Ratio Analysis - FAC - Section E & F

06-09-2022
Financial Accounting & Control

PGP 2022-24 (Term-I)
Surya Bhushan Kumar, Ph.D.

5 Sep 2022
Surya B. Kumar/ Finance and Accounting
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06-09-2022
Financial Numbers…
Different users
• Investors
• Promoters
• Banks/Financial Institutions
• Govt.
• FIIs
• Internal employees
• Society
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Analysis of Financial Statement

• Vertical analysis (as % of sales or
Revenue, or TA for BS items)
• Horizontal analysis (across time periods)
• Industry analysis (Peer analysis)
• Ratio analysis
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Ratio analysis
• Profitability analysis- a class of financial metrics that are used to
assess a business's ability to generate earnings relative to its
revenue, operating costs, balance sheet assets, or shareholders'
equity over time, using data from a specific point in time.
• Activity/Efficiency/Turnover analysis- a type of financial metric
that indicates how efficiently a company is leveraging the assets
on its balance sheet, to generate revenues and cash.
• Solvency analysis- a key metric used to measure an enterprise's
ability to meet its long-term debt obligations and is used often by
prospective business lenders.
• Liquidity analysis- Liquidity refers to both an enterprise's ability
to pay short-term bills and debts and a company's capability to
sell assets quickly to raise cash.
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Profitability ratios
• Gross Profit Margin (Rev from operation-
COGS)
• EBITDA Margin- (Gross profit– other
expenses)
• EBIT margin- (EBITDA + other income-
Dep)
• PAT margin
• Earnings per share (EPS)
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Profitability ratio
 The firm’s ability to earn maximum profit by the best
utilisation of its resources is called profitability.
 Gross Profit Ratio or Margin Ratio is calculated as,
𝐺𝑃 𝑅𝑎𝑡𝑖𝑜 = ∗ 100
 Higher ratio indicates higher margins that can be
o Due to higher selling price
o Lower Cost of goods sold
o Excess combination of selling price and cost where margin
is more
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Profitability ratios…contd.
• EBITDA Margin- (Gross profit– other expenses)
EBITDA
• = ∗ 100
 A metrics from operational perspective-Operational profitability.
 Tells investors how much operating cash is generated from each
dollar of revenue earned.
 Very important for industries with higher proportions of fixed
assets.
• EBIT margin- (EBITDA + other income- Dep)

EBIT
• = ∗ 100
 an alternative to EBITDA margin where FA is lower.
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• PAT Margin (Net income ratio)= ∗ 100
 How net income is generated as a percentage of revenue.
 Helps investors to assess whether the firm is generating income
after providing for all expenses or not.
 It is one of the most important indicators for a firm’s
profitability.
 Varies industry-wise.
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• EPS =
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Solvency & Liquidity ratios

• Current Ratio
• Acid test ratio or Quick ratio
• Debt to Equity (DE) ratio
• Interest coverage ratio
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Current Assets or Current Liabilities

 Current Liabilities common examples:
o Payables, Income Tax payables, Unclaimed
dividend, outstanding expenses, proposed
dividends, others
 Current Assets common examples:
o Cash and Bank balances, Receivables, Short term
investment, Marketable Securities, Prepaid
Expenses, Advance payments, Inventories
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Current ratio
 Current Ratio
 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 =
 High current ratio indicates blocked assets.
 Very low current ratio may indicate inability of
firm to settle current liabilities.
 Nothing like an ideal ratio- all industry specific or
contextual.
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Liquid ratio
 𝐿𝑖𝑞𝑢𝑖𝑑 𝑅𝑎𝑡𝑖𝑜 = ∗ 100
 Liquid assets means Current assets- (Inventory)
 Also known as the Quick ratio, or the Acid-test ratio.
 Represents the ability of the firm to settle liabilities even if inventory
cannot be sold.
 Liquid ratio is an indication of a firm’s ability to meet unexpected
demand of working capital.
 A high liquid ratio compared to current ratio may indicate under
stocking while a low liquid ratio indicate over stocking.
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Debt to Equity ratio

