Financial Statements Analysis

Financial ratio analysis:

It refers to the quantitative relationship between two or more sets of financial data
derived from income statement and balance sheet.

Types of financial ratios

1. Liquidity Ratios
2. Assets Management Ratios
3. Debt Management Ratios
4. Profitability ratios
5. Market value ratios

1. Liquidity ratios
 It measures a firm’s ability to pay its short-term obligations out of current or
liquid assets.
 It is used to ascertain the short-term solvency of a firm.
 It includes:
a. Current Ratio,
b. Quick Ratio,
c. Cash Ratio and
d. Net Working Capital to Total Asset Ratio.
a. Current ratio:
 It is the ratio between current assets and current liabilities.
 It measures the ability of the firm to meet obligations due within one year.
Current Assets (CA)
 Current ratio = (…. times)
Current Liabilities (CL)
 Standard ratio 2:1.
 Less or more than standard ratio is not preferable.
Current assets Current liabilities
Cash balance or cash in hand Creditors/Account Payables/Bills
Payables

Bank balance or cash at bank Outstanding expenses or Expenses

payable or Expenses due
 Debtors/Accounts Receivables/Bills Bank overdraft
Receivables Unclaimed dividend

Prepaid expenses or Unexpired Short-term bank loan

expenses or Prepayments Notes payable (Short-term)

Marketable securities Advance income

Closing stock or inventory Tax payable or Provision for tax
Short-term investment Dividend payable
Accrued incomes Proposed dividend

b. Quick ratio:
 It shows the relationship between quick assets and current liabilities.
 It measures the ability of the firm to meet its short-term obligations as and when
without relying upon the realization of the stock.
Quick Assets(QA )
Quick ratio = (…. times)
Current Liabilities (CL)
 Standard ratio 1:1.
Quick assets = Total current assets – Inventory – Prepaid expenses
Cash
c. Cash ratio =
Current Liabilities
Net Working Capital
d. Net working capital to total asset =
Total Assets

2. Assets Management Ratios [Turnover Ratios or Activity Ratios or Efficiency

Ratios]
 It measures how effectively and efficiently the firm can utilize its assets.
 It is essential to measure a firm’s performance whether its assets can generate
sufficient revenue or not.
 The higher turnover ratio is a good indicator of assets management ratio and
vice versa.
 It includes:
 Inventory Turnover Ratio
 Debtors or Receivables Turnover Ratio
 Days Sales Outstanding
 Fixed Assets Turnover Ratio
  Total Assets Turnover Ratio
 Capital Employed Turnover Ratio
 Working Capital Turnover Ratio
i. Inventory Turnover Ratio (ITR) or Stock Turnover Ratio
 It measures how well a company generates sales from its inventory.
 The higher inventory turnover ratio is a good indicator that reflects firm’s
capacity of managing its inventory effectively and vice versa.
a. When Cost of Goods Sold (COGS) and average inventory is given:

COGS
ITR = = (…. times)
Average inventory

Where,
COGS = Sales – Gross profit
Or
COGS = opening stock + Purchases + Carriage inwards +
Direct expenses + Factory expenses – Closing stock

Opening inventory +Closing inventory

Average inventory =
2
b. When COGS and average inventory is not given:

Sales
ITR = = (…. times)
Closinginventory
NOTE:
Priority must be given to first formula i.e., related to COGS.

ii. Receivable Turnover Ratio (RTR) or Debtors’ Turnover Ratio

 It measures how effectively and quickly a firm converts its account receivables
into cash within a given accounting period.
 It helps to measure how many times a company’s receivables are converted
into cash in a period.
 A high RTR is a good indicator.
a. When credit sales and average A/R is given:
Annual credit sales
RTR = (…. times)
Average accounts receivable
Where,
Opening A / R+Closing A / R
Average accounts receivable =
2
 b. When credit sales and average A/R is not given:
Total sales
RTR = (…. times)
Closing debtors∨ A /R
Where,
Debtors = Sundry debtors + Bills receivables
iii. Days Sales Outstanding (DSO) or Average Collection Period (ACP)
 It refers to the average number of days required for a firm to receive payment
for a credit sale.
 A high DSO is not a good indicator because a firm is experiencing delays in
receiving payments.
A / R × Days∈a year
DSO = (…. days)
Annual credit sales

