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Financial Statements Analysis



                            6-1
                            6-1
FINANCIAL STATEMENTS
      ANALYSIS

        Ratio Analysis


   Common Size Statements

 Importance and Limitations of
        Ratio Analysis

          Mini Case

                                 6-2
                                 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
                                              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




                                                            6-4
                                                            6-4
Types of Ratios

Liquidity Ratios
Capital Structure Ratios
Profitability Ratios
Efficiency ratios
Integrated Analysis Ratios
Growth Ratios


                              6-5
                              6-5
Net Working Capital
     Net working capital is a measure of liquidity calculated by
         subtracting current liabilities from current assets.

Table 1: Net Working Capital
Particulars                                   Company A      Company B
Total current assets                           Rs 1,80,000     Rs 30,000
Total current liabilities                         1,20,000        10,000
NWC                                                60,000        20,000

Table 2: Change in Net Working Capital
Particulars                                   Company A      Company B
Current assets                                 Rs 1,00,000    Rs 2,00,000
Current liabilities                                 25,000       1,00,000
NWC                                                75,000       1,00,000


                                                                    6-6
                                                                    6-6
Liquidity Ratios



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




                                               6-7
                                               6-7
Current Ratio
Current Ratio is a measure of liquidity calculated dividing the current
assets by the current liabilities


                                        Current Assets
         Current Ratio =
                                    Current Liabilities


Particulars             Firm A                  Firm B
Current Assets          Rs 1,80,000             Rs 30,000
Current Liabilities     Rs 1,20,000             Rs 10,000
Current Ratio           = 3:2 (1.5:1)           3:1

                                                                   6-8
                                                                   6-8
Acid-Test Ratio
The quick or acid test ratio takes into consideration the
differences in the liquidity of the components of current
assets.


                               Quick Assets
  Acid-test Ratio =
                            Current Liabilities


      Quick Assets = Current assets – Stock –
                Pre-paid expenses

                                                      6-9
                                                      6-9
Example 1: Acid-Test Ratio

Cash                        Rs 2,000
Debtors                        2,000
Inventory                     12,000
Total current assets          16,000
Total current liabilities      8,000
(1) Current Ratio               2:1
(2) Acid-test Ratio           0.5 : 1



                                  6 - 10
                                  6 - 10
Supplementary Ratios for
           Liquidity

Inventory Turnover Ratio
Debtors Turnover Ratio
Creditors Turnover Ratio




                               6 - 11
                               6 - 11
Inventory Turnover Ratio

The ratio indicates how fast inventory is sold. 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.


                                         Cost of goods sold
 Inventory turnover ratio =
                                         Average inventory

      The cost of goods sold means sales minus gross profit.

 The average inventory refers to the simple average of the opening
                      and closing inventory.
                                                                        6 - 12
                                                                        6 - 12
Example 2: Inventory Turnover Ratio

A firm has sold goods worth Rs 3,00,000 with a gross profit
margin of 20 per cent. The stock at the beginning and the end of
the year was Rs 35,000 and Rs 45,000 respectively. What is the
inventory turnover ratio?


                     (Rs 3,00,000 – Rs 60,000)
   Inventory                                           6 (times per
                 =                                 =
turnover ratio       (Rs 35,000 + Rs 45,000) ÷ 2           year)

                             12 months
  Inventory
               =                               = 2 months
holding period   Inventory turnover ratio, (6)

                                                              6 - 13
                                                              6 - 13
Debtors Turnover Ratio
The ratio measures how rapidly receivables are collected. A high
ratio is indicative of shorter time-lag between credit sales and
cash collection. A low ratio shows that debts are not being
collected rapidly.

                                          Net credit sales
  Debtors turnover ratio           =
                                         Average debtors

Net credit sales consist of gross credit sales minus returns, if any,
from customers.

Average debtors is the simple average of debtors (including
bills receivable) at the beginning and at the end of year.

                                                                6 - 14
                                                                6 - 14
Example 3: Debtors Turnover Ratio

A firm has made credit sales of Rs 2,40,000 during the year.
The outstanding amount of debtors at the beginning and at
the end of the year respectively was Rs 27,500 and Rs
32,500. Determine the debtors turnover ratio.


                              Rs 2,40,000
   Debtors                                                 8 (times per
                 =                                     =
turnover ratio       (Rs 27,500 + Rs 32,500) ÷ 2               year)

                                 12 Months
     Debtors                                                   1.5
                     =                                 =
collection period        Debtors turnover ratio, (8)          Months

                                                                 6 - 15
                                                                 6 - 15
Creditors Turnover Ratio
A low turnover ratio reflects liberal credit terms granted by
suppliers, while a high ratio shows that accounts are to be settled
rapidly. 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.

                                    Net credit purchases
   Creditors turnover
                               =
          ratio                       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
                                                               6 - 16
Example 4: Creditors Turnover Ratio

The firm in previous Examples has made credit purchases of Rs
1,80,000. The amount payable to the creditors at the beginning
and at the end of the year is Rs 42,500 and Rs 47,500 respectively.
Find out the creditors turnover ratio.

                               (Rs 1,80,000)
  Creditors                                                  4 (times
                 =                                       =
turnover ratio           (Rs 42,500 Rs 47,500) ÷ 2           per year)

                                 12 months
  Creditor’s
                     =                                   = 3 months
payment period           Creditors turnover ratio, (4)

                                                                  6 - 17
                                                                  6 - 17
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, collections
from debtors and payment to creditors.



       The combined effect of the three turnover ratios
                       is summarised below:
Inventory holding period                                     2 months
  Add: Debtor’s collection period                         + 1.5 months
  Less: Creditor’s payment period                          – 3 months
                                                           0.5 months
 As a rule, the shorter is the cash cycle, the better are the liquidity
              ratios as measured above and vice versa.

