Ratio analysis


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Ratio analysis

  1. 1. Financial Statement Analysis Prof. Anjali Kulkarni
  2. 2. <ul><li>Assessment of the firm’s past, present and future financial conditions </li></ul><ul><li>Done to find firm’s financial strengths and weaknesses </li></ul><ul><li>Primary Tools: </li></ul><ul><ul><li>Financial Statements </li></ul></ul><ul><ul><li>Comparison of financial ratios to past, industry, sector and all firms </li></ul></ul>Financial Analysis Prof. Anjali Kulkarni
  3. 3. Financial Statements <ul><li>Balance Sheet </li></ul><ul><li>Income Statement </li></ul><ul><li>Cashflow Statement </li></ul><ul><li>Statement of Retained Earnings </li></ul>Prof. Anjali Kulkarni
  4. 4. Sources of Data <ul><li>Annual reports </li></ul><ul><ul><li>Via mail, SEBI or company websites </li></ul></ul><ul><li>Published collections of data </li></ul><ul><ul><li>Newspapers, magazines etc. </li></ul></ul><ul><li>Investment sites on the web </li></ul><ul><ul><li>Examples </li></ul></ul><ul><ul><ul><li>http://moneycontrol.com </li></ul></ul></ul><ul><ul><ul><li>http://www.indiainfoline.com </li></ul></ul></ul>Prof. Anjali Kulkarni
  5. 5. Why needed ? <ul><li>Lenders’ need it for carrying out the following </li></ul><ul><li>Technical Appraisal </li></ul><ul><li>Commercial Appraisal </li></ul><ul><li>Financial Appraisal </li></ul><ul><li>Economic Appraisal </li></ul><ul><li>Management Appraisal </li></ul>Prof. Anjali Kulkarni
  6. 6. Ratio Analysis <ul><li>It’s a tool which enables the banker or lender to arrive at the following factors : </li></ul><ul><li>Liquidity position </li></ul><ul><li>Profitability </li></ul><ul><li>Solvency </li></ul><ul><li>Financial Stability </li></ul><ul><li>Quality of the Management </li></ul><ul><li>Safety & Security of the loans & advances to be or already been provided </li></ul>Prof. Anjali Kulkarni
  7. 7. Important Aspects <ul><li>Financial analysts often assess the firm's: </li></ul><ul><li>1. Profitability - Its ability to earn income and sustain growth in both short-term and long-term. A company's degree of profitability is usually based on the income statement , which reports on the company's results of operations; </li></ul><ul><li>2. Solvency - its ability to pay its obligation to creditors and other third parties in the long-term; </li></ul><ul><li>3. Liquidity - its ability to maintain positive cash flow , while satisfying immediate obligations; </li></ul><ul><li>Both 2 and 3 are based on the company's balance sheet , which indicates the financial condition of a business as of a given point in time. </li></ul><ul><li>4. Stability - the firm's ability to remain in business in the long run, without having to sustain significant losses in the conduct of its business. Assessing a company's stability requires the use of both the income statement and the balance sheet, as well as other financial and non-financial indicators. </li></ul>Prof. Anjali Kulkarni
  8. 8. Who All Needs It? <ul><li>Internal users </li></ul><ul><ul><li>Management for </li></ul></ul><ul><ul><ul><li>Performance evaluation – compensation and comparison between divisions </li></ul></ul></ul><ul><ul><ul><li>Planning for the future – guide in estimating future cash flows </li></ul></ul></ul><ul><li>External users </li></ul><ul><ul><li>Creditors </li></ul></ul><ul><ul><li>Suppliers </li></ul></ul><ul><ul><li>Customers </li></ul></ul><ul><ul><li>Stockholders </li></ul></ul>Prof. Anjali Kulkarni
