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Slide 1: 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 1 Financial Statements Analysis

Slide 2: 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 2 FINANCIAL STATEMENTS ANALYSIS Ratio Analysis Importance and Limitations of Ratio Analysis Common Size Statements

Ratio Analysis : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 3 Ratio Analysis Ratio analysis is a widely used tool of financial analysis. It is defined as the systematic use of ratio to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical performance and current financial condition can be determined.

Basis of Comparison : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 4 Basis of Comparison 1) Trend Analysis involves comparison of a firm over a period of time, that is, present ratios are compared with past ratios for the same firm. It indicates the direction of change in the performance – improvement, deterioration or constancy – over the years. 2) Interfirm Comparison involves comparing the ratios of a firm with those of others in the same lines of business or for the industry as a whole. It reflects the firm’s performance in relation to its competitors. 3) Comparison with standards or industry average.

Types of Ratios : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 5 Types of Ratios Liquidity Ratios Capital Structure Ratios Profitability Ratios Efficiency ratios Integrated Analysis Ratios Growth Ratios

Net Working Capital : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 6 Net working capital is a measure of liquidity calculated by subtracting current liabilities from current assets. Net Working Capital

Liquidity ratios measure the ability of a firm to meet its short-term obligations : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 7 Liquidity ratios measure the ability of a firm to meet its short-term obligations Liquidity Ratios

Current Ratio : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 8 Current Ratio is a measure of liquidity calculated dividing the current assets by the current liabilities Current Ratio

Acid-Test Ratio : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 9 The quick or acid test ratio takes into consideration the differences in the liquidity of the components of current assets Quick Assets = Current assets – Stock – Pre-paid expenses Acid-Test Ratio

Example 1: Acid-Test Ratio : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 10 Example 1: Acid-Test Ratio

Supplementary Ratios for Liquidity : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 11 Supplementary Ratios for Liquidity Inventory Turnover Ratio Debtors Turnover Ratio Creditors Turnover Ratio

Inventory Turnover Ratio : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 12 Inventory Turnover Ratio The cost of goods sold means sales minus gross profit. The average inventory refers to the simple average of the opening and closing inventory. The ratio indicates how fast inventory is sold. A high ratio is good from the viewpoint of liquidity and vice versa. A low ratio would signify that inventory does not sell fast and stays on the shelf or in the warehouse for a long time.

Example 2: Inventory Turnover Ratio : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 13 Example 2: Inventory Turnover Ratio A firm has sold goods worth Rs 3,00,000 with a gross profit margin of 20 per cent. The stock at the beginning and the end of the year was Rs 35,000 and Rs 45,000 respectively. What is the inventory turnover ratio?

Debtors Turnover Ratio : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 14 Debtors Turnover Ratio Net credit sales consist of gross credit sales minus returns, if any, from customers. Average debtors is the simple average of debtors (including bills receivable) at the beginning and at the end of year. The ratio measures how rapidly receivables are collected. A high ratio is indicative of shorter time-lag between credit sales and cash collection. A low ratio shows that debts are not being collected rapidly.

Example 3: Debtors Turnover Ratio : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 15 Example 3: Debtors Turnover Ratio A firm has made credit sales of Rs 2,40,000 during the year. The outstanding amount of debtors at the beginning and at the end of the year respectively was Rs 27,500 and Rs 32,500. Determine the debtors turnover ratio.

Creditors Turnover Ratio : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 16 Creditors Turnover Ratio Net credit purchases = Gross credit purchases - Returns to suppliers. Average creditors = Average of creditors (including bills payable) outstanding at the beginning and at the end of the year. A low turnover ratio reflects liberal credit terms granted by suppliers, while a high ratio shows that accounts are to be settled rapidly. The creditors turnover ratio is an important tool of analysis as a firm can reduce its requirement of current assets by relying on supplier’s credit.

Example 4: Creditors Turnover Ratio : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 17 Example 4: Creditors Turnover Ratio The firm in previous Examples has made credit purchases of Rs 1,80,000. The amount payable to the creditors at the beginning and at the end of the year is Rs 42,500 and Rs 47,500 respectively. Find out the creditors turnover ratio.

