Financial

Statements
Analysis

Dr Haritika Chhatwal
Financial Statements Analysis

Learning Understand the meaning and rationale of ratio analysis

Objectives Discuss and interpret liquidity ratios
Explain and interpret capital structure ratios
Analyse profitability ratios
Illustrate and interpret efficiency ratios
Identify integrated ratios
Analyse the common size statements
Describe the importance and limitations of ratio analysis
Ratio analysis
❑ Ratio analysis is a systematic use of ratios to interpret/
assess the performance and status of the firm.
❑ 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.
Basis of
Comparison
❑ Trend ratios involve evaluation of financial performance
over a period of time using financial ratio analysis.
• comparison of items within a single year’s financial
statement of a firm, and
• comparison with standards or plans.
❑ Inter-firm comparison involves comparison of different
firms’ financial ratios at the same point of time; involves
comparison of a firm’s ratios to those of others in its
industry or to industry average.
Types of Ratios

• Ratios can be classified into six broad groups:

(i) Liquidity ratios,
(ii) Capital structure/leverage ratios,
(iii) Profitability ratios,
(iv) Activity/Efficiency ratios and
(v) Integrated analysis of ratios.
LIQUIDITY
RATIOS
 Liquidity Ratios
Liquidity ratio is the ability of a firm to satisfy its short-term obligations as
they become due.
The ratios which indicate the liquidity of a firm are:
(i) net working capital,
(ii) current ratios,
(iii) acid test/quick ratios,
(iv) super quick ratios,
(v) turnover ratios,
(vi) defensive-interval ratios and
(vii) cash flow from operations ratio.
Net Working Capital

Net working capital is a measure of

liquidity calculated by subtracting current
liabilities from current assets.
An enterprise should have sufficient NWC
in order to be able to meet the claims of
the creditors and the day-to-day needs of
business. The greater is the amount of
NWC, the greater is the liquidity of the
firm. Accordingly, NWC is a measure of
liquidity. Inadequate working capital is
the first sign of financial problems for a
firm
Net Working Capital

Change in Net Working Capital

Deterioration in the liquidity position. In the first year, the firm had `2 of current assets for each rupee of
current liabilities; but by the end of the second year the amount of current assets for each rupee of
current liabilities declined to `1.5 only, that is, by 25 per cent. For these reasons, NWC is not a
satisfactory measure of the liquidity of a firm for inter-firm comparison or for trend analysis. A better
indicator is the current ratio.
Current ratio

Current ratio is a measure of liquidity

calculated dividing the current assets by the
current liabilities
Current Assets= cash and bank balances,
marketable securities, inventory of raw
materials, semi-finished (work-in-progress)
and finished goods, debtors net of provision
for bad and doubtful debts, bills receivable
and prepaid expenses.
Current Liabilities= trade creditors, bills
payable, bank credit, provision for taxation,
dividends payable and outstanding
expenses.
Rationale

❑ Measures its short-term solvency, that is, its ability

to meet short-term obligations. As a measure of
short-term/current financial liquidity, it indicates
the rupees of current assets (cash balance and its
potential source of cash) available for each rupee
of current liability/obligation payable.
❑ The higher the current ratio, the larger is the
amount of rupees available per rupee of current
liability, the more is the firm’s ability to meet
current ions and the greater is the safety of funds
of short-term creditors.
❑ Thus, current ratio, in a way, is a measure of
margin of safety to the creditors.
The fact that a firm can rarely count on such an even flow requires that the size
of the current assets should be sufficiently larger than current liabilities so that
the firm would be assured of being able to pay its current maturing debt as and
when it becomes due.

Moreover, the current liabilities can be settled only by making payment

whereas the current assets available to liquidate them are subject to shrinkage
for various reasons, such as bad debts, inventories becoming obsolete or
unsaleable and occurrence of unexpected losses in marketable securities and
so on.

The current ratio measures the size of the short-term liquidity ‘buffer’. A
satisfactory current ratio would enable a firm to meet its obligations even when
the value of the current assets declines.
Interpretation
In the case of company A in the above example, the current ratio is 1.5 : 1. It implies that for every one rupee of current
liabilities, current assets of one-and-half rupees are available to meet them. In other words, the current assets are one-
and-half times the current liabilities.

The current ratio of 3 : 1 for company B signifies that current assets are three-fold its short-term obligations. The liquidity
position, as measured by the current ratio, is better in the case of B as compared to A.

This is because the safety margin in the B (200 per cent) is substantially higher than in the A (50 per cent). A slight decline
in the value of current assets will adversely affect the ability of firm A to meet its obligations and, therefore, from the
viewpoint of creditors, it is a more risky venture. In contrast, there is a sufficient cushion in firm B and even with two-thirds
shrinkage in the value of its assets, it will be able to meet its obligations in full.

