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NPTEL Course

Course Title: Security Analysis and Portfolio Management

Instructor: Dr. Chandra Sekhar Mishra

Module-5

Session-10Financial Statement Analysis II

Outline

Ratios for Financial Statement Analysis

o Profitability

o Efficiencyo Liquidity

o Solvency

o Market Standing or Valuation Ratios

Financial Ratios: Financial ratio is a relationship between two variables as part of financialresults of a particular company. The figures can be taken from the financial statements, financial

markets based on the objective. Financial ratios can indicate possible opportunities or problems

associated with companies. Usually the financial ratios are classified as below:

Profitability

Efficiency

Liquidity

Solvency and Leverage

Capital market standing

Profitability Ratios:Generation of profit by business is taken as a sound objective of businessorganization. This also acts as an incentive for stakeholders like investors and management.

Profitability ratios are of two types viz. those related to revenue and those related to investment.

Gross profit margin: Gross profit is defined as the difference between sales and cost ofgoods sold. For companies in manufacturing sector this ratio indicates the coverage ofmajor expenses particularly with respect to manufacturing of products.

Operating profit margin: Operating profit is calculated after subtracting other operating

expenses (like selling and distribution expenses) from gross profit. Operating profit is

also known as earnings before interest and tax (EBIT). Operating profit margin is the

ration between operating profit and sales. Higher operating profit margin indicates theefficiency of organization and makes companies more comfortable in meeting non-

operating expenses like interest.

Net profit margin: This ratio indicates the profit meant for shareholders bothpreference and equity and is measured as a ratio of net profit to sales. This is also another

measure of business efficiency.

Return on investment or Earning Power: Earnings before interest and taxes (EBIT) toTotal Assets: This ratio indicates the return available to all investors together irrespective

of proportion of different types of capital. This ratio is ideal for comparison across firms

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since it is not affected by capital structure and tax policy of the firms. It reflects the

earning power of assets.

Return on equity: This is the return available for equity shareholders, the residual owners

of the business. The return on equity is measured as below:

Return on Equity (RoE) =Net profit

Average net worth

Net worth includes equity, reserves and surplus adjusted for any fictitious assets. The net

worth of current year and previous year are averaged for the purpose. Besides

profitability, RoE is affected by leverage, i.e. presence of debt in capital structure. Undergood conditions, leverage magnifies RoE compared to an unlevered company.

Earnings per share (EPS): This ratio is measured by dividing net profit [available forequity shareholders] with number equity shares. This is an absolute measure and

indicated in the currency. This measure can be misleading while comparing between

different companies when their equity capital structure in terms of amount of paid-upcapital or face value share are different.

EPS in Rs. =Profit after tax less preference dividend if any

Number of equity shares

Dividend per share (DPS): This is measured as below:

DPS =Equity dividend

Number of equity shares

Investors like senior citizens and pension funds prefer higher dividend since such income

is considered as a regular source of income. Besides, declaration of dividend is

considered normally as a healthy sign since it denotes liquidity and profitability of thecompanies.

Efficiency Ratios: Such ratios (also known as turnover ratios) indicate efficiency in asset

utilization and in broad terms are expressed as a relationship between sales and assets.

Total assets turnover ration (TATR): This ratio measures the revenue generation incomparison to the funds deployed by the investors. Higher the ratio is always better. This

reflects overall efficiency in utilization of assets.

TATR =Net sales

Average total assets

Similarly to know the efficiency of a particular type of asset the TATR is modified toreflect the average value of particular asset. The other asset turnover rations that are used

by analysts:

o Fixed assets turnovero Current assets turnover

o Inventory turnover

o Receivables or debtors turnover

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The Du Pont financial analysis:This is propounded by Du Pont Company of the US and is

widely appreciated. This analysis combines two major aspects of business performance:profitability in terms of net profit margin and asset utilization in terms of total assets turnover

ratio.

Return on Assets RoA Net profit


Net profit

Net sales

xNet sales


For improving RoA, firms need to focus on increased profit margin [i.e. cost reduction] and

better utilization of assets. Du Pont analysis can be extended to measure the return on equity andits components.

The Du Pont framework is revised to reflect the factors affecting return on equity. In the revised

formula, the leverage effect (asset to equity ratio) is considered.

Return on Equity (RoE) =Net profit

Average net worth=

Net profit

Net salesx

Net sales

Average total assetsx


Average net worth

Liquidity or Short Term Solvency: Liquidity ratios measure the firms ability to meet short

term obligations.

Current Ratio: this is the ratio between current assets and current liabilities. A currentratio of 2 indicates that the company has two rupees of current assets to meet one rupee

of current liability. Although higher current ratio indicates better short term solvency orliquidity, very high current ratio can be due to idle current assets like inventories. Current

assets include cash, bank, short term deposits, inventories, receivables, prepaid expenses.

