FINANCIAL PERFORMANCE

ACCOUNTING RATIOS

Accounting Ratio Analysis Information contained in financial

statements is of major significant to internal and external stakeholders if it is interpreted properly

Accounting ratios are relative measures that provides an aid to interpret the information provided by financial statements.

Analysis of accounting ratios involves calculating and interpreting financial ratios to assess the firm’s performance and status.

Basic inputs are balance sheet and income statements.

4 Main Categories of Accounting Ratios

Liquidity Ratio Profitability Ratio Working capital/ Efficiency

Ratio Investment Ratio

Liquidity Ratio Net working Capital

Current assets – Current liabilities NWC is useful for internal control. Used as a measure of a firm’s liquidity position. Firms should have sufficient NWC in order to be able to

meet the claims of the creditors and meeting the day-to-day needs of business.

NWC is a measure of firms liquidity but not an appropriate measure

Inadequate NWC is the first sign of financial problems for a firm.

Liquidity Ratio Contd..

Current RatioCurrent assets / current liabilities

It measure the firm’s ability to meet its short-term obligations (short term solvency).

Higher this ratio, more is the firm’s ability to meet current obligations and the greater safety of funds of short-term creditors.

But a very high ratio maybe indicative of slack management practices: it may signal excessive inventories for the current requirement and poor credit management of over extended accounts receivable.

Or firm is not making full use of its current borrowing capacity.

Liquidity Ratio Contd..

Quick Ratio (Acid-test ratio)(Current assets – inventories) / Current liabilities

Similar to current ration except that it excludes inventory and prepaid expenses (which are the least liquid asset).

Is a better measure of overall liquidity only when firm’s inventory cannot easily be converted into cash.

Profitability Ratio Gross profit margin

Gross profit / Sales x 100 High ratio is a sign of good management, as it

implies that cost of production is low. It may show higher sales without corresponding

increase in the cost of goods sold. A relatively low ratio is a danger signal, which

may be due to High cost of production A low selling price

Profitability Ratio Contd..

Net Profit marginNet profit / Sales x 100

It measures the percentage of each sales rupee remaining after all expenses have been deducted.

It measures firm’s success with respect to earnings on the sales

Profitability Ratio Contd..

Return on AssetsEBIT / Total assets

Return on investmentNet profit / Total asset x 100

It measures the overall effectiveness of management in generating profits with its available assets.

Profitability Ratio Contd..

Return on capital employed(EBIT / Fixed assets + NWC) x 100

It provides a test of profitability related to the sources of long term assets.

It tells how efficiently the long term funds of owners and creditors is being used.

Higher the ratio more efficient is the use.

Profitability Ratio Contd..

Return on equity (shareholder fund)Net profit / Ordinary share capital +

Reserves (R.E)

Efficiency Ratio Inventory turnover

Cost of goods sold / Average inventory In general a high inventory turnover ratio is

better. It shows good inventory management. A very high ratio calls for careful analysis, as

it may mean very low level of inventory A very low ratio signifies excessive inventory. Firms should have neither too high nor too

low inventory turnover.

Efficiency Ratio Contd..

Avg. No. of days inventory is sold (Stock held / cost of sales) x 365

Debtors/ Receivables turnoverSales / Avg. Receivables

Debtors settlement period(Receivables / Sales) x 365

Higher the turnover ratio and shorter the settlement period, the better the trade credit management.

Efficiency Ratio Contd..

Creditors TurnoverCost of sales / Avg. Creditors (accounts payable)

Creditors Settlement period(Avg. Creditors / Cost of sales ) x 365

Sales on capital employedSales / Capital employed

Total Asset TurnoverSales / Total assets

Investment Ratio

Dividends payout ratio(div announced/ earnings for the year) orDPS / EPS

Dividend yield(Div per share / Market price per share) x 100

Earnings per shareNet profit / no. of ordinary shares

Investment Ratio Contd..

Price/Earning ratio Market price per share / EPS

It indicates the degree of confidence that investors have in the firms future performance.

Higher is the ratio, better it is for the owners

A case study of ratio analysis

Profitability Ratio:2007 2006 2005 2004 2003 2002 2001 2000

47.48 47.17 45.76 47.27 48.49 48.31 41.49 40.51

10.54 9.89 9.02 11.10 11.51 11.36 5.90 5.30

19.47 17.97 16.92 22.94 22.52 30.97 13.33 18.41

15.56 14.10 13.27 17.05 18.73 24.75 10.32 9.06

Gross profit Margin:

Net profit margin:

ROCE:

ROE

A case study of ratio analysis

Liquidity Ratio:

2007 2006 2005 2004 2003 2002 2001 2000

2.04 1.87 1.77 1.56 1.57 1.35 1.13 1.15

1.66 1.43 1.34 1.16 1.17 0.99 0.74 0.80

Current Ratio

Acid test Ratio

A case study of ratio analysis

Efficiency Ratio:

2007 2006 2005 2004 2003 2002 2001 2000

57.81 70.15 67.97 56.80 63.61 52.85 63.03 63.04

50.78 52.10 49.42 43.18 47.85 35.29 40.38 47.63

31.66 43.39 17.77 22.10 23.56 17.49 12.35 19.68

Inventory turnover (in days):

Debtors settlement period:

Creditors settlement period:

A case study of ratio analysis

Investment Ratio:2007 2006 2005 2004 2003 2002 2001 2000

0.51 0.53 0.43 0.44 0.41 0.40 0.47 0.54

3.39% 4.08 5.55 4.69 5.26 4.62 3.94 3.86

0.50 0.44 0.38 0.51 0.44 0.44 0.52 0.18

14.97 12.52 9.50 11.99 8.11 9.54 10.49 8.45

Dividend payout ratio:

Dividend yield:

Earnings per share:

Price/Earning ratio: