Ratio Analysis As A Tool For Financial Analysis

RATIO ANALYSIS AS A TOOL
FOR FINANCIAL ANALYSIS

AFTERSCHO☺OL
– DEVELOPING CHANGE MAKERS
CENTRE FOR SOCIAL ENTREPRENEURSHIP
PGPSE PROGRAMME –
World’ Most Comprehensive programme in social
entrepreneurship & spiritual entrepreneurship
OPEN FOR ALL FREE FOR ALL
let us change the world

www.afterschoool.tk afterschoool
AFTERSCHO☺OL's
- PGPSE MATERIAL
- online mba programme
FORwww.afterschoool.tk
PGPSE PARTICIPANTS
RATIO ANALYSIS AS A TOOL
FOR FINANCIAL ANALYSIS
Dr. T.K. Jain.
AFTERSCHO☺OL
Centre for social entrepreneurship
Bikaner M: 9414430763
tkjainbkn@yahoo.co.in
www.afterschool.tk, www.afterschoool.tk
let us change the world
www.afterschoool.tk afterschoool
AFTERSCHO☺OL's
- PGPSE MATERIAL
- online mba programme
FORwww.afterschoool.tk
PGPSE PARTICIPANTS
Why to study ratio analysis ?
• To find the real financial health of the
company
• To decide where to invest money in stock
market
• To improve the performance of the
company
• To predict future performance of a
company
let us change the world afterschoool - PGPSE - online mba programme
www.afterschoool.tk
Ratio Analysis
• Cross-sectional and time series analysis
• Controls for size differences
• Controls for currency differences
• Evaluate related components of different
financial statements simultaneously
• Ratios are easily (and commonly) modified

www.afterschoool.tk
WHAT DO YOU LOOK AT ?
• Is the company using assets properly (activity and
turnover ratios)
• Is the company having capability to meet its liabilities
(liquidity ratios)
• Is the company capable in giving reasonable returns to
the investors (profitability ratios)
• Is the company progressing over time (time series
analysis)
• Is the company having good financial health
(commonsize ratio analysis)
• Is the company able to use working capital properly
(cash flow and funds flow analysis)
• Is the company properly valued by the market (PE ratio)

www.afterschoool.tk
Ratio Analysis Categories
• Activity (operations and asset
management)
• Liquidity (meeting short-term obligations)
• Solvency (meeting long-term obligations)
• Profitability (earnings and cost coverage)
• Cash Flow (quality of earnings)
• Price Multiples (stock price)

www.afterschoool.tk
Activity Ratios
How day-to-day operations function
• Inventory management
• Inventory Turnover
– Compares income statement and balance sheet amounts
– Must average balance sheet figures ((Beg + End)/2)
– Turnover = COGS/Average total inventory
– Ex: sales = 400, avg. inventory = 20, what is turnover = 400/20 =
20
• Days inventory = 365/Turnover
– How many days was inventory held before being sold?
– Ex : 360/20 =18 days of inventory is kept on an average

www.afterschoool.tk
Activity Ratios
Critical operating cash accounts
• Accounts receivable turnover
– How many times a credit sale is made and subsequently
collected
– [credit sales/average accounts receivable]
– Ex: sales=100, BR=25, turnover = 4
– Try to use credit sales (if available)
– Consistency is important
• Days receivable
– Number of days between the charge sale and collection
– [365/accounts receivable turnover]
– Ex : 360/4 = 90 days receivables – more than the acceptable
credit period (it depends on industry standards).

www.afterschoool.tk
Activity Ratios
Critical operating cash accounts
• Accounts payable turnover
– Number of times a credit purchase is made and subsequently
paid
– [credit purchases/average accounts payable]
– Often assume all purchases are on credit
– Purchases = [COGS + Ending Inv. - Beginning Inv.]
– Ex : purchase = 100, creditors = 20, turnover = 5
• Days payable
– Number of days between credit purchase and payment
– [365/accounts payable turnover]
– 360 / 5 = 72 days credit (your creditors are helping you)

www.afterschoool.tk
Activity Ratios
Cash Cycle
• Also a measure of liquidity
• If low, small number of days in operating
cycle to finance
[Days inventory + Days receivable - Days payable]

