Ratio Analysis

Rajendra K. LaguRajendra K. Lagu

Balance Sheet• Shows the status of company’s financial position. It is

actually a snap shot at the instant it is prepared, what the company owns and owes.

• Not duration specific such as P&L statement isNot duration specific, such as P&L statement is.

• Ideally, can be calculated every day; however i icompanies usually calculate on a quarterly basis.

• Shows the sources and applications of funds.Shows the sources and applications of funds.

• Numbers by themselves are not important; ratios are.

Balance Sheet continued…

• Double entry accounting system: Assets and Liabilities must balance

• Every transaction gets entered at two places under different heads so that accounts are “balanced”different heads so that accounts are “balanced”.

• Credit / Debit or Assets / Liabilities

• Compare the movement across the quarters or years

• Scope for manipulation: Asset valuation, payment realization (GAAP)

Balance Sheet Structure

Assets LiabilitiesFixed Assets Long Term Liabilities

Land, Buildings, Vehicles, Equipment

Equity, Term Loans, Debentures

Current Assets Current Liabilities

Cash, Accounts Receivable Accounts Payable

Inventory:WIP, Finished Goods

Short Term Loans

Financial Management DecisionsgAssets Liabilities

Fi d A t L T Li bilitiFixed Assets Long Term Liabilities

Land, Buildings, Vehicles, Equipment

Equity, Term Loans, Debentures

Capital budgeting decisions

Capital structureq p

Current Assets Current Liabilities

Cash, Accounts Accounts Payable

structure decisions

,Receivable, Marketable

Securities

y

Inventory: Short Term LoansWIP, Finished Goods

Operating policy decisionsp g p y

Assets• You pay for them to acquire them and so you “own”

them• They generate revenues later in short or long term• Liquidity of an asset: Length of the time it takes to

generate revenue• Their value generally depreciates over time• They can be revalued on some events• They can be revalued on some events• They can be tangible or intangible (goodwill,

monopoly)p y)

Examples of Assets• Cash in bank and in hand (bank balance, physical cash)• Marketable Securities (parked funds)Marketable Securities (parked funds)• Accounts Receivables• Inventory (Work In Progress)Inventory (Work In Progress)• Inventory (Finished goods)• Land Building Plants Offices Vehicles• Land, Building, Plants, Offices, Vehicles• Equipment (PCs, Office equipment, Test jigs)• Patents Copyrights Trademarks• Patents, Copyrights, Trademarks• Goodwill, Brand Position

Liabilities

• Money that has been made available to theMoney that has been made available to the firm, received from outside sources.

• The firm owes them to outside agents including the shareholders

• Liabilities can have short term, long term, or b es c ve s o e , o g e , ono term repayment schedules

Examples of Liabilitiesp

• Accounts payable (supplier credit)p y ( pp )• Accrued corporate tax• Short term loans• Short term loans• Debentures• Long term loans• Equity (common stock + preferred stock)q y ( p )• Retained earnings

Balance Sheet of a Prototype Companyyp p y

• Frequency of P&L statement calculation

• Operating Cycle duration: 2 weeks, 2 months, 1 yearyear

• Inventory turns and profit margins are closelyInventory turns and profit margins are closely linked to the operating cycle

• Traders, Manufacturers, Knowledge-based companies

A Typical Manufacturing Company Starts Operation

Two promoters deposit Rs 5 lakhs in the company account asTwo promoters deposit Rs 5 lakhs in the company account as equity

XYZ Private Limited

Balance Sheet at April 1, 2001

Assets Liabilities

p

Cash 5,00,000 Equity 5,00,000

Total 5,00,000 Total 5,00,000

A lathe is bought on cash basisA lathe is bought on cash basis

Owner pays Rs 3 lakhs from the bank acount

Assets Liabilities

Cash 2,00,000 Equity 5,00,000

Plant 3 00 000Plant 3,00,000Total 5,00,000 Total 5,00,000

Raw material worth Rs 80,000 bought gon a 60 day credit basis

No payment is done so cash position does not change

Assets Liabilities

No payment is done so cash position does not change

Assets Liabilities

Cash 2,00,000 Equity 5,00,000

Plant 3,00,000 Account Payable 80,000Inventory 80,000y ,

Total 5,80,000 Total 5,80,000

Raw material worth Rs 40,000 processed and sold for Rs 50,000 with a 30 day credit

No payment is done so cash position does not change, but inventory is reduced

Assets Liabilities

y

Cash 2,00,000 Equity 5,00,000

Plant 3,00,000 Accounts Payable 80,000, , ,Inventory 40,000 Retained Earnings 10,000

Accounts Receivable 50 00050,000Total 5,90,000 Total 5,90,000

Customer pays up after 20 days

Payment deposited in bank so cash position changes

Assets Liabilities

Cash 2,50,000 Equity 5,00,000

Plant 3,00,000 Accounts Payable 80,000, , ,Inventory 40,000 Retained Earnings 10,000

Accounts Receivable 00 00000,000Total 5,90,000 Total 5,90,000

Supplier credit period is over and raw material is paid for after 60 days

Payment done from bank so cash balance reduces

Assets Liabilities

Cash 1,70,000 Equity 5,00,000

Plant 3,00,000 Accounts Payable 00,000, , ,Inventory 40,000 Retained Earnings 10,000

