Financial Statement Analysis

RATIO ANALYSIS
Tata McGraw-Hill Publishing Company Limited, Financial Management

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6-1
Ratio Analysis
Ratio analysis is a widely used tool of financial
analysis. It is defined as the systematic use of
ratio to interpret the financial statements so
that the strengths and weaknesses of a firm as
well as its historical performance and current
financial condition can be determined.

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Basis of Comparison
1) Trend Analysis involves comparison of a firm over a
period of time, that is, present ratios are compared with
past ratios for the same firm. It indicates the direction of
change in the performance improvement, deterioration
or constancy over the years.
2) Interfirm Comparison involves comparing the ratios of a
firm with those of others in the same lines of business or
for the industry as a whole. It reflects the firms
performance in relation to its competitors.
3) Comparison with standards or industry average.

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Types of Ratios
Liquidity Ratios
Capital Structure Ratios
Profitability Ratios
Efficiency ratios
Integrated Analysis Ratios
Growth Ratios

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Net Working Capital

Net working capital is a measure of liquidity calculated by
subtracting current liabilities from current assets.
Table 1: Net Working Capital
Particulars
Total current assets
Total current liabilities
NWC
Company A
Rs 1,80,000
1,20,000
60,000
Company B
Rs 30,000
10,000
20,000
Table 2: Change in Net Working Capital

Particulars
Current assets
Current liabilities
NWC
Company A
Rs 1,00,000
25,000
75,000

Company B
Rs 2,00,000
1,00,000
1,00,000
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Liquidity Ratios
Liquidity ratios measure the ability of a firm to

meet its short-term obligations.

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Current Ratio
Current Ratio is a measure of liquidity calculated dividing the current
assets by the current liabilities
Current Ratio =
Current Assets
Current Liabilities
Particulars
Firm A
Firm B
Current Assets
Rs 1,80,000
Rs 30,000
Current Liabilities
Rs 1,20,000
Rs 10,000
Current Ratio
= 3:2 (1.5:1)
3:1

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Acid-Test Ratio
The quick or acid test ratio takes into consideration the
differences in the liquidity of the components of current
assets.
Acid-test Ratio =
Quick Assets
Current Liabilities
Quick Assets = Current assets Stock

Pre-paid expenses
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Example 1: Acid-Test Ratio

Cash
Debtors
Inventory
Total current assets
Total current liabilities
(1) Current Ratio
(2) Acid-test Ratio

Rs 2,000
2,000
12,000
16,000
8,000
2:1
0.5 : 1
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Supplementary Ratios for

Liquidity
Inventory Turnover Ratio
Debtors Turnover Ratio
Creditors Turnover Ratio

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Inventory Turnover Ratio

The ratio indicates how fast inventory is sold. A high ratio is good from
the viewpoint of liquidity and vice versa. A low ratio
would signify that inventory does not sell fast and stays on the shelf or in
the warehouse for a long time.
Inventory turnover ratio =
Cost of goods sold

Average inventory
The cost of goods sold means sales minus gross profit.

The average inventory refers to the simple average of the opening
and closing inventory.
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6 - 11
Example 2: Inventory Turnover Ratio

A firm has sold goods worth Rs 3,00,000 with a gross profit
margin of 20 per cent. The stock at the beginning and the end of
the year was Rs 35,000 and Rs 45,000 respectively. What is the
inventory turnover ratio?
Inventory
turnover ratio
(Rs 3,00,000 Rs 60,000)

=
(Rs 35,000 + Rs 45,000) 2
6 (times per
year)
12 months
Inventory
=
= 2 months
holding period
Inventory turnover ratio, (6)
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The ratio measures how rapidly receivables are collected. A high
ratio is indicative of shorter time-lag between credit sales and
cash collection. A low ratio shows that debts are not being
collected rapidly.
Debtors turnover ratio
Net credit sales

Average debtors
Net credit sales consist of gross credit sales minus returns, if any,
from customers.
Average debtors is the simple average of debtors (including
bills receivable) at the beginning and at the end of year.
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Example 3: Debtors Turnover Ratio

A firm has made credit sales of Rs 2,40,000 during the year.
The outstanding amount of debtors at the beginning and at
the end of the year respectively was Rs 27,500 and Rs
32,500. Determine the debtors turnover ratio.
Debtors
turnover ratio
Rs 2,40,000
=
Debtors
collection period
(Rs 27,500 + Rs 32,500) 2
8 (times per
year)
12 Months
=
Debtors turnover ratio, (8)

