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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 thebalance 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 bycurrent 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

Liquidity the ability of the firm to pay its way

Investment/shareholders information to enable decisions to be made on the extent of the risk and the earning potential of a business investment

Gearing information on the relationship between the exposure of the business to loans as opposed to share capital

Profitability how effective the firm is at generating profits given sales and or its capital assets

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

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

ParticularsAmountRaw materials (Opening stock)2,501Raw materials (Closing stock)2,611Raw materials consumed10,164Work in progress (Opening stock)489Work in progress (Closing stock)363Finished goods (Opening stock)3,862Finished goods (Closing stock)5,553Sundry debtors ((Opening stock)9,123Sundry debtors (Closing stock)10,185

Problem (cont)

ParticularsAmountSales59,852Cost of goods sold50,693Purchases10,274Sundry creditors (Opening stock)9,480Sundry 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:

Work in progress

Finished goods

Sundry debtors

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