Shaheed Sukhdev College of Business Studies

Ratio Analysis
Presented By: Dhruv Agarwal Keshav Dogra (16036) (16037) Subject: Management Accounting Teacher: Ms. Achint Arora

Siddharth Mehta (16044) Raghav Srivastava (15956)

(BFIA 2)

Table of Contents
Introduction ........................................................................................ 3 Utility of Ratios ................................................................................. 3 Merits & Demerits of Ratio Analysis ................................................. 4 Types of ratio ................................................................................... 5 Liquidity ratio ................................................................................ 6 Solvency Ratio- .............................................................................. 8 Activity Ratio- ................................................................................ 9 Profitability ratios ........................................................................ 11 Ratio Analysis of Larson & Toubro ...................................................... 5 Some Pre-existing Notions .............................................................. 186 Correct Facts ................................................................................ 197 Bibliography .................................................................................... 219

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Introduction
1. Ratio Analysis is a technique of analyzing the financial statements by computing the financial ratios. 2. Ratio Analysis is a study of relationship among various financial factors in a business. Myers 3. Ratio Analysis is a process of determining and interpreting relationship between the items of financial statements to provide a meaningful understanding of the performance and financial position of an enterprise. 4. Ratio Analysis is an accounting tool to present accounting variables in a simple, concise, intelligible and understandable manner.

Utility of Ratios
Comparisons may be in any one of the following forms: 1. 2. 3. 4. 5. For same enterprise over a number of years. For two enterprise in the same industry. For one enterprise against industry as a whole. For one enterprise against pre-determined standards. For inter-segment comparison within the same enterprise.

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Merits & Demerits of Ratio Analysis

Merits
1. Simplifies financial statements: It simplifies the comprehension of financial statements. Ratios tell the whole story of changes in the financial condition of the business 2. Help in analysis of financial statements: It helps in investment decisions in the case of investors and lending decisions in the case of bankers etc. and is generally helpful to anyone interested in the firm. 3. Facilitates inter-firm comparison: It provides data for inter-firm comparison. Ratios highlight the factors associated with successful and unsuccessful firms. They also reveal strong firms and weak firms, overvalued and undervalued firms. 4. Helps in planning: It helps in planning and forecasting. Ratios can assist management, in its basic functions of forecasting, planning, co-ordination, control and communications. 5. Study of financial soundness: Ratios analysis also makes possible comparison of the performance of different divisions of the firm. The ratios are helpful in finding their efficiency in the past and likely performance in the future.

Demerits
1. Limitations of financial statements: Ratios are based only on the information which has been recorded in the financial statements. Financial statements themselves are subject to several limitations. Thus ratios derived therefore, are also subject to those limitations. For example, non-financial changes though important for the business are not relevant by the financial statements. Financial statements are affected to a very great extent by accounting conventions and concepts. Personal judgment plays a great part in determining the figures for financial statements. 2. Window dressing: Some companies resort to window dressing in order to cover up their bad financial position. This is the practice of showing a better position than the one which really exists. 3. Ratios alone are not adequate: Ratios are only indicators, they cannot be taken as the final word regarding good or bad financial position of the business. Other things must also be considered. 4. Problems of price level changes: A change in price level can affect the validity of ratios calculated for different time periods. In such a case the ratio analysis may not clearly indicate the trend in solvency and profitability of the company. The financial statements, therefore, must be adjusted keeping in view the price level changes if a meaningful comparison is to be made through accounting ratios.

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Types of ratio
Ratios can be classified according to the way they are constructed and their general characteristics. By construction, ratios can be classified as a coverage ratio, a return ratio, a turnover ratio, or a component percentage: 1. A coverage ratio is a measure of a company's ability to satisfy (meet) particular obligations. 2. A return ratio is a measure of the net benefit, relative to the resources expended. 3. A turnover ratio is a measure of the gross benefit, relative to the resources expended. 4. A component percentage is the ratio of a component of an item to the item.

When we assess a company's operating performance, we want to know if it is applying its assets in an efficient and profitable manner. When we assess a company's financial condition, we want to know if it is able to meet its financial obligations. There are six aspects of operating performance and financial condition we can evaluate from financial ratios: 1. Liquidity Ratios Measures the short-term solvency. 2. Solvency Ratios Conveys an enterprises ability to meet its long term obligations. 3. Activity Ratios Measures the effectiveness of an enterprise with which it uses its resources. 4. Profitability Ratios Measures the efficiency of an enterprise.

