Ratio analysis

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Financial Statements AnalysisFinancial Statements Analysis

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FINANCIAL STATEMENTS ANALYSIS

Ratio Analysis

Importance and Limitations of Ratio Analysis

Common Size Statements

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Ratio AnalysisRatio 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 ComparisonBasis 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 firm’s performance in relation to its competitors.

3) Comparison with standards or industry average.

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Types of RatiosTypes of Ratios

Liquidity RatiosLiquidity Ratios Capital Structure RatiosCapital Structure Ratios

Profitability RatiosProfitability Ratios Efficiency ratiosEfficiency ratios

Integrated Analysis Ratios

Integrated Analysis Ratios

Growth RatiosGrowth Ratios

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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

Rs 1,80,000

1,20,000

60,000

Rs 30,000

10,000

20,000

Table 2:  Change in Net Working Capital

Particulars Company A Company B

Current assets

Current liabilities

NWC

Rs 1,00,000

25,000

75,000

Rs 2,00,000

1,00,000

1,00,000

Net Working CapitalNet Working Capital

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Liquidity ratios measure the ability of a firm to meet its short-term

obligations

Liquidity RatiosLiquidity Ratios

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Particulars Firm A Firm B

Current Assets Rs 1,80,000 Rs 30,000

Current Liabilities Rs 1,20,000 Rs 10,000

Current Ratio = 3:2 (1.5:1) 3:1

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

Current Ratio

Current Ratio =Current Assets

Current Liabilities

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The quick or acid test ratio takes into consideration the differences in the liquidity of the

components of current assets

Quick Assets = Current assets – Stock – Pre-paid expenses

Acid-Test RatioAcid-Test Ratio

Acid-test Ratio =Quick Assets

Current Liabilities

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Example 1: Example 1: Acid-Test RatioAcid-Test Ratio

Cash

Debtors

Inventory

Total current assets

Total current liabilities

Rs 2,000

2,000

12,000

16,000

8,000

(1) Current Ratio

(2) Acid-test Ratio

2 : 1

0.5 : 1

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Supplementary Ratios for Supplementary Ratios for LiquidityLiquidity

Inventory Turnover Ratio

Inventory Turnover Ratio

Debtors Turnover RatioDebtors Turnover Ratio

Creditors Turnover RatioCreditors Turnover Ratio

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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 sold

Average inventory

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Example 2: 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)

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Debtors Turnover Ratio

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.

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

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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

=8 (times per

year)(Rs 27,500 + Rs 32,500) ÷ 2

Debtors collection period

=12 Months

=1.5

MonthsDebtors turnover ratio, (8)

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Creditors Turnover RatioCreditors Turnover Ratio

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.

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 supplier’s credit.

Creditors turnover ratio

=Net credit purchases

Average creditors

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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

=(Rs 1,80,000)

=4 (times per year)(Rs 42,500 Rs 47,500) ÷ 2

Creditor’s payment period

=12 months

= 3 monthsCreditors 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.

Inventory holding period

Add: Debtor’s collection period

Less: Creditor’s 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.

The combined effect of the three turnover ratios

is summarised below:

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Defensive interval ratio is the ratio between quick assets and projected daily cash requirement.

DEFENSIVE INTERVAL RATIO

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

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 =Rs 1,82,500

= Rs 500365

Defensive-interval ratio =Rs 40,000

= 80 daysRs 500

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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 operations

Current liabilities

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Leverage Capital Structure RatioLeverage Capital Structure Ratio

Capital 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:

(i) Ability to repay the principal when due, and

(ii) Regular payment of the interest .

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 ratioI. Debt-equity ratio

Debt-equity ratio measures the ratio of long-term or total de3bt to shareholders equityDebt-equity ratio =

Total DebtShareholders’ equity

Long-term Debt + Short term debt + Other Current Liabilities = Total external

Obligations

Debt-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.

