A very nice & precise presentation....Its very useful to refer it for students. Thanks a lot..Great work.
Can you pls forward it to my mail Id- dsvakrani_4@rediffmail.com
Best Regrads,
Dipak Vakrani.
Faculty for Finance & Accounting.

Financial Ratios ‘Financial ratios are no substitute for a crystal ball. They are just a convenient way to summarize large quantities of financial data and to compare financial performances. Ratios help you to ask the right questions; they seldom answer them’
Brealey and Myers

Concepts of Stock & Flow Position and their Reconciliation :

Concepts of Stock & Flow Position and their Reconciliation Balance Sheet represents a stock position, i.e., assets and liability position as on the last date of the financial year (say, 31st March 2010), while Profit & Loss Account represents a flow position i.e., income and expenses data for a given period, usually for a financial year (say, 2009-10). While calculating ratios involving data from Balance Sheet and P&L Account, usually average figure of assets and liabilities at the beginning and end of the year is taken for the purpose of reconciliation of stock and flow positions.

Concept of Sources & Uses of Funds :

Concept of Sources & Uses of Funds Liability side of the Balance Sheet represents both Short Term Sources (Current Liabilities) and Long Term Sources (Other Long Term Borrowings and Capital) of funds, while Asset side represents both Short Term Uses (Current Assets) and long Term Uses (Investments and Fixed Assets) of funds. To the extent possible, short term sources should finance short term uses and long term sources should finance long term uses. The gap between short term uses (current assets) and short term sources (current liabilities) is known as Working Capital Gap which need to be financed by short term Bank borrowings. Any diversion of funds from one type (short term or long term sources) to (long term or short term uses) is considered undesirable/ unacceptable by the banks / FIs.

Balancing of Sources and Uses :

Balancing of Sources and Uses Balancing is Desirable Short Term
Sources Short Term
Uses Long Term
Sources Long Term
Uses

Diversion - Type I :

Diversion - Type I Diversion of Long term funds to meet Working Capital Needs Short Term
Sources Long Term
Sources Short Term
Uses Long Term
Uses

Diversion – Type II :

Diversion – Type II Diversion of Short Term Funds for Long Term Uses ( Working capital funds used for buying machinery) Short Term
Sources Long Term
Sources Short Term
Uses Long Term
Uses

Possible Manipulation of Stock Position – (Window Dressing) Conceptual Understanding :

Possible Manipulation of Stock Position – (Window Dressing) Conceptual Understanding Assets and liabilities position representing “Stock Position on a given date” can be easily manipulated by accounting jugglery - passing adjustment entries on the balance sheet date.
If the current assets and current liabilities decrease by an equal amount, the current ratio will go up, if it was greater than one before the decrease and will go down if it was less than one.
The accountant can pass adjustment entry before closure, on the date of balance sheet to pay off creditors out of the current account (cash and bank) balance and improve the current ratio.

There is “No Ideal Value of Ratio”, but there can be “Minimum or Maximum Acceptable Values” for Banks / FIs :

There is “No Ideal Value of Ratio”, but there can be “Minimum or Maximum Acceptable Values” for Banks / FIs There is no ideal value of a ratio. The acceptable values will vary from industry to industry, place to place and from time to time based on the then prevailing economic environment.
Banks and Financial Institutions, however, have their minimum or maximum acceptable values for each ratio based on their risk perception. For example, banks accept a minimum current ratio of 1.33 and a maximum debt equity ratio of 2 for a manufacturing concern..
Analysts normally compare a particular ratio of a company with the industry average and try to ascertain statistically where its value lies in comparison with other companies in the same industry.

An analyst has to properly interpret high or low values of ratios :

An analyst has to properly interpret high or low values of ratios Text books say that a current ratio of 2 and more is ideal, but a high current ratio, e.g. 3.5 may be interpreted to represent an unhealthy situation, where current assets are not properly utilized. If a company prefers to have more of cash to address its liquidity risk, it suffers from the problem of having more of idle asset in its balance sheet, as cash is an idle asset.
An analyst always tries to dissect a given situation in to components and tries to analyze. If current ratio is as high as 3.5, he finds out which component of current ratio is more in relation to industry averages, whether it is “cash holding”, “inventory holding” or “debtors” ? He makes interpretation based on his findings.

Ratios which are correlated have to be taken together for interpretation :

Ratios which are correlated have to be taken together for interpretation “Current Ratio” value alone may not lead to any conclusive interpretation of liquidity situation. It has to be analyzed along with “Quick Ratio”, “Cash Ratio”, “Interval Measure”, “Age of Debtors” etc in order to have a meaningful interpretation of liquidity situation.
To test Solvency both short term solvency ratios such as Current Ratio, Quick Ratio and long term solvency ratios such as Debt : Equity Ratio, Total liability to Net worth Ratio, Debt service coverage ratio etc need to be considered.

