Ratio Analysis

Sensitivity: LNT Construction Internal Use

 Ratio Analysis ….
• This is most popular and widely used tool of financial analysis
• However, it has its limitations and we should not use it mechanically.
• A ratio per se does not mean anything more than the results of a mathematical relation between
two numbers….
• Its significance derives from the economically relevant relationship between the two
components or its absence.
• Ratio of Cost of Goods Sold to Sales; as against
• Ratio of Interest Cost to Cost of Goods Sold or Freight Expenses
• Some time the absolute value of the Ratio at a point in time does not convey a message but the
trend in the ratio over a period of time may convey actionable message or give an important
insight.
• Let’s look at a Car mileage example ……

2
Sensitivity: LNT Construction Internal Use
 Ratio Analysis ….2
• Ratios ….no doubt …. provide insights….
• But we should treat those as start points of analysis and further
examination….not “finish” lines !!
• Interpretation of the ratios requires skill, experience and ability…..
• To relate the ratio movements to an actual understanding or assessment
as to what actually must have happened on the ground.
• Ratios have to be used in relevant groups or clusters …..
• Not one or two in an isolated manner without context or considering the
inter-relationship.
• We can improve operating margin by cutting sales promo expenses…
but what will be the longer term impact ?

Sensitivity: LNT Construction Internal Use

 Ratio Analysis ….3
• Ratios to be a potent tool ….must be used with care and practice…
• Relate it to the values of the same ratio in prior periods
• Relate it to pre-determined standard values
• Relate it to values of competitors
• We should use tenets of accounting analysis to make sure that the
numbers underlying the ratios are correct
• Limitation in accounting measurements dilutes the impact of ratio analysis
• Lease rent liabilities are often excluded from the main accounts …they are referred to only
in the notes ….. To that extent the accuracy of the Debt/Equity ratio is diluted
• Off-balance sheet financing through “Bill discounting” also affects current ratios
• Current ratio is again understated with LIFO valuation of inventory…
in a scenario of rising prices…. As inventory value is understated.

Sensitivity: LNT Construction Internal Use

 Ratio Analysis ….4

Capital Structure and

Liquidity Ratios
Solvency
• Current Ratio • Total Debt to Equity
• Acid-Test Ratio • Long Term Debt to
• Collection Period Equity
• Days to sell inventory • Interest Cover

Sensitivity: LNT Construction Internal Use

 Ratios Analysis…5
LIQUIDITY RATIOS Current Ratio Current Assets / Current Liabilities
(Cash + Receivables + Inventory) / (Current Liabilities)

Acid -Test Ratio (Cash + Receivables)/ Current Liabilities

Collection Period Receivables /(Average Daily Sales)

Days to sell Inventory Inventory / (Average Daily Cost of Goods Sold )

CAPITAL STRUCTURE (Total Long term Debt + Total Short Term debt) / Total
AND SOLVENCY Total Debt to Equity Equity

Long term Debt to Equity Long Term Debt / Total Equity

Interest Cover Profit Before Interest and Tax / Interest

Sensitivity: LNT Construction Internal Use

 Ratio Analysis ….6

Operating Return on
Performance Investment
• Gross Profit Margin • Return on Assets
• Operating Profit • Return on Equity
Margin
• Net Profit Margin

Sensitivity: LNT Construction Internal Use

 OPERATING
Ratio Analysis…..7
PERFORMANCE
Gross Profit Margin = Gross Margin / Sales
= (Sales - Variable Cost) / Sales

Operating Profit Margin = Operating Profit / Sales

= Profit before Interest and Tax / Sales
Net Profit Margin
( Return on Sales) = Profit after Tax / Sales

RETURN ON INVESTMENT Return on Assets (ROA) = Profit After Tax / Total Assets
= Profit after Tax / (Current Assets +
Fixed Assets)

Return on Equity (ROE) = Profit After Tax / Total Equity

Sensitivity: LNT Construction Internal Use

 Ratio Analysis ….8
Asset Utilisation Market Measures
• Accounts Receivable • Price Earnings ratio
Turnover • Earnings Yield
• Inventory Turnover • Dividend Yield
• Working Capital • Dividend Payout Rate
Turnover • Price-to-Book Value
• Total Asset turnover

Sensitivity: LNT Construction Internal Use

 Ratio Analysis ….9
ASSET UTILISATION Accounts Receivable Turnover Sales / Receivables

Inventory Turnover Sales / Inventory

Working Capital Turnover Sales / ( Receivables + Inventory - Current Liabilities)

Total Asset turnover Sales / Total Assets

MARKET MEASURES Price Earnings ratio (PE or P/E ratio) Share Price / Earnings per Share
Share Price / ( Profit after Tax for previous 12 months / No.
of shares outstanding)

Earnings Yield Earnings per Share / Share Price

Dividend Yield Dividends per Share / Share Price

Dividend Payout Rate Total Dividends / Profit after Tax

Price-to-Book Value Share Price / Book Value per share

Sensitivity: LNT Construction Internal Use

 Fund Flow Analysis
• It is a tool to evaluate the sources and uses of funds
• It can also be used as a supplement to liquidity analysis
• Funds flow analysis starts from the Balance Sheet.
• It is useful to get a fix on
• the financial strategy of the Company and
• assess the potential risks of such a strategy.
• It can help us relate ……
• the tenure of funds availability ; with
• the tenure of its utilization ; and
• the presence / absence of balance in the dimensions.

11
Sensitivity: LNT Construction Internal Use