RATIO ANALYSIS Part 1 | CAP CLASSES

RATIO ANALYSIS

a)     MEANING OF A RATIO

ü  An Accounting Ratio may be defined as the mathematical expression of the relationship between two accounting figures.

ü  But these figures must be related to each other (i.e., these figures must have a mutual cause and effect relationship) to produce a meaningful and useful ratio.

ü  Rations can be expressed as Percentage, Proportion, Fraction and Times.

b)       CLASSIFICATION OF RATIOS:

In view of the requirements of various users (e.g., Short-term Creditors, Long-term Creditors, Management, Investors) of the ratios, one may classify the ratios into the following four groups.

1. Liquidity ratios
2. Solvency ratios
3. Activity ratios
4. Profitability ratios

c)        SIGNIFICANCE OF RATIO ANALYSIS IN DECISION-MAKING

Ratio Analysis is a useful tool in the following aspects:

1.      Evaluation of Liquidity:

ü  The ability of the firm to meet its short-term payment commitments is called liquidity.

ü  Current Ratio and Quick Ratio help to assess the short-term solvency (liquidity) of the firm.

2.      Evaluation of Profitability:

ü  Profitability ratios i.e. Gross Profit Ratio, Operating Profit Ratio, Net Profit Ratio are basic indicators of the profitability of the firm.

ü  In addition, various profitability indicators like Return on Capital Employed (ROCE), Earnings per share (EPS), Return on Assets (ROA) etc. are used to assess the financial performance.

3.      Evaluation of Operating Efficiency:

ü  Ratios throw light on the degree of efficiency in the management and utilization of assets and resources.

ü  These are indicated by activity or performance or turnover ratios E.g. Stock Turnover Ratio, Debtors Turnover Ratio, Fixed Assets Turnover Ratio.

ü  These indicate the ability of the firm to generate revenue (sale) per rupee of investment in its assets.

4.      Evaluation of Financial Strength:

ü  Long-term solvency or Financial Strength is indicated by Capital Structure Ratios like Dept-Equity Ratio, Gearing Ratio, Leverage Ratios etc.

ü  These ratios signify the effect of various Sources of Finance E.g. Debt, Preference and Equity.

ü  They also picture as to whether the firm is exposed to serious financial strain or is justified in the use of debt funds.

5.      Inter-Firm and Intra-Firm Comparison:

ü  Comparison of the firm’s ratios with the industry average will help evaluate the firm’s position vis-à-vis the industry.

ü  It will help in analyzing the firm’s strengths and weaknesses and take corrective action.

ü  Trend Analysis of ratios over a period of years will indicate the direction of the firm’s financial policies.

6.      Budgeting:

ü  Ratios are not mere Post-mortem of operations.

ü  They help in depicting Future Financial Positions.

ü  Ratios have predatory value and are helpful in planning and forecasting the business activities of a firm for future periods.

E.g. Estimation of Working Capital Requirements

LIMITATIONS OF FINANCIAL RATIOS

The limitations of financial ratios are listed below:

1)        Diversified Product lines:

ü Many businesses operate a large number of divisions in quite different industries.

ü In such cases ratios calculated on the basis of aggregate data cannot be used for inter-firm comparisons.

2)        Inflation:

ü Financial Data are badly distorted by Inflation.

ü Historical cost values may be substantially different from true values.

ü Such distortions of financial data are also carried in the financial ratios.

3)        Seasonal Factors:

Seasonal Factors may also influence financial data.

4)        Window Dressing:

ü To give a good shape to the popularly used Financial Ratios (like current ratio, debt- equity ratios, etc.) the business man may make some year-end adjustments.

ü Such window dressing can change the character of financial ratios which would be different had there been no such change.

5)     Different in Accounting Policies:

Differences in Accounting Policies and Accounting Period can make the accounting data of two firms non-comparable as also the accounting ratios.

6)     No Standard Set of Ratios:

ü  There is no Standard Set of Ratios against which a firm’s ratios can be compared.

ü  Sometimes a firm’s ratios are compared with the industry average.

ü  But if a firm desires to be above the average, then industry average becomes a low standard.

ü  On the other hand, for a below average firm, industry averages become too high a standard to achieve.

7)     Difficulty to Decide:

ü  It is very difficult to generalise whether a particular ratio is good or bad.

ü  For example, a low current ratio may be said ‘bad’ from the point of view of low liquidity, but a high current ratio may not be ‘good’ as this may result from inefficient working capital management.

8)     Financial ratios are inter-related, not independent:

ü  Viewed in isolation one ratio may highlight efficiency. But when considered as a set of ratios they may speak differently.

ü  Such interdependence among the ratios can be taken care of through multivariate analysis.

Financial ratios provide clues but not conclusions. These are tools only in the hands of experts because there is no standard ready-made interpretation of financial ratios.

DU PONT ANALYSIS OF RETURN ON EQUITY

1.       Return on Equity can be calculated with the following formula.

     

Return on Equity	=	PAT	X 100
		Networth

2.       Two companies can have same return on equity, yet one can be a much better business than the other.

3.       To analyse the same, ROE is broken into the below three components under Du Pont Analysis. 

a)      The net profit margin

Ø  Profitability of the firm is measured by the net profit margin

Ø  Net profit margin is the ratio between the profits after tax to the sales of the firm.

