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RATIO ANALYSIS FOR BUSINESS DECISION MAKING

Learning Objectives : On completion of their studies students should be able to:


Calculate and interpret a full range of accounting ratios
Analyse financial statements (in the context of information provided in the accounts and corporate report) to
comment on performance and position
Prepare a concise report on the results of an analysis of financial statements
Understand the limitations of accounting ratio analysis and analysis based on financial statements
Meaning of Ratio Analysis
A Ratio is a simple mathematical expression of the relationship of one item to another. It can be expressed as a
percent, rate, or portion. Ratio analysis involves studying various relationships between different items reported in a
set of financial statements.
Ratio analysis helps to interpret the information in such a way that it can be understood by even those people who
are not much familiar with financial figures and statistics. However, all the problems of a business cant be solved
by ratio analysis. It will merely give a general indication of a trend, at the same time spotlighting any divergence
from normality. This knowledge, however, should enable management to correct whatever may be going wrong in
business. This unit deals with meaning, classification, advantages and calculation of ratios.
1. LIQUIDITY RATIOS
Current Ratio
Quick Ratio
Absolute Liquid Ratio
Accounts Receivable to Working Capital
Inventory to Working Capital
2. ACTIVITY RATIOS
Short Term
Inventory Turnover Ratio

Inventory holding period


Debtors Turnover Ratio
Debtors Collection Period
Creditors Turnover Ratio
Creditors Payment Period
Operating Cycle Days
Long Term / Efficiency

Total Assets Turnover ratio


Net Fixed Assets Turnover ratio
Working Capital Turnover ratio
3. PROFITABILITY RATIOS
Gross Profit margin
Net Profit Margin

Operating Ratio
Operating Profit Ratio
4. SOLVENCY RATIOS
Debt to Equity
Debt to Total Assets
Proprietary Ratio
Capital Gearing Ratio

Financial Flexibility Ratio


Net Fixed Assets to Equity

Analysis of Financial Statements

1.1
1.2
1.3
1.4
1.5

2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9
2.10

3.1
3.2
3.3
3.4

4.1
4.2
4.3
4.4
4.5
4.6

5. COVERAGE RATIOS
Interest Coverage ratio
Dividend Coverage
Debt Service Coverage Ratio
Basic Defence Interval

5.1
5.2
5.3
5.4

6. INVESTMENT VALUATION RATIOS

Earnings Per Share


Price Earnings Ratio
Price Earnings to Growth Ratio
Dividend Per Share
Dividend Payout Ratio
Dividend Yield Ratio
Book Value Per Share
7. Return on Investment Measurements
Return on Assets Employed
Return On Equity
Financial Leverage Index

The DuPont formula


1.

6.1
6.2
6.3
6.4
6.5
6.6
6.7

7.1
7.2
7.3
7.4

LIQUIDITY RATIO

Liquidity is the ability of the company to repay its debts in the short-term (one year). Consequently, these ratios will
focus on the current assets and the current liabilities. Current assets can, by definition, generally be converted into
cash (liquidated) within 12 months of year-end and similarly, current liabilities are debts that must generally be
settled within 12 months of year-end. These ratios give an indication of managements operational capabilities
regarding the management of working capital.
The main liquidity ratios include:
Current ratio;
Acid-test ratio; and
Working capital ratio.
The following ratios look at each of the individual components of the current assets and current liabilities (indicating
how liquid each item is):
Debtors: collection period and turnover ratios;
Inventory: days on hand and turnover ratios;
Creditors: repayment period and turnover ratios; and
Business cycle ratio.
1.1 Current Ratio

Current ratio =

Total current assets


Total current liabilitie s

This ratio reflects the number of times short-term assets cover short-term liabilities and is a fairly accurate indication
of a company's ability to service its current obligations. A higher number is preferred because it indicates a strong
ability to service short-term obligations. The composition of current assets is a key factor in the evaluation of this
ratio.

Analysis of Financial Statements

A rule of thumb is that a ratio of 2 : 1 (Rs.2 in current assets for every Re.1 of current liabilities) is acceptable.
However, the current ratio may vary from less than one in such industries as fast foods to more than two in the
telephone apparatus manufacturing industry. Consequently, it is important to utilize the industry averages.
Analysis:
Firstly, the numerator of this ratio includes the estimate of inventories and accounts receivable. As the inventory
evaluation methods may differ this affects the comparability of the values, and the same must be taken into account
for the treatment and accounting of debts;
Secondly, the value of the ratio is in fact closely related to the level of efficiency in the enterprise in respect of stock
management: some companies with high level of organisation of the technological process, for example, by
implementing such raw materials and consumables supply systems which is known as just-in-time can reduce the
level of stock considerably, i.e., by also reducing the current ratio to the minimum than on average in the industry
thus keeping the current financial position free from losses;
Thirdly, some enterprises with a high turnover of cash assets can afford to keep the liquidity ratios relatively low, for
example, in retail trade. In this situation acceptable liquidity was ensured on account of a more intensive cash flow
from current operations.
It is important to identify the specific types of current assets that are excessive such as
1. Excessive stock levels, indicating poor stock control or a decline in sales volume
2. Excessive debtors, indicating poor credit control and an increasing risk of bad debts
3. Excessive cash or near cash equivalents, indicating a lack of suitable investment opportunities in capital projects.
If the ratio is too high (>3), this indicates that there is a possible asset management problem in the enterprise and that
the working capital is not efficiently used. A ratio that is much higher than the industry average indicates that the
firm may have excessive current assets. Further investigation may demonstrate the cause of the excess. One reason
may be that the firm is having trouble in the collection of its debtors or has high inventory, both of which will be
identified through the use of other ratios. Another reason may be that the firm is holding too much cash or short term
investments which could be earning more money if they were invested in long term instruments. Still another reason
for a high ratio is that the firm may be at a specific point in its business cycle. The company that sells woolen goods
in winter is expected to have high inventory in November, December, January and high debtors in February.
A ratio which is much lower than the industry average indicates that the firm is having liquidity problems, meaning
that it may not be able to meet its short term obligations. Accordingly, an extremely low current ratio should be a red
flag to the company being analyzed.
How to Manage the Current Ratio
The apparent simplicity of the current ratio can have real-world limitations. An addition of equal amounts to both the
numerator and the denominator causes the ratio to change.
Assume, for example, that a company has 2,000,000 of current assets and 1,000,000 of current liabilities. Its current
ratio is 2:1. If it purchases 1,000,000 of inventory on account, it will have 3,000,000 of current assets and 2,000,000
of current liabilities. Its current ratio
will decrease to 1.5:1. If, instead, the company pays off 500,000 of its current liabilities, it will have 1,500,000 of
current assets and 500,000 of current liabilities, and its current ratio will increase to 3:1. Thus, any trend analysis
should be done with care, because the ratio is susceptible to quick changes and is easily influenced by management.
1.2 Quick Ratio / Acid test Ratio / Liquidity Ratio
Depending on the type of business or industry, current assets may include slow-moving inventories that could
potentially affect analysis of a company's liquidity. How long could it potentially take to convert raw materials and
inventory into finished products? (For this reason, the quick ratio may be preferable to the current ratio because it

