1

RATIO ANALYSIS

2

Ratio Analysis•A Ratio can be defined as relationship

between two or more things/ numbers.•A Financial Ratio is the relationship

between two financial items, (i.e. from the Balance Sheet and the P&L Account)

•Financial Ratio Analysis is the ascertainment of ratios, their interpretation for the purpose of measuring financial strengths/ weaknesses.

3

Role of Ratio AnalysisRatios are used as a benchmark for evaluating financial position and performance of a firm.Ratios help to summarize large quantities of financial data into more meaningful element.Ratios facilitate qualitative judgement about the firm’s financial performance.Ratio analysis help meaningful interpretation of financial statements w.r.t. its performance, credit analysis, security analysis, trend analysis.

4

Standards of ComparisonRatio analysis involves comparisons for a moremeaningful understanding of the facts & figures given in the financial statements. The standards of comparison consist are as follows:

Time Series/ Trend Analysis (past ratios)Cross-sectional Analysis (competitor ratios)Industry AnalysisProjected Ratios

5

Users of Financial Ratios Investors – to determine firm’s earnings,

balancing risk & return for dividend & capital appreciation.

Trade Creditors – to determine the firm’s ability to pay its liability in short term, i.e. liquidity issues

Financial Institutions – to determine long term solvency & profitability of a firm, cash flows for interest payment & repayment of principal amt.

Management – measuring every aspect of business w.r.t. risk, profitability, performance, liquidity etc.

6

Important Concepts

7

Important Conceptsa)Cost of Goods Sold (COGS) – manufacturing

costs of the goods sold during an accounting period e.g. material, labour, power, fuel, repairs

b)Non-operating Revenue (NOR) – not relating to main operations, these are included in the gross profit. E.g. asset sale, interest on investments.

c)Gross Profit (GP) – Sales (+) NOR (-) COGSd)Operating expenses – expenses relating to

main operations of the business, e.g. administration, selling, distribution, depreciation etc.

8

Important Conceptse)Operating Profit – GP (less) Operating

expenses. Also known as Earnings /Profit before Interest and Tax (EBIT / PBIT)

f) Interest – paid on borrowed funds like loan, debn

g)Profit before Taxes (PBT) – PBIT (-) Interesth)Profit after Taxes (PAT) – PBT (-) Taxesi) Dividends – amount distributed to

shareholdersj) Retained Earnings – balance remaining after

distribution of dividends, i.e. PAT (-) Dividends.

9

Particulars Rs.Sales (A) 10,000

(-) Cost of goods sold (B) 4,000

Gross Profit (C = A - B) 6,000

(-) Operating expenses (D) 3,500

Operating Profit (EBIT) (E = C - D) 2,500

(-) Interest (F) 1,000

EBT (G = E - F) 1,500

(-) Tax @ 50% (H) 750

PAT (I = G - H) 750

(-) Preference Dividends (J) 200

Profit for Equity Shareholders (K = I - J) 550

(-) Equity Dividends 400

Retained Earnings 150

Illustration

10

Types of Ratios

11

Classification of RatiosThe classification of ratios depends upon the financial activity or function to be evaluated, with reference to the users of these ratios.

Liquidity ratios – measures the firm’s ability to meet current obligations.

Leverage ratios – shows the proportion of debt and equity in financing the firm’s assets

Activity ratios – reflects the firm’s efficiency in utilization of its assets

Profitability ratios – measures the performance and effectiveness of the firm

12

Liquidity RatiosCurrent Ratio = Current Assets

Current Liabilities•Current assets are assets that can be converted into cash within a short period (upto 1 year). For e.g. inventory, receivables, cash & bank bal., prepaid exp., B/R, short-term Invts etc.

•Current liabilities are obligations that must be paid within a short time (upto 1 year) – BP, creditors, accured exp, ST loans, bank overdraft

•This ratio measures firm’s short-term solvency

13

Liquidity RatiosCurrent Ratio

•Universal convention, a current ratio of 2:1 is good. In India, a ratio of 1.33:1 is also accepted.

•Current ratio serves as a margin of safety for the creditors and other short-term lenders. Hence, higher the ratio, greater the margin of safety.

•However, a very high current ratio may indicate idle assets that are non-productive.

•Further, the quality of current assets also needs to be checked. E.g. immovable inventory, doubtful debtors reflect a wrong current ratio.

