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Ratio Analysis

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Rijish Chandran

The document discusses various financial ratios used to analyze the financial position of a business. It defines financial ratios as relationships between accounting figures expressed mathematically. Financial ratio analysis is used to study information in financial statements, ascertain a business's overall financial position, and interpret key information. The document then discusses various types of ratios including liquidity ratios, solvency ratios, activity ratios, and profitability ratios. It provides examples of specific ratios like the current ratio, quick ratio, debt-to-equity ratio, and return on assets ratio and how they are calculated and interpreted.

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11/01/16 1 Analysis of Financial Ratios
11/01/16 2 Analysis of Financial Ratios • The relationship between two accounting figures expressed mathematically is known as financial ratio
11/01/16 3 Introduction • What is the purpose of analysis of financial ratios • – It is for a meaningful study of information in the financial statements • – Ascertaining overall financial position of a business organisation • – Interpretation of key information in the financial statements
11/01/16 4 Objective • The objectives: • – Assess credit risk profile of the borrower • – Stipulation of terms and conditions • – Assess utilization of credit facility • – Establish sound well defined credit granting criteria • – Ensure safety of bank funds
11/01/16 5 Factors that banks consider • Credit worthiness of the borrower • Integrity/reputation • Credit risk profile • Sensitivity to economic and market developments • Liquidity • Solvency • Profitability of business • Resource efficiency
11/01/16 6 Financial Analysis • Trends in the financial planning • Analysis of projected financial statements
11/01/16 7 Ratios can be expressed in different ways • Ratios can be expressed as • A) Percentage say gross profit ratio is 20% of sales • B) Proportion say current ratio 2:1 • C) Fraction- Say net profit is one-tenth of sales • D) Times say capital turn over ratio is 5times
11/01/16 8 Classification of Ratios • Liquidity Ratios • Solvency Ratios • Activity Ratios • Profitability Ratios
11/01/16 9 Measures of Liquidity / Liquidity Ratios • Net Working Capital • Current Ratio • Quick Ratio • Net Working Capital/Net Assets • Net Working Capital/Current Assets
11/01/16 10 Net Working Capital • Gross Working Capital ( GWC) • It is the investment required to be made by the borrower in Current Assets • How ? • From own contributions • From creditors, borrowings • Other short term resources
11/01/16 11 Gross Working Capital • Gross Working Capital • How funded • From own resources and other long term sources • Short fall if any from short term resources
11/01/16 12 Short Term Resources • Short term resources constitute what are known • as ‘ Current Liabilities’ • Current Liabilities should be lower than Current Assets • Excess of Current Assets over Current Liabilities is Net Working Capital • Contribution from long term resources applied to financing of Current Assets ( excess of Current Assets) is owner’s stake or margin money
11/01/16 13 Concept of NWC • NWC represents the surplus long term funds • applied towards financing of Current Assets • Current assets are financed from two sources • – Surplus from Long Term Liabilities • – Current Liabilities • Difference between Current assets and Current Liabilities should always be positive
11/01/16 14 NWC • Negative Net Working Capital • What is the Implication • Business has applied part of surplus Current Liabilities towards meeting shortfall in Long Term resources
11/01/16 15 NWC • Positive NWC means • i. Borrower has brought in his contribution • ii. Any fall in value of Current Assets will be cushioned by borrower’s stake • iii. Loss in sale of Current Assets will not affect Short term creditors
11/01/16 16 NWC • Net Working Capital ( NWC ) is a measure of • liquidity • • Sources for NWC • Long Term Liabilities net of Long Term Assets • ( LTLs including Net Worth less LTAs which includes • Fixed Assets, miscellaneous assets and • intangibles. • Another measure of liquidity is the Current Ratio
11/01/16 17 Current Ratio • Current Ratio: • Current Assets/ Current Liabilities • If Net Working Capital is to be of positive value the Current Ratio must be higher than 1. • Ideally for calculating MPBF Current Ratio should be 1.33: 1
11/01/16 18 Assets & Liabililities (Rs.crore) Liabilities Assets
11/01/16 19 Computation • Current Ratio is computed by dividing the current assets by the current liabilities • Current ratio is expressed as a pure ratio e.g 2:1Traditionally a current ratio of 2:1 is considered as a satisfactory ratio. • Current ratio is calculated at a particular date and not for a particular period • The excess of current ratio over current liabilities is known as working capital.
