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RATIO ANALYSIS AS A TOOL

FOR FINANCIAL ANALYSIS


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RATIO ANALYSIS AS A TOOL
FOR FINANCIAL ANALYSIS
Dr. T.K. Jain.
AFTERSCHO☺OL
Centre for social entrepreneurship
Bikaner M: 9414430763
tkjainbkn@yahoo.co.in
www.afterschool.tk, www.afterschoool.tk
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Why to study ratio analysis ?
• To find the real financial health of the
company
• To decide where to invest money in stock
market
• To improve the performance of the
company
• To predict future performance of a
company
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Ratio Analysis
• Cross-sectional and time series analysis
• Controls for size differences
• Controls for currency differences
• Evaluate related components of different
financial statements simultaneously
• Ratios are easily (and commonly) modified

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WHAT DO YOU LOOK AT ?
• Is the company using assets properly (activity and
turnover ratios)
• Is the company having capability to meet its liabilities
(liquidity ratios)
• Is the company capable in giving reasonable returns to
the investors (profitability ratios)
• Is the company progressing over time (time series
analysis)
• Is the company having good financial health
(commonsize ratio analysis)
• Is the company able to use working capital properly
(cash flow and funds flow analysis)
• Is the company properly valued by the market (PE ratio)

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Ratio Analysis Categories
• Activity (operations and asset
management)
• Liquidity (meeting short-term obligations)
• Solvency (meeting long-term obligations)
• Profitability (earnings and cost coverage)
• Cash Flow (quality of earnings)
• Price Multiples (stock price)

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Activity Ratios
How day-to-day operations function
• Inventory management
• Inventory Turnover
– Compares income statement and balance sheet amounts
– Must average balance sheet figures ((Beg + End)/2)
– Turnover = COGS/Average total inventory
– Ex: sales = 400, avg. inventory = 20, what is turnover = 400/20 =
20
• Days inventory = 365/Turnover
– How many days was inventory held before being sold?
– Ex : 360/20 =18 days of inventory is kept on an average

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Activity Ratios
Critical operating cash accounts
• Accounts receivable turnover
– How many times a credit sale is made and subsequently
collected
– [credit sales/average accounts receivable]
– Ex: sales=100, BR=25, turnover = 4
– Try to use credit sales (if available)
– Consistency is important
• Days receivable
– Number of days between the charge sale and collection
– [365/accounts receivable turnover]
– Ex : 360/4 = 90 days receivables – more than the acceptable
credit period (it depends on industry standards).

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Activity Ratios
Critical operating cash accounts
• Accounts payable turnover
– Number of times a credit purchase is made and subsequently
paid
– [credit purchases/average accounts payable]
– Often assume all purchases are on credit
– Purchases = [COGS + Ending Inv. - Beginning Inv.]
– Ex : purchase = 100, creditors = 20, turnover = 5
• Days payable
– Number of days between credit purchase and payment
– [365/accounts payable turnover]
– 360 / 5 = 72 days credit (your creditors are helping you)

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Activity Ratios
Cash Cycle
• Also a measure of liquidity
• If low, small number of days in operating
cycle to finance

[Days inventory + Days receivable - Days payable]


Example : 18 + 90 – 72 = 36 days

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Activity Ratios
Asset Turnover
• Long-term
– Revenues generated by long-term assets
– [Sales revenue/Average noncurrent assets]
– Ex : sales=100, fixed assets=40 turnover=2.5
– Higher the better – if less than industry standards, it
means you are not able to use assets properly
• Total assets
– Efficiency of generating revenues given total assets
– [Sales revenue/Average total assets]

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Liquidity Ratios
• Current ratio
– Ability to meet short-term obligations
– [Current assets/current liabilities]
– Ideal = 2:1 or more
– Current assets = 100, current liabilities = 30
C/R=3.3:1
• Quick ratio
– Remove less liquid assets (inventory is not a very
liquid asset)
– Keep cash, liquid investments, A/R
– [(Current assets-inventory-ppd expenses-other)/current liabilities]
– [(Cash+short-term investments + A/R)/current liabilities]