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Liquidity ratio
Liquidity reflects the ability of a company to meet its short-term obligations using assets that are most readily converted into cash. Assets that may be converted into cash in a short period of time are referred to as liquid assets; they are listed in financial statements as current assets. Current assets are often referred to as working capital because these assets represent the resources needed for the day-to-day operations of the company's long-term, capital investments. Current assets are used to satisfy short-term obligations, or current liabilities. The amount by which current assets exceed current liabilities is referred to as the net working capital Current Ratio It is a relationship between current assets and current liability. Significance- The Ratio shows short term financial soundness of the business. Higher the ratio means better capacity to meet its current obligations. The ideal ratio is said to be 2:1 Current Assets Current Liabilities Quick Ratio It is a relationship between liquid assets and current liability. Significance- This ratio is fairly stringent measure liquidity. It is based on those current assets which are highly liquid. The ideal ratio is said to be 1:1

Quick Assets Current Liabilities

The role of the operating cycle The operating cycle is the duration between the time cash is invested in goods and services to the time that investment produces cash. For example, a company that produces and sells goods has an operating cycle comprising four phases: 1. purchase raw material and produce goods, investing in inventory; 2. sell goods, generating sales, which may or may not be for cash; 3. extend credit, creating accounts receivables, and 4. collect accounts receivables, generating cash.

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The operating cycle is the length of time it takes to convert an investment of cash in inventory back into cash (through collections of sales). The net operating cycle is the length of time it takes to convert an investment of cash in inventory and back into cash considering that some purchases are made on credit. The number of days a company ties up funds in inventory is determine by: (1) the total amount of money represented in inventory, and (2) the average day's cost of goods sold. The current investment in inventory -- that is, the money "tied up" in inventory -- is the ending balance of inventory on the balance sheet. The average day's cost of goods sold is the cost of goods
We can extend the same logic for calculating the number of days between a sale -- when an account receivable is created -- to the time it is collected in cash. If the ending balance of receivables at the end of the year is representative of the receivables on any day throughout the year, then it takes, on average, approximately the "number of days credit" to collect the accounts receivable, or the number of days receivables: Number of days receivables = Accounts receivable = Accounts receivable

Average day's sales on credit

Sales on credit / 365

The longer the operating cycle, the more current assets needed (relative to current liabilities) because it takes longer to convert inventories and receivables into cash. In other words, the longer the operating cycle, the more net working capital required.

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Solvency RatioA company can finance its assets either with equity or debt. Financing through debt involves risk because debt legally obligates the company to pay interest and to repay the principal as promised. Equity financing does not obligate the company to pay anything -- dividends are paid at the discretion of the board of directors. There is always some risk, which we refer to as business risk, inherent in any operating segment of a business. But how a company chooses to finance its operations -- the particular mix of debt and equity -- may add financial risk on top of business risk financial risk is the extent that debt financing is used relative to equity.

Debt Equity Ratio expresses relationship between external equities (debt) and internal equities (equity). The ideal ratio is said to be 2:1 Significance- judges long term financial position and soundness of the long term financial policies of the firm. Debt Equity

Total Asset to Debt Ratio relationship between total assets and external equities (debt) Significance- measures the safety margins available to the suppliers of long term debts. It measures the extent to which debts are covered by assets. Total Assets Long Term Debts

Proprietary Ratio - establishes relation between shareholders fund and total assets Significance- Shows the extent to which total assets have been financed by the proprietor. Higher the ratio greater satisfaction for lenders and creditors. As a rough guide 65% to 75% is advisable. Shareholders fund Total Assets

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Activity RatioActivity ratios are measures of how well assets are used. Activity ratios -- which are, for the most part, turnover ratios -- can be used to evaluate the benefits produced by specific assets, such as inventory or accounts receivable. Or they can be use to evaluate the benefits produced by all a company's assets collectively. These measures help us gauge how effectively the company is at putting its investment to work. A company will invest in assets e.g., inventory or plant and equipment and then use these assets to generate revenues. The greater the turnover, the more effectively the company is at producing a benefit from its investment in assets.