Assumption of Linear Relationship between financial ratios :

Assumption of Linear Relationship between financial ratios Another basic assumption of ratio analysis is that there exists a linear relationship between financial ratios, which makes it possible to write
EBIT
Return on Net Assets = ----------------
Net Assets
Sales Gross Profit EBIT
= ---------- * --------------- * ----------------
Net Assets Sales Gross Profit

Note to Accounts & Off – Balance Sheet items may have stories to tell :

Note to Accounts & Off – Balance Sheet items may have stories to tell The Analyst must read “note to accounts” (stating among other things, changes in accounting policies if any & their effects on the financials of the company) and inquire about off balance sheet items ( providing guarantees to subsidiaries etc.), before trying to interpret the financial accounts or go for ratio analysis. These some times may reveal a lot for consideration. Without giving effects to these and noting auditor’s observations, one can not do justice to Financial Analysis.

General advice to analysts regarding use of Ratio Analysis :

General advice to analysts regarding use of Ratio Analysis Financial ratios seldom provide answers, but they do help you to ask the right questions.
There is no international standard for financial ratios. A little thought and common sense are worth far more than blind application of formulas.
Be selective in your choice of ratios. Different ratios often tell you similar things.
You need a benchmark for assessing a company’s financial position. Compare financial ratios with company’s ratios in earlier years and with the ratios of other firms in the same business.
Be careful not to extrapolate past rates of earning growth - earning follows approximately a random walk.

Types of Comparison of Ratios :

Types of Comparison of Ratios Comparison with past ratios of the same company (Trend or Time Series Analysis)
Comparison with ratios of competing companies of the same industry (Cross-sectional Analysis)
Comparison with industry averages (ratios) – Industry Analysis
Forecasting and Pro-forma Analysis

Liquidity Ratios Liquidity refers to the ability of a firm to meet its short-term (usually up to 1 year) obligations. The major ratios which indicate the liquidity of a company are Current ratio, Quick /Acid-Test ratio, and Cash ratio. However an analyst may consider other ratios to appropriately analyze and interpret the liquidity situation.

Liquidity Ratios ( Analysis For Short term Creditors- Bankers) :

Liquidity Ratios ( Analysis For Short term Creditors- Bankers) Current Assets
Current Ratio (CR) = ----------------------
Current liabilities
Current Assets - Inventory
Quick Ratio (QR) = ------------------------------------
Current Liabilities
Inventory
CR - QR = -------------------
Current Liabilities
(Current Assets include Cash, Bills Receivables, Debtors, Short Tem Investments and Inventory)

Reporting an Analysis Effectively(Shows Inventory Accumulation – An Unhealthy Situation) :

Reporting an Analysis Effectively(Shows Inventory Accumulation – An Unhealthy Situation)

Other Liquidity Ratios :

Other Liquidity Ratios Cash + Short term Securities + Receivables
Cash Ratio = -------------------------------------------------------------
Current Liabilities
Cash + Short term Securities + Receivables
Interval Measure = -----------------------------------------------------------
Average daily expenditure from operations
Average daily expenditure from operations is calculated by dividing (Cost of goods sold + other expenses) by 365

Other Liquidity Ratios :

Other Liquidity Ratios Current assets are those assets which the company expects to turn into cash in the near future. The difference between current assets and current liabilities is known as net working capital. It roughly measures company’s potential reservoir of cash. Analysts often express net working capital as a proportion of total assets to measure liquidity:
Net Working Capital
----------------------------
Total Assets

Other liquidity ratios :

Other liquidity ratios The Net working capital to Sales ratio indicates a company’s liquid assets (after meeting short term liabilities) relative to its need for liquidity (Sales)
Net Working capital
----------------------------
Sales
This can be also considered as a measure of liquidity

Other Liquidity Ratios :

Other Liquidity Ratios Turnover ratios measure the efficiency of working capital management by looking at the relationship of accounts receivable and inventory to sales and cost of goods sold.
Sales
Accounts receivable Turnover = ---------------------------------------
Average Accounts Receivable
Cost of Goods Sold
Inventory Turnover = ---------------------------------
Average inventory
365
Days Receivable outstanding = ---------------------------------------
Accounts Receivable turnover
365
Days Inventory held = -------------------------------------
Inventory turnover

Other Liquidity Ratios :

Other Liquidity Ratios A similar pair of statistics can be computed for accounts payable, relative to purchases
Purchases
Accounts Payable Turnover = ------------------------------------
Average Accounts Payable
365
Days Accounts Payable outstanding = -------------------------
Payable Turnover
From this we can compute:
Required Financing period = Days Receivable Outstanding + Days Inventory Held – Days Accounts Payable Outstanding = Net Operating Cycle
How much liquidity a company needs depends on its operating cycle. The operating cycle is the duration between the time the cash is invested in goods and services to the time the investment produces cash

