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02/01/15 1 Financial Ratio Analysis

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Page 1: Financial ratio analysis

02/01/15 1

Financial Ratio Analysis

Page 2: Financial ratio analysis

02/01/15 2

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.

Page 4: Financial ratio analysis

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

Page 5: Financial ratio analysis

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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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

Page 20: Financial ratio analysis

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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

Page 26: Financial ratio analysis

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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