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Ratio Analysis concept in Accounting

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Ratio analysis

  3. 3. Ratio Analysis –Measure relationships between resources and financial flows –Show ways in which firm’s situation deviates from • Its own past • Other firms • The industry
  4. 4. Ratio Analysis The study and interpretation of the relationships between various financial variables, by investors or lenders.
  5. 5. Ratio Analysis - SignificanceRatio Analysis - SignificanceRatio Analysis - SignificanceRatio Analysis - Significance The discussion of ratios will include the following types of comparisons. A single ratio by itself is not very meaningful.
  6. 6. • To identify aspects of a business’s performance to aid decision making • Quantitative process – may need to be supplemented by qualitative factors to get a complete picture • Standardize financial information for comparisons Ratio Analysis - PurposeRatio Analysis - PurposeRatio Analysis - PurposeRatio Analysis - Purpose
  7. 7. • Provide the all-important early warning indications that allow us to solve our business problems before our business is destroyed by those problems. • Enables the business owner/manager to spot trends in a business Ratio Analysis - SignificanceRatio Analysis - SignificanceRatio Analysis - SignificanceRatio Analysis - Significance
  8. 8. 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.
  9. 9. Ratio Analysis
  10. 10. Ratio Analysis 1. Liquidity – the ability of the firm to pay its way 2. Investment/shareholders – information to enable decisions to be made on the extent of the risk and the earning potential of a business investment 3. Gearing – information on the relationship between the exposure of the business to loans as opposed to share capital 4. Profitability – how effective the firm is at generating profits given sales and or its capital assets 5. Financial – the rate at which the company sells its stock and the efficiency with which it uses its assets
  11. 11. TERMS USED IN RATIO ANALYSIS • Current Assets • Quick Assets (Current Assets- Inventories- Prepaid Expenses) • Absolute Liquid Assets (Cash, bank & short term securities) • Working Capital • Receivables • Payables • Fixed Assets • Fictitious Assets • Intangible Assets
  12. 12. TERMS USED IN RATIO ANALYSIS • Capital Employed • Investments • Current Liabilities • Debt • Equity • Cost of Goods Sold • Cost of Sales • Long term funds • Long term loans
  13. 13. 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 Ratio Current Ratio Quick Asset 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,
  14. 14. Format of balance sheet for ratio analysis 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
  15. 15. Some important notes • Liabilities have Credit balance and Assets have Debit balance • 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 • Current Assets are those which undergo change in their shape/form within 12 months. These are also called Working Capital or Gross Working Capital • Net Worth & Long Term Liabilities are also called Long Term Sources of Funds • Current Liabilities are known as Short Term Sources of Funds • Long Term Liabilities & Short Term Liabilities are also called Outside Liabilities • Current Assets are Short Term Use of Funds
  16. 16. Some important notes • Assets other than Current Assets are Long Term Use of Funds • Installments of Term Loan Payable in 12 months are to be taken as Current Liability only for Calculation of Current Ratio & Quick Ratio. • Investments in Govt. Securities to be treated current only if these are marketable and due. Investments in other securities are to be treated as Current if they are quoted. Investments in allied/associate/sister units or firms to be treated as Non-current. • 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.
  17. 17. Groups of Financial Ratios Liquidity Activity Debt Profitability
  18. 18. Liquidity
  19. 19. Analyzing Liquidity Liquidity refers to the solvency of the firm's overall financial position, i.e. a "liquid firm" is one that can easily meet its short-term obligations as they come due. A second meaning includes the concept of converting an asset into cash with little or no loss in value.
