RATIO ANALYSIS FOR BUSINESS DECISION MAKING Learning Objectives : On completion of their studies students should be able to: • Calculate and interpret a full range of accounting ratios • Analyse financial statements (in the context of information provided in the accounts and corporate report) to comment on performance and position • Prepare a concise report on the results of an analysis of financial statements • Understand the limitations of accounting ratio analysis and analysis based on financial statements Meaning of Ratio Analysis A Ratio is a simple mathematical expression of the relationship of one item to another. It can be expressed as a percent, rate, or portion. Ratio analysis involves studying various relationships between different items reported in a set of financial statements. Ratio analysis helps to interpret the information in such a way that it can be understood by even those people who are not much familiar with financial figures and statistics. However, all the problems of a business can’t be solved by ratio analysis. It will merely give a general indication of a trend, at the same time spotlighting any divergence from normality. This knowledge, however, should enable management to correct whatever may be going wrong in business. This unit deals with meaning, classification, advantages and calculation of ratios. 1. LIQUIDITY RATIOS Current Ratio Quick Ratio Absolute Liquid Ratio Accounts Receivable to Working Capital Inventory to Working Capital 2. ACTIVITY RATIOS Short Term Inventory Turnover Ratio
Inventory holding period Debtors Turnover Ratio Debtors Collection Period Creditors Turnover Ratio Creditors Payment Period Operating Cycle Days Long Term / Efficiency
Total Assets Turnover ratio Net Fixed Assets Turnover ratio Working Capital Turnover ratio 3. PROFITABILITY RATIOS Gross Profit margin Net Profit Margin
Operating Ratio Operating Profit Ratio 4. SOLVENCY RATIOS Debt to Equity Debt to Total Assets Proprietary Ratio Capital Gearing Ratio
Financial Flexibility Ratio Net Fixed Assets to Equity
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Analysis of Financial Statements
1.1 1.2 1.3 1.4 1.5
2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10
3.1 3.2 3.3 3.4
4.1 4.2 4.3 4.4 4.5 4.6
5. COVERAGE RATIOS Interest Coverage ratio Dividend Coverage Debt Service Coverage Ratio Basic Defence Interval
5.1 5.2 5.3 5.4
6. INVESTMENT VALUATION RATIOS
Earnings Per Share Price Earnings Ratio Price Earnings to Growth Ratio Dividend Per Share Dividend Payout Ratio Dividend Yield Ratio Book Value Per Share 7. Return on Investment Measurements Return on Assets Employed Return On Equity Financial Leverage Index
The DuPont formula 1.
6.1 6.2 6.3 6.4 6.5 6.6 6.7
7.1 7.2 7.3 7.4
LIQUIDITY RATIO
Liquidity is the ability of the company to repay its debts in the short-term (one year). Consequently, these ratios will focus on the current assets and the current liabilities. Current assets can, by definition, generally be converted into cash (liquidated) within 12 months of year-end and similarly, current liabilities are debts that must generally be settled within 12 months of year-end. These ratios give an indication of management’s operational capabilities regarding the management of working capital. The main liquidity ratios include: • Current ratio; • Acid-test ratio; and • Working capital ratio. The following ratios look at each of the individual components of the current assets and current liabilities (indicating how liquid each item is): • Debtors: collection period and turnover ratios; • Inventory: days on hand and turnover ratios; • Creditors: repayment period and turnover ratios; and • Business cycle ratio. 1.1 Current Ratio
Current ratio =
Total current assets Total current liabilitie s
This ratio reflects the number of times short-term assets cover short-term liabilities and is a fairly accurate indication of a company's ability to service its current obligations. A higher number is preferred because it indicates a strong ability to service short-term obligations. The composition of current assets is a key factor in the evaluation of this ratio.
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Analysis of Financial Statements
A rule of thumb is that a ratio of 2 : 1 (Rs.2 in current assets for every Re.1 of current liabilities) is acceptable. However, the current ratio may vary from less than one in such industries as fast foods to more than two in the telephone apparatus manufacturing industry. Consequently, it is important to utilize the industry averages. Analysis: Firstly, the numerator of this ratio includes the estimate of inventories and accounts receivable. As the inventory evaluation methods may differ this affects the comparability of the values, and the same must be taken into account for the treatment and accounting of debts; Secondly, the value of the ratio is in fact closely related to the level of efficiency in the enterprise in respect of stock management: some companies with high level of organisation of the technological process, for example, by implementing such raw materials and consumables supply systems which is known as ‘just-in-time’ can reduce the level of stock considerably, i.e., by also reducing the current ratio to the minimum than on average in the industry thus keeping the current financial position free from losses; Thirdly, some enterprises with a high turnover of cash assets can afford to keep the liquidity ratios relatively low, for example, in retail trade. In this situation acceptable liquidity was ensured on account of a more intensive cash flow from current operations. It is important to identify the specific types of current assets that are excessive such as 1. Excessive stock levels, indicating poor stock control or a decline in sales volume 2. Excessive debtors, indicating poor credit control and an increasing risk of bad debts 3. Excessive cash or near cash equivalents, indicating a lack of suitable investment opportunities in capital projects. If the ratio is too high (>3), this indicates that there is a possible asset management problem in the enterprise and that the working capital is not efficiently used. A ratio that is much higher than the industry average indicates that the firm may have excessive current assets. Further investigation may demonstrate the cause of the excess. One reason may be that the firm is having trouble in the collection of its debtors or has high inventory, both of which will be identified through the use of other ratios. Another reason may be that the firm is holding too much cash or short term investments which could be earning more money if they were invested in long term instruments. Still another reason for a high ratio is that the firm may be at a specific point in its business cycle. The company that sells woolen goods in winter is expected to have high inventory in November, December, January and high debtors in February. A ratio which is much lower than the industry average indicates that the firm is having liquidity problems, meaning that it may not be able to meet its short term obligations. Accordingly, an extremely low current ratio should be a red flag to the company being analyzed. How to Manage the Current Ratio The apparent simplicity of the current ratio can have real-world limitations. An addition of equal amounts to both the numerator and the denominator causes the ratio to change. Assume, for example, that a company has 2,000,000 of current assets and 1,000,000 of current liabilities. Its current ratio is 2:1. If it purchases 1,000,000 of inventory on account, it will have 3,000,000 of current assets and 2,000,000 of current liabilities. Its current ratio will decrease to 1.5:1. If, instead, the company pays off 500,000 of its current liabilities, it will have 1,500,000 of current assets and 500,000 of current liabilities, and its current ratio will increase to 3:1. Thus, any trend analysis should be done with care, because the ratio is susceptible to quick changes and is easily influenced by management. 1.2 Quick Ratio / Acid test Ratio / Liquidity Ratio Depending on the type of business or industry, current assets may include slow-moving inventories that could potentially affect analysis of a company's liquidity. How long could it potentially take to convert raw materials and inventory into finished products? (For this reason, the quick ratio may be preferable to the current ratio because it