                                                                   6 - 18
                                                                   6 - 18
DEFENSIVE INTERVAL RATIO

Defensive interval ratio is the ratio between quick
assets and projected daily cash requirement.


                                     Liquid assets
  Defensive-
                   =
 interval ratio             Projected daily cash requirement


                           Projected cash operating expenditure
 Projected daily
                       =
cash requirement              Number of days in a year (365)


                                                           6 - 19
                                                           6 - 19
Example 5: Defensive Interval Ratio

The projected cash operating expenditure of a firm from the
next year is Rs 1,82,500. It has liquid current assets
amounting to Rs 40,000. Determine the defensive-interval
ratio.



                                        Rs 1,82,500
   Projected daily cash requirement =                 = Rs 500
                                            365
                                        Rs 40,000
           Defensive-interval ratio =               = 80 days
                                         Rs 500

                                                         6 - 20
                                                         6 - 20
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
   Cash-flow from
                       =
   operations ratio             Current liabilities



                                                      6 - 21
                                                      6 - 21
Leverage Capital Structure Ratio
There are two aspects of the long-term solvency of a firm:
(i) Ability to repay the principal when due, and
(ii) Regular payment of the interest .
        Capital structure or leverage ratios throw light on the
                     long-term solvency of a firm.

    Accordingly, there are two different types of leverage ratios.
 First type: These ratios are       Second type: These ratios are
 computed from the balance           computed from the Income
             sheet                           Statement
(a) Debt-equity ratio            (a) Interest coverage ratio
(b) Debt-assets ratio            (b) Dividend coverage ratio
(c) Equity-assets ratio
                                                                  6 - 22
                                                                  6 - 22
I. Debt-equity ratio
       Debt-equity ratio measures the ratio of long-term or total
                      debt to shareholders equity.

                                                         Long-term Debt + Short
     Debt-equity ratio measures the ratio of long-term debt + Other Current
                              Total Debt
  Debt-equitytotal de3bt to shareholders equity Liabilities = Total external
     term or  ratio =
                           Shareholders’ equity          Obligations


If the D/E ratio is high, the owners are putting up relatively less
money of their own. It is danger signal for the lenders and
creditors. If the project should fail financially, the creditors would
lose heavily.

A low D/E ratio has just the opposite implications. To the creditors, a
relatively high stake of the owners implies sufficient safety
margin and substantial protection against shrinkage in assets.

                                                                       6 - 23
                                                                       6 - 23
For the company also, the servicing of debt is
less burdensome and consequently its credit
standing is not adversely affected, its
operational flexibility is not jeopardised and it
will be able to raise additional funds.
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.



                                              6 - 24
                                              6 - 24
Trading on Equity
Trading on equity (leverage) is the use of borrowed funds in
expectation of higher return to equity-holders.

Trading on Equity                      (Amount in Rs thousand)
   Particular                    A          B       C      D
(a) Total assets              1,000      1,000   1,000   1,000
    Financing pattern:
     Equity capital           1,000        800     600    200
     15% Debt                    —         200     400    800
(b)Operating profit (EBIT)      300        300     300    300
    Less: Interest               —          30      60    120
Earnings before taxes           300        270     240    180
Less: Taxes (0.35)              105       94.5      84     63
Earnings after taxes            195      175.5     156    117
Return on equity (per cent)     19.5      21.9      26    58.5
                                                           6 - 25
                                                           6 - 25
II. Debt to Total Capital
The relationship between creditors’ funds and owner’s
capital can also be expressed using Debt to total capital
ratio.

                                  Total debt
Debt to total capital ratio =
                                Permanent capital


Permanent       Capital    =    Shareholders’ equity   +
                                 Long-term debt.


                                                       6 - 26
                                                       6 - 26
III. Debt to total assets ratio
                                Total debt
Debt to total assets ratio =
                                Total assets
Proprietary Ratio
Proprietary ratio indicates the        extent   to   which    assets
are financed by owners funds.

                        Proprietary funds
Proprietary ratio =                       X 100
                          Total assets

Capital Gearing Ratio
Capital gearing ratio is used to know the relationship between equity
funds (net worth) and fixed income bearing funds (Preference
shares, debentures and other borrowed funds.

                                                                 6 - 27
                                                                 6 - 27
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 coverage ratio =
                                        Interest

Dividend Coverage Ratio
Dividend Coverage Ratio measures the firm’s ability to pay dividend
on preference share which carry a stated rate of return.

                                 EAT (Earning after taxes)
Dividend coverage ratio =
                                   Preference dividend

                                                                6 - 28
                                                                6 - 28
Total fixed charge coverage ratio
Total fixed charge coverage ratio measures the firm’s ability to meet all fixed
payment obligations.

 Total fixed charge                      EBIT + Lease Payment
  coverage ratio    =      Interest + Lease payments + (Preference dividend
                                      + Instalment of Principal)/(1-t)

Total Cashflow Coverage Ratio
However, coverage ratios mentioned above, suffer from one major
limitation, that is, they relate the firm’s ability to meet its various
financial obligations to its earnings. Accordingly, it would be
more appropriate to relate cash resources of a firm to its
 various fixed financial obligations.