For the creditors the firm is less risky. The interpretation is: in interfirm comparison, the firm with the higher current ratio
has better liquidity/short-term solvency.
Rule of Thumb and factors affecting CR

Development of the capital market and Availability of long-term funds to finance current assets : Capital-
rich countries, where long-term funds from the capital market are available in abundance, firms depend
on current liabilities for financing a relatively small part of their current asset requirements and it is not
unusual for a firm to finance two-thirds to three-quarters of its current assets by long-term sources.

Nature of industry : Public Utility companies generally have a very low current ratio, as normally such
companies have very little need for current assets. The wholesale dealers, on the other hand, purchasing
goods on cash basis or on credit basis for a very short period but selling to retailers on credit basis,
require a higher current ratio.
Acid-Test/Quick Ratio

❑Acid-test ratio (quick ratio) is a measure of liquidity calculated

dividing current assets minus inventory and prepaid expenses by
current liabilities.
❑One weakness of the current ratio is that it fails to convey any
information on the composition of the current assets of a firm
❑The acid-test ratio is a measure of liquidity designed to overcome this
shortcoming of the current ratio. It is often referred to as quick ratio
because it is a measurement of a firm’s ability to convert its current
assets quickly into cash in order to meet its current liabilities.
 Compute Current Ratio and Acid Test Ratio

❑ Generally, an acid-test ratio of 1:1 is considered satisfactory as a firm can easily meet all current
claims. In the case of the hypothetical firm the quick ratio (0.5 : 1) is less than the standard/norm,
the satisfactory current ratio notwithstanding. The interpretation that can be placed on the current
ratio (2 : 1) and acid-test (0.5 : 1) is that a large part of the current assets of the firm is tied up in
slow moving and unsaleable inventories and slow paying debts. The firm would find it difficult to
pay its current liabilities.
❑ The acid-test ratio provides, in a sense, a check on the liquidity position of a firm as shown by its
current ratio. The quick ratio is a more rigorous and penetrating test of the liquidity position of a
firm. Yet, it is not a conclusive test. Both the current and quick ratios should be considered in
relation to the industry average to infer whether the firm’s short-term financial position is
satisfactory or not.
 Turnover Ratio
❑ To determine how quickly certain current assets are
converted into cash. The ratios to measure these are referred
to as turnover ratios. These are, as activity ratios, Acid-test
ratio (quick ratio) is a measure of liquidity calculated dividing
current assets minus inventory and prepaid expenses by
current liabilities.
❑ Poor debtor or inventory turnover ratios limit the usefulness
of the current and acid-test ratios.
❑ Both obsolete/unsaleable inventory and uncollectible
debtors are unlikely to be sources of cash. Therefore, the
liquidity ratios should be examined in conjunction with
relevant turnover ratios affecting liquidity.
❑ The three relevant turnover ratios are (i) inventory turnover
ratio; (ii) debtors turnover ratio; and (iii) creditors turnover
ratio.
 Inventory Turnover Ratio It is computed by dividing
the cost of goods sold by the 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.
EXAMPLE
A firm has sold goods worth `300 lakh with a gross profit margin of 20 per cent. The stock at the
beginning and the end of the year was `35 lakh and `45 lakh respectively. What is the inventory
turnover ratio?
Debtors Turnover Ratio It is determined by dividing
the net credit sales by average debtors outstanding
during the year.
EXAMPLE
A firm has made credit sales of `240 lakh during the year. The
outstanding amount of debtors at the beginning and at the
end of the year respectively was `27.5 lakh and `32.5 lakh.
Determine the debtors turnover ratio
 Creditors Turnover Ratio :It is a ratio between net
credit purchases and the average amount of
creditors outstanding during the year.
A low turnover ratio reflects liberal credit terms granted by suppliers,
while a high ratio shows that accounts are to be settled rapidly.
Defensive interval ratio is the ratio between quick
assets and projected daily cash requirement.

Alternatively, a very rough estimate of cash operating expenses can be obtained by subtracting the
non-cash expenses like depreciation and amortization from total expenses. Liquid assets, as already
stated, include current assets excluding inventory and prepaid expenses.
The defensive-interval ratio measures the timespan a firm can operate on present liquid assets
(comprising cash, marketable securities and debtors) without resorting to next year’s income.
❑The figure of 80 days indicates that the firm has liquid
assets which can meet the operating cash requirements
of business for 80 days without resorting to future
revenues.
❑A higher ratio would be favourable as it would reflect the
ability of a firm to meet cash requirements for a longer
period of time.
❑ It provides a safety margin to the firm in determining its
ability to meet basic operational costs.
❑A higher ratio would provide the firm with a relatively
higher degree of protection and tends to offset the
weakness indicated by low current and acid-test ratios.
❑Many authors have also suggested a ratio of liquid assets
to daily cash operating expenditure as a measure of
short-term solvency.
 Cash-Flow From Operations Ratio
• This ratio measures liquidity of a firm by comparing actual cash flows
from operations (in lieu of current and potential cash inflows from
CAs such as inventory and debtors) with current liability.

