Ch 06 FinancialStatementAnalysis

7/28/2019 Ch 06 FinancialStatementAnalysis

1/56

6 - 1

Chapter 6

Financial Statements Analysis


2/56

6 - 2

FINANCIAL STATEMENTS

ANALYSIS

Ratio Analysis

Importance and Limitations of

Ratio Analysis

Common Size Statements

Mini Case


3/56

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 sothat the strengths and weaknesses of a firm as

well as its historical performance and current

financial condition can be determined.


4/56

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, deteriorationor 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 firms

performance in relation to its competitors.

3) Comparison with standards or industry average.


5/56

6 - 5

Types of Ratios

Liquidity Ratios

Capital Structure RatiosProfitability Ratios

Efficiency ratios

Integrated Analysis Ratios

Growth Ratios


6/56

6 - 6

Net working capital is a measure of liquidity calculated by

subtracting current liabilities from current assets.

Table 1: Net Working Capital

Particulars Company A Company B

Total current assets

Total current liabilities

NWC

Rs 1,80,000

1,20,000

60,000

Rs 30,000

10,000

20,000

Table 2: Change in Net Working Capital

Particulars Company A Company B

Current assets

Current liabilities

NWC

Rs 1,00,000

25,000

75,000

Rs 2,00,000

1,00,000

1,00,000

Net Working Capital


7/56

6 - 7

Liquidity Ratios

Liquidity ratios measure the ability of a firm to

meet its short-term obligations.


8/56

6 - 8

Particulars Firm A Firm B

Current Assets Rs 1,80,000 Rs 30,000

Current Liabilities Rs 1,20,000 Rs 10,000

Current Ratio = 3:2 (1.5:1) 3:1

Current Ratio

Current Ratio = Current AssetsCurrent Liabilities

Current Ratio is a measure of liquidity calculated dividing the current

assets by the current liabilities


9/56

6 - 9

Quick Assets = Current assets Stock

Pre-paid expenses

Acid-Test Ratio

Acid-test Ratio =Quick Assets

Current Liabilities

The quick or acid test ratio takes into consideration the

differences in the liquidity of the components of current

assets.


10/56

6 - 10

Example 1: Acid-Test Ratio

Cash

Debtors

Inventory

Total current assets

Total current liabilities

Rs 2,000

2,000

12,000

16,000

8,000

(1) Current Ratio(2) Acid-test Ratio

2 : 10.5 : 1


11/56

6 - 11

Supplementary Ratios for

Liquidity

Inventory Turnover Ratio

Debtors Turnover Ratio

Creditors Turnover Ratio


12/56

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.

Inventory turnover ratio =Cost of goods sold

Average 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.


13/56

6 - 13

Example 2: Inventory Turnover Ratio

Inventory

turnover ratio=

(Rs 3,00,000 Rs 60,000)=

6 (times

per year)(Rs 35,000 + Rs 45,000) 2

Inventory

holding period=

12 months= 2 months

Inventory turnover ratio, (6)

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?


14/56

6 - 14


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.

Debtors turnover ratio =Net credit sales

Average debtors

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.


15/56

6 - 15

Example 3: Debtors Turnover Ratio

Debtors

turnover ratio=

Rs 2,40,000=

8 (times

per year)(Rs 27,500 + Rs 32,500) 2

Debtors

collection period=

12 Months=

1.5

MonthsDebtors turnover ratio, (8)

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.


16/56

6 - 16

Creditors Turnover Ratio

Net credit purchases = Gross credit purchases - Returns tosuppliers.

Average creditors = Average of creditors (including bills payable)

outstanding at the beginning and at the end of the year.

Creditors turnover

ratio=

Net credit purchases

Average creditors

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 suppliers credit.


17/56

6 - 17

Example 4: Creditors Turnover Ratio

Creditors

turnover ratio=

(Rs 1,80,000)=

4 (times

per year)(Rs 42,500 Rs 47,500) 2

Creditors

payment period=

12 months= 3 months

Creditors turnover ratio, (4)

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.


18/56

6 - 18

Inventory holding period

Add: Debtors collection period

Less: Creditors payment period

2 months

+ 1.5 months

3 months0.5 months

As a rule, the shorter is the cash cycle, the better are the liquidity

ratios as measured above and vice versa.

The combined effect of the three turnover ratios

is summarised below:

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.


19/56

6 - 19

Defensive interval ratio is the ratio between quick

assets and projected daily cash requirement.

