Financial Statement Analysis (Ratio Analysis)

Prof. Mishu Tripathi Faculty-Finance

Financial Analysis
Financial analysis is the process of identifying the financial strengths and weaknesses of the firm by establishing relationships between the item of the balance sheet and the profit and loss account.

Financial Analysis
Ratio-analysis is a concept or technique which is as old as accounting concept. Financial analysis is a scientific tool. It has been assumed to be an important tool for appraising the real worth of an enterprise, its performance during a period of time and its pit falls. Financial analysis is a vital apparatus for the interpretation of financial statements. It also helps to find out any cross-sectional and time series linkages between various ratios.

Financial Analysis
Unlike in the past when security was considered to be sufficient consideration for banks and financial institutions to grant loans and advances, nowadays the entire lending is need-based and the emphasis is on the financial viability of a proposal and not only on security alone. Further all business decision contains an element of risk. The risk is more in the case of decisions relating to credits. Ratio analysis and other quantitative techniques facilitate assessment of this risk.

Ratio Analysis (RA)

Ratio-Analysis is the process of computing, determining and presenting the relationship of related items/ groups of items of the financial statements. RA provide summarized idea about the financial position of a unit. They are important tools for financial analysis. RA is used as a decision making tool.

Definition and Uses of Ratio

A ratio can be defined as one number divided by another. Two numbers when viewed as ratio provide a relationship of one with respect to another. Financial ratios is used in 3 ways namely: As an absolute number As a historic sequence or time series As a comparison with the industry or a benchmark.

Users of Financial Analysis

1. 2. 3. 4. Trade creditors Lenders Investors Management

Importance of Ratio Analysis

It is a tool which enables the banker or lender to arrive at the following factors : Liquidity position Profitability Solvency Financial Stability Quality of the Management Safety & Security of the loans & advances to be or already been provided

Precaution while using Ratio Analysisfinancial statements a. The dates and duration of the
being compared should be the same. If not, the effects of seasonality may cause erroneous conclusions to be drawn. b. The accounts to be compared should have been prepared on the same bases. Different treatment of stocks or depreciations or asset valuations will distort the results. c. In order to judge the overall performance of the firm a group of ratios, as opposed to just one or two should be used. In order to identify trends at least three years of ratios are normally required.

How a Ratio is Expressed?

1. As Percentage-such as 25% or 50% . For example if net profit is Rs.25,000/- and the sales is Rs.1,00,000/- then the net profit can be said to be 25% of the sales. 2. As Proportion-The above figures may be expressed in terms of the relationship between net profit to sales as 1 : 4. 3. As Pure Number /Times-The same can also be expressed in an alternatively way such as the sale is 4 times of the net profit or profit is 1/4th of the sales.

Types of Financial Ratios

Liquidity Ratios

Market Based Ratios

Ratio Analysis Operating Ratios Profitability Ratios

Leverage Ratios

Asset Management Ratios

Liquidity Ratios
The liquidity ratios measure the liquidity of the firm and its ability to meet its maturing short term obligations. Liquidity is defined as the ability to realize value in money, the most liquid of assets. It refers to the ability to pay in cash, the obligations that are due. The corporate liquidity has two dimensions
Quantitative Concept Qualitative Concept

Quantitative and Qualitative Concept

Quantitative aspect includes the quantum, structure and utilization of liquid assets while in the qualitative aspect it is the ability to meet all present and potential demands on cash from any source in a manner that minimizes cost and maximizes the value of the firm. Corporate liquidity is the vital factor in business.

How liquid the firm should be?

Excess liquidity though the guarantor of solvency would reflect lower profitability, deterioration in managerial efficiency, increased speculation ,unjustified expansion and extension of too liberal credit and dividend policies. Too little liquidity may lead to frustration, business objections, reduced rate of return, missing of profitable business opportunities and weakening of morale.

Types of Liquidity Ratios

Current Ratio
Quick Ratio/Acid Test Ratio Cash Ratio

Current Ratio
Current ratio is defined as the ratio of current assets to current liabilities. Current assets would include debtors, inventories and cash while current liabilities would include payment due to suppliers of materials and services, provisions, and installments of loans falling in next 12 months. Depending upon the need, some analysts especially bankers are inclined to include bank borrowings, normally forming part of secured loans, for working capital in the current liabilities.

Importance of Current Ratio

A current ratio of more than 1 indicates the excess of current assets over current liabilities and the firm is said to be liquid. Higher the current ratio the better is the firm from the lenders perspective. But the firm has to be cautions of a very high current ratio as it affects the profitability adversely.

