Transcript DUTY DRAWBACK - Force 9! | Positive Thinkers

RATIO ANALYSIS
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Ratio Analysis
• A Ratio can be defined as relationship
between two or more things/ numbers.
• A Financial Ratio is the relationship
between two financial items, (i.e. from the
Balance Sheet and the P&L Account)
• Financial Ratio Analysis is the ascertainment
of ratios, their interpretation for the
purpose of measuring financial strengths/
weaknesses.
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Role of Ratio Analysis
Ratios are used as a benchmark for evaluating
financial position and performance of a firm.
Ratios help to summarize large quantities of
financial data into more meaningful element.
Ratios facilitate qualitative judgement about
the firm’s financial performance.
Ratio analysis help meaningful interpretation
of financial statements w.r.t. its performance,
credit analysis, security analysis, trend analysis.
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Standards of Comparison
Ratio analysis involves comparisons for a more
meaningful understanding of the facts &
figures given in the financial statements. The
standards of comparison consist are as
follows:
Time Series/ Trend Analysis (past ratios)
Cross-sectional Analysis (competitor ratios)
Industry Analysis
Projected Ratios
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Users of Financial Ratios
 Investors
– to determine firm’s earnings, balancing
risk & return for dividend & capital appreciation.
 Trade
Creditors – to determine the firm’s ability to
pay its liability in short term, i.e. liquidity issues
 Financial
Institutions – to determine long term
solvency & profitability of a firm, cash flows for
interest payment & repayment of principal amt.
 Management
– measuring every aspect of business
w.r.t. risk, profitability, performance, liquidity etc.
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Important Concepts
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Important Concepts
a) Cost
of Goods Sold (COGS) – manufacturing
costs of the goods sold during an accounting
period e.g. material, labour, power, fuel, repairs
b) Non-operating Revenue (NOR) – not relating to
main operations, these are included in the gross
profit. E.g. asset sale, interest on investments.
c) Gross Profit (GP) – Sales (+) NOR (-) COGS
d) Operating expenses – expenses relating to main
operations of the business, e.g. administration,
selling, distribution, depreciation etc.
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Important Concepts
e) Operating
Profit – GP (less) Operating expenses.
Also known as Earnings /Profit before Interest
and Tax (EBIT / PBIT)
f) Interest – paid on borrowed funds like loan, debn
g) Profit before Taxes (PBT) – PBIT (-) Interest
h) Profit after Taxes (PAT) – PBT (-) Taxes
i) Dividends – amount distributed to shareholders
j) Retained Earnings – balance remaining after
distribution of dividends, i.e. PAT (-) Dividends.
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Particulars
Sales (A)
Illustration
Rs.
10,000
(-) Cost of goods sold (B)
4,000
Gross Profit (C = A - B)
6,000
(-) Operating expenses (D)
3,500
Operating Profit (EBIT) (E = C - D)
2,500
(-) Interest (F)
1,000
EBT (G = E - F)
1,500
(-) Tax @ 50% (H)
750
PAT (I = G - H)
750
(-) Preference Dividends (J)
200
Profit for Equity Shareholders (K = I - J)
550
(-) Equity Dividends
400
Retained Earnings
150 9
Types of Ratios
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Classification of Ratios
The classification of ratios depends upon the
financial activity or function to be evaluated, with
reference to the users of these ratios.
 Liquidity ratios – measures the firm’s ability to
meet current obligations.
 Leverage ratios – shows the proportion of debt
and equity in financing the firm’s assets
 Activity ratios – reflects the firm’s efficiency in
utilization of its assets
 Profitability ratios – measures the performance
and effectiveness of the firm
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Liquidity Ratios
 Current
Ratio = Current Assets
Current Liabilities
• Current assets are assets that can be converted
into cash within a short period (upto 1 year).
For e.g. inventory, receivables, cash & bank bal.,
prepaid exp., B/R, short-term Invts etc.
• Current liabilities are obligations that must be
paid within a short time (upto 1 year) – BP,
creditors, accured exp, ST loans, bank overdraft
• This ratio measures firm’s short-term solvency
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Liquidity Ratios
 Current
Ratio
• Universal convention, a current ratio of 2:1 is
good. In India, a ratio of 1.33:1 is also accepted.
• Current ratio serves as a margin of safety for
the creditors and other short-term lenders.
Hence, higher the ratio, greater the margin of
safety.
• However, a very high current ratio may indicate
idle assets that are non-productive.
