Slide 1

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 2

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 3

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 4

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 5

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 6

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 7

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 8

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 9

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 10

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 11

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 12

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 13

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 14

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 15

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 16

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 17

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 18

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 19

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 20

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 21

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 22

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 23

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 24

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 25

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 26

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 27

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 28

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 29

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 30

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 31

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 32

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 33

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 34

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 35

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 36

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 37

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 38

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 39

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 40

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 41

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 42

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 43

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 44

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.


Slide 45

Financial Statement Analysis
Using Ratios

Use of ratios
•

•
•

The purpose of using financial ratios is to
make sense of the complex information usually
presented in a set of published accounts
As time has passed the complexity of accounts
has increased greatly
Not only is there a balance sheet and profit
and loss account but now a cash flow
statement is included and increasingly a
Statement of Recognised Gains and Losses

Purpose of Ratios
•
1.
2.
3.
4.

There are four main reason for the use of
ratios
To act as a set of summary statistics
To identify industry benchmarks
As an input for making formal decisions
Standardise for size

Uses of Financial Ratios
•

The two most common uses of ratios are

1. Analysis of the performance of a
company over time
2. Comparing performance of a company
against those of similar companies
•

This has obvious implications for the
analysis of individual securities

Common Size Financial Accounts
• One way of trying to compare performance
over time and amongst peers is to use a
common size financial accounts
• In this everything would be expressed as a
percentage of a fixed amount such as
turnover for P&L
• In the balance sheet it would be for total
funds as an example

Liquidity Ratios
• These assess the ability of a business to
meet its obligations in the short run
• They generally relate current assets to
current liabilities

Current Ratio
Current Assets
Current Liabilities
• Current assets and liabilities?
• Measures ability of business to meet its
current liabilities
• Generally the higher the ratio the better
• Depends on the nature of the assets

Acid Test Ratio
•

•
•

Quick assets are current assets less
stock
Quick Assets
Current Liabilities
Stringent measure of liquidity
Stock is excluded because these are
seen as the least liquid of the current
assets

Cash Ratio
Cash and bank balances plus current investments
Current Liabilities
• These assets are the most liquid of the current assets
• Stringent measure of liquidity
• May be too stringent as there are other options available
such as delaying payments
• Another option would be to borrow short notice money
such as extending the overdraft or to extend suppliers
terms

Leverage Ratios
• Debt capital is a cheaper source of finance
than equity
• It is also riskier than equity or other capital
finance instruments
• Leverage ratios indicate the level of risk
associated with debt finance
• There are two types of ratio
– Structural
– Coverage

Debt to Equity Ratio
Debt
Equity
• Shows relative contribution of owners and creditors
• Debt is long and short term debt
• Equity is net worth plus preference capital less deferred
taxes
• Problems are fixed asset at book rather than MV
• Some debt are protected by charges against assets
• A lower D/E ratio is preferable

Debt to Asset Ratio
Debt
Assets
• Debt here is all debt
• Assets are all assets
• Measures the extent that borrowed funds
support the businesses assets

Interest Coverage Ratio
Profit before interest and taxes
Interest
• Taxes are excluded from profit as interest
is a tax deductible expense
• In this case the higher the ratio the more
easily the business can pay its interest
• A high ratio means that interest can be
met even if there is a sharp decline in
turnover

Fixed Charge Coverage Ratio
Profit before interest, taxes and depreciation
Interest+Loan Repayment
1-Tax Rate
• This shows the amount of cash flow to cover all interest
and taxes
• This shows the comprehensive debt servicing ability as it
covers both interest repayment and the capital
repayment
• The measure can be expanded to include other fixed
payments such as lease payments and preference
dividends

Debt Service Coverage Ratio
Profit after tax+Depreciation+Other non
cash charges+Interest on term
loans+Lease Rentals
Interest on term loans+lease rentals +
Repayment of term loans

Debt Service Coverage Ratio
• I personally have never seen this ratio and
Chandra suggests that it is used by Indian
financial institutions
• It calculates the ratio for the period for
which the loan is applicable
• A ratio of 1.5 to 2 is regarded as being
satisfactory

Turnover Ratios
• These can also be called as activity ratios
or asset management ratios
• These ratios relate the level of activity, as
given by sales or COGS, to the level of
various assets.
• They are measures of how efficiently the
assets are employed by the firm

Inventory Turnover Ratio
COGS
Average inventory
• Shows how quickly stock is moving
through the firm thus generating sales
• It is a measure of inventory management
• Issues are
• Too low inventory leading to stock outs
• Too high stock giving inefficient use of working
capital

Debtor Turnover Ratio
Net Credit Sales
Average Sundry Debtors
• The higher the debtors turnover the
greater the efficiency of the credit
management system
• If NCS not available then sales could be
used

Average Collection Period Ratio
Average Sundry Debtors
Average Daily Credit Sales
• Represents the number of days of credit
sales included in sundry debtors
• The measure will depend on the nature of
the trade but a figure approaching 30
would be sought

