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Financial Statements Analysis

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FINANCIAL STATEMENTS
ANALYSIS
Ratio Analysis
Importance and Limitations of
Ratio Analysis
Common Size Statements
Mini Case
6 - 3
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.
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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.
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Types of Ratios
Liquidity Ratios
Capital Structure Ratios
Profitability Ratios
Efficiency ratios
Integrated Analysis Ratios
Growth Ratios
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Net working capital is a measure of liquidity calculated by
subtracting current liabilities from current assets.
Table 1: Net Working Capital
Particulars Company A Company B
Total current assets
Total current liabilities
NWC
Rs 1,80,000
1,20,000
60,000
Rs 30,000
10,000
20,000
Table 2: Change in Net Working Capital
Particulars Company A Company B
Current assets
Current liabilities
NWC
Rs 1,00,000
25,000
75,000
Rs 2,00,000
1,00,000
1,00,000
Net Working Capital
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Liquidity Ratios
Liquidity ratios measure the ability of a firm to
meet its short-term obligations.
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Particulars Firm A Firm B
Current Assets Rs 1,80,000 Rs 30,000
Current Liabilities Rs 1,20,000 Rs 10,000
Current Ratio = 3:2 (1.5:1) 3:1
Current Ratio
Current Ratio =
Current Assets
Current Liabilities
Current Ratio is a measure of liquidity calculated dividing the current
assets by the current liabilities
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Quick Assets = Current assets Stock
Pre-paid expenses
Acid-Test Ratio
Acid-test Ratio =
Quick Assets
Current Liabilities
The quick or acid test ratio takes into consideration the
differences in the liquidity of the components of current
assets.
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Example 1: Acid-Test Ratio
Cash
Debtors
Inventory
Total current assets
Total current liabilities
Rs 2,000
2,000
12,000
16,000
8,000
(1) Current Ratio
(2) Acid-test Ratio
2 : 1
0.5 : 1
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Supplementary Ratios for
Liquidity
Inventory Turnover Ratio
Debtors Turnover Ratio
Creditors Turnover Ratio
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Inventory Turnover Ratio

