Financial Statement Analysis –

Ratio Analysis
 Suggested Readings

• PRESCRIBED TEXTBOOK

Brigham and Ehrhardt, Financial Management Theory and

Practice, (14/ed) Cengage Learning.

• OTHER READINGS AND REFERENCES:

I M Pandey, (latest) financial management, Vikas publishing house 11/ed.
Brealey, R., Myers, S. C., Allen, F and Pitabas Mohanty (latest), Principles of Corporate
Finance (11th edition), McGraw Hill.
 Project Guidelines

• FAS WG teams will work on the project.

• All team members must contribute equally. All Groups must select the
industry and five listed companies within the same industry. Out of
the five companies, identify one as base company and rest four will be the
peers.

• Their annual reports (for each of the three most recent fiscal years; you
need to work on their consolidated financial statements (Resources can
be downloaded from the Bloomberg Terminal or Annual Reports).
 Project Guidelines
• Deliverable 1 (5-page Word document with excel file): Ratio analysis
for all the five companies for the last three/four years should be done
and a detailed report with interpretations and implication needs to be
prepared.
• Analysis of dividends declared by firms - For all the firms get the dividends
declaration details for the past 10 years and analyze their dividend policy.
• In Excel (Sheet 1 to Sheet 5), enter the data from Income Statement,
Balance Sheet and Cash Flow Statement for three latest financial years
2019, 2020, 2021 and 2022 from 2018-2019, 2019-2020, 2020-2021 and
2021-2022 annual reports. An annual report has two set of financial
statements, viz. Standalone and Consolidated; but you must use only the
consolidated financial statements data. You must do this for all the five
companies in separate excel files.
 Project Guidelines

• In Excel (Sheet 6 to Sheet 10), Prepare a) Ratio analysis b) Common

Size financial statements – I/S, B/S, CF/S for the three years and c)
Trend Analysis d) DuPont and MVA analysis. You have to do this for all
five companies in separate excel files.

• In Excel (Sheet 11), for three future years (2023 till 2025) a) forecast
financial ratios only for the base company and b) prepare forecasted
financial statements only for the base company.

• Deliverable 2 (1-page Word document with excel file): Assumptions

related to forecasted financial statements.
 Project Guidelines

• Deliverable 2 (2-page Word document with excel file): Impact of

working capital ratios on the profitability of the base company.

• In Excel Spreadsheets
• In Excel (Sheet 12 to Sheet 16), For each of the five companies
calculate the Operating Cycle and Cash Conversion Cycle for the last
three/four FY (2019, 2020, 2021 and 2022 ).

• In Excel (Sheet 17), Using Simple linear regression with the dependent
variable taken as Profit ratio (ROA, ROIC, GOI, NOI etc) and the
independent variable as Working Capital ratio (CCC, OC), analyse the
impact of working capital on the profitability of the base company.
 Financial Statements

• Financial statements provide information about the financial activities and

position of a firm.

• Important financial statements are:

• Balance sheet

• Profit & Loss statement

• Cash flow statement

 Balance Sheet

• Balance sheet indicates the financial condition of a firm at a specific point

of time. It contains information about the firm’s: assets, liabilities and
equity.

• Assets are always equal to equity and liabilities:

Assets = Equity + Liabilities

 Assets

• Assets are economic resources or properties owned by the firm.

• There are two types of assets:

• Fixed assets (Non-Current Assets)

• Current assets
 Current Assets

• Current assets (liquid assets) are those which can be converted into
cash within a year in the normal course of business.

• Cash and bank balance

• Accounts receivable (debtors)
• Inventory (stocks)
• Advances to suppliers
• Prepaid expenses
 Non-Current Assets

• NCA are long-term assets.

• Tangible fixed assets are physical assets like plant.