• Further, the quality of current assets also needs
to be checked. E.g. immovable inventory,
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Liquidity Ratios
 Quick
Ratio = Current Assets – Inventories
Current Liabilities – BOD
• Quick ratio states the relation between quick/
liquid assets & current liabilities. (Acid-test ratio)
• Liquid assets are assets that can be converted into
cash immediately and without loss of value.
• Inventories are less liquid since it takes time to
realize and also its values are fluctuating.
• Generally, a quick ratio of 1:1 is satisfactory. But,
quality of liquid assets needs to be checked w.r.t.
slow/ non paying debtors and other receivables.
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Liquidity Ratios
 Cash
Ratio = Cash + Bank + Marketable securities
Current Liabilities
• Cash is the most liquid asset. Hence, cash ratio
verifies the relationship between cash & cash
equivalents to current liabilities.
• This is the most stringent measure of liquidity
of a firm.
• However, a low cash ratio is acceptable, since
companies have reserve borrowing power, in
the form of sanctioned credit limits from banks
and financial institutions.
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Liquidity Ratios
 Interval
Measure = Current assets – Inventories * 365
Total daily expenses
Interval Measure is a ratio to judge the firm’s
ability to meet its regular cash expenses.
• Total daily expenses are the sum of COGS,
admin exp, and selling & distribution expenses
(except deprn).
• The interval measure gives us the period for
which a firm has sufficient funds to meet its
daily expenses, without receiving any cash.
•
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Leverage Ratios
Leverage ratios measures long term solvency of
a firm. Also called ‘Capital Structure ratios’.
Debt is more risky as the firm has legal
obligation to pay interest, even in case of losses.
Default may lead to litigation & even liquidation
However, debt is cheaper than equity and may
result into higher returns for equity
shareholders in case of a favourable financial
leverage effect.
Higher equity component is treated as safety
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Leverage Ratios
 Debt-Equity
Ratio = Total LT Debt
Net Worth
• Total long term debts, borrowing from financial
inst., debentures, bank, public deposits.
• Net Worth includes equity & preference capital
and reserves & surplus. (‘shareholders’ funds’)
• A high ratio indicates excessive borrowing by the
firm. High borrowing may put restrictions on a
firm w.r.t. dividend payout, dilutes control
• Low debt-equity ratio is good in low profits. For
high profits, high financial leverage is favourable.
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Leverage Ratios
 Debt-Asset
Ratio = Total Debt
Net Assets
• Total debt - short & long term borrowings from
financial inst., debentures, bank, public deposits
• Net Assets includes net fixed assets and net
current assets (i.e. CA – CL)
• This ratio indicates the proportion of total
assets financed by the debt component.
• A high ratio indicates that the total assets are
financed by borrowing, in excess of the owners’
equity.
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Leverage Ratios
 Capital
Gearing = Pref. capital + Debenture + LT loans
Equity capital + Reserves & Surplus
Capital gearing ratio measures the proportion of
fixed interest and preference dividend bearing
capital to the shareholders’ equity.
• This ratio indicates the proportion of fixed
obligations in the capital structure vis-à-vis
shareholders’ funds (w/o any fixed obligations)
• Ratio is used for providers of long term sources
of finance, i.e. financial institutions, banks,
interested debenture holders, pref. share holders.
•
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Leverage Ratios
 Interest
Coverage Ratio = EBIT or EBDIT
Interest
Interest
• Measures firm’s ability to pay interest obligation
• This ratio shows the number of times the interest
charges are covered by the available funds.
• Since deprn is a non-cash item, the same can be
added back to EBIT to calculate the coverage.
• Ratio used by banks, financial inst., debentures.
• Higher the ratio, better safety. But, a high ratio
indicates a conservative approach in using debt,
which may reduce shareholders’ earning capacity. 21
Leverage Ratios
 Debt
Service coverage =
EBDIT
Interest + (Loan repayment/1-tax rate)
 Debt
Service coverage = PAT + Deprn + Interest
Interest + Loan repayment
Measures the firm’s ability to meet interest as well
as loan repayment obligation.
• Debt service coverage ratio shows the number of
times the interest & loan repayment are covered
by the available funds.
• Loan repayment is made out of post-tax earnings.
So different formulae given to adjust the same. 22
•
Leverage Ratios
 Pref.
Dividend Coverage Ratio = EAT
Pref. Dividend
• Measures
the firm’s ability to meet dividend
obligation on preference shares.
• Pref. dividend coverage ratio shows the
number of times the pref. dividends are
covered by the available post tax funds. This
ratio used by preference shareholders.
• Higher the ratio, better for a firm.
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Activity/ Performance Ratios
☺A
firm makes investment in various assets for
the purpose of increasing sales and hence profits
☺ Performance ratios are used to evaluate the
efficiency of management & utilization of
assets
☺ Also known as Turnover ratios, since they
indicate the speed of assets utilization for sales.
