BUSINESS SYSTEMSBANGALORE

HK/0403

FINANCIAL STATEMENT ANALYSIS - RATIOS

1. Financial statements - i.e., Balance Sheet and Profit & Loss account, provide a wealth of information. If properly analysed and interpreted, they can provide valuable insights into a firm’s performance and position.

2. Before undertaking any analysis, the analyst must clearly define -

a) The viewpoint taken (e.g. lender, investor, management etc.)b) The objectives of the analysis andc) The standards of comparison.

In financial analysis there is always a temptation to ‘run all the numbers’ - yet only a few relationships will generally yield the information and insights the analyst really needs.

3. There are many analytical techniques, chief among them being

- Ratio Analysis, Du Pont Analysis- Fund Flow & Cash flow Analysis- Time Series- Common Size AnalysisThis note is restricted to ratio analysis.

3.1 RATIO ANALYSIS

A ratio relates any magnitude to any other, such as net profits to sales or net profit to total assets. The choices are limited only by the analyst’s imagination.

The actual usefulness of any particular ratio depends on the specific ‘objectives’ of the analysis. Ratios serve best to point out changes in financial conditions or operating performance. They help to illustrate the trends and patterns of such changes. These may indicate to the analyst, the risks and opportunities for the business under review.

A further caution should be noted here. Performance assessment based on financial statements deals with the past data and conditions. Hence it may be difficult to extrapolate future expectations. Yet decisions are taken based on past financial analysis, which affect the future!

The following are some of the key ratios:

i) Liquidity Ratios - Current Ratio, - Acid Test Ratio (Quick Ratio)

ii) Leverage Ratios - Debt – Equity Ratio- Debt – Service – Coverage Ratio

iii) Turnover Ratios - Inventory Turnover Ratio- Average collection period- Fixed Assets Turnover Ratio

iv) Profitability Ratios - Net Profit to Sales- Return on Investment- Return on Equity- Earnings per share

v) Valuation Ratios - Price – earnings ratio- Yield

Table 1 gives some of the important ratios and their formulae. Table 2 gives the relevant ratios from different viewpoints.

a) LIQUIDITY RATIOS:

Liquidity refers to the ability of a firm to meet its obligations in the short run, usually one year. A very low ratio indicates that the firm may default on short-term commitments and would therefore be considered risky. At the same time a very high ratio may indicate inefficient use of potential.

(i) Current Ratio Current AssetsCurrent Liabilities

Current Assets include cash, marketable securities, debtors, inventories, loans and advances and prepaid expenses. Current liabilities consist of loans and advances (taken), trade creditors, accrued expenses and provisions.

This is a very popular ratio. Though it would be arbitrary to define an ideal ratio without going into the type of industry, market conditions etc., banks and lenders usually insist on a minimum of 1.25 - 1.33.

(ii) Acid test Ratio Quick Assets

Current Liabilities

Quick assets are current assets excluding inventories.This is a more stringent measure of liquidity, as inventories are considered to be least liquid of the current assets and hence excluded.

b) LEVERAGE RATIOS:

Leverage refers to the use of debt finance. Debt is cheaper than equity, but is also a riskier source of finance. There are structural ratios and coverage ratios of leverage. Structural ratios indicate the proportion or use of debt and equity in the financial structure of the Company. Coverage ratios indicate the relationship between the debt servicing commitments and the sources for meeting these burdens. Though norms would have to be based on relative risk, size and nature of industry and market conditions, the usual expectations of lenders are indicated for an ‘average’ enterprise. High leverage ratio indicates that the company is exposed to high risk of foreclosure / liquidation in case of

default. Low leverage ratios indicate that the management is conservative and not aggressive and it also indicates high security for the lenders, and consequently a good borrowing potential.

(i) Debt / Equity Debt Debt = Long term debtEquity Equity = Paid up capital and Reserves

The norms range between a maximum of 1:1 and 2:1 and in some capital-intensive industries it could be as high as 4:1. (For e.g. shipping)

(ii) Interest Coverage Ratio E B I T (Earnings Before Interest & Tax)

Debt interest

Institutional norms range between 1.5 to 2.

