Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - *Financial Statements Analysis

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *FINANCIAL STATEMENTS ANALYSISRatio AnalysisImportance and Limitations of Ratio AnalysisCommon Size Statements

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Ratio AnalysisRatio 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.

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Basis of Comparison1) 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 firms performance in relation to its competitors. 3) Comparison with standards or industry average.

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Types of RatiosLiquidity RatiosCapital Structure RatiosProfitability RatiosEfficiency ratiosIntegrated Analysis RatiosGrowth Ratios

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Net working capital is a measure of liquidity calculated by subtracting current liabilities from current assets.Net Working Capital

Table 1:Net Working CapitalParticularsCompany ACompany BTotal current assetsTotal current liabilitiesNWC Rs 1,80,0001,20,00060,000 Rs 30,00010,00020,000

Table 2:Change in Net Working CapitalParticularsCompany ACompany BCurrent assetsCurrent liabilitiesNWC Rs 1,00,00025,00075,000 Rs 2,00,0001,00,0001,00,000

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Liquidity ratios measure the ability of a firm to meet its short-term obligationsLiquidity Ratios

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Current Ratio is a measure of liquidity calculated dividing the current assets by the current liabilitiesCurrent Ratio

ParticularsFirm AFirm BCurrent AssetsRs 1,80,000Rs 30,000Current LiabilitiesRs 1,20,000Rs 10,000Current Ratio= 3:2 (1.5:1)3:1

Current Ratio =Current AssetsCurrent Liabilities

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *The quick or acid test ratio takes into consideration the differences in the liquidity of the components of current assetsQuick Assets = Current assets Stock Pre-paid expensesAcid-Test Ratio

Acid-test Ratio =Quick AssetsCurrent Liabilities

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Example 1: Acid-Test Ratio

Cash DebtorsInventoryTotal current assetsTotal current liabilitiesRs 2,0002,00012,00016,0008,000(1) Current Ratio(2) Acid-test Ratio2 : 10.5 : 1

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Supplementary Ratios for LiquidityInventory Turnover RatioDebtors Turnover RatioCreditors Turnover Ratio

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Inventory Turnover Ratio

The cost of goods sold means sales minus gross profit.The average inventory refers to the simple average of the opening and closing inventory.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.

Inventory turnover ratio =Cost of goods soldAverage inventory

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *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?

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

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

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Debtors Turnover RatioNet 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. 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.

Debtors turnover ratio=Net credit salesAverage debtors

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Example 3: Debtors Turnover RatioA 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.

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

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

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Creditors Turnover RatioNet 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.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 suppliers credit.

Creditors turnover ratio=Net credit purchasesAverage creditors

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Example 4: Creditors Turnover RatioThe 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.

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

Creditors payment period=12 months=3 monthsCreditors turnover ratio, (4)

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *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 periodAdd: Debtors collection periodLess: Creditors payment period 2 months+ 1.5 months 3 months0.5 months As a rule, the shorter is the cash cycle, the better are the liquidity ratios as measured above and vice versa.

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - *Defensive interval ratio is the ratio between quick assets and projected daily cash requirement.DEFENSIVE INTERVAL RATIO

Defensive-interval ratio=Liquid assetsProjected daily cash requirement

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

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Example 5: Defensive Interval RatioThe 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.

Projected daily cash requirement =Rs 1,82,500= Rs 500365

Defensive-interval ratio =Rs 40,000= 80 daysRs 500

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *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 Ratio

Cash-flow from operations ratio=Cash-flow from operationsCurrent liabilities

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Leverage Capital Structure RatioCapital structure or leverage ratios throw light on the long-term solvency of a firm. There are two aspects of the long-term solvency of a firm: Ability to repay the principal when due, and Regular payment of the interest .

Accordingly, there are two different types of leverage ratios. First type: These ratios are computed from the balance sheetSecond type: These ratios are computed from the Income StatementDebt-equity ratioDebt-assets ratioEquity-assets ratio Interest coverage ratioDividend coverage ratio

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - *I. Debt-equity ratioLong-term Debt + Short term debt + Other Current Liabilities = Total external ObligationsDebt-equity ratio measures the ratio of long-term or total debt to shareholders equity.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.

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - * 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.

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Trading on EquityTrading on Equity (Amount in Rs thousand)Particular A B C D(a) Total assets1,0001,0001,0001,000Financing pattern:Equity capital1,00080060020015% Debt200400800(b)Operating profit (EBIT)300300300300Less: Interest3060120Earnings before taxes300270240180Less: Taxes (0.35)10594.58463Earnings after taxes195175.5156117Return on equity (per cent) 19.521.92658.5Trading on equity (leverage) is the use of borrowed funds in expectation of higher return to equity-holders.

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *II. Debt to Total CapitalThe relationship between creditors funds and owners capital can also be expressed using Debt to total capital ratio.Debt to total capital ratio =Total debtPermanent capitalPermanent Capital = Shareholders equity + Long-term debt.

