Management Accounting

FINC001
FINANCIAL STATEMENT ANALYSIS
USING FINANCIAL RATIOS
UNIT 5
Financial ratios
• Financial ratios explain the relationship between two
numbers. For example, ₹2 lakh net profit may look
impressive, but the firm’s performance can be
commented as good or bad only when the net profit is
associated to the firm’s sales or investment.
• Financial ratios depict the relationships among the
items extracted from a firm’s financial statements.
Importance of ratio analysis
• To assess the liquidity, profitability, solvency and efficiency
position of a firm.
• To present relevant information for doing cross-sectional
analysis.
• To present relevant information extracted from financial
statements for making future projections about a firm.
• To identify the areas of a business that requires more attention
and;
• To study and understand the riskiness of the firm's operations.
Check your progress

The notion of ratio with respect to the items depicted in

the financial statements is known as
a) Accounting ratio
b) Marginal ratio
c) Both a and b.
d) None of the above
Classification of Financial ratios

Liquidity Activity Leverage

ratios ratios ratios

Profitability Valuation
ratios ratios
LIQUIDITY RATIOS
• Liquidity ratios determine the capability of a firm to
meet its current/ short term obligations.

Types of Liquidity ratios

Net Working Capital Current Ratio Liquid Ratio/Acid-

test Ratio

Working Capital
Cash Ratio
Ratio
 Liquidity ratios
Net working capital
• Working capital is a capital which a firm needs to run its everyday operations such
as paying wages, salaries, suppliers and creditors.

Gross Working Capital = Current Assets

Net Working Capital = Current Assets – Current Liabilities
Where,
Current assets = Cash + Cash Equivalents + Inventory + Accounts Receivable +
Market Securities + Prepaid Expenses+ Other Liquid Assets.
Current liabilities = Notes payable + Accounts payable + Accrued expenses +
Unearned revenue+ Current portion of long-term debt + other short-term debt+
provisions
• If current assets > current liabilities then working capital is +.
• If current assets < current liabilities then working capital is -.
 Liquidity ratios
Current ratio Acid test/ Quick ratio
• The current ratio is a ratio of Current • The Acid test ratio determines the
Assets to Current Liabilities. absolute liquidity of a firm.
• It is calculated by excluding those
Current ratio = Current Assets current assets which cannot be
liquidated immediately.
Current Liabilities
• Acid test ratio =

• The thumb rule for current ratio is 2:1

i.e. current assets should be twice to
the current liabilities in a firm. =
• However, current ratio differs across
industries.
 Liquidity ratios
Cash ratio
• For a firm, cash and cash equivalents
are the most liquid assets.
• The cash ratio is a ratio of cash and
cash equivalents to current liabilities.
Cash ratio =
• A low cash ratio may not be a concern
to a firm if a firm can borrow on short
notice.
Working Capital ratio
• The working capital ratio depicts the
association between net working
capital and net sales of a firm.
• It help to check how much funds
are required to be kept by a firm
from its sales to meet its net
working capital requirements.
Working Capital ratio =
Liquidity ratios of Ultratech Ltd-
FY 2018/19
• Net working capital : 10238.67 – 9589.87 = 648.80 crores

• Current ratio: = 1.07

• Acid test ratio: = =0.69

• Cash ratio: = 0.07

• Working Capital ratio: =0.02

Check your progress

Which ratio would a firm most likely use to measure its

ability to meet short-term commitments?
a) Current ratio.
b) Accounts Payable turnover.
c) Gross profit ratio.
d) Price to Earnings ratio.
Leverage ratios
• A firm’s short term and long term financial position is known by
leverage ratios. Both short term and long term suppliers of funds
are concerned to know the present solvency position of a firm.