Being a cash measure, the ratio does not encounter the problems of actual convertibility of current assets
(such as debtors and inventory) and the need for maintaining minimum levels of these assets. In general, the
higher the ratio, the better is a firm from the point of view of liquidity.
Are high ratios always desirable ????
❑ High current and acid-test ratios would imply that funds have unnecessarily accumulated and are not
being profitably utilized.
❑ Similarly, an unusually high rate of inventory turnover may indicate that a firm is losing business by
failing to maintain an adequate level of inventory to serve the customer’s needs.
❑ A rapid turnover of debtors may reflect strict credit policies that hold revenue below levels that could
be obtained by granting more liberal credit terms.
❑ Finally, while interpreting the short-term position of the firm by the creditors, it should be recognised
that the management may be tempted to indulge in ‘window-dressing’ just before the financial
statements are prepared so as to make the current financial position appear better than what it
actually is. For instance, by postponing purchases, allowing inventories to fall below the normal levels,
using all available cash to pay off current liabilities and pressing collection on debtors, the current and
acid-test ratios, and debtors turnover ratios may be artificially improved. Even when no deliberate
attempt has been made to present a good picture, the current financial position shown by the year-
end financial statements is probably more favourable than at any other time of the year. This is
particularly true when a firm adopts a natural business year that ends during an ebb in the seasonal
swing of business activity. At the time of peak activity, debtors, inventories and current liabilities tend
to be at higher levels. In such cases, an analysis of current financial position based solely on year-end
data will tend to over-state a firm’s average liquidity position.12
 Is management tempted to indulge in ‘window-dressing’ just
before the financial statements are prepared so as to make the
current financial position appear better than what it actually
is???
• Postponing purchases, allowing inventories to fall below the normal levels
• Using all available cash to pay off current liabilities and pressing collection on
debtors, the current and acid-test ratios, and debtors turnover ratios may be
artificially improved.
• Even when no deliberate attempt has been made to present a good picture, the
current financial position shown by the year-end financial statements is
probably more favourable than at any other time of the year.
• This is particularly true when a firm adopts a natural business year that ends
during an ebb in the seasonal swing of business activity.
• At the time of peak activity, debtors, inventories and current liabilities tend to be
at higher levels.
• In such cases, an analysis of current financial position based solely on year-end
data will tend to over-state a firm’s average liquidity position.
Leverage/Capital
Structure Ratios
 Leverage/Capital Structure Ratios- long-term
solvency
• The long-term lenders/creditors would judge the soundness of a firm
on the basis of the long-term financial strength measured in terms of its
ability to pay the interest regularly as well as repay the instalment of the
principal on due dates or in one lump sum at the time of maturity.
• The long-term solvency of a firm can be examined by using leverage
or capital structure ratios. The leverage or capital structure ratios may
be defined as financial ratios which throw light on the long-term
solvency of a firm as reflected in its ability to assure the long-term
lenders with regard to (i) periodic payment of interest during the
period of the loan and (ii) repayment of principal on maturity or in
predetermined instalments at due dates.
These ratios are computed from the balance sheet and have many
variations such as
(a) debt-equity ratio,
(b) debt-assets ratio,
(c) equity-assets ratio, and so on.
The second type of capital structure ratios, popularly called coverage
ratios, are calculated from the profit and loss account. Included in this
category are
(a) interest coverage ratio,
(b) dividend coverage ratio,
(c) total fixed charges coverage ratio,
(d) cash flow coverage ratio, and
(e) debt services coverage ratio.
 Debt-equity ratio- measures the ratio of long-
term or total debt to shareholders equity.
The former excludes current
liabilities , the latter includes them in
the numerator (debt).
❑This ratio reflects the relative claims of creditors and shareholders against the assets of
the firm.
❑This ratio indicates the relative proportions of debt and equity in financing the assets
of a firm.
❑The relationship between outsiders’ claims and owner’s capital can be shown in
different ways and, accordingly, there are many variants of the debt-equity (D/E) ratio.
❑The shareholders’ equity includes (i) equity and preference share capital, (ii) past
accumulated profits but excludes fictitious assets like past accumulated losses, (iii)
discount on issue of shares and so on.
❑For one thing, individual items of current liabilities are certainly short-term and may
fluctuate widely, but, as a whole, a fixed amount of them is always in use so that they
are available more or less on a long-term footing.
❑Moreover, some current liabilities like bank credit, which are ostensibly short-term,
are renewed year after year and remain by and large permanently in the business.
❑Also, current liabilities have, like the long-term creditors, a prior right on the assets
of the business and are paid along with long-term lenders at the time of liquidation
of the firm.
❑Finally, the short-term creditors exercise as much, if not more, pressure on
management. The omission of current liabilities in calculating the D/E ratio would
lead to misleading results.
❑If the object is to examine the financial solvency of a firm in terms of its ability to
avoid financial risk, preference capital should be clubbed with equity capital. If,
however, the D/E ratio is calculated to show the effect of the use of fixed-
interest/dividend sources of funds on the earnings available to the ordinary
shareholders, preference capital should be clubbed with debt
 Interpretation
❑The D/E ratio indicates the margin of safety to the creditors. If, for instance, the D/E
ratio is 1 : 2, it implies that for every rupee of outside liability, the firm has two rupees
of owner’s capital or the stake of the creditors is one-half of the owners. There is,
therefore, a safety margin of 66.67 per cent available to the creditors of the firm.
❑f the D/E ratio is high, the owners are putting up relatively less money of their own. It
is danger signal for the creditors. With a small financial stake in the firm, the owners
may behave irresponsibly indulge in speculative activity.
❑A high proportion of debt in the capital structure would lead to inflexibility in the
operations of the firm as creditors would exercise pressure and interfere in
management.
❑A firm would be able to borrow only under very restrictive terms and conditions.
Further, it would have to face a heavy burden of interest payments, particularly in
adverse circumstances when profits decline.
❑Finally, the firm will have to encounter serious difficulties in raising funds in future
Trading on equity (leverage) is the use of borrowed funds
in expectation of higher return to equity holders.
❑High and low D/E ratios not desirable. Required is a ratio which strikes a proper balance
between debt and equity. It will depend upon the circumstances, prevailing practices and so
on. The general proposition is: “other’s money should be in reasonable proportion to the
owner’s capital and the owners should have sufficient stake in the fortunes of the enterprise”.
❑Capital-rich country, (use as little debt as possible). A D/E ratio of 1 : 3 is regarded as
indicative of a fairly heavy debt; a ratio Trading on equity (leverage) is the use of borrowed
funds in expectation of higher return to equity holders of 1 : 1 would indicate an extremely
heavy and unsatisfactory debt situation.
❑ In underdeveloped countries such standards cannot be expected. It was not unusual to find
firms having a D/E ratio of 2 : 1 or even 3 : 1 in the case of joint stock enterprises in India.
❑One reason for such heavy dose of debt was to be found in the fact that enterprises had to
depend, by and large, on public financial institutions (PFIs) which provided most of the funds
in the form of loans. This had made the financial structure of companies lopsided and, on
canons of sound financing practices, highly imprudent. The borrowers were finding it
extremely difficult to service the debt burden and the over-dues of the financial institutions
rose unabated.
❑ With the shift in the post-1991 period of dependence of the corporates on the capital
market, their dependence on loans/debt has significantly declined.
• Secondly, the D/E ratio cannot be applied mechanically
without regard to the circumstances of each case, such as
type and size of business, the nature of the industry and the
degree of risk involved.
• For example, firms having a stable income such as an
electricity company, can afford to have a higher D/E ratio.
Similarly, capital intensive industries and firms producing a
basic product, like cement, tend to use a larger proportion
of debt. The tolerable D/E ratio of a new company would be
much lower than for an established one.
• Finally, there is an important issue whether to use book or
market values to compute leverage ratio.
• Valuation models in finance are generally based on the market
value of debt and equity. Therefore, the use of market values
can make the D/E ratio a more useful analytical tool. For
instance, if the market value of equity is higher than its book
value, the market value based D/E ratio will be lower than the
one using book value. This would imply that the firm can raise
funds at attractive financial costs. The financial costs would be
higher if the market value of equity is lower than its book value
as equity capital can be issued at a discount to book value.
Debt to Total Capital Ratio-The relationship between
creditors’ funds and owner’s capital can also be expressed
in terms of another leverage ratio.
• This is the debt to total capital ratio. Here, the outside liabilities
are related to the total capitalisation of the firm and not merely
to the shareholder’s equity.

