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CHAPTER OBJECTIVES
Ratio Analysis
Measure relationships between resources
and financial flows
Show ways in which firms situation
deviates from
Its own past
Other firms
The industry
Ratio Analysis
The study and
interpretation of the
relationships between
various financial variables,
by investors or lenders.
Ratio
Ratio Analysis
Analysis -- Significance
Significance
A single ratio by itself is not very meaningful.
The discussion of ratios will
include the following types of comparisons.
Ratio
Ratio Analysis
Analysis -- Purpose
Purpose
Ratio
Ratio Analysis
Analysis -- Significance
Significance
Provide the all-important early warning
indications that allow us to solve our business
problems before our business is destroyed by
those problems.
Enables the business owner/manager to spot
trends in a business
Ratio Analysis
Ratio Analysis
1.
2.
3.
4.
5.
Capital Employed
Investments
Current Liabilities
Debt
Equity
Cost of Goods Sold
Cost of Sales
Long term funds
Long term loans
Classification of Ratios
Balance Sheet
Ratio
P&L Ratio or
Income/Revenue
Statement Ratio
Financial Ratio
Operating Ratio
Composite Ratio
Current Ratio
Quick Asset Ratio
Debt Equity Ratio
ASSETS
CURRENT LIABILTIES
Bank
Working
Capital
Limits
such
as
CC/OD/Bills/Export Credit
Sundry /Trade Creditors/Creditors/Bills Payable, Short
duration loans or deposits
Expenses payable & provisions against various items
INTANGIBLE ASSETS
Patent, Goodwill, Debit balance in P&L A/c, Preliminary
or Preoperative expenses
Assets other than Current Assets are Long Term Use of Funds
Installments of Term Loan Payable in 12 months are to be taken as
Current Liability only for Calculation of Current Ratio & Quick Ratio.
Investments in Govt. Securities to be treated current only if these
are marketable and due. Investments in other securities are to be
treated as Current if they are quoted. Investments in
allied/associate/sister units or firms to be treated as Non-current.
Bonus Shares as issued by capitalization of General reserves and
as such do not affect the Net Worth. With Rights Issue, change
takes place in Net Worth and Current Ratio.
Liquidity
Analyzing Liquidity
Liquidity
Current Ratio
Ideal level? 2 : 1
The ideal Current Ratio preferred by Banks is 1.33 : 1
A ratio of 5 : 1 would imply the firm has Rs.5 of assets to cover
every Rs.1 in liabilities
A ratio of 0.75 : 1 would suggest the firm has only 75p in assets
available to cover every Rs.1 it owes
Too high Might suggest that too much of its assets are tied up
in unproductive activities too much stock, for example?
Too low - risk of not being able to pay your way
Assets/Current
Example :
Cash
Debtors
Inventories
Total Current Assets
50,000
1,00,000
1,50,000
3,00,000
Current Liabilities
3,00,000/1,00,000
1,50,000/1,00,000
50,000/1,00,000
300000-100000
1,00,000
= 3:1
= 1.5:1
= .5:1
= 200000
Analyzing Activity
Activity
is a more sophisticated
analysis of a firm's liquidity,
evaluating the speed with which
certain accounts are converted
into sales or cash; also
measures a firm's efficiency
IT =
ACP =
Annual Sales/360
Accounts
Payable
APP=
Annual
Purchases/360
FAT =
Sales
Net Fixed Assets
Sales
365/12/52
STR
(Opening Stock + Closing Stock)
-----------------------------------------
This ratio indicates the number of times the inventory is rotated during
the relevant accounting period
the
type of business supermarkets might have high stock turnover ratios
whereas a shop selling high value musical instruments might have low stock
turnover ratio
Low stock turnover could mean poor customer satisfaction if people are
not
buying the goods
period
(Debtors
Days)
DTR
This ratio tells about the time taken to collect money
from the debtors
ACP:
APP:
Higher the better
Gives a measure of how long it takes the business to pay
its debts
Asset Turnover
Asset Turnover = Sales turnover / assets
employed
Using assets to generate profit
Asset turnover x net profit margin = ROCE
Profitability
Profitability
Gross Profit Margin = Gross profit / turnover
x 100
The higher the better
Enables the firm to assess the impact of its
sales and how much it cost to generate
(produce) those sales
A gross profit margin of 45% means that for
every 1 of sales, the firm makes 45p in gross
profit
Profitability
Net Profit Margin = Net Profit / Turnover x 100
Net profit takes into account the fixed costs involved
in production the overheads
Keeping control over fixed costs is important could
be easy to overlook for example the amount of waste
- paper, stationery, lighting, heating, water, etc.
e.g. leaving a photocopier on overnight uses enough electricity to
make 5,300 A4 copies. (1,934,500 per year)
1 ream = 500 copies. 1 ream = 5.00 (on average)
Total cost therefore = 19,345 per year or 1 persons salary
Profitability
Operating Profit Margin = Operating Profit /
Turnover x 100
Measures overall operating efficiency and incorporates
all of the expenses associated with ordinary business
activities
Profitability
Return on Capital Employed (ROCE) =
Profit / capital employed x 100
Be aware that there are different
interpretations of what capital employed
means see
http://www.bized.ac.uk/compfact/ratios/ror3.htm for more
information!
