session 9 - ratio analysis

8/8/2019 Session 9 - Ratio Analysis

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FINANCIAL ACCOUNTINGANALYSIS OF

FINANCIAL STATEMENTS

See chapter 7


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Financial Statements

1. Profit & Loss Account showsa. cost structure of the businessb. relationship of costs to the revenuesc. information relating to margin available on sales

2. Balance Sheet showsa. owners contribution in the total funds requirement

b. proportion of short term and long term fundsc. proportion of fixed and current asset

However, accounting data in absolute terms does not havemuch meaning without analysis and comparison


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In most cases, there are no standards against which agiven set of data could be tested or compared

ExampleX had sale of Rs 15L & cost of goods sold of Rs 12LY had sale of Rs 20L & cost of goods sold of Rs 14L

This set of data is not open to direct comparison easily.

But if we say that for X, Cost of goods sold is 80% ofsales and for Y it is 70% of sales - it is more lucidand meaningful.

Continued


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Common Size StatementsProfit & Loss Account

shows the net sales as 100% and each component

of expenses and profits as a % of net sales

Balance Sheet

1. shows each item of asset as a % of total assets

2. similarly each item of liability and owners equity is

shown as a % of total liabilities


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Rs Million IndustryAverage

Rs Million ABC Ltd

Sales 600 100 280 100

Cost of goods sold 240 40.00 140 50.00

Gross Profit (i) 360 60.00 140 50.00Total operating expenses 150 25.00 80 28.57

Operating Profit (ii) 210 35.00 60 21.43

Interest expense 24 4.00 13 4.64

Profit Before Tax (iii) 186 31.00 47 16.79

Income tax 48 8.00 23 8.21

Profit After Tax (iv) 138 23.00 24 8.57

Dividends 60 10.00 2 0.71

Profit Retained (v) 78 13.00 22 7.86

Repairs to Plant & Machinery 3 0.50 5.6 2.00

PROFIT/COST COMPARISONS


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1. Many pieces of information do not have significantmeaning in isolation. They become more meaningfulwhen related to an appropriate base.

2. Ratios reduce large figures to an easily understoodrelationship.

3. Ratios do not make conclusions. There are no good

or bad ratios. It is for the analyst to draw conclusionby evaluating ratios.

4. Company performance is usually analyzed on two

parameters - (1) Profitability, and (2) Solvency/Liquidity

FINANCIAL RATIOS


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Profitability RatiosMarginon sales

Gross Profit Margin

Operating Profit Margin

Earnings Before Interest & Tax

Profit before tax

Net Profit Margin (i.e., Profit after tax)

Return onInvestment

Operating Profit to Operating Assets (ROA)

Net Income to Total Assets (ROTA)

Return on Equity (ROE)

Efficiency(Activity)

Total Asset Turnover

Fixed Asset Turnover

Working Capital Turnover

Shareholder Equity Turnover

Return

per share

Earnings per share (EPS)

Price to Earnings (P/E ratio)

Dividend per share


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Short-term

(Liquidity)

Net Working Capital

Current Ratio

Quick Ratio

Accounts Receivable Turnover

Collection Period

Inventory Turnover

Conversion Period

Long-term

(Leverage)

Total Debt to Total Capital

Long Term Debt to Total Capital

Long Term Debt to Fixed AssetsInterest Cover

Times Fixed Charges Covered

Gearing

Equity Multiplier

Solvency Ratios


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The long-term survival depends on ability toearn sufficient surpluses and to grow

Margin on Sales Profits are generated by sales

First step in analyzing profitability is understanding

costs in relation to revenue and thus profits inrelation to revenue

Each component of profit & loss account is

expressed as percentages of sales

PROFITABILITY


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Rs Million % (2006) Rs Million % (2005)

Sales 300 100 280 100

Cost of goods sold 148 49.33 140 50.00

Gross Profit (i) 152 50.67 140 50.00Total operating expenses 85 28.33 80 28.57

Operating Profit (ii) 67 22.33 60 21.43Interest expense 14 4.67 13 4.64

Profit Before Tax (iii) 53 17.67 47 16.79Income tax 26 8.67 23 8.21

Profit After Tax (iv) 27 9.00 24 8.57Dividends 15 5.00 10 3.57

Profit Retained (v) 12 4.00 14 5.00

P & L a/c of M/s ABC Ltd


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(i) Gross Margins1.Surplus available from sales after subtracting cost of goods sold

