FINANCIAL MANAGEMENT

4/12/2014

Financial Ratio Analysis

4/12/2014

SIGNIFICANCE OF RATIO ANALYSIS

CSD A earns Rs 50,000 CSD B earns Rs 40,000

Which is more efficient? A or B

CSD A has emp Rs 4,00,000 CSD B has emp Rs 3,00,000

Profit as a % of Capital emp

A = (50,000/ 4,00,000) * 100 =12.50% B = (40,000/ 3,00,000) * 100 =13.33%

4/12/2014 3

RATIO
A ratio is a statistical yardstick that provides a measure of the relationship between two variables or figures.

4/12/2014

BALANCE SHEET ABC COMPANY AS AT 31 MAR2008

31MAR07

LIABILITIES

31MAR08
170 120 50 215 151 50 101 30

ASSETS
31MAR07
213 FIXED ASSETS NET GROSS STOCK LESS DEPRECIATION 11 INTANGIBLE ASSETS 5 INVESTMENTS

31MAR08 229
594 365

170 SHARE CAPITAL EQUITY PREFERENCE 180 RESERVES AND SURPLUSES 150 SECURED LOANS DEBENTURES
LOANS /ADVANCES

15 5

20 UNSECURED LOANS

670 CURRENT ASSETS CASH IN BANK RECEIVABLES INVENTORIES PRE-PAID EXPENSES 73 189 355 64

681

409 CURRENT LIABILITIES SUNDRY CREDITORS PROVISIONS

399
330 69 965

30 MISC EXPDR/LOSSES
929 TOTAL (Rs Lacs) 929 TOTAL (Rs Lacs)

35
965

INCOME STATEMENT OF ABC COMPANY FOR YEAR ENDED 31 MAR 08

FIGS 2007 847 657 NET SALES COST OF GOODS SOLD STOCKS WAGES AND SALARIES OTHER MANUFACTURING EXPENSES GROSS PROFIT OPERATING EXPENSES: SELLING/ADM DEPRECIATION OPERATING PROFIT NON-OPERATING PROFIT/DEFICIT PROFIT BEFORE INTEREST&TAX (EBIT) INTEREST(ON BANK BORROWINGS/LOANS) DEBENTURES PROFIT BEFORE TAX TAX PROFIT AFTER TAX
DIVIDENDS:EQUITY/ PREFERENCE RETAINED EARNINGS(RESERVE & SURPLUS)

FIGS 2008 904 366 188 160 714

190 103

190 71 25 96

87 11 98 26 72 36 36 12 24

94 49 143 29 4 33 110 58 52 14 / 3 17 35

WHY BOTHER WITH RATIOS?

A comparison is more useful than mere Nos

Analysis of financial ratios involves two types of comparisons:

Present ratio with the past ratios & expected future ratios Ratios of one firm with those of similar firms or with industry averages at same point of time

Essential to consider nature of business (apples cannot be compared with oranges)

4/12/2014

CLASSIFICATION OF RATIOS

Liquidity ratios Leverage / Solvency ratios Turnover / Activity ratios Profitability ratios

Valuation ratios

4/12/2014

LIQUIDITY RATIOS

Shows ability of company to pay its current financial

obligations

Company should not be selling its assets at a loss to meet its financial obligations; worst scenario be forced into liquidation

Current ratio Quick / Acid test ratio

4/12/2014 9

CURRENT RATIO (CR)

Measure of companys ability to meet short term requirements

Indicates whether current liabilities are adequately covered

by current assets

Measures safety margin available for short term creditors CR = Current assets/Current liabilities If Net Working Capital is to be positive, CR >1

Indian avg for non banking industries is 2

Current assets CR = 681/399

= 681

Current liabilities = 399

4/12/2014

= 1.71

12

CURRENT RATIO (CR) - IMPORTANCE

Higher ratio ensures firm does not face problems in meeting increased working capital requirements

Low ratio implies repeated withdrawls from bank to meet liquidity requirements

High CR as compared to other firms implies advantage of

lower int rates from banks

4/12/2014

13

ACID TEST RATIO/QUICK RATIO(QR)

