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6-1

**FINANCIAL STATEMENTS ANALYSIS
**

Ratio Analysis

**Common Size Statements
**

Importance and Limitations of Ratio Analysis Mini Case

6-2

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.

6-3

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) Interfirm 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.

6-4

Types of Ratios Liquidity Ratios Capital Structure Ratios Profitability Ratios Efficiency ratios Integrated Analysis Ratios Growth Ratios 6-5 .

000 20.000 6-6 .000 1.000 75.00.000 1.000 Rs 30.00.80. Table 1: Net Working Capital Particulars Company A Company B Total current assets Total current liabilities NWC Table 2: Change in Net Working Capital Particulars Rs 1.000 1.000 10.00.20.00.000 Rs 2.000 60.000 Company A Company B Current assets Current liabilities NWC Rs 1.Net Working Capital Net working capital is a measure of liquidity calculated by subtracting current liabilities from current assets.000 25.

6-7 .Liquidity Ratios Liquidity ratios measure the ability of a firm to meet its short-term obligations.

80.000 3:1 6-8 .000 Particulars Current Assets Firm A Rs 1.Current Ratio Current Ratio is a measure of liquidity calculated dividing the current assets by the current liabilities Current Ratio = Current Assets Current Liabilities Firm B Rs 30.000 Current Liabilities Current Ratio Rs 1.5:1) Rs 10.000 = 3:2 (1.20.

Acid-test Ratio = Quick Assets Current Liabilities Quick Assets = Current assets – Stock – Pre-paid expenses 6-9 .Acid-Test Ratio The quick or acid test ratio takes into consideration the differences in the liquidity of the components of current assets.

5 : 1 6 .Example 1: Acid-Test Ratio Cash Debtors Inventory Total current assets Total current liabilities (1) Current Ratio (2) Acid-test Ratio Rs 2.000 2.000 12.10 .000 2:1 0.000 16.000 8.

Supplementary Ratios for Liquidity Inventory Turnover Ratio Debtors Turnover Ratio Creditors Turnover Ratio 6 .11 .

12 . Cost of goods sold Inventory turnover ratio = Average inventory The cost of goods sold means sales minus gross profit. 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. The average inventory refers to the simple average of the opening and closing inventory. 6 .Inventory Turnover Ratio The ratio indicates how fast inventory is sold.

000 + Rs 45.Example 2: Inventory Turnover Ratio A firm has sold goods worth Rs 3. (6) 6 .00.000 respectively.00.000 – Rs 60. The stock at the beginning and the end of the year was Rs 35.000 and Rs 45.000) (Rs 35.000) ÷ 2 = 6 (times per year) 12 months Inventory = = 2 months holding period Inventory turnover ratio. What is the inventory turnover ratio? Inventory turnover ratio = (Rs 3.13 .000 with a gross profit margin of 20 per cent.

14 . Debtors turnover ratio = Net credit sales Average debtors Net credit sales consist of gross credit sales minus returns. from customers. Average debtors is the simple average of debtors (including bills receivable) at the beginning and at the end of year. A high ratio is indicative of shorter time-lag between credit sales and cash collection. 6 . if any.Debtors Turnover Ratio The ratio measures how rapidly receivables are collected. A low ratio shows that debts are not being collected rapidly.

000 8 (times per year) 1. The outstanding amount of debtors at the beginning and at the end of the year respectively was Rs 27.500 and Rs 32.000 during the year.500) ÷ 2 = 12 Months Debtors turnover ratio.40.40. (8) = Debtors collection period = .500.500 + Rs 32. Determine the debtors turnover ratio.5 Months 6 .15 = (Rs 27. Debtors turnover ratio Rs 2.Example 3: Debtors Turnover Ratio A firm has made credit sales of Rs 2.

Creditors Turnover Ratio A low turnover ratio reflects liberal credit terms granted by suppliers. 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. while a high ratio shows that accounts are to be settled rapidly. Creditors turnover ratio = Net credit purchases Average creditors Net credit purchases = Gross credit purchases .Returns to suppliers. Average creditors = Average of creditors (including bills payable) outstanding at the beginning and at the end of the year. 6 .16 .