Determinants of Current Ratio

Inventory holding period Amount and days of credit provided to the customers Amount and days of credit availed from suppliers A firm keeping inventory and availing credit as per the requirements of the industry must exhibit the current ratio consistent with what is prevalent in the industry.

Acid Test Ratio

Acid Test Ratio is a more stringent measure of liquidity than the current ratio. It is the ratio of all the current assets excluding inventory to the current liabilities. It is also referred to as quick ratio. Why inventory is excluded from current assets??
It is the slowest moving component of current asset.

Acid Test Ratio

It is calculated as: Acid Test or Quick Ratio =(Current AssetsInventory)/Current Liabilities Quick ratio indicates the extent to which a firm is able to meets its current liabilities at a very short notice. Generally a quick ratio in excess of 1.00 is regarded as satisfactory

Cash Ratio
Cash Ratio is the most stringent measure of firms liquidity. It denotes the extend to which cash and near cash marketable securities are sufficient to meet the current liabilities. It is calculated as: Cash Ratio= Cash + Marketable Securities/Current Liabilities

Significance of Cash Ratio

Measurement of firm liquidity through cash ratio seems to be more of academic interest rather than of practical significance as firms flush with cash only invest in financial security to earn some income, and the liquidity is measured from current ratio or quick ratio. Large values of cash is a indicator of profitability of the firm rather than its liquidity. It implies that the firm has paid of creditors before investing surplus in the marketable securities. It also indicates the poor utilization of funds as idle cash translates into high opportunity cost.

Types of Capital Structure Ratios

Leverage Ratio Debt Equity Ratio Interest Cover Fixed Charge/Debt Service Coverage Ratio

Debt Coverage Ratios

Capital Structure Ratios

Capital Structure Ratios measure the relationship between owners funds and borrowed funds. A high usage of borrowed funds bring down the cost of financing but makes the firm more risky.

Capital Structure Ratios

Debt equity ratio, debt to asset ratio, total outside liabilities to net worth, total outside liabilities to assets, debt coverage ratio, interest coverage ratio and the debt service coverage ratio are the most prominent measure of capital structure.

Debt Equity Ratio

The debt equity ratio is defined as amount of long term debt divided by the amount of shareholders funds. The current ratio is more meaningful for shortterm creditors of the firm, who are concerned about cash generation in immediate future, the long term creditors prepared to look farther into the future are more concerned about debt equity ratio.

 The lower the value the better is the debt equity ratio The increasing amount of debt, as reflected in higher debt ratios, the firm is considered more vulnerable to external stocks and its operations are deemed risky. The low values of debt ratios imply foregoing the advantage of debt. Since debt is the cheapest source of funds than equity, its use enhances shareholders earnings

Significance of Debt Equity Ratio

 Higher value of debt ratio is disliked by one and all because: Increased debt makes the firm more vulnerable to economic or business cycles. Debt always carries with it a fixed interest burden that remains insensitive to the declining revenues under unfavorable economic conditions. The high debt firm is considered to be more risky in its operations

Significance of Debt Equity Ratio

Examples of Debt Equity Ratio

Capital Intensive Industries such as cement, steel, and infrastructure would have higher debt ratio as compared to industries such as software development, consumer goods etc. Role of banks and Financial institutions in debt equity ratio??
More debt is provided to capital intensive industries because they have large base of fixed assets

Debt Coverage Ratios

Debt coverage ratios are the measure of the firms capacity to service its debt obligations. Higher the coverage safer is the firm from the lenders perspective. It includes:
Interest cover Ratio Fixed Charge Coverage Ratio

Interest Cover Ratio

It indicates the extend to which profits (PBIT) are sufficient to pay the existing interest obligations. Higher the ratio more is the cushion available to lenders.

 PBIT as stated in the Profit & Loss Account includes many items such as depreciation, amortization, write offs etc, which do not reflect cash flows, interest cover can be calculated on the basis of cash available for payment of interest. Formulae: Interest Cover (on cash basis)= PBIT + Depreciation + Non cash expense non cash income/ Interest Obligation

Interest Cover Ratio (Cash Basis)

Fixed Charge/Debt Service Coverage Ratio

It measures the ability of the firm to meet its total debt obligations (both interest and principal) Formula for calculating DSCR: PBIT + Depreciation + Non cash expense non cash income/ (Interest Obligation + Loan Installment/ (1-Tax Rate))

Fixed Charge/Debt Service Coverage Ratio

The numerator represents the cash available to the firm before taxes. The denominator includes interest obligation and installment for the loan repayable. Since taxes have to be paid before loan installment and the numerator is pre-tax earning, the loan installment must be modified to pre-tax basis by dividing the amount by the factor of (1-tax rate)

Working Capital Ratios

Current Asset Turnover

Inventory Turnover Ratio

Debtors Turnover Ratio

Working Capital Ratios

It denotes the efficiency of firms in handling its operations. More quickly a firm turns over the different current assets eventually into cash, more efficient is the firm.

