FINANCIAL MANAGEMENT

11/17/2014

Financial Ratio
Analysis

11/17/2014

SIGNIFICANCE OF RATIO ANALYSIS

CSD A earns Rs 50,000
CSD B earns Rs 40,000

Which is more efficient? A or B

CSD A has emp Rs 4,00,000
CSD B has emp Rs 3,00,000

Profit as a % of Capital emp

A = (50,000/ 4,00,000) * 100 =12.50%

B = (40,000/ 3,00,000) * 100 =13.33%
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RATIO
A ratio is a statistical yardstick that
provides

measure

of

the

relationship

between two variables or figures.

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BALANCE SHEET ABC COMPANY AS AT 31 MAR2008

31MAR07

LIABILITIES

170 SHARE CAPITAL

EQUITY
PREFERENCE

31MAR08
170
120
50

180 RESERVES AND

SURPLUSES

215

150 SECURED LOANS

DEBENTURES

151

LOANS /ADVANCES

31MAR07
213 FIXED ASSETS NET
GROSS STOCK
LESS DEPRECIATION

229
594
365

15

11 INTANGIBLE
ASSETS

5 INVESTMENTS

30

670 CURRENT ASSETS

399

CASH IN BANK
RECEIVABLES
INVENTORIES
PRE-PAID EXPENSES

330
69

30 MISC EXPDR/LOSSES
929 TOTAL (Rs Lacs)

31MAR08

50
101

20 UNSECURED LOANS

409 CURRENT
LIABILITIES
SUNDRY CREDITORS
PROVISIONS

ASSETS

965

929 TOTAL (Rs Lacs)

681
73
189
355
64

35
965

INCOME STATEMENT OF ABC COMPANY FOR YEAR ENDED 31 MAR 08

FIGS 2007

FIGS 2008

847

NET SALES

904

657

COST OF GOODS SOLD

STOCKS
WAGES AND SALARIES
OTHER MANUFACTURING EXPENSES

714

190

GROSS PROFIT

103

OPERATING EXPENSES:
SELLING/ADM
DEPRECIATION

366
188
160

190
71
25

96

87

OPERATING PROFIT

94

11

NON-OPERATING PROFIT/DEFICIT

49

98

PROFIT BEFORE INTEREST&TAX (EBIT)

26

INTEREST(ON BANK BORROWINGS/LOANS)

DEBENTURES

72

PROFIT BEFORE TAX

36

TAX

58

36

PROFIT AFTER TAX

52

12

DIVIDENDS:EQUITY/ PREFERENCE

24

RETAINED EARNINGS(RESERVE & SURPLUS)

143
29
4

33
110

14 / 3

17
35

WHY BOTHER WITH RATIOS?

A comparison is more useful than mere Nos

Analysis of financial ratios involves two types of

comparisons:

Present ratio with the past ratios & expected future ratios
Ratios of one firm with those of similar firms or with
industry averages at same point of time

Essential to consider nature of business

(apples cannot be compared with oranges)

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CLASSIFICATION OF RATIOS

Liquidity ratios

Leverage / Solvency ratios

Turnover / Activity ratios

Profitability ratios

Valuation ratios

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LIQUIDITY RATIOS

Shows ability of company to pay its current financial

obligations

Company should not be selling its assets at a loss to meet its

financial obligations; worst scenario be forced into
liquidation

Current ratio

Quick / Acid test ratio

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CURRENT RATIO (CR)

Measure of companys ability to meet short term

requirements

Indicates whether current liabilities are adequately covered

by current assets

Measures safety margin available for short term creditors

CR = Current assets/Current liabilities

If Net Working Capital is to be positive, CR >1

Indian avg for non banking industries is 2

Current assets

= 681

Current liabilities = 399

CR = 681/399

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= 1.71

12

CURRENT RATIO (CR) - IMPORTANCE

Higher ratio ensures firm does not face problems in

meeting increased working capital requirements

Low ratio implies repeated withdrawls from bank to

meet liquidity requirements

High CR as compared to other firms implies advantage of

lower int rates from banks

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13

ACID TEST RATIO/QUICK RATIO(QR)