(iii) Debt - Service coverage ratio E B I T + Depreciation

Interest + installment of Loan Repayment

This indicates resource availability for servicing debts, paying interest and installment falling due for payment during the year.

Institutional Norms range between 1.3 - 1.5

c) TURNOVER RATIOS:

These ratios measure how efficiently assets have been employed in the firm. They are based on the relationship between activity level (e.g. sales) and levels of various assets. The higher the ratio the better the usage of the asset. However, one has to look for moderation in these ratios, to avoid the risks of over use of assets.

(i) Inventory Turnover Ratio Net Sales

Average inventory

High ratio indicates effective utilization of inventory in terms of costs and cycle time. Care should be taken that the inventory level is not too low to result in frequent stock outs. Conversely low ratio would indicate inefficient inventory management.

(ii) Average collection period Average ReceivablesAverage Sales per day

This could be compared with the firm’s credit terms to judge the efficiency of receivables Management.

(iii) Receivables Turnover Ratio Net SalesAverage Receivables

The higher the ratio the better the utilization. Obviously, the shorter the collection period, the higher the receivables turnover ratio and vice versa.

If Average collection period is significantly less than the credit terms, it may be indicative of excessive conservatism in credit granting that may result in the loss of some desirable sales.

(iv) Fixed Assets Turnover Ratio Net Sales

Fixed Assets

This is supposed to measure the efficiency of fixed assets employment. Caution - when fixed assets are old and substantially depreciated, this ratio tends to be high and can mislead conclusion.

d) PROFITABILITY RATIOS:

Profitability reflects the final result of business operations.

(i) Net Profit Margin Ratio Net ProfitNet Sales

This ratio shows the earnings left for shareholders (both equity and preference) as a percentage of net sales. It measures the overall efficiency of production, administration, selling, financing, pricing, and tax management. Jointly considered, the gross and net profit margin ratios provide a valuable understanding of the cost and profit structure of the firm and enable the analyst to identify the sources of business efficiency/inefficiency.

(ii) Return on Investment Earnings before interest and taxesTotal assets

The return on investment is a measure of business performance, which is not affected by interest charges and tax payments. It abstracts away the effect of financial structure and tax rate and focuses on operating performance. Hence, it is eminently suited for inter-firm comparisons. Further, it is internally consistent. The numerator represents a measure of pre-tax earnings belonging to all sources of finance and the denominator represents total financing.

(iii) Return on Equity Equity earnings Net worth

Equity earnings = PATNet worth = Paid up Capital + Reserves

The return on equity measures the profitability of equity funds invested in the firm. It is regarded as a very important measure because it reflects the productivity of the owner’s (or risk) capital employed in the firm. It is influenced by several factors: such as Return on Investment, Debt-Equity ratio, Average cost of debt funds, and Tax rate.

(iv) Earnings per share PAT No. of Shares

e) VALUATION RATIOS :

Valuation ratios indicate how the equity stock of the company is assessed in the capital market. Since the market value of equity reflects the combined influence of risk and return, valuation ratios are the most comprehensive measures of a firm’s performance. The important valuation ratios are: Price-earnings ratio, Yield, and Market value to Book value ratio.

(i) Price-earnings Ratio Market price per share Earnings per share

The market price per share may be the price prevailing on a certain day, or preferably the average price over a period of time. The earnings per share is simply: profit after tax divided by number of outstanding equity shares.

The price-earnings ratio (or the price-earnings multiple as it is commonly referred to) is a summary measure, which primarily reflects the following factors: growth prospects, risk characteristics, shareholder orientation, corporate image, and degree of liquidity.

(ii) Yield Dividend + Price ChangeInitial price

Generally, companies with low growth prospects offer a high dividend yield and a low capital gains yield. On the other hand, companies with superior growth prospects offer a low dividend yield and a high capital gains yield.