  20. 20. 1. Current Ratio : It is the relationship between the current assets and current liabilities of a concern. Current Ratio = Current Assets/Current Liabilities If the Current Assets and Current Liabilities of a concern are Rs.4,00,000 and Rs.2,00,000 respectively, then the Current Ratio will be : Rs.4,00,000/Rs.2,00,000 = 2 : 1
  21. 21. Current Ratio • Ideal level? – 2 : 1 • The ideal Current Ratio preferred by Banks is 1.33 : 1 • A ratio of 5 : 1 would imply the firm has Rs.5 of assets to cover every Rs.1 in liabilities • A ratio of 0.75 : 1 would suggest the firm has only 75p in assets available to cover every Rs.1 it owes • Too high – Might suggest that too much of its assets are tied up in unproductive activities – too much stock, for example? • Too low - risk of not being able to pay your way
  22. 22. 2. ACID TEST or QUICK RATIO or Liquid Ratio : It is the ratio between Quick Current Assets and Current Liabilities. Quick Current Assets : Cash/Bank Balances + Receivables upto 12 months + Quickly realizable securities such as Govt. Securities or quickly marketable/quoted shares and Bank Fixed Deposits Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities (Current assets – stock-prepaid expenses) : liabilities • 1.5:1 seen as ideal • The omission of stock gives an indication of the cash the firm has in relation to its liabilities (what it owes) • A ratio of 3:1 therefore would suggest the firm has 3 times as much cash as it owes – very healthy! • A ratio of 0.5:1 would suggest the firm has twice as many liabilities as it has cash to pay for those liabilities. This might put the firm under pressure but is not in itself the end of the world!
  23. 23. 3. ABSOLUTE LIQUIDITY TEST or Cash Ratio : It is the ratio between Absolute liquid assets and Current Liabilities. Quick Current Assets : Cash/Bank Balances + Quickly realizable securities such as Govt. Securities or quickly marketable/quoted shares and Bank Fixed Deposits Absolute Liquidity Ratio = Absolute Liquid Assets/Current Liabilities (Current assets – stock-receivables) : liabilities 0.5:1 seen as ideal • The omission of stock and receivables gives an indication of the cash the firm has in relation to its liabilities (what it owes) • A ratio of 3:1 therefore would suggest the firm has 6 times as much cash as it owes – very healthy! • A ratio of 0.2:1 would suggest the firm has five times as many liabilities as it has ready cash to pay for those liabilities. This might put the firm under pressure but is not in itself the end of the world! 4. NET WORKING CAPITAL : Current Assets – Current Liabilities
  24. 24. Example : Cash 50,000 Debtors 1,00,000 Inventories 1,50,000 Current Liabilities 1,00,000 Total Current Assets 3,00,000 Current Ratio = > 3,00,000/1,00,000 = 3:1 Quick Ratio = > 1,50,000/1,00,000 = 1.5:1 Absolute Liquidity Ratio = > 50,000/1,00,000 = .5:1 Net Working Capital => 300000-100000 = 200000
  25. 25. Analyzing Activity Activity is a more sophisticated analysis of a firm's liquidity, evaluating the speed with which certain accounts are converted into sales or cash; also measures a firm's efficiency
  26. 26. Inventory Turnover (IT) Average Collection Period (ACP) Average Payment Period (APP) Fixed Asset Turnover (FAT) Total Asset Turnover (TAT) Cost of Goods Sold IT = Average Inventory Accounts Receivable ACP = Annual Sales/360 Accounts Payable APP= Annual Purchases/360 Sales FAT = Net Fixed Assets Sales TAT = Total Assets Five Important Activity Measures
  27. 27. STOCK/INVENTORY TURNOVER RATIO : STR = COGS/ Average Stock Average Conversion period = 365/12/52 STR Average Inventory or Stocks = (Opening Stock + Closing Stock) ----------------------------------------- 2 • This ratio indicates the number of times the inventory is rotated during the relevant accounting period • A high stock turnover might mean increased efficiency? But: dependent on the type of business – supermarkets might have high stock turnover ratios whereas a shop selling high value musical instruments might have low stock turnover ratio • Low stock turnover could mean poor customer satisfaction if people are not buying the goods
  28. 28. DEBTORS TURNOVER RATIO : This is also called Debtors Velocity or Average Collection Period or Period of Credit given . DTR = Net Credit Sales/ Average Receivables Average Collection period (Debtors Days) = 365/52/12 DTR This ratio tells about the time taken to collect money from the debtors ACP: • Shorter the better • Gives a measure of how long it takes the business to recover debts • Can be skewed by the degree of credit facility a firm offers
