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Financial Statements Analysis

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FINANCIAL STATEMENTS
ANALYSIS

Ratio Analysis

Common Size Statements

Importance and Limitations of

Ratio Analysis

Ratio Analysis

Ratio 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.

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Basis of Comparison
1) 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.

Types of Ratios

Liquidity Ratios Capital Structure Ratios

Profitability Ratios Efficiency ratios

Integrated
Growth Ratios
Analysis Ratios

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Net Working Capital

Net working capital is a measure of liquidity calculated by
subtracting current liabilities from current assets.

Table 1: Net Working Capital (Rs. In Lakh)

Particulars Company A Company B
Total current assets Rs 180 Rs 30
Total current liabilities 120 10
NWC 60 20
Table 2: Change in Net Working Capital (Rs. in Lakh)
Particulars Company A Company B
Current assets Rs 150 Rs 300
Current liabilities 75 200
NWC 75 100

Liquidity Ratios

Liquidity ratios measure the ability

of a firm to meet its short-term
obligations

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Current Ratio
Current Ratio is a measure of liquidity calculated dividing
the current assets by the current liabilities

Current Assets
Current Ratio =
Current Liabilities
(Rs. in Lakh) (Rs. in Lakh)
Particulars Firm A Firm B
Current Assets Rs 180 Rs 30
Current Liabilities Rs 120 Rs 10
Current Ratio = 3:2 (1.5:1) 3:1

Acid-Test Ratio
The quick or acid test ratio takes into consideration
the differences in the liquidity of the
components of current assets

Quick Assets
Acid-test Ratio =
Current Liabilities

Quick Assets = Current assets Stock

Pre-paid expenses

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Example 1: Acid-Test Ratio

(Rs. in Lakh)

Cash Rs 20
Debtors 20
Inventory 120
Total current assets 160
Total current liabilities 80
(1) Current Ratio 2:1
(2) Acid-test Ratio 0.5 : 1

Supplementary Ratios for

Liquidity

Inventory Turnover
Debtors Turnover Ratio
Ratio

Creditors Turnover Ratio

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Inventory Turnover Ratio

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.

Cost of goods sold

Inventory turnover ratio =
Average inventory

The cost of goods sold means sales minus gross profit.

The average inventory refers to the simple average of the opening

and closing inventory.

Example 2: Inventory Turnover Ratio

A firm has sold goods worth Rs 300 lakh with a gross profit margin of
20 per cent. The stock at the beginning and the end of the year
was Rs 35 lakh and Rs 45 lakh respectively. What is the
inventory turnover ratio?

Inventory (Rs 300 Rs 60) 6 (times

= =
turnover ratio (Rs 35 + Rs 45) 2 per year)

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

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Debtors Turnover Ratio

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.

Net credit sales

Debtors turnover ratio =
Average debtors

Net 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.

Example 3: Debtors Turnover Ratio

A firm has made credit sales of Rs 240 lakh during the year. The
outstanding amount of debtors at the beginning and at the end
of the year respectively was Rs 27.5 lakh and Rs 32.5 lakh.
Determine the debtors turnover ratio.

Debtors Rs 240 8 (times

= =
turnover ratio (Rs 27.5 + Rs 32.5) 2 per year)

Debtors 12 Months 1.5

= =
collection period Debtors turnover ratio, (8) Months

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Creditors Turnover Ratio

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 Net credit purchases

=
ratio Average creditors
Net 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.

Example 4: Creditors Turnover Ratio

The firm in previous Examples has made credit purchases of Rs 180

lakh. The amount payable to the creditors at the beginning
and at the end of the year is Rs 42.5 lakh and Rs 47.5 lakh
respectively. Find out the creditors turnover ratio.

Creditors (Rs 180) 4 (times

= =
turnover ratio (Rs 42.5 Rs 47.5) 2 per year)

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

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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 period 2 months

Add: Debtors collection period + 1.5 months
Less: Creditors payment period 3 months
0.5 months
As a rule, the shorter is the cash cycle, the better are the liquidity
ratios as measured above and vice versa.

