Financial Statements & Ratio

Analysis
 Financial Analysis
• Assessment of the firm’s past,
present and future financial
conditions
• Done to find firm’s financial
strengths and weaknesses
• Primary Tools:
– Financial Statements
– Comparison of financial ratios to past,
industry, sector and all firms
 Financial Statements
• Balance Sheet
• Income Statement
• Cashflow Statement
• Statement of Retained
Earnings
 Objectives of Ratio Analysis
• Standardize financial information
for comparisons
• Evaluate current operations
• Compare performance with past
performance
• Compare performance against other
firms or industry standards
• Study the efficiency of operations
• Study the risk of operations
Ratio Analysis
 Ratio Analysis
1. Liquidity – the ability of the firm to pay its way
2. Investment/shareholders – information to enable
decisions to be made on the extent of the risk and the
earning potential of a business investment
3. Gearing – information on the relationship between
the exposure of the business to loans as opposed to
share capital
4. Profitability – how effective the firm is at generating
profits given sales and or its capital assets
5. Financial – the rate at which the company sells its
stock and the efficiency with which it uses its assets
Liquidity
 Acid Test
• Also referred to as the ‘Quick ratio’
• (Current assets – stock) : liabilities
• 1:1 seen as ideal
• The omission of stock gives an indication of the cash
the firm has in relation to its liabilities (what it owes)
• A ratio of 3:1 therefore would suggest the firm has 3
times as much cash as it owes – very healthy!
• A ratio of 0.5:1 would suggest the firm has twice as
many liabilities as it has cash to pay for those liabilities.
This might put the firm under pressure but is not in
itself the end of the world!
 Current Ratio
• Looks at the ratio between Current Assets and Current
Liabilities
• Current Ratio = Current Assets : Current
Liabilities
• Ideal level? – 1.5 : 1
• A ratio of 5 : 1 would imply the firm has £5 of assets to
cover every £1 in liabilities
• A ratio of 0.75 : 1 would suggest the firm has only 75p
in assets available to cover every £1 it owes
• Too high – Might suggest that too much of its assets
are tied up in unproductive activities – too much stock,
for example?
• Too low - risk of not being able to pay your way
Investment/Shareholders
 Investment/Shareholders
• Earnings per share – profit after tax / number of
shares
• Price earnings ratio – market price / earnings per
share – the higher the better generally for
company. Comparison with other firms helps to
identify value placed on the market of the business.
• EV / EBITDA Ratio - Enterprise Value / EBITDA
ratio - the higher the better generally for company .
It measures the operational performance of the
firm.
• Dividend yield – ordinary share dividend / market
price x 100 – higher the better. Relates the return
on the investment to the share price.
Gearing
 Gearing
• Gearing Ratio = Long term
loans / Capital employed x 100
• The higher the ratio the more the
business is exposed to interest
rate fluctuations and to having to
pay back interest and loans before
being able to re-invest earnings
Profitability
 Profitability
• Profitability measures look at how much
profit the firm generates from sales or
from its capital assets
• Different measures of profit – gross and
net
– Gross profit – effectively total revenue
(turnover) – variable costs (cost of sales)
– Net Profit – effectively total revenue
(turnover) – variable costs and fixed costs
(overheads)
 Profitability
• Gross Profit Margin = Gross profit /
turnover x 100
• The higher the better
• Enables the firm to assess the impact of
its sales and how much it cost to
generate (produce) those sales
• A gross profit margin of 45% means
that for every £1 of sales, the firm
makes 45p in gross profit
 Profitability
• Net Profit Margin = Net Profit / Turnover
x 100
• Net profit takes into account the fixed costs
involved in production – the overheads
• Keeping control over fixed costs is important –
could be easy to overlook for example the
amount of waste - paper, stationery, lighting,
heating, water, etc.
– e.g. – leaving a photocopier on overnight uses enough
electricity to make 5,300 A4 copies. (1,934,500 per year)
– 1 ream = 500 copies. 1 ream = £5.00 (on average)
– Total cost therefore = £19,345 per year – or 1 person’s
salary
 Profitability
• Return on Capital Employed
(ROCE) = Profit / capital
employed x 100
 Profitability
• The higher the better
• Shows how effective the firm is in
using its capital to generate profit
• A ROCE of 25% means that it uses
every £1 of capital to generate 25p
in profit
• Partly a measure of efficiency in
organisation and use of capital
Financial
 Asset Turnover
• Asset Turnover = Sales turnover / assets
employed
• Using assets to generate profit
• Asset turnover x net profit margin = ROCE
 Stock Turnover
• Stock turnover = Cost of goods sold / stock
expressed as times per year
• The rate at which a company’s stock is turned over
• A high stock turnover might mean increased efficiency?
– But: dependent on the type of business –
supermarkets might have high stock turnover ratios
whereas a shop selling high value musical
instruments might have low stock turnover ratio
– Low stock turnover could mean poor customer
satisfaction if people are not buying the goods
(Marks and Spencer?)
 Debtor Days
• Debtor Days = Debtors / sales turnover x
365
• Shorter the better
• Gives a measure of how long it takes the
business to recover debts
• Can be skewed by the degree of credit facility
a firm offers
Before looking at the ratios there are a number of cautionary
points concerning their use that need to be identified :