Calculating the debt to capital ratio is to relate the total debt to the total assets of the firm. The
total debt of the firm comprises long-term debt plus current liabilities. The total assets consist of
permanent capital plus current liabilities.
 Proprietary ratio indicates the extent to which
assets are financed by owners funds.
❑The ratio indicates the proportion of total assets financed by owners.
❑Finally, it may also be of some interest to know the relationship
between equity funds (also referred to as net worth) and fixed-income
bearing funds (preference shares, debentures and other borrowed
funds).
❑This ratio, called the capital gearing ratio, is useful when the objective
is to Proprietary ratio indicates the extent to which assets are financed
by owners funds show the effect of the use of fixed-interest/dividend
source of funds on the earnings available to the equity shareholders.
Interpretation
❑Although no hard and fast rules exist, conventionally a ratio of
1 : 2 is considered to be satisfactory.
❑The second ratio measures the share of the total assets financed
by outside funds. The third variant shows what portion of the
total assets are financed by the owner’s capital. A low ratio of
debt to total assets is desirable from the point of the creditors/
lenders as there is sufficient margin of safety available to them.
But its implications for the shareholders are that debt is not
being exploited to make available to them the benefit of trading
on equity. A firm with a very high ratio would expose the
creditors to higher risk.
 Coverage Ratios : measure the firm’s ability to
pay certain fixed charges
❑The soundness of a firm, from the view-point of long-term creditors, lies in
its ability to service their claims. This ability is indicated by the coverage
ratios. The coverage ratios measure the relationship between what is
normally available from operations of the firms and the claims of the
outsiders.
❑ The important coverage ratios are:
(i) interest coverage,
(ii) dividend coverage,
(iii) total coverage,
(iv) total cashflow coverage, and
(v) debt service coverage ratio.
 Interest Coverage Ratio:measures the firm’s ability
to make contractual interest payments

