CHAPTER 2

COMPARATIVE AND HISTORICAL ANALYSIS

CONTENTS

Introduction

Balance Sheet
Profit & Loss Account Cash Flow Statement Stakeholders Ratios and their types:

Liquidity ratios, Capital Structure ratios, Working Capital ratios, Profitability ratios, Valuation ratios, DU PONT analysis
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CONTENTS

Common size statements Uses of ratio analysis Limitations of ratio analysis.

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I NTRODUCTION

The historical financial performance is of significant importance for the various stakeholders.
Past performance forms the basis for future expectations. Past financial performance is reflected in financial statements. Financial statements consist of:

Balance Sheet Profit and Loss Account Cash Flow Statement.

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COMPARATIVE AND HISTORICAL ANALYSIS

B ALANCE S HEET

Reflects the financial condition of the firm as on a particular date.

Consists of:

Assets Liabilities

Owners Equity

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B ALANCE S HEET
Assets denote uses of funds

Assets are classified broadly into:

Fixed assets Investments Current assets, loans and advances Miscellaneous assets and losses.

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B ALANCE S HEET

Liabilities are the sources of external funds.

They are also referred to as obligations (or what the business owes) to outsiders.

Liabilities are broadly classified as:

Secured and unsecured loans Current liabilities and provisions Contingent liabilities.

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B ALANCE S HEET

Owners equity refers to the capital contributed by the shareholders (owners).

It consists of:

Paid up capital Reserves and Surplus

Share capital is of two types:

Equity share capital

Preference share capital
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P ROFIT A ND L OSS A CCOUNT

Shows the income earned and the expenses incurred during a period. Reflects earning capacity and profitability for a period. Also referred to as Income Statement.

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C ASH F LOW S TATEMENT

Summarizes sources and uses of cash.

Provides vital information for decision making and analysis.

Shows inflows and outflows of cash under the following three activities:

Cash flow from operating activities Cash flow from investing activities

Cash flow from financing activities.

Reflects the quality of liquidity (cash) of the business.

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S TAKEHOLDERS

All those who have stake in the business. Are varied and so are their interests. Examples include: Shareholders Suppliers Customers Competitors Lenders Employees Government & Society.
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S TAKEHOLDERS

Depending on their stake, they look for some specific set of information in the financial statements.
Though profitability remains their common focus, specific areas of financial performance are of greater interest to them. Financial statements at regular intervals provide answers to most questions that the they may have regarding the firms performance.
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R ATIO A ND T YPES

Tool for review and analysis of financial performance.

A ratio expresses the relationship between two related financial variables. It facilitates analysis by eliminating:

the problem of size and the bias that creeps in because of size.
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R ATIO A ND T YPES

By converting absolute figures into relative values, ratio analysis makes possible comparisons across time and firms.
There are 5 prominent categories of ratios:

Liquidity Ratios Capital Structure or Leverage Ratios Working Capital Ratios Profitability Ratios Valuation Ratios.
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L IQUIDITY R ATIOS

Denotes the firms capacity to pay its short-term obligations on time.

Depends on the level of current assets owned by the firm. Three prominent measures of liquidity:

Current ratio,

Acid test ratio and

Cash ratio.
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L IQUIDITY R ATIOS C URRENT R ATIO

The ratio of current assets to current liabilities.

Current Ratio=

Current Assets Current Liabilitie s

A current ratio of more than 1 indicates that the current assets are in excess of current liabilities.

Higher the current ratio better is the firm from the lenders perspective.

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L IQUIDITY R ATIOS A CID T EST R ATIO

Ratio of current assets, excluding inventory, to the current liabilities.

Acid Test Ratio =

Current Assets - Inventory Current Liabilities

Inventories are excluded as they are least liquid of the current assets. It is also referred to as quick ratio. It is more stringent measure of liquidity than current ratio.
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L IQUIDITY R ATIO C ASH R ATIO

Denotes the extent to which cash and near cash marketable securities are sufficient to meet the current liabilities.
Most stringent measure of firms liquidity.

Cash Marketable Securiti es Cash Ratio = Current Liabilities

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C APITAL S TRUCTURE R ATIOS

Measure the relationship between owners funds and borrowed funds.

