Financial Statements Analysis

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FINANCIAL STATEMENTS ANALYSIS

Ratio Analysis

Common Size Statements Importance and Limitations of Ratio Analysis

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Ratio Analysis
Ratio analysis is a widely used tool of financial analysis. It is defined as the systematic use of ratio to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical performance and current financial condition can be determined.

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Basis of Comparison
1) Trend Analysis involves comparison of a firm over a period of time, that is, present ratios are compared with past ratios for the same firm. It indicates the direction of change in the performance improvement, deterioration or constancy over the years. 2) Interfirm Comparison involves comparing the ratios of a firm with those of others in the same lines of business or for the industry as a whole. It reflects the firms performance in relation to its competitors. 3) Comparison with standards or industry average.
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Types of Ratios
Liquidity Ratios Liquidity Ratios Capital Structure Ratios Capital Structure Ratios

Profitability Ratios Profitability Ratios

Efficiency ratios Efficiency ratios

Integrated Integrated Analysis Ratios Analysis Ratios

Growth Ratios Growth Ratios

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Net Working Capital

Net working capital is a measure of liquidity calculated by subtracting current liabilities from current assets.
Table 1: Net Working Capital Particulars Total current assets Total current liabilities NWC Table 2: Change in Net Working Capital Particulars Current assets Current liabilities NWC Company A Company B Rs 2,00,000 1,00,000 1,00,000
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Company A

Company B Rs 30,000 10,000 20,000

Rs 1,80,000 1,20,000 60,000

Rs 1,00,000 25,000 75,000

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Liquidity Ratios

Liquidity ratios measure the ability of a firm to meet its short-term obligations

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Current Ratio
Current Ratio is a measure of liquidity calculated dividing the current assets by the current liabilities

Current Ratio =

Current Assets Current Liabilities

Firm B Rs 30,000 Rs 10,000 3:1
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Particulars Current Assets Current Liabilities Current Ratio

Firm A Rs 1,80,000 Rs 1,20,000 = 3:2 (1.5:1)

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Acid-Test Ratio
The quick or acid test ratio takes into consideration the differences in the liquidity of the components of current assets Acid-test Ratio = Quick Assets Current Liabilities

Quick Assets = Current assets Stock Pre-paid expenses

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Example 1: Acid-Test Ratio

Cash Debtors Inventory Total current assets Total current liabilities (1) Current Ratio (2) Acid-test Ratio Rs 2,000 2,000 12,000 16,000 8,000 2:1 0.5 : 1

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Supplementary Ratios for Liquidity

Inventory Turnover Inventory Turnover Ratio Ratio

Debtors Turnover Ratio Debtors Turnover Ratio

Creditors Turnover Ratio Creditors Turnover Ratio

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Inventory Turnover Ratio

The ratio indicates how fast inventory is sold. A high ratio is good from the viewpoint of liquidity and vice versa. A low ratio would signify that inventory does not sell fast and stays on the shelf or in the warehouse for a long time.

Inventory turnover ratio =

Cost of goods sold Average inventory

The cost of goods sold means sales minus gross profit. The average inventory refers to the simple average of the opening and closing inventory.
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Example 2: Inventory Turnover Ratio

A firm has sold goods worth Rs 3,00,000 with a gross profit margin of 20 per cent. The stock at the beginning and the end of the year was Rs 35,000 and Rs 45,000 respectively. What is the inventory turnover ratio?

Inventory turnover ratio

= 6 (times per year) (Rs 35,000 + Rs 45,000) 2 12 months Inventory turnover ratio, (6) = 2 months

(Rs 3,00,000 Rs 60,000)

Inventory = holding period

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Debtors Turnover Ratio

The ratio measures how rapidly receivables are collected. A high ratio is indicative of shorter time-lag between credit sales and cash collection. A low ratio shows that debts are not being collected rapidly.

Debtors turnover ratio

Net credit sales Average debtors

Net credit sales consist of gross credit sales minus returns, if any, from customers. Average debtors is the simple average of debtors (including bills receivable) at the beginning and at the end of year.
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Example 3: Debtors Turnover Ratio

A firm has made credit sales of Rs 2,40,000 during the year. The outstanding amount of debtors at the beginning and at the end of the year respectively was Rs 27,500 and Rs 32,500. Determine the debtors turnover ratio.