Used to examine whether firm has adequate cash or cash

equivalents to meet current obligations without resorting to
liquidating non cash assets such as inventories

Measures position of liquidity at a point of time

QR = Quick Assets / Current Liabilities

Quick assets = Current assets (inventories + prepaid expenses)

= 681(355+64) = 262
Current liabilities = 399

QR = 262/399 = 0.66

As a thumb rule ideal QR = 1; should not be less than 1

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CLASSIFICATION OF RATIOS

Liquidity ratios

Leverage / Solvency ratios

Turnover / Activity ratios

Profitability ratios

Valuation ratios

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LEVERAGE RATIOS

Shows dependence of firm on outside long term finance

Shows long term financial solvency & measures firms ability
to pay interest & principle regularly when due

To assess extent to which the firm borrowed money vis--vis

funds supplied by owners; Use of debt finance

Debt - Equity ratio

Companies whose EBIT <= Interest payments are risky

Debt - Total fund ratio

Debt - Assets ratio

Interest coverage ratio

Liability coverage ratio

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DEBT EQUITY RATIO

Measures relative proportion of debt & equity in financing assets of

a firm

Company can have good current ratio and liquidity position,

however liquidity may have come from long term borrowed funds,
the repayment of which along with interest will put liquidity under
pressure

DER = Long term debt / Share holders funds

Creditors would like this to be low; Lower ratio implies larger

credit cushion (margin of protection to creditors)

IDB expects DER of 2:1 in respect of SMEs

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DEBT EQUITY RATIO

Debt (loans) = Secure loans + Unsecure loans

= 151+30=181

Share holders funds = (equity+ preference capital + res

& surplus fictitious assets &

accumulated losses not written off )

= 120+50+215 = 385

DER = 181/385 = 0.47 = (0.47:1)

Creditors are providing Rs 0.47 financing for each rupee

provided by shareholders
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DEBT TOTAL FUND RATIO

DTF ratio= Long term debt / Total fund

Debt (long term)

Total funds (debt + sh holders funds)

181

= 181+(170+215-35) = 531

DTF ratio = 181/531 = 0.34

34% of the firms funds are debt (of various types)

remaining 66% is financed by owners/ share holders

Higher the debt - total funds ratio, greater the

financial risk
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DEBT ASSETS RATIO

Debt - Assets ratio = Debt / Net assets

Debt = 181

Net assets (less fictitious assets & losses) = 930

Ratio = 181/930 = 0.19

19% of the firms assets are financed with debt (of

various types).

Shows coverage provided by the assets to total debt

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INTEREST COVERAGE RATIO

Gives ability of company to pay back long term loans

along with interest or other charges from generation of
profit from its operations

Interest coverage ratio = EBIT / Debt interest

EBIT = 143

Interest = 29+4 = 33

Ratio = 143/33=4.33

EBIT should be 6 7 times of debt interest

Shows margin of cover to lenders; of prime imp

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21

LIABILITY COVERAGE RATIO

Calculated to determine time a company would take to

pay off all its liabilities from internally generated funds

Assumes that liabilities will not be liquidated from

additional borrowings or from sale of assets

LCR = Internally generated funds / Total liabilities

Internally gen funds = Equity + Pref + R&S = 385

Total liabilities

LCR = 385/965 = 0.399

Firm will take 2.5 yrs (1/.399) to repay all its liabilities
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= 965

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CLASSIFICATION OF RATIOS

Liquidity ratios

Leverage / Solvency ratios

Turnover / Activity ratios

Profitability ratios

Valuation ratios

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ACTIVITY / TURN OVER RATIOS

Allows to examine whether total amount of each type of asset

a company owns is reasonable, too high or too low in light of

current and forecast operating needs

In order to purchase / acquire assets, companies need to

borrow or obtain Capital from elsewhere :

More assets acquired implies high int and low profits

Lesser assets implies operations not as efficient as
possible

Activity turn over ratios used to assess efficiency with which

Inventory
turnover
company utilizing
its assets

ratio

Average
collection
period
Relates to level
of activity
represented
by sales or cost of
goods
sold
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Fixed assets turn over ratio