500) ÷ 2 12 months = 4 (times per year) = Creditors turnover ratio.500 respectively.80.000) (Rs 42.500 Rs 47. (4) = 3 months 6 . Find out the creditors turnover ratio.17 . Creditors turnover ratio Creditor’s payment period = (Rs 1.500 and Rs 47. The amount payable to the creditors at the beginning and at the end of the year is Rs 42.80.000.Example 4: Creditors Turnover Ratio The firm in previous Examples has made credit purchases of Rs 1.

the shorter is the cash cycle. collections from debtors and payment to creditors.The summing up of the three turnover ratios (known as a cash cycle) has a bearing on the liquidity of a firm. The cash cycle captures the interrelationship of sales.5 months – 3 months 0.18 . the better are the liquidity ratios as measured above and vice versa. 6 .5 months As a rule. The combined effect of the three turnover ratios is summarised below: Inventory holding period Add: Debtor’s collection period Less: Creditor’s payment period 2 months + 1.

19 . Defensiveinterval ratio Liquid assets = Projected daily cash requirement Projected daily cash requirement = Projected cash operating expenditure Number of days in a year (365) 6 .DEFENSIVE INTERVAL RATIO Defensive interval ratio is the ratio between quick assets and projected daily cash requirement.

000.500.82.000 Rs 500 Projected daily cash requirement = Defensive-interval ratio = = Rs 500 = 80 days 6 . Rs 1.82.Example 5: Defensive Interval Ratio The projected cash operating expenditure of a firm from the next year is Rs 1.500 365 Rs 40. Determine the defensive-interval ratio.20 . It has liquid current assets amounting to Rs 40.

Cash-flow From Operations Ratio Cash-flow from operation ratio measures liquidity of a firm by comparing actual cash flows from operations (in lieu of current and potential cash inflows from current assets such as inventory and debtors) with current liability. Cash-flow from operations ratio Cash-flow from operations Current liabilities = 6 .21 .

22 Second type: These ratios are computed from the Income Statement (a) Interest coverage ratio (b) Dividend coverage ratio .Leverage Capital Structure Ratio There are two aspects of the long-term solvency of a firm: (i) Ability to repay the principal when due. there are two different types of leverage ratios. Accordingly. and (ii) Regular payment of the interest . First type: These ratios are computed from the balance sheet (a) Debt-equity ratio (b) Debt-assets ratio (c) Equity-assets ratio 6 . Capital structure or leverage ratios throw light on the long-term solvency of a firm.

a relatively high stake of the owners implies sufficient safety margin and substantial protection against shrinkage in assets. If the project should fail financially. Debt-equity ratio measures the ratio of long-term debt = Total external Total Debt Obligations Debt-equity ratio = to shareholders equity term or total de3bt Shareholders’ equity If the D/E ratio is high. the creditors would lose heavily. To the creditors.23 Long-term Debt + Short .I. It is danger signal for the lenders and creditors. the owners are putting up relatively less money of their own. A low D/E ratio has just the opposite implications. Debt-equity ratio Debt-equity ratio measures the ratio of long-term or total debt to shareholders equity. 6 .

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.24 . its operational flexibility is not jeopardised and it will be able to raise additional funds.For the company also. the servicing of debt is less burdensome and consequently its credit standing is not adversely affected. 6 .

000 600 400 300 60 240 84 156 26 D 1. Trading on Equity Particular (a) Total assets Financing pattern: Equity capital 15% Debt (b)Operating profit (EBIT) Less: Interest Earnings before taxes Less: Taxes (0.5 6 .5 21.5 (Amount in Rs thousand) B 1.5 175.000 1.35) Earnings after taxes Return on equity (per cent) A 1.000 200 800 300 120 180 63 117 58.9 C 1.25 .000 — 300 — 300 105 195 19.Trading on Equity Trading on equity (leverage) is the use of borrowed funds in expectation of higher return to equity-holders.000 800 200 300 30 270 94.

+ 6 .II. Debt to Total Capital 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.26 .

extent to which assets Total debt Total assets Proprietary ratio = Capital Gearing Ratio Proprietary funds X 100 Total assets Capital gearing ratio is used to know the relationship between equity funds (net worth) and fixed income bearing funds (Preference shares.III.27 . debentures and other borrowed funds. 6 . Debt to total assets ratio Debt to total assets ratio = Proprietary Ratio Proprietary ratio indicates the are financed by owners funds.

28 .Coverage Ratio Interest Coverage Ratio Interest Coverage Ratio measures the firm’s ability to make contractual interest payments. EBIT (Earning before interest and taxes) Interest Dividend coverage ratio = EAT (Earning after taxes) Preference dividend 6 . Interest coverage ratio = Dividend Coverage Ratio Dividend Coverage Ratio measures the firm’s ability to pay dividend on preference share which carry a stated rate of return.

Debt Service Coverage Ratio Debt-service coverage ratio (DSCR) is considered a more comprehensive and apt measure to compute debt service capacity of a business firm. ∑ DSCR n = t=1 EATt + Interestt ∑ t=1 n + Depreciationt + OAt Instalmentt DEBT SERVICE CAPACITY Debt service capacity is the ability of a firm to make the contractual payments required on a scheduled basis over the life of the debt.29 . 6 .

