COMPANY OVERVIEW

HCL is a leading global Technology and IT Enterprise with annual revenues of US$ 6.3 billion. The HCL Enterprise comprises two companies listed in India, HCL Technologie( www.hcltech.com ) and HCL Infosystems (www.hclinfosystems.in) The 35 year old enterprise, founded in 1976, is one of India's original IT garage start ups. Its range of offerings span R&D and Technology Services, Enterprise and Applications Consulting, Remote Infrastructure Management, BPO services, IT Hardware, Systems Integration and Distribution of Technology and Telecom products in India. The HCL team comprises 92,000 professionals of diverse nationalities, operating across 31 countries including 505 points of presence in India. HCL has global partnerships with several leading Fortune 1000 firms, including several IT and Technology majors.

RATIO ANALYSIS
INTRODUCTION The ratio analysis is one of the most important and powerful tools of financial analysis. It is the process of establishing and interpreting various ratios. It is with the help of ratios that the ratios that the financial statement can be analyzed more clearly and decisions made from such analysis. CONCEPT OF RATIO A ratio is a simple arithmetical expression of the relationship of one number to another. It may be defined as the indicated quotient of two mathematical expressions. According to Accountants handbook by Wixonkell and Bedford, a ratio is an expression of the quantitative relationship between two numbers. RATIO ANALYSIS Ratio analysis is the technique of calculation of number of accounting ratios from the data found in the financial statements, the comparison of the accounting ratios with those of the previous years or with those of other concerns engaged in similar line of activities or with those of standard ratios and the interpretation of the comparison. CLASSIFICATION OF ACCOUNTING RATIOS The use of ratio analysis is not confined to financial manager only. There are different parties interested in the ratio analysis for knowing the financial position of a firm for different purposes. In view of various users of ratio which can be calculated from the information given in the financial statement.

Ratios

Traditional classification

Functional classification

Significance ratios

1. Balance sheet ratios 2. Revenue statement ratios

1. Liquidity ratios 2. Leverage ratios 3. Activity ratios

1. Primary ratios 2. Secondary ratios

CLASSIFICATION ACCORDING TO TESTS

Liquidity ratios

Long-term solvency ratios

Activity ratios

Probability ratios

1.

Current ratio 2. Acid test ratio

1. Debt equity ratio 2. Proprietory ratio 3. Capital gearing ratio 4. Fixed assets to net worth 5. Current assets to

1. Stock turn over ratio 2. Debtors turnover ratio 3. Debt-collection period 4. Creditors turnover ratio 5. Debt-payment period 6. Fixed assets turnover ratio 7. Total assets

1. Gross profit ratio 2. Net profit ratio 3. Operating profit ratio 4. Return on capital employed 5. Return on total

Liquidity Ratios
A. Current Ratio The current ratio is an indication of a firm's market liquidity and ability to meet creditor's demands. Acceptable current ratios vary from industry to industry and are generally between 1.5 and 3 for healthy businesses. If a company's current ratio is in this range, then it generally indicates good short-term financial strength. If current liabilities exceed current assets (the current ratio is below 1), then the company may have problems meeting its short-term obligations. If the current ratio is too high, then the company may not be efficiently using its current assets or its short-term financing facilities. This may also indicate problems in working capital management. Low values for the current or quick ratios (values less than 1) indicate that a firm may have difficulty meeting current obligations. Low values, however, do not indicate a critical problem. If an organization has good long-term prospects, it may be able to borrow against those prospects to meet current obligations. Some types of businesses usually operate with a current ratio less than one. For example, if inventory turns over much more rapidly than the accounts payable become due, then the current ratio will be less than one. This can allow a firm to operate with a low current ratio. Anything that increases or decreases current assets or current liabilities can affect working capital and the current ratio. 1) A buildup or decline in inventory or A/R 2) A change in available cash 3) A reduction in short-term debt 4) A backlog of bills to pay The more quickly Inventory and Accounts Receivable can be converted to cash, the more secure your cushion.

To improve your current ratio, these things may help:

collect outstanding accounts receivable pay off some current liabilities convert fixed assets to cash: sell unused equipment increase current assets with new equity investments take fewer owner withdrawals and reinvest profits back into the business increase your cash balance with a long-term loan

Current assets Current Ratio = ________________ Current liabilities

Significance: Current ratio is the primary measure of a company's liquidity. Minimum levels of current ratio are often defined in loan covenants to protect the interest of the lenders in the event of deteriorating financial position of the borrowers. Financial regulations of various countries also impose restrictions on financial institutions to lend credit facilities to potential borrowers that have a current ratio which is lower than the defined limits. Limitations of current ratio Current ratio suffers from a number of limitations. Some are given below:

1) Some businesses have different trading activities in different seasons. Such businesses may show low or high current ratio in certain periods during the year.