❑An interest coverage of 10 times would imply that even if the firm’s EBIT were to decline
to one-tenth of the present level, the operating profits available for servicing the interest
on loan would still be equivalent to the claims of the lenders.
❑From the point of view of the lenders, the larger the coverage, the greater is the ability of
the firm to handle fixed-charge liabilities and the more assured is the payment of interest
to them.
❑However, too high a ratio may imply unused debt capacity.
❑In contrast, a low ratio is a danger signal that the firm is using excessive debt and does
not have the ability to offer assured payment of in
Dividend Coverage Ratio: It measures the ability of a firm to pay dividend on preference shares
which carry a stated rate of return.

Total fixed charge coverage ratios :measure the firm’s ability to meet all fixed payment
obligations.

Total Cashflow Coverage Ratio: These payments are met out of cash available with the
firm. Accordingly, it would be more appropriate to relate cash resources of a firm to its
various fixed financial obligations. The ratio, so determined, is referred to as total cash flow
coverage ratio.
• Capital Expenditure Ratio : measures the relationship between the firm’s ability to generate CFO and
its capital expenditure requirements. It is determined dividing CFO by capital expenditure. The higher
the ratio, the better it is. The ratio greater than one indicates that the firm has cash to service debt as
well as to make payment of dividends.
• Debt-Service Coverage Ratio (DSCR): It is comprehensive and apt measure to compute debt service
capacity of a business firm. It provides the value in terms of the number of times the total debt service
obligations consisting of interest and repayment of principal in instalments are covered by the total
operating funds available after the payment of taxes: Earnings after taxes, EAT + Interest +
Depreciation + Other non-cash expenditures like amortisation (OA).

The higher the ratio, the better it is. A ratio of less than one may be taken as a sign of long-term
solvency problem as it indicates that the firm does not generate enough cash internally to service
debt. In general, lending financial institutions consider 2:1 as satisfactory ratio.
 Profitability Ratios
Profitability ratios can be determined on the basis of either sales or
investments. The profitability ratios in relation to sales are
(a) profit margin (gross and net) and
(b) expenses ratio.
Profitability in relation to investments is measured by
(a) return on assets,
(b) return on capital employed, and
(c) return on shareholders’ equity.
Profit Margin – Gross and Net Profit Margin
• Gross Profit Margin
• Net Profit Margin: measures the percentage of each sales rupee
remaining after all costs and expenses including interest and
taxes have been deducted.
❑A high net profit margin would ensure adequate return to the
owners as well as enable a firm to withstand adverse economic
conditions when selling price is declining, cost of production is
rising and demand for the product is falling.
❑A low net profit margin has the opposite implications. However,
a firm with a low profit margin, can earn a high rate of return on
investments if it has a higher inventory turnover.
❑The profit margin should, therefore, be evaluated in relation to
the turnover ratio. In other words, the overall rate of return is the
product of the net profit margin and the investment turnover
ratio. Similarly, the gross profit margin and the net profit margin
should be jointly evaluated.
 Expenses Ratio :It is computed by dividing
expenses by sales.

