The Financial Ratios Analysis

1. 02/01/15 1
Financial Ratio
Analysis

2. 02/01/15 2
SIGNIFICANCE OF RATIO
ANALYSIS
CSD ‘A’ earns Rs 50,000
CSD ‘B’ earns Rs 40,000
Which is more efficient? A or B
CSD ‘A’ has emp Rs 4,00,000
CSD ‘B’ has emp Rs 3,00,000
Profit as a % of Capital emp
‘A’ = (50,000/ 4,00,000) * 100 =12.50%
‘B’ = (40,000/ 3,00,000) * 100 =13.33%

3. 02/01/15 3
RATIO
A ratio is a statistical yardstick that
provides a measure of the relationship
between two variables or figures.

4. LIABILITIES
31MAR07
31MAR08
ASSETS
31MAR07
31MAR08
170 SHARE CAPITAL
EQUITY
PREFERENCE
120
50
170 213 FIXED ASSETS
NET
GROSS STOCK
LESS
DEPRECIATION
594
365
229
180 RESERVES AND
SURPLUSES
215 11 INTANGIBLE
ASSETS
15
150 SECURED LOANS
DEBENTURES
LOANS /ADVANCES
50
101
151 5 INVESTMENTS 5
20 UNSECURED
LOANS
30 670 CURRENT ASSETS
CASH IN BANK
RECEIVABLES
INVENTORIES
PRE-PAID
EXPENSES
73
189
355
64
681
409 CURRENT
LIABILITIES
SUNDRY CREDITORS
PROVISIONS
330
69
399
30 MISC 35
BALANCE SHEET ABC COMPANY AS AT 31
MAR2008

5. MAR 08
FIGS 2007 FIGS 2008
847 NET SALES 904
657 COST OF GOODS SOLD
STOCKS
WAGES AND SALARIES
OTHER MANUFACTURING EXPENSES
366
188
160
714
190 GROSS PROFIT 190
103 OPERATING EXPENSES:
SELLING/ADM
DEPRECIATION
71
25
96
87 OPERATING PROFIT 94
11 NON-OPERATING PROFIT/DEFICIT 49
98 PROFIT BEFORE INTEREST&TAX
(EBIT)
143
26 INTEREST(ON BANK
BORROWINGS/LOANS)
DEBENTURES
29
4
33
72 PROFIT BEFORE TAX 110
36 TAX 58
36 PROFIT AFTER TAX 52
12 DIVIDENDS:EQUITY/ PREFERENCE 14 / 3 17

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 A comparison is more useful than mere Nos
 Analysis of financial ratios involves two types of
comparisons:
 Present ratio with the past ratios & expected future
ratios
 Ratios of one firm with those of similar firms or with
industry averages at same point of time
 Essential to consider nature of business
(apples cannot be compared with oranges)
WHY BOTHER WITH
RATIOS?

7. 02/01/15 7
CLASSIFICATION OF RATIOS
 Liquidity ratios
 Leverage / Solvency ratios
 Turnover / Activity ratios
 Profitability ratios
 Valuation ratios

8. 02/01/15 8
LIQUIDITY RATIOS
 Current ratio
 Quick / Acid test ratio
 Shows ability of company to pay its current financial
obligations
 Company should not be selling its assets at a loss to meet
its financial obligations; worst scenario be forced into
liquidation

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CURRENT RATIO (CR)
 Measure of company’s ability to meet short term
requirements
 Indicates whether current liabilities are adequately
covered by current assets
 Measures safety margin available for short term creditors
 CR = Current assets/Current liabilities
 If Net Working Capital is to be positive, CR >1
 Indian avg for non banking industries is 2
 Current assets = 681
 Current liabilities = 399
 CR = 681/399 = 1.71

10. 02/01/15 12
CURRENT RATIO (CR) -
IMPORTANCE
 Higher ratio ensures firm does not face problems in
meeting increased working capital requirements
 Low ratio implies repeated withdrawls from bank to
meet liquidity requirements
 High CR as compared to other firms implies advantage
of lower int rates from banks

