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Chapter 6Chapter 6

Financial Statements AnalysisFinancial Statements Analysis

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FINANCIAL STATEMENTS ANALYSIS

Ratio Analysis

Importance and Limitations of Ratio Analysis

Common Size Statements

Mini Case

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Ratio AnalysisRatio Analysis

Ratio analysis is a widely used tool of financial analysis. It is defined as the systematic use of ratio to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical performance and current financial condition can be determined.

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Basis of ComparisonBasis of Comparison

1) Trend Analysis involves comparison of a firm over a period of time, that is, present ratios are compared with past ratios for the same firm. It indicates the direction of change in the performance – improvement, deterioration or constancy – over the years.

2) Interfirm Comparison involves comparing the ratios of a firm with those of others in the same lines of business or for the industry as a whole. It reflects the firm’s performance in relation to its competitors.

3) Comparison with standards or industry average.

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Types of RatiosTypes of Ratios

Liquidity RatiosCapital Structure RatiosProfitability RatiosEfficiency ratiosIntegrated Analysis RatiosGrowth Ratios

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

Table 1:  Net Working Capital

Particulars Company A Company BTotal current assetsTotal current liabilitiesNWC

Rs 1,80,0001,20,000

60,000

Rs 30,00010,00020,000

Table 2:  Change in Net Working CapitalParticulars Company A Company BCurrent assetsCurrent liabilitiesNWC

Rs 1,00,00025,00075,000

Rs 2,00,0001,00,000

1,00,000

Net Working CapitalNet Working Capital

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Liquidity RatiosLiquidity Ratios

Liquidity ratios measure the ability of a firm to meet its short-term obligations.

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Particulars Firm A Firm BCurrent Assets Rs 1,80,000 Rs 30,000

Current Liabilities Rs 1,20,000 Rs 10,000Current Ratio = 3:2 (1.5:1) 3:1

Current Ratio

Current Ratio =Current Assets

Current Liabilities

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

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Quick Assets = Current assets – Stock – Pre-paid expenses

Acid-Test RatioAcid-Test Ratio

Acid-test Ratio =Quick Assets

Current Liabilities

The quick or acid test ratio takes into consideration the differences in the liquidity of the components of current assets.

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Example 1: Example 1: Acid-Test RatioAcid-Test Ratio

Cash DebtorsInventoryTotal current assetsTotal current liabilities

Rs 2,0002,000

12,00016,000

8,000(1) Current Ratio(2) Acid-test Ratio

2 : 10.5 : 1

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Supplementary Ratios for Supplementary Ratios for LiquidityLiquidity

Inventory Turnover RatioDebtors Turnover RatioCreditors 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 opening and closing inventory.

Inventory turnover ratio =Cost of goods sold

Average inventory

The ratio indicates how fast inventory is sold. A high ratio is good from the viewpoint of liquidity and vice versa. A low ratio would signify that inventory does not sell fast and stays on the shelf or in the warehouse for a long time.

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Example 2: Example 2: Inventory Turnover Ratio

Inventory turnover ratio =

(Rs 3,00,000 – Rs 60,000)= 6 (times per

year)(Rs 35,000 + Rs 45,000) ÷ 2

Inventory holding period =

12 months= 2 months

Inventory turnover ratio, (6)

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 year was Rs 35,000 and Rs 45,000 respectively. What is the inventory turnover ratio?

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Debtors Turnover Ratio

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

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

Debtors turnover ratio =Net credit salesAverage debtors

The ratio measures how rapidly receivables are collected. A high ratio is indicative of shorter time-lag between credit sales and cash collection. A low ratio shows that debts are not being collected rapidly.

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Example 3: Debtors Turnover Ratio

Debtors turnover ratio =

Rs 2,40,000= 8 (times per

year)(Rs 27,500 + Rs 32,500) ÷ 2

Debtors collection period =

12 Months= 1.5

MonthsDebtors turnover ratio, (8)

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.

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Creditors Turnover RatioCreditors Turnover Ratio

Net credit purchases = Gross credit purchases - Returns to suppliers.

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

Creditors turnover ratio =

Net credit purchases

Average creditors

A low turnover ratio reflects liberal credit terms granted by suppliers, while a high ratio shows that accounts are to be settled rapidly. The creditors turnover ratio is an important tool of analysis as a firm can reduce its requirement of current assets by relying on supplier’s credit.

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Example 4: Creditors Turnover Ratio

Creditors turnover ratio =

(Rs 1,80,000)= 4 (times

per year)(Rs 42,500 Rs 47,500) ÷ 2

Creditor’s payment period =

12 months= 3 months

Creditors turnover ratio, (4)

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.

