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EXCEL BOOKS

Chapter 12
Financial Statements Analysis

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Introduction
The financial health of a company can be gauged from two angles:
its financial results and position as reported in financial statements capital market response to firm performance

The basic purpose of providing two-year information (current year and previous year) in financial statements is to facilitate comparison. However, simple comparison of absolute numbers in the financial statements does not offer much insight due to size disparity, accounting policy changes etc.
Financial Statements Analysis

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Common Size Statements (CSS)

These are size neutral financial statements. CSS express the financial elements in percentage. Common size balance sheet is prepared by expressing all the elements as percentages of total assets (or total liabilities). Common size profit and loss account is prepared by expressing all items of income and expenditure as percentages of sales revenue.

Financial Statements Analysis

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Common Size Statements

CSS make two financial statements really comparable- whether they relate to the same company for two consecutive years or they relate to two different companies for the same year.

CSS also demonstrate an important fact that the financial statements have an industry character. In other words, financial statements can help one determine the nature of the industry which such financial statements represent.

Financial Statements Analysis

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Identify the companies


Common Size Balance Sheet Gross fixed assets Net Fixed Assets Investments Deferred tax asset Current Assets Misc. Exp Total Assets Paid up capital Reserves and surplus Borrowings A 29.88 20.24 30.97 4.87 43.85 0.07 100.00 2.93 24.91 19.57 B 71.63 42.08 21.06 0.45 35.15 1.26 100.00 1.72 48.19 23.20

Deferred tax liability


Current Liabilities and Provisions Total Liabilities

1.86
50.73 100.00

5.72
21.16 100.00

Two companies are: Reliance Industries Ltd. and Hidustan Level Ltd.
Financial Statements Analysis

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Features of common size balance sheet

Company A:

Net fixed assets is only 20% of total assets. Investments are more than net fixed assets. This implies that the company is not expanding production capacity and instead following inorganic route. Current Assets are more than 40% of total assets. Current liabilities and provision account for 50% of total liabilities. Reserves and surplus is 12 times of paid up capital.

Financial Statements Analysis

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Features of common size balance sheet

Company B:

Net fixed assets (as a percentage) is twice that of Company A. Only 20% of total assets are invested outside the company. This implies that the company is growing internally and at the same has sizable investment in group/associate companies. Reserves and surplus is 28 times of paid up capital. This implies that the company has been consistently earning profits in the past and more importantly ploughing back a significant part of profits.

Financial Statements Analysis

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Identification of Companies

Company A

Hindustan Level Ltd.


Reliance Industries Ltd.

Company B

This analysis proves that each balance sheet has an industry feature. This is the essence or utility of CSS.

Financial Statements Analysis

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Financial Ratios

Financial ratio represents a relative measure where both the numerator and the denominator are financial numbers. There are three class of financial ratios:

Balance Sheet Ratio Where both the variables are taken from the Balance Sheet. Profit and Loss Ratio Where both the variables are taken from Profit and Loss Account. Mixed Ratio Where one variable is taken from Balance Sheet and the other from Profit and Loss Account.

Financial Statements Analysis

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Performance Analysis: Four window approach


Liquidity

Efficiency

Shareholders value

Profitability

Leverage

Financial Statements Analysis

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Liquidity Ratios
These ratios indicate the ability of the firm to meet its short-term obligations (e.g., payment of salary, taxes, loans etc.) The timeframe for the expression short-term is generally twelve months. The challenge for any treasury manager is to manage the cash flow leads and lags. Liquidity management essentially involve constant monitoring of cash flow position.

Financial Statements Analysis

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Liquidity Ratios
Current Ratio
Current assets+ Advance tax+other short-term advances+Short-term marketable investments Current liabilities + short-term loans+ Provisions

Quick Ratio
Current assets-illiquid assets-prepaid expenses+ Advance tax+other short-term advances Current liabilities + short-term loans cash credit+ Provisions

Financial Slack

Cash and Bank balances X 100 Total Assets

Financial Statements Analysis

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Liquidity Ratios
Quick ratio is a better indicator of liquidity than current ratio. Financial slack represents the percentage of cash and bank balances that a firm holds. Higher financial slack denotes better liquidity but lesser profitability. From the Balance Sheet and other details given in next slide, compute the three liquidity ratios for both the years and comment.