If daily sales or average sales per day is given:

A /R
DSO = (…. days)
Daily credit sales∨Average sales per day

If debtor’s turnover ratio is given:

Days∈ a year
DSO = (…. days)
Debtor turnover ratio
iv. Fixed Assets Turnover Ratio (FATR)
 It measures how well a company uses its fixed assets to generate sales.
 This ratio helps to assess whether a firm is able to utilize its fixed assets
effectively or not.
 A high ratio indicates that a firm uses its fixed assets effectively to generate
sales.
Sales
FATR = assets ¿ (…. times)
Net ¿
Where,
Net fixed assets = Fixed assets – Depreciation
Fixed assets
Land and buildings Business premises Franchise agreement
Plant and machinery Equipment Copyright
Furniture and fixtures Lease hold premises, Trademark
Free hold premises
 Vehicles Goodwill Patent right
Note: Fixed assets do not include fictitious assets.
v. Total Assets Turnover Ratio (TATR)
 It measures how effectively a company uses its assets to produce sales.
 A high ratio indicates that a firm uses its total assets effectively to generate
sales.
Sales
TATR = (…. times)
Total assets
Where,
Total assets = Current assets + Tangible fixed assets + Intangible fixed
assets
Intangible fixed assets include goodwill, copyright, patent right,
trademark, franchise agreement, etc.
NOTE:
Fictitious assets do not include in the total assets such as preliminary expenses,
underwriting commission, discount or loss on issue of shares and debentures,
deferred advertising expenses, P/L a/c (Dr.) etc.

vi. Capital Employed Turnover Ratio (CETR)

 It helps to determine efficiency with which the capital employed or long-term
fund or permanent capital is utilized.
 Higher the ratio the more efficient the management and utilization of capital
employed and vice versa.
Net Sales
CETR = (…. times)
Capital employed
Where,
Capital employed = Shareholders’ equity + Long-term debt
or
Capital employed = Total assets – Current liabilities or Fixed assets + Working
capital
Shareholders’ equity includes:
Shareholders’ Fund or Shareholders’ Equity
Equity Share Capital Preference Share Capital General Reserve
Reserve And Surplus Retained Earnings Capital Reserve
Share Premium Share Forfeiture Reserve For Contingency
 Sinking Fund Dividend Equalization Fund Capital Redemption Reserve
P/L A/C (Cr)
Less: Fictitious assets and P/L a/c (Dr.)

Long-term debt includes:

Bonds or debentures, secured loan, mortgage loan, any other long-term debts, etc.
vii. Working Capital Turnover Ratio (WCTR)
 It measures the firm’s ability to generate sales with given investment in net
working capital.
 It is used to assess how much sales the company can get with a given level of
working capital.
Sales
WCTR = (…. times)
Net working capital
Net Working Capital = Total current assets – Total current liabilities

3. Debt Management Ratios or Leverage Ratios or Capital Structure Ratios

 It is the measure of the long-term solvency of a firm, i.e., whether the firm is
financially sound in relation to its long-term obligations.
 It measures the firm’s ability to pay the interest regularly and to repay the
principal on the due date.
 It includes:
 Debt Ratio
 Debt-Equity Ratio
 Long-Term Debt to Total Assets Ratio
 Equity Multiplier
 Times Interest Earned Ratio
 Cash Coverage Ratio
 EBITDA Coverage Ratio
i. Debt Ratio or Debt-Asset Ratio (DA Ratio)
 It shows the proportion of total debt used to finance the total assets of a firm.
 It measures to what extent a firm has used debt financing.
 The low debt ratio is better from the creditor’s perspective whereas a high
ratio may be better from the firm’s management perspective.
 Total debt
 DA ratio = (……%)
Total assets
Where,
Total debt = Long-term debt + Current liabilities
Total assets = Current assets + Tangible fixed assets + Intangible fixed assets
ii. Debt-Equity Ratio (DE ratio)
 It measures the relative contribution of the creditors and shareholders in the
capital employed in the business.
 It reflects the proportion of a company’s equity capital that is financed by debt.
 The low debt ratio is better from the creditor’s perspective whereas a high
ratio may be better from the firm’s management perspective.
Long−term debts
DE ratio= ' (……%)
Total shareholder s equity
or
Total debts Total Debt
= ' or
Total Equity
Total shareholder s equity
 Relationship between DA and DE ratio
DE
DA ratio =
1+ DE
DA
DE ratio =
1−DA
iii. Long-Term Debt to Total Assets Ratio
 It shows the use of long-term debt capital in financing total assets of the firm.
Long−term debt
Long term debt ratio to total assets ratio = (……%)
Total assets
iv. Equity Multiplier (EM)
 It is also known as the leverage factor.
 It measures the extent to which the total assets of a firm are greater than the
firm’s equity capital.
 It is a risk indicator that measures the portion of a company’s assets financed
by total equity rather than by debt.
 It is a ratio used to analyze a company’s debt and equity financing strategy.
Total assets
EM = = (…. times)
Total equity
or
 1
=
1−DA
or
= 1 + DE

