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

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. Dividend Average ordinary shareholders’ equity or net worth Earning per share = Net profit available to equity shareholders No. of ordinary shares outstanding

Various formulae Dividend per share = NP distributed to ordinary shareholders No. of ordinary shares outstanding Dividend pay out ratio = Total dividend to equity holders(cash div) Total NP belonging to equity holders