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Financial Ratio Analysis

Intrduction

A firm communicates financial information to the users through statements and


reports. The financial statements contain summarized information of the firm’s
financial affairs, organized systematically. Preparation of financial statements is the
responsibility of top management. As these statements are used by investors and
financial analysts in order to examine the firm’s performance and make investment
decisions, they should be prepared very carefully and contain as much as information
as possible.

Two basic financial statements prepared for the purpose of external reporting to
owners, investors and creditors are (i) balance sheet (or statement of financial
position) and (ii) profit and loss account (or income statement). For internal
management purposes, i.e. planning and controlling, much more information than
contained in the published financial statements is needed therefore, the financial
accounting information is presented in different statements and reports in such a way
as to serve the internal needs of managements, creditors, investors and others to
form judgments about the operating performance and financial position of the
position of the firm use the information contained in these statements. Users of
financial statements can get better insight about the financial strengths and
weakness of the firm if they properly analyse the information reported in these
statements. Management is also interested in knowing the financial strengths and
find out the weakness of the firm to take suitable actions at right time. The future
plan of the firm is laid down in the view of the firm’s financial strength’s and
weakness. Thus financial analysis is the starting point for making plans, before
making any sophisticated forecasting and planning procedures. Understanding the
past is the prerequisite for anticipating the future.

Financial ratio analysis is a study of ratios between various items or groups of items
in financial statements. A ratio is an arithmetical relationship between two figures.
Ratio analysis is a powerful tool of financial analysis. A ratio is defined as “the
indicated quotient of the two mathematical expression “ and as “ the relationship
between two or more things.” In financial analysis, a ratio is used as an index or
yardstick for evaluating the financial position and performance of a firm. The absolute
accounting figures reported in the financial statements do not provide a meaningful
understanding of the performance and financial position of a firm. An accounting
figure conveys meaning when it related to some other relevant information. For
example, a Rs. 5 crore net profit may look impressive, but the firm’s performance can
be said to be good or bad only when the net profit margin is related to the firm’
investment. The relationship between two accounting figure, expressed
mathematically is known as a financial ratio (or simply as a ratio). Ratios help to
summarise the large quantities of financial data and to make qualitative judgment
about the firm’s financial performance. For example, consider current ratio (discussed
later) it is calculated by dividing current assets by current liabilities; the ratios
indicates a relationship—a quantified relationship between current asset and current
liabilities; This relationship is an index or yardstick, which permits a qualitative
judgment to be formed about the firm’s ability to meet its current obligation. It
measures the firm’s liquidity. The greater the ratio, the greater the firm ‘s liquidity
and vive verse. The point to note is that a ratio indicates a quantitative relationship,
which can be, in turn, used to make a qualitative judgment. Such is the nature of all
financial ratios

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• Liquidity Ratios: Liquidity refers to the ability of a firm to meet its
obligations in the short run, usually one year. The important liquidity ratios
are: current ratio and acid-test ratio.

• Leverage Ratios: Leverage refers to the use of debt finance. While debt
capital is cheaper source of finance, it is also risk source of finance. Leverage
ratios help is assessing the risk arising from the use of debt capital. The
commonly used leverage ratios are: debt-equity ratio, interest coverage ratio,
and debt service coverage ratio.

• Turnover Ratios: Turnover ratios also referred to as activity ratios or asset


management ratios, measure how efficiently the assets are employed by the
firm. The important turnover ratios are: inventory turnover ratio, receivables
turnover ratio, average collection period, fixed assets turnover ratio, and total
assets turnover ratio.

• Profit margin Ratios: Profit margins reflect the relationship between profits
(defined variously) and sales. The common used profit margin ratios are gross
profit margin ratio, EBIT/Sales ratio, and net profit margin ratio.

• Return on Investment Ratios: Reflecting the relationship between profit


and investment, return on investment ratios measure the overall financial
performance of the firm. The most important return on investment ratios is:
net income to total assets ratio, earning power, and return on equity.

• Valuation Ratios: Valuation Ratios indicate how the equity stock of the
company is assed in the capital market. The commonly employed valuation
ratios are: price earnings ratio, yield, and market price to book value ratio.

To facilitate this discussion, the financial statement of ABC Limited, shown in


exhibits 2.2 and 2.3 shall be used.