Debtors turnover ratio

= 8 (times per year) (Rs 27,500 + Rs 32,500) 2

Rs 2,40,000

Debtors collection = 12 Months = 1.5 Months period Debtors turnover ratio, (8)

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Creditors Turnover Ratio

A low turnover ratio reflects liberal credit terms granted by suppliers, while a high ratio shows that accounts are to be settled rapidly. The creditors turnover ratio is an important tool of analysis as a firm can reduce its requirement of current assets by relying on suppliers credit.

Creditors turnover ratio =

Net credit purchases Average creditors

Net credit purchases = Gross credit purchases - Returns to suppliers. Average creditors = Average of creditors (including bills payable) outstanding at the beginning and at the end of the year.
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Example 4: Creditors Turnover Ratio

The firm in previous Examples has made credit purchases of Rs 1,80,000. The amount payable to the creditors at the beginning and at the end of the year is Rs 42,500 and Rs 47,500 respectively. Find out the creditors turnover ratio.

Creditors turnover ratio Creditors payment period

(Rs 1,80,000) (Rs 42,500 Rs 47,500) 2 = 12 months Creditors turnover ratio, (4)

= 4 (times per year) = 3 months

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The summing up of the three turnover ratios (known as a cash cycle) has a bearing on the liquidity of a firm. The cash cycle captures the interrelationship of sales, collections from debtors and payment to creditors.

The combined effect of the three turnover ratios is summarised below:

Inventory holding period Add: Debtors collection period Less: Creditors payment period 2 months + 1.5 months 3 months 0.5 months

As a rule, the shorter is the cash cycle, the better are the liquidity ratios as measured above and vice versa.
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DEFENSIVE INTERVAL RATIO Defensive interval ratio is the ratio between quick assets and projected daily cash requirement.
Defensiveinterval ratio = Liquid assets Projected daily cash requirement

Projected daily cash = requirement

Projected cash operating expenditure Number of days in a year (365)

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Example 5: Defensive Interval Ratio

The projected cash operating expenditure of a firm from the next year is Rs 1,82,500. It has liquid current assets amounting to Rs 40,000. Determine the defensive-interval ratio. Projected daily cash requirement = Rs 1,82,500 = Rs 500 365 Defensive-interval ratio = Rs 40,000 = 80 days Rs 500
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Cash-flow From Operations Ratio

Cash-flow from operation ratio measures liquidity of a firm by comparing actual cash flows from operations (in lieu of current and potential cash inflows from current assets such as inventory and debtors) with current liability. Cash-flow from operations ratio = Cash-flow from operations Current liabilities

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Leverage Capital Structure Ratio

There are two aspects of the long-term solvency of a firm: (i) Ability to repay the principal when due, and (ii) Regular payment of the interest . Capital structure or leverage ratios throw light on the long-term solvency of a firm. Accordingly, there are two different types of leverage ratios. First type: These ratios are computed from the balance sheet (a) Debt-equity ratio (b) Debt-assets ratio (c) Equity-assets ratio
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Second type: These ratios are computed from the Income Statement (a) Interest coverage ratio (b) Dividend coverage ratio

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I. Debt-equity ratio
Debt-equity ratio measures the ratio of long-term or total debt to shareholders equity.

Debt-equity ratio measures the ratio of long-termdebt + Other Current term Total Debt Debt-equity ratio to= or total de3bt shareholders equity equity Liabilities = Total external Shareholders Obligations
If the D/E ratio is high, the owners are putting up relatively less money of their own. It is danger signal for the lenders and creditors. If the project should fail financially, the creditors would lose heavily. A low D/E ratio has just the opposite implications. To the creditors, a relatively high stake of the owners implies sufficient safety margin and substantial protection against shrinkage in assets.
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Long-term Debt + Short

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For the company also, the servicing of debt is less burdensome and consequently its credit standing is not adversely affected, its operational flexibility is not jeopardised and it will be able to raise additional funds.

The disadvantage of low debt-equity ratio is that the shareholders of the firm are deprived of the benefits of trading on equity or leverage.

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Trading on Equity
Trading on equity (leverage) is the use of borrowed funds in expectation of higher return to equity-holders. Trading on Equity Particular (a) Total assets Financing pattern: Equity capital 15% Debt (b)Operating profit (EBIT) Less: Interest Earnings before taxes Less: Taxes (0.35) Earnings after taxes Return on equity (per cent) A 1,000 1,000 300 300 105 195 19.5 (Amount in Rs thousand) B 1,000 800 200 300 30 270 94.5 175.5 21.9 C 1,000 600 400 300 60 240 84 156 26 D 1,000 200 800 300 120 180 63 117 58.5
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II. Debt to Total Capital

The relationship between creditors funds and owners capital can also be expressed using Debt to total capital ratio.
Debt to total capital ratio = Total debt Permanent capital

Permanent

Capital

Shareholders equity Long-term debt.