2) To compare the ratio of two companies it is necessary that both the companies use same inventory valuation method. For example, comparing current ratio of two companies would be like comparing apples to oranges if one uses fast-in, first-out (FIFO) method and the other uses Last-in, first-out (LIFO) method for the valuation of inventory. So the analyst would not be able to compare the ratio of two companies even in the same industry. 3) It is not exact science to test the liquidity of a company because the quality of each Individual asset is not taken into account while computing this ratio. 4) It can be easily manipulated by equal increase or decrease in current assets and current liabilities. For example, if current assets of a company are $10,000 and current liabilities are $5,000, the current ratio would be 2:1 as computed below: $10,000 / $5,000 2:1 If both current assets and current liabilities are reduced by $1,000, the ratio would be increased to 2.25:1 as computed below: $9,000 / $4,000 2.25:1

Table: 5.1

CURRENT RATIO

Current Year Assets Rs. in 2011 2012 crores 3974.08 4009.97

Current Liabilities Rs. in crores 2349.39 2654.49 1.6:1 1.5:1 Ratio

Interpretation: The current ratio has been decreasing year after year which shows decreasing working capital. But still the situation of company is under control and assets can easily handle the liabilities. a) Satisfactory level b) There is increase in Fixed assets means the cash has been utilized for fixed assets c) Some thing might have invested in inventories

Chart no.: 5.1

CURRENT RATIO

4500 4000 3500 3000 2500

e l t T s i x A

2000 1500 1000 500 0 2011 2012 Current assets 3974.08 4009.97 Curent liablities 2349.39 2654.49 Current ratio 1.6 1.5

B. Quick Ratio Measures assets that are quickly converted into cash and they are compared with current liabilities. This ratio realizes that some of current assets are not easily convertible to cash e.g. inventories. Quick ratio or Acid Test ratio is the ratio of the sum of cash and cash equivalents, marketable securities and accounts receivable to the current liabilities of a business. It measures the ability of a company to pay its debts by using its cash and near cash current assets. The quick ratio, also referred to as acid test ratio, examines the ability of the business to cover its short-term obligations from its quick assets only (i.e. it ignores stock). The quick ratio is calculated as follows Quick assets Quick Ratio = ____________________ Current liabilities

Significance:

The standard liquid ratio is supposed to be 1:1 i.e., liquid assets should be equal to current liabilities. If the ratio is higher, i.e., liquid assets are more than the current liabilities, the short term financial position is supposed to be very sound. On the other hand, if the ratio is low, i.e., current liabilities are more than the liquid assets, the short term financial position of the business shall be deemed to be unsound. When used in conjunction with current ratio, the liquid ratio gives a better picture of the firms capacity to meet its short-term obligations out of short-term assets. A quick ratio of 1.00 means that the most liquid assets of a business are equal to its total debts and the business will just manage to repay all its debts by using its cash, marketable securities and accounts receivable. A quick ratio of more than one indicates that the most liquid assets of a business exceed its total debts. On the opposite side, a quick ratio of less than one indicates that a business would not be able to repay all its debts by using its most liquid assets. Thus we conclude that, generally, a higher quick ratio is preferable because it means greater liquidity. However a quick ratio which is quite high, say 4.00 is not favorable to a business as whole because this means that the business has idle current assets which could have been used to create additional projects thus increasing profits. In other words, very high value of quick ratio may indicate inefficiency.

Table: 5.2 Quick Year Assets Rs. in 2011 2012 crores 3387.83 3351.02

QUICK RATIO Current Liabilities Rs. in crores 2349.39 2654.49 1.44 1.26 Ratio

Interpretation:

As a quick ratio of 1:1 is considered satisfactory as a firm can easily meet all current claims. It is a more rigorous and penetrating test of the liquidity position of a firm. But the liquid ratio has been decreasing year after year which indicates a high operation of the business. From the above statement, it is clear that the liquidity position of the HCL is satisfactory. a) Stock turnover has increased hence increasing the stock turnover ratio b) Sales have reduced hence reducing sales turnover ratio c) COGS have increased hence increasing the cost can be the reason of reduction in sales as the selling cost will be high d) Company can easily cover its current liabilities with its quick assets

Chart no.: 5.2

4000 3500 3000 2500 2000

QUICK RATIO

e l t T s i x A

1500 1000 500 0 2011 2012 Quick assets 3387.83 3351.02 Curent liablities 2349.39 2654.49 Current ratio 1.26 1.44

C. Cash ratio:

This is also known as cash position ratio or super quick ratio. It is a variation of quick ratio. This ratio establishes the relationship between absolute liquid assets and current liabilities. Absolute liquid assets are cash in hand, bank balance and readily marketable securities. Both the debtors and the bills receivable are exclude from liquid assets as there is always an uncertainty with respect to their realization. In other words, liquid assets minus debtors and bills receivable are absolute liquid assets. The cash ratio is calculated as follows Cash in hand & at bank + Marketable securities Cash Ratio = ________________________________________ Current liabilities Significance: This ratio gains much significance only when it is used in conjunction with the first two ratios. The accepted norm for this ratio is 50% or 0.5:1 or 1:2(i.e.,) Re. 1 worth absolute liquid assets are considered adequate to pay Rs.2 worth current liabilities in time as all the creditors are not expected to demand cash at the same time and then cash may also be realized from debtors and inventories. This test is a more rigorous measure of a firms liquidity position. This type of ratio is not widely used in practice. Quick ratio is an indicator of solvency of an entity and must be analyzed over a period of time and also in the context of the industry the company operates in. Generally, companies should aim to maintain a quick ratio that provides sufficient leverage against liquidity risk given the level of predictability and volatility in a specific business sector among other considerations. The more uncertain the business environment, the more likely that companies would maintain higher quick ratios. Conversely, where cash flows are stable and predictable, companies would seek to keep quick ratio at relatively lower levels. In any case, companies must achieve the right balance between liquidity risk arising from a low quick ratio and the risk of loss resulting from a high quick ratio. A

quick ratio that is greater than industry average may suggest that the company is investing too many resources in the working capital of the business which may more profitably be used elsewhere. If a company has too much spare cash, it may consider investing the surplus funds in new ventures and in case company is out of investment options it may be prudent to return the excess funds to shareholders in the form of increased dividend payments. Acid test ratio which is lower than the industry average may suggest that the company is taking too much risk by not maintaining an appropriate buffer of liquid resources. Alternatively, a company may have a lower quick ratio due to better credit terms with suppliers than the competitors. When analyzing the quick ratio over several periods, it is important to take into account seasonal variations in some industries which may cause the ratio to be traditionally higher or lower at certain times of the year as seasonal businesses experience irregular bursts of activities leading to varying levels current assets and liabilities over time. Table: 5.3 Cash in Year Hand & at Bank Rs. in 2011 2012 crores 655.97 853.12 CASH RATIO Current Liabilities Rs. in crores 2654.49 2349.39 0.24 0.36 Ratio

Interpretation:

a) The cash ratio is below the accepted norm. b) So the cash position is not utilized effectively and efficiently. c) It is also not healthy sign because cash has been used for paying off long tem debts and increasing fixed assets. Chart no.: 5.3
3000 2500 2000 1500

CASH RATIO

e l t T s i x A
1000 500 0 2011 2012 cash equilents and cash 655.97 853.12

Curent liablities 2349.39 2654.49

Current ratio 0.24 0.36

5.2.2 Activity Ratio A. Inventory Turnover Ratio: This ratio measures the stock in relation to turnover in order to determine how often the stock turns over in the business. It indicates the efficiency of the firm in selling its product. It is calculated by dividing he cost of goods sold by the average inventory. A business can take a range of actions to improve its stock turnover:

Sell-off or dispose of slow-moving or obsolete stocks Introduce lean production techniques to reduce stock holdings Rationalize the product range made or sold to reduce stock-holding requirements

Negotiate sale or return arrangements with suppliers so the stock is only paid for when a customer buys it

Cost of goods sold Inventory Turnover Ratio = ___________________ Average Inventory

a) Cost of goods sold figure is obtained from the income statement of a business b) Average inventory is calculated as the sum of the inventory at the beginning and at the end of the period divided by 2. The values of beginning and ending inventory are obtained from the balance sheets at the start and at the end of the accounting period. Significance: This ratio is calculated to ascertain the number of times the stock is turned over during the periods. In other words, it is an indication of the velocity of the movement of the stock during the year. In case of decrease in sales, this ratio will decrease. This serves as a check on the control of stock in a business. This ratio will reveal the excess stock and accumulation of obsolete or damaged stock. The ratio of net sales to stock is satisfactory relationship, if the stock is more than three-fourths of the net working capital. This ratio gives the rate at which inventories are converted into sales and then into cash and thus helps in determining the liquidity of a firm. Inventory turnover ratio is used to measure the inventory management efficiency of a business. In general, a higher value of inventory turnover indicates better performance and lower value means inefficiency in controlling inventory levels. A lower inventory turnover ratio may be an indication of over-stocking which may pose risk of obsolescence and increased inventory holding costs. However, a very high value of this ratio may be accompanied by loss of sales due to inventory shortage. Inventory turnover is different for different industries. Businesses which trade perishable goods have very higher turnover compared to those dealing in durables. Hence a comparison would only be fair if made between businesses of same industry.

Table: 5.4 Year 2011 2012

INVENTORY TURNOVER RATIO Cost of goods sold Rs. in crores 9223.08 8890.88 Average Inventory Rs. in crores 622.6 622.6 Ratio 14.8 times 14.2 times

Interpretation: A higher turnover ratio is always beneficial to the concern. In this the number of times the inventory is turned over has been increasing from one year to another year. This increasing turnover indicates immediate sales. And in turn activates production process and is responsible for further development in the business. This indicates a good inventory policy of the company. Chart no.: 5.4
10000 9000 8000 7000 6000 5000 4000 3000 2000 1000 0 COGS 2011 2012 9223.08 8890.88 Average Inventory 622.6 622.6 Inventory turnover ratio 14.80% 14.20%

