Ratio analysis

Financial Statement Analysis

Prof. Anjali Kulkarni

Prof. Anjali Kulkarni 2

• Assessment of the firm’s past, present and future financial conditions

• Done to find firm’s financial strengths and weaknesses

• Primary Tools:– Financial Statements– Comparison of financial ratios to past,

industry, sector and all firms

Financial Analysis


Financial Statements

• Balance Sheet

• Income Statement

• Cashflow Statement

• Statement of Retained Earnings


Sources of Data

• Annual reports– Via mail, SEBI or company websites

• Published collections of data– Newspapers, magazines etc.

• Investment sites on the web– Examples

• http://moneycontrol.com• http://www.indiainfoline.com


Why needed ?

• Lenders’ need it for carrying out the following

• Technical Appraisal

• Commercial Appraisal

• Financial Appraisal

• Economic Appraisal

• Management Appraisal


Ratio Analysis

• It’s a tool which enables the banker or lender to arrive at the following factors :

• Liquidity position• Profitability• Solvency• Financial Stability• Quality of the Management• Safety & Security of the loans & advances to

be or already been provided


Important AspectsFinancial analysts often assess the firm's:• 1. Profitability- Its ability to earn income and sustain growth in

both short-term and long-term. A company's degree of profitability is usually based on the income statement, which reports on the company's results of operations;

• 2. Solvency- its ability to pay its obligation to creditors and other third parties in the long-term;

• 3. Liquidity- its ability to maintain positive cash flow, while satisfying immediate obligations;

• Both 2 and 3 are based on the company's balance sheet, which indicates the financial condition of a business as of a given point in time.

• 4. Stability- the firm's ability to remain in business in the long run, without having to sustain significant losses in the conduct of its business. Assessing a company's stability requires the use of both the income statement and the balance sheet, as well as other financial and non-financial indicators.

http://en.wikipedia.org/wiki/Income_statement

http://en.wikipedia.org/wiki/Cash_flow

http://en.wikipedia.org/wiki/Balance_sheet


Who All Needs It?

• Internal users– Management for

• Performance evaluation – compensation and comparison between divisions

• Planning for the future – guide in estimating future cash flows

• External users– Creditors– Suppliers– Customers– Stockholders


• As Percentage - such as 25% or 50% . For example if net profit is Rs.25,000/- and the sales is Rs.1,00,000/- then the net profit can be said to be 25% of the sales.

• As Proportion - The above figures may be expressed in terms of the relationship between net profit to sales as 1 : 4.

• As Pure Number /Times - The same can also be expressed in an alternative way such as the sale is 4 times of the net profit or profit is 1/4th of the sales.

How a ratio is expressed ?


Five Major Categories of Ratios and Their Implications• Liquidity: Can we make required payments?

• Asset management: right amount of assets vs. sales? Also known as Turnover/ Activity Ratios.

• Debt management: Right mix of debt and equity? Also known as Leverage/ Capital Structure Ratios.

• Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA?

• Market value: Do investors like what they see as reflected in P/E and M/B ratios? Also known as Valuation Ratios.


Classification of Ratios

Balance Sheet Ratio

P&L Ratio or Income/Revenue Statement Ratio

Balance Sheet and Profit & Loss Ratio

Financial Ratio Operating Ratio Composite Ratio

Current RatioQuick Asset RatioProprietary RatioDebt Equity Ratio

Gross Profit RatioOperating RatioExpense RatioNet profit RatioStock Turnover Ratio

Fixed Asset Turnover Ratio, Return on Total Resources Ratio, Return on Own Funds Ratio, Earning per Share Ratio, Debtors’ Turnover Ratio,


Format of Balance Sheet for Ratio Analysis

LIABILITIES ASSETS

NET WORTH/EQUITY/OWNED FUNDSShare Capital/Partner’s Capital/Paid up Capital/ Owners FundsReserves ( General, Capital, Revaluation & Other Reserves) Credit Balance in P&L A/c

FIXED ASSETS : LAND & BUILDING, PLANT & MACHINERIES Original Value Less DepreciationNet Value or Book Value or Written down value

LONG TERM LIABILITIES/BORROWED FUNDS : Term Loans (Banks & Institutions)Debentures/Bonds, Unsecured Loans, Fixed Deposits, Other Long Term Liabilities

