Ratio Analysis Basics

Ratio Analysis
Fundamental Analysis
Dheeraj Vaidya
dheerajvaidya@corporatebridge.net
www.cbresearch.in
www.cbacademy.in
www.cbreserach.in
Private and Confidential Not for Circulation
Discussion topics
How to analyze a company?
Ratio Analysis
Analytical techniques for Financial Statement Analysis
Horizontal Analysis
Trend Analysis
Vertical Analysis
Ratio Analysis
Solvency
Current Ratio /Quick Ratio / Cash ratio
Receivables turnover / Inventory turnover / Payables turnover / Cash Conversion Cycle
Operating
Operating Efficiency ratios
Operating Profitability
DuPont Formula
Extended DuPont Formula
Risk
Business Risk
Financial risk
External liquidity risk
Growth
Limitations of Financial Ratios
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Ratio Analysis
How to analyze a company?
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Analytical techniques for FSA
Ratio Analysis
Purpose of Financial Statement Analysis is to evaluate management performance in
Profitability
Efficiency
Risk
Although financial statement information is historical, it is used to project future performance
Horizontal
and Trend
Analysis
Vertical
Analysis
Ratio
Analysis
Compares two financial statements to determine dollar and

percentage changes
Compute dollar changes and percentage changes
Shows relationship of each item to a base amount on financial

statements
Income statement (each item expressed as percentage of net
sales)
Balance sheet (each item expressed as percentage of total
assets)
Which method is the

Best?
Puts numbers in perspective with other numbers

Helps control for different sizes of firms
Ratios provide meaningful relationships between individual
values in the financial statements
An Analyst is expected to do a complete synthesis using all three methods

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Ratio Analysis
Horizontal / Trend / Vertical Analysis
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Horizontal Analysis
Horizontal analysis shows the changes between years in the financial data in both dollar
and percentage form
Horizontal analysis on the income statement

GKSR Income Statement
Ratio Analysis
Rental Operations
Direct Sales
Net Revenues
Cost of rental operations
Cost of direct sales
Selling and administrative costs
Operating Expenses
Ebitda
Depreciation
Amortization of intangibles
Ebit
Interest Expense
Income before income taxes
Provision for taxes
PAT
Basic EPS
Diluted EPS
2006
2007
Increase ($)
% YoY change
801,240
79,603
$880,843
(518,543)
(57,522)
(186,652)
($762,717)
847,401
82,141
$929,542
(541,392)
(59,579)
(203,614)
($804,585)
5.8%
3.2%
5.5%
4.4%
3.6%
9.1%
5.5%
$118,126
(32,479)
(10,784)
$74,863
(13,226)
$61,637
(19,786)
$41,851
$124,957
(34,789)
(10,806)
$79,362
(13,901)
$65,461
(22,271)
$43,190
46,161
2,538
$48,699
(22,849)
(2,057)
(16,962)
($41,868)
$6,831
(2,310)
(22)
$4,499
(675)
$3,824
(2,485)
$1,339
$1.98
$1.97
$2.03
$2.02
$0.05
$0.05
5.8%
7.1%
0.2%
6.0%
5.1%
6.2%
12.6%
3.2%
[Current year Base year] /

[Base year]
Why provision for tax has

increased by 12.6%, while the
revenues increased by only 5.5%?
Why there is an increase of 9.1%
in Selling and administrative cost?
2.5%
2.4%
Horizontal analysis can also be done on the liabilities or shareholders equity
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Ratio Analysis
Trend Analysis
Trend percentages state several years financial data in terms of a base year, which equals
100%
In the example below, we have taken base year as 2002
Income Statement
Net Revenues
Operating Expenses
PAT
2002
677,591
565,077
38,267
2003
705,588
598,974
33,689
2004
733,447
625,064
35,384
2005
788,775
674,566
38,179
2006
880,843
762,717
41,851
2007
929,542
804,585
43,190
Trend Analysis
Net Revenues
Operating Expenses
PAT
2002
100.0%
100.0%
100.0%
2003
104.1%
106.0%
88.0%
2004
108.2%
110.6%
92.5%
2005
116.4%
119.4%
99.8%
2006
130.0%
135.0%
109.4%
2007
137.2%
142.4%
112.9%
[Current year ] / [Base year] * 100
We can use the trend percentages to construct a graph so we can see the trend over time
Trend Analysis
160%
140%
120%
While Operating cost has increased