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III. Debt to total assets ratio

Debt to total assets ratio =
Proprietary Ratio Proprietary ratio indicates the extent to which assets are financed by owners funds.

Total debt Total assets

Proprietary ratio =
Capital Gearing Ratio

Proprietary funds X 100 Total assets

Capital gearing ratio is used to know the relationship between equity funds (net worth) and fixed income bearing funds (Preference shares, debentures and other borrowed funds.
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Coverage Ratio
Interest Coverage Ratio Interest Coverage Ratio measures the firms ability to make contractual interest payments. EBIT (Earning before interest and Interest coverage ratio = taxes) Interest Dividend Coverage Ratio
Dividend Coverage Ratio measures the firms ability to pay dividend on preference share which carry a stated rate of return.

Dividend coverage ratio =

EAT (Earning after taxes) Preference dividend

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Total fixed charge coverage ratio

Total fixed charge coverage ratio measures the firms ability to meet all fixed payment obligations. EBIT + Lease Payment Total fixed charge = Interest + Lease payments + (Preference dividend coverage ratio + Instalment of Principal)/(1-t)

Total Cashflow Coverage Ratio

However, coverage ratios mentioned above, suffer from one major limitation, that is, they relate the firms ability to meet its various financial obligations to its earnings. Accordingly, it would be more appropriate to relate cash resources of a firm to its various fixed financial obligations.
EBIT + Lease Payments + Depreciation + Non-cash expenses Lease payment + + Interest (Principal repayment) (1 t) + (Preference dividend) (1 - t)
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Total cashflow = coverage ratio

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Debt Service Coverage Ratio

Debt-service coverage ratio (DSCR) is considered a more comprehensive and apt measure to compute debt service capacity of a business firm.

DSCR

t=1

EATt

Interestt

t=1 n

Depreciationt

OAt

Instalmentt

DEBT SERVICE CAPACITY Debt service capacity is the ability of a firm to make the contractual payments required on a scheduled basis over the life of the debt.
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Example 6: Debt-Service Coverage Ratio

Agro Industries Ltd has submitted the following projections. You are required to work out yearly debt service coverage ratio (DSCR) and the average DSCR.
(Figures in Rs lakh) Year Net profit for the year 1 2 3 4 5 6 7 8 21.67 34.77 36.01 19.20 18.61 18.40 18.33 16.41 Interest on term loan during the year 19.14 17.64 15.12 12.60 10.08 7.56 5.04 Nil Repayment of term loan in the year 10.70 18.00 18.00 18.00 18.00 18.00 18.00 18.00

The net profit has been arrived after charging depreciation of Rs 17.68 lakh every year.
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Solution
Table 3: Determination of Debt Service Coverage Ratio (Amount in lakh of rupees)
Year Net profit Depreciation Interest Cash Principal available instalment (col. 2+3+4) 5 58.49 70.09 68.81 49.48 46.37 43.64 41.05 34.09 6 10.70 18.00 18.00 18.00 18.00 18.00 18.00 18.00 Debt obligation (col. 4 + col. 6) 7 29.84 35.64 33.12 30.60 28.08 25.56 23.04 18.00 1.83 6 - 32 6 - 32 DSCR [col. 5 col. 7 (No. of times)] 8 1.96 1.97 2.08 1.62 1.65 1.71 1.78 1.89

1 1 2 3 4 5 6 7 8

2 21.67 34.77 36.01 19.20 18.61 18.40 18.33 16.41

3 17.68 17.68 17.68 17.68 17.68 17.68 17.68 17.68

4 19.14 17.64 15.12 12.60 10.08 7.56 5.04 Nil

Average DSCR (DSCR 8)

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Profitability Ratio
Profitability ratios can be computed either from sales or investment. Profitability Ratios Related to Sales (i) Profit Margin (ii) Expenses Ratio Profitability Ratios Related to Investments (i) Return on Investments (ii) Return on Shareholders Equity

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Profit Margin
Gross Profit Margin
Gross profit margin measures the percentage of each sales rupee remaining after the firm has paid for its goods.

