Financial ratio analysis
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Transcript of Financial ratio analysis
04/11/23 1
FINANCIAL MANAGEMENTFINANCIAL MANAGEMENT
04/11/23 2
Financial Ratio Analysis
04/11/23 3
SIGNIFICANCE OF RATIO ANALYSIS
CSD ‘A’ earns Rs 50,000 CSD ‘B’ earns Rs 40,000
Which is more efficient? A or B
CSD ‘A’ has emp Rs 4,00,000CSD ‘B’ has emp Rs 3,00,000
Profit as a % of Capital emp ‘A’ = (50,000/ 4,00,000) * 100 =12.50% ‘B’ = (40,000/ 3,00,000) * 100 =13.33%
04/11/23 4
RATIO
A ratio is a statistical yardstick that
provides a measure of the relationship
between two variables or figures.
LIABILITIES 31MAR07
31MAR08
ASSETS31MAR07
31MAR08
170 SHARE CAPITALEQUITYPREFERENCE
12050
170 213 FIXED ASSETS NETGROSS STOCKLESS DEPRECIATION
594365
229
180 RESERVES AND SURPLUSES
215 11 INTANGIBLE ASSETS
15
150 SECURED LOANSDEBENTURESLOANS /ADVANCES
50101
151 5 INVESTMENTS 5
20 UNSECURED LOANS
30 670 CURRENT ASSETS
CASH IN BANKRECEIVABLESINVENTORIESPRE-PAID EXPENSES
73189355
64
681
409 CURRENT LIABILITIESSUNDRY CREDITORSPROVISIONS
33069
399
30 MISC EXPDR/LOSSES 35
929 TOTAL (Rs Lacs) 965 929 TOTAL (Rs Lacs) 965
BALANCE SHEET ABC COMPANY AS AT 31 MAR2008
INCOME STATEMENT OF ABC COMPANY FOR YEAR ENDED 31 MAR 08
FIGS 2007 FIGS 2008
847 NET SALES 904
657 COST OF GOODS SOLD STOCKSWAGES AND SALARIESOTHER MANUFACTURING EXPENSES
366188160
714
190 GROSS PROFIT 190
103 OPERATING EXPENSES: SELLING/ADMDEPRECIATION
7125
96
87 OPERATING PROFIT 94
11 NON-OPERATING PROFIT/DEFICIT 49
98 PROFIT BEFORE INTEREST&TAX (EBIT)
143
26 INTEREST(ON BANK BORROWINGS/LOANS)DEBENTURES
294
33
72 PROFIT BEFORE TAX 110
36 TAX 58
36 PROFIT AFTER TAX 52
12 DIVIDENDS:EQUITY/ PREFERENCE 14 / 3 17
24 RETAINED EARNINGS(RESERVE & SURPLUS)
35
04/11/23 7
A comparison is more useful than mere Nos Analysis of financial ratios involves two types
of comparisons: Present ratio with the past ratios & expected future
ratios Ratios of one firm with those of similar firms or with
industry averages at same point of time
Essential to consider nature of business
(apples cannot be compared with oranges)
WHY BOTHER WITH RATIOS?