Operating ratio+operating profit ratio=1. A low operating ratio is by and large a test of operational
efficiency. In case of firms whose major source of income and expenses are non-operating, the
operating ratio, however, cannot be used as a yardstick of profitability
❑The assets turnover ratio, howsoever defined, measures the efficiency of a firm in
managing and utilising its assets.
❑The higher the turnover ratio, the more efficient is the management and utilisation of the
assets while low turnover ratios are indicative of underutilisation of available resources
and presence of idle capacity.
❑In operational terms, it implies that the firm can expand its activity level (in terms of
production and sales) without requiring additional capital investments.
❑In the case of high ratios, the firm would normally be required, other things being equal,
to make additional capital investments to operate at higher level of activity.
❑To determine the efficiency of the ratio, it should be compared across time as well as with
the industry average. In using the assets turnover ratios one point must be carefully kept
in mind.
❑The concept of assets/fixed assets is net of depreciation.
❑As a result, the ratio is likely to be higher in the case of an old and established company
as compared to a new one, other things being equal.
❑The turnover ratio is in such cases likely to give a misleading impression regarding the
relative efficiency with which assets are being used. It should, therefore, be cautiously used.
Profitability Ratios Related to Investments

❑Return on investments (ROI) measures the overall effectiveness

of management in generating profits with its available assets.
❑There are three different concepts of investments in vogue in
financial literature: assets, capital employed and shareholders’
equity. Based on each of them, there are three broad categories
of ROIs. They are (i) return on assets, (ii) return on capital
employed and (iii) return on shareholders’ equity.
 Return on Assets (ROA) :The ROA may also be
called profit-to-asset ratio.
• The concept of net profit may be (i) net profits after taxes, (ii) net
profits after taxes plus interest, and (iii) net profits after taxes plus
interest minus tax savings. Assets may be defined as (i) total assets, (ii)
fixed assets, and (iii) tangible assets.
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑆𝑎𝑙𝑒𝑠
= 𝑋
𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠

❑Net Profit X Asset Turnover Ratio

❑How well a company utilises its assets in
terms of profitability .
❑It gives an idea to the investor as to how
efficient is the management in using its
assets to generate earnings
 Return on Assets (ROA) :The ROA may also
be called profit-to-asset ratio.
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑆𝑎𝑙𝑒𝑠
= 𝑋
𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠

❑Net Profit X Asset Turnover Ratio

❑How well a company utilises its assets in terms of profitability .
❑It gives an idea to the investor as to how efficient is the management in
using its assets to generate earnings
• These measures, however, may not provide correct results for inter-
firm comparisons particularly when these firms have markedly
varying capital structures as interest payment on debt qualifies for
tax deduction in determining net taxable income. Therefore the
effective cash outflows is less than the actual payment of interest by
the amount of tax shield on interest payment. As a measure of
operating performance,

This equation correctly reports the operating efficiency of firms as if they are all
equity-financed.
Limitation: It, however, throws no light on the profitability of the different sources
of funds which finance the total assets. These aspects are covered by other ROIs.
 Return on Equity
Return on Equity measures a company’s profitability in relation to
shareholders equity
A good rule of thumb is to target an ROE that is equal to or just
above the average for the peer group.

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐸𝑞𝑢𝑖𝑡𝑦
 Return on Equity DUPONT
Net Profit Margin X Asset Turnover X Financial Leverage
Affected by Margins
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝑋 𝑋
𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡
reflects operational efficiency
𝑆𝑎𝑙𝑒𝑠

𝑆𝑎𝑙𝑒𝑠
if the company is able to generate more sales on the same asset base . This
𝐴𝑠𝑠𝑒𝑡𝑠
is the concept of deleveraging. This is also known as operating Leverage .

𝐴𝑠𝑠𝑒𝑡𝑠
is financial Leverage . It is also known as Equity Multiplier.
𝐸𝑞𝑢𝑖𝑡𝑦
𝐴𝑠𝑠𝑒𝑡𝑠
is financial Leverage . It is also known as Equity Multiplier.
𝐸𝑞𝑢𝑖𝑡𝑦

Liabilities +Equity Assets

Equity 80

Debt 40 Assets 120

Total 120 120

In the current case the financial leverage is 120/80.