Analysis of Financial Statements

eliminates inventory and prepaid expenses from this ratio for a more accurate gauge of a company's liquidity and
ability to meet short-term obligations.)
(Quick assets / Quick liabilities ) OR ( Quick assets / Current liabilities )

This ratio measures immediate liquidity - the number of times cash, accounts receivable, and marketable securities
cover short-term obligations. A higher number is preferred because it suggests a company has a strong ability to
service short-term obligations. This ratio is a more reliable variation of the Current ratio because inventory, prepaid
expenses, and other less liquid current assets are removed from the calculation.
1.3 Absolute Liquid Ratio
(Cash + Cash equivalents) / (Current liabilities)
Cash Equivalents includes marketable securities. Absolute Liquid Ratio is also called as Cash Position Ratio (or)
Over Due Liability Ratio. This ratio establishes the relationship between the absolute liquid assets and current
liabilities. Absolute Liquid Assets include cash in hand, cash at bank, and marketable securities or temporary
investments. The optimum value for this ratio should be one, i.e., 1: 2. It indicates that 50% worth absolute liquid
assets are considered adequate to pay the 100% worth current liabilities in time. If the ratio is considerably more
than one, the absolute liquid ratio represents enough funds in the form of cash to meet its short-term obligations in
time.
1.4 Accounts Receivable to Working Capital
Trade Accounts Receivable / (Current Assets - Current Liabilities)
This ratio measures the dependency of working capital on the collection of receivables. A lower number for this
ratio is preferred, indicating that a company has a satisfactory level of working capital and accounts receivable
makes up an appropriate portion of current assets.
1.5 Inventory to Working Capital
Inventory / (Current Assets - Current Liabilities)
This ratio measures the dependency of working capital on inventory. A lower number for this ratio is preferred
indicating that a company has a satisfactory level of working capital and inventory makes up a reasonable portion of
current assets.
2.

ACTIVITY RATIOS / Turn over ratios

Generally, turn over ratios indicate the operating efficiency. These are used to measure the speed with which
various accounts are converted into sales or cash. The higher the ratio, the higher the degree of efficiency and hence
these assume significance. Further, depending upon the type of turn over ratio, indication would either be about
liquidity or profitability also. For example, inventory or stocks turn over would give us a measure of the
profitability of the operations, while receivables turn over ratio would indicate the liquidity in the system.
These ratios are used along with liquidity ratio because measures of liquidity are generally inadequate due to the
composition of the firms current assets and current liabilities.
2.1 Stock Turnover Ratio (STO)
STO = COGS / Average stock at cost

Analysis of Financial Statements

It commonly measures the activity or liquidity of the firms stock.. The STO is also known as stock velocity.
Velocity refers to speed with which an object travel. Here, it is the speed on converting the stock into sales then to
cash. It indicates the number of times the stock has been turned over as cash during a given period of time. It
evaluates the efficiency with which a firm is able to manage its stock.
This ratio directly contributes to the profitability of the organisation. The inventory should turn over at least 4 times
in a year, even for a capital goods industry. But there are capital goods industries with a very long production cycle
and in such cases, the ratio would be low. The production cycle and the corporate policy of keeping high stocks
affect this ratio. The less the production cycle, the better the ratio and vice-versa. The higher the level of stocks, the
lower would be the ratio and vice-versa.
2.2 Inventory holding period / Stock Conversion period
This is inverse of stock turnover ratio. It shows no. of days to convert raw material to finished goods.
1/ Inventory Turnover Ratio OR ( Inventory / Cost of goods sold) X

0 days

2.3 Debtors Turnover Ratio


= Total credit sales/Average debtors outstanding during the year
This ratio measures the number of times receivables turn over in a year and reveals how successful a company is in
collecting its outstanding receivables. A higher number is preferred because it indicates a shorter time between sales
and cash collection. It indicates the efficiency of collection of receivables and contributes to the liquidity of the
system.
Hence the minimum would be 3 to 4 times, but this depends upon so many factors such as, type of industry, etc
(a) capital goods, consumer goods - For capital goods, this would be less and consumer goods, this would be
significantly higher;
(b) Conditions of the market monopolistic or competitive monopolistic, this would be higher and competitive it
would be less as you are forced to give credit;
(c) Whether new enterprise or established new enterprise would be required to give higher credit in the initial
stages while an existing business would have a more fixed credit policy evolved over the years of business;
Hence any deterioration over a period of time assumes significance for an existing business this indicates change
in the market conditions to the business and this could happen due to general recession in the economy or the
industry specifically due to very high capacity or could be this unit employs outmoded technology, which is forcing
them to dump stocks on its distributors and hence realisation is coming in late etc.
2.4 Debtors Collection period
Average collection period = inversely related to debtors turn over ratio.
1 / (Debtors Turnover Ratio) X No. of Days

OR

( Debtors + BR / Net credit sales) x No. of Days

It is also known as Debtors velocity. The birth of debtor comes from credit sales. Total debtors include the Bills
Receivable also. The Bills receivables are written promise of trade debtors. Trade debtors are normally provided
with 3 months credit time. After the expiry, they will pay cash. Thus, debtors are expected to be converted into cash
within a short period.
This ratio explains the average number of days a company's receivables are outstanding. A lower number of days is
desired. An increase in the number of days receivables are outstanding indicates an increased possibility of late
payment by customers. Companies should attempt to reduce the number of days sales in receivables in order to
increase cash flow.

