Recap
Financial statement analysis
It is the process of identifying strengths and weaknesses between BS and P &L a/c.
Can be under taken by the management or by the parties outside the firm
Trade creditors: short period liquidity position
Suppliers of long-term debt long-term solvency and survival
Investors: steady growth in earning profitability
Management: every aspect
Nature of Ratio Analysis
Ratio: “Quotient of two mathematical expression” and as “the relationship between two or
more things”
Used as a benchmark for evaluating the financial position and performance of a firm
An accounting figure conveys meaning when it is related to some other relevant information.
Can be expressed as a fraction, proportion, percentage and a number of times
Helps to summarize large quantities of financial data and to make qualitative judgment about
financial performance.
Standards of Comparison
(i) Past ratio (ii) Competitor's ratio (iii) Industry ratio
(iv) Projected ratio
Objectives
To know the areas of the business which need more attention;
To know about the potential areas which can be improved
Deeper analysis of the profitability, liquidity, solvency and efficiency levels
For cross-sectional analysis
For projections and estimates for the future.
Types of Ratios
Liquidity ratios
Leverage ratios
Activity ratios
Profitability ratios
Liquidity ratio
Ability of a firm to meet its current obligations
High and lack of liquidity are creating problem.
1. Current ratio:
Measures firm’s short-term solvency
Indicates the availability of current assets in rupee for every one rupee of current liability [2 is
satisfactory]
Represent a margin of safety
Since it include inventory, may lead to overestimation of the liquidity position
Current investments,
Inventories,
Trade receivables (debtors and bills receivables)
Cash and cash equivalents,
Short-term loans and advances
Other current assets such as prepaid expenses, advance tax and accrued income
Cash = $15 million
Marketable securities = $20 million
Inventory = $25 million
Short-term debt = $15 million
Accounts payables = $15 million
Current assets = 15 + 20 + 25 = 60 million
Current liabilities = 15 + 15 = 30 million
Current ratio = 60 million / 30 million = 2.0
Interpreting current ratio
A ‘good’ or ‘bad’ ratio depends on how it is changing
2017 2018 2019 2020 2021 2022
Sara’s co .73 .82 .93 .95 .97 1.00
Mews ltd 1.25 1.14 1.35 1.26 1.15 1.00
2. Quick Ratio ( Acid-test ratio) :
Indicator of a companies short-term liquidity position and measures its ability to meet the short
term obligations using the most liquid assets
Ratio of liquid asset to current liability.
( cash, debtors, money market instruments, marketable securities)
Exclude inventories, prepaid expenses, and advance tax
Commercial paper, CD
[ 1: 1 is a good measure]
3. Cash Ratio ( expressed in percentage)
CR=
4. Interval Measure
Provides information about how many days a company will can continue to operate using
the funds it has its own.
Relates liquid assets to average daily operating expenses
Operating expenses: cost of good sold, selling, administrative and general expenditure less
depreciations
Interval Measures =
Could be expressed in number of days
Leverage Ratios
L R Shows firms ‘long terms debt-paying ability’
Long term investors are more concerned with long term financial position.
These ratios indicate mix of funds provided by owners and lenders.
Between debt and equity
The process of magnifying the share holders return through the use of debt is called financial
leverage.
1. Debt-Equity Ratio :
A relationship that describes the lenders contribution for each rupee of owners
For eg: 60/ 40= 1.5 ( lenders contribution is 1.5 times of owners).
DER= or =
Shareholders fund= Share capital + Reserves and Surpluses+ Money Received
against share Warrant+ share
application money pending
allotment
Net Worth = Non-Current asset + Working Capital- Non-
Current
Liability
High debt ratio (higher claim of creditors) leads to debt trap
Lower debt ratio ( higher claim of owners)
2. Proprietary Ratio
Expresses relationship of proprietor’s (shareholders) funds to net assets
Proprietary Ratio = Shareholders’ Funds/Capital employed (or net assets)
Higher proportion of shareholders funds in financing the assets is a positive feature as it provides security
to creditors.
3. Total Assets to Debt Ratio
This ratio measures the extent of the coverage of long-term debts by assets.
Total assets to Debt Ratio = Total assets/Long-term debts
The higher ratio indicates that assets have been mainly financed by owners funds
and the long-term loans is adequately covered by assets.
This ratio primarily indicates the rate of external funds in financing the assets
and the extent of coverage of their debts are covered by assets.
Activity Ratios (Turnover ratio)
Evaluates the efficiency with which the firm manages and utilizes its asset
Estimates the relationship between sales and assets
1. Inventory Turnover :
1. Efficiency of firm in producing and selling its product.
2. Number of days a company will take to sell the inventory on hand
Inv. Turn =
Average Inventory = (beginning inventory + ending inventory)/number of months in the A/c
period
Alternate =
Example
Cherry Woods Furniture is a specialized supplier of handmade dining sets made from specialty woods.
Over Q3, its busiest period, the retailer posted $48,000 in COGS and $16,000 in average inventory. To
find the inventory turnover ratio, we divide $48,000 by $16,000. The inventory turnover is 3.
In the second example, we’ll use the same company and the same scenario as above, but this time
compute the average inventory period—meaning how long it will take to sell the inventory currently on
hand.
365/3=121.67 days
2. Assets Turnover Ratio: or
Profitability Ratio
1. Profitability in relation to sales
2. Profitability in relation to investment
Profitability in relation to sales
1. Gross Profit Margin (GPM) : (in %)
2. Net Profit Margin (NPM) :
3. Operating Expense Ratio :
Return on Investment
Measures the probability of gaining a return from an investment
ROI is calculated by subtracting the initial value of the investment from the final value of the
investment (which equals the net return), then dividing this new number (the net return) by the cost of
the investment, then finally, multiplying it by 100.
Using net return because it may be positive or negative
Example
Number of shares bought=1000
Cost per share =10
Selling price after one year =12.5
Earner dividend=500(total)
Trading cost= 125 (total)
ROI= X 100 = 28.75%
ROE
Shows how efficiently a company (management team) is handling the money
that shareholder have contributed to it.
Return on Equity (ROE) : or (net income/equity)
DuPont analysis
In ROE, we use book value of a company's common equity
A generalized method of calculating the ROE
Used to decompose the different drivers of ROE
The decomposition allows investors to focus on the key matrices of financial performance
individually to identity the strength and weaknesses
DuPont Analysis ROE = NPM x Asset Turnover x Equity multiplier
Equity multiplier = Average total assets/ Average shareholders equity
Equity multiplier is a risk indicator