INVENTORY TURNOVER RATIO

B. Fixed Assets Turnover Ratio:

e l t T s i x A

The fixed assets turnover ratio measures the efficiency with which the firm has been using its fixed assets to generate sales. Asset turnover ratio is the ratio of a company's sales to its assets. It is an efficiency ratio which tells how successfully the company is using its assets to generate revenue. It is calculated by dividing the firms sales by its net fixed assets as follows: Sales Fixed Assets Turnover =________________ Fixed assets Significance: This ratio gives an ideal about adequate investment or over investment or under investment in fixed assets. As a rule, over-investment in unprofitable fixed assets should be avoided to the possible extent. Under-investment is also equally bad affecting unfavorably the operating costs and consequently the profit. In manufacturing concerns, the ratio is important and appropriate, since sales are produced not only by use of working capital but also the capital invested in fixed assets. An increase in this ratio is the indicator of efficiency in work performance and a decrease in this ratio speaks of unwise and improper investment in fixed assets. If a company can generate more sales with fewer assets it has a higher turnover ratio which tells it is a good company because it is using its assets efficiently. A lower turnover ratio tells that the company is not using its assets optimally. Total asset turnover ratio is a key driver of return on equity as discussed in the DuPont analysis Table: 5.5 Year FIXED ASSETS TURNOVER RATIO Fixed Sales Rs. in crores 2011 11062.40 Assets Rs. in crores 250.55 44.152 Ratio

2012

10380.81

298.22

34.809

Interpretation: The fixed assets turnover ratio is maintained year after year. The overall higher ratio indicates the efficient utilization of the fixed assets. There is little decrease of 9.343 in FATR this may be due to a) Increase in Fixed assets b) Reduction in sales c) The proportion is not same

Chart no.: 5.5

FIXED ASSETS TURNOVER RATIO

12000 10000 8000 6000

e l t T s i x A
4000 2000 0 2011 2012 Sales 11062.4 10380.81 Fixed assets 250.55 298.22 FATR 44.152 34.809

5.2.3 Financial Leverage (Gearing) Ratios A. Proprietary Ratio: This ratio is also known as Owners fund ratio (or) Shareholders equity ratio (or) Equity ratio (or) Net worth ratio. This ratio establishes the relationship between the proprietors fund and total tangible assets. The formula for this ratio may be written as follows. Shareholders funds Proprietary Ratio = _____________________ Total assets

Significance: This ratio represents the relationship of owners funds to total tangible assets, higher the ratio or the share of the shareholders in the total capital of the company, better is the long term solvency position of the company. This ratio is of

importance to the creditors who can ascertain the proportion of the shareholders funds in the total assets employed in the firm. A ratio below 50% may be alarming for the creditors since they may have to lose heavily in the event of companys liquidation on account of heavy losses.

Depends on Risk Appetite: The ideal value of the proprietary ratio of the company depends on the risk appetite of the investors. If the investors agree to take a large amount of risk, then a lower proprietary ratio is preferred. This is because, more debt means more leverage means profits and losses both will be magnified. The result will be highly uncertain payoffs for the investors. On the other hand, if investors are from the old school of thought, they would prefer to keep the proprietary ratio high. This ensures less leverage and more stable returns to the shareholders. Depends on Stage of Growth: The ideal value of the proprietary ratio also depends upon the stage of growth the company is in. Most companies require a lot of capital when they are at the early stages. Issuing too much equity could dilute the earnings potential at this stage. Therefore a lower proprietary ratio would be desirable at such a stage allowing the firm to access the capital it wants at a lower cost. Depends on Nature of Business: The firm has to undertake many risks and balance them out. There are market risks which are external to the firm and there are capital structure risks that are internal to the firm. If the external risks are high, the firm must not undertake aggressive financing because this could lead to a complete washout of the firm. On the other hand, if the external environment is stable, the firm can afford to take more risks.

Table: 5.6 Year 2011

PROPRIETARY RATIO Shareholders Fund Rs. in crores 1947.04 Total Assets Rs. in crores 4565.87 Ratio 42.64%

2012

1917.16

4867.20

39.38%

Interpretation: This ratio is particularly important to the creditors and it focuses on the general financial strength of the business. a) There is decrease in ratio of 3.26% b) There is rise in fixed assets c) Parallely a fall in Shareholders fund

Chart no.: 5.6

PROPRIETARY RATIO

6000 5000 4000 3000

e l t T s i x A
2000 1000 0 2011 2012 Shareholder fund 1947.04 1917.16 Fixed assets 4565.87 4867.2 Propritor ratio 42.64% 39.38%

B. Debt Ratio A debt ratio of greater than 1 indicates that a company has more debt than assets, meanwhile, a debt ratio of less than 1 indicates that a company has more assets than debt. Used in conjunction with other measures of financial health, the debt ratio can help investors determine a company's level of risk.

Significance Debt ratio is a ratio that indicates the proportion of a company's debt to its total assets. It shows how much the company relies on debt to finance assets. The debt ratio gives users a quick measure of the amount of debt that the company has on its balance sheets compared to its assets. The higher the ratio, the greater the risk associated with the firm's operation. A low debt ratio indicates conservative financing with an opportunity to borrow in the future at no significant risk. The debt ratio of a company is highly subjective. There is no such thing as an ideal debt ratio. Neither are industry wide comparisons very helpful because the capital structure of a company is an internal decision. Here is how to interpret the debt ratio of a company.

