Ratio Analysis

Professor Rajendra K. Lagu

Department of Electrical Engineering

e-mail: rklagu@ee.iitb.ac.in
Webpage: http://www.ee.iitb.ac.in/~rklagu
 Balance Sheet
• Shows the status of company’s financial position. It
is actually a snap shot at the instant it is prepared,
what the company owns and owes.

• Not duration specific, such as P&L statement is.

• Ideally, can be calculated every day; however

companies usually calculate on a quarterly basis.

• Shows the sources and applications of funds.

• Numbers by themselves are not important; ratios

are.

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 Balance Sheet continued…

• Double entry accounting system: Assets and

Liabilities must balance

• Every transaction gets entered at two places under

different heads so that accounts are “balanced”.

• Credit / Debit or Assets / Liabilities

• Compare the movement across the quarters or

years

• Scope for manipulation: Asset valuation, payment

realization (GAAP)

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Balance Sheet Structure

Assets Liabilities
Fixed Assets Long Term Liabilities
Land, Buildings, Equity, Term Loans,
Vehicles, Equipment Debentures
Current Assets Current Liabilities
Cash, Accounts Accounts Payable
Receivable
Inventory: Short Term Loans
WIP, Finished Goods

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 Financial Management Decisions

Assets Liabilities
Capital Fixed Assets Long Term Liabilities
budgeting Land, Buildings, Equity, Term Loans, Capital
decisions Vehicles, Equipment Debentures structure
Current Assets Current Liabilities decisions
Cash, Accounts Accounts Payable
Receivable,
Marketable Securities
Inventory: Short Term Loans
WIP, Finished Goods

Operating policy decisions

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Assets

• You pay for them to acquire them and so you

“own” them
• They generate revenues later in short or long
term
• Liquidity of an asset: Length of the time it
takes to generate revenue
• Their value generally depreciates over time
• They can be revalued on some events
• They can be tangible or intangible (goodwill,
monopoly)

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 Examples of Assets

• Cash in bank and in hand (bank balance, physical

cash)
• Marketable Securities (parked funds)
• Accounts Receivables
• Inventory (Work In Progress)
• Inventory (Finished goods)
• Land, Building, Plants, Offices, Vehicles
• Equipment (PCs, Office equipment, Test jigs)
• Patents, Copyrights, Trademarks
• Goodwill, Brand Position

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Liabilities

• Money that has been made available to

the firm, received from outside sources.

• The firm owes them to outside agents

including the shareholders

• Liabilities can have short term, long

term, or no term repayment schedules

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Examples of Liabilities

• Accounts payable (supplier credit)

• Accrued corporate tax
• Short term loans
• Debentures
• Long term loans
• Equity (common stock + preferred
stock)
• Retained earnings
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Balance Sheet of a Prototype Company

• Frequency of P&L statement calculation

• Operating Cycle duration: 2 weeks, 2 months,

1 year

• Inventory turns and profit margins are closely

linked to the operating cycle

• Traders, Manufacturers, Knowledge-based

companies

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 A Typical Manufacturing Company Starts
Operation

Two promoters deposit Rs 5 lakhs in the company account as

equity

XYZ Private Limited

Balance Sheet at April 1, 2001

Assets Liabilities
Cash 5,00,000 Equity 5,00,000
Total 5,00,000 Total 5,00,000

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A lathe is bought on cash basis

Owner pays Rs 3 lakhs from the bank acount

Assets Liabilities
Cash 2,00,000 Equity 5,00,000
Plant 3,00,000
Total 5,00,000 Total 5,00,000

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 Raw material worth Rs 80,000 bought on a 60
day credit basis

No payment is done so cash position does not change

Assets Liabilities
Cash 2,00,000 Equity 5,00,000
Plant 3,00,000 Account 80,000
Payable
Inventory 80,000
Total 5,80,000 Total 5,80,000

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Raw material worth Rs 40,000 processed and sold for Rs 50,000 with
a 30 day credit

No payment is done so cash position does not change, but

inventory is reduced

Assets Liabilities
Cash 2,00,000 Equity 5,00,00
0
Plant 3,00,000 Accounts Payable 80,000
Inventory 40,000 Retained Earnings 10,000
Accounts 50,000
Receivable
Total 5,90,000 Total 5,90,00
0
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Customer pays up after 20 days

Payment deposited in bank so cash position changes

Assets Liabilities

Cash 2,50,000 Equity 5,00,000

Plant 3,00,000 Accounts Payable 80,000

Inventory 40,000 Retained Earnings 10,000

Accounts 00,000
Receivable
Total 5,90,000 Total 5,90,000

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Supplier credit period is over and raw material is paid for after 60 days

