1. Chapter 6
Financial Statements Analysis
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2. FINANCIAL STATEMENTS
ANALYSIS
Ratio Analysis
Common Size Statements
Importance and Limitations of
Ratio Analysis
Mini Case
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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.
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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
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.
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5. Types of Ratios
Liquidity Ratios
Capital Structure Ratios
Profitability Ratios
Efficiency ratios
Integrated Analysis Ratios
Growth Ratios
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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
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7. Liquidity Ratios
Liquidity ratios measure the ability of a firm to
meet its short-term obligations.
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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
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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
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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
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11. Supplementary Ratios for
Liquidity
Inventory Turnover Ratio
Debtors Turnover Ratio
Creditors Turnover Ratio
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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.
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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)
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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.
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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
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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.
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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)
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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.
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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)
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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
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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
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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
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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.
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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.
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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
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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.
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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.
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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
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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)
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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.
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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.
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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.
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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
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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.
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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)
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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
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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
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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
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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
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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
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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.
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51. CASE STUDY
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52. From the following selected financials of Reliance Industries Ltd (RIL) for the period 2001-2006, appraise its financial
health from the point of view of liquidity, solvency, and profitability.
Selected financial data and ratios (Amount in Rs crore)
Particulars 2001 2002 2003 2004 2005 2006
(I) Related to Liquidity Analysis
Current assets 9,844.48 13,025.31 17,925.25 23,245.88 28,988.62 24,591.03
Marketable investments 3387.25 536.80 536.19 536.11 536.11 16.58
Inventory 2299.85 4976.07 7510.14 7,231.22 7,412.88 10,119.82
Debtors 1,134.17 2,722.46 2,975.49 3,189.93 3,927.81 4,163.62
Advances 2,922.58 3,310.27 6,756.22 12,064.38 13,503.03 8,144.85
Cash and bank balance 100.63 1,760.71 147.21 224.24 3,608.79 2,146.16
Current liabilities 5,312.06 9,830.10 18,160.39 16,966.15 21,934.45 21,441.88
Short-term bank borrowings 337.76 2,148.27 7,193.77 9,145.14 12,684.39 11,438.69
Sundry creditors 3,754.50 5,847.20 8288.10 366.78 366.95 310.42
Interest accrued 223.00 389.23 380.15 676.45 525.37 728.18
Creditors for capital goods 104.72 175.16 717.48 2,670.75 3471.80 3,890.98
Other current liabilities & provisions 892.08 1270.24 1580.89 4,107.03 4,885.94 2,073.61
Other data and ratios
Net working capital 4,532.42 3,195.21 -235.14 6,279.73 7,054.17 3,149.15
Credit sales 22,886.51 45,073.88 49,743.54 56,247.03 73,164.10 89,124.16
Cost of goods sold 21,290.91 45,957.85 54,642.60 41,657.92 53,345.03 65,535.84
Cost of raw material used 18,155.98 41,023.35 50,378.65 34,721.39 45,931.87 58,342.31
Credit purchases 21,608.85 45,083.06 56,884.49 60,246.91 70,014.80 68,516.87
Average debtors 988.31 1,928.31 2,848.97 3,094.02 3,558.87 4,045.71
Average creditors 3,170.68 4,800.85 7,067.65 9,413.58 11,515.6 12,688.31
Current ratio 1.85 1.33 0.99 1.75 1.66 1.49
Acid test ratio 0.87 0.51 0.20 .26 .55 .38
Debtors turnover 23 23 17 17.63 18.62 21.40
Creditors turnover 7 9 8 6.40 6.08 5.40
Debtors cycle (days) 16 16 21 21 20 17
