financial-ratios-bcas-160213154906.pdf

1. Financial Ratios and their use in
understanding Financial
Statements
Speaker: Pranav N Dedhia
CA Final Student
BCAS Study Circle: 19/03/2015
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Financial Ratios

2. Flow of the presentation
Financial Ratios
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Introduction to Fundamental Analysis
What is Ratio Analysis?
Categories of Financial Ratios
DuPont Analysis
Other important points
Q&A

3. Fundamental Analysis
A method of evaluating a security that entails attempting to measure its intrinsic
value by examining related economic, financial and other qualitative and quantitative
factors. Fundamental analysts attempt to study everything that can affect the
security's value, including macroeconomic factors (like the overall economy and
industry conditions) and company-specific factors (like financial condition and
management). The end goal of performing fundamental analysis is to produce a
value that an investor can compare with the security's current price, with the aim of
figuring out what sort of position to take with that security (underpriced = buy,
overpriced = sell or short).
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4. Basic steps in Fundamental Analysis
• Step 1. Acquire the company’s financial statements for several years
• Step 2. Quickly scan all of the statements to look for large movements in specific
items from one year to the next
• Step 3. Examine the Balance Sheet, Income statement and Cash Flow Statement
• Step 3. Calculate financial ratios for each year (all categories of ratios)
• Step 4. Obtain data for the company’s key competitors, and data about the industry,
company’s stock price, dividend payout, etc
• Step 5. Review all of the data that you have generated
At this point…
• You will probably find that there is a mix of positive and negative results. Answer the
following question:
• “Based on everything I know about this company and its strategies, the industry
and the competitors, and the external factors that will influence the company in the
future, do I think this company is worth investing in for the long term?”
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Financial Ratios

5. Ratio Analysis
Ratio-analysis means the process of computing, determining and presenting the
relationship of related items and groups of items of the financial statements. They
provide in a summarized and concise form of fairly good idea about the financial
position of a unit. They are important tools for financial analysis
• A ratio is a relationship between two numbers, e.g. ratio of A: B = 1.5:1 ==> A is
1.5 times B
• A given ratio is compared to:
1. Ratios from previous years for internal trends
2. Ratios of other firms in the same industry for external trends
Ratio Analysis acts as diagnostic tool that helps to identify problem areas and
opportunities within a company. They provide an insight into company’s liquidity,
profitability, financial leverage, efficiency and value
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6. Ratio Analysis
Before looking at the ratios there are a number of cautionary points concerning their use
that need to be identified :
• The dates and duration of the financial statements being compared should be the same. If
not, the effects of seasonality may cause erroneous conclusions to be drawn
• The accounts to be compared should have been prepared on the same bases. Different
treatment of stocks or depreciations or asset valuations will distort the results
• In order to judge the overall performance of the firm a group of ratios, as opposed to just
one or two should be used. In order to identify trends at least three years of ratios are
normally required
The utility of ratio analysis will get further enhanced if following comparison is possible.
1. Between the borrower and its competitor
2. Between the borrower and the best enterprise in the industry
3. Between the borrower and the average performance in the industry
4. Between the borrower and the global average
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7. How a Ratio is expressed?
• As Percentage - such as 25% or 50% . For example if net profit is Rs.25,000/- and the
sales is Rs.1,00,000/- then the net profit can be said to be 25% of the sales.
• As Proportion - The above figures may be expressed in terms of the relationship
between net profit to sales as 1 : 4.
• As Pure Number /Times - The same can also be expressed in an alternatively way
such as the sale is 4 times of the net profit or profit is 1/4th of the sales.
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Financial Ratios
Classification of Ratios
Balance Sheet Ratio P&L Ratio or Income/Revenue
Statement Ratio
Balance Sheet and Profit &
Loss Ratio
Financial Ratio Operating Ratio Composite/Mixed Ratio
Current Ratio
Quick Asset Ratio
Proprietary Ratio
Debt Equity Ratio
Gross Profit Ratio
Operating Ratio
Expense Ratio
Net profit Ratio
Stock Turnover Ratio
Fixed Asset Turnover Ratio,
Return on Total Resources
Ratio,
Return on Own Funds Ratio,
Earning per Share Ratio,
Debtors’ Turnover Ratio,

8. Categories of Ratios
Category Description
Activity Ratios Measures how efficiently a company performs day to day tasks,
such as the collection of receivables and management of
inventory
Liquidity Ratios Measures the company’s ability to meet its short term
obligations
Solvency Ratios Measures a company’s ability to meet long term debt
obligations. Subsets of these ratios are known as “leverage” and
“long term debt” ratios
Profitability Ratios Measures the company’s ability to generate profitable sales
from its resources (assets)
Valuation Ratios Measures the quantity of an asset or flow associated with
ownership of a specified claim
Coverage Ratios Measures a company's ability to pay its liabilities
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Financial Ratios