Types of leverage ratios

Debt Ratio Debt to Equity Ratio Long Term Debt to

Equity Ratio

Interest Coverage Debt Service Cash Flow Coverage

Ratio Coverage Ratio Ratio
 Leverage ratios
Debt ratio
• Capital structure of a firm comprises of
equity (owners funds + reserves &
surplus), preference share capital and
debt (loan from banks and financial
institutions + bonds/ debentures).
Debt ratio=
Where Total debt (secured debt and
unsecured debt) = long term debt + short
term debt.
Total Assets = Net block of assets + Capital
work in progress+ investments + current
assets+ net deferred tax+ other assets
Debt to equity ratio
• Financial leverage is sometimes
calculated by a ratio of total debt to
equity. It measures the proportion of
borrowed funds to the owner’s
funds.
Debt to equity ratio =
Where Total Debt = Secured Loan +
Unsecured loan + current liabilities
Equity = share capital + Reserves &
Surplus
• The thumb rule for debt to equity
ratio is 1:1
 Leverage ratios
Long Term Debt to equity ratio
• The long term debt to equity ratio
measures the proportion of only long
term debt assuming that short debt is
transitory and will not affect the long
term solvency position of a firm.
Long term debt to equity ratio=
Interest Coverage ratio
• It determines the capacity of a firm
to pay interest.
• This interest expense is to be paid
from EBIT (earnings before interest
and taxes i.e. pre interest and pre-
tax).
Interest coverage ratio =
• The higher interest coverage ratio
guards a firm against payment of
interest expense out of its earnings.
 Leverage ratios
Debt service coverage ratio
• It is an extension of the interest
coverage ratio.
• It depicts the capability of a firm to
duly repay interest and principal
repayments/ instalments.
Debt service coverage ratio =
Cashflow coverage ratio
• It depicts the capability of a firm to
duly repay interest and principal
repayments/ instalments from its
operating cashflows.
• This ratio indicates the number of
times the financial obligations of a
firm are covered by its operating
cashflows.
Cashflow coverage ratio=
Where, Net operating cashflows is the
amount of funds a firm earns through
its normal business activities like
manufacturing and selling of goods and
providing the services to its customers.
 Check your progress
In order to measure a firm’s capability to fulfil its long-term
obligations, a finance manager would most likely examine:
a) Activity ratios.
b) Liquidity ratios.
c) Solvency ratios.
d) Valuation ratios.
 Leverage ratios of Ultratech Ltd-
FY 2018/19
• Debt ratio = = 0.52

• Debt to equity ratio = = 1.11

• Long term debt to equity ratio = = 0.80

• Interest coverage ratio = = 3.29

• Debt service coverage ratio = = = 0.26 times

• Cashflow coverage ratio = = = 0.27 times

 Activity Ratios
• The funds raised from borrowers and owners must be utilised
efficiently. This efficient utilisation means that the assets/
investments in which these funds have been deployed must
generate sufficient returns.

Types of Activity ratios

Activity or Turnover Ratios

Fixed Total Working

Inventory Debtor Creditor
Assets Asset Capital
Turnover Turnover Turnover
Turnover Turnover Turnover
Raio Ratio Ratio
Ratio Ratio Ratio
 Activity Ratios
Fixed Assets turnover ratio
• A fixed assets turnover ratio to
determine how efficiently the firm
generates sales from its investments in
fixed assets.
Fixed assets turnover ratio =
Where Average fixed assets = (Opening fixed
assets + closing fixed assets)/2
• Usually, a higher fixed asset turnover
ratio indicates more proficient use of
fixed assets in generating sales.
• A low ratio indicates the less efficient
use of fixed assets.
Total assets turnover ratio
• This ratio measures the efficient
utilisation of total assets.
Total assets turnover ratio=
Where Average total assets = (Opening total
assets + closing total assets)/2
• Usually, a higher total asset turnover
ratio indicates more proficient use of
assets (current + fixed assets) in
generating sales.
• A low ratio indicates the less efficient
use of total assets
 Activity Ratios
Inventory Turnover ratio Days of inventory
• It measures the rate of conversion of • After the inventory turnover ratio is
inventory into sales (CoGS) during the calculated, it can be changed to days
year. by dividing 365 by the inventory
• This turnover rate helps in turnover ratio.
understanding the speed at which the
inventories are converted into sales.
Days of inventory =
Inventory turnover ratio =

