Financial Statements Analysis
FINANCIAL STATEMENTS ANALYSIS
Ratio Analysis
Common Size Statements Importance and Limitations of Ratio Analysis
Ratio Analysis
Ratio analysis is a widely used tool of financial analysis. It is defined as the systematic use of ratio to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical performance and current financial condition can be determined.
Basis of Comparison 1) Trend Analysis involves comparison of a firm over a period of time, that is, present ratios are compared with past ratios for the same firm. It indicates the direction of change in the performance – – improvement, improvement, deterioration or constancy – constancy – over over the years. 2) Interfirm Comparison involves comparing the ratios of a firm with those of others in the same lines of business or for the industry as a whole. It reflects the firm’s performance in relation to its competitors. 3) Comparison with standards or industry average.
Types of Ratios Liquidity Ratios
Capital Structure Ratios
Profitability Ratios
Efficiency ratios
Integrated Analysis Ratios
Growth Ratios
Net Working Capital Net working capital is a measure of liquidity calculated by subtracting current liabilities from current assets. Table 1: Net Working Capital Particulars Particular s Total current assets Total current liabilities NWC
Company A
Company B
Rs 1,80,000
Rs 30,000
1,20,000
10,000
60,000
20,000
Table 2: Change in Net Working Capital Particulars Particular s Current assets
Company A
Company B
Rs 1,00,000
Rs 2,00,000
Current liabilities
25,000
1,00,000
NWC
75,000
1,00,000
Liquidity Ratios
Liquidity ratios measure the ability of a firm to meet its short-term obligations
Current Ratio Current Ratio is a measure of liquidity calculated dividing the current assets by the current liabilities
Current Ratio =
Current Assets Current Liabilities
Particulars
Firm A
Firm B
Current Assets
Rs 1,80,000
Rs 30,000
Current Liabilities
Rs 1,20,000
Rs 10,000
Current Ratio
= 3:2 (1.5:1)
3:1
Acid-Test Ratio The quick or acid test ratio takes into consideration the differences in the liquidity of the components of current assets
Acid-test Ratio =
Quick Assets Current Liabilities
Quick Assets = Current assets – Stock – Pre-paid expenses
Example 1: Acid-Test Ratio Cash Debtors
Rs 2,000 2,000
Inventory
12,000
Total current assets
16,000
Total current liabilities (1) Current Ratio (2) Acid-test Ratio
8,000 2:1 0.5 : 1
Supplementary Ratios for Liquidity
Inventory Turnover Ratio
Debtors Turnover Ratio
Creditors Turnover Ratio
Inventory Turnover Ratio The ratio indicates how fast inventory is sold. A high ratio is good from the viewpoint of liquidity and v i c e v e r s a . A low ratio would signify that inventory does not sell fast and stays on the shelf or in the warehouse for a long time.
Inventory turnover ratio =
Cost of goods sold Average inventory
The cost of goods sold means sales minus gross profit. The average inventory refers to the simple average of the opening and closing inventory.
Example 2: Inventory Turnover Ratio A firm has sold goods worth Rs 3,00,000 with w ith a gross profit margin of 20 per cent. The stock at the beginning and the end of the year was Rs 35,000 and Rs 45,000 respectively. respectively. What is the inventory turnover ratio?
Inventory turnover ratio
=
(Rs 3,00,000 – 3,00,000 – Rs Rs 60,000) (Rs 35,000 + Rs 45,000) ÷ 2
6 (times = per year)
12 months Inventory = = 2 months holding period Inventory turnover ratio, (6)
Debtors Turnover Ratio The ratio measures how rapidly receivables are collected. A high high ratio is indicative of shorter time-lag between credit sales and cash collection. A low ratio shows that debts are not being collected rapidly.
Debtors turnover ratio
=
Net credit sales Average debtors
Net credit sales consist of gross credit sales minus returns, if any, from customers. Average debtors is the simple average of debtors (including Average bills receivable) at the beginning and at the end of year. year.