Stock Turnover RatioEstablishes relationship between cost of goods sold and average inventory. Significance- Ratio is to ascertain whether investment in stock has been judicious or not, i.e., only required amount is invested in stock. Cost of goods sold Average Stock

Debtors Turnover RatioEstablishes relationship between net credit sales and average receivables. Significance- Shows how quickly debtors are converted into cash and thus, indicates the efficiency of staff entrusted with collection of amounts due from debtors. Net Credit Sales Average Receivables

Creditors Turnover RatioEstablishes relationship between net credit purchases and average payables. Significance- Shows the number of times the creditors are turned over in relation to purchases. A high turnover ratio shows the availability of less credit. Net Credit Purchases Average Payables

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Working Capital Turnover Ratio Establishes relationship between working capital and sales. Significance- Ratio is to ascertain whether or not working capital has been affectively utilized in making sales. Net Sales Working Capital Fixed Asset Turnover Ratio Establishes a relationship between Fixed Asset and Net Sales. Significance- Ratio is to establish whether the investment in fixed assets is justified in relation to sales achieved. A high ratio indicates efficient utilization of fixed assets. Net Sales Net Fixed Assets Current Asset Turnover Ratio Establishes relationship between net sales and current assets. Significance- Ratio is to establish whether the current assets have been effectively used to produce the sales. Net Sales Current Assets Capital Employed Turnover Ratio Establishes relationship between net sales and capital employed. Significance- Ratio is to determine the efficiency in which the capital employed is being used, and this in turn shows the promise of profitability and efficiency of management. Net Sales Capital Employed

Total Asset Turnover Ratio Shows the relationship between total assets and net sales. Significance- Ratio determines how effectively assets have been utilized and in turn it shows profitability and efficiency of management. Net Sales Total Assets

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Profitability ratios
Profitability ratios (also referred to as profit margin ratios) compare components of income with sales. They give us an idea of what makes up a company's income and are usually expressed as a portion of each dollar of sales. The profit margin ratios we discuss here differ only by the numerator. It's in the numerator that we reflect and thus evaluate performance for different aspects of the business

Gross Profit Ratio Establishes relationship between gross profit and net sales. Significance- ratio is a reliable guide to the adequacy of selling prices and efficiency of trading activities. Ratio helps in comparison. Gross Profit x100 Net Sales

Operating Ratio Establish relationship between operating costs and net sales. Significance- Ratio is the test of the operational efficiency of the business. It shows the %age of sales absorbed by sales and operating expenses. Operating Cost x100 Net Sales

Net Profit Ratio Establish relationship between net profit and net sales. Significance- This is an indicator of overall efficiency of the business. Higher the ratio better it is for the firm. Net Profit x100 Net Sales

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Return on Investment Ratio Establishes the relationship between profit (before interest & tax) with capital employed. Significance- It judges the overall performance of the enterprise. It measures how efficiently the sources entrusted to the business are used. Profit before Interest Tax & Dividend x100 Capital Employed

Earning Per Share Establishes the relationship between net profit after tax, and the number of equity shares Significance- The ratio helps in evaluating the prevailing market price of the share in the light of profit earning capacity. Net Profit after Tax x100 No. of Equity Shares

Dividend Per Share Establishes the relationship between the dividend paid to the equity shareholders and the number of equity shares. Significance- The ratio helps measure the dividend distributed per equity share. Dividend paid to Equity Shareholders No. of Equity Shares

Price Earning Ratio Establishes the relationship between the market price per share and the earning per share. Significance- The ratio helps find out the expectation of the shareholders. A high ratio indicates investors faith in stability and appreciation of company earnings. Market Price Per Share Earnings Per Share

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Ratio Analysis of Larson & Toubro

Larsen & Toubro Limited is a technology, engineering, construction and manufacturing company. Engineering & Construction Segment comprises execution of engineering and construction projects in India/abroad to provide solutions in civil, mechanical, electrical and instrumentation engineering. Electrical & Electronics Segment comprises manufacture and sale of low and medium voltage switchgear, custombuilt switchboards and control gear. Machinery & Industrial Products Segment includes manufacture and sale of industrialmachinery & equipment, marketing of industrial valves, construction equipment and welding/industrial products. Others include property development activity, integrated engineering services and ready mix concrete. In February 2010, the Company announced the launch of its Asset Management operations, and its financial services subsidiary, L&T Finance Limited, completed the acquisition of DBS Chola Mandalam Asset Management Company Limited. Larsen & Toubro Limited (L&T) is a technology, engineering, construction and manufacturing company. It is one of the largest and most respected companies in India's private sector. L&T has an international presence, with a global spread of offices. A thrust on international business has seen overseas earnings grow significantly. It continues to grow its overseas manufacturing footprint, with facilities in China and the Gulf region. L&T believes that progress must be achieved in harmony with the environment. A commitment to community welfare and environmental protection are an integral part of the corporate vision. Larsen & Toubro Limited (L&T) is India's largest engineering and construction conglomerate with additional interests in electricals, electronics and IT. A strong customer-focus approach and constant quest for top-class quality have enabled L&T to attain and sustain leadership over 6 decades EPC project business constitutes a critical part of the L&T's engineering core. L&T has integrated its strengths in basic and detailed engineering, process technology, project management, procurement, fabrication and erection, construction and commissioning, to offer single point responsibility under stringent delivery schedules. Strategic alliances with world leaders enable L&T to access technical know-how and execute process intensive, large scale turnkey projects to maintain its leadership position.