by 42% since 2002, Net income
grew marginally by 13% during the
corresponding period
100%
80%
60%
2002
2003
Net Revenues
2004
2005
Operating Expense
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2006
2007
Net Income
Vertical Analysis
Common-size statements use percentages to express the relationship of individual

components to a total within a single period is known as Vertical Analysis
Income Statement (as a percentage of Total Revenues)
Balance Sheet (As a percentage of Total Asset / Total Liabilities)
Ratio Analysis
Vertical Analysis
2002
2003
2004
2005
2006
2007
96.8%
3.2%
100.0%
96.6%
3.4%
100.0%
96.6%
3.4%
100.0%
93.9%
6.1%
100.0%
91.0%
9.0%
100.0%
91.2%
8.8%
100.0%
-59.5%
-2.3%
-21.6%
-83.4%
-60.5%
-2.5%
-21.9%
-84.9%
-61.1%
-2.6%
-21.5%
-85.2%
-59.6%
-4.5%
-21.4%
-85.5%
-58.9%
-6.5%
-21.2%
-86.6%
-58.2%
-6.4%
-21.9%
-86.6%
Ebitda
16.6%
15.1%
14.8%
14.5%
13.4%
13.4%
Depreciation
Amortization of intangibles
Ebit
-4.4%
-0.9%
11.3%
-4.3%
-1.0%
9.8%
-4.3%
-1.1%
9.4%
-4.1%
-1.2%
9.2%
-3.7%
-1.2%
8.5%
-3.7%
-1.2%
8.5%
Interest Expense
Income before income taxes
-2.0%
9.3%
-1.9%
7.8%
-1.6%
7.8%
-1.4%
7.8%
-1.5%
7.0%
-1.5%
7.0%
Provision for taxes

PAT
-3.7%
5.6%
-3.1%
4.8%
-3.0%
4.8%
-2.9%
4.8%
-2.2%
4.8%
-2.4%
4.6%
Rental Operations
Alcohol
Net Revenues
Cost of rental operations
Cost of direct sales
Selling and administrative costs
Operating Expenses
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Since 2004, cost of rentals have

decreased
EBITDA/EBIT/PAT margins a
concern - continuously
decreasing trend
Ratio Analysis
Ratio Analysis
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Ratio Analysis
Puts numbers in perspective with other numbers
Helps control for different sizes of firms
Ratios provide meaningful relationships between individual values in the financial statements
Ratios can be used to evaluate four different areas of companys performance and conditions
Ratio Analysis
Ratios can often be more informative that raw numbers
Ratio
Analysis
Solvency
Ratios
Current/Cash
/Quick Ratio
Turnover
Ratios
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Operating
Performance
Operating
Efficiency
Operating
Profitability
Risk Analysis
Business
Risk
Growth
Financial
Risk
External
liquidity risk
Sustainable
growth rate
10
Ratio Analysis
Ratio Analysis - Solvency
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Analyst employ these ratios to determine the firms ability to pay its short-term liabilities
Ratio Analysis
Current Ratio examines current assets and current liabilities
Higher the current ratio, more likely is that the company will be able to pay its short-term bills
Current Ratio
A ratio of less than 1, means that the company has negative working capital and is probably facing
liquidity crisis
Quick Ratio adjusts current assets by removing less liquid assets
More stringent measure of liquidity
Quick Ratio
Current Assets
Current Liabilitie s
Cash Marketable Securities Receivable s

Higher the quick ratio, more likely is that the company will be able to pay its short-term bills
Cash ratio relates cash (ultimate liquid asset) to current liabilities
Higher the cash ratio, more likely is that the company will be able to pay its short-term bills
Cash Ratio
Cash Marketable Securities

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Receivables turnover examines the management of accounts receivable
Ratio Analysis
Net Annual Sales

Average Receivable s
It is desirable to have a collections period closer to the industry norm
Average Receivable s Collection Period
365
Receivable s Turnover
Collection period too high mean that customers are too slow in paying their bills, which implies too much
capital is tied up in assets
Inventory turnover measures firms efficiency with respect to its processing and inventory
management
Receivable s Turnover
Average collection period is the average number of days it takes for the companys
customer to pay their bills
Balance sheet items are taken as average of the account
Inventory Turnover
Cost of Goods Sold

Average Inventory
Given the turnover values, you can compute the average inventory processing time
It is desirable to have a collections period closer to the industry norm
Average Inventory Processing Period

