ch_6 ratio analysis

8/2/2019 Ch_6 Ratio Analysis

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Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 1

Chapter 6

Financial Statements Analysis


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FINANCIAL STATEMENTS

ANALYSIS

Ratio Analysis

Importance and Limitations ofRatio Analysis

Common Size Statements


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Ratio Analysis

Ratio analysis is a widely used tool of financial analysis. It

is defined as the systematic use of ratio to interpret thefinancial statements so that the strengths andweaknesses of a firm as well as its historical

performance and current financialcondition can be determined.


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Basis of Comparison

1) Trend Analysis involves comparison of a firm over aperiod of time, that is, present ratios are compared withpast ratios for the same firm. It indicates the direction ofchange in the performance improvement, deteriorationor constancy over the years.

2) Interfirm Comparison involves comparing the ratios of afirm with those of others in the same lines of business or

for the industry as a whole. It reflects the firmsperformance in relation to its competitors.

3) Comparison with standards or industry average.


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Types of Ratios

Liquidity Ratios Capital Structure Ratios

Profitability Ratios Efficiency ratios

IntegratedAnalysis Ratios

Growth Ratios


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Net working capital is a measure of liquidity calculated bysubtracting current liabilities from current assets.

Table 1: Net Working Capital

Particulars Company A Company B

Total current assets

Total current liabilities

NWC

Rs 1,80,000

1,20,000

60,000

Rs 30,000

10,000

20,000

Table 2: Change in Net Working Capital

Particulars Company A Company B

Current assets

Current liabilities

NWC

Rs 1,00,000

25,000

75,000

Rs 2,00,000

1,00,000

1,00,000

Net Working Capital


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Liquidity ratios measure the abilityof a firm to meet its short-term

obligations

Liquidity Ratios


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Particulars Firm A Firm B

Current Assets Rs 1,80,000 Rs 30,000

Current Liabilities Rs 1,20,000 Rs 10,000

Current Ratio = 3:2 (1.5:1) 3:1

Current Ratio is a measure of liquidity calculated dividingthe current assets by the current liabilities

Current Ratio

Current Ratio = Current AssetsCurrent Liabilities


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The quick or acid test ratio takes into considerationthe differences in the liquidity of the

components of current assets

Quick Assets = Current assets StockPre-paid expenses

Acid-Test Ratio

Acid-test Ratio =Quick Assets

Current Liabilities


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Example 1: Acid-Test Ratio

Cash

Debtors

Inventory

Total current assets

Total current liabilities

Rs 2,000

2,000

12,000

16,000

8,000

(1) Current Ratio(2) Acid-test Ratio

2 : 10.5 : 1


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Supplementary Ratios forLiquidity

Inventory TurnoverRatio

Debtors Turnover Ratio

Creditors Turnover Ratio


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Inventory Turnover Ratio

The cost of goods sold means sales minus gross profit.

The average inventory refers to the simple average of the openingand closing inventory.

The ratio indicates how fast inventory is sold. A high ratio is goodfrom the viewpoint of liquidity and vice versa. A low ratiowould signify that inventory does not sell fast and stays

on the shelf or in the warehouse for a long time.

Inventory turnover ratio =Cost of goods sold

Average inventory


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Example 2: Inventory Turnover Ratio

A firm has sold goods worth Rs 3,00,000 with a gross profit margin of

20 per cent. The stock at the beginning and the end of the yearwas Rs 35,000 and Rs 45,000 respectively. What is the

inventory turnover ratio?

Inventoryturnover ratio

=(Rs 3,00,000 Rs 60,000)

=6 (timesper year)(Rs 35,000 + Rs 45,000) 2

Inventoryholding period

=12 months

= 2 monthsInventory turnover ratio, (6)


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Net credit sales consist of gross credit sales minusreturns, if any, from customers.

Average debtors is the simple average of debtors (includingbills receivable) at the beginning and at the end of year.

The ratio measures how rapidly receivables are collected. A highratio is indicative of shorter time-lag between credit sales and

cash collection. A low ratio shows that debts are notbeing collected rapidly.

Debtors turnover ratio =Net credit sales

Average debtors


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Example 3: Debtors Turnover Ratio

A firm has made credit sales of Rs 2,40,000 during the year. The

outstanding amount of debtors at the beginning and at the end

of the year respectively was Rs 27,500 and Rs 32,500.

Determine the debtors turnover ratio.

Debtorsturnover ratio

=Rs 2,40,000

=8 (timesper year)(Rs 27,500 + Rs 32,500) 2

Debtorscollection period

=12 Months

=1.5

MonthsDebtors turnover ratio, (8)


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Creditors Turnover Ratio

Net credit purchases = Gross credit purchases - Returns tosuppliers.