Used to examine whether firm has adequate cash or cash equivalents to meet current obligations without resorting to liquidating non cash assets such as inventories

Measures position of liquidity at a point of time QR = Quick Assets / Current Liabilities

Quick assets = Current assets (inventories + prepaid expenses) = 681(355+64) = 262 Current liabilities = 399

QR = 262/399 = 0.66 As a thumb rule ideal QR = 1; should not be less than 1

4/12/2014 14

CLASSIFICATION OF RATIOS

Liquidity ratios Leverage / Solvency ratios Turnover / Activity ratios Profitability ratios

Valuation ratios

4/12/2014

15

LEVERAGE RATIOS

Shows dependence of firm on outside long term finance Shows long term financial solvency & measures firms ability to pay interest & principle regularly when due

To assess extent to which the firm borrowed money vis--vis funds supplied by owners; Use of debt finance

Debt - Equity ratio

Companies whose EBIT <= Interest payments are risky

Debt - Total fund ratio Debt - Assets ratio

Interest coverage ratio Liability coverage ratio

16

4/12/2014

DEBT EQUITY RATIO

Measures relative proportion of debt & equity in financing assets of a firm

Company can have good current ratio and liquidity position, however liquidity may have come from long term borrowed funds, the repayment of which along with interest will put liquidity under pressure

DER = Long term debt / Share holders funds Creditors would like this to be low; Lower ratio implies larger credit cushion (margin of protection to creditors)

IDB expects DER of 2:1 in respect of SMEs

4/12/2014 17

DEBT EQUITY RATIO

Debt (loans) = Secure loans + Unsecure loans = 151+30=181

Share holders funds = (equity+ preference capital + res & surplus fictitious assets &

accumulated losses not written off )

= 120+50+215 = 385

DER = 181/385 = 0.47 = (0.47:1) Creditors are providing Rs 0.47 financing for each rupee provided by shareholders
4/12/2014 18

DEBT TOTAL FUND RATIO

DTF ratio= Long term debt / Total fund

Debt (long term)

181

Total funds (debt + sh holders funds) = 181+(170+215-35) = 531

DTF ratio = 181/531 = 0.34 34% of the firms funds are debt (of various types)

remaining 66% is financed by owners/ share holders

Higher the debt - total funds ratio, greater the financial risk
4/12/2014 19

DEBT ASSETS RATIO

Debt - Assets ratio = Debt / Net assets

Debt = 181
Net assets (less fictitious assets & losses) = 930 Ratio = 181/930 = 0.19 19% of the firms assets are financed with debt (of various types).

Shows coverage provided by the assets to total debt

4/12/2014

20

INTEREST COVERAGE RATIO

Gives ability of company to pay back long term loans along with interest or other charges from generation of profit from its operations

Interest coverage ratio = EBIT / Debt interest

EBIT = 143
Interest = 29+4 = 33 Ratio = 143/33=4.33 EBIT should be 6 7 times of debt interest Shows margin of cover to lenders; of prime imp
4/12/2014 21

LIABILITY COVERAGE RATIO

Calculated to determine time a company would take to pay off all its liabilities from internally generated funds

Assumes that liabilities will not be liquidated from additional borrowings or from sale of assets

LCR = Internally generated funds / Total liabilities

Internally gen funds = Equity + Pref + R&S = 385 Total liabilities = 965

LCR = 385/965 = 0.399 Firm will take 2.5 yrs (1/.399) to repay all its liabilities
4/12/2014 22

CLASSIFICATION OF RATIOS

Liquidity ratios Leverage / Solvency ratios Turnover / Activity ratios Profitability ratios

Valuation ratios

4/12/2014

23

ACTIVITY / TURN OVER RATIOS

Allows to examine whether total amount of each type of asset a company owns is reasonable, too high or too low in light of

current and forecast operating needs

In order to purchase / acquire assets, companies need to borrow or obtain Capital from elsewhere :

More assets acquired implies high int and low profits Lesser assets implies operations not as efficient as possible