Creditors cycle (days) 54 39 45 57 60 67
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53. CONTD.
Particulars 2001 2002 2003 2004 2005 2006
(II) Related to Solvency Analysis
Free reserves 9,307.89 21,834.29 23,656.31 33,056.50 39,010.23 48,411.09
Paid up capital 1,053.49 1,395.85 1,395.92 1,395.95 1,393.09 1,393.17
Preference capital 0.00 0.00 0.00 0.00 0.00 0.00
Bonus equity capital 481.77 481.77 481.77 481.77 481.77 481.77
Total equity 10,843.15 23,711.91 25,534.00 34,934.22 40,885.09 50,286.03
Long-term borrowings 9,798.03 16,780.21 12,564.54 11,149.38 6,172.98 8,185.60
Current liabilities 5,312.06 9,830.10 18,160.39 12,955.22 17,131.52 16,454.48
Total debt 15,110.09 26,610.31 30,724.93 24,104.60 23,304.50 24,640.08
EBIT 4,032.37 6,307.71 6,551.17 7,735.86 10,537.34 11,581.10
Interest 1,215.56 1,827.85 1,555.40 1,434.72 1,468.66 877.04
Total debt-equity ratio 1.39 1.12 1.20 0.69 0.57 0.49
Long-term debt-equity ratio 0.90 0.71 0.49 .31 .15 .16
Interest coverage ratio 3.32 3.45 4.21 5.39 7.17 13.20
(III) Related to Profitability Analysis
Sales (manufacturing) 22886.51 45073.88 49,743.54 56,247.03 73.164.10 89,124.46
Cost of goods sold 21290.91 45957.85 54,642.60 41,657.92 53,345.03 65,535.84
EBDIT (including other earnings) 5,597.48 9,123.85 9,388.26 10,982.88 14,260.84 14,982.01
EBIT 4,032.37 6,307.71 6,551.17 7,735.86 10,537.34 11,581.10
EBT 2,786.00 4,434.17 4,982.75 6,301.14 9,068.68 10,704.06
EAT 2,646.50 3,242.17 4,106.85 5,160.14 7,571.68 9,069.34
Interest 1,215.55 1,827.84 1,555.4 1,434.72 1,468.66 877.04
Average total capital employed 19235.95 27,053.32 34,388.04 50,030.24 54,560.80 61,738.85
Average total assets 29622.14 43,325.86 60,415.77 52,764.91 57,292.51 65,428.89
Average equity funds 10715.17 17,277.53 24,622.96 1,396.38 1,394.94 1,393.51
Gross profit % 24.46 20.24 18.87 18.41 19.40 17.43
Operating profit ratio % 17.62 13.99 13.17 13.75 14.40 12.99
Net profit ratio % 11.56 7.19 8.26 9.95 11.48 11.21
Cost of goods sold ratio % 93.03 101.96 109.85 80.34 80.92 81.03
Rate of return on capital employed (ROCE)1 20.07 18.74 16.47 13.18 16.56 16.11
ROR (Total assets)2 13.03 11.7 9.37 12.4 15.77 15.20
ROR (Equity funds) 24.70 18.77 16.68 16.26 20.09 20.08
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1. ROCE = (EAT + Interest)/ Average capital employed 2. ROR (Total assets) = (EAT + Interest)/ Average assets

54. Solution: The appraisal of financial health of RIL is presented below.
Liquidity Analysis:
The liquidity position of RIL does not appear to be commendable during all the
years under reference. In fact, its current ratio was less than one implying
negative working capital (in 2003) and acid-test ratio was at an alarming low level
of 0.2. Though the current ratio range of 1.33 – 1.85 (during 2001-2 and 2004-6) is
an indicative of satisfactory liquidity position, the acid-test ratios appear to be on
the lower side, the range being 0.20 – 0.55 (during 2002-6). The major reason for
the sharp difference in these two liquidity ratios may be ascribed to a significant
proportion of inventory (in current assets).
The other notable observation is that the RIL seems to be banking on bank
borrowings to finance its working capital requirements evidenced by a
substantial increase in such borrowings over the years. From 337.76 crore (in
2001), they steadily increased to 7,193.77 crore (by 2003) and to Rs 11,438.69
crore by 2006: (registering more than 30 times increase in 2006 compared to
2001). In fact, short-term borrowings constitute more than one-half of its total
current liabilities during the 6 year period. The reliance on short-term bank
borrowings, to such a marked extent, is contrary to sound tenets of finance.
Likewise, it appears that its net working capital is inadequate in relation to its
credit sales which stood at Rs. 89,124 crore in 2006 compared to Rs. 73,164
crore in 2005. Contrary to increase in net working capital, however, there has
been a more than 50 per cent decrease in net working capital of the RIL; (the
relevant figures being Rs 7,054.17 crore and Rs 3,149.15 crore in years 2005 and
2006 respectively).
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55. The RIL has the advantage of much higher creditors payment period
compared to debtors collection period. The debtors collection period (varying
from 16 days in 2001 and 2002 to 21 days in 2004) seems to be at a very
satisfactory level. In marked contrast, the creditors payment period is three-
times (varying in the range of 39-67 days) during the same period. This
favourable gap, provides some leverage to RIL to operate at relatively low
acid-test ratio.
To conclude, the liquidity position of the RIL does not appear to be
satisfactory. It is suggested that RIL should substitute a fair share of short-
term bank borrowings by long-term loans (which have shown sharp decrease
trend over the years). Such a step would help to improve its liquidity ratios.
Solvency Analysis:
The solvency position of the RIL is sound for two reasons: First, it has a
satisfactory level of interest coverage ratio during all the 6 years, being in the
range of 3.32 and 13.2. The RIL is not likely to commit default in payment of
interest to its lenders as even though its operating profits (EBIT) decline by
more than nine-tenth (2006), it l would stil have enough margin to meet its
interest obligations. Secondly, its total debt-equity ratio over the years has
shown a substantial decrease from 1.39 in 2001 to 0.49 by 2006. Likewise, the
long-term debt to equity ratio during over the years has improved
substantially.
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56. Profitability Analysis:
The profit margins (gross, operating and net) of the RIL over the years have
reduced, albeit recent improvements. For instance gross profit margin has
decreased from 24.46 per cent (in 2001) to 17.43 per cent (in 2006). Likewise
operating profit margins have declined from 17.62 per cent to 12.99 per cent
and net profit margins from 11.56 per cent to 11.21 per cent during these
years. The lower operating profit margins have an unfavourable effect on the
ROR on capital employed. It fell from 20.07 per cent in 2001 to 16.11 per cent
by 2006. However, it is gratifying to note that there has been an increase in
other rates of return. For instance, the ROR on total assets has improved from
13.03 per cent in 2001 to 15.20 per cent in 2006. Likewise a notable increase in
observed in ROR on equity funds. From 16.68 in 2003, it has increased to
more than 20 per cent in 2005 as well as in 2006. There seems to be a
potential for further improvement in its various ROR’s by increasing its gross
profit and operating profit margins.
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