Factors on which analysis & interpretation of financial ratios depend

the size of the business

the state of the economy

the policies of management

the company philosophy

the industry norms

government rules and regulations

Purpose of Interpretation of financial statements

• To measure profitability of the business

• To analyse past trend

• To evaluate growth potential of business

• To examine solvency of business

• To assess overall financial strength of business

• To do comparative study of firm position in relation to other firms in

industry
Various users of financial statements

1. Investors and potential investors

2. Lenders and potential lenders

3. Trade payables and other suppliers

4. Management

5. Employees
 Financial ratios

The result of dividing one financial statement item by another is a financial

ratio. Ratios help analysts interpret financial statements by focussing on
specific relationships.

Helps to analyse the profitability of a company. The

1. Profitability ratios
best way to start an analysis of the profitability of a
company is by examining the revenue it earns.

2. Efficiency ratios Helps to analyse how efficiently the assets of a

company are being used in generating revenue.

3. Liquidity ratios Helps to assess the liquidity and cash position of the
company.

help in the analysis of financial position of the

4. Financial Position company and in determining the stability of the
ratios company and the ability of the company to repay its
long-term debts.
 Profitability ratios

1. Gross Profit Margin reflects the gross margin that a

company makes on its sales

Gross profit
Gross Profit Margin  x 100
Sales revenue
Rule of thumb for analysis purposes - The higher this ratio

 the more efficient is the performance of the company.

 the more efficient it is in controlling direct costs.
 the better is its sales mix and its performance.

Warning: Any late adjustments made by the company could lead to an

unrealistically high gross profit ratio. Some examples of such adjustments are:
 Sales made to colluding customers which will be taken back in the next
financial year.
 Discounts received from colluding suppliers which will be reversed in the
next financial year.
 Improper valuation of inventory

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 Profitability ratios continued..

reflects the net margin that a

2. Net Profit Margin company makes on its sales

Net profit
Net Profit Margin  x 100
Sales revenue

Rule of thumb for analysis purposes - The higher this ratio

 the more efficient is the performance of the company

 the more efficient it is in controlling its borrowings and borrowing costs.

Warning: Any late adjustments made by the company could lead to a high
net profit margin.

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 Profitability ratios continued…

reflects the operating margin

that a company makes on
3. Operating Profit Margin
its sales

Operating profit
Operating Profit Margin  x 100
Sales revenue

Rule of thumb for analysis purposes - The higher this ratio

 the more efficient is the performance of the company

 the more efficient it is in controlling selling and administration costs.

Warning: Any late adjustments made by the company could lead to a high
net profit ratio.

A company could put off acknowledging bad debts to a year where it can
earn sufficient profits which will absorb such bad debts.
Profitability ratios continued..

4. Return on capital employed It reflects the relationship between the

profits earned by a company and capital
employed by the company

Operating profit
Return on capital employed  x 100
Capital employed
 Profit used in this calculation is profit before interest and tax.
 Capital employed includes shareholders’ equity and all long-term borrowings (non-
current liabilities) or total assets – current liabilities.

Rule of thumb for analysis purposes - The higher this ratio the more efficiently the
business is being managed in generating profits from the resources available.

Warning: Any conscious decisions taken by management which reduce returns in one
year, but will prove beneficial in the long term, will reduce this ratio.

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Profitability ratios continued..

5. Return on assets It reflects the relationship between the profits

earned by a company and its total assets.

Operating profit
Return on assets  x 100
Total assets
 Profit used in this calculation is profit before interest and tax.
 Total assets are the SOFP (balance sheet) total.

Rule of thumb for analysis purposes - The higher this ratio, the more efficiently the total
assets are being managed in generating profits from the resources available.

Warning: Any conscious decisions taken by management which reduce returns in

one year, but will prove beneficial in the long term, will reduce this ratio.
Efficiency ratios

It shows how much revenue is

1. Asset Turnover generated by a $ worth of assets. This
calculation is not expressed as a
percentage but as number of times.
Sales revenue
Asset Turnover  (times p.a.)
Total assets

Rule of thumb for analysis purposes - The higher this ratio

the more efficiently are the assets being used to generate revenues.

Warning:

The ratio could be unrealistically high if the non-current assets are at the end
of their productive lives and have been depreciated to a considerable extent.
It could be unrealistically low if they have been recently revalued and there
has been a profit on revaluation.

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LIQUIDITY RATIOS
INTERPRETATION OF F.S
 Liquidity ratios

1. Current Ratio It helps to decide whether the current

assets will be able to generate sufficient
cash to pay off the current liabilities as
and when they fall due.

Current assets
Current Ratio 
Current liabilities

This effectively tells us how many current assets we have to pay $1 of liabilities.

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Liquidity ratios continued…

It helps decide whether the quick assets

2. Quick Ratio of a company will be able to generate
sufficient cash to pay off the current
liabilities as and when they fall due.

Quick assets
Quick Ratio =
Current liabilities

Quick Ratio = Current assets - Inventory

Rule of thumb for analysis purposes - The higher the current ratio and the
quick ratio, the better cash flow the company has.

Warning: High liquidity could indicate a problem of a different kind. It could

mean that the company is not able to invest its cash into more profitable
investments.
EFFICIENCY RATIOS
INTERPRETATION OF F.S
Efficiency ratios continued…

It indicates how many times the

inventory is being turned over in a
2. Inventory Turnover year.