Gross profit margin =

Gross Profit Sales

X 100

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Net Profit Margin

Net profit margin measures the percentage of each sales rupee remaining after all costs and expense including interest and taxes have been deducted. Net profit margin can be computed in three ways Earning before interest and taxes Net sales Earnings before taxes Net sales Earning after interest and taxes Net sales
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i. Operating Profit Ratio =

ii. Pre-tax Profit Ratio =

iii. Net Profit Ratio =

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Example 7: From the following information of a firm, determine (i) Gross profit margin and (ii) Net profit margin. 1. Sales 2. Cost of goods sold 3. Other operating expenses
(1) Gross profit margin = Rs 1,00,000 Rs 2,00,000 (2) Net profit margin = Rs 50,000 Rs 2,00,000 = 25 per cent

Rs 2,00,000 1,00,000 50,000

= 50 per cent

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Expenses Ratio
i. Cost of goods sold = ii. Operating expenses = Cost of goods sold X 100 Net sales Administrative exp. + Selling exp. Net sales Administrative expenses Net sales Selling expenses Net sales X 100 X 100

iii. Administrative expenses = iv. Selling expenses ratio = v. Operating ratio =

X 100

Cost of goods sold + Operating expenses X 100 Net sales Financial expenses X 100 Net sales
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vi. Financial expenses =

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Return on Investment
Return on Investments measures the overall effectiveness of management in generating profits with its available assets. i. Return on Assets (ROA) ROA = EAT + (Interest Tax advantage on interest) Average total assets

ii. Return on Capital Employed (ROCE) ROCE = EAT + (Interest Tax advantage on interest) Average total capital employed
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Return on Shareholders Equity

Return on shareholders equity measures the return on the owners (both preference and equity shareholders ) investment in the firm. Return on total shareholders equity = Net profit after taxes X 100 Average total shareholders equity Return on ordinary shareholders equity (Net worth) = Net profit after taxes Preference dividend X 100 Average ordinary shareholders equity
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Efficiency Ratio
Activity ratios measure the speed with which various accounts/assets are converted into sales or cash. Inventory turnover measures the efficiency of various types of inventories. Cost activity/liquidity i. Inventory Turnover measures the of goods sold of Inventory Turnover Ratio = Average inventory inventory of a firm; the speed with whichinventory is sold Cost activity/liquidity of i. Inventory Turnover measures theof raw materials used Raw materials turnover = inventory of a firm; the speed with which material inventory Average raw inventory is sold i. Inventory Turnover measures Costactivity/liquidity of the of goods manufactured Work-in-progress turnover = Average work-in-progress sold inventory of a firm; the speed with which inventory is inventory
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Debtors Turnover Ratio

Liquidity of a firms receivables can be examined in two ways.
Credit sales i. Inventory Turnover i. Debtors turnover = measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold Average debtors + Average bills receivable (B/R) 2. Average collection period = Months (days) in a year Debtors turnover

Months measures the (x) (Average Debtors + Average (B/R) i. Inventory Turnover(days) in a year activity/liquidity of inventory of a Alternatively = Total sold firm; the speed with which inventory is credit sales

Ageing Schedule enables analysis to identify slow paying debtors.

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Assets Turnover Ratio

Assets turnover indicates the efficiency with which firm uses all its assets to generate sales. Cost activity/liquidity i. Total assets turnover = Inventory Turnover measures the of goods sold of inventory i. of a firm; the speed with which inventory is assets Average total sold ii. Fixed assets turnover = Cost of goods sold Average fixed assets

Cost of goods sold i. Inventory Turnover measures the activity/liquidity of inventory iii. Capital turnover = Average capital employed of a firm; the speed with which inventory is sold Cost of goods sold iv. Current assets turnover = Average current assets i. Inventory capital turnover = Cost activity/liquidity of inventory Turnover measures the of goods sold v. Working of a firm; the speed with which Net working capital inventory is sold
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1) 2)

Return on shareholders equity = EAT/Average total shareholders equity. Return on equity funds = (EAT Preference dividend)/Average ordinary shareholders equity (net worth).

3)

Earnings per share (EPS) = Net profit available to equity shareholders (EAT Dp)/Number of equity shares outstanding (N).