11/01/16 20 Quick Ratio or liquid ratio or Acid Test Ratio • This ratio establishes relationship between quick assets and current liabilities • This ratio measures ability of the firm to meet short term obligations without relying upon realisation of stock • Quick assets- Cash ,Bank balance,Debtors ( after deducting provisions ) , Bills receivables,Marketable securities,Short term loans and advances(debit balance)
11/01/16 21 Current Liabilities • Current Liabilities – those which are expected to be matured normally within a year. • Examples-Creditors for goods,Bills payable, Creditors for expenses,provision for tax unclaimed dividend,income received in advance,short term loans and advances(credit balance)
11/01/16 22 Quick Ratio • Quick ratio is computed by dividing quick assets by current liabilities. • Quick Ratio or Acid Test Ratio = Current Assets-Inventory/Current Liabilities • It indicates rupees of quick assets available for each rupee of current liability • A quick ratio of 1:1 is said to be satisfactory
11/01/16 23 Excercise • Work out • Current Ratio • Quick Ratio • Net working Capital to net sales (%) • Net working Capital to Current Assets (%)
11/01/16 24 Details
11/01/16 25 Liquidity Ratios
11/01/16 26 Financing of Current Assets • 1. Current Assets = Current Liabilities + NWC or • 3088 = 2652 + 436 • 2. NWC = Current Assets – Current Liabilities or • 436 = 3088 – 2652 • 3. Current Assets = Current Liabilities + Contribution from Long Term Liabilities 3088 = 2249 +[(8104-7668)] =2652+436 (i.e.NWC = 3088)
11/01/16 27 NWC/Net Sales • This percentage should be around 8-12 % • NWC is lower: • Business is growing too fast without • building an adequate cushion in the form of NWC It indicates symptom of overtrading and Undue reliance on borrowed short term funds
11/01/16 28 Falling NWC/Net Sales • Indicative of overtrading and serious liquidity problems It needs to be investigated
11/01/16 29 NWC/Current Assets
11/01/16 30 Solvency Ratios • Debt Equity ratio • Debt –Service coverage Ratio
11/01/16 31 Debt Equity ratio • Debt Equity ratio establishes relationship between long term debts and share holder’s funds • Objective of this ratio is to measure the relative proportion of debt and equity in financing the assets of a firm • This ratio indicates margin of safety to long term creditors. • A low debt equity ratio implies use of more equity than debt which means a larger safety margin for creditors and vice versa. • Traditionally debt equity ratio of 2:1 is considered as satisfactory
11/01/16 32 Debt Equity Ratio • DER = TLT Liabilities/TNW • DER = Long term debts/ Shareholders funds • Low ratio has a better leverage for borrowing, From a firm’s point of view debt servicing is less burdensome • Not more than 1.5 for providing finance by banks
11/01/16 33 Debt Service Coverage Ratio • This ratio measures relationship between Net profits before interest and Tax and Interset+Principal portion of installment. • It shows the number of times the amount of interest on long term debts and the principal portion of installments covered by the profits out of which that will be paid • To judge whether ratios is satisfactory or not it should be compared with its own past ratios or with ratios of similar enterprises in the same industry
11/01/16 34 Debt Service coverage Ratio • Debt Service coverage Ratio = • Net profit before interest and tax ____________________________ Principal portion of installment Int+----------------------------------------= times 1-Tax Rate
11/01/16 35 Example • Net profit before int and Tax Rs 8,50,000,10% debentures payable in 10 installments Rs 7,00,000 Tax rate 30% • Calculate Debt Service coverage ratio
11/01/16 36 Solution • DSCR= • 8,50,000 • =------------------------ • 70,000 • 70,000 +------------- = 5 times • (1-0.3)
11/01/16 37 DSCR • DSCR =( Net profit +Depcn+ Annual amount of • int.on LTLs)/Interest + principal Indicative of funds available for servicing long term debt • DSCR = 6+4+2/6 = 12/6= 2 • This is comfortable Should not be less than 1.5:1 while considering projects
11/01/16 38 Profitability Ratio In relation to Sales 1.Gross Profit Ratio 2.Operating profit ratio 3.Net profit ratio In relation to Investments 1.Return on Total Assets 2.Return on capital employed 3 Return on Share holders funds In relation to Share holder’s funds 1.Earnings per share 2.Price- Earning Ratio 3.Dividend pay out Ratio
