C.V.M.

UNIVERSITY
S. G. M. COLLEGE OF COMMERCE AND MANAGEMENT
[Link]:- SEMESTER -4
SUBJECT: SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
MODULE 3: FUNDAMENTAL ANALYSIS: COMPANY ANALYSIS I

3 Fundamental Analysis: Company Analysis I

Topics included
• Financial Statements of Companies
 Concept of Ratios
 Types/Classification of Ratios
 Performance Ratios
 Profitability Ratios
 Market Valuation Ratios
 Du Pont Analysis
 Problems in Financial Statement Analysis

3.1 Introduction

Financial ratios are essential tools for evaluating stocks and making informed investment decisions. These
metrics, derived from a company’s financial statements, provide insights into its profitability, liquidity,
efficiency, and valuation. By analyzing key ratios like Price-to-Earnings (P/E), Debt-to-Equity (D/E), and
Return on Equity (ROE), investors can assess the health and potential of a business, compare it with
industry peers, and identify growth opportunities or risks. Integrating these ratios into stock selection
ensures a data-driven approach, helping investors make balanced and strategic choices.

3.2 Financial Statements of Companies

Financial statements are essential tools for understanding a company's financial health and performance.
They typically include:
- Balance Sheet: Provides a snapshot of a company's assets, liabilities and equity at a specific
point in time.
- Income Statement (Profit and Loss Statement): Shows the company's revenues,
expenses and profits over a period.
- Cash Flow Statement: Tracks the inflow and outflow of cash, highlighting how a company
manages its cash from operating activities, investment activities and financing activities.
3.3 Concept of Ratios
Financial ratios are tools used to evaluate a company's financial health and performance by analyzing data
from its financial statements. These ratios provide insights into various aspects of a business, such as
profitability, liquidity, efficiency and solvency.

3.4 Types/Classification of Ratios

Financial ratios can be broadly classified into the following:

Financial Ratios

Liquidity Solvency Profitability Operating

Gross Profit
Net Profit
Operating Profit Asset Turnover
Current Ratio Inventory
Debt to Equity ROA
Quick Ratio Turnover
Interest Coverage Ratio ROE
Cash Ratio Debtors Turnover
ROCE
Creditors Turnover
Yield
Dividend Payout
3.5 Liquidity Ratios

1. Current Ratio:
The current ratio is a liquidity ratio which is a liquidity ratio that measures a Company’s
ability to pay short term obligations or those due within one year.

2. Liquid Ratio:
Liquid ratios are used to determine the debtor's ability to pay off current debt obligations
without raising external debt.

3. Cash Ratio:
Measures a company’s ability to pay short term liabilities using only cash and cash equivalents. A
higher ratio indicates strong liquidity.

3.6 Operating Ratios

1. Fixed assets ratio:

Fixed-asset turnover is the ratio of sales to the value of fixed assets. It indicates how well the
business is using its fixed assets to generate sales.

2. Working capital turnover ratio:

Working Capital Turnover Ratio helps in determining how efficiently the company is using its
working capital (current assets – current liabilities) in the business.
 3. Inventory turnover ratio:
The inventory turnover ratio is an effective measure of how well a company is turning its inventory
into sales. The ratio also shows how well management is managing the costs associated with
inventory and whether they're buying too much inventory or too little.

4. Debtors turnover ratio:

Debtor's Turnover Ratio is an accounting measure used to measure how effective a company is in
extending credit as well as collecting debts.

3.7 Profitability Ratios

1. Gross profit ratio:
Gross profit ratio (GP ratio) is a financial ratio that measures the performance and efficiency of a
business by dividing its gross profit figure by the total net sales.

2. Net profit ratio:

It reveals the remaining profit after all costs of production, administration, and financing have
been deducted from sales, and income taxes recognized.

3. Operating profit ratio:

The operating profit margin ratio indicates how much profit a company makes after paying for
variable costs of production such as wages, raw materials, etc.
3.8 Market Valuation Ratios

1. Return on capital employed:

Return on capital employed (ROCE) is a financial ratio that can be used to assess a company's
profitability and capital efficiency. In other words, this ratio can help to understand how well a
company is generating profits from its capital as it is put to use.

