Course Title Financial Management (MBA –

521)

Chapter-III Financial Statements Analysis ( Ratio

Analysis)

Financial statement analysis can be referred as a process of understanding the risk and profitability of a company by analyzing reported financial information.

It is an evaluative method of determining the past, current and projected performance of a company.

Several techniques are commonly used as part of financial statement analysis including horizontal and vertical analysis.

Horizontal analysis which compares two or more years of financial data in both dollar and percentage form;

Vertical analysis, where each category of accounts on the balance sheet is shown as a percentage of the total account; and ratio analysis, which calculates statistical relationships between data.

Financial statement analysis - Introduction

It is described as a relationship between two or more things to evaluate the performance of a company.

What is Ratio Analysis?

Kennedy and Mc Mulla, “The relationship of one to another, expressed in simple term of mathematical is know as ratio”.

According to Accountant’s Handbook by Wixon, kell and Bedford, a ratio “is an expression of the quantitative relationship between two numbers”.

According to Myers, " Ratio analysis of financial statements is a study of relationship among various financial factors in a business as disclosed by a single set of statements and a study of trend of these factors as shown in a series of statements."

Definition

It simplifies the financial statements.

Measuring the efficiency of organization.

Measuring the liquidity position of the companies.

Determining the profitability of the company.

Measuring the capacity of companies to borrow in the future.

Understanding the overall financial position of organization.

Helps in planning and forecasting.

Advantages of Ratio Analysis

Based on Historical

Data

No Standard Interpreta

tion. Same

data may be

interpreted in

different ways.

Difference in

Accounting

Methods make

comparison

difficult.

Effect of Price Level

Changes

Limitations of Ratio Analysis

Ratios have a great significance for

different kinds of people. They are:-Investors

Managers

Creditors

Debenture holders

Government

Employees

General public

Who are the Users of Ratio Analysis?

As Percentage - such as 25% or 50% . For example if net profit is Birr. 25,000/- and the sales is Birr. 100,000/- then the net profit can be said to be 25% of the sales.

As Proportion - The above figures may be expressed in terms of the relationship between net profit to sales as 1 : 4.

As Pure Number /Times - The same can also be expressed in an alternative way such as the sale is 4 times of the net profit or profit is 1/4th of the sales.

8

How a ratio is expressed ?

Different Types of Ratios

Liquidity Ratios

Solvency/Leverage

Activity Ratios

Profitability Ratios

The liquidity ratios are used to test the short term solvency or liquidity position of the business.

It enables to know whether short term liabilities can be paid out of short term assets.

It indicates whether a firm has adequate working capital to carry out routine business activity.

It is a valuable aid to management in checking the efficiency with which working capital is being employed.

I- LIQUIDITY RATIO

Current ratio. Quick ratio. Absolute liquid ratio.

Important Ratios in Test of Liquidity

A. Current Ratio

The current ratio is a commonly used liquidity ratio that measures a company's ability to pay its current liabilities with its current assets. It establishes relationship between total current assets and current liabilities.

Current assets Current ratio= Current liabilities

Ideal ratio: 2:1High ratio indicates under trading and over capitalization.Low ratio indicates over trading and under capitalization.

Balance Sheet for Company XYZ Year ending December 31, 2011

Assets Cash 1,000Accounts Receivable 500Inventory 500Total Current Assets 2,000

Liabilities Accounts Payable 500Current Long-Term Debt 500Total Current Liabilities 1,000

Long Term Debt 500Total Liabilities 1,500

Owners' Equity 500

Solution:- We can calculate Company XYZ's Current ratio as:

2,000 / 1,000 = 2.0 As of the end of 2011, Company XYZ had

$2.00 in current assets for every dollar of current liabilities.

This ratio can also be presented as 2:1. In current ratio current liabilities are taken

as 1 . The company appears to be able to

easily service its short-term debt obligations.

There is a high degree of safety for creditors of the company.

Example:- Calculation of Current Ratio:let's look at the balance sheet for Company XYZ:

The quick ratio is a measure of how well a company can meet its short-term financial liabilities.

It establishes relationship between liquid assets and liquid liabilities. It is a refinement to current ratio and second testing device for working capital.

It can be calculated as follows:Quick ratio= (Cash + Marketable Securities + Accounts Receivable)/Current Liabilities

(or) A common alternative quick ratio formula is: (Current assets – Inventory)/Current Liabilities Ideal ratio: 1:1Usually, a high acid test ratio is an indication that the firm is liquid and has ability to meet its current or liquid liabilities in time and on the other hand a low quick ratio represents that the firm’s liquidity position is not good.

