Manac I FA ch_ 13 RA-

8/6/2019 Manac I FA ch_ 13 RA-

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ManagementAccounting I-13

Analysis of Financial Statements-

Ratio Analysis


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Financial Analysis

Financial Analysis is the process of identifying

the financial strengths and weaknesses of the

firm by properly establishing relationshipsbetween the items of the balance sheet and

the Profit & Loss Account.

It can be under taken by management of the

firm, or by parties outside the firm, viz.owners, Creditors, Investors and others. E.g.


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Financial Analysis

Trade Creditors Liquidity

Suppliers of Long Term

Debt

Solvency

Survival

& Profitability of the firm

Investors Firms Earnings

Firms Present & Future

Profitability

Firms financial results asthey influence its earnings

ability & risk.

Management Every aspect of Financial

Analysis.


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Nature of Ratio Analysis

A tool of Financial Analysis.

Indicates the relationship between twoaccounting figures, expressedmathematically.

Index or yardstick for evaluating the financialposition & performance of a firm.

Summarizes the financial data to makequalitative relationship, which can be, in turnused to make a qualitative judgment.


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Standards of Comparison

.Ratios calculated from the past financial

statements of the same firm.

2. Ratios developed using the projected, orPerforma, financial statements of the same

firm.

3. Cross sectional analysis

4. Industry analysis

5. Comparison of ratios over a period of time.


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Types of Ratios

. Liquidity Ratios Firms ability to meet

current obligations.

2. Leverage Ratios Proportion of Debt &Equity in Financing the firms Assets.

3. Activity Ratios Firms efficiency in utilizing

its assets.

4. Profitability Ratios overall Performance &

Effectiveness of the Firm.


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Liquidity Ratios

.Liquidity Ratios measure the ability of the firm tomeet its current obligations.

2.The failure of co. to meet its current obligations due

to lack of sufficient liquidity, will result in :- Bad credit image

Loss of Creditors confidence

Litigations resulting in the closure of the company.

3.A very high degree of liquidity is also bad, idle assetsearn nothing.

4.Most common liquidity ratios are:

(i) Current Ratio (ideal 2:1)

(ii) Quick Ratio (ideal 1:1)


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Formulas ofLiquidity ratios

Current ratio = Current assets

Current Liabilities

Quick Ratio = Current assets Inventory

Current Liabilities

Cash Ratio = Cash + Marketable securitiesCurrent liabilities


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Current Ratio calculation of Hindustan

Manufacturing Company & Interpretation

ForThe Hindustan Manufacturing Co., The Ratio For 1993 is:

Current ratio =Rs1404.55 = 1.25, Rs 1870.92 = 1.20:1

Rs1123.57 Rs 1555.75

This ratio establishes a relation between current assets and currentliablities of a firm. As a conventional rule, a current ratio of 2:1 ormore is considered satisfactory. The Hindustan manufacturingcompany has current ratios of 1.24:1 (1991), 1.25:1(1992), 1.20:1(1993) which are interpreted to be insufficiently liquid. But thisstandard should not be blindly followed firms with less than 2:1 ratio

may be doing well it depends upon the components of current assetsif a company's Current Assets consist of slow moving debtors andunsaleble stock, then the firms ability to pay its bills is impaired. Thusinvestigation about quality of current assets should be carried out.However it is a crude and a quick measure of firms liquidity.


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Quick Ratio calculation of Hindustan


Quick ratio,1993 = Rs 720.53 = 0.46:1

Rs 1555.75

This ratio establishes a relationship between Quick or Liquid assetsand current liabilities. Thus, if the Hindustan manufacturing Cos

inventories do not sell, and it has to pay all its current liabilities, itmay find it difficult to meet its obligations because its quickassets are 0.46 times of Current liabilities.

A quick ratio of 1:1 or more is considered to represent asatisfactory current financial condition but it should be used

cautiously. A quick ratio of 1:1 or more doesn't imply soundliquidity position if its book debts and receivables are slowpaying, doubtful and stretched-out-in age. Nevertheless, thequick ratio remains an important index of firms liquidity.


