05/02/23 1

Analysis ofFinancial Ratios

05/02/23 2

Analysis ofFinancial Ratios

• The relationship between two accounting figures expressed mathematically is known as financial ratio

05/02/23 3

Introduction

• What is the purpose of analysis of financial ratios

• – It is for a meaningful study of information in the financial statements• – Ascertaining overall financial position of a business organisation• – Interpretation of key information in the financial statements

05/02/23 4

Objective

• The objectives:• – Assess credit risk profile of the borrower• – Stipulation of terms and conditions• – Assess utilization of credit facility• – Establish sound well defined credit granting criteria• – Ensure safety of bank funds

05/02/23 5

Factors that banks consider

• Credit worthiness of the borrower• Integrity/reputation• Credit risk profile• Sensitivity to economic and market developments• Liquidity• Solvency• Profitability of business• Resource efficiency

05/02/23 6

Financial Analysis

• Trends in the financial planning• Analysis of projected financial statements

05/02/23 7

Ratios can be expressed in different ways

• Ratios can be expressed as• A) Percentage say gross profit ratio is 20% of sales• B) Proportion say current ratio 2:1• C) Fraction- Say net profit is one-tenth of sales• D) Times say capital turn over ratio is

5times

05/02/23 8

Classification of Ratios

• Liquidity Ratios• Solvency Ratios• Activity Ratios• Profitability Ratios

05/02/23 9

Measures of Liquidity / Liquidity Ratios

• Net Working Capital• Current Ratio• Quick Ratio• Net Working Capital/Net Assets• Net Working Capital/Current Assets

05/02/23 10

Net Working Capital

• Gross Working Capital ( GWC)• It is the investment required to be made

by the borrower in Current Assets• How ?• From own contributions• From creditors, borrowings• Other short term resources

05/02/23 11

Gross Working Capital

• Gross Working Capital• How funded• From own resources and other long term

sources• Short fall if any from short term resources

05/02/23 12

Short Term Resources

• Short term resources constitute what are known• as ‘ Current Liabilities’• Current Liabilities should be lower than Current Assets• Excess of Current Assets over Current Liabilities is Net Working Capital• Contribution from long term resources applied to financing of Current Assets ( excess of Current Assets) is owner’s stake or margin money

05/02/23 13

Concept of NWC

• NWC represents the surplus long term funds• applied towards financing of Current Assets• Current assets are financed from two sources• – Surplus from Long Term Liabilities• – Current Liabilities• Difference between Current assets and Current

Liabilities should always be positive

05/02/23 14

NWC

• Negative Net Working Capital• What is the Implication• Business has applied part of surplus

Current Liabilities towards meeting shortfall in Long Term resources

05/02/23 15

NWC• Positive NWC means• i. Borrower has brought in his contribution• ii. Any fall in value of Current Assets will be cushioned by borrower’s stake• iii. Loss in sale of Current Assets will not affect Short term creditors

05/02/23 16

NWC

• Net Working Capital ( NWC ) is a measure of• liquidity• • Sources for NWC• Long Term Liabilities net of Long Term Assets• ( LTLs including Net Worth less LTAs which

includes• Fixed Assets, miscellaneous assets and• intangibles. • Another measure of liquidity is the Current

Ratio

05/02/23 17

Current Ratio

• Current Ratio:• Current Assets/ Current Liabilities• If Net Working Capital is to be of positive

value the Current Ratio must be higher than 1.

• Ideally for calculating MPBF Current Ratio should be 1.33: 1

05/02/23 18

Assets & Liabililities(Rs.crore)

Liabilities Assets

05/02/23 19

Computation

• Current Ratio is computed by dividing the current assets by the current liabilities

• Current ratio is expressed as a pure ratio e.g 2:1Traditionally a current ratio of 2:1 is considered as a satisfactory ratio.

• Current ratio is calculated at a particular date and not for a particular period

• The excess of current ratio over current liabilities is known as working capital.

05/02/23 20

Quick Ratio or liquid ratio or Acid Test Ratio

• This ratio establishes relationship between quick assets and current liabilities

• This ratio measures ability of the firm to meet short term obligations without relying upon realisation of stock

• Quick assets- Cash ,Bank balance,Debtors ( after deducting provisions ) , Bills

receivables,Marketable securities,Short term loans and advances(debit balance)

05/02/23 21

Current Liabilities

• Current Liabilities – those which are expected to be matured normally within a year.

