**FINANCIAL MANAGEMENT

**Financial Ratio Analysis

**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 3,00,000Profit as a % of Capital emp A = (50,000/ 4,00,000) * 100 =12.50% B = (40,000/ 3,00,000) * 100 =13.33%

**RATIOA ratio is a statistical yardstick that provides a measure of the relationship between two variables or figures.

BALANCE SHEET ABC COMPANY AS AT 31 MAR2008

LIABILITIES 31MAR07 31MAR08ASSETS31MAR07 31MAR08170SHARE CAPITALEQUITYPREFERENCE12050170213FIXED ASSETS NETGROSS STOCKLESS DEPRECIATION594365229180RESERVES AND SURPLUSES21511INTANGIBLE ASSETS15150SECURED LOANSDEBENTURESLOANS /ADVANCES501011515INVESTMENTS520UNSECURED LOANS30670CURRENT ASSETS

CASH IN BANKRECEIVABLESINVENTORIESPRE-PAID EXPENSES

7318935564681409CURRENT LIABILITIESSUNDRY CREDITORSPROVISIONS

3306939930MISC EXPDR/LOSSES35929TOTAL (Rs Lacs)965929TOTAL (Rs Lacs)965

INCOME STATEMENT OF ABC COMPANY FOR YEAR ENDED 31 MAR 08

FIGS 2007FIGS 2008847NET SALES904657COST OF GOODS SOLD STOCKSWAGES AND SALARIESOTHER MANUFACTURING EXPENSES 366188160714190GROSS PROFIT190103OPERATING EXPENSES: SELLING/ADMDEPRECIATION 71259687OPERATING PROFIT9411NON-OPERATING PROFIT/DEFICIT4998PROFIT BEFORE INTEREST&TAX (EBIT)14326INTEREST(ON BANK BORROWINGS/LOANS)DEBENTURES2943372PROFIT BEFORE TAX11036TAX5836PROFIT AFTER TAX5212DIVIDENDS:EQUITY/ PREFERENCE14 / 31724RETAINED EARNINGS(RESERVE & SURPLUS)35

**A comparison is more useful than mere NosAnalysis of financial ratios involves two types of comparisons:Present ratio with the past ratios & expected future ratiosRatios of one firm with those of similar firms or with industry averages at same point of timeEssential to consider nature of business (apples cannot be compared with oranges)WHY BOTHER WITH RATIOS?

**CLASSIFICATION OF RATIOSLiquidity ratiosLeverage / Solvency ratiosTurnover / Activity ratiosProfitability ratiosValuation ratios

** LIQUIDITY RATIOSCurrent ratioQuick / Acid test ratio

Shows ability of company to pay its current financial obligationsCompany should not be selling its assets at a loss to meet its financial obligations; worst scenario be forced into liquidation

**NET WORKING CAPITALNet Current Assets or Net Working Capital reqd by a company to meet operational requirements and sp salesNet Working Capital = Current Assets Current LiabilitiesFor anticipated incr in sales, current assets will have to be incr; leads to incr in Net Working Capital Ratio of Incr in Sales / Net Working Capital indicates amount necessary to sp certain volumes of salesEg, Ratio of 30% implies should sales incr by Rs 100/-, companies Net Working Capital should incr by Rs 30/-

**NET WORKING CAPITALSITUATIONNet Working Capital is positiveIMPLICATIONProprietor has brought in his own money Any fall in value of Current Assets will be cushioned by proprietors stake / Res & SurplusLoss in sale of Current Assets will not affect short term creditorsSITUATIONNet Working Capital is negativeIMPLICATIONBusiness has applied part of surplus towards meeting shortfall in resources

**CURRENT RATIO (CR)Measure of companys ability to meet short term requirementsIndicates whether current liabilities are adequately covered by current assetsMeasures safety margin available for short term creditorsCR = Current assets/Current liabilitiesIf Net Working Capital is to be positive, CR >1Indian avg for non banking industries is 2 Current assets = 681 Current liabilities = 399 CR = 681/399 = 1.71

**CURRENT RATIO (CR) - IMPORTANCEHigher ratio ensures firm does not face problems in meeting increased working capital requirementsLow ratio implies repeated withdrawls from bank to meet liquidity requirementsHigh CR as compared to other firms implies advantage of lower int rates from banks