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Inventory holding periodAdd: Debtor’s collection periodLess: Creditor’s payment period

2   months+ 1.5 months– 3   months0.5 months

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

The combined effect of the three turnover ratios is summarised below:

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.

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Defensive interval ratio is the ratio between quick assets 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

Projected daily cash requirement =Rs 1,82,500

= Rs 500365

Defensive-interval ratio =Rs 40,000

= 80 daysRs 500

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 the defensive-interval ratio.

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Cash-flow from operation ratio measures liquidity of a firm by comparing actual cash flows from operations (in lieu of current and potential cash inflows from current 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 RatioLeverage Capital Structure Ratio

Capital structure or leverage ratios throw light on the long-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 ratioI. 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 + Short term debt + Other Current Liabilities = 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 less burdensome and consequently its credit standing is not adversely affected, its operational flexibility is not jeopardised and it will be able to raise additional funds. The disadvantage of low debt-equity ratio is that the shareholders of the firm are deprived of the benefits of trading on equity or leverage.

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Trading on EquityTrading on Equity

Trading on Equity (Amount in Rs thousand)

Particular A B C D   

(a) Total assets 1,000 1,000 1,000 1,000  Financing pattern:    Equity capital 1,000 800 600 200    15% Debt —  200 400 800

(b)Operating profit (EBIT) 300 300 300 300  Less: Interest —  30 60 120

Earnings 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 in expectation of higher return to equity-holders.

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II. Debt to Total CapitalII. Debt to Total Capital

Debt to total capital ratio = Total debtPermanent capital

Permanent Capital = Shareholders’ equity + Long-term debt.

The relationship between creditors’ funds and owner’s capital can also be expressed using Debt to total capital ratio.

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III. Debt to total assets ratioIII. Debt to total assets ratioDebt to total assets ratio = Total debt

Total assets

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

Proprietary ratio = Proprietary fundsTotal assets X 100

Capital gearing ratio is used to know the relationship between equity funds (net worth) and fixed income bearing funds (Preference shares, debentures and other borrowed funds.

Proprietary Ratio

Capital Gearing Ratio

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Coverage RatioCoverage Ratio

Interest Coverage Ratio measures the firm’s 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 firm’s ability to pay dividend on 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 firm’s ability to meet all fixed payment obligations.

Total fixed charge coverage ratio

EBIT + Lease PaymentInterest + Lease payments + (Preference dividend

+ Instalment of Principal)/(1-t)=

Total fixed charge coverage ratio

However, coverage ratios mentioned above, suffer from one major limitation, that is, they relate the firm’s ability to meet its various financial obligations to its earnings. Accordingly, it would be more appropriate to relate cash resources of a firm to its various fixed financial obligations.

Total Cashflow Coverage Ratio 

Total cashflow coverage 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 RatioDebt Service Coverage RatioDebt-service coverage ratio (DSCR)  is considered a more comprehensive 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 the contractual 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 are required to work out yearly debt service coverage ratio (DSCR)

and the average DSCR.(Figures in Rs lakh)

Year Net profit for the year

Interest on term loan during the year

Repayment of termloan in the year

12345678

21.6734.7736.0119.2018.6118.4018.3316.41

19.1417.6415.1212.6010.087.565.04Nil 

10.7018.0018.0018.0018.0018.0018.0018.00

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

Example 6: Debt-Service Coverage RatioExample 6: Debt-Service Coverage Ratio

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SolutionSolutionTable 3:  Determination of Debt Service Coverage Ratio

(Amount in lakh of rupees)Year

Net profit

Depreciation Interest Cashavailable

(col. 2+3+4)

 Principalinstalment

 Debtobligation

(col. 4 + col. 6)

DSCR [col. 5 ÷ col. 7

(No. of times)]

1 2 3 4 5 6 7 812345678

21.6734.7736.0119.2018.6118.4018.3316.41

17.6817.6817.6817.6817.6817.6817.6817.68

19.1417.6415.1212.6010.087.565.04Nil 

58.4970.0968.8149.4846.3743.6441.0534.09

10.7018.0018.0018.0018.0018.0018.0018.00

29.8435.6433.1230.6028.0825.5623.0418.00

1.961.972.081.621.651.711.781.89

  Average DSCR (DSCR ÷ 8) 1.83

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Profitability RatioProfitability RatioProfitability ratios can be computed either from

sales or investment.