11/01/16 39 Return on Assets • RoA = PBIT/Total Assets • To measure profitability and efficiency • Higher the ratio, the more efficient is the firm in using resources
11/01/16 40 Summary
11/01/16 41 Thank You

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Ratio Analysis

  • 2. 11/01/16 2 Analysis of Financial Ratios • The relationship between two accounting figures expressed mathematically is known as financial ratio
  • 3. 11/01/16 3 Introduction • What is the purpose of analysis of financial ratios • – It is for a meaningful study of information in the financial statements • – Ascertaining overall financial position of a business organisation • – Interpretation of key information in the financial statements
  • 4. 11/01/16 4 Objective • The objectives: • – Assess credit risk profile of the borrower • – Stipulation of terms and conditions • – Assess utilization of credit facility • – Establish sound well defined credit granting criteria • – Ensure safety of bank funds
  • 5. 11/01/16 5 Factors that banks consider • Credit worthiness of the borrower • Integrity/reputation • Credit risk profile • Sensitivity to economic and market developments • Liquidity • Solvency • Profitability of business • Resource efficiency
  • 6. 11/01/16 6 Financial Analysis • Trends in the financial planning • Analysis of projected financial statements
  • 7. 11/01/16 7 Ratios can be expressed in different ways • Ratios can be expressed as • A) Percentage say gross profit ratio is 20% of sales • B) Proportion say current ratio 2:1 • C) Fraction- Say net profit is one-tenth of sales • D) Times say capital turn over ratio is 5times
  • 8. 11/01/16 8 Classification of Ratios • Liquidity Ratios • Solvency Ratios • Activity Ratios • Profitability Ratios
  • 9. 11/01/16 9 Measures of Liquidity / Liquidity Ratios • Net Working Capital • Current Ratio • Quick Ratio • Net Working Capital/Net Assets • Net Working Capital/Current Assets
  • 10. 11/01/16 10 Net Working Capital • Gross Working Capital ( GWC) • It is the investment required to be made by the borrower in Current Assets • How ? • From own contributions • From creditors, borrowings • Other short term resources
  • 11. 11/01/16 11 Gross Working Capital • Gross Working Capital • How funded • From own resources and other long term sources • Short fall if any from short term resources
  • 12. 11/01/16 12 Short Term Resources • Short term resources constitute what are known • as ‘ Current Liabilities’ • Current Liabilities should be lower than Current Assets • Excess of Current Assets over Current Liabilities is Net Working Capital • Contribution from long term resources applied to financing of Current Assets ( excess of Current Assets) is owner’s stake or margin money
  • 13. 11/01/16 13 Concept of NWC • NWC represents the surplus long term funds • applied towards financing of Current Assets • Current assets are financed from two sources • – Surplus from Long Term Liabilities • – Current Liabilities • Difference between Current assets and Current Liabilities should always be positive
  • 14. 11/01/16 14 NWC • Negative Net Working Capital • What is the Implication • Business has applied part of surplus Current Liabilities towards meeting shortfall in Long Term resources
  • 15. 11/01/16 15 NWC • Positive NWC means • i. Borrower has brought in his contribution • ii. Any fall in value of Current Assets will be cushioned by borrower’s stake • iii. Loss in sale of Current Assets will not affect Short term creditors
  • 16. 11/01/16 16 NWC • Net Working Capital ( NWC ) is a measure of • liquidity • • Sources for NWC • Long Term Liabilities net of Long Term Assets • ( LTLs including Net Worth less LTAs which includes • Fixed Assets, miscellaneous assets and • intangibles. • Another measure of liquidity is the Current Ratio
  • 17. 11/01/16 17 Current Ratio • Current Ratio: • Current Assets/ Current Liabilities • If Net Working Capital is to be of positive value the Current Ratio must be higher than 1. • Ideally for calculating MPBF Current Ratio should be 1.33: 1
  • 18. 11/01/16 18 Assets & Liabililities (Rs.crore) Liabilities Assets
  • 19. 11/01/16 19 Computation • Current Ratio is computed by dividing the current assets by the current liabilities • Current ratio is expressed as a pure ratio e.g 2:1Traditionally a current ratio of 2:1 is considered as a satisfactory ratio. • Current ratio is calculated at a particular date and not for a particular period • The excess of current ratio over current liabilities is known as working capital.
