RATIO ANALYSIS

SESSION-1

Ratio Analysis
Ratios are well known and most widely used tools of financial analysis. A ratio gives the mathematical relationship between one variable and another. Ratio analysis mainly helps in valuing the firm in quantitative terms.

Ratios are mainly divided into three parts: Liquidity ratio Profitability or Efficiency ratio and Ownership ratio

Liquidity ratios
Liquidity implies a firms ability to pay its debts in the short run. This ability can be measured by the use of liquidity ratios. Short term liquidity involves the relationship between current assets and current liabilities. If a firm has sufficient net working capital, it is assumed to have enough liquidity.

Liquidity can be measured directly by two ratios: Current ratio and Quick ratio Liquidity can be measured indirectly by following three ratios: Inventory turnover ratio Account receivable turnover ratio and Average collection period

Current ratio
It is defined as Current assets Current liabilities Current assets include cash, marketable securities, debtors, inventories, loans and advances and prepaid expenses. Current liabilities include loans and advances taken, creditors, accrued expenses and provisions. Higher the current ratio higher the liquidity.

Quick ratio
It is defined as Current assets-Inventories Current liabilities

Account receivable turnover ratio

This ratio gives, how many times on an average the receivables are generated and collected during the year. It is defined as: Net credit sales Average account receivable The average account receivable is obtained by adding and beginning receivables of the period and the ending receivable, and dividing the sum by two.

Average collection period

Average collection period gives the time in days it take to collect the account receivable. It is defined as:
360

Account receivable turnover ratio Or, Average account receivable Average daily sales

Inventory turnover ratio

The inventory turnover or stock turnover, measures how fast the inventory is moving through the firm and generating sales. It is defined as: Cost of goods sold Average inventory Higher the ratio, greater the efficiency of inventory management. It heps to measure the adequacy of goods available to sell in comparison to the actual sales order.

Profitability or efficiency ratios

These ratios measure the efficiency of the firms activities and its ability to generate profits. There are following profitability ratios: Gross profit margin ratio Net profit margin ratio Asset turnover Earning power and Return on equity

Gross profit margin ratio

It is defined as: Gross profit Net sales Where net sales = sales excise duty This ratio shows the profit relative to sales after the direct production costs are deducted.

Net profit margin ratio

It is defined as: Net profit Net sales It measures the overall efficiency of production, administration, selling, financing, pricing and tax management.

Asset turnover ratio

It highlights the amount of assets that the firm used to generate its total sales. Mathematically it is defined as: Sales Average assets Average assets is calculated by adding the opening and closing stock of the assets of the current year and dividing by two.

Earning power
The earning power is a measure of the operating business performance which is not affected by interest charges and tax payments. It is defined as: Earning before interest and taxes Average total assets

Return on equity
The return on equity measures the profitability of equity funds invested in the firms. Mathematically it is defined as: PAT Average equity

Ownership ratio
Ownership ratio will help the share holder to analyze their present and future investment in a firm. Stock holders(owners) are interested to know how the value of their holdings is affected by certain variables. By analyzing the ownership ratios, the analyst can assess the likely future value of the market. It is mainly classified into three parts: Earning ratio Leverage ratio and Dividend ratio

Earning ratios
Further it has two parts: Earning per share and Price earning ratio

Earning per share

Shareholders are concerned with the earnings of the firm in two ways. One is the availability of funds to pay their dividends and the other to expand their interest in the firm with the retained earnings. Mathematically it is defined as: PAT Number of outstanding shares

Price earning ratio

This ratio gives the relationship between the market price of the stock and its earnings by revealing how earnings affect the market price of the firms stock. Mathematically it is defined as: Market price of the share Earning per share

Leverage ratio
With the help of leverage ratio we analyze the long term solvency of a firm. Leverage ratios have two types: Capital structure ratio and Coverage ratio

Capital structure ratio

It has further two types: Debt equity ratio and Debt assets ratio

Debt equity ratio

The debt equity ratio indicates the relative proportions of capital contribution by creditors and shareholders. Mathematically it is defined as : Debt equity Debt = all liabilities including current Equity = net worth + preference capital

Debt assets ratio

The debt asset ratio measures the extent to which borrowed funds support the firms assets. It is defined as: Debt asset

Uses of capital structure ratio

To measure the financial risk To identify the sources of funds and To forecast borrowing prospects

Coverage ratios
Coverage ratios give the relationship between the financial charges of a firm its liability to service them. It has following types: Interest coverage ratio Fixed charge coverage ratio and Debt service coverage ratio

Interest coverage ratio

One measure of a firms ability to handle financial burdens is the interest coverage ratio. This ratio tells us how many times the firm can cover or meet the interest payments associated with debts. Mathematically it is defined as: EBIT Interest expense The greater the ratio, the higher the firms ability to pay its interest expense.

Fixed charge coverage ratio

This ratio shows how many times the pre tax operating income covers all fixed financing charges. It is defined as: Earning before depreciation, debt interest and lease rentals and taxes Debt interest + lease rentals + loan repayment installments/(1-tax rate) + preference dividends/ (1-tax rate)

Debt service coverage ratio

This ratio is defined as: PAT + depreciation + other non cash charges + interest on term loan Interest on term loan + repayment of the term loan

Dividend ratios
It has mainly two parts: Dividend yield and Dividend pay out ratio

Dividend pay out ratio

This ratio indicates what percentage of total earnings are paid to the share holders. T6he percentage of the earnings that is not paid out is retained for the firms future needs. Mathematically it is defined as: Dividend per share Earning per share

Dividend yield
This ratio gives current return on ones investment. This is mainly of interest to the investors who are desirous of getting income in the form of dividends. It is defied as: Dividend per share Market price of the share