Profitability Ratios Related to Sales

Profitability Ratios Related to Investments

(i) Profit Margin

(ii) Expenses Ratio

(i) Return on Investments

(ii) Return on Shareholders’ Equity

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Profit MarginProfit Margin

Gross profit margin measures the percentage of each sales rupee 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 taxesNet sales

i. Operating Profit Ratio = Earning before interest and taxesNet sales

Net profit margin measures the percentage of each sales rupee remaining after all costs and expense including interest and 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 profit margin.1. Sales2. Cost of goods sold3. Other operating expenses

Rs 2,00,0001,00,000

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 RatioExpenses Ratio

i. Cost of goods sold = Cost of goods soldNet sales X 100

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

X 100

iii. Administrative expenses = Administrative expensesNet sales

X 100

iv. Selling expenses ratio = Selling expensesNet sales

X 100

v. Operating ratio = Cost of goods sold + Operating expensesNet sales X 100

vi. Financial expenses = Financial expensesNet sales

X 100

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Return on InvestmentReturn on InvestmentReturn on Investments measures the overall effectiveness of 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’ EquityReturn on Shareholders’ Equity

Return on total shareholders’ equity =Net profit after taxes

Average total shareholders’ equity X 100

Return on ordinary shareholders’ equity (Net worth) =Net profit after taxes – Preference dividend

Average ordinary shareholders’ equity X 100

Return on shareholders equity measures the return on the owners (both preference and equity shareholders) investment in the firm.

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Efficiency RatioEfficiency RatioActivity ratios measure the speed with which various accounts/assets are converted into sales or cash.

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

Cost of goods manufacturedAverage work-in-progress inventory

Inventory turnover measures the efficiency of various types of inventories.

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Liquidity of a firm’s receivables can be examined in two ways.

i. Inventory Turnover measures the activity/liquidity of inventory of a 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 yearDebtors 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 identify slow paying debtors.

Debtors Turnover RatioDebtors Turnover Ratio

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Assets Turnover RatioAssets Turnover Ratio

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

Cost of goods soldAverage total assets

ii. Fixed assets turnover = Cost of goods soldAverage fixed assets

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

Cost of goods soldAverage capital employed

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

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

Cost of goods soldNet working capital

Assets turnover indicates the efficiency with which firm uses 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 RatioIntegrated Analysis Ratio

(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)

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

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Rate of Return on Assets

EAT as percentage of sales

Assets turnover

EAT SalesDivided by Sales Total AssetsDivided by

Current assetsFixed assetsGross profit = Sales less

cost of goods sold

Minus

Expenses: Selling Administrative Interest

Minus

Income-tax

Shareholder equity

Plus

Long-term borrowed funds

Plus

Current liabilities

Plus

Alternatively

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Return on AssetsReturn on AssetsEarning PowerEarning power is the overall profitability of a firm; is computed by 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 of a firm; the speed with which inventory is soldEarning Power =

Earning after taxesSales

SalesTotal Assets

EATTotal assets

xx x

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Assume that there are two firms, A and B, each having total assets amounting 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 BParticulars Firm A Firm B1. Net sales2. Net profit3. Total assets4. Profit margin (2 ÷ 1) (per cent)5. Assets turnover (1 ÷ 3) (times)6. ROA ratio (4 × 5) (per cent)

Rs 4,00,00040,000

4,00,00010

110

Rs 40,00,00040,000

4,00,0001

1010

Firm A has sales of Rs 4,00,000, whereas the sales of firm B aggregate Rs 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)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 to consider the effect of interest and tax payments.

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

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

EATEarnings before taxes

EBTEBIT

EBITSales

Net ProfitSales

xx =

EATEBT

EBTEBIT

EBITSales

SalesAssets

AssetsEquity

x 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 interest payments and tax payments separately from operating profitability. To illustrate further assume 8 per cent interest rate, 35 per cent tax rate and other operating expense of Rs 3,22,462 (Firm A) and Rs 39,26,462 (Firm B) for the facts contained in Example 8. Table 5 shows the ROE (based on the 5 components) of Firms A and B.

Table 5: ROE (Five-way Basis) of Firms A and BParticulars Firm A Firm BNet sales

Less: Operating expensesEarnings before interest and taxes (EBIT)

Less: Interest (8%)Earnings before taxes (EBT)

Less: Taxes (35%)Earnings after taxes (EAT)Total assetsDebtEquityEAT/EBT (times)EBT/EBIT (times)EBIT/Sales (per cent)Sales/Assets (times)Assets/Equity (times)ROE (per cent)

Rs 4,00,0003,22,462

77,53816,00061,53821,53840,000

4,00,0002,00,0002,00,000

0.650.7919.4

12

20

Rs 40,00,00039,26,462

73,53812,00061,53821,53840,000

4,00,0002,50,0001,50,000

0.650.841.84

101.616

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Common Size StatementsCommon Size StatementsPreparation of common-size financial statements is an extension of ratio analysis. These statements convert absolute sums into more easily understood percentages of some base amount. It is sales 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 be considered only as a tool for analysis rather than as an end in itself. The reliability and significance attached to ratios will largely hinge upon the quality of data on which they are based. They are as good or as bad as the data itself. Nevertheless, they are an important tool of financial analysis.