Operating Cycle – The Concept :

Operating Cycle – The Concept Operating Cycle (Cash to Cash)
Credit Sales
Cash Sales
Credit Sales Cash Raw Materials Work in Process Finished Goods Debtors Trade
Creditors

Activity Ratios :

Activity Ratios These ratios determine how quickly certain current assets can be converted into cash. They are also called efficiency ratios or asset utilization ratios as they measure the efficiency of a firm in managing assets. These ratios are based on the relationship between the level of activity represented by sales or cost of goods sold and levels of investment in various assets. The important turnover ratios are debtors turnover ratio, average collection period, inventory/stock turnover ratio, fixed assets turnover ratio, and total assets turnover ratio.

Activity Ratios :

Activity Ratios Cash Conversion Cycle = Inventory Conversion Period +
Receivable Conversion Period – Payable Conversion Period Inventory
Inventory Conversion Period = ---------------- * 365 Days
COGS
Receivables
Receivable Conversion Period = --------------- * 365 Days
Sales
Payables
Payable Conversion Period = -------------------- * 365 Days
Purchases

Activity Ratios :

Activity Ratios Net Sales
Assets Turnover = -----------------------------
Average Total Assets
Cost of Goods Sold
Inventory Turnover = ---------------------------------
Average Inventory
Net Credit Sales
Receivable Turnover = ---------------------------
Average Receivables
Credit Purchases
Payable Turnover = ------------------------
Average Payables

Leverage or Capital Structure Ratios :

Leverage or Capital Structure Ratios These ratios measure the long-term solvency of a firm. Financial leverage refers to the use of debt finance. While debt capital is a cheaper source of finance, it is also a risky source. Leverage ratios help us assess the risk arising from the use of debt capital. Two types of ratios are commonly used to analyze financial leverage - structural ratios and coverage ratios. Structural ratios are based on the proportions of debt and equity in the financial structure of a firm. Coverage ratios show the relationship between the debt commitments and the sources for meeting them.
The long-term creditors of a firm evaluate its financial strength on the basis of its ability to pay the principal and interest on the loan regularly during the period of the loan.

Structural & Coverage Ratios :

Structural & Coverage Ratios Total Debt
Debt Ratio = ---------------------
Total Equity
Long Term Debt
Debt Equity Ratio = ----------------------------------------
Average Shareholders Equity
EBIT + Depreciation
Interest Coverage Ratio = ----------------------------------
Annual Interest Expenses
EBIT+ Depreciation
Debt Service Coverage Ratio = --------------------------------
Total Annual Debt Service*
Total annual Debt Service includes both principal and interest repayments for the year

Profitability Ratios Profitability ratios measure the company's use of its assets and control of its expenses to generate an acceptable rate of return.
Gross Margin / Gross Profit Margin / Gross Profit Rate
Gross Profit Net Sales – Cost of Goods Sold
= ------------------ = -------------------------------------------
Net Sales Net Sales
Operating Profit
Operating Profit Margin = ------------------------
Net Sales
Note :
Operating income is the difference between operating revenues and operating expenses, but it is also sometimes used as a synonym for EBIT and operating profit This is true if the firm has no non-operating income. (Earning before interest and taxes / Sales)

Profitability Ratios :

Profitability Ratios Net Profit
Net Profit Margin = ---------------------
Net Sales
Net Income (PAT) – Pref. Dividend
Return on Equity (ROE) = ----------------------------------------
Average Shareholder’s Equity
Net Income
Return on Assets (ROA) = ------------------------------
Average Total Assets
Net Income
Return on Investment (ROI) = -------------------------------
Capital Employed

Profitability Ratios :

Profitability Ratios Net Income
Return on Net Assets (RONA) = --------------------------
Average Net Assets
(Where Net Assets = Net Fixed Asset +Net Working Capital)
EBIT
Return on Capital Employed (ROCE) = ----------------------
Capital Employed
Net Income Net Sales
ROA (Du Pont) = -------------- * ----------------------------
Net Sales Average Total Assets
(Capital Employed = Net Fixed assets + Net Working Capital)

Market Ratios / Valuation Ratios :

Market Ratios / Valuation Ratios Market / Valuation ratios indicate the performance of the equity stock of a company in the stock market. Since the market value of equity reflects the combined influence of risk and return, valuation ratios play an important role in assessing a company's performance in the stock market. The important valuation ratios are: P/E Ratio, P/B Ratio, P/S Ratio, PEG Ratio,
EV / IBITDA ,EV / Sales etc.