11. 02/01/15 13
ACID TEST RATIO/QUICK
RATIO(QR)
 Used to examine whether firm has adequate cash or cash
equivalents to meet current obligations without resorting to
liquidating non cash assets such as inventories
 Measures position of liquidity at a point of time
 QR = Quick Assets / Current Liabilities
 Quick assets = Current assets – (inventories + prepaid
expenses)
= 681–(355+64) = 262
 Current liabilities = 399
 QR = 262/399 = 0.66
 As a thumb rule ideal QR = 1; should not be less than 1

12. 02/01/15 14
CLASSIFICATION OF RATIOS
 Liquidity ratios
 Leverage / Solvency ratios
 Turnover / Activity ratios
 Profitability ratios
 Valuation ratios

13. 02/01/15 15
LEVERAGE RATIOS
 Shows dependence of firm on outside long term finance
Shows long term financial solvency & measures firm’s ability
to pay interest & principle regularly when due
To assess extent to which the firm borrowed money vis-à-
vis funds supplied by owners; Use of debt finance
Companies whose EBIT <= Interest payments are risky
 Debt - Equity ratio
 Debt - Total fund ratio
 Debt - Assets ratio
 Interest coverage ratio
 Liability coverage ratio

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 Measures relative proportion of debt & equity in financing assets
of a firm
 Company can have good current ratio and liquidity position,
however liquidity may have come from long term borrowed
funds, the repayment of which along with interest will put
liquidity under pressure
 DER = Long term debt / Share holders funds
 Creditors would like this to be low; Lower ratio implies larger
credit cushion (margin of protection to creditors)
 IDB expects DER of 2:1 in respect of SMEs
DEBT EQUITY RATIO

15. 02/01/15 17
 Debt (loans) = Secure loans + Unsecure loans
= 151+30=181
 Share holders funds = (equity+ preference capital +
res & surplus – fictitious assets &
accumulated losses not written off )
= 120+50+215 = 385
 DER = 181/385 = 0.47 = (0.47:1)
 Creditors are providing Rs 0.47 financing for each rupee
provided by shareholders
DEBT EQUITY RATIO

16. 02/01/15 18
DEBT – TOTAL FUND
RATIO
 DTF ratio= Long term debt / Total fund
 Debt (long term) = 181
 Total funds (debt + sh holders’ funds)
= 181+(170+215-35) = 531
 DTF ratio = 181/531 = 0.34
 34% of the firms funds are debt (of various types)
remaining 66% is financed by owners/ share holders
 Higher the debt - total funds ratio, greater the
financial risk

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DEBT – ASSETS RATIO
 Debt - Assets ratio = Debt / Net assets
 Debt = 181
 Net assets (less fictitious assets & losses) =
930
 Ratio = 181/930 = 0.19
 19% of the firms assets are financed with debt (of
various types).
 Shows coverage provided by the assets to total debt

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INTEREST COVERAGE RATIO
 Gives ability of company to pay back long term loans
along with interest or other charges from generation
of profit from its operations
 Interest coverage ratio = EBIT / Debt interest
 EBIT = 143
 Interest = 29+4 = 33
 Ratio = 143/33=4.33
 EBIT should be 6 – 7 times of debt interest
 Shows margin of cover to lenders; of prime imp

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LIABILITY COVERAGE
RATIO
 Calculated to determine time a company would take
to pay off all its liabilities from internally generated
funds
 Assumes that liabilities will not be liquidated from
additional borrowings or from sale of assets
 LCR = Internally generated funds / Total liabilities
 Internally gen funds = Equity + Pref + R&S = 385
 Total liabilities = 965
 LCR = 385/965 = 0.399

20. 02/01/15 22
CLASSIFICATION OF RATIOS
 Liquidity ratios
 Leverage / Solvency ratios
 Turnover / Activity ratios
 Profitability ratios
 Valuation ratios

21. 02/01/15 23
ACTIVITY / TURN OVER
RATIOS
 Allows to examine whether total amount of each type of
asset a company owns is reasonable, too high or too low in
light of current and forecast operating needs
 In order to purchase / acquire assets, companies need to
borrow or obtain Capital from elsewhere :-
 More assets acquired implies high int and low profits
 Lesser assets implies operations not as efficient as
possible
 Activity turn over ratios used to assess efficiency with
which company utilizing its assets
 Relates to level of activity represented by sales or cost of
goods sold
• Inventory turnover ratio
• Average collection period
• Fixed assets turn over ratio

