Financial ratio analysis
Transcript of Financial ratio analysis
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02/01/15 1
Financial Ratio Analysis
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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%
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RATIO
A ratio is a statistical yardstick that
provides a measure of the relationship
between two variables or f igures.
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LIABILITIES 31MAR07
31MAR08
ASSETS31MAR07
31MAR08170 SHARE CAPITAL
EQUITYPREFERENCE
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
7318935564
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
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INCOME STATEMENT OF ABC COMPANY FOR YEAR ENDED 31 MAR 08
FIGS 2007 FIGS 2008847 NET SALES 904657 COST OF GOODS SOLD
STOCKSWAGES AND SALARIESOTHER MANUFACTURING EXPENSES
366188160
714
190 GROSS PROFIT 190103 OPERATING EXPENSES:
SELLING/ADMDEPRECIATION
7125
96
87 OPERATING PROFIT 9411 NON-OPERATING PROFIT/DEFICIT 4998 PROFIT BEFORE INTEREST&TAX
(EBIT)143
26 INTEREST(ON BANK BORROWINGS/LOANS)DEBENTURES
294
33
72 PROFIT BEFORE TAX 11036 TAX 5836 PROFIT AFTER TAX 5212 DIVIDENDS:EQUITY/ PREFERENCE 14 / 3 1724 RETAINED EARNINGS(RESERVE &
SURPLUS)35
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A comparison is more useful than mere Nos Analysis of f inancial ratios involves two types of
comparisons: Present ratio with the past ratios & expected future
ratios Ratios of one firm with those of similar f irms or with
industry averages at same point of t ime
Essential to consider nature of business
(apples cannot be compared with oranges)
WHY BOTHER WITH RATIOS?
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CLASSIFICATION OF RATIOS
Liquidity ratios
Leverage / Solvency ratios
Turnover / Activity ratios
Profitabil i ty ratios
Valuation ratios
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LIQUIDITY RATIOS
Current ratio
Quick / Acid test ratio
Shows abil i ty of company to pay its current f inancial
obligations
Company should not be sell ing its assets at a loss to meet
its f inancial obligations; worst scenario be forced into
l iquidation
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CURRENT RATIO (CR) Measure of company’s abil i ty to meet short term
requirements
Indicates whether current l iabil i t ies are adequately
covered by current assets
Measures safety margin available for short term creditors
CR = Current assets/Current l iabil i t ies
If Net Working Capital is to be positive, CR >1
Indian avg for non banking industries is 2 Current assets = 681
Current l iabil i t ies = 399
CR = 681/399 = 1.71
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CURRENT RATIO (CR) - IMPORTANCE
Higher ratio ensures f irm does not face problems in
meeting increased working capital requirements
Low ratio implies repeated withdrawls from bank to
meet l iquidity requirements
High CR as compared to other f irms implies advantage
of lower int rates from banks
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ACID TEST RATIO/QUICK RATIO(QR)
Used to examine whether f irm has adequate cash or cash
equivalents to meet current obligations without resorting to
l iquidating non cash assets such as inventories
Measures posit ion of l iquidity at a point of t ime
QR = Quick Assets / Current Liabil i t ies
Quick assets = Current assets – ( inventories + prepaid
expenses)
= 681–(355+64) = 262
Current l iabil i t ies = 399
QR = 262/399 = 0.66
As a thumb rule ideal QR = 1; should not be less than 1
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02/01/15 14
CLASSIFICATION OF RATIOS
Liquidity ratios
Leverage / Solvency ratios
Turnover / Activity ratios
Profitabil i ty ratios
Valuation ratios
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LEVERAGE RATIOS
Shows dependence of f irm on outside long term finance
Shows long term financial solvency & measures firm’s abil i ty
to pay interest & principle regularly when due
To assess extent to which the f irm borrowed money vis-à-
vis funds supplied by owners; Use of debt f inance
Companies whose EBIT <= Interest payments are risky
Debt - Equity ratio
Debt - Total fund ratio
Debt - Assets ratio
Interest coverage ratio
Liabil i ty coverage ratio
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Measures relative proportion of debt & equity in f inancing assets
of a f irm
Company can have good current ratio and l iquidity posit ion,
however l iquidity may have come from long term borrowed
funds, the repayment of which along with interest wil l put
l iquidity under pressure
DER = Long term debt / Share holders funds
Creditors would l ike 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
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Debt (loans) = Secure loans + Unsecure loans
= 151+30=181
Share holders funds = (equity+ preference capital +
res & surplus – f ict it ious 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
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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 f irms funds are debt (of various types)
remaining 66% is f inanced by owners/ share holders
Higher the debt - total funds rat io, greater the
f inancial r isk
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DEBT – ASSETS RATIO
Debt - Assets ratio = Debt / Net assets
Debt = 181
Net assets ( less f ict it ious assets & losses) =
930
Ratio = 181/930 = 0.19
19% of the f irms assets are f inanced with debt (of
various types).