**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 inventoriesMeasures position of liquidity at a point of timeQR = Quick Assets / Current LiabilitiesQuick assets = Current assets (inventories + prepaid expenses) = 681(355+64) = 262 Current liabilities = 399QR = 262/399 = 0.66As a thumb rule ideal QR = 1; should not be less than 1

**CLASSIFICATION OF RATIOSLiquidity ratiosLeverage / Solvency ratiosTurnover / Activity ratiosProfitability ratiosValuation ratios

**LEVERAGE RATIOS Shows dependence of firm on outside long term financeShows long term financial solvency & measures firms ability to pay interest & principle regularly when dueTo assess extent to which the firm borrowed money vis--vis funds supplied by owners; Use of debt financeCompanies whose EBIT

**Measures relative proportion of debt & equity in financing assets of a firmCompany 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 fundsCreditors 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 SMEsDEBT EQUITY RATIO

**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 = 385DER = 181/385 = 0.47 = (0.47:1)Creditors are providing Rs 0.47 financing for each rupee provided by shareholdersDEBT EQUITY RATIO

**DEBT TOTAL FUND RATIODTF ratio= Long term debt / Total fundDebt (long term)=181Total funds (debt + sh holders funds) = 181+(170+215-35) = 531 DTF ratio = 181/531 = 0.3434% of the firms funds are debt (of various types) remaining 66% is financed by owners/ share holdersHigher the debt - total funds ratio, greater the financial risk

**DEBT ASSETS RATIODebt - Assets ratio = Debt / Net assetsDebt = 181Net assets (less fictitious assets & losses) =930Ratio = 181/930 = 0.1919% of the firms assets are financed with debt (of various types).Shows coverage provided by the assets to total debt

**INTEREST COVERAGE RATIOGives ability of company to pay back long term loans along with interest or other charges from generation of profit from its operationsInterest coverage ratio = EBIT / Debt interestEBIT = 143Interest = 29+4 = 33Ratio = 143/33=4.33 EBIT should be 6 7 times of debt interestShows margin of cover to lenders; of prime imp

**LIABILITY COVERAGE RATIOCalculated to determine time a company would take to pay off all its liabilities from internally generated fundsAssumes that liabilities will not be liquidated from additional borrowings or from sale of assetsLCR = Internally generated funds / Total liabilitiesInternally gen funds= Equity + Pref + R&S = 385Total liabilities= 965LCR = 385/965 = 0.399Firm will take 2.5 yrs (1/.399) to repay all its liabilities

**CLASSIFICATION OF RATIOSLiquidity ratiosLeverage / Solvency ratiosTurnover / Activity ratiosProfitability ratiosValuation ratios

**ACTIVITY / TURN OVER RATIOSAllows 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 needsIn order to purchase / acquire assets, companies need to borrow or obtain Capital from elsewhere :-More assets acquired implies high int and low profitsLesser assets implies operations not as efficient as possibleActivity 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

**Measures No of times inventory turned over in a yearORNo of days of inventory held by company to sp salesTimes Inventory turned over = Net sales OR COGS Avg inventory Avg stocksInventory measured in days of sale =365 x Avg inventory Net Sales INVENTORY TURN OVER RATIO

**A ratio of 6 times indicates inventory turned over six times in a yearOR Ratio of 60 days indicates enough inventory to support sales for 60 days held by companyExcessive inventories unproductive; represent investment with zero rate of returnConversely less inventory results in loss of customersABCs ratio = 904/355 = 2.54ABCs Days of Inv = (355 x 365)/904 = 143.33 daysINVENTORY TURN OVER RATIO

**AVERAGE COLLECTION PERIODRepresents duration a company must wait after making sales, before it actually receives cash from its customersACP = Avg receivablesORAverage sales per day = Avg receivables x 365 SalesImp For assessing effectiveness of credit policy of firmEnables mgmt to take timely measures to effectively manage creditToo high value - firm facing difficulties in collecting debtsToo low value - restrictive credit policyReceivables = 189Sales = 904ACP = (189 x 365)/ 904 = 76.2 days say 76 days