Example 3: Debtors Turnover Ratio A firm has made credit sales of Rs 2,40,000 during the year. year. The outstanding amount of debtors at the beginning and at the end of the year respectively was Rs 27,500 and Rs 32,500. Determine the debtors turnover ratio.
Debtors turnover ratio
=
Debtors collection period
Rs 2,40,000 (Rs 27,500 + Rs 32,500) ÷ 2 =
12 Months Debtors turnover ratio, (8)
8 (times = per year)
=
1.5 Months
Creditors Turnover Ratio A low turnover ratio reflects liberal credit terms granted by suppliers, while a high ratio shows that accounts are to be settled rapidly. The creditors turnover ratio is an important tool of analysis as a firm can reduce its requirement of current assets by relying on supplier’s credit.
Creditors turnover ratio
=
Net credit purchases Average creditors
Net credit purchases = Gross credit purchases - Returns to suppliers. Average Av erage creditors = Average Average of creditors (including bills payable) outstanding at the beginning and at the end end of the year year..
Example 4: Creditors Turnover Ratio The firm in previous Examples has made credit purchases of Rs 1,80,000. The amount payable to the creditors at the beginning and at the end of the year is Rs 42,500 and Rs 47,500 respectively. Find out the creditors turnover ratio.
Creditors turnover ratio Creditor’s payment period
(Rs 1,80,000)
=
(Rs 42,500 Rs 47,500) ÷ 2
=
12 months Creditors turnover ratio, (4)
=
4 (times per year)
= 3 months
The summing up of the three turnover ratios (known as a cash cycle) has a bearing on the liquidity of a firm. The cash cycle captures the interrelationship of sales, collections from debtors and payment to creditors.
The combined effect of the three turnover ratios is summarised below: Inventory holding period
2 months
Add: Debtor’s collection period
+ 1.5 months
Less: Creditor’s payment period
– 3 months
0.5 months As a rule, the shorter is the cash cycle, the better are the liquidity ratios as measured above and vice versa.
DEFENSIVE INTERVAL RATIO Defensive interval ratio is the ratio between quick assets and projected daily cash requirement.
Defensiveinterval ratio
Projected daily cash requirement
Liquid assets =
Projected daily cash requirement
=
Projected cash operating expenditure Number of days in a year (365)
Example 5: Defensive Interval Ratio The projected cash operating expenditure of a firm from the next year is Rs 1,82,500. It has liquid current assets amounting to Rs 40,000. Determine the defensive-interval ratio.
Projected daily cash requirement = Defensive-interval ratio =
Rs 1,82,500 365 Rs 40,000 Rs 500
= Rs 500
= 80 days
Cash-flow From Operations Ratio Cash-flow from operation ratio measures liquidity of a firm by comparing actual cash flows from f rom operations (in lieu of current and potential cash inflows from current assets such as inventory and debtors) with current liability. Cash-flow from operations ratio
=
Cash-flow from operations Current liabilities
Leverage Capital Structure Ratio There are two aspects of the long-term solvency of a firm: (i) Abili Ability ty to repay the princi principal pal when due, and (ii) Regul Regular ar payment payment of the interest interest . Capital structure or leverage ratios throw light on the long-term solvency of a firm. Accordingly,, there are two different types of leverage ratios. Accordingly First type: These ratios are computed from the balance sheet
Second type: These ratios are computed from the Income Statement
(a) Debt-equity ra ratio
(a)) In (a Inte tere rest st co cove vera rage ge ra rati tio o
(b)) De (b Debt bt-a -as sse sets ts ra rati tio o
(b)) Di (b Div vid iden end d cov cover erag age e rat ratio io
(c)) Eq (c Equ uit ity y-a -ass sset ets s rat ratio io
I. Debt-equity ratio Debt-equity ratio measures the ratio of long-term or total debt to shareholders equity. Long-term Debt + Short Debt-equity ratio measures ratio of long-term debt + Other Current Totalthe Debt Debt-equity ratiode3bt = to shareholders equity Liabilities = Total external term or total Shareholders’ equity Obligations
If the D/E ratio is high, the owners are putting up relatively less money of their own. It is danger signal for the lenders and creditors. If the project should fail financially financially,, the creditors would lose heavily. A low D/E ratio has just the opposite implications. To To the creditors, a relatively high stake of the owners implies sufficient safety margin and substantial protection against shrinkage in assets.