Analysis of Financial Statements

2.5 Creditors Turnover Ratio : CTO


( Creditors + Bills Payable / Credit purchases ) x 365 days
Creditors come into being out of credit purchases. Creditors include both trade creditors and bills payables. It is
included in the current liability since the payment has to be made within three months normally.
2.6 Creditors Payment Period
1 / (Creditors Turnover Ratio) X No. of Days

OR ( Creditors + BP / Net credit Purchases) x No. of Days

A calculation of the days of accounts payable gives an outside observer a fair indication of a companys ability to
pay its bills on time. If the accounts payable days are inordinately long, this is probably a sign that the company does
not have sufficient cash flow to pay its bills and may find itself out of business in short order. Alternatively, a small
number of accounts payable days indicate that a company is either taking advantage of early payment discounts or is
simply paying its bills earlier than it has to.
2.7 Operating Cycle Days
(Stock Holding period + Debtors Collection Period ) Creditors Payment Period
This ratio calculates the total conversion period for a company, or in other words, the average number of days it
takes to convert inventory into cash from sales. It is calculated by adding together the days cost of sales in inventory
to the days sales in receivables. Evaluating this ratio can be helpful in gauging the effectiveness of marketing,
determining credit terms to extend to customers, and collecting outstanding accounts.

2.8 Assets Turnover ratio - Asset utilization Ratio


Sales / Total Assets
This ratio measures a company's ability to produce sales in relation to total assets to determine the effectiveness of
the company's asset base in producing sales. A higher number is preferred, indicating that a company is using its
assets to successfully generate sales. This ratio does not take into account the depreciation methods employed by
each company and should not be the only measure of effectiveness of a company in this area.
Overcapitalization
Overcapitalization is a situation in which actual profits of a company are not sufficient enough to pay interest on
debentures, on loans and pay dividends on shares over a period of time. This situation arises when the company
raises more capital than required. A part of capital always remains idle. With a result, the rate of return shows a
declining trend.
Undercapitalization
An undercapitalized company is one which incurs exceptionally high profits as compared to industry. An
undercapitalized company situation arises when the estimated earnings are very low as compared to actual profits.
This gives rise to additional funds, additional profits, high goodwill, high earnings and thus the return on capital
shows an increasing trend.
2.9 Net Fixed Assets Turnover ratio
Sales / (Fixed Assets - Accumulated Depreciation)

Analysis of Financial Statements

This ratio measures a company's ability to effectively utilize its fixed assets to generate sales. This ratio is similar to
the sales to assets ratio, but it excludes current assets, long-term investments, intangible assets, and other non-current
assets. A higher number is desired, indicating that a company productively uses its fixed assets to produce sales. In
addition, fixed assets that are almost fully depreciated, and labor-intensive operations may interfere with the
interpretation of this ratio.
2.10 Working Capital Turnover ratio
Sales / (Current Assets - Current Liabilities)
This ratio measures a company's ability to finance current operations. Working capital is another measure of
liquidity and the ability to cover short-term obligations. This ratio relates the ability of a company to generate sales
using its working capital to determine how efficiently working capital is being used.
Significance:
It is an index to know whether the working capital has been effectively utilized or not in making sales. This ratio
shows the amount of Working Capital required to maintain a certain level of sales. It is most effective when tracked
on a trend line, so that management can see if there is a long-term change in the amount of Working Capital required
by the business in order to generate the same amount of sales.
A higher working capital turnover ratio indicates efficient utilization of working capital, i.e., a firm can repay its
fixed liabilities out of its working capital. Also, a lower working capital turnover ratio shows that the firm has to
face the shortage of working capital to meet its day-to-day business activities unsatisfactorily.
3. PROFITABILITY RATIOS
The term profitability means the profit earning capacity of any business activity. Profitability ratios measure a
companys ability to use its capital or assets to generate profits. Improving profitability is a constant challenge for all
companies and their management. Evaluating profitability ratios is a key component in determining the success of a
company.
This is an analysis of the profits as per the statement of income as well as the analysis of the profitability in relation
to the related capital investment/s and sources of finance per the statement of financial position. The profitability
ratios can therefore, be divided into three separate areas:
Pure analysis of the statement of income: e.g. gross profit percentage and net profit percentage;
3.1 Gross Profit margin
((Sales - Cost of Sales) / Sales) * 100
Gross Profit Margin reflects the efficiency with which management produces each unit of product. It indicates the
average spread between the cost of goods sold and the sales revenue.
This ratio measures the gross profit earned on sales and reports how much of each rupee of sales is available to cover
operating expenses and contribute to profits.
3.2 Net Profit Margin
Earnings after Taxes / Sales * 100
This ratio measures how much profit a company makes on sales received and how well a company could potentially
deal with higher costs or lower sales in the future.