Example : 18 + 90 – 72 = 36 days

www.afterschoool.tk
Activity Ratios
Asset Turnover
• Long-term
– Revenues generated by long-term assets
– [Sales revenue/Average noncurrent assets]
– Ex : sales=100, fixed assets=40 turnover=2.5
– Higher the better – if less than industry standards, it
means you are not able to use assets properly
• Total assets
– Efficiency of generating revenues given total assets
– [Sales revenue/Average total assets]

www.afterschoool.tk
Liquidity Ratios
• Current ratio
– Ability to meet short-term obligations
– [Current assets/current liabilities]
– Ideal = 2:1 or more
– Current assets = 100, current liabilities = 30
C/R=3.3:1
• Quick ratio
– Remove less liquid assets (inventory is not a very
liquid asset)
– Keep cash, liquid investments, A/R
– [(Current assets-inventory-ppd expenses-other)/current liabilities]
– [(Cash+short-term investments + A/R)/current liabilities]

www.afterschoool.tk
Liquidity Ratios
• Defensive interval ratio
– Compare 1 day’s costs to quick assets
– [((COGS+SGA+RD)/365)/(Cash+short-term investments + A/R)]
– Example :
– Cost of goods sold, other expenses and research and
development is 360000, Cash = 20000, Short term investments
= 200000, Accounts receivables = 80000
– (360000/360)/(20000+200000+80000)
– 1000/300000
– .003

www.afterschoool.tk
Solvency Ratios
• Debt to assets: Total liabilities/Total assets
– Proportion of assets financed with debt
• Could include interest bearing debt only
[(short term debt + noncurrent debt)/total assets]
Ex: Total debt 100, assets = 20, D/E ratio=5:1 (which is
more), ideally it should not be more than 2:1.
• Be aware that assets are recorded at historical
cost, which may be different from current market
value

www.afterschoool.tk
Solvency Ratios
• Debt to equity: Total liabilities/Total equity
– A measure of how assets are financed
• Or… (current debt + noncurrent debt)/Total equity
– Examine relative sizes of debt and equity financing
• Capitalization ratio:
[(current debt+noncurrent debt)/
(current debt+noncurrent debt+total equity)]
Ex: Loans= 200,Creditors=100,Capital=300,
capitalisation ratio = 300/600 = .5

www.afterschoool.tk
Solvency Ratios
Coverage Ratios
• Adequacy of resources for meeting firm’s
contractual obligations
• Times interest earned
– Can the firm cover its interest obligations?
– (EBIT/Interest expense)
– Ex : EBIT = 100, interest to be paid to bank=10,
coverage ratio = 10, the higher the better from
financier perspective
– Also called DSCR = debt service coverage ratio
• Cash interest coverage
– (Cash from ops + interest paid + tax paid)/Interest paid

www.afterschoool.tk
Solvency Ratios
Coverage Ratios
• Target a specific expense

– [(EBIT+Rent expense)/(Interest expense+rent
expense)]
• Target principal on debt that is about to be
repaid
– [EBIT/(interest expense + principal payments)]

www.afterschoool.tk
Profitability Ratios
Common-size
• Income statement
– Divide item of interest by sales
– ROS = Net income/Sales revenue
– Gross margin = Gross profit/Sales revenue
– Salary=100, rent = 20, purchases 200, sales = 500,
so the ratios will be : salary=.2,
rent=.04,purchase=.4
• Balance sheet
– Divide item of interest by total assets

www.afterschoool.tk
Return Ratios
• ROA (return on assets) = Net

income/Average total assets
• Or, [(Net income + After-tax interest
expense)/Average total assets]
• Also, [EBIT/Average total assets] reflects
pre-tax, pre-interest return

www.afterschoool.tk
Return Ratios
• ROE (return on equity) = Net income/Average

total equity
– Return generated relative to the capital provided by
the owners over time
• Or, if firm has preferred stock
[(Net income – Prfd dividends)/Average total common equity]
ROMVE = Net income/Market value of equity
Market value is different from book value.

www.afterschoool.tk
Cash Flow Ratios
Quality of earnings
• Ability to pay obligations

– CFO/Total liabilities
– CFO = Cash flows from operations
• Profitability (cash flow relative to sales)
– CFO/Sales revenue
• Cash return on assets
– CFO/Average total assets

www.afterschoool.tk
Cash Flow Ratios
Quality of earnings
• Cash flow-earnings index