Average creditors = Average of creditors (including bills payable)outstanding at the beginning and at the end of the year.

A low turnover ratio reflects liberal credit terms granted bysuppliers, while a high ratio shows that accounts are to be settledrapidly. The creditors turnover ratio is an important tool ofanalysis as a firm can reduce its requirement of current assets by

relying on suppliers credit.

Creditors turnoverratio

=Net credit purchases

Average creditors


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Example 4: Creditors Turnover Ratio

The firm in previous Examples has made credit purchases of Rs

1,80,000. The amount payable to the creditors at the beginning

and at the end of the year is Rs 42,500 and Rs 47,500

respectively. Find out the creditors turnover ratio.

Creditorsturnover ratio

=(Rs 1,80,000)

=4 (timesper year)(Rs 42,500 Rs 47,500) 2

Creditors

payment period=

12 months= 3 months

Creditors turnover ratio, (4)


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The summing up of the three turnover ratios (known as a cash cycle)

has a bearing on the liquidity of a firm. The cash cycle captures

the interrelationship of sales, collections from debtors

and payment to creditors.

Inventory holding period

Add: Debtors collection period

Less: Creditors payment period

2 months

+ 1.5 months

3 months0.5 months

As a rule, the shorter is the cash cycle, the better are the liquidityratios as measured above and vice versa.

The combined effect of the three turnover ratios

is summarised below:


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Defensive interval ratio is the ratio between quickassets and projected daily cash requirement.

DEFENSIVE INTERVAL RATIO

Defensive-

interval ratio=

Liquid assets

Projected daily cash requirement

Projected daily

cash requirement=

Projected cash operating expenditure

Number of days in a year (365)


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Example 5: Defensive Interval Ratio

The projected cash operating expenditure of a firm from the

next year is Rs 1,82,500. It has liquid current assets

amounting to Rs 40,000. Determine thedefensive-interval ratio.

Projected daily cash requirement =Rs 1,82,500

= Rs 500365

Defensive-interval ratio =Rs 40,000

= 80 daysRs 500


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Cash-flow from operation ratio measures liquidity of afirm by comparing actual cash flows from operations

(in lieu of current and potential cash inflows fromcurrent assets such as inventory and debtors)

with current liability.

Cash-flow From Operations Ratio

Cash-flow from

operations ratio=

Cash-flow from operations

Current liabilities


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Leverage Capital Structure Ratio

Capital structure or leverage ratios throw light on thelong-term solvency of a firm.

There are two aspects of the long-term solvency of a firm:

(i) Ability to repay the principal when due, and

(ii) Regular payment of the interest .

Accordingly, there are two different types of leverage ratios.

First type: These ratios are

computed from the balance

sheet

Second type: These ratios are

computed from the Income

Statement(a) Debt-equity ratio

(b) Debt-assets ratio

(c) Equity-assets ratio

(a) Interest coverage ratio

(b) Dividend coverage ratio


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I. Debt-equity ratio

Debt-equity ratio measures the ratio of long-

term or total de3bt to shareholders equityDebt-equity ratio =Total Debt

Shareholders equity

Long-term Debt + Shortterm debt + Other CurrentLiabilities = Total external

Obligations

Debt-equity ratio measures the ratio of long-term or total

debt to shareholders equity.

If the D/E ratio is high, the owners are putting up relatively less

money of their own. It is danger signal for the lenders and

creditors. If the project should fail financially, the

creditors would lose heavily.

A low D/E ratio has just the opposite implications. To the creditors, a

relatively high stake of the owners implies sufficient safety

margin and substantial protection against

shrinkage in assets.


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For the company also, the servicing of debt is lessburdensome and consequently its credit standingis not adversely affected, its operational flexibility

is not jeopardised and it will be able toraise additional funds.

The disadvantage of low debt-equity ratio is thatthe shareholders of the firm are deprived

of the benefits of trading on equity

or leverage.


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Trading on Equity

Trading on Equity (Amount in Rs thousand)

Particular A B C D

(a) Total assets 1,000 1,000 1,000 1,000Financing pattern:Equity capital 1,000 800 600 200

15% Debt 200 400 800(b)Operating profit (EBIT) 300 300 300 300

Less:Interest 30 60 120Earnings before taxes 300 270 240 180Less:Taxes (0.35) 105 94.5 84 63Earnings after taxes 195 175.5 156 117Return on equity (per cent) 19.5 21.9 26 58.5

Trading on equity (leverage) is the use of borrowed funds inexpectation of higher return to equity-holders.


