Chapter-3 C FINANCIAL RATIO ANALYSIS. BSNL, India For Internal Circulation Only 1

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1 Chapter-3 C FINANCIAL RATIO ANALYSIS BSNL, India For Internal Circulation Only 1

2 RATIO ANALYSIS FINANCIAL ANALYSIS is the process of identifying the financial strengths and weakness of the firm by properly establishing relationships between the items of the balance sheet and the profit and loss account. RATIO ANALYSIS is a powerful tool of financial analysis. The relationship between two accounting figures, expressed mathematically, is known as a financial ratio. s help to summarize the large quantities of financial data and to make qualitative judgment about the firm s financial performance. Standards of comparison: A single ratio in itself does not indicate favourable or unfavorable conditions. It should be compared with some standard. Standards of comparison may consist of: 1. s calculated from the past financial statements of the same firm; 2. s developed using the projected, or pro forma, financial statements of the same firm; Advantages of Analysis: 3. s of some selected firms, especially the most progressive and successful, at the same point of time, and 4. s of the industry to which the firm belongs. i. Simplifies, Summarizes and Systematizes accounting figures for easy understanding; ii. iii. iv. s helps the management in measuring things like Long-term Solvency, Operational Efficiency, etc. of the firm Facilitates the understanding of financial statements showing the whole story of changes in financial conditions of business; Facilitates inter-firm comparison showing relative performance of enterprise in the industry; v. Facilitates intra-firm comparison showing the improvement/degradation in the performance of the enterprise; vi. vii. viii. Facilitates the Planning of Operations; Facilitates in Establishing Standards; Facilitates Management by Exception higher management can concentrate the area where its intervention is required; thereby making the best use of time & available resources. BSNL, India For Internal Circulation Only 2

3 Limitations of Analysis: 1) s has little meaning by itself; unless there exists a comparison; 2) s are arithmetical expressions, so, qualitative aspects cannot be presented through ratios directly; 3) s are calculated from accounting records which are subject to their own limitations. Hence, ratios are also considerably affected by limitations of accounting records; 4) s are only a tool, whose best use ultimately depends upon the craftsman who uses it. So, they are only means & not end in themselves. 5) Strongly affected by manipulations of financial statements [like window dressing]; & this fact is not revealed by Analysis. 6) Factors like Inflation also strongly distort the Analysis. Classification of s: Structural Classification of s: This is the Conventional mode of classifying ratios where the ratios are classified on the basis of information given in the financial statements. The classification is as follows: S. No: Type What it is Examples 1. Balance Sheet s These are the ratios for which the components for computation are drawn from the Balance Sheet. These are called Financial s. * Current * Liquid * Debt Equity * Proprietary * Capital Gearing * Fixed Assets 2. Profit and Loss Account s 3. Interstatement s Combined s or These are the ratios for which the components for computation are drawn from the Profit & Loss Account. These are called Income Statement s or Operating s. These are the ratios for which the components for computation are drawn both from the Balance Sheet and Profit & Loss Account. These are called Financial s. * Gross Profit * Net Profit * Operating * Stock * Expenses * Return on Capital Employed [ROCE] * Return on Investments [ROI] * Debtors * Creditors * Fixed Assets * Working Capital BSNL, India For Internal Circulation Only 3

4 Functional Classification Of s: RATIOS LIQUIDITY RATIOS CAPITAL STRUCTU RE COVERAGE RATIOS TURNOVER RATIOS PROFITABILITY RATIOS * Current * Acid Test or Quick * Absolute Cash * Interval Measure * Equity to Funds * Debt Equity * Capital Gearing * Fixed Assets to Long- term Funds * Proprietary * Debt Service Coverage * Interest Coverage * Preference Dividend Coverage * Capital * Fixed Asset * Working Capital * Raw Materials * FG/Stock * Creditors Based on Sale * Gross Profit * Operating Profit * Net Profit Based on Capital * Return on Investment [ROI] or Return on Capital Employed [ROCE] * Return on Equity [ROE] * Return on Assets [ROA] * Earnings per Share [EPS] * Dividend per Share [DPS] * Dividend Yield [DYR] * Price Earnings [P/E ] * Dividend Pay out [D/P ] * Reserves to Capital BSNL, India For Internal Circulation Only 4