Current Asset Turnover

It indicates how many times the current assets have been turned over into sales in a given period (usually a year) An increasing ratio is a sign of improving efficiency Formula: Sales/ Average Current Assets

Current Assets Holding Period

Formula Average Current Assets/Sales*365 days Expressing current assets as holding period in number of days provides an estimate about the length of the firms working cycle. There is an inverse relationship between current assets turnover and the holding period.

 A higher turnover ratio or shorter current assets holding period denotes better utilization of funds deployed in current assets With smaller holding period- lower level of funds in current assets- it is implied that the firm can achieve larger sales with smaller capital, and exhibits better profitability to the extent of savings made in the cost of funds.

Significance of Current Assets Holding Period

Net Current Assets Turnover

It expresses the relationship between the sales and long-term financed component of current assets. A very high ratio for a given current assets turnover indicates low current ratio, i.e. poor liquidity. Formula for calculating is: Sales/Average Net Current Assets

Significance of Net Current Assets Turnover

It is higher than the gross current assets turnover. The minimum value could be equal to current assets turnover where the firms avail no credit. A very high net current assets turnover ratio as compared to current assets turnover ratio signals poor liquidity and/or unsatisfactory capital structure.

 Net current assets ratio close to zero would give inordinately high returns for the net working capital but it also implies rather lower net working capital than desired. Ideally, net current asset ratio should be 4 times of gross current asset ratio. Ideally both gross and net ratio is not an aggregate measure of efficiency of working capital. It does not tell us which part of working capital the efficiency or inefficiency comes from.

Significance of Net Current Assets Turnover

Inventory Turnover Ratios

Inventory component in the current assets is farthest from cash and deserves attention. It expresses the relationship between cost of goods sold and inventory It denotes the efficiency in inventory management. An increasing ratio signifies better inventory management. Formula: Cost of Goods Sold (COGS)/Average Inventory

Inventory Turnover Ratios

There are three components of inventory turnover ratio:
Raw-Material Turnover Ratio (Raw Material Consumption/Average Raw Material Inventory) W.I.P. Turnover Ratio (Cost of Production/ Average WIP Inventory) Finished Goods Turnover Ratio (Cost of Sales/ Average Finished Goods Inventory)

Inventory-Holding Period
It denotes the shelf life of inventory. It shares the inverse relationship with inventory turnover ratio. Formula Average Inventory/Cost of Goods Sold (COGS)*365 days.

Reason of using sales as numerator??

1. Uniformity of Interpretation 2. Non-availability of relevant figures of raw material consumption, cost of production and cost of sales in publicly available financial statements 3. As a matter of convenience

Uses of Inventory Turnover Ratios or Holding Periods

1. Measurement tools for determining the efficiency of inventory management, and the trend over successive periods 2. Diagnostic tools to find weak areas such as accumulation of non-moving or slow moving stocks 3. Norm-setting tools for developing guidelines for financing 4. Comparative tools for accessing relative performance of a firm with respect to its competitors, industry and against a benchmark.

Debtors Turnover Ratio

It expresses the relationship between sales and debtors. It reflects the efficiency with which the debtors are turned over into cash Improvement in the ratio indicates better receivables management.

Debtors Turnover Ratio

Debtors Turnover Ratio=Sales/Average Debtors Average Collection Period= Average Debtors/Sales*365 days Increasing debtors turnover brings down collection period and hence reduces the blockage of fund sin receivables.

Uses of Debtors Turnover Ratio

It is a measurement tool to know the speed of collection and efficiency of collection department It is a comparative tool to assess the collection policy with respect to competitors and industry A norm-setting tool to formulate guidelines for financing by banks and financial institutions collection and credit policy on sales, volume and profit.