Analysis of Financial Statements

This ratio indicates the firms ability withstand adverse economic conditions. It establishes a relationship between
net profit and sales and also indicates managements efficiency in manufacturing, administering and selling of
products. Net profit margin ratio is the overall measure of the firms ability to turn each rupee sales into Net profit
3.3 Operating Ratio
Operating Cost / Net Sales * 100
Operating Cost = Cost of goods sold + Administrative Expenses + Selling and Distribution Expenses
Operating Ratio is calculated to measure the relationship between total operating expenses and sales. The total
operating expenses is the sum total of cost of goods sold, office and administrative expenses and selling and
distribution expenses. In other words, this ratio indicates a firm's ability to cover total operating expenses.
3.4 Operating Profit Ratio
Operating Profit / Net Sales * 100
Operating Profit Ratio indicates the operational efficiency of the firm and is a measure of the firm's ability to cover
the total operating expenses.
4. SOLVENCY/ STRUCTURE
This is the ability of the company to repay its debts in the long-term. The ratios, therefore, are not restricted to the
current assets and current liabilities but deal rather with the total assets and total liabilities.
The solvency ratios give an estimate of the structural safety of the company, by calculating, in various ways, the
ratio of internally sourced finance to externally sourced finance. Internally sourced finance is more expensive but yet
a low risk source of finance (owners ordinary or preference share capital) versus externally sourced finance, which
is cheaper but yet a riskier source of finance (loans from the bank, debentures etc.).
It assess companys ability to meet its long-term obligations, remain solvent, and avoid bankruptcy. It measures how
well a companys cash flow covers its short-term financial obligations. Lenders evaluate these ratios to determine
the degree to which a company could become vulnerable when faced with economic downturns. A company with a
high level of debt poses a higher risk to lenders and investors.
4.1 Debt to Equity
Long term Liabilities / Total Equity = Borrowed Funds / Owners Funds
OR
Debt / (Debt + Equity)
The debt-equity ratio deals with the long term liabilities and equity portion of the balance sheet. Note that
shareholders equity includes retained earning (Equity may also be known as net worth). The debt-equity ratio
provides information on the capital structure (relationship between debt and equity) of the firm. Such information is
important because it affects the value of the firm. The value of the firm is important because it has an impact on the
ability to raise funds, either through increased borrowing or the sale of shares or both.
A high debt-equity ratio indicates a poor capital structure because it signifies that the firm has high debt in
comparison to its level of shareholders equity. This means that the firms lenders may be concerned about the
repayment of debt, which in turn leads to high interest rates, which in turn leads to higher required returns on the
firms potential investments.

Analysis of Financial Statements

This ratio measures the financial leverage of a company by indicating what proportion of debt and equity a company
is using to finance its assets. A lower number suggests there is both a lower risk involved for creditors and strong,
long-term, financial security for a company. A low debt equity ratio is an indication that the firm is in sound
financial position and therefore is not considered risky. Normally, the debt equity ratio vary tremendously from
industry to industry.
4.2 Debt to Total Assets
Total Long term Liabilities / Total Assets* 100
This is another variation of Debt- Equity Ratio. This ratio tells you how much of the firms assets are financed with
debt. A high debt ratio indicates that the firm may be carrying too much debt. This is of concern to the firm because
it may not be able to repay the debt nor to borrow additional funds they are needed. Accordingly, a firm in this
situation is considered risky because short term financing is limited and may not be available in an emergency.
A low debt means that the firm has a low level of liabilities compared to its total assets. Such a ratio indicates that
the firm is not risky because it has plenty of financing available when compared to its need. However, a low ratio
may also indicate that the firm should take on more debt. The reason for this is that the ability to borrow is
considered a resource and a firm with low debt may not be taking advantage of this resource. Naturally, companies
and creditors prefer a lower number.
4.3 Proprietory ratio
Proprietors Funds / Total Assets * 100
This is another variation of debt to total assets ratio. This ratio measures what proportion of total assets was provided
by the owners equity. The higher the number the more total capital has been contributed by owners and the less by
creditors.
Significance : This ratio used to determine the financial stability of the concern in general. Proprietary Ratio
indicates the share of owners in the total assets of the company. It serves as an indicator to the Creditors who can
find out the proportion of shareholders' funds in the total assets employed in the business. A higher proprietary ratio
indicates relatively little secure position in the event of solvency of a concern. A lower ratio indicates greater risk to
the creditors. A ratio below 0.5 is alarming for the creditors.
Equity Multiplier = Total Assets / Total Equity*100

This ratio measures the extent to which a company uses debt to finance its assets. The higher the number is, the more
a company is relying on debt to finance its assets.
4.4 Capital Gearing Ratio:
Capital Gearing

Fixed Interest BearingFunds


Variable cost bearing Funds

It denotes the extent of reliance of a company on the fixed cost bearing securities viz. the preference share capital
and the debentures as against the equity funds provided by the equity shareholders. The ratio is calculated as:
Fixed cost bearing capital = preference share capital, debentures , long term bank borrowings.
Variable cost bearing capital = equity share capital, reserves and surplus.
If fixed cost bearing capital is more than the equity capital, i.e. if the ratio is more than 1, the firm is said to be
highly geared. On the reverse, it is low geared.
Few Concepts

Analysis of Financial Statements

Equity Capital = Loan Capital = Even Gear


Equity Capital > Loan Capital = Low Gear = Over Capitalisation
Equity Capital < Loan Capital = Higher Gear = Under Capitalisation
It is useful to ascertain whether a company is practicing trading on equity and if so, to what extent is done.
Factors to consider in analysing whether gearing is at a suitable level:

Industry average?
Interest rates?
Return for shareholders?
Is debt finance put to good use?
Stability of profits?
Suitable assets for security?

-term debt be included in the calculation?

4.5 Financial Flexibility Ratio


working capital / shareholders equity
The financial flexibility ratio shows how much amount is utilized for working capital out of capital invested. This
measure is close to liquidity measures, but it is complementing and considerably increasing the financial leverage
ratio.
The cover of working capital by equity capital is a guarantee of a sustainable credit policy. High value of the
financial flexibility ratio positively describes the financial position of an enterprise as well as convinces that the
management of the enterprise show sufficient flexibility in their use of own resources.
Finance experts believe that the optimum level of this ratio is between 0.2 and 0.5 and the closer the value is to the
higher limit (0.5) the greater is the potential of the enterprise for financial flexibility. However, the level of the
financial flexibility ratio depends on the type of the enterprise operations. From the financial perspective, the
higher the flexibility ratio, the better is the financial position of the enterprise.
4.6 Net Fixed Assets to Equity
(Fixed Assetst - Accumulated Depreciation) / shareholders equity
This ratio measures the extent to which investors' capital was used to finance productive assets. A lower ratio
indicates a proportionally smaller investment in fixed assets in relation to net worth, which is desired by creditors in
case of liquidation. Note that this ratio could appear deceptively low if a significant number of a company's fixed
assets are leased.
5. COVERAGE RATIOS
In addition to the leverage ratios that use information about how debt is related to either assets or equity, there are a
number of financial coverage ratios that capture the ability of the company to satisfy its debt obligations.
5.1 Interest Coverage ratio / Times Interest Earned
Earnings before Interest and Taxes / Interest Expense
This ratio measures the number of times a company can meet its interest expense. The lower the ratio, the more the
company is burdened by debt expense. When a company's interest coverage ratio is only 1.5 or lower, its ability to
meet interest expenses may be questionable. A higher number is preferred, suggesting a company can easily meet