  9. 9. <ul><li>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. </li></ul><ul><li>As Proportion - The above figures may be expressed in terms of the relationship between net profit to sales as 1 : 4. </li></ul><ul><li>As Pure Number /Times - The same can also be expressed in an alternative way such as the sale is 4 times of the net profit or profit is 1/4th of the sales. </li></ul>How a ratio is expressed ? Prof. Anjali Kulkarni
  10. 10. Five Major Categories of Ratios and Their Implications <ul><li>Liquidity: Can we make required payments? </li></ul><ul><li>Asset management: right amount of assets vs. sales? Also known as Turnover/ Activity Ratios. </li></ul><ul><li>Debt management: Right mix of debt and equity? Also known as Leverage/ Capital Structure Ratios . </li></ul><ul><li>Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? </li></ul><ul><li>Market value: Do investors like what they see as reflected in P/E and M/B ratios? Also known as Valuation Ratios . </li></ul>Prof. Anjali Kulkarni
  11. 11. Classification of Ratios Prof. Anjali Kulkarni Balance Sheet Ratio P&L Ratio or Income/Revenue Statement Ratio Balance Sheet and Profit & Loss Ratio Financial Ratio Operating Ratio Composite 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,
  12. 12. Format of Balance Sheet for Ratio Analysis Prof. Anjali Kulkarni LIABILITIES ASSETS NET WORTH/EQUITY/OWNED FUNDS Share Capital/Partner’s Capital/Paid up Capital/ Owners Funds Reserves ( General, Capital, Revaluation & Other Reserves) Credit Balance in P&L A/c FIXED ASSETS : LAND & BUILDING, PLANT & MACHINERIES Original Value Less Depreciation Net Value or Book Value or Written down value LONG TERM LIABILITIES/BORROWED FUNDS : Term Loans (Banks & Institutions) Debentures/Bonds, Unsecured Loans, Fixed Deposits, Other Long Term Liabilities NON CURRENT ASSETS Investments in quoted shares & securities Old stocks or old/disputed book debts Long Term Security Deposits Other Misc. assets which are not current or fixed in nature CURRENT LIABILTIES Bank Working Capital Limits such as CC/OD/Bills/Export Credit Sundry /Trade Creditors/Creditors/Bills Payable, Short duration loans or deposits Expenses payable & provisions against various items CURRENT ASSETS : Cash & Bank Balance, Marketable/quoted Govt. or other securities, Book Debts/Sundry Debtors, Bills Receivables, Stocks & inventory (RM,SIP,FG) Stores & Spares, Advance Payment of Taxes, Prepaid expenses, Loans and Advances recoverable within 12 months INTANGIBLE ASSETS Patent, Goodwill, Debit balance in P&L A/c, Preliminary or Preoperative expenses
  13. 13. Review: Income Statement <ul><li>Gross Profit = Sales - Costs of Goods Sold </li></ul><ul><li>EBITDA = Gross Profit - Cash Operating Expenses </li></ul><ul><li>EBIT = EBDIT - Depreciation - Amortization </li></ul><ul><li>EBT = EBIT - Interest </li></ul><ul><li>NI or EAT = EBT- Taxes </li></ul><ul><li>Net Income is a primary determinant of the firm’s cashflows and, thus, the value of the firm’s shares </li></ul>Prof. Anjali Kulkarni
  14. 14. Some Basics <ul><li>Liabilities have Credit balance and Assets have Debit balance </li></ul><ul><li>Current Liabilities are those which have either become due for payment or shall fall due for payment within 12 months from the date of Balance Sheet </li></ul><ul><li>Current Assets are those which undergo change in their shape/form within 12 months. These are also called Working Capital or Gross Working Capital </li></ul><ul><li>Net Worth & Long Term Liabilities are also called Long Term Sources of Funds </li></ul>Prof. Anjali Kulkarni