Shows coverage provided by the assets to total debt
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INTEREST COVERAGE RATIO
Gives abil i ty 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 t imes of debt interest
Shows margin of cover to lenders; of prime imp
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LIABILITY COVERAGE RATIO
Calculated to determine t ime a company would take
to pay off all i ts l iabil i t ies from internally generated
funds
Assumes that l iabil i t ies wil l not be l iquidated from
addit ional borrowings or from sale of assets
LCR = Internally generated funds / Total l iabil i t ies
Internally gen funds = Equity + Pref + R&S = 385
Total l iabil i t ies = 965
LCR = 385/965 = 0.399
Firm wil l take 2.5 yrs (1/.399) to repay all i ts
l iabil i t ies
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CLASSIFICATION OF RATIOS
Liquidity ratios
Leverage / Solvency ratios
Turnover / Activity ratios
Profitabil i ty ratios
Valuation ratios
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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
l ight 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 eff iciency with
which company uti l izing 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
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Measures No of t imes inventory turned over in a year
ORNo 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
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A ratio of 6 t imes indicates inventory turned over six t imes 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
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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 f irm Enables mgmt to take timely measures to effectively
manage credit Too high value - f irm facing diff icult ies in collecting debts Too low value - restrictive credit policy
Receivables = 189
Sales = 904
ACP = (189 x 365)/ 904 = 76.2 days
say 76 days
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FIXED ASSETS TURNOVER RATIO
Measures effectiveness of uti l ization of f ixed assets by
company
Used to compare fixed assets uti l ization of two firms
Not truly reflective of performance / eff iciency
High ratio (depreciation) i f old assets
Low ratio if capital assets procured recently
FATR = Net sales (or COGS)/ Fixed assets
Higher ratio indicates better uti l isation of assets (with a
caution on age of assets)
Fixed Assets = 229
Net Sales = 904
FATR = 904 / 229 = 3.95
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CLASSIFICATION OF RATIOS
Liquidity ratios
Leverage / Solvency ratios
Turnover / Activity ratios
Profitabil i ty ratios
Valuation ratios
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PROFITABILITY RATIOS
Gross profit margin ratio (GPMR) Net profit margin ratio (NPMR) Return on investment
• Profitabil i ty rat ios indicate
• Company's profitabil i ty in relat ion to other
companies
• Internal comparison with last yrs profits
•Managements effectiveness as shown by returns
generated on sales and investments
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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 f irm’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
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NET PROFIT MARGIN RATIO(NPMR)
Takes into account not only cost of production but also
administrative expenses l ike staff salary, sell ing &
distribution overheads
Represents surplus of gross profit after meeting expenses
Net profit appropriated to meet tax l iabil i ty, 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
profi t 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 BSALES 2,00,000 2,50,000GROSS PROFIT 40,000 40,000NET PROFIT 20,000 22,000GROSS PROFIT MARGIN
20% 16%
NET PROFIT MARGIN 10% 8.8%
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PROFITABILITY IN RELATION TO INVESTMENT- RETURN ON INVESTMENT (ROI)
Indicates eff iciency 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 f in leveraging
Enables one to check whether return made on investment
is better than other alternatives available
Suited for inter-f irm comparisons
ROI = EBIT x100 / Capital employed
• EBIT = 143
• Capital employed = 566 ( (120+50+215+181)-(0+0) )
(Eq +Pref sh +Res & surp+Debt)-(Ficti t ious 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
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CLASSIFICATION OF RATIOS
Liquidity ratios
Leverage / Solvency ratios
Turnover / Activity ratios
Profitabil i ty ratios
Valuation ratios
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VALUATION RATIOS
Earning per share (EPS)
Price Earnings (PE) Mult iple
Price Earnings Growth (PEG) Mult iple
Dividend Payout Ratio
Dividend Yield
Beta of Stock
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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
t ime
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 r isky ventures
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PRICE EARNING (PE) MULTIPLE
Simplest method of comparing different stocks at a point
of t ime 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/- i t 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
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PRICE EARNING GROWTH (PEG) MULTIPLE
An extension of PE which also takes into account growth
rate of the company
PEG Mult iple = PE / Growth
COMPANY A
COMPANY B
Analysis
Market Price 200 200EPS 10 20
Growth rate 5% 2%PE Mult iple 20 (200/10) 10 (100/20) A overvalued
PEG Mult iple 4 (20/5) 5 (10/2) B overpriced wrt growth potential
Which company stocks to be purchased ?
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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
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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
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BETA OF SECURITY
Refers to overall market risk which a security is carrying
and which cannot be diversif ied
Responsiveness of share price of a company with respect
to overall market movement
If over a period of t ime, 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
wil l not take that much hit
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FINANCIAL RATIOS
.
LIQUIDITYNWC = CA - CLCR = CA/CLATR = (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 Collect ion 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
Uti l isationCredit mgtRestrict ionsEff icency
Eff icencyAcceptabil i tyOverall performanceMargin of SafetyAbil i ty for PAT