– CFO/Net income
• Free cash flow ratio
– CFO/Capital expenditures
– If ratio>1, free cash flow exists

www.afterschoool.tk
Price Multiple Ratios
• Market’s valuation of a firm’s common stock

– P/E = Share price/Earnings per share
– Ex: reliance price=2000, EPS = 100, P/E = 20
– Generally PE ratio is in the range between 5 to 40
– If it is less than 5, it may be undervalued stock, so study it, it may
be a good investment
• Price/book ratio compares stock’s price to the recorded
value of the net assets
[Share price/(Book value of equity/Share outstanding)]
• Price/sales = Share price/Sales per share
• Also, compare price to cash flow per share
www.afterschoool.tk
Ratio Integration
DuPont analysis (decomposition)

ROE = ROA x Leverage
Net income Net income Average total assets
= ∗
Average total equity Average total assets Average total equity
Net income Net income Sales Average total assets

= ∗ ∗
Average total equity Sales Average total assets Average total equity
And more…
www.afterschoool.tk
Ratio Integration
ROA = Profitability x Turnover
Net income Net income Sales

= ∗
Average total assets Sales Average total assets

www.afterschoool.tk
Analysis
• Generally compare 3-5 years
• Requires 4-6 years of data
– Balance sheet numbers may be averaged
– Example : comparison of Motorola and Nokia

www.afterschoool.tk
Activity Ratios
2001 2000 1999 1998

Inventory Turns
MOT 5.36 5.28 5.54 5.33
NOK 9.77 9.45 7.98 6.58
A/R Turns
MOT 5.14 5.91 6.19 5.94
NOK 5.51 6.45 5.96 5.99

www.afterschoool.tk
Liquidity Ratios
2001 2000 1999 1998

Current ratio
MOT 1.77 1.22 1.36 1.18
NOK 1.62 1.57 1.69 1.75
Quick ratio
MOT 1.11 0.66 0.76 0.58
NOK 1.24 1.14 1.25 1.28

www.afterschoool.tk
Solvency Ratios
2001 2000 1999 1998

Debt-to-assets
MOT 57.6% 54.9% 52.6% 57.5%
NOK 44.7% 44.8% 47.5% 48.5%
Times interest earned
MOT -7.54 6.05 5.65 -3.56
NOK 43.38 51.97 16.14 13.40

www.afterschoool.tk
2001 2000 1999 1998
ROA
MOT -10.4% 3.2% 2.6% -3.4%
NOK 10.4% 23.1% 21.2% 20.5%
ROE
MOT -23.7% 6.9% 5.7% -7.6%
NOK 18.8% 42.6% 40.7% 40.7%

www.afterschoool.tk
Limitations to consider
• Historical cost of balance sheet items
• GAAP vs. IAS rules
• There is no perfect standard regarding ideal
ratio – it depends on industry standards so
compare with similar firms in industry to
determine ideal levels.
• Accounting method differences
– LIFO vs. FIFO inventory valuation

www.afterschoool.tk
Some other points
• In turnover ratios, sales is usually the
numerator
• In returns ratios, net profit is usually the
numerator

www.afterschoool.tk
LEVERAGE
• Leverage ratios tell you about ratio of fixed
cost resources in your overall structure
• Operating leverage = shows ratio of fixed
cost to total cost
• Financial leverage = shows ratio of debt
(or fixed interest bearing securities) to total
capital
• Higher the ratio, greater the risk and
greater is earnings possible.
www.afterschoool.tk
WHY STUDY LEVERAGE ?
• It shows relation between various aspects
– particularly risk and reward
• Leverage is a relation of your efforts and
rewards
• Some factors like fixed cost resources etc
have impact on increase or decrease in
profit.

www.afterschoool.tk
WHAT IS LEVERAGE?
• Lever is some tool to help you accelerate
your speed – have you used it ????
• It increases your speed and also your risk.
• We have two types of leverages in
FINANCIAL MANAGEMENT :
• A. operating leverage
• B. financial leverage

www.afterschoool.tk
WHAT IS FINANCIAL
LEVERAGE?
• Use of fixed charge securities like
debentures in the overall capital structure
is called financial leverage.
• DFL = degree of financial leverage
• It tells us about the level of financial risk
that we are taking. If financial leverage
increases, the risk of the firm increases.