Accounts Receivable 00 00000,000Total 5,10,000 Total 5,10,000

A new promoter buys 10,000 shares of Rs 10 face value at a premium of Rs 20

Payment done to bank so cash balance increases

Assets Liabilities

y

Cash 4,70,000 Equity 6,00,000

Plant 3,00,000 Accounts Payable 00,000Inventory 40,000 Retained Earnings 10,000

Accounts Receivable 00,000 Share Premium a/c 2,00,000Total 8,10,000 Total 8,10,000, , , ,

Profit & Loss Account (Income Statement)

Sales Revenues 4,00,000Other Revenues 1,00,000

Total Revenues 5,00,000 100 %Cost of Goods Sold 2,00,000 40 %

Gross Profit 3,00,000 60 %Operating Expenses 1,50,000 30 %

PBITD 1,50,000 30 %, ,Interest + Tax + Depreciation 25,000 5 %

Net Profit 1,25,000 25 %1,25,000 25 %

Cash Flow / Funds Flow Statement• Differences in successive balance sheets• Sources of Funds

Net profitI f h it lIssue of new share capitalSale of fixed assetsNew loans

• Use of FundsPayment of dividendsPurchase of fixed assetsRepayment of loans

Ratio Analysis

• Compare the performance of the company for three successive yearsthree successive years

• The absolute numbers change so compare ratios• The absolute numbers change so compare ratios

C t i f diff i i b t f• Compare two companies of differing size but from the same industry, e.g, Infosys and Mastek

• Calculate industry-wide numbers (net profit margins for automobile companies)margins for automobile companies)

Liquidity Ratios

• Measure a firm’s ability to meet its short term obligations• Show trends early and so corrective actions can be taken inShow trends early and so corrective actions can be taken in

the working capital management

C R i C A / C Li bili i• Current Ratio: Current Assets / Current Liabilities

• Acid Test Ratio or Quick Ratio:Acid Test Ratio or Quick Ratio:(Current Assets – Inventory) / Current Liability(Cash or cash equivalent) / Current Liability

A firm is “solvent” if its assets are greater than outside liabilities. A firm is “liquid” if its current assets areliabilities. A firm is liquid if its current assets are greater than its current liabilities

Gearing Ratiosg• Leverage of a firm: Proportion of its long

li bili i h d bterm liabilities that are debts

• Long term liabilities = Debts + Equity• Debt/Equity ratioDebt/Equity ratio

Loan Capital / Share holder’s funds

Gears, Leverage: Mechanical Engg terms

Asset Utilization Ratios

• Return on Total Investment: management’s gskill in exploiting the funds made available

ROI =PBT / (Shareholders’ funds + Long term loans)

• Return on Shareholders’ EquityReturn on Shareholders EquityROE =

PBT / (Sh h ld ’ f d )PBT / (Shareholders’ funds)Sales / Total Capital Employed

Profitability Ratios

• Net Profit Margin = NP / Sales

• Gross Profit Margin = GP / SalesGross Profit Margin GP / Sales

Market Value related Ratios

• EPS (Earning Per Share) : NP / Total outstanding shares

• P/E : Market Price / Earning Per Share

• Revenue Multiple: Revenues / Assets

• Market to Book: Market Value / Book Value

Limitations of Financial Statements

• They are backward looking: Accrued results of the past year / quarterp y q

• Company’s value depends on its future profitability which depends on many factors not reflected in the balance sheet, which are non-monetary

Nature and innovativeness of it productsTechnology landscape (product obsolescence)CompetitorsEconomic conditions (recession / boom), government policiesStaff and management morale

Balance Sheet of Three IT Companies at 31.03.2001 (in Rs Cr) (http://www.indiainfoline.com)

Company Infosys Wipro SatyamEquity 33.0 47.0 56.0q y

Share premium 320.0 592.0 87.0

Retained earnings 1030.0 1300.0 670.0Retained earnings 1030.0 1300.0 670.0

Net Worth 1383.0 1965.0 813.0

Debt 0 0 45 0 172 0Debt 0.0 45.0 172.0

Capital employed 1383.0 2010.0 985.0

Fixed Assets 600 0 902 0 288 0Fixed Assets 600.0 902.0 288.0

Account receivable 430.0 600.0 475.0Cash & bank balance 385 0 446 0 151 0Cash & bank balance 385.0 446.0 151.0

Profit and Loss Statement of Three IT Companies for 12 Months Ending 31.03.2001 (in Rs Cr)

Company Infosys Wipro SatyamSales 1900.0 3054.0 1220.0

Other income 59.0 69.0 22.0

Total income 1959.0 3123.0 1242.0

Cost of material 238.0 380.0 128.0Comm + traveling cost 190.0 633.0 128.0

Employee cost 718.0 422.0 486.0

Total cost of sales 1151.0 2252.0 776.0Total cost of sales 1151.0 2252.0 776.0

PBIDT 808.0 870.0 466.0PAT 629 0 668 0 Prior year PAT 629.0 668.0 y

adjusted