a. The dates and duration of the financial statements being

compared should be the same. If not, the effects of
seasonality may cause erroneous conclusions to be drawn.

b. The accounts to be compared should have been prepared

on the same bases. Different treatment of stocks or
depreciations or asset valuations will distort the results.

c. In order to judge the overall performance of the firm a

group of ratios, as opposed to just one or two should be
used. In order to identify trends at least three years of
ratios are normally required.
SOME IMPORTANT NOTES
• Liabilities have Credit balance and Assets have Debit balance
• Current Liabilities are those which have either become due for
payment or shall fall due for payment within 12 months from
the date of Balance Sheet
• Current Assets are those which undergo change in their
shape/form within 12 months. These are also called Working
Capital or Gross Working Capital
• Net Worth & Long Term Liabilities are also called Long Term
Sources of Funds
• Current Liabilities are known as Short Term Sources of
Funds
• Long Term Liabilities & Short Term Liabilities are also called
Outside Liabilities
• Current Assets are Short Term Use of Funds
SOME IMPORTANT NOTES
• Assets other than Current Assets are Long Term Use of
Funds
• Installments of Term Loan Payable in 12 months are to be
taken as Current Liability only for Calculation of Current Ratio
& Quick Ratio.
• If there is profit it shall become part of Net Worth under the
head Reserves and if there is loss it will become part of
Intangible Assets
• Investments in Govt. Securities to be treated current only if
these are marketable and due. Investments in other securities
are to be treated Current if they are quoted. Investments in
allied/associate/sister units or firms to be treated as Non-
current.
• Bonus Shares as issued by capitalization of General reserves
and as such do not affect the Net Worth. With Rights Issue,
change takes place in Net Worth and Current Ratio.
EXERCISE 1

LIABILITES ASSETS
Capital 180 Net Fixed Assets 400
Reserves 20 Inventories 150
Term Loan 300 Cash 50
Bank C/C 200 Receivables 150
Trade Creditors 50 Goodwill 50
Provisions 50
800 800

a. What is the Net Worth : Capital + Reserve = 200

b. Tangible Net Worth is : Net Worth - Goodwill = 150
c. Outside Liabilities : TL + CC + Creditors + Provisions = 600

d. Net Working Capital : C A - C L = 350 - 250 = 50

e. Current Ratio : C A / C L = 350 / 300 = 1.17 : 1
f. Quick Ratio : Quick Assets / C L = 200/300 = 0.66 : 1
 EXERCISE 2
LIABILITIES 2005-06 2006-07 ASSETS 2005- 2006-
06 07
Capital 300 350 Net Fixed Assets 730 750
Reserves 140 160 Security 30 30
Electricity
Bank Term Loan 320 280 Investments 110 110
Bank CC (Hyp) 490 580 Raw Materials 150 170
Unsec. Long T L 150 170 S I P 20 30