A high usage of borrowed funds:

brings down the cost of financing increases returns to shareholders makes the firm more risky.

Can be sub-divided into:

structural ratios coverage ratio.

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C APITAL S TRUCTURE R ATIOS S TRUCTURAL R ATIOS

Structural ratios denote the composition of capital (i.e. proportion of

debt vis--vis equity used in financing).

Most commonly used structural ratios are:

Debt to equity ratio

Debt to asset ratio

Total outside liabilities to net worth.
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C APITAL S TRUCTURE R ATIOS S TRUCTURAL R ATIOS

Debt-equity ratio
Long Term Debt = Net Worth

Debt to asset ratio

Long Term Debt Net Assets

Total outside liabilities to net worth

= Total Outside Liabilitie s Net Worth
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C APITAL S TRUCTURE R ATIOS S TRUCTURAL R ATIOS

Denote the relationship between the borrowed funds and owners funds.
Generally a large value of structural ratio is disliked. It makes the firm vulnerable to business cycles.

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CAPITAL STRUCTURE RATIOSC OVERAGE R ATIOS

While structural ratios depict proportion of debt compared to equity or assets, coverage ratios express ability of the firm to service its debt.
Commonly used coverage ratios are:

Interest coverage ratio Debt service coverage ratio

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CAPITAL STRUCTUREC OVERAGE R ATIOS

Interest Cover =

Profit Before Interest and Taxes (PBIT) Interest obligation

Debt Service Coverage Ratio= PBIT Depreciation Non Cash Expense/Income Loan Instalment Interest Obligation 1 - Tax Rate

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CAPITAL STRUCTUREC OVERAGE R ATIOS

Higher the value of coverage ratios safer is the firm from the lenders perspective. Interest cover indicates the extent to which profit is able to pay interest. Higher ratio means more cushion available to lenders. Debt service coverage ratio measures the ability of the firm to meet out its total debt obligations (both interest and principal).
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W ORKING C APITAL R ATIOS

Denote the efficiency of firms in handling their operations.

More quickly a firm turns over the current assets into cash, more efficient it is.

Also referred to as Turnover ratios or Activity Ratios.

At an aggregate level, efficiency of internal operations is measured by current assets required to generate sales (i.e. current assets
turnover ratio).
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W ORKING C APITAL R ATIOS

Further insight to operational efficiency is provided by analysing components of working capital.

Commonly used ratios are:

Inventory turnover Debtors turnover Creditors turnover.

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C URRENT A SSET T URNOVER

Defined as sales to current assets.

Current Assets Turnover Ratio Sales = Average Current Assets

Indicates how many times the current assets have been turned over into sales in a given period (usually a year). An increasing ratio is a sign of improving efficiency.
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C URRENT A SSET T URNOVER

Alternatively, it can also be expressed in terms of no. of days (i.e. current assets holding period)
Lesser the holding period, more efficient the operations.

Current Assets HoldingPeriod Average Current Assets = X 365 days Sales

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I NVENTORY T URNOVER R ATIO

Expresses the relationship between cost of goods sold and inventory.

Inventory Turnover Ratio= Cost of Goods Sold Average Inventory

Alternatively it can also be expressed as no. of days of inventory (referred to as

Inventory holding period)
Inventory Holding Period = Average Inventory x 365 Days Cost of Goods Sold

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I NVENTORY T URNOVER R ATIO

Denotes efficiency in inventory management.

An increasing ratio (or a decreasing holding period) signifies better inventory management.

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D EBTOR T URNOVER R ATIO

Expresses the relationship between sales and debtors.

Debtors Turnover Ratio= Sales Average Debtors

Alternatively, it can be expressed in no. of days (referred to as Average Collection Period)

Average Collection Period = Average Debtors x 365 Days Sales

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DEBTOR TURNOVER RATIO

It reflects the efficiency with which the firm realises its sales i.e. how fast the debtors are turned over into cash. Improvement in the ratio (or reduction in the average collection period) indicates better receivables management.

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C REDITORS T URNOVER R ATIO

Reflects the number of times the dues to the suppliers are settled.
Creditors Turnover Ratio= Purchases Creditors

Alternatively, it can be expressed in terms of no. of days (referred to as average

credit availed)
Average Credit Availed Creditors = x 365 Days Purchases
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P ROFITABILITY R ATIOS

Reflect business's ability to generate earnings.

