Ratio Analysis

Dr Simran Kaur

RATIO ANALYSIS
Unlike in the past when security was considered to be sufficient consideration for banks and financial institutions to grant loans and advances, nowadays the entire lending is need-based and the emphasis is on the financial viability of a proposal and not only on security alone. Further all business decision contains an element of risk. The risk is more in the case of decisions relating to credits. Ratio analysis and other quantitative techniques facilitate assessment of this risk.

WHY FINANCIAL ANALYSIS

Lenders need it for carrying out the following Technical Appraisal Commercial Appraisal Financial Appraisal Economic Appraisal Management Appraisal

Financial Analysis
Assessment of the firms past, present and future financial conditions Done to find firms financial strengths and weaknesses Primary Tools:
Financial Statements Comparison of financial ratios to past, industry, sector and all firms
4

Ratio Analysis
Purpose: To identify aspects of a businesss performance to aid decision making Quantitative process may need to be supplemented by qualitative factors to get a complete picture 5 main areas:

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
6

Financial Statements
Balance Sheet Income Statement Cashflow Statement Statement of Retained Earnings

Ratio Analysis
1. 2. Liquidity the ability of the firm to pay its way Investment/shareholders information to enable decisions to be made on the extent of the risk and the earning potential of a business investment Gearing information on the relationship between the exposure of the business to loans as opposed to share capital Profitability how effective the firm is at generating profits given sales and or its capital assets Financial the rate at which the company sells its stock and the efficiency with which it uses its assets

3. 4. 5.

Ratio Analysis
Its a tool which enables the banker or lender to arrive at the following factors : Liquidity position Profitability Solvency Financial Stability Quality of the Management Safety & Security of the loans & advances to be or already been provided

Ratio Analysis

How a Ratio is expressed?

As Percentage - such as 25% or 50% . For example
if net profit is Rs.25,000/- and the sales is Rs.1,00,000/- then the net profit can be said to be 25% of the sales. As Proportion - The above figures may be expressed in terms of the relationship between net profit to sales as 1 : 4. As Pure Number /Times - The same can also be expressed in an alternatively way such as the sale is 4 times of the net profit or profit is 1/4th of the sales.

Review: Major Balance Sheet Items

Assets Current assets:
Cash & securities Receivables Inventories

Liabilities and Equity Current liabilities:

Payables Short-term debt

Fixed assets:
Tangible assets Intangible assets

Long-term liabilities Shareholders' equity

12

Classification of Ratios
Balance Sheet Ratio P&L Ratio or Income/Revenue Statement Ratio
Operating Ratio

Balance Sheet and Profit & Loss Ratio

Financial Ratio

Composite Ratio

Current Ratio Quick Asset Ratio Proprietary Ratio Debt Equity Ratio

Gross Profit Ratio Operating Ratio Expense Ratio Net profit Ratio Stock Turnover Ratio

Fixed Asset Turnover Ratio, Return on Total Resources Ratio, Return on Own Funds Ratio, Earning per Share Ratio, Debtors Turnover Ratio,

Format of balance sheet for ratio analysis

LIABILITIES ASSETS
NET WORTH/EQUITY/OWNED FUNDS FIXED ASSETS : LAND & BUILDING, PLANT & Share Capital/Partners Capital/Paid up Capital/ MACHINERIES Owners Funds Original Value Less Depreciation Reserves ( General, Capital, Revaluation & Other Net Value or Book Value or Written down value Reserves) Credit Balance in P&L A/c
LONG TERM LIABILITIES/BORROWED FUNDS : Term Loans (Banks & Institutions) Debentures/Bonds, Unsecured Loans, Fixed Deposits, Other Long Term Liabilities NON CURRENT ASSETS Investments in quoted shares & securities Old stocks or old/disputed book debts Long Term Security Deposits Other Misc. assets which are not current or fixed in nature CURRENT ASSETS : Cash & Bank Balance, Marketable/quoted Govt. or other securities, Book Debts/Sundry Debtors, Bills Receivables, Stocks & inventory (RM,SIP,FG) Stores & Spares, Advance Payment of Taxes, Prepaid expenses, Loans and Advances recoverable within 12 months INTANGIBLE ASSETS Patent, Goodwill, Debit balance in P&L A/c, Preliminary or Preoperative expenses

CURRENT LIABILTIES Bank Working Capital Limits such as CC/OD/Bills/Export Credit Sundry /Trade Creditors/Creditors/Bills Payable, Short duration loans or deposits Expenses payable & provisions against various items

Liquidity

Current ratio
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 Current Ratio : It is the relationship between the current assets and current liabilities of a concern.