5 TYPES OF RATIOS LIQUIDITY RATIOS : LIQUIDITY RATIOS MEASURE THE ABILITY OF THE FIRM TO MEET ITS CURRENT OBLIGATIONS. 1. Current ratio = Current assets Current Liabilities Current assets include cash and those assets which can be converted into cash within a year, such as marketable securities, debtors and inventories. Prepaid expenses also included in current assets as they represent the payments that will have not to be made by the firm in the near future. All obligations maturing within a year are included in current liabilities. Thus current liabilities include creditors, bills payable, accrued expenses, short-term bank loan, income-tax liability and long-term debt maturing in the current year. The current ratio is a measure of the firm s short-term solvency. A ratio of greater than one means that the firm has more current assets than current claims against them. As a conventional rule, a current ratio of 2 to 1 or more is considered satisfactory. Too much reliance should not be placed on the current ratio. Further investigations about the quality of current assets should be carried. 2. Quick ratio = Current Assets-Inventories Current liabilities This ratio establishes a relationship between quick or liquid, assets and current liabilities. Generally a quick ratio of 1 to 1 is considered to represent a satisfactory current financial condition. 3. Cash ratio = Cash + Marketable securities Current liabilities 4. Interval measure =Current assets-inventory Average daily operating expenses This ratio assesses a firm s ability to meet its regular cash outgoings. The daily operating expenses will be equal to cost of goods sold plus selling, administrative and general expenses less depreciation(and other non-cash expenditure) divided by number of days in the year (say 360) 5. Net working capital ratio =Net working capital Net assets The difference between current assets and current liabilities is called net working capital. NWC is sometimes used as a measure of a firm s liquidity. It can be related to net assets (or capital employed). It is considered that, between two firms, the one having the larger NWC has the greater ability to meet its current obligations. BSNL, India For Internal Circulation Only 5

6 LEVERAGE RATIOS : Leverage ratios are calculated to measure the financial risk and the firm s ability of using debt for the benefit of shareholders. Leverage ratios may be calculated from the balance sheet items to determine the proportion of debt in total financing. Leverage ratios are also computed from the income statement items by determining the extent to which operating profits are sufficient to cover the fixed charges. 1. Total Debt ratio = Total Debt = TD Total debt + Net worth TD + NW OR = Total debt = TD Capital employed CE Total debt (TD) will include short and long-term borrowing financial institutions, debentures/bonds, deferred payment arrangements for buying capital equipments, and bank borrowing, public deposits and nay other interest- bearing loan. Capital employed (CE) will include total debt and net worth (NW) Capital employed (CE) equals net assets (NA) which consist of net fixed assets (NFA) and net current assets (NCA). Net current assets (NCA) are equal to current assets(ca) minus current liabilities (CL) excluding interest- bearing debt. 2. Debt-Equity ratio =Total Debt Net Worth Relationship describing the lenders contribution for each rupee of the owners contribution is called debt-equity ratio. 3. Total liabilities to total assets ratio = Total liabilities Total assets THIS RATIO assesses the proportion of total funds-short-term and long-term provided by outsiders to finance total assets. 4. Debt ratio = Total debt + Value of lease COVERAGE RATIOS : Total debt + Value of lease + Net worth 1. Interest coverage = EBIT + Depreciation Interest EBIT = Earnings before interest and taxes BSNL, India For Internal Circulation Only 6

