PGDM 2013-15 Ratio Analysis

Ratio Analysis is a study of relationship among various financial factors in a business. Ratio Analysis is a technique of analysing the financial statements by computing Ratios. A Ratio is an arithmetical expression of relationship between two related or interdependent items. Expression of Ratio 1. Pure 2. Percentage 3. Time 4. Fraction Users of Ratio Analysis 1. Shareholders/Owners 2. Managers 3. Creditors/Lenders 4. Potential Investors 5. Analysts Ratios computed for different users are compared with 1. Past Year(s) Data 2. Nearest Competitor 3. Industry Leader 4. Industry averages Types of Ratios 1. Return on Investment Ratio 2. Activity/Turnover Ratio 3. Liquidity Ratio 4. Solvency Ratio 5. Profitability Ratio

Caution (What analysts must ensure in calculating, using and interpreting Ratio)
1. 2. 3. 4. Look for any difference in Industry group, Accounting Policies, Size & Nature. Look for any change in Price Level. Similarity in defining various terms in financial statements and Ratio. Reliance on past to predict future.

Cash Flow Statement Analysis The Analyst should analyze the Cash Flow Statement also. While doing so, he/she should carefully look into the cash flows being generated/used from/in Operating activities, cash flows being generated/used from/in Investing activities, cash flows being generated/used from/in Financing activities. The analyst should also compare the Net Profit and Cash Flow generated from Operating Activities. This shows the quality of Earning, whether Business is able to convert its sales into Cash quickly or it has large amount of Trade Receivables on its Balance Sheet. The analyst should also see whether Business is self sufficient to fund its Investing Activities through its Cash flows from Operating Activities or it has to rely on cash flows from financing activities which may attract heavy Interest charges affecting the profitability of the Business.

Why Ratios Return on Investment Ratio 1. Return on Assets Useful for those divisional heads who have no control over the financing pattern of assets they have. The financing pattern (debt and equity) is decided by the top management of the Organisation. 2. Return on Invested Capital Useful for those shareholders, Bankers and Financial Institutions who have provided the funds to the Organisation for a longer period (more than 5 years). 3. Return on Net Worth Useful for present and potential shareholders and also for the management of the Organisation as an important indicator of Wealth Creation for shareholder. Activity/Turnover Ratio 1. Total Asset Turnover Ratio Useful for managers. Indicates how much sales are being generated on Total Assets of Business or how effectively total assets have been put to use by the Organisation.The other variant of this ratio is Fixed Assets Turnover Ratio. 2. Invested Capital Turnover Ratio Useful for Long Term Fund Providers. Indicates the level of sales generated by using Long term Funds. 3. Net worth Turnover Ratio - Useful for Share capital providers. Indicates how much sales is being generated by using shareholders funds. 4. Average Collection Period (ACP) Useful for Managers and Working Capital Funds providers. Indicates the period, company takes to collect money from its debtors. 5. Inventory Turnover Ratio - Useful for Managers and Working Capital Funds providers. Indicates the velocity with which Inventory moves or how quickly a company is able to convert its inventory into cash or cash equivalents. 6. Working Capital Turnover Ratio - Useful for Managers and Working Capital Funds providers. Indicates how much sales company is able to make on working capital. 7. Days Inventory Useful for managers. Indicates the no of days for which the company has the inventory in hand. 8. Average Credit Period Useful for managers so that they can compare Average Credit period with Average Collection Period. Indicates the no of days ,within which company pays off to its creditors for goods. Liquidity Ratio 1. Current Ratio Useful for Managers and working capital fund providers. Measures the companys liquidity and also the margin of safety ,the company has in order to meet any emergency arising out of uneven flows of funds through current assets and current liabilities account. 2. Acid Test Ratio Useful for Managers and working capital fund providers. A better indicator of immediate liquidity position of the Organisation. Companies having similar Current Ratio are analysed on Acid Test Ratio as it gives better picture of liquidity position of the Organisation.