2. Return on shareholders fund:

Return on shareholders' funds is an accounting measure of the rate of return that shareholders
have obtained on the capital which they have invested in the business.

3. Earnings per share:

The earnings per share ratio (EPS ratio) measures the amount of a company's net income that is
theoretically available for payment to the holders of its common stock.

4. Book value per share:

It is a method to calculate the per-share book value of a company based on common shareholders'
equity in the company.

5. Dividend payout ratio:

The Dividend Payout Ratio (DPR) is the amount of dividends paid to shareholders in relation to the
total amount of net income the company generates. In other words, the dividend payout ratio
measures the percentage of net income that is distributed to shareholders in the form of dividends.
3.9 Du Pont Analysis
The DuPont equation is an expression which breaks return on equity down into three parts:
profit margin, asset turnover, and leverage.

Components of the DuPont Equation:

Profit Margin Profit margin is a measure of profitability. It is an indicator of a company’s pricing
strategies and how well the company controls costs. Profit margin is calculated by finding the net profit as
a percentage of the total revenue. As one feature of the DuPont equation, if the profit margin of a
company increases, every sale will bring more money to a company’s bottom line, resulting in a higher
overall return on equity.
Components of the DuPont Equation: Asset Turnover
Asset turnover is a financial ratio that measures how efficiently a company uses its assets to generate
sales revenue or sales income for the company. Companies with low profit margins tend to have high
asset turnover, while those with high profit margins tend to have low asset turnover. Similar to profit
margin, if asset turnover increases, a company will generate more sales per asset owned, once again
resulting in a higher overall return on equity.
Components of the DuPont Equation: Financial Leverage
Financial leverage refers to the amount of debt that a company utilizes to finance its operations, as
compared with the amount of equity that the company utilizes. As was the case with asset turnover and
profit margin, Increased financial leverage will also lead to an increase in return on equity. This is
because the increased use of debt as financing will cause a company to have higher interest payments,
which are tax deductible. Because dividend payments are not tax deductible, maintaining a high
proportion of debt in a company’s capital structure leads to a higher return on equity.
3.10 Limitations of Financial Ratio Analysis

1. Absence of identical situations: It is difficult to obtain identical situations for different firms.
Circumstances do not remain the same, even, for the same firm between two different periods.
Ratios are useful in judging the efficiency of business, only when they are compared with the past
results of the firm, with identical circumstances, or with the results of similar businesses.
Comparison becomes difficult due to lack of uniformity of situation between two companies.
2. Change in accounting policies: Management has a choice about the accounting policies. The
management of different companies may adopt different accounting policies regarding valuation
of inventories, depreciation, research and development expenditure and treatment of deferred
revenue expenditure etc. The differences between the accounting policies, followed by different
companies, make the interpretation of the ratios difficult. For example, one may calculate
depreciation on straight-line method, while the other may be following written down value
method. Different companies may be following different methods of valuation of closing stock
(e.g. FIFO or LIFO etc).
3. Based on historical data: The ratios are calculated from past financial statements, and so they are
no indicators of future. Such ratios may provide information about the past. But, for forecasting
the future, there are many factors that may change, in future.
4. Qualitative factors are ignored: Ratios are expressed in quantitative form only. Qualitative
factors are ignored. A high current ratio may not guarantee liquidity, as current assets may be high
due to inclusion of obsolete inventory and non-paying debtors.
5. Ratios are only indicators, not final: Ratios are means of financial analysis and they are not end
in themselves. They are indicators. They cannot be taken as final regarding good or bad financial
position of the business.
6. Over use could be dangerous: Over use of ratios as controls on managers could be dangerous. If
too much reliance is placed on ratios, management may concentrate in improving the ratios, rather
than dealing with significant issues.
7. Window dressing: The term ‘window dressing’ means manipulation of accounts in a way so as to
conceal the actual facts and present the financial statements, in a way, to show better position than
what actually it is. For example, a high current ratio is considered as satisfactory. To show an
impressive current ratio, firm may postpone credit purchases. A company may have current assets
of Rs. 4,000 and current liabilities of Rs. 2,000. So, its current ratio is 2:1 that is satisfactory.