10

Analysis of Financial Statements

interest obligations and can potentially take on additional debt. Note that this particular ratio uses earnings before
interest and taxes because this is the income amount available to cover interest.
5.2 Preference Dividend Coverage Ratio
It measures the ability of a firm to pay dividend on preference shares which carry a stated rate of return. Higher
the coverage, better is the position.
Dividend Coverage =

Net Profit after Tax and Interest


Preference Dividend

(For Preference)
5.3 Debt Service Coverage Ratio / Fixed Charge Coverage Ratio
A company may have such a high level of fixed costs that it cannot survive a sudden downturn in profit. The fixed
charge coverage ratio can be used to see if this is the case.
Earnings available for debt service / Interest + Installment

OR

Earnings before interest and taxes / Interest + Scheduled principal payments


A key solvency issue is the ability of a company to pay its debts. This can be measured with the debt coverage ratio,
which compares reported earnings to the amount of scheduled interest and principal payments to see if there is
enough income available to cover the payments.
If the ratio is less than one, it indicates that a company will probably be unable to make its debt payments. The
measure is of particular interest to lenders, who are concerned about a companys ability to repay them for issued
loans.
A ratio close to one reveals that a company must use nearly all of its cash flows to cover fixed costs and is a strong
indicator of future problems if sales drop to any extent. A company in this position can also be expected to drop
prices in order to retain business, because it cannot afford to lose any sales.
EBITDA Coverage This is another variation of DSCR.

Earnings before interest, taxes, depreciation and amortization/Interest expense + Principal portion (debt service)
Both ratios pretend to define cash available to satisfy obligations. Debts are paid with cash, not with earnings.
Eliminates the effects of financing and accounting decisions
If EBITDA Coverage < 1, there is a high possibility that the company will not be able to pay its current obligation
as it will probably use the funds to pay its operating expenditure.
5.4 Basic Defence Interval / Expense Coverage Days
(Cash + Receivables + Marketable Securities) / (Annual Cash Expenditure /365)
OR
Liquid Assets / Expected daily operating expenses
This calculation yields the number of days that a company can cover its ongoing expenditures with existing liquid
assets. This is a most useful calculation in situations where the further inflow of liquid assets may be cut off, so the
management team needs to know how long the company will last without an extra cash infusion. The calculation is
also useful for seeing if there is an excessive amount of liquid assets on hand, which could lead to a decision to pay
down debt or buy back stock, rather than keep the assets on hand.
6. INVESTMENT VALUATION RATIOS
11 Analysis of Financial Statements

These ratios can be used by investors to estimate the attractiveness of a potential or existing investment and get an
idea of its valuation.
6.1 Earning Per Share Ratio
Net Profit After Tax and Preference Dividend / No. of Equity Shares
Earning Per Share Ratio (EPS) measures the earning capacity of the concern from the owner's point of view and it is
helpful in determining the price of the equity share in the market place.
6.2 Price Earning Ratio
Market Price Per Equity Share / Earning Per Share
Price Earning Ratio establishes the relationship between the market price of an equity share and the earning per
equity share. It measures how many times a stock is trading (its price) per each rupee of EPS. This ratio helps to find
out whether the equity shares of a company are undervalued or not. This ratio is also useful in financial forecasting.
A stock with high P/E ratio suggests that investors are expecting higher earnings growth in the future compared to
the overall market, as investors are paying more for today's earnings in anticipation of future earnings growth.
Hence, stocks with this characteristic are considered to be growth stocks. Conversely, a stock with a low P/E ratio
suggests that investors have more modest expectations for its future growth compared to the market as a whole.

6.3 Price Earnings to Growth Ratio


( P/E Ratio ) / Projected Earnings Per Share
The price/earnings to growth ratio, commonly referred to as the PEG ratio, is obviously closely related to the P/E
ratio. The PEG ratio is a refinement of the P/E ratio and factors in a stock's estimated earnings growth into its current
valuation. By comparing a stock's P/E ratio with its projected, or estimated, earnings per share (EPS) growth,
investors are given insight into the degree of overpricing or under pricing of a stock's current valuation, as indicated
by the traditional P/E ratio.
The general consensus is that if the PEG ratio indicates a value of 1, this means that the market is correctly valuing
(the current P/E ratio) a stock in accordance with the stock's current estimated earnings per share growth. If the PEG
ratio is less than 1, this means that EPS growth is potentially able to surpass the market's current valuation. In other
words, the stock's price is being undervalued. On the other hand, stocks with high PEG ratios can indicate just the
opposite that the stock is currently overvalued.
6.4 Dividend Per Share
Earnings paid to shareholders (Dividend) / Number of ordinary shares outstanding
This is the earnings distributed to ordinary shareholders against the outstanding number of ordinary shares.
6.5 Dividend Payout Ratio
Equity Dividend / Net Profit After Tax and Preference Dividend
OR
Dividend Per Equity Share / Earning Per Equity Share x 100