Financial Statements Analysis

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BALANCE SHEET AS ON Sources of Funds: Shareholders Funds: Share Capital Reserves and Surplus Loan Funds: Long - term Loans Cash Credit TOTAL SOURCES Applications of Funds: Fixed Assets: Gross Block Less: Accumulated Depreciation Net Block Investments Current Assets, Loans, and Advances: Inventories Debtors Prepaid Expenses Cash and Bank Balance Advance Income Tax Staff Advance A. Total Current Assets, Loans, and Advances Less: Current Liabilities and Provision: Sundry Creditors Provision for Tax Proposed Dividend B. Total Current Liabilities and Provision Net Current Assets (A - B) Total Applications NOTE: 1. 2. Debtors are net of provisions for doubtful debts of Rs.25 lacs as on March 31, 2001 (Rs.20 lacs in the previous year). Investments include Rs.5 lacs of short term, investments (Rs.2 lacs in previous year). ( FIGURES IN RS. LACS ) 31 .03.2001 30.03.2000

200 225 125 75 625

200 200 100 100 600

435 165 270 30 175 125 45 30 40 65 480 (80) (25) (50) (155) 325 625

300 120 180 20 210 175 25 10 30 90 540 (90) (20) (30) (140) 400 600

Financial Statements Analysis

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Liquidity Ratios
31.03.2001 31.03.2000 210 175 25 10 30 90 540 2 140 100 240 2.26 2.19 1.35 175 125 45 30 40 65 480 5 155 75 230 2.11 1.71 3.85

Inventories Debtors Prepaid expenses Cash and bank balance Advance income tax Staff advance Total current asset, loans and advances(A) Short-term marketable investment(B) Current liabilities and provisions Cash credit Total short-term liabilities (C) Current Ratio (A+B)/C Quick Ratio (A-inventories-prepaid exp+B)/(C-cash credit) Financial Slack (Cash and bank balance/total assets)

Financial Statements Analysis

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Liquidity Ratios: Story of three companies


Mar 2000
1.02 0.49 0.65 4.20 4.19 42.91 Mar 2001 Mar 2002 Mar 2003 1.08 0.78 1.74 2.70 2.70 22.23 1.16 0.79 1.49 3.12 3.12 29.93 1.67 1.36 18.06 3.29 3.29 36.94 Mar 2004 1.26 0.77 4.18 1.52 1.52 31.57

Year Mar 1999 Maruti Udyog Ltd. Current Ratio 1.29 Quick Ratio 0.87 Financial slack 19.27 Infosys Technologies Ltd. Current Ratio 6.43 Quick Ratio 6.43 Financial slack 61.43 Indian Oil Corpn. Ltd. Current Ratio 0.70 Quick Ratio 0.56 Financial slack 1.49

0.94 0.84 1.43

1.23 1.00 1.40

0.67 0.58 1.19

0.80 0.60 1.59

0.84 0.59 1.09

Financial Statements Analysis

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Efficiency Ratios
Total asset turnover ratio. Fixed assets turnover ratio. Working capital turnover ratio. Working capital cycle:

Inventory holding period. Collection period. Suppliers credit period.