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LIQUIDITY RATIOS
1) Current ratio = Current assets/ Current Liabilities

2010
26361.61/21242.86 1.240:1

2009
22324.39/16718.78 1.335:1

Both current assets and current liabilities have increased. CL have increased by 4524 whereas CA only by 4037. The reduction in current ratio is not a good sign for the company as the liquidity position has gone worse.

2) Liquidity Ratio = Liquid Assets/ Current liabilities

2010
24946.24/21242.86 1.174:1

2009
20853.88/16718.78 1.247:1

On analysis of the B/S we see that the cash and bank balances have increased drastically and creditors have also increased. This shows that the company is buying on longer credit and selling in short credit. This accumulates cash in the process.

SOLVENCY RATIOS
3) Debt equity ratio = Debt/ Equity

2010
6800.83/18311.64 0.371:1

2009
6556.03/12459.69 0.526:1

Equity has gone up as a result of the Employee stock option exercised and the debt increases marginally. So the situation is still safe for the equity shareholders.

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4) Total assets to debt ratio = Total assets/ Debt

2010
46744.6/6800.83 6.873:1

2009
36169.4/6556.03 5.516:1

L&T raised substantial amount of capital during the current year. This lead to major addition in the fixed capital. This increased the assets to debt ratio.

5) Proprietary ratio = Total assets/ debt

2010
18311.64/46744.6 39.17%

2009
12459.69/36169.4 34.44%

Both the shareholders funds as well as the total assets have increased and the ratio has increased which is favourable as result of the increase in the Equity share capital due to employee stock option scheme.

TURNOVER RATIOS
6) Working Capital Turnover Ratio = Net sales/ Net working capital

2010
36675.15/5118.75 7.16 times

2009
33646.57/5605.61 6.00 times

This ratio shows the no. Of times the working capital has been employed in the process of carrying on the business. The increase in ratio is a positive sign for the company. It implies that the working capital recycled on an average 7.16 times during2010 as compared to 6 times during 2009.

7) Fixed Assets turnover ratio= Net sales/ Net fixed assets

2010
36675.15/6365.76 5.76 times

2009
33646.57/5194.6 6.47 times

The fall in the fixed assets turnover ratio from 6.47 times to 5.76 times shows that the fixed assets werent utilized efficiently enough to generate sales. The addition in the fixed assets couldnt generate much sales.

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8) Current Assets Turnover Ratio = Net sales/ Current assets

2010
36675.15/26361.61 1.39 times

2009
33646.57/22324.39 1.50 times

Similarly in this case also the current assets turnover ratio is decreasing despite an increase in the current assets which shows that the current assets need to be utilized in a more efficient manner so as to increase sales.

PROFITABILITY RATIOS
9) Gross Profit ratio = Gross profit/ net sales 100

2010
12.74

2009
11.39

The Gross Profit Ratio has increased from 11.9% in 2009 to 12.74% in 2010. This is good as it shows that the company is efficiently converting sales into income. The profit margin indicates expenses. A higher profit margin is a better profit margin, though volume of sales needs to be taken into account. 10) Net profit ratio = Net profit / net sales 100

2010
11.56

2009
10.6

The Net Profit Ratio has also increased from 10.6% in 2009 to 11.56% in 2010. This is again a good indication and shows that the net profit margin is increasing. This is good for the company and indicates efficiency in the company. The Net Profit is taking into account here whereas in the previous calculation the gross profit was taken into consideration.

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11) Operating ratio = (COGS + Operating expenses / net sales) 100

2010
13.78

2009
12.23

The Operating ratio is a ratio which helps us to establish a relation between operating costs and net sales. The operating profit is calculated herein to find the operating ratio. Operating profit includes all the operating revenue and does not include the operating costs. The Operating Ratio of L&T has risen from 12.23% in 2009 to 13.78% in 2010. It means that a higher percentage of sales is being absorbed by sales and operating expenses.