04/11/23 8
CLASSIFICATION OF RATIOS
Liquidity ratios
Leverage / Solvency ratios
Turnover / Activity ratios
Profitability ratios
Valuation ratios
04/11/23 9
LIQUIDITY RATIOS
Current ratio
Quick / Acid test ratio
Shows ability of company to pay its current financial
obligations
Company should not be selling its assets at a loss to
meet its financial obligations; worst scenario be forced
into liquidation
04/11/23 12
CURRENT RATIO (CR)
Measure of company’s ability to meet short term
requirements
Indicates whether current liabilities are adequately
covered by current assets
Measures safety margin available for short term creditors
CR = Current assets/Current liabilities
If Net Working Capital is to be positive, CR >1
Indian avg for non banking industries is 2
Current assets = 681
Current liabilities = 399
CR = 681/399 = 1.71
04/11/23 13
CURRENT RATIO (CR) - IMPORTANCE
Higher ratio ensures firm does not face problems
in meeting increased working capital requirements
Low ratio implies repeated withdrawls from bank
to meet liquidity requirements
High CR as compared to other firms implies
advantage of lower int rates from banks
04/11/23 14
ACID TEST RATIO/QUICK RATIO(QR)
Used to examine whether firm has adequate cash or cash
equivalents to meet current obligations without resorting
to liquidating non cash assets such as inventories
Measures position of liquidity at a point of time
QR = Quick Assets / Current Liabilities
Quick assets = Current assets – (inventories + prepaid
expenses)
= 681–(355+64) = 262
Current liabilities = 399
QR = 262/399 = 0.66
As a thumb rule ideal QR = 1; should not be less than 1
04/11/23 15
CLASSIFICATION OF RATIOS
Liquidity ratios
Leverage / Solvency ratios
Turnover / Activity ratios
Profitability ratios
Valuation ratios
04/11/23 16
LEVERAGE RATIOS
Shows dependence of firm on outside long term
finance
Shows long term financial solvency & measures firm’s
ability to pay interest & principle regularly when due
To assess extent to which the firm borrowed money vis-
à-vis funds supplied by owners; Use of debt finance
Companies whose EBIT <= Interest payments are risky
Debt - Equity ratio
Debt - Total fund ratio
Debt - Assets ratio
Interest coverage ratio
Liability coverage ratio
04/11/23 17
Measures relative proportion of debt & equity in financing
assets of a firm
Company can have good current ratio and liquidity
position, however liquidity may have come from long term
borrowed funds, the repayment of which along with
interest will put liquidity under pressure
DER = Long term debt / Share holders funds
Creditors would like this to be low; Lower ratio implies
larger credit cushion (margin of protection to creditors)
IDB expects DER of 2:1 in respect of SMEs
DEBT EQUITY RATIO
04/11/23 18
Debt (loans) = Secure loans + Unsecure loans
= 151+30=181
Share holders funds = (equity+ preference capital +
res & surplus – fictitious assets &
accumulated losses not
written off )
= 120+50+215 = 385
DER = 181/385 = 0.47 = (0.47:1)
Creditors are providing Rs 0.47 financing for each
rupee provided by shareholders
DEBT EQUITY RATIO
04/11/23 19
DEBT – TOTAL FUND RATIO
DTF ratio= Long term debt / Total fund
Debt (long term) = 181
Total funds (debt + sh holders’ funds) =
181+(170+215-35) = 531
DTF ratio = 181/531 = 0.34
34% of the firms funds are debt (of various types)
remaining 66% is financed by owners/ share holders
Higher the debt - total funds ratio, greater the
financial risk
04/11/23 20
DEBT – ASSETS RATIO
Debt - Assets ratio = Debt / Net assets
Debt = 181
Net assets (less fictitious assets & losses) =
930
Ratio = 181/930 = 0.19
19% of the firms assets are financed with debt (of
various types).
Shows coverage provided by the assets to total
debt
04/11/23 21
INTEREST COVERAGE RATIO
Gives ability of company to pay back long term
loans along with interest or other charges from
generation of profit from its operations
Interest coverage ratio = EBIT / Debt interest
EBIT = 143
Interest = 29+4 = 33
Ratio = 143/33=4.33
EBIT should be 6 – 7 times of debt interest
Shows margin of cover to lenders; of prime imp
04/11/23 22
LIABILITY COVERAGE RATIO
Calculated to determine time a company would take to
pay off all its liabilities from internally generated funds
Assumes that liabilities will not be liquidated from
additional borrowings or from sale of assets
LCR = Internally generated funds / Total liabilities
Internally gen funds = Equity + Pref + R&S = 385
Total liabilities = 965
LCR = 385/965 = 0.399
Firm will take 2.5 yrs (1/.399) to repay all its liabilities
04/11/23 23
CLASSIFICATION OF RATIOS
Liquidity ratios
Leverage / Solvency ratios
Turnover / Activity ratios
Profitability ratios
Valuation ratios
04/11/23 24
ACTIVITY / TURN OVER RATIOS
Allows to examine whether total amount of each type
of asset a company owns is reasonable, too high or too