14

Liquidity RatiosQuick Ratio = Current Assets – Inventories

Current Liabilities – BOD•Quick ratio states the relation between quick/ liquid assets & current liabilities. (Acid-test ratio)

•Liquid assets are assets that can be converted into cash immediately and without loss of value.

•Inventories are less liquid since it takes time to realize and also its values are fluctuating.

•Generally, a quick ratio of 1:1 is satisfactory. But, quality of liquid assets needs to be checked w.r.t. slow/ non paying debtors and other receivables.

15

Liquidity RatiosCash Ratio = Cash + Bank + Marketable

securities Current Liabilities

•Cash is the most liquid asset. Hence, cash ratio verifies the relationship between cash & cash equivalents to current liabilities.

•This is the most stringent measure of liquidity of a firm.

•However, a low cash ratio is acceptable, since companies have reserve borrowing power, in the form of sanctioned credit limits from banks and financial institutions.

16

Liquidity Ratios Interval Measure = Current assets – Inventories *

365 Total daily expenses

•Interval Measure is a ratio to judge the firm’s ability to meet its regular cash expenses.

•Total daily expenses are the sum of COGS, admin exp, and selling & distribution expenses (except deprn).

•The interval measure gives us the period for which a firm has sufficient funds to meet its daily expenses, without receiving any cash.

17

Leverage RatiosLeverage ratios measures long term solvency of a firm. Also called ‘Capital Structure ratios’.Debt is more risky as the firm has legal obligation to pay interest, even in case of losses. Default may lead to litigation & even liquidationHowever, debt is cheaper than equity and may result into higher returns for equity shareholders in case of a favourable financial leverage effect.Higher equity component is treated as safety margin by creditors and financial institutions.

18

Leverage RatiosDebt-Equity Ratio = Total LT Debt

Net Worth•Total long term debts, borrowing from financial inst., debentures, bank, public deposits.

•Net Worth includes equity & preference capital and reserves & surplus. (‘shareholders’ funds’)

•A high ratio indicates excessive borrowing by the firm. High borrowing may put restrictions on a firm w.r.t. dividend payout, dilutes control

•Low debt-equity ratio is good in low profits. For high profits, high financial leverage is favourable.

19

Leverage RatiosDebt-Asset Ratio = Total Debt

Net Assets•Total debt - short & long term borrowings from financial inst., debentures, bank, public deposits

•Net Assets includes net fixed assets and net current assets (i.e. CA – CL)

•This ratio indicates the proportion of total assets financed by the debt component.

•A high ratio indicates that the total assets are financed by borrowing, in excess of the owners’ equity.

20

Leverage Ratios Capital Gearing = Pref. capital + Debenture + LT

loans Equity capital + Reserves &

Surplus•Capital gearing ratio measures the proportion of fixed interest and preference dividend bearing capital to the shareholders’ equity.

•This ratio indicates the proportion of fixed obligations in the capital structure vis-à-vis shareholders’ funds (w/o any fixed obligations)

•Ratio is used for providers of long term sources of finance, i.e. financial institutions, banks, interested debenture holders, pref. share holders.

21

Leverage RatiosInterest Coverage Ratio = EBIT or EBDIT

Interest Interest•Measures firm’s ability to pay interest obligation•This ratio shows the number of times the interest charges are covered by the available funds.

•Since deprn is a non-cash item, the same can be added back to EBIT to calculate the coverage.

•Ratio used by banks, financial inst., debentures.•Higher the ratio, better safety. But, a high ratio indicates a conservative approach in using debt, which may reduce shareholders’ earning capacity.

22

Leverage Ratios Debt Service coverage = EBDIT

Interest + (Loan repayment/1-tax rate)

Debt Service coverage = PAT + Deprn + Interest Interest + Loan repayment

•Measures the firm’s ability to meet interest as well as loan repayment obligation.

•Debt service coverage ratio shows the number of times the interest & loan repayment are covered by the available funds.

•Loan repayment is made out of post-tax earnings. So different formulae given to adjust the same.

23

Leverage RatiosPref. Dividend Coverage Ratio = EAT

Pref. Dividend•Measures the firm’s ability to meet dividend obligation on preference shares.

•Pref. dividend coverage ratio shows the number of times the pref. dividends are covered by the available post tax funds. This ratio used by preference shareholders.

•Higher the ratio, better for a firm.

24

Activity/ Performance Ratios☺ A firm makes investment in various assets

for the purpose of increasing sales and hence profits

☺ Performance ratios are used to evaluate the efficiency of management & utilization of assets

☺ Also known as Turnover ratios, since they indicate the speed of assets utilization for sales.