  15. 15. <ul><li>Current Liabilities are known as Short Term Sources of Funds </li></ul><ul><li>Long Term Liabilities & Short Term Liabilities are also called Outside Liabilities </li></ul><ul><li>Current Assets are Short Term Use of Funds </li></ul><ul><li>Assets other than Current Assets are Long Term Use of Funds </li></ul><ul><li>Installments of Term Loan Payable in 12 months are to be taken as Current Liability only for Calculation of Current Ratio & Quick Ratio. </li></ul><ul><li>If there is profit it shall become part of Net Worth under the head Reserves and if there is loss it will become part of Intangible Assets </li></ul>Some Basics Prof. Anjali Kulkarni
  16. 16. <ul><li>Investments in Govt. Securities to be treated current only if these are marketable and due. Investments in other securities are to be treated current if they are quoted. Investments in allied/associate/sister units or firms to be treated as non-current. </li></ul><ul><li>Bonus Shares as issued by capitalization of General reserves and as such do not affect the Net Worth. With Rights Issue, change takes place in Net Worth and Current Ratio. </li></ul>Some Basics Prof. Anjali Kulkarni
  17. 17. Ratios : Liquidity <ul><li>1. Current Ratio : It is the relationship between the current </li></ul><ul><li>assets and current liabilities of a concern. </li></ul><ul><li>Current Ratio = Current Assets/Current Liabilities </li></ul><ul><li>If the Current Assets and Current Liabilities of a concern are </li></ul><ul><li>Rs.4,00,000 and Rs.2,00,000 respectively, then the Current </li></ul><ul><li>Ratio will be : Rs.4,00,000/Rs.2,00,000 = 2 : 1 </li></ul><ul><li>The ideal Current Ratio preferred by Banks is 1.33 : 1 </li></ul><ul><li>2. Net Working Capital : This is worked out as surplus of Long Term Sources over Long Term Uses, alternatively it is the difference of Current Assets and Current Liabilities. </li></ul><ul><li>NWC = Current Assets – Current Liabilities </li></ul>Prof. Anjali Kulkarni
  18. 18. <ul><li>3. ACID TEST or QUICK RATIO : It is the ratio between Quick Current Assets and Current Liabilities . </li></ul><ul><li>Quick Current Assets : Cash/Bank Balances + Receivables upto 6 months + Quickly realizable securities such as Govt. Securities or quickly marketable/quoted shares and Bank Fixed Deposits. </li></ul><ul><li>Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities </li></ul><ul><li>Example : </li></ul><ul><li>Cash 50,000 </li></ul><ul><li>Debtors 1,00,000 </li></ul><ul><li>Inventories 1,50,000 Current Liabilities 1,00,000 </li></ul><ul><li>Total Current Assets 3,00,000 </li></ul><ul><li>Current Ratio = > 3,00,000/1,00,000 = 3 : 1 </li></ul><ul><li>Quick Ratio = > 1,50,000/1,00,000 = 1.5 : 1 </li></ul>Ratios : Liquidity Prof. Anjali Kulkarni
  19. 19. Ratios: Leverage <ul><li>4. DEBT EQUITY RATIO : It is the relationship between borrower’s fund (Debt) and Owner’s Capital (Equity). </li></ul><ul><li> Debt </li></ul><ul><li> DER = ----------- </li></ul><ul><li> Equity </li></ul><ul><li> Debentures + Long Term loans </li></ul><ul><li> = ------------------------------------------------------------------------------------- </li></ul><ul><li> Equity Shares+ Preference Shares + Reserves and Surplus </li></ul><ul><li>For instance, if the Firm is having the following : </li></ul><ul><li>Capital = Rs. 200 Lacs </li></ul><ul><li>Free Reserves & Surplus = Rs. 300 Lacs </li></ul><ul><li>Long Term Loans/Liabilities = Rs. 800 Lacs </li></ul><ul><li>Debt Equity Ratio will be => 800/500 i.e. 1.6 : 1 </li></ul>Prof. Anjali Kulkarni