Ageing of Debtors

Uses of Debtors Turnover Ratio

A predictive tool for understanding the level of competition and likely changes in the profitability. Normally increasing credit implies hotter competition and declining profitability A analytical tool for cost volume profit planning by ascertaining the impact of changes in the collection and credit policy on sales, volume and profit. It is a policy determinant for deciding the cash discount incorporating the cost of capital of the firm

Ageing of Debtors
Debtors ageing schedule categorizes the debtors as per the period for which they have been outstanding. It is the device for monitoring of receivables and helps in identifying the potential defaulters and the corresponding risk.

Creditors Turnover Ratio

It reflects the number of times average dues to the suppliers is settled. Higher the turnover, lower the payment period offered by the suppliers Creditors Turnover Ratio= Purchases/Average Creditors Average Credit Availed= Average Creditors/Purchases*365 days

Uses Creditors Turnover Ratio

It is better for the firm if it has low creditors turnover or large credit period availed from the creditors. Since higher credit from suppliers means deferment of cash, it provided more leeway to the firm in managing the cash resource. For effective working capital management, both current assets and current liabilities should be managed independent to each other.

Use of Average Figures

In case of working capital ratios, average of the opening and closing values of stock, debtors, creditors and stock is used because the corresponding figure relates to the period rather than one point of time. It is to smoothen out the changes over the period of time In case of high-growth firms use of average figures rather than end-of-the-period values would lead to more sound conclusions

Profitability Ratios
Profitability ratios refer to those financial metrics that are used to assess a businesss ability to generate earnings. A higher profitability ratio relative to a competitor's ratio or the same ratio from a previous period is indicative of better performance.

Dividend Per Share (DPS)

Value Addition

Contribution Margin

Earning Per Share (EPS)

Profitability Ratios

Gross Profit Margin

Return on Equity

Return on Capital Employed (ROCE)

Net Profit Margin

Value Addition
Value addition is the enhancement made to the value of a product or service before offering the same to customers. Higher the value added as a percentage of sales, better is the bottom-line for the firm. Value Addition= Sales-Purchases Value Addition in %=( SalesPurchases)Sales*100

Uses of Value Addition

Increasing value addition in absolute terms without the increase in value addition ratio implies increasing volumes and market share but stagnation in the area of product development If value addition ratio is increasing without the increase in value addition ratio in absolute terms it would imply creativity, product innovation etc on part of the firm.

Contribution Margin
The margin available once the variable costs have been covered before is known as contribution margin. The margin goes to meet the fixed costs. A larger contribution margin is desirable. Contribution =Sales-Variable Cost Contribution in % = (Sales-Variable Cost)*Sales

Gross Profit Margin

Gross profit margin is defined as excess of sales over cost of goods sold. While computing Gross Profit Margin the following must be kept in mind:
Depreciation is to be included in cost of production Selling, general and administrative overheads must be excluded from the cost and Non-operational income must be excluded from the revenue

Gross Profit Margin

Gross Profit Margin is the excess of total sales revenue over its cost of goods sold. It reflects production efficiency. Higher the gross margin, more is the cushion available to meet its overheads. Formula Gross Profit Margin= Sales-Cost of Goods Sold (COGS)/ Sales and EBIT/Sales*100

Gross Profit Margin

Gross Margin in absolute terms represents the amount of money the company generated over the cost of producing its goods and services. In relation to sales, it reflects the proportion of sales revenue that the company generates as gross profit to be put towards paying off general and administrative expenses and ultimately banked as net income.

Precautions while calculating Gross Profit Margin

1. Depreciation to be included in the cost of production 2. Selling, general and distribution overheads must be excluded from the cost and 3. Non-operational income must be excluded from the revenue.

Significance of Gross Profit Margin

Good Gross Profit margin reflects the ability of the firm to meet production expenses while EBIT based profitability reflects the ability to recover all expenses of procurement, production and sales. Financial expenses, which depend upon the capital structure are excluded The comparison of EBIT based profit of various firm excludes the leverage employed in financing by the enterprise

Significance of Gross Profit Margin

Poor profit indicates any one of the following: 1. Inability of the firm to procure inputs at competitive prices 2. Selling finished product at lower prices 3. Excessive overheads 4. High capital investment resulting in higher utilization or; 5. Poor utilization of production capacity

Net Profit Margin

Net profit often referred to as the bottom line is arrived by taking revenues and adjusting them for the cost of doing business, depreciation, interest, taxes and other expenses Net Margin as a percentage of sale reflects the overall profitability of the business. Formula: PAT/Sales*100

Significance of Net Profit Margin

It measures the efficiency of the firm in managing production, procurement, sales, financing and tax planning

PriceEarnings Ratio

Earnings Yield & Dividend Yield Market Value to Book Value Ratio

Valuation Ratios