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Cash Ratio calculation of Hindustan


Cash ratio, 1993 = Rs 26.08 = 0.017 or 0.02

Rs 1555.75

Since cash is the most liquid asset, a relationship is established between cash +marketable securities and current liabilities.Hindustan manufacturing Co is carrying a

very small amount of cash in comparison toits current liabilities. But a company need notworry if it has reserve borrowing power andcredit limits sanctioned by the banks.


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Hindustan Manufacturing Company:

Liquidity ratios

Ratio 1991 1992 1993

1. Current

ratio

2. Quickratio

3. Cash

Ratio

1.24

0.56

.01

1.25

0.56

0.09

1.20

0.46

0.02

The overall trend of major liquidity ratios of Hindustan Manufacturing

Company vividly shows that on one hand its liquidity ratios are

unsatisfactory and on the other hand Liquidity is deteriorating over the

years. If such a condition continues for coming years as well it may lead

the company into troubles like Bad credit image, Loss of Creditors

confidence, Litigations resulting in the closure of the company etc.


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Leverage Ratios

To judge the long term financial position.

To measure the financial risk and the firms abilityof using debt for the benefit of shareholders.

There should be an appropriate mix of debt andowners equity in financing the firms assets.

Most important leverage ratios are:

(i) Total debt ratio

(ii) Debt Equity Ratio (ideal 2:1, lower this ratio betterit is)

(iii) Interest coverage ratio


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Formulas ofLeverage Ratios

Total Debt Ratio = Total Debt

Capital employed orTotal Debt + Net worth

Where, capital employed is Net assets (FA +CA CL)

Debt-Equity Ratio = Total Debt

Net WorthInterest Coverage ratio = EBIT

Interest


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Total Debt Ratio calculation of Hindustan


Total debt Ratio,1993 = TD = Rs 1229.6 = 0.646

CE Rs 1901.87

For Hindustan manufacturing co. the debt ratio of

0.646 means that lenders have financed 64.6 % or

about two thirds of Hindustan's net assets (Capital

employed). It obviously implies that owner's have

provided the remaining finances. They have

financed (1- 0.646 = 0.354 or 35.4 % or about onethird of net assets.


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Debt-Equity Ratio calculation of Hindustan


Debt-EquityRatio1993=TD = Rs 1229.06 = 1.83

NW Rs 672.81

This ratio describes the lenders contribution foreach rupee of the owners contribution. It is

clear in case of Hindustan, lenders have

contributed more funds than owners; lenders

contribution is 1.83 times of ownerscontribution, (0.646 / 0.354 = 1.83)


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Hindustan Manufacturing Company:

Leverage ratios

1991 1992 1993

Total Debt to

capita Employed

Debt Equity

0.56

0.28

0.63

1.72

0.65

1.83

The co seems to depend more on outsiders funds to finance its

expanding activities. As much as of the cos funds are financed byoutsiders money: the stake of the owners is quite low in the total capital

employed by the firm. From creditors point of view, the trend is risky and

undesirable.


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Interest Coverage Ratio calculation of

Hindustan Manufacturing Company &

Interpretation

Interest coverage1993 = Rs 342.61 = 2.4 times

Rs 143.46

The interest coverage shows the no of times the

interest charges are covered by the funds that are

ordinarily available for their payment. The earnings

available to Hindustan to meet its interest obligation

are 2.4 times its interest charges which shows a

good margin of safety for lenders.


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Activity Ratios

These are employed to evaluate the efficiencywith which the firm manages and utilizes itsassets.

They indicate the speed with which assets arebeing converted or turned over into sales, hencealso called Turnover Ratios.

Important Activity ratios are:

(i) Inventory Turnover Ratio (efficiency in selling)

(ii) Debtors Turnover Ratio ( efficiency in convertingthe debtors into cash)

(iii) Assets Turnover Ratio (ability of assets togenerate sales)


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Inventory Turnover Ratio calculation of


Interpretation

Inventory Turnover Ratios = Cost of goods sold

Average inventory

If the figure of COGS is not available then sales/Inventorycan beused.