B. Quick Ratio or Acid Test Ratio

Calculation of Company XYZ's quick ratio as follows:

($60,000 + $10,000 + $40,000)/$65,000 = 1.7

This means that for every dollar of Company XYZ's current liabilities, the firm has $1.70 of very liquid assets to cover those immediate obligations.

Example:- Calculation of Quick Ratio from the balance sheet of Company XYZ:

This ratio establishes a relationship between absolute liquid assets and current liabilities.

Formula: Absolute liquid ratio =

Absolute liquid assets / Current liabilities Where absolute liquid assets are = [ Cash + Bank + marketable securities.] Current Liabilities = [Bank overdraft, sundry creditors, bills

payable and outstanding expenses.] Ideal ratio: 0.5:1

C. Absolute Liquidity Ratio or Cash ratio

Liabilities $ Assets

$ Share capital   5,00,000 Goodwill 50,000

Reserves 1,90,000 Plant & machinery 4,00,000

Bank overdraft1,00,000 Trade investments 2,00,000

Sundry creditors 1,40,000 Marketable securities 1,50,000

Bills payable 50,000 Bills receivable 40,000

Outstanding expenses 10,000 Cash 45,000  

Bank 30,000    

Inventories 75,000    

 

Total 9,90,000   9,90,000

Solution: ABSOLUTE LIQUID RATIO =

Absolute liquid assets/Current liabilities

Absolute liquid assets are: marketable securities, cash and bank. Thus, 

$1,50,000 +  $45,000 +  $30,000 =  $2,25,000

Current liabilities are: bank overdraft, sundry creditors, bills

payable and outstanding expenses. = 1,00,000 + 1,40,000 + 50,000 +

10,000 =  $3,00,000. Absolute liquid ratio = 2,25,000 /

3,00,000 = 0.75 The absolute liquid ratio in this case is

0.75 which is better as compared to rule of thumb standard which is 0.50.

Example:From the following balance sheet calculate absolute liquid ratio:

Solvency indicates that position of an enterprise where it is capable of meeting long term obligations.

Long term solvency ratios denote the ability of the organization to repay the loan and interest.

When an organization's assets are more than its liabilities is known as solvent organization.

It is useful for bankers and creditors to find out the paying capacity of the company. The most important ratios under leverage are:-

Debt equity ratioProprietary ratioSolvency ratioCapital gearing ratioFixed assets ratio Interest coverage ratio

II- SOLVENCY/LEVERAGE RATIOS

The debt-to-equity ratio is a measure of the relationship between the capital contributed by creditors and the capital contributed by shareholders.

It is calculated using the following formula: Debt-to-Equity Ratio =

Total Liabilities/ Shareholders' EquityIdeal ratio: 2:1; It means for every 2 shares there is 1 debt. If the debt is less than 2 times the equity, it means the creditors are relatively less and the financial structure is sound. If the debt is more than 2 times the equity, the state of long term creditors are more and indicate weak financial structure.

A. Debt-to-Equity Ratio

Debt-to-Equity Ratio = Total Debt / Total Equity

$15,000,000/  $10,000,000 = 1.5 times, or 150%

This means that for every dollar of Company XYZ owned by the shareholders, Company XYZ owes $1.50 to creditors.

Example:Calculation of Debt-to-Equity Ratio

It establishes relationship between the proprietors fund or shareholders funds and the total assets.

Proprietary Ratio = Shareholders funds / Total AssetsIdeal ratio: 0.5:1

Higher the ratio better the long term solvency (financial) position of the company. This ratio indicates the extent to which the assets of the company can be lost without affecting the interest of the creditors of the company.

B. Proprietary Ratio

CC Ltd has total shareholders funds of $2,200,000 and the total assets are $2,750,000.

Then:Equity Ratio = Shareholders funds / Total Assets

2,200,000 / 2,750,000 = 0.8 This means that shareholders contribute 80 cents for every

$1 employed in the business, with creditors contributing the remaining 20 cents.

Example :

It expresses the relationship between total assets and total liabilities of a business. This ratio is a small variant of equity ratio and can be simply calculated as 100-equity ratio. Solvency Ratio =Total Assets / Total

Liabilities No standard ratio is fixed in this regard. It

may be compared with similar, such organizations to evaluate the solvency position.

Higher the solvency ratio, the stronger is its financial position and vice-versa.

C. Solvency Ratio

Capital gearing ratio is mainly used to analyze the capital structure of a company.

