Академический Документы
Профессиональный Документы
Культура Документы
6-1
Ratio 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.
6-3
Basis 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 firms performance in relation to its competitors. 3) Comparison with standards or industry average.
6-4
Types of Ratios
Liquidity Ratios Capital Structure Ratios
Profitability Ratios
Efficiency ratios Integrated Analysis Ratios Growth Ratios
6-5
Company A
Company B
Liquidity Ratios
6-7
Current Ratio
Current Ratio is a measure of liquidity calculated dividing the current assets by the current liabilities
Current Ratio =
Current Assets
Current Liabilities
Firm B Rs 30,000
Firm A Rs 1,80,000
Current Liabilities
Current Ratio
Rs 1,20,000
= 3:2 (1.5:1)
Rs 10,000
3:1
6-8
Acid-Test Ratio
The quick or acid test ratio takes into consideration the differences in the liquidity of the components of current assets.
Acid-test Ratio =
Quick Assets
Current Liabilities
6 - 10
6 - 11
The cost of goods sold means sales minus gross profit. The average inventory refers to the simple average of the opening and closing inventory.
6 - 12
6 - 13
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.
6 - 14
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.
6 - 16
= 3 months
6 - 17
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.
As a rule, the shorter is the cash cycle, the better are the liquidity ratios as measured above and vice versa.
6 - 18
Defensiveinterval ratio
6 - 19
ratio.
Rs 1,82,500 365 Rs 40,000 Rs 500
= Rs 500
= 80 days
6 - 20
6 - 21
(ii) Regular payment of the interest . Capital structure or leverage ratios throw light on the long-term solvency of a firm. Accordingly, there are two different types of leverage ratios.
First type: These ratios are computed from the balance sheet (a) Debt-equity ratio (b) Debt-assets ratio (c) Equity-assets ratio
6 - 22
Second type: These ratios are computed from the Income Statement (a) Interest coverage ratio (b) Dividend coverage ratio
I. Debt-equity ratio
Debt-equity ratio measures the ratio of long-term or total debt to shareholders equity.
Debt-equity ratio measures the ratio of long-term debt = Total external Total Debt Obligations Debt-equity ratio = to shareholders equity term or total de3bt 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.
6 - 23
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.
6 - 24
Trading on Equity
Trading on equity (leverage) is the use of borrowed funds in expectation of higher return to equity-holders. Trading on Equity Particular (a) Total assets Financing pattern: Equity capital 15% Debt (b)Operating profit (EBIT) Less: Interest Earnings before taxes Less: Taxes (0.35) Earnings after taxes Return on equity (per cent) A 1,000 1,000 300 300 105 195 19.5 (Amount in Rs thousand) B 1,000 800 200 300 30 270 94.5 175.5 21.9 C 1,000 600 400 300 60 240 84 156 26 D 1,000 200 800 300 120 180 63 117 58.5
6 - 25
Permanent
Capital
6 - 26
Proprietary ratio =
Capital Gearing Ratio
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.
6 - 27
Coverage Ratio
Interest Coverage Ratio Interest Coverage Ratio measures the firms ability to make contractual interest payments. Interest coverage ratio = Dividend Coverage Ratio
Dividend Coverage Ratio measures the firms ability to pay dividend on preference share which carry a stated rate of return.
DSCR
t=1
EATt
Interestt
t=1 n
Depreciationt
OAt
Instalmentt
The net profit has been arrived after charging depreciation of Rs 17.68 lakh every year.