ITR for Hindustan, 1993 = Rs 3053.66(Rs 244.26 + Rs 461.81)/2

= Rs 3053.66 = 8.6 times

Rs 353.03

Days of Inventory holding (DIH) =360 / Inventory Turnover = 360/8.6= 42 days.

Hindustan is turning its inventory offinished goods into sales (atcost) 8.6 times in a year. In other words, it holds averageinventory for 42 days.

Note: in a manufacturing co inventory of finished goods is used tocalculate inventory turnover.


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Inventory Turnover Ratio calculation of


Interpretation

1991 1992 1993

Inventory

turnoverratio

Days of

Inventory

holding

12.9

28

11.9

30

8.6

42

It is clear that Hindustan manufacturing companys efficiency in turning its inventories

is continuously deteriorating and the yearly holding of all types of inventories is

increasing.


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e tors urnover at o ca cu at on o


Interpretation

Debtors Turnover Ratio = Credit sales

Average Debtors

If the figure of credit sales and op & cl Debtors are not given then

DTR = Sales

Debtors

For Hindustan DTR, 1993 = Rs 3717.23 = 7.7 times

Rs 483.18

Average Collection Period (ACP) = 360/DTR = 360/7.7 = 47 days

Hindustan is able to turnover its debtors 7.7 times in a year. In otherwords, its book debts remain outstanding for 47 days. The ACPmeasures the quality of debtors since it indicates the rapidity orslowness of their collectablity. The shorter this period the betterthe quality of debtors.


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Asset Turnover Ratio calculation of


Interpretation

Net Asset Turnover Ratio = Sales

Net Assets

For Hindustan 1993 = Rs 3717.23 = 1.95 times

Rs 1901.87

A firms ability to produce a large volume of sales for a givenamount of net assets is the most important aspect of its operatingperformance. Since net assets equal capital employed, netassets turnover may also be called Capital Employed Turnover.

The net assets ratio of 1.95 times indicates that Hindustan isproducing Rs 1.95 of sales for one rupee of capital employed.

There can also be Total asset Turnover ratio, FAT, CAT,NCATratios as well.


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Debtors Turnover Ratio calculation of Hindustan


1991 1992 1993

Debtors

Turnover

(times)

Average

Collection

Period

Asset

Turnover

ratio

9.2

39

2.03

8.3

43

1.78

7.7

47

1.95

Hindustans ACP has been increasing; it has increased from 39 days in 1991

to 47 days in 1993. this may be due to change in the economic conditions

and/or laxity in managing receivables. Hindustans asset turnover ratio over

three years also do not any improvement.


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Profitability Ratios

The profitability ratios are calculated to

measure the operating efficiency of the

company, creditors & Owners are also

interested in Profitability of the firm.

Generally, two MajorTypes of profitability

ratios are calculated:

(i) Profitability in relation to Sales.

(ii) Profitability in relation to Investment.


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Formulas ofProfitability ratios in relation to sales

Gross Profit margin = Gross profit

sales

For Hindustan 1993 = Rs 663.57 = 0.179 or 17.9%Rs 3717.23

The gross profit margin reflects the efficiency with which mgmt.produces each unit of product. This ratio indicates the avg.spread between COGS and sales revenue.

Net Profit Margin = Profit AfterT

axSales

For Hindustan 1993 = Rs 134.86 = 0.036 or 3.6%

Rs 3717.23

Net profit margin ratio establishes a relation ship between net profitand sales and indicates managements efficiency in

manufacturing, administering and selling the products. This ratiois the overall measure of the firms ability to turn each rupeesales into net profit.

