MBA503 - Session 4 - Ratio Analysis

Module Code: MBA503
Module Title: Managerial Accounting and Economics
Session 4- Financial Statement Analysis
Prof. Usha J C
E mail : usha.ms.mc@msruas.ac.in
Prof. Reshma K.J.
E mail : reshma.ms.mc@msruas.ac.in
Prof. Savitha K
E mail : savitha.ms.mc@msruas.ac.in
Prof. Rakesh C
E mail : rakeshc.co.mc@msruas.ac.in
1
Faculty of Management and Commerce ©Ramaiah University of Applied Sciences
Session Contents
 Business Analysis
 Financial Statement Analysis
 Tools for analysis
 Ratio Analysis
• Introduction
• Different types of ratios
• Inter-relation between Ratio’s
• DuPont analysis
2
Learning Objectives
At the end of this session, student will be able to:

 Discuss the tools and techniques used for financial analysis
 Discuss the importance of Ratio Analysis in evaluating the

financial performance of a firm
 Compute accounting ratios like short term liquidity, long term

solvency, turnover and profitability ratios
3
Financial analysis
Financial analysis is a process of selecting, evaluating, and
interpreting financial data, along with other pertinent information, in
order to formulate an assessment of a company’s present and future
financial condition and performance.
Financial
Market Data Disclosures
Economic Data
Financial Analysis
4
Financial Statement Analysis
Introduction
Financial statement analysis is defined as:
The process of establishing the meaningful relationship between

the items of the two financial statements with the objective of
identifying the financial and operational strengths and
weaknesses
5
Financial Statements
• The balance sheet, which summarizes what a firm owns and

owes at a point in time
• The income statement, which reports on how much a firm

earned in the period of analysis
• The statement of cash flows, which reports on cash inflows

and outflows to the firm during the period of analysis
6
Users of Information
• Managers
• Suppliers
• Creditors
• Share Holders
• Potential Investors
• Regulatory Agencies
7
Financial Statement Analysis
 Financial statements are prepared to meet external reporting

obligations and also for decision making purposes
 No meaningful conclusions can be drawn from these statements

alone
 The information provided in the financial statements is of immense

use in making decisions through analysis and interpretation
8
Types of Financial Analysis
On the Basis of Material Used On the Basis of Modus Operandi
External Analysis Horizontal

Analysis
Internal Vertical Analysis
Analysis
Long Term Short Term

Analysis Analysis
9
I. On the Basis of Materials Used

a) External Analysis
• Meant for the outsiders of the business firm
• Outsiders includes investors, creditors, suppliers, government

agencies, shareholders etc.
• Rely only on the published financial statements for important

decision making
10
Types of Financial Analysis (Cont.)
b) Internal Analysis
• Performed by the persons who are internal to the organization
• Access to the books of accounts and other information are required
• Assist managerial personnel to take corrective action and

appropriate decisions
11
II. On the basis of Modus Operandi

(a) Horizontal Analysis
• Also termed as Dynamic Analysis
• The trend of each item in the financial statements over the number
of years are analysed
• Helps to identify the trend in various indicators of performance
• current year figures are compared with base year
12
Horizontal Analysis (Contd.)
13
(b) Vertical Analysis

• Also termed as Static Analysis
• A meaningful quantitative relationship between the items of

financial statements during the particular period is established
through ratios
• Useful in comparing the performance, efficiency and profitability of

several companies in the same industry
14
Methods or Tools of Analysis
There are various methods or techniques that are used in analysing

financial statements:
 Comparative financial statements
 Common size statements
 Fund flow analysis and Cash flow analysis
 Ratio analysis
15
Comparative Financial Statements
• Statement which compares financial data from different
periods of time
• It lines up a section of the income statement, balance sheet or

cash flow statement
• Compares corresponding section from a previous period
• Comparative financial statement analysis is also called as

horizontal analysis and trend analysis
16
Comparative Financial Statements contd..
• Absolute figures (rupee amounts).
• Changes in absolute figures i.e., increase or decrease in

