CH - 6 Ratio Analysis

Chapter 6
Financial Statements Analysis
Tata McGraw-Hill Publishing Company Limited, Management Accounting
6-1
FINANCIAL STATEMENTS ANALYSIS
Ratio Analysis
Common Size Statements Importance and Limitations of Ratio Analysis

6-2
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.
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Types of Ratios
Liquidity Ratios Capital Structure Ratios
Profitability Ratios
Efficiency ratios
Integrated Analysis Ratios
Growth 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 Particulars Company A Company B
Total current assets Total current liabilities NWC

Table 2: Change in Net Working Capital
Rs 1,80,000 1,20,000 60,000
Rs 30,000 10,000 20,000
Particulars
Current assets Current liabilities NWC
Company A
Rs 1,00,000 25,000 75,000
Company B
Rs 2,00,000 1,00,000 1,00,000
6-6
Liquidity Ratios
Liquidity ratios measure the ability of a firm to meet its short-term obligations
6-7
Current Ratio
Current Ratio is a measure of liquidity calculated dividing the current assets by the current liabilities
Current Ratio =
Current Assets Current Liabilities

Firm B Rs 30,000 Rs 10,000 3:1
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Particulars Current Assets Current Liabilities Current Ratio
Firm A Rs 1,80,000 Rs 1,20,000 = 3:2 (1.5:1)
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
Current Liabilities
Acid-test Ratio =
Quick Assets = Current assets Stock Pre-paid expenses

6-9
Example 1: Acid-Test Ratio

Cash Debtors Inventory Total current assets Total current liabilities (1) Current Ratio (2) Acid-test Ratio Rs 2,000 2,000 12,000 16,000 8,000 2:1 0.5 : 1
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Supplementary Ratios for Liquidity
Inventory Turnover Ratio
Debtors Turnover 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.
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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)
(Rs 35,000 + Rs 45,000) 2
6 (times = per year)
12 months Inventory = = 2 months holding period Inventory turnover ratio, (6)
6 - 13

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 sales

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.
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Example 3: Debtors Turnover Ratio

A 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 (Rs 27,500 + Rs 32,500) 2 = 12 Months Debtors turnover ratio, (8)
8 (times = per year)
Debtors collection period
1.5 Months
6 - 15
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 ratio
Net credit purchases 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.
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Example 4: Creditors Turnover Ratio

The 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 Creditors payment period
(Rs 1,80,000) (Rs 42,500 Rs 47,500) 2
4 (times per year)
12 months
Creditors turnover ratio, (4)
= 3 months
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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 Add: Debtors collection period Less: Creditors payment period 2 months + 1.5 months 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.
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DEFENSIVE INTERVAL RATIO

Defensive interval ratio is the ratio between quick assets and projected daily cash requirement.
Defensiveinterval ratio
Liquid assets = Projected daily cash requirement
Projected daily cash requirement
Projected cash operating expenditure Number of days in a year (365)
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Example 5: Defensive Interval Ratio

The 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 = Defensive-interval ratio =
Rs 1,82,500
365 Rs 40,000 Rs 500
= Rs 500
= 80 days
6 - 20
Cash-flow From Operations Ratio

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 Current liabilities
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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 Second type: These ratios are computed from the Income Statement
(a) Debt-equity ratio

(b) Debt-assets ratio (c) Equity-assets ratio
(a) Interest coverage ratio

(b) Dividend coverage ratio
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I. Debt-equity ratio
Debt-equity ratio measures the ratio of long-term or total debt to shareholders equity.
Debt-equity ratio measures the ratio of long-term debt + Other Current Total Debt Debt-equitytotal de3bt to shareholders equity Liabilities = Total external term or ratio = Shareholders equity Obligations
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.
Long-term Debt + Short
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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.
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Trading on Equity
Trading on equity (leverage) is the use of borrowed funds in expectation of higher return to equity-holders. Trading on Equity Particular (a) Total assets Financing pattern: Equity capital 15% Debt (b)Operating profit (EBIT) Less: Interest Earnings before taxes Less: Taxes (0.35) Earnings after taxes Return on equity (per cent) A 1,000 1,000 300 300 105 195 19.5 (Amount in Rs thousand) B 1,000 800 200 300 30 270 94.5 175.5 21.9 C 1,000 600 400 300 60 240 84 156 26 D 1,000 200 800 300 120 180 63 117 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.
Debt to total capital ratio =
Total debt Permanent capital
Permanent
Capital
Shareholders equity Long-term debt.
6 - 26
III. Debt to total assets ratio