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Liquidity Ratios
• Defensive interval ratio
– Compare 1 day’s costs to quick assets
– [((COGS+SGA+RD)/365)/(Cash+short-term investments + A/R)]
– Example :
– Cost of goods sold, other expenses and research and
development is 360000, Cash = 20000, Short term investments
= 200000, Accounts receivables = 80000
– (360000/360)/(20000+200000+80000)
– 1000/300000
– .003

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Solvency Ratios
• Debt to assets: Total liabilities/Total assets
– Proportion of assets financed with debt
• Could include interest bearing debt only
[(short term debt + noncurrent debt)/total assets]
Ex: Total debt 100, assets = 20, D/E ratio=5:1 (which is
more), ideally it should not be more than 2:1.
• Be aware that assets are recorded at historical
cost, which may be different from current market
value

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Solvency Ratios
• Debt to equity: Total liabilities/Total equity
– A measure of how assets are financed
• Or… (current debt + noncurrent debt)/Total equity
– Examine relative sizes of debt and equity financing
• Capitalization ratio:
[(current debt+noncurrent debt)/
(current debt+noncurrent debt+total equity)]
Ex: Loans= 200,Creditors=100,Capital=300,
capitalisation ratio = 300/600 = .5

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Solvency Ratios
Coverage Ratios
• Adequacy of resources for meeting firm’s
contractual obligations
• Times interest earned
– Can the firm cover its interest obligations?
– (EBIT/Interest expense)
– Ex : EBIT = 100, interest to be paid to bank=10,
coverage ratio = 10, the higher the better from
financier perspective
– Also called DSCR = debt service coverage ratio
• Cash interest coverage
– (Cash from ops + interest paid + tax paid)/Interest paid

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Solvency Ratios
Coverage Ratios

• Target a specific expense


– [(EBIT+Rent expense)/(Interest expense+rent
expense)]
• Target principal on debt that is about to be
repaid
– [EBIT/(interest expense + principal payments)]

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Profitability Ratios
Common-size

• Income statement
– Divide item of interest by sales
– ROS = Net income/Sales revenue
– Gross margin = Gross profit/Sales revenue
– Salary=100, rent = 20, purchases 200, sales = 500,
so the ratios will be : salary=.2,
rent=.04,purchase=.4
• Balance sheet
– Divide item of interest by total assets

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Profitability Ratios
Return Ratios

• ROA (return on assets) = Net


income/Average total assets
• Or, [(Net income + After-tax interest
expense)/Average total assets]
• Also, [EBIT/Average total assets] reflects
pre-tax, pre-interest return

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Profitability Ratios
Return Ratios

• ROE (return on equity) = Net income/Average


total equity
– Return generated relative to the capital provided by
the owners over time
• Or, if firm has preferred stock
[(Net income – Prfd dividends)/Average total common equity]
ROMVE = Net income/Market value of equity
Market value is different from book value.

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Cash Flow Ratios
Quality of earnings

• Ability to pay obligations


– CFO/Total liabilities
– CFO = Cash flows from operations
• Profitability (cash flow relative to sales)
– CFO/Sales revenue
• Cash return on assets
– CFO/Average total assets

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Cash Flow Ratios
Quality of earnings

• Cash flow-earnings index


– CFO/Net income
• Free cash flow ratio
– CFO/Capital expenditures
– If ratio>1, free cash flow exists

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Price Multiple Ratios

• Market’s valuation of a firm’s common stock


– P/E = Share price/Earnings per share
– Ex: reliance price=2000, EPS = 100, P/E = 20
– Generally PE ratio is in the range between 5 to 40
– If it is less than 5, it may be undervalued stock, so study it, it may
be a good investment
• Price/book ratio compares stock’s price to the recorded
value of the net assets
[Share price/(Book value of equity/Share outstanding)]
• Price/sales = Share price/Sales per share
• Also, compare price to cash flow per share
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Ratio Integration

DuPont analysis (decomposition)


ROE = ROA x Leverage
Net income Net income Average total assets
= ∗
Average total equity Average total assets Average total equity

Net income Net income Sales Average total assets


= ∗ ∗
Average total equity Sales Average total assets Average total equity

And more…
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Ratio Integration

ROA = Profitability x Turnover

Net income Net income Sales


= ∗
Average total assets Sales Average total assets

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Analysis
• Generally compare 3-5 years
• Requires 4-6 years of data
– Balance sheet numbers may be averaged
– Example : comparison of Motorola and Nokia