Tata McGraw-Hill Publishing Company Limited, Financial Management
6 - 30
Solution
Table 3: Determination of Debt Service Coverage Ratio (Amount in lakh of rupees)
Ye ar Net profit Depreciation Interest Cash available (col. 2+3+4) 5 58.49 70.09 68.81 49.48 46.37 43.64 41.05 34.09 Principal instalment Debt obligation (col. 4 + col. 6) 7 29.84 35.64 33.12 30.60 28.08 25.56 23.04 18.00 DSCR [col. 5 col. 7 (No. of times)] 8 1.96 1.97 2.08 1.62 1.65 1.71 1.78 1.89
1 1 2 3 4 5 6 7 8
1.83
6 - 31
Profitability Ratio
Profitability ratios can be computed either from sales or investment. Profitability Ratios Profitability Ratios
Related to Sales
(i) Profit Margin (ii) Expenses Ratio
Related to Investments
(i) Return on Investments (ii) Return on Shareholders Equity
6 - 32
Profit Margin
Gross Profit Margin
Gross profit margin measures the percentage of each sales rupee remaining after the firm has paid for its goods.
6 - 33
Example 7: From the following information of a firm, determine (i) Gross profit margin and (ii) Net profit margin. 1. Sales Rs 2,00,000 2. Cost of goods sold 1,00,000 3. Other operating expenses 50,000
(1) Gross profit margin = Rs 1,00,000 Rs 2,00,000 Rs 50,000 Rs 2,00,000 = 50 per cent
= 25 per cent
6 - 35
Expenses Ratio
i. Cost of goods sold = ii. Operating expenses = Cost of goods sold X 100 Net sales Administrative exp. + Selling exp. Net sales Administrative expenses iii. Administrative expenses = Net sales iv. Selling expenses ratio = Selling expenses Net sales X 100 X 100
X 100
Cost of goods sold + Operating expenses v. Operating ratio = X 100 Net sales vi. Financial expenses = Financial expenses Net sales X 100
6 - 36
Return on Investment
Return 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
Efficiency Ratio
Activity ratios measure the speed with which various accounts/assets are converted into sales or cash.
Inventory turnover measures the efficiency of various types of inventories.
Cost goods sold i. Inventory Turnover measures theof activity/liquidity of Inventory Turnover Ratio = Average inventory inventory of a firm; the speed with which inventory is sold
Cost of raw materials used i. Inventory Turnover measures the activity/liquidity of Raw materials turnover = inventory of a firm; the speed with which inventory is sold Average raw material inventory
of goods manufactured i. Inventory Turnover measuresCost the activity/liquidity of Work-in-progress turnover = Average work-in-progress inventory inventory of a firm; the speed with which inventory is sold
6 - 39
Months (days) in a year (x) (Average Debtors + Average (B/R) i. Inventory Turnover measures the activity/liquidity of inventory of a Alternatively = Total firm; the speed with which inventory is credit sold sales
analysis
to
identify
6 - 40
Cost of goods sold of inventory of i. Inventory Turnover measures the activity/liquidity i. Total assets turnover = a firm; the speed with which inventory Average total is sold assets ii. Fixed assets turnover = Cost of goods sold Average fixed assets
Cost of goods sold i. Inventory Turnover measures the activity/liquidity of inventory of iii. Capital turnover = Average is capital a firm; the speed with which inventory sold employed Cost of goods sold iv. Current assets turnover = Average current assets Cost of goods sold of inventory of i. Inventory Turnover measures the activity/liquidity v. Working capital turnover = Net working capital a firm; the speed with which inventory is sold
6 - 41
1)
2)
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
5)
6) 7)
8)
9)
Return on Assets
Earning Power
Earning power is the overall profitability of a firm; is computed by multiplying net profit margin and assets turnover.
Earning power = Net profit margin Assets turnover Where, Net profit margin = Earning after taxes/Sales Asset turnover = Sales/Total assets
Earning after taxes Sales of inventory EAT of i. Inventory Turnover measures the activity/liquidity x x Earning Power = a firm; the speed with which Salesinventory isTotal sold Assets Total assets
6 - 43
EXAMPLE: 8
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.
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.
EAT EBT
EBT EBIT
EBIT x Sales
Sales Assets
Assets Equity
6 - 45
Limitations
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.
6 - 46