☺ Activity ratios involve a relationship between
sales and assets. These ratios also facilitates
performance evaluation of a firm’s individual
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Activity Ratios
 Inventory
turnover =
COGS or Sales
Avg. inventory
• Inventory turnover ratio indicates the efficiency
of a firm in producing and selling its products.
• Avg. inventory is the avg. of opening and closing
stock of finished goods. Averraging eliminates
the fluctuations in inventory levels. In absence of
avg. inventory, closing inventory may be used.
• COGS figure may not be available to the outside
analyst and hence ‘Sales’ is taken to compute the
ratio. But, sales includes profit, so COGS is better 25
Activity Ratios
 Inventory
turnover
Inventory turnover shows the speed of inventory
conversion into receivables / cash through sales.
• High turnover ratio is a sign of good inventory
mgt. while low ratio indicates excessive inventory
levels or slow and/or obsolete inventory.
• But, a very high ratio may imply low inventory
levels resulting in stock-outs, affecting goodwill.
• Hence, adequate attention should be given to the
inventory turnover ratios. It should be compared
with past ratios, industry averages etc.
•
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Activity Ratios
 Inventory
turnover
• The reciprocal of inventory turnover ratio (x) 360
days gives the average inventory holding period.
• Avg. inventory x 365 days
COGS or Sales
• Inventory turnover can be analyzed for RM & WIP
levels also, to judge their conversions.
• RM turnover = RM consumed
Similarly, holding
period computed as
Avg. inventory of RM above. (no. of days)
• WIP turnover = Cost of production
Avg. inventory of WIP
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Activity Ratios
 Debtors
turnover = Credit Sales
Avg. debtors
• Debtors’ turnover ratio indicates speed of
conversion of debtors into cash during a year.
• Higher the debtors’ turnover ratio, more
efficient is the credit management.
• In absence of credit sales & avg. debtors, total
sales & closing debtors be used for computation
• Measures the efficiency of the marketing team,
treasury team and business managers.
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Activity Ratios
 Debtors’
collection = 365 days = Avg. Debtors x 365
Debtors’ turnover Credit Sales
Debtors’ collection period calculates the period
for conversion of receivables into cash, i.e.
duration for which the debtors are outstanding.
• Shorter the period better is the quality of
debtors i.e. faster conversion into cash.
• Collection period must be compared with the
firm’s avg. credit period granted to customers
• Long collection period impairs firm’s liquidity
and also increases chances of bad debts.
•
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Activity Ratios
 Debtors
ageing schedule
• An ageing schedule breaks
down debtors according to
the length of time for
which they are outstanding.
• It provides enhanced
information by recognizing
the slow-paying debtors.
• It is a better analysis tool
than collection period and
the used extensively during
audits and investigations.
O/s period O/s amount of % of total
(days)
debtors (Rs.)
debtors
00 - 30
250
42%
31 - 60
150
25%
61 - 90
70
12%
91 - 180
55
9%
above 181
75
13%
Total
600
100%
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Activity Ratios
 Creditors’
turnover = Credit Purchases
Avg. creditors
 Creditors’ payment = 365 days = Avg. Crs. x 365
Crs. turnover Credit Purchases
• Creditors’ turnover ratio indicates the number
of times creditors are paid during a year.
• Lower the creditors’ turnover ratio, more
efficient is the payables management i.e. delays
in payment or avoiding early payment.
• Measures the efficiency of the payables &
purchases team.
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Activity Ratios
 Working
capital turnover =
Sales
Avg. working capital
• This ratio measures the utilization of working
capital for generation of sales, and profits.
• Higher the ratio implies better management of
working capital.
• It indicates the amount of sales per rupee
investment in working capital.
• High ratio implies that less funds are blocked
in WC, better liquidity, better management.
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Activity Ratios
 Fixed
Assets turnover =
Sales
Avg. net fixed assets
• Fixed assets turnover ratio measures the sales
volume per rupee of investment in fixed assets.
• A firm’s ability to produce large volumes of sales
for a given amount of fixed assets is an important
aspect of its operating performance. Higher the
ratio, better for firm.
• Unutilized/ under-utilized assets increase a firm’s
costs via maintenance without giving returns.
• A very high ratio may be misleading, due to
presence of old assets with minimal book value. 33
Activity Ratios
Capital
turnover =
Sales
Capital Employed
• Capital
turnover ratio measures the sales
volume per rupee of capital employed (i.e.
Equity + Debt).
• Higher the ratio indicates better use of
capital employed by a firm.
