Unit II

Financial Analysis
Ratio Analysis
• Ratio analysis is a quantitative method of gaining insight into a
company's liquidity, operational efficiency, and profitability by
comparing information contained in its financial statements.

• Outside analysts use several types of ratios to assess companies,

while corporate insiders rely on them less because of their access to
more detailed operational data about a company.
Characteristics of Ratio Analysis
• When investors and analysts talk about fundamental or quantitative analysis,
they are usually referring to ratio analysis. Ratio analysis involves evaluating the
performance and financial health of a company by using data from the current
and historical financial statements.

• The data retrieved from the statements is used to compare a company's

performance over time to assess whether the company is improving or
deteriorating, to compare a company's financial standing with the industry
average, or to compare a company to one or more other companies operating in
its sector to see how the company stacks up.
Cont….
• Ratio analysis can be used to establish a trend line for one company's
results over a large number of financial reporting periods. This can
highlight company changes that would not be evident if looking at a given
ratio that represents just one point in time.

• Comparing a company to its peers or its industry averages is another useful

application for ratio analysis. Calculating one ratio for competitors in a
given industry and comparing across the set of companies can reveal both
positive and negative information.
Categories of Ratio Analysis
• Liquidity Ratios:
It measure a company's ability to pay off its short-term debts as they come
due using the company's current or quick assets. Liquidity ratios include the
current ratio, quick ratio, and working capital ratio.

• Solvency Ratios:
Also called financial leverage ratios, it compare a company's debt levels with
its assets, equity, and earnings to evaluate whether a company can stay
afloat in the long-term by paying its long-term debt and interest on the debt.
Examples of solvency ratios include debt-equity ratio, debt-assets ratio, and
interest coverage ratio.
Cont….
• Profitability Ratios:
These ratios show how well a company can generate profits from its
operations. Profit margin, return on assets, return on equity, return on
capital employed, and gross margin ratio are all examples of profitability
ratios.

• Efficiency Ratios:
Also called activity ratios, efficiency ratios evaluate how well a company uses
its assets and liabilities to generate sales and maximize profits. Key efficiency
ratios are the asset turnover ratio, inventory turnover, and days' sales in
inventory.
Cont….
• Coverage Ratios:
These ratios measure a company's ability to make the interest payments and
other obligations associated with its debts. The times interest earned
ratio and the debt-service coverage ratio are both examples of coverage
ratios.

• Market Prospect Ratios:

These are the most commonly used ratios in fundamental analysis and
include dividend yield, P/E ratio, earnings per share, and dividend payout
ratio. Investors use these ratios to determine what they may receive in
earnings from their investments and to predict what the trend of a stock will
be in the future.
Importance of Ratio Analysis
• Ratio analysis can provide an early warning of potential improvement or
deterioration in a company’s financial situation or performance. Analysts
engage in extensive number-crunching of the financial data in a company’s
quarterly financial reports for any such hints.

• Successful companies generally have solid ratios in all areas, and any hints
of weakness in one area may spark a significant sell-off of the stock.
Certain ratios are closely scrutinized because of their relevance to a certain
sector, such as inventory turnover for the retail sector and days sales
outstanding (DSOs) for technology companies.
Cont….
• Using any ratio in any of the categories can only be considered as a
starting point. Further analysis using additional ratios and qualitative
analysis should be incorporated to effectively analyze a company's
overall financial position.

• Ratios are usually only comparable across companies in the same

sector, since an acceptable ratio in one industry may be regarded as
too high to too low in another. For example, companies in sectors
such as utilities typically have a high debt-equity ratio which is normal
for its industry, while a similar ratio for a technology company may be
regarded as unsustainably high.
Fund Flow Analysis
• Fund flow analysis is one of the simplest and the basic tools for stock analysis.

• Fund flow analysis helps investors in identifying the key areas of utilization of
funds for a company during any period along with the key sources of those funds.

• Fund flow analysis provides a great help to investors in finding companies, which
are giving loans to promoters/related parties, doing significant capital
expenditure, investments in subsidiaries etc.

• Fund flow analysis is the tool, which lets investors follow the money and bring to
the light a lot of hidden aspects of the promoter/management decisions. This in
turn lets the investor know whether her interests are being cared for by the
company/management.
Cont….
• More importantly, fund flow analysis helps the investors in identifying from
where the company got this money, which it is now giving as loans to
promoters/related parties/subsidiaries etc.

• An investor can easily find out whether the company is giving away the
money, which it earned in profits or it is taking costly loans from banks and
then forwarding this money to promoters/related parties.

• If the company is taking loans from banks to give it to promoters, then an

investor would note that the company is doing so at the cost of public
shareholders. This is because, the benefits of the money are being enjoyed
by the promoters, whereas it will be the company (including public
shareholders) who will have to repay the loan & interest to the banks.
Fund Flow Assessment
• Movement of funds in the company’s balance sheet can be assessed
by doing a comparative assessment of different sections of the
balance sheet. An investor should compare the values of every
section at the reporting date of current year and the previous year
and calculate the change in their values.
Categories of Fund Flow Assessment
• Equities and Liabilities:
In the liabilities section, any increase in an item means that the company has
received funds (inflow), which need to be paid to external parties like:
- shareholders (equity and reserves),
- lenders (long term debt, short term debt etc),
- vendors (trade payables),
- customers (advances from customers usually part of other current
liabilities)
- employees (leaves, gratuity etc. as part of short term provisions)
• Similarly, a decrease in any item in the liability section means that the
funds have gone out (outflow) from the company to third parties to satisfy
the existing liability.
Cont….
• Assets:
In the assets section, any increase in an items means that the company has spent funds (outflow) to
purchase assets, which would generate cash/funds inflow in future like:
- Fixed assets (purchase of plant and machinery)
- Long term loans & advances/Non-current investments (investments in long term financial
products, JVs, subsidiaries etc.)
- Current Investments (investments in short term financial products)
- Inventory (raw material)
- Trade receivables (payment due from customers)
- Cash & equivalents (bank balance)
- Short term loans & advances (loans to related parties, vendors etc.)
• Similarly, a decrease in any item in the assets section means that the funds have come into the
company (inflow) from third parties by way of sale of assets or collection of dues from third
parties.
Case Study
Fund Flow Analysis
• The fund-flow analysis depicts that Ambika Cotton Mills Limited, has received funds of about ₹75.6 crores from:
- reserves (net profits – dividends paid): ₹33.8 crores
- inventory (used in creating goods for sales): ₹20 crores
- fixed assets (depreciation – non cash expense in P&L): ₹14.8 crores
- long term loans & advances (recovered money back, sold long financial products): ₹7 crores

• The analysis also indicates that these funds have been used by the company in the period under analysis (March 2015 to March
2016) in the following manner:
- payment of long term debt: ₹3.7 crores
- payment of short term debt: ₹26 crores
- payment of other current liabilities (primarily current maturity of long term debt and customer advances that are recognized as
sales and therefore removed from balance sheet liabilities: see the section below): ₹13 crores
- payment of trade payables to the vendors: ₹4 crores
- providing credit to customers (trade receivables): ₹12.5 crores
- deposits in banks (cash and equivalents): ₹2 crores
- given as short term loans and advances: ₹2 crores
Fund flow analysis has the potential of highlighting
and early stage identification of cases where
management uses funds generated from the
company (profits/reserves and debt) for its own
benefits in form of loans and advances to group
companies/promoter entities.
• Jan24th
• 5, 12,21,37,40,45,55,57,59,60,65