Financial Statements Analysis

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Overall Efficiency Fixed Assets Efficiency (or Turnover) Ratio

Sales/Capital Employed Sales/(Net Block + Capital WIP)

Working Capital Efficiency(Turnover)


Inventory Turnover Debtors Turnover Creditors Turnover Average Inventory Inventory Holding Period Debtors Collection Period Suppliers Credit Period

Sales/ Working Capital


Cost of Goods Sold / Average Inventory Credit Sales / (Average Debtors + Average Bills Receivable) Credit Purchase / (Average Creditors + Average Bills Payable) (Average Inventory/Cost of Goods Sold) x No. of Days/Months in a Year ((Average Debtors + Average Bills Receivables)/ Credit Sales) x No. of Days/Months in a Year ((Average Creditors + Average Bills Payable)/ Credit Purchases) x No. of Days/months in a year

Financial Statements Analysis

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Working Capital Cycle: Two wheeler Companies


HERO HONDA Working capital cycle Holding period (no. of days) Raw materials & spares Production Finished goods Debtors Gross working capital cycle Credit availed from creditors Net working capital cycle BAJAJ AUTO Holding period (no. of days) Raw materials & spares Production Finished goods Debtors Gross working capital cycle Credit availed from creditors Net working capital cycle 27 3 8 18 56 40 16 26 3 7 19 55 49 6 26 3 11 15 55 49 6 18 2 10 13 43 43 0 11 1 9 13 34 42 -8 9 1 9 9 28 45 -17 29 3 3 6 41 40 1 1999 28 2 3 4 37 37 0 2000 23 1 3 4 31 31 0 2001 17 1 3 5 26 32 -6 2002 14 1 3 8 26 35 -9 2003 13 1 3 5 22 42 -20 2004 1999 2000 2001 2002 2003 2004

Which company is managing its working capital more efficiently?


Financial Statements Analysis

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Working Capital Cycle: Tobacco Companies


ITC Working capital cycle Holding period (no. of days) 1999 2000 2001 2002 2003 2004

Raw materials & spares


Production Finished goods Debtors Gross working capital cycle Credit availed from creditors

186
0 36 14 236 124

198
0 32 10 240 142

192
0 31 4 227 172

201
1 36 5 243 166

171
1 38 6 216 184

149
1 46 7 203 228

Net working capital cycle


GODFREY PHILLIPS Holding period (no. of days) Raw materials & spares Production Finished goods

112
1998

98
1999

55
2000

77
2001

32
2002

-25
2003

185 0 16

236 0 23

327 0 33

212 0 33

343 0 39

172 0 31

Debtors
Gross working capital cycle Credit availed from creditors Net working capital cycle

4
205 72 133

2
261 51 210

1
361 38 323

1
246 44 202

1
383 62 321

2
205 70 135

Can you identify the distinguishing features between two-wheeler and tobacco companies?
Financial Statements Analysis

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Capital Structure (or Long-term solvency)


Debt-equity ratio. Interest coverage ratio. Debt service coverage ratio.

Financial Statements Analysis

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Long-term Solvency Ratios Defined


Long - term Debt/Equity Cash Flow from Operating Activities After Tax/ (Interest + Installments Paid during the year on long term loans).

Debt - Equity Ratio (D/E) Debt - Service Coverage Ratio (DSCR) Debt Ratio Interest Coverage Ratio

[Long - term D ebt/(Long - term Debt + Equity)] (PAT + Interest)/Interest

x 100

Financial Statements Analysis

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Long term solvency: Story of four companies


Year 2004-2005 Debt-equity Ratio DSCR Interest coverage Ratio Debt Ratio Bharti 0.83 1.91 5.82 45.31 Hero Honda 0.14 42.72 420.93 11.90 ITC 0.01 99.10 219141.00 0.97 RIL 0.43 1.80 8.37 29.95

Bharti =Bharti Tele-ventures Ltd. RIL= Reliance Industries Ltd.

Comment on the long-term solvency of the above companies. Why do you think Bharti has higher debtequity ratio?

