NPTEL Course

Course Title: Security Analysis and Portfolio Management

Instructor: Dr. Chandra Sekhar Mishra
Module-5
Session-10
Financial Statement Analysis II
Outline
Ratios for Financial Statement Analysis
o Profitability
o Efficiency
o Liquidity
o Solvency
o Market Standing or Valuation Ratios
Financial Ratios: Financial ratio is a relationship between two variables as part of financial
results of a particular company. The figures can be taken from the financial statements, financial
markets based on the objective. Financial ratios can indicate possible opportunities or problems
associated with companies. Usually the financial ratios are classified as below:
Profitability
Efficiency
Liquidity
Solvency and Leverage
Capital market standing
Profitability Ratios: Generation of profit by business is taken as a sound objective of business
organization. This also acts as an incentive for stakeholders like investors and management.
Profitability ratios are of two types viz. those related to revenue and those related to investment.
Gross profit margin: Gross profit is defined as the difference between sales and cost of
goods sold. For companies in manufacturing sector this ratio indicates the coverage of
major expenses particularly with respect to manufacturing of products.
Operating profit margin: Operating profit is calculated after subtracting other operating
expenses (like selling and distribution expenses) from gross profit. Operating profit is
also known as earnings before interest and tax (EBIT). Operating profit margin is the
ration between operating profit and sales. Higher operating profit margin indicates the
efficiency of organization and makes companies more comfortable in meeting nonoperating expenses like interest.
Net profit margin: This ratio indicates the profit meant for shareholders both
preference and equity and is measured as a ratio of net profit to sales. This is also another
measure of business efficiency.
Return on investment or Earning Power: Earnings before interest and taxes (EBIT) to
Total Assets: This ratio indicates the return available to all investors together irrespective
of proportion of different types of capital. This ratio is ideal for comparison across firms
1

since it is not affected by capital structure and tax policy of the firms. It reflects the
earning power of assets.
Return on equity: This is the return available for equity shareholders, the residual owners
of the business. The return on equity is measured as below:
Return on Equity (RoE) =

Net profit
Average net worth

Net worth includes equity, reserves and surplus adjusted for any fictitious assets. The net
worth of current year and previous year are averaged for the purpose. Besides
profitability, RoE is affected by leverage, i.e. presence of debt in capital structure. Under
good conditions, leverage magnifies RoE compared to an unlevered company.

Earnings per share (EPS): This ratio is measured by dividing net profit [available for
equity shareholders] with number equity shares. This is an absolute measure and
indicated in the currency. This measure can be misleading while comparing between
different companies when their equity capital structure in terms of amount of paid-up
capital or face value share are different.
EPS in Rs. =

Profit after tax less preference dividend if any

Number of equity shares

Dividend per share (DPS): This is measured as below:

DPS =

Equity dividend
Number of equity shares

Investors like senior citizens and pension funds prefer higher dividend since such income
is considered as a regular source of income. Besides, declaration of dividend is
considered normally as a healthy sign since it denotes liquidity and profitability of the
companies.
Efficiency Ratios: Such ratios (also known as turnover ratios) indicate efficiency in asset
utilization and in broad terms are expressed as a relationship between sales and assets.
Total assets turnover ration (TATR): This ratio measures the revenue generation in
comparison to the funds deployed by the investors. Higher the ratio is always better. This
reflects overall efficiency in utilization of assets.
TATR =

Net sales
Average total assets

Similarly to know the efficiency of a particular type of asset the TATR is modified to
reflect the average value of particular asset. The other asset turnover rations that are used
by analysts:
o Fixed assets turnover
o Current assets turnover
o Inventory turnover
o Receivables or debtors turnover
2

The Du Pont financial analysis: This is propounded by Du Pont Company of the US and is
widely appreciated. This analysis combines two major aspects of business performance:
profitability in terms of net profit margin and asset utilization in terms of total assets turnover
ratio.
Return on Assets RoA

Net profit
Net profit
Net sales

x
Average total assets
Net sales Average total assets

For improving RoA, firms need to focus on increased profit margin [i.e. cost reduction] and
better utilization of assets. Du Pont analysis can be extended to measure the return on equity and
its components.
The Du Pont framework is revised to reflect the factors affecting return on equity. In the revised
formula, the leverage effect (asset to equity ratio) is considered.
Return on Equity (RoE) =

Net profit
Net profit
Net sales
Average total assets
=
x
x
Average net worth
Net sales Average total assets
Average net worth