12) Return on investment = (Profit before intrest, tax and dividend / Capital employed) 100

2010
22.49

2009
24.14

Return on Investment (ROI) is a performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. It judges the overall performance of a company. The ROI in this case has decreased from 24.14% in 2009 to 22.49% in 2010.

13) Dividend per share = Dividend paid to equity shareholders / No. Of equity shares

2010
12.50

2009
10.50

Dividend per share (DPS) is the total dividends paid out over an entire year (including interim dividends but not including special dividends) divided by the number of outstanding ordinary shares issued. In this case the dividend per share has gone up from 10.50 in 2009 to 12.50 in 2010. Basically means that the company is paying more dividend in 2010 to its shareholders.

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Some Pre-existing Notions

Conventionally it is thought and said that certain ratios would be ideal at a certain level. Such ratios are:

Current Ratio: It is said to ideal when ratio between current assets and current liabilities is 2:1. This means that every company belonging to any industry should maintain this ratio to be best placed in the industry.

Quick Ratio: Conventionally it is said that the ratio between quick asset (current asset inventory) and current liabilities should be 1:1.

Debt Equity Ratio: Most of the books of the high school level suggest that the ideal ratio would be 2:1.

Proprietory Ratio: it is said that proprietory ratio should be somewhere between 65%- 75% as this would be best for the company.

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Correct Facts
Below are the tables which state the various ratios of the top companies of India of different sectors to prove that the conventional ideal ratios dont exist anymore as they exist according to the requirement of different company, industry and market.

Current Ratio

Company Name
Infosys Technologies NTPC Tata Steel Maruti Suzuki Lancho Infratech Reliance Industry

Industry
IT Power Steel Motor Infrastructure Oil & Gas

Mar10
4.28 2.81 1.12 1.02 1.61 1.29

Mar09
4.71 2.89 0.97 1.53 1.31 1.23

Mar08
3.30 2.36 3.92 1.03 1.10 1.39

Mar07
4.96 2.42 1.77 1.42 1.41 1.17

If we study the above table then none of the above 6 companies are nearby the so called ideal ratio of 2:1. Quick Ratio

Company Name
Infosys Technologies NTPC Tata Steel Maruti Suzuki Lancho Infratech Reliance Industry

Industry
IT Power Steel Motor Infrastructure Oil & Gas

Mar10
4.20 2.56 0.76 0.67 1.48 0.76

Mar09
4.67 2.59 0.57 1.26 1.16 0.90

Mar08
3.28 2.16 3.52 0.66 1.03 0.93

Mar07
4.91 2.18 1.37 1.13 1.08 0.68

The same goes for quick ratio as was for current ratio. So the condition of 1:1 ratio doesnt exist anymore.

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Debt-Equity Ratio

Company Name
Infosys Technologies NTPC Tata Steel Maruti Suzuki Lancho Infratech Reliance Industry

Industry
IT Power Steel Motor Infrastructure Oil & Gas

Mar10
Nil 0.59 0.67 0.06 0.88 0.48

Mar09
Nil 0.58 1.34 0.07 0.72 0.64

Mar08
Nil 0.50 1.08 0.10 0.34 0.46

Mar07
Nil 0.51 0.69 0.09 0.11 0.45

Infosys is a company which doesnt believe in debt. If the company even needs debt then either it retires the same in a period of 1 year or converts it into equity. All the other companies have a debt which is less than equity only Tata steel has more debt than equity that too only on two occasions. These companies are nowhere near the ratio of 2:1.

Proprietory Ratio

Company Name
Infosys Technologies NTPC Tata Steel Maruti Suzuki Lancho Infratech Reliance Industry

Industry
IT Power Steel Motor Infrastructure Oil & Gas

Mar10
100 62.76 59.55 93.51 53.02 67.25

Mar09
100 63.05 42.77 93.04 58.08 60.77

Mar08
100 66.62 48.16 90.33 74.23 68.38

Mar07
100 65.90 59.12 91.57 89.23 69.76

Ideally the proprietory ratio should be somewhere between 65-75% but none of these companies fall under the same bracket.

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Bibliography
Google.com Investopedia.com Fundamentals to accounting by T.S. Grewal Money.rediff.com Moneycontrol.com Financial statements of L&T

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