00 18.00 18.00 18.60 10.67 34.00 18.01 19.00 18.40 18.41 Interest on term loan during the year 19.70 18.Example 6: Debt-Service Coverage Ratio Agro Industries Ltd has submitted the following projections.08 7.12 12.61 18.68 lakh every year.77 36.14 17. You are required to work out yearly debt service coverage ratio (DSCR) and the average DSCR.00 The net profit has been arrived after charging depreciation of Rs 17.30 . © Tata McGraw-Hill Publishing Company Limited. (Figures in Rs lakh) Year 1 2 3 4 5 6 7 8 Net profit for the year 21.20 18.64 15.00 18.04 Nil Repayment of term loan in the year 10.33 16. Financial Management 6 .56 5.

97 2.77 36.68 4 19.65 1.00 18.00 18.56 23.00 18. 4 + col.33 16.62 1.68 17.67 34.00 18.04 18.12 12.04 Nil 6 10.68 17.60 28.00 DSCR [col. Financial Management .71 1.61 18.78 1.08 7.05 34.40 18.68 17.64 41.14 17.48 46.56 5.83 6 . 6) 7 29.Solution Table 3: Determination of Debt Service Coverage Ratio (Amount in lakh of rupees) Ye ar Net profit Depreciation Interest Cash available (col. of times)] 8 1.08 1.00 18.09 Principal instalment Debt obligation (col.31 © Tata McGraw-Hill Publishing Company Limited. 5 ÷ col.96 1.08 25.49 70.70 18. 2+3+4) 5 58.64 33.68 17.68 17.41 3 17.60 10.09 68.89 1 1 2 3 4 5 6 7 8 2 21. 7 (No.37 43.12 30.81 49.01 19.84 35.00 Average DSCR (DSCR ÷ 8) 1.00 18.68 17.64 15.68 17.20 18.

32 .Profitability Ratio Profitability ratios can be computed either from sales or investment. Profitability Ratios Profitability Ratios Related to Sales (i) Profit Margin (ii) Expenses Ratio Related to Investments (i) Return on Investments (ii) Return on Shareholders’ Equity 6 .

Gross profit margin = Gross Profit X 100 Sales 6 .33 .Profit Margin Gross Profit Margin Gross profit margin measures the percentage of each sales rupee remaining after the firm has paid for its goods.

Net Profit Ratio = Earning after interest and taxes Net sales 6 . Pre-tax Profit Ratio = iii. Net profit margin can be computed in three ways Earning before interest and taxes Net sales Earnings before taxes Net sales i. Operating Profit Ratio = ii.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.34 .

00. Cost of goods sold 1.000 Rs 2. determine (i) Gross profit margin and (ii) Net profit margin.000 3. 1.000 Rs 2.35 .00.00.000 Rs 50.00.00. Sales Rs 2.000 2. Other operating expenses 50.000 = 50 per cent (2) Net profit margin = = 25 per cent 6 .Example 7: From the following information of a firm.000 (1) Gross profit margin = Rs 1.

Administrative expenses = Net sales iv.36 . Net sales Administrative expenses iii. Operating ratio = X 100 Net sales vi. Financial expenses = Financial expenses Net sales X 100 6 . Cost of goods sold = ii.Expenses Ratio i. Selling expenses ratio = Selling expenses Net sales X 100 X 100 X 100 Cost of goods sold + Operating expenses v. + Selling exp. Operating expenses = Cost of goods sold X 100 Net sales Administrative exp.

i.Return on Investment Return on Investments measures the overall effectiveness of management in generating profits with its available assets.37 . Return on Capital Employed (ROCE) ROCE = EAT + (Interest – Tax advantage on interest) Average total capital employed 6 . Return on Assets (ROA) ROA = EAT + (Interest – Tax advantage on interest) Average total assets ii.

Return on Shareholders’ Equity Return on shareholders equity measures the return on the owners (both preference and equity shareholders) investment in the firm.38 . Return on total shareholders’ equity = Net profit after taxes X 100 Average total shareholders’ equity Return on ordinary shareholders’ equity (Net worth) = Net profit after taxes – Preference dividend X 100 Average ordinary shareholders’ equity 6 .