24

INVENTORY TURN OVER RATIO

Measures No of times inventory turned over in a year

OR
No of days of inventory held by company to sp sales
Times Inventory turned over =
Net sales

OR

Avg inventory

COGS

Avg stocks

Inventory measured in days of sale =

365 x Avg inventory
Net Sales

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INVENTORY TURN OVER RATIO

A ratio of 6 times indicates inventory turned over six

times in a year
OR
Ratio of 60 days indicates enough inventory to
support sales for 60 days held by company
Excessive inventories unproductive; represent
investment with zero rate of return

Conversely less inventory results in loss of customers

ABCs ratio = 904/355 = 2.54

ABCs Days of Inv = (355 x 365)/904 = 143.33 days

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AVERAGE COLLECTION PERIOD

Represents duration a company must wait after making

sales, before it actually receives cash from its customers

ACP =
=

Avg receivables
Average sales per day
Avg receivables x 365
Sales

OR

Imp

For assessing effectiveness of credit policy of firm

Enables mgmt to take timely measures to effectively manage
Receivables
= 189
credit
Salesvalue - firm facing
= 904difficulties in collecting debts
Too high
Too low
credit
policy
ACP value - restrictive
= (189
x 365)/
904 = 76.2 days
say 76 days
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FIXED ASSETS TURNOVER RATIO

Measures effectiveness of utilization of fixed assets by

company

Used to compare fixed assets utilization of two firms

Not truly reflective of performance / efficiency

High ratio (depreciation) if old assets

Low ratio if capital assets procured recently

FATR = Net sales (or COGS)/ Fixed assets

Fixed indicates
Assets
= 229utilisation of assets (with a
Higher ratio
better
= 904
cautionNet
on Sales
age of assets)
FATR
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= 904 / 229 = 3.95

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CLASSIFICATION OF RATIOS

Liquidity ratios

Leverage / Solvency ratios

Turnover / Activity ratios

Profitability ratios

Valuation ratios

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PROFITABILITY RATIOS
Profitability ratios indicate
Company's profitability in relation to other companies
Internal comparison with last yrs profits
Managements effectiveness as shown by returns
generated on sales and investments

Gross profit margin ratio (GPMR)

Net profit margin ratio (NPMR)
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Return on investment

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GROSS PROFIT MARGIN RATIO

(GPMR)

Represents cost of production

Helps in understanding proportion of raw materials used and

direct expenses incurred in overall production process

Reflects income being generated which can be apportioned

by promoters

Sales
= 904
ReflectsNet
efficiency
of firms
operations as well as how
Gross
products
are Profit
priced
GPMR

= Net sales - COGS = 904 - 714 = 190

= Gross Profit / Net sales

GPMR = Gross profit/ Net sales

= 190 / 904 = 0.21 = 21%

Implies 79% (100-21%) of sales contribute towards direct

expenses
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and raw mtrl

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NET PROFIT MARGIN RATIO

(NPMR)

Takes into account not only cost of production but also

administrative expenses like staff salary, selling &
distribution overheads

Represents surplus of gross profit after meeting expenses

Net Sales

COMPANY
A
= 904

NetSALES
profit appropriated to 2,00,000
meet tax liability,2,50,000
dividend
Net Profit after taxes

= 52

GROSS PROFIT
40,000
payments
and to retain part
in business

NPMR
NET PROFIT

COMPANY B
40,000

= Net
Profit / Net sales22,000
20,000

NPMR
= PROFIT
Net profit
(Profit
after
tax)/
Net sales
= 52
/ 904
= 0.057
= 5.7%
GROSS
MARGIN
20%
16%

NET PROFIT
MARGIN
10% of sales, Rs 5.7/8.8%earned as
Implies
for every Rs 100/-

profit which can be used for dividend distr and apportioned

Company B has outperformed Company A in total sales

to res & surplus

However
11/17/2014 A has utilized its resources more efficiently

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PROFITABILITY IN RELATION TO INVESTMENTRETURN ON INVESTMENT (ROI)

Indicates efficiency with which company used its Capital

(Equity as well as debt)