DEFENSIVE INTERVAL RATIO

Defensive interval ratio is the ratio between quick

assets and projected daily cash requirement.

Defensive- Liquid assets

=
interval ratio Projected daily cash requirement

Projected daily Projected cash operating expenditure

=
cash requirement Number of days in a year (365)

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Leverage Capital Structure Ratio

There are two aspects of the long-term solvency of a firm:
(i) Ability to repay the principal when due, and
(ii) Regular payment of the interest .
Capital structure or leverage ratios throw light on the
long-term solvency of a firm.

Accordingly, there are two different types of leverage ratios.

First type: These ratios are
computed from the balance
sheet
(a) Debt-equity ratio
(b) Debt-assets ratio
(c) Equity-assets ratio
Second type: These ratios are
computed from the Income
Statement
(a) Interest coverage ratio
(b) Dividend coverage ratio

I. Debt-equity ratio
Debt-equity ratio measures the ratio of long-term or total
debt to shareholders equity.

Debt-equity ratio measures

Totalthe ratio of long-
Debt
Debt-equity ratiode3bt
term or total = to shareholders equity
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.

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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.

Trading on Equity
Trading on equity (leverage) is the use of borrowed funds in
expectation of higher return to equity-holders.

Trading on Equity (Amount in Rs thousand)

Particular A B C D
(a) Total assets 1,000 1,000 1,000 1,000
Financing pattern:
Equity capital 1,000 800 600 200
15% Debt 200 400 800
(b)Operating profit (EBIT) 300 300 300 300
Less: Interest 30 60 120
Earnings before taxes 300 270 240 180
Less: Taxes (0.35) 105 94.5 84 63
Earnings after taxes 195 175.5 156 117
Return on equity (per cent) 19.5 21.9 26 58.5

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II. Debt to Total Capital

The relationship between creditors funds and
owners capital can also be expressed using
Debt to total capital ratio.

Total debt
Debt to total capital ratio =
Permanent capital

Permanent Capital = Shareholders equity +

Long-term debt.

III. Debt to total assets ratio

Total debt
Debt to total assets ratio =
Total assets
Proprietary Ratio
Proprietary ratio indicates the extent to which assets
are financed by owners funds.

Proprietary funds
Proprietary ratio = X 100
Total assets

Capital Gearing Ratio

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.

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Coverage Ratio
Interest Coverage Ratio
Interest Coverage Ratio measures the firms ability to make
contractual interest payments.

EBIT (Earning before interest and taxes)

Interest coverage ratio =
Interest

Dividend Coverage Ratio

Dividend Coverage Ratio measures the firms ability to pay dividend
on preference share which carry a stated rate of return.

EAT (Earning after taxes)

Dividend coverage ratio =
Preference dividend

Profitability Ratio
Profitability ratios can be computed either from
sales or investment.

Profitability Ratios Profitability Ratios

Related to Sales Related to Investments
(i) Profit Margin (i) Return on Investments

(ii) Expenses Ratio (ii) Return on Shareholders

Equity

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Profit Margin

Gross Profit Margin

Gross profit margin measures the percentage of each sales

rupee remaining after the firm has paid for its goods.

Gross profit margin = Gross Profit

X 100
Sales

Net Profit Margin

Net 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 can be computed in three ways

Earning before interest and taxes

i. Operating Profit Ratio =
Net sales

Earnings before taxes

ii. Pre-tax Profit Ratio =
Net sales

Earning after interest and taxes

iii. Net Profit Ratio = Net sales

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Example 7: From the following information of a firm,

determine (i) Gross profit margin and (ii) Net profit
margin. (Amount in Rs Lakh)
1. Sales Rs 200
2. Cost of goods sold 100
3. Other operating expenses 50