Higher ratios indicate better performance. Examples of profitability ratios are:

Profit margin Return on capital employed Return on assets Return on equity.

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P ROFITABILITY R ATIOS C ONTRIBUTION M ARGIN

Margin available, vis--vis sales, once the variable costs have been covered.
Contribution Margin (%) = Sales - Variable cost x 100 Sales

As this margin goes to meet the fixed costs larger margin is desirable.

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P ROFITABILITY R ATIO G ROSS P ROFIT M ARGIN

Gross Profit expressed as a percentage of sales.

Gross Profit Margin (%) Sales - Cost of Goods Sold x100 Sales

Reflects production efficiency.

Higher the gross profit margin more is the cushion to meet out the overheads.
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P ROFITABILITY R ATIO N ET P ROFIT M ARGIN

Net Profit Margin (or simple Net margin) is ratio of Profit After Tax (PAT) to sales.
PAT Net Profit Margin(%) x100 Sales

Reflects the overall efficiency of the business.

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P ROFITABILITY R ATIO
R ETURN

ON

C APITAL E MPLOYED (ROCE)

Is a measure of efficiency of capital.

Return on Capital Employed (ROCE) % = EBIT(1 - T) x100 Net Assets

Also known as Return on Investment (ROI).

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P ROFITABILITY R ATIO R ETURN ON E QUITY (ROE)

Return that the firm has been able to earn on the equity financed portion of its capital.
ROE% = Profit After T ax (PAT ) x100 Net Worth

Increasing ROE denotes improving efficiency of the firm in handling its shareholders funds.
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P ROFITABILITY R ATIO EPS A ND DPS

Earnings per Share (EPS) is the return earned on a per share basis.
EPS (Rs./Share = ) PAT Number of shares

The part of EPS that the firm distributes to the shareholders is known as Dividend per share (DPS).
DPS (Rs./Share = ) Dividend Number of shares

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VALUATION R ATIOS

Assess the value that stock market places on stocks.

Commonly used ratios are:

Earnings and dividends yield

Price earnings ratio Price to book ratio.

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VALUATION R ATIO
E ARNINGS AND D IVIDENDS Y IELD

Earnings/dividends expressed as a percentage of market price gives earnings/dividends yields respectively.

EPS Market Price per Share

Earnings Yield (%)

DPS Dividends Yield (%) Market Price per Share

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VALUATION RATIOSP RICE E ARNINGS R ATIO

Shows how much the investors are willing to pay per rupee of reported profits.
Price Earnings Ratio (P/E) Market Price per Share Earnings per Share

Also referred to as P/E multiple. Reflects the confidence that the market reposes in a given firm/scrip.
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VALUATION R ATIO P RICE B OOK R ATIO

Ratio of market price of a stock to its book value.

Price to Book Ratio (P/B) Market Price per Share Book Value per Share

Reflects the perception of investors towards a stock. Firms with relatively higher returns on equity generally sell at higher P/B.
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D UPONT A NALYSIS

Introduced by DU Pont Co. of USA.

Establishes relationship of few important ratios.

Return on assets or the return on capital employed is a function of margin on sales (i.e. profitability) and the efficiency of the assets utilisation (i.e. operating efficiency).
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D UPONT A NALYSIS
ROE Profit After Tax Profit After Tax Assets Net Worth Assets Net Worth Profit After Tax Loan Net Worth Assets Net Worth

ROA ( 1

Debt ) Equity
Debt ) Equity

Net Profit Asset Turnover (1

OperatingMargin OperatingEfficiency FinancialLeverage

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C OMMON S IZE S TATEMENTS

A financial statement that displays all items as percentages of a common base figure.
Allow easy analysis across companies and across time. Enables to remove bias due to size.

The values are expressed as a percentages of revenue or assets.

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U SES O F R ATIO A NALYSIS

Ratio analysis helps in:

Diagnosis and objective analysis of financial performance. Financial planning and decision-making by creditors Setting a benchmark for performance.

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L IMITATIONS O F R ATIO A NALYSIS

Arbitrariness in the selection Lack of unanimous definitions

Locational, business, and accounting differences.

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