                     EBIT + Lease Payments + Depreciation + Non-cash expenses
Total cashflow
               =
coverage ratio                       (Principal repayment)       (Preference dividend)
                   Lease payment                             +
                                 +
                      + Interest             (1– t)                     (1 - t)

                                                                                  6 - 29
                                                                                  6 - 29
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.

                n
               ∑     EATt   +   Interestt
                                            +   Depreciationt   +   OAt
               t=1
 DSCR    =                          n
                                   ∑     Instalmentt
                                   t=1



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.
                                                                    6 - 30
                                                                    6 - 30
Example 6: Debt-Service Coverage Ratio
Agro Industries Ltd has submitted the following projections. You are
  required to work out yearly debt service coverage ratio (DSCR)
                       and the average DSCR.
                                                                       (Figures in Rs lakh)
Year    Net profit for the           Interest on term loan            Repayment of term
              year                      during the year                loan in the year
 1            21.67                            19.14                           10.70
 2            34.77                            17.64                           18.00
 3            36.01                            15.12                           18.00
 4            19.20                            12.60                           18.00
 5            18.61                            10.08                           18.00
 6            18.40                            7.56                            18.00
 7            18.33                            5.04                            18.00
 8            16.41                             Nil                            18.00

The net profit has been arrived after charging depreciation of Rs 17.68 lakh
every year.
         © Tata McGraw-Hill Publishing Company Limited, Financial Management
         © Tata McGraw-Hill Publishing Company Limited, Financial Management           6 - 31
                                                                                       6 - 31
Solution
Table 3: Determination of Debt Service Coverage Ratio
                                                                  (Amount in lakh of rupees)
Ye    Net     Depreciation   Interest     Cash        Principal           Debt          DSCR [col. 5
ar   profit                             available   instalment        obligation           ÷ col. 7
                                          (col.                    (col. 4 + col. 6)   (No. of times)]
                                         2+3+4)
1      2            3           4          5             6                 7                  8
1    21.67       17.68        19.14      58.49        10.70             29.84               1.96
2    34.77       17.68        17.64      70.09        18.00             35.64               1.97
3    36.01       17.68        15.12      68.81        18.00             33.12               2.08
4    19.20       17.68        12.60      49.48        18.00             30.60               1.62
5    18.61       17.68        10.08      46.37        18.00             28.08               1.65
6    18.40       17.68         7.56      43.64        18.00             25.56               1.71
7    18.33       17.68         5.04      41.05        18.00             23.04               1.78
8    16.41       17.68         Nil       34.09        18.00             18.00               1.89

Average DSCR (DSCR ÷ 8)                                                  1.83


           © Tata McGraw-Hill Publishing Company Limited, Financial Management
           © Tata McGraw-Hill Publishing Company Limited, Financial Management                    6 - 32
                                                                                                  6 - 32
Profitability Ratio
  Profitability ratios can be computed either from
                  sales or investment.

  Profitability Ratios      Profitability Ratios
   Related to Sales        Related to Investments
(i) Profit Margin        (i) Return on Investments

(ii) Expenses Ratio      (ii) Return on Shareholders’
                              Equity


                                                     6 - 33
                                                     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.



Gross profit margin =     Gross Profit
                                       X 100
                            Sales



                                                     6 - 34
                                                     6 - 34
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.

           Net profit margin can be computed in three ways


                                  Earning before interest and taxes
i. Operating Profit Ratio =
                                             Net sales


                                Earnings before taxes
 ii. Pre-tax Profit Ratio =
                                    Net sales

                              Earning after interest and taxes
 iii. Net Profit Ratio =                 Net sales

                                                                      6 - 35
                                                                      6 - 35
Example 7: From the following information of a firm,
determine (i) Gross profit margin and (ii) Net profit
margin.
1. Sales                                     Rs 2,00,000
2. Cost of goods sold                           1,00,000
3. Other operating expenses                      50,000

                              Rs 1,00,000
  (1) Gross profit margin =                 = 50 per cent
                              Rs 2,00,000

                              Rs 50,000
   (2) Net profit margin =                  = 25 per cent
                              Rs 2,00,000



                                                      6 - 36
                                                      6 - 36
Expenses Ratio
                            Cost of goods sold
i. Cost of goods sold =                        X 100
                                Net sales
                            Administrative exp. + Selling exp.
ii. Operating expenses =                                         X 100
                                        Net sales
                                 Administrative expenses
iii. Administrative expenses =                                X 100
                                       Net sales
                                 Selling expenses
iv. Selling expenses ratio =                          X 100
                                   Net sales
                       Cost of goods sold + Operating expenses
v. Operating ratio =                                           X 100
                                     Net sales
                             Financial expenses
vi. Financial expenses =                            X 100
                                Net sales
                                                                      6 - 37
                                                                      6 - 37
Return on Investment
Return on Investments measures the overall effectiveness
of management in generating profits with its available
assets.

i. Return on Assets (ROA)
          EAT + (Interest – Tax advantage on interest)
ROA =
                    Average total assets


ii. Return on Capital Employed (ROCE)
           EAT + (Interest – Tax advantage on interest)
ROCE =
                Average total capital employed

                                                          6 - 38
                                                          6 - 38
Return on Shareholders’ Equity
Return on shareholders equity measures the return on the
owners (both preference and equity shareholders)
investment in the firm.

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 - 39
                                                         6 - 39
Efficiency Ratio
Activity ratios measure the speed with which various
accounts/assets are converted into sales or cash.
Inventory turnover measures the efficiency of various types
of inventories.

i. Inventory Turnover measures theof goods sold
Inventory Turnover Ratio =
                              Cost activity/liquidity of
                                Average inventory
inventory of a firm; the speed with which inventory is sold

i. Inventory Turnover measures the activity/liquidityused
Raw materials turnover =
                              Cost of raw materials of
inventory of a firm; the speed with whichmaterial inventory
                            Average raw inventory is sold

i. Inventory Turnover measuresCost activity/liquidity of
                                the of goods manufactured
Work-in-progress turnover =
inventory of a firm; the speed with which inventory is sold
                            Average work-in-progress inventory
                                                          6 - 40
                                                          6 - 40
Debtors Turnover Ratio
Liquidity of a firm’s receivables can be examined
in two ways.