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 Measures No of times inventory turned over in a
year
OR
No of days of inventory held by company to sp
sales
 Times Inventory turned over =
Net sales OR COGS
Avg inventory Avg stocks
 Inventory measured in days of sale =
365 x Avg inventory
Net Sales
INVENTORY TURN OVER RATIO

23. 02/01/15 25
 A ratio of 6 times indicates inventory turned over
six times in a year
OR
Ratio of 60 days indicates enough inventory to
support sales for 60 days held by company
 Excessive inventories unproductive; represent
investment with zero rate of return
 Conversely less inventory results in loss of
customers
 ABC’s ratio = 904/355 = 2.54
 ABC’s Days of Inv = (355 x 365)/904 = 143.33 days
INVENTORY TURN OVER RATIO

24. 02/01/15 26
AVERAGE COLLECTION PERIOD
 Represents duration a company must wait after making
sales, before it actually receives cash from its customers
 ACP = Avg receivables OR
Average sales per day
= Avg receivables x 365
Sales
 Imp
 For assessing effectiveness of credit policy of firm
 Enables mgmt to take timely measures to effectively
manage credit
 Too high value - firm facing difficulties in collecting debts
 Too low value - restrictive credit policy
Receivables = 189
Sales = 904
ACP = (189 x 365)/ 904 = 76.2 days
say 76 days

25. 02/01/15 27
FIXED ASSETS TURNOVER RATIO
 Measures effectiveness of utilization of fixed assets by
company
 Used to compare fixed assets utilization of two firms
 Not truly reflective of performance / efficiency
 High ratio (depreciation) if old assets
 Low ratio if capital assets procured recently
 FATR = Net sales (or COGS)/ Fixed assets
 Higher ratio indicates better utilisation of assets (with a
caution on age of assets)
Fixed Assets = 229
Net Sales = 904
FATR = 904 / 229 = 3.95

26. 02/01/15 28
CLASSIFICATION OF RATIOS
 Liquidity ratios
 Leverage / Solvency ratios
 Turnover / Activity ratios
 Profitability ratios
 Valuation ratios

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PROFITABILITY RATIOS
 Gross profit margin ratio (GPMR)
 Net profit margin ratio (NPMR)
 Return on investment
• Profitability ratios indicate
• Company's profitability in relation to other
companies
• Internal comparison with last yrs profits
•Managements effectiveness as shown by returns
generated on sales and investments

28. 02/01/15 30
GROSS PROFIT MARGIN RATIO
(GPMR)
 Represents cost of production
 Helps in understanding proportion of raw materials used
and direct expenses incurred in overall production process
 Reflects income being generated which can be
apportioned by promoters
 Reflects efficiency of firm’s operations as well as how
products are priced
 GPMR = Gross profit/ Net sales
Net Sales = 904
Gross Profit = Net sales - COGS = 904 - 714 = 190
GPMR = Gross Profit / Net sales
= 190 / 904 = 0.21 = 21%
Implies 79% (100-21%) of sales contribute towards
direct expenses and raw mtrl

29. 02/01/15 31
NET PROFIT MARGIN RATIO
(NPMR)
 Takes into account not only cost of production but also
administrative expenses like staff salary, selling &
distribution overheads
 Represents surplus of gross profit after meeting expenses
 Net profit appropriated to meet tax liability, dividend
payments and to retain part in business
 NPMR = Net profit (Profit after tax)/ Net sales
Net Sales = 904
Net Profit after taxes = 52
NPMR = Net Profit / Net sales
= 52 / 904 = 0.057 = 5.7%
Implies for every Rs 100/- of sales, Rs 5.7/- earned as
profit which can be used for dividend distr and
apportioned to res & surplus
• Company B has outperformed Company A in total sales
• However A has utilized its resources more efficiently
COMPANY A COMPANY B
SALES 2,00,000 2,50,000
GROSS PROFIT 40,000 40,000
NET PROFIT 20,000 22,000
GROSS PROFIT
MARGIN
20% 16%
NET PROFIT MARGIN 10% 8.8%