1.5
Months
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Creditors Turnover Ratio

A low turnover ratio reflects liberal credit terms granted by
suppliers, while a high ratio shows that accounts are to be settled
rapidly. The creditors turnover ratio is an important tool of
analysis as a firm can reduce its requirement of current assets by
relying on suppliers credit.
Creditors turnover
ratio
Net credit purchases

=
Average creditors
Net credit purchases = Gross credit purchases - Returns to

suppliers.
Average creditors = Average of creditors (including bills payable)
outstanding at the beginning and at the end of the year.
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Example 4: Creditors Turnover Ratio

The firm in previous Examples has made credit purchases of Rs
1,80,000. The amount payable to the creditors at the beginning
and at the end of the year is Rs 42,500 and Rs 47,500 respectively.
Find out the creditors turnover ratio.
Creditors
turnover ratio
Creditors
payment period
(Rs 1,80,000)
=
(Rs 42,500 Rs 47,500) 2
4 (times
per year)
12 months
=
Creditors turnover ratio, (4)
= 3 months

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The summing up of the three turnover ratios (known as a

cash cycle) has a bearing on the liquidity of a firm. The cash
cycle captures the interrelationship of sales, collections
from debtors and payment to creditors.
The combined effect of the three turnover ratios

is summarised below:
Inventory holding period
Add: Debtors collection period
Less: Creditors payment period
2 months
+ 1.5 months
3 months
0.5 months
As a rule, the shorter is the cash cycle, the better are the liquidity
ratios as measured above and vice versa.
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Leverage Capital Structure Ratio

There are two aspects of the long-term solvency of a firm:
(i) Ability to repay the principal when due, and
(ii) Regular payment of the interest .
Capital structure or leverage ratios throw light on the
long-term solvency of a firm.
Accordingly, there are two different types of leverage ratios.
First type: These ratios are
computed from the balance
sheet
Second type: These ratios are

computed from the Income
Statement
(a) Debt-equity ratio
(a) Interest coverage ratio
(b) Debt-assets ratio
(b) Dividend coverage ratio
(c) Equity-assets ratio

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I. Debt-equity ratio
Debt-equity ratio measures the ratio of long-term or total
debt to shareholders equity.
Long-term Debt + Short
Debt-equity ratio measures

ratio of long-term debt + Other Current
Totalthe
Debt
Debt-equity
ratiode3bt
= to shareholders equity Liabilities = Total external
term or total
Shareholders equity
Obligations
If the D/E ratio is high, the owners are putting up relatively less
money of their own. It is danger signal for the lenders and
creditors. If the project should fail financially, the creditors would
lose heavily.
A low D/E ratio has just the opposite implications. To the creditors, a
relatively high stake of the owners implies sufficient safety
margin and substantial protection against shrinkage in assets.
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For the company also, the servicing of debt is

less burdensome and consequently its credit
standing is not adversely affected, its
operational flexibility is not jeopardised and it
will be able to raise additional funds.
The disadvantage of low debt-equity ratio is
that the shareholders of the firm are deprived
of the benefits of trading on equity
or leverage.

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Trading on Equity
Trading on equity (leverage) is the use of borrowed funds in
expectation of higher return to equity-holders.
Trading on Equity
Particular
(a) Total assets
Financing pattern:
Equity capital
15% Debt
(b)Operating profit (EBIT)
Less: Interest
Earnings before taxes
Less: Taxes (0.35)
Earnings after taxes
Return on equity (per cent)
(Amount in Rs thousand)
A
1,000
1,000
1,000
1,000
1,000
300
300
105
195
19.5
800
200
300
30
270
94.5
175.5
21.9
600
400
300
60
240
84
156
26
200
800
300
120
180
63
117
58.5

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Coverage Ratio
Interest Coverage Ratio
Interest Coverage Ratio measures the firms ability to make
contractual interest payments.
Interest coverage ratio =
EBIT (Earning before interest and taxes)

Interest
Dividend Coverage Ratio

Dividend Coverage Ratio measures the firms ability to pay dividend
on preference share which carry a stated rate of return.
Dividend coverage ratio =
EAT (Earning after taxes)

Preference dividend

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Debt Service Coverage Ratio

Debt-service coverage ratio (DSCR) is considered a more
comprehensive and apt measure to compute debt service capacity
of a business firm.
DEBT SERVICE CAPACITY