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II. Debt to Total Capital

The relationship between creditors funds and

owners capital can also be expressed using

Debt to total capital ratio.

Debt to total capital ratio =Total debt

Permanent capital

Permanent Capital = Shareholders equity +Long-term debt.


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III. Debt to total assets ratio

Debt to total assets ratio =Total debt

Total assets

Proprietary ratio indicates the extent to which assetsare financed by owners funds.

Proprietary ratio =Proprietary funds

Total assetsX 100

Capital gearing ratio is used to know the relationship between equityfunds (net worth) and fixed income bearing funds (Preference

shares, debentures and other borrowed funds.

Proprietary Ratio

Capital Gearing Ratio


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Coverage Ratio

Interest Coverage Ratio measures the firms ability to make

contractual interest payments.

Interest coverage ratio = EBIT (Earning before interest and taxes)

Interest

Dividend coverage ratio =EAT (Earning after taxes)

Preference dividend

Dividend Coverage Ratio measures the firms ability to pay dividendon preference share which carry a stated rate of return.

Interest Coverage Ratio

Dividend Coverage Ratio


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Total fixed charge coverage ratio measures the firms ability to meet all fixed

payment obligations.

Total fixed chargecoverage ratio

EBIT + Lease Payment

Interest + Lease payments + (Preference dividend+ Instalment of Principal)/(1-t)

=

Total fixed charge coverage ratio

However, coverage ratios mentioned above, suffer from one majorlimitation, that is, they relate the firms ability to meet its various

financial obligations to its earnings. Accordingly, it would bemore appropriate to relate cash resources of a firm to its

various fixed financial obligations.

Total Cashflow Coverage Ratio

Total cashflowcoverage ratio

Lease payment+ Interest

EBIT + Lease Payments + Depreciation + Non-cash expenses

=(Principal repayment)

(1 t)

(Preference dividend)

(1 - t)+ +


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Debt Service Coverage Ratio

Debt-service coverage ratio (DSCR) is considered a morecomprehensive and apt measure to compute debt

service capacity of a business firm.

DEBT SERVICE CAPACITY

DSCR =Instalmentt

n

t=1

EATt OAt+ +n

t=1Depreciationt+Interestt

Debt service capacity is the ability of a firm to make thecontractual payments required on a scheduled

basis over the life of the debt.


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Agro Industries Ltd has submitted the following projections. You arerequired to work out yearly debt service coverage ratio (DSCR)

and the average DSCR.

(Figures in Rs lakh)

Year Net profit for theyear

Interest on term loan

during the year

Repayment of term

loan in the year

12

3

4

5

6

7

8

21.6734.77

36.01

19.20

18.61

18.40

18.33

16.41

19.1417.64

15.12

12.60

10.08

7.56

5.04

Nil

10.7018.00

18.00

18.00

18.00

18.00

18.00

18.00

The net profit has been arrived after charging depreciation of Rs 17.68 lakhevery year.

Example 6: Debt-Service Coverage Ratio


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SolutionTable 3: Determination of Debt Service Coverage Ratio

(Amount in lakh of rupees)

Year

Netprofit

Depreciation Interest Cash

available

(col.

2+3+4)

Principal

instalment

Debt

obligation

(col. 4 + col. 6)

DSCR [col. 5

col. 7

(No. of times)]

1 2 3 4 5 6 7 8

1

2

3

4

5

6

7

8

21.67

34.77

36.01

19.20

18.61

18.40

18.33

16.41

17.68

17.68

17.68

17.68

17.68

17.68

17.68

17.68

19.14

17.64

15.12

12.60

10.08

7.56

5.04

Nil

58.49

70.09

68.81

49.48

46.37

43.64

41.05

34.09

10.70

18.00

18.00

18.00

18.00

18.00

18.00

18.00

29.84

35.64

33.12

30.60

28.08

25.56

23.04

18.00

1.96

1.97

2.08

1.62

1.65

1.71

1.78

1.89

Average DSCR (DSCR 8) 1.83


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Profitability Ratio

Profitability ratios can be computed either fromsales or investment.

Profitability RatiosRelated to Sales

Profitability RatiosRelated to Investments

(i) Profit Margin

(ii) Expenses Ratio

(i) Return on Investments

(ii) Return on Shareholders

Equity


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Profit Margin

Gross profit margin measures the percentage of each salesrupee remaining after the firm has paid for its goods.

Gross profit margin = Gross ProfitSales X 100

Gross Profit Margin


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Net profit margin can be computed in three ways

iii. Net Profit Ratio =Earning after interest and taxes

Net sales

ii. Pre-tax Profit Ratio =Earnings before taxes

Net sales

i. Operating Profit Ratio =Earning before interest and taxes

Net sales

Net profit margin measures the percentage of each sales rupee

remaining after all costs and expense including interestand taxes have been deducted.