Financial Statements Analysis

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Profitability Ratios

Sales-based

Operating margin Net profit margin Return on Total Assets (ROTA) ROCE/ROI RONW EPS Cash EPS (CEPS) DPS Pay out ratio

Asset-based

Profitability indicators for shareholders:


Financial Statements Analysis

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Operating Profit Margin Net Profit Margin Return on Total Assets (ROTA) Return on Capital Employed (ROCE) or Return on Investment (ROI) Return on Net Worth (RONW) Dividend (DPS) Per Share

[Operating Profit/Sales] x 100 [Profit After Tax (PAT)/Sales] x 100 (Profit Before Interest and After Tax/Total Assets) x100 (Operating Profit/Capital Employed) x 100

(PAT/Net Worth) x 100 Proposed Dividend/Number of Shares (Proposed Dividend/PAT) x 100

Pay-out Ratio Basic Earning Share (EPS) Diluted EPS Per

(PAT Dividend on Preference Average Number of Equity Shares

Shares)/Weighted

Diluted Earnings/(Weighted Average Number of Shares as Adjusted for Dilutive Potential Ordinary Shares) Cash Profit for Equity Shareholders/Average Outstanding Shares

Cash EPS

Financial Statements Analysis

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Market-based ratios
Price-earning (P/E) multiple.

Price-to-book ratio.
Dividend yield. Total shareholder return (TSR)

Financial Statements Analysis

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Price-Earning Multiple

Market Price/Earning per share

Price-to-Book Multiple

Market price/Book value per share

Dividend Yield (on market value basis)

(Proposed Equity Capitalization) x 100

Dividend/Market

Total Return to Shareholders (TRS)

[Dividend Per Share + (Closing Market Price Opening Market Price)]/Opening Market Price

Financial Statements Analysis

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Profitability & Market Indicators: ONGC


Profitability Ratios ONGC Operating Margin (%) Net (PAT) Margin(%) ROCE/ROI (%) ROE/RONW(%) EPS (Rs.) P/E Multiple (X) P/B Multiple (X) 1999 41.77 25.96 13.78 11.66 19.32 6.12 0.7 2000 40.15 20.24 21.13 13.66 25.45 5.33 0.72 2001 47.75 24.79 29.42 18.24 33.65 3.94 0.64 2002 54.63 30.54 32.81 20.56 40.98 6.67 1.17 2003 64.87 39.11 34.57 34.62 73.84 4.82 1.42 2004 61.12 32.1 38.57 22.56 60.76 13.83 2.96

Financial Statements Analysis

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Profitability & Market Indicators: IOC


Profitability Ratios IOC Operating Margin (%) Net (PAT) Margin(%) ROCE/ROI (%) ROE/RONW(%) EPS (Rs.) P/E Multiple (X) P/B Multiple (X) 1999 7.13 4.33 28.94 23.58 56.85 5.13 0.92 2000 4.79 2.93 22.53 18.66 31.38 6.01 1.04 2001 3.95 2.22 17.28 16.67 29.67 5.5 0.82 2002 6.25 3.04 25.09 20.12 29.55 6.77 0.92 2003 8.12 5.33 43.38 34.75 78.52 2.96 0.96 2004 8.14 5.5 42.25 31.78 59.97 8.28 2.51

Financial Statements Analysis

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Profitability & Market Indicators: Ranbaxy Lab


Profitability Ratios Ranbaxy Lab Operating Margin (%) Net (PAT) Margin(%) ROCE/ROI (%) ROE/RONW(%) EPS (Rs.) P/E Multiple (X) P/B Multiple (X) 1998 15.53 9.7 12.87 9.33 12.93 20.66 2.21 1999 16.3 10.98 19.04 14.2 17.17 53.57 7.17 2000 13.74 9.71 17.65 12.75 14.21 47.3 4.94 2001 11.08 7.85 16.94 12.29 22.64 30.49 4.99 2002 20.02 16.59 40.26 33.68 25.8 23 5.87 2003 21.74 17.54 43.06 34.83 42.83 25.64 8.78

Financial Statements Analysis

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Profitability & Market Indicators: Dr. Reddys Lab


Profitability Ratios Dr. Reddy's Lab Operating Margin (%) Net (PAT) Margin(%) ROCE/ROI (%) ROE/RONW(%) EPS (Rs.) P/E Multiple (X) P/B Multiple (X) 1998 19.3 13.78 20.74 16.19 22.94 21.32 3.51 1999 19.12 13.88 20.8 16.76 16.66 86.57 9.44 2000 23.97 15.85 43.81 34.62 33.56 37.93 6.95 2001 36.9 33.6 58.6 57.43 52.42 17.62 9.34 2002 27.32 24.46 26.83 24.31 48.84 18.39 4.2 2003 19.82 18.43 17.83 16.81 51.23 27.87 5.37

Financial Statements Analysis

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Interdependence of financial ratios


Financial ratios are not independent. Du-Pont analysis shows the interdependence of ratios. Du Pont chart is designed to show the relationships among return on equity, profit margin, asset efficiency and leverage.