Limitations

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CASE STUDYCASE STUDY

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From the following selected financials of Reliance Industries Ltd (RIL) for the period 2001-2006, appraise its financial health from the point of view of liquidity, solvency, and profitability.

Selected financial data and ratios (Amount in Rs crore)

Particulars 2001 2002 2003 2004 2005 2006

(I) Related to Liquidity Analysis Current assets

Marketable investmentsInventoryDebtorsAdvancesCash and bank balance

Current liabilitiesShort-term bank borrowingsSundry creditorsInterest accruedCreditors for capital goodsOther current liabilities & provisions

Other data and ratiosNet working capitalCredit salesCost of goods soldCost of raw material usedCredit purchasesAverage debtorsAverage creditorsCurrent ratioAcid test ratioDebtors turnoverCreditors turnoverDebtors cycle (days)Creditors cycle (days)

9,844.483387.252299.851,134.172,922.58

100.635,312.06

337.763,754.50

223.00104.72892.08

4,532.4222,886.5121,290.9118,155.9821,608.85

988.313,170.68

1.850.87

23 7 16 54

13,025.31 536.80

4976.072,722.463,310.271,760.719,830.102,148.275,847.20

389.23175.16

1270.24

3,195.2145,073.8845,957.8541,023.3545,083.06

1,928.314,800.85

1.330.51

23 9

16 39

17,925.25536.19

7510.142,975.496,756.22

147.2118,160.39

7,193.778288.10

380.15717.48

1580.89

-235.1449,743.5454,642.6050,378.6556,884.49

2,848.977,067.65

0.990.20

178

2145

23,245.88536.11

7,231.223,189.93

12,064.38224.24

16,966.159,145.14

366.78 676.45 2,670.75

4,107.03

6,279.7356,247.0341,657.9234,721.3960,246.91

3,094.029,413.58

1.75.26

17.636.40

2157

28,988.62536.11

7,412.883,927.81

13,503.033,608.79

21,934.4512,684.39

366.95525.37

3471.804,885.94

7,054.1773,164.1053,345.0345,931.8770,014.80

3,558.8711,515.6

1.66.55

18.626.08

2060

24,591.0316.58

10,119.824,163.628,144.852,146.16

21,441.8811,438.69

310.42728.18

3,890.982,073.61

3,149.1589,124.1665,535.8458,342.3168,516.87

4,045.7112,688.31

1.49.38

21.405.40

1767

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Particulars 2001 2002 2003 2004 2005 2006

(II) Related to Solvency Analysis Free reservesPaid up capitalPreference capitalBonus equity capitalTotal equityLong-term borrowingsCurrent liabilitiesTotal debtEBITInterestTotal debt-equity ratioLong-term debt-equity ratioInterest coverage ratio

9,307.891,053.49

0.00481.77

10,843.159,798.035,312.06

15,110.094,032.371,215.56

1.390.903.32

21,834.291,395.85

0.00481.77

23,711.9116,780.21

9,830.1026,610.31

6,307.711,827.85

1.120.713.45

23,656.311,395.92

0.00481.77

25,534.0012,564.5418,160.3930,724.93

6,551.171,555.40

1.200.494.21

33,056.501,395.95

0.00481.77

34,934.2211,149.3812,955.2224,104.60

7,735.861,434.72

0.69.31

5.39

39,010.231,393.09

0.00481.77

40,885.096,172.98

17,131.5223,304.5010,537.34

1,468.660.57

.157.17

48,411.091,393.17

0.00481.77

50,286.038,185.60

16,454.4824,640.0811,581.10

877.040.49

.1613.20

(III) Related to Profitability Analysis Sales (manufacturing)Cost of goods soldEBDIT (including other earnings)EBITEBTEATInterestAverage total capital employedAverage total assetsAverage equity fundsGross profit %Operating profit ratio %Net profit ratio %Cost of goods sold ratio %Rate of return on capital employed (ROCE)1

ROR (Total assets)2

ROR (Equity funds)