Creditors (RM) 120 70 Finished Goods 140 170

Bills Payable 40 80 Cash 30 20

Expenses Payable 20 30 Receivables 310 240

Provisions 20 40 Loans/Advances 30 190

Goodwill 50 50
Total 1600 1760 1600 1760

1. Tangible Net Worth for 1st Year : ( 300 + 140) - 50 = 390

2. Current Ratio for 2nd Year : (170 + 30 +170+20+ 240 + 190 ) / (580+70+80+70)
820 /800 = 1.02
3. Debt Equity Ratio for 1st Year : 320+150 / 390 = 1.21
Exercise 3.

LIABIITIES ASSETS
Equity Capital 200 Net Fixed Assets 800
Preference Capital 100 Inventory 300
Term Loan 600 Receivables 150
Bank CC (Hyp) 400 Investment In Govt. 50
Secu.
Sundry Creditors 100 Preliminary Expenses 100
Total 1400 1400
1. Debt Equity Ratio will be : 600 / (200+100) = 2:1

2. Tangible Net Worth : Only equity Capital i.e. = 200

3. Total Outside Liabilities / Total Tangible Net Worth : (600+400+100) / 200
= 11 : 2

4. Current Ratio will be : (300 + 150 + 50 ) / (400 + 100 ) = 1 : 1

 Exercise 4.

LIABILITIES ASSETS
Capital + Reserves 355 Net Fixed Assets 265
P & L Credit Balance 7 Cash 1
Loan From S F C 100 Receivables 125
Bank Overdraft 38 Stocks 128
Creditors 26 Prepaid Expenses 1
Provision of Tax 9 Intangible Assets 30
Proposed Dividend 15
550 550
Q. What is the Current Ratio ? Ans : (1+125 +128+1) / (38+26+9+15)
: 255/88 = 2.89 : 1

Q What is the Quick Ratio ? Ans : (125+1)/ 88 = 1.43 : 11

Q. What is the Debt Equity Ratio ? Ans : LTL / Tangible NW

= 100 / ( 362 – 30)
= 100 / 332 = 0.30 : 1
 Exercise 4. contd…
LIABILITIES ASSETS
Capital + Reserves 355 Net Fixed Assets 265
P & L Credit Balance 7 Cash 1
Loan From S F C 100 Receivables 125
Bank Overdraft 38 Stocks 128
Creditors 26 Prepaid Expenses 1
Provision of Tax 9 Intangible Assets 30
Proposed Dividend 15
550 550

Q. What is the Debtors Velocity Ratio ? If the sales are Rs. 15 Lac.

Ans : ( Average Debtors / Net Sales) x 12 = (125 / 1500) x 12

= 1 month

Q. What is the Creditors Velocity Ratio if Purchases are Rs.10.5 Lac ?

Ans : (Average Creditors / Purchases ) x 12 = (26 / 1050) x 12 = 0.3 months
Exercise 5. : Profit to sales is 2% and amount of profit is say
Rs.5 Lac. Then What is the amount of Sales ?

Answer : Net Profit Ratio = (Net Profit / Sales ) x 100

2 = (5 x100) /Sales
Therefore Sales = 500/2 = Rs.250 Lac
Exercise 6. A Company has Net Worth of Rs.5 Lac, Term
Liabilities of Rs.10 Lac. Fixed Assets worth RS.16 Lac and
Current Assets are Rs.25 Lac. There is no intangible Assets
or other Non Current Assets. Calculate its Net Working
Capital.
Answer
Total Assets = 16 + 25 = Rs. 41 Lac
Total Liabilities = NW + LTL + CL = 5 + 10+ CL = 41 Lac
Current Liabilities = 41 – 15 = 26 Lac

Therefore Net Working Capital = C. A – C.L

= 25 – 26 = (- )1 Lac
Exercise 7 : Current Ratio of a concern is 1 : 1. What will be the Net
Working Capital ?