Financial Statements Analysis

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Du-Pont Equation
Equation 1:

Return on investment (ROI) =Operating margin X Asset turnover = ( Operating profit/Sales) X ( Sales/Capital employed)

Equation 2:
= ROI X (1/Equity Ratio) X (1/Leverage Impact) = ROI X (Capital Employed/Equity) X ( PAT / Operating profit )

Return on Equity (ROE)

Financial Statements Analysis

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Economic Value Added (EVA)


It is a measure of firm performance. EVA is a residual income that subtracts the cost of capital from the operating profits generated by a firm. EVA is a registered trademark of a New York based consulting firm- Stern Stewart & Co. More than 300 companies across the globe have implemented EVA framework for financial management and incentive compensation.

Financial Statements Analysis

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How to measure EVA?

EVA is defined as:


EVA = ( NOPAT

Capital

Cost of Capital )

Capital

Where, NOPAT= Net operating profit after tax =Operating profit after tax net of depreciation and after adjustments for equity equivalents Cost of Capital= Weighted average cost of capital

Capital= Capital invested in the business


Equity equivalents= Adjustments to convert accounting profit to economic profit
Financial Statements Analysis

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The Components of EVA

1. NOPAT (Net Operating Profit After Tax)


Operating profit Amount of money invested in the business

2. Capital

3. Cost of Capital (WACC)

The return the investors require for the risk of investing their money in your business
Minimum profit required Calculated as Capital multiplied by the required return.

4. Capital Charge

Financial Statements Analysis

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Equity Equivalent adjustments: Common examples


Deferred tax liability/(asset):

Should be added/(deducted) with NOPAT and a corresponding increase should be shown in invested capital. Where inventories are valued on LIFO basis (which is hardly practiced in India now), LIFO reserve is the difference between FIFO and LIFO value of inventory. Periodic increase in LIFO reserve should be added to NOPAT and invested capital.

LIFO Reserve

R&D Costs

R&D expenses should be added back to NOPAT and a defined amortization policy should be followed.
Goodwill should not be amortized and it can only be subject to impairment.

Goodwill

Financial Statements Analysis

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Other elements
Cash operating tax

In computing NOPAT, cash operating tax should be deducted. Cash operating tax=Provision for current tax+ tax shield on interest.
Invested capital= Net Block+ Long-term Strategic investments+ Net Current Assets
Debt Equity + Cost of equity X Capital Capital

Capital

Weighted average cost of capital (WACC)


WACC = Cost of debt X

Financial Statements Analysis

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Market Value Added (MVA)


MVA refers to capital market response to a firms performance. It shows how much money the market is willing to pay per rupee of invested capital of a firm. MVA= Market value of the firm-invested capital = (Market value of equity + Market value of debt)- (Book value of equity + book value of debt) Where, market value and book value of debt are equal: MVA= Market value of equity- Book value of equity.

Financial Statements Analysis

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EVA of Infosys: An Example


In Rs.Crore,except as stated otherwise
2005 6.80 7.00 0.98 13.63 NA 13.63 4,330.95 42.63 2004 5.20 7.00 1.27 14.09 NA 14.09 3,124.82 39.80 2003 6.00 7.00 1.57 16.99 NA 16.99 2,493.40 38.29 2002 7.30 7.00 1.41 17.17 NA 17.17 1,734.97 46.57 2001 10.30 7.00 1.54 21.08 NA 21.08 1,111.47 56.08