• Intangible fixed assets are the firm’s rights and claims, such
as patents, copyrights, goodwill etc.
• Gross block represents all tangible assets at acquisition
costs.
• Net block is gross block net of depreciation.
 Liabilities

• Liability is a firm’s obligation to pay cash or provide

goods or services in the future. Two types of
liabilities are:

• Current liabilities
• Long-term liabilities
 Current Liabilities

• Current liabilities are payable within a year in the

normal course of business. They include:

• Accounts payable (creditors)

• Outstanding expenses
• Advances from customers
• Provision for tax
• Provision for dividend
 Long-term Liabilities

• Long-term liabilities are payable after a year.

They include:

• Borrowings from financial institutions and banks

etc.
• Debentures/bonds
 Shareholders’ Funds or Equity

• Share capital is owners’ contribution divided into shares. A

share is a certificate acknowledging the amount of capital
contributed by the shareholder.
• Reserves and surplus or retained earnings are undistributed
profits.
• Shareholders’ funds or equity is the sum of share capital plus
reserves & surplus. It is also called net worth.
 Balance Sheet Relationship

• Total assets (TA) equal net fixed assets (NFA) plus current
assets (CA):
TA = NFA + CA
• Net current assets (NCA) is the difference between current
assets (CA) and current liabilities (CL):

NCA = CA – CL
 Balance Sheet Relationship

• Net assets (NA) equal net fixed assets (NFA) plus net current
assets (NCA):
NA = NFA + NCA
• Capital employed (CE) is the sum of net worth or equity (E) and
borrowing/debt (D) and it is equivalent of net assets:

CE = Net Worth + Borrowing = E + D

Capital Employed = Net Assets
 Functions of Balance Sheet

• Measurement of liquidity

• Measurement of solvency
 Profit & Loss Statement

• Profit & Loss statement provides

information about a firm’s:

• revenues,
• expenses, and
• profit or loss.
 Nature of Revenues

• Revenue is the amount received or

receivable within the accounting period from
the sale of the firm’s goods or services.

• Operating revenue is the one that arises from

main operations of the firm, and the revenue
arising from other activities is called non-
operating revenue.
 Nature of Expenses

• Expense is the amount paid or payable within

the accounting period for generating revenue.

Examples: raw material consumed, salary and

wages, power and fuel, repairs and maintenance,
rent, selling and marketing expenses, administrative
expenses.

• Expenses are expired costs and capital

expenditures represent un-expired costs and
appear as assets in balance sheet.
 Depreciation

• Depreciation is a charge for the use of

fixed assets; it is an expense. It is a non-
cash expense since cash was paid at the
time fixed assets were acquired.
Expenditures incurred on acquiring assets
are called capital expenditures.
Depreciation is allocation of these
expenditures over the life of assets that
have helped in generating revenue.
 Concepts of Profit

Sales – cost of goods sold (COGS)

Gross Profit = COGS = raw material consumed + manufacturing expenses of
goods that have been sold

PBDIT = sales – expenses, except dep., interest and tax

PBIT = PBDIT - Depreciation

PBT = PBIT - Interest

PAT = PBT – Tax

Functions of Income Statement

• Summary of revenues and expenses

• Measurement of profitability
 Cash Flow
• Liquidity refers to resources currently available with the firm. It
is reflected by the funds or cash flows rather than the stock of
current assets and liabilities.

• Cash flow is a change in the firm’s cash position. Cash flows

occur due to changes in items in the balance sheet and profit &
loss statement. Thus, liquidity analysis involves measurement
of changes in assets, liabilities and equity.
Sources and Uses of Funds and Cash
Flows
• Sources of funds or cash flows:
• funds from operations
• sale of fixed assets
• issue of share capital
• borrowings
• Uses of funds are:
• losses
• purchase of fixed assets
• repayment of borrowings
• payment of dividends
 Cash from Operations
• Cash flow from operations
+ PAT (– loss)
+ Depreciation
+ Other non-cash expenses
– Non-cash incomes
+ Loss from the sale of fixed assets
– Gain from the sale of fixed assets
+ Increases in net working capital
– Decreases in net working capital
 Statement of Cash Flows Analysis

Operating Investing Financing General Explanation

Building up pile of cash,
1.
+ + + Possibly looking for
Acquisition

2. + ─ ─ Operating cash flow being

Used to buy fixed assets
And pay down debt

3. + + ─ Operating cash flow and sale of fixed

assets being used to pay down debt.