4)

Dividends

per

share

(DPS)

Dividend

paid

to

ordinary

shareholders/Number of ordinary shares outstanding (N). 5) 6) 7) 8) 9) Earnings yield = EPS/Market price per share. Dividend Yield = DPS/Market price per share. Dividend payment/payout (D/P) ratio = DPS/EPS. Price-earnings (P/E) ratio = Market price of a share/EPS. Book value per share = Ordinary shareholders equity/Number of equity shares outstanding.
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Integrated Analysis Ratio

Integrated ratios provide better insight about financial and economic analysis of a firm.
(1) Rate of return on assets (ROA) can be decomposed in to (i) Net profit margin (EAT/Sales) (ii) Assets turnover (Sales/Total assets) (2) Return on Equity (ROE) can be decomposed in to (i) (EAT/Sales) x (Sales/Assets) x (Assets/Equity) (ii) (EAT/EBT) x (EBT/EBIT) x (EBIT/Sales) x (Sales/Assets) x (Assets/Equity)
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Rate of Return on Assets EAT as percentage of sales EAT Divided by Sales Sales Fixed assets Assets turnover Divided by Plus Total Assets Current assets

Gross profit = Sales less cost of goods sold Minus Expenses: Selling Administrative Interest Minus Income-tax

Alternatively Shareholder equity Plus Long-term borrowed funds Plus Current liabilities

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Return on Assets
Earning Power
Earning power is the overall profitability of a firm; is computed by multiplying net profit margin and assets turnover. Earning power = Net profit margin Assets turnover Where, Net profit margin = Earning after taxes/Sales Asset turnover = Sales/Total assets Earning after the activity/liquidity of inventory Sales EAT i. Inventory Turnover measurestaxes x x Earning Power = of a firm; the speed with which inventory is sold Sales Total Assets Total assets

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EXAMPLE: 8
Assume that there are two firms, A and B, each having total assets amounting to Rs 4,00,000, and average net profits after taxes of 10 per cent, that is, Rs 40,000, each. Firm A has sales of Rs 4,00,000, whereas the sales of firm B aggregate Rs 40,00,000. Determine the ROA of firms A and B. Table 4 shows the ROA based on two components.

Table 4: Return on Assets (ROA) of Firms A and B Particulars 1. Net sales 2. Net profit 3. Total assets 4. Profit margin (2 1) (per cent) 5. Assets turnover (1 3) (times) 6. ROA ratio (4 5) (per cent) Firm A Rs 4,00,000 40,000 4,00,000 10 1 10 Firm B Rs 40,00,000 40,000 4,00,000 1 10 10
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Return on Equity (ROE)

ROE is the product of the following three ratios: Net profit ratio (x) Assets turnover (x) Financial leverage/Equity multiplier Three-component model of ROE can be broadened further to consider the effect of interest and tax payments.

Net Profit EBT EBIT EAT i. Inventory Turnover measures the activity/liquidity of x = x Sales Earnings before taxes speed with which inventorySales inventory of a firm; the EBIT is sold
As a result of three sub-parts of net profit ratio, the ROE is composed of the following 5 components.

EAT EBT

EBT EBIT

EBIT x Sales

Sales Assets

Assets Equity
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A 5-way break-up of ROE enables the management of a firm to analyse the effect of interest payments and tax payments separately from operating profitability. To illustrate further assume 8 per cent interest rate, 35 per cent tax rate and other operating expense of Rs 3,22,462 (Firm A) and Rs 39,26,462 (Firm B) for the facts contained in Example 8. Table 5 shows the ROE (based on the 5 components) of Firms A and B. Table 5: ROE (Five-way Basis) of Firms A and B Particulars Net sales Less: Operating expenses Earnings before interest and taxes (EBIT) Less: Interest (8%) Earnings before taxes (EBT) Less: Taxes (35%) Earnings after taxes (EAT) Total assets Debt Equity EAT/EBT (times) EBT/EBIT (times) EBIT/Sales (per cent) Sales/Assets (times) Assets/Equity (times) ROE (per cent) Firm A Firm B Rs 4,00,000 3,22,462 77,538 16,000 61,538 21,538 40,000 4,00,000 2,00,000 2,00,000 0.65 0.79 19.4 1 2 20 Rs 40,00,000 39,26,462 73,538 12,000 61,538 21,538 40,000 4,00,000 2,50,000 1,50,000 0.65 0.84 1.84 10 1.6 16 6 - 49 6 - 49

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Common Size Statements

Preparation of common-size financial statements is an extension of ratio analysis. These statements convert absolute sums into more easily understood percentages of some base amount. It is sales in the case of income statement and totals of assets and liabilities in the case of the balance sheet.

Limitations
Ratio analysis in view of its several limitations should be considered only as a tool for analysis rather than as an end in itself. The reliability and significance attached to ratios will largely hinge upon the quality of data on which they are based. They are as good or as bad as the data itself. Nevertheless, they are an important tool of financial analysis.
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