Certainty: Debt is not harmful as long as the revenues in question are fairly certain. Debt becomes a problem when the revenues of the company are wildly fluctuating. This is when there arise situations when

the company may not have enough cash on hand to meet its interest obligations. Hence while looking at the debt ratio analysts usually also look at the revenues with regards to how certain they are to gauge the riskiness. Whether these revenues are converted to cash fast enough to meet the interest obligations is also under consideration. Tax Shield Advantages: Debt is a tax deductible expense. Hence the amount of interest paid reduces the tax bill of the company. One of the advantages of having a higher debt ratio is that you have to pay less to the government in taxes.

Table: 5.7

DEBT RATIO Total Long term debt Rs. in crores 269.44 295.55 16.94 16.46 Ratio

Year

Assets Rs. in crores 4565.87 4867.20

2011 2012

Interpretation a) The ratio is maintained b) But the significant rise in Long term debts c) The rise in Total assets is there but not much significant d) Thus giving a little decrease in ratio

Chart5.7
6000 5000 4000 3000

Debt Ratio

e l t T s i x A
2000 1000 0 2011 2012 Total assets 4565.87 4867.87 Long termdebt 269.44 295.55 Propritor ratio 16.94 16.46

C. Debt to Equity ratio This ratio indicates the extent to which debt is covered by shareholders funds. It reflects the relative position of the equity holders and the lenders and indicates the companys policy on the mix of capital funds. The debt to equity ratio is the most important of all capital adequacy ratios. It is seen by investors and analysts worldwide as the true measure of riskiness of the firm. This ratio is often quoted in the financials of the company as well as in discussions pertaining to the financial health of the company in TV shows newspapers etc. The debt to equity ratio tells the shareholders as well as debt holders the relative amounts they are contributing to the capital. It needs to be understood that it is a part to part comparison and not a part to whole comparison. The debt to equity ratio is calculated as follows:

Total debt Debt to Equity Ratio = ____________ Total equity

Significance: The importance of debt-equity ratio is very well reflected in the words of Weston and brigham which are reproduced here: Debt-equity ratio indicates to what extent the firm depends upon outsiders for its existence. For the creditors, this provides a margin of safety. For the owners, it is useful to measure the extent to which they can gain the benefits of maintaining control over the firm with a limited investment: The debt-equity ratio states unambiguously the amount of assets provided by the outsiders for every one rupee of assets provided by the shareholders of the company. Debt to equity ratio provides two very important pieces of information to the analysts. They have been listed below.

Interest Expenses: A high debt to equity ratio implies a high interest expense. Along with the interest expense the company also has to redeem some of the debt it issued in the past which is due for maturity. This means a huge expense. Moreover this expense needs to be paid in cash, which has the potential to hurt the cash flow of the firm. Investors are never keen on investing in cash strapped firm and therefore have a keen eye on this ratio. Liquidation Scenario: Another interpretation of the debt equity ratio is the event of a liquidation of the company. Shareholders as well as debt holders want to know what the maximum downside is and debt to equity ratio helps them understand what they would end up with if the company were to stop functioning as a going concern. Table: 5.8 DEBT TO EQUITY RATIO

Total Year Debt Rs. in 2011 2012 crores 269.44 295.55

Total Equity Rs. in crores 1947.04 1917.16 0.14 0.15 Ratio

Interpretation: The debt to equity ratio is decreasing year after year. A low debt equity ratio is considered favorable from management. It means greater claim of shareholders over the assets of the company than those of creditors. For the company also, the servicing of debt is less burdensome and consequently its credit standing is not adversely affected. Therefore debt to equity ratio is satisfactory to the company. There is little increse due to a) Fall in value of equity b) Rise in Debt c) Not convincing for shareholders

Chart no.: 5.8

2500 2000 1500

DEBT TO EQUITY RATIO

e l t T s i x A

1000 500 0 2011 2012

Total debt 269.33 295.55

Totla equity 1947.04 1917.16

Propritor ratio 0.14 0.15

D. Interest coverage ratio The times interest earned shows how many times the business can pay its interest bills from profit earned. Present and prospective loan creditors such as bondholders, are vitally interested to know how adequate the interest payments on their loans are covered by the earnings available for such payments. Owners, managers and directors are also interested in the ability of the business to service the fixed interest charges on outstanding debt. The ratio is calculated as follows: EBIT Interest Coverage Ratio = _______________ Interest charges Significance:

It is always desirable to have profit more than the interest payable. In case profit is either equal or lesser than the interest, the position will be unsafe. It will show that there this nothing left for the shareholders and the position of the lendors is also unsafe. A high ratio is a sign of low burden of dept servicing and lower utilization of borrowing capacity. From the points of view of creditors, the larger the coverage, the greater the ability of the firm to handle fixed charges liabilities and the more assessed the payment of interest to the creditors. In contrast the low ratio signifies the danger the signal that the firm is highly dependent on borrowings and its earnings cannot meet obligations fully. The standard for this ratio for an industrial undertaking is 6 to 7 times.