Cost goods sold i. Inventory Turnover measures the activity/liquidity of Raw materials turnover = inventory of a firm. Inventory Turnover measures theof activity/liquidity of Inventory Turnover Ratio = Average inventory inventory of a firm.39 .Efficiency Ratio Activity ratios measure the speed with which various accounts/assets are converted into sales or cash. the speed with which inventory is sold Average raw material inventory of goods manufactured i. the speed with which inventory is sold Cost of raw materials used i. Inventory Turnover measuresCost the activity/liquidity of Work-in-progress turnover = Average work-in-progress inventory inventory of a firm. the speed with which inventory is sold 6 . Inventory turnover measures the efficiency of various types of inventories.

Debtors turnover = a firm.Debtors Turnover Ratio Liquidity of a firm’s receivables can be examined in two ways. the speed with Average whichdebtors inventory + Average is sold bills receivable (B/R) 2.40 . analysis to identify 6 . Average collection period = Months (days) in a year Debtors turnover Months (days) in a year (x) (Average Debtors + Average (B/R) i. the speed with which inventory is credit sold sales Ageing Schedule enables slow paying debtors. Credit sales i. Inventory Turnover measures the activity/liquidity of inventory of a Alternatively = Total firm. Inventory Turnover measures the activity/liquidity of inventory of i.

Inventory Turnover measures the activity/liquidity of inventory of iii.Assets Turnover Ratio Assets turnover indicates the efficiency uses all its assets to generate sales. Inventory Turnover measures the activity/liquidity v. Total assets turnover = a firm. Capital turnover = Average is capital a firm.41 . the speed with which inventory is sold 6 . Fixed assets turnover = Cost of goods sold Average fixed assets Cost of goods sold i. the speed with which inventory sold employed Cost of goods sold iv. Working capital turnover = Net working capital a firm. Current assets turnover = Average current assets Cost of goods sold of inventory of i. the speed with which inventory Average total is sold assets ii. with which firm Cost of goods sold of inventory of i. Inventory Turnover measures the activity/liquidity i.

4) Dividends per share (DPS) = Dividend paid to ordinary shareholders/Number of ordinary shares outstanding (N). Dividend payment/payout (D/P) ratio = DPS/EPS. 6 . 8) 9) Price-earnings (P/E) ratio = Market price of a share/EPS. Dividend Yield = DPS/Market price per share. 3) Earnings per share (EPS) = Net profit available to equity shareholders’ (EAT – Dp)/Number of equity shares outstanding (N). Book value per share = Ordinary shareholders’ equity/Number of equity shares outstanding. 5) 6) 7) Earnings yield = EPS/Market price per share. Return on equity funds = (EAT – Preference dividend)/Average ordinary shareholders’ equity (net worth).1) 2) Return on shareholders’ equity = EAT/Average total shareholders’ equity.42 .

Net profit margin = Earning after taxes/Sales Asset turnover = Sales/Total assets Earning after taxes Sales of inventory EAT of i.43 . is computed by multiplying net profit margin and assets turnover. Earning power = Net profit margin × Assets turnover Where.Return on Assets Earning Power Earning power is the overall profitability of a firm. the speed with which Salesinventory isTotal sold Assets Total assets 6 . Inventory Turnover measures the activity/liquidity x x Earning Power = a firm.

that is.00.00. Table 4 shows the ROA based on two components.EXAMPLE: 8 Assume that there are two firms. Total assets 4. Table 4: Return on Assets (ROA) of Firms A and B Particulars 1.000 4. each having total assets amounting to Rs 4.00.000 10 1 10 Firm B Rs 40.000.00. Firm A has sales of Rs 4. whereas the sales of firm B aggregate Rs 40.000 40.000 4.00.000 1 10 10 6 . Assets turnover (1 ÷ 3) (times) 6.000.00. Net sales 2. Determine the ROA of firms A and B. A and B. each. Net profit 3. ROA ratio (4 × 5) (per cent) Firm A Rs 4. Profit margin (2 ÷ 1) (per cent) 5.00. and average net profits after taxes of 10 per cent.000. Rs 40.000.44 .000 40.

Return on Equity (ROE) ROE is the product of the following three ratios: Net profit ratio (x) Assets turnover (x) Financial leverage/Equity multiplier EAT EBT x EBT EBIT x EBIT x Sales Sales Assets x Assets Equity 6 .45 .

they are an important tool of financial analysis. Limitations Ratio analysis in view of its several limitations should be considered only as a tool for analysis rather than as an end in itself. It is sales in the case of income statement and totals of assets and liabilities in the case of the balance sheet. These statements convert absolute sums into more easily understood percentages of some base amount. 6 . The reliability and significance attached to ratios will largely hinge upon the quality of data on which they are based. They are as good or as bad as the data itself.Common Size Statements Preparation of common-size financial statements is an extension of ratio analysis. Nevertheless.46 .

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