  20. 20. <ul><li>5. PROPRIETARY RATIO : This ratio indicates the extent to which Tangible Assets are financed by Owner’s Fund. </li></ul><ul><li>Proprietary Ratio = (Tangible Net Worth/Total Tangible Assets) x 100 </li></ul><ul><li>T he ratio will be 100% when there is no Borrowing for purchasing of Assets. </li></ul><ul><li>6. GEARING RATIO Debt + Preference Shares </li></ul><ul><li> = --------------------------------------- </li></ul><ul><li> Equity </li></ul><ul><li>7. INTEREST COVERAGE RATIO: Extent of earnings available to pay off interest burden. Is given by </li></ul><ul><li>Earnings Before Interest and Taxes (EBIT ) </li></ul><ul><li>ICR = ------------------------------------------------------- </li></ul><ul><li>Interest </li></ul>Ratios : Leverage Prof. Anjali Kulkarni
  21. 21. Ratios: Profitability <ul><li>8. GROSS PROFIT RATIO : By comparing Gross Profit percentage to Net Sales we can arrive at the Gross Profit Ratio which indicates the manufacturing efficiency as well as the pricing policy of the concern. </li></ul><ul><li>Gross Profit Ratio = (Gross Profit / Net Sales ) x 100 </li></ul><ul><li>Alternatively , since Gross Profit is equal to Sales minus Cost of Goods Sold, it can also be interpreted as below : </li></ul><ul><li>Gross Profit Ratio = [ (Sales – Cost of goods sold)/ Net Sales] x 100 </li></ul><ul><li>A higher Gross Profit Ratio indicates efficiency in production of the unit. </li></ul>Prof. Anjali Kulkarni
  22. 22. <ul><li>9. OPERATING PROFIT RATIO : </li></ul><ul><li>It is expressed as => (Operating Profit / Net Sales ) x 100 </li></ul><ul><li>Higher OP ratio indicates higher operational efficiency </li></ul><ul><li>Operating Profit = NP + Non-operating Expenses – Non-operating Income </li></ul><ul><li>10. NET PROFIT RATIO : </li></ul><ul><li>It is expressed as => ( Net Profit / Net Sales ) x 100 </li></ul><ul><li>It measures overall profitability. </li></ul>Ratios : Profitability Prof. Anjali Kulkarni
  23. 23. <ul><li>11. STOCK/INVENTORY TURNOVER RATIO : </li></ul><ul><li> COGS </li></ul><ul><li>STR = ----------------------------- </li></ul><ul><li>Average Inventory </li></ul><ul><li> (Opening Stock + Closing Stock) </li></ul><ul><li>Average Inventory or Stocks = ------------------------------------------------- </li></ul><ul><li>2 </li></ul><ul><li>COGS = Sales – GP or OS+ Purchases – CS </li></ul><ul><li>This ratio indicates the number of times the inventory </li></ul><ul><li>is rotated during the relevant accounting period </li></ul>Ratios : Turnover Prof. Anjali Kulkarni
  24. 24. <ul><li>12. DEBTORS TURNOVER RATIO : This ratio reflects the relationship between credit sales and debtors. </li></ul><ul><li> Credit Sales </li></ul><ul><li>DTR = ----------------------------- </li></ul><ul><li>Average Debtors </li></ul><ul><li> 365 </li></ul><ul><li>Average Collection Period = ---------------- </li></ul><ul><li> DTR </li></ul><ul><li>13. CREDIT TURNOVER RATIO : This ratio indicates the intention of the firm to pay quickly to its creditors </li></ul><ul><li> Credit Purchases </li></ul><ul><li>CTR = -------------------------------- </li></ul><ul><li>Average Creditors </li></ul><ul><li> 365 </li></ul><ul><li>Average Payment Period = ------------- </li></ul><ul><li> CTR </li></ul>Ratios : Turnover Prof. Anjali Kulkarni
  25. 25. <ul><li>14. CURRENT ASSET TURNOVER RATIO : </li></ul><ul><li>CATR = Net Sales / Current Assets </li></ul><ul><li>15. FIXED ASSET TURNOVER RATIO : </li></ul><ul><li>FATR = Net Sales /Fixed Assets </li></ul><ul><li>16. TOTAL ASSETS TURNOVER RATIO : </li></ul><ul><li>TATR = Net Sales / Total Assets </li></ul>Ratios : Turnover Prof. Anjali Kulkarni