Net Profit Margin


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Example 7: From the following information of a firm,determine (i) Gross profit margin and (ii) Net profitmargin.

1. Sales

2. Cost of goods sold

3. Other operating expenses

Rs 2,00,000

1,00,000

50,000

(1) Gross profit margin =Rs 1,00,000

= 50 per centRs 2,00,000

(2) Net profit margin = Rs 50,000 = 25 per centRs 2,00,000


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Expenses Ratio

i. Cost of goods sold =Cost of goods sold

Net sales X 100

ii. Operating expenses =Administrative exp. + Selling exp.

Net salesX 100

iii. Administrative expenses = Administrative expensesNet sales

X 100

iv. Selling expenses ratio =Selling expenses

Net salesX 100

v. Operating ratio = Cost of goods sold + Operating expensesNet sales

X 100

vi. Financial expenses =Financial expenses

Net salesX 100


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Return on Investment

Return on Investments measures the overall effectivenessof management in generating profits with

its available assets.

i. Return on Assets (ROA)

ROA =EAT + (Interest Tax advantage on interest)

Average total assets

ii. Return on Capital Employed (ROCE)

ROCE =EAT + (Interest Tax advantage on interest)

Average total capital employed


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Return on Shareholders Equity

Return on total shareholders equity =Net profit after taxes

Average total shareholders equityX 100

Return on ordinary shareholders equity (Net worth) =

Net profit after taxes Preference dividend

Average ordinary shareholders equityX 100

Return on shareholders equity measures the return on theowners (both preference and equity shareholders )

investment in the firm.


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Efficiency Ratio

Activity ratios measure the speed with which variousaccounts/assets are converted into sales or cash.

i. Inventory Turnover measures the activity/liquidity ofinventory of a firm; the speed with which inventory is soldInventory Turnover Ratio =

Cost of goods sold

Average inventory

i. Inventory Turnover measures the activity/liquidity ofinventory of a firm; the speed with which inventory is soldRaw materials turnover =

Cost of raw materials used

Average raw material inventory

i. Inventory Turnover measures the activity/liquidity ofinventory of a firm; the speed with which inventory is soldWork-in-progress turnover =

Cost of goods manufactured

Average work-in-progress inventory

Inventory turnover measures the efficiency of various types

of inventories.


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Liquidity of a firms receivables can be examinedin two ways.

i. Inventory Turnover measures the activity/liquidity of inventory ofa firm; the speed with which inventory is soldi. Debtors turnover =

Credit sales

Average debtors + Average bills receivable (B/R)

2. Average collection period =Months (days) in a year

Debtors turnover

i. Inventory Turnover measures the activity/liquidity of inventory of a

firm; the speed with which inventory is sold

Alternatively =Months (days) in a year (x) (Average Debtors + Average (B/R)

Total credit sales

Ageing Schedule enables analysis to identifyslow paying debtors.



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Assets Turnover Ratio

i. Inventory Turnover measures the activity/liquidity of inventory ofa firm; the speed with which inventory is soldi. Total assets turnover =

Cost of goods sold

Average total assets

ii. Fixed assets turnover =Cost of goods sold

Average fixed assets

i. Inventory Turnover measures the activity/liquidity of inventory ofa firm; the speed with which inventory is soldiii. Capital turnover =

Cost of goods sold

Average capital employed

iv. Current assets turnover = Cost of goods soldAverage current assets

i. Inventory Turnover measures the activity/liquidity of inventory ofa firm; the speed with which inventory is soldv. Working capital turnover =

Cost of goods sold

Net working capital

Assets turnover indicates the efficiency with which firmuses all its assets to generate sales.


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1) Return on shareholders equity = EAT/Average total shareholders equity.

2) Return on equity funds = (EAT Preference dividend)/Average ordinary

shareholders equity (net worth).

3) Earnings per share (EPS) = Net profit available to equity shareholders

(EAT Dp)/Number of equity shares outstanding (N).

4) Dividends per share (DPS) = Dividend paid to ordinary

shareholders/Number of ordinary shares outstanding (N).

5) Earnings yield = EPS/Market price per share.

6) Dividend Yield = DPS/Market price per share.

7) Dividend payment/payout (D/P) ratio = DPS/EPS.

8) Price-earnings (P/E) ratio = Market price of a share/EPS.

9) Book value per share = Ordinary shareholders equity/Number of equity

shares outstanding.