12

Analysis of Financial Statements

The dividend payout ratio tells an investor what proportion of earnings are being paid back in the form of dividends.
This is particularly important when the ratio is greater than one, since it indicates that a company is dipping into its
cash reserves in order to pay dividends, which is not a sustainable trend. Alternatively, if only a small proportion of
earnings is being paid back as dividends, the remaining cash is likely being plowed back into operations, which
should result in an increase in the stock price.
This ratio indicates the dividend policy adopted by the top management about utilization of divisible profit to pay
dividend or to retain or both. The dividend payout ratio is an indicator of how well earnings support the dividend
payment.
6.6 Dividend Yield Ratio
Dividend Per Share / Market Value Per Share x 100
Dividend Yield Ratio indicates the relationship is established between dividend per share and market value per
share. This ratio is a major factor that determines the dividend income from the investors' point of view.
This ratio allows investors to compare the latest dividend they received with the current market value of the share as
an indicator of the return they are earning on their shares. This enables an investor to compare ratios for different
companies and industries. Higher the ratio, the higher is the return to the investor
6.7 Book Value Per Share
Total equity Cost to liquidate preference shares / Total number of Equity shares outstanding
The book value per share measurement is used by investors and analysts to see if the market price of a share is in
excess of or less than its book value. A higher market price indicates that investors have assigned extra value to a
company, perhaps due to excellent management, products, patents, and so on.
7. RETURN ON INVESTMENT MEASUREMENTS
These ratios aimed at measurements that can be used to determine a companys ability to create a return on
investment. These measures encompass net worth, several types of return on assets and equity, economic value
added, and return on dividends. They can be used by investors to determine what to pay for a companys shares as
well as to measure the return on investment. Company management can use these measures to determine its ability
to generate a reasonable rate of return.
7.1 Return on Assets Employed
Earnings after Taxes / Total Assets * 100
This ratio measures how effectively a company's assets are being used to generate profits. It is one of the most
important ratios when evaluating the success of a business.
A company is deemed efficient by investors if it can generate an adequate return while using the minimum amount
of assets to do so. This also keeps investors from having to put more cash into the company and allows the company
to shift its excess cash to investments in new endeavors. Consequently, the return on assets employed measure is
considered a critical one for determining a companys overall level of operating efficiency.
Heavily depreciated assets, a large number of intangible assets, or any unusual income or expenses can easily distort
this calculation.
ROA can be alternatively computed as:

13

Analysis of Financial Statements

It's a useful number for comparing competing companies in the same industry. The number will vary widely across
different industries. Return on assets gives an indication of the capital intensity of the company, which will depend
on the industry; companies that require large initial investments will generally have lower return on assets.
ROA is an indicator of how profitable a company is before leverage, and is compared with companies in the same
industry. Since the figure for total assets of the company depends on the carrying value of the assets, some caution is
required for companies whose carrying value may not correspond to the actual market value.
ROA is a common figure used for comparing performance of financial institutions (such as banks), because the
majority of their assets will have a carrying value that is close to their actual market value. Return on assets is not
useful for comparisons between industries because of factors of scale and peculiar capital requirements (such as
reserve requirements in the insurance and banking industries).Return on assets is one of the elements used in
financial analysis using the Du Pont Identity.
7.2 Return On Equity

Return on Equity (ROE, Return on average common equity, return on net worth, Return on ordinary shareholders'
funds) (requity) measures the rate of return on the ownership interest (shareholders' equity) of the common stock
owners. It measures a firm's efficiency at generating profits from every unit of shareholders' equity (also known as
net assets or assets minus liabilities). ROE shows how well a company uses investment funds to generate earnings
growth. A higher number is preferred for this commonly analyzed ratio.
High ROE yields no immediate benefit. Since stock prices are most strongly determined by earnings per share
(EPS). The benefit comes from the earnings reinvested in the company at a high ROE rate, which in turn gives the
company a high growth rate. ROE is presumably irrelevant if the earnings are not reinvested.
Limitations:

The sustainable growth model shows us that when firms pay dividends, earnings growth lowers. If the
dividend payout is 20%, the growth expected will be only 80% of the ROE rate.

The growth rate will be lower if the earnings are used to buy back shares. If the shares are bought at a
multiple of book value (say 3 times book), the incremental earnings returns will be only 'that fraction' of
ROE (ROE/3).

New investments may not be as profitable as the existing business. Ask "what is the company doing with its
earnings?"

Remember that ROE is calculated from the company's perspective, on the company as a whole. Since much
financial manipulation is accomplished with new share issues and buyback, always recalculate on a 'per
share' basis, i.e., earnings per share/book value per share.

7.3 Financial Leverage Index


Return on equity / Return on assets

14

Analysis of Financial Statements

The financial leverage index can indicate whether a large proportion of debt in relation to equity is being used to
fund a companys operations. It compares the rate of return on equity to the rate of return on assets. If the rate of
return on equity is significantly higher than the return on assets, then the equity base is comparatively small in
relation to the base of assets, which inherently means that the difference between the two is composed of nonequity
sources of funding.

7.4 The DuPont formula


The DuPont formula, also known as the strategic profit model, is a common way to break down ROE into three
important components.
Essentially, ROE will equal the net margin multiplied by asset turnover multiplied by financial leverage. Splitting
return on equity into three parts makes it easier to understand changes in ROE over time.
For example, if the net margin increases, every sale brings in more money, resulting in a higher overall ROE.
Similarly, if the asset turnover increases, the firm generates more sales for every unit of assets owned, again
resulting in a higher overall ROE.
Finally, increasing financial leverage means that the firm uses more debt financing relative to equity financing.
Interest payments to creditors are tax deductible, but dividend payments to shareholders are not. Thus, a higher
proportion of debt in the firm's capital structure leads to higher ROE. Financial leverage benefits diminish as the risk
of defaulting on interest payments increases. So if the firm takes on too much debt, the cost of debt rises as creditors
demand a higher risk premium, and ROE decreases. Increased debt will make a positive contribution to a firm's
ROE only if the matching Return on assets (ROA) of that debt exceeds the interest rate on the debt.

The DuPont system decomposes ROE into the following components:

There are three components in the calculation of return on equity using the traditional Du Pont Model- the net profit
margin, assets turnover, and the equity multiplier. By examining each input individually, the sources of a companys
return on equity can be discovered and compared to its competitors.