absolute figures.
• Absolute data in terms of percentages.
• Increase or decrease in terms of percentages.
17
Types of Comparative financial statements
• Balance sheet
• Income statement
18
Comparative Balance sheet
• The comparative balance sheet analysis is the study of the trend

of the same items, group of items and computed items in two
or more balance sheets
• The changes can be observed by comparison of the balance

sheet at the beginning and at the end of a period
• The changes can help in forming an opinion about the progress

of an enterprise
19
Example on Comparative Balance sheet
20
Comparative Income Statement
• The Income statement gives the results of the operations of a

business
• The comparative income statement gives an idea of the progress

of a business over a period of time
• The changes in absolute data in money values and percentages can

be determined to analyze the profitability of the business
• Third and fourth columns are used to show increase or decrease in

figures in absolute amounts and percentages respectively
21
Example on Comparative Balance sheet
22
Common Size Statements
• Common size statement uses the aggregate value in a financial

statement for a given year as the base, and each account’s amount
is restated as a percentage of the aggregate
• Common size statement is also called as vertical analysis
• Balance sheet: Aggregate amount is total assets
• Income statement: Aggregate amount is revenues or sales
23
Example: Common-size analysis
Year 2008 2009 2010 2011 2012 2013
Cash 6% 6% 5% 5% 5% 5%
Inventory 23% 23% 23% 23% 22% 22%
Accounts receivable 16% 16% 16% 15% 15% 15%
Net plant and equipment 50% 50% 51% 51% 52% 52%
Intangibles 6% 6% 5% 5% 5% 5%
Total assets 100% 100% 100% 100% 100% 100%
Graphically:
100%
Proportion
50%
of Assets
0%
2008 2009 2010 2011 2012 2013
Fiscal Year
Cash Inventory Accounts receivable Net plant and equipment Intangibles
24
Common Size Statements Vs Comparative Financial
Statements
Common Size Statements Comparative Financial Statements
• A common-size statement that • Comparative financial statements are also
expresses all values as percentages of called year-to-year change statements
the base value in the same year • Comparative financial statements can use
• Vertical analysis is most beneficial with both absolute amounts and percentages
income statements to provide meaningful analysis
• Total sales figure is usually the base • This type of analysis puts absolute
value (100 percent) changes and percentage changes in
• Various expenses, such as cost of perspective
goods sold, advertising and • No changes can be computed if there is no
administrative expenses, are expressed base figure available and no meaningful
as percentages of total sales change can be calculated if one figure is
• When used with balance sheets, positive and the other is negative
vertical analysis shows how various
balance sheet items (assets, liabilities,
equity) relate to the total assets figure
25
Cash flow statement
• Cash flow statement is a listing of the flows of cash into and out of
the business or project
• The statement of cash flows is important to investors because it

provides insight into how a company generates and expends cash,
and ultimately, its ability to return value to shareholders
26
Funds flow statement
• Statement prepared to analyse the reasons for changes in the

Financial Position of a Company between two Balance Sheets
• Shows the inflow and outflow of funds i.e. Sources and Applications
of funds for a particular period
27
Ratio Analysis
• Ratios simply means one number expressed in terms of another
• Establish relationship between the two interrelated accounting

figures in financial statements
• Effective tool which is used to ascertain the liquidity and

operational efficiency of the concern
28
Limitations of Financial Statement Analysis
• Financial Statements emphasise to disclose only monetary facts i.e.,

quantitative information and ignore qualitative information
• Financial Statements disclose only the historical information. It does

not consider changes in money value, fluctuations of price level etc.
• Comparability of financial data between companies
• Influences of personal judgments leads to opportunities for

manipulation while preparing of financial statements
29
Advantages of Financial Statement Analysis
• Investors will get information for investment decision making