 𝐷𝑒𝑏𝑡 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜 =
– No fixed value is suitable.
• Indicative of Financial Position: The ratio implies how much debt a company
has, per unit of equity. As Equity comprises the capital owned by the
shareholders while debt is borrowed from third parties, this ratio can tell how
well positioned a company is in meeting its financial obligations by way of
equity funds. Therefore, a ratio of less than 1 would mean that the company
has a greater proportion of owned capital in comparison to borrowed one and
the opposite is true when it comes to a ratio greater than 1
• Target Capital Structure Metric: Most companies have built up their strategies
of targeted capital structure and work towards achieve the same, therefore an
over the time observation of this ratio is required to analyze how well is the
company meeting this criterion and how long a way it still needs to cover
• Investment Research Metric: When the market value numbers are used as
inputs to the ratio, the movement in share and debt prices indicate how
volatile the company stock is and acts as a starting point of whether the
company securities are a good fit into the investment portfolio
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Interest coverage ratio

 Interest coverage ratio or debt service ratio is
calculated as,
 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑎𝑡𝑖𝑜 =
 How well a firm is ready to pay its interest on
outstanding debt.
 Very useful for highly leveraged firms.
 Higher the number, better it is.
 Varies across industries.
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Activity/ turnover ratio

• Assets turnover ratio
• Working Capital turnover ratio
• Accounts receivable turnover ratio (ARTR) (times)
• Inventory turnover ratio (ITR) (times)
• Accounts payable turnover ratio (APTR) (times)
• Debtors days (in days)
• Inventory days (in days)
• Payable days (in days)
• Cash conversion cycle (in days)
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Activity ratio or efficiency ratio

 The funds of creditors and Owners are invested in various
assets to generate sale and profit. Better the management of
these assets, larger the amount of the sale and profit.
 These ratios indicate the speed with which assets are being
converted or turned over into sale. The reason why these
ratios are called turnover ratios or sales ratios.
 An activity ratio is the relationship between sales or cost of
goods sold and investment in various assets of the firm.
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Working Capital turnover ratio

 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜 =
 Higher ratio means low investment which leads to more profit or over
trading, leading to efficient management
 Lower ratio means high investment, leads to low profit or under
trading
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Assets turnover ratio

 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜 =
( )
 Investment in Fixed assets is made for the ultimate purpose of
efficient sale, the ratio is used to measure the efficiency in utilisSation
of fixed assets.
 Investment will not be included in fixed assets
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𝑨𝒄𝒄𝒐𝒖𝒏𝒕𝒔 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓

 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜 =
 Receivable turnover ratio provides for the collection and credit policies
of the firm.
 Provision for the bad debts shall not be deducted
 High ratio means high efficiency in collection and that receivables are
being collected more promptly
 A similar thing can be presented in days also
 Similarly, the payables can also be expressed as Payable turnover ratio
and in days.
• Accounts payable turnover ratio =
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Inventory turnover ratio

 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜 =
 It normally establishes a relationship between cost of sale and average
inventory levels.
 This ratio reveals the number of times finished stock is turned over
during a given accounting period in relation to sale
 Higher is better
o Reflects more profit
o Higher is also good from the liquidity point
 Inventory turnover can also be presented in days.
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Turnover ratios (in days)

• Accounts receivables days (365/Accounts receivables
turnover)
• Inventory days (365/ Inventory turnover)
• Payable days (365/Accounts payable turnover)
• Cash conversion cycle
– (inventory days + Accounts receivables – accounts payables)
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Market related/Overall ratios

• Price-to-Earnings (PE)
• Price to Book (PB) Ratio
• Dividend per Share (DPS)
• Dividend Payout (DP) Ratio
• Return on Assets (ROA)
• Return on Equity (ROE)
• Return on Capital Employed (ROCE)
• Dividend Yield
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Overall ratios… contd.

( )
• PE ratio = ( )
A metric showing the relationship of firms stock
price with its earnings.
Higher value may show the investors higher
expectation from the firm’s stock prices.
Highly dependent on EPS. May mislead the
investors in some distressful times. Why?
Forward and Trailing (TTM) PE
o Forward: estimated numbers for future
o Trailing: recent trailing 12 months-shows immediate
past results for the firm.
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• Price to Book Ratio =

Compares the firm’s market price to its book
value. Market valuation vs book value.
In general, MV > BV
Concept of Undervalued or Overvalued for
investors.
A tool of choice for value investors for long.
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• Dividend per Share =
A metric for investors who is interested in
knowing the part of profit due to him/her in the
firm’s income.
Are usually a cash payment to investors.
In long run, consistent and increasing dividend
provides for healthy operation of firm- the
Signalling hypothesis.
Do every company pay dividend?
Does the lower dividend per share a signal of
poor performance of the firm?
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• Return on Assets (ROA) =
• Return on Equity (ROE) =
• Return on Capital Employed (ROCE)=
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 Return on Equity
 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 (𝑅𝑂𝐸) = ∗ 100
 A simple but very useful metric for investment returns. An increasing

trend in ROE shows that the firm is generating the value for shareholders
in long run.
 Return on Total Assets