                                 Credit sales
i. Debtors turnover = measures the activity/liquidity of inventory of
i. Inventory Turnover
a firm; the speed with which inventoryAverage bills receivable (B/R)
                   Average debtors + is sold

                                    Months (days) in a year
2. Average collection period =
                                      Debtors turnover

i. Inventory Turnover(days) in a year activity/liquidity of inventory of a
Alternatively =
               Months measures the (x) (Average Debtors + Average (B/R)
firm; the speed with which inventory is credit sales
                                   Total sold


Ageing Schedule enables                  analysis       to    identify
slow paying debtors.
                                                                     6 - 41
                                                                     6 - 41
Assets Turnover Ratio
Assets turnover indicates the efficiency with which firm
uses all its assets to generate sales.

   Inventory Turnover measures the of goods sold of inventory of
i. Total assets turnover =
i.
                               Cost activity/liquidity
a firm; the speed with which inventory total assets
                              Average is sold
                               Cost of goods sold
ii. Fixed assets turnover =
                               Average fixed assets
                                Cost of goods sold
i. Inventory Turnover measures the activity/liquidity of inventory of
iii. Capital turnover =
a firm; the speed with which inventory is sold employed
                               Average capital
                                Cost of goods sold
iv. Current assets turnover =
                               Average current assets

i. Inventory capital turnover = Costactivity/liquidity of inventory of
v. Working   Turnover measures the of goods sold
                                Net working capital
a firm; the speed with which inventory is sold

                                                                  6 - 42
                                                                  6 - 42
1)   Return on shareholders’ equity = EAT/Average total shareholders’ equity.

2)   Return on equity funds = (EAT – Preference dividend)/Average ordinary
     shareholders’ equity (net worth).

3)   Earnings per share (EPS) = Net profit available to equity shareholders’
     (EAT – Dp)/Number of equity shares outstanding (N).

4)   Dividends    per   share    (DPS)    =    Dividend    paid   to   ordinary
     shareholders/Number of ordinary shares outstanding (N).

5)   Earnings yield = EPS/Market price per share.

6)   Dividend Yield = DPS/Market price per share.

7)   Dividend payment/payout (D/P) ratio = DPS/EPS.

8)   Price-earnings (P/E) ratio = Market price of a share/EPS.

9)   Book value per share = Ordinary shareholders’ equity/Number of equity
     shares outstanding.
                                                                        6 - 43
                                                                        6 - 43
Integrated Analysis Ratio
Integrated ratios provide better insight about financial and
economic analysis of a firm.

(1) Rate of return on assets (ROA) can be decomposed in to
   (i) Net profit margin (EAT/Sales)
   (ii) Assets turnover (Sales/Total assets)
(2) Return on Equity (ROE) can be decomposed in to
   (i) (EAT/Sales) x (Sales/Assets) x (Assets/Equity)
   (ii) (EAT/EBT) x (EBT/EBIT) x (EBIT/Sales) x (Sales/Assets) x
        (Assets/Equity)

                                                             6 - 44
                                                             6 - 44
Rate of Return on Assets


   EAT as percentage of                                          Assets
          sales                                                 turnover


EAT        Divided by          Sales        Sales      Divided by       Total Assets


                                       Fixed assets      Plus       Current assets
Gross profit = Sales less
  cost of goods sold                                    Alternatively

         Minus                                        Shareholder equity
  Expenses: Selling                                          Plus
Administrative Interest
                                                      Long-term borrowed
         Minus                                               funds

      Income-tax                                             Plus
                                                       Current liabilities

                                                                              6 - 45
                                                                              6 - 45
Return on Assets
Earning Power
Earning power is the overall profitability of a firm; is computed
by multiplying net profit margin and assets turnover.


Earning power               = Net profit margin × Assets turnover
Where, Net profit margin = Earning after taxes/Sales
Asset turnover           = Sales/Total assets


i. Inventory Turnover measurestaxes x
Earning Power =
                  Earning after the activity/liquidity of inventory of
                                                Sales
                                                        x
                                                              EAT
a firm; the speed with which inventory isTotal Assets Total assets
                        Sales             sold



                                                                  6 - 46
                                                                  6 - 46
EXAMPLE: 8
Assume that there are two firms, A and B, each having total assets
amounting to Rs 4,00,000, and average net profits after
taxes of 10 per cent, that is, Rs 40,000, each.

Firm A has sales of Rs 4,00,000, whereas the sales of firm B aggregate
Rs 40,00,000. Determine the ROA of firms A and B. Table 4 shows
the ROA based on two components.

Table 4: Return on Assets (ROA) of Firms A and B
Particulars                              Firm A           Firm B
1. Net sales                            Rs 4,00,000     Rs 40,00,000
2. Net profit                                40,000           40,000
3. Total assets                            4,00,000         4,00,000
4. Profit margin (2 ÷ 1) (per cent)               10               1
5. Assets turnover (1 ÷ 3) (times)                 1              10
6. ROA ratio (4 × 5) (per cent)                  10               10

                                                                6 - 47
                                                                6 - 47
Return on Equity (ROE)
ROE is the product of the following three ratios: Net profit ratio (x)
    Assets turnover (x) Financial leverage/Equity multiplier


Three-component model of ROE can be broadened further to
consider the effect of interest and tax payments.

        EAT               EBT       EBIT         Net Profit
i. Inventory Turnover measures the activity/liquidity of
                        x       x             =
inventory of a firm; the EBIT       Sales
Earnings before taxes speed with which inventory is sold
                                                   Sales
As a result of three sub-parts of net profit ratio, the ROE
is composed of the following 5 components.

   EAT           EBT         EBIT         Sales          Assets
            x            x         x                 x
   EBT          EBIT         Sales        Assets         Equity
                                                                  6 - 48
                                                                  6 - 48
A 5-way break-up of ROE enables the management of a firm to analyse the effect of interest
payments and tax payments separately from operating profitability. To illustrate further assume 8
per cent interest rate, 35 per cent tax rate and other operating expense of Rs 3,22,462 (Firm A) and
Rs 39,26,462 (Firm B) for the facts contained in Example 8. Table 5 shows the ROE (based on the
5 components) of Firms A and B.