v. Times Interest Earned Ratio (TIE ratio) or (Interest Coverage Ratio)

 It measures the extent to which interest on debt capital is covered by EBIT.
 It is a measure of debt serving capacity of a firm.
EBIT
TIE = = (……. times)
Interest expenses
Where,
EBIT = Sales revenue – Cost of goods sold – Operating
expenses
Or
EAT
EBIT = + Interest
1−t
EAT = (EBIT – Interest) (1 – t)
vi. Cash Coverage Ratio
 It gives the appropriate measures of interest payment capacity out of firm’s
cash.
 It includes both EBIT and depreciation.
EBIT + Depreciation
Cash Coverage Ratio = (…. times)
Interest
vii. EBITDA Coverage Ratio
 It measures the ability of an organization to pay off its fixed obligations such as
loans and lease payments.
 A higher EBITDA coverage ratio is desirable by creditors, financial
institutions, and other agencies.
 Higher the ratio, better the firm’s capability to pay its fixed obligations.
EBITDA Coverage Ratio =
EBITDA + Lease payment
Interest + Principal payment + Lease payment
= (…times)
1. Profitability Ratios:
 Profitability is the end result of a number of corporate policies and decisions.
 It measures the profitability position of a firm.
 This ratio measures the ability to make a profit compared to different elements.
 It includes:
a) Gross Profit Margin
b) Net Profit Margin
c) Operating Profit Margin
d) Basic Earning Power Ratio
e) Return on Assets
f) Return on Equity
g) Return on Capital Employed
1. Gross profit margin
 It is the ratio of gross profit and sales of a firm.
 It shows the profit of a firm before deducting selling, general and
administrative costs.
 It measures the quantitative relationship between gross profit and sales.
 A higher gross profit margin is desirable by most business organizations
because a firm is more efficient in generating sufficient income and vice
versa.
Gross Profit
Gross profit margin or ratio = ×100 = (……%)
Sales
2. Net profit margin or Net profit ratio
 It is the ratio of net profit to sales of a firm.
 It shows the firm’s ability to generate net income per rupee of sales.
 A higher net profit margin is preferred by the owners, the management as
well as the creditors.
Net profit after tax
Net Profit margin or ratio = × 100 = (.…. %)
Sales
3. Operating profit margin
 It shows the relationship between operating profit and sales.
 It indicates the operating efficiency of a firm.
 A higher operating profit margin is preferred.
Operating profit (EBIT )
Operating profit margin = ×100 = (…. %)
Sales
4. Basic Earning Power Ratio
 This ratio helps to determine how effectively a firm uses its assets to
generate income.
 It is calculated to evaluate the firm’s ability to generate profit before the
payment of interest and taxes out of the assets used.
 A higher earning power ratio indicates better asset utilization.
EBIT
Basic Earning Power = ×100 = (…. %)
Total assets
5. Return on Assets (ROA)
 It is the percentage of net income on total assets.
 It is an indicator of how profitable a company is relative to its total assets.
 Higher ROA denotes more effective and efficient management.
 A higher ROA is desirable for the company.
Net profit after tax+ Interest expenses
ROA = ×100 = (…. %)
Total assets
Or
Net profit after tax
ROA = × 100 = (…. %)
Total assets
6. Return on Shareholders’ Equity (ROSE)
 It shows the relationship between net profit after tax and shareholders’ fund.
 It is calculated to find out how efficiently the funds supplied by the
shareholders’ have been used.
Net profit after tax
ROSE = ' × 100 = (…. %)
Shareholder s equity
Shareholders’ equity = Total assets – Fictitious assets – Total liabilities
7. Return on Equity (ROE)
 It is the percentage of net income on total equity.
 It measures the return on the owner’s investment in the firm.
 Higher ROE indicates a better return to the shareholders and vice versa.
 A higher ROE is desirable for a firm.
Net profit after tax−Preference Dividend
ROE = ' × 100 = (…. %)
Total Shareholders equity−Preference share
Or
Net profit after tax
ROE = × 100
Total equity
 Where,
Total equity = Equity capital + Retained earnings + Additional
paid- in capital (Share premium)