Higher Ratio Means Solvent: The higher the interest coverage ratio of any firm, the more solvent it is. If an organization, under normal circumstances, earns way more than what its interest costs are, then it is financially secure. This is because earnings would have to take a real beating for the firm to default on its obligations. Hence, interest coverage ratio is of prime importance to lenders like banks and bond traders. Credit rating agencies also pay close attention to this number before they rate the company. Tolerance Depends On Variability: In industries where sales are very stable, such as utilities companies, a lower interest coverage ratio should suffice. This is because, these industries, by nature record stable revenues. Hence the sales and profits of the company are unlikely to witness wild fluctuation. This means that even in tough times the company will most probably be able to make good its interest obligations because its performance is not affected by the business cycle. On the other hand, companies with highly variable sales, like technology and apparel companies, need to have a high interest coverage ratio. These industries are prone to wild fluctuations is sales and investors want to ensure that their cash flow is not interrupted as a result. Hence they demand a higher interest coverage ratio before they give out their money. Ability To Take On More Credit: This is a corollary of the fact that high interest coverage ratio means the company is solvent. Lenders want to lend money to people who are solvent. This ensures that they get repaid on time and the risks of business are assumed by the owner. Thus, companies with high interest coverage ratios are more likely to get credit easily and on more favorable terms.

Table: 5.9 Year 2011 2012

INTEREST COVERAGE RATIO EBIT Rs. in crores 311.07 141.63 Interest on Fixed Loans Rs. in crores 15.74 33.08 Ratio 19.7 4.28

Interpretation: The Interest coverage ratio is increasing year after year. A high ratio is a sign of low burden of dept servicing and lower utilization of borrowing capacity. Therefore this ratio is satisfactory to the company. a) EBIT has reduced b) Interest rate has increased c) Ultimately ratio has decreased

Chart no.: 5.9

INTEREST COVERAGE RATIO

350 300 250 200

e l t i T s x A

150 100 50 0 2011 2012 EBIT 311.07 141.63 Intrest expenses 15.74 33.08 Propritor ratio 19.7 4.28

5.2.4 Profitability Ratios

Profitability is the ability of a business to earn profit over a period of time. Although the profit figure is the starting point for any calculation of cash flow, as already pointed out, profitable companies can still fail for a lack of cash.

A company should earn profits to survive and grow over a long period of time. Profits are essential, but it would be wrong to assume that every action initiated by management of a company should be aimed at maximizing profits, irrespective of social consequences.

The ratios examined previously have tendered to measure management efficiency and risk. A. Gross Profit Margin

Normally the gross profit has to rise proportionately with sales. It can also be useful to compare the gross profit margin across similar businesses although there will often be good reasons for any disparity.

Gross profit Gross Profit Margin = ________________ Sales

*100

Significance:

The gross profit ratio helps in measuring the results of trading or manufacturing operations. It shows the gap between revenue and expenses at a point after which an enterprise has to meet the expenses related to the nonmanufacturing activities, like marketing, administration, finance and also taxes and appropriations. The gross profit shows the gap between revenue and trading costs. It, therefore, indicates the extent to which the revenue have a potential to generate a surplus. In other words, the gross profit reveals the mark up on the sales. Gross profit ratio reveals profit earning capacity of the business with reference to its sale. Increase in gross profit ratio will mean reduction in cost of production or direct expenses or sale at a reasonably good price and decrease in the will mean increased cost of production or sales at a lesser price. Higher gross profit ratio is always in the interest of the business. Gross margin ratio measures profitability. Higher values indicate that more cents are earned per dollar of revenue which is favorable because more profit will be available to cover non-production costs. But gross margin ratio analysis may mean different things for different kinds of businesses. For example, in case of a large manufacturer, gross margin measures the efficiency of production process. For small retailers it gives an impression of pricing strategy of the business. In this case higher gross margin ratio means that the retailer charges higher markup on goods sold.

Table: 5.10 Year

GROSS PROFIT MARGIN Gross Profit Rs. in corers 1695.28 1051.08 Net Sales Rs. in corers 10918.36 10918.36 15.52% 10.57% Ratio

2011 2012

Interpretation:

In the year 2011, the Gross Profit Ratio was 15.52% but then it decreased to 10.57%, which does not shows a good profit earning capacity of the business with reference to its sales. There is decrease in the percentage of gross profit as compared to the previous year; it is indicator of one or more of the following factors. a) There may be decrease in the selling rate of the goods sold without corresponding decrease in the cost of goods sold. b) There may be increase in the cost of goods sold without corresponding increase in the selling price of the goods sold. c) There may be omission of sales. d) Increase in direct expenses e) Sales have not increased proportionally

Chart no.: 5.10

GROSS PROFIT MARGIN

12000 10000 8000 6000

e l t T s i x A
4000 2000 0 2011 2012 gross profit 1695.28 1051.08 Net sales 10918.36 9914.96 Current ratio 15.52 10.57