The term capital structure refers to the relationship between the various long-term form of financing such as debentures, preference and equity share capital including reserves and surpluses.

High geared means lower proportion of equity, while low geared means higher proportion of equity.

Capital gearing ratio = equity share capital / fixed interest bearing funds

D. Capital Gearing Ratio

The calculation for gearing ratio is as follows: For example: Equity share capital = $200,000 Surpluses = $100,000 Long-term loans = $150,000 Then, capital gearing ratio =

equity share capital / fixed interest bearing funds(200,000 + 100,000) / 150,000 = 2The gearing ratio can be used by analysts to determine how healthy a corporation is. A gearing ratio above 1.0 is considered healthy, while less than 1 is less robust.

It establishes the relationship between fixed assets and capital employed.

Fixed Asset Ratio can show that how much the company depends on Fixed Assets to run their business.

Fixed Asset Ratio = Fixed Asset /Total long term funds X 100

Total long term funds = Shareholders funds, Long-term loans, Long-term deposits and Debentures.

Ideal ratio: 0.67:1This ratio enables to know how fixed assets are financed i.e. by use of short term funds or by long term funds. This ratio should not be more than 1.

E. Fixed Assets Ratio

The interest coverage ratio, also known as times interest earned, is a measure of how well a company can meet its interest-payment obligations.

formula is: Interest Coverage = (Earnings Before Interest and Taxes) / (Interest Expense) Example: Here is some information about XYZ Company:

Net Income $350,000Interest Expense ($400,000)Taxes ($50,000)

Using the formula and the information above, we can calculate that XYZ's interest coverage ratio is: ($350,000 + $400,000 + $50,000)/$400,000 = 2.0 This means that XYZ Company is able to meet its interest payments two times over.

F. Interest Coverage Ratio

Activity ratios indicate the performance of an organization. This indicate the effective utilization of the various assets of

the organization. Most of the ratio falling under this category is based on

turnover and hence these ratios are called as turnover ratios. Important Ratios in Activity Ratio

a. Stock/Inventory turnover ratio.b. Debtors turnover ratio.c. Creditors turnover ratio.d. Wording capital turnover ratio.e. Fixed assets turnover ratio.f. Current assets turnover ratio.

III- ACTIVITY RATIOS (OR) CURRENT ASSETS MOVEMENT/EFFICIENCY RATIOS

This ratio establishes the relationship between the cost of goods sold during a given period and the average sock holding during that period.

It tells us as to how many times stock has turned over (sold) during the period.

Indicates operational and marketing efficiency. Helps in evaluating inventory policy to avoid over stocking. Inventory Turnover Ratio = Cost of goods sold / Average inventory at cost

Cost of goods sold= sales-gross profit (or)

= opening stock + purchases – closing stock

Average stock= Opening stock + Closing stock/2 Ideal ratio: 8 times; A low inventory turnover may reflect dull business, a

high stock turnover ratio means that the concern is efficient and hence it sells its goods quickly.

Stock/Inventory turnover ratio

The cost of goods sold is $500,000. The opening stock is $40,000 and the closing stock is $60,000 (at cost).

Inventory Turnover Ratio (ITR) = 500,000 / 50,000* = 10 times This means that an average one dollar

invested in stock will turn into ten times in sales.

*($40,000 + $60,000) / 2 = $50,000

Example:

This ratio explains the relationship of net credit sales of a firm to its book debts indicating the rate at which cash is generated by turnover of receivables or debtors.The purpose of this ratio is to measure the liquidity of the receivables or to find out the period over which receivables remain uncollected.Debtors Turnover Ratio = Net Credit Sales / Average Trade DebtorsAverage debtors=

Opening balance + closing balance/2

Debtors include bills receivables along with book debts

When information about opening and closing balances of trade debtors are not available then the debtor turnover ratio can be calculated by dividing the total sales by the balances of debtors.

Debtor turnover ratio = total sales/debtors

Debtors/Receivables Turnover Ratio

Average Collection Period =The average collection period represents the average number of days for which a firm has to wait before its receivables are converted into cash

Average collection period= Number of working day in year/ Debtor turnover ratio

Ideal ratio: 10 to 12 times; debt collection period of 30 to 36 days is considered ideal.

A high debtor turnover ratio or low collection period is indicative of sound management policy.

The amount of trade debtors at the end of period should not exceed a reasonable proportion of net sales. Larger the trade debtors greater the expenses of collection.

Continued….

Net credit sales of Company A during the year ended June 30, 2010 were $644,790. Its accounts receivable at July 1, 2009 and June 30, 2010 were $43,300 and $51,730 respectively. Calculate the debtors turnover ratio.

