understanding of financial ratio analysis

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understanding of financial ratio analysis

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Intrduction

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

1

• 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.

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.

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.

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

2

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.

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.

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.

Net Sales

Receivables

3

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:

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.

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.

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.

4

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

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 (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

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.

5

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.

Equity before depreciation interest and taxes

Total assets (all original cost)

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.

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.

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

Initial price Initial price

6

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 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.

Liquidity

Ratios

Current Ratio

1 Current Ratio

Current Liabilities

2 Quick Ratio

Current Liabilities

3 Interval Ratio Average daily cash operating

expenses

Leverage

Ratios

Total Debt

4 Total debt ratio

Capital Employed

5

ratio Total Debt

6

ratio Net worth

7

coverage Interest

Activity

Ratios

7

Inventory Cost of goods sold or sales

8

turnover Inventory

9

Inventory Inventory turnover

10

turnover Debtors

Collection 360

11

period Debtors turnover

Sales

12 Assets turnover

Net assets or capital employed

13

turnover Net working capital

Profitability

Ratios

Gross profit

14 Gross Margin

Sales

15 Net Margin

Sales

16

ratio PAT

17

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

22

ratio EPS

23 book value

ratio Book value of the share

8

Dividend + Price Change

24 Yield

Initial price

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.

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.

when due

Managers might need segmental and total information to see how they

fit into the overall picture

employers to assess the ability of the business to provide

remuneration, retirement benefits and employment

opportunities

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!

long term involvement with, or are dependent on, the

business

and their business. To regulate the activities of business, determine

taxation policies and as the basis for national income and

agencies similar statistics

information about the trends and recent developments in the

prosperity of the business and the range of its activities as

they affect their area

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

groups informing us about how they are working to keep their

environment clean.

9

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

Investors Return on Capital Employed

creditors

Customers Profitability

agencies

interesting list

measures

study

The ratio analysis is the most powerful tool of the financial analysis. With the help of

ratios, we can determine:

10

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

that sector.

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.

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?

11

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