  29. 29. CREDITORS TURNOVER RATIO : This is also called Creditors Velocity Ratio, which determines the creditor payment period. CTR = Net Credit Purchase/ Average Payables Average Payment period (Creditors Days) = 365/52/12 CTR This ratio tells about the time available to make payment to the creditors APP: • Higher the better • Gives a measure of how long it takes the business to pay its debts
  30. 30. ASSET TRUNOVER RATIO : Net Sales/Tangible Assets FIXED ASSET TURNOVER RATIO : Net Sales /Fixed Assets CURRENT ASSET TURNOVER RATIO : Net Sales / Current Assets
  31. 31. Asset Turnover • Asset Turnover = Sales turnover / assets employed • Using assets to generate profit • Asset turnover x net profit margin = ROCE
  32. 32. Profitability
  33. 33. Profitability ratios measure the overall performance of a firm and its efficiency in managing assets, liabilities, and equity. Key Financial Ratios Profitability Ratios
  34. 34. Profitability ratios include • gross profit margin • operating profit margin • net profit margin • cash flow margin • return on total assets (ROA) or return on investment (ROI) • return on equity (ROE) • cash return on assets Key Financial Ratios Profitability Ratios
  35. 35. Profitability • Gross Profit Margin = Gross profit / turnover x 100 • The higher the better • Enables the firm to assess the impact of its sales and how much it cost to generate (produce) those sales • A gross profit margin of 45% means that for every £1 of sales, the firm makes 45p in gross profit
  36. 36. Profitability • Net Profit Margin = Net Profit / Turnover x 100 • Net profit takes into account the fixed costs involved in production – the overheads • Keeping control over fixed costs is important – could be easy to overlook for example the amount of waste - paper, stationery, lighting, heating, water, etc. – e.g. – leaving a photocopier on overnight uses enough electricity to make 5,300 A4 copies. (1,934,500 per year) – 1 ream = 500 copies. 1 ream = £5.00 (on average) – Total cost therefore = £19,345 per year – or 1 person’s salary
  37. 37. Profitability • Operating Profit Margin = Operating Profit / Turnover x 100 Measures overall operating efficiency and incorporates all of the expenses associated with ordinary business activities
  38. 38. Profitability • Return on Capital Employed (ROCE) = Profit / capital employed x 100 • Be aware that there are different interpretations of what capital employed means – see http://www.bized.ac.uk/compfact/ratios/ror3.htm for more information!
  39. 39. Profitability Ratios Overall Efficiency and Performance Measures ability to translate sales into cash Cash Flow Margin Cash flow from operating activitiesCash flow from operating activities Net salesNet sales
  40. 40. Profitability Ratios Overall Efficiency and Performance Measures overall efficiency of firm in managing investment in assets and generating profits Return on Total Assets (ROA) or Return on Investment (ROI) Net earningsNet earnings Total assetsTotal assets
  41. 41. Profitability Ratios Overall Efficiency and Performance Measures rate of return on stockholders’ investment Return on Equity (ROE) Net earningsNet earnings Stockholders’ equityStockholders’ equity
  42. 42. Profitability Ratios Overall Efficiency and Performance Measures firm’s ability to generate cash from the utilization of its assets Cash Return on Assets Cash flow from operating activitiesCash flow from operating activities Total assetsTotal assets
  43. 43. Operating Ratio Thais ratio establishes relationships between operating cost & net sales. This ratio indicates the proportion that the cost of sales. Cost of sale included direct cost of good sold & as well as other operating expenses administration, selling & distribution expenses Operating ratio = Cost of good sold + operating expenses X 100 Net sale = Operating cost X 100 Net sale Cost of good sold = opening stock + purchase + direct expenses – closing stock – GP Operating expenses = administrative expenses + selling & distribution expenses
  44. 44. OBJECTIVE & SIGNIFICANCE Operating ration is the test of the operational efficiency of the business .it shows the percentage of sales that is absorbed by the cost of sales & operating expenses. This ratio serves following objective 1. To determine whether the cost content has increased or decreased in the figure of sales. 2. To determine which element of the cost has gone up.