Solvency Ratio 1. Debt Equity Ratio Useful for Lenders, Shareholders and potential shareholders. Indicates the Organisations reliance on own funds or debt funds. Higher debt is cause of concern for Organisation. 2. Debt to Total Invested Capital Useful for Lenders, Shareholders and potential shareholders. Indicates the proportion of debt in total Long Term Funds available with the Organisation. 3. Interest Coverage Ratio Useful for Lenders and Managers. Indicates the safety net available to the Organisation for the payment of Interest Charges. Capital Market Ratio 1. Earning Per Share Useful for Shareholders. Indicates the amount of profit available for equity shareholders after paying off all expenses. 2. Book value to Market value Useful for Shareholders. Indicates whether share is properly priced, under priced or overpriced. 3. Dividend Payout Useful for Shareholders. Indicates how much dividend is paying out by the Organisation. 4. Price Earning Ratio Useful for shareholders. Expresses the market price as a certain multiple of earning per share. Profitability Ratio 1. Gross profit Ratio Useful for Managers, Shareholders/Owners and Lenders. Indicates how much amount of Profit is left after paying the manufacturing/trading Expenses. Provide information of the cushion available for paying Interest and other operating Expenses. 2. Operating Profit Ratio - Useful for Managers, Shareholders/Owners and Lenders. Indicates the profit available after deducting Manufacturing and Operating Expenses (including depreciation) from Total Revenue. Provide information of the cushion available for paying Interest. 3. Net Profit Ratio - Useful for Managers, Shareholders/Owners and Lenders. Indicates the amount of profit available after deducting total expenses from total revenue. 4. Expenses to Sales Ratio Profitability ratios are useful for all the parties interested in Financial Statements. These ratios indicate the different types of profits being generated by the Organisation.The Expenses to sales ratio is significant in finding out the portion of different expenses in the total expenditures.

Ratio Computation
1). Return on Investment Ratio Return on Assets (ROA) = Profit after Tax + Interest Total Assets Total Assets = Non Current Assets + Current Assets

Return on Invested Capital (ROIC) =

Profit After Tax _____ Non Current Liabilities + Shareholders Fund

Return on Net Worth (RONW) = Profit after Preference Share Dividend (If any) Net Worth Net Worth = Shareholders Funds +Share Application Money Pending Allotments

2). Activity/Turnover Ratio Total Asset Turnover Ratio = Sales Revenue (Net of returns & Excise) Total Assets

Invested Capital Turnover Ratio = Sales Revenue (Net of returns &Excise)_____ Non Current Liabilities + Shareholders Fund

Average Collection Period =

Trade Receivables*365 Credit Sales

In absence of data on Credit Sales, Net Sales can also be taken. Inventory Turnover Ratio = Cost of Goods Sold Inventory Cost of Goods Sold = Material consumed + Change in Stock + Manufacturing Expenses +Purchase of Tradable goods Inventory = Closing inventory

Working Capital Turnover Ratio = _Sales (Net) ___ Working Capital Working Capital = Current Assets Current Liabilities Days Inventory = 365/Inventory Turnover Ratio

Average Credit Period = Trade Payables*365 Credit Purchases In absence of data on Credit Purchases, Net Purchases of Raw Material/Finished goods/Goods for Trading can also be taken.

3). Liquidity Ratio Current Ratio = Current Assets /Current Liabilities Acid Test Ratio = Current Assets (Inventory + Prepaid Expenses)/Current Liability

4). Solvency Ratio Debt Equity Ratio = Non Current Liability/Shareholders Funds

Debt to Total Invested Capital =

Non Current Liability______________ Non Current Liabilities + Shareholders Fund

Interest Coverage Ratio = Earnings before Interest & Tax / Total Interest Charges

5). Capital Market Ratio Earnings per Share = _PAT Preference Share Dividend_____ No of Equity Shares outstanding/issued Cash Realisation = Cash Generated by Operations PAT This Ratio is useful for Managers and Lenders. It indicates how close PAT is of being realised in cash. Higher the ratio better is the quality of earning.

Book Value to Market Value = Book Value of Share/Current Market Price

Dividend Payout Ratio = Dividend/Profit after Tax

Price Earning Ratio = Market Price/EPS

6). Profitability Ratio Gross Profit Ratio = ______Gross Profit*100_____ Sales net of returns & Excise Gross Profit = Sales Cost of Goods Sold

Net Profit Ratio = ______Net Profit*100______ Sales net of returns & Excise

Operating Profit Ratio =___Operating Profit*100_____ Sales net of returns & Excise