Fixed Asset Turnover Ratio
Net Sales
Average Net Fixed Assets
• Measures the sales in terms of the
investment in fixed assets.
• Measures the efficiency of use of fixed
assets
• Beware the use of NBV of assets

Total Asset Turnover Ratio
Net Sales
Average Total Sales
• Ratio measures how efficiently the assets
are employed

Profitability Ratios
• These reflect the final results of the
business
• There are two types of ratio
• Profit margin ratios showing the
relationship of sales and profits
• Rate of return ratios showing the
relationship between profit and investment

Gross Profit Margin Ratio
Gross Profit
Net Sales
• This is the difference between sales and
COGS
• This shows the difference between sales
and costs
• This may be broken down into the various
elements of direct costs such as labour

Net Profit Margin Ratio
Net Profit
Net Sales
• This shows the amount of earnings left for
ordinary and preference shareholders
• It measures the overall performance of
control of the indirect costs in the P&L

Gross and Net Profit Rate
• These two measures taken together give
an overall view of the cost and profit
structures of the companies
• Their joint use can identify where any
problems lie in either direct or indirect
costs
• Again, this information is of use to many
parties

Return on Assets Ratio
Profit after tax
Average total assets
• The numerator measures the available
return to shareholders
• The denominator measures the
contribution of all contributors including
lenders
• Remember ARR in Project Appraisal

Earning Power Ratio
Profit before interest and taxes
Average total assets
• Focuses on only earnings before other
external claims, i.e. interest and tax.
• Measures efficiency without consideration
of capital structure or current tax rate.
• Good peer group comparison measure

Return on Capital Employed Ratio
Profit before interest and tax(1-tax rate)
Average total assets
• This is Earning Power after tax
• Does not reflect the capital structure of the
business
• Can be compared directly with post tax
WACC

Return on Equity Ratio
Equity Earnings
Average Equity
• Numerator is profit after tax less preference
dividends therefore is the amount available to
ordinary shareholders
• The denominator is ALL contributions by equity
shareholders including paid up capital, reserves
and surpluses
• The measure is of great interest to the stock
markets as it gives the return on the investment

Valuation Ratios
• These ratios measure how the equity of a
company is viewed in the markets
• Equity MV measures how markets
perceive the risk and return on a stock
• These can be seen as the most
comprehensive of the ratios

Price to Earnings Ratio (PER)
Market price per share
Earnings per share
• The most popular measure of financial
efficiency
• Reflects
• Risk characteristics
• Growth prospects
• Shareholder orientation of management

EV to EBITDA Ratio
Enterprise value (EV)
Earnings before interest, taxes, depreciation and amortisation

•
•
•
•

EV is the sum of market value of debt and of equity
MV equity is outstanding shares times MV of shares
Debt was discussed in detail in Project Appraisal
Chandra suggests this reflects profitability, growth, risk,
liquidity and corporate image

Market Value to Book Value Ratio
Market Value per share
Book Value per share
• This shows how much wealth has been
generated for the society at large
• If ratio >1 then a net contribution to the
wealth of the country has been achieved

Q Ratio
Market value of equity and liabilities
Estimated replacement cost of assets
• Resembles MV to BV ratio
• Different in that
– Numerator includes equity
– Denominator includes all assets
– These assets are at their replacement costs

Disaggregating of Ratios
• DuPont analysis is an example of
disaggregating of ratios where the Return
on Assets (ROA) is broken down into its
component parts
• Many more ratios than the Return on
Assets (ROA) can be broken down to give
further information

DuPont in short
• A shortened version of DPA is
Net Profit

Av Total Assets
ROA

= Net Profit

Net Sales
NPM

*

Net Sales

Av Total Assets
TATR

• When supplemented by comparing common size
statements then this shows where cost control measures
can be directed

Du Pont Analysis

A variation on DuPont
This disaggregates ROE or Net Income / Total
Equity
Net Income =
Total Equity

Net Income * Assets
Assets
Total Equity
(ROA)
* (Equity Multiplier)
(1+D/E Ratio)

Aggregation of Ratios
• Similarly some of the ratios can be
aggregated to give further reaching
measures
• As mentioned my particular favourite was
comparing debtors and creditors ratios to
indicate potential liquidity measures

Audience for Ratios - Internal
• Performance evaluation of managers

• Comparison of performance for different
divisions
• Planning for the future

Audience for Ratios - External
• Assessment of creditworthiness by
suppliers
• Assessment of future prospects by
customers
• Credit rating agencies
• Evaluating competitors
• Acquiring other firms

Problems with ratios
•
•
•
•
•
•

Selection of ratios
Based on accounting data inc. estimation
Data unavailable – time lag & division
Unsynchronised data
Different accounting standards
Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of
problems

The need to compare
• As stressed throughout this presentation
these ratios are in themselves pretty
meaningless
• They need to be compared
– Across time with previous results of the
company to measure changes in performance
– With other businesses in the same risk class
– With other businesses in the structuring of a
portfolio

That’s all folks
• Read Chandra pp 152 ff
• If further reading is required I have both
RW&J and BM&M in both Indian and
Western publications
• In addition I have Bill Rees “Financial
Analysis” which is one of the seminal
works on the subject.