  • 20. 11/01/16 20 Quick Ratio or liquid ratio or Acid Test Ratio • This ratio establishes relationship between quick assets and current liabilities • This ratio measures ability of the firm to meet short term obligations without relying upon realisation of stock • Quick assets- Cash ,Bank balance,Debtors ( after deducting provisions ) , Bills receivables,Marketable securities,Short term loans and advances(debit balance)
  • 21. 11/01/16 21 Current Liabilities • Current Liabilities – those which are expected to be matured normally within a year. • Examples-Creditors for goods,Bills payable, Creditors for expenses,provision for tax unclaimed dividend,income received in advance,short term loans and advances(credit balance)
  • 22. 11/01/16 22 Quick Ratio • Quick ratio is computed by dividing quick assets by current liabilities. • Quick Ratio or Acid Test Ratio = Current Assets-Inventory/Current Liabilities • It indicates rupees of quick assets available for each rupee of current liability • A quick ratio of 1:1 is said to be satisfactory
  • 23. 11/01/16 23 Excercise • Work out • Current Ratio • Quick Ratio • Net working Capital to net sales (%) • Net working Capital to Current Assets (%)
  • 26. 11/01/16 26 Financing of Current Assets • 1. Current Assets = Current Liabilities + NWC or • 3088 = 2652 + 436 • 2. NWC = Current Assets – Current Liabilities or • 436 = 3088 – 2652 • 3. Current Assets = Current Liabilities + Contribution from Long Term Liabilities 3088 = 2249 +[(8104-7668)] =2652+436 (i.e.NWC = 3088)
  • 27. 11/01/16 27 NWC/Net Sales • This percentage should be around 8-12 % • NWC is lower: • Business is growing too fast without • building an adequate cushion in the form of NWC It indicates symptom of overtrading and Undue reliance on borrowed short term funds
  • 28. 11/01/16 28 Falling NWC/Net Sales • Indicative of overtrading and serious liquidity problems It needs to be investigated
  • 30. 11/01/16 30 Solvency Ratios • Debt Equity ratio • Debt –Service coverage Ratio
  • 31. 11/01/16 31 Debt Equity ratio • Debt Equity ratio establishes relationship between long term debts and share holder’s funds • Objective of this ratio is to measure the relative proportion of debt and equity in financing the assets of a firm • This ratio indicates margin of safety to long term creditors. • A low debt equity ratio implies use of more equity than debt which means a larger safety margin for creditors and vice versa. • Traditionally debt equity ratio of 2:1 is considered as satisfactory
  • 32. 11/01/16 32 Debt Equity Ratio • DER = TLT Liabilities/TNW • DER = Long term debts/ Shareholders funds • Low ratio has a better leverage for borrowing, From a firm’s point of view debt servicing is less burdensome • Not more than 1.5 for providing finance by banks
  • 33. 11/01/16 33 Debt Service Coverage Ratio • This ratio measures relationship between Net profits before interest and Tax and Interset+Principal portion of installment. • It shows the number of times the amount of interest on long term debts and the principal portion of installments covered by the profits out of which that will be paid • To judge whether ratios is satisfactory or not it should be compared with its own past ratios or with ratios of similar enterprises in the same industry
  • 34. 11/01/16 34 Debt Service coverage Ratio • Debt Service coverage Ratio = • Net profit before interest and tax ____________________________ Principal portion of installment Int+----------------------------------------= times 1-Tax Rate
  • 35. 11/01/16 35 Example • Net profit before int and Tax Rs 8,50,000,10% debentures payable in 10 installments Rs 7,00,000 Tax rate 30% • Calculate Debt Service coverage ratio
  • 36. 11/01/16 36 Solution • DSCR= • 8,50,000 • =------------------------ • 70,000 • 70,000 +------------- = 5 times • (1-0.3)
  • 37. 11/01/16 37 DSCR • DSCR =( Net profit +Depcn+ Annual amount of • int.on LTLs)/Interest + principal Indicative of funds available for servicing long term debt • DSCR = 6+4+2/6 = 12/6= 2 • This is comfortable Should not be less than 1.5:1 while considering projects
  • 38. 11/01/16 38 Profitability Ratio In relation to Sales 1.Gross Profit Ratio 2.Operating profit ratio 3.Net profit ratio In relation to Investments 1.Return on Total Assets 2.Return on capital employed 3 Return on Share holders funds In relation to Share holder’s funds 1.Earnings per share 2.Price- Earning Ratio 3.Dividend pay out Ratio
  • 39. 11/01/16 39 Return on Assets • RoA = PBIT/Total Assets • To measure profitability and efficiency • Higher the ratio, the more efficient is the firm in using resources
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