  45. 45. Example:  Cost of good sales 6 lac Operating expenses 40,000 Sales 8,20,000 Sales returns 20,000 Operating Ratio = Cost of good sold + operating expenses X 100 Net Sales = 6 lac + 40000 X 100 820000-20000 = 640000 X 100 800000 = 80%
  46. 46. Profitability • The higher the better • Shows how effective the firm is in using its capital to generate profit • A ROCE of 25% means that it uses every Rs.1 of capital to generate 25p in profit • Partly a measure of efficiency in organisation and use of capital
  47. 47. Key Financial Ratios Leverage Ratios Leverage ratios measure the extent of a firm’s financing with debt relative to equity and its ability to cover interest and other fixed charges.
  48. 48. Key Financial Ratios Leverage Ratios Leverage ratios include • Debt ratio • Long-term debt to total capitalization • Debt to equity • Times interest earned • Fixed charge coverage • Cash flow adequacy
  49. 49. Analyzing Debt Debt is a true "double-edged" sword as it allows for the generation of profits with the use of other people's (creditors) money, but creates claims on earnings with a higher priority than those of the firm's owners. Financial Leverage is a term used to describe the magnification of risk and return resulting from the use of fixed-cost financing such as debt and preferred stock.
  50. 50. SOLVENCY RATIOS The term ‘solvency’ implies ability of an enterprise to meet its long-term indebtedness and thus, solvency ratios convey an enterprises ability to meet its long-term obligations. Some important solvency ratios are : • Debt-Equity Ratio, • Interest Coverage Ratio, • Debt to Total Funds Ratio, • Fixed Asset Ratio,
  51. 51. Debt Equity Ratio. The debt-equity ratio is worked out to ascertain soundness of the long-term financial policies of the firm. The ratio ascertained as follows; Debt-Equity Ratio = Debt (Long-Term Loans) Equity (Shareholders’ Funds) Dept – equity ratio indicates the proportion between shareholders’ funds and the long-term borrowed funds. A higher ratio indicates a risky financial position while a lower ratio indicates safer financial position.
  52. 52. Objective and Significance This ratio is sufficient to assess the soundness of long-term financial position. It also indicates the extent to which the firm depends upon outsiders for its existence
  53. 53. Ascertain Dept-Equity ratio; Equity share capital 2,00,000 General reserve 1,60,000 10% debenture 1,50,000 Current liabilities 1,00,000 Preliminary expenses 10,000 Solution ; Dept-equity Ratio = Dept Equity Dept = debentures = Rs. 1,50,000 Equity= Equity Share Capital + General Reserve- preliminary Expenses = 2,00,000+1,60,000-10,000 = 3,50,000 Dept-Equity ratio= 1,50,000 3,50,000 = 15:35= 3:7
  54. 54. Interest Coverage ratio: when a business borrows money, the lender is interested in finding out whether the business would earn sufficient profit to pay periodically the interest charge. A ratio which expresses this is called Interest Coverage Ratio or Dept service Ratio or fixed charges cover. This ratio is determined by dividing profit before interest by the interest charges Interest Coverage Ratio =Net profit before interest and tax Interest on fixed (long-term) loans or Debentures
  55. 55. Objective and Significance : This ratio indicates how many times the profit covers fixed interest. It measures the margin of safety for the lenders. The higher the number, more secure the lender is in respect of his periodical interest income.
  56. 56. Example: The operating profit of Exe. Ltd. After charging interesr on debentures and tax is Rs 1,00,000. The amount of interest is Rs 20,000 and the provision for tax has been made at Rs 40,000. Calculate the interest coverage ratio. Solution: Interest Coverage Ratio = net profit before interest and tax Interest charges = 1,60,000 20,000
  57. 57. DEBT TO TOTAL FUNDS RATIO • The Debt to Total Funds Ratio is a measure for long term financial soundness. • Debt Total Funds Ratio = Debt Equity + Debt • Objective and Significance: The main purpose of the ratio is to determine the relative stock of outsiders and shareholders.