Debt to total assets ratio =
Proprietary Ratio Proprietary ratio indicates the extent to which assets are financed by owners funds.
Total debt Total assets
Proprietary ratio =
Capital Gearing Ratio
Proprietary funds X 100 Total assets
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. Interest coverage ratio = Dividend Coverage Ratio
Dividend Coverage Ratio measures the firms ability to pay dividend on preference share which carry a stated rate of return.
EBIT (Earning before interest and taxes) Interest
Dividend coverage ratio =
EAT (Earning after taxes) Preference dividend

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Total fixed charge coverage ratio

Total fixed charge coverage ratio measures the firms ability to meet all fixed payment obligations. EBIT + Lease Payment Total fixed charge = coverage ratio Interest + Lease payments + (Preference dividend + Instalment of Principal)/(1-t)
Total Cashflow Coverage Ratio

However, 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.
EBIT + Lease Payments + Depreciation + Non-cash expenses
Lease payment + + Interest (Principal repayment) (1 t) + (Preference dividend) (1 - t)
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Total cashflow = coverage ratio
Debt Service Coverage Ratio

Debt-service coverage ratio (DSCR) is considered a more comprehensive and apt measure to compute debt service capacity of a business firm.
DSCR
t=1
EATt
Interestt
t=1 n
Depreciationt
OAt
Instalmentt
DEBT SERVICE CAPACITY

Debt service capacity is the ability of a firm to make the contractual payments required on a scheduled basis over the life of the debt.
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Example 6: Debt-Service Coverage Ratio

Agro Industries Ltd has submitted the following projections. You are required to work out yearly debt service coverage ratio (DSCR) and the average DSCR.
(Figures in Rs lakh) Year 1 2 3 4 5 6 7 8 Net profit for the year 21.67 34.77 36.01 19.20 18.61 18.40 18.33 16.41 Interest on term loan during the year 19.14 17.64 15.12 12.60 10.08 7.56 5.04 Nil Repayment of term loan in the year 10.70 18.00 18.00 18.00 18.00 18.00 18.00 18.00
The net profit has been arrived after charging depreciation of Rs 17.68 lakh every year.
6 - 31
Solution
Table 3: Determination of Debt Service Coverage Ratio
(Amount in lakh of rupees)

Ye ar Net profit Depreciation Interest Cash available (col. 2+3+4) 5 58.49 70.09 68.81 49.48 46.37 43.64 41.05 34.09 Principal instalment Debt obligation (col. 4 + col. 6) 7 29.84 35.64 33.12 30.60 28.08 25.56 23.04 18.00 1.83 6 - 32 DSCR [col. 5 col. 7 (No. of times)] 8 1.96 1.97 2.08 1.62 1.65 1.71 1.78 1.89
1 1 2 3 4 5 6 7 8
2 21.67 34.77 36.01 19.20 18.61 18.40 18.33 16.41
3 17.68 17.68 17.68 17.68 17.68 17.68 17.68 17.68
4 19.14 17.64 15.12 12.60 10.08 7.56 5.04 Nil
6 10.70 18.00 18.00 18.00 18.00 18.00 18.00 18.00
Average DSCR (DSCR 8)
Profitability Ratio
Profitability ratios can be computed either from sales or investment. Profitability Ratios Profitability Ratios
Related to Sales
(i) Profit Margin (ii) Expenses Ratio
Related to Investments
(i) Return on Investments (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
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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 Net sales Earnings before taxes Net sales
i. Operating Profit Ratio =
ii. Pre-tax Profit Ratio =
iii. Net Profit Ratio =
Earning after interest and taxes Net sales