**FIXED ASSETS TURNOVER RATIOMeasures effectiveness of utilization of fixed assets by companyUsed to compare fixed assets utilization of two firmsNot truly reflective of performance / efficiencyHigh ratio (depreciation) if old assetsLow ratio if capital assets procured recentlyFATR = Net sales (or COGS)/ Fixed assetsHigher ratio indicates better utilisation of assets (with a caution on age of assets)Fixed Assets = 229Net Sales = 904FATR = 904 / 229 = 3.95

**CLASSIFICATION OF RATIOSLiquidity ratiosLeverage / Solvency ratiosTurnover / Activity ratiosProfitability ratiosValuation ratios

**PROFITABILITY RATIOSGross 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 profitsManagements effectiveness as shown by returns generated on sales and investments

**GROSS PROFIT MARGIN RATIO(GPMR)

Represents cost of productionHelps in understanding proportion of raw materials used and direct expenses incurred in overall production processReflects income being generated which can be apportioned by promotersReflects efficiency of firms operations as well as how products are pricedGPMR = Gross profit/ Net sales Net Sales = 904Gross Profit= Net sales - COGS = 904 - 714 = 190GPMR = Gross Profit / Net sales= 190 / 904 = 0.21 = 21%Implies 79% (100-21%) of sales contribute towards direct expenses and raw mtrl

**NET PROFIT MARGIN RATIO(NPMR)Takes into account not only cost of production but also administrative expenses like staff salary, selling & distribution overheadsRepresents surplus of gross profit after meeting expensesNet profit appropriated to meet tax liability, dividend payments and to retain part in businessNPMR = Net profit (Profit after tax)/ Net sales

Net Sales = 904Net Profit after taxes= 52NPMR = 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 ACOMPANY BSALES2,00,0002,50,000GROSS PROFIT40,00040,000NET PROFIT20,00022,000GROSS PROFIT MARGIN20%16%NET PROFIT MARGIN10%8.8%

**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 debtGives overall returns including adjustments of earnings for fin leveragingEnables one to check whether return made on investment is better than other alternatives availableSuited for inter-firm comparisonsROI = EBIT x100 / Capital employed EBIT = 143Capital 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

**CLASSIFICATION OF RATIOSLiquidity ratiosLeverage / Solvency ratiosTurnover / Activity ratiosProfitability ratiosValuation ratios

** VALUATION RATIOSEarning per share (EPS)Price Earnings (PE) MultiplePrice Earnings Growth (PEG) MultipleDividend Payout RatioDividend YieldBeta of Stock

**EARNINGS PER SHARE(EPS)Represents total earnings of a company available for distribution among equity shareholdersEvaluates performance of company shares over a period of timeEPS = 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 shareFaulty reasons of High EPS Less No of Equity sharesInvestment in risky ventures

**PRICE EARNING (PE) MULTIPLESimplest method of comparing different stocks at a point of time to make investment decisionsAs 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 companyPE Ratio = Market Price per share/ EPS

**PRICE EARNING GROWTH (PEG) MULTIPLEAn extension of PE which also takes into account growth rate of the companyPEG Multiple = PE / GrowthWhich company stocks to be purchased ?

COMPANY ACOMPANY BAnalysisMarket Price200200EPS1020Growth rate5%2%PE Multiple20 (200/10)10 (100/20)A overvaluedPEG Multiple4 (20/5)5 (10/2)B overpriced wrt growth potential

**DIVIDEND PAYOUT RATIOShows amount of dividend paid out of earningsAn indication of amount of profits put back into companyImp ratio to assess long term prospects of companyDividend Payout Ratio = Dividend / Net Income

**DIVIDEND YIELDShows relationship between Dividend per share and market priceAn imp ratio to compare two companiesDividend Yield (%) = Dividend amount per share *100 Market price of share

**BETA OF SECURITYRefers to overall market risk which a security is carrying and which cannot be diversifiedResponsiveness of share price of a company with respect to overall market movementIf 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 = 0.5If 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

****FINANCIAL RATIOS . LIQUIDITYNWC = CA - CLCR= CA/CLATR= (CA INVENTORY)/CLLEVERAGEDebt-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 , RiskLong term solvencyRisk due to debtOwners StakeCoverage provided by assetsInterest burdenUtilisationCredit mgtRestrictionsEfficencyEfficencyAcceptabilityOverall performanceMargin of SafetyAbility for PAT