Liquidity or Short Term Solvency: Liquidity ratios measure the firms ability to meet short
term obligations.
Current Ratio: this is the ratio between current assets and current liabilities. A current
ratio of 2 indicates that the company has two rupees of current assets to meet one rupee
of current liability. Although higher current ratio indicates better short term solvency or
liquidity, very high current ratio can be due to idle current assets like inventories. Current
assets include cash, bank, short term deposits, inventories, receivables, prepaid expenses.
Current liabilities include creditors for supplies and other inputs, payables, provisions for
tax, proposed dividend, and outstanding expenses.
Quick Ratio: Also known as acid test ratio, this is a stringent measure of liquidity and is
measured as a ratio between quick assets and current liabilities. As part of quick assets,
all current assets except inventory are considered. Inventories are considered less liquid
in comparison to other current assets.
Inventory turnover ratio (ITR) and inventory conversion period: ITR This ratio measures
the efficiency of inventory utilization and is measured as:
ITR in times =

Cost of goods sold

Average inventory

Higher inventory turnover ratio indicates that the company holds less inventory to meet the
sales. By dividing 365 with ITR, inventory conversion period can be found. With an ITR of 5
times, inventory conversion period is calculated as 73 days. Thus, it takes 73 days on an
average to convert inventory into sales.

Receivables or Debtors turnover ratio (DTR) and average collection period: DTR is
calculated as below:
DTR in times =

Net Credit Sales

Average receivables

Higher debtor turnover ratio indicates stringent credit policy and terms as well as timely
collection of receivables. Average collection period is calculated by dividing 365 with DTR.
Long Term Solvency: Companies depend upon borrowing for financing the business. While
borrowing leads to leverage and helps in magnifying earnings available for equity shareholders,
it can also lead to problems of solvency. Higher borrowing ratio can invite higher interest
charges by bankers and other lenders. Hence companies try to have an optimal borrowing level.
The different measures of long term solvency are discussed below.
Debt-to-equity ratio: This ratio is calculated as Debt / Net worth. Debt consists of interest
bearing liabilities. A debt-equity ratio of 1.5 indicates that the company has borrowed
Rs.1.5 for every one rupee contributed by the owners.
Liabilities-to-equity ratio: This ratio is like debt to equity ratio but for the fact that in this
case, in numerator, all liabilities whether interest bearing or not are considered.
Total debt to total capital (debt + equity): this is a variety of debt-equity ratio and is
indicated in terms of %. A debt equity ratio 2:1 is essentially a debt to total capital ratio
of 66.67% [2 / (2+1)]
Interest coverage ratio (EBIT / Interest, expressed in times): this ratio indicates the
comfort level of the firms in the ability to pay interest. Bankers attach a lot of importance
to this coverage ratio while appraising a loan.
Fixed charges coverage ratio: This ratio measures the ability of company to honour all the
debt obligation like interest and repayment of debt
Fixed charges coverage ratio in times) =

EBIT + Depreciation
Interest +

Repayment of debt
1 - Tax rate

In the above formula repayment of debt is adjusted for tax since unlike interest, this is not a
tax deductible payment
Capital Market Standing
Price-earnings (P/E) ratio: P/E ratio, a very popular ratio for financial market players, is a
relative valuation measure for equity share and is measured as Market price per share to
EPS. P/E ratio is essentially compared with an average P/E ratio of stocks of similar
industry or benchmark index. High P/E ratio in comparison to benchmark or average P/E
indicates over valuation and vice versa.
Enterprise value / EBIDTA or EBIDTA multiple: Enterprise value is combination of
market value of equity and debt; EBIDTA: Earnings before interest, tax, depreciation and
amortization. EBIDTA multiple neutralizes the effect of capital structure, new or old
company [i.e. new or old assets thus leading to different depreciation] and corporate tax
effect. This ratio indicates the value of the company unlike P/E ratio which indicates the
value of equity.
Price-to-book ratio: Measured as Market price per share to book value per share this is
another realative valuation ratio. This ratio is appropriate for companies that depend on
assets held as value driver. However for companies that has intangibles [not reflected in
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balance sheet like, brand, image, human resources, etc.] this ratio is not appropriate. The
book value of share is measured as Net worth / Number of equity shares
Dividend-yield: Measured as Dividend per share to Market price per share, dividend
yield indicates the return in terms of dividend for the stockholders on the equity shares.
Certain investors prefer high dividend yield stocks.

Although ratio analysis help investors in identifying suitable companies for investment and also
provides alert in advance, the mechanism suffers from different limitations viz. historical nature
of financial statements, different accounting policies followed by companies, window dressing
among other things.