Operating cash flow and borrowed

4. + ─ + money being used
to expand
 Statement of Cash Flows Analysis

Operating Investing Financing General Explanation

5. ─ + + Operating cash flow problems covered by

sale of fixed assets, borrowing and owner
contributions.

6. Rapid growth, short falls in operating cash

─ ─ +
flow; purchase of fixed assets.

Sale of fixed assets is financing operating

cash flow shortages.
7.
─ + ─
Company is using reserves
to finance cash flow
8. ─ ─ ─ short falls.
 Uses of and Cash Flow Statements
• Liquidity position
• Capital expenditures
• Dividends paid
• Retained earnings
• External financing
• Repayment of loans
• Non-performing assets
Overview: Linking the Financial Statements

2021 Balance Sheet Statement of Cash Flows 2022 Balance Sheet

• Year ended 2022
(I) Cash
Net Change in Cash
Cash

Income Statement Contributed

Contributed • Year ended 2022 Capital
(II) Capital
Net Income Retained Earnings
Retained Earnings
Statement of Shareholders’ Equity
• Year ended 2022
Contributed Capital
(2021)
Retained Earnings
(2021)
+ Net Income
- Dividends Paid
 Financial Statement Analysis Overview
I. Ratio Analysis
II. DuPont system
III. Effects of improving ratios
IV. Limitations of ratio analysis
V. Qualitative factors
 Financial Analysis

• Financial analysis is the process of identifying

the financial strengths and weaknesses of the
firm (to understand the overall business
situation) by properly establishing relationships
between the item of the balance sheet and the
profit and loss account.
 Users of Financial Analysis

• Trade creditors
• Lenders
• Investors
• Management
 Nature of Ratio Analysis

A financial ratio is a relationship between two accounting

numbers. Ratios help to make a qualitative judgment about
the firm’s financial performance.

• Effective in selecting investments and

• Predicting financial distress

 Ratio Analysis
• Ratio Analysis widely used tool of financial analysis.

• Ratio Analysis focuses on how financial statements are

analyzed by management, investors and creditors.

• Ratios facilitate comparison of:

• One company over time
• One company versus other companies
 Ratio Analysis – Five Categories
Ratio Analysis makes use of 5 Categories to measure performance :

1. Financial Condition/Solvency Analysis

2. Profitability Analysis
3. Investment Utilization Analysis
4. Working Capital Analysis
5. Overall Performance Analysis

• Longitudinal Analysis or Trend Analysis – comparison of the ratios of a

firm over time.
• Vertical Analysis – comparison of items within a single year’s financial
statement of a firm.
 Liquidity Ratios
Liquidity ratios measure a firm’s ability to meet its current
obligations

Liquidity ratio: (in times)

a. CR = CA/CL

Conditions :

• Inference : Higher the CR, better the firm performance

• Inference Depends on industry standards
 Liquidity Ratios
Liquidity ratio: (in times)

QR or Acid – Test Ratio = (CA – Inventories – Prepaid

Expenses)/CL

Conditions :

• Inference : Higher the QR, better the firm performance

 Liquidity Ratios
Cash ratio:

Cash ratio = Cash + Marketable securities/CL

Conditions :

• Inference : Cash Ratio of 0.5 to 1 - Good

 Solvency Ratios
Leverage ratio:
Debt
Debt-equity
Debt Ratio = Totalratio =
Liabilities/Total Assets
Equity (Net Worth)
Debt Debt
Debt ratio = =
Debt + Equity Capital employed
Earnings before interest and tax
: coverage =
Interest
Conditions
Interest
• Inference : Lower the Debt/ ratio, less risky is the firm.
 Solvency Ratios
Leverage ratio:
Debt/Equity = (LTB+ STB)/ OE

Conditions :
• Inference : Lower the Debt/Equity, better the firm performance
• Debt can taken as 1) LTB 2) LTB + STB
• OE is Shareholder’s fund (Share Capital + RE)
 Solvency Ratios
Interest Coverage ratio: (in times)
Interest Coverage = EBIT/ Interest expense (Finance cost)

Conditions :
• Inference : Higher the Interest Coverage, better the firm
performance
• Important for Credit Rating
• Also known as Times Interest Earned (TIE) ratio
• Measures the extent to which the operating income can decline
before the firm is unable to meet its annual interest costs.
• Failure to meet this obligation can bring legal action by the firm’s
creditors and result in bankruptcy.
 Profitability Analysis
• Objective of business is to create value for its shareholders,
ROI and sound financial position.

