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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)10,185Problem (cont)
ParticularsAmountSales59,852Cost of goods sold50,693Purchases10,274Sundry creditors (Opening stock)9,480Sundry creditors (Closing stock)11,697Solution
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