(iii) Market Value to Book Value Ratio Market value per shareBook value per share

In a very important sense, this ratio reflects the contribution of a firm to the net wealth of the society. When this ratio exceeds 1 it means that the firm has contributed to the creation of net wealth in the society. When this ratio is equal to 1, it implies that the firm has neither contributed to nor detracted from the net wealth of the society.

It may be emphasised here that if the market value to book value ratio is equal to 1, all the three ratios, namely, Return on Equity, Earnings-price ratio (which is the inverse of the price-earnings ratio), and Total yield, are equal.

3.2 DU PONT ANALYSIS:

The Du Pont Company of USA pioneered a system of financial analysis, which has received widespread recognition and acceptance. It clearly shows the inter-linkage of the various ratios. Table 3 gives the outline of the Du Pont chart.

3.3 PROBLEMS OF FINANCIAL STATEMENT ANALYSIS:

The following will have to be taken care of and kept in mind in any financial analysis:

a) The standards against which the ratios are to be bench marked should be chosen carefully so that information is consistent and comparable.

b) Changes in accounting practices within the same firm between year to year.

c) If Price level changes are significant then analysis can lead to wrong conclusions.

d) It must be borne in mind that ratios are at best indicative of a trend. Interpretation of any particular ratio and passing a judgement of ‘good’ or ‘bad’ is only relative and a proper yardstick should be used for such judgement.

e) Lastly the reasons for a particular trend and the correlation of ratios are a must before drawing any conclusion.

Table - 1

Ratio Formula

Liquidity

* Current ratio Current assetsCurrent liabilities

* Acid-test ratio Quick assetsCurrent liabilities

* Bank finance-working Short-term bank borrowingsCapital gap ratio Working capital gap

Leverage

* Debt-equity ratio DebtEquity

* Debt-assets ratio DebtAssets

* Interest coverage ratio EBITInterest

* Debt-Service coverage ratio EBIT + DepreciationInterest + Loan Repayment

Turnover

* Inventory turnover ratio Net salesInventory

* Average collection period ReceivablesAverage sales per day

* Fixed assets turnover ratio Net salesFixed assets

* Total assets turnover ratio Net salesTotal assets

...........2

- 2 -

Ratio Formula

Profitability

* Gross profit margin ratio Gross profitNet sales

* Net profit margin ratio Net profitNet sales

* Net income to assets ratio Net profitTotal assets

* Return on investment EBITTotal assets

* Return on equity Equity earningsNet worth

Valuation

* Price-earnings ratio Market price per shareEarnings per share

* Yield Dividend + Price changeInitial price

* Market value to book value ratio Market price per shareBook value per share

TABLE - 2

FINANCIAL PERFORMANCE MEASURES BY AREA AND VIEWPOINT

Management Owners Lenders

Operational analysis Profitability Liquidity

Gross margin Return on total net worth Current Ratio

Profit margin Earnings on common equity Acid test

Operating expense analysis Earnings per share Quick sale value

Contribution analysis Cash flow per share Cash flow patterns

Operating leverage Share price appreciation

Total share holder return

Shareholder value analysis

Resource management Disposition of earnings Financial leverage

Asset turnover Dividends per share Debt to assets

Working capital management Dividend yield Debt to capitalization

Inventory turnover Payout / retention Debt to equity

Accounts receivable patterns Dividend coverage Risk/ reward tradeoff

Accounts payable patterns

Human resource effectiveness

Profitability Market indicators Debt service

Return on assets (after taxes) Price / earnings ratio Interest coverage

Return before interest and taxes Market to book value Interest & principal coverage

Return on current value basis Relative price movements Cash flow analysis

Cash flow multiples

TABLE - 3

Du Pont Chart

Return on Total Assets

Net Profit Margin X Total Assets Turnover

Net Income Net Sales

Net Sales Total Assets

Net Sales +/ TotalNon-Operating CostSurplus / Deficit

Current Assets Fixed Assets

Cost of Goods Operating Cash, Bank, and ReceivablesSold Expenses Marketable Securities

Interest Tax Inventories Others