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *III. Debt to total assets ratioProprietary ratio indicates the extent to which assets are financed by owners funds.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.Proprietary RatioCapital Gearing Ratio

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Coverage RatioInterest Coverage Ratio measures the firms ability to make contractual interest payments.Dividend Coverage Ratio measures the firms ability to pay dividend on preference share which carry a stated rate of return.Interest Coverage RatioDividend Coverage Ratio

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - *Total fixed charge coverage ratio measures the firms ability to meet all fixed payment obligations.Total fixed charge coverage ratioHowever, coverage ratios mentioned above, suffer from one major limitation, that is, they relate the firms 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. Total Cashflow Coverage Ratio

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Debt Service Coverage RatioDebt-service coverage ratio (DSCR)is considered a more comprehensive and apt measure to compute debt service capacity of a business firm. DEBT SERVICE CAPACITYDebt service capacity is the ability of a firm to make the contractual payments required on a scheduled basis over the life of the debt.

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Agro Industries Ltd has submitted the following projections. You are required to work out yearly debt service coverage ratio (DSCR) and the average DSCR.Example 6: Debt-Service Coverage Ratio

(Figures in Rs lakh)YearNet profit for the yearInterest on term loan during the year Repayment of termloan in the year 12345678 21.6734.7736.0119.2018.6118.4018.3316.41 19.1417.6415.1212.6010.087.565.04Nil 10.7018.0018.0018.0018.0018.0018.0018.00 The net profit has been arrived after charging depreciation of Rs 17.68 lakh every year.

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Solution

Table 3:Determination of Debt Service Coverage Ratio (Amount in lakh of rupees)YearNet profitDepreciationInterestCashavailable(col. 2+3+4) Principalinstalment Debtobligation(col.4+col.6) DSCR [col. 5 col. 7(No. of times)] 123456781234567821.6734.7736.0119.2018.6118.4018.3316.41 17.6817.6817.6817.6817.6817.6817.6817.68 19.1417.6415.1212.6010.087.565.04Nil 58.4970.0968.8149.4846.3743.6441.0534.09 10.7018.0018.0018.0018.0018.0018.0018.00 29.8435.6433.1230.6028.0825.5623.0418.00 1.961.972.081.621.651.711.781.89 Average DSCR (DSCR 8)1.83

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Profitability RatioProfitability ratios can be computed either from sales or investment.

Profitability Ratios Related to SalesProfitability Ratios Related to InvestmentsProfit MarginExpenses RatioReturn on InvestmentsReturn on Shareholders Equity

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Profit MarginGross profit margin measures the percentage of each sales rupee remaining after the firm has paid for its goods.Gross Profit Margin

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Net profit margin can be computed in three waysNet 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

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *

Example 7: From the following information of a firm, determine (i) Gross profit margin and (ii) Net profit margin.1.Sales2.Cost of goods sold3.Other operating expenses Rs 2,00,0001,00,00050,000

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

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

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Expenses Ratio

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Return on InvestmentReturn on Investments measures the overall effectiveness of management in generating profits with its available assets.

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Return on Shareholders EquityReturn on shareholders equity measures the return on the owners (both preference and equity shareholders ) investment in the firm.

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Efficiency RatioActivity 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.

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - *Liquidity of a firms receivables can be examined in two ways.Ageing Schedule enables analysis to identify slow paying debtors.Debtors Turnover Ratio

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Assets Turnover RatioAssets turnover indicates the efficiency with which firm uses all its assets to generate sales.

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - *Return on shareholders equity = EAT/Average total shareholders equity. Return on equity funds = (EAT Preference dividend)/Average ordinary shareholders equity (net worth). Earnings per share (EPS) = Net profit available to equity shareholders (EAT Dp)/Number of equity shares outstanding (N). Dividends per share (DPS) = Dividend paid to ordinary shareholders/Number of ordinary shares outstanding (N). Earnings yield = EPS/Market price per share. Dividend Yield = DPS/Market price per share. Dividend payment/payout (D/P) ratio = DPS/EPS. Price-earnings (P/E) ratio = Market price of a share/EPS.Book value per share = Ordinary shareholders equity/Number of equity shares outstanding.

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Integrated Analysis RatioIntegrated 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)

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Return on AssetsEarning PowerEarning 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/SalesAsset turnover = Sales/Total assets

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *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.EXAMPLE: 8

Table 4: Return on Assets (ROA) of Firms A and BParticularsFirm AFirm B1.Net sales2.Net profit3.Total assets4.Profit margin (2 1) (per cent)5.Assets turnover (1 3) (times)6.ROA ratio (4 5) (per cent) Rs 4,00,00040,0004,00,00010110 Rs 40,00,00040,0004,00,00011010

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *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. As a result of three sub-parts of net profit ratio, the ROE is composed of the following 5 components.

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *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 BParticularsFirm AFirm BNet salesLess: Operating expensesEarnings before interest and taxes (EBIT)Less: Interest (8%)Earnings before taxes (EBT)Less: Taxes (35%)Earnings after taxes (EAT)Total assetsDebtEquityEAT/EBT (times)EBT/EBIT (times)EBIT/Sales (per cent)Sales/Assets (times)Assets/Equity (times)ROE (per cent) Rs 4,00,0003,22,46277,53816,00061,53821,53840,0004,00,0002,00,0002,00,0000.650.7919.41220 Rs 40,00,00039,26,46273,53812,00061,53821,53840,0004,00,0002,50,0001,50,0000.650.841.84101.616

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Tata McGraw-Hill Publishing Company Limited, Management Accounting6 - *Common Size StatementsPreparation 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.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. Limitations

Tata McGraw-Hill Publishing Company Limited, Management Accounting

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