2.Reflects the efficiency of use of direct inputs given the sales price(ii) Operating Margins1.It is considered as a reflection of the managements performance2.Frequently used as a basis of comparison across companies

(iii) Profit Before Tax (PBT)1.Surplus after meeting interest expense

2.Influenced to a great extent by the financing decisions(iv) Profit After Tax (Net Income or PAT)1.Overall surplus available out of sales to shareholders

2.Influenced by operating efficiency & financing efficiency

3.As a percentage of sales it is known as Net Profit Margin

Margin on Sales


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Balance Sheet of M/s ABC Ltd

Rs Million % (2006) Rs Million % (2005)

Fixed Assets 180 40.00 200 50.00

Less depreciation 18 4.00 20 5.00

Net Fixed Assets 162 36.00 180 45.00Total Current Assets 258 57.33 200 50.00

Other Assets 30 6.67 20 5.00

Total Assets 450 100 400 100Share Capital 175 38.89 175 43.75Retained Earnings 12 2.67 14 3.50

Total Shareholders Equity 187 41.56 189 47.25

Total Long term Liabilities 150 33.33 125 31.25

Current Liabilities/Provs 113 25.11 86 21.50

Total Liabilities 450 100.00 400 100.00


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Reflects successful utilization of the assets.

Profitability should be judged on the basis of amount

of resources used for obtaining the profit

(i) Return on Operating Assets (ROA)Operating profit as a % of average operating assets

Operating assets = fixed + currentAverage operating assets = (opening + closing) / 2

67 / ((420 + 380) / 2) = 67 / 400 = 16.75 %

Return on Investment


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(ii) Return on Total Assets (ROTA)PAT as a % of average total assets

27 / ((450 + 400) / 2) = 27 / 425 = 6.35 %

(iii) Return on Capital Employed (ROCE), orReturn on Equity (ROE)PAT as a % of average shareholders fund

(capital + retained earnings)

27 / ((187 + 189) / 2) = 27 / 188 = 14.36 %

NOTE : When borrowed money is used to earn more thanthe cost of such borrowing, the ROE increases

Continued


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(i) Earnings per share (EPS)(PAT Dividend on Preference shares) / Number of equity shares

Measures profit available to equity shareholders on per sharebasis

(ii) Price Earnings Ratio (P/E)MP per share / EPS

Used by investors to compare alternate investment avenues

(iii) Dividend per shareShows the cash income available to the shareholder

Return per Share


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1. Measure the level of sales generated by a given quantum of

assets

2. Are a measure of the efficiency of the management inusing the assets

3. Measure the speed at which various assets are converted

into sales (or cash)

4. The greater is the rate of turnover or conversion, the more

efficient is the utilization of assets, other things being

equal.

Efficiency (Activity) Ratios


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1. Total assets turnoverSales / Average total assets

Indicates the efficiency with which the assets

are used

2. Fixed assets turnoverSales / Average fixed assets

Indicates the efficient use of fixed assets

3. Working Capital turnoverSales / Average Net working capital

4. Shareholder equity TurnoverSales/Average Shareholders Equity

Indicates efficiency in the use of equity

Continued


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Solvency (Liquidity) Ability to meet all short-term commitments and to have

enough assets to cover all the liabilities arising in the long run

Companies can be liquid (solvent) but not profitable.

Example : a cash rich construction company with no orders

Companies can be profitable but not liquid.

Example : a construction company with lot of orders but no

cash to execute them

Hence, we need both profitability and solvency

Solvency is of two types Short Term and Long Term


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Liquidity is of major concern to short-term creditors and

management

Sale of merchandise (inventory turnover) and collection of

receivable (receivable turnover) generate liquidity

1. Net Working CapitalExcess of current assets over current liabilities

a. Net working capital is financed by long-term sources of funds

and as such provides a cushion for liquidity

b. It is obvious that since it is financed by long-term sources it is

not required to be repaid in the short-term

Short term Solvency


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2. Current RatioCurrent Assets / Current Liabilities

Indicates amount of current assets available for each rupee ofcurrent liability. However, making a specific conclusion based

on current ratio would depend on:

(a) Various components of current assets,

(b) Time taken for conversion of current assets to cash, and

(c) Speed of maturity of current liabilities, etc.