☺ Activity ratios involve a relationship between sales and assets. These ratios also facilitates performance evaluation of a firm’s individual departments.

25

Activity RatiosInventory turnover = COGS or Sales

Avg. inventory•Inventory turnover ratio indicates the efficiency of a firm in producing and selling its products.

•Avg. inventory is the avg. of opening and closing stock of finished goods. Averraging eliminates the fluctuations in inventory levels. In absence of avg. inventory, closing inventory may be used.

•COGS figure may not be available to the outside analyst and hence ‘Sales’ is taken to compute the ratio. But, sales includes profit, so COGS is better

26

Activity RatiosInventory turnover

•Inventory turnover shows the speed of inventory conversion into receivables / cash through sales.

•High turnover ratio is a sign of good inventory mgt. while low ratio indicates excessive inventory levels or slow and/or obsolete inventory.

•But, a very high ratio may imply low inventory levels resulting in stock-outs, affecting goodwill.

•Hence, adequate attention should be given to the inventory turnover ratios. It should be compared with past ratios, industry averages etc.

27

Activity Ratios Inventory turnover

•The reciprocal of inventory turnover ratio (x) 360 days gives the average inventory holding period.

•Avg. inventory x 365 daysCOGS or Sales

• Inventory turnover can be analyzed for RM & WIP levels also, to judge their conversions.

•RM turnover = RM consumedAvg. inventory of RM

•WIP turnover = Cost of production Avg. inventory of

WIP

Similarly, holding period computed as above. (no. of days)

28

Activity RatiosDebtors turnover = Credit Sales

Avg. debtors•Debtors’ turnover ratio indicates speed of conversion of debtors into cash during a year.

•Higher the debtors’ turnover ratio, more efficient is the credit management.

•In absence of credit sales & avg. debtors, total sales & closing debtors be used for computation

•Measures the efficiency of the marketing team, treasury team and business managers.

29

Activity Ratios Debtors’ collection = 365 days = Avg. Debtors x

365 Debtors’ turnover Credit Sales

•Debtors’ collection period calculates the period for conversion of receivables into cash, i.e. duration for which the debtors are outstanding.

•Shorter the period better is the quality of debtors i.e. faster conversion into cash.

•Collection period must be compared with the firm’s avg. credit period granted to customers

•Long collection period impairs firm’s liquidity and also increases chances of bad debts.

30

Activity Ratios Debtors ageing schedule

•An ageing schedule breaks down debtors according to the length of time for which they are outstanding.

•It provides enhanced information by recognizing the slow-paying debtors.

•It is a better analysis tool than collection period and the used extensively during audits and investigations.

O/ s period (days)

O/ s amount of debtors (Rs.)

% of total debtors

00 - 30 250 42%31 - 60 150 25%61 - 90 70 12%91 - 180 55 9%above 181 75 13%

Total 600 100%

31

Activity RatiosCreditors’ turnover = Credit Purchases

Avg. creditorsCreditors’ payment = 365 days = Avg. Crs. x

365 Crs. turnover Credit

Purchases•Creditors’ turnover ratio indicates the number of times creditors are paid during a year.

•Lower the creditors’ turnover ratio, more efficient is the payables management i.e. delays in payment or avoiding early payment.

•Measures the efficiency of the payables & purchases team.

32

Activity RatiosWorking capital turnover = Sales

Avg. working capital•This ratio measures the utilization of working capital for generation of sales, and profits.

•Higher the ratio implies better management of working capital.

•It indicates the amount of sales per rupee investment in working capital.

•High ratio implies that less funds are blocked in WC, better liquidity, better management.

33

Activity RatiosFixed Assets turnover = Sales

Avg. net fixed assets•Fixed assets turnover ratio measures the sales volume per rupee of investment in fixed assets.

•A firm’s ability to produce large volumes of sales for a given amount of fixed assets is an important aspect of its operating performance. Higher the ratio, better for firm.

•Unutilized/ under-utilized assets increase a firm’s costs via maintenance without giving returns.

•A very high ratio may be misleading, due to presence of old assets with minimal book value.

34

Activity RatiosCapital turnover = Sales

Capital Employed•Capital turnover ratio measures the sales volume per rupee of capital employed (i.e. Equity + Debt).

•Higher the ratio indicates better use of capital employed by a firm.