Net Profit Margin	=	PAT
		Revenue

b)     Asset turnover ratio

Ø  The asset turnover ratio is a measure of how effectively a company uses its assets to generate sales.

Ø  The Asset turnover ratio is a ratio between revenue and the assets of the company.

Asset Turnover Ratio	=	Revenue
		Assets

c)      Equity multiplier

Ø  Financial leverage is measured by the equity multiplier

Ø  Equity multiplier is a measure of financial leverage which allows the investor to see what portion of the return of equity is the result of debt.

Equity Multiplier	=	Assets
		Equity

 Calculation of Return on Equity

ROE	=	Profits after tax
		Net worth

 ROE = NPM x ATO x EM

ROE	=	PAT	X	Sales	X	Assets
		Sales		Assets		Net worth

CATEGORY A : LIQUIDITY RATIOS
SL No	RATIO	FORMULA
1	Current Ratio / Net Working Capital Ratio	Current Assets Current Liabilities
2	Quick Ratio / Acid Test Ratio / Liquid Ratio	Quick Assets Quick Liabilities
3	Cash Ratio or Absolute liquidity Ratio	Cash + MS Current Liabilities
4	Basic Defense Interval	Cash + Debtors + MS (OP EXPS + INT + I TAX)/365
5	Net Working Capital	Current Assets – Current Liabilities Excluding Short Term Bank Borrowings
CATEGORY B : CAPITAL STRUCTURE OR LEVERAGE RATIOS PART 1: CS RATIOS
SL No	RATIO	FORMULA
1	Equity Ratio	Shareholders’ Equity Total Capital Employed
2	Debt Ratio	Debt Capital Employed
3	Debt to Equity Ratio	Debt Shareholders’ Equity
4	Debt to Total Assets Ratio	Debt Total Assets
CATEGORY B : CAPITAL STRUCTURE OR LEVERAGE RATIOS PART 2: COVERAGE RATIOS
SL No	RATIO	FORMULA
1	Debt Service Coverage Ratio	EBIT + Depreciation Interest + installments
2	Interest Coverage Ratio	EBIT Interest
3	Preference Dividend Coverage Ratio	PAT PD
4	Capital Gearing Ratio	PS + Debentures + LT Loan Equity Shareholders Funds
5	Fixed Assets To LT fund Ratio	Fixed Assets Long Term Funds
6	Proprietary Ratio	Prop. Funds Total Assets
7	Fixed Assets to Proprietors funds Ratio	Fixed Assets Proprietors Funds
CATEGORY C : ACTIVITY RATIOS
1	Capital Turnover Ratio	Sales Capital Employed
2	Fixed Assets Turnover Ratio	Sales Fixed Assets
3	Total Assets Turnover Ratio	Sales Total Assets
4	Working Capital Turnover Ratio	Sales Working Capital
5	Raw Materials Turnover Ratio	Raw Materials Consumed Average Stock of RM
6	Work In Progress Turnover Ratio	Works Cost Average WIP
7	FG Turnover Ratio (Inventory Turnover Ratio)	COGS Average stock of FG
8	Debtors Turnover Ratio	Credit Sales Average Debtors
9	Creditors Turnover Ratio	Credit Purchases Average Creditors
10	Inventory Holding Period	Average Inventory * 365 COGS
11	Average Collection period (ACP) Debtors Credit Period	Average Debtors * 365 Credit Sales
12	Creditors Payment Period	Average Creditors * 365 Credit Purchases
Note: Debtors = Credit Sales * ACP / 365 Creditors = Credit purchases * CPP / 365 FG = COGS * IHP / 365
CATEGORY D : PROFITABILITY RATIOS (INVESTORS POINT OF VIEW)
1	Return on Equity (ROE)	Profit After Tax *100 Net Worth
2	EPS	Earnings Available To Eq Shareholders Number of Equity Shares
3	DPS	Total profits distributed to Eq Sh Number of Equity Shares Or FV * Dividend Rate
4	Price Earnings Ratio (PE Ratio)	MPS EPS
5	Dividend Payout Ratio	DPS*100 EPS
PROFITABILITY RATIOS BASED ON ASSETS / INVESTMENTS
1	Return on Capital Employed (ROCE)	EBIT * 100 Capital Employed
2	Return on Assets (ROA)	Profit After Tax Average Total Assets
3	Return on Assets (ROA)	NOPAT Average Total Assets
PROFITABILITY RATIOS BASED ON SALES OF THE FIRM
1	Gross Profit Ratio	Gross Profit * 100 Sales
2	P V Ratio	Contribution * 100 Sales
3	Net Profit Ratio	Net Profit * 100 Sales
4	Operating Profit Ratio	Operating Profit * 100 Sales
5	Operating Expenses Ratio	Operating Expenses * 100 Sales
PROFITABILITY RATIOS BASED ON CAPITAL MARKET INFORMATION
1	Dividend Yield Ratio	DPS * 100 MPS
2	Earnings Yield Ratio	EPS * 100 MPS
3	Market Value to Book Value Ratio	MPS Book value per share
4	Book Value per share	Net Worth Number of Equity Shares