The cost of goods sold means sales minus gross profit.
The average inventory refers to the simple average of the opening
and closing inventory.
Inventory turnover ratio =
Cost of goods sold
Average inventory
The ratio indicates how fast inventory is sold. A high ratio is good from
the viewpoint of liquidity and vice versa. A low ratio
would signify that inventory does not sell fast and stays on the shelf or in
the warehouse for a long time.
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Example 2: Inventory Turnover Ratio
Inventory
turnover ratio
=
(Rs 3,00,000 Rs 60,000)
=
6 (times
per year)
(Rs 35,000 + Rs 45,000) 2
Inventory
holding period
=
12 months
= 2 months
Inventory turnover ratio, (6)
A firm has sold goods worth Rs 3,00,000 with a gross profit
margin of 20 per cent. The stock at the beginning and the end of
the year was Rs 35,000 and Rs 45,000 respectively. What is the
inventory turnover ratio?
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Debtors Turnover Ratio
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.
Debtors turnover ratio =
Net credit sales
Average debtors
The ratio measures how rapidly receivables are collected. A high
ratio is indicative of shorter time-lag between credit sales and
cash collection. A low ratio shows that debts are not being
collected rapidly.
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Example 3: Debtors Turnover Ratio
Debtors
turnover ratio
=
Rs 2,40,000
=
8 (times
per year)
(Rs 27,500 + Rs 32,500) 2
Debtors
collection period
=
12 Months
=
1.5
Months
Debtors turnover ratio, (8)
A firm has made credit sales of Rs 2,40,000 during the year.
The outstanding amount of debtors at the beginning and at
the end of the year respectively was Rs 27,500 and Rs
32,500. Determine the debtors turnover ratio.
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Creditors Turnover Ratio
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.
Creditors turnover
ratio
=
Net credit purchases
Average creditors
A low turnover ratio reflects liberal credit terms granted by
suppliers, while a high ratio shows that accounts are to be settled
rapidly. The creditors turnover ratio is an important tool of
analysis as a firm can reduce its requirement of current assets by
relying on suppliers credit.
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Example 4: Creditors Turnover Ratio
Creditors
turnover ratio
=
(Rs 1,80,000)
=
4 (times
per year)
(Rs 42,500 Rs 47,500) 2
Creditors
payment period
=
12 months
= 3 months
Creditors turnover ratio, (4)
The firm in previous Examples has made credit purchases of Rs
1,80,000. The amount payable to the creditors at the beginning
and at the end of the year is Rs 42,500 and Rs 47,500 respectively.
Find out the creditors turnover ratio.
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Inventory holding period
Add: Debtors collection period
Less: Creditors payment period
2 months
+ 1.5 months
3 months
0.5 months
As a rule, the shorter is the cash cycle, the better are the liquidity
ratios as measured above and vice versa.
The combined effect of the three turnover ratios
is summarised below:
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.
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Defensive interval ratio is the ratio between quick
assets and projected daily cash requirement.
DEFENSIVE INTERVAL RATIO
Defensive-
interval ratio
=
Liquid assets
Projected daily cash requirement
Projected daily
cash requirement
=
Projected cash operating expenditure
Number of days in a year (365)
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Example 5: Defensive Interval Ratio
Projected daily cash requirement =
Rs 1,82,500
= Rs 500
365
Defensive-interval ratio =
Rs 40,000
= 80 days
Rs 500
The projected cash operating expenditure of a firm from the
next year is Rs 1,82,500. It has liquid current assets
amounting to Rs 40,000. Determine the defensive-interval
ratio.
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Cash-flow from operation ratio measures liquidity of a
firm by comparing actual cash flows from operations
(in lieu of current and potential cash inflows from
current assets such as inventory and debtors)
with current liability.
Cash-flow From Operations Ratio
Cash-flow from
operations ratio
=
Cash-flow from operations
Current liabilities
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Leverage Capital Structure Ratio
Capital structure or leverage ratios throw light on the
long-term solvency of a firm.
There are two aspects of the long-term solvency of a firm:
(i) Ability to repay the principal when due, and
(ii) Regular payment of the interest .
Accordingly, there are two different types of leverage ratios.
First type: These ratios are
computed from the balance
sheet
Second type: These ratios are
computed from the Income
Statement
(a) Debt-equity ratio
(b) Debt-assets ratio
(c) Equity-assets ratio
(a) Interest coverage ratio
(b) Dividend coverage ratio
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I. Debt-equity ratio
Debt-equity ratio measures the ratio of long-
term or total de3bt to shareholders equity
Debt-equity ratio =
Total Debt
Shareholders equity
Long-term Debt + Short
term debt + Other Current
Liabilities = Total external
Obligations
Debt-equity ratio measures the ratio of long-term or total
debt to 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.
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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.
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Trading on Equity
Trading on Equity (Amount in Rs thousand)
Particular A B C D
(a) Total assets 1,000 1,000 1,000 1,000
Financing pattern:
Equity capital 1,000 800 600 200
15% Debt 200 400 800
(b)Operating profit (EBIT) 300 300 300 300
Less: Interest 30 60 120
Earnings before taxes 300 270 240 180
Less: Taxes (0.35) 105 94.5 84 63
Earnings after taxes 195 175.5 156 117
Return on equity (per cent) 19.5 21.9 26 58.5
Trading on equity (leverage) is the use of borrowed funds in
expectation of higher return to equity-holders.
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II. Debt to Total Capital
Debt to total capital ratio =
Total debt
Permanent capital
Permanent Capital = Shareholders equity +
Long-term debt.
The relationship between creditors funds and owners
capital can also be expressed using Debt to total capital
ratio.
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III. Debt to total assets ratio
Debt to total assets ratio =
Total debt
Total assets
Proprietary ratio indicates the extent to which assets
are financed by owners funds.
Proprietary ratio =
Proprietary funds
Total assets
X 100
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.
Proprietary Ratio
Capital Gearing Ratio
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Coverage Ratio
Interest Coverage Ratio measures the firms ability to make
contractual interest payments.
Interest coverage ratio =
EBIT (Earning before interest and taxes)
Interest
Dividend coverage ratio =
EAT (Earning after taxes)
Preference dividend
Dividend Coverage Ratio measures the firms ability to pay dividend
on preference share which carry a stated rate of return.
Interest Coverage Ratio
Dividend Coverage Ratio
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Total fixed charge coverage ratio measures the firms ability to meet all fixed
payment obligations.
Total fixed charge
coverage ratio
EBIT + Lease Payment
Interest + Lease payments + (Preference dividend
+ Instalment of Principal)/(1-t)
=
Total fixed charge coverage ratio
However, coverage ratios mentioned above, suffer from one major
limitation, that is, they relate the firms ability to meet its various
financial obligations to its earnings. Accordingly, it would be
more appropriate to relate cash resources of a firm to its
various fixed financial obligations.
Total Cashflow Coverage Ratio
Total cashflow
coverage ratio
Lease payment
+ Interest
EBIT + Lease Payments + Depreciation + Non-cash expenses
=
(Principal repayment)
(1 t)
(Preference dividend)
(1 - t)
+
+
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Debt Service Coverage Ratio
Debt-service coverage ratio (DSCR) is considered a more
comprehensive and apt measure to compute debt service capacity
of a business firm.
DEBT SERVICE CAPACITY
DSCR
=
Instalment
t