15

Analysis of Financial Statements

Return on Equity = (Net profit Margin) (Asset turnover) (Equity Multiplier)

Profit Margin =
EBIT Sales
Return on Net Assets
(RONA) = EBITNA
Assets
turnover=
Sales NA

Return on Equity (ROE) =


PAT NW

Financial Leverage
(income) = PATEBIT

Financial Leverage
(Balance Sheet) = NA
NW

Where
NA = Net Assets
NW = Net worth
PAT = Profit after Tax
EBIT = Earning before Interest & Tax
Miscellaneous Ratios
REPAIRS AND MAINTENANCE EXPENSE TO FIXED ASSETS RATIO
Total repairs and maintenance expense
X 100
Total fixed assets before depreciation
This ratio is useful for estimating the age of the collective group of fixed assets listed in the financial statements. If
the ratio follows an increasing trend line, then the company is probably in need of some asset replacements. An
increasing trend line may also be indicative of high asset-usage levels, which can prematurely require advanced
levels of repair work. Of particular interest is an increasing ratio that suddenly drops with no corresponding increase
in the amount of fixed assets, this indicates that a company is running out of cash and cannot afford to repair its
existing assets or purchase new ones.

16

Analysis of Financial Statements

INDICATORS OF FINANCIAL HEALTH OF COMPANY


Objective
about)

(To

know Relevant indicator/Remarks

1. Financial position of Net worth, i.e., share capital, reserves and unallocated surplus in balance sheet carried
the company
down from profit and loss appropriation account. For a healthy company, it is
necessary that there is a balance struck between dividend paid and profit retained in
business so much the net worth keeps on increasing.
Current ratio should not be too high like 4:1 or 5:1 or too low like less than 1.5:1. This
2. Liquidity of the means that the company is either too liquid thereby increasing its opportunity cost or
company,
not liquid at all, both of which are not desirable. Quick ratio could be at least 1:1.
Quick ratio is a better indicator of liquidity position.
3. Whether the
What are the sources, besides internal accruals to finance fixed assets.
company has
Examination of increase in secured or unsecured loans for this purpose. Without
acquired new fixed
adequate financial planning, there is always the risk of diverting working capital funds
assets during the
for fixed assets. This is best assessed through a funds flow statement for the period as
year?
even net cash accruals (Retained earnings + depreciation + amortisation) would be
available for fixed assets.
whether the main operations of the company like manufacturing have been in profit or
4. Profitability of the the profit of the company is derived from other income, i.e., income from investment in
company in general shares/debentures etc.
and operating profits
in particular, i.e.,
5. Relationship
between the net
worth
of
the
company and its
external
liabilities
(both short-term and
long-term).
What
about only medium
and long-term debts?

Debt/Equity ratio, which establishes this relationship. From the lenders point of view,
this should not exceed 3:1. Is there any sharp deterioration in this ratio? Is so, please
be on guard, as the financial risk for the company increases to that extent.
For only medium and long-term debts, it cannot exceed 2:1.

6. Has the companys


investments
in
shares/debentures of
other
companies
reduced in value in
comparison with last
year?

Difference between the market value of the investments and the purchase price, which
is theoretically a loss in value of the investment. Actual loss is booked upon only
selling. The periodic reduction every year should warn us that at the time of actual
sales, there would be substantial loss, which immediately would reduce the net worth
of the company. Banks, Financial Institutions, Investment companies or NBFCs would
be required to declare their investment every year in the balance sheet at cost price or
market price whichever is less.

7. Relationship
between
average
debtors
(bills
receivable)
and
average
creditors
(bills
payable)
during the year.

Average debtors in the year/average creditors in the year. This should be greater than
1:1, as bills receivable are at gross value {cost of development (+) profit margin},
whereas; creditors are at purchase price for software or components, which would be
much less than the final sales value. If it is less than 1:1, it shows that while receivable
management is quite good, the company is not paying its creditors, which could cause
problems in future. Too high a ratio would indicate that receivable management is
very poor.

17

Analysis of Financial Statements

8. Future plans of the like acquisition of new technology, entering into new collaboration agreement,
company,
diversification programme, expansion programme etc.
Directors report. This would reveal the financial plans for the company, like whether
they are coming out with a public issue/Rights issue etc.
9. Has the company Auditors comments in the Notes to Accounts relevant for this. Frequent revaluation
revalued its fixed is not desirable and healthy.
assets during the
year,
thereby
creating revaluation
reserves, without any
inflow of capital into
the company, as this
is just an entry
passed in the books?

10. Whether
the
company
has
increased
its
investment and if so,
what is the source
for it? What is the
nature
of
investment?

Is it in tradable securities or long-term Securities, which can have a lock-in-period and


cannot be liquidated in the near future?
Increase in amount of investment in shares/debentures/Govt. securities etc. in
comparison with last year and any investment within group companies? Any undue
increase in investment should put us on guard, as working capital funds could have
been diverted for it.

11. Has the company Any increase in unsecured loans. If the loans are to group companies, then all the more
during the year given reason to be cautious. Hence, where the figures have increased, further probing is
any unsecured loans called for.
substantially other
than to employees of
the company?
12. Are the companys Any comments to this effect in the notes to accounts should put us on caution. This
unsecured
loans examination would indicate about likely impact on the future profits of the company.
(given)
not
recoverable and very
old?
13. Has the company Any comments about over dues as in the Notes to Accounts should be looked into.
been
regular
in Any serious default is likely to affect the credit rating of the company with its
payment of its dues lenders, thereby increasing its cost of borrowing in future.
on account of loans
or periodic interest
on its liabilities?

14. Has the


defaulted

18

company Any comments about this in the Notes to Accounts should be looked into.
in

Analysis of Financial Statements

providing for bonus


liability,
P.F.
liability,
E.S.I.
liability, gratuity
liability etc?

15. Whether
the Cash balance together with bank balance in current account, if any, is very high in the
company is holding current assets.
very huge cash, as it
is not desirable and
increases
the
opportunity cost?
16. How many times the
average
inventory
has turned over
during the year?

Relationship between cost of goods sold and average inventory during the year (only
where cost of goods sold cannot be determined, net sales can be taken as the
numerator). In a manufacturing company, which is not in capital goods sector, this
should not be less than 4:1 and for a consumer goods industry, this should be higher
even. For a capital goods industry, this would be less.
17. Has the company If it was a public issue, how did it fare in the market?
issued fresh share
capital during the Increase in paid-up capital in the balance sheet and share premium reserves in case the
period and what is issue has been at a premium.
the purpose for
which it has raised
equity capital?
18. Has the company Increase in paid-up capital and simultaneous reduction in general reserves. Enquiry into
issued any bonus the companys ability to keep up the dividend rate of the immediate past.
shares during the
year?
19. Has the company Increase in paid-up capital and share premium reserves, in case the issue has been at a
made any rights premium.
issue in the period
and what is the
purpose of the issue?
If it was a public
issue, how did it fare
in the market?

