Ratio Analysis
Objective of a Business
• Create value for its shareholders while
maintaining a sound financial position.
• Return on investment.
• Sound financial position.
• Other important objectives include:
– Employee satisfaction.
– Social responsibility.
– Ethical considerations.
2
Annual Reports
Functions performed by a public company’s annual
report:
1. Regulatory
– provision of financial statements
– declarations of accounting policies
– provision of directors’ and auditor’s reports
2. Public relations based - enables public to view and
understand the primary operations of the company.
3. Decision making - information contained in annual
reports helps make performance, investment and
credit-related decisions.
Profit and Loss Statement
Shows how profitable a firm has been over the past
year. Includes:
–
–
–
–
–
–
revenues - sales, interest and dividends received
expenses
operating profit
abnormal items
income tax
extraordinary items
Balance Sheet
Provides a summary of the assets, liabilities
and shareholders’ equity of the company on a
nominated balance date. Includes:
– assets - current and non-current
– liabilities - current and non-current
– shareholders’ equity - share capital, reserves,
retained profits
Statement of Cash Flows
Represents a sources and uses of funds
statement. Includes:
– cash flows from operating activities
– cash flows from investing activities
– cash flows from financing activities
Need for Financial Statement Analysis
Comparison
????
Financial Statement Analysis Tools
• Trend %
• Common Size
• Ratio Analysis
8
Trend Percentages...
– are computed by selecting a base year
whose amounts are set equal to 100%.
• The amounts of each following year are
expressed as a percentage of the base
amount.
Trend % = Any year Rs. ÷ Base year Rs.
Trend Percentages
Year
2012
2011
2010
Revenues
Rs.27,611 Rs.24,215 Rs.21,718
Cost of sales
15,318 14,709
13,049
Gross profit
Rs.12,293 Rs. 9,506 Rs. 8,669
2010 is the base year.
What are the trend percentages?
Trend Percentages
Year
Revenues
Cost of sales
Gross profit
2012
127%
117%
142%
2011
2010
111% 100%
113% 100%
110% 100%
These percentages were calculated by
dividing each item by the base year.
Common Size
– compares each item in a financial statement
to a base number set to 100%.
• Every item on the financial statement is then
reported as a percentage of that base.
Common Size
Revenues
Cost of sales
Gross profit
Total operating expenses
Operating income
Other income
Income before taxes
Income taxes
Net income
2012
Rs.38,303
19,688
Rs.18,615
13,209
Rs. 5,406
2,187
Rs. 7,593
2,827
Rs. 4,766
%
100.0
51.4
48.6
34.5
14.1
5.7
19.8
7.4
12.4
Common Size
Assets
Current assets:
Cash
Receivables net
Inventories
Prepaid expenses
Total current assets
Plant and equipment, net
Other assets
Total assets
2012
%
Rs. 1,816
10,438
6,151
3,526
Rs.21,931
6,847
9,997
Rs.38,775
4.7
26.9
15.9
9.1
56.6
17.7
25.7
100.0
Ratios
Financial analysis using ratios is useful to
investors because the ratios capture critical
dimensions of the economic performance of the
company.
Managers use ratios to guide, measure, and
reward workers.
Often companies base employee bonuses on a
specific financial ratio or a combination of some
other performance measure and a financial ratio.
15
Ratios- a double edged weapon
Ratios mean different things to different groups.
A creditor might think that a high current ratio is
good because it means that the company has the
cash to pay the debt.
However, a manager might think that a high current
ratio is undesirable because it could mean that the
company is carrying too much inventory or is allowing
its receivables to get too high.
16
Cont…
 GAAP does not define ratios.
 Multiple equally valid approaches to ratios and
analysis.
 Managers (e.g., division manager, sales manager)
should be measured to items that they control.
 Investors and top management are most interested
in overall performance or broadest measures of
performance.
 Understanding less broad measures of performance may
give additional insight into overall performance.
17
Structure of analysis
• From broadest to more specific levels.
 Principal value of financial analysis:
 Suggests questions not answers.
 Ratio comparisons start with the supposition that all
other things are equal. (They rarely are.)
18
Evaluating Financial Ratios
Financial ratios are evaluated using three types
of comparisons.
Benchmarks - general rules of thumb specifying
appropriate levels for financial ratios
