Gross Profit

** Average Inventory = Simple average of opening and closing inventory

Inventory Turnover Ratio - Example
Q. A firm has sold goods worth Rs 300 lakh with a gross profit margin of 20 per cent. The stock
at the beginning and the end of the year was Rs 35 lakh and Rs 45 lakh respectively. What is
the inventory turnover ratio?

A. Sales = Rs 300 Lakh

Gross Profit = 20% of 300 = Rs 60 Lakh
COGS = Sales – Gross Profit = 300 – 60 = Rs 240 Lakh
Average Inventory = (35+45) ÷ 2 = Rs 40 Lakh

Inventory Turnover Ratio = Cost of Goods Sold (COGS)

Average Inventory

= 240 ÷ 40 = 6 (times per year)

Inventory Holding Period = 12 Months = 12 ÷ 6 = 2 months

Inventory Turnover Ratio
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 = Gross credit sales - Returns, if any, from customers

** Average Debtors = Simple average of debtors (including bills receivable) at the

beginning and at the end of year
Debtors Turnover Ratio - Example
Q. A firm has made credit sales of Rs 240 lakh during the year. The outstanding amount of
debtors at the beginning and at the end of the year respectively was Rs 27.5 lakh and Rs 32.5
lakh. Determine the debtors turnover ratio.

A. Net Credit Sales = Rs 240 Lakh

Average Debtors = (27.5+32.5) ÷ 2 = Rs 30 Lakh

Debtors Turnover Ratio = Net Credit Sales

Average Debtors

= 240 ÷ 30 = 8 (times per year)

Debtors Collection Period = 12 Months = 12 ÷ 8 = 1.5 months

Debtors Turnover Ratio
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 supplier's credit.

Creditors Turnover Ratio = Net Credit Purchases*

Average Creditors**

* Net Credit Sales = Gross credit purchases - Returns, if any, to suppliers

** Average Debtors = Simple average of creditors (including bills payable)

outstanding at the beginning and at the end of year
Creditors Turnover Ratio - Example
Q. The firm in previous Examples has made credit purchases of Rs 180 lakh. The amount
payable to the creditors at the beginning and at the end of the year is Rs 42.5 lakh and Rs
47.5 lakh respectively. Find out the creditors turnover ratio.

A. Net Credit Purchases = Rs 180 Lakh

Average Debtors = (42.5+47.5) ÷ 2 = Rs 45 Lakh

Creditors Turnover Ratio = Net Credit Purchases

Average Creditors

= 180 ÷ 45 = 4 (times per year)

Creditors Payment Period = 12 Months = 12 ÷ 4 = 3 months

Creditors Turnover Ratio
Cash Cycle
• The summing up of the three turnover ratios i.e. Inventory Turnover Ratio, Debtors
Turnover Ratio & Creditors Turnover Ratio (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 summarized below:

Inventory Holding Period Months 2.0
Add: Debtor's collection period Months + 1.5
Less: Creditor's payment period Months - 3.0
Net Months 0.5

As a rule, the shorter is the cash cycle, the better are the liquidity ratios
as measured above and vice versa.
Defensive Interval Ratio
• Defensive Interval Ratio is the ratio between quick assets and projected
daily cash requirement.

Defensive Interval Ratio = Liquid Assets

Projected Daily Cash Requirement*

* Projected Daily Cash Requirement = Projected Cash Operating Expenditure

No. of Days in a year (365)
Capital Structure Ratios
Leverage or 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 Second type

These ratios are computed from the These ratios are computed from the
balance sheet Income Statement

a) Debt - Equity Ratio a) Interest Coverage Ratio

b) Debt - Assets Ratio b) Dividend Coverage Ratio
c) Equity - Assets Ratio
Debt-Equity Ratio
• Debt-Equity Ratio measures the ratio of long-term or total debt to
shareholders equity.

Debt-Equity (D/E) Ratio = Total Debt

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.
Debt-Equity Ratio

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 jeopardized 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.
Trading on Equity
• Trading on equity (leverage) is the use of borrowed funds in expectation of
higher return to equity-holders.
Particular A B C D
a) Total Assets Rs. 000 1,000 1,000 1,000 1,000
Financing Pattern
Debt @ 15% Interest % 0% 20% 40% 80%
Debt Amount Rs. 000 0 200 400 800
Equity Capital Amount Rs. 000 1,000 800 600 200
b) Operating Profit (EBIT) Rs. 000 300 300 300 300
Less: Interest Rs. 000 0 30 60 120
Earning Before Taxes (EBT) Rs. 000 300 270 240 180
Less: Taxes @ 35% Rs. 000 105 94.5 84 63
Earning After Taxes (EAT) Rs. 000 195 175.5 156 117
Return on Equity (RoE) – EAT / Equity Capital % 19.5% 21.9% 26% 58.5%
Debt to Total Capital Ratio
• The relationship between creditors' funds and owner's 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

Debt to Total Assets Ratio
Debt to Total Assets Ratio = Total Debt
Total Assets
Some Other Ratios
Proprietary Ratio
Proprietary ratio indicates the extent to which assets are financed by owners
funds.