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365
Inventory Turnover
13
Evaluating Solvency Ratios
Ratio Analysis
Payables turnover measures the use of trade credit by the firm
Payables Turnover
Given the turnover values, we can compute the average payment period processing time
Cost of goods sold

Average Payables
It is desirable to have a collections payment closer to the industry norm
Average Payment Period
365
Payable Turnover
Cash Conversion Cycle
Combines information from the receivables turnover, inventory turnover, and accounts payable turnover
Cash Con Cycle
Receivable period
Inventory period
Payable period
High conversion cycle is undesirable
Too high conversion cycle implies that company has excessive amount of capital investment in the sales
process
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Ratio Analysis
Ratio Analysis Operating
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Ratio Analysis Operating Efficiency
Operating Efficiency Ratios
Ratio Analysis
Examines how management uses its assets to generate sales and it considers the relationship between
various asset categories and sales
Total Asset Turnover ratio indicates effectiveness of a firms use of its total asset base to
produce sales
Different types of industries have different asset turnovers. Infrastructure business are capital intensive
and may have Asset Turnover closer to 1, however, retail business might have turnover ratios in double
digits
Total Asset Turnover
Low asset turnover may mean that the company has much capital tied up in its asset base
Net Sales
Average Total Net Assets
Equity Turnover measures the employment of owners capital
Equity capital includes all preferred and common stock, paid-in capital and retained earnings
Equity Turnover
Net Sales
Average Equity
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Ratio Analysis Operating Profitability
Ratio Analysis
Operating profitability ratios
Examines how management is doing at controlling costs so that a large proportion of the sales dollar is
converted into profit
What proportion of the sales dollar is left after cost of goods sold?
Is the firm buying inputs (inventory and direct labor) at good prices?
Gross Profit Margin
Gross Profit Margin
Gross Profit
Net Sales
Operating Profit Margin
Gross profit margin measures the rate of return after cost of goods sold
Operating profit margin measures the rate of profit on sales after operating expenses
Operating Profit Margin
Operating Profit
Net Sales
Operating income can be thought of as the bottom line from operations
Net Margin
Shows the combined effect of operating profitability and the firms financing decisions (since net income is
after interest and tax payments)
Net Profit Margin
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Net Income
Net Sales
17
Ratio Analysis Operating Profitability
DuPont System divides ROE into several ratios that collectively equal ROE while individually
providing insight
Ratio Analysis
Most important term in ratio analysis
ROE
Net Income
Common Equity
Basic algebra for ROE breakdown
Net Income
Common Equity
Net Income
Sales
Profit margin
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Sales
Total Assets
Total Assets Common Equity
Asset Turnover
Financial Leverage
18
Ratio Analysis
Ratio Analysis Risk
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Ratio Analysis
Ratio Analysis Risk
Risk analysis examines the uncertainty of income for the firm and for an investor
Total firm risks can be decomposed into three basic sources 1) Business risk 2) Financial
Risk 3) External Liquidity Risk
Business Risk
Function of Business variability, Sales variability and Operating leverage
Between five to ten years of data should be used for calculating business and sales variability
Business variabili ty
Sales variabili ty
Standard Deviation (operating income)

Mean operating income
Standard Deviation (sales)

Mean sales
Also critical is the measure of how much companys production costs are fixed (as opposed to variable)
Operating leverage
% change in Operating Earnings

% change in Sales
Greater the use of fixed costs, greater the impact of a change in sales on the operating income of a
company and hence, higher is the risk
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Ratio Analysis Financial Risk
Ratio Analysis
Financial risk
The added uncertainty in a firms net income resulting from a firms financing decisions (primarily through
employing leverage)
Interest payments are deducted before we get to net income and these are fixed obligations. Similar to
fixed production costs, these lead to larger earnings during good times, and lower earnings during a
business decline
The use of debt financing increases financial risk and possibility of default while increasing profitability
when sales are high
Two sets of financial ratios help measure financial risk
Balance sheet ratios
Earnings or cash flow available to pay fixed financial charges
Balance Sheet Ratios
How much debt does the firm employ in relation to its use of equity?
Debt to equity ratio
Long term debt

Long term equity
Assessment of overall debt load, including short-term
Debt Ratio
Current liabilitie s Long term debt