Activity turn over ratios used to assess efficiency with which

Inventory turnover company utilizing its assets

ratio

Average collection period Relates to level of activity represented by sales or cost of

goods sold 4/12/2014

Fixed assets turn over ratio

24

INVENTORY TURN OVER RATIO

Measures No of times inventory turned over in a year OR No of days of inventory held by company to sp sales Times Inventory turned over = Net sales OR COGS

Avg inventory

Avg stocks

Inventory measured in days of sale = 365 x Avg inventory Net Sales

4/12/2014

25

INVENTORY TURN OVER RATIO

A ratio of 6 times indicates inventory turned over six times in a year OR Ratio of 60 days indicates enough inventory to support sales for 60 days held by company Excessive inventories unproductive; represent investment with zero rate of return Conversely less inventory results in loss of customers ABCs ratio = 904/355 = 2.54 ABCs Days of Inv = (355 x 365)/904 = 143.33 days

4/12/2014

26

AVERAGE COLLECTION PERIOD

Represents duration a company must wait after making sales, before it actually receives cash from its customers

ACP =
=

Avg receivables Average sales per day Avg receivables x 365 Sales

OR

Imp

For assessing effectiveness of credit policy of firm Enables mgmt to take timely measures to effectively manage Receivables = 189 credit Salesvalue - firm facing = 904difficulties in collecting debts Too high Too low credit policy ACP value - restrictive = (189 x 365)/ 904 = 76.2 days say 76 days
4/12/2014 27

FIXED ASSETS TURNOVER RATIO

Measures effectiveness of utilization of fixed assets by company

Used to compare fixed assets utilization of two firms Not truly reflective of performance / efficiency

High ratio (depreciation) if old assets

Low ratio if capital assets procured recently

FATR = Net sales (or COGS)/ Fixed assets

Fixed indicates Assets = 229utilisation of assets (with a Higher ratio better = 904 cautionNet on Sales age of assets) FATR
4/12/2014

= 904 / 229 = 3.95

28

CLASSIFICATION OF RATIOS

Liquidity ratios Leverage / Solvency ratios Turnover / Activity ratios Profitability ratios

Valuation ratios

4/12/2014

29

PROFITABILITY RATIOS
Profitability ratios indicate Company's profitability in relation to other companies Internal comparison with last yrs profits Managements effectiveness as shown by returns generated on sales and investments

Gross profit margin ratio (GPMR) Net profit margin ratio (NPMR) Return on investment 4/12/2014

30

GROSS PROFIT MARGIN RATIO (GPMR)

Represents cost of production Helps in understanding proportion of raw materials used and direct expenses incurred in overall production process

Reflects income being generated which can be apportioned

by promoters

Net Sales = 904 Reflects efficiency of firms operations as well as how Gross products are Profit priced GPMR = Net sales - COGS = 904 - 714 = 190 = Gross Profit / Net sales = 190 / 904 = 0.21 = 21%

GPMR = Gross profit/ Net sales

Implies 79% (100-21%) of sales contribute towards direct

expenses 4/12/2014 and raw mtrl
31

NET PROFIT MARGIN RATIO (NPMR)

Takes into account not only cost of production but also administrative expenses like staff salary, selling & distribution overheads

Represents surplus of gross profit after meeting expenses

Net profit appropriated to 2,00,000 meet tax liability, dividend SALES 2,50,000
GROSS PROFIT 40,000 payments and to retain part in business

Net Sales

COMPANY A = 904

COMPANY B 40,000

Net Profit after taxes

= 52

NPMR = PROFIT Net profit (Profit after tax)/ Net sales = 52 / 904 = 0.057 = 5.7% GROSS MARGIN 20% 16%

NPMR NET PROFIT

= Net Profit / Net sales 20,000 22,000

NET PROFIT MARGIN 10% of sales, Rs 5.7/8.8% Implies for every Rs 100/earned as

Company B has outperformed Company A in total sales However 4/12/2014 A has utilized its resources more efficiently
to res & surplus

profit which can be used for dividend distr and apportioned

32

PROFITABILITY IN RELATION TO INVESTMENTRETURN ON INVESTMENT (ROI)

Indicates efficiency with which company used its Capital (Equity as well as debt)