  26. 26. <ul><li>16. RETRUN ON ASSETS : Net Profit after Taxes/Total Assets </li></ul><ul><li>17 . RETRUN ON CAPITAL EMPLOYED : </li></ul><ul><li>( Net Profit before Interest & Tax / Average Capital Employed) x 100 </li></ul><ul><li>Average Capital Employed is the average of the equity share capital and long term funds provided by the owners and the creditors of the firm at the beginning and end of the accounting period. </li></ul>Ratios : Profitability Prof. Anjali Kulkarni
  27. 27. <ul><li>17. RETRUN ON EQUITY CAPITAL (ROE) : </li></ul><ul><li>Net Profit after Taxes / Tangible Net Worth </li></ul><ul><li>EARNING PER SHARE : EPS indicates the quantum of net profit of the year that would be ranking for dividend for each share of the company being held by the equity share holders . </li></ul><ul><li>Net profit after Taxes and Preference Dividend/ No. of Equity Shares </li></ul><ul><li>19. PRICE EARNING RATIO : PE Ratio indicates the number of times the Earning Per Share is covered by its market price . </li></ul><ul><li>Market Price Per Equity Share/Earning Per Share </li></ul>Prof. Anjali Kulkarni
  28. 28. <ul><li>20. DEBT SERVICE COVERAGE RATIO : This ratio is one of the most important one which indicates the ability of an enterprise to meet its liabilities by way of payment of installments of Term Loans and Interest thereon from out of the cash accruals and forms the basis for fixation of the repayment schedule in respect of the Term Loans raised for a project. (The Ideal DSCR Ratio is considered to be 2 ) </li></ul><ul><li>PAT + Depr. + Annual Interest on Long Term Loans & Liabilities </li></ul><ul><li>--------------------------------------------------------------------------------- </li></ul><ul><li>Annual interest on Long Term Loans & Liabilities + Annual Installments payable on Long Term Loans & Liabilities </li></ul><ul><li>( Where PAT is Profit after Tax and Depr. is Depreciation) </li></ul>Prof. Anjali Kulkarni
  29. 29. Limitations of Financial Statement Analysis Prof. Anjali Kulkarni <ul><li>We must be careful with financial statement analysis. </li></ul><ul><ul><li>Strong financial statement analysis does not necessarily mean that the organisation has a strong financial future. </li></ul></ul><ul><ul><li>Financial statement analysis might look good but there may be other factors that can cause an organisation to collapse. </li></ul></ul><ul><ul><li>Published industry averages are only guidelines </li></ul></ul><ul><ul><li>Accounting practices differ across firms </li></ul></ul><ul><ul><li>Sometimes difficult to interpret deviations in ratios </li></ul></ul><ul><ul><li>Industry ratios may not be desirable targets </li></ul></ul><ul><ul><li>Seasonality affects ratios </li></ul></ul><ul><ul><li>Window dressing techniques can make statements and ratios look better </li></ul></ul>
  30. 30. Prof. Anjali Kulkarni More issues regarding ratios <ul><li>Different operating and accounting practices can distort comparisons. </li></ul><ul><li>Sometimes it is hard to tell if a ratio is “good” or “bad”. </li></ul><ul><li>Difficult to tell whether a company is, on balance, in strong or weak position. </li></ul>
  31. 31. Prof. Anjali Kulkarni Qualitative factors to be considered when evaluating a company’s future financial performance <ul><li>Are the firm’s revenues tied to 1 key customer, product, or supplier? </li></ul><ul><li>What percentage of the firm’s business is generated overseas? </li></ul><ul><li>Competition </li></ul><ul><li>Future prospects </li></ul><ul><li>Legal and regulatory environment </li></ul>
  32. 32. Common Size Statements Prof. Anjali Kulkarni Common-size statements use percentages to express the relationship of individual components to a total within a single period. This is also known as vertical analysis .