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Analysis of Financial Statements
eliminates inventory and prepaid expenses from this ratio for a more accurate gauge of a company's liquidity and ability to meet short-term obligations.) (Quick assets / Quick liabilities ) OR ( Quick assets / Current liabilities )
This ratio measures immediate liquidity - the number of times cash, accounts receivable, and marketable securities cover short-term obligations. A higher number is preferred because it suggests a company has a strong ability to service short-term obligations. This ratio is a more reliable variation of the Current ratio because inventory, prepaid expenses, and other less liquid current assets are removed from the calculation. 1.3 Absolute Liquid Ratio (Cash + Cash equivalents) / (Current liabilities) Cash Equivalents includes marketable securities. Absolute Liquid Ratio is also called as Cash Position Ratio (or) Over Due Liability Ratio. This ratio establishes the relationship between the absolute liquid assets and current liabilities. Absolute Liquid Assets include cash in hand, cash at bank, and marketable securities or temporary investments. The optimum value for this ratio should be one, i.e., 1: 2. It indicates that 50% worth absolute liquid assets are considered adequate to pay the 100% worth current liabilities in time. If the ratio is considerably more than one, the absolute liquid ratio represents enough funds in the form of cash to meet its short-term obligations in time. 1.4 Accounts Receivable to Working Capital Trade Accounts Receivable / (Current Assets - Current Liabilities) This ratio measures the dependency of working capital on the collection of receivables. A lower number for this ratio is preferred, indicating that a company has a satisfactory level of working capital and accounts receivable makes up an appropriate portion of current assets. 1.5 Inventory to Working Capital Inventory / (Current Assets - Current Liabilities) This ratio measures the dependency of working capital on inventory. A lower number for this ratio is preferred indicating that a company has a satisfactory level of working capital and inventory makes up a reasonable portion of current assets. 2.
ACTIVITY RATIOS / Turn over ratios
Generally, turn over ratios indicate the operating efficiency. These are used to measure the speed with which various accounts are converted into sales or cash. The higher the ratio, the higher the degree of efficiency and hence these assume significance. Further, depending upon the type of turn over ratio, indication would either be about liquidity or profitability also. For example, inventory or stocks turn over would give us a measure of the profitability of the operations, while receivables turn over ratio would indicate the liquidity in the system. These ratios are used along with liquidity ratio because measures of liquidity are generally inadequate due to the composition of the firm’s current assets and current liabilities. 2.1 Stock Turnover Ratio (STO) STO = COGS / Average stock at cost
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Analysis of Financial Statements
It commonly measures the activity or liquidity of the firm’s stock.. The STO is also known as stock velocity. Velocity refers to “speed” with which an object travel. Here, it is the speed on converting the stock into sales then to cash. It indicates the number of times the stock has been turned over as cash during a given period of time. It evaluates the efficiency with which a firm is able to manage its stock. This ratio directly contributes to the profitability of the organisation. The inventory should turn over at least 4 times in a year, even for a capital goods industry. But there are capital goods industries with a very long production cycle and in such cases, the ratio would be low. The production cycle and the corporate policy of keeping high stocks affect this ratio. The less the production cycle, the better the ratio and vice-versa. The higher the level of stocks, the lower would be the ratio and vice-versa. 2.2 Inventory holding period / Stock Conversion period This is inverse of stock turnover ratio. It shows no. of days to convert raw material to finished goods. 1/ Inventory Turnover Ratio OR ( Inventory / Cost of goods sold) X
0 days
2.3 Debtors Turnover Ratio = Total credit sales/Average debtors outstanding during the year This ratio measures the number of times receivables turn over in a year and reveals how successful a company is in collecting its outstanding receivables. A higher number is preferred because it indicates a shorter time between sales and cash collection. It indicates the efficiency of collection of receivables and contributes to the liquidity of the system. Hence the minimum would be 3 to 4 times, but this depends upon so many factors such as, type of industry, etc (a) capital goods, consumer goods - For capital goods, this would be less and consumer goods, this would be significantly higher; (b) Conditions of the market – monopolistic or competitive – monopolistic, this would be higher and competitive it would be less as you are forced to give credit; (c) Whether new enterprise or established – new enterprise would be required to give higher credit in the initial stages while an existing business would have a more fixed credit policy evolved over the years of business; Hence any deterioration over a period of time assumes significance for an existing business – this indicates change in the market conditions to the business and this could happen due to general recession in the economy or the industry specifically due to very high capacity or could be this unit employs outmoded technology, which is forcing them to dump stocks on its distributors and hence realisation is coming in late etc. 2.4 Debtors Collection period Average collection period = inversely related to debtors turn over ratio. 1 / (Debtors Turnover Ratio) X No. of Days
OR
( Debtors + BR / Net credit sales) x No. of Days
It is also known as Debtors velocity. The birth of debtor comes from credit sales. Total debtors include the Bills Receivable also. The Bills receivables are written promise of trade debtors. Trade debtors are normally provided with 3 months credit time. After the expiry, they will pay cash. Thus, debtors are expected to be converted into cash within a short period. This ratio explains the average number of days a company's receivables are outstanding. A lower number of days is desired. An increase in the number of days receivables are outstanding indicates an increased possibility of late payment by customers. Companies should attempt to reduce the number of days sales in receivables in order to increase cash flow.