7 2. Fixed coverage = EBIT + depreciation Interest + Loan repayment 1-tax rate ACTIVITY RATIOS: Activity ratios are employed to evaluate the efficiency with which the firm manages and utilizes its assets. These ratios are also called turnover ratios because they indicate the speed with which assets are being converted or turned over into sales. 1. Inventory turnover =Cost of goods sold Average inventory This ratio indicates the efficiency of the firm in selling its product. The average inventory is the average of opening and closing balances of inventory. 2. Days of inventory holdings (DIH) = Number of days in a year (say 360) Inventory turnover 3. Raw material inventory turnover = Material consumed Average raw material inventory 4. Work in process inventory turnover = Cost of production Average work in process inventory 5. Debtors turn over = Credit Sales Average debtors 6. Average collection period (ACP) = 360 Debtors turnover Debtors turnover ratio and average collection period ratio judge the quality or liquidity of debtors. ASSET TURNOVER Assets are used to generate sales. Therefore, a firm should manage its assets efficiently to maximize sales. The relationship between sales and assets is called assets turnover. 7. Net assets turnover = Sales Net assets 8. Total assets turnover = Sales 9.Fixed assets turnover = Sales Total assets BSNL, India For Internal Circulation Only 7

8 Net fixed assets 10.Current assets turnover = Sales Current assets 11. Net currents assets turnover = sales Net current assets PROFITABILITY RATIOS: The profitability ratios are calculated to measure the operating efficiency of the company. 1. Gross profit margin = Gross profit Sales Gross profit= Sales-cost of goods sold 2. Net profit margin =Profit after tax or EBIT Sales sales EBIT = Earnings before interest and tax 3. Operating expense ratio =Operating expenses Sales 4. Return on Investment =EBDIT GFA+NCA EBDIT=Earnings before depreciation, interest and Tax GFA=Gross fixed Assets CFA=Net current assets 5.Return on equity = Profit after tax Net worth 6.Earnings per share (EPS) = Profit after tax Number of common shares outstanding 7.Dividends per share (DPS) = Earnings paid to shareholders Number of common shares outstanding 8.Dividend payout ratio = DPS EPS 9.Price-earnings ratio = Market value per share (MVPS) Earnings per share (EPS) 10.Market value-book value ratio = Market value of the share Book value of the share BSNL, India For Internal Circulation Only 8

9 Illustration: The ABC company s financial statements contain the following information: 31 st March 2007 Rs. 31 st March 2006 Rs. Cash Sundry debtors Temporary investments Stock Prepaid expenses Total current assets Total assets Current liabilities % debentures Equity share capital Retained earnings Statement of Profit for the year ended 31 st March,2007 Rs. Sales Less: cost of goods sold Less: Interest Net profit for Less: 50% (i) Dividend declared on equity shares = Rs Liquidity s (a) Current ratio = Current assets Current liabilities 2000= = = =3.82 BSNL, India For Internal Circulation Only 9

10 (ii) (iii) (b) Acid Test =Liquid assets Solvency s Current liabilities 2000=720000= =880000= (a) Debt equity ratio: Long term debts shareholders funds 2000= =0.65(approx.) = =0.57(approx.) b) Interest coverage ratio: Profit before interest and taxes Profitability ratios 2001= =7.5 times (a) Net Profit ratio = Net profit x = x 100= 13% Sales (b) Returns on capital employed : Net profit before interest and taxes x 100 (iv) Activity ratios 2001= x 100=27.2% (a) Stock turnover ratio: Cost of goods sold (b) Total assets turnover ratio: sales Average stock 2001= =1.4 times Total assets Interest charges Total capital employed BSNL, India For Internal Circulation Only 10

11 Limitations of the ratio analysis 2001= =0.625 times It is difficult to decide on the proper basis of comparison. 2. The comparison is rendered difficult because of differences in situations of two companies or of one company over years. 3. The price level changes make the interpretations of ratios invalid. 4. The differences in the definitions of items in the balance sheet and the profit and loss statement make the interpretation of ratios difficult. 5. The ratios calculated at a point of time are less informative and defective as they suffer from short-term-changes. 6. The ratios are generally calculated from past financial statements and, thus are no indicators of future. Questions:- 1. What is the Financial Analysis? 2. What is the Analysis? 3. What are the advantages of Analysis? 4. What are the Standard Comparisons of Analysis? 5. What are the points to be borne in mind while using Analysis Techniques? 6. What is the classification of Analysis? 7. What is the structural classification of Analysis? 8. What is the Activity Analysis of Analysis? 9. What are the limitations of Analysis? 10. What is the classification of Analysis? 11. What are the Liquidity s? 12. What are the Profitability Analysis s? BSNL, India For Internal Circulation Only 11

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