  58. 58. Calculate Debt to Total Funds Ratio: 9% Pref. Share Capital 10,00,000 Equity Share Capital 20,00,000 Reserves 10,00,000 10% Debentures 30,00,000 Loans From Industrial Finance corporation 20,00,000 Current liabilities 8,00,000 Debt to Total Funds Ratio = Long-term loans Shareholders funds + Long-term loans = 30,00,000 + 20,00,000 10,00,000 + 20,00,000 + 10,00,000 + 30,00,000 + 20,00,000 = Rs. 50,00,000 = 5 : 9 or 0.56. Rs. 90,00,000
  59. 59. FIXED ASSETS RATIO Fixed Assets Ratio = Shareholders’ funds + Long-term loans Net Fixed Assets Objective and Significance. This ratio indicates as to what extent fixed assets are financed out of long-term solvency.
  60. 60. Calculate Fixed Assets Ratio: Share capital 2,00,000 Reserves 50,000 9% Debentures 2,00,000 Trade Creditors 75,000 Plant and Machinery 2,00,000 Land and Building 2,00,000 Furniture 50,000 Trade Debtors 60,000 Cash Balance 40,000 Bills Payable 24,000 Stock 80,000 Fixed Assets Ratio = Long-term Funds Fixed Assets = 2,00,000 + 50,000 + 2,00,000 = 4,50,000 = 1 2,00,000 + 2,00,000 + 50,000 4,50,000
  61. 61. RETURN ON EQUITY  Common shareholders are entittled to the residual profit.The rate of divident is not fixed and earning may be distributed to shareholders or retained in the business.  A ROE is calculated to se the profitability of owner’s investment.  ROE indicates how well the firm has used the resources of owners.  It is a most important relationship in financial analysis. Formula: ROE= PAI . Net Worth Equity
  62. 62. Earning per share • It is a measure for calculating the profitability of shareholder’s investment. • EPS is calculated as;EPS=PAT/NO. OF OUTSTANDING SHARES • EPS shows the profitability of the firm on share basis,it does’t reflect how much is paid as dividend and how much is retained in the business? But as profitability index as it is valuable. • The higher the EPS,the more attractive will be the investment plan or vice-versa
  63. 63. Return on investment  The term investment refer to total asset or net asset.  the conventional approach of calculating ROI is to divide PAT by investment,investment represents pool of funds,supplied by shareholders and lenders,  while pat represents residue income of shareholders.  The formulae for calculating ROI is;  ROI=ROTA=EBIT(1-T)/ TA OR NA  Since taxes are not controllable by management and firm’s opportunities far availing tax incentives differ,it may be more prudent to use before tax measure of ROI,thus the before tax ratios are;  ROI=ROTA=EBIT/TA OR NA
  64. 64. Investment/Shareholders
  65. 65. Key Financial Ratios Market Ratios Market ratios measure returns to stockholders and the value the marketplace puts on a company’s stock. Market ratios include • earnings per common shareearnings per common share • price-to-earningsprice-to-earnings • dividend payoutdividend payout • dividend yielddividend yield
  66. 66. Market Ratios Earnings per Common Share Provides the investor with a common denominator to gauge investment returns Earnings per Common Share Net earningsNet earnings Average shares outstandingAverage shares outstanding
  67. 67. Market Ratios Price-to-Earnings Relates earnings per common share to the market price at which the stock trades, expressing the “multiple” that the stock market places on a firm’s earnings Price-to-Earnings Market price of common stockMarket price of common stock Earnings per shareEarnings per share
  68. 68. PEG Ratio • The market is usually more concerned about the future than the present, it is always looking for some way to figure out what is going to happen in the companies future. • PEG = (P/E) / (projected growth in earnings)
  69. 69. • The lower the PEG number, the less you pay for each unit of future earnings growth. So even a stock with a high P/E, but high projected earning growth may be a good value.
  70. 70. You have a stock with a low P/E. Since the stock has a low P/E, you start do wonder why the stock has a low P/E. Is it that the stock market does not like the stock? Or is it that the stock market has overlooked a stock that is actually fundamentally very strong and of good value?