Table 5: ROE (Five-way Basis) of Firms A and B
Particulars                                          Firm A                Firm B
Net sales                                                   Rs 4,00,000                Rs 40,00,000
   Less: Operating expenses                                    3,22,462                   39,26,462
Earnings before interest and taxes (EBIT)                        77,538                      73,538
   Less: Interest (8%)                                           16,000                      12,000
Earnings before taxes (EBT)                                      61,538                      61,538
   Less: Taxes (35%)                                             21,538                      21,538
Earnings after taxes (EAT)                                       40,000                      40,000
Total assets                                                   4,00,000                    4,00,000
Debt                                                           2,00,000                    2,50,000
Equity                                                         2,00,000                    1,50,000
EAT/EBT (times)                                                    0.65                        0.65
EBT/EBIT (times)                                                   0.79                        0.84
EBIT/Sales (per cent)                                              19.4                        1.84
Sales/Assets (times)                                                   1                          10
Assets/Equity (times)                                                  2                         1.6
ROE (per cent)                                                       20                          16

                                                                                            6 - 49
                                                                                            6 - 49
Common Size Statements
Preparation of common-size financial statements is an extension
of ratio analysis. These statements convert absolute sums into
more easily understood percentages of some base amount. It is
sales in the case of income statement and totals of assets and
liabilities in the case of the balance sheet.


                           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. 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. Nevertheless, they are an
important tool of financial analysis.