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Analysis of Financial Statements
2.5 Creditors Turnover Ratio : CTO ( Creditors + Bills Payable / Credit purchases ) x 365 days Creditors come into being out of credit purchases. Creditors include both trade creditors and bills payables. It is included in the current liability since the payment has to be made within three months normally. 2.6 Creditors Payment Period 1 / (Creditors Turnover Ratio) X No. of Days
OR ( Creditors + BP / Net credit Purchases) x No. of Days
A calculation of the days of accounts payable gives an outside observer a fair indication of a company’s ability to pay its bills on time. If the accounts payable days are inordinately long, this is probably a sign that the company does not have sufficient cash flow to pay its bills and may find itself out of business in short order. Alternatively, a small number of accounts payable days indicate that a company is either taking advantage of early payment discounts or is simply paying its bills earlier than it has to. 2.7 Operating Cycle Days (Stock Holding period + Debtors Collection Period ) – Creditors Payment Period This ratio calculates the total conversion period for a company, or in other words, the average number of days it takes to convert inventory into cash from sales. It is calculated by adding together the days cost of sales in inventory to the days sales in receivables. Evaluating this ratio can be helpful in gauging the effectiveness of marketing, determining credit terms to extend to customers, and collecting outstanding accounts.
2.8 Assets Turnover ratio - Asset utilization Ratio Sales / Total Assets This ratio measures a company's ability to produce sales in relation to total assets to determine the effectiveness of the company's asset base in producing sales. A higher number is preferred, indicating that a company is using its assets to successfully generate sales. This ratio does not take into account the depreciation methods employed by each company and should not be the only measure of effectiveness of a company in this area. Overcapitalization Overcapitalization is a situation in which actual profits of a company are not sufficient enough to pay interest on debentures, on loans and pay dividends on shares over a period of time. This situation arises when the company raises more capital than required. A part of capital always remains idle. With a result, the rate of return shows a declining trend. Undercapitalization An undercapitalized company is one which incurs exceptionally high profits as compared to industry. An undercapitalized company situation arises when the estimated earnings are very low as compared to actual profits. This gives rise to additional funds, additional profits, high goodwill, high earnings and thus the return on capital shows an increasing trend. 2.9 Net Fixed Assets Turnover ratio Sales / (Fixed Assets - Accumulated Depreciation)
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Analysis of Financial Statements
This ratio measures a company's ability to effectively utilize its fixed assets to generate sales. This ratio is similar to the sales to assets ratio, but it excludes current assets, long-term investments, intangible assets, and other non-current assets. A higher number is desired, indicating that a company productively uses its fixed assets to produce sales. In addition, fixed assets that are almost fully depreciated, and labor-intensive operations may interfere with the interpretation of this ratio. 2.10 Working Capital Turnover ratio Sales / (Current Assets - Current Liabilities) This ratio measures a company's ability to finance current operations. Working capital is another measure of liquidity and the ability to cover short-term obligations. This ratio relates the ability of a company to generate sales using its working capital to determine how efficiently working capital is being used. Significance: It is an index to know whether the working capital has been effectively utilized or not in making sales. This ratio shows the amount of Working Capital required to maintain a certain level of sales. It is most effective when tracked on a trend line, so that management can see if there is a long-term change in the amount of Working Capital required by the business in order to generate the same amount of sales. A higher working capital turnover ratio indicates efficient utilization of working capital, i.e., a firm can repay its fixed liabilities out of its working capital. Also, a lower working capital turnover ratio shows that the firm has to face the shortage of working capital to meet its day-to-day business activities unsatisfactorily. 3. PROFITABILITY RATIOS The term profitability means the profit earning capacity of any business activity. Profitability ratios measure a company’s ability to use its capital or assets to generate profits. Improving profitability is a constant challenge for all companies and their management. Evaluating profitability ratios is a key component in determining the success of a company. This is an analysis of the profits as per the statement of income as well as the analysis of the profitability in relation to the related capital investment/s and sources of finance per the statement of financial position. The profitability ratios can therefore, be divided into three separate areas: • Pure analysis of the statement of income: e.g. gross profit percentage and net profit percentage; 3.1 Gross Profit margin ((Sales - Cost of Sales) / Sales) * 100 Gross Profit Margin reflects the efficiency with which management produces each unit of product. It indicates the average spread between the cost of goods sold and the sales revenue. This ratio measures the gross profit earned on sales and reports how much of each rupee of sales is available to cover operating expenses and contribute to profits. 3.2 Net Profit Margin Earnings after Taxes / Sales * 100 This ratio measures how much profit a company makes on sales received and how well a company could potentially deal with higher costs or lower sales in the future.