  71. 71. • If the PEG ratio is big (or close to the P/E ratio), kind of stock that the stock market thinks is of not much value. On the other hand, if the PEG ratio is small (or very small as compared to the P/E ratio, kind of fundamentally strong stock that the market has overlooked for some reason.
  72. 72. Market Ratios Dividend Payout Determined by the formula cash dividends per share divided by earnings per share Dividend Payout Dividends per shareDividends per share Earnings per shareEarnings per share
  73. 73. Market Ratios Dividend Yield Shows the relationship between cash dividends and market price Dividend Yield Dividends per shareDividends per share Market price of common stockMarket price of common stock
  74. 74. Analyzing the Data There are five broad areas that would typically constitute a fundamental analysis of financial statements: • Background on the firm, industry, economy, and outlook • Short-term liquidity • Operating efficiency • Capital structure and long-term solvency • Profitability
  75. 75. Background: Economy, Industry, and Firm Economic developments and the actions of competitors affect the ability of any business enterprise to perform successfully. It is necessary to evaluate the environment in which the firm conducts business. This process involves blending hard facts with guess and estimates.
  76. 76. Short-Term Liquidity Especially important to creditors, suppliers, management, and others who are concerned with the ability of a firm to meet near-term demands for cash Should include analysis of selected financial ratios and a comparison with industry averages Predicts the future ability of the firm to meet prospective needs for cash
  77. 77. Operating Efficiency Turnover ratios measure the operating efficiency of a firm. The efficiency in managing a company’s accounts receivable, inventory, and accounts payable is discussed in the short-term liquidity analysis.
  78. 78. Capital Structure and Long-Term Solvency Analytical process includes an evaluation of the amount and proportion of debt in a firm’s capital structure as well as the ability to service debt. Debt financing implies risk and leverage.
  79. 79. Profitability Analysis of how well the firm has performed in terms of profitability, beginning with the evaluation of several key ratios
  80. 80. DuPont Framework • The DuPont framework was developed internally at DuPont around 1920. • It provides a systematic approach to identifying general factors causing ROE to deviate from normal. • It establishes a framework for computing financial ratios to yield more in-depth analysis of a company’s areas of strength and weakness.
  81. 81. The number of pennies in profits generated from each dollar of sales The number of dollars in sales generated by each dollar of assets The number of dollars of assets a company is able to acquire using each dollar invested by stockholders
  82. 82. $180,000 $5,700,000
  83. 83. $5,700,000
  84. 84. $5,700,000 $2,278,000
  85. 85. $2,278,000
  86. 86. $2,278,000 $1,468,000
  87. 87. DuPont Framework Coleville’s ROE for 2011 is 12.3%. The ROE for 2010 would be calculated the same way.
  88. 88. Relating the Ratios The Du Pont System Helpful to complete the evaluation of a firm by considering the interrelationship among the individual ratios Looks at how the various pieces of financial measurement work together to produce an overall return Helps analyst see how the firm’s decisions and activities over the course of an accounting period interact to produce overall return to shareholders
  89. 89. Relating the Ratios The Du Pont System The first three ratios reveal that return on investment is a product of the net profit margin and the total asset turnover. The second three ratios show how the return on equity is the product of return on investment and financial leverage.
  90. 90. Relating the Ratios The Du Pont System By reviewing this series of relationships, the analyst can identify strengths and weaknesses as well as trace potential causes of problems in the overall financial condition and performance of the firm. Analyst can evaluate changes in condition and performance. Evaluation can then focus on specific areas contributing to changes.
  91. 91. Projections and Pro Forma Statements Pro forma financial statements are projections based on a set of assumptions regarding • future revenues • expenses • level of investment in assets • financing methods and costs • working capital management
  92. 92. Projections and Pro Forma Statements Pro forma financial statements are used primarily for long-range planning and long-term credit decisions. Many firms have made up their own definitions of pro forma statements, which should not be confused with the pro forma statement described above.
  93. 93. Summary of Analysis Analysis of any firm’s financial statements consists of a mixture of steps and pieces that interrelate and affect each other. No one part of the analysis should be interpreted in isolation. The last step of analysis is to integrate the separate pieces into a whole, leading to conclusions about the business enterprise.
