Presentation in Financial Ratio Analysis

Financial Statement Analysis Financial statements include :•Income Statement or Profit and Loss A/C,•Position Statement or Balance Sheet and •A statement of changes in financial position or a cash flow statement These financial statements are the end product of accounting process that starts with recording of monetary transactions and events and culminates in the preparation of financial statements. Financial statements help in achieving the objectives of accounting. The main objective of accounting is to supply decision relevant information to various groups of users who are associated with the firm.

MAHESH KUMAR FINANCIAL MANAGEMENT

2

Financial statements are the principal means of providing the information to these groups – on which they base their decisions.

• Main financial statements :1. Income statement : it is a report on the firm’s operation

over some past period. Revenue from business operations and income from other sources is matched with the expenses required to generate the revenue. What is the net result over a period of time.

2. Position statement : it reports on the financial position on a particular date. It shows the various assets on one side which tells us about the uses of funds deployed in the business. They are matched with the liabilities on the opposite side which tell us about the sources of funds deployed in the business


3

Financial statement analysis : means detailed and in-depth study of the information given in the financial statements so as to draw important conclusions

Need for financial statement analysis :• Financial statements are same for every user but the

information requirements of different users are different. During analysis every user can focus on the relations in which he is interested.

• Financial statements provide information about the past but users are more interested in the present and future projections. So they need to analyