Ratio Analysis

Ratio analysis is the process of establishing and interpreting various ratios

A ratio is a simple arithmetical expression of the relationship of one number to another.

Steps Involved in Ratio Analysis

1. Selection of relevant data

Selection of relevant data from the financial statements depending upon the objective of the analysis.

2. Calculation of appropriate ratios from the above data. 3. Comparison of the calculated ratios with

The ratios of the same firm in the past, or The ratios developed from projected financial statements or The ratios of some other firms or Ratios of the industry to which the firm belongs.

4. Interpretation of the ratio.

Categories of Financial Ratios

1. Liquidity Ratios 2. Efficiency/Activity Ratios 3. Leverage/Solvency Ratios

4. Profitability Ratios
Liquidity and leverage ratios primarily measure risk; efficiency and profitability ratios measure performance and return.

Liquidity Ratios
Current ratio
Current assets Current ratio Current liability Purpose: Measures a firms ability to pay its current

liabilities from its current assets. Rule of thumb: A strong current ratio is 2.00.

Liquidity Ratios
Quick (acid-test) ratio
Current assets - Inventory - Prepaid Expenses Quick ratio Current liability - Bank Overdraft

Purpose: Measures a firms ability to pay its current liabilities without relying on the sale of its inventory.

Inventories and prepayments are excluded from current assets and the bank overdraft from current liabilities Ratio well above 1:1 is acceptable

EXAMPLE

Example: From the following, compute the Current ratio and acid-test ratio
Sundry Debtors Sundry 40,000 Creditors 20,000

Prepaid Expenses

20,000 Debentures

1,00,000

Short-term investments

10,000 Inventories

20,000

Outstanding Expenses

20,000 Bills Payable

10,000

Efficiency Ratios
Inventory turnover

Inventory turnover =
OR

Cost of goods sold Average inventory

Sales Inventory turnover Inventory

Low turnover rate indicates inventory levels are too high. Product demand may have slowed.

Efficiency Ratios
Stock Velocity Days/Months/Weeks

Inventory Turnover ratio

EXAMPLE
Example:
The following is the Trading account of ABC LTD. Calculated Stock Turnover and Stock Velocity Ratio. Assume 360 days in a year.

Opening Stock Purchases

Direct Expenses

60,000 Sales 1,50,000 Closing Stock

20,000

2,50,o00 50,000

Gross Profit

70,000 3,00,000

3,00,000

Efficiency Ratios
Debtors turnover ratio Net credit sales = Average accounts receivable Purpose: Indicates the number of times that a firm collects its accounts receivable each year.

Efficiency Ratios
Average collection period
Days/Weeks/Months Debtors' turnover ratio Accounts receivable Accounts receivable Annual sales Average daily sales 365

Measures the efficiency of management in collecting the debts of the business

The shorter the period of collection, the greater the cash flow of the business. Long collection periods may lead to bad debt.

Example:
The following figures have been extracted from the books of XYZ CO. Ltd for the year 2005.

Sales Revenue
Cash Sales

2,00,000
10,000

Sales Returns
Debtors on 31.12.04 Debtors on 31.12.05 Bills Receivable on 31.12.04 Bills Receivable on 31.12.05

10,000
50,000 60,000 5,000 6,000

Calculate Debtors turnover ratio and average collection period in Months.

Efficiency Ratios
Creditors turnover ratio Net credit purchases = Average accounts payable Purpose: Indicates the number of times that a firm pays its accounts payable each year.

Efficiency Ratios
Average creditors payment period
Days/Weeks /Months Creditors' turnoverratio

Measures the efficiency of management in collecting the debts of the business

The shorter the period of collection, the greater the cash flow of the business. Long collection periods may lead to bad debt.

Efficiency Ratios
Fixed assets turnover
Cost of Goods sold/Sales Fixed assets

Assets Turnover

Sales Assets turnover Total assets OR Net Assets

Net Working capital turnover

Sales Net working capital turnover Net working capital

Capital turnover =
Cost of Goods sold/Sales Capital Employed (Equity LongTerm Liabilitie s - Miscellane ous Expenditur e)

Leverage Ratios
Debt to Total Funds Ratio Debt (Long - term loans and Debentures) Debt Equity Debt-to-Equity ratio
Debt (Long - term loans and Debentures) Equity (Equity Share capital Reserves P & L A/c - Miscellaneous Expenditure)

This ratio measures a businesss ability to pay total liabilities. A low debt ratio is safer than a high debt ratio.