For the company also, the servicing of debt is less burdensome and consequently its credit standing is not adversely affected, its operational flexibility is not jeopardised and it will be able to raise additional funds.
The disadvantage of low debt-equity ratio is that the shareholders of the firm are deprived of the benefits of trading on equity or leverage.
Trading on Equity Trading on equity (leverage) is the use of borrowed funds in expectation of higher return to equity-holders. Trading on Equity Particular (a) Total assets Financing pattern: Equity capital 15% Debt (b)Operating profit (EBIT) Less: Interest Earnings before taxes L e s s : Taxes (0.35) Earnings after taxes Return on equity (per cent)
(Amount in Rs thousand) A
B
C
D
1,000
1,000
1,000
1,000
1,000 — 300 — 300 105 195 19.5
800 200 300 30 270 94.5 175.5 21.9
600 400 300 60 240 84 156 26
200 800 300 120 180 63 117 58.5
II. Debt to Total Capital The relationship between creditors’ funds and owner’s capital can also be expressed using Debt to total capital ratio. Debt to total capital ratio =
Permanent
Capital
=
Total debt Permanent capital
Shareholders’ equity Long-term debt.
+
III. Debt to total assets ratio Debt to total assets ratio =
Total debt Total assets
Proprietary Ratio Proprietary ratio indicates the extent to which assets are financed by owners funds.
Proprietary ratio =
Proprietary funds X 100 Total assets
Capital Gearing Ratio Capital gearing ratio is used to know the relationship between equity funds (net worth) and fixed income bearing funds (Preference (P reference shares, debentures and other borrowed funds.
Coverage Ratio Interest Coverage Ratio Interest Coverage Ratio measures the firm’s ability to make contractual interest payments.
Interest coverage ratio =
EBIT (Earning before interest and taxes) Interest
Dividend Coverage Ratio Dividend Coverage Ratio measures the firm’s ability to pay dividend on preference share which carry a stated rate of return.
Dividend coverage ratio =
EAT (Earning after taxes) Preference dividend
Total fixed charge coverage ratio Total fixed charge coverage ratio measures m easures the firm’s ability to meet all fixed payment obligations.
Total fixed charge coverage ratio
EBIT + Lease Payment
=
Interest + Lease payments + (Preference dividend + Instalment of Principal)/(1-t)
Total Cashflow Coverage Ratio However, coverage ratios mentioned above, suffer from one major limitation, that is, they relate the firm’s ability to meet its various financial obligations to its earnings. Accordingly, it would be more appropriate to relate cash resources of a firm to its various fixed financial obligations.
Total cashflow = coverage ratio
EBIT + Lease Payments + Depreciation + Non-cash expenses Lease payment + + Interest
(Principal repayment) (1 – t)
(Preference dividend) +
(1 - t)
Debt Service Coverage Ratio Debt-service coverage ratio (DSCR) is considered a more comprehensive and apt measure to compute debt service capacity of a business firm. n
∑
DSCR
=
t=1
EAT EA Tt
+
Interestt n
∑ t=1
+
Depreciationt
+
Instalmentt
DEBT SERVICE CAPACITY Debt service capacity is the ability of a firm to make the contractual payments required on a scheduled basis over the life of the debt.
OAt
Example 6: Debt-Service Coverage Ratio Agro Industries Ltd has submitted the following projections. You You are required to work out yearly debt service coverage ratio (DSCR) and the average DSCR. (Figures in Rs lakh) Year Y ear
Net profit for the year
Interest on term loan
Repayment of term
during the year
loan in the year
1
21.67
19.14
10.70
2
34.77
17.64
18.00
3
36.01
15.12
18.00
4
19.20
12.60
18.00
5
18.61
10.08
18.00
6
18.40
7.56
18.00
7
18.33
5.04
18.00
8
16.41
Nil
18.00
The net profit has been arrived after charging depreciation of Rs 17.68 lakh every year.
Solution Table 3: Determinatio Determination n of Debt Service Coverage Ratio (Amount in lakh of rupees) Ye ar
Net profit
Depreciation
Interest
Cash
Principal
Debt
DSCR [col. 5
available
instalment
obligation
÷ col. 7
(col. 4 + col. 6)
(No. of times)]
(col. 2+3+4) 1
2
3
4
5
6
7
8
1
21.67
17.68
19.14
58.49
10.70
29.84
1.96
2
34.77
17.68
17.64
70.09
18.00
35.64
1.97
3
36.01
17.68
15.12
68.81
18.00
33.12
2.08
4
19.20
17.68
12.60
49.48
18.00
30.60
1.62
5
18.61
17.68
10.08
46.37
18.00
28.08
1.65
6
18.40
17.68
7.56
43.64
18.00
25.56
1.71
7
18.33
17.68
5.04
41.05
18.00
23.04
1.78
8
16.41
17.68
Nil
34.09
18.00
18.00
1.89
Average DSCR (DSCR ÷ 8)
1.83
Profitability Ratio Profitability ratios can be computed either from sales or investment. Profitability Ratios
Profitability Ratios
Related to Sales
Related to Investments
(i) Profit Margin
(i) Return on Investments
(ii) Expenses Ratio
(ii) Return on Shareholders’ Equity
Profit Margin Gross Profit Margin Gross profit margin measures the percentage of each sales rupee remaining after the firm has paid for its goods.
Gross profit margin =
Gross Profit X 100 Sales
Net Profit Margin Net profit margin measures the percentage of each sales rupee remaining after all costs and expense including interest and taxes have been deducted. Net profit margin can be computed in three ways
i. Operating Profit Ratio =
ii. Pre-tax Profit Ratio =
iii. Net Profit Ratio =
Earning before interest and taxes Net sales Earnings before taxes Net sales
Earning after interest and taxes Net sales
Example 7: From the following information of a firm, determine (i) Gross profit margin and (ii) Net profit margin. 1. Sales
Rs 2,00,000
2. Cost of goods sold
1,00,000
3. Other operating expenses (1) Gross profit margin =
(2) Net profit margin =
Rs 1,00,000 Rs 2,00,000 Rs 50,000 Rs 2,00,000
50,000 = 50 per cent
= 25 per cent
Expenses Ratio i. Cost of goods sold = ii. Operating expenses =
Cost of goods sold Net sales
X 100
Administrative exp. + Selling exp. Net sales
iii. Administrative Administrative expenses =
Administrative expenses Net sales
iv. Selling expenses ratio =
Selling expenses Net sales
v. Operating ratio =
X 100
X 100
X 100
Cost of goods sold + Operating expenses X 100 Net sales
vi. Financial expenses =
Financial expenses Net sales
X 100
Return on Investment Return on Investments measures the overall effectiveness of management in generating profits with its available assets. i. Return on Assets (ROA) ROA =
EAT + (Interest – (Interest – Tax Tax advantage on interest) Average total assets
ii. Return on Capital Employed (ROCE) ROCE =
EAT + (Interest – (Interest – Tax Tax advantage on interest) Average total capital employed