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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 EquityTrading on Equity

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 180Less: Taxes (0.35) 105 94.5 84 63Earnings after taxes 195 175.5 156 117Return on equity (per cent) 19.5 21.9 26 58.5

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

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II. Debt to Total CapitalII. Debt to Total Capital

The relationship between creditors’ funds and owner’s 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.

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III. Debt to total assets ratioIII. Debt to total assets ratio

Debt to total assets ratio =Total debt

Total assets

Proprietary ratio indicates the extent to which assets are financed by owners funds.

Proprietary ratio =Proprietary funds

Total assetsX 100

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 Ratio

Capital Gearing Ratio

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Coverage RatioCoverage Ratio

Interest Coverage Ratio measures the firm’s ability to make contractual interest payments.

Interest coverage ratio =EBIT (Earning before interest and taxes)

Interest

Dividend coverage ratio =EAT (Earning after taxes)

Preference dividend

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

Interest Coverage Ratio

Dividend Coverage Ratio

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Total fixed charge coverage ratio measures the firm’s ability to meet all fixed payment obligations.

Total fixed charge coverage ratio

EBIT + Lease Payment

Interest + Lease payments + (Preference dividend + Instalment of Principal)/(1-t)

=

Total fixed charge coverage ratio

However, coverage ratios mentioned above, suffer from one major limitation, that is, they relate the firm’s 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 

Total cashflow coverage ratio

Lease payment + Interest

EBIT + Lease Payments + Depreciation + Non-cash expenses=

(Principal repayment)

(1– t)

(Preference dividend)

(1 - t)+ +

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Debt Service Coverage RatioDebt 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.

DEBT SERVICE CAPACITY

DSCR =Instalmentt

∑n

t=1

EATt OAt+ +∑∑n

t=1Depreciationt+Interestt

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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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 Net profit for the year

Interest on term loan

during the year

Repayment of term

loan in the year

1

2

3

4

5

6

7

8

21.67

34.77

36.01

19.20

18.61

18.40

18.33

16.41

19.14

17.64

15.12

12.60

10.08

7.56

5.04

Nil 

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.

Example 6: Debt-Service Coverage RatioExample 6: Debt-Service Coverage Ratio

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SolutionSolutionTable 3:  Determination of Debt Service Coverage Ratio

(Amount in lakh of rupees)Year

Net profit

Depreciation Interest Cash

available

(col. 2+3+4)

 Principal

instalment

 Debt

obligation

(col. 4 + col. 6)

DSCR [col. 5

÷ col. 7

(No. of times)]

1 2 3 4 5 6 7 8

1

2

3

4

5

6

7

8

21.67

34.77

36.01

19.20

18.61

18.40

18.33

16.41

17.68

17.68

17.68

17.68

17.68

17.68

17.68

17.68

19.14

17.64

15.12

12.60

10.08

7.56

5.04

Nil 

58.49

70.09

68.81

49.48

46.37

43.64

41.05

34.09

10.70

18.00

18.00

18.00

18.00

18.00

18.00

18.00

29.84

35.64

33.12

30.60

28.08

25.56

23.04

18.00

1.96

1.97

2.08

1.62

1.65

1.71

1.78

1.89

  Average DSCR (DSCR ÷ 8) 1.83

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Profitability RatioProfitability Ratio

Profitability ratios can be computed either from sales or investment.

Profitability Ratios

Related to Sales

Profitability Ratios

Related to Investments

(i) Profit Margin

(ii) Expenses Ratio

(i) Return on Investments

(ii) Return on Shareholders’

Equity

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Profit MarginProfit Margin

Gross profit margin measures the percentage of each sales rupee remaining after the firm has paid for its goods.

Gross profit margin = Gross ProfitSales

X 100

Gross Profit Margin

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Net profit margin can be computed in three ways

iii. Net Profit Ratio =Earning after interest and taxes

Net sales

ii. Pre-tax Profit Ratio =Earnings before taxes

Net sales

i. Operating Profit Ratio =Earning before interest and taxes

Net sales

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

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Example 7: From the following information of a firm, determine (i) Gross profit margin and (ii) Net profit margin.