The financial leverage can increase in 2 situations
❑If the company Buyback its shares as the reserves will go down. The denominator
will fall leading to increase in financial leverage
❑If the assets are increasing and the equity remains constant , it implies it is being
financed by the debt
❑Note – Increasing ROE may not be always good !
 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝑋 𝑋
𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
❑If the reserves are going up it implies that Margins are improving i.e NP Margin is
improving but the increase in reserves will lead to decrease in financial lev as the
equity goes up.
❑There might be operating deleveraging . But that is also upto a certain point i.e
after achieving 100% capacity operating leverage is useless.
❑If the company s efficiently able to use debt it’s the best thing. Banks always work
on debt .
❑If the company uses debt for capex the operating leverage will decrease as
denominator is going up
❑Some cos may have constant fixed asset turnover ratio after capex as it has not
become operational as they , may require some approvals for operations ex
=Laurus labs.(2017-2019)
• Whenever a co puts extra capex it has challenge how to convert
capex into sales .Will the co achieve operational efficiency
• Will the market absorb the production? Will net margins increase ?
• If the company is not able to efficiently generate margins by use of
assets through employment of debt , you will immediately see it in
the balance sheet
•
Return on Capital Employed (ROCE)
 ROCE
• A financial ratio that can be used to assess a company's
profitability and capital efficiency.
• Hygiene of return on capital employed gets reflected much
more vividly in balance sheet rather than P & L statement
• Helps to understand how well a co is generating profit from its
capital as it is put to use.
• To a large extent balance sheet is a greater reality than what
a profit and loss statement would imply
How to use and interpret ROCE?
❑A comparatively higher ROCE indicates that a company has been able to utilise
its capital more efficiently
❑Since the ROCE ratio considers debt and other liabilities instead of only
profitability of a company, it helps in comparing companies within capital-
intensive sectors, such as telecom and power.
❑A company that shows a stable ROCE over many years is considered having
excellent performance. Investors mostly prefer such companies that reflect a
consistent rise in ROCE as against those which show fluctuating ROCE.
❑It is important to note, for investors, that comparing only ROCE results of two
companies may not offer a holistic picture about the company’s performance.
Therefore, they must consider other factors that are part
of fundamental and technical analysis.
Assume that:
1. company ABC has an EBIT of Rs. 200 crores in a financial year.
2. company XYZ has an EBIT of Rs. 150 crores in the same financial year.
• One may interpret this as company ABC having a better investment, since its EBIT is higher. However, this
is not the right interpretation as far as the profitability of the company is concerned. To understand these
figures correctly, one must look at the ROCE of both these companies.
Advantages and Disadvantages of ROCE
Some of the advantages of ROCE are:
• ROCE helps in capturing the monetary returns on equity and debt. Thus, it is used by
investors as a criterion for establishing an investment portfolio and designing
investment strategies.
• It can be used in comparing companies that have different capital structures. Thus, it is
a good tool that can be used by companies for peer comparison.
Here are a few of the limitations of ROCE
• ROCE is prone to the risk of accounting manipulation, resulting in elevated returns. One
such example is classifying long-term liabilities as current liabilities.
• Since this ratio is based on book value, the returns may not be reflective of the market
value. As the company’s assets depreciate, the ROCE goes up despite cash flows
remaining constant. This means that businesses that are older and have depreciated
assets will have higher ROCEs as compared to new companies.
Example of Return on Capital Employed

• Return on Capital Employed (ROCE) is a financial metric used to

measure the efficiency and profitability of a company. A simple
example could be:
• A company has a capital employed (total assets minus current
liabilities) of Rs. 100 crore and generates a profit of Rs. 20 crore in a
year. The ROCE for the company would be 20% (20 crore / 100
crore). This means the company is generating 20% return on every
rupee invested in the business.
Conclusion

• As we have seen, ROCE is one of the important financial metrics

that can be used by investors to assess the overall return from
investing in a company. It overcomes the drawbacks of changing
capital structures. However, investors must note that this ratio too
is vulnerable to certain accounting misrepresentation. Therefore,
one must be vigilant while using ROCE to analyse companies.
 What is ROIC vs ROCE?
Understanding financial ratios such as ROCE vs ROIC is important to
investors in determining the viability of an investment. ROIC is the net
operating income divided by invested capital. ROCE, on the other hand, is
the net operating income divided by the capital employed.

Invested capital is the amount of capital that is circulating in the business while capital employed is the
total capital it has. Invested capital is, therefore, a subset of capital employed. Capital employed
includes every aspect of capital in the entity, such as debts and shareholders’ capital. Invested capital
includes the active capital in circulation, and it excludes non-active assets, especially those outside the
business, such as securities held in other companies.
What is ROIC?
ROIC is an abbreviation for Return on Invested Capital. ROIC is a profitability ratio
that measures the returns that investors earn from the capital they’ve invested in
a company. It shows how efficiently the company is using the funds provided by
the investors to generate income for the business.
The invested capital is a subset of employed capital, and it is the percentage of
capital that is actively invested in the business. ROIC is calculated by obtaining the
Net Profit After Tax (Net income – Dividends) divided by invested capital.

Invested capital may be either:

Net Working Capital + Property Plant and Equipment (PP&E) + Goodwill and
Intangibles
or
Total Debt and Leases + Total Equity and Equity Equivalents + Non-Operating Cash
and Investments
The invested capital is generally a more detailed analysis of a firm’s overall capital.
Why Is ROCE Useful If We Already Have ROE and ROA
Measures?
Some analysts prefer ROCE over return on equity and return on
assets because the return on capital considers both debt and
equity financing. These investors believe the return on capital is
a better gauge for the performance or profitability of a company
over a more extended period of time.