DEFENSIVE INTERVAL RATIO

Defensive-

interval ratio=

Liquid assets

Projected daily cash requirement

Projected daily

cash requirement=

Projected cash operating expenditure

Number of days in a year (365)


20/56

6 - 20

Example 5: Defensive Interval Ratio

Projected daily cash requirement =

Rs 1,82,500

= Rs 500365

Defensive-interval ratio =Rs 40,000

= 80 daysRs 500

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-intervalratio.


21/56

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

Cash-flow from

operations ratio=

Cash-flow from operations

Current liabilities


22/56

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:

(i) Ability to repay the principal when due, and

(ii) Regular payment of the interest .

Accordingly, there are two different types of leverage ratios.

First type: These ratios are

computed from the balance

sheet

Second type: These ratios are

computed from the Income

Statement(a) Debt-equity ratio

(b) Debt-assets ratio

(c) Equity-assets ratio

(a) Interest coverage ratio

(b) Dividend coverage ratio


23/56

6 - 23

I. Debt-equity ratio

Debt-equity ratio measures the ratio of long-

term or total de3bt to shareholders equityDebt-equity ratio =Total Debt

Shareholders equity

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.


24/56

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.


25/56

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 120Earnings 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.


26/56

6 - 26

II. Debt to Total Capital

Debt to total capital ratio =Total debt

Permanent capital

Permanent Capital = Shareholders equity +

Long-term debt.

The relationship between creditors funds and owners

capital can also be expressed using Debt to total capital

ratio.


27/56

6 - 27

III. Debt to total assets ratio

Debt to total assets ratio =Total debt

Total assets

Proprietary ratio indicates the extent to which assetsare financed by owners funds.

Proprietary ratio =Proprietary funds

Total assetsX 100

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


28/56

6 - 28

Coverage Ratio

Interest Coverage Ratio measures the firms ability to make

contractual interest payments.

Interest coverage ratio =EBIT (Earning before interest and taxes)

Interest

Dividend coverage ratio =EAT (Earning after taxes)

Preference dividend

Dividend Coverage Ratio measures the firms ability to pay dividendon preference share which carry a stated rate of return.

Interest Coverage Ratio

Dividend Coverage Ratio


29/56

6 - 29

Total fixed charge coverage ratio measures the firms ability to meet all fixed

payment obligations.

Total fixed charge

coverage ratio

EBIT + Lease Payment

Interest + Lease payments + (Preference dividend

+ Instalment of Principal)/(1-t)

=

Total fixed charge coverage ratio

However, coverage ratios mentioned above, suffer from one major

limitation, that is, they relate the firms 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

Total cashflow

coverage ratioLease payment

+ Interest

EBIT + Lease Payments + Depreciation + Non-cash expenses

=(Principal repayment)

(1 t)

(Preference dividend)

(1 - t)+ +


30/56

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

DSCR =Instalmentt

n

t=1

EATt OAt+ +n

t=1Depreciationt+Interestt

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.


31/56

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.

(Figures in Rs lakh)

Year Net profit for the

year

Interest on term loan

during the year

Repayment of term

loan in the year

12

3

4

5

6

7

8

21.6734.77

36.01

19.20

18.61

18.40

18.33

16.41

19.1417.64

15.12

12.60

10.08

7.56

5.04

Nil

10.7018.00

18.00

18.00

18.00

18.00

18.00

18.00

The net profit has been arrived after charging depreciation of Rs 17.68 lakh

every year.

Example 6: Debt-Service Coverage Ratio


32/56

6 - 32

Solution

Table 3: Determination of Debt Service Coverage Ratio

(Amount in lakh of rupees)

Ye

ar

Net

profit

Depreciation Interest Cash

available

(col.

2+3+4)

Principal

instalment

Debt

obligation

(col. 4 + col. 6)

DSCR [col. 5

col. 7

(No. of times)]

1 2 3 4 5 6 7 8

1

2

3

4

5

6

7

8

21.67

34.77

36.01

19.20

18.61

18.40

18.33

16.41

17.68

17.68

17.68

17.68

17.68

17.68

17.68

17.68

19.14

17.64

15.12

12.60

10.08

7.56

5.04

Nil

58.49

70.09

68.81

49.48

46.37

43.64

41.05

34.09

10.70

18.00

18.00

18.00

18.00

18.00

18.00

18.00

29.84

35.64

33.12

30.60

28.08

25.56

23.04

18.00

1.96

1.97

2.08

1.62

1.65

1.71

1.78

1.89

Average DSCR (DSCR 8) 1.83


33/56

6 - 33

Profitability Ratio

Profitability ratios can be computed either from

sales or investment.