 Current ratio

Current Assets
Current Liabilities

Current assets include cash, marketable securities, debtors, inventories, loans and
advances, and pre-paid expenses. Current liabilities consist of loans and advances
(taken). Trade creditors, accrued expenses, and provisions.
The current ratio, a very popular financial ratio, measures the ability of the
firm to meet its current liabilities – current assets get converted into cash in the
operational cycle of the firm and provide the funds needed to the pay current
liabilities. Apparently, the higher the current ratio, the greater the short term
solvency

Acid – Test Ratio

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Quick assets
Current Liabilities

Quick assets are defined as current assets excluding inventories. The acid-test ratio,
also called the quick ratio, is a fairly stringent measure of liquidity. It is a based on
those current assets, which are highly liquid-inventories are excluded from the
numerator of this ratio because inventories are deemed to be the least liquid
component of current assets.

Debt-Equity Ratio

Debt
Equity

The numerator of this ratio consists of all liabilities, short-term as well as long-term,
and the denominator consists of net worth plus preference capital.
In general, the lower the debt-equity ratio, the higher the degree of protection
enjoyed by the creditors.

Interest Coverage Ratio

Earnings before interest and taxes


Debt Interest

It may be noted that earnings before interest and taxes are used in the numerator of
this ratio because the ability of a firm to pay interest is not affected by tax payment,
as interest on debt funds is a tax-deductible expense. A high interest coverage ratio
means that the firm can easily meet its interest burden even if earnings before
interest and taxes suffer a considerable decline. A low interest coverage ratio may
result in financial embarrassment when earnings before interest and taxes decline. A
low interest coverage ratio may result in financial embarrassment when earnings
before interest and taxes decline.

Inventory Turnover Ratio

Net Sales
Inventory

The numerator of this ratio is the net sales for the year and the denominator is the
inventory balance at the end of the year.
The inventory turnover ratio is deemed to reflect the efficiency of inventory
management. The higher the ratio, the more efficient the management of inventories
and vice versa. However, this may not always be inventory, which may result in
frequent stock outs and loss of sales and customer goodwill.

Receivables Turnover Ratio

Net Sales
Receivables

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If the figure for credit sales is available, it is preferable to use it is in the numerator of
this ratio. The receivables figure used in the denominator of this ratio is generally the
receivables figure at the end of the period. However, when sales are highly seasonal
or when sales growth is high, the year-end receivables figure is somewhat
inappropriate. When sales are highly seasonal, the average of the receivables figures
at the end of each month or each season may be used and when sales growth is high
the average of the beginning and ending receivables balances may be used.
The receivables turnover ratio and the average collection period related as follows:

Average collection period= 360


Receivables turnover ratio

Obviously, the shorter the average collection period the higher the receivables
turnover ratio and vice versa. The average collection period may be compared with
the firm’s credit terms judge the efficiency of receivables management. Form
example, if the credit terms are 2/10, net45, an average collection period of 85 days
means that collection is slow and an average collection period of 40 days means that
the collection is prompt. As a rule of thumb, the average collection period should not
exceed One and ½ times time the credit period. (This indeed is an arbitrary guide.)
An average collection period, which is shorter than the credit period allowed by the
firm, needs to be interpreted carefully. It may mean efficiency of credit management
or excessive conservation in credit granting that may result in the loss of some
desirables sales.

Fixed Assets Turnover Ratio

Net Sales
Fixed assets

The numerator of this ratio is the net sales for the period and the denominator is the
balance in the net fixed assets account at the end of the year.
This ratio is supposed to measure the efficiency with which fixed assets are employed
- a high ratio indicates a high degree of efficiency in asset utilizations and a low ratio
reflects inefficient use of assets. However, in interpreting this ratio, one caution
should be borne in mind. When the fixed assets of the firm are old and substantially
depreciated, the fixed assets turnover ratio tends to be high because the
denominator of the ratio is very low.

 Total Assets Turnover Ratio

Net Sales
Total assets

Total assets are simply the balance sheet at the end of the year. The ratio measures
how efficiently assets are employed. Overall. It is all akin to the output – capital ratio
used in economic analysis.

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 Gross Profit Turnover Ratio

Gross Profit
Net Sales

Gross profit is defined as the difference between net sales and cost of goods sold.
This ratio shows the margin left after meeting manufacturing costs. It measures the
efficiency of production as well as pricing. To analyze the factors underlying the
variation in gross profit margin, the proportion of various elements of cost (labour,
materials and manufacturing overheads) to sales may be studied in detail.

 Net profit Margin Ratio


Net Profit
Net Sales

This ratio shows the earnings left for shareholders (both equity and preference) as a
percentage of net sales. It measures the overall efficiency of production,
administration, selling, financing, pricing, and tax management. Jointly considered,
the gross and net profit margin ratios provide a valuable understanding of the cost
and profit structure of the firm and enable the analyst to identify the sources of
business efficiency / inefficiency.