• Regulatory authorities can ensure whether the company is
following accounting standards or not
• Provide reliable information about the financial performance
and financial soundness of the concern
30
3. Financial Ratio Analysis
• Financial ratio analysis is the use of relationships among financial
statement accounts to gauge the financial condition and
performance of a company.
• Ratio can be classified based on the type of information the ratio

provides:
Profitability
Activity Ratios Liquidity Ratios Solvency Ratios
Ratios
Ability to
Effectiveness in Ability to meet
Ability to satisfy manage
putting its asset short-term,
debt expenses to
investment to immediate
obligations. produce profits
use. obligations.
from sales.
31
Activity Ratios
• Turnover ratios reflect the number of times assets flow into and out
of the company during the period
• A turnover is a gauge of the efficiency of putting assets to work

Cost of goods sold How many times inventory is
Inventory turnover =
Average inventory created and sold during the
period.
Total revenue How many times accounts
Receivables turnover =
Average receivables receivable are created and
collected during the period.
Total revenue The extent to which total assets
Total asset turnover =
Average total assets create revenues during the
period.
Total revenue The efficiency of putting working
Working capital turnover =
Average working capital capital to work
32
Operating cycle components
• The operating cycle is the length of time from when a company makes an
investment in goods and services to the time it collects cash from its
accounts receivable
• The net operating cycle is the length of time from when a company
makes an investment in goods and services, considering the company
makes some of its purchases on credit, to the time it collects cash from its
accounts receivable
• The length of the operating cycle and net operating cycle provides
information on the company’s need for liquidity: The longer the operating
cycle, the greater the need for liquidity
33
Operating cycle components
Number of Days of Inventory Number of Days of Receivables
| | | |
Buy Inventory on Pay Accounts Sell Inventory on Collect Accounts

Credit Payable Credit Receivable
Number of Days of Payables Net Operating Cycle
Operating Cycle
34
Operating Cycle Formulas
Inventory 365 Average time it takes to

Number of days of inventory = Average day′s = Inventory turnover create and sell inventory.
cost of goods sold
Receivables 365 Average time it takes to

Number of days of receivables = =
Average day′s Receivables turnover collect on accounts
revenues receivable.
Accounts payable 365 Average time it takes to

Number of days of payables = =
Average day′s Accounts payable turnover pay suppliers.
purchases
Copyright © 2013 CFA Institute 35 35

Operating Cycle Formulas
Number of days Number of days Time from investment in

Operating cycle = +
of inventory of receivables inventory to collection of
accounts.
Net operating Number of days Number of days Number of days Time from investment in
= + −
cycle of inventory of receivables of payables inventory to collection of
accounts, considering the use
of trade credit in purchases.
Copyright © 2013 CFA Institute 36 36

Liquidity
• Liquidity is the ability to satisfy the company’s short-term
obligations using assets that can be most readily converted into
cash.
• Liquidity ratios:
Current assets Ability to satisfy current
Current ratio =
Current liabilities liabilities using current assets
Short−term Ability to satisfy current

Cash + + Receivables
Quick ratio = investments liabilities using the most
Current liabilities liquid of current assets
Short−term Ability to satisfy current

Cash +
Cash ratio = investments liabilities using only cash and
Current liabilities cash equivalents
37
Solvency Analysis
• A company’s business risk is determined, in large part,
from the company’s line of business
Risk
• Financial risk is the risk resulting from a company’s
choice of how to finance the business using debt or
equity Business Risk Financial Risk
• We use solvency ratios to assess a company’s financial
risk
• There are two types of solvency ratios: component Sales Risk
percentages and coverage ratios
– Component percentages involve comparing the
elements in the capital structure Operating Risk
– Coverage ratios measure the ability to meet

interest and other fixed financing costs
38
Solvency ratios
Total debt Proportion of assets financed with debt.
Debt−to−assets ratio =
Total assets
Long−term debt
Component-Percentage
Long−term debt−to−assets ratio = Proportion of assets financed with long-

Total assets term debt.
Solvency Ratios
Total debt Debt financing relative to equity financing.

Debt−to−equity ratio =
Total shareholders′ equity
Total assets Reliance on debt financing.

Financial leverage =
Total shareholders′ equity
EBIT Ability to satisfy interest obligations.