n
t=1
EAT
t
OA
t

+ +

n
t=1
Depreciation
t

+
Interest
t

Debt service capacity is the ability of a firm to make the
contractual payments required on a scheduled basis over the life
of the debt.
Tata McGraw-Hill Publishing Company Limited, Financial Management
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Agro Industries Ltd has submitted the following projections. You are
required to work out yearly debt service coverage ratio (DSCR)
and the average DSCR.
(Figures in Rs lakh)
Year Net profit for the
year
Interest on term loan
during the year
Repayment of term
loan in the year
1
2
3
4
5
6
7
8
21.67
34.77
36.01
19.20
18.61
18.40
18.33
16.41
19.14
17.64
15.12
12.60
10.08
7.56
5.04
Nil
10.70
18.00
18.00
18.00
18.00
18.00
18.00
18.00
The net profit has been arrived after charging depreciation of Rs 17.68 lakh
every year.
Example 6: Debt-Service Coverage Ratio
Tata McGraw-Hill Publishing Company Limited, Financial Management
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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)
Principal
instalment
Debt
obligation
(col. 4 + col. 6)
DSCR [col. 5
col. 7
(No. of times)]
1 2 3 4 5 6 7 8
1
2
3
4
5
6
7
8
21.67
34.77
36.01
19.20
18.61
18.40
18.33
16.41
17.68
17.68
17.68
17.68
17.68
17.68
17.68
17.68
19.14
17.64
15.12
12.60
10.08
7.56
5.04
Nil
58.49
70.09
68.81
49.48
46.37
43.64
41.05
34.09
10.70
18.00
18.00
18.00
18.00
18.00
18.00
18.00
29.84
35.64
33.12
30.60
28.08
25.56
23.04
18.00
1.96
1.97
2.08
1.62
1.65
1.71
1.78
1.89
Average DSCR (DSCR 8) 1.83
Tata McGraw-Hill Publishing Company Limited, Financial Management
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Profitability Ratio
Profitability ratios can be computed either from
sales or investment.
Profitability Ratios
Related to Sales
Profitability Ratios
Related to Investments
(i) Profit Margin
(ii) Expenses Ratio
(i) Return on Investments
(ii) Return on Shareholders
Equity
Tata McGraw-Hill Publishing Company Limited, Financial Management
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Profit Margin
Gross profit margin measures the percentage of each sales
rupee remaining after the firm has paid for its goods.
Gross profit margin =
Gross Profit
Sales
X 100
Gross Profit Margin
Tata McGraw-Hill Publishing Company Limited, Financial Management
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Net profit margin can be computed in three ways
iii. Net Profit Ratio =
Earning after interest and taxes
Net sales
ii. Pre-tax Profit Ratio =
Earnings before taxes
Net sales
i. Operating Profit Ratio =
Earning before interest and taxes
Net sales
Net profit margin measures the percentage of each sales rupee
remaining after all costs and expense including interest
and taxes have been deducted.
Net Profit Margin
Tata McGraw-Hill Publishing Company Limited, Financial Management
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Example 7: From the following information of a firm,
determine (i) Gross profit margin and (ii) Net profit
margin.
1. Sales
2. Cost of goods sold
3. Other operating expenses
Rs 2,00,000
1,00,000
50,000
(1) Gross profit margin =
Rs 1,00,000
= 50 per cent
Rs 2,00,000
(2) Net profit margin =
Rs 50,000
= 25 per cent
Rs 2,00,000
Tata McGraw-Hill Publishing Company Limited, Financial Management
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Expenses Ratio
i. Cost of goods sold =
Cost of goods sold
Net sales
X 100
ii. Operating expenses =
Administrative exp. + Selling exp.
Net sales
X 100
iii. Administrative expenses =
Administrative expenses
Net sales
X 100
iv. Selling expenses ratio =
Selling expenses
Net sales
X 100
v. Operating ratio =
Cost of goods sold + Operating expenses
Net sales
X 100
vi. Financial expenses =
Financial expenses
Net sales
X 100
Tata McGraw-Hill Publishing Company Limited, Financial Management
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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
ii. Return on Capital Employed (ROCE)
ROCE =
EAT + (Interest Tax advantage on interest)
Average total capital employed
Tata McGraw-Hill Publishing Company Limited, Financial Management
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Return on Shareholders Equity
Return on total shareholders equity =
Net profit after taxes
Average total shareholders equity