Answer : It suggest that the Current Assets is equal to Current Liabilities

hence the NWC would be NIL ( since NWC = C.A - C.L )

Exercise 8 : Suppose Current Ratio is 4 : 1. NWC is Rs.30,000/-. What

is the amount of Current Assets ?

Answer : 4a - 1a = 30,000
Therefore a = 10,000 i.e. Current Liabilities is Rs.10,000
Hence Current Assets would be 4a = 4 x 10,000 = Rs.40,000/-

Exercise 9. The amount of Term Loan installment is Rs.10000/ per

month, monthly average interest on TL is Rs.5000/-. If the amount
of Depreciation is Rs.30,000/- p.a. and PAT is Rs.2,70,000/-. What
would be the DSCR ?

DSCR = (PAT + Depr + Annual Intt.) / Annual Intt + Annual Installment

= (270000 + 30000 + 60000 ) / 60000 + 120000
= 360000 / 180000 = 2
Exercise 10 : Total Liabilities of a firm is Rs.100 Lac and Current Ratio is
1.5 : 1. If Fixed Assets and Other Non Current Assets are to the tune of
Rs. 70 Lac and Debt Equity Ratio being 3 : 1. What would be the Long
Term Liabilities?

Ans : We can easily arrive at the amount of Current Asset being Rs. 30 Lac
i.e. ( Rs. 100 L - Rs. 70 L ). If the Current Ratio is 1.5 : 1, then Current
Liabilities works out to be Rs. 20 Lac. That means the aggregate of Net
Worth and Long Term Liabilities would be Rs. 80 Lacs. If the Debt Equity
Ratio is 3 : 1 then Debt works out to be Rs. 60 Lacs and equity Rs. 20 Lacs.
Therefore the Long Term Liabilities would be Rs.60 Lac.

Exercise 11 : Current Ratio is say 1.2 : 1 . Total of balance sheet being

Rs.22 Lac. The amount of Fixed Assets + Non Current Assets is Rs. 10
Lac. What would be the Current Liabilities?

Ans : When Total Assets is Rs.22 Lac then Current Assets would be 22 – 10
i.e Rs. 12 Lac. Thus we can easily arrive at the Current Liabilities figure which
should be Rs. 10 Lac
Exercise 12. From the following financial statement calculate (i) Current Ratio (ii)
Acid test Ratio (iii) Inventory Turnover (iv) Average Debt Collection Period (v)
Average Creditors’ payment period.
C.Assets
Sales 1500 Inventories 125
Cost of sales 1000 Debtors 250
Gross profit 500 Cash 225
C. Liabilities
Trade Creditors
200

(i) Current Ratio : 600/200 = 3 : 1

(ii)Acid Test Ratio : Debtors+Cash /Trade creditors = 475/200 = 2.4 : 1
(iii) Inventory Turnover Ratio : Cost of sales / Inventories = 1000/125 = 8 times
(iv) Average Debt collection period : (Debtors/sales) x 365 = (250/1500)x365 = 61
days
(v)Average Creditors’ payment period : (Trade Creditors/Cost of sales) x 365
(200/100) x 365 = 73 days
Summary of Financial Ratios
• Ratios help to:
– Evaluate performance
– Structure analysis
– Show the connection between
activities and performance
• Benchmark with
– Past for the company
– Industry
• Ratios adjust for size differences
 Limitations of Ratio Analysis
• A firm’s industry category is often
difficult to identify
• Published industry averages are only
guidelines
• Accounting practices differ across
firms
• Sometimes difficult to interpret
deviations in ratios
• Industry ratios may not be desirable
targets
• Seasonality affects ratios