Profitability Ratios

Related to Sales

Profitability Ratios

Related to Investments

(i) Profit Margin

(ii) Expenses Ratio

(i) Return on Investments

(ii) Return on Shareholders

Equity


34/56

6 - 34

Profit Margin

Gross profit margin measures the percentage of each salesrupee remaining after the firm has paid for its goods.

Gross profit margin = Gross ProfitSales X 100

Gross Profit Margin


35/56

6 - 35

Net profit margin can be computed in three ways

iii. Net Profit Ratio =Earning after interest and taxes

Net sales

ii. Pre-tax Profit Ratio =Earnings before taxes

Net sales

i. Operating Profit Ratio =Earning before interest and taxes

Net sales

Net profit margin measures the percentage of each sales rupee

remaining after all costs and expense including interestand taxes have been deducted.

Net Profit Margin


36/56

6 - 36

Example 7: From the following information of a firm,

determine (i) Gross profit margin and (ii) Net profit

margin.

1. Sales

2. Cost of goods sold

3. Other operating expenses

Rs 2,00,000

1,00,000

50,000

(1) Gross profit margin =Rs 1,00,000

= 50 per centRs 2,00,000

(2) Net profit margin = Rs 50,000 = 25 per centRs 2,00,000


37/56

6 - 37

Expenses Ratio

i. Cost of goods sold =Cost of goods sold

Net sales X 100

ii. Operating expenses =Administrative exp. + Selling exp.

Net salesX 100

iii. Administrative expenses = Administrative expensesNet sales

X 100

iv. Selling expenses ratio =Selling expenses

Net salesX 100

v. Operating ratio = Cost of goods sold + Operating expensesNet sales

X 100

vi. Financial expenses =Financial expenses

Net salesX 100


38/56

6 - 38

Return on Investment

Return on Investments measures the overall effectiveness

of management in generating profits with its available

assets.

i. Return on Assets (ROA)

ROA =EAT + (Interest Tax advantage on interest)

Average total assets

ii. Return on Capital Employed (ROCE)

ROCE =EAT + (Interest Tax advantage on interest)

Average total capital employed


39/56

6 - 39

Return on Shareholders Equity

Return on total shareholders equity =Net profit after taxes

Average total shareholders equityX 100

Return on ordinary shareholders equity (Net worth) =

Net profit after taxes Preference dividend

Average ordinary shareholders equityX 100

Return on shareholders equity measures the return on the

owners (both preference and equity shareholders)

investment in the firm.


40/56

6 - 40

Efficiency Ratio

Activity ratios measure the speed with which various

accounts/assets are converted into sales or cash.

i. Inventory Turnover measures the activity/liquidity of

inventory of a firm; the speed with which inventory is soldInventory Turnover Ratio =

Cost of goods sold

Average inventory


inventory of a firm; the speed with which inventory is soldRaw materials turnover =Cost of raw materials used

Average raw material inventory


inventory of a firm; the speed with which inventory is soldWork-in-progress turnover =

Cost of goods manufactured

Average work-in-progress inventory

Inventory turnover measures the efficiency of various types

of inventories.


41/56

6 - 41

Liquidity of a firms receivables can be examinedin two ways.

i. Inventory Turnover measures the activity/liquidity of inventory of

a firm; the speed with which inventory is soldi. Debtors turnover =

Credit sales

Average debtors + Average bills receivable (B/R)

2. Average collection period =Months (days) in a year

Debtors turnover

i. Inventory Turnover measures the activity/liquidity of inventory of a

firm; the speed with which inventory is sold

Alternatively =Months (days) in a year (x) (Average Debtors + Average (B/R)

Total credit sales

Ageing Schedule enables analysis to identify

slow paying debtors.



42/56

6 - 42

Assets Turnover Ratio


a firm; the speed with which inventory is soldi. Total assets turnover =

Cost of goods sold

Average total assets

ii. Fixed assets turnover =Cost of goods sold

Average fixed assets


a firm; the speed with which inventory is soldiii. Capital turnover =

Cost of goods sold

Average capital employed

iv. Current assets turnover = Cost of goods soldAverage current assets


a firm; the speed with which inventory is soldv. Working capital turnover =

Cost of goods sold

Net working capital

Assets turnover indicates the efficiency with which firm

uses all its assets to generate sales.


