Financial Statement Analysis

An introduction to Ratio Analysis

Steps in Financial Analysis

• Select the information • relevant information• arrange the information• to highlight significant

relationships• interpretation

Types of comparisons

• Trend ratios• inter firm comparisons• comparison of items within a

single year’s financial statement of a firm

• comparison with standards or plans

Liquidity Ratios

• Measure of firms ability to meet short term /current liabilities

• inverse relationship between liquidity and profitability

• Types of liquidity ratios

Current ratio

• CR = CA/CL• CA= cash , bank balance,

marketable securities, inventory, debtors net of provisions, Bills receivable and prepaid expenses

• CL= trade creditors, bills payable, bank credit, provision for taxation, dividend payable and outstanding expenses

Current ratio (contd..)

• Rationale – indicates rupees of CA available for

each Rupee of CL.– Measure of margin of safety to the

creditors

Current ratio (contd..)

• Interpretation– higher the ratio, the better– very high ratio is indicative of slack

management– development of capital market will

influence norms– suitability depends on nature of industry– it’s a quantitative but not qualitative

measure

Acid test or quick ratio

• ATR/QR= QA/CL• QA= CA- inventories-prepaid

expenses• Interpretation

– qualitative measure of liquidity– relationship between CR and ATR/QR

Turnover ratios

• Also called activity ratios• measure how quickly certain

current assets are converted into cash

• these supplement the earlier ratios• Types of turnover/activity ratios

Types of turnover/activity ratios• Inventory turnover ratio• debtors turnover ratio• creditors turnover ratio

Inventory turnover ratio

• ITR= cost of goods sold•Average inventory

• COGS= Sale - Gross profit• Avg. Inventory = simple avg. of

opening and closing stock• Interpretation• Inventory holding period= 12

months / ITR

Debtors turnover ratio

• DTR = Net credit sales/ Avg. debtors

• interpretation• Debt collection period = 12 mths/

DTR

Creditors turnover ratio

• CTR = Net credit purchases/ Avg. creditors

• Interpretation• Creditor’s payment period = 12

mths/ CTR

Defensive interval ratio

• Ability to meet daily projected cash expenditure from operations

• DIR=quick assets/ projected daily cash requirement(PDCR)

• PDCR= projected cash operating exp./ 365

ratios between borrowed funds and owner’s capital• Debt - equity ratio• Debt - asset ratio• Equity - asset ratio

Debt - equity ratio

• Relative claims of creditors and shareholders against the assets of the firm

• Two alternative formulae• D/E ratio = long term debts/shareholders

equity– Debts are exclusive of current liabilities– shareholders equity is net worth including

preference share capital– also called debt to networth ratio

Contd...

• D/E ratio = Total debt/Shareholder’s equity– total outside liabilities I.e. long term +

current– Why include current liabilities

• fixed amount of them is always in use• exercise prior right to assets of the business

• Interpretation– margin of safety to the creditors

Contd...• implications from

– creditors angle,• stake of shareholders and • degree of their commitment

– firms angle• influence of creditors• borrowing under restrictive conditions

– shareholders angle • trading on equity• maintain control inspite of limited stake

Debt - asset ratio• Also called debt to total capital ratio• D/A ratio=Long term debt/ permanent

capital,– permanent capital = shareholder’s

equity+long term debt

• OR D/A ratio=Total debt/total assets,– where, total debt = long term debt + CL– total assets= permanent capital + current

liability

Equity - asset ratio

• Also called Proprietor’s ratio• E/A ratio= Proprietor’s funds x 100

»total assets

Dividend coverage ratio

• = EAT/Preference dividend• reveals safety margin available to

preference shareholders

Total coverage ratio

• Takes into account all fixed obligations of the firm

• = EBIT+Lease payments/{Interest payment + Lease payment + (preference dividend + instalment of principal)/(1-t)}

Profitability ratios

• Reflect operating efficiency and return on investment

• profitability ratios are measured w.r.t.– sales– investment

Profit margin ratios

• Operating profit margin= EBIT x 100

» Sales• Net profit margin= EAT x 100

» Sales

Profitability ratios related to investment• Also called Return on Investment

(ROI) ratios• Three broad types

– Return on Assets– Return on Capital Employed– Return on Shareholder’s equity

Return on Assets

• ROA = EAT+Interest-tax advantage on int.

–Avg. total assets/Tangible assets/Fixed assets

Return on Shareholders’ Equity• Return on total shareholders’ equity• Return on ordinary shareholders’

equity• Earning per share• Dividend per share• Dividend pay-out ratio• dividend and earning yield• Price - Earning ratio

Various formulae

• Return on total shareholders’ equity = Net profit after taxes Avg. total shareholders’ equity

– Where, Avg. total shareholders’ includes preference share capital, ordinary share capital, share premium, reserves and surplus, accumulated losses I.e. net worth

Various formulae

Return on ordinary shareholders equity = Net profit after taxes - Pref. DividendAverage ordinary shareholders’ equity or

net worthEarning per share =Net profit available to equity

shareholdersNo. of ordinary shares outstanding

Various formulae

• Dividend per share = NP distributed to ordinary shareholdersNo. of ordinary shares outstanding

• Dividend pay out ratio =Total dividend to equity holders(cash

div)Total NP belonging to equity holders