Time-series comparisons - comparisons of a
company’s financial ratios with its own historical
ratios
Cross-sectional comparisons - comparisons of a
company’s financial ratios with the ratios of other
companies or with industry averages
19
Evaluating Financial RatiosBenchmarks
 Experience. A feel for what is right or reasonable.
 Budget. A target developed within the company.
Factors to be considered:
 How carefully was budget constructed?
 What circumstances are different now?
 Historical standards.
Prior period’s results
adjusted for changes in accounting methods.
• External benchmarks. Competitor, industry
average
20
Ratio Standards of ComparisonCross-Sectional standards
Cross-Sectional standards
Compare a firm’s financial ratios to other firms or industry
average
Industry averages are published by companies such as
Moody’s
Standard & Poor’s
Fitchs
Deshaw
Copal Partners
And Lot of Indian Firms Like Motilal Oswal, India Bulls
etc.
Can reveal a firm’s strengths/weaknesses compared to
other firms
21
Ratio Standards of ComparisonTime-series comparisons
Time-Series standards
Compare a firm to its own ratios from other
years
Helps highlight trends/changes that have occurred
22
Category of Financial Ratios
Leverage ratios
Measure extent to which firm has been financed by creditors
liquidity ratio
Measure firm’s ability to meet short-term obligations
Profitability ratios
Measures productivity of money invested in firm
Turnover ratios
Measure rate of activity
Per share data
Examines items that affect common stock’s market price per share
Growth ratios
Measures contribution of various items to firm’s development
Risk analysis ratios
Measures variability
23
Making comparisons
 Finding the appropriate standard is difficult.
 A high ratio (e.g., current ratio, ROI) may be
good or bad. It can’t be viewed in isolation.
 Is a high CR good or bad?
 Is a high ROI always good?
 Values of ratios compared across time 
trend analysis.
24
Leverage Ratios
Show how heavily the company is in debt.
long- termdebt
Debt ratio =
long- termdebt + equity
long- termdebt
Debt - equity ratio =
equity
Leverage Ratios
Debt tototalcapitalisation ratio =
long- termdebt
totalcapitalisation
EBIT
Int erestcover =
interestexpense
total shareholde rs' equity
Equity ratio =
total assets
Liquidity Ratios
Measure how easily the firm can obtain cash to
pay its debts as they fall due.
current assets
Current ratio =
current liabilities
Liquidity Ratios
cash + short - term securities + receivable s
Quick ratio =
current liabilitie s
Activity Ratios
Measure how different asset groups contribute to
overall profitability.
Sales
T otalasset turnover =
average total assets
Sales
Net Worki
ng CapitalT urnover=
average net working capital
Activity Ratios
Cost of Goods Sold or Sales
InventoryT urnover=
AverageInventory
365
Days sales in inventory =
ITR
Credit Sales or Sales
ReceivableT urnover=
AverageReceivable
365
Days Receivable turnover 
DTR
Profitability Ratios
Used to judge how efficiently the firm is using its
assets.
Net profit margin =
PAT
sales
P BIT
Ret urn on t ot alsales =
average t ot alsales
Profitability Ratios
P AT
Ret urn on Equit y =
t ot alshareholders' equit y
Sh. Equity= E S Capital + reserves
PBIT
Return on Investment=
E.Sh. Capital P.Sh.Capital Reserves Debt
Net worth is E.S. Capital + P.S. Capital + Reserves and Surplus
The others in this category may be ROA and ROCE
Market Value Ratios
Show how the firm is valued by investors.
div iden ds
P ay o utrat io =
earn in gs
Profitafter tax
EPS
# ordinaryshareson issue
market val ue per share
PE Ratio =
EPS
Price/Earnings (PE) ratio
 Measure of overall performance.
 Market price is not controlled by company;
reflects all information available to the market.
 Reflects how investors judge the future
performance or prospects of the company.
 Commonly compared to other companies in the
same industry.
34
Market Value Ratios
EPS
Earningsyield =
market val
ue per share
dividend per share
Dividend yield =
market val
ue per share
DuPont Identity
• The DuPont Identity is essentially just an
expanded version of ROE. It is used to
compare two companies’ profitability,
efficiency, and leverage.
Net Income X Sales X Assets
Sales
Assets Equity
– By breaking down ROE into these three things, it
allows you to determine exactly why one company
has a better ROE than another.
– While this isn’t “Security Valuation” it can prove to
be a very important metric.
36
ROE
Return on Assets
(Profitability)
Financial
leverage