X 100
Return on ordinary shareholders equity (Net worth) =
Net profit after taxes Preference dividend
Average ordinary shareholders equity
X 100
Return on shareholders equity measures the return on the
owners (both preference and equity shareholders)
investment in the firm.
Tata McGraw-Hill Publishing Company Limited, Financial Management
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Efficiency Ratio
Activity ratios measure the speed with which various
accounts/assets are converted into sales or cash.
i. Inventory Turnover measures the activity/liquidity of
inventory of a firm; the speed with which inventory is sold
Inventory Turnover Ratio =
Cost of goods sold
Average inventory
i. Inventory Turnover measures the activity/liquidity of
inventory of a firm; the speed with which inventory is sold
Raw materials turnover =
Cost of raw materials used
Average raw material inventory
i. Inventory Turnover measures the activity/liquidity of
inventory of a firm; the speed with which inventory is sold
Work-in-progress turnover =
Cost of goods manufactured
Average work-in-progress inventory
Inventory turnover measures the efficiency of various types
of inventories.
Tata McGraw-Hill Publishing Company Limited, Financial Management
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Liquidity of a firms receivables can be examined
in two ways.
i. Inventory Turnover measures the activity/liquidity of inventory of
a firm; the speed with which inventory is sold
i. Debtors turnover =
Credit sales
Average debtors + Average bills receivable (B/R)
2. Average collection period =
Months (days) in a year
Debtors turnover
i. Inventory Turnover measures the activity/liquidity of inventory of a
firm; the speed with which inventory is sold
Alternatively =
Months (days) in a year (x) (Average Debtors + Average (B/R)
Total credit sales
Ageing Schedule enables analysis to identify
slow paying debtors.
Debtors Turnover Ratio
Tata McGraw-Hill Publishing Company Limited, Financial Management
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Assets Turnover Ratio
i. Inventory Turnover measures the activity/liquidity of inventory of
a firm; the speed with which inventory is sold
i. Total assets turnover =
Cost of goods sold
Average total assets
ii. Fixed assets turnover =
Cost of goods sold
Average fixed assets
i. Inventory Turnover measures the activity/liquidity of inventory of
a firm; the speed with which inventory is sold
iii. Capital turnover =
Cost of goods sold
Average capital employed
iv. Current assets turnover =
Cost of goods sold
Average current assets
i. Inventory Turnover measures the activity/liquidity of inventory of
a firm; the speed with which inventory is sold
v. Working capital turnover =
Cost of goods sold
Net working capital
Assets turnover indicates the efficiency with which firm
uses all its assets to generate sales.
Tata McGraw-Hill Publishing Company Limited, Financial Management
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1) Return on shareholders equity = EAT/Average total shareholders equity.
2) Return on equity funds = (EAT Preference dividend)/Average ordinary
shareholders equity (net worth).
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
shareholders/Number of ordinary shares outstanding (N).
5) Earnings yield = EPS/Market price per share.
6) Dividend Yield = DPS/Market price per share.
7) Dividend payment/payout (D/P) ratio = DPS/EPS.
8) Price-earnings (P/E) ratio = Market price of a share/EPS.
9) Book value per share = Ordinary shareholders equity/Number of equity
shares outstanding.
Tata McGraw-Hill Publishing Company Limited, Financial Management
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Integrated Analysis Ratio
(1) Rate of return on assets (ROA) can be decomposed in to
(i) Net profit margin (EAT/Sales)
(ii) Assets turnover (Sales/Total assets)
(2) Return on Equity (ROE) can be decomposed in to
(i) (EAT/Sales) x (Sales/Assets) x (Assets/Equity)
(ii) (EAT/EBT) x (EBT/EBIT) x (EBIT/Sales) x (Sales/Assets) x
(Assets/Equity)
Integrated ratios provide better insight about financial and
economic analysis of a firm.
Tata McGraw-Hill Publishing Company Limited, Financial Management
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Rate of Return on Assets
