Ratio Analysis

Prof. Milind Dalvi

Asst. Prof. Finance
Kohinoor Business School, Mumbai

Objectives:
To identify aspects of a businesss performance to aid decision

making
Quantitative process may need to be supplemented by
qualitative factors to get a complete picture.

Examples of external users of statement

analysis
Trade Creditors -- Focus on the liquidity of
the firm.
Bondholders -- Focus on the long-term cash
flow of the firm.
Shareholders -- Focus on the profitability and
long-term health of the firm.

Examples of internal users of statement

analysis
Plan -- Focus on assessing the current financial

position and evaluating potential firm opportunities.

Control -- Focus on return on investment for
various assets and asset efficiency.
Understand -- Focus on understanding how
suppliers of funds analyze the firm.

Ratio Analysis
Ratio analysis isn't just comparing different numbers from

the balance sheet, income statement and cash flow statement.

It's comparing the number against previous years, other
companies, the industry or even the economy in general.
Ratios look at the relationships between individual values and
relate them to how a company has performed in the past, and
how it might perform in the future.
For example, current assets alone don't tell us a whole lot, but
when we divide them by current liabilities we are able to
determine whether the company has enough money to cover
short-term debts.

Where do you get the data?

The first step in ratio analysis is to find the data.
Company Websites - Almost every public company has a

website or investor relations department. For the most current

quarterly or annual report you might want to check in these
places first. Walt Disney is an excellent example of a company
that uses the web to get information out to shareholders and
prospective investors.

Where do you get the data?

Yahoo Finance - A touchstone for many individual investors,

Yahoo! Finance is a great resource for financial news, and lays

out ratios and performance data for individual companies.
SEBI: Securities Exchange Board of India: All listed companies
have to present quarterly data to SEBI.
Hoovers.com - A great site for company analysis; some of the
data requires a subscription.

Ratio analysis
1. Liquidity the ability of the firm to pay its way
2. Investment/shareholders information to enable decisions to

be made on the extent of the risk and the earning potential of a

business investment
3. Gearing information on the relationship between the
exposure of the business to loans as opposed to share capital
4. Profitability how effective the firm is at generating profits
given sales and or its capital assets
5. Financial the rate at which the company sells its stock and
the efficiency with which it uses its assets

Liquidity ratios
Current ratio
Liquid ratio

Activity ratios
Stock / Inventory turnover ratio
Debtors turnover ratio
Creditors turnover ratio

Leverage ratios
Debt equity ratio
Interest coverage ratio

Performance ratios
1.
2.
3.
4.
5.
6.
7.
8.
9.

Book value per share

Return on Asset (ROA)
Dividend payout ratio
Earnings per share (EPS)
Gross Margin ratio
Price Earnings ratio (P/E)
Profit Margin
Return on Equity (ROE)
Return on Capital Employed (ROCE)

Liquidity ratio Current ratio

Looks at the ratio between Current Assets and Current Liabilities
Current Ratio = Current Assets / Current Liabilities
A ratio of 5 : 1 would imply the firm has Rs 5 of assets to cover

every Re 1 in liabilities
A ratio of 0.75 : 1 would suggest the firm has only 75p in assets
available to cover every Re 1 it owes
Too high Might suggest that too much of its assets are tied up
in unproductive activities too much stock.

Liquidity ratio Quick ratio

Also referred to as the Quick ratio
(Current assets stock) : liabilities
The omission of stock gives an indication of the cash the firm

has in relation to its liabilities (what it owes)

A ratio of 3:1 therefore would suggest the firm has 3 times as
much cash as it owes very healthy!
A ratio of 0.5:1 would suggest the firm has twice as many
liabilities as it has cash to pay for those liabilities. This might put
the firm under pressure but is not in itself the end of the world!

Turnover ratio Stock turnover ratio

Stock turnover = Cost of goods sold / stock expressed as

times per year

The rate at which a companys stock is turned over
A high stock turnover might mean increased efficiency?
But: dependent on the type of business supermarkets might have

high stock turnover ratios whereas a shop selling high value

musical instruments might have low stock turnover ratio
Low stock turnover could mean poor customer satisfaction if
people are not buying the goods (Marks and Spencer?)

Turnover ratios Debtors turnover

Indicates quality of receivables and how successful the firm is in

its collections.
Debtor Days = Debtors / sales turnover x 365
Shorter the better
Gives a measure of how long it takes the business to recover
debts
Can be skewed by the degree of credit facility a firm offers

Turnover ratios Creditors turnover

Indicates quality of payables and how successful the firm is in its

payment.
Creditor Days = Creditors / purchases turnover x 365
Gives a measure of how long it takes the business to pay the
debts
Can be skewed by the degree of credit facility offered by the
suppliers.

Problem
Particulars

Amount

Raw materials (Opening stock)

2,501

Raw materials (Closing stock)

2,611

Raw materials consumed

10,164

Work in progress (Opening stock)

489

Work in progress (Closing stock)

363

Finished goods (Opening stock)

3,862

Finished goods (Closing stock)

5,553

Sundry debtors ((Opening stock)

9,123

Sundry debtors (Closing stock)

10,185

Problem (cont)
Particulars

Amount

Sales

59,852

Cost of goods sold

50,693

Purchases

10,274

Sundry creditors (Opening stock)

9,480

Sundry creditors (Closing stock)

11,697

Solution
Raw materials = Average inventory of raw materials / raw

materials consumed
= (2,501 + 2,611)/2 / 10,164/365
= 92 days.
Calculate:
1) Work in progress
2) Finished goods
3) Sundry debtors
4) Sundry creditors.

Leverage ratio
Debt Equity ratio:
Calculated as Debt / Shareholders equity
Other things being equal, higher debt equity ratio can

force a company into bankruptcy.

Higher debt entails higher interest payment and debt
holders can force the company into liquidation on non
payment of their dues.

Leverage ratio
Times interest earned ratio:
EBIT / Interest.
It is calculated to know the payment of companys

available income towards interest charges.

Interest payments are more often associated with long
term liabilities.

Profitability ratios
Gross Profit ratio = Gross profit / Net sales
Profit Margin ratio = Net income (PAT) / Net sales
Return on Assets (ROA) = Net income / Average total assets