20. What
is
the
proportion
of
marketable
investment to total
investment
and
whether this has
decreased
in
comparison with the
previous year?
21. What is the increase
in sales income over

19

Percentage of marketable investment to total investment and comparison with previous


year. Any decrease should put us on guard, as it reduces liquidity on one hand and
increases the risk of non-payment on due date, especially if the investment is in its own
subsidiary or group companies, thereby forcing the company to provide for the loss.

Comparison with previous years sales income and whether the growth has been more

Analysis of Financial Statements

last year in % terms? or less than the estimate.


Is it due to increase
in
numbers
or
change in product
mix or increase in
prices of finished
products only?
22. What is the amount In percentage terms, how much is it of total debts outstanding and what are the reasons
of provision for bad for such provision in the notes to accounts by the auditors?
and doubtful debts or
advances
outstanding?
23. What is the amount Is there any comment about valuation of work in progress by the auditors? It can be
of work in progress seen that profit from operations can be manipulated by increase/decrease in closing
as shown in the stocks of both finished goods and work in progress.
Profit and Loss
Account?
24. Whether
the
company is paying
any lease rentals and
if so what is the
amount of lease
liability outstanding?

Examination of expenses schedule would show this. What is the comment in notes to
accounts about this? Lease liability is an off-balance sheet item and hence this
examination, to ascertain the correct external liability and to include the lease rentals in
future also in projected income statements; otherwise, the company may be having
much less disclosed liability and much more lease liability which is not disclosed. This
has to be taken into consideration by an analyst while estimating future expenses for
the purpose of estimating future profits.

25. Has the company Auditors comments on Accounting policies. Change over from straight-line method
changed its method to written down value method or vice-versa does affect the deprecation charge for the
of depreciation on year thereby affecting the profits during the year of change.
fixed assets, due to
which, there is an
impact on the profits
of the company?
26. If
it
is
a Relationship between materials consumed during the year and the sales.
manufacturing
company, whether
the % of materials
consumed
is
increasing in relation
to sales?
27. Has the company
changed its method Auditors comments on Accounting policies.
of
valuation
of
inventory, due to
which there is an
impact of the profits
of the company?

20

Analysis of Financial Statements

28. Whether the % of Relationship between general and administrative expenses during the year and the
administration and sales. In case there is any extraordinary increase, what are the reasons therefore?
general expenses has
increased during the
year under review?
29. Whether
the Interest coverage ratio = earnings before interest and tax/total interest on all short-term
company
had and long-term liabilities. Minimum should be 3:1 and anything less than this is not
sufficient income to satisfactory.
pay the interest
charges?
30. Whether the finance
charges have gone
up
disproportionately as
compared with the
increase in sales
income during the
same period?

Relationship between interest charges and sales income whether it is consistent with
the previous year or is there any spurt?
Is there any explanation for this, like substantial expansion or new project or
diversification for which the company has taken financial assistance? While a
benchmark % is not available, any level in excess of 6% calls for examination.

31. Whether the % of Relationship between payment to and provision for employees and the sales. In case
employee costs to any undue increase is seen, it could be due to expansion of activity etc. that would be
sales has increased? included in the Directors Report.
32. Whether the % of
selling expenses in
relation to sales has
gone up?

Relationship between selling and marketing expenses and the sales. Any undue
increase could either mean that the company is in a very competitive industry or it is
aggressive to increase its market share by adopting a marketing strategy that would
increase the marketing expenses including offer of higher commission to the
intermediaries like agents etc.

33. Whether
the
company
had
sufficient
internal
accruals to meet
repayment obligation
of principal amount
of loans, debentures
etc.?

Debt service coverage ratio


The term-lending institution or bank looks for 1.75:1 on an average for the loan period.
This is a very critical ratio to indicate the ability of the company to take care of its
obligation towards the loans it has taken both by way of interest as well as repayment
of the principal.

34. Return
on Earnings before interest and tax/average total invested capital, i.e., net worth (+) debt
investment
in capital. This should be higher than the average cost of funds in the form of loans, i.e.,
business to compare interest cost on loans/debentures etc.
it with return on
similar investment
elsewhere.
35. Return on equity
(includes
reserves
and surplus)
21 Analysis of

Profit after tax (-) dividend on preference share capital/net worth (-) preference share
capital (return in percentage). Anything less than 15% means that our investment in
this company is earning less than the average return in the market.
Financial Statements

36. How much earning Profit after tax (-) dividend on preference share capital/number of equity shares. In
has our share made? terms of percentage anything less than 40% to 50% of the face value of the shares
(EPS)
would not go well with the market sentiments.

37. Whether
the Relationship between amount of dividend payout and profit after tax last year and this
company
has year. Is there any reason for this like liquidity crunch that the company is experiencing
reduced its dividend or the need for conserving cash for business activity, like purchase of fixed assets in
payout
in the immediate future?
comparison with last
year?
38. Is
there
any
significant increase
in the contingent
liabilities due to any
of the following?

Disputed central excise duty, customs duty, income tax, octroi, sales tax, contracts
remaining unexecuted, guarantees given by the banks on behalf of the company as well
as the guarantees given by the company on behalf of its subsidiary or associate
company, letter of credit outstanding for which goods not yet received etc.
Notes on Accounts as given at the end of the accounts.
Any substantial increase especially in disputed amount of duties should put us on
guard.

39. Has the company Substantial change in vendor charges, or subcontracting charges.
changed its policy of
outsourcing its work
from vendors and if
so, what are the
reasons?

40. Is
there
any Increase in consultancy charges.
substantial increase in
charges
paid
to
consultants?
41. Has the company Directors Report or sudden spurt in general and administration expenses.
opened any branch
office in the last
year?

22

Analysis of Financial Statements