22886.5121290.915,597.484,032.372,786.002,646.501,215.55

19235.9529622.1410715.17

24.4617.6211.5693.0320.0713.0324.70

45073.8845957.859,123.856,307.714,434.173,242.171,827.84

27,053.3243,325.8617,277.53

20.2413.99

7.19101.96

18.7411.7

18.77

49,743.5454,642.60

9,388.266,551.174,982.754,106.85

1,555.434,388.0460,415.7724,622.96

18.8713.17

8.26109.85

16.479.37

16.68

56,247.0341,657.9210,982.88

7,735.866,301.145,160.141,434.72

50,030.2452,764.91

1,396.3818.4113.75

9.9580.3413.18

12.416.26

73.164.1053,345.0314,260.8410,537.34

9,068.687,571.681,468.66

54,560.8057,292.51

1,394.9419.4014.4011.4880.9216.5615.7720.09

89,124.4665,535.8414,982.0111,581.1010,704.06

9,069.34877.04

61,738.8565,428.89

1,393.5117.4312.9911.2181.0316.1115.2020.08

1. ROCE = (EAT + Interest)/ Average capital employed 2. ROR (Total assets) = (EAT + Interest)/ Average assets

CONTD.

6 - 6 - 5454

Solution: The appraisal of financial health of RIL is presented below.Liquidity Analysis:The liquidity position of RIL does not appear to be commendable during all the years under reference. In fact, its current ratio was less than one implying negative working capital (in 2003) and acid-test ratio was at an alarming low level of 0.2. Though the current ratio range of 1.33 – 1.85 (during 2001-2 and 2004-6) is an indicative of satisfactory liquidity position, the acid-test ratios appear to be on the lower side, the range being 0.20 – 0.55 (during 2002-6). The major reason for the sharp difference in these two liquidity ratios may be ascribed to a significant proportion of inventory (in current assets).The other notable observation is that the RIL seems to be banking on bank borrowings to finance its working capital requirements evidenced by a substantial increase in such borrowings over the years. From 337.76 crore (in 2001), they steadily increased to 7,193.77 crore (by 2003) and to Rs 11,438.69 crore by 2006: (registering more than 30 times increase in 2006 compared to 2001). In fact, short-term borrowings constitute more than one-half of its total current liabilities during the 6 year period. The reliance on short-term bank borrowings, to such a marked extent, is contrary to sound tenets of finance. Likewise, it appears that its net working capital is inadequate in relation to its credit sales which stood at Rs. 89,124 crore in 2006 compared to Rs. 73,164 crore in 2005. Contrary to increase in net working capital, however, there has been a more than 50 per cent decrease in net working capital of the RIL; (the relevant figures being Rs 7,054.17 crore and Rs 3,149.15 crore in years 2005 and 2006 respectively).

6 - 6 - 5555

The RIL has the advantage of much higher creditors payment period compared to debtors collection period. The debtors collection period (varying from 16 days in 2001 and 2002 to 21 days in 2004) seems to be at a very satisfactory level. In marked contrast, the creditors payment period is three-times (varying in the range of 39-67 days) during the same period. This favourable gap, provides some leverage to RIL to operate at relatively low acid-test ratio.To conclude, the liquidity position of the RIL does not appear to be satisfactory. It is suggested that RIL should substitute a fair share of short-term bank borrowings by long-term loans (which have shown sharp decrease trend over the years). Such a step would help to improve its liquidity ratios.

Solvency Analysis:The solvency position of the RIL is sound for two reasons: First, it has a satisfactory level of interest coverage ratio during all the 6 years, being in the range of 3.32 and 13.2. The RIL is not likely to commit default in payment of interest to its lenders as even though its operating profits (EBIT) decline by more than nine-tenth (2006), it l would stil have enough margin to meet its interest obligations. Secondly, its total debt-equity ratio over the years has shown a substantial decrease from 1.39 in 2001 to 0.49 by 2006. Likewise, the long-term debt to equity ratio during over the years has improved substantially.

6 - 6 - 5656

Profitability Analysis:

The profit margins (gross, operating and net) of the RIL over the years have reduced, albeit recent improvements. For instance gross profit margin has decreased from 24.46 per cent (in 2001) to 17.43 per cent (in 2006). Likewise operating profit margins have declined from 17.62 per cent to 12.99 per cent and net profit margins from 11.56 per cent to 11.21 per cent during these years. The lower operating profit margins have an unfavourable effect on the ROR on capital employed. It fell from 20.07 per cent in 2001 to 16.11 per cent by 2006. However, it is gratifying to note that there has been an increase in other rates of return. For instance, the ROR on total assets has improved from 13.03 per cent in 2001 to 15.20 per cent in 2006. Likewise a notable increase in observed in ROR on equity funds. From 16.68 in 2003, it has increased to more than 20 per cent in 2005 as well as in 2006. There seems to be a potential for further improvement in its various ROR’s by increasing its gross profit and operating profit margins.