Proprietary Ratio = Proprietary Funds

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.
Coverage Ratios
Interest Coverage Ratio

Interest Coverage Ratio measures the firm's ability to make contractual interest payments.

Interest Coverage Ratio = EBIT (Earning before interest and taxes)

Interest

Dividend Coverage Ratio

Dividend Coverage Ratio measures the firm's ablllty to pay dividend on preference share which
carry a stated rate of return.

Dividend Coverage Ratio = EAT (Earning after taxes)

Preference Dividend
Profitability Ratios
Profitability Ratios
• Profitability Ratios can be computed either from

(i) sales; or
(ii) investments.

Related to Sales Related to Investments

a) Profit Margin a) Return on Investments

b) Expenses Ratio b) Return on Shareholders' Equity
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

100
Sales

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.
Profit Margin
Net profit margin can be computed in three ways:

(i) Operating Profit Ratio = EBIT (Earning before interest and taxes)
Net Sales

(ii) Pre-tax Profit Ratio = EBT (Earning before taxes)

Net Sales

(iii) Net Profit Ratio = Earning after interest and taxes

Net Sales
Profit Margin - Example
Q: From the following information of a firm, determine Particulars Amount
(i) Gross Profit Margin and Sales Rs Lakh 200
(ii) Net Profit Margin. Cost of Goods Sold (COGS) Rs Lakh 100
Other Operating Expenses Rs Lakh 50

A: Gross Profit = Sales – COGS = 200 – 100 = 100

Net Profit = Sales – COGS – Other Operating Expenses = 200 – 100 – 50 = 50

Gross Profit Margin = Gross Profit = 100 = 50%

Sales 200

Net Profit Margin = Net Profit = 50 = 25%

Sales 200
Expenses Ratio
(i) Cost of Goods Sold (COGS) = Cost of Goods Sold 100
Net Sales

(ii) Operating Expenses = Administrative Expenses + Selling Expenses

100
Net Sales

(iii) Administrative Expenses = Administrative Expenses

100
Net Sales

(iv) Selling Expenses = Selling Expenses 100

Net Sales

(v) Operating Ratio = COGS + Operating Expenses 100

Net Sales

(vi) Financial Expenses = Financial Expenses

100
Net Sales
Return on Investment
Return on Investments measures the overall effectiveness of management in
generating profits with its available assets.

Return on Assets (RoA) = EBIT (Earning before interest and taxes)

Average Total Assets

Return on Capital Employed (RoCE) = EBIT (Earning before interest and taxes)
Average Total Capital Employed
Return on Shareholder’s 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

Average Total Shareholder’s Equity

Return on Ordinary Shareholders' Equity (Net Worth)

= Net Profit after Taxes - Preference Dividend

Average Ordinary Shareholder’s Equity
Efficiency Ratios
Efficiency Ratios
• Activity ratios measure the speed with which various accounts/assets are converted into sales or cash.

• Inventory Turnover Ratio measures the efficiency of various types of inventories.

(i) Inventory Turnover Ratio = Cost of Goods Sold

Average Inventory

(ii) Raw Materials Turnover Ratio = Cost of Raw Materials Used

Average Raw Material Inventory

(iii) Work-in-Progress Turnover = Cost of Goods Manufactured

Average Work-in-Progress Inventory
Debtors Turnover Ratios
• Liquidity of a firm's receivables can be examined in two ways.

(i) Debtors Turnover Ratio = Credit Sales

Average debtors + Average Bills Receivable (B/R)

(ii) Average Collection Period = Month (Days) in a year

Debtors Turnover

Alternatively = Months (days) in a year (x) (Average Debtors+ Average (B/R)

Total Credit Sales

Ageing Schedule enables analysis to identify slow paying debtors.

Assets Turnover Ratio
(i) Total Assets Turnover = Cost of Goods Sold (COGS)
Average Total Assets

(ii) Fixed Assets Turnover = Cost of Goods Sold (COGS)

Average Fixed Assets

(iii) Capital Turnover = Cost of Goods Sold (COGS)

Average Capital Employed

(iv) Current Assets Turnover = Cost of Goods Sold (COGS)

Average Current Assets

(v) Working Capital Turnover = Cost of Goods Sold (COGS)

Net Working Capital
Some More Ratios
SN Ratio
1 Return on Shareholders' Equity
2 Return on Equity Funds
3 Earnings per Share (EPS)
4 Dividends per Share (DPS)
5 Earnings Yield
6 Dividend Yield
7 Dividend Payment/Payout (D/P Ratio)
8 Price-Earnings (P/E Ratio)
9 Book Value per Share
Formula
EAT / Average Total Shareholders' Equity
(EAT - Preference dividend) / Average Ordinary shareholders' equity (net
worth)
Net Profit available to Equity Shareholders' (EAT - DPS) / Number of Equity
Shares Outstanding (N)
Dividend paid to Ordinary Shareholders / Number of Ordinary Shares
Outstanding (N)
EPS / Market Price per Share
DPS / Market Price per Share
DPS / EPS
Market Price of a share / EPS
Ordinary Shareholders' Equity / Number of Equity Shares Outstanding
THANK YOU