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Analysis of Financial Statements
This ratio indicates the firm’s ability withstand adverse economic conditions. It establishes a relationship between net profit and sales and also indicates management’s efficiency in manufacturing, administering and selling of products. Net profit margin ratio is the overall measure of the firm’s ability to turn each rupee sales into Net profit 3.3 Operating Ratio Operating Cost / Net Sales * 100 Operating Cost = Cost of goods sold + Administrative Expenses + Selling and Distribution Expenses Operating Ratio is calculated to measure the relationship between total operating expenses and sales. The total operating expenses is the sum total of cost of goods sold, office and administrative expenses and selling and distribution expenses. In other words, this ratio indicates a firm's ability to cover total operating expenses. 3.4 Operating Profit Ratio Operating Profit / Net Sales * 100 Operating Profit Ratio indicates the operational efficiency of the firm and is a measure of the firm's ability to cover the total operating expenses. 4. SOLVENCY/ STRUCTURE This is the ability of the company to repay its debts in the long-term. The ratios, therefore, are not restricted to the current assets and current liabilities but deal rather with the total assets and total liabilities. The solvency ratios give an estimate of the structural safety of the company, by calculating, in various ways, the ratio of internally sourced finance to externally sourced finance. Internally sourced finance is more expensive but yet a low risk source of finance (owners’ ordinary or preference share capital) versus externally sourced finance, which is cheaper but yet a riskier source of finance (loans from the bank, debentures etc.). It assess company’s ability to meet its long-term obligations, remain solvent, and avoid bankruptcy. It measures how well a company’s cash flow covers its short-term financial obligations. Lenders evaluate these ratios to determine the degree to which a company could become vulnerable when faced with economic downturns. A company with a high level of debt poses a higher risk to lenders and investors. 4.1 Debt to Equity Long term Liabilities / Total Equity = Borrowed Funds / Owners Funds OR Debt / (Debt + Equity) The debt-equity ratio deals with the long term liabilities and equity portion of the balance sheet. Note that shareholders’ equity includes retained earning (Equity may also be known as net worth). The debt-equity ratio provides information on the capital structure (relationship between debt and equity) of the firm. Such information is important because it affects the value of the firm. The value of the firm is important because it has an impact on the ability to raise funds, either through increased borrowing or the sale of shares or both. A high debt-equity ratio indicates a poor capital structure because it signifies that the firm has high debt in comparison to its level of shareholders’ equity. This means that the firm’s lenders may be concerned about the repayment of debt, which in turn leads to high interest rates, which in turn leads to higher required returns on the firm’s potential investments.
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Analysis of Financial Statements
This ratio measures the financial leverage of a company by indicating what proportion of debt and equity a company is using to finance its assets. A lower number suggests there is both a lower risk involved for creditors and strong, long-term, financial security for a company. A low debt equity ratio is an indication that the firm is in sound financial position and therefore is not considered risky. Normally, the debt equity ratio vary tremendously from industry to industry. 4.2 Debt to Total Assets Total Long term Liabilities / Total Assets* 100 This is another variation of Debt- Equity Ratio. This ratio tells you how much of the firm’s assets are financed with debt. A high debt ratio indicates that the firm may be carrying too much debt. This is of concern to the firm because it may not be able to repay the debt nor to borrow additional funds they are needed. Accordingly, a firm in this situation is considered risky because short term financing is limited and may not be available in an emergency. A low debt means that the firm has a low level of liabilities compared to its total assets. Such a ratio indicates that the firm is not risky because it has plenty of financing available when compared to its need. However, a low ratio may also indicate that the firm should take on more debt. The reason for this is that the ability to borrow is considered a resource and a firm with low debt may not be taking advantage of this resource. Naturally, companies and creditors prefer a lower number. 4.3 Proprietory ratio Proprietors Funds / Total Assets * 100 This is another variation of debt to total assets ratio. This ratio measures what proportion of total assets was provided by the owners equity. The higher the number the more total capital has been contributed by owners and the less by creditors. Significance : This ratio used to determine the financial stability of the concern in general. Proprietary Ratio indicates the share of owners in the total assets of the company. It serves as an indicator to the Creditors who can find out the proportion of shareholders' funds in the total assets employed in the business. A higher proprietary ratio indicates relatively little secure position in the event of solvency of a concern. A lower ratio indicates greater risk to the creditors. A ratio below 0.5 is alarming for the creditors. Equity Multiplier = Total Assets / Total Equity*100
This ratio measures the extent to which a company uses debt to finance its assets. The higher the number is, the more a company is relying on debt to finance its assets. 4.4 Capital Gearing Ratio: Capital Gearing
Fixed Interest BearingFunds Variable cost bearing Funds
It denotes the extent of reliance of a company on the fixed cost bearing securities viz. the preference share capital and the debentures as against the equity funds provided by the equity shareholders. The ratio is calculated as: Fixed cost bearing capital = preference share capital, debentures , long term bank borrowings. Variable cost bearing capital = equity share capital, reserves and surplus. If fixed cost bearing capital is more than the equity capital, i.e. if the ratio is more than 1, the firm is said to be highly geared. On the reverse, it is low geared. Few Concepts
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Analysis of Financial Statements
Equity Capital = Loan Capital = Even Gear Equity Capital > Loan Capital = Low Gear = Over Capitalisation Equity Capital < Loan Capital = Higher Gear = Under Capitalisation It is useful to ascertain whether a company is practicing “trading on equity” and if so, to what extent is done. Factors to consider in analysing whether gearing is at a suitable level:
Industry average? Interest rates? Return for shareholders? Is debt finance put to good use? Stability of profits? Suitable assets for security?
-term debt be included in the calculation?