EAT as percentage of
sales
Assets
turnover
EAT Sales Divided by Sales Total Assets Divided by
Current assets Fixed assets
Gross profit = Sales less
cost of goods sold
Minus
Expenses: Selling
Administrative Interest
Minus
Income-tax
Shareholder equity
Plus
Long-term borrowed
funds
Plus
Current liabilities
Plus
Alternatively
Tata McGraw-Hill Publishing Company Limited, Financial Management
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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
i. Inventory Turnover measures the activity/liquidity of inventory of
a firm; the speed with which inventory is sold
Earning Power =
Earning after taxes
Sales
Sales
Total Assets
EAT
Total assets
x x x
Tata McGraw-Hill Publishing Company Limited, Financial Management
6 - 47
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.
Table 4: Return on Assets (ROA) of Firms A and B
Particulars Firm A Firm B
1. Net sales
2. Net profit
3. Total assets
4. Profit margin (2 1) (per cent)
5. Assets turnover (1 3) (times)
6. ROA ratio (4 5) (per cent)
Rs 4,00,000
40,000
4,00,000
10
1
10
Rs 40,00,000
40,000
4,00,000
1
10
10
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.
EXAMPLE: 8
Tata McGraw-Hill Publishing Company Limited, Financial Management
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Return on Equity (ROE)
ROE is the product of the following three ratios: Net profit ratio (x)
Assets turnover (x) Financial leverage/Equity multiplier
Three-component model of ROE can be broadened further to
consider the effect of interest and tax payments.
As a result of three sub-parts of net profit ratio, the ROE
is composed of the following 5 components.
i. Inventory Turnover measures the activity/liquidity of
inventory of a firm; the speed with which inventory is sold
EAT
Earnings before taxes
EBT
EBIT
EBIT
Sales
Net Profit
Sales
x
x
=
EAT
EBT
EBT
EBIT
EBIT
Sales
Sales
Assets
Assets
Equity
x x x x
Tata McGraw-Hill Publishing Company Limited, Financial Management
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A 5-way break-up of ROE enables the management of a firm to analyse the effect of interest
payments and tax payments separately from operating profitability. To illustrate further assume 8
per cent interest rate, 35 per cent tax rate and other operating expense of Rs 3,22,462 (Firm A) and
Rs 39,26,462 (Firm B) for the facts contained in Example 8. Table 5 shows the ROE (based on the 5
components) of Firms A and B.
Table 5: ROE (Five-way Basis) of Firms A and B
Particulars Firm A Firm B
Net sales
Less: Operating expenses
Earnings before interest and taxes (EBIT)
Less: Interest (8%)
Earnings before taxes (EBT)
Less: Taxes (35%)
Earnings after taxes (EAT)
Total assets
Debt
Equity
EAT/EBT (times)
EBT/EBIT (times)
EBIT/Sales (per cent)
Sales/Assets (times)
Assets/Equity (times)
ROE (per cent)
Rs 4,00,000
3,22,462
77,538
16,000
61,538
21,538
40,000
4,00,000
2,00,000
2,00,000
0.65
0.79
19.4
1
2
20
Rs 40,00,000
39,26,462
73,538
12,000
61,538
21,538
40,000
4,00,000
2,50,000
1,50,000
0.65
0.84
1.84
10
1.6
16
Tata McGraw-Hill Publishing Company Limited, Financial Management
6 - 50
Common Size Statements
Preparation of common-size financial statements is an extension
of ratio analysis. These statements convert absolute sums into
more easily understood percentages of some base amount. It is
sales in the case of income statement and totals of assets and
liabilities in the case of the balance sheet.
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.
Limitations
Tata McGraw-Hill Publishing Company Limited, Financial Management
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CASE STUDY
Tata McGraw-Hill Publishing Company Limited, Financial Management
6 - 52
From the following selected financials of Reliance Industries Ltd (RIL) for the period 2001-2006, appraise its financial
health from the point of view of liquidity, solvency, and profitability.
Selected financial data and ratios (Amount in Rs crore)
Particulars 2001 2002 2003 2004 2005 2006
(I) Related to Liquidity Analysis
Current assets
Marketable investments
Inventory
Debtors
Advances
Cash and bank balance
Current liabilities
Short-term bank borrowings
Sundry creditors
Interest accrued
Creditors for capital goods
Other current liabilities & provisions