Payment done from bank so cash balance reduces

Assets Liabilities

Cash 1,70,000 Equity 5,00,000

Plant 3,00,000 Accounts Payable 00,000

Inventory 40,000 Retained Earnings 10,000

Accounts 00,000
Receivable
Total 5,10,000 Total 5,10,000

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A new promoter buys 10,000 shares of Rs 10 face value at a premium
of Rs 20

Payment done to bank so cash balance increases

Assets Liabilities

Cash 4,70,000 Equity 6,00,000

Plant 3,00,000 Accounts Payable 00,000

Inventory 40,000 Retained Earnings 10,000

Accounts 00,000 Share Premium a/c 2,00,000

Receivable
Total 8,10,000 Total 8,10,000

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Profit & Loss Account (Income Statement)

Sales Revenues 4,00,000

Other Revenues 1,00,000
Total Revenues 5,00,000 100 %
Cost of Goods Sold 2,00,000 40 %
Gross Profit 3,00,000 60 %
Operating Expenses 1,50,000 30 %
PBITD 1,50,000 30 %
Interest + Tax + 25,000 5%
Depreciation
Net Profit 1,25,000 25 %

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Cash Flow / Funds Flow Statement

• Differences in successive balance sheets

• Sources of Funds
 Net profit
 Issue of new share capital
 Sale of fixed assets
 New loans

• Use of Funds
 Payment of dividends
 Purchase of fixed assets
 Repayment of loans

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Ratio Analysis
• Compare the performance of the company for
three successive years

• The absolute numbers change so compare

ratios

• Compare two companies of differing size but

from the same industry, e.g, Infosys and Mastek

• Calculate industry-wide numbers (net profit

margins for automobile companies)

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 Liquidity Ratios

• Measure a firm’s ability to meet its short term

obligations
• Show trends early and so corrective actions can be
taken in the working capital management

• Current Ratio: Current Assets / Current Liabilities

• Acid Test Ratio or Quick Ratio:

(Current Assets – Inventory) / Current Liability
(Cash or cash equivalent) / Current Liability

A firm is “solvent” if its assets are greater than

outside liabilities. A firm is “liquid” if its current
assets are greater than its current liabilities

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Gearing Ratios

• Leverage of a firm: Proportion of its

long term liabilities that are debts

• Long term liabilities = Debts + Equity

• Debt/Equity ratio
Loan Capital / Share holder’s funds

Gears, Leverage: Mechanical Engg terms

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Asset Utilization Ratios

• Return on Total Investment: management’s

skill in exploiting the funds made available
ROI =
PBT / (Shareholders’ funds + Long term
loans)
• Return on Shareholders’ Equity
ROE =
PBT / (Shareholders’ funds)
Sales / Total Capital Employed

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Profitability Ratios

• Net Profit Margin = NP / Sales

• Gross Profit Margin = GP / Sales

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Market Value related Ratios

• EPS (Earning Per Share) :

NP / Total outstanding shares

• P/E : Market Price / Earning Per Share

• Revenue Multiple: Revenues / Assets

• Market to Book: Market Value / Book Value

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Limitations of Financial Statements

• They are backward looking: Accrued results

of the past year / quarter
• Company’s value depends on its future
profitability which depends on many factors
not reflected in the balance sheet, which are
non-monetary

 Nature and innovativeness of it products

 Technology landscape (product obsolescence)
 Competitors
 Economic conditions (recession / boom), government
policies
 Staff and management morale

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Balance Sheet of Three IT Companies at 31.03.2001
(in Rs Cr) (http://www.indiainfoline.com)

Company Infosys Wipro Satyam

Equity 33.0 47.0 56.0

Share premium 320.0 592.0 87.0

Retained earnings 1030.0 1300.0 670.0

Net Worth 1383.0 1965.0 813.0

Debt 0.0 45.0 172.0

Capital employed 1383.0 2010.0 985.0

Fixed Assets 600.0 902.0 288.0

Account receivable 430.0 600.0 475.0

Cash & bank 385.0 446.0 151.0

balance
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Profit and Loss Statement of Three IT Companies for 12 Months Ending
31.03.2001 (in Rs Cr)

Company Infosys Wipro Satyam

Sales 1900.0 3054.0 1220.0

Other income 59.0 69.0 22.0

Total income 1959.0 3123.0 1242.0

Cost of material 238.0 380.0 128.0

Comm + traveling 190.0 633.0 128.0

cost
Employee cost 718.0 422.0 486.0

Total cost of sales 1151.0 2252.0 776.0

PBIDT 808.0 870.0 466.0

PAT 629.0 668.0 Prior year

adjusted
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