  33. 33. Common Size Statements <ul><ul><li>For Common Size Balance Sheets, </li></ul></ul><ul><ul><li>Compute all accounts as a percent of total assets or liabilities </li></ul></ul><ul><ul><li>For Common Size Income Statements </li></ul></ul><ul><ul><li>Compute all line items as a percent of sales </li></ul></ul>Prof. Anjali Kulkarni
  34. 34. Prof. Anjali Kulkarni Common Size Balance Sheets: Divide All Items by Total Assets Assets 200 6 200 7 200 8 Cash 0.6% 0.3% 0.4% ST Invest. 3.3% 0.7% 2.0% AR 23.9% 21.9% 25.0% Invent. 48.7% 44.6% 48.8% Total CA 76.5% 67.4% 76.2% Net FA 23.5% 32.6% 23.8% TA 100.0% 100.0% 100.0%
  35. 35. Prof. Anjali Kulkarni Divide all items by Total Liabilities & Equity 200 6 200 7 200 8 AP 9.9% 11.2% 10.2% Notes pay. 13.6% 24.9% 8.5% Accruals 9.3% 9.9% 10.8% Total CL 32.8% 46.0% 29.6% LT Debt 22.0% 34.6% 14.2% Total eq. 45.2% 19.3% 56.2% Total L&E 100.0% 100.0% 100.0%
  36. 36. Prof. Anjali Kulkarni Trend analysis <ul><li>Analyzes a firm’s financial ratios over time </li></ul><ul><li>Can be used to estimate the likelihood of improvement or deterioration in financial condition. </li></ul>
  37. 37. Trend Percentages Prof. Anjali Kulkarni Trend percentages state several years’ financial data in terms of a base year, which equals 100 percent.
  38. 38. Trend Analysis Prof. Anjali Kulkarni Trend Percentage Current Year Amount Base Year Amount 100% = ×
  39. 39. Du Pont Analysis <ul><li>The Du Pont system focuses on: </li></ul><ul><ul><li>Expense control (PM) </li></ul></ul><ul><ul><li>Asset utilization (TATO) </li></ul></ul><ul><ul><li>Debt utilization (EM) </li></ul></ul><ul><li>It shows how these factors combine to determine the ROE. </li></ul>Prof. Anjali Kulkarni
  40. 40. Prof. Anjali Kulkarni Deriving the Du Pont Identity <ul><li>ROE = NI / E </li></ul><ul><li>Multiply by 1 and then rearrange </li></ul><ul><ul><li>ROE = (NI / E) (TA / TA) </li></ul></ul><ul><ul><li>ROE = (NI / TA) (TA / E) = ROA * EM </li></ul></ul><ul><li>Multiply by 1 again and then rearrange </li></ul><ul><ul><li>ROE = (NI / TA) (TA / E) (Sales / Sales) </li></ul></ul><ul><ul><li>ROE = (NI / Sales) (Sales / TA) (TA / E) </li></ul></ul><ul><ul><li>ROE = PM * TATR * EM </li></ul></ul>
  41. 41. The DuPont System Prof. Anjali Kulkarni
  42. 42. The DuPont System Prof. Anjali Kulkarni
  43. 43. The DuPont System Prof. Anjali Kulkarni
  44. 44. The DuPont System Prof. Anjali Kulkarni
  45. 45. The DuPont System Prof. Anjali Kulkarni
  46. 46. Q.1Following is the profit for the year ended : Prof. Anjali Kulkarni Particulars Rs. Rs. Sales - COGS Gross Profit - Operating Expenses Net Profit -Taxes Net Profit After Tax
  47. 47. Du Pont Chart Evolution Prof. Anjali Kulkarni Strategic Drivers Operating Drivers Industry Attractiveness Competitive Position Revenue/ Customer Customer Service Level Receivables Policy Sourcing Costs Original Du Pont Chart High Level Financial Drivers The idea has been extended forward to shareholder value … and back to the operating and strategic drivers of value. Price Cost W/c NFA Margin Turnover ROI Financing Contribution ROE NI Growth Cash Flow COC Value