Fiscal Cost of Capital Risk-free debt cost (%) Market premium Beta variant Cost of equity (%) Average Debt/Total capital(%) Cost of debt net of tax (%) Weighted Average Cost of Capital(WACC) (%) Average capital employed PAT as a percentage of average capital employed (%) Economic Value Added (EVA) Operating profit (excluding extraordinary income) Less: Tax Cost of capital Economic Value Added

2,048.09
325.58 590.40 1,132.11

1,357.46
227.54 440.29 689.63

1,079.28
201.00 423.63 454.65

943.39
135.43 297.90 510.06

696.03
72.71 234.30 389.02

Financial Statements Analysis

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Financial Statements Analysis of Banks


Financial statements of banks are quite distinct from those of manufacturing and trading firms. A banks major source of revenue is interest income and its biggest expense is interest expenses. Loans and advances are the main assets of bank. Debt-equity ratio of banks is very high.

Financial Statements Analysis

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Major sources of income for a bank


Operating income:

Interest income ( earned on loans) Fee income (e.g., commission, guarantee fee, loan processing fee, income from credit cards etc.) Treasury income (e.g., profit from derivative transactions, profit on sale of financial instruments) Lease income (e.g., lease rental) dividend, interest on investment

Non-operating income:

Financial Statements Analysis

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Major sources of expenses for a bank


Operating Expenses:

Interest expenses (on various borrowings) Establishment charges Direct marketing agent expenses Provision for credit loses (e.g., provision for nonperforming assets)

Financial Statements Analysis

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Performance Indicators for a bank


Capital Adequacy Ratio Net Interest Margin Yield Spread Return on Assets Credit-Deposit Ratio Burden Ratio Return on Equity

Financial Statements Analysis

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Capital Adequacy Ratio


Banks are financial intermediaries. Banks depend more on external borrowing to fund their basic operations. A banks ability to meet its commitment towards depositors and lenders is measured by capital adequacy ratio (CAR). Capital adequacy ratio is a measure of solvency risk of the bank. Higher the CAR, greater the solvency.

Financial Statements Analysis

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Capital Adequacy Ratio

Capital, for CAR purposes, is of two types:

Tier I Capital (e.g., paid up capital, free reserves, statutory reserves etc.) Tier II Capital (e.g., Cumulative perpetual preference share capital, revaluation reserve, subordinated debt, hybrid debt instrument)

CAR=Tier I Capital + Tier II Capital Risk weighted assets


Where risk weighted assets include off-balance sheet items.

As per RBI guidelines, banks are required to maintain a minimum CAR of 10%.

Financial Statements Analysis

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Other Financial Ratios


Net interest margin
Net interest income (NII) X 100 Average interest-earning assets

Yield Spread
Average yield- Average cost of fund Average yield= Interest income X 100 Average interest earning assets Average cost of funds= Interest expenses X 100 Average interest bearing liabilities

Financial Statements Analysis

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Other Financial Ratios

Return on Assets

Operating profit (net of provisions) X 100 Average assets Loans and advances (net of provisions) Total Deposits (Non-interest income-non-interest opex) X 100 Total (or average) assets PAT X 100 Average equity

Credit-Deposit Ratio (C/D Ratio)

Burden Ratio

Return on Equity

Financial Statements Analysis

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Return on Assets
Return on assets (ROA) can also be computed as:

ROA=(NII/Average Assets)+Burden Ratio (Provisions & Contingencies)/Average Assets Where NII=Interest income-interest expenses.

If burden ratio is positive and is more than the proportion of provisions & contingencies, overall ROA will improve.

Financial Statements Analysis

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Financial Ratios for Banks


Burden ratio indicates contribution of fee based operating income in recovering non-interest operating expenses (i.e., bank overheads). A bank should try to ensure that this ratio is positive. A negative burden ratio indicates the banks inability to meet its non-interest operating costs from fee based income. A negative burden ratio depresses a banks ROA. C/D ratio indicates proportion of public deposits disbursed as credit (i.e., loans and advances ).

Financial Statements Analysis