Other data and ratios
Net working capital
Credit sales
Cost of goods sold
Cost of raw material used
Credit purchases
Average debtors
Average creditors
Current ratio
Acid test ratio
Debtors turnover
Creditors turnover
Debtors cycle (days)
Creditors cycle (days)

9,844.48
3387.25
2299.85
1,134.17
2,922.58
100.63
5,312.06
337.76
3,754.50
223.00
104.72
892.08


4,532.42
22,886.51
21,290.91
18,155.98
21,608.85
988.31
3,170.68
1.85
0.87
23
7
16
54

13,025.31
536.80
4976.07
2,722.46
3,310.27
1,760.71
9,830.10
2,148.27
5,847.20
389.23
175.16
1270.24


3,195.21
45,073.88
45,957.85
41,023.35
45,083.06
1,928.31
4,800.85
1.33
0.51
23
9
16
39

17,925.25
536.19
7510.14
2,975.49
6,756.22
147.21
18,160.39
7,193.77
8288.10
380.15
717.48
1580.89


-235.14
49,743.54
54,642.60
50,378.65
56,884.49
2,848.97
7,067.65
0.99
0.20
17
8
21
45

23,245.88
536.11
7,231.22
3,189.93
12,064.38
224.24
16,966.15
9,145.14
366.78
676.45
2,670.75
4,107.03


6,279.73
56,247.03
41,657.92
34,721.39
60,246.91
3,094.02
9,413.58
1.75
.26
17.63
6.40
21
57