ROCE = EBIT/ Debt+Equity

ROIC =EBIT(1-T) or NOPAT/(Debt+Equity-Investment-Cash)
 ROCE
❑ROCE is based on capital employed, which is
broader than invested capital on which ROIC is
anchored. Therefore, the scope of ROCE is
more extensive than ROIC, since the former
considers the total capital employed, which is a
total of debt and equity financing less short-
term liabilities.
❑A company is said to be profitable or utilizing
the capital effectively if the ROCE is greater than effectively.
the cost of capital.
❑ROCE is based on pre-tax figures
❑ROCE is more relevant from the company’s
perspective,
❑ROCE becomes most suitable for use in
comparison purposes between companies in
different countries or tax systems.
ROIC
❑ROIC is more refined, and it calculates the
return of a company according to the capital
that is actively circulating in the business.
❑In the case of ROIC, a company can be
described as profitable if the ROIC value is
greater than zero. When ROCE is below the cost
of capital or the ROIC is negative, it shows that
the company has not used invested capital
❑ROIC is based on after-tax figures.
❑ ROIC is more relevant from the investor’s
perspective because it gives them an indication
of what they are likely to get as dividends.
❑ROIC, nonetheless, can be used in comparison
for companies under similar tax regimes for
easy inferences.
 Return on shareholders equity measures the return on the owners
(both preference and equity shareholders) investment in the firm

There are several measures to calculate the return on shareholders equity:

(i) Rate of return on
a) total shareholders’ equity and
b) equity of ordinary shareholders;
(ii) earnings per share;
(iii) dividends per share;
(iv) dividend–pay-out ratio;
(v) dividend and earnings yield; and
(vi) price-earnings ratio.
 Return on Total Shareholders’ Equity

❑ Measures the return on the owners (both preference and equity shareholders) investment in the firm.

❑ The ratio reveals how profitably the owners’ funds have been utilised by the firm. A comparison of this
ratio with that of similar firms as also with the industry average will throw light on the relative performance
and strength of the firm.
 Return on Ordinary Shareholders’ Equity (Net
Worth)

Measures the return on the total equity funds of ordinary shareholders. This is probably the single
most important ratio to judge whether the firm has earned a satisfactory return for its equity-holders
or not. Its adequacy can be judged by
(i) comparing it with the past record of the same firm,
(ii) inter-firm comparison, and
(iii) comparisons with the overall industry average.
The rate of return on ordinary shareholders’ equity is of crucial significance in ratio analysis vis-a-vis
from the point of the owners of the firm.
 Earnings Per Share (EPS)

Cash Earnings Per Share: The ratio indicates the cash generating ability (per
equity share) of the firm.
• Book Value Per Share: represents the equity/claim of the
equity shareholder on a per share basis. It is computed
dividing net worth (equity share capital + reserves and
surplus – accumulated losses) by the number of equity
shares outstanding (at balance sheet date). a benchmark for
comparisons with the market price per share.
 • Price-to-Book Value Ratio Also known as price to book
(P/B) ratio, measures the relationship between the market
price of an equity share (MPS) with book value per share
(BPS).

The P/B ratio is significant in predicting future stock returns. For

instance, Fama and French observed that the P/B ratio (along with
size) was the best predictor of future stock returns. Firms with low P/B
ratios had consistently higher returns compared to the firms with
high P/B ratios.
Dividend payout (D/P) ratio measures the proportion of
dividends paid to earning available to shareholders.
• If the D/P ratio is subtracted from 100, retention ratio is
obtained.
• Earnings and Dividend Yield is closely related to the EPS and
DPS. While the EPS and DPS are based on the book value per
share, the yield is expressed in terms of the market value per
share.
• The earnings yield may be defined as the ratio of earnings per
share to the market value per ordinary share. Similarly, the
dividend yield is computed by dividing the cash dividends per
share by the market value per share.
 • Price/Earnings (P/E) ratio measures the amount investors are willing
to pay for each rupee of earnings; the higher the ratio, the larger
the investors confidence in the firm’s future.

❑ The P/E ratio reflects the price currently being paid by the market for each
rupee of currently reported EPS.
❑ In other words, the P/E ratio measures investors’ expectations and the market
appraisal of the performance of a firm.
❑ In estimating the earnings, therefore, only normally sustainable earnings
associated with the assets are taken into account.
❑ That is, the earnings are adjusted for income from, say, discontinued operations
and extraordinary items as well as many other items not expected to occur.
 Integrated Analysis of Ratios
❑The various profitability ratios discussed eariler throw light on the profitability of a
firm from the viewpoint of (i) the owners of the firm, and (ii) the operating efficiency
of the firm.
❑The ratios covered under the rate of return to the equity-holders fall under the first
category. The operating efficiency of a firm in terms of the efficient utilisation of the
resources is reflected in net profit margin.
❑It has been observed that although a high profit margin is a test of better
performance, a low margin does not necessarily imply a lower rate of return on
investments if a firm has higher investments/assets turnover.
❑Therefore, the overall operating efficiency of a firm can be assessed on the basis of a
combination of the two. The combined profitability is referred to as earning
power/return on assets (ROA) ratio.
Checklist of financial Ratios for the _____ Company .