43/56

6 - 43

1) Return on shareholders equity = EAT/Average total shareholders equity.

2) Return on equity funds = (EAT Preference dividend)/Average ordinary

shareholders equity (net worth).

3) Earnings per share (EPS) = Net profit available to equity shareholders

(EAT Dp)/Number of equity shares outstanding (N).

4) Dividends per share (DPS) = Dividend paid to ordinary

shareholders/Number of ordinary shares outstanding (N).

5) Earnings yield = EPS/Market price per share.

6) Dividend Yield = DPS/Market price per share.

7) Dividend payment/payout (D/P) ratio = DPS/EPS.

8) Price-earnings (P/E) ratio = Market price of a share/EPS.

9) Book value per share = Ordinary shareholders equity/Number of equity

shares outstanding.


44/56

6 - 44

Integrated Analysis Ratio

(1) Rate of return on assets (ROA) can be decomposed in to(i) Net profit margin (EAT/Sales)

(ii) Assets turnover (Sales/Total assets)

(2) Return on Equity (ROE) can be decomposed in to

(i) (EAT/Sales) x (Sales/Assets) x (Assets/Equity)

(ii) (EAT/EBT) x (EBT/EBIT) x (EBIT/Sales) x (Sales/Assets) x

(Assets/Equity)

Integrated ratios provide better insight about financial and

economic analysis of a firm.

R t f R t A t


45/56

6 - 45

Rate of Return on Assets

EAT as percentage of

sales

Assets

turnover

EAT SalesDivided by Sales Total AssetsDivided by

Current assetsFixed assetsGross profit = Sales less

cost of goods sold

Minus

Expenses: Selling

Administrative Interest

Minus

Income-tax

Shareholder equity

Plus

Long-term borrowedfunds

Plus

Current liabilities

Plus

Alternatively


46/56

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 turnover

Where, Net profit margin = Earning after taxes/Sales

Asset turnover = Sales/Total assets


a firm; the speed with which inventory is soldEarning Power =

Earning after taxes

Sales

Sales

Total Assets

EAT

Total assetsxx x


47/56


48/56

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 toconsider the effect of interest and tax payments.

As a result of three sub-parts of net profit ratio, the ROEis composed of the following 5 components.


inventory of a firm; the speed with which inventory is sold

EAT

Earnings before taxes

EBT

EBIT

EBIT

Sales

Net Profit

Salesxx =

EAT

EBT

EBT

EBIT

EBIT

Sales

Sales

Assets

Assets

Equityx x x x


49/56

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.

Table 5: ROE (Five-way Basis) of Firms A and B

Particulars Firm A Firm B

Net sales

Less: Operating expenses

Earnings before interest and taxes (EBIT)

Less: Interest (8%)

Earnings before taxes (EBT)

Less: Taxes (35%)

Earnings after taxes (EAT)

Total assets

Debt

Equity

EAT/EBT (times)

EBT/EBIT (times)

EBIT/Sales (per cent)

Sales/Assets (times)

Assets/Equity (times)

ROE (per cent)

Rs 4,00,000

3,22,462

77,538

16,000

61,538

21,538

40,000

4,00,000

2,00,000

2,00,000

0.65

0.79

19.4

1

2

20

Rs 40,00,000

39,26,462

73,538

12,000

61,538

21,538

40,000

4,00,000

2,50,000

1,50,000

0.65

0.84

1.84

10

1.6

16


50/56

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


51/56

6 - 51

CASE STUDY

From the following selected financials of Reliance Industries Ltd (RIL) for the period 2001-2006, appraise its financial


52/56

6 - 52

g ( ) p , pp

health from the point of view of liquidity, solvency, and profitability.

Selected financial data and ratios (Amount in Rs crore)

Particulars 2001 2002 2003 2004 2005 2006

(I) Related to Liquidity Analysis

Current assets

Marketable investmentsInventory

Debtors

Advances

Cash and bank balance

Current liabilities

Short-term bank borrowings

Sundry creditors

Interest accrued

Creditors for capital goods

Other current liabilities & provisions

Other data and ratios

Net working capital

Credit sales

Cost of goods sold

Cost of raw material used

Credit purchasesAverage debtors

Average creditors

Current ratio

Acid test ratio

Debtors turnover

Creditors turnover

Debtors cycle (days)

Creditors cycle (days)