Liquidity
Net profit
Margin
Net income
Sales
—
/
Asset
turnover

Sales
Total cost
Cost of goods sold
SG&A
R&D
Interest expense
Income taxes
Sales
/
Current
assets
Solvency
Total assets
+
Cash
Acc. Receivables
Inventory
Other
Noncurrent
assets
Land
Building
Equipment
Intangibles
Others
37
Growth measures
• Key accounting items for which growth is
computed: sales, net income, earnings per
share.
 Average growth = (growth per year for n
years)/n
 Compound growth rate = based on present
value concepts.
 May be misleading due to abnormally high or
low beginning or ending year.
38
Implied growth rate
=Return on shareholders’ equity X Profit
retention rate
= ROE X (1 – Dividend payout)
• Estimates potential to grow profits without an
injection of new capital.
39
Analysis of Growth

Common stock price appreciation depends on
various factors


Growth financed internally depends on the amount
of retained earnings
A corporation’s growth rate depends on the return
on equity
Shows that multiple
factors influence
growth—one factor
can rise and another
fall and growth can
remain unchanged.
• Growth rate = RR x ROE

Substituting the three-part DuPont ROE
equation, we obtain
Growth rate RR 
Sales
T otalassets Net income


T otalassets
Equity
Sales
40
Credit Risk Analysis
• Procedure to determine the likelihood a customer
will pay its bills. Consider the customer’s previous
credit history, bank or trade references, financial
statements, and any other information supplied by
the customer or collected.
• Credit agencies provide reports on the credit
worthiness of a potential customer.
• Financial ratio analysis can be used to help
determine a customer’s ability to pay its bills.
41
Credit Risk Analysis
A technique used to develop a measurement
of solvency, sometimes called a Z Score.
Edward Altman developed a Z Score formula
that was able to identify bankrupt firms
approximately 95% of the time.
42
Credit Risk Analysis
Altman ZScore formula
EBIT
sales
market val
ue of equity
Z = 3.3
+ 1.0
+ 0.6
tot alassets
tot alassets
tot albook debt
retainedearnings
workingcapit al
+ 1.4
+ 1.2
tot alassets
tot alassets
43
Credit Risk Analysis
Example - If the Altman Z Score cut off for a credit
worthy business is 2.7 or higher, would we accept
the following client?
EBIT
 1.2
t ot alasset s
retainedearnings
 0 .4
totalassets
sales
 1.4
t ot alasset s
marketequit y
 0.9
book debt
working capital
 0.12
totalassets
44
Credit Risk Analysis
Example - If the Altman Z Score cut off for a credit
worthy business is 2.7 or higher, would we accept
the following client?
Firm's Z Score
 (3.3 x 0.12)  (1.0 x 1.4)  (0.6 x 0.9)
 (1.4 x 0.4)  (1.2 x 0.12)  3.04
A score above 2.7 indicates good credit.
45
Credit Risk Analysis
• Credit analysis is only worth while if the
expected savings exceed the cost.
– Don’t undertake a full credit analysis unless the
order is big enough to justify it.
– Undertake a full credit analysis for the doubtful
orders only.
46
Economic Value Added

The idea behind economic value added (EVA) is
that a company must earn more than it must pay
for capital if it is to increase in value.