B. Net Profit Margin This is a widely used measure of performance and is comparable across companies in similar industries. The fact that a business works on a very low margin need not cause alarm because there are some sectors in the industry that work on a basis of high turnover and low margins, for examples supermarkets and motorcar dealers. What is more important in any trend is the margin and whether it compares well with similar businesses. Earnings after interest and taxes Net Profit Margin =______________________________ *100 Net Sales Significance: An objective of working net profit ratio is to determine the overall efficiency of the business. Higher the net profit ratio, the better the business. The net profit ratio indicates the managements ability to earn sufficient profits on sales not only to cover all revenue operating expenses of the business, the cost of borrowed funds

and the cost of merchandising or servicing, but also to have a sufficient margin to pay reasonable compensation to shareholders on their contribution to the firm. A high ratio ensures adequate return to shareholders as well as to enable a firm to with stand adverse economic conditions. A low margin has an opposite implication. Net profit ratio is used to measure the overall profitability and hence it is very useful to proprietors. The ratio is very useful as if the net profit is not sufficient, the firm shall not be able to achieve a satisfactory return on its investment. This ratio also indicates the firm's capacity to face adverse economic conditions such as price competition, low demand, etc. Obviously, higher the ratio the better is the profitability. But while interpreting the ratio it should be kept in mind that the performance of profits also be seen in relation to investments or capital of the firm and not only in relation to sales.

Table: 5.11 Year 2011 2012

NET PROFIT MARGIN Net Profit Rs. in crores 237.10 61.54 Sales Rs. in crores 10918.36 9941.96 Ratio

2.17% 0.6%

Interpretation: In the year 2011 the Net Profit margin is 2.17%, but in the year 2012 it was decreased to 0.6% which may due to a) Excessing selling and distribution expenses. b) Increase in finance cost c) Increase in Depreciation cost

d) Reduction in interest income Chart no.: 5.11

12000 10000 8000 6000

NET PROFIT MARGIN

e l t T s i x A
4000 2000 0 2011 2012 Net profit 237.1 61.54 Net sales 10918.36 9914.96 Net profit margin 2.17% 0.60%

C. Operating Profit Margin Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest Also known as "operating profit margin" or "net profit margin". Operating margin is used to measure company's pricing strategy and operating efficiency. It gives an idea of how much a company makes (before interest and taxes) on each dollar of sales. Operating margin ratio shows whether the fixed costs are too high for the production or sales volume. A high or increasing operating margin is preferred because if the operating margin is increasing, the company is earning more per dollar of sales. Operating margin can be used to compare a company with its competitors and with its past performance. It is best to analyze the changes of

operating margin over time and to compare company's figure to those of its competitors. Operating margin shows the profitability of sales resulting from regular business. Operating income results from ordinary business operations and excludes other revenue or losses, extraordinary items, interest on long term liabilities and income taxes. Operating margin gives analysts an idea of how much a company makes (before interest and taxes) on each dollar of sales. When looking at operating margin to determine the quality of a company, it is best to look at the change in operating margin over time and to compare the company's yearly or quarterly figures to those of its competitors. If a company's margin is increasing, it is earning more per dollar of sales. The higher the margin, the better

Significance Operating income is revenue less operating expenses for a given period of time, such as a quarter or year. Operating margin is a percentage figure usually given as operating income for some period of time divided by revenue for the same time period. Operating margin is the percentage of revenue that a company generates that can be used to pay the company's investors (both equity investors and debt investors) and the tax man. It is a key measure in analyzing a stock's value. Other things being equal, the higher the operating margin, the better. Using a percentage figure is also very useful for comparing companies against or analyzing the operating results of one company over various revenue scenarios. Operating margin ratio of 9% means that a net profit of $0.09 is made on each dollar of sales. Thus a higher value of operating margin ratio is favorable which indicates that more proportion of revenue is converted to operating income. An increase in operating margin ratio overtime means that the profitability is improving. It is also important to compare the gross margin ratio of a business to the average gross

profit margin of the industry. In general, a business which is more efficient is controlling its overall costs will have higher operating margin ratio. Operating profit is important because it is an indirect measure of efficiency. The higher the operating profit, the more profitable a company's core business is. Several things can affect operating profit, such as pricing strategy, prices for raw materials, or labor costs, but because these items directly relate to the day-to-day decisions managers make, operating profit is also a measure of managerial flexibility and competency, particularly during rough economic times. It is also important to note that some industries have higher labor or materials costs than others. This is why comparing operating profits or operating margins is generally most meaningful among companies within the same industry, and the definition of a "high" or "low" profit should be made within this context.

Operating income Year 2011 2012 Rs. in crores 18.12 183.55

Net sales Rs. in crores 11062.40 10380.81 Ratio 0.16% 1.76%

Interpretation a) Rise in Operating income b) Fall in net sales c) Ultimately increasing the ratio Chart no.: 5.12 Operating profit margin

12000 10000 8000 6000

e l t T s i x A
4000 2000 0 Operating income 2011 2012 18.12 183.55 Net sales 11062.4 10380.81 Operating profit margin 0.16% 1.76%