9,844.48

3387.25

2299.85

1,134.17

2,922.58

100.63

5,312.06

337.76

3,754.50

223.00

104.72

892.08

4,532.42

22,886.51

21,290.91

18,155.98

21,608.85

988.31

3,170.68

1.85

0.87

23

7

16

54

13,025.31

536.804976.07

2,722.46

3,310.27

1,760.71

9,830.10

2,148.27

5,847.20

389.23

175.16

1270.24

3,195.21

45,073.88

45,957.85

41,023.35

45,083.06

1,928.31

4,800.85

1.33

0.51

23

9

16

39

17,925.25

536.19

7510.14

2,975.49

6,756.22

147.21

18,160.39

7,193.77

8288.10

380.15

717.48

1580.89

-235.14

49,743.54

54,642.60

50,378.65

56,884.49

2,848.97

7,067.65

0.99

0.20

17

8

21

45

23,245.88

536.11

7,231.22

3,189.93

12,064.38

224.24

16,966.15

9,145.14

366.78

676.45

2,670.75

4,107.03

6,279.73

56,247.03

41,657.92

34,721.39

60,246.91

3,094.02

9,413.58

1.75

.26

17.63

6.40

21

57

28,988.62

536.11

7,412.88

3,927.81

13,503.03

3,608.79

21,934.45

12,684.39

366.95

525.37

3471.80

4,885.94

7,054.17

73,164.10

53,345.03

45,931.87

70,014.80

3,558.87

11,515.6

1.66

.55

18.62

6.08

20

60

24,591.03

16.58

10,119.82

4,163.62

8,144.85

2,146.16

21,441.88

11,438.69

310.42

728.18

3,890.98

2,073.61

3,149.15

89,124.16

65,535.84

58,342.31

68,516.87

4,045.71

12,688.31

1.49

.38

21.40

5.40

17

67

Particulars 2001 2002 2003 2004 2005 2006

CONTD.


53/56

6 - 53

(II) Related to Solvency Analysis

Free reserves

Paid up capital

Preference capital

Bonus equity capital

Total equity

Long-term borrowingsCurrent liabilities

Total debt

EBIT

Interest

Total debt-equity ratio

Long-term debt-equity ratio

Interest coverage ratio

9,307.89

1,053.49

0.00

481.77

10,843.15

9,798.03

5,312.06

15,110.09

4,032.37

1,215.56

1.39

0.90

3.32

21,834.29

1,395.85

0.00

481.77

23,711.91

16,780.21

9,830.10

26,610.31

6,307.71

1,827.85

1.12

0.71

3.45

23,656.31

1,395.92

0.00

481.77

25,534.00

12,564.54

18,160.39

30,724.93

6,551.17

1,555.40

1.20

0.49

4.21

33,056.50

1,395.95

0.00

481.77

34,934.22

11,149.38

12,955.22

24,104.60

7,735.86

1,434.72

0.69

.31

5.39

39,010.23

1,393.09

0.00

481.77

40,885.09

6,172.98

17,131.52

23,304.50

10,537.34

1,468.66

0.57

.15

7.17

48,411.09

1,393.17

0.00

481.77

50,286.03

8,185.60

16,454.48

24,640.08

11,581.10

877.04

0.49

.16

13.20

(III) Related to Profitability AnalysisSales (manufacturing)

Cost of goods sold

EBDIT (including other earnings)

EBIT

EBT

EAT

Interest

Average total capital employed

Average total assetsAverage equity funds

Gross profit %

Operating profit ratio %

Net profit ratio %

Cost of goods sold ratio %

Rate of return on capital employed (ROCE)1

ROR (Total assets)2

ROR (Equity funds)

22886.51

21290.91

5,597.48

4,032.37

2,786.00

2,646.50

1,215.55

19235.95

29622.14

10715.17

24.46

17.62

11.56

93.03

20.07

13.03

24.70

45073.88

45957.85

9,123.85

6,307.71

4,434.17

3,242.17

1,827.84

27,053.32

43,325.86

17,277.53

20.24

13.99

7.19

101.96

18.74

11.7

18.77

49,743.54

54,642.60

9,388.26

6,551.17

4,982.75

4,106.85

1,555.4

34,388.04

60,415.77

24,622.96

18.87

13.17

8.26

109.85

16.47

9.37

16.68

56,247.03

41,657.92

10,982.88

7,735.86

6,301.14

5,160.14

1,434.72

50,030.24

52,764.91

1,396.38

18.41

13.75

9.95

80.34

13.18

12.4

16.26

73.164.10

53,345.03

14,260.84

10,537.34

9,068.68

7,571.68

1,468.66

54,560.80

57,292.51

1,394.94

19.40

14.40

11.48

80.92

16.56

15.77

20.09

89,124.46

65,535.84

14,982.01

11,581.10

10,704.06

9,069.34

877.04

61,738.85

65,428.89

1,393.51

17.43

12.99

11.21

81.03

16.11

15.20

20.08

1. ROCE = (EAT + Interest)/ Average capital employed 2. ROR (Total assets) = (EAT + Interest)/ Average assets

Solution: The appraisal of financial health of RIL is presented below.