Current liabilities include creditors for supplies and other inputs, payables, provisions fortax, proposed dividend, and outstanding expenses.

Quick Ratio: Also known as acid test ratio, this is a stringent measure of liquidity and ismeasured as a ratio between quick assets and current liabilities. As part of quick assets,all current assets except inventory are considered. Inventories are considered less liquid

in comparison to other current assets.

Inventory turnover ratio (ITR) and inventory conversion period: ITR This ratio measures

the efficiency of inventory utilization and is measured as:

ITR in times =Cost of goods sold

Average inventory

Higher inventory turnover ratio indicates that the company holds less inventory to meet thesales. By dividing 365 with ITR, inventory conversion period can be found. With an ITR of 5

times, inventory conversion period is calculated as 73 days. Thus, it takes 73 days on an

average to convert inventory into sales.

Receivables or Debtors turnover ratio (DTR) and average collection period: DTR is

calculated as below:

DTR in times =Net Credit Sales

Average receivables

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Higher debtor turnover ratio indicates stringent credit policy and terms as well as timely

collection of receivables. Average collection period is calculated by dividing 365 with DTR.

Long Term Solvency: Companies depend upon borrowing for financing the business. Whileborrowing leads to leverage and helps in magnifying earnings available for equity shareholders,

it can also lead to problems of solvency. Higher borrowing ratio can invite higher interestcharges by bankers and other lenders. Hence companies try to have an optimal borrowing level.The different measures of long term solvency are discussed below.

Debt-to-equity ratio: This ratio is calculated as Debt / Net worth. Debt consists of interest

bearing liabilities. A debt-equity ratio of 1.5 indicates that the company has borrowedRs.1.5 for every one rupee contributed by the owners.

Liabilities-to-equity ratio: This ratio is like debt to equity ratio but for the fact that in this

case, in numerator, all liabilities whether interest bearing or not are considered.

Total debt to total capital (debt + equity): this is a variety of debt-equity ratio and is

indicated in terms of %. A debt equity ratio 2:1 is essentially a debt to total capital ratio

of 66.67% [2 / (2+1)] Interest coverage ratio (EBIT / Interest, expressed in times): this ratio indicates the

comfort level of the firms in the ability to pay interest. Bankers attach a lot of importance

to this coverage ratio while appraising a loan.

Fixed charges coverage ratio: This ratio measures the ability of company to honour all thedebt obligation like interest and repayment of debt

Fixed charges coverage ratio in times) =EBIT + Depreciation

Interest +Repayment of debt

1 - Tax rate

In the above formula repayment of debt is adjusted for tax since unlike interest, this is not atax deductible payment

Capital Market Standing

Price-earnings (P/E) ratio: P/E ratio, a very popular ratio for financial market players, is arelative valuation measure for equity share and is measured as Market price per share to

EPS. P/E ratio is essentially compared with an average P/E ratio of stocks of similarindustry or benchmark index. High P/E ratio in comparison to benchmark or average P/E

indicates over valuation and vice versa.

Enterprise value / EBIDTA or EBIDTA multiple: Enterprise value is combination of

market value of equity and debt; EBIDTA: Earnings before interest, tax, depreciation and

amortization. EBIDTA multiple neutralizes the effect of capital structure, new or oldcompany [i.e. new or old assets thus leading to different depreciation] and corporate tax

effect. This ratio indicates the value of the company unlike P/E ratio which indicates thevalue of equity.

Price-to-book ratio: Measured as Market price per share to book value per share this is

another realative valuation ratio. This ratio is appropriate for companies that depend on

assets held as value driver. However for companies that has intangibles [not reflected in

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balance sheet like, brand, image, human resources, etc.] this ratio is not appropriate. The

book value of share is measured as Net worth / Number of equity shares

Dividend-yield: Measured as Dividend per share to Market price per share, dividend

yield indicates the return in terms of dividend for the stockholders on the equity shares.

Certain investors prefer high dividend yield stocks.

Although ratio analysis help investors in identifying suitable companies for investment and also

provides alert in advance, the mechanism suffers from different limitations viz. historical nature

of financial statements, different accounting policies followed by companies, window dressing

among other things.

