RATIO ANALYSIS

FINANCIAL STATEMENT ANALYSIS

The financial statements of an entity present the summarized data of its assets, liabilities, and equities in the balance sheet and
its revenue and expenses in the income statement. If not analyzed, such data may lead one to draw erroneous conclusions
about the firm’s financial condition. Various measuring instruments may be used to evaluate the financial health of a business,
including horizontal, vertical, and ratio analyses. A financial analyst uses the ratios to make two types of comparisons;
1. Industry Comparison
2. Trend analysis

The sources of information for financial statement analysis are:

 Annual Reports
 Interim financial statements
 Notes to Accounts
 Statement of cash flows

Financial ratio or accounting ratio which is a mathematical expression of the relationship between accounting figures.

Limitation of Accounting Measure → Limitation of ratio analysis.

 Accounting has a bias towards conservatism [intellectual capital is not taken as an asset]
 Different measures are adopted for different types of assets.
 Accounting principles are inadequate to deal with complex transactions
 Accrual system of accounting depends on management perspective

Financial Ratios may be categorized into five (05) subheads for analysis purpose;

1. Profitability Ratios
1. Gross profit margin reveals the percentage of each dollar left over after the business has paid for its goods.
2. Net profit margin: Profitability generated from revenue and hence is an important measure of operating performance.
It also provides clues to a company’s pricing, cost structure, and production efficiency.
3. Return on investment (ROI) is a key, but rough, measure of performance. Although ROI shows the extent to which
earnings are achieved on the investment made in the business, the actual value is generally somewhat distorted. There
are basically two ratios that evaluate the return on investment.
a. return on total assets (ROA) –indicates the efficiency with which management has used its available resources
to generate income.
b. the other is the return on owners’ equity (ROE).
[The return on common equity (ROE) measures the rate of return earned on the common stockholders’ investment.
ROE and ROA are closely related through what is known as the equity multiplier (leverage, or debt ratio)]

4. ROCE (Return on Capital Employed) = Operating Profit ÷ Capital Employed.

5. Operating ratio = Operating Cost (COGS + operating expenses) ÷ Net sales.

1|P a g e
RATIO ANALYSIS

Du Pont Analysis
Du Pont Company of USA introduced the system in 1921.
Return on Investment (ROI) can be improved by increasing one or both of its components viz., the net profit margin and the
Capital turnover in any of the following ways:
a) Increasing the net profit margin, or
b) Increasing the capital turnover, or
c) Increasing both net profit margin and investment turnover.

2. Liquidity ratios [Short term Solvency]

Liquidity is a company’s ability to meet its maturing short-term obligations. If liquidity is insufficient to cushion such losses,
serious financial difficulty may result. Poor liquidity is analogous to a person having a fever — it is a symptom of a fundamental
problem.
a. Net W/c and other working capital ratios.
b. Current ratio.
c. Quick (acid test) ratio.
d. Defensive interval ratio [liquid asset ÷ daily cash requirement]// Cash burn rate = (current assets) ÷ (average daily
operating expenses).
e. The cash ratio (or doomsday ratio) = (cash) ÷ (current liabilities) [This ratio is most relevant for companies in financial
distress. The name doomsday ratio comes from the worst-case assumption that the business ceases to exist and only the
cash on hand is available to meet credit obligations].
Suppose that a company is facing a strike and cash inflows begin to dry up. How long could the company keep running?
One answer is given by the cash burn rate:

Interrelationship of Liquidity and Activity to Earnings

Liquidity risk is minimized by holding greater current assets than noncurrent assets. However, the rate of return will decline
because the return on current assets (i.e., marketable securities) is typically less than the rate earned on productive fixed assets.
Also, excessively high liquidity may mean that management has not aggressively searched for desirable capital investment
opportunities. Maintaining a proper balance between liquidity and return is important to the overall financial health of a
business.
High profitability does not necessarily infer a strong cash flow position. Income may be high but cash problems may exist because
of maturing debt and the need to replace assets, among other reasons. For example, it is possible that a growth company may
experience a decline in liquidity since the net working capital needed to support the expanding sales is tied up in assets that
cannot be realized in time to meet the current obligations. The impact of earning activities on liquidity is highlighted by comparing
cash flow from operations to net income. If accounts receivable and inventory turnover quickly, the cash flow received from
customers can be invested for a return, thus increasing net income.

2|P a g e
RATIO ANALYSIS

3. Activity ratios are used to determine how quickly various accounts are converted into sales or cash. Overall liquidity ratios
generally do not give an adequate picture of a company’s real liquidity, due to differences in the kinds of current assets and
liabilities the company holds. Thus, it is necessary to evaluate the activity or liquidity of specific current accounts
 Fixed asset turnover = [net sales ÷ Fixed assets]
 Overall Turnover = Net sales ÷ Capital Employed
 Accounts receivable turnover = [net sales ÷ average receivables]
o Average collection period =365 ÷ ART
 Inventory turnover = [COGS ÷ average inventory]
o Average age of inventory = 365 ÷ IT
 Accounts payables turnover = [COGS ÷ average accounts payable]
o Accounts payable period = 365 ÷ APT
 Operating cycle = average collection period + average age of inventory
 Cash conversion cycle = operating cycle + accounts payable period

4. Capital Structure ratios

 Solvency is a company’s ability to meet it long-term obligations as they become due.
 An analysis of solvency concentrates on the long-term financial and operating structure of the business.
 The degree of long-term debt in the capital structure is also considered.
 Solvency is dependent upon profitability since in the long run a firm will not be able to meet its debts unless it is
profitable.
a. Debt Ratio = [Total liabilities ÷ Total Assets]
b. Debt/Equity Ratio = [Total Debt ÷ Total Equity]
c. Interest Coverage = EBIT ÷ Interest Expense
d. Cash Coverage = EBIDT ÷ Interest Expense (based not on ‘earnings’ but on cash earnings]
e. Debt Service Coverage ratio = (NPAT [Net Profit after Tax]) + Depreciation + Interest) ÷ (Interest + Loan Principal
Repayment) [Indicates the number of times earnings are sufficient to repay the Loan Instalments]

Free Cash Flow. This is a valuable tool for evaluating the cash position of a business. Free cash flow (FCF) is a measure of
operating cash flows available for corporate purposes after providing sufficient fixed asset additions to maintain current
productive capacity and dividends.
It is calculated as follows:
Cash flow from operations **
Less: Cash used to purchase fixed assets **
Less: Cash dividends **
Free cash flow **

5. Market value ratios

a. EPS
b. P/E ratio = P0 ÷ EPS
[A high P/E multiple is good because it indicates that the investing public considers the company in a favourable light ].
c. Book Value per share.
d. Market Value Added [MVA= (market value of the firm’s equity – equity capital supplied by shareholders)]
= [(P0× shares outstanding) – equity].
e. Economic Value Added (EVA)
f. Dividend ratios.
i. Dividend yield = DPS ÷ P0
ii. Dividend pay-out = DPS ÷ EPS

3|P a g e