4.5 Financial Flexibility Ratio working capital / shareholders’ equity The financial flexibility ratio shows how much amount is utilized for working capital out of capital invested. This measure is close to liquidity measures, but it is complementing and considerably increasing the financial leverage ratio. The cover of working capital by equity capital is a guarantee of a sustainable credit policy. High value of the financial flexibility ratio positively describes the financial position of an enterprise as well as convinces that the management of the enterprise show sufficient flexibility in their use of own resources. Finance experts believe that the optimum level of this ratio is between 0.2 and 0.5 and the closer the value is to the higher limit (0.5) the greater is the potential of the enterprise for financial flexibility. However, the level of the financial flexibility ratio depends on the type of the enterprise operations. From the financial perspective, the higher the flexibility ratio, the better is the financial position of the enterprise. 4.6 Net Fixed Assets to Equity (Fixed Assetst - Accumulated Depreciation) / shareholders’ equity This ratio measures the extent to which investors' capital was used to finance productive assets. A lower ratio indicates a proportionally smaller investment in fixed assets in relation to net worth, which is desired by creditors in case of liquidation. Note that this ratio could appear deceptively low if a significant number of a company's fixed assets are leased. 5. COVERAGE RATIOS In addition to the leverage ratios that use information about how debt is related to either assets or equity, there are a number of financial coverage ratios that capture the ability of the company to satisfy its debt obligations. 5.1 Interest Coverage ratio / Times Interest Earned Earnings before Interest and Taxes / Interest Expense This ratio measures the number of times a company can meet its interest expense. The lower the ratio, the more the company is burdened by debt expense. When a company's interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable. A higher number is preferred, suggesting a company can easily meet
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Analysis of Financial Statements
interest obligations and can potentially take on additional debt. Note that this particular ratio uses earnings before interest and taxes because this is the income amount available to cover interest. 5.2 Preference Dividend Coverage Ratio It measures the ability of a firm to pay dividend on preference shares which carry a stated rate of return. Higher the coverage, better is the position. Dividend Coverage =
Net Profit after Tax and Interest Preference Dividend
(For Preference) 5.3 Debt Service Coverage Ratio / Fixed Charge Coverage Ratio A company may have such a high level of fixed costs that it cannot survive a sudden downturn in profit. The fixed charge coverage ratio can be used to see if this is the case. Earnings available for debt service / Interest + Installment
OR
Earnings before interest and taxes / Interest + Scheduled principal payments A key solvency issue is the ability of a company to pay its debts. This can be measured with the debt coverage ratio, which compares reported earnings to the amount of scheduled interest and principal payments to see if there is enough income available to cover the payments. If the ratio is less than one, it indicates that a company will probably be unable to make its debt payments. The measure is of particular interest to lenders, who are concerned about a company’s ability to repay them for issued loans. A ratio close to one reveals that a company must use nearly all of its cash flows to cover fixed costs and is a strong indicator of future problems if sales drop to any extent. A company in this position can also be expected to drop prices in order to retain business, because it cannot afford to lose any sales. EBITDA Coverage – This is another variation of DSCR.
Earnings before interest, taxes, depreciation and amortization/Interest expense + Principal portion (debt service) •Both ratios pretend to define cash available to satisfy obligations. Debts are paid with cash, not with earnings. Eliminates the effects of financing and accounting decisions •If EBITDA Coverage < 1, there is a high possibility that the company will not be able to pay its current obligation as it will probably use the funds to pay its operating expenditure. 5.4 Basic Defence Interval / Expense Coverage Days (Cash + Receivables + Marketable Securities) / (Annual Cash Expenditure /365) OR Liquid Assets / Expected daily operating expenses This calculation yields the number of days that a company can cover its ongoing expenditures with existing liquid assets. This is a most useful calculation in situations where the further inflow of liquid assets may be cut off, so the management team needs to know how long the company will last without an extra cash infusion. The calculation is also useful for seeing if there is an excessive amount of liquid assets on hand, which could lead to a decision to pay down debt or buy back stock, rather than keep the assets on hand. 6. INVESTMENT VALUATION RATIOS 11 Analysis of Financial Statements
These ratios can be used by investors to estimate the attractiveness of a potential or existing investment and get an idea of its valuation. 6.1 Earning Per Share Ratio Net Profit After Tax and Preference Dividend / No. of Equity Shares Earning Per Share Ratio (EPS) measures the earning capacity of the concern from the owner's point of view and it is helpful in determining the price of the equity share in the market place. 6.2 Price Earning Ratio Market Price Per Equity Share / Earning Per Share Price Earning Ratio establishes the relationship between the market price of an equity share and the earning per equity share. It measures how many times a stock is trading (its price) per each rupee of EPS. This ratio helps to find out whether the equity shares of a company are undervalued or not. This ratio is also useful in financial forecasting. A stock with high P/E ratio suggests that investors are expecting higher earnings growth in the future compared to the overall market, as investors are paying more for today's earnings in anticipation of future earnings growth. Hence, stocks with this characteristic are considered to be growth stocks. Conversely, a stock with a low P/E ratio suggests that investors have more modest expectations for its future growth compared to the market as a whole.
6.3 Price Earnings to Growth Ratio ( P/E Ratio ) / Projected Earnings Per Share The price/earnings to growth ratio, commonly referred to as the PEG ratio, is obviously closely related to the P/E ratio. The PEG ratio is a refinement of the P/E ratio and factors in a stock's estimated earnings growth into its current valuation. By comparing a stock's P/E ratio with its projected, or estimated, earnings per share (EPS) growth, investors are given insight into the degree of overpricing or under pricing of a stock's current valuation, as indicated by the traditional P/E ratio. The general consensus is that if the PEG ratio indicates a value of 1, this means that the market is correctly valuing (the current P/E ratio) a stock in accordance with the stock's current estimated earnings per share growth. If the PEG ratio is less than 1, this means that EPS growth is potentially able to surpass the market's current valuation. In other words, the stock's price is being undervalued. On the other hand, stocks with high PEG ratios can indicate just the opposite –that the stock is currently overvalued. 6.4 Dividend Per Share Earnings paid to shareholders (Dividend) / Number of ordinary shares outstanding This is the earnings distributed to ordinary shareholders against the outstanding number of ordinary shares. 6.5 Dividend Payout Ratio Equity Dividend / Net Profit After Tax and Preference Dividend OR Dividend Per Equity Share / Earning Per Equity Share x 100
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Analysis of Financial Statements