Takes into account overall returns of the company assuming company has not taken any debt Gives EBIT = 143 overall returns including adjustments of earnings for fin Capital employed = 566 ( (120+50+215+181)-(0+0) ) leveraging

(Eq +Pref sh +Res & surp+Debt)-(Fictitious assets + Enables one to check whether return made on investment is Non operating investments) better than other alternatives available ROI = 143/566 x 100 = 25.26 %. Suited for inter-firm comparisons The company has earned a profit of 25.26 paise on every ROI = EBIT x100 / Capital employed 100 Re invested 4/12/2014 33

CLASSIFICATION OF RATIOS

Liquidity ratios Leverage / Solvency ratios Turnover / Activity ratios Profitability ratios

Valuation ratios

4/12/2014

34

VALUATION RATIOS

Earning per share (EPS)

Price Earnings (PE) Multiple

Price Earnings Growth (PEG) Multiple Dividend Payout Ratio Dividend Yield Beta of Stock

4/12/2014

35

EARNINGS PER SHARE (EPS)

Represents total earnings of a company available for distribution among equity shareholders

Evaluates performance of company shares over a period of

time

EPS = Net profit available for equity shareholders / No of Equity shares

EPS alone should not be basis of decision making with respect to purchase of any company share

Faulty reasons of High EPS

Less No of Equity shares Investment in risky ventures

4/12/2014

36

PRICE EARNING (PE) MULTIPLE

Simplest method of comparing different stocks at a point of time to make investment decisions

As a layman, this is the price being paid for buying one rupee of earning of a company eg If PE of Infosys share is Rs 9/- it

means we are paying to the market a price of 9 for every

Rs 1/- earning of the company

PE Ratio = Market Price per share/ EPS

4/12/2014

37

PRICE EARNING GROWTH (PEG) MULTIPLE

An extension of PE which also takes into account growth rate of the company

PEG Multiple = PE / Growth

COMPANY A COMPANY B
Market Price
EPS Growth rate PE Multiple PEG Multiple

Analysis

200
10 5% 20 (200/10) 4 (20/5)

200
20 2% 10 (100/20) 5 (10/2) A overvalued B overpriced wrt growth potential

Which company stocks to be purchased ?

4/12/2014 38

DIVIDEND PAYOUT RATIO

Shows amount of dividend paid out of earnings An indication of amount of profits put back into company Imp ratio to assess long term prospects of company Dividend Payout Ratio = Dividend / Net Income

4/12/2014

39

DIVIDEND YIELD

Shows relationship between Dividend per share and market price

An imp ratio to compare two companies Dividend Yield (%) = Dividend amount per share *100

Market price of share

4/12/2014

40

BETA OF SECURITY

Refers to overall market risk which a security is carrying and which cannot be diversified

Responsiveness of share price of a company with respect to overall market movement

If over a period of time, market has given a return of 20%; individual share of company A has given return of 10%;
Beta of A = 10 / 20 = 0.5

If investor is risk averse, should invest in stocks with low

Beta; Even if market falls by drastic amount his investment will not take that much hit
4/12/2014 41

FINANCIAL RATIOS
LIQUIDITY NWC = CR = ATR =
CA - CL CA/CL (CA INVENTORY)/CL Solvency , Safety Margins, Idle Resources , Risk

Long term solvency LEVERAGE Risk due to debt Debt-Equity Ratio = Debt/Net Worth Owners Stake Liab Coverage Ratio = Int gen funds / Total Liab Coverage provided Debt to Assets Ratio = Debt/Total Assets by assets Interest Coverage Ratio = EBIT/Debt Interest Interest burden ACTIVITY/TURNOVER Inventory Turn Over Ratio = Net Sales/Inventory FATR = Net Sales/Total Assets Avg Collection Period = 365/ RTOR PROFITABILITY . GPMR = Gross Profit/Net Sales NPMR = Net Profit/Net Sales ROI = EBIT x 100/ Capital ROE = Equity earnings/ NW
4/12/2014

Utilisation Credit mgt Restrictions Efficency

Efficency Acceptability Overall performance Margin of Safety Ability for PAT

42