Debt service capacity is the ability of a firm to make the
contractual payments required on a scheduled basis over the life
of the debt.
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Profit Margin
Gross Profit Margin
Gross profit margin measures the percentage of each sales
rupee remaining after the firm has paid for its goods.
Gross profit margin =
Gross Profit
X 100
Sales

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Net Profit Margin

Net profit margin measures the percentage of each sales rupee
remaining after all costs and expense including interest
and taxes have been deducted.
Net profit margin can be computed in three ways
i. Operating Profit Ratio =
ii. Pre-tax Profit Ratio =
iii. Net Profit Ratio =
Earning before interest and taxes

Net sales
Earnings before taxes
Net sales
Earning after interest and taxes

Net sales

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Example 7: From the following information of a firm,

determine (i) Gross profit margin and (ii) Net profit
margin.
1. Sales
2. Cost of goods sold
3. Other operating expenses
(1) Gross profit margin =
(2) Net profit margin =
Rs 1,00,000
Rs 2,00,000
Rs 50,000
Rs 2,00,000
Rs 2,00,000
1,00,000
50,000
= 50 per cent
= 25 per cent

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Expenses Ratio
i. Cost of goods sold =
ii. Operating expenses =
Cost of goods sold

X 100
Net sales
Administrative exp. + Selling exp.
Net sales
iii. Administrative expenses =
Administrative expenses
Net sales
iv. Selling expenses ratio =
Selling expenses
Net sales
v. Operating ratio =
X 100
X 100
X 100
Cost of goods sold + Operating expenses

X 100
Net sales
vi. Financial expenses =
Financial expenses
Net sales
X 100

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Return on Investment
Return on Investments measures the overall effectiveness
of management in generating profits with its available
assets.
i. Return on Assets (ROA)
ROA =
EAT + (Interest Tax advantage on interest)

Average total assets
ii. Return on Capital Employed (ROCE)

ROCE =
EAT + (Interest Tax advantage on interest)

Average total capital employed

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Return on Shareholders Equity

Return on shareholders equity measures the return on the
owners (both preference and equity shareholders)
investment in the firm.
Return on total shareholders equity =
Net profit after taxes
X 100
Average total shareholders equity
Return on ordinary shareholders equity (Net worth) =
Net profit after taxes Preference dividend
X 100
Average ordinary shareholders equity
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Efficiency Ratio
Activity ratios measure the speed with which various
accounts/assets are converted into sales or cash.
Inventory turnover measures the efficiency of various types
of inventories.
Cost
goods sold of
i. Inventory
Turnover
measures
the of
activity/liquidity
Inventory
Turnover
Ratio
=
Average
inventory of a firm; the speed with
whichinventory
inventory is sold
Cost
raw materials used
i. Inventory
Turnover
measures
theofactivity/liquidity
of
Raw
materials
turnover
=
inventory of a firm; the speed
with which
inventory
is sold
Average
raw material
inventory
of goods manufactured
i. Inventory Turnover measuresCost
the activity/liquidity
of
Work-in-progress turnover =
Average
work-in-progress
inventory of a firm; the speed
with which
inventory isinventory
sold
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Liquidity of a firms receivables can be examined
in two ways.
Credit sales
i. Debtors
Inventoryturnover
Turnover
i.
= measures the activity/liquidity of inventory of
a firm; the speed with
Average
whichdebtors
inventory
+ Average
is sold bills receivable (B/R)
2. Average collection period =
Months (days) in a year

Debtors turnover
Months (days)
in a year
(x) (Average Debtors
+ Average
(B/R)
i.
Inventory
Turnover
measures
the
activity/liquidity
of
inventory
of
a
Alternatively =
Total
firm; the speed with which inventory
is credit
sold sales
Ageing Schedule enables

slow paying debtors.
analysis
to

identify
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Assets Turnover Ratio

Assets turnover indicates the efficiency with which firm
uses all its assets to generate sales.
Cost
of goods sold of inventory of
i.
Inventory
Turnover
measures
the
activity/liquidity
i. Total assets turnover =
a firm; the speed with which inventory
Average total
is sold
assets

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1)
Earnings per share (EPS) = Net profit available to equity shareholders

(EAT Dp)/Number of equity shares outstanding (N).
2)
Dividends
per
share
(DPS)
Dividend
paid
to
ordinary
shareholders/Number of ordinary shares outstanding (N).