54/56

6 - 54

Liquidity Analysis:

The liquidity position of RIL does not appear to be commendable during all theyears under reference. In fact, its current ratio was less than one implyingnegative working capital (in 2003) and acid-test ratio was at an alarming low level

of 0.2. Though the current ratio range of 1.33 1.85 (during 2001-2 and 2004-6) isan indicative of satisfactory liquidity position, the acid-test ratios appear to beon the lower side, the range being 0.20 0.55 (during 2002-6). The major reasonfor the sharp difference in these two liquidity ratios may be ascribed to asignificant proportion of inventory (in current assets).

The other notable observation is that the RIL seems to be banking on bank

borrowings to finance its working capital requirements evidenced by asubstantial increase in such borrowings over the years. From 337.76 crore (in2001), they steadily increased to 7,193.77 crore (by 2003) and to Rs 11,438.69crore by 2006: (registering more than 30 times increase in 2006 compared to2001). In fact, short-term borrowings constitute more than one-half of its totalcurrent liabilities during the 6 year period. The reliance on short-term bankborrowings, to such a marked extent, is contrary to sound tenets of finance.

Likewise, it appears that its net working capital is inadequate in relation to itscredit sales which stood at Rs. 89,124 crore in 2006 compared to Rs. 73,164crore in 2005. Contrary to increase in net working capital, however, there hasbeen a more than 50 per cent decrease in net working capital of the RIL; (therelevant figures being Rs 7,054.17 crore and Rs 3,149.15 crore in years 2005 and2006 respectively).

The RIL has the advantage of much higher creditors payment period


55/56

6 - 55

g g p y p

compared to debtors collection period. The debtors collection period (varying

from 16 days in 2001 and 2002 to 21 days in 2004) seems to be at a very

satisfactory level. In marked contrast, the creditors payment period is three-

times (varying in the range of 39-67 days) during the same period. This

favourable gap, provides some leverage to RIL to operate at relatively lowacid-test ratio.

To conclude, the liquidity position of the RIL does not appear to be

satisfactory. It is suggested that RIL should substitute a fair share of short-

term bank borrowings by long-term loans (which have shown sharp decrease

trend over the years). Such a step would help to improve its liquidity ratios.

Solvency Analysis:

The solvency position of the RIL is sound for two reasons: First, it has a

satisfactory level of interest coverage ratio during all the 6 years, being in the

range of 3.32 and 13.2. The RIL is not likely to commit default in payment of

interest to its lenders as even though its operating profits (EBIT) decline by

more than nine-tenth (2006), it l would stil have enough margin to meet its

interest obligations. Secondly, its total debt-equity ratio over the years has

shown a substantial decrease from 1.39 in 2001 to 0.49 by 2006. Likewise, the

long-term debt to equity ratio during over the years has improved

substantially.


56/56

Profitability Analysis:

The profit margins (gross, operating and net) of the RIL over the years have

reduced, albeitrecent improvements. For instance gross profit margin has

decreased from 24.46 per cent (in 2001) to 17.43 per cent (in 2006). Likewise

operating profit margins have declined from 17.62 per cent to 12.99 per cent

and net profit margins from 11.56 per cent to 11.21 per cent during these

years. The lower operating profit margins have an unfavourable effect on the

ROR on capital employed. It fell from 20.07 per cent in 2001 to 16.11 per cent

by 2006. However, it is gratifying to note that there has been an increase in

other rates of return. For instance, the ROR on total assets has improved from

13.03 per cent in 2001 to 15.20 per cent in 2006. Likewise a notable increase in

observed in ROR on equity funds. From 16.68 in 2003, it has increased to

more than 20 per cent in 2005 as well as in 2006. There seems to be a

potential for further improvement in its various RORs by increasing its gross

profit and operating profit margins.

Documents

Ch 06 FinancialStatementAnalysis