 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 = ∗ 100
 A metric measuring the profitability in comparison to its total assets.
 While doing a relative comparison, a higher value for both ratios mean that the
company is in a better position vis-a-vis its peer.
 This ratio does not yield sound result if assets are financed by funds provided by
Owners’ and Creditors both.
 The basic objective is to measure the effectiveness of the use of the funds, but
income earned by use of funds is not true because amount of interest is charged
against profit. 29
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 𝑹𝒆𝒕𝒖𝒓𝒏 𝒐𝒏 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒎𝒑𝒍𝒐𝒚𝒆𝒅 (𝑹𝑶𝑪𝑬) = ∗ 100
.
 How much operating income is generated for each doller

invested.
 Capital employed = Equity share capital + Reserve and
Surplus + Long term liab.
 The managerial efficiency of the firm can be assessed by
this measure. Higher number shows more efficient use of
capital put to use in firm.
 Compare the firm in similar industry.
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• Dividend yield =
 Mature companies will have more Dividend yield. Why?
 The market price has a major role and may mislead the
interpretation.
 Nature of industry is also important. E.g. technology
firms, Real estate firms etc.
 High dividend yield looks attractive to investors but may
be detrimental to firms. Why?
 https://economictimes.indiatimes.com/markets/stocks/n
ews/the-pros-and-cons-of-investing-in-high-dividend-
paying-stocks/articleshow/78965579.cms?from=mdr
 https://www.motilaloswal.com/blog-details/how-
attractive-are-dividend-yield-stocks-in-reality/1718
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The DuPont analysis

• ROE =
The 3-step DuPont is

• ROE = X X
Net profit Equity

Asset Turnover
Margin Multiplier
• Note: the avg values for Total Assets, and Shareholders’ equity may yield a different results
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Our managers’ quote…
But the
Market may
be EFFICIENT

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Assignment
• Industry wise ratio comparisons for HUL
• Why there is such difference?
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Thank You
Surya Bhushan Kumar

Room No. B-207
Mail: suryak@iimidr.ac.in
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06-09-2022

Financial Accounting & Control

Financial Accounting & Control

Surya Bhushan Kumar, Ph.D.

Surya B. Kumar/ Finance and Accounting

Financial Accounting & Control

Financial Accounting & Control

Financial Accounting & Control

Analysis of Financial Statement

Financial Accounting & Control

Financial Accounting & Control

Financial Accounting & Control

Financial Accounting & Control

• EBIT margin- (EBITDA + other income- Dep)

Financial Accounting & Control

Financial Accounting & Control

Financial Accounting & Control

Solvency & Liquidity ratios

Financial Accounting & Control

Current Assets or Current Liabilities

Financial Accounting & Control

Financial Accounting & Control

Financial Accounting & Control

Debt to Equity ratio

Financial Accounting & Control

Interest coverage ratio

Financial Accounting & Control

Activity/ turnover ratio

Financial Accounting & Control

Activity ratio or efficiency ratio

Financial Accounting & Control

Working Capital turnover ratio

Financial Accounting & Control

Assets turnover ratio

Financial Accounting & Control

𝑨𝒄𝒄𝒐𝒖𝒏𝒕𝒔 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓

• Accounts payable turnover ratio =

Financial Accounting & Control

Inventory turnover ratio

Financial Accounting & Control

Turnover ratios (in days)

Financial Accounting & Control

Market related/Overall ratios

Financial Accounting & Control

Overall ratios… contd.

Financial Accounting & Control

• Price to Book Ratio =

Financial Accounting & Control

Overall ratios… contd.

Financial Accounting & Control

Overall ratios… contd.

• Return on Equity (ROE) =

• Return on Capital Employed (ROCE)=

Financial Accounting & Control

Overall ratios… contd.

 A simple but very useful metric for investment returns. An increasing

 Return on Total Assets

Financial Accounting & Control

Overall ratios… contd.

 How much operating income is generated for each doller

Financial Accounting & Control

Overall ratios… contd.