• Examples-Creditors for goods,Bills payable, Creditors for expenses,provision for tax unclaimed dividend,income received in advance,short term loans and advances(credit balance)

05/02/23 22

Quick Ratio

• Quick ratio is computed by dividing quick assets by current liabilities.

• Quick Ratio or Acid Test Ratio = Current Assets-Inventory/Current Liabilities

• It indicates rupees of quick assets available for each rupee of current liability

• A quick ratio of 1:1 is said to be satisfactory

05/02/23 23

Excercise

• Work out • Current Ratio• Quick Ratio• Net working Capital to net sales (%)• Net working Capital to Current Assets (%)

05/02/23 24

Details

05/02/23 25

Liquidity Ratios

05/02/23 26

Financing of Current Assets

• 1. Current Assets = Current Liabilities + NWC or• 3088 = 2652 + 436• 2. NWC = Current Assets – Current Liabilities or• 436 = 3088 – 2652• 3. Current Assets = Current Liabilities + Contribution from Long Term Liabilities 3088 = 2249 +[(8104-7668)] =2652+436 (i.e.NWC = 3088)

05/02/23 27

NWC/Net Sales

• This percentage should be around 8-12 %• NWC is lower:• Business is growing too fast without• building an adequate cushion in the form

of NWC It indicates symptom of overtrading and

Undue reliance on borrowed short term funds

05/02/23 28

Falling NWC/Net Sales

• Indicative of overtrading and serious liquidity problems It needs to be investigated

05/02/23 29

NWC/Current Assets

05/02/23 30

Solvency Ratios

• Debt Equity ratio• Debt –Service coverage Ratio

05/02/23 31

Debt Equity ratio• Debt Equity ratio establishes relationship between long

term debts and share holder’s funds• Objective of this ratio is to measure the relative

proportion of debt and equity in financing the assets of a firm

• This ratio indicates margin of safety to long term creditors.

• A low debt equity ratio implies use of more equity than debt which means a larger safety margin for creditors and vice versa.

• Traditionally debt equity ratio of 2:1 is considered as satisfactory

05/02/23 32

Debt Equity Ratio

• DER = TLT Liabilities/TNW• DER = Long term debts/ Shareholders funds• Low ratio has a better leverage for

borrowing, From a firm’s point of view debt servicing is less burdensome

• Not more than 1.5 for providing finance by banks

05/02/23 33

Debt Service Coverage Ratio• This ratio measures relationship between Net

profits before interest and Tax and Interset+Principal portion of installment.

• It shows the number of times the amount of interest on long term debts and the principal portion of installments covered by the profits out of which that will be paid

• To judge whether ratios is satisfactory or not it should be compared with its own past ratios or with ratios of similar enterprises in the same industry

05/02/23 34

Debt Service coverage Ratio

• Debt Service coverage Ratio =• Net profit before interest and tax____________________________ Principal portion of installmentInt+----------------------------------------= times 1-Tax Rate

05/02/23 35

Example

• Net profit before int and Tax Rs 8,50,000,10% debentures payable in 10 installments Rs 7,00,000 Tax rate 30%

• Calculate Debt Service coverage ratio

05/02/23 36

Solution

• DSCR=• 8,50,000• =------------------------• 70,000• 70,000 +------------- = 5 times• (1-0.3)

05/02/23 37

DSCR

• DSCR =( Net profit +Depcn+ Annual amount of

• int.on LTLs)/Interest + principalIndicative of funds available for servicing

long term debt• DSCR = 6+4+2/6 = 12/6= 2• This is comfortable Should not be less

than 1.5:1 while considering projects

05/02/23 38

Profitability RatioIn relation to Sales

1.Gross Profit Ratio2.Operating profit ratio3.Net profit ratio

In relation to Investments

1.Return on Total Assets2.Return on capital employed3 Return on Share holders funds

In relation to Share holder’s funds

1.Earnings per share2.Price- Earning Ratio3.Dividend pay out Ratio

05/02/23 39

Return on Assets

• RoA = PBIT/Total Assets• To measure profitability and efficiency• Higher the ratio, the more efficient is the

firm in using resources

05/02/23 40

Summary

05/02/23 41

Thank You