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Analysis of
Financial Ratios
• The relationship between two accounting
figures expressed mathematically is
known as financial ratio
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Introduction
• What is the purpose of analysis of financial
ratios
• – It is for a meaningful study of information in the
financial statements
• – Ascertaining overall financial position of a
business organisation
• – Interpretation of key information in the financial
statements
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Objective
• The objectives:
• – Assess credit risk profile of the borrower
• – Stipulation of terms and conditions
• – Assess utilization of credit facility
• – Establish sound well defined credit
granting criteria
• – Ensure safety of bank funds
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Factors that banks consider
• Credit worthiness of the borrower
• Integrity/reputation
• Credit risk profile
• Sensitivity to economic and market
developments
• Liquidity
• Solvency
• Profitability of business
• Resource efficiency
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Ratios can be expressed in
different ways
• Ratios can be expressed as
• A) Percentage say gross profit ratio is
20%
of sales
• B) Proportion say current ratio 2:1
• C) Fraction- Say net profit is one-tenth
of sales
• D) Times say capital turn over ratio is
5times
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Measures of Liquidity /
Liquidity Ratios
• Net Working Capital
• Current Ratio
• Quick Ratio
• Net Working Capital/Net Assets
• Net Working Capital/Current Assets
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Net Working Capital
• Gross Working Capital ( GWC)
• It is the investment required to be made
by the borrower in Current Assets
• How ?
• From own contributions
• From creditors, borrowings
• Other short term resources
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Gross Working Capital
• Gross Working Capital
• How funded
• From own resources and other long term
sources
• Short fall if any from short term resources
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Short Term Resources
• Short term resources constitute what are known
• as ‘ Current Liabilities’
• Current Liabilities should be lower than Current
Assets
• Excess of Current Assets over Current Liabilities
is Net Working Capital
• Contribution from long term resources applied to
financing of Current Assets ( excess of Current
Assets) is owner’s stake or margin money
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Concept of NWC
• NWC represents the surplus long term funds
• applied towards financing of Current Assets
• Current assets are financed from two sources
• – Surplus from Long Term Liabilities
• – Current Liabilities
• Difference between Current assets and Current
Liabilities should always be positive
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NWC
• Negative Net Working Capital
• What is the Implication
• Business has applied part of surplus
Current Liabilities towards meeting
shortfall in Long Term resources
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NWC
• Positive NWC means
• i. Borrower has brought in his contribution
• ii. Any fall in value of Current Assets will
be cushioned by borrower’s stake
• iii. Loss in sale of Current Assets will not
affect Short term creditors
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NWC
• Net Working Capital ( NWC ) is a measure of
• liquidity
• • Sources for NWC
• Long Term Liabilities net of Long Term Assets
• ( LTLs including Net Worth less LTAs which
includes
• Fixed Assets, miscellaneous assets and
• intangibles.
• Another measure of liquidity is the Current
Ratio
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Current Ratio
• Current Ratio:
• Current Assets/ Current Liabilities
• If Net Working Capital is to be of positive
value the Current Ratio must be higher
than 1.
• Ideally for calculating MPBF Current Ratio
should be 1.33: 1
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Computation
• Current Ratio is computed by dividing the
current assets by the current liabilities
• Current ratio is expressed as a pure ratio
e.g 2:1Traditionally a current ratio of 2:1 is
considered as a satisfactory ratio.
• Current ratio is calculated at a particular
date and not for a particular period
• The excess of current ratio over current
liabilities is known as working capital.
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Quick Ratio or liquid ratio or Acid
Test Ratio
• This ratio establishes relationship between quick
assets and current liabilities
• This ratio measures ability of the firm to meet
short term obligations without relying upon
realisation of stock
• Quick assets- Cash ,Bank balance,Debtors
( after deducting provisions ) , Bills
receivables,Marketable securities,Short term
loans and advances(debit balance)
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Current Liabilities
• Current Liabilities – those which are
expected to be matured normally within a
year.
• Examples-Creditors for goods,Bills
payable, Creditors for expenses,provision
for tax unclaimed dividend,income
received in advance,short term loans and
advances(credit balance)
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Quick Ratio
• Quick ratio is computed by dividing quick
assets by current liabilities.
• Quick Ratio or Acid Test Ratio = Current
Assets-Inventory/Current Liabilities
• It indicates rupees of quick assets
available for each rupee of current liability
• A quick ratio of 1:1 is said to be
satisfactory
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Excercise
• Work out
• Current Ratio
• Quick Ratio
• Net working Capital to net sales (%)
• Net working Capital to Current Assets (%)
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Financing of Current Assets
• 1. Current Assets = Current Liabilities + NWC or
• 3088 = 2652 + 436
• 2. NWC = Current Assets – Current Liabilities or
• 436 = 3088 – 2652
• 3. Current Assets = Current Liabilities +
Contribution from Long Term Liabilities
3088 = 2249 +[(8104-7668)] =2652+436
(i.e.NWC = 3088)
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NWC/Net Sales
• This percentage should be around 8-12 %
• NWC is lower:
• Business is growing too fast without
• building an adequate cushion in the form
of NWC
It indicates symptom of overtrading and
Undue reliance on borrowed short term
funds
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Falling NWC/Net Sales
• Indicative of overtrading and serious
liquidity problems It needs to be
investigated
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Debt Equity ratio
• Debt Equity ratio establishes relationship between long
term debts and share holder’s funds
• Objective of this ratio is to measure the relative
proportion of debt and equity in financing the assets of a
firm
• This ratio indicates margin of safety to long term
creditors.
• A low debt equity ratio implies use of more equity than
debt which means a larger safety margin for creditors
and vice versa.
• Traditionally debt equity ratio of 2:1 is considered as
satisfactory
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Debt Equity Ratio
• DER = TLT Liabilities/TNW
• DER = Long term debts/
Shareholders funds
• Low ratio has a better leverage for
borrowing, From a firm’s point of view
debt servicing is less burdensome
• Not more than 1.5 for providing finance by
banks
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Debt Service Coverage Ratio
• This ratio measures relationship between Net
profits before interest and Tax and
Interset+Principal portion of installment.
• It shows the number of times the amount of
interest on long term debts and the principal
portion of installments covered by the profits out
of which that will be paid
• To judge whether ratios is satisfactory or not it
should be compared with its own past ratios or
with ratios of similar enterprises in the same
industry
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Debt Service coverage Ratio
• Debt Service coverage Ratio =
• Net profit before interest and tax
____________________________
Principal portion of installment
Int+----------------------------------------= times
1-Tax Rate
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Example
• Net profit before int and Tax Rs
8,50,000,10% debentures payable in 10
installments Rs 7,00,000 Tax rate 30%
• Calculate Debt Service coverage ratio
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DSCR
• DSCR =( Net profit +Depcn+ Annual
amount of
• int.on LTLs)/Interest + principal
Indicative of funds available for servicing
long term debt
• DSCR = 6+4+2/6 = 12/6= 2
• This is comfortable Should not be less
than 1.5:1 while considering projects
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Profitability Ratio
In relation to
Sales
1.Gross Profit Ratio
2.Operating profit ratio
3.Net profit ratio
In relation to
Investments
1.Return on Total Assets
2.Return on capital employed
3 Return on Share holders
funds
In relation to
Share holder’s
funds
1.Earnings per share
2.Price- Earning Ratio
3.Dividend pay out Ratio
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Return on Assets
• RoA = PBIT/Total Assets
• To measure profitability and efficiency
• Higher the ratio, the more efficient is the
firm in using resources