Market Ratios/ Valuation Ratios :

Market Ratios/ Valuation Ratios Net Earnings - Pref. Dividend
Earning Per Share (EPS) = -------------------------------------
Number of Shares
Market price per share
P/E Ratio = ------------------------------
EPS
Market Price per Share
P/B Ratio = -------------------------------
Book Value per share
Market Price per Share
P/S Ratio = ---------------------------------
Sales per share

Market / Valuation Ratios :

Market / Valuation Ratios Dividend paid per Share 1
Payout Ratio = ------------------------------ = ------------------
Earning per share Dividend Cover
Dividend per share
Dividend Yield = ----------------------------
Market price per share
P/E Ratio
PEG Ratio = ----------------------------
Growth Rate of EPS

Market / Valuation Ratios :

Market / Valuation Ratios Enterprise Value
EV/ EBITDA = ----------------------------------------------------
Earning Before Interest, Tax Depreciation & Annuity
Enterprise Value
EV/ Sales = -----------------------------------
Sales
Enterprise Value is equal to market value of debt and equity less cash and short term marketable securities

Over and Under Capitalization A concern is said to be over-capitalized if its earnings are not sufficient to justify a fair return on the amount of share capital and debentures. It is also said to be over capitalized when total of owned and borrowed capital exceeds its fixed and current assets, ie, when it shows accumulated losses on the asset side of the balance sheet. It can be remedied by reduction of capital.
If the owned capital of the business is much less compared to borrowed capital, then it is sign of under-capitalization. Under capitalization leads to excessive interest payment on borrowed capital. It could also happen because of over trading.

Limitations of Ratio Analysis :

Limitations of Ratio Analysis Ratio analysis is based on financial statements which are themselves subject to severe limitations. Financial Statements are based on accounting policies which vary from enterprise to enterprise both within a single country and among countries. Especially inventory valuation (LIFO,FIFO, Weighted Average) charging of depreciation (Straight line or Accelerated Method of charging Depreciation) etc. Some companies might have goodwill as an asset, some may not. Some may have created a revaluation reserve, some others might not have.
Intangible assets rarely show up in the balance sheet. Companies spend large sums on R&D, Advertising, Staff Training – these expenditures create valuable assets- know-how, brand loyalty, skilled workforce –that may generate cash flows for many years. To the extent these intangible assets do not form part of the total balance sheet assets, the book rate of return (ROA) tends to be overstated.

Limitations of Ratio Analysis :

Limitations of Ratio Analysis Financial statements do not disclose non-financial information relating to changes in management, expiry of JV agreements etc., which have a vital bearing on earning of the company and can affect value of ratios.
In the case of inter-firm comparison, no two firms are similar in age, size and product-mix. Therefore, any comparison of ratios of two such firms would have some limitations.
Both inter-period and inter-firm comparisons are affected by price level changes.
One single ratio, like current ratio, may not give any appropriate interpretation of liquidity position. Other correlated ratios like quick ratio cash ratio etc. have to be considered simultaneously to give a meaningful interpretation of liquidity position.

Limitations of Ratio Analysis :

Limitations of Ratio Analysis The ratio analysis is based on the balance sheet prepared on the accounting date. Sometimes the Finance Manager may resort to window dressing to cover up unhealthy financial position.
Ratio Analysis is only a tool to spot out symptoms. The analyst has to carry out further investigation and exercise his judgment in arriving at a proper diagnosis.

Common Size Statement Analysis (Vertical Analysis) :

Common Size Statement Analysis (Vertical Analysis) Common-size statements analysis expresses balance sheet components as a percentage of total assets and income statement components as a percentage of total revenue (net sales). This approach facilitates identifying
deviations in the components of statements by focusing on relative differences through time. Common size statement analysis is also used as an important tool for comparison of performances of any two companies in the same industry.

Trend Analysis (Horizontal Analysis) :

Trend Analysis (Horizontal Analysis) Trend analysis usually involves choosing one fiscal period as a base period and then expressing data for subsequent period as a percentage of the data associated with this base period. In the case of an income statement, changes in all items could be assessed in relation to the base period. Significant changes can then be investigated further. Note that trend analysis can be performed to determine changes in the number of physical units as well as in monetary terms.

Group Work for Practice & Better Understanding (Must Do) :

Group Work for Practice & Better Understanding (Must Do) 1. Read the Case Study Analysis provided for HLL.
2. Take out any company from “Net” whose financial statements are available for the past 3 years, calculate all the relevant ratios for the past 3 years and provide your own interpretations.
3. Carry out inter-firm comparison using ratio analysis, common size statement analysis and trend analysis taking the above data and similar data for another company in the same industry. Compare the performance of the two companies and give your interpretations.

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By: afreen6 (40 month(s) ago)

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