Slide 18: 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 18 The summing up of the three turnover ratios (known as a cash cycle) has a bearing on the liquidity of a firm. The cash cycle captures the interrelationship of sales, collections from debtors and payment to creditors. The combined effect of the three turnover ratios is summarised below:

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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 19 Defensive interval ratio is the ratio between quick assets and projected daily cash requirement. DEFENSIVE INTERVAL RATIO

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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 20 Example 5: Defensive Interval Ratio The projected cash operating expenditure of a firm from the next year is Rs 1,82,500. It has liquid current assets amounting to Rs 40,000. Determine the defensive-interval ratio.

Slide 21: 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 21 Cash-flow from operation ratio measures liquidity of a firm by comparing actual cash flows from operations (in lieu of current and potential cash inflows from current assets such as inventory and debtors) with current liability. Cash-flow From Operations Ratio

Leverage Capital Structure Ratio : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 22 Leverage Capital Structure Ratio Capital structure or leverage ratios throw light on the long-term solvency of a firm. There are two aspects of the long-term solvency of a firm: Ability to repay the principal when due, and Regular payment of the interest .

I. Debt-equity ratio : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 23 I. Debt-equity ratio Long-term Debt + Short term debt + Other Current Liabilities = Total external Obligations Debt-equity ratio measures the ratio of long-term or total debt to shareholders equity. If the D/E ratio is high, the owners are putting up relatively less money of their own. It is danger signal for the lenders and creditors. If the project should fail financially, the creditors would lose heavily. A low D/E ratio has just the opposite implications. To the creditors, a relatively high stake of the owners implies sufficient safety margin and substantial protection against shrinkage in assets.

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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 24 For the company also, the servicing of debt is less burdensome and consequently its credit standing is not adversely affected, its operational flexibility is not jeopardised and it will be able to raise additional funds. The disadvantage of low debt-equity ratio is that the shareholders of the firm are deprived of the benefits of trading on equity or leverage.

Trading on Equity : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 25 Trading on Equity Trading on Equity (Amount in Rs thousand) Particular A B C D (a) Total assets 1,000 1,000 1,000 1,000   Financing pattern:     Equity capital 1,000 800 600 200     15% Debt —  200 400 800 (b) Operating profit (EBIT) 300 300 300 300   Less: Interest —  30 60 120 Earnings before taxes 300 270 240 180 Less: Taxes (0.35) 105 94.5 84 63 Earnings after taxes 195 175.5 156 117 Return on equity (per cent) 19.5 21.9 26 58.5 Trading on equity (leverage) is the use of borrowed funds in expectation of higher return to equity-holders.

II. Debt to Total Capital : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 26 II. Debt to Total Capital The relationship between creditors’ funds and owner’s capital can also be expressed using Debt to total capital ratio. Debt to total capital ratio = Total debt Permanent capital Permanent Capital = Shareholders’ equity + Long-term debt.

III. Debt to total assets ratio : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 27 III. Debt to total assets ratio Proprietary ratio indicates the extent to which assets are financed by owners funds. Capital gearing ratio is used to know the relationship between equity funds (net worth) and fixed income bearing funds (Preference shares, debentures and other borrowed funds. Proprietary Ratio Capital Gearing Ratio

Coverage Ratio : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 28 Coverage Ratio Interest Coverage Ratio measures the firm’s ability to make contractual interest payments. Dividend Coverage Ratio measures the firm’s ability to pay dividend on preference share which carry a stated rate of return. Interest Coverage Ratio Dividend Coverage Ratio

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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 29 Total fixed charge coverage ratio measures the firm’s ability to meet all fixed payment obligations. Total fixed charge coverage ratio However, coverage ratios mentioned above, suffer from one major limitation, that is, they relate the firm’s ability to meet its various financial obligations to its earnings. Accordingly, it would be more appropriate to relate cash resources of a firm to its various fixed financial obligations. Total Cashflow Coverage Ratio

Debt Service Coverage Ratio : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 30 Debt Service Coverage Ratio Debt-service coverage ratio (DSCR)  is considered a more comprehensive and apt measure to compute debt service capacity of a business firm. DEBT SERVICE CAPACITY Debt service capacity is the ability of a firm to make the contractual payments required on a scheduled basis over the life of the debt.