35

Profitability Ratios αProfitability is the key to survival

and growth of any organization.αProfitability ratios are calculated

to measure the operating effectiveness of a firm.

αOwners are interested in these ratios to ensure their returns while creditors/ lenders are concerned about their interest and loan repayments.

36

Profitability RatiosGross Profit Margin = Gross Profit (GP)

Sales•Gross profit margin reflects the efficiency of production activities and the pricing strategy.

•This ratio indicates the average spread between ales & COGS. (i.e. prodn cost vis-à-vis selling price)

•A high GP margin is a sign of good management & shows that firm is able to produce at low costs.

•A low ratio may be due to inefficient purchases, poor plant utillization or selling price pressures.

•Constant attention is reqd. to maintain/ improve GP margin.

37

Profitability RatiosNet Profit (NP) Margin = Profit after Tax

(PAT) Sales

•PAT is obtained when operating exp., interest & taxes are deducted from the gross profit.

•NP margin reflects management’s efficiency in manufacturing, administration, selling its product

•The ratio is an overall measure of a firm’s ability to convert sales into profits (sh-holders’ earnings)

•Higher ratio acts as a buffer in cases of decline in selling price, increasing costs, decreasing demands etc. & also accelerates profits at faster rate in favourable conditions

38

Profitability RatiosModified Net Profit Margin = EBIT

Sales•PAT figure excludes interest on borrowing. Interest is tax deductible and provides taxation benefits. Thus, PAT is affected by a firm’s financial structure.

•Hence, use of PAT may give misleading results in firms with different financial structures.

•As a true measure of operating efficiencies, we ignore the effect of debt-equity mix and consider EBIT as profit.

39

Profitability RatiosReturn on Capital Employed = EBIT

Capital Employed•Capital employed includes equity and pref. capital, reserves & surplus, debentures, long term loans from financial institutions etc.

•It measures the return/ profits generated by a firm against the capital employed in business.

•These returns are shared by the capital providers (lenders and shareholders) in the form of interest and dividends respectively.

40

Profitability RatiosReturn on Equity = PAT

Shareholders’ funds•Shareholders’ funds includes equity capital and reserves & surplus (less) accumulated/ misc. loss

•It measures the return generated by a firm against the shareholders’ funds used in the business.

•One of the most important ratios for financial analysis since the primary objective of a firm is maximization of shareholders’ wealth.

•Thus, this ratio is scrutinized by current and more importantly by prospective investors.

41

Profitability RatiosEarning per Share (EPS) = PAT

No. of equity shares o/s•EPS measures the return/ profits generated by a firm per equity share.

•EPS is an important ratio for securities analysis & it facilitates comparison with other companies and the industry average.

•EPS reveals the relative performance & strength of the company in attracting future investments.

•Hence, this ratio is widely used by prospective investors and current shareholders.

42

Profitability RatiosDividend per Share (DPS) = Dividends paid

No. of equity shares o/s•DPS measures the returns/profits distributed by a firm to the equity shareholders.

•Since all profits may not be distributed, shareholders and potential investors are more interested in the actual dividends declared by a firm (i.e. distributed profits).

•Hence, this ratio is widely used by current shareholders and prospective investors.

43

Profitability RatiosDividend Yield = Dividends per share (DPS)

Current Market Price per Share

Earnings Yield = Earnings per share (EPS) Current Market Price per Share

•Dividend Yield & Earnings Yield evaluates the shareholders’ return in relation to the current market value of the share.

•Earnings yields is also known as earnings-price (E/P) ratio

•Current market price per share may not be available in the financial statements, but can be taken from the stock exchanges, newspapers etc.

44

Comparative Common Size Analysis¤ Absolute figures in financial statements may

not give a true picture of the state of affairs, especially while making comparisons.

¤ A simple technique of meaningful analysis is to prepare ‘comparative common size statements (CCS)’.

¤ Financial statements (B.S and P&L A/c) are prepared in terms of common base percentages.

¤ Analysis becomes uncomplicated, with increased clarity and superior results/ findings. By use of CCS, possibility of ambiguity is reduced.

45

Ratio Analysis – shortcomingsκRatios only provide with indicators for

identifying problems. Solutions are not provided by ratios.

κDissimilarity in situations of two companies may make the ratios misleading

κDifferences in the definitions of items in B.S and P&L A/c may lead to incorrect interpretation.

κRatios are calculated from past records and do not predict the future events.