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Activity Ratios

2001 2000 1999 1998


Inventory Turns
MOT 5.36 5.28 5.54 5.33
NOK 9.77 9.45 7.98 6.58
A/R Turns
MOT 5.14 5.91 6.19 5.94
NOK 5.51 6.45 5.96 5.99

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Liquidity Ratios

2001 2000 1999 1998


Current ratio
MOT 1.77 1.22 1.36 1.18
NOK 1.62 1.57 1.69 1.75
Quick ratio
MOT 1.11 0.66 0.76 0.58
NOK 1.24 1.14 1.25 1.28

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Solvency Ratios

2001 2000 1999 1998


Debt-to-assets
MOT 57.6% 54.9% 52.6% 57.5%
NOK 44.7% 44.8% 47.5% 48.5%
Times interest earned
MOT -7.54 6.05 5.65 -3.56
NOK 43.38 51.97 16.14 13.40

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Profitability Ratios
2001 2000 1999 1998
ROA
MOT -10.4% 3.2% 2.6% -3.4%
NOK 10.4% 23.1% 21.2% 20.5%
ROE
MOT -23.7% 6.9% 5.7% -7.6%
NOK 18.8% 42.6% 40.7% 40.7%

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Limitations to consider
• Historical cost of balance sheet items
• GAAP vs. IAS rules
• There is no perfect standard regarding ideal
ratio – it depends on industry standards so
compare with similar firms in industry to
determine ideal levels.
• Accounting method differences
– LIFO vs. FIFO inventory valuation

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Some other points
• In turnover ratios, sales is usually the
numerator
• In returns ratios, net profit is usually the
numerator

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LEVERAGE
• Leverage ratios tell you about ratio of fixed
cost resources in your overall structure
• Operating leverage = shows ratio of fixed
cost to total cost
• Financial leverage = shows ratio of debt
(or fixed interest bearing securities) to total
capital
• Higher the ratio, greater the risk and
greater is earnings possible.
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WHY STUDY LEVERAGE ?
• It shows relation between various aspects
– particularly risk and reward
• Leverage is a relation of your efforts and
rewards
• Some factors like fixed cost resources etc
have impact on increase or decrease in
profit.

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WHAT IS LEVERAGE?
• Lever is some tool to help you accelerate
your speed – have you used it ????
• It increases your speed and also your risk.
• We have two types of leverages in
FINANCIAL MANAGEMENT :
• A. operating leverage
• B. financial leverage

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WHAT IS FINANCIAL
LEVERAGE?
• Use of fixed charge securities like
debentures in the overall capital structure
is called financial leverage.
• DFL = degree of financial leverage
• It tells us about the level of financial risk
that we are taking. If financial leverage
increases, the risk of the firm increases.

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How is financial leverage
measured?
• % change in net income / % change in EBIT
• EBIT = earnings before interest and taxes, it is
also called net operating income
• Net income = income after payment of all dues
including interest.
• Example : your EBIT is 1000, your interest is
500. your EBIT increases by 20%, interest
remains same, so net income increases from
500 to 700. Thus DFL = 40/20 = 2 answer
• (% change in net income is 40% due to increase
in earning, but no change in interest).

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What is operating leverage ?
• It measures the impact of change in
volume (sales) on EBIT. It measures the
riskiness due to fixed cost resources in the
organisation.
• DOL = degree of financial leverage = %
change in EBIT / % change in sales
• It measures the impact of fixed cost on
profitability
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Example of operating leverage ..
• Suppose your sales are 300 and your
expenditures are 200. out of your total
expenditure, 120 is fixed expenditure and and
variable expenditureis 80. Suppose sales
increase by 40%, the variable expenses will also
increase by 40%. New sales = 420, new variable
exp. = 112. New total exp. = 232. Profit changed
from 100 to 188.
• DOL = 88/40 = 2.2 ans.

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What is DCL?
• DCL = degree of combined leverage
• DCL = DOL * DFL (PRODUCT OF DOL
AND DFL)

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