NON CURRENT ASSETSInvestments in quoted shares & securitiesOld stocks or old/disputed book debtsLong Term Security DepositsOther Misc. assets which are not current or fixed in nature

CURRENT LIABILTIESBank Working Capital Limits such as CC/OD/Bills/Export CreditSundry /Trade Creditors/Creditors/Bills Payable, Short duration loans or depositsExpenses payable & provisions against various items

CURRENT ASSETS : Cash & Bank Balance, Marketable/quoted Govt. or other securities, Book Debts/Sundry Debtors, Bills Receivables, Stocks & inventory (RM,SIP,FG) Stores & Spares, Advance Payment of Taxes, Prepaid expenses, Loans and Advances recoverable within 12 months

INTANGIBLE ASSETSPatent, Goodwill, Debit balance in P&L A/c, Preliminary or Preoperative expenses


Review: Income Statement

• Gross Profit = Sales - Costs of Goods Sold

• EBITDA = Gross Profit - Cash Operating Expenses

• EBIT = EBDIT - Depreciation - Amortization

• EBT = EBIT - Interest • NI or EAT = EBT- Taxes

• Net Income is a primary determinant of the firm’s cashflows and, thus, the value of the firm’s shares


Some Basics• Liabilities have Credit balance and Assets have Debit

balance

• Current Liabilities are those which have either become due for payment or shall fall due for payment within 12 months from the date of Balance Sheet

• Current Assets are those which undergo change in their shape/form within 12 months. These are also called Working Capital or Gross Working Capital

• Net Worth & Long Term Liabilities are also called Long Term Sources of Funds


• Current Liabilities are known as Short Term Sources of Funds

• Long Term Liabilities & Short Term Liabilities are also called Outside Liabilities

• Current Assets are Short Term Use of Funds• Assets other than Current Assets are Long Term Use

of Funds • Installments of Term Loan Payable in 12 months are

to be taken as Current Liability only for Calculation of Current Ratio & Quick Ratio.

• If there is profit it shall become part of Net Worth under the head Reserves and if there is loss it will become part of Intangible Assets

Some Basics


• Investments in Govt. Securities to be treated current only if these are marketable and due. Investments in other securities are to be treated current if they are quoted. Investments in allied/associate/sister units or firms to be treated as non-current.

• Bonus Shares as issued by capitalization of General reserves and as such do not affect the Net Worth. With Rights Issue, change takes place in Net Worth and Current Ratio.

Some Basics


Ratios : Liquidity

1. Current Ratio : It is the relationship between the current assets and current liabilities of a concern.

Current Ratio = Current Assets/Current Liabilities If the Current Assets and Current Liabilities of a concern areRs.4,00,000 and Rs.2,00,000 respectively, then the Current Ratio will be : Rs.4,00,000/Rs.2,00,000 = 2 : 1 The ideal Current Ratio preferred by Banks is 1.33 : 1

2. Net Working Capital : This is worked out as surplus of Long Term Sources over Long Term Uses, alternatively it is the difference of Current Assets and Current Liabilities.

NWC = Current Assets – Current Liabilities


3. ACID TEST or QUICK RATIO : It is the ratio between Quick Current Assets and Current Liabilities.

Quick Current Assets : Cash/Bank Balances + Receivables upto 6 months + Quickly realizable securities such as Govt. Securities or quickly marketable/quoted shares and Bank Fixed Deposits.

Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities

Example : Cash 50,000Debtors 1,00,000Inventories 1,50,000 Current Liabilities 1,00,000Total Current Assets 3,00,000

Current Ratio = > 3,00,000/1,00,000 = 3 : 1Quick Ratio = > 1,50,000/1,00,000 = 1.5 : 1

Ratios : Liquidity


Ratios: Leverage 4. DEBT EQUITY RATIO : It is the relationship between borrower’s

fund (Debt) and Owner’s Capital (Equity).

Debt DER = -----------

Equity

Debentures + Long Term loans = ------------------------------------------------------------------------------------- Equity Shares+ Preference Shares + Reserves and Surplus

For instance, if the Firm is having the following :

Capital = Rs. 200 Lacs Free Reserves & Surplus = Rs. 300 Lacs Long Term Loans/Liabilities = Rs. 800 Lacs

Debt Equity Ratio will be => 800/500 i.e. 1.6 : 1


5. PROPRIETARY RATIO : This ratio indicates the extent to which Tangible Assets are financed by Owner’s Fund.

Proprietary Ratio = (Tangible Net Worth/Total Tangible Assets) x 100

The ratio will be 100% when there is no Borrowing for purchasing of

Assets.

