Ratio Analysis

12-1
EXCEL BOOKS
Chapter 12
Financial Statements Analysis
12-2
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.
12-3
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.
12-4
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.
12-5
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.
12-6
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.
12-7
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.
12-8
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.
12-9
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.
12-10
Performance Analysis: Four window approach

Liquidity
Efficiency
Shareholders value
Profitability
Leverage
12-11
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.
12-12
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
12-13
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.
12-14
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
12-15
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)
12-16
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
12-17
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.
12-18
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
12-19
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?

12-20
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?
12-21
Capital Structure (or Long-term solvency)

Debt-equity ratio. Interest coverage ratio. Debt service coverage ratio.
12-22
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
12-23
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?
12-24
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:

12-25
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
12-26
Market-based ratios
Price-earning (P/E) multiple.
Price-to-book ratio.
Dividend yield. Total shareholder return (TSR)
12-27
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
12-28
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
12-29
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
12-30
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
12-31
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
12-32
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.
12-33
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)
12-34
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.
12-35
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
12-36
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
12-37
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
12-38
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
12-39
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.
12-40
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
12-41
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.
12-42
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:
12-43
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)
12-44
Performance Indicators for a bank

Capital Adequacy Ratio Net Interest Margin Yield Spread Return on Assets Credit-Deposit Ratio Burden Ratio Return on Equity
12-45
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.
12-46
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%.
12-47
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
12-48
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
12-49
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.
12-50
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 ).

Ratio Analysis

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Ratio Analysis

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12-1

Common Size Statements (CSS)

Financial Statements Analysis

Common Size Statements

Financial Statements Analysis

Identify the companies

Deferred tax liability

Features of common size balance sheet

Financial Statements Analysis

Features of common size balance sheet

Financial Statements Analysis

Hindustan Level Ltd.

Financial Statements Analysis

Financial Statements Analysis

Performance Analysis: Four window approach

Financial Statements Analysis

Financial Statements Analysis

Cash and Bank balances X 100 Total Assets

Financial Statements Analysis

Financial Statements Analysis

200 225 125 75 625

200 200 100 100 600

Financial Statements Analysis

Financial Statements Analysis

Liquidity Ratios: Story of three companies

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

Inventory holding period. Collection period. Suppliers credit period.

Financial Statements Analysis

Overall Efficiency Fixed Assets Efficiency (or Turnover) Ratio

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

Working Capital Efficiency(Turnover)

Sales/ Working Capital

Financial Statements Analysis

Working Capital Cycle: Two wheeler Companies

Which company is managing its working capital more efficiently?

Working Capital Cycle: Tobacco Companies

Raw materials & spares

Net working capital cycle

Capital Structure (or Long-term solvency)

Financial Statements Analysis

Long-term Solvency Ratios Defined

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

Financial Statements Analysis

Long term solvency: Story of four companies

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

Financial Statements Analysis

Profitability indicators for shareholders:

Financial Statements Analysis

(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

Financial Statements Analysis

Financial Statements Analysis

Market Price/Earning per share

Market price/Book value per share

Dividend Yield (on market value basis)

(Proposed Equity Capitalization) x 100

Total Return to Shareholders (TRS)