                                                                   6 - 50
                                                                   6 - 50

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Financial statementanalysis

  • 2. FINANCIAL STATEMENTS ANALYSIS Ratio Analysis Common Size Statements Importance and Limitations of Ratio Analysis Mini Case 6-2 6-2
  • 3. 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 6-3
  • 4. 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 6-4 6-4
  • 5. Types of Ratios Liquidity Ratios Capital Structure Ratios Profitability Ratios Efficiency ratios Integrated Analysis Ratios Growth Ratios 6-5 6-5
  • 6. Net Working Capital Net working capital is a measure of liquidity calculated by subtracting current liabilities from current assets. Table 1: Net Working Capital Particulars Company A Company B Total current assets Rs 1,80,000 Rs 30,000 Total current liabilities 1,20,000 10,000 NWC 60,000 20,000 Table 2: Change in Net Working Capital Particulars Company A Company B Current assets Rs 1,00,000 Rs 2,00,000 Current liabilities 25,000 1,00,000 NWC 75,000 1,00,000 6-6 6-6
  • 7. Liquidity Ratios Liquidity ratios measure the ability of a firm to meet its short-term obligations. 6-7 6-7
  • 8. Current Ratio Current Ratio is a measure of liquidity calculated dividing the current assets by the current liabilities Current Assets Current Ratio = Current Liabilities Particulars Firm A Firm B Current Assets Rs 1,80,000 Rs 30,000 Current Liabilities Rs 1,20,000 Rs 10,000 Current Ratio = 3:2 (1.5:1) 3:1 6-8 6-8
  • 9. Acid-Test Ratio The quick or acid test ratio takes into consideration the differences in the liquidity of the components of current assets. Quick Assets Acid-test Ratio = Current Liabilities Quick Assets = Current assets – Stock – Pre-paid expenses 6-9 6-9
  • 10. Example 1: Acid-Test Ratio Cash Rs 2,000 Debtors 2,000 Inventory 12,000 Total current assets 16,000 Total current liabilities 8,000 (1) Current Ratio 2:1 (2) Acid-test Ratio 0.5 : 1 6 - 10 6 - 10
  • 11. Supplementary Ratios for Liquidity Inventory Turnover Ratio Debtors Turnover Ratio Creditors Turnover Ratio 6 - 11 6 - 11
  • 12. Inventory Turnover Ratio The ratio indicates how fast inventory is sold. 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. Cost of goods sold Inventory turnover ratio = Average inventory The cost of goods sold means sales minus gross profit. The average inventory refers to the simple average of the opening and closing inventory. 6 - 12 6 - 12
  • 13. Example 2: Inventory Turnover Ratio A firm has sold goods worth Rs 3,00,000 with a gross profit margin of 20 per cent. The stock at the beginning and the end of the year was Rs 35,000 and Rs 45,000 respectively. What is the inventory turnover ratio? (Rs 3,00,000 – Rs 60,000) Inventory 6 (times per = = turnover ratio (Rs 35,000 + Rs 45,000) ÷ 2 year) 12 months Inventory = = 2 months holding period Inventory turnover ratio, (6) 6 - 13 6 - 13
  • 14. Debtors Turnover Ratio The ratio measures how rapidly receivables are collected. A high ratio is indicative of shorter time-lag between credit sales and cash collection. A low ratio shows that debts are not being collected rapidly. Net credit sales Debtors turnover ratio = Average debtors Net credit sales consist of gross credit sales minus returns, if any, from customers. Average debtors is the simple average of debtors (including bills receivable) at the beginning and at the end of year. 6 - 14 6 - 14
  • 15. Example 3: Debtors Turnover Ratio A firm has made credit sales of Rs 2,40,000 during the year. The outstanding amount of debtors at the beginning and at the end of the year respectively was Rs 27,500 and Rs 32,500. Determine the debtors turnover ratio. Rs 2,40,000 Debtors 8 (times per = = turnover ratio (Rs 27,500 + Rs 32,500) ÷ 2 year) 12 Months Debtors 1.5 = = collection period Debtors turnover ratio, (8) Months 6 - 15 6 - 15
  • 16. Creditors Turnover Ratio A low turnover ratio reflects liberal credit terms granted by suppliers, while a high ratio shows that accounts are to be settled rapidly. 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. Net credit purchases Creditors turnover = ratio 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 6 - 16
  • 17. Example 4: Creditors Turnover Ratio The firm in previous Examples has made credit purchases of Rs 1,80,000. The amount payable to the creditors at the beginning and at the end of the year is Rs 42,500 and Rs 47,500 respectively. Find out the creditors turnover ratio. (Rs 1,80,000) Creditors 4 (times = = turnover ratio (Rs 42,500 Rs 47,500) ÷ 2 per year) 12 months Creditor’s = = 3 months payment period Creditors turnover ratio, (4) 6 - 17 6 - 17
  • 18. 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, collections from debtors and payment to creditors. The combined effect of the three turnover ratios is summarised below: Inventory holding period 2 months Add: Debtor’s collection period + 1.5 months Less: Creditor’s payment period – 3 months 0.5 months As a rule, the shorter is the cash cycle, the better are the liquidity ratios as measured above and vice versa. 6 - 18 6 - 18
  • 19. DEFENSIVE INTERVAL RATIO Defensive interval ratio is the ratio between quick assets and projected daily cash requirement. Liquid assets Defensive- = interval ratio Projected daily cash requirement Projected cash operating expenditure Projected daily = cash requirement Number of days in a year (365) 6 - 19 6 - 19
  • 20. Example 5: Defensive Interval Ratio The projected cash operating expenditure of a firm from the next year is Rs 1,82,500. It has liquid current assets amounting to Rs 40,000. Determine the defensive-interval ratio. Rs 1,82,500 Projected daily cash requirement = = Rs 500 365 Rs 40,000 Defensive-interval ratio = = 80 days Rs 500 6 - 20 6 - 20
  • 21. 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 Cash-flow from = operations ratio Current liabilities 6 - 21 6 - 21
  • 22. Leverage Capital Structure Ratio There are two aspects of the long-term solvency of a firm: (i) Ability to repay the principal when due, and (ii) Regular payment of the interest . Capital structure or leverage ratios throw light on the long-term solvency of a firm. Accordingly, there are two different types of leverage ratios. First type: These ratios are Second type: These ratios are computed from the balance computed from the Income sheet Statement (a) Debt-equity ratio (a) Interest coverage ratio (b) Debt-assets ratio (b) Dividend coverage ratio (c) Equity-assets ratio 6 - 22 6 - 22
  • 23. I. Debt-equity ratio Debt-equity ratio measures the ratio of long-term or total debt to shareholders equity. Long-term Debt + Short Debt-equity ratio measures the ratio of long-term debt + Other Current Total Debt Debt-equitytotal de3bt to shareholders equity Liabilities = Total external term or ratio = Shareholders’ equity Obligations If the D/E ratio is high, the owners are putting up relatively less money of their own. It is danger signal for the lenders and creditors. If the project should fail financially, the creditors would lose heavily. A low D/E ratio has just the opposite implications. To the creditors, a relatively high stake of the owners implies sufficient safety margin and substantial protection against shrinkage in assets. 6 - 23 6 - 23