 Net Income to Assets Ratio


Net Income (Profit)
Total Assets

The net income to total assets ratio is supposedly a measure of how efficiently the
capital is employed. This ratio, however, is internally inconsistent because the
numerator measures the return to shareholders (equity and preference) and the
denominator represents the contribution of shareholders as well as creditors.

 Earning Power
Earnings before interest and taxes
Total Assets

The earning power is a measure of business performance, which is not affected by


interest charges and tax payments. It abstracts away the effect of financial structure
and tax rate and focuses on operating performance. Hence, it is eminently suited for
inter-firm comparisons. Further, it is internally consistent. The numerator represents
a measure of pre-tax earnings belonging to all resources of finance and the
denominator represents total financing.

 Return on Equity
Equity Earnings
Net worth

The numerator of this ratio is equal to profit after tax less preference dividends. The
denominator includes all contribution made by equity shareholders (paid-up capital +
reserves and surplus). This ratio is also called return on net worth.

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The return on equity measures the profitability of equity funds invested in the
firm. It is regarded as a very important measure because it reflects the productivity
of the ownership (or risk) capital employed in the firm. It is influenced by several
factors: earning power, debt-equity ratio, average cost of debt funds, and tax rate.

In judging all the profitability measures it should be borne in mind that the historical
valuation of assets imparts an upward bias to profitability measures during an
inflationary period. This happens because the numerator of these measures
represents current values, whereas the denominator represents historical values.

 EBDIT to Total Assets Ratio


Equity before depreciation interest and taxes
Total assets (all original cost)

This measures is a variant of earning power. The numerator of this measure is


obtained by adding back depreciation to earnings before interest and taxes (EBDIT).
Similarly, in the denominator assets are shown at their original cost, not their
depreciated value. The rationale for such adjustments appears to be two-fold. First, it
is meant to focus on cash flow from operations. Second, it seeks to remove the
distortion that normally arises from the book depreciation as it rarely, if ever,
corresponds to economic depreciation.

 Price – earning Ratio


Market price per share
Earning per share

The market price per share may be the price prevailing on a certain day, or
preferably the average price over a period of time. The earnings per share are
simply: profit after tax divided by the number of outstanding equity shares.

The price-earnings ratio (or the price-earnings multiples as it is commonly referred


to) is a summary measure, which primarily reflects the following factor: growth
prospects, risk characteristics, shareholder orientation, corporate image and degree
of liquidity.

 Yield
Dividend + Price Change
Initial price

This may be split into two parts:

Dividend + Price change


Initial price Initial price

Dividend Yield Capital gains/loses yield

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Generally, companies with low growth prospects offer high dividend yield and a low
capital gains yield. On the other hand, companies with superior growth prospects
offer a low dividend yield and a high capital gains yield.

 Market Value to Book Value Ratio


Market value per share
Book value per share

This ratio reflects the contribution of affirm to the net wealth of the society. When
this ratio exceeds 1 it means that the firm has contributed to the creation of net
wealth in the society – if this ratio is, say, 2, the firm has created a net wealth of one
rupee for every rupee invested in it. When this ratio is equal to 1, it implies that the
firm has neither contributed to nor detracted from the net wealth of the society.

Important Financial Ratios

Liquidity
Ratios
Current Ratio
1 Current Ratio
Current Liabilities

Current assets- Inventory


2 Quick Ratio
Current Liabilities

Current assets- Inventory


3 Interval Ratio Average daily cash operating
expenses

Leverage
Ratios
Total Debt
4 Total debt ratio
Capital Employed

Debt-equity Net worth


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ratio Total Debt

Capital-equity Capital employed or net assets


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ratio Net worth

Interest EBIT + Depreciation


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coverage Interest

Activity
Ratios

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Inventory Cost of goods sold or sales
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turnover Inventory

No. of days, 360


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Inventory Inventory turnover

Debtors Creditors sales or sales


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turnover Debtors

Collection 360
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period Debtors turnover

Sales
12 Assets turnover
Net assets or capital employed

Working capital Sales


13
turnover Net working capital

Profitability
Ratios
Gross profit
14 Gross Margin
Sales

Profit after tax/EBIT


15 Net Margin
Sales

PAT to EBIT EBIT


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ratio PAT

Return on EBIT or (1-Tax rate)


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Investment Net assets or Capital employed

Profit after a
Return on
18 Tax
Equity
Net worth

PAT
19 EPS
No of Shares

Profit distributed
20 DPS
No of Shares

DPS
21 Payout
EPS

Price-earning Market price of share


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ratio EPS

Market value- Market price of the ratio


23 book value
ratio Book value of the share

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Dividend + Price Change
24 Yield
Initial price

What do the Users of Accounts Need to Know?