Interest Coverage Ratio

Earnings before interest and taxes Interest
Purpose: Indicates the number of times that a firms interest expense is covered by earnings.

Profitability Ratios
Gross profit margin
Gross profit Sales - Cost of goods sold Net Sales Net Sales

Operating profit margin

Operating profit (EBIT) Operating profit margin Net Sales

Profitability Ratios
Net profit margin
net profit after taxes Net profit margin sales

Return on Capital employed

net profits before taxes Return on capital employed (ROCE/ROI) Capital employed

Return on equity (ROE)

net profits after tax Return on equity Equity

Ratios example
Campsey Computer Company: Balance Sheet as of December 31, 1995 Cash Receivables Inventories Total current assets Net fixed assets Total assets 77,500 336,000 241,500 655,000 292,500 947,500 Accounts payable Notes payable Other current liabilities Total current liabilities Long-term debt Common equity Total liabilities and equity 129,000 84,000 117,000 330,000 256,500 361,000 947,500

Campsey Computer Company: Income Statement Sales Cost of goods sold Gross profit Fixed operating expenses Depreciation Earnings before interest and taxes Interest Earnings before taxes Taxes (40%) Net Income $ 1,607,500 (1,353,000) 254,500 (143,000) (41,500) 70,000 (24,500) 45,500 (18,200) 27,300

Example - results
Ratio Current ratio Days sales outstanding Inventory turnover Total assets turnover Profit margin on sales Return on assets Return on equity Debt ratio Campsey 1.98 76 days 6.7 1.7 1.7% 2.9% 7.6% 61.9% Industry Average 2.0 35 days 5.6 3.0 1.2% 3.6% 9.0% 60.0%

Ratio Analysis Profitability Ratios

Earning Per share (EPS)
= Profit After Tax (PAT) preferred dividend Weighted average no. of Equity Shares

The more the EPS, better are the performance and prospects of the company. Higher EPS increases the possibility of more cash-dividend or bonus shares Higher EPS has a favourable effect on the market price of the share

Eg: In 2003 PAT of ABC Ltd. was Rs. 5 lacs. Between 1st Jan'03 and 30th Jun'03 the company had 2 lac shares of Rs. 10 each. On 1st Jul'03 the company issued an additional 1 lac shares. The EPS would be: Rs.2 500000 21 (200000*0.5 + 300000*0.5)

Ratio Analysis Profitability Ratios

Price Earning Ratio (PE)
= Market price per equity share Earning per share

PE ratio would be high so long as the investing public has faith in a company's ability to grow and to earn a return Helps in predicting future market price of the share Helps in evaluating whether shares of the company are undervalued/overvalued Eg: if PE ratio of XYZ Ltd. is 7 whereas that of the industry is 9, then it can be concluded that shares of XYZ Ltd. are undervalued.
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Ratio Analysis Profitability Ratios

Dividend Payout Ratio = Dividend per equity share Earning per share Indicates proportion of EPS used for paying dividend and what has been retained for ploughing back

An investor interested in price appreciation should invest

in shares having low dividend payout ratio Normally young, aggressive growth companies have low dividend payout ratios as they plough back their profits for future growth. Mature companies have high dividend
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payout.

Ratio Analysis Profitability Ratios

Dividend Yield Ratio = Dividend per equity share Market price per share Useful by investor interested in dividend income If shares are purchased by the investor in open market, rate of return is not equal to rate of dividend declared by the company
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Word of caution regarding ratio analysis

Usefulness is dependent on accuracy of figures. Eg: Enron

A single ratio rarely tells enough to make a sound judgment

Financial statements used in ratio analysis must be from similar points in time. Audited financial statements are more reliable than unaudited statements

The financial data used to compute ratios must be developed in the same manner
Inflation can distort comparisons
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Limitations of Financial Ratio Analysis

Seasonal factors can distort ratios.
Window dressing techniques can make statements and

ratios look better.

Different accounting and operating practices can distort comparisons. Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition. Ratios are clues, not bases for immediate conclusion. They merely convey certain observations pointing to the probability of matters needing investigation.
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