High gross profit & Net Profit margin is a sign of goodmanagement and reduces the risk of firm from falling pricesrising costs, declining demand and helps the firm to withstand

adversities


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Formulas ofProfitability ratios

in relation to InvestmentReturn on Investment (ROI) Return on Total Assets ROTA = EBIT

Total assets


Rs 2617.75

Return on Net Assets RONA = EBIT

Net AssetsFor Hindustan 1993 = Rs 342.61 = .180 or 18.0%

Rs 1901.87

Return On Shareholder's equity ROE =Profit AfterTaxes

Net Worth

Where NW, (SC + SP + Reserves & surpluses Accumulated Losses

if any)For Hindustan 1993 = Rs 134.86 = .20 or 20%

Rs 672.81

ROE indicates how well the firm has used the resources of owners. Itis of great interest to the present and prospective shareholdersand also of great concern to management, which has the

responsibility of maximizing the owners welfare.


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Hindustan manufacturing Company :

Profitability ratios

1991 1992 1993

Gross

margin

Net MarginROTA

RONA

ROE

.175

.036

.131

.161

.164

.178

.039

.129

.168

.191

.179

.036

.131

.180

.200

The sales as well as the investment related ratios of the co. have remained more

or less constant. ROE has shown an increase. This is perhaps because of

employment of more debt over the years by the company.


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in relation to Investment

Earnings Per share = Profit after tax

No of Common shares Outstanding

For Hindustan 1993 = Rs 134.86 = Rs 6.0022.50 (it indicates whether or

not the firms earnings power on per share basis haschanged over that period . It simply shows theProfitability of the firm on Per share basis. The

companys EPS for 1993 is Rs 6.00)

Dividend Per share = Earnings Paid to shareholders

No of Common shares Outstanding


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Formulas ofProfitability ratios in

relation to Investment

For Hindustan 1993 = Rs 45.00 = Rs 2.00Rs 22.50 (Though the PAT belongs to

shareholders but the income they really receive is the amount ofearnings distributed as cash dividends. Therefore a large no ofpresent and potential investors may be interested in DPS thanEPS. The company distributed Rs 2.00 per share as dividend out ofRs 6.00 earned per share. The difference per share is retained in

the business)

Dividend Payout Ratio = DPS

EPS


Rs 6.00 (earnings not distribute to shareholders

are retained in the business. Thus retention ratio is 1 payoutratio = 1 0.333 = .667. we can also know the growth inshareholders equity as a result of retention policy. )

For Hindustan growth in Equity1993 = Retention ratio X ROE = .667 X.20 = .113 or 13.3%)


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Dividend Yield = DPS

MVPS

For Hindustan 1993 = RS 2.00 = 0.068 or 6.8%

Rs 29.25Earnings Yield = EPS

MVPS


Rs 29.25The Dividend Yield and earnings yield evaluate theshareholder's return in relation to the market valueof the share.


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Price Earning Ratio (P/E) = Market value per share (MVPS)

Earning Per Share (EPS)

For Hindustan 1993 = Rs 29.25 = 4.88 times

Rs 6.00 (P/E ratio reflects the investorsexpectations about the growth of the firms earnings management is

also interested in this market appraisal of the firms performance andwill like to find the causes if the P/E ratio declines)

Market Value- to-Book-Value (MV/BV) Ratio = MVPS

BVPS (NW/ No of Shares)

For Hindustan 1993 = Rs 29.25 = 0.98

Rs 29.90 (Hindustans MV/BV ratio of 0.98 meansthat the company is worth 2 % less than the funds which shareholdershave put into it)


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Formulas ofProfitability ratios in relation

to Investment

1991 1992 1993

EPS

DPS

DP

EarningsYield

Dividend

Yield

P/E

MV/BV

3.72

1.50

.40

.141

.057

7.09

1.16

4.94

1.75

.35

.143

.051

7.00

1.33

5.99

2.00

.33

.205

.068

4.88

.98


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Formulas ofProfitability ratios in relation

to Investment & Interpretation

It is indicated that the Co.s EPS and DPSare increasing; but the proportionate increasein DPS is Less Than That In EPS and

Therefore, DP is declining EPS may be increasing more as a result of

increased use of Debt Because of theincrease in The financial risk the MP of Share

may come down as a result there is Declinein P/E MV/BV. Thus in relation to marketperformance co is showing Deterioration.

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Manac I FA ch_ 13 RA-