Current ratio=current Assets\current liabilities Ideal level=2:1

3. ACID TEST or QUICK RATIO : It is the ratio between Quick Current

Assets and Current Liabilities. The should be at least equal to 1.
Quick Current Assets : Cash/Bank Balances + Receivables upto 6 months + Quickly realizable securities such as Govt. Securities or quickly marketable/quoted shares and Bank Fixed Deposits Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities

Example : Cash 50,000 Debtors 1,00,000 Inventories 1,50,000 Total Current Assets 3,00,000

Current Liabilities 1,00,000

Current Ratio = > Quick Ratio =>

3,00,000/1,00,000 1,50,000/1,00,000

= 3:1 = 1.5 : 1

Investment/Shareholders

Investment/Shareholders
Earnings per share profit after tax / number of shares It gives income earned to each equity shareholder Price earnings ratio market price / earnings per share the higher the better generally. Comparison with other firms helps to identify value placed on the market of the business. Dividend yield ordinary share dividend / market price x 100 higher the better. Relates the return on the investment to the share price. It is calculated by those investors who are merely interested in dividend income.

Gearing

Gearing
Gearing Ratio = Long term loans / Capital employed x 100 Capital Employed=Fixed assets +working capital 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) Gross profit/net sales *100 Gross Profit=Sales- Cost of Good Sold Net Profit effectively total revenue (turnover) variable costs and fixed costs (overheads).It measures the rate of profit on net sales. Net Profit/Net Sales

Profitability
Return on Capital Employed (ROCE) = Profit (after tax)-preferred dividend/ capital employed x 100
This ratio measures the profitability of capital committed to the business by equity shareholders.It measures business success and managerial efficiency The higher the better A ROCE of 25% means that it uses every 1 of capital to generate 25p in profit

Financial

Stock Turnover
Stock turnover = Cost of goods sold / Average Stock Average Inventory or Stocks = (Opening Stock + Closing Stock) -----------------------------------------

2
The rate at which a companys stock is turned over It signifies number of times inventry turned into stock. 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 Average Debtors/Sales ) x 365 for days (52 for weeks & 12 for months) 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

11. ASSET TRUNOVER RATIO :

12. FIXED ASSET TURNOVER RATIO :

Net Sales/Tangible Assets

Net Sales /Fixed Assets

13. CURRENT ASSET TURNOVER RATIO : Net Sales / Current Assets

14. CREDITORS TURNOVER RATIO : This is also called Creditors Velocity Ratio, which determines the creditor payment period. (Average Creditors/Purchases)x365 for days (52 for weeks & 12 for months) The smaller the creditor turnover ,the larger the period of credit enjoyed by campany.

RETRUN ON CAPITAL EMPLOYED :

( Net Profit before Interest & Tax / Average Capital Employed) x 100

Average Capital Employed is the average of the equity share capital and long term funds provided by the owners and the creditors of the firm at the beginning and end of the accounting period. OPERATING PROFIT RATIO : It is expressed as = (Operating Profit / Net Sales ) x 100 Higher the ratio indicates operational efficiency

4. DEBT EQUITY RATIO : It is the relationship between borrowers fund (Debt) and Owners Capital (Equity).
Long Term Outside Liabilities / Net Worth

Net worth= Equity+reserves+irredemable preferenceshares+all undistributed Profit

For instance, if the Firm is having the following :

Capital = Rs. 200 Lacs Free Reserves & Surplus = Rs. 300 Lacs Long Term Loans/Liabilities = Rs. 800 Lacs
Debt Equity Ratio will be => 800/500 i.e. 1.6 : 1 Ideal Ratio=2:1

Expense Ratios-There are many types of expense ratios such as administrative expense ratio, factory expense ratio ,selling and distribution ratios. Factory Expense ratio=Total factory expense ratio/net sales *100 Operating rati0=Cost of good sold +operating exp/net sales Operating expenses includes all adminstrative,office and selling and distribution exp. It do not include financial expenses.

Lower the ratio greater is the profitability

Limitations of Ratio Analysis

A firms 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
32

Thank You!