6. GEARING RATIO Debt + Preference Shares = ---------------------------------------

Equity7. INTEREST COVERAGE RATIO: Extent of earnings

available to pay off interest burden. Is given by Earnings Before Interest and Taxes

(EBIT ) ICR = ------------------------------------------------------- Interest

Ratios : Leverage


Ratios: Profitability8. GROSS PROFIT RATIO : By comparing Gross Profit

percentage to Net Sales we can arrive at the Gross Profit Ratio which indicates the manufacturing efficiency as well as the pricing policy of the concern.

Gross Profit Ratio = (Gross Profit / Net Sales ) x 100

Alternatively , since Gross Profit is equal to Sales minus Cost of Goods Sold, it can also be interpreted as below :

Gross Profit Ratio = [ (Sales – Cost of goods sold)/ Net

Sales] x 100 A higher Gross Profit Ratio indicates efficiency in

production of the unit.


9. OPERATING PROFIT RATIO :

It is expressed as => (Operating Profit / Net Sales ) x 100

Higher OP ratio indicates higher operational efficiency

Operating Profit = NP + Non-operating Expenses – Non-operating Income

10. NET PROFIT RATIO :

It is expressed as => ( Net Profit / Net Sales ) x 100

It measures overall profitability.

Ratios : Profitability


11. STOCK/INVENTORY TURNOVER RATIO :

COGS STR = ----------------------------- Average Inventory

(Opening Stock + Closing Stock)

Average Inventory or Stocks = ------------------------------------------------- 2 COGS = Sales – GP or OS+ Purchases – CS

This ratio indicates the number of times the inventory is rotated during the relevant accounting period

Ratios : Turnover


12. DEBTORS TURNOVER RATIO : This ratio reflects the relationship

between credit sales and debtors. Credit Sales

DTR = ----------------------------- Average Debtors

365Average Collection Period = ----------------

DTR

13. CREDIT TURNOVER RATIO : This ratio indicates the intention of the firm to pay quickly to its creditors

Credit Purchases CTR = -------------------------------- Average Creditors 365 Average Payment Period = ------------- CTR

Ratios : Turnover


14. CURRENT ASSET TURNOVER RATIO :

CATR = Net Sales / Current Assets

15. FIXED ASSET TURNOVER RATIO : FATR = Net Sales /Fixed Assets

16. TOTAL ASSETS TURNOVER RATIO :

TATR = Net Sales / Total Assets

Ratios : Turnover


16. RETRUN ON ASSETS : Net Profit after Taxes/Total Assets

17. RETRUN ON CAPITAL EMPLOYED :

( Net Profit before Interest & Tax / Average Capital Employed) x 100

Average Capital Employed is the average of the equity

share capital and long term funds provided by the owners and the creditors of the firm at the beginning and end of the accounting period.

Ratios : Profitability


17. RETRUN ON EQUITY CAPITAL (ROE) : Net Profit after Taxes / Tangible Net Worth

EARNING PER SHARE : EPS indicates the quantum of net profit of the year that would be ranking for dividend for each share of the company being held by the equity share holders.

Net profit after Taxes and Preference Dividend/ No. of Equity Shares

19. PRICE EARNING RATIO : PE Ratio indicates the number of times the Earning Per Share is covered by its market price.

Market Price Per Equity Share/Earning Per Share


20. DEBT SERVICE COVERAGE RATIO : This ratio is one of the most important one which

indicates the ability of an enterprise to meet its liabilities by way of payment of installments of Term Loans and Interest thereon from out of the cash accruals and forms the basis for fixation of the repayment schedule in respect of the Term Loans raised for a project. (The Ideal DSCR Ratio is considered to be 2 )

PAT + Depr. + Annual Interest on Long Term Loans & Liabilities --------------------------------------------------------------------------------- Annual interest on Long Term Loans & Liabilities + Annual Installments payable on Long

Term Loans & Liabilities ( Where PAT is Profit after Tax and Depr. is Depreciation)


• We must be careful with financial statement analysis.

– Strong financial statement analysis does not necessarily mean that the organisation has a strong financial future.

– Financial statement analysis might look good but there may be other factors that can cause an organisation to collapse.