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Integrated Analysis Ratio

Integrated ratios provide better insight about financial andeconomic analysis of a firm.

(1) Rate of return on assets (ROA) can be decomposed in to(i) Net profit margin (EAT/Sales)

(ii) Assets turnover (Sales/Total assets)

(2) Return on Equity (ROE) can be decomposed in to

(i) (EAT/Sales) x (Sales/Assets) x (Assets/Equity)

(ii) (EAT/EBT) x (EBT/EBIT) x (EBIT/Sales) x (Sales/Assets) x

(Assets/Equity)

R t f R t A t


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Rate of Return on Assets

EAT as percentage ofsales

Assetsturnover

EAT SalesDivided by Sales Total AssetsDivided by

Current assetsFixed assetsGross profit = Sales less

cost of goods sold

Minus

Expenses: SellingAdministrative Interest

Minus

Income-tax

Shareholder equity

Plus

Long-term borrowedfunds

Plus

Current liabilities

Plus

Alternatively


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Return on Assets

Earning Power

Earning power is the overall profitability of a firm; is computedby multiplying net profit margin and

assets turnover.

Earning power = Net profit margin Assets turnoverWhere, Net profit margin = Earning after taxes/SalesAsset turnover = Sales/Total assets

i. Inventory Turnover measures the activity/liquidity of inventory ofa firm; the speed with which inventory is soldEarning Power =

Earning after taxes

Sales

Sales

Total Assets

EAT

Total assetsxx x


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Assume that there are two firms, A and B, each having total assetsamounting to Rs 4,00,000, and average net profits after

taxes of 10 per cent, that is, Rs 40,000, each.

Table 4: Return on Assets (ROA) of Firms A and B


1. Net sales

2. Net profit

3. Total assets4. Profit margin (2 1) (per cent)

5. Assets turnover (1 3) (times)

6. ROA ratio (4 5) (per cent)

Rs 4,00,000

40,000

4,00,00010

1

10

Rs 40,00,000

40,000

4,00,0001

10

10

Firm A has sales of Rs 4,00,000, whereas the sales of firm B aggregateRs 40,00,000. Determine the ROA of firms A and B. Table 4 shows

the ROA based on two components.

EXAMPLE: 8


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Return on Equity (ROE)

ROE is the product of the following three ratios: Net profit ratio (x)Assets turnover (x) Financial leverage/Equity multiplier

Three-component model of ROE can be broadened further toconsider the effect of interest and tax payments.

As a result of three sub-parts of net profit ratio, the ROEis composed of the following 5 components.

i. Inventory Turnover measures the activity/liquidity ofinventory of a firm; the speed with which inventory is sold

EAT

Earnings before taxes

EBT

EBIT

EBIT

Sales

Net Profit

Salesxx =

EAT

EBT

EBT

EBIT

EBIT

Sales

Sales

Assets

Assets

Equityx x x x


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A 5-way break-up of ROE enables the management of a firm to analyse the effect of interestpayments and tax payments separately from operating profitability. To illustrate further assume 8per cent interest rate, 35 per cent tax rate and other operating expense of Rs 3,22,462 (Firm A) andRs 39,26,462 (Firm B) for the facts contained in Example 8. Table 5 shows the ROE (based on the 5components) of Firms A and B.

Table 5: ROE (Five-way Basis) of Firms A and B


Net sales

Less: Operating expenses

Earnings before interest and taxes (EBIT)

Less: Interest (8%)

Earnings before taxes (EBT)

Less: Taxes (35%)

Earnings after taxes (EAT)

Total assets

Debt

Equity

EAT/EBT (times)

EBT/EBIT (times)

EBIT/Sales (per cent)

Sales/Assets (times)

Assets/Equity (times)

ROE (per cent)

Rs 4,00,000

3,22,462

77,538

16,000

61,538

21,538

40,000

4,00,000

2,00,000

2,00,000

0.65

0.79

19.4

1

2

20

Rs 40,00,000

39,26,462

73,538

12,000

61,538

21,538

40,000

4,00,000

2,50,000

1,50,000

0.65

0.84

1.84

10

1.6

16


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Common Size Statements

Preparation of common-size financial statements is an extensionof ratio analysis. These statements convert absolute sums intomore easily understood percentages of some base amount. It issales in the case of income statement and totals of assets and

liabilities in the case of the balance sheet.

Ratio analysis in view of its several limitations should beconsidered only as a tool for analysis rather than as an end in

itself. The reliability and significance attached to ratios will largelyhinge upon the quality of data on which they are based. They areas good or as bad as the data itself. Nevertheless, they are animportant tool of financial analysis.

Limitations

ch_6 ratio analysis

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