Question

How can financial statement analysis be used to assist management in their evaluation? Discuss the different ratios that exist and how they differ from each other.

Answer 1

Financial Ratios-

• Help assess the risk and return of companies
• comparison within a industry at a particular point of time.
• provide a profile of the firm, economic characteristics, competitive strategies
• depict unique operating, financial and investing characteristics.

Broad categories of Ratios

• Profitability
• Long term solvency
• Activity ( Efficiency )
• Short term solvency (Liquidity)
• Valuation

I.Profitability Analysis – Ability to generate and maintain profitability.

Two dimensions

w.r.t Sales -    (i) Gross Profit margin

                     (ii) Net Profit margin

                     (iii) EBIT margin

w.r.t Investment (i) Return on Capital Employed (ROCE/ ROTC)

                (ii) Return on equity (ROE )

                (iii)   Return on Total Assets (ROA)

1. Gross Profit margin = Gross Profit*   100

                                     Sales

2. Net profit margin=    PAT * 100                                           

Sales

3. EBIT Margin =             EBIT *100

                             Sales

4. Operating Profit Margin = Operating profit *100

                                        Sales

These ratios measures profit in relation to Sales

5.ROI/ ROCE      =   EBIT (1-t)

         Total capital employed

6.ROE/RONW = PAT – Preference dividend *100          

                         Net worth ( ESHs Fund )

7. ROA =    EBIT (1-t)            * 100

               Average Total Assets

These ratios measures the profit in relation to capital investments. It is the ultimate measure of the company’s overall performance and productivity of capital employed.

Long term solvency Analysis – The ability of a company to meet its long term obligations primarily debt. It evaluates the risk borne by the firm.

•Debt ratio

•Debt to Equity

•Net tangible assets to long term debt

•Cash flow from Operations to total debt

•Interest coverage

•Cash interest coverage

•Debt service coverage

1.Debt ratio =         Total Debt ( ST+LT) / Total Assets

2.Debt to Equity (D/E) = Total Debt (ST+LT)

                                                    Total Equity

Book values or Market values can be used. However market value based D/E has to be interpreted carefully

3. Total Debt to Tangible Net worth

                                  Total Debt

                     Tangible Net worth ( equity – intangible assets)

These ratios examines the capital structure and ability to meet obligations

4.Interest coverage ratio (ICR) =

                      EBIT

                  Interest expense

5. Debt service coverage ratio (DSCR) or Fixed charge coverage =

                          EBIT

Interest expense+ principal payments

These ratios measures the availability of profits to meet interest and principal repayments.

6. Cash flow from Operations to Debt ratio =

                      CFO

                   Total Debt

This ratio examines the availability of cash from operations to meet debt obligation.

Should Preference share capital be included as debt or net worth while calculating debt equity ratio

If the ratio is used to assess the impact of leverage on equity shareholders , it should be included in debt

If the ratio is used to assess financial risk , it should be included in net worth

Activity (Efficiency) Analysis – examines the relationship between the company’s operating assets ( fixed and current ) and its revenues

• Inventory Turnover ratio
• Receivables Turnover ratio
• Payables Turnover ratio
• Working capital turnover ratio
• Fixed Assets turnover ratio
• Total Asset Turnover ratio

1.Inventory Turnover ratio (ITO) ( in times) =                                       COGS

                         Average Inventory

Measures the efficiency of inventory management. Higher the ratio, faster is the movement of inventory.

Average number of days inventory in stock =      365 / ITO

2. Receivables Turnover (RTO) =

                 Net Credit Sales

               Average receivables

Measures the efficiency of receivable management. Higher the ratio, faster is the recovery from receivables.

Average number of days receivables o/s = 365/ RTO

3. Payables Turnover(PTO) = Purchases

                                  Average Accounts Payable

Measures the credit available from vendors/suppliers

4. Working Capital Turnover ratio =       Sales

                                                                    Working Capital

It reflects the quantum of working capital needed for a given level of sales.

For the above ratio, operating current assets and liabilities are considered.

Length of operating cycle / cash cycle – indicator of short term solvency

Operating cycle = Inventory TO in days + Receivables TO in days – Payables Turnover in days

It indicates the number of days cash is tied up in operating assets. The period of time that elapses between acquisition of goods and final cash from customers from sales

5. Fixed Asset Turnover ratio =                  Sales

                                                             Average Fixed Assets

This ratio indicates the quantum of sales generated form a given level of investment in Fixed Assets. It reflects the productivity of the fixed assets.

The above ratio should be interpreted carefully as it is affected by life cycle of the company, timing of investment, discrete nature of fixed asset investment etc.

6. Total Asset Turnover =     Sales

                                                Total Assets

This ratio measures the overall efficiency of assets

Short term solvency Analysis – These ratios compare the firms current assets with current liabilities to examine short term solvency.

1. Current ratio =                 Current Assets

                                 Current liabilities

2. Quick ratio =

                                        Cash+Marketable securities+Accounts receivable

                                                        Current liabilities

These 2 ratios helps in analyzing the current assets and current liabilities of the company and its ability to discharge its day to day obligations Quick ratio is more realistic. It indicates the extent to which the company has current assets to meet its current liabilities. Higher the ratio higher is the solvency level of the company and less risk of default.

3. Cash ratio =           Cash + Marketable securities

Current liabilities

This ratio indicates the availability of cash for meeting current liabilities.

4. Cash flow from Operations ratio =    CFO

                                                                Current Liabilities

Du Pont Analysis

Du Pont Analysis helps an analyst to understand the relation between two ratios and its impact on the return ratios.

It helps to identify the factors which affects the return to the equity shareholders

ROA =                 Net Profit Margin * Total Asset Turnover

         =   PAT     *    Sales        

           Sales        Total Assets

                     ROA             Profitability * Efficiency

ROE = Net Profit margin * Total Assets T.O * Equity Multiplier

ROE =   NPAT    *   Sales     *    Total Assets

            Sales    Total Assets           Equity

               ROE = ROA * Financial leverage

                ROE             Profitability * Efficiency * Leverage

Valuation ratios

1. EPS =   PAT – Preference dividend           

                    Number of equity shares

This ratio gives the return earned on each share. It is an important measure of profitability for the investors. This ratio is the basis for valuation of companies in the event of mergers etc, strategic investments by owners. Higher ratio shows company in a positive light. Higher ratio indicates higher returns

2. P/E ratio =   Market price of equity share

                     EPS      

This ratio is the most popular ratio for valuation of a company by the investors. This ratio indicates market confidence in the company and its future prospects.

3. Book value per share ( Net Asset Value ) = Net worth

No. of equity shares

This ratio measure the net worth per equity share. This ratio indicates the efficiency of the company’s management in building up reserves and its prudent financial practices.

4. EV-EBITDA ratio = Enterprise Value (EV)

                                        EBITDA

EV = Market value of equity + market value of debt

5. Dividend payout ratio =     DPS

EPS

   This ratio indicates the proportion of earnings distributed as dividend. Higher ratio indicates low re investment of income.