The dividend payout ratio tells an investor what proportion of earnings are being paid back in the form of dividends. This is particularly important when the ratio is greater than one, since it indicates that a company is dipping into its cash reserves in order to pay dividends, which is not a sustainable trend. Alternatively, if only a small proportion of earnings is being paid back as dividends, the remaining cash is likely being plowed back into operations, which should result in an increase in the stock price. This ratio indicates the dividend policy adopted by the top management about utilization of divisible profit to pay dividend or to retain or both. The dividend payout ratio is an indicator of how well earnings support the dividend payment. 6.6 Dividend Yield Ratio Dividend Per Share / Market Value Per Share x 100 Dividend Yield Ratio indicates the relationship is established between dividend per share and market value per share. This ratio is a major factor that determines the dividend income from the investors' point of view. This ratio allows investors to compare the latest dividend they received with the current market value of the share as an indicator of the return they are earning on their shares. This enables an investor to compare ratios for different companies and industries. Higher the ratio, the higher is the return to the investor 6.7 Book Value Per Share Total equity – Cost to liquidate preference shares / Total number of Equity shares outstanding The book value per share measurement is used by investors and analysts to see if the market price of a share is in excess of or less than its book value. A higher market price indicates that investors have assigned extra value to a company, perhaps due to excellent management, products, patents, and so on. 7. RETURN ON INVESTMENT MEASUREMENTS These ratios aimed at measurements that can be used to determine a company’s ability to create a return on investment. These measures encompass net worth, several types of return on assets and equity, economic value added, and return on dividends. They can be used by investors to determine what to pay for a company’s shares as well as to measure the return on investment. Company management can use these measures to determine its ability to generate a reasonable rate of return. 7.1 Return on Assets Employed Earnings after Taxes / Total Assets * 100 This ratio measures how effectively a company's assets are being used to generate profits. It is one of the most important ratios when evaluating the success of a business. A company is deemed efficient by investors if it can generate an adequate return while using the minimum amount of assets to do so. This also keeps investors from having to put more cash into the company and allows the company to shift its excess cash to investments in new endeavors. Consequently, the return on assets employed measure is considered a critical one for determining a company’s overall level of operating efficiency. Heavily depreciated assets, a large number of intangible assets, or any unusual income or expenses can easily distort this calculation. ROA can be alternatively computed as:
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Analysis of Financial Statements
It's a useful number for comparing competing companies in the same industry. The number will vary widely across different industries. Return on assets gives an indication of the capital intensity of the company, which will depend on the industry; companies that require large initial investments will generally have lower return on assets. ROA is an indicator of how profitable a company is before leverage, and is compared with companies in the same industry. Since the figure for total assets of the company depends on the carrying value of the assets, some caution is required for companies whose carrying value may not correspond to the actual market value. ROA is a common figure used for comparing performance of financial institutions (such as banks), because the majority of their assets will have a carrying value that is close to their actual market value. Return on assets is not useful for comparisons between industries because of factors of scale and peculiar capital requirements (such as reserve requirements in the insurance and banking industries).Return on assets is one of the elements used in financial analysis using the Du Pont Identity. 7.2 Return On Equity
Return on Equity (ROE, Return on average common equity, return on net worth, Return on ordinary shareholders' funds) (requity) measures the rate of return on the ownership interest (shareholders' equity) of the common stock owners. It measures a firm's efficiency at generating profits from every unit of shareholders' equity (also known as net assets or assets minus liabilities). ROE shows how well a company uses investment funds to generate earnings growth. A higher number is preferred for this commonly analyzed ratio. High ROE yields no immediate benefit. Since stock prices are most strongly determined by earnings per share (EPS). The benefit comes from the earnings reinvested in the company at a high ROE rate, which in turn gives the company a high growth rate. ROE is presumably irrelevant if the earnings are not reinvested. Limitations:
The sustainable growth model shows us that when firms pay dividends, earnings growth lowers. If the dividend payout is 20%, the growth expected will be only 80% of the ROE rate.
The growth rate will be lower if the earnings are used to buy back shares. If the shares are bought at a multiple of book value (say 3 times book), the incremental earnings returns will be only 'that fraction' of ROE (ROE/3).
New investments may not be as profitable as the existing business. Ask "what is the company doing with its earnings?"
Remember that ROE is calculated from the company's perspective, on the company as a whole. Since much financial manipulation is accomplished with new share issues and buyback, always recalculate on a 'per share' basis, i.e., earnings per share/book value per share.
7.3 Financial Leverage Index Return on equity / Return on assets
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Analysis of Financial Statements
The financial leverage index can indicate whether a large proportion of debt in relation to equity is being used to fund a company’s operations. It compares the rate of return on equity to the rate of return on assets. If the rate of return on equity is significantly higher than the return on assets, then the equity base is comparatively small in relation to the base of assets, which inherently means that the difference between the two is composed of nonequity sources of funding.
7.4 The DuPont formula The DuPont formula, also known as the strategic profit model, is a common way to break down ROE into three important components. Essentially, ROE will equal the net margin multiplied by asset turnover multiplied by financial leverage. Splitting return on equity into three parts makes it easier to understand changes in ROE over time. For example, if the net margin increases, every sale brings in more money, resulting in a higher overall ROE. Similarly, if the asset turnover increases, the firm generates more sales for every unit of assets owned, again resulting in a higher overall ROE. Finally, increasing financial leverage means that the firm uses more debt financing relative to equity financing. Interest payments to creditors are tax deductible, but dividend payments to shareholders are not. Thus, a higher proportion of debt in the firm's capital structure leads to higher ROE. Financial leverage benefits diminish as the risk of defaulting on interest payments increases. So if the firm takes on too much debt, the cost of debt rises as creditors demand a higher risk premium, and ROE decreases. Increased debt will make a positive contribution to a firm's ROE only if the matching Return on assets (ROA) of that debt exceeds the interest rate on the debt.
The DuPont system decomposes ROE into the following components:
There are three components in the calculation of return on equity using the traditional Du Pont Model- the net profit margin, assets turnover, and the equity multiplier. By examining each input individually, the sources of a company’s return on equity can be discovered and compared to its competitors.