  • 24. For the company also, the servicing of debt is less burdensome and consequently its credit standing is not adversely affected, its operational flexibility is not jeopardised and it will be able to raise additional funds. 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. 6 - 24 6 - 24
  • 25. Trading on Equity Trading on equity (leverage) is the use of borrowed funds in expectation of higher return to equity-holders. Trading on Equity (Amount in Rs thousand) Particular A B C D (a) Total assets 1,000 1,000 1,000 1,000 Financing pattern: Equity capital 1,000 800 600 200 15% Debt — 200 400 800 (b)Operating profit (EBIT) 300 300 300 300 Less: Interest — 30 60 120 Earnings before taxes 300 270 240 180 Less: Taxes (0.35) 105 94.5 84 63 Earnings after taxes 195 175.5 156 117 Return on equity (per cent) 19.5 21.9 26 58.5 6 - 25 6 - 25
  • 26. II. Debt to Total Capital The relationship between creditors’ funds and owner’s capital can also be expressed using Debt to total capital ratio. Total debt Debt to total capital ratio = Permanent capital Permanent Capital = Shareholders’ equity + Long-term debt. 6 - 26 6 - 26
  • 27. III. Debt to total assets ratio Total debt Debt to total assets ratio = Total assets Proprietary Ratio Proprietary ratio indicates the extent to which assets are financed by owners funds. Proprietary funds Proprietary ratio = X 100 Total assets Capital Gearing Ratio Capital gearing ratio is used to know the relationship between equity funds (net worth) and fixed income bearing funds (Preference shares, debentures and other borrowed funds. 6 - 27 6 - 27
  • 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 coverage ratio = Interest Dividend Coverage Ratio Dividend Coverage Ratio measures the firm’s ability to pay dividend on preference share which carry a stated rate of return. EAT (Earning after taxes) Dividend coverage ratio = Preference dividend 6 - 28 6 - 28
  • 29. Total fixed charge coverage ratio Total fixed charge coverage ratio measures the firm’s ability to meet all fixed payment obligations. Total fixed charge EBIT + Lease Payment coverage ratio = Interest + Lease payments + (Preference dividend + Instalment of Principal)/(1-t) Total Cashflow Coverage Ratio However, coverage ratios mentioned above, suffer from one major limitation, that is, they relate the firm’s ability to meet its various financial obligations to its earnings. Accordingly, it would be more appropriate to relate cash resources of a firm to its various fixed financial obligations. EBIT + Lease Payments + Depreciation + Non-cash expenses Total cashflow = coverage ratio (Principal repayment) (Preference dividend) Lease payment + + + Interest (1– t) (1 - t) 6 - 29 6 - 29
  • 30. 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. n ∑ EATt + Interestt + Depreciationt + OAt t=1 DSCR = n ∑ Instalmentt t=1 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. 6 - 30 6 - 30
  • 31. Example 6: Debt-Service Coverage Ratio Agro Industries Ltd has submitted the following projections. You are required to work out yearly debt service coverage ratio (DSCR) and the average DSCR. (Figures in Rs lakh) Year Net profit for the Interest on term loan Repayment of term year during the year loan in the year 1 21.67 19.14 10.70 2 34.77 17.64 18.00 3 36.01 15.12 18.00 4 19.20 12.60 18.00 5 18.61 10.08 18.00 6 18.40 7.56 18.00 7 18.33 5.04 18.00 8 16.41 Nil 18.00 The net profit has been arrived after charging depreciation of Rs 17.68 lakh every year. © Tata McGraw-Hill Publishing Company Limited, Financial Management © Tata McGraw-Hill Publishing Company Limited, Financial Management 6 - 31 6 - 31
  • 32. Solution Table 3: Determination of Debt Service Coverage Ratio (Amount in lakh of rupees) Ye Net Depreciation Interest Cash Principal Debt DSCR [col. 5 ar profit available instalment obligation ÷ col. 7 (col. (col. 4 + col. 6) (No. of times)] 2+3+4) 1 2 3 4 5 6 7 8 1 21.67 17.68 19.14 58.49 10.70 29.84 1.96 2 34.77 17.68 17.64 70.09 18.00 35.64 1.97 3 36.01 17.68 15.12 68.81 18.00 33.12 2.08 4 19.20 17.68 12.60 49.48 18.00 30.60 1.62 5 18.61 17.68 10.08 46.37 18.00 28.08 1.65 6 18.40 17.68 7.56 43.64 18.00 25.56 1.71 7 18.33 17.68 5.04 41.05 18.00 23.04 1.78 8 16.41 17.68 Nil 34.09 18.00 18.00 1.89 Average DSCR (DSCR ÷ 8) 1.83 © Tata McGraw-Hill Publishing Company Limited, Financial Management © Tata McGraw-Hill Publishing Company Limited, Financial Management 6 - 32 6 - 32
  • 33. Profitability Ratio Profitability ratios can be computed either from sales or investment. Profitability Ratios Profitability Ratios Related to Sales Related to Investments (i) Profit Margin (i) Return on Investments (ii) Expenses Ratio (ii) Return on Shareholders’ Equity 6 - 33 6 - 33
  • 34. Profit Margin Gross Profit Margin Gross profit margin measures the percentage of each sales rupee remaining after the firm has paid for its goods. Gross profit margin = Gross Profit X 100 Sales 6 - 34 6 - 34
  • 35. 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. Net profit margin can be computed in three ways Earning before interest and taxes i. Operating Profit Ratio = Net sales Earnings before taxes ii. Pre-tax Profit Ratio = Net sales Earning after interest and taxes iii. Net Profit Ratio = Net sales 6 - 35 6 - 35
  • 36. Example 7: From the following information of a firm, determine (i) Gross profit margin and (ii) Net profit margin. 1. Sales Rs 2,00,000 2. Cost of goods sold 1,00,000 3. Other operating expenses 50,000 Rs 1,00,000 (1) Gross profit margin = = 50 per cent Rs 2,00,000 Rs 50,000 (2) Net profit margin = = 25 per cent Rs 2,00,000 6 - 36 6 - 36
  • 37. Expenses Ratio Cost of goods sold i. Cost of goods sold = X 100 Net sales Administrative exp. + Selling exp. ii. Operating expenses = X 100 Net sales Administrative expenses iii. Administrative expenses = X 100 Net sales Selling expenses iv. Selling expenses ratio = X 100 Net sales Cost of goods sold + Operating expenses v. Operating ratio = X 100 Net sales Financial expenses vi. Financial expenses = X 100 Net sales 6 - 37 6 - 37
  • 38. Return on Investment Return on Investments measures the overall effectiveness of management in generating profits with its available assets. i. Return on Assets (ROA) EAT + (Interest – Tax advantage on interest) ROA = Average total assets ii. Return on Capital Employed (ROCE) EAT + (Interest – Tax advantage on interest) ROCE = Average total capital employed 6 - 38 6 - 38
  • 39. Return on Shareholders’ Equity Return on shareholders equity measures the return on the owners (both preference and equity shareholders) investment in the firm. 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 - 39 6 - 39
