Financial and Ratio analysis

Indian Institute of Management Ahmedabad

Adapted from AHM, 13th edition

 Purpose of financial analysis
▶ The purpose of financial analysis is to evaluate financial performance, financial
position and liquidity position of a company.

▶ Such an evaluation is done in 3 ways:

▶ Compare the data/results of the same company over a period of time –

trend analysis

▶ Compare the data with that of other companies/competitor

▶ Compare the data with industry average

 Ratios
▶ How liquid is the company?

▶ Liquidity Ratios

▶ How efficiently are the assets being utilized?

▶ Activity/Turnover/Efficiency Ratios

▶ How profitable is the company?

▶ Profitability Ratios

▶ Possibility of insolvency?

▶ Solvency/Leverage Ratios

▶ How highly is the firm valued by investors?

▶ Shareholder related/Market-value Ratios

 Liquidity ratios
Current Assets
Current Ratio =
Current Liabilities
▶ Short term liquidity of a firm

▶ Its ability to pay-off its Current Liabilities

▶ Rupee of Current Assets available for each rupee of Current Liabilities

▶ Should not be very high, as that may indicate that the funds are blocked in
Current Assets which do not earn any return
 Liquidity ratios
Current Assets − Inventory
Quick ratio =
Current Liabilities
▶ Short term liquidity of a firm

▶ It is a comparatively rigorous test as huge amount may be blocked in

inventories which may have inflated the current ratio

▶ Inventories are considered as the least liquid among the current assets

▶ Current ratio of 2 firms may be same but still one firm may be more liquid
 Liquidity ratios

Cashandcashequivalents + Othermarketablesecurities
Cash ratio =
Current Liabilities

▶ Short term liquidity of a firm

▶ Very rigorous measure

▶ Amount of cash available to meet current liabilities

 Activity/Turnover/Efficiency Ratios
Cost of Goods Sold
Inventory Turnover Ratio =
Average Inventory
365days or 12months
Inventory Holding Period =
ITR

▶ How quickly inventory is sold?

▶ Funds blocked vs. underinvestment in the inventory

 Activity/Turnover/Efficiency Ratios

Credit Sales
Acc.Rec. Turnover Ratio =
Average Accounts Receivable

365days or 12months
Average Collection Period =
ARTR

▶ How quickly Accounts Receivables are converted into cash?

▶ Liberal credit policy/Poor quality of receivables

 Operating cycle
▶ Average collection period + Inventory holding period
 Activity/Turnover/Efficiency Ratios

Credit Purchases
Accounts Payable Turnover Ratio =
Average Accounts Payable

365days or 12months
Average Payment Period =
APTR

▶ How quickly Accounts Payable are converted into cash?

▶ Able to utilize others’ money without an adverse affect to your reputation

 Cash conversion cycle
▶ Average collection period + Inventory holding period – Average payment period
 Activity/Turnover/Efficiency Ratios
Sales
Asset Turnover Ratio =
Average Total Assets
▶ Efficiency in utilization of assets

▶ Sales per rupee of investment

 Profitability Ratios
Gross Profit × 100
Gross Profit Margin =
Sales
▶ High or low Cost of Goods Sold
 Profitability Ratios
PBIT × 100
Operating Profit Margin =
Sales
▶ High or low Operating Expenses
 Profitability Ratios
Net profit × 100
Net Profit Margin =
Sales
▶ High or low Cost of Goods Sold and Operating Expenses

▶ Should be jointly evaluated with Gross Profit Ratio

 Profitability Ratios

EBIT × 100
Return on CapitalEmployed(ROCE ) =
AverageCapitalEmployed

▶ Capital employed is the sum of Owners’ equity and Long-term debt (or Total
Assets - Current Liabilities)

▶ Profitability of investments
 Profitability Ratios

EBIT × (1 − tax ) × 100

Return on InvestedCapital(ROIC ) =
AverageInvestedCapital

▶ Invested Capital is the sum of Owners’ equity and Net Interest bearing debt
(both long and short-term)

▶ EBIT × (1-Tax) is also called as Net operating profit after tax (NOPAT)

▶ A measure of operating returns from invested capital.

 Profitability Ratios
Profit after Tax × 100
Return on Equity =
Average Owners ′ Equity
▶ Are the shareholders earning satisfactory return
 Profitability Ratios

Profit after Tax

Earnings per share(EPS) =
Outstanding equity shares
 Solvency/Leverage Ratio
Total Interest Bearing Debt
DebtAsset Ratio =
Total Assets
▶ High ratio: High risk for lenders and high interest payments

▶ Low ratio: Higher borrowing capacity and lower interest payments

 Solvency/Leverage Ratio
Total Interest Bearing Debt
DebtEquity Ratio =
Owners ′ Equity
▶ High ratio: High risk for lenders and high interest payments

▶ Low ratio: Higher borrowing capacity and lower interest payments

 Solvency/Leverage Ratio

EBIT
Interest Coverage Ratio(Times Interest Earned) =
Interest Expense

▶ Low ratio: High risk for lenders

▶ High ratio: Higher borrowing capacity

 Solvency/Leverage Ratio

Total interest bearing debt

Solvency Ratio(Times EBITDA Earned) =
EBITDA

▶ High ratio: High risk for lenders as it takes longer time to repay the dues

▶ Low ratio: Higher borrowing capacity as the firm generates good operating
earnings to repay the debt
 Shareholder related/Market-value Ratios
Dividend per Share
DividendYield =
Market Price per Share

▶ Current return on the investment

▶ More important for investors desirous of getting regular returns

 Shareholder related/Market-value Ratios
Dividend per Share
Dividend Payout Ratio =
Earning per Share

▶ Percentage of profit paid to the shareholders, and that retained in the business
 Shareholder related/Market-value Ratios
Market Price per Share
PriceEarning Ratio(P/E Ratio) =
Earning per Share

▶ Price currently being paid by the market for every rupee of EPS

▶ High ratio: Firm with growth opportunities and thus valued more
 Shareholder related/Market-value Ratios
Earning per Share
EarningYield =
Market Price per Share

▶ Earnings available on every rupee of investment

 Shareholder related/Market-value Ratios
Owners ′ Equity
Book Value per share =
No. of outstanding equity shares

▶ In India we find companies that have a book value of share which is greater
than market value of shares. This is very rare.
 Shareholder related/Market-value Ratios

Market Price per Share

Market − Book Value Ratio(M/B or P/B) =
Book Value per share

▶ Is the firm worth more than the initial investment?

 Limitations
▶ Benchmarks

▶ In case of a well-diversified company

▶ Availability of industry averages

▶ Price level changes

▶ Assets recorded at book value

▶ Window-dressing

▶ Different accounting policies

▶ Extraordinary years