1. Sales

2. Cost of goods sold

3. Other operating expenses

Rs 2,00,000

1,00,000

50,000

(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

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Expenses RatioExpenses Ratio

i. Cost of goods sold =Cost of goods sold

Net salesX 100

ii. Operating expenses =Administrative exp. + Selling exp.

Net salesX 100

iii. Administrative expenses =Administrative expenses

Net salesX 100

iv. Selling expenses ratio =Selling expenses

Net salesX 100

v. Operating ratio =Cost of goods sold + Operating expenses

Net salesX 100

vi. Financial expenses =Financial expenses

Net salesX 100

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Return on InvestmentReturn 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

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Return on Shareholders’ EquityReturn on Shareholders’ Equity

Return on total shareholders’ equity =

Net profit after taxesAverage total shareholders’ equity X 100

Return on ordinary shareholders’ equity (Net worth) =

Net profit after taxes – Preference dividendAverage ordinary shareholders’ equity X 100

Return on shareholders equity measures the return on the owners (both preference and equity shareholders )

investment in the firm.

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Efficiency RatioEfficiency Ratio

Activity ratios measure the speed with which various accounts/assets are converted into sales or cash.

i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is soldInventory Turnover Ratio =

Cost of goods soldAverage inventory

i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is soldRaw materials turnover =

Cost of raw materials used

Average raw material inventory

i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is soldWork-in-progress turnover =

Cost of goods manufactured

Average work-in-progress inventory

Inventory turnover measures the efficiency of various types of inventories.

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Liquidity of a firm’s receivables can be examined in two ways.

i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is soldi. Debtors turnover =

Credit salesAverage debtors + Average bills receivable (B/R)

2. Average collection period = Months (days) in a year

Debtors turnover

i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold

Alternatively =Months (days) in a year (x) (Average Debtors + Average (B/R)

Total credit sales

Ageing Schedule enables analysis to identify slow paying debtors.

Debtors Turnover RatioDebtors Turnover Ratio

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Assets Turnover RatioAssets Turnover Ratio

i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is soldi. Total assets turnover =

Cost of goods sold

Average total assets

ii. Fixed assets turnover =Cost of goods sold

Average fixed assets

i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is soldiii. Capital turnover =

Cost of goods soldAverage capital employed

iv. Current assets turnover =Cost of goods sold

Average current assets

i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is soldv. Working capital turnover =

Cost of goods soldNet working capital

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

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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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Integrated Analysis RatioIntegrated 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)

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Rate of Return on Assets

EAT as percentage of sales

Assets turnover

EAT SalesDivided by Sales Total AssetsDivided by

Current assetsFixed assetsGross profit = Sales less

cost of goods sold

Minus

Expenses: Selling Administrative Interest

Minus

Income-tax

Shareholder equity

Plus

Long-term borrowed funds

Plus

Current liabilities

Plus

Alternatively

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Return on AssetsReturn on Assets

Earning 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 turnoverWhere, Net profit margin = Earning after taxes/SalesAsset turnover = Sales/Total assets

i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is soldEarning Power =

Earning after taxes

Sales

Sales

Total Assets

EAT

Total assetsxx x

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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.

Table 4: Return on Assets (ROA) of Firms A and B

Particulars Firm A Firm B

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)

Rs 4,00,000

40,000

4,00,000

10

1

10

Rs 40,00,000

40,000

4,00,000

1

10

10

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

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Return on Equity (ROE)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.

i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold

EATEarnings before taxes

EBT

EBIT

EBITSales

Net Profit

Salesxx =

EAT

EBT

EBT

EBITEBITSales

SalesAssets

AssetsEquity

x x x x

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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 Firm A Firm B

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)

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

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

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Common Size StatementsCommon 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.

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