• It tells how many days a firm holds its

Where average inventory cost =(opening cost
of inventory + closing cost of inventory)/2 inventory to meet its sales.
Cost of goods sold= Raw material + Power &
fuel costs + Employee costs+ other
manufacturing costs
• When turnover ratio is high it indicates
that a firm does not hold more capital in
raw material and finished goods.
 Activity Ratios
Accounts receivables or debtors
turnover ratio
• Receivables are sales for which the firm
has not been paid yet.
• It is the amount of time that falls
between sales and collection of cash
from customers is significant for a firm
liquidity/ cash position.
Accounts receivables turnover ratio =
Average collection period in days
• Once the accounts receivable ratio is
calculated, it can be converted to days
by dividing 365 with the accounts
receivable turnover.
Average collection period =

• A short collection period means timely

payment by accounts receivables.
Where Average accounts receivable=(opening
accounts receivable+ closing accounts
receivable)/2
• Higher value of accounts receivable
turnover indicates the effective
management of receivables.
 Activity Ratios
Working capital ratio
• It indicates how well the firm generates sales from its working capital.

Working capital ratio =

Where Average working capital = (opening working capital + closing working capital)/2

• A higher working capital ratio indicates high efficiency of working capital

management.
• A lower working capital ratio indicates better working capital management
efficiency in revenue generation
 Activity Ratios
Accounts payable or Creditor Average payment period in days
turnover ratio • The average payable period
• It indicates the average number of days indicates the speed of payment of
of payables a firm takes to disburse its accounts payable.
suppliers/ creditors. Average payment period in days

Account payable ratio =

=

Where Average accounts payable= (opening

accounts payable+ closing accounts • So, longer average payable period
payable)/2 refers to the credit allowed by the
supplier is for a longer period which
is very good for the company in
• Stretching the payment unduly may improving its liquidity.
result into loss of creditworthiness.
 Activity ratios of Ultratech Ltd-
FY 2018/19
• Fixed assets turnover ratio: = 1.92 times

• Assets turnover ratio: =0.77 times

• Inventory turnover ratio: =5.77 times

• Days of Inventory: = 63.26 days approx

• Accounts Receivable Turnover Ratio: = 15.91 times

• Average collection period in days: = 23 days

 Activity ratios of Ultratech Ltd-
FY 2018/19
• Working capital ratio: = 285.01 times

• Accounts payable ratio: = 2.54 times

• Average payment period in days: = 144 days

 Profitability Ratios
• Profitability or margin ratios are mostly summarized from the profit
& loss account/ income statement of a firm.
• Profit is the difference between sales and operating and non-
operating expenses.
• There are two types of profitability ratios:
Profitability in relation to net sales.
Profitability in relation to capital employed.
Types of Profitability Ratios
Return on
Profitability
Investment
Margin Ratios
Ratios

Return on
Gross Profit Capital
Ratio Employed
Ratio

Operating Return on
Profit Ratio Equity Ratio

Return on Asset
Net Profit Ratio
Ratio
Profitability in association with net
sales
Gross Profit ratio (GPR) Operating profit ratio (OPR)
• This ratio depicts the association between • Operating profit is calculated as gross
gross profit and net sales. profit minus operating expenses.
• Gross profit is calculated as sales minus
cost of goods sold. Operating profit ratio= *100
Gross profit ratio = *100

• It helps a firm in evaluating its operating

Where Gross profit = Total Revenue (Sales) – efficiency.
cost of goods sold; Cost of goods sold= Raw
material + Power & fuel costs + Employee • So, an increased operating profit ratio
costs+ other manufacturing costs than the gross profit ratio depicts a better
control and monitoring of operating
expenses.
• The gross profit ratio indicates the
efficiency at which a firm produces per
unit of a product.
 Profitability in association with
net sales
Net Profit ratio (NPR)
• Net profit/ net income/ profit after taxes is calculated as sales minus all the
expenses (operating and nonoperating).
• It depicts the overall profitability position of a firm.