Return on Shareholders’ Equity Return on shareholders equity measures the return on the owners (both preference and equity shareholders ) investment in the firm. Return on total shareholders’ equity = Net profit after taxes X 100 Average total shareholders’ equity Return on ordinary shareholders’ equity (Net worth) = Net profit after taxes – taxes – Preference Preference dividend X 100 Average ordinary shareholders’ equity
Efficiency Ratio Activity ratios measure the speed with which various accounts/assets are converted into sales or cash. Inventory turnover measures the efficiency of various types of inventories. Cost of goods sold i. Inventory T Turnover urnover measures the activity/liquidity of Inventory Turnover Ratio = Average inventory of a firm; the speed with whichinventory inventory is sold Cost raw materials used i. Inventory Turnover Turnover measures theofactivity/liquidity of Raw materials turnover = inventory of a firm; the speed with which inventory is sold Average raw material inventory of goods manufactured i. Inventory Turnover Turnover measuresCost the activity/liquidity of Work-in-progress turnover = Average work-in-progress inventory inventory of a firm; the speed with which inventory is sold
Debtors Turnover Ratio Liquidity of a firm’s receivables can be examined in two ways. Credit sales i. Inventory Turnover measures the activity/liquidity of inventory of i. Debtors turnover = a firm; the speed with Average whichdebtors inventory + Average is sold bills receivable (B/R) 2. Average Average collection period =
Months (days) in a year Debtors turnover
Months (days) in a year (x) (Average Debtors + Average (B/R) i. Inventory Turnov Turnover er measures the activity/liquidity of inventory of a Alternatively = Total credit sales firm; the speed with which inventory is sold
Ageing Schedule enables analysis to identify slow paying debtors.
Assets Turnover Ratio Assets turnover indicates the efficiency with which firm uses all its assets to generate sales. goods sold of inventory of i. Inventory Turnover measuresCost the of activity/liquidity i. Total assets turnover = a firm; the speed with which inventory Average Av erage total is sold assets ii. Fixed assets turnover =
Cost of goods sold Average Av erage fixed assets
Cost of goods sold i. Inventory Turnover measures the activity/liquidity of inventory of iii. Capital turnover = Average is capital a firm; the speed with which inventory sold employed iv. Current assets turnover =
Cost of goods sold Average Ave rage current assets
of goods sold of inventory of i. Inventory Turnover measuresCost the activity/liquidity v. Working capital turnover = Net working capital a firm; the speed with which inventory is sold
1)
Return on shareholders’ equity = EAT/Average total shareholders’ equity.
2)
Return on equity funds = (EAT – Preference dividend)/Average ordinary shareholders’ equity (net worth).
3)
Earnings per share (EPS) = Net profit available to equity shareholders’ (EAT – Dp)/Number of equity shares outstanding (N).
4)
Dividends
per
share
(DPS)
=
Dividend
paid
to
ordinary
shareholders/Number shareholders/Num ber of ordinary shares outstanding (N). 5)
Earnings yield = EPS/Market price per share.
6)
Dividend Yield = DPS/Market price per share.
7)
Dividend payment/payout (D/P) ratio = DPS/EPS.
8)
Price-earnings (P/E) ratio = Market price of a share/EPS.
9)
Book value per share = Ordinary shareholders’ equity/Number of equity shares outstanding.