Cost of sales
Inventory Turnover  (times p.a.)
Inventory

Rule of thumb for analysis purposes - The lower the inventory turnover days, the more
quickly inventory is being sold.

Warning:

The number of days could be unrealistically high if management has stocked more goods
in anticipation of a shortage, in order to obtain bulk discounts. It could be unrealistically
low if management has just passed inventory to accommodating customers and plans to
take it back in the next financial year.

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Efficiency ratios continued…

3. Receivable days
This reflects the number of days
it takes for a customer to pay.

Receivables
Receivable days  x 365
Credit sales

This ratio can also be calculated using average receivables. In that case, it
reflects the number of days it takes for an average customer to pay.

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Efficiency ratios continued…

4. Payable days
This reflects the number of days it takes
for a company to settle its bills.

Payables
Payable days  x 365
Credit purchases

This ratio can also be calculated using average

payables. In that case, it reflects the number of days
it takes on average for a company to settle its bills.

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Efficiency ratios continued…

5. Working capital cycle

can be expressed in number of days
in the following manner

Working capital cycle

 Inventory turnover  Receivabledays - Payable days

is the approximate number of days it takes to purchase

the inventory, sell the inventory and receive cash

Rule of thumb for analysis purposes – The lesser the length of this cycle, the more
solvent the business.

Warning: The liquidity of business should not be achieved at the cost of loss of opportunity.
FINANCIAL POSITION
RATIOS
INTERPRETATION OF F.S
 Financial position ratios

It expresses the relationship between a

1. Capital gearing ratio company’s borrowings and its own funds.

includes long-term borrowings,

Total long - term debt debentures and preference
Capital gearing ratio  x 100 shares
Shareholder' s funds
includes equity share capital
and reserves
Rule of thumb for analysis purposes - There can be no rule of thumb or limit for this ratio. It
has to be analysed keeping in mind the circumstances under which a company operates.

The higher the ratio, the more geared the company is. This means that it relies heavily on
debts for conducting its business.

A low capital gearing ratio is suitable for companies which have erratic sales / erratic profits
and an insufficient asset base.

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 Financial position ratios continued…

It is the ratio of total liabilities (total debt) to total

2. Debt ratio assets. It is percentage of total funds obtained from
lenders and trade payables. The debt ratio can help
investors to determine whether to invest in a
particular company would be risky.

Total liabilities
Debt ratio =
Total assets

For trade payables – Lower debt ratio will be favourable as it will ensure high safety margin.

For investors – Higher debt ratio will be favourable as rate of dividend can be accelerated by increasing
the debt component. This is because the debt component carries a fixed interest charge after which the
entire profits are available for distribution among the equity shareholders.

Warning
Interpretation of debt-equity ratio needs caution. In case of few companies certain contingent obligations
are not shown in the SOFP and are disclosed only through the notes to accounts. For example there may
be certain legal case pending for decision against the company. They should not be ignored while analysing
financial leverage and risk of the firm.

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Financial position ratios continued…

indicates how many times the

3. Interest cover profit covers the interest charge

Profit before interest & tax

Interest cover 
Interest expense

Rule of thumb for analysis purposes - The higher the ratio the better; the
company is in a better position to pay the fixed charge of interest.
Interrelationship between ratios & DuPont System

The variables used in the ratios are used at more than one ratios, many ratios are
interrelated to each other. For example in profitability ratios, sales revenue is the
denominator, whereas in the efficiency ratios, the sales revenue is at the numerator.

It evaluates profitability, operating efficiency and leverage, all

DuPont
within the ROE analysis. And shows the interrelationship between
System
key financial ratios.

ROE = Profit Margin (Profit/Sales) X Total Asset Turnover (Sales/Assets) X Equity

Multiplier (Assets/Equity)

Or

ROE = Return on assets (Profit margin x Assets turnover) X Equity Multiplier

(Assets/Equity)
General tips on solving a problem on ratio analysis

 Write down the interpretation of the ratios clearly. Ratios have to spill the beans
i.e. the whole purpose of ratio analysis is to reveal the truths of the numbers which
are hiding behind veils.
 If the question requires writing a report then ratios should be included as an
appendix to the main report. The workings of the ratios can follow the appendix.
 Any report should have a conclusion and may also include a suggested future
course of action / steps to redress the situation.
 When it is difficult to interpret a ratio or arrive at any conclusion it is advisable
to state the reasons for the difficulty. Furthermore, it is necessary to specify the type
of additional information (e.g. industry averages competitor’s ratios) which is
required, to arrive at a definite conclusion.
 Ratio analysis is highly subjective in nature. That is why it is advisable to justify
your interpretations.
Methods of comparison

Vertical  Identifies the relationship of each item to its base amount

analysis e.g. sales or total assets

 Involves comparison of ratios of two or more entities

Comparison  Identifies the causes for increase or decrease in profits of
with similar an entity, the level of efficiency of the management in
company using its total assets, liquidity, capital gearing of the
company.

 Involves comparison of ratios of a firm with industry

Industry averages
comparison  To determine if the company is performing well as
compared to its competitors

Comparison of firm’s present ratio with its past and

Trend analysis expected future ratios to determine whether the company’s
financial position is improving or deteriorating over time.
The end…..
Thank you