  94. 94. LIABILITES ASSETS Capital 180 Net Fixed Assets 400 Reserves 20 Inventories 150 Term Loan 300 Cash 50 Bank C/C 200 Receivables 150 Trade Creditors 50 Goodwill 50 Provisions 50 800 800 EXERCISE 1 a. What is the Net Worth : Capital + Reserve = 200 b. Tangible Net Worth is : Net Worth - Goodwill = 150 c. Outside Liabilities : TL + CC + Creditors + Provisions = 600 d. Net Working Capital : C A - C L = 350 - 250 = 50 e. Current Ratio : C A / C L = 350 / 300 = 1.17 : 1 f. Quick Ratio : Quick Assets / C L = 200/300 = 0.66 : 1
  95. 95. EXERCISE 2 LIABILITIES 2005-06 2006-07 2005-06 2006-07 Capital 300 350 Net Fixed Assets 730 750 Reserves 140 160 Security Electricity 30 30 Bank Term Loan 320 280 Investments 110 110 Bank CC (Hyp) 490 580 Raw Materials 150 170 Unsec. Long T L 150 170 S I P 20 30 Creditors (RM) 120 70 Finished Goods 140 170 Bills Payable 40 80 Cash 30 20 Expenses Payable 20 30 Receivables 310 240 Provisions 20 40 Loans/Advance s 30 190 Goodwill 50 50 Total 1600 1760 1600 1760 1. Tangible Net Worth for 1st Year : ( 300 + 140) - 50 = 390 2. Current Ratio for 2nd Year : (170 + 20 + 240 + 2+ 190 ) / (580+70+80+70) 820 /800 = 1.02 3. Debt Equity Ratio for 1st Year : 320+150 / 390 = 1.21
  96. 96. Exercise 3. LIABIITIES ASSETS Equity Capital 200 Net Fixed Assets 800 Preference Capital 100 Inventory 300 Term Loan 600 Receivables 150 Bank CC (Hyp) 400 Investment In Govt. Secu. 50 Sundry Creditors 100 Preliminary Expenses 100 Total 1400 1400 1. Debt Equity Ratio will be : 600 / (200+100) = 2 : 1 2. Tangible Net Worth : Only equity Capital i.e. = 200 3. Total Outside Liabilities / Total Tangible Net Worth : (600+400+100) / 200 = 11 : 2 4. Current Ratio will be : (300 + 150 + 50 ) / (400 + 100 ) = 1 : 1
  97. 97. LIABILITIES ASSETS Capital + Reserves 355 Net Fixed Assets 265 P & L Credit Balance 7 Cash 1 Loan From S F C 100 Receivables 125 Bank Overdraft 38 Stocks 128 Creditors 26 Prepaid Expenses 1 Provision of Tax 9 Intangible Assets 30 Proposed Dividend 15 550 550 Q. What is the Current Ratio ? Ans : (125 +128+1+30) / (38+26+9+15) : 255/88 = 2.89 : 1 Q What is the Quick Ratio ? Ans : (125+1)/ 88 = 1.43 : 11 Q. What is the Debt Equity Ratio ? Ans : LTL / Tangible NW = 100 / ( 362 – 30) = 100 / 332 = 0.30 : 1 Exercise 4.