Example 6: Debt-Service Coverage Ratio : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 31 Agro Industries Ltd has submitted the following projections. You are required to work out yearly debt service coverage ratio (DSCR) and the average DSCR. Example 6: Debt-Service Coverage Ratio

Solution : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 32 Solution

Profitability Ratio : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 33 Profitability Ratio Profitability ratios can be computed either from sales or investment.

Profit Margin : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 34 Profit Margin Gross profit margin measures the percentage of each sales rupee remaining after the firm has paid for its goods. Gross Profit Margin

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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 35 Net profit margin can be computed in three ways Net profit margin measures the percentage of each sales rupee remaining after all costs and expense including interest and taxes have been deducted. Net Profit Margin

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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 36

Expenses Ratio : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 37 Expenses Ratio

Return on Investment : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 38 Return on Investment Return on Investments measures the overall effectiveness of management in generating profits with its available assets.

Return on Shareholders’ Equity : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 39 Return on Shareholders’ Equity Return on shareholders equity measures the return on the owners (both preference and equity shareholders ) investment in the firm.

Efficiency Ratio : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 40 Efficiency Ratio Activity ratios measure the speed with which various accounts/assets are converted into sales or cash. Inventory turnover measures the efficiency of various types of inventories.

Slide 41: 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 41 Liquidity of a firm’s receivables can be examined in two ways. Ageing Schedule enables analysis to identify slow paying debtors. Debtors Turnover Ratio

Assets Turnover Ratio : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 42 Assets Turnover Ratio Assets turnover indicates the efficiency with which firm uses all its assets to generate sales.

Slide 43: 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 43 Return on shareholders’ equity = EAT/Average total shareholders’ equity. Return on equity funds = (EAT – Preference dividend)/Average ordinary shareholders’ equity (net worth). Earnings per share (EPS) = Net profit available to equity shareholders’ (EAT – Dp)/Number of equity shares outstanding (N). Dividends per share (DPS) = Dividend paid to ordinary shareholders/Number of ordinary shares outstanding (N). Earnings yield = EPS/Market price per share. Dividend Yield = DPS/Market price per share. Dividend payment/payout (D/P) ratio = DPS/EPS. Price-earnings (P/E) ratio = Market price of a share/EPS. Book value per share = Ordinary shareholders’ equity/Number of equity shares outstanding.

Integrated Analysis Ratio : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 44 Integrated Analysis Ratio Integrated ratios provide better insight about financial and economic analysis of a firm.

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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 45

Return on Assets : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 46 Return on Assets Earning Power Earning power is the overall profitability of a firm; is computed by multiplying net profit margin and assets turnover. Earning power = Net profit margin × Assets turnoverWhere, Net profit margin = Earning after taxes/Sales Asset turnover = Sales/Total assets

EXAMPLE: 8 : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 47 Assume that there are two firms, A and B, each having total assets amounting to Rs 4,00,000, and average net profits after taxes of 10 per cent, that is, Rs 40,000, each. Firm A has sales of Rs 4,00,000, whereas the sales of firm B aggregate Rs 40,00,000. Determine the ROA of firms A and B. Table 4 shows the ROA based on two components. EXAMPLE: 8

Return on Equity (ROE) : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 48 Return on Equity (ROE) ROE is the product of the following three ratios: Net profit ratio (x) Assets turnover (x) Financial leverage/Equity multiplier Three-component model of ROE can be broadened further to consider the effect of interest and tax payments. As a result of three sub-parts of net profit ratio, the ROE is composed of the following 5 components.

Slide 49: 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 49 A 5-way break-up of ROE enables the management of a firm to analyse the effect of interest payments and tax payments separately from operating profitability. To illustrate further assume 8 per cent interest rate, 35 per cent tax rate and other operating expense of Rs 3,22,462 (Firm A) and Rs 39,26,462 (Firm B) for the facts contained in Example 8. Table 5 shows the ROE (based on the 5 components) of Firms A and B.

Common Size Statements : 

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 50 Common Size Statements Preparation of common-size financial statements is an extension of ratio analysis. These statements convert absolute sums into more easily understood percentages of some base amount. It is sales in the case of income statement and totals of assets and liabilities in the case of the balance sheet. Ratio analysis in view of its several limitations should be considered only as a tool for analysis rather than as an end in itself. The reliability and significance attached to ratios will largely hinge upon the quality of data on which they are based. They are as good or as bad as the data itself. Nevertheless, they are an important tool of financial analysis. Limitations