– Published industry averages are only guidelines– Accounting practices differ across firms– Sometimes difficult to interpret deviations in ratios– Industry ratios may not be desirable targets– Seasonality affects ratios– Window dressing techniques can make statements and ratios

look better

Limitations of Financial Statement Analysis


More issues regarding ratios

• Different operating and accounting practices can distort comparisons.

• Sometimes it is hard to tell if a ratio is “good” or “bad”.

• Difficult to tell whether a company is, on balance, in strong or weak position.


Qualitative factors to be considered when evaluating a company’s future financial performance

• Are the firm’s revenues tied to 1 key customer, product, or supplier?

• What percentage of the firm’s business is generated overseas?

• Competition• Future prospects• Legal and regulatory environment


Common Size StatementsCommon-sizeCommon-size

statements use percentages to express

the relationship of individual components to a total within a singlesingle

period. This is also known as vertical vertical

analysisanalysis.


Common Size Statements

– For Common Size Balance Sheets, – Compute all accounts as a percent of total

assets or liabilities– For Common Size Income Statements– Compute all line items as a percent of

sales


Common Size Balance Sheets:Divide All Items by Total Assets

Assets 2006 2007 2008

Cash 0.6% 0.3% 0.4%

ST Invest. 3.3% 0.7% 2.0%

AR 23.9% 21.9% 25.0%

Invent. 48.7% 44.6% 48.8%

Total CA 76.5% 67.4% 76.2%

Net FA 23.5% 32.6% 23.8%TA 100.0% 100.0% 100.0%


Divide all items by Total Liabilities & Equity

2006 2007 2008

AP 9.9% 11.2% 10.2%

Notes pay. 13.6% 24.9% 8.5%

Accruals 9.3% 9.9% 10.8%

Total CL 32.8% 46.0% 29.6%

LT Debt 22.0% 34.6% 14.2%

Total eq. 45.2% 19.3% 56.2%

Total L&E 100.0% 100.0% 100.0%


Trend analysis

• Analyzes a firm’s financial ratios over time

• Can be used to estimate the likelihood of improvement or deterioration in financial condition.


Trend percentages state several years’ financial data in terms of a base year, which equals 100 percent.

Trend Percentages


Trend Analysis

TrendPercentage

Current Year Amount Base Year Amount

100%= ×


Du Pont Analysis

• The Du Pont system focuses on:– Expense control (PM)– Asset utilization (TATO)– Debt utilization (EM)

• It shows how these factors combine to determine the ROE.


Deriving the Du Pont Identity

• ROE = NI / E• Multiply by 1 and then rearrange

ROE = (NI / E) (TA / TA)

ROE = (NI / TA) (TA / E) = ROA * EM

• Multiply by 1 again and then rearrange ROE = (NI / TA) (TA / E) (Sales / Sales)

ROE = (NI / Sales) (Sales / TA) (TA / E)

ROE = PM * TATR * EM


Profi t M argin T ota l A sse t T urnover

RO A E quity M ultip l ie r

RO E

The DuPont System




RO E

EquityCommon

Assets Total

Assets Total

IncomeNet MultiplierEquity ROAROE

The DuPont System




RO E

Assets Total

Sales

Sales

IncomeNet TurnoverAsset TotalMarginProfit ROA

The DuPont System




RO E

EquityCommon

Assets Total

Assets Total

Sales

Sales

IncomeNet MultiplierEquity TurnoverAsset TotalMarginProfit ROE

The DuPont System


Multiplier EquityROA

Multiplier EquityTurnover Asset TotalMarginProfit Equity Common

AssetsTotal

AssetsTotal

Sales

Sales

IncomeNet ROE

The DuPont System


Q.1Following is the profit for the year ended :

Particulars Rs. Rs.

Sales

- COGS

Gross Profit

- Operating Expenses

Net Profit

-Taxes

Net Profit After Tax


Du Pont Chart Evolution

Price

Cost

W/c

NFA

Margin

Turnover

ROI

Strategic Drivers

Operating Drivers

Industry Attractiveness

Competitive Position

Revenue/ Customer

Customer Service Level

Receivables Policy

Sourcing Costs

Financing Contribution

ROE

NI Growth

Cash Flow

COC

Value

Original Du Pont Chart

High Level Financial Drivers

The idea has been extended forward to shareholder value

…and back to the operating and strategic drivers of value.

Ratio analysis

Economy & Finance

Transcript of Ratio analysis