References
Reilly and Brown (2006), Investment Analysis and Portfolio Management, 8e, Thomson
(Cengage) Learning, New Delhi
Bodieet al (2009), Investments, 8e, Tata McGraw Hill, New Delhi
Prasanna Chandra (2008), Investment Analysis and Portfolio Management, 3e, Tata
McGraw Hill, New Delhi
Ramachandran and Kakani (2008), Financial Accounting for Management, 2e, Tata
McGraw Hill, New Delhi
Narayanaswamy (2008), Financial Accounting: A Managerial Perspective, Prentice Hall
India, New Delhi

Questions and Answers

Q.1. Refer information given related to ABC Limited as below and find profitability and
asset turnover ratios of ABC Limited.
ABC limited
Income Statement
2008-09
(Rs. Crore)

2009-10
(Rs. Crore)

350

410

Raw Materials

120

130

Power & Fuel Cost

80

95

Employee Cost

40

50

Other Manufacturing Expenses

17

24

Selling and
Expenses

11

14

Total Expenditure

268

313

Operating Profit (PBDIT)

82

97

Interest

10

10

PBDT

72

87

Depreciation

24

28

Profit Before Tax

48

59

Tax

14.4

17.7

Reported Net Profit

33.6

41.3

Net Sales
Expenditure:

Administration

Balance Sheet
SOURCES OF FUNDS :

2008-09
(Rs. Crore)

2009-10
(Rs. Crore)

Share Capital (Face Value: Rs.10)

40

40

Reserves Total

95

135

Total Shareholders Funds

135

140

Secured Loans

90

85

Unsecured Loans

35

41

Total Debt

125

126

Current Liabilities and Provisions

6

Current Liabilities

45

56

Provisions

30

48

Total Current Liabilities

75

104

Total Liabilities

335

370

Gross Block

90

110

Less : Accumulated Depreciation

22

29

Net Block

68

81

Capital Work in Progress

12

14

Investments

70

78

Inventories

75

57

Sundry Debtors

56

87

Cash and Bank

38

30

Loans and Advances

28

37

Total Current Assets

197

211

Total Assets

335

370

APPLICATION OF FUNDS :

Current Assets, Loans & Advances

Ans.
Ratio/ Measure

Explanation/
Formula

2008-09

2009-10

Operating margin (%)

(Operating profit /
Sales)*100

23.43

23.66

Net profit margin (%)

(Net
profit
Sales)*100

9.60

10.07

Profitability related to Sales (or

income)

Profitability related to investment

Return on total assets (%)

(PBIT to Total
Assets)*100

17.31

18.65

Return on Equity

(PAT
/
Worth)*100

24.89

29.50

Earnings per share (Rs.)

PAT / Number of
Equity Shares

8.40

10.33

Net

Asset Turnover Ratios

Total Assets Turnover (in times)

Sales / Average
Total Assets

NA*

1.16

Current Assets Turnover

Sales / Average
Current Assets

NA*

2.01

Not available since data for 2007-08 are required.

Q.2. Find out liquidity i.e. short term solvency ratios (current ratio, quick ratio), long term
solvency ratios (debt-equity ratio, debt to total assets, interest coverage ratio) of ABC
Limited.
Ans.:
Ratio/ Measure

Explanation/
Formula

2008-09

2009-10

Current Ratio

Current Assets/
Current Liabilities

2.63

3.77

Quick Ratio

Current Assets less

Inventory/ Current
Liabilities

1.63

1.48

Debt Equity Ratio (times)

Long term debt /

Net Worth

0.93

0.90

Debt to Total Assets (%)

(Total Debt i.e.

Long term debt +
current liabilities
and provisions /
Total Assets) *
100

59.70

62.16

Interest coverage ratio (times)

PBIT / Interest

5.8

6.9

Liquidity or Short term solvency:

Long term solvency:

Q.3: a. Find out inventory turnover ratio, inventory conversion period debtor turnover ratio
and average collection period of ABC Limited.
Ans.:
Ratio/ Measure

Explanation/
Formula

2008-09

2009-10

Inventory turnover ratio (ITR)

Cost of goods sold

/
Average
inventory*

N.A.**

6.21

Inventory conversion period (days)

365 / ITR

N.A.**

59

Debtor turnover ratio (DTR)

Sales / Average
Debtors

N.A.**

5.74

Average Collection Period (days)

365 / DTR

N.A.**

64

Instead of cost of goods sold, sales is taken as proxy for the same for calculating this ratio.
** Since 2007-08 data are not available, this ratio is not found for 2008-09.
Q.4. With the help of additional information as below, find out Dividend yield, P/E ratio and
P/B ratio of ABC limited
Dividend declared and paid during 2009-10: Rs.5.00 per share
Average market price of share of ABC Limited: Rs.58
Ans.:
Dividend yield (%) = Dividend per share / Average market price per share * 100 = 8.62%
P/E ratio = Average market price / EPS = 5.62 times
P/B ratio = Average market price / book value per share
Book value per share = Net worth / number of equity shares = 140 / 4 = Rs.35
Hence, P/B ratio = Rs.58/Rs.35 = 1.67 times.