• Top Management and Investors are interested in the overall

performance or broad measures of performance.

• Financial statement analysis should be done on consolidated

basis rather than on standalone basis.

• Question is How to Measure Performance

 Profit Margin Analysis
Format for Profit Margin Analysis
Format for Profit Margin Analysis
 EPS Analysis

• Equity-related ratios measure the shareholders’ return and

value.
• Basic EPS = PAT/ Number of ordinary shares
• Diluted EPS = PAT/(Number of ordinary shares + Additional
shares due to conversion of ESOP & Convertible bonds into
equity shares).
 Equity-related Ratios

• DPS = Dividends / Number of ordinary shares

• Payout ratio = DPS/EPS

= Dividends/Profit after tax
• Dividend yield = DPS/ Market value per share

• Earnings yield = EPS/ Market value per share

 Investment Utilization
Answers as to How well the assets are managed:

• Turnover ratios (in times)

• Numerator is always Total Revenue (Sales Revenue)

Investment Utilization ratios:

a. Asset Turnover = Turnover / TA = Total Revenue / TA
b. Fixed Asset Turnover or Capital Intensity = Turnover / Net PPE
= Total Revenue/ Net PPE
c. Invested Capital Turnover = Turnover /IC = Total Revenue / IC
d. Equity Turnover = Turnover / OE= Total Revenue / OE
 Investment Utilization

a. Asset Turnover = Turnover / TA = Total

Revenue / Average TA

Conditions :
• For Equity and Debt Investors
• Inference: Higher the Asset Turnover, better
the performance of the firm.
 Investment Utilization
b. Fixed Asset Turnover = Turnover / Net Fixed Assets = Total Revenue/ Net
PPE

Conditions :
• For Equity and Debt Investors
• Applicable for Capital goods industry e.g. Manufacturing
• Not computed for Service sectors
• Do not include Capital WIP (B/S); include only productive fixed
assets and exclude intangible assets.
• Inference: Higher the Fixed Asset Turnover, better the
performance of the firm.
 Investment Utilization

c. Invested Capital Turnover = Turnover /IC = Total Revenue / IC

Conditions :
• For Debt & Equity Investors
• Invested Capital (IC) or Capital Employed (CE)
• IC = CE which is Permanent Capital or Long-Term Capital.
TA – CL = OE + LTL
• Inference: Higher the Invested Capital Turnover, better the
performance of the firm.
 Investment Utilization

d. Equity Turnover = Turnover / OE= Total Revenue / OE

Conditions :
• For Equity Investors
• Inference: Higher the Equity Turnover, better the
performance of the firm.
 Working Capital Analysis
Working Capital ratio:
a. Working Capital Turnover = Total Revenue/WC (in times)

b. Inventory Turnover = COGS / Inventory (in times)

c. Days’ Cash = Cash / Daily Cash expense = Cash / (Total cash expense/365) (in days )

d. Days’ Inventory = Inventory/ Daily CGS (in days)

e. Days’ Receivables = A/R / Daily Credit Sales Revenue (in days)

f. Days’ Payables = A/P / Daily CGS (in days)

g. Operating Cycle (OC) = (Days’ Inventory + Days’ Receivables) (in days)

e. Cash Conversion Cycle(CCC)= (Days’ Inventory + Days’ Receivables) – Days’ Payables

(in days)
 Working Capital Analysis
❑ Working Capital Turnover = Total Revenue/WC (in times)

Conditions :
• Higher the WC turnover ratio, better the performance of the firm

❑ Inventory Turnover = COGS / Avg (or Closing) Inventory

(in times)