  98. 98. LIABILITIES ASSETS Capital + Reserves 355 Net Fixed Assets 265 P & L Credit Balance 7 Cash 1 Loan From S F C 100 Receivables 125 Bank Overdraft 38 Stocks 128 Creditors 26 Prepaid Expenses 1 Provision of Tax 9 Intangible Assets 30 Proposed Dividend 15 550 550 Q . What is the Proprietary Ratio ? Ans : (T NW / Tangible Assets) x 100 [ (362 - 30 ) / (550 – 30)] x 100 (332 / 520) x 100 = 64% Q . What is the Net Working Capital ? Ans : C. A - C L. = 255 - 88 = 167 Q . If Net Sales is Rs.15 Lac, then What would be the Stock Turnover Ratio in Times ? Ans : Net Sales / Average Inventories/Stock 1500 / 128 = 12 times approximately Exercise 4. contd…
  99. 99. LIABILITIES ASSETS Capital + Reserves 355 Net Fixed Assets 265 P & L Credit Balance 7 Cash 1 Loan From S F C 100 Receivables 125 Bank Overdraft 38 Stocks 128 Creditors 26 Prepaid Expenses 1 Provision of Tax 9 Intangible Assets 30 Proposed Dividend 15 550 550 Q. What is the Debtors Velocity Ratio ? If the sales are Rs. 15 Lac. Ans : ( Average Debtors / Net Sales) x 12 = (125 / 1500) x 12 = 1 month Q. What is the Creditors Velocity Ratio if Purchases are Rs.10.5 Lac ? Ans : (Average Creditors / Purchases ) x 12 = (26 / 1050) x 12 = 0.3 months Exercise 4. contd…
  100. 100. Exercise 5. : Profit to sales is 2% and amount of profit is say Rs.5 Lac. Then What is the amount of Sales ? Answer : Net Profit Ratio = (Net Profit / Sales ) x 100 2 = (5 x100) /Sales Therefore Sales = 500/2 = Rs.250 Lac Exercise 6. A Company has Net Worth of Rs.5 Lac, Term Liabilities of Rs.10 Lac. Fixed Assets worth RS.16 Lac and Current Assets are Rs.25 Lac. There is no intangible Assets or other Non Current Assets. Calculate its Net Working Capital. Answer Total Assets = 16 + 25 = Rs. 41 Lac Total Liabilities = NW + LTL + CL = 5 + 10+ CL = 41 Lac Current Liabilities = 41 – 15 = 26 Lac Therefore Net Working Capital = C. A – C.L = 25 – 26 = (- )1 Lac
  101. 101. Exercise 7 : Current Ratio of a concern is 1 : 1. What will be the Net Working Capital ? Answer : It suggest that the Current Assets is equal to Current Liabilities hence the NWC would be NIL Exercise 8 : Suppose Current Ratio is 4 : 1. NWC is Rs.30,000/-. What is the amount of Current Assets ? Answer : 4 x - 1 x = 30,000 Therefore x = 10,000 i.e. Current Liabilities is Rs.10,000 Hence Current Assets would be 4x = 4 x 10,000 = Rs.40,000/- Exercise 9. The amount of Term Loan installment is Rs.10000/ per month, monthly average interest on TL is Rs.5000/-. If the amount of Depreciation is Rs.30,000/- p.a. and PAT is Rs.2,70,000/-. What would be the DSCR ? DSCR = (PAT + Depr + Annual Intt.) / Annual Intt + Annual Installment = (270000 + 30000 + 60000 ) / 60000 + 120000 = 360000 / 180000 = 2
  102. 102. Exercise 10 : Total Liabilities of a firm is Rs.100 Lac and Current Ratio is 1.5 : 1. If Fixed Assets and Other Non Current Assets are to the tune of Rs. 70 Lac and Debt Equity Ratio being 3 : 1. What would be the Long Term Liabilities? Ans : We can easily arrive at the amount of Current Asset being Rs. 30 Lac i.e. ( Rs. 100 L - Rs. 70 L ). If the Current Ratio is 1.5 : 1, then Current Liabilities works out to be Rs. 20 Lac. That means the aggregate of Net Worth and Long Term Liabilities would be Rs. 80 Lacs. If the Debt Equity Ratio is 3 : 1 then Debt works out to be Rs. 60 Lacs and equity Rs. 20 Lacs. Therefore the Long Term Liabilities would be Rs.60 Lac. Exercise 11 : Current Ratio is say 1.2 : 1 . Total of balance sheet being Rs.22 Lac. The amount of Fixed Assets + Non Current Assets is Rs. 10 Lac. What would be the Current Liabilities? Ans : When Total Assets is Rs.22 Lac then Current Assets would be 22 – 10 i.e Rs. 12 Lac. Thus we can easily arrive at the Current Liabilities figure which should be Rs. 10 Lac
  103. 103. THANK YOU 11