  • 40. Efficiency Ratio Activity ratios measure the speed with which various accounts/assets are converted into sales or cash. Inventory turnover measures the efficiency of various types of inventories. i. Inventory Turnover measures theof goods sold Inventory Turnover Ratio = Cost activity/liquidity of Average inventory inventory of a firm; the speed with which inventory is sold i. Inventory Turnover measures the activity/liquidityused Raw materials turnover = Cost of raw materials of inventory of a firm; the speed with whichmaterial inventory Average raw inventory is sold i. Inventory Turnover measuresCost activity/liquidity of the of goods manufactured Work-in-progress turnover = inventory of a firm; the speed with which inventory is sold Average work-in-progress inventory 6 - 40 6 - 40
  • 41. Debtors Turnover Ratio Liquidity of a firm’s receivables can be examined in two ways. Credit sales i. Debtors turnover = measures the activity/liquidity of inventory of i. Inventory Turnover a firm; the speed with which inventoryAverage bills receivable (B/R) Average debtors + is sold Months (days) in a year 2. Average collection period = Debtors turnover i. Inventory Turnover(days) in a year activity/liquidity of inventory of a Alternatively = Months measures the (x) (Average Debtors + Average (B/R) firm; the speed with which inventory is credit sales Total sold Ageing Schedule enables analysis to identify slow paying debtors. 6 - 41 6 - 41
  • 42. Assets Turnover Ratio Assets turnover indicates the efficiency with which firm uses all its assets to generate sales. Inventory Turnover measures the of goods sold of inventory of i. Total assets turnover = i. Cost activity/liquidity a firm; the speed with which inventory total assets Average is sold Cost of goods sold ii. Fixed assets turnover = Average fixed assets Cost of goods sold i. Inventory Turnover measures the activity/liquidity of inventory of iii. Capital turnover = a firm; the speed with which inventory is sold employed Average capital Cost of goods sold iv. Current assets turnover = Average current assets i. Inventory capital turnover = Costactivity/liquidity of inventory of v. Working Turnover measures the of goods sold Net working capital a firm; the speed with which inventory is sold 6 - 42 6 - 42
  • 43. 1) Return on shareholders’ equity = EAT/Average total shareholders’ equity. 2) Return on equity funds = (EAT – Preference dividend)/Average ordinary shareholders’ equity (net worth). 3) Earnings per share (EPS) = Net profit available to equity shareholders’ (EAT – Dp)/Number of equity shares outstanding (N). 4) Dividends per share (DPS) = Dividend paid to ordinary shareholders/Number of ordinary shares outstanding (N). 5) Earnings yield = EPS/Market price per share. 6) Dividend Yield = DPS/Market price per share. 7) Dividend payment/payout (D/P) ratio = DPS/EPS. 8) Price-earnings (P/E) ratio = Market price of a share/EPS. 9) Book value per share = Ordinary shareholders’ equity/Number of equity shares outstanding. 6 - 43 6 - 43
  • 44. Integrated Analysis Ratio Integrated ratios provide better insight about financial and economic analysis of a firm. (1) Rate of return on assets (ROA) can be decomposed in to (i) Net profit margin (EAT/Sales) (ii) Assets turnover (Sales/Total assets) (2) Return on Equity (ROE) can be decomposed in to (i) (EAT/Sales) x (Sales/Assets) x (Assets/Equity) (ii) (EAT/EBT) x (EBT/EBIT) x (EBIT/Sales) x (Sales/Assets) x (Assets/Equity) 6 - 44 6 - 44
  • 45. Rate of Return on Assets EAT as percentage of Assets sales turnover EAT Divided by Sales Sales Divided by Total Assets Fixed assets Plus Current assets Gross profit = Sales less cost of goods sold Alternatively Minus Shareholder equity Expenses: Selling Plus Administrative Interest Long-term borrowed Minus funds Income-tax Plus Current liabilities 6 - 45 6 - 45
  • 46. Return on Assets Earning Power Earning power is the overall profitability of a firm; is computed by multiplying net profit margin and assets turnover. Earning power = Net profit margin × Assets turnover Where, Net profit margin = Earning after taxes/Sales Asset turnover = Sales/Total assets i. Inventory Turnover measurestaxes x Earning Power = Earning after the activity/liquidity of inventory of Sales x EAT a firm; the speed with which inventory isTotal Assets Total assets Sales sold 6 - 46 6 - 46
  • 47. EXAMPLE: 8 Assume that there are two firms, A and B, each having total assets amounting to Rs 4,00,000, and average net profits after taxes of 10 per cent, that is, Rs 40,000, each. Firm A has sales of Rs 4,00,000, whereas the sales of firm B aggregate Rs 40,00,000. Determine the ROA of firms A and B. Table 4 shows the ROA based on two components. Table 4: Return on Assets (ROA) of Firms A and B Particulars Firm A Firm B 1. Net sales Rs 4,00,000 Rs 40,00,000 2. Net profit 40,000 40,000 3. Total assets 4,00,000 4,00,000 4. Profit margin (2 ÷ 1) (per cent) 10 1 5. Assets turnover (1 ÷ 3) (times) 1 10 6. ROA ratio (4 × 5) (per cent) 10 10 6 - 47 6 - 47
  • 48. Return on Equity (ROE) ROE is the product of the following three ratios: Net profit ratio (x) Assets turnover (x) Financial leverage/Equity multiplier Three-component model of ROE can be broadened further to consider the effect of interest and tax payments. EAT EBT EBIT Net Profit i. Inventory Turnover measures the activity/liquidity of x x = inventory of a firm; the EBIT Sales Earnings before taxes speed with which inventory is sold Sales As a result of three sub-parts of net profit ratio, the ROE is composed of the following 5 components. EAT EBT EBIT Sales Assets x x x x EBT EBIT Sales Assets Equity 6 - 48 6 - 48
  • 49. A 5-way break-up of ROE enables the management of a firm to analyse the effect of interest payments and tax payments separately from operating profitability. To illustrate further assume 8 per cent interest rate, 35 per cent tax rate and other operating expense of Rs 3,22,462 (Firm A) and Rs 39,26,462 (Firm B) for the facts contained in Example 8. Table 5 shows the ROE (based on the 5 components) of Firms A and B. Table 5: ROE (Five-way Basis) of Firms A and B Particulars Firm A Firm B Net sales Rs 4,00,000 Rs 40,00,000 Less: Operating expenses 3,22,462 39,26,462 Earnings before interest and taxes (EBIT) 77,538 73,538 Less: Interest (8%) 16,000 12,000 Earnings before taxes (EBT) 61,538 61,538 Less: Taxes (35%) 21,538 21,538 Earnings after taxes (EAT) 40,000 40,000 Total assets 4,00,000 4,00,000 Debt 2,00,000 2,50,000 Equity 2,00,000 1,50,000 EAT/EBT (times) 0.65 0.65 EBT/EBIT (times) 0.79 0.84 EBIT/Sales (per cent) 19.4 1.84 Sales/Assets (times) 1 10 Assets/Equity (times) 2 1.6 ROE (per cent) 20 16 6 - 49 6 - 49
  • 50. Common Size Statements Preparation of common-size financial statements is an extension of ratio analysis. These statements convert absolute sums into more easily understood percentages of some base amount. It is sales in the case of income statement and totals of assets and liabilities in the case of the balance sheet. 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. 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. Nevertheless, they are an important tool of financial analysis. 6 - 50 6 - 50