Profitability Ratios
Overall Efficiency and Performance
Cash Flow Margin
Measures ability to translate sales into
cash
Cash flow from operating activities
Net sales
Profitability Ratios
Overall Efficiency and Performance
Return on Total Assets (ROA) or
Return on Investment (ROI)
Measures overall efficiency of firm in
managing investment in assets and
generating profits
Net earnings
Total assets
Profitability Ratios
Overall Efficiency and Performance
Return on Equity (ROE)
Measures rate of return on stockholders
investment
Net earnings
Stockholders equity
Profitability Ratios
Overall Efficiency and Performance
Cash Return on Assets
Measures firms ability to generate cash
from the utilization of its assets
Operating Ratio
Thais ratio establishes relationships between operating cost & net
sales. This ratio indicates the proportion that the cost of sales.
Cost of sale included direct cost of good sold & as well as other
operating expenses administration, selling & distribution expenses
Operating ratio = Cost of good sold + operating expenses X 100
Net sale
= Operating cost X 100
Net sale
Cost of good sold = opening stock + purchase + direct expenses
closing stock GP
Operating expenses = administrative expenses + selling &
distribution expenses
Example:
Cost of good sales
Operating expenses
Sales
Sales returns
6 lac
40,000
8,20,000
20,000
Profitability
The higher the better
Shows how effective the firm is in using its
capital to generate profit
A ROCE of 25% means that it uses every
Rs.1 of capital to generate 25p in profit
Partly a measure of efficiency in
organisation and use of capital
Debt ratio
Long-term debt to total capitalization
Debt to equity
Times interest earned
Fixed charge coverage
Cash flow adequacy
Analyzing Debt
Debt is a true "double-edged" sword as it
allows for the generation of profits with the
use of other people's (creditors) money, but
creates claims on earnings with a higher
priority than those of the firm's owners.
Financial Leverage is a term used to
describe the magnification of risk and return
resulting from the use of fixed-cost financing
such as debt and preferred stock.
SOLVENCY RATIOS
The term solvency implies ability of an
enterprise to meet its long-term indebtedness
and thus, solvency ratios convey an
enterprises ability to meet its long-term
obligations. Some important solvency ratios
are :
Debt-Equity Ratio,
Interest Coverage Ratio,
Debt to Total Funds Ratio,
Fixed Asset Ratio,
2,00,000
1,60,000
1,50,000
1,00,000
10,000
Solution ;
Dept-equity Ratio =
Dept
Equity
Example:
The operating profit of Exe. Ltd. After charging interesr on
debentures and tax is Rs 1,00,000. The amount of interest is Rs
20,000 and the provision for tax has been made at Rs 40,000.
Calculate the interest coverage ratio.
Solution:
Interest Coverage Ratio = net profit before interest and tax
Interest charges
= 1,60,000
20,000
Debt
Equity + Debt
10,00,000
20,00,000
10,00,000
30,00,000
20,00,000
8,00,000
Long-term loans
Shareholders funds + Long-term loans
30,00,000 + 20,00,000
10,00,000 + 20,00,000 + 10,00,000 + 30,00,000
+ 20,00,000
= Rs. 50,00,000 = 5 : 9 or 0.56.
Rs. 90,00,000
2,00,000
50,000
2,00,000
75,000
2,00,000
2,00,000
50,000
60,000
40,000
24,000
80,000
= 4,50,000 = 1
4,50,000
RETURN ON EQUITY
Common shareholders are entittled to the residual
profit.The rate of divident is not fixed and earning may be
distributed to shareholders or retained in the business.
A ROE is calculated to se the profitability of owners
investment.
ROE indicates how well the firm has used the resources
of owners.
It is a most important relationship in financial analysis.
Formula:
ROE=
PAI
.
Net Worth Equity
Return on investment
The term investment refer to total asset or net asset.
the conventional approach of calculating ROI is to divide PAT by
investment,investment represents pool of funds,supplied by
shareholders and lenders,
while pat represents residue income of shareholders.
The formulae for calculating ROI is;
ROI=ROTA=EBIT(1-T)/ TA OR NA
Since taxes are not controllable by management and firms
opportunities far availing tax incentives differ,it may be more prudent
to use before tax measure of ROI,thus the before tax ratios are;
ROI=ROTA=EBIT/TA OR NA
Investment/Shareholders
Market Ratios
Earnings per Common Share
Earnings per Common Share
Provides the investor with a common
denominator to gauge investment
returns
Net earnings
Average shares outstanding
Market Ratios
Price-to-Earnings
Price-to-Earnings
Relates earnings per common share to
the market price at which the stock
trades, expressing the multiple that the
stock market places on a firms earnings
Market price of common stock
Earnings per share
PEG Ratio
The market is usually more concerned
about the future than the present, it is
always looking for some way to figure out
what is going to happen in the companies
future.
PEG = (P/E) / (projected growth in
earnings)
Market Ratios
Dividend Payout
Dividend Payout
Determined by the formula cash
dividends per share divided by earnings
per share
Dividends per share
Earnings per share
Market Ratios
Dividend Yield
Dividend Yield
Shows the relationship between cash
dividends and market price
Dividends per share
Market price of common stock
Short-Term Liquidity
Especially important to creditors, suppliers,
management, and others who are concerned
with the ability of a firm to meet near-term
demands for cash
Should include analysis of selected financial ratios
and a comparison with industry averages
Predicts the future ability of the firm to meet
prospective needs for cash
Operating Efficiency
Turnover ratios measure the operating
efficiency of a firm.
The efficiency in managing a companys
accounts receivable, inventory, and
accounts payable is discussed in the
short-term liquidity analysis.
Profitability
Analysis of how well the firm has
performed in terms of profitability,
beginning with the evaluation of
several key ratios
DuPont Framework
The DuPont framework was developed
internally at DuPont around 1920.
It provides a systematic approach to
identifying general factors causing ROE to
deviate from normal.
It establishes a framework for computing
financial ratios to yield more in-depth analysis
of a companys areas of strength and
weakness.
$180,000
$5,700,000
$5,700,000
$5,700,000
$2,278,000
$2,278,000
$2,278,000
$1,468,000
DuPont Framework
Projections and
Pro Forma Statements
Pro forma financial statements are
projections based on a set of
assumptions regarding
future revenues
expenses
level of investment in assets
financing methods and costs
working capital management
Projections and
Pro Forma Statements
Pro forma financial statements are used
primarily for long-range planning and
long-term credit decisions.
Many firms have made up their own
definitions of pro forma statements,
which should not be confused with the
pro forma statement described above.
Summary of Analysis
Analysis of any firms financial statements
consists of a mixture of steps and pieces
that interrelate and affect each other.
No one part of the analysis should be
interpreted in isolation.
The last step of analysis is to integrate the
separate pieces into a whole, leading to
conclusions about the business enterprise.
EXERCISE 1
LIABILITES
Capital
Reserves
ASSETS
180 Net Fixed Assets
20 Inventories
Term Loan
300 Cash
Bank C/C
200 Receivables
Trade Creditors
50 Goodwill
Provisions
50
800
400
150
50
150
50
800
a.
b.
c.
d.
e.
f.
EXERCISE 2
LIABILITIES
2005-06
2006-07
2005-06
2006-07
730
750
30
30
Capital
300
Reserves
140
320
280 Investments
110
110
Bank CC (Hyp)
490
150
170
Unsec. Long T L
150
170 S I P
20
30
Creditors (RM)
120
140
170
30
20
310
240
30
190
70 Finished Goods
Bills Payable
40
80 Cash
Expenses Payable
20
30 Receivables
Provisions
20
40 Loans/Advance
s
Goodwill
50
50
1. Tangible Net Worth for 1st Year : ( 300 + 140) - 50 = 390
Total
1600
1760
1600
1760
2. Current Ratio for 2nd Year : (170 + 20 + 240 + 2+ 190 ) / (580+70+80+70)
820 /800 = 1.02
3. Debt Equity Ratio for 1st Year : 320+150 / 390 = 1.21
Exercise 3.
LIABIITIES
ASSETS
Equity Capital
800
Preference Capital
100 Inventory
300
Term Loan
600 Receivables
150
Bank CC (Hyp)
Sundry Creditors
Total
1400
50
100
1400
= 2:1
Exercise 4.
LIABILITIES
ASSETS
Capital + Reserves
355
7 Cash
Loan From S F C
100 Receivables
265
1
125
Bank Overdraft
38 Stocks
Creditors
26 Prepaid Expenses
9 Intangible Assets
30
Provision of Tax
Proposed Dividend
15
550
128
550
Exercise 4.
contd
LIABILITIES
Capital + Reserves
P & L Credit Balance
Loan From S F C
ASSETS
355
265
7 Cash
100 Receivables
1
125
Bank Overdraft
38 Stocks
Creditors
26 Prepaid Expenses
9 Intangible Assets
30
Provision of Tax
Proposed Dividend
128
15
550
550
Exercise 4.
contd
LIABILITIES
Capital + Reserves
P & L Credit Balance
Loan From S F C
ASSETS
355
7 Cash
100 Receivables
265
1
125
Bank Overdraft
38 Stocks
Creditors
26 Prepaid Expenses
9 Intangible Assets
30
Provision of Tax
Proposed Dividend
128
15
550
550
Q. What is the Debtors Velocity Ratio ? If the sales are Rs. 15 Lac.
Ans : ( Average Debtors / Net Sales) x 12 = (125 / 1500) x 12
= 1 month
Q. What is the Creditors Velocity Ratio if Purchases are Rs.10.5 Lac ?
Ans : (Average Creditors / Purchases ) x 12 = (26 / 1050) x 12 = 0.3 months
THANK YOU
11