Interest coverage ratio =
Interest payments
Fixed charge EBIT + Lease payments

Coverage Ratios
= Ability to satisfy interest and lease

coverage ratio Interest payments + Lease payments obligations.
Cash flow CFO + Interest payments + Tax payments Ability to satisfy interest obligations with
=
coverage ratio Interest payments cash flows.
Cash−flow−to− CFO Length of time needed to pay off debt with

=
debt ratio Total debt cash flows.
39
Profitability
• Margins and return ratios provide information on the profitability of

a company and the efficiency of the company
• A margin is a portion of revenues that is a profit
• A return is a comparison of a profit with the investment necessary

to generate the profit
40
Profitability ratios: Margins
Each margin ratio compares a measure of income with total revenues:

Gross profit
Gross profit margin =
Total revenue
Operating profit
Operating profit margin =
Total revenue
Net profit
Net profit margin =
Total revenue
Earnings before taxes
Pretax profit margin =
Total revenue
41
Profitability Ratios: Returns
Return ratios compare a measure of profit with the investment that produces the profit:
Operating income
Operating return on assets =
Average total assets
Net income
Return on assets =
Net income
Return on total capital =
Average interest−bearing debt + Average total equity
Net income
Return on equity =
Average shareholders′ equity
Operating income
Operating return on assets =
Net Operating Profit x 100
Return on Investments = Capital Employed
Operating Profit = Profit before interest and Tax

42
The DuPont Formulas
• The DuPont formula uses the relationship
among financial statement accounts to Return on Equity
decompose a return into components
• Three-factor DuPont for the return on equity:
Net Profit Total Asset Financial
– Total asset turnover Margin Turnover Leverage
– Financial leverage
– Net profit margin Operating Profit
Margin
• Five-factor DuPont for the return on equity:

– Total asset turnover
Effect of Nonoperating
– Financial leverage Items
– Operating profit margin

– Effect of nonoperating items Tax
– Tax effect Effect
43
Five-Component DuPont Model
Return on Total assets Return on

= ×
equity Shareholders′ assets
equity
Return on Total assets Net income

= ×
equity Shareholders′ Total assets
equity
Return on Total assets Revenues Net income

= × ×
equity Shareholders′ Total assets Revenues
equity
Income
Operating before
Return on Total assets Revenues Taxes
= × × income × taxes × 1−
equity Shareholders′ Total assets Revenues Operating Income
equity income before
taxes
44
Example: The DuPont Formula
Suppose that an analyst has noticed that the return on equity of the D
Company has declined from FY2012 to FY2013. Using the DuPont formula,
explain the source of this decline.
(millions) 2013 2012

Revenues $1,000 $900
Earnings before interest and taxes $400 $380
Interest expense $30 $30
Taxes $100 $90
Total assets $2,000 $2,000

Shareholders’ equity $1,250 $1,000
45
Example: the DuPont Formula
2013 2012
Return on equity 0.20 0.22
Return on assets 0.13 0.11
Financial leverage 1.60 2.00

Total asset turnover 0.50 0.45
Net profit margin 0.25 0.24
Operating profit margin 0.40 0.42
Effect of nonoperating items 0.83 0.82

Tax effect 0.76 0.71
46
Other Ratios
• Earnings per share is net income, restated on a per share basis:

Net income available to common shareholders
Earnings per share =
Number of common shares outstanding
• Basic earnings per share is net income after preferred dividends,

divided by the average number of common shares outstanding
• Diluted earnings per share is net income minus preferred

dividends, divided by the number of shares outstanding considering
all dilutive securities
47
Other Ratios
• Book value per share is book value of equity divided by number of

shares.
• Price-to-earnings ratio (PE or P/E) is the ratio of the price per share
of equity to the earnings per share.
– If earnings are the last four quarters, it is the trailing P/E
48
Other Ratios
Measures of Dividend Payment:
Dividends per Dividends paid to shareholders
=
share (DPS) Weighted average number of ordinary shares outstanding
Dividends paid to common shareholders

Dividend payout ratio =
Net income attributable to common shares
Plowback ratio = 1 – Dividend payout ratio