28,988.62
536.11
7,412.88
3,927.81
13,503.03
3,608.79
21,934.45
12,684.39
366.95
525.37
3471.80
4,885.94


7,054.17
73,164.10
53,345.03
45,931.87
70,014.80
3,558.87
11,515.6
1.66
.55
18.62
6.08
20
60

24,591.03
16.58
10,119.82
4,163.62
8,144.85
2,146.16
21,441.88
11,438.69
310.42
728.18
3,890.98
2,073.61


3,149.15
89,124.16
65,535.84
58,342.31
68,516.87
4,045.71
12,688.31
1.49
.38
21.40
5.40
17
67
Tata McGraw-Hill Publishing Company Limited, Financial Management
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Particulars 2001 2002 2003 2004 2005 2006
(II) Related to Solvency Analysis
Free reserves
Paid up capital
Preference capital
Bonus equity capital
Total equity
Long-term borrowings
Current liabilities
Total debt
EBIT
Interest
Total debt-equity ratio
Long-term debt-equity ratio
Interest coverage ratio

9,307.89
1,053.49
0.00
481.77
10,843.15
9,798.03
5,312.06
15,110.09
4,032.37
1,215.56
1.39
0.90
3.32

21,834.29
1,395.85
0.00
481.77
23,711.91
16,780.21
9,830.10
26,610.31
6,307.71
1,827.85
1.12
0.71
3.45

23,656.31
1,395.92
0.00
481.77
25,534.00
12,564.54
18,160.39
30,724.93
6,551.17
1,555.40
1.20
0.49
4.21

33,056.50
1,395.95
0.00
481.77
34,934.22
11,149.38
12,955.22
24,104.60
7,735.86
1,434.72
0.69
.31
5.39

39,010.23
1,393.09
0.00
481.77
40,885.09
6,172.98
17,131.52
23,304.50
10,537.34
1,468.66
0.57
.15
7.17

48,411.09
1,393.17
0.00
481.77
50,286.03
8,185.60
16,454.48
24,640.08
11,581.10
877.04
0.49
.16
13.20
(III) Related to Profitability Analysis
Sales (manufacturing)
Cost of goods sold
EBDIT (including other earnings)
EBIT
EBT
EAT
Interest
Average total capital employed
Average total assets
Average equity funds
Gross profit %
Operating profit ratio %
Net profit ratio %
Cost of goods sold ratio %
Rate of return on capital employed (ROCE)
1
ROR (Total assets)
2

ROR (Equity funds)

22886.51
21290.91
5,597.48
4,032.37
2,786.00
2,646.50
1,215.55
19235.95
29622.14
10715.17
24.46
17.62
11.56
93.03
20.07
13.03
24.70

45073.88
45957.85
9,123.85
6,307.71
4,434.17
3,242.17
1,827.84
27,053.32
43,325.86
17,277.53
20.24
13.99
7.19
101.96
18.74
11.7
18.77

49,743.54
54,642.60
9,388.26
6,551.17
4,982.75
4,106.85
1,555.4
34,388.04
60,415.77
24,622.96
18.87
13.17
8.26
109.85
16.47
9.37
16.68

56,247.03
41,657.92
10,982.88
7,735.86
6,301.14
5,160.14
1,434.72
50,030.24
52,764.91
1,396.38
18.41
13.75
9.95
80.34
13.18
12.4
16.26

73.164.10
53,345.03
14,260.84
10,537.34
9,068.68
7,571.68
1,468.66
54,560.80
57,292.51
1,394.94
19.40
14.40
11.48
80.92
16.56
15.77
20.09