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Analysis of Financial Statements
Return on Equity = (Net profit Margin) (Asset turnover) (Equity Multiplier)
Profit Margin = EBIT ÷Sales Return on Net Assets (RONA) = EBIT÷NA Assets turnover= Sales÷ NA
Return on Equity (ROE) = PAT ÷NW
Financial Leverage (income) = PAT÷EBIT
Financial Leverage (Balance Sheet) = NA ÷NW
Where NA = Net Assets NW = Net worth PAT = Profit after Tax EBIT = Earning before Interest & Tax Miscellaneous Ratios REPAIRS AND MAINTENANCE EXPENSE TO FIXED ASSETS RATIO Total repairs and maintenance expense ———————————————— X 100 Total fixed assets before depreciation This ratio is useful for estimating the age of the collective group of fixed assets listed in the financial statements. If the ratio follows an increasing trend line, then the company is probably in need of some asset replacements. An increasing trend line may also be indicative of high asset-usage levels, which can prematurely require advanced levels of repair work. Of particular interest is an increasing ratio that suddenly drops with no corresponding increase in the amount of fixed assets, this indicates that a company is running out of cash and cannot afford to repair its existing assets or purchase new ones.
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Analysis of Financial Statements
INDICATORS OF FINANCIAL HEALTH OF COMPANY Objective about)
(To
know Relevant indicator/Remarks
1. Financial position of Net worth, i.e., share capital, reserves and unallocated surplus in balance sheet carried the company down from profit and loss appropriation account. For a healthy company, it is necessary that there is a balance struck between dividend paid and profit retained in business so much the net worth keeps on increasing. Current ratio should not be too high like 4:1 or 5:1 or too low like less than 1.5:1. This 2. Liquidity of the means that the company is either too liquid thereby increasing its opportunity cost or company, not liquid at all, both of which are not desirable. Quick ratio could be at least 1:1. Quick ratio is a better indicator of liquidity position. 3. Whether the What are the sources, besides internal accruals to finance fixed assets. company has Examination of increase in secured or unsecured loans for this purpose. Without acquired new fixed adequate financial planning, there is always the risk of diverting working capital funds assets during the for fixed assets. This is best assessed through a funds flow statement for the period as year? even net cash accruals (Retained earnings + depreciation + amortisation) would be available for fixed assets. whether the main operations of the company like manufacturing have been in profit or 4. Profitability of the the profit of the company is derived from other income, i.e., income from investment in company in general shares/debentures etc. and operating profits in particular, i.e., 5. Relationship between the net worth of the company and its external liabilities (both short-term and long-term). What about only medium and long-term debts?
Debt/Equity ratio, which establishes this relationship. From the lender’s point of view, this should not exceed 3:1. Is there any sharp deterioration in this ratio? Is so, please be on guard, as the financial risk for the company increases to that extent. For only medium and long-term debts, it cannot exceed 2:1.
6. Has the company’s investments in shares/debentures of other companies reduced in value in comparison with last year?
Difference between the market value of the investments and the purchase price, which is theoretically a loss in value of the investment. Actual loss is booked upon only selling. The periodic reduction every year should warn us that at the time of actual sales, there would be substantial loss, which immediately would reduce the net worth of the company. Banks, Financial Institutions, Investment companies or NBFCs would be required to declare their investment every year in the balance sheet at cost price or market price whichever is less.
7. Relationship between average debtors (bills receivable) and average creditors (bills payable) during the year.
Average debtors in the year/average creditors in the year. This should be greater than 1:1, as bills receivable are at gross value {cost of development (+) profit margin}, whereas; creditors are at purchase price for software or components, which would be much less than the final sales value. If it is less than 1:1, it shows that while receivable management is quite good, the company is not paying its creditors, which could cause problems in future. Too high a ratio would indicate that receivable management is very poor.
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Analysis of Financial Statements
8. Future plans of the like acquisition of new technology, entering into new collaboration agreement, company, diversification programme, expansion programme etc. Directors’ report. This would reveal the financial plans for the company, like whether they are coming out with a public issue/Rights issue etc. 9. Has the company Auditors’ comments in the “Notes to Accounts” relevant for this. Frequent revaluation revalued its fixed is not desirable and healthy. assets during the year, thereby creating revaluation reserves, without any inflow of capital into the company, as this is just an entry passed in the books?
10. Whether the company has increased its investment and if so, what is the source for it? What is the nature of investment?
Is it in tradable securities or long-term Securities, which can have a lock-in-period and cannot be liquidated in the near future? Increase in amount of investment in shares/debentures/Govt. securities etc. in comparison with last year and any investment within group companies? Any undue increase in investment should put us on guard, as working capital funds could have been diverted for it.
11. Has the company Any increase in unsecured loans. If the loans are to group companies, then all the more during the year given reason to be cautious. Hence, where the figures have increased, further probing is any unsecured loans called for. substantially other than to employees of the company? 12. Are the company’s Any comments to this effect in the notes to accounts should put us on caution. This unsecured loans examination would indicate about likely impact on the future profits of the company. (given) not recoverable and very old? 13. Has the company Any comments about over dues as in the “Notes to Accounts” should be looked into. been regular in Any serious default is likely to affect the “credit rating” of the company with its payment of its dues lenders, thereby increasing its cost of borrowing in future. on account of loans or periodic interest on its liabilities?
14. Has the defaulted
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company Any comments about this in the “Notes to Accounts” should be looked into. in
Analysis of Financial Statements
providing for bonus liability, P.F. liability, E.S.I. liability, gratuity liability etc?
15. Whether the Cash balance together with bank balance in current account, if any, is very high in the company is holding current assets. very huge cash, as it is not desirable and increases the opportunity cost? 16. How many times the average inventory has turned over during the year?
