Ratio Analysis in Decision Making

Ratio analysis provides a meaningful comparison of a

company to its industry.
Ratios are ways of comparing and investigating the
relationships between different pieces of financial
information.

Financial ratios are used to weigh and evaluate to

operating performance of a firm.

An absolute value such as earnings of 50,000 or A/R

of 1,00,000 may appear satisfactory, its acceptability
can be measured only in relation to other values.

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We can separate 13 significant ratios into four
primary categories
A.Liquidity Ratios
i) Current Ratios
ii) Quick Ratios

B.Asset Utilization Ratios

a. Receivables turnover
b. Average collection period
c. Inventory turnover
d. Fixed asset turnover
e. Total asset Turnover

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C. Debt Utilization Ratios
i) Debt to total assets
ii) Times interest earned ratios
iii) Fixed charge coverage

D. Profitability
i) Profit Margin
ii) Return on Asset
iii) Return on Equity

E.Market Value ratio

i) Price /Earning Ratio
ii) Market/Book ratio

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 ABC Company
Income Statement
For the year ended December 31, 2004
Sales (all on credit) 40,00,000
Cost of good s sold 30,00,000
Gross profit 10,00,000
Selling and Admin 6,50,000
Operating Profit (EBIT) 3,50,000
Interest Expenses 50,000
Net income before tax 3,00,000
Tax (33%) 1,00,000
Net Income 2,00,000

** Includes 50,000 in lease payment.

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 Balance Sheet
As on December 31, 2005
Assets
Cash 30,000
Marketable Securities 50,000
Account Receivables 3,50,000
Inventory 3,70,000
Total current assets 8,00,000
Net plant & equipment 8,00,000
Net assets 16,00,000

Liabilities & Stockholders Equity

Accounts Payable 50,000
Notes Payable 2,50,000
Total current liabilities 3,00,000
Long term liabilities 3,00,000
Total liabilities 6,00,000
Common Stock 4,00,000
Returned Earnings 6,00,000
Total liabilities & stockholders equity 16,00,000
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No of common shares outstanding is 10,000
Choosing a Bench Mark
After calculating the ratios, we must compare the
results with some standard.

The average may be industry average

Or Time trend analysis
Or Peer group analysis

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C. Liquidity Ratios

Current Asset
1. Current Ratio =
Current Liabilities
800000
=
300000
= 2.67 times
Ind. Average = 2.1 times

C. Assets - Inventory
2. Quick Ratio =
C. Liabilities
430000
=
300000
= 1.43
Ind. Average = 1.00

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B. Asset Utilization Ratios

Sales
3. Receivable Turnover = Receivables
4000000
= 350000
= 11.40 times
Ind. Average = 10 times

A/R
4. Average Collection Period (DSO) = Average daily crdit sales

350000
= 11111

= 32 days
Ind. Average = 36 days

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 Sales
5. Inventory Turnover =
Inventory
4000000
=
370000
= 10.8 times
Ind. Average = 7 times

Sales
6. Fixed Asset Turnover =
Fixed Assets
4000000
=
800000
= 5 times
Ind. Average = 5.4 times

Sales
7. Total Asset Turnover =
Total Assets
4000000
=
1600000
= 2.5 times
Ind. Average = 1.5 times

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D. Debt Utilization Ratio
600000
10. Debt to total assets =
1600000
= 37.5%
Ind. Average = 33.00%

Earnings before Interest & Taxes

11. Times Int. Earned Ratio =
Interest
550000
=
50000
= 11 times
Ind. Average = 7 times.

Income before fixed charge & tax

12. Fixed charge coverage ratio=
Fixed charge
EBIT + Lease Payment
=
Interest + Lease Payment
550000 + 50000
=
50000 + 50000
600000
=
100000
= 6 times
Ind. Average = 5.5 times
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Here we have used the industry average as standard for
comparison.

Profitability Ratios
Net Income
12. Profit Margin =
Sales
200000
=
4000000
= 5%
Ind. Average = 6.7%

Net Income
13. Return on Asset =
Total Assets
200000
=
1600000
= 12.5%
Ind. Average = 10%

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 Net Income
14. Return on Equity =
Stockholders equity
200000
=
1000000
= 20%
Ind. Average = 15%

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 E.Market Value Ratios

Price/Earning ratio(P/E) =Price per Share/ Earnings per Share

Market / Book ratio(M/B) = Market Price per share/ Book value per share

These group of ratios are applicable for companies whose shares are
publicly traded.

Price/Earning ratio--The EPS of the company is 2,00,000/10,000=20.

Suppose
if the market price of the share is 40 then P/E ratio would be 40/20=2.

Market/Book ratio:
Book value of the share would be Common equity/Shares outstanding
Here BV per share =1,000,000/10,000
=100
Then M/B ratio = 40/100
=.4
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 Summary of Ratios
ABC Ind. Remarks
Co. Average
A. Profitability
1. Profit Margin 5.00 6.70 Below average
2. ROA 12.50 10.00 Above average due to
high turnover
3. ROE 2.00 15.00 Good due to 2 & 11
B. Asset Utilization
4. Receivable turnover 11.40% 10 Good
5. Average collection period 32 36 Good
6. Inventory turnover 10.80 7.00 Good
7. Fixed asset turnover 5.00 5.40 Good
8. Total assets turnover 2.50 1.50 Good
C. Liquidity
9. Current ratio 2.67 2.10 Good
10. Quick ratio 1.43 1.00 Good
D. Debt Utilization
11. Debt to total Assets 37.50 33.00 More debt
12. Times interest earned 11.00 7.00 Good
13. Fixed charge coverage 6.00 5.50 Good

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Why Evaluate Financial Statement
Internal Uses
Performance Evaluation

It helps to plan for the future

Predictive purpose of ratios. Ratios can be used to predict

bankruptcy (Altman). He developed a model known as Z score.

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External Use
Short Term, Long Term Creditors

Potential Investors

Supplier

Credit Rating

Assessing Competitors

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Limitations of Ratio Analysis
Many firms are conglomerate owning many unrelated business. The
consolidated financial statement does not really fit in any neat
industry category.
Inflation may distort firm’s Balance Sheet causing reported values to
be different from true values since inflation affects inventory costs,
profits are also affected.
Firms use “Window Dressing” to make this financial statement look
stronger.
Different accounting practices can distort comparison. Inventory
valuation and depreciation can distort comparison.

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Looking Beyond the Number
Are the revenues tied to one key customer?
To what extent are the company’s revenues tied to one
key product?
To what extent the company relies on single supplier.
What percentage of the company business generated
overseas?
Competition
Future prospect
Legal & regulatory environment.

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THANK YOU

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b) ROE can be decomposed into its component part which is known as
Du-Pont Identity.

Du-Port Equation:
ROA = Profit Margin × Total Asset Turnover

If the company uses no debt then ROA and ROE would be same. But if the
company uses debt then ROE > ROA.

Modified Du-Pont Version:

Return on Asset
ROE =
1- Debt/Asset
12.5%
=
1 - 0.375
= 20%

An example of Du-Port Analysis:

Profit Margin × Asset Turnover = ROA ÷ (1 – Debt/Asset) = ROE

Wall-mart: 3.5 × 2.5 = 8.8 ÷ (1 – 0.580) = 21.00%
N-Mercus: 4.3 × 1.1 = 4.7 ÷ (1 – 0.543) = 10.30%
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