– The proportion of earnings retained by the company.
49
Effective Use of Ratio Analysis
• In addition to ratios, an analyst should describe the company (e.g.,

line of business, major products, major suppliers), industry
information, and major factors or influences
• Effective use of ratios requires looking at ratios

– Over time
– Compared with other companies in the same line of business
– In the context of major events in the company (for example, mergers or

divestitures), accounting changes, and changes in the company’s product mix
50
Summary
 Business analysis is the process of evaluating a company’s economic
prospects and risks.
 Financial Statement Analysis is the process of identifying financial

strengths and weaknesses of the firm by properly establishing
relationship between the items of the balance sheet and the profit and
loss account
 Comparison of two or more year's financial data is known as horizontal

analysis, or trend analysis
 Trend percentage states several years' financial data in terms of a base

year
51
Summary (Contd.)
 Vertical analysis is the procedure of preparing and presenting common
size statements
 A ratio is a statistical yardstick by means of which relationship between

two or various figures can be compared or measured
 Common size analysis indicates the proportion of an asset/ liability/

expense is as a function of total assets/liabilities/revenue
 A DuPont system is a breakdown of Return On Equity (ROE) and Return

On Assets (ROA) in to component ratios
52

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Module Code: MBA503

Module Title: Managerial Accounting and Economics

Session 4- Financial Statement Analysis

 Financial Statement Analysis

 Tools for analysis

• Different types of ratios

• Inter-relation between Ratio’s

At the end of this session, student will be able to:

 Discuss the importance of Ratio Analysis in evaluating the

 Compute accounting ratios like short term liquidity, long term

Financial statement analysis is defined as:

The process of establishing the meaningful relationship between

• The balance sheet, which summarizes what a firm owns and

• The income statement, which reports on how much a firm

• The statement of cash flows, which reports on cash inflows

 Financial statements are prepared to meet external reporting

 No meaningful conclusions can be drawn from these statements

 The information provided in the financial statements is of immense

Types of Financial Analysis

On the Basis of Material Used On the Basis of Modus Operandi

External Analysis Horizontal

Long Term Short Term

I. On the Basis of Materials Used

• Outsiders includes investors, creditors, suppliers, government

• Rely only on the published financial statements for important

• Access to the books of accounts and other information are required

• Assist managerial personnel to take corrective action and

II. On the basis of Modus Operandi

• Helps to identify the trend in various indicators of performance

• current year figures are compared with base year

(b) Vertical Analysis

• A meaningful quantitative relationship between the items of

• Useful in comparing the performance, efficiency and profitability of

There are various methods or techniques that are used in analysing

 Comparative financial statements

 Common size statements

 Fund flow analysis and Cash flow analysis

• It lines up a section of the income statement, balance sheet or

• Compares corresponding section from a previous period

• Comparative financial statement analysis is also called as

• Absolute figures (rupee amounts).

• Changes in absolute figures i.e., increase or decrease in

• Absolute data in terms of percentages.

• Increase or decrease in terms of percentages.

• The comparative balance sheet analysis is the study of the trend

• The changes can be observed by comparison of the balance

• The changes can help in forming an opinion about the progress

• The Income statement gives the results of the operations of a

• The comparative income statement gives an idea of the progress

• The changes in absolute data in money values and percentages can

• Third and fourth columns are used to show increase or decrease in

• Common size statement uses the aggregate value in a financial

• Common size statement is also called as vertical analysis

• Balance sheet: Aggregate amount is total assets

• Income statement: Aggregate amount is revenues or sales

Cash Inventory Accounts receivable Net plant and equipment Intangibles

• The statement of cash flows is important to investors because it

• Statement prepared to analyse the reasons for changes in the

• Ratios simply means one number expressed in terms of another

• Establish relationship between the two interrelated accounting

• Effective tool which is used to ascertain the liquidity and

• Financial Statements emphasise to disclose only monetary facts i.e.,

• Financial Statements disclose only the historical information. It does

• Comparability of financial data between companies