Takes into account overall returns of the company

assuming company has not taken any debt

Gives
EBIT
= 143returns including adjustments of earnings for
overall
fin Capital
employed = 566 ( (120+50+215+181)-(0+0) )
leveraging

(Eq +Pref sh +Res & surp+Debt)-(Fictitious assets +

Enables one to check whether return made on investment is
Non operating investments)
better than other alternatives available
ROI = 143/566 x 100 = 25.26 %.
Suited for inter-firm comparisons
The company has earned a profit of 25.26 paise on every
ROI = EBIT x100 / Capital employed
100
Re invested
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CLASSIFICATION OF RATIOS

Liquidity ratios

Leverage / Solvency ratios

Turnover / Activity ratios

Profitability ratios

Valuation ratios

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VALUATION RATIOS

Earning per share (EPS)

Price Earnings (PE) Multiple

Price Earnings Growth (PEG) Multiple

Dividend Payout Ratio

Dividend Yield

Beta of Stock

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EARNINGS PER SHARE

(EPS)

Represents total earnings of a company available for

distribution among equity shareholders

Evaluates performance of company shares over a period of

time

EPS = Net profit available for equity shareholders / No of

Equity shares

EPS alone should not be basis of decision making with

respect to purchase of any company share

Faulty reasons of High EPS

Less No of Equity shares

Investment in risky ventures
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PRICE EARNING (PE) MULTIPLE

Simplest method of comparing different stocks at a point of

time to make investment decisions

As a layman, this is the price being paid for buying one rupee
of earning of a company eg If PE of Infosys share is Rs 9/- it

means we are paying to the market a price of 9 for every

Rs 1/- earning of the company

PE Ratio = Market Price per share/ EPS

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PRICE EARNING GROWTH (PEG)

MULTIPLE

An extension of PE which also takes into account growth

rate of the company

PEG Multiple = PE / Growth

COMPANY A COMPANY B

Analysis

Market Price

200

200

EPS

10

20

Growth rate

5%

2%

PE Multiple

20 (200/10)

10 (100/20)

A overvalued

PEG Multiple

4 (20/5)

5 (10/2)

B overpriced wrt
growth potential

Which company stocks to be purchased ?

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DIVIDEND PAYOUT RATIO

Shows amount of dividend paid out of earnings

An indication of amount of profits put back into company

Imp ratio to assess long term prospects of company

Dividend Payout Ratio = Dividend / Net Income

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DIVIDEND YIELD

Shows relationship between Dividend per share and market

price

An imp ratio to compare two companies

Dividend Yield (%) = Dividend amount per share *100

Market price of share

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BETA OF SECURITY

Refers to overall market risk which a security is carrying and

which cannot be diversified

Responsiveness of share price of a company with respect to

overall market movement

If over a period of time, market has given a return of 20%;

individual share of company A has given return of 10%;
Beta of A = 10 / 20 = 0.5

If investor is risk averse, should invest in stocks with low

Beta; Even if market falls by drastic amount his investment
will not take that much hit
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FINANCIAL RATIOS
LIQUIDITY
NWC
=
CR
=
ATR
=

CA - CL
CA/CL
(CA INVENTORY)/CL

Solvency , Safety Margins,

Idle Resources , Risk

Long term solvency

LEVERAGE
Risk due to debt
Debt-Equity Ratio
= Debt/Net Worth
Owners Stake
Liab Coverage Ratio = Int gen funds / Total Liab Coverage provided
Debt to Assets Ratio
= Debt/Total Assets
by assets
Interest Coverage Ratio = EBIT/Debt Interest
Interest burden
ACTIVITY/TURNOVER
Inventory Turn Over Ratio = Net Sales/Inventory
FATR
= Net Sales/Total Assets
Avg Collection Period
= 365/ RTOR
PROFITABILITY
.
GPMR
= Gross Profit/Net Sales
NPMR
= Net Profit/Net Sales
ROI
= EBIT x 100/ Capital
ROE
= Equity earnings/ NW
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Utilisation
Credit mgt
Restrictions
Efficency

Efficency
Acceptability
Overall performance
Margin of Safety
Ability for PAT
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