6 - 35
Example 7: From the following information of a firm, determine (i) Gross profit margin and (ii) Net profit margin. 1. Sales Rs 2,00,000 2. Cost of goods sold 1,00,000 3. Other operating expenses 50,000
(1) Gross profit margin =
Rs 1,00,000
Rs 2,00,000
Rs 50,000
= 50 per cent
(2) Net profit margin =
Rs 2,00,000
= 25 per cent
6 - 36
Expenses Ratio
i. Cost of goods sold = ii. Operating expenses = Cost of goods sold X 100 Net sales Administrative exp. + Selling exp. Net sales Administrative expenses iii. Administrative expenses = Net sales iv. Selling expenses ratio = Selling expenses Net sales X 100 X 100
X 100
Cost of goods sold + Operating expenses v. Operating ratio = X 100 Net sales vi. Financial expenses = Financial expenses Net sales X 100
6 - 37
Return on Investment
Return on Investments measures the overall effectiveness of management in generating profits with its available assets.
i. Return on Assets (ROA) ROA = EAT + (Interest Tax advantage on interest) Average total assets
ii. Return on Capital Employed (ROCE)

ROCE = EAT + (Interest Tax advantage on interest) Average total capital employed
6 - 38
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.
Cost activity/liquidity of i. Inventory Turnover measures theof goods sold Inventory Turnover Ratio = Average inventory inventory of a firm; the speed with which inventory is sold
Cost of raw materials of i. Inventory Turnover measures the activity/liquidityused Raw materials turnover = inventory of a firm; the speed with whichmaterial inventory Average raw inventory is sold i. Inventory Turnover measuresCost activity/liquidity of the of goods manufactured Work-in-progress turnover = Average work-in-progress inventory inventory of a firm; the speed with which inventory is sold
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Liquidity of a firms receivables can be examined in two ways.
Credit sales i. Debtors turnover = measures the activity/liquidity of inventory of Inventory Turnover i. a firm; the speed with whichdebtors + Average bills receivable (B/R) Average inventory is sold
2. Average collection period =
Months (days) in a year Debtors turnover
i. Inventory =Months (days) in a year (x) (Average Debtors + Average (B/R) Alternatively Turnover measures the activity/liquidity of inventory of a Total sold firm; the speed with which inventory is credit sales
Ageing Schedule enables analysis to identify slow paying debtors.

6 - 41
Assets Turnover Ratio

Assets turnover indicates the efficiency with which firm uses all its assets to generate sales. Cost of goods sold i. Total assets turnover = Inventory Turnover measures the activity/liquidity of inventory of i. a firm; the speed with which inventory total assets Average is sold ii. Fixed assets turnover = Cost of goods sold Average fixed assets
Cost of goods sold i. Inventory Turnover measures the activity/liquidity of inventory of iii. Capital turnover = Average capital a firm; the speed with which inventory is sold employed Cost of goods sold iv. Current assets turnover = Average current assets i. Inventorycapital turnover = Costactivity/liquidity of inventory of Turnover measures the of goods sold v. Working Net working capital a firm; the speed with which inventory is sold
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1)
2)
Return on shareholders equity = EAT/Average total shareholders equity.

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)
6) 7)
Earnings yield = EPS/Market price per share.

Dividend Yield = DPS/Market price per share. Dividend payment/payout (D/P) ratio = DPS/EPS.
8)
9)
Price-earnings (P/E) ratio = Market price of a share/EPS.

Book value per share = Ordinary shareholders equity/Number of equity shares outstanding.
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Integrated Analysis Ratio

Integrated 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)

6 - 44
Rate of Return on Assets EAT as percentage of sales EAT Divided by Sales Sales Fixed assets Gross profit = Sales less cost of goods sold Minus Expenses: Selling Administrative Interest Assets turnover Divided by Plus Total Assets Current assets
Alternatively Shareholder equity Plus Long-term borrowed funds Plus Current liabilities
Minus
Income-tax
6 - 45
Return on Assets
Earning Power
Earning 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/Sales Asset turnover = Sales/Total assets
Earning after the activity/liquidity of inventory of Sales EAT i. Inventory Turnover measurestaxes x x Earning Power = a firm; the speed with which inventory isTotal Assets Total assets Sales sold
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EXAMPLE: 8
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.
Table 4: Return on Assets (ROA) of Firms A and B