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PROFITABILITY IN RELATION TO INVESTMENT-
RETURN ON INVESTMENT (ROI)
 Indicates efficiency with which company used its Capital
(Equity as well as debt)
 Takes into account overall returns of the company
assuming company has not taken any debt
 Gives overall returns including adjustments of earnings
for fin leveraging
 Enables one to check whether return made on investment
is better than other alternatives available
 Suited for inter-firm comparisons
 ROI = EBIT x100 / Capital employed
• EBIT = 143
• Capital employed = 566 ( (120+50+215+181)-(0+0) )
(Eq +Pref sh +Res & surp+Debt)-(Fictitious assets +
Non operating investments)
• ROI = 143/566 x 100 = 25.26 %.
• The company has earned a profit of 25.26 paise on
every 100 Re invested

31. 02/01/15 33
CLASSIFICATION OF RATIOS
 Liquidity ratios
 Leverage / Solvency ratios
 Turnover / Activity ratios
 Profitability ratios
 Valuation ratios

32. 02/01/15 34
VALUATION RATIOS
 Earning per share (EPS)
 Price Earnings (PE) Multiple
 Price Earnings Growth (PEG) Multiple
 Dividend Payout Ratio
 Dividend Yield
 Beta of Stock

33. 02/01/15 35
EARNINGS PER SHARE
(EPS)
 Represents total earnings of a company available for
distribution among equity shareholders
 Evaluates performance of company shares over a period of
time
 EPS = Net profit available for equity shareholders / No of
Equity shares
 EPS alone should not be basis of decision making with
respect to purchase of any company share
 Faulty reasons of High EPS
 Less No of Equity shares
 Investment in risky ventures

34. 02/01/15 36
PRICE EARNING (PE) MULTIPLE
 Simplest method of comparing different stocks at a point
of time to make investment decisions
 As a layman, this is the price being paid for buying one
rupee of earning of a company eg If PE of Infosys share is
Rs 9/- it means we are paying to the market a price of 9
for every Rs 1/- earning of the company
 PE Ratio = Market Price per share/ EPS

35. 02/01/15 37
PRICE EARNING GROWTH (PEG)
MULTIPLE
 An extension of PE which also takes into account growth
rate of the company
 PEG Multiple = PE / Growth
COMPANY
A
COMPANY
B
Analysis
Market Price 200 200
EPS 10 20
Growth rate 5% 2%
PE Multiple 20 (200/10) 10 (100/20) A overvalued
PEG Multiple 4 (20/5) 5 (10/2) B overpriced wrt
growth potential
Which company stocks to be purchased ?

36. 02/01/15 38
DIVIDEND PAYOUT RATIO
 Shows amount of dividend paid out of earnings
 An indication of amount of profits put back into company
 Imp ratio to assess long term prospects of company
 Dividend Payout Ratio = Dividend / Net Income

37. 02/01/15 39
DIVIDEND YIELD
 Shows relationship between Dividend per share and
market price
 An imp ratio to compare two companies
 Dividend Yield (%) = Dividend amount per share *100
Market price of share

38. 02/01/15 40
BETA OF SECURITY
 Refers to overall market risk which a security is carrying
and which cannot be diversified
 Responsiveness of share price of a company with respect
to overall market movement
 If over a period of time, market has given a return of 20%;
individual share of company ‘A’ has given return of 10%;
Beta of A = 10 / 20 = 0.5
 If investor is risk averse, should invest in stocks with low
Beta; Even if market falls by drastic amount his investment
will not take that much hit

39. 02/01/15 4102/01/15 41
FINANCIAL RATIOS
.
LIQUIDITY
NWC = CA - CL
CR = CA/CL
ATR = (CA –INVENTORY)/CL
LEVERAGE
Debt-Equity Ratio = Debt/Net Worth
Liab Coverage Ratio = Int gen funds / Total
Liab Debt to Assets Ratio = Debt/Total
Assets Interest Coverage Ratio = EBIT/Debt
Interest
ACTIVITY/TURNOVER
Inventory Turn Over Ratio = Net Sales/Inventory
FATR = Net Sales/Total
Assets
Avg Collection Period = 365/ RTOR
PROFITABILITY
GPMR = Gross Profit/Net Sales
NPMR = Net Profit/Net Sales
ROI = EBIT x 100/
Capital
ROE = Equity earnings/
Solvency , Safety
Margins,
Idle Resources , Risk
Long term solvency
Risk due to debt
Owners Stake
Coverage provided
by assets
Interest burden
Utilisation
Credit mgt
Restrictions
Efficency
Efficency
Acceptability
Overall performance
Margin of Safety
Ability for PAT