www.afterschoool.tk
How is financial leverage
measured?
• % change in net income / % change in EBIT
• EBIT = earnings before interest and taxes, it is
also called net operating income
• Net income = income after payment of all dues
including interest.
• Example : your EBIT is 1000, your interest is
500. your EBIT increases by 20%, interest
remains same, so net income increases from
500 to 700. Thus DFL = 40/20 = 2 answer
• (% change in net income is 40% due to increase
in earning, but no change in interest).

www.afterschoool.tk
What is operating leverage ?
• It measures the impact of change in
volume (sales) on EBIT. It measures the
riskiness due to fixed cost resources in the
organisation.
• DOL = degree of financial leverage = %
change in EBIT / % change in sales
• It measures the impact of fixed cost on
profitability
www.afterschoool.tk
Example of operating leverage ..
• Suppose your sales are 300 and your
expenditures are 200. out of your total
expenditure, 120 is fixed expenditure and and
variable expenditureis 80. Suppose sales
increase by 40%, the variable expenses will also
increase by 40%. New sales = 420, new variable
exp. = 112. New total exp. = 232. Profit changed
from 100 to 188.
• DOL = 88/40 = 2.2 ans.

www.afterschoool.tk
What is DCL?
• DCL = degree of combined leverage
• DCL = DOL * DFL (PRODUCT OF DOL
AND DFL)

www.afterschoool.tk
About AFTERSCHO☺OL
• PGPSE - World’s most comprehensive
programme on social entrepreneurship –
after class 12th
• Flexible – fast changing to meet the
requirements
• Admission open throughout the year
• Complete support from beginning to the
end – from idea generation to making the
project viable.
www.afterschoool.tk
Branches of AFTERSCHO☺OL
• PGPSE programme is open all over the
world as free online programme.
• Those who complete PSPSE have the
freedom to start branches of
AFTERSCHO☺OL
• A few branches have already started -
one such branch is at KOTA (Rajasthan).

www.afterschoool.tk
Workshop on social
entrepreneurship
• We conduct workshop on social
entrepreneurship – all over India and out
of India also - in school, college, club,
association or any such place - just send
us a call and we will come to conduct the
workshop on social entrepreeurship.
• These workshops are great moments of
learning, sharing, and commitments.

www.afterschoool.tk
FREE ONLINE PROGRAMME
• AFTERSCHO☺OL is absolutely free
programme available online – any person can
join it. The programme has four components :
• 1. case studies – writing and analysing – using
latest tools of management
• 2. articles / reports writing & presentation of
them in conferences / seminars
• 3. Study material / books / ebooks / audio / audio
visual material to support the study
• 4. business plan preparation and presentations
of those plans in conferences / seminars

www.afterschoool.tk
100% placement / entrepreneurship
• AFTERSCHO☺OL has the record of
100% placement / entrepreneurship till
date
• Be assured of a bright career – if you join
AFTERSCHO☺OL

www.afterschoool.tk
Pursue professional courses along
with PGPSE
• AFTERSCHO☺OL permits you to pursue
distance education based professional /
vocational courses and gives you support
for that also. Many students are doing
CA / CS/ ICWA / CMA / FRM / CFP / CFA
and other courses along with PGPSE.
• Come and join AFTERSCHO☺OL

www.afterschoool.tk

Ratio Analysis As A Tool For Financial Analysis

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Ratio Analysis As A Tool For Financial Analysis

Uploaded by

Copyright:

Available Formats

RATIO ANALYSIS AS A TOOL

FOR FINANCIAL ANALYSIS

let us change the world

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

[Days inventory + Days receivable - Days payable]

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

• Target a specific expense

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

• ROA (return on assets) = Net

let us change the world afterschoool - PGPSE - online mba programme

• ROE (return on equity) = Net income/Average

let us change the world afterschoool - PGPSE - online mba programme

• Ability to pay obligations

let us change the world afterschoool - PGPSE - online mba programme

• Cash flow-earnings index

let us change the world afterschoool - PGPSE - online mba programme

• Market’s valuation of a firm’s common stock

DuPont analysis (decomposition)

Net income Net income Sales Average total assets

ROA = Profitability x Turnover

Net income Net income Sales

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

2001 2000 1999 1998

let us change the world afterschoool - PGPSE - online mba programme

2001 2000 1999 1998

let us change the world afterschoool - PGPSE - online mba programme

2001 2000 1999 1998

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

let us change the world afterschoool - PGPSE - online mba programme

You might also like