References

Reilly and Brown (2006), Investment Analysis and Portfolio Management, 8e, Thomson

(Cengage) Learning, New Delhi

Bodieet al(2009), Investments, 8e, Tata McGraw Hill, New Delhi

Prasanna Chandra (2008), Investment Analysis and Portfolio Management, 3e, TataMcGraw Hill, New Delhi

Ramachandran and Kakani (2008), Financial Accounting for Management, 2e, Tata

McGraw Hill, New Delhi

Narayanaswamy (2008), Financial Accounting: A Managerial Perspective, Prentice Hall

India, New Delhi

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Questions and Answers

Q.1. Refer information given related to ABC Limited as below and find profitability and

asset turnover ratios of ABC Limited.

ABC limited

Income Statement

2008-09

(Rs. Crore)

2009-10

(Rs. Crore)

Net Sales 350 410

Expenditure:

Raw Materials 120 130

Power & Fuel Cost 80 95

Employee Cost 40 50

Other Manufacturing Expenses 17 24

Selling and Administration

Expenses

11 14

Total Expenditure 268 313

Operating Profit (PBDIT) 82 97

Interest 10 10

PBDT 72 87

Depreciation 24 28

Profit Before Tax 48 59Tax 14.4 17.7

Reported Net Profit 33.6 41.3

Balance Sheet

SOURCES OF FUNDS : 2008-09

(Rs. Crore)

2009-10

(Rs. Crore)

Share Capital (Face Value: Rs.10) 40 40

Reserves Total 95 135

Total Shareholders Funds 135 140

Secured Loans 90 85

Unsecured Loans 35 41

Total Debt 125 126

Current Liabilities and Provisions

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Current Liabilities 45 56

Provisions 30 48

Total Current Liabilities 75 104

Total Liabilities 335 370

APPLICATION OF FUNDS :

Gross Block 90 110

Less : Accumulated Depreciation 22 29

Net Block 68 81

Capital Work in Progress 12 14

Investments 70 78

Current Assets, Loans & Advances

Inventories 75 57

Sundry Debtors 56 87

Cash and Bank 38 30

Loans and Advances 28 37

Total Current Assets 197 211

Total Assets 335 370

Ans.

Ratio/ Measure Explanation/

Formula

2008-09 2009-10

Profitability related to Sales (or

income)

Operating margin (%) (Operating profit /

Sales)*100

23.43 23.66

Net profit margin (%) (Net profit /Sales)*100

9.60 10.07

Profitability related to investment

Return on total assets (%) (PBIT to Total

Assets)*100

17.31 18.65

Return on Equity (PAT / Net

Worth)*100

24.89 29.50

Earnings per share (Rs.) PAT / Number ofEquity Shares

8.40 10.33

Asset Turnover Ratios

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Total Assets Turnover (in times) Sales / Average

Total Assets

NA* 1.16

Current Assets Turnover Sales / Average

Current Assets

NA* 2.01

Not available since data for 2007-08 are required.Q.2. Find out liquidity i.e. short term solvency ratios (current ratio, quick ratio), long termsolvency ratios (debt-equity ratio, debt to total assets, interest coverage ratio) of ABC

Limited.

Ans.:


Formula

2008-09 2009-10

Liquidity or Short term solvency:

Current Ratio Current Assets/

Current Liabilities

2.63 3.77

Quick Ratio Current Assets lessInventory/ Current

Liabilities

1.63 1.48

Long term solvency:

Debt Equity Ratio (times) Long term debt /

Net Worth

0.93 0.90

Debt to Total Assets (%) (Total Debt i.e.

Long term debt +current liabilities

and provisions /

Total Assets) *

100

59.70 62.16

Interest coverage ratio (times) PBIT / Interest 5.8 6.9

Q.3: a. Find out inventory turnover ratio, inventory conversion period debtor turnover ratio

and average collection period of ABC Limited.

Ans.:


Formula

2008-09 2009-10

Inventory turnover ratio (ITR) Cost of goods sold/ Average

inventory*

N.A.** 6.21

Inventory conversion period (days) 365 / ITR N.A.** 59

Debtor turnover ratio (DTR) Sales / AverageDebtors

N.A.** 5.74

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Average Collection Period (days) 365 / DTR N.A.** 64

Instead of cost of goods sold, sales is taken as proxy for the same for calculating this ratio.

** Since 2007-08 data are not available, this ratio is not found for 2008-09.

Q.4. With the help of additional information as below, find out Dividend yield, P/E ratio and

P/B ratio of ABC limitedDividend declared and paid during 2009-10: Rs.5.00 per share

Average market price of share of ABC Limited: Rs.58

Ans.:

Dividend yield (%) = Dividend per share / Average market price per share * 100 = 8.62%

P/E ratio = Average market price / EPS = 5.62 times

P/B ratio = Average market price / book value per share

Book value per share = Net worth / number of equity shares = 140 / 4 = Rs.35

Hence, P/B ratio = Rs.58/Rs.35 = 1.67 times.

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