low in light of current and forecast operating needs
In order to purchase / acquire assets, companies need
to borrow or obtain Capital from elsewhere :- More assets acquired implies high int and low
profits Lesser assets implies operations not as efficient as
possible
Activity turn over ratios used to assess efficiency with
which company utilizing its assets
Relates to level of activity represented by sales or cost
of goods sold
• Inventory turnover ratio
• Average collection period
• Fixed assets turn over ratio
04/11/23 25
Measures No of times inventory turned over in a yearOR
No of days of inventory held by company to sp sales Times Inventory turned over =
Net sales OR COGS
Avg inventory Avg stocks Inventory measured in days of sale =
365 x Avg inventory
Net Sales
INVENTORY TURN OVER RATIO
04/11/23 26
A ratio of 6 times indicates inventory turned over six times in a year
OR Ratio of 60 days indicates enough inventory to support sales for 60 days held by company
Excessive inventories unproductive; represent investment with zero rate of return
Conversely less inventory results in loss of customers
ABC’s ratio = 904/355 = 2.54 ABC’s Days of Inv = (355 x 365)/904 = 143.33 days
INVENTORY TURN OVER RATIO
04/11/23 27
AVERAGE COLLECTION PERIOD Represents duration a company must wait after making
sales, before it actually receives cash from its
customers ACP = Avg receivables OR
Average sales per day = Avg receivables x 365
Sales
Imp For assessing effectiveness of credit policy of firm Enables mgmt to take timely measures to effectively
manage credit Too high value - firm facing difficulties in collecting debts Too low value - restrictive credit policy
Receivables = 189
Sales = 904
ACP = (189 x 365)/ 904 = 76.2 days
say 76
days
04/11/23 28
FIXED ASSETS TURNOVER RATIO
Measures effectiveness of utilization of fixed assets by
company
Used to compare fixed assets utilization of two firms
Not truly reflective of performance / efficiency
High ratio (depreciation) if old assets
Low ratio if capital assets procured recently
FATR = Net sales (or COGS)/ Fixed assets
Higher ratio indicates better utilisation of assets (with
a caution on age of assets)
Fixed Assets = 229
Net Sales = 904
FATR = 904 / 229 = 3.95
04/11/23 29
CLASSIFICATION OF RATIOS
Liquidity ratios
Leverage / Solvency ratios
Turnover / Activity ratios
Profitability ratios
Valuation ratios
04/11/23 30
PROFITABILITY RATIOS
Gross profit margin ratio (GPMR) Net profit margin ratio (NPMR) Return on investment
• Profitability ratios indicate
• Company's profitability in relation to other
companies
• Internal comparison with last yrs profits
•Managements effectiveness as shown by
returns generated on sales and investments
04/11/23 31
GROSS PROFIT MARGIN RATIO(GPMR)
Represents cost of production
Helps in understanding proportion of raw materials
used and direct expenses incurred in overall
production process
Reflects income being generated which can be
apportioned by promoters
Reflects efficiency of firm’s operations as well as how
products are priced
GPMR = Gross profit/ Net sales
Net Sales = 904
Gross Profit = Net sales - COGS = 904 - 714 = 190
GPMR = Gross Profit / Net sales
= 190 / 904 = 0.21 = 21%
Implies 79% (100-21%) of sales contribute towards
direct expenses and raw mtrl
04/11/23 32
NET PROFIT MARGIN RATIO(NPMR)
Takes into account not only cost of production but
also administrative expenses like staff salary, selling
& distribution overheads
Represents surplus of gross profit after meeting
expenses
Net profit appropriated to meet tax liability, dividend
payments and to retain part in business
NPMR = Net profit (Profit after tax)/ Net sales
Net Sales = 904
Net Profit after taxes = 52
NPMR = Net Profit / Net sales
= 52 / 904 = 0.057 = 5.7%
Implies for every Rs 100/- of sales, Rs 5.7/- earned
as profit which can be used for dividend distr and
apportioned to res & surplus• Company B has outperformed Company A in total sales
• However A has utilized its resources more efficiently
COMPANY A COMPANY B
SALES 2,00,000 2,50,000
GROSS PROFIT 40,000 40,000
NET PROFIT 20,000 22,000
GROSS PROFIT MARGIN
20% 16%
NET PROFIT MARGIN 10% 8.8%
04/11/23 33
PROFITABILITY IN RELATION TO INVESTMENT- RETURN ON INVESTMENT (ROI)
Indicates efficiency with which company used its
Capital (Equity as well as debt)
Takes into account overall returns of the company
assuming company has not taken any debt
Gives overall returns including adjustments of
earnings for fin leveraging
Enables one to check whether return made on
investment is better than other alternatives available
Suited for inter-firm comparisons
ROI = EBIT x100 / Capital employed
• EBIT = 143
• Capital employed = 566 ( (120+50+215+181)-
(0+0) )
(Eq +Pref sh +Res & surp+Debt)-(Fictitious assets
+ Non operating investments)
• ROI = 143/566 x 100 = 25.26 %.