8. Return on capital employed (ROCE)

 It indicates how efficiently the long-term funds supplied by the creditors
and shareholders have been used.
Net profit after tax+ Interest expense
ROCE = × 100 = (…. %)
Capital employed
Or
Net profit after tax
= = (…. %)
Capital employed

Market Value Ratios

 These ratios are used to assess a firm’s stock price in relation to its earnings and
book value of shares.
 It includes:
a. Price Earnings Ratio and
b. Market-to- Book Ratio
1. Price Earnings Ratio
 It is the ratio of market price per share to earnings per share.
 It represents the amount per share that investors are willing to pay for each
rupee of the firm’s earnings.
 A higher P/E ratio indicates a positive future performance, higher expectations
for future earnings growth, and willingness to pay more by the investors.
 A higher ratio is desirable for the firm.
Market price per share (MPS)
P/E ratio = = (…… times)
Earnings per share(EPS)
Where,
Net profit after tax−Preference dividend
Earnings Per Share = =
No. of equity shares outstanding
Rs…
2. Market-to- Book Ratio
 It is the ratio of market price per share to book value per share.
 It measures the extent to which the financial market added value to the firm’s
overall management and efficiency over the time.
  A higher ratio indicates that the firm’s overall activities have enhanced the
value of the firm.
Market price per share (MPS)
Market-to-book ratio = = (…… times)
Book value per share(BVPS )
Where,
'
Common shareholder s equity
Book value per share = = Rs….
No . of shares outstanding
Dividend payout ratio
 It refers to the percentage of earnings paid to shareholders in dividends.
 It indicates how much money a firm is returning to shareholders and how much
it is reinvesting.
Dividend per share(DPS )
D/P ratio = = (…...%)
Earnings per share (EPS)
Or
Total dividend paid
=
Net income
Where,
DPS =
Total dividend paid ¿ equity shareholders ¿
No. of equity shares outstanding = Rs….

Total dividend paid to equity shareholders = % of dividend × Paid up

capital

Du-Pont System
 It is a framework for analyzing actual performance popularized by the Du-Pont
Corporation.
 It is a comprehensive model to represent an integrated view on financial analysis,
planning and control processes relating to a firm.
 It provides a summary of a firm’s profitability in terms of return on assets and
return on equity.
ROE = ROA × Equity Multiplier
ROE = Net profit margin × Total assets turnover × Equity Multiplier
ROA = Net profit margin × Total assets turnover
Net income Sales
ROA = ×
Sales Total assets
Uses of Financial Ratios
1. Useful to various stakeholders
2. Useful for vertical and horizontal analysis
Vertical analysis = to make a judgement whether the performance of the firm at
a point of time is good or bad
Horizontal analysis = whether the financial condition of a firm is improving or
not
3. Useful in internal and external comparison
Internal comparison = the comparison of financial performance of a single firm
over different point of time
External comparison = the comparison of financial performance of a firm with
that of other firms in the industry
4. Useful in managerial performance evaluation

Limitations of Ratio Analysis

1. Requires basis of comparison
2. Differences in interpretation
3. Difference in situation of two firms
4. Change in price level
5. Short-term changes
6. No indication of the future