Capital is considered both debt and equity.
The cost of capital in EVA is a weighted average of
interest cost and the returns required by equity
investors.
If a company has positive EVA, the company is
adding value; if a company has negative EVA, the
company is losing value and might be better off
liquidating.
47
EVA
• EVA can also be defined as the difference between
the net operating profit before interest, but after tax
(NOPAT) and a capital charge based on the WACC
multiplied by the IC:
• EVA = NOPAT – (WACC x IC)
48
EVA
•
•
•
•
•
•
EVA is calculated as follows:
EVA = (ROIC – WACC) x IC
where
ROIC = Return on invested capital
WACC = Weighted Average Cost of Capital
IC = Invested Capital (at the beginning of the
year)
49
MVA
• The link between MVA, the cumulative
measure, and EVA, which is an incremental
measure, is that MVA is equal to the present
value of all future EVA to be generated by the
company.
• MVA = present value of all future EVA
50
Example
• Company Z has invested capital amounting to R100
million at the beginning of the year. This is financed by
60% equity and 40% debt. The debt has an interest rate
of 12% before tax. The tax rate is 30% and the WACC
15%. The net income for the year before interest and tax
is R30 million.
• ROIC is R30 million / R100 million x (1 – tax rate of 30%) =
21%.
• EVA = (ROIC – WACC) x IC
• = (21% - 15%) x R100 million
• = 6% x R100 million
• = R6 million
51
Cont…
• Applying the second formula given for EVA, the result is
the same:
• EVA = EBIAT – (WACC x IC)
• = R21 million – (15% x R100 million)
• = R6 million
• where
• EBIAT = Earnings before interest, after adjusted tax
• If the future EVAs are expected to remain indefinitely at
R6 million per year, the MVA can be calculated as follows:
• MVA = EVA / WACC
• = R6 million / 15%
• = R40 million
52
53
Potential Problems with Financial Analysis
Inflation distortions
Can be a serious problem with the balance sheet
Some fixed assets are reported at their historical costs
After several years of high inflation historical costs
can be irrelevant
Vague definition of accounting income
A firm can modify its accounting income depending upon
certain actions
Such as which depreciation method or inventory valuation technique
is used
54
Potential Problems with Financial Analysis
Consolidated financial statements
When a firm owns a subsidiary corporation
accounting issues arise when considering
minority interests
Goodwill
When a company merges, oftentimes ‘goodwill’
is then reflected on the consolidated balance
sheet
This intangible asset cannot be measured with
precision
55
Financial Statement AnalysisSector Specific
Banks & FIs
57
Banking Regulation act, 1949
Schedule
01
02
03
04
05
12
Liability
Capital
Reserves and surplus
Deposits
Borrowings
Other liabilities and
provisions
Contingent liabilities
58
Banking Regulation act, 1949
Schedule
06
07
08
09
10
11
Assets
Cash and balances with
RBI
Balances with banks
and money at call and
short notice
Investments
Advances
Fixed Assets
Other assets
59
Banking Regulation act, 1949
Schedule
13
14
15
16
Income and expense
Interest earned
Other incomes
Interest expensed
Operating expense
60
Balance sheet
Minimum capital 100 Cr. (old banks are exempted)
Statutory Reserves- not less then 20% of profits
before dividend
Capital reserve- Surplus due to revaluation
Share premium
Others
61
Deposits
Demand Deposits
 Savings Deposits
 Term Deposits

62
Cont…
Borrowings-Include RBI And other banks borrowings
 Other liabilities- B/P, Inter office adjustment, interest
accrued etc.

63
Assets
 Cash and balances with RBI (CRR)
 Balances kept with other banks
 Investment include
•
•
•
Loans made in interbank call money market
Investment in approved securities (SLR)
Government securities
64
Advances
 Classification based on Type/nature of assets
Secured/unsecured
 Sectorial disbursement

65
Analysis of Banks Performance
• CAMELS
Capital Adequacy
Assets Quality
Management Effectiveness
Earnings
Liquidity (ALM)
Systems control
66
Capital Adequacy of Banks
Need for Capital:
Financial Intermediaries need capital for two reasons:
•To run operations of their business.
•To safeguard against the losses, that may arise.
Adequate capital helps banks to survive even during substantial losses.
It gives time to re-establish the business and avoid any break in
operations.
To ensure the good performance of banks the regulatory authority
(RBI) has specified the minimum capital for the Financial
Intermediaries.
This requirement is called Capital Adequacy, and it is specified for
Banks and Non Banking Financial Corporations (NBFCs).
67
Ratios