❑ Days’ Inventory = Inventory (Closing balance from B/S) / Daily COGS

(in days)

Conditions :
• Lower the days’ inventory in days, better the performance of the firm;
as less capital will be blocked
• Daily COGS = (COGS / 365)
 Working Capital Analysis
❑ Debtors/Receivables Turnover = Credit Sales or Net Sales/ Avg (or
Closing) Receivables
(in times)

❑ Days’ Receivables = A/R / Daily Credit Sales Revenue (in days)

Conditions :
• Lower the days’ receivables in days, better the performance of the firm
• Assumption is Operating Revenue is considered as credit sales revenue
• Daily Credit Sales Revenue = (Operating revenue / 365)
• Average Sales per day = (Operating revenue / 365)
 Working Capital Analysis
Days’ Payables = A/P / Daily COGS (in days)
Conditions :
• Higher the days’ payables in days, better the performance of the firm
• Daily COGS = (COGS / 365)

Days’ Cash = Cash / Daily Cash expense

= Cash / (Total cash expense/365) (in days)

Conditions :
• Cash is Cash + Cash Equivalents (marketable securities from B/S)
• Cash expense is Total expense – Depreciation & Amortization – other
non-cash expenses
• Ability of the firm to meet cash expenses in time.
 Working Capital Analysis

• Operating Cycle (OC) = (Days’ Inventory + Days’ Receivables) (in days)

Conditions :
• Lower the OC in days, better the performance of the firm.
• Lower OC indicates better efficiency

• CCC = (Days’ Inventory + Days’ Receivables) – Days’ Payables (in days)

= OC – payment deferral period
Conditions :
• Lower the CCC(Cash Conversion Cycle) in days, better the performance of
the firm.
• Can also be used to measure the WC efficiency of the firm.
• Indicates time period for which additional short-term financing might be needed
to support a spurt in sales.
 Overall Performance Analysis
What is the company’s rate of return on:
• Assets?

Overall Performance Analysis requires to compute return on investment:

a. ROA or ROTA
b. ROIC or ROCE or ROC
c. ROE
d. P/E ratio

Compute tax rate (t):

Effective tax rate (t) = (tax expense / PBT) *100
Tax expense is Current and Deferred tax
(1-t) = tax retention rate
 Overall Performance Analysis
Overall Performance Analysis requires to compute return on
investment:
Variants of returns – EBIT or operating profit; PAT

Variants of investments– Assets, Owner’s Equity, Invested Capital or Capital Employed

• ROA or ROTA = (Returns / Total Assets)*100

= [EBIT (1-t) / Total Assets]*100

• ROIC or ROCE or ROC = (Returns / (OE+LTL))*100

= [EBIT (1-t) / (OE+LTL))*100

• ROE = (Returns / Equity)*100 = (PAT / OE)*100

 Overall Performance Analysis
• ROA or ROTA = (Returns / Total Assets)*100 = [EBIT / Total Assets]*100

Conditions :
• Both for Equity and Debt Investors
• How well management is using the pool of capital or how well an enterprise uses
its funds
• Internal Overall Performance measure
• Should be used for internal comparison only (branch or divisional performance)
• To evaluate individual business units in large companies and for
comparison of divisions when managers do not influence financing decisions
(how assets are financed)
• Used predominantly in Banking and financial services sector for external
comparison
• Inference: Higher the ROA, better the performance of the firm.
 Overall Performance Analysis
• ROIC or ROCE or ROC = (Returns / IC or CE)*100 = [EBIT / IC or CE]*100

Conditions :
• For Equity and Debt Investors
• Should be used for external comparison (compare with
firm’s historical data and compare with industry peers or
industry average)
• Inference: Higher the ROIC, better the performance of the
firm.
 Overall Performance Analysis
• ROE = (Returns / Equity)*100 = (PAT / OE)*100

Conditions :
• For Equity Investors (current and prospective EQ investors)
• Can compare across industries
• Reflects return on funds invested by equity shareholders
• Inference: Higher the ROE, better the performance of the
firm.