89,124.46
65,535.84
14,982.01
11,581.10
10,704.06
9,069.34
877.04
61,738.85
65,428.89
1,393.51
17.43
12.99
11.21
81.03
16.11
15.20
20.08
1. ROCE = (EAT + Interest)/ Average capital employed 2. ROR (Total assets) = (EAT + Interest)/ Average assets
CONTD.
Tata McGraw-Hill Publishing Company Limited, Financial Management
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Solution: The appraisal of financial health of RIL is presented below.
Liquidity Analysis:
The liquidity position of RIL does not appear to be commendable during all the
years under reference. In fact, its current ratio was less than one implying
negative working capital (in 2003) and acid-test ratio was at an alarming low level
of 0.2. Though the current ratio range of 1.33 1.85 (during 2001-2 and 2004-6) is
an indicative of satisfactory liquidity position, the acid-test ratios appear to be
on the lower side, the range being 0.20 0.55 (during 2002-6). The major reason
for the sharp difference in these two liquidity ratios may be ascribed to a
significant proportion of inventory (in current assets).
The other notable observation is that the RIL seems to be banking on bank
borrowings to finance its working capital requirements evidenced by a
substantial increase in such borrowings over the years. From 337.76 crore (in
2001), they steadily increased to 7,193.77 crore (by 2003) and to Rs 11,438.69
crore by 2006: (registering more than 30 times increase in 2006 compared to
2001). In fact, short-term borrowings constitute more than one-half of its total
current liabilities during the 6 year period. The reliance on short-term bank
borrowings, to such a marked extent, is contrary to sound tenets of finance.
Likewise, it appears that its net working capital is inadequate in relation to its
credit sales which stood at Rs. 89,124 crore in 2006 compared to Rs. 73,164
crore in 2005. Contrary to increase in net working capital, however, there has
been a more than 50 per cent decrease in net working capital of the RIL; (the
relevant figures being Rs 7,054.17 crore and Rs 3,149.15 crore in years 2005 and
2006 respectively).
Tata McGraw-Hill Publishing Company Limited, Financial Management
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The RIL has the advantage of much higher creditors payment period
compared to debtors collection period. The debtors collection period (varying
from 16 days in 2001 and 2002 to 21 days in 2004) seems to be at a very
satisfactory level. In marked contrast, the creditors payment period is three-
times (varying in the range of 39-67 days) during the same period. This
favourable gap, provides some leverage to RIL to operate at relatively low
acid-test ratio.
To conclude, the liquidity position of the RIL does not appear to be
satisfactory. It is suggested that RIL should substitute a fair share of short-
term bank borrowings by long-term loans (which have shown sharp decrease
trend over the years). Such a step would help to improve its liquidity ratios.
Solvency Analysis:
The solvency position of the RIL is sound for two reasons: First, it has a
satisfactory level of interest coverage ratio during all the 6 years, being in the
range of 3.32 and 13.2. The RIL is not likely to commit default in payment of
interest to its lenders as even though its operating profits (EBIT) decline by
more than nine-tenth (2006), it l would stil have enough margin to meet its
interest obligations. Secondly, its total debt-equity ratio over the years has
shown a substantial decrease from 1.39 in 2001 to 0.49 by 2006. Likewise, the
long-term debt to equity ratio during over the years has improved
substantially.
Tata McGraw-Hill Publishing Company Limited, Financial Management
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Profitability Analysis:
The profit margins (gross, operating and net) of the RIL over the years have
reduced, albeit recent improvements. For instance gross profit margin has
decreased from 24.46 per cent (in 2001) to 17.43 per cent (in 2006). Likewise
operating profit margins have declined from 17.62 per cent to 12.99 per cent
and net profit margins from 11.56 per cent to 11.21 per cent during these
years. The lower operating profit margins have an unfavourable effect on the
ROR on capital employed. It fell from 20.07 per cent in 2001 to 16.11 per cent
by 2006. However, it is gratifying to note that there has been an increase in
other rates of return. For instance, the ROR on total assets has improved from
13.03 per cent in 2001 to 15.20 per cent in 2006. Likewise a notable increase in
observed in ROR on equity funds. From 16.68 in 2003, it has increased to
more than 20 per cent in 2005 as well as in 2006. There seems to be a
potential for further improvement in its various RORs by increasing its gross
profit and operating profit margins.