Total Debt Total Equity
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Ratio Analysis Financial Risk
Ratio Analysis
Earnings/Cash flow ratios
Relate operating income (EBIT) to fixed payments required from debt obligations
Higher ratio means lower risk
Interest coverage ratio determines the firms ability to repay its debt obligations
Interest coverage
EBIT
Interest expense
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Ratio Analysis External Liquidity Risk
Ratio Analysis
External liquidity risk
External market liquidity is a source of risk to investors
Market Liquidity is the ability to buy or sell an asset quickly with little price change from a prior
transaction assuming no new information
The most important factor of external market liquidity is the dollar value of shares traded
This can be estimated from the total market value of outstanding securities
It will be affected by the number of security owners
Numerous buyers and sellers provide liquidity
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Ratio Analysis
Ratio Analysis Growth
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Ratio Analysis Growth
Ratio Analysis
Growth is important to both creditors and owners
Creditors interested in ability to pay future obligations
For owners, the value of a firm depends on its future growth in earnings, cash flow, and dividends
If the company doesnt grow, it stands a much greater chance of defaulting on its loans
Sustainable growth rate is a function of two variables:
What is the rate of return on equity (which gives the maximum possible growth)?
How much of that growth is put to work through earnings retention (rather than being paid out in
dividends)?
Growth = ROE x Retention rate
Also remember ROE is a function of
Net profit margin
Total asset turnover
Financial leverage (total assets/equity)
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Ratio Analysis
Limitations of Financial Ratios
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Ratio Analysis
Limitation of Financial Ratios
Accounting treatments may vary among firms, especially among non-U.S. firms
Always consider relative financial ratios. They do not make any sense when viewed in
isolation
Firms may have divisions operating in different industries making it difficult to derive industry
ratios
Conclusions cannot be made by just looking at only one set of ratios
Ratios outside an industry range may be cause for concern
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Ratio Analysis Basics

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Ratio Analysis Basics

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Ratio Analysis

Private and Confidential Not for Circulation

How to analyze a company?

Analytical techniques for Financial Statement Analysis

Current Ratio /Quick Ratio / Cash ratio

Receivables turnover / Inventory turnover / Payables turnover / Cash Conversion Cycle

Operating Efficiency ratios

Extended DuPont Formula

External liquidity risk

Limitations of Financial Ratios

How to analyze a company?

Analytical techniques for FSA

Purpose of Financial Statement Analysis is to evaluate management performance in

Although financial statement information is historical, it is used to project future performance

Compares two financial statements to determine dollar and

Shows relationship of each item to a base amount on financial

Which method is the

Puts numbers in perspective with other numbers

An Analyst is expected to do a complete synthesis using all three methods

PRIVATE AND CONFIDENTIAL

Horizontal / Trend / Vertical Analysis

PRIVATE AND CONFIDENTIAL

Horizontal analysis on the income statement

[Current year Base year] /

Why provision for tax has

Horizontal analysis can also be done on the liabilities or shareholders equity

PRIVATE AND CONFIDENTIAL

In the example below, we have taken base year as 2002

[Current year ] / [Base year] * 100

While Operating cost has increased

PRIVATE AND CONFIDENTIAL

Common-size statements use percentages to express the relationship of individual

Income Statement (as a percentage of Total Revenues)

Balance Sheet (As a percentage of Total Asset / Total Liabilities)

Provision for taxes

PRIVATE AND CONFIDENTIAL

Since 2004, cost of rentals have

Puts numbers in perspective with other numbers

Helps control for different sizes of firms

Ratios can often be more informative that raw numbers

PRIVATE AND CONFIDENTIAL

Ratio Analysis - Solvency

Ratio Analysis - Solvency

Current Ratio examines current assets and current liabilities

Quick Ratio adjusts current assets by removing less liquid assets

More stringent measure of liquidity

Cash Marketable Securities Receivable s

Cash ratio relates cash (ultimate liquid asset) to current liabilities

Cash Marketable Securities

PRIVATE AND CONFIDENTIAL

Ratio Analysis - Solvency

Receivables turnover examines the management of accounts receivable

Net Annual Sales

It is desirable to have a collections period closer to the industry norm

Average Receivable s Collection Period

Balance sheet items are taken as average of the account

Balance sheet items are taken as average of the account

Cost of Goods Sold

It is desirable to have a collections period closer to the industry norm

Average Inventory Processing Period

PRIVATE AND CONFIDENTIAL

Evaluating Solvency Ratios

Payables turnover measures the use of trade credit by the firm