Integrated Analysis Ratio Integrated ratios provide better insight about financial and economic analysis of a firm. (1) Rate of return on assets (ROA) can be decomposed in to (i) Net profit profit margin margin (EAT/Sales) (EAT/Sales) (ii) Assets turnover (Sales/T (Sales/Total otal assets) (2) Return on Equity (ROE) can be decomposed in to (i) (EAT/Sales) (EAT/Sales) x (Sales/Assets) x (Assets/Equity) (ii) (EAT/EBT) x (EBT/EBIT) x (EBIT/Sales) x (Sales/Assets) x (Assets/Equity)
Rate of Return on Assets EAT as percentage of sales
EAT
Divided by
Assets turnover
Sales
Sales Fixed assets
Gross profit = Sales less cost of goods sold
Divided by
Total Assets
Plus
Current assets
Alternatively
Minus
Shareholder equity
Expenses: Selling Administrative Interest
Plus
Minus
Long-term borrowed funds
Income-tax
Plus Current liabilities
Return on Assets Earning Power Earning power is the overall profitability of a firm; is computed by multiplying net profit margin and assets turnover. Earning power = Net profit margin × Assets turnover Where, Net profit margin = Earning after taxes/Sales Asset turnover = Sales/T Sales/Total otal assets Earning after taxes Sales of inventory EAT of i. Inventory Turnover measures the activity/liquidity x x Earning Power = a firm; the speed with which Salesinventory isTsold otal Assets Asset s Total assets
EXAMPLE: 8 Assume that there are two firms, A and B, each having total assets amounting to Rs 4,00,000, and average net profits after taxes of 10 per cent, that is, Rs 40,000, each. Firm A has sales of Rs 4,00,000, whereas the sales of firm B aggregate Rs 40,00,000. Determine the ROA of firms A and B. Table Table 4 shows show s the ROA based on two components.
Table 4: Return on Assets (ROA) of Firms A and B Particulars
Firm A
Firm B
1. Net sales
Rs 4,00,000
Rs 40,00,000
2. Net profit
40,000
40,000
4,00,000
4,00,000
4. Profit margin (2 ÷ 1) (per cent)
10
1
5. Assets turnover turnover (1 ÷ 3) (times)
1
10
10
10
3. Total assets
6. ROA ratio (4 × 5) (per cent)
Return on Equity (ROE) ROE is the product of the following three ratios: Net profit ratio (x) Assets turnover (x) Financial leverage/Equity multiplier Three-component model of ROE can be broadened further to consider the effect of interest and tax payments.
Net Profit EBT the activity/liquidity EBIT EAT Turnover i. Inventory Turnover measures of x = x SalesinventorySales Earnings taxes EBITwith which inventory before of a firm; the speed is sold As a result of three sub-parts of net profit ratio, the ROE is composed of the following 5 components.
EAT EBT
x
EBT EBIT
x
EBIT x Sales
Sales Assets
x
Assets Equity
A 5-way break-up of ROE enables the management of a firm to analyse the effect of interest payments and tax payments separately from operating profitability. To illustrate further assume 8 per cent interest rate, 35 per cent tax rate and other operating expense of Rs 3,22,462 (Firm A) and Rs 39,26,462 (Firm B) for the facts contained in Example 8. Table Table 5 shows the ROE (based on the 5 components) of Firms A and B. Table 5: ROE (Five-way Basis) of Firms A and B Particulars Net sales
Firm A
Firm B
Rs 4,00,000
Rs 40,00,000
3,22,462
39,26,462
77,538
73,538
16,000
12,000
61,538
61,538
21,538
21,538
40,000
40,000
Total assets
4,00,000
4,00,000
Debt
2,00,000
2,50,000
Equity
2,00,000
1,50,000
EAT/EBT (times)
0.65
0.65
EBT/EBIT (times)
0.79
0.84
EBIT/Sales (per cent)
19.4
1.84
Sales/Assets (times)
1
10
Assets/Equity (times)
2
1.6
20
16
Less: Operating expenses Earnings before interest and taxes (EBIT) Less: Interest (8%) Earnings before taxes (EBT) Less: Taxes (35%) Earnings after taxes (EAT) (EAT)
ROE (per cent)
Common Size Statements Preparation of common-size financial statements is an extension of ratio analysis. These statements convert absolute sums into more easily understood percentages of some base amount. It is sales in the case of income statement and totals of assets and liabilities in the case of the balance sheet.
Limitations Ratio analysis in view of its several limitations should be considered only as a tool for analysis rather than as an end in itself. The reliability and significance attached to ratios will largely hinge upon the quality of data on which they are based. They are as good or as bad as the data itself. Nevertheless, they are an important tool of financial analysis.