Rs 100
(1) Gross profit margin = = 50 per cent
Rs 200

Rs 50
(2) Net profit margin = = 25 per cent
Rs 200

Expenses Ratio
Cost of goods sold
i. Cost of goods sold = X 100
Net sales
Administrative exp. + Selling exp.
ii. Operating expenses = X 100
Net sales
Administrative expenses
iii. Administrative expenses = X 100
Net sales
Selling expenses
iv. Selling expenses ratio = X 100
Net sales
Cost of goods sold + Operating expenses
v. Operating ratio = X 100
Net sales
Financial expenses
vi. Financial expenses = X 100
Net sales

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Return on Investment
Return on Investments measures the overall effectiveness
of management in generating profits with
its available assets.

i. Return on Assets (ROA)

EBIT
ROA =
Average total assets

ii. Return on Capital Employed (ROCE)

EBIT
ROCE =
Average total capital employed

Return on Shareholders Equity

Return on shareholders equity measures the return on the
owners (both preference and equity shareholders )
investment in the firm.

Return on total shareholders equity =

Net profit after taxes
X 100
Average total shareholders equity

Return on ordinary shareholders equity (Net worth) =

Net profit after taxes Preference dividend
X 100
Average ordinary shareholders equity

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Efficiency Ratio
Activity 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.

i. Inventory Turnover Cost

measures theof goods sold
activity/liquidity of
Inventory Turnover Ratio =
Average
inventory of a firm; the speed with whichinventory
inventory is sold

i. Inventory Turnover Cost

measures theofactivity/liquidity
raw materials usedof
Raw materials turnover =
inventory of a firm; the speed with which
Average inventory
raw material is sold
inventory

i. Inventory Turnover measuresCost of goods manufactured

the activity/liquidity of
Work-in-progress turnover =
Average
inventory of a firm; the speed work-in-progress
with which inventory isinventory
sold

Debtors Turnover Ratio

Liquidity of a firms receivables can be examined
in two ways.

i. Credit sales
i. Inventory Turnover
Debtors turnover = measures the activity/liquidity of inventory of
a firm; the speed with
Average
whichdebtors
inventory
+ Average
is sold bills receivable (B/R)

Months (days) in a year

2. Average collection period =
Debtors turnover

Months (days)
i. Inventory Turnover in a year
measures (x) (Average Debtors
the activity/liquidity + Average
of inventory of a(B/R)
Alternatively =
Total credit
firm; the speed with which inventory is sold sales

Ageing Schedule enables analysis to identify

slow paying debtors.

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Assets Turnover Ratio

Assets turnover indicates the efficiency with which firm
uses all its assets to generate sales.

i. Cost of goods sold of inventory of

i. Inventory Turnover
Total assets measures
turnover = the activity/liquidity
a firm; the speed with which inventory
Average total
is sold
assets
Cost of goods sold
ii. Fixed assets turnover =
Average fixed assets
Cost of goods sold
i. Inventory
iii. Turnover
Capital turnover = measuresAverage
the activity/liquidity of inventory of
a firm; the speed with which inventory iscapital
sold employed
Cost of goods sold
iv. Current assets turnover =
Average current assets

i. Cost of goods sold

v. Inventory Turnover
Working capital measures
turnover = the activity/liquidity of inventory of
Net working
a firm; the speed with which inventory capital
is sold

1) Return on shareholders equity = EAT/Average total shareholders equity.

2) Return on equity funds = (EAT Preference dividend)/Average ordinary

shareholders equity (net worth).

3) Earnings per share (EPS) = Net profit available to equity shareholders

(EAT Dp)/Number of equity shares outstanding (N).

4) Dividends per share (DPS) = Dividend paid to ordinary

shareholders/Number of ordinary shares outstanding (N).

5) Earnings yield = EPS/Market price per share.

6) Dividend Yield = DPS/Market price per share.

7) Dividend payment/payout (D/P) ratio = DPS/EPS.

8) Price-earnings (P/E) ratio = Market price of a share/EPS.

9) Book value per share = Ordinary shareholders equity/Number of equity

shares outstanding.

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