SolutionDebtors Turnover Ratio = Net Credit Sales / Average Trade Debtors Average trade debtors = ( $43,300 + $51,730 ) / 2 = $47,515

Debtors Turnover Ratio = $644,790 / $47,515 = 13.57

Example :

This ratio indicates the number of times the creditors are paid in a year. It is useful for creditors in finding out how much time the firm is likely to take in repaying its trade creditors.

Formula: Creditors Turnover Ratio = Net Credit Purchase / Average Trade CreditorsAverage creditors=

Opening balance + closing balance/2

Average Payment period= Number of working day in year/ Creditors turnover ratio If information about credit purchases is not available, total purchases may be taken,

if opening and closing balances of creditors are not given the balances of creditors may be taken.

Trade creditors include sundry creditors and bills payable. Ideal ratio: 12 times; debt payment period of 30 days is considered ideal. Very less creditors turnover ratio, or a high debt payment period may indicate the firms inability in

meeting its obligation in time.

Creditors/Payables Turnover Ratio

Money online Ltd has the following information:Trade creditors at 1 Jan 2010: $6,000Trade creditors at 31 Dec 2010: $8,000Total Purchases (including cash purchases $2,000): $12,000Solution:Creditors Turnover Ratio =

Net Credit Purchase / Average Trade Creditors Credit Purchases = 12,000 - 2,000 = $10,000

Average Trade Creditors = (6,000 + 8,000) / 2 = $7,000

Creditors Turnover Ratio = 10,000 / 7,000 = 1.43

Example :

This ratio indicates the number of times the working capital is turned over in the course of the year.

It Measures efficiency in working capital usage. It establishes relationship between cost of sales and working capital. Formula:

Working capital turnover ratio=Cost of sales/Average working capital

Average working capital = Opening + closing working capital/2

If cost of sales is not given, then sales can be used. If opening working capital is not disclosed then working capital at the year end will be used.

Working capital turnover ratio= cost of sales (sales)/net working capital. Net Working Capital = Current assets – Current liabilities

Working Capital Turnover Ratio

A higher ratio indicates efficient utilization of working capital and a low ratio indicates inefficient utilization of working capital.

But a very high ratio is not a good situation for any firm and hence care must be taken while interpreting the ratio.

Example:Cash 10,000 Bills Receivables 5,000 Sundry Debtors 25,000 Stock 20,000 Sundry Creditors 30,000 Cost of sales 150,000

Calculation: Calculate working capital turnover ratio Working Capital Turnover Ratio = Cost of Sales / Net Working

Capital Current Assets = $10,000 + $5,000 + $25,000 + $20,000 = $60,000 Current Liabilities = $30,000 Net Working Capital = Current assets – Current liabilities = $60,000 − $30,000 = $30,000 So the working Capital Turnover Ratio = 150,000 / 30,000 = 5 times

Continued….

This ratio establishes a relationship between fixed assets and sales.

It indicates how well the business is using its fixed assets to generate sales.

Fixed assets turnover ratio=Net sales/ Fixed assets

Ideal ratio: 5 times A high ratio indicates better utilization of fixed assets. A low ratio indicates under utilization of fixed assets.

Fixed Assets Turnover Ratio

A high current assets turnover ratio indicates the capability of the organization to achieve maximum sales with the maximum investment in current assets.

It indicates that the current assets are turned over in the form of sales more number of times.

As such, higher the current assets turnover ratio, better will be the situation.

Current assets turnover ratio:     Net sales/current assets Current assets include the assets like inventories,

sundry debtors, bills receivables, cash in hand or at bank, marketable securities, prepaid expenses and short term loans and advances.

Current Assets Turnover Ratio

This ratio establishes a relationship between total assets and sales. This ratio enables to know the efficient utilization of total assets of a business.

Total assets turnover ratio= Net sales/ Total assets

Ideal ratio: 2 timesHigh ratio indicates efficient utilization and ratio less than 2 indicates under utilization.

Total Asset Turnover Ratio

Profitability ratios indicate the profit earning capacity of a business.

Profitability ratios are calculated either in relation to sales or in relation to investments.

Profitability ratios can be classified into two categories.

a) General Profitability Ratios. b) Overall Profitability Ratios.