3)
Earnings yield = EPS/Market price per share.
4)
Dividend Yield = DPS/Market price per share.
5)
Dividend payment/payout (D/P) ratio = DPS/EPS.
6)
Price-earnings (P/E) ratio = Market price of a share/EPS.

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Rate of Return on Assets

EAT as percentage of
sales
EAT
Divided by
Gross profit = Sales less

cost of goods sold
Assets
turnover
Sales
Sales
Fixed assets
Divided by
Total Assets
Plus
Current assets
Alternatively
Minus
Shareholder equity
Expenses: Selling
Administrative Interest
Plus
Minus
Long-term borrowed
funds
Income-tax
Plus
Current liabilities

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Return on Assets
Earning Power
Earning power is the overall profitability of a firm; is computed
by multiplying net profit margin and assets turnover.
Earning power
= Net profit margin Assets turnover
Where, Net profit margin = Earning after taxes/Sales
Asset turnover
= Sales/Total assets

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EXAMPLE: 8
Assume that there are two firms, A and B, each having total assets
amounting to Rs 4,00,000, and average net profits after
taxes of 10 per cent, that is, Rs 40,000, each.
Firm A has sales of Rs 4,00,000, whereas the sales of firm B aggregate
Rs 40,00,000. Determine the ROA of firms A and B. Table 4 shows
the ROA based on two components.
Table 4: Return on Assets (ROA) of Firms A and B

Particulars
Firm A
1. Net sales
2. Net profit
3. Total assets
4. Profit margin (2 1) (per cent)
5. Assets turnover (1 3) (times)
6. ROA ratio (4 5) (per cent)
Rs 4,00,000
40,000
4,00,000
10
1
10
Firm B
Rs 40,00,000
40,000
4,00,000
1
10
10

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RATIO ANALYSIS

Tata McGraw-Hill Publishing Company Limited, Financial Management

Tata McGraw-Hill Publishing Company Limited, Financial Management

Tata McGraw-Hill Publishing Company Limited, Financial Management

Tata McGraw-Hill Publishing Company Limited, Financial Management

Net Working Capital

Table 2: Change in Net Working Capital

Tata McGraw-Hill Publishing Company Limited, Financial Management

Liquidity ratios measure the ability of a firm to

Tata McGraw-Hill Publishing Company Limited, Financial Management

Tata McGraw-Hill Publishing Company Limited, Financial Management

Quick Assets = Current assets Stock

Example 1: Acid-Test Ratio

Tata McGraw-Hill Publishing Company Limited, Financial Management

Supplementary Ratios for

Tata McGraw-Hill Publishing Company Limited, Financial Management

Inventory Turnover Ratio

Inventory turnover ratio =

Cost of goods sold

The cost of goods sold means sales minus gross profit.

Example 2: Inventory Turnover Ratio

(Rs 3,00,000 Rs 60,000)

(Rs 35,000 + Rs 45,000) 2

Debtors Turnover Ratio

Debtors turnover ratio

Net credit sales

Example 3: Debtors Turnover Ratio

(Rs 27,500 + Rs 32,500) 2

Debtors turnover ratio, (8)

Tata McGraw-Hill Publishing Company Limited, Financial Management

Creditors Turnover Ratio

Net credit purchases

Net credit purchases = Gross credit purchases - Returns to

Example 4: Creditors Turnover Ratio

(Rs 42,500 Rs 47,500) 2

Creditors turnover ratio, (4)

Tata McGraw-Hill Publishing Company Limited, Financial Management

The summing up of the three turnover ratios (known as a

The combined effect of the three turnover ratios

Leverage Capital Structure Ratio

Second type: These ratios are

(a) Debt-equity ratio

(a) Interest coverage ratio

(b) Debt-assets ratio

(b) Dividend coverage ratio

(c) Equity-assets ratio

Debt-equity ratio measures

For the company also, the servicing of debt is

Tata McGraw-Hill Publishing Company Limited, Financial Management

Tata McGraw-Hill Publishing Company Limited, Financial Management

EBIT (Earning before interest and taxes)

Dividend Coverage Ratio

Dividend coverage ratio =

EAT (Earning after taxes)

Tata McGraw-Hill Publishing Company Limited, Financial Management

Debt Service Coverage Ratio

DEBT SERVICE CAPACITY

Gross profit margin =

Tata McGraw-Hill Publishing Company Limited, Financial Management

Net Profit Margin

i. Operating Profit Ratio =

ii. Pre-tax Profit Ratio =

iii. Net Profit Ratio =

Earning before interest and taxes