3. Quick Ratio, or Acid Test RatioQuick Assets / Current Liabilities

Quick Assets = Current assets - inventories


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4. Expenses CoverCurrent Assets / Daily Operating Exp(Operating Expenses/365)

(Current assets as equal to number of days expenses)5. Accounts Receivable TurnoverNet Sales / Average Accounts Receivablesay 300 / ((70 + 90) / 2) = 300 / 80 = 3.75 (means credit sales and

its collection happened 3.75 times during the year)6. Average Collection Period365 / Accounts Receivable Turnover

say 365 / 3.75 = 97.33 days (means it takes approx 97.33 days

for collection of accounts receivable)7. Inventory TurnoverCost of Goods sold /Average Inventory

(Indicates the speed of conversion of inventories to cash)


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Long Term SolvencyThe Long-term creditors would judge the soundness of a firm on the

basis of the long-term financial strength measured in terms of its

ability to pay

1. the interest regularly

2. as well as repay the installment of the principal on due dates

or in one lump sum at the time of maturity

Creditors have a prior claim on the assets of the company and hencethe owners equity forms the margin of safety for lenders claims

Capital Structure / Leverage Ratios


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1. Debt-Equity Ratio

Long-term Debt / Shareholders equity

A high ratio shows a large share of financing by the creditors

of the firm.

2. Long-term Debt to Total Capital(Shareholders Equity)Measures amount of long-term debt for every rupeeof shareholders equity

3. Long-term debt to Fixed AssetsMeasures fixed assets available as a backing for long-term debt

Continued


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Continued

4. Times Interest Earned

EBIT / Expenses on Interest outflow

Larger this cover, greater is the safety of the lenders interestAlso shows the risk in case the firms earnings decrease

5. Capital Gearing Ratio(Preference Capital + Debentures + other borrowed funds)

(Equity + Reserves & Surplus Fictitious Assets)

Shows the extent to which the company is in a position to

increase the earnings to shareholders by having fixed

interest bearing borrowing in the capital structure.


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6. Equity Multiplier

Total Assets / Owners Equity

The equity multiplier will show the extent of enhancement of

return to equity holder due to leverage or borrowing

Continued

DUPONT ANALYSIS


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DUPONT ANALYSIS

A combination of margin on sales ratio, efficiency ratio, and long-term

solvency ratio is popularly known as the DuPont analysis

Return on Equity (ROE)Net Profit Margin (defined as Net Profit/Sales) x Asset Utilization Ratio

(defined as Sales/Total Asset) x Equity Multiplier Ratio (Total

Assets/Owners Equity)

Net Profit x Sales x Total AssestsSales Total Assets Owners Equity

The DuPont analysis approach helps in identifying and pinpointing the

reasons behind high or low profitability of a firm vis--vis itscompetitors

C


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Hidden Assumptions Mean Caution

We generally tend to assume :-1. All the firms have similar accounting policies and practices (such

as the method of depreciation allocation)

2. All the firms did not have any significant change in accountingpolicy (such as a change in the inventory valuation policy)

3. The processes of generating the accounting numbers are reliable

across the firms

A large number of such assumptions might be violated even while

making comparisons of a single firm over many years

Hence, care must be taken while making significant conclusions


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ILLUSTRATIONSome details about a firm are given below :-

1. Total Sales 50,0002. Gross Profit Margin 40%3. Operating Profit Margin 25%4. Net Profit Margin 10%5. Total Assets Turnover 5:76. Current Ratio 4:3

7. Working Capital Turnover 108. Equity Multiplier 2

Construct the P & L a/c and the Balance Sheet

to find the Debt : Equity Ratio of the firm


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Answer1. Total Assets Turnover = Sales / Total assets = 5:7

Since Sales = 50,000, Total Assets = 70,000

So Total Liabilities also = 70,000

2. Working Capital Turnover = Sales / Working Capital = 10

Since Sales = 50,000, Working capital = 5,000

3. Current Ratio = Current assets / current liabilities = 4:3Since Working capital = 5,000 = 4x 3x = x

So, Current assets = 20,000; Current liabilities = 15,000

4. Equity Multiplier = Total Assets / Owners equity = 2

Since Total Assets = 70,000; Owners equity = 35,000

5. On the Liabilities side in the balance sheet, we have :

a. Owners equity = 35,000

b. Current Liabilities = 15,000

c. Total Liabilities = 70,000

so Long term liabilities = 20,000

6. Hence, Debt : Equity ratio = Long term debt / owners equity

= 35,000 / 20,000 = 7 : 4 Answer


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THANK YOU

session 9 - ratio analysis

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