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Profitability Ratios
α Profitability is the key to survival and
growth of any organization.
α Profitability ratios are calculated to
measure the operating effectiveness of a
firm.
α Owners are interested in these ratios to
ensure their returns while creditors/
lenders are concerned about their interest
and loan repayments.
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Profitability Ratios
 Gross
Profit Margin = Gross Profit (GP)
Sales
• Gross profit margin reflects the efficiency of
production activities and the pricing strategy.
• This ratio indicates the average spread between
ales & COGS. (i.e. prodn cost vis-à-vis selling price)
• A high GP margin is a sign of good management
& shows that firm is able to produce at low costs.
• A low ratio may be due to inefficient purchases,
poor plant utillization or selling price pressures.
• Constant attention is reqd. to maintain/ improve
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GP margin.
Profitability Ratios
 Net
Profit (NP) Margin = Profit after Tax (PAT)
Sales
PAT is obtained when operating exp., interest &
taxes are deducted from the gross profit.
• NP margin reflects management’s efficiency in
manufacturing, administration, selling its product
• The ratio is an overall measure of a firm’s ability
to convert sales into profits (sh-holders’ earnings)
• Higher ratio acts as a buffer in cases of decline in
selling price, increasing costs, decreasing demands
etc. & also accelerates profits at faster rate in
favourable conditions
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•
Profitability Ratios
 Modified
Net Profit Margin = EBIT
Sales
PAT figure excludes interest on borrowing.
Interest is tax deductible and provides taxation
benefits. Thus, PAT is affected by a firm’s
financial structure.
• Hence, use of PAT may give misleading results in
firms with different financial structures.
• As a true measure of operating efficiencies, we
ignore the effect of debt-equity mix and consider
EBIT as profit.
•
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Profitability Ratios
 Return
on Capital Employed =
EBIT
Capital Employed
• Capital employed includes equity and pref.
capital, reserves & surplus, debentures, long
term loans from financial institutions etc.
• It measures the return/ profits generated by a
firm against the capital employed in business.
• These returns are shared by the capital
providers (lenders and shareholders) in the
form of interest and dividends respectively.
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Profitability Ratios
 Return
on Equity =
PAT
Shareholders’ funds
Shareholders’ funds includes equity capital and
reserves & surplus (less) accumulated/ misc. loss
• It measures the return generated by a firm against
the shareholders’ funds used in the business.
• One of the most important ratios for financial
analysis since the primary objective of a firm is
maximization of shareholders’ wealth.
• Thus, this ratio is scrutinized by current and more
importantly by prospective investors.
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•
Profitability Ratios
 Earning
per Share (EPS) =
PAT
No. of equity shares o/s
EPS measures the return/ profits generated by a
firm per equity share.
• EPS is an important ratio for securities analysis &
it facilitates comparison with other companies
and the industry average.
• EPS reveals the relative performance & strength
of the company in attracting future investments.
• Hence, this ratio is widely used by prospective
investors and current shareholders.
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•
Profitability Ratios
 Dividend
per Share (DPS) = Dividends paid
No. of equity shares o/s
• DPS measures the returns/profits distributed
by a firm to the equity shareholders.
• Since all profits may not be distributed,
shareholders and potential investors are more
interested in the actual dividends declared by
a firm (i.e. distributed profits).
• Hence, this ratio is widely used by current
shareholders and prospective investors.
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Profitability Ratios
 Dividend
Yield = Dividends per share (DPS)
Current Market Price per Share
 Earnings Yield = Earnings per share (EPS)
Current Market Price per Share
• Dividend Yield & Earnings Yield evaluates the
shareholders’ return in relation to the current
market value of the share.
• Earnings yields is also known as earnings-price
(E/P) ratio
• Current market price per share may not be
available in the financial statements, but can be
taken from the stock exchanges, newspapers etc.
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Comparative Common Size Analysis
¤ Absolute figures in financial statements may not
give a true picture of the state of affairs,
especially while making comparisons.
¤ A simple technique of meaningful analysis is to
prepare ‘comparative common size statements (CCS)’.
¤ Financial statements (B.S and P&L A/c) are
prepared in terms of common base
percentages.
¤ Analysis becomes uncomplicated, with
increased clarity and superior results/ findings.
By use of CCS, possibility of ambiguity is
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Ratio Analysis – shortcomings
κ Ratios only provide with indicators for
identifying problems. Solutions are not
provided by ratios.
κ Dissimilarity in situations of two companies
may make the ratios misleading
κ Differences in the definitions of items in B.S
and P&L A/c may lead to incorrect
interpretation.
κ Ratios are calculated from past records and do
not predict the future events.
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