Net Profit ratio = *100

• A higher net profit ratio depicts efficient control over the expenditure coupled with
a better price realisation compared to its expenses.
• Whereas a lower net profit ratio shows that a firm is using an ineffective control
over expenses and its pricing strategies.
 Profitability in association with *

capital employed
Return on capital employed (ROCE) Return on Assets (ROE)
• Return on capital employed/ investment • Return on equity determines the
determines the return earned by a firm return earned by a firm on its
on its capital/ investments. equity.
ROCE = * 100
ROE = *100
Where Capital employed = long-term funds +
owner’s funds+ debentures, and long-term
debt employed OR Capital employed=net Where Equity = share capital + Reserves &
fixed assets + net current assets . Surplus

Profit refers to the Earnings before Interest and

Tax (EBIT) • ROE also provide insight into how a
• ROCE depicts the efficiency of assets firm’s management is employing
utilisation. It also facilitates inter and equity to grow its business.
intra firm comparison of profitability.
 Profitability in association with
capital employed
Return on Assets (ROA)
• Return on assets determines how much profit the firm is able to generate from
its total assets.

ROA = *100

• ROA depicts how efficiently the firm management is in utilising its total assets
on their balance sheet.
 Profitability ratios of Ultratech
Ltd- FY 2018/19
• Gross profit ratio: *100 = 47.10%

• Operating profit ratio: *100= 12.44%

• Net profit ratio: *100= 6.51%

• ROCE: *100= 10.87%

• ROE: *100= 8.57%

• ROA: *100= 4.99%

 Valuation Ratios
• Valuation ratios are employed in investment decision
making.

Types of valuation ratios

Valuation
Ratios

Price to
Earnings Dividend Dividend
Earnings
per Share per Share Pay-out
Ratio
 Valuation Ratios
Earnings per share (EPS) Dividend per share (DPS)

• Earnings per share is calculated by • Dividend per share (DPS) is the

dividing profit available for equity dividend distributed by a firm for each
shareholders (net profit) to the number ordinary share outstanding.
of shares outstanding.
Dividend per share=
Earnings per share =

• EPS gives information about the earnings

attributable to each equity share.
 Valuation Ratios

Dividend payout ratio (DPR) Price to earnings ratio (PE)

• The dividend payout ratio determines • Price-earnings ratio explains the
the proportion of earnings that the firm relationship between market price per
pays out as dividends to its share to earnings per share.
shareholders. • The PE ratio is often included in stock
market data and its analysis for
Dividend payout ratio= investor’s information.
Price earnings ratio=

• It depicts an investor’s anticipation

about the growth in the firm’s
earnings and rationality of the market
price per share.
 Valuation ratios of Ultratech Ltd-
FY 2018/19

• EPS: = ₹88.54

• DPS: = ₹ 11.50

• DPR: = 12.99%

• PE ratio: = 45.46times
 Check your progress
From the following information calculate the market price of
the share (MPS) of Phantom Film ltd.

Profit after tax is ₹2,00,000, the number of shares

outstanding is 40,000, P/E ratio is 9 and Current ratio is
4.5.
Advantages of financial ratio
analysis
• Trend analysis
• Data simplification and analysis
• Identification of attention-seeking domains
• Facilitate SWOT analysis
• Comparative analysis
 Limitations of Financial ratios
• Past Data
• The soundness of Financial Statements
• Differences in Accounting Practices
• Price-level adjustments
• Non-monetary Aspects
• Future projections
Du Pont analysis: The disintegration
of ROE
• The Du Pont model decomposes the return on equity/net worth/
net assets into net profit ratio, asset turnover ratio and a ratio of
assets to equity.
Return on equity/ Net worth/ Net assets (ROE/RONW/RONA)

= * *

Where the net profit ratio depicts finance managers focus on the association
between the selling price and cost of sales.
Assets turnover ratio depicts the focus on the efficient utilisation of assets in
producing goods and services.
Assets to equity depict the ability of managers to decide the optimum level of
debt in a firm to maximise equity shareholders return.
Du Pont analysis: The disintegration
of ROE
• The relationship of ROE to its component ratios depicts that the
return to shareholders can be increased in any of the following
manners:

By increasing the profit margin, which is the function of the

pricing power of a firm or cost-efficiency.
By increasing the Asset turnover, which is a function of efficient
utilization of assets to generate sales.
By using the fixed cost debt for the projects which generate ROI
greater than the cost of debt, thereby multiplying the return to
shareholders.