IV. PROFITABILITY RATIO

Gross profit ratio : It expresses the relationship of gross profit to net sales

and is expressed in terms of percentage. Higher the gross profit ratio better the results. Net profit ratio : It expresses the relationship between net profit after

taxes to sales. Higher the ratio better is the profitability. Operating ratio: This ratio establishes a relationship between cost of

goods sold plus other operating expenses and net sales. Higher the ratio the less favorable. Operating profit ratio: This ratio establishes the relationship between operation

profit and net sales.

General Profitability Ratios

Return on shareholders investment or Net worth ratio.

Return on equity capital. Return on capital employed. Return on total resources. Dividend yield ratio. Preference dividend cover ratio. Equity dividend cover ratio. Price covering ratio. Dividend pay out ratio. Earning per share.

Test Of Overall Profitability

Return on Shareholders Investment

Shareholders investment also called return on proprietor’s funds is the ratio of net profit to proprietor’s funds. It is calculated by the prospective investor in the business to find out whether the investment would be worth-making in terms of return as compared to the risk involved in the business.

Net profit (After tax and int)Return on shareholders investment=

Proprietors funds

This ratio is of great importance to the present and prospective shareholders as well as the management of the company.

As this ratio reveals how well the resources of a firm are being used, higher the ratio, better are the results.

The return on shareholders investment should be compared with the return of other similar firms in the same industry.

The inter firm comparison of this ratio determines whether their investments in the firm are attractive or not as the investors would like to invest only where their return is higher.

Similarly, trend ratios can also be calculated for a number of years to get5 an idea of the prosperity, growth of deterioration in the company’s profitability and efficiency.

Return on Shareholders Investment

Return On Equity CapitalThis ratio establishes the relationship between net profit available to equity shareholders ad the amount of capital invested by them. It is used to compare the performance of company's equity capital with those of other companies, and thus help the investor in choosing a company with higher return on equity capital.

Net profit – preference dividend Return on equity capital= Equity share capital (paid up)

Return on Capital EmployedThis ratio is the most appropriate indicator of the earning power of the capital employed in the business. It also acts as a pointer to the management showing the progress or deterioration in the earning capacity and efficiency of the business.

Net profit before taxes and interest on long – term loans and debentures Return on capital employed= Capital employedIdeal ratio: 15% If the actual ratio is equal ratio is equal to or above 15% It indicates higher productivity of the capital employed and vice versa

Return of Total Resources

This ratio acts as an yardstick to assess the efficiency of the efficiency of the operations of the business as it indicates the extent to which assets employed in the business are utilized to results in net profit.

Net profit Return on total recourses = X 100 Total assets

Dividend Yield Ratio

It refers to the percentage or ratio of dividend paid per share to the market price per share. This ratio throws light on the effective rate of return on investment, which potential investors may hope to earn.

Dividend paid per equity shareDividend yield ratio = Market price per equity share

Preference Dividend Cover

It indicates how many times the preference dividend is covered by profits after tax. This ratio measures the margin o safety for preference shareholders. Such investors normally expect their dividend to be covered about 3 times by profits available for dividend purpose.

Profit after tax Preference dividend cover = Annual programme dividend

Equity Dividend CoverThis ratio indicates the number of times the dividend is covered by the amount of profit available for equity shareholders.

Net profit after tax - pref dividendEquity dividend cover = Dividend paid on equity capital

Earning per equity share = Dividend per equity share

Ideal ratio: 2 times; i.e. for every Rs. 100 profits available for dividend, Rs. 50 is retained in the business and Rs. 50 is distributed. Higher the ratio higher is extent of retained earnings and higher is the degree of certainty that dividend will be repeated in future

Price Earning Ratio

It shows how many times the annual earnings the present shareholders are willing to pay to get a share. This ratio helps investors to know the effect of earnings per share on the market price of the share.This ratio when calculated for several years can be used as term analysis for predicting future price earning ratios and therefore, future stock prices.

Average market price per sharePrice earning ratio= Earning per share

Dividend Pay Out RatioThis ratio indicates the proportion of earnings available which equity share holders actually receive in the form of dividend.

Dividend paid per sharePay out ratio = Earning per share

An investor primarily interested should invest in equity share of a company with high pay out ratio. A company having low pay out ratio need not necessarily be a bad company. A company having income may like to finance expansion out of the income, thus low pay out ratio. investor interested in stock price appreciation may well invest in such a company though the pay out ratio is low.

Earning Per Share

This ratio indicates the earning per equity share. It establishes the relationship between net profit available for equity shareholders and the number of equity shares.

Net profit available for equity share holdersEarning per share = Number of equity shares

Example:-

ByDr. Suresh Vadde

Associate ProfessorDepartment of ManagementSamara University, Ethiopia.