9. Commonly used Activity Ratios
Activity Ratios Numerator Denominator
Inventory turnover Cost of goods sold Average inventory
Days of inventory in hand Number of days in period Inventory turnover
Receivables turnover Revenue Average receivables
Days of sales outstanding Number of days in period Receivables turnover
Payables turnover Purchases Average trade payables
Number of days of payables Number of days in period Payables turnover
Working capital turnover Revenue Average working capital
Fixed asset turnover Revenue Average net fixed assets
Total asset turnover Revenue Average total assets
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10. Commonly used Liquidity Ratios
Liquidity Ratios Numerator Denominator
Current ratio Current assets Current liabilities
Quick ratio Cash + short term
marketable investments +
receivables
Current liabilities
Cash Ratio Cash + short term
marketable investments
Current liabilities
Defensive intervals ratios Cash + short term
marketable investments +
receivables
Daily cash expenditures
Additional Liquidity Measures
Cash conversion cycle (net operating cycle) = Days of inventory on hand + days of sales
outstanding – number of days of payables
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11. Commonly used Solvency Ratios
Solvency Ratios Numerator Denominator
Debt Ratios
Debt to assets ratio Total debt Total assets
Debt to capital ratio Total debt Total debt + Total
shareholders equity
Debt to equity ratios Total debt Total shareholders equity
Financial leverage ratios Average total assets Average total equity
Coverage Ratios
Interest coverage EBIT Interest payments
Fixed charge coverage EBIT + lease payments Interest payments + lease
payments
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Financial Ratios

12. Commonly used Profitable Ratios
Profitability Ratios Numerator Denominator
Return on Sales
Gross profit margin Gross profit Revenue
Operating profit margin Operating income Revenue
Pretax margin EBT Revenue
Net profit margin Net income Revenue
Return on Investment
Operating ROA Operating income Average total assets
ROA Net income Average total assets
Return on total capital EBIT Short and long term debt
and equity
ROE Net income Average total equity
Return on common equity Net income – preferred
dividend
Average common equity
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13. Valuation Ratios
Valuation Ratios Numerator Denominator
P/E Ratio Price per share Earnings per share
P/B Ratio Price per share Book Value per share
EV/EBITDA Ratio Enterprise Value EBITDA
PEG Ratio PE Ratio EPS Growth Rate
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14. Coverage Ratios
Coverage Ratios Numerator Denominator
Interest Coverage Ratio EBIT Interest Expense
Fixed Charge Coverage
Ratio
EBIT + Fixed charges before
tax
Fixed charges before tax +
Interest
Debt Service Coverage Ratio Operating Income Total Debt service costs
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15. DuPont Analysis
The Dupont analysis also called the Dupont model is a financial ratio based on the
return on equity ratio that is used to analyze a company's ability to increase its return
on equity. In other words, this model breaks down the return on equity ratio to
explain how companies can increase their return for investors.
The Dupont analysis looks at three main components of the ROE ratio.
1.Profit Margin
2.Total Asset Turnover
3.Financial Leverage
Based on these three performances measures the model concludes that a company
can raise its ROE by maintaining a high profit margin, increasing asset turnover, or
leveraging assets more effectively.
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16. The DuPont Formulas
• The DuPont formula uses the
relationship among financial statement
accounts to decompose a return into
components.
• Three-factor DuPont for the return on
equity:
▫ Total asset turnover
▫ Financial leverage
▫ Net profit margin
• Five-factor DuPont for the return on
equity:
▫ Total asset turnover
▫ Financial leverage
▫ Operating profit margin
▫ Effect of nonoperating items
▫ Tax effect
Return on Equity
Net Profit
Margin
Operating Profit
Margin
Effect of
Nonoperating
Items
Tax
Effect
Total Asset
Turnover
Financial
Leverage
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17. DuPont Analysis
Return on
Equity
Return on
Asset
Net Profit
margin
Tax burden
Interest
Burden
EBIT
margin
Total Asset
Turnover
Financial
leverage
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18. Five-Component DuPont Model
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19. Example
Consider two companies A Ltd and Z Ltd
Both of these companies operate in the same apparel industry and have the same
return on equity ratio of 45 percent. This model can be used to show the strengths
and weaknesses of each company. Each company has the following ratios:
Ratio Sally Joe
• Profit Margin 30% 15%
• Total Asset Turnover .50 6.0
• Financial Leverage 3.0 .50
Calculate the ROE
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20. Analysis
As you can see, both companies have same ROE
• A Ltd ROE = .30*.50*3.0 = 45%
• Z Ltd ROE = .15*6.0*.50 = 45%
A Ltd is generating sales while maintaining a lower cost of goods as evidenced by its
higher profit margin. It is having a difficult time turning over large amounts of sales.
Z Ltd’s business, on the other hand, is selling products at a smaller margin, but it is
turning over a lot of products. You can see this from its low profit margin and extremely
high asset turnover.
This model helps investors compare similar companies like these with similar ratios.
Investors can then apply perceived risks with each company's business model.
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21. Summary
• Financial ratio analysis and common-size analysis help gauge the financial
performance and condition of a company through an examination of relationships
among these many financial items.
• A thorough financial analysis of a company requires examining its efficiency in
putting its assets to work, its liquidity position, its solvency, and its profitability.
• We can use the tools of common-size analysis and financial ratio analysis, including
the DuPont model, to help understand where a company has been.
• We then use relationships among financial statement accounts in pro forma analysis,
forecasting the company’s income statements and balance sheets for future periods,
to see how the company’s performance is likely to evolve.
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22. This is not the end…
• List of Ratios not exhaustive
• Numbers provide indicators
• Financial indicators vary from industry to industry
• Financial analysis is an art
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