Particulars 1. Net sales 2. Net profit 3. Total assets 4. Profit margin (2 1) (per cent) 5. Assets turnover (1 3) (times) 6. ROA ratio (4 5) (per cent) Firm A Rs 4,00,000 40,000 4,00,000 10 1 10 Firm B Rs 40,00,000 40,000 4,00,000 1 10 10
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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.
Net Profit EBT EBIT EAT i. Inventory Turnover measures the activity/liquidity of x = x Sales Earnings before taxes speed with which inventory is sold Sales inventory of a firm; the EBIT
As a result of three sub-parts of net profit ratio, the ROE is composed of the following 5 components.
EAT EBT
EBT EBIT
EBIT x Sales
Sales Assets
Assets Equity
6 - 48
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 B Particulars Net sales Less: Operating expenses Earnings before interest and taxes (EBIT) Less: Interest (8%) Earnings before taxes (EBT) Less: Taxes (35%) Earnings after taxes (EAT) Total assets Debt Equity EAT/EBT (times) EBT/EBIT (times) EBIT/Sales (per cent) Sales/Assets (times) Assets/Equity (times) ROE (per cent) Firm A Rs 4,00,000 3,22,462 77,538 16,000 61,538 21,538 40,000 4,00,000 2,00,000 2,00,000 0.65 0.79 19.4 1 2 20 Firm B Rs 40,00,000 39,26,462 73,538 12,000 61,538 21,538 40,000 4,00,000 2,50,000 1,50,000 0.65 0.84 1.84 10 1.6 16 6 - 49
Common Size Statements

Preparation 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.
Limitations
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.
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Chapter 6

Financial Statements Analysis

Tata McGraw-Hill Publishing Company Limited, Management Accounting

FINANCIAL STATEMENTS ANALYSIS

Common Size Statements Importance and Limitations of Ratio Analysis

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Integrated Analysis Ratios

Tata McGraw-Hill Publishing Company Limited, Management Accounting

Net Working Capital

Total current assets Total current liabilities NWC

Rs 1,80,000 1,20,000 60,000

Rs 30,000 10,000 20,000

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Current Assets Current Liabilities

Particulars Current Assets Current Liabilities Current Ratio

Firm A Rs 1,80,000 Rs 1,20,000 = 3:2 (1.5:1)

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Quick Assets = Current assets Stock Pre-paid expenses

Example 1: Acid-Test Ratio

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Supplementary Ratios for Liquidity

Inventory Turnover Ratio

Debtors Turnover Ratio

Creditors Turnover Ratio

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Inventory Turnover Ratio

Cost of goods sold

Example 2: Inventory Turnover Ratio

Inventory turnover ratio

(Rs 3,00,000 Rs 60,000)

(Rs 35,000 + Rs 45,000) 2

6 (times = per year)

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

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Debtors Turnover Ratio

Debtors turnover ratio

Net credit sales

Example 3: Debtors Turnover Ratio

Debtors turnover ratio

Rs 2,40,000 (Rs 27,500 + Rs 32,500) 2 = 12 Months Debtors turnover ratio, (8)

8 (times = per year)

Debtors collection period

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Creditors Turnover Ratio

Creditors turnover ratio

Net credit purchases Average creditors

Example 4: Creditors Turnover Ratio

Creditors turnover ratio Creditors payment period

(Rs 1,80,000) (Rs 42,500 Rs 47,500) 2

4 (times per year)

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the interrelationship of sales, collections from debtors

The combined effect of the three turnover ratios is summarised below:

DEFENSIVE INTERVAL RATIO

Liquid assets = Projected daily cash requirement

Projected daily cash requirement

Projected cash operating expenditure Number of days in a year (365)

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Example 5: Defensive Interval Ratio

Projected daily cash requirement = Defensive-interval ratio =

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