Relationship between cost of goods sold and average inventory during the year (only where cost of goods sold cannot be determined, net sales can be taken as the numerator). In a manufacturing company, which is not in capital goods sector, this should not be less than 4:1 and for a consumer goods industry, this should be higher even. For a capital goods industry, this would be less. 17. Has the company If it was a public issue, how did it fare in the market? issued fresh share capital during the Increase in paid-up capital in the balance sheet and share premium reserves in case the period and what is issue has been at a premium. the purpose for which it has raised equity capital? 18. Has the company Increase in paid-up capital and simultaneous reduction in general reserves. Enquiry into issued any bonus the company’s ability to keep up the dividend rate of the immediate past. shares during the year? 19. Has the company Increase in paid-up capital and share premium reserves, in case the issue has been at a made any rights premium. issue in the period and what is the purpose of the issue? If it was a public issue, how did it fare in the market?
20. What is the proportion of marketable investment to total investment and whether this has decreased in comparison with the previous year? 21. What is the increase in sales income over
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Percentage of marketable investment to total investment and comparison with previous year. Any decrease should put us on guard, as it reduces liquidity on one hand and increases the risk of non-payment on due date, especially if the investment is in its own subsidiary or group companies, thereby forcing the company to provide for the loss.
Comparison with previous year’s sales income and whether the growth has been more
Analysis of Financial Statements
last year in % terms? or less than the estimate. Is it due to increase in numbers or change in product mix or increase in prices of finished products only? 22. What is the amount In percentage terms, how much is it of total debts outstanding and what are the reasons of provision for bad for such provision in the notes to accounts by the auditors? and doubtful debts or advances outstanding? 23. What is the amount Is there any comment about valuation of work in progress by the auditors? It can be of work in progress seen that profit from operations can be manipulated by increase/decrease in closing as shown in the stocks of both finished goods and work in progress. Profit and Loss Account? 24. Whether the company is paying any lease rentals and if so what is the amount of lease liability outstanding?
Examination of expenses schedule would show this. What is the comment in notes to accounts about this? Lease liability is an off-balance sheet item and hence this examination, to ascertain the correct external liability and to include the lease rentals in future also in projected income statements; otherwise, the company may be having much less disclosed liability and much more lease liability which is not disclosed. This has to be taken into consideration by an analyst while estimating future expenses for the purpose of estimating future profits.
25. Has the company Auditors’ comments on “Accounting” policies. Change over from straight-line method changed its method to written down value method or vice-versa does affect the deprecation charge for the of depreciation on year thereby affecting the profits during the year of change. fixed assets, due to which, there is an impact on the profits of the company? 26. If it is a Relationship between materials consumed during the year and the sales. manufacturing company, whether the % of materials consumed is increasing in relation to sales? 27. Has the company changed its method Auditors’ comments on “Accounting” policies. of valuation of inventory, due to which there is an impact of the profits of the company?
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Analysis of Financial Statements
28. Whether the % of Relationship between general and administrative expenses during the year and the administration and sales. In case there is any extraordinary increase, what are the reasons therefore? general expenses has increased during the year under review? 29. Whether the Interest coverage ratio = earnings before interest and tax/total interest on all short-term company had and long-term liabilities. Minimum should be 3:1 and anything less than this is not sufficient income to satisfactory. pay the interest charges? 30. Whether the finance charges have gone up disproportionately as compared with the increase in sales income during the same period?
Relationship between interest charges and sales income – whether it is consistent with the previous year or is there any spurt? Is there any explanation for this, like substantial expansion or new project or diversification for which the company has taken financial assistance? While a benchmark % is not available, any level in excess of 6% calls for examination.
31. Whether the % of Relationship between “payment to and provision for employees” and the sales. In case employee costs to any undue increase is seen, it could be due to expansion of activity etc. that would be sales has increased? included in the Directors’ Report. 32. Whether the % of selling expenses in relation to sales has gone up?
Relationship between “selling and marketing” expenses and the sales. Any undue increase could either mean that the company is in a very competitive industry or it is aggressive to increase its market share by adopting a marketing strategy that would increase the marketing expenses including offer of higher commission to the intermediaries like agents etc.
33. Whether the company had sufficient internal accruals to meet repayment obligation of principal amount of loans, debentures etc.?
Debt service coverage ratio The term-lending institution or bank looks for 1.75:1 on an average for the loan period. This is a very critical ratio to indicate the ability of the company to take care of its obligation towards the loans it has taken both by way of interest as well as repayment of the principal.
34. Return on Earnings before interest and tax/average total invested capital, i.e., net worth (+) debt investment in capital. This should be higher than the average cost of funds in the form of loans, i.e., business to compare interest cost on loans/debentures etc. it with return on similar investment elsewhere. 35. Return on equity (includes reserves and surplus) 21 Analysis of
Profit after tax (-) dividend on preference share capital/net worth (-) preference share capital (return in percentage). Anything less than 15% means that our investment in this company is earning less than the average return in the market. Financial Statements
36. How much earning Profit after tax (-) dividend on preference share capital/number of equity shares. In has our share made? terms of percentage anything less than 40% to 50% of the face value of the shares (EPS) would not go well with the market sentiments.
37. Whether the Relationship between amount of dividend payout and profit after tax last year and this company has year. Is there any reason for this like liquidity crunch that the company is experiencing reduced its dividend or the need for conserving cash for business activity, like purchase of fixed assets in payout in the immediate future? comparison with last year? 38. Is there any significant increase in the contingent liabilities due to any of the following?
Disputed central excise duty, customs duty, income tax, octroi, sales tax, contracts remaining unexecuted, guarantees given by the banks on behalf of the company as well as the guarantees given by the company on behalf of its subsidiary or associate company, letter of credit outstanding for which goods not yet received etc. “Notes on Accounts” as given at the end of the accounts. Any substantial increase especially in disputed amount of duties should put us on guard.
39. Has the company Substantial change in vendor charges, or subcontracting charges. changed its policy of outsourcing its work from vendors and if so, what are the reasons?
40. Is there any Increase in consultancy charges. substantial increase in charges paid to consultants? 41. Has the company Directors’ Report or sudden spurt in general and administration expenses. opened any branch office in the last year?
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Analysis of Financial Statements