• The company has earned a profit of 25.26 paise on
every 100 Re invested
04/11/23 34
CLASSIFICATION OF RATIOS
Liquidity ratios
Leverage / Solvency ratios
Turnover / Activity ratios
Profitability ratios
Valuation ratios
04/11/23 35
VALUATION RATIOS
Earning per share (EPS)
Price Earnings (PE) Multiple
Price Earnings Growth (PEG) Multiple
Dividend Payout Ratio
Dividend Yield
Beta of Stock
04/11/23 36
EARNINGS PER SHARE(EPS)
Represents total earnings of a company available for
distribution among equity shareholders
Evaluates performance of company shares over a
period of time
EPS = Net profit available for equity shareholders / No
of Equity shares
EPS alone should not be basis of decision making with
respect to purchase of any company share
Faulty reasons of High EPS Less No of Equity shares Investment in risky ventures
04/11/23 37
PRICE EARNING (PE) MULTIPLE
Simplest method of comparing different stocks at a
point of time to make investment decisions
As a layman, this is the price being paid for buying
one rupee of earning of a company eg If PE of Infosys
share is Rs 9/- it means we are paying to the market a
price of 9 for every Rs 1/- earning of the company
PE Ratio = Market Price per share/ EPS
04/11/23 38
PRICE EARNING GROWTH (PEG) MULTIPLE
An extension of PE which also takes into account
growth rate of the company
PEG Multiple = PE / Growth
COMPANY A
COMPANY B
Analysis
Market Price 200 200
EPS 10 20
Growth rate 5% 2%
PE Multiple 20 (200/10) 10 (100/20) A overvalued
PEG Multiple 4 (20/5) 5 (10/2) B overpriced wrt growth potentialWhich company stocks to be purchased ?
04/11/23 39
DIVIDEND PAYOUT RATIO Shows amount of dividend paid out of earnings
An indication of amount of profits put back into company
Imp ratio to assess long term prospects of company
Dividend Payout Ratio = Dividend / Net Income
04/11/23 40
DIVIDEND YIELD
Shows relationship between Dividend per share and market price
An imp ratio to compare two companies
Dividend Yield (%) = Dividend amount per share *100
Market price of share
04/11/23 41
BETA OF SECURITY
Refers to overall market risk which a security is carrying
and which cannot be diversified
Responsiveness of share price of a company with respect
to overall market movement
If over a period of time, market has given a return of
20%; individual share of company ‘A’ has given return of
10%;
Beta of A = 10 / 20 = 0.5
If investor is risk averse, should invest in stocks with low
Beta; Even if market falls by drastic amount his
investment will not take that much hit
04/11/23 4204/11/23 42
FINANCIAL RATIOS
.
LIQUIDITYNWC = CA - CLCR = CA/CL
ATR = (CA –INVENTORY)/CL
LEVERAGEDebt-Equity Ratio = Debt/Net WorthLiab Coverage Ratio = Int gen funds / Total Liab Debt to Assets Ratio = Debt/Total Assets Interest Coverage Ratio = EBIT/Debt InterestACTIVITY/TURNOVER Inventory Turn Over Ratio = Net Sales/Inventory
FATR = Net Sales/Total Assets Avg Collection Period = 365/ RTOR
PROFITABILITYGPMR = Gross Profit/Net Sales
NPMR = Net Profit/Net Sales ROI = EBIT x 100/ Capital ROE = Equity earnings/ NW
Solvency , Safety Margins, Idle Resources , Risk
Long term solvencyRisk due to debtOwners StakeCoverage provided by assetsInterest burden
UtilisationCredit mgtRestrictionsEfficency
EfficencyAcceptabilityOverall performanceMargin of SafetyAbility for PAT