D. Return on Equity (ROE) This ratio shows the profit attributable to the amount invested by the owners of the business. It also shows potential investors into the business what they might hope to receive as a return. The stockholders equity includes share capital, share premium, distributable and non-distributable reserves. Return on equity or return on capital is the ratio of net income of a business during a year to its stockholders' equity during that year. It is a measure of profitability of stockholders' investments. It shows net income as percentage of shareholder equity. The ratio is calculated as follows: Net profit after taxes and preference dividend Return on Equity =__________________________________________ Equity capital

a) Net income is the after tax income

b) Average shareholders' equity is calculated by dividing the sum of shareholders' equity at the beginning and at the end of the year by 2. The net income figure is obtained from income statement and the shareholders' equity is found on balance sheet. Significance: This ratio measures the profitability of the capital invested in the business by equity shareholders. As the business is conducted with a view to earn profit, return on equity capital measures the business success and managerial efficiency. It reveals whether the firm has earned a reasonable profit to its equity shareholders or not by comparing it with its own past records, inter-firm comparison and comparison with the overall industry average. This ratio is of significant use in the ratio analysis from the standpoint of the owners of the firm. Return on equity is an important measure of the profitability of a company. Higher values are generally favorable meaning that the company is efficient in generating income on new investment. Investors should compare the ROE of different companies and also check the trend in ROE over time. However, relying solely on ROE for investment decisions is not safe. It can be artificially influenced by the management, for example, when debt financing is used to reduce share capital there will be an increase in ROE even if income remains constant.

Table: 5.13

RETURN ON EQUITY

Net Profit after Year Tax and Preference Dividend 2011 2012 Rs. in crores 237.10 61.54 Equity Capital Rs. in crores 1947.04 1917.16 12.17% 3.2% Ratio

Interpretation In the year 2011, the return on equity ratio is 12.17% but in the year 2012 it reduced to 3.2%, which may due to a) Capital investment b) Shortage in Reserve and Surplus c) Excessing selling and distribution expenses. d) Increase in finance cost e) Increase in Depreciation cost f) Reduction in interest income

Chart no.: 5.13

RETURN ON EQUITY

2500 2000 1500

e l t T s i x A

1000 500 0 2011 2012

Net profit 237.1 61.54

Equity 1947.04 1917.16

Return on Equity 12.17% 3.20%

E. Return on Assets An indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's annual earnings by its total assets, ROA is displayed as a percentage. Return on assets is the ratio of annual net income to average total assets of a business during a financial year. It measures efficiency of the business in using its assets to generate net income. ROA = Annual Net Income Average Total Assets a) Net income is the after tax income. It can be found on income statement. b) Average total assets are calculated by dividing the sum of total assets at the beginning and at the end of the financial year by 2. Total assets at the beginning and at the end of the year can be obtained from year ending balance sheets of two consecutive financial years.

Significance

ROA tells you what earnings were generated from invested capital (assets). ROA for public companies can vary substantially and will be highly dependent on the industry. This is why when using ROA as a comparative measure, it is best to compare it against a company's previous ROA numbers or the ROA of a similar company. Return on assets indicates the number of cents earned on each dollar of assets. Thus higher values of return on assets show that business is more profitable. This ratio should be only used to compare companies in the same industry. The reason for this is that companies in some industries are most asset-insensitive i.e. they need expensive plant and equipment to generate income compared to others. Their ROA will naturally be lower than the ROA of companies which are low asset-insensitive. An increasing trend of ROA indicates that the profitability of the company is improving. Conversely, a decreasing trend means that profitability is deteriorating. Table 5.14 Return on Assets Net Income Year 2011 2012 Rs. in crores 237.10 61.54 Total Assets Rs. in crores 4565.87 4867.20 Ratio 5.19% 1.26%

Interpretation a) Significant fall in Net income major reason of fall in Ratio b) Rise in Assets but not much significant

c) Giving a great fall I ratio by 3.93%

Chart no. 5.14 Assets

6000 5000 4000 3000 2000 1000 0 2011 2012 Net Income 237.1 61.54 Total Assets 4565.87 4867.2 Ratio 5.19% 1.26%

Return on

F. Return on Capital Employed A ratio that indicates the efficiency and profitability of a company's capital investments. ROCE should always be higher than the rate at which the company borrows; otherwise any increase in borrowing will reduce shareholders' earnings. Return on capital employed (ROCE) is the ratio of net operating profit of a company to its capital employed. It measures the profitability of a company by expressing its operating profit as a percentage of its capital employed. Capital employed is the sum of stockholders' equity and long-term finance

Significance By comparing net income to the sum of a company's debt and equity capital, investors can get a clear picture of how the use of leverage impacts a company's profitability. Financial analysts consider the ROCE measurement to be a more comprehensive profitability indicator because it gauges management's ability to generate earnings from a company's total pool of capital. A higher value of return on capital employed is favorable indicating that the company generates more earnings per dollar of capital employed. A lower value of ROCE indicates lower profitability. A company having less assets but same profit as its competitors will have higher value of return on capital employed and thus higher profitability. Table 5.14 Year Return on Capital Employed EBIT Rs. in crores Capital Employed Rs. in crores 2214.6 2241.6 Ratio

2011 2012

311.07 141.63

0.13 0.06

Interpretation a) Significant fall in EBIT b) Hence reducing the Ratio by 0.07

Chart no. 5.14

2500 2000 1500 1000 500 0 2011 2012

Return on Capital Employed

EBIT 311.07 141.63

Capital Employed 2214.6 2214.6

Ratio 0.13 0.06

Bibliography
www.hcl.in www.hclinfosystems.in www.investopedia.com http://accountingexplained.com http://www.managementstudyguide.com http://www.ccdconsultants.com http://www.answers.com