Financial Statement Analysis
An introduction to Ratio Analysis
Steps in Financial Analysis
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Select the information
relevant information
arrange the information
to highlight significant relationships
interpretation
Types of comparisons
• Trend ratios
• inter firm comparisons
• comparison of items within a single year’s
financial statement of a firm
• comparison with standards or plans
Liquidity Ratios
• Measure of firms ability to meet short term
/current liabilities
• inverse relationship between liquidity and
profitability
• Types of liquidity ratios
Current ratio
• CR = CA/CL
• CA= cash , bank balance, marketable
securities, inventory, debtors net of
provisions, Bills receivable and prepaid
expenses
• CL= trade creditors, bills payable, bank
credit, provision for taxation, dividend
payable and outstanding expenses
Current ratio (contd..)
• Rationale
– indicates rupees of CA available for each
Rupee of CL.
– Measure of margin of safety to the creditors
Current ratio (contd..)
• Interpretation
– higher the ratio, the better
– very high ratio is indicative of slack
management
– development of capital market will influence
norms
– suitability depends on nature of industry
– it’s a quantitative but not qualitative measure
Acid test or quick ratio
• ATR/QR= QA/CL
• QA= CA- inventories-prepaid expenses
• Interpretation
– qualitative measure of liquidity
– relationship between CR and ATR/QR
Turnover ratios
• Also called activity ratios
• measure how quickly certain current
assets are converted into cash
• these supplement the earlier ratios
• Types of turnover/activity ratios
Types of turnover/activity ratios
• Inventory turnover ratio
• debtors turnover ratio
• creditors turnover ratio
Inventory turnover ratio
• ITR= cost of goods sold
• Average inventory
• COGS= Sale - Gross profit
• Avg. Inventory = simple avg. of opening
and closing stock
• Interpretation
• Inventory holding period= 12 months / ITR
Debtors turnover ratio
• DTR = Net credit sales/ Avg. debtors
• interpretation
• Debt collection period = 12 mths/ DTR
Creditors turnover ratio
• CTR = Net credit purchases/ Avg. creditors
• Interpretation
• Creditor’s payment period = 12 mths/ CTR
Defensive interval ratio
• Ability to meet daily projected cash
expenditure from operations
• DIR=quick assets/ projected daily cash
requirement(PDCR)
• PDCR= projected cash operating exp./ 365
ratios between borrowed funds
and owner’s capital
• Debt - equity ratio
• Debt - asset ratio
• Equity - asset ratio
Debt - equity ratio
• Relative claims of creditors and shareholders
against the assets of the firm
• Two alternative formulae
• D/E ratio = long term debts/shareholders equity
– Debts are exclusive of current liabilities
– shareholders equity is net worth including preference
share capital
– also called debt to networth ratio
Contd...
• D/E ratio = Total debt/Shareholder’s equity
– total outside liabilities I.e. long term + current
– Why include current liabilities
• fixed amount of them is always in use
• exercise prior right to assets of the business
• Interpretation
– margin of safety to the creditors
Contd...
• implications from
– creditors angle,
• stake of shareholders and
• degree of their commitment
– firms angle
• influence of creditors
• borrowing under restrictive conditions
– shareholders angle
• trading on equity
• maintain control inspite of limited stake
Debt - asset ratio
• Also called debt to total capital ratio
• D/A ratio=Long term debt/ permanent capital,
– permanent capital = shareholder’s equity+long term
debt
• OR D/A ratio=Total debt/total assets,
– where, total debt = long term debt + CL
– total assets= permanent capital + current liability
Equity - asset ratio
• Also called Proprietor’s ratio
• E/A ratio= Proprietor’s funds x 100
» total assets
Dividend coverage ratio
• = EAT/Preference dividend
• reveals safety margin available to
preference shareholders
Total coverage ratio
• Takes into account all fixed obligations of
the firm
• = EBIT+Lease payments/{Interest payment
+ Lease payment + (preference dividend +
instalment of principal)/(1-t)}
Profitability ratios
• Reflect operating efficiency and return on
investment
• profitability ratios are measured w.r.t.
– sales
– investment
Profit margin ratios
• Operating profit margin= EBIT x 100
»
Sales
• Net profit margin= EAT x 100
»
Sales
Profitability ratios related to
investment
• Also called Return on Investment (ROI)
ratios
• Three broad types
– Return on Assets
– Return on Capital Employed
– Return on Shareholder’s equity
Return on Assets
• ROA = EAT+Interest-tax advantage on int.
–Avg. total assets/Tangible
assets/Fixed assets
Return on Shareholders’ Equity
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Return on total shareholders’ equity
Return on ordinary shareholders’ equity
Earning per share
Dividend per share
Dividend pay-out ratio
dividend and earning yield
Price - Earning ratio
Various formulae
• Return on total shareholders’ equity =
Net profit after taxes
Avg. total shareholders’ equity
– Where, Avg. total shareholders’ includes
preference share capital, ordinary share
capital, share premium, reserves and surplus,
accumulated losses I.e. net worth
Various formulae
Return on ordinary shareholders equity =
Net profit after taxes - Pref. Dividend
Average ordinary shareholders’ equity or net
worth
Earning per share =
Net profit available to equity shareholders
No. of ordinary shares outstanding
Various formulae
• Dividend per share =
NP distributed to ordinary shareholders
No. of ordinary shares outstanding
• Dividend pay out ratio =
Total dividend to equity holders(cash div)
Total NP belonging to equity holders