Capital Adequacy
Minimum capital requirement = (CRAR)
Total Capital/RWA
Where RWA is risk weighted assets
68
Cont…
2. Core CRAR
Tier I capital/ RWA
3. Adjusted CRAR
Total Capital- Net NPAs/ RWA
Higher the ratio better it is
69
Cont…
• Computation of capital adequacy ratio (CAR)
of banks:
• For computation of CAR, we need to calculate:
• Tier I capital
• Tier II capital
• Risk Weighted Assets (RWA)
70
Cont…
Step 1: Compute Tier I capital: Tier I capital is the most
permanent and readily available support against unexpected
losses. It consists of1. Paid up equity capital
2. Statutory reserves
3. Capital reserves
4. Other disclosed free reserves
Less:
1. Equity investments in subsidiaries
2. Intangible assets
3. Current and Accumulated Losses, if any
71
Cont…
• Step 2: Compute Risk Weighted Assets Step
2: Calculation of Risk Weighted Assets
(RWA)
• RWA are calculated by multiplying the
relevant weights to the value of assets and
off-balance sheet items.
• The weights assigned to each of the items
are as follows:
72
Cont…
Domestic Operations
73
Cont…
Domestic Operations
74
Cont…
Domestic Operations
75
Cont…
Domestic Operations
76
Cont…
• Step
3:
Compute
tier
II
capital
These are not permanent in nature or, are not readily
available.
• Tier II capital consists of1. Undisclosed reserves and cumulative perpetual
preference shares- Cumulative preference shares should be
fully paid and should not contain clauses which permit
redemption from shareholders.
2. Revaluation Reserves (RR)- 45% of RR is only taken in
calculation of tier II capital
3. General Provisions and Loss Reserves (GPLR)- Actual GPLR
or 1.25% of Risk Weighted Assets, whichever is lower, is taken.
77
Cont…
4. Hybrid Debt Capital Instruments- These combine
characteristics of both equity and debt. As they are more or
less similar to equity, they are included in the Tier II capital
5. Subordinated Debts- These must be fully paid up,
unsecured, subordinated to the claims of other creditors,
also there should be no such clause which permits
redemption. The amount of subordinate debts to be taken as
Tier II capital depends upon the maturity of debt.
Subordianate Debt Instruments will be limited to 50% of Tier
I capital.
78
Cont…
Note: Tier II capital cannot be more than Tier I
capital.
Capital Adequacy Ratio:
Capital Adequacy Ratio = (Tier I capital + Tier II
capital) / RWA
According to the present norm, the Capital Adequacy
Ratio of bank as defined earlier should be at least
10%.
79
Asset Quality
 Gross NPA/Gross advances
 Net NPA/ Net advances
• Where Net NPA=gross NPA- Provisions
• Net advances= Net bank credit- Provisions






Gross NPA/ Total Assets
Net NPA/ Total Assets
Net NPA/ Total Equity
Provision for loan losses/ Gross Advances
Provisions for loan losses/ NPAs
Provisions for loans and investment/Total Asset
80
Profitability
• Interest Expense= Interest exp/ Total income
• Non interest exp= Non-Interest Exp./Total
income
• ROA
• ROE
• EPS
• P/E
• NP Margin
81
Cont…
• Interest earned on Investment
• Interest earned on deposits
• Assets utilization= Total income/Total asset
82
Liquidity
• Total loans/ Total assets
• Net loans/ Total asset
• Net loans= Total loan-Provisions
• Net NPA=gross NPA- Provisions
• Net advances= Net bank credit- Provisions
83
Cont…




Non priority sector credit/ total credit (loans)
Unsecured credit/ total credit
Investments/ total asset
Investment in money market instruments/
total assets
 SLR securities/ total investments
 Cash and bank including call money/ Demand deposits
 Cash and bank including call money/ Total deposits
 Cash and bank including call money/ Total Asset
84