The users of accounts that we have listed will want to know the sorts of things we can
see in the table below: this is not necessarily everything they will ever need to know,
but it is a starting point for us to think about the different needs and questions of
different users.

Investors to help them determine whether they should buy shares in


the business, hold on to the shares they already own or sell
the shares they already own. They also want to assess the
ability of the business to pay dividends.

Lenders to determine whether their loans and interest will be paid


when due

Managers might need segmental and total information to see how they
fit into the overall picture

Employees information about the stability and profitability of their


employers to assess the ability of the business to provide
remuneration, retirement benefits and employment
opportunities

Suppliers and businesses supplying goods and materials to other


other trade businesses will read their accounts to see that they don't
have problems: after all, any supplier wants to know if his
creditors customers are going to pay their bills!

Customers the continuance of a business, especially when they have a


long term involvement with, or are dependent on, the
business

Governments the allocation of resources and, therefore, the activities of


and their business. To regulate the activities of business, determine
taxation policies and as the basis for national income and
agencies similar statistics

Local community Financial statements may assist the public by providing


information about the trends and recent developments in the
prosperity of the business and the range of its activities as
they affect their area

Financial They need to know, for example, the accounting concepts


analysts employed for inventories, depreciation, bad debts and so on

Environmental Many organizations now publish reports specifically aimed at


groups informing us about how they are working to keep their
environment clean.

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Researchers Researchers’ demands cover a very wide range of lines of
enquiry ranging from detailed statistical analysis of the
income statement and balance sheet data extending over
many years to the qualitative analysis of the wording of the
statements

Which ratios will each of these groups be interested in?

Interest Group Ratios to watch


Investors Return on Capital Employed

Lenders Gearing ratios

Managers Profitability ratios

Employees Return on Capital Employed

Suppliers and other trade Liquidity


creditors

Customers Profitability

Governments and their Profitability


agencies

Local Community This could be a long and


interesting list

Financial analysts Possibly all ratios

Environmental groups Expenditure on anti-pollution


measures

Researchers Depends on the nature of their


study

Utility of Ratio Analysis

The ratio analysis is the most powerful tool of the financial analysis. With the help of
ratios, we can determine:

1. Examining trends in results over a number of years.

2. Comparing the results of a business with results of other businesses.

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3. Comparing the results of the business with the average results of all businesses in
that sector.

4. Ability of the firm to meet its current obligation.

As stated previously, a short-term creditor will be interested in current financial


position of the firm, while a long-term creditor will pay more attention to solvency of
the firm. The long-term creditor will also be interested in the profitability of the firm.

The equity shareholders are generally concerned with their return and may bother
about firm’s financial condition only when their earnings are depressed.

The ratio analysis is also useful in security analysis. The major focus in security
analysis is on the long-term profitability. Profitability is dependent on a number of
factors and, therefore, the security analyst also analyses other ratios.

Management has to protect the interest of all concerned parties, creditors, owners
and others. They have to ensure some minimum operating efficiency and keep the
risk of the firm at a minimum level. Their survival depends upon their operating
performance. From time to time, management uses ratio analysis to determine the
firm’s financial strengths and weakness, and accordingly takes actions to improve the
firm’s position. Management is in a better position to analyse the firm’s financial
position as it has access to internal information, which is not available to the credit
analyst or the security analyst.

Diagnostic role of Ratios

The essence of the financial soundness of a company lies in balancing its goals,
commercial strategy, product-marketing choices and resultant financial needs. The
company should have financial capability and flexibility to pursue its commercial
strategy. Ratio analysis is a very useful analytical technique to raise pertinent
questions on a number of managerial issues. It provides bases or clues to investigate
such issues in detail. While assessing the financial health of the company with the
help of ratio analysis, answers to the following questions may be sought:

1. How profitable is the company? What accounting polices and practices are
followed by the company? Are they stable?
2. Is the profitability (RONA) of the company high/low/average? Is it due to:
a. Profit margin
b. Asset utilization
c. Non-operating income
d. Window dressing
e. Change in accounting policy
f. Inflationary condition?
3. Is the return on equity (ROE) high/low/average? Is it due to:
a. Return on investment
b. Financing mix
c. Capitalization of reserves?
4. What is the trend in profitability? Is it improving because of better utilization
of resources or curtailment of expenses of strategic importance?
What is the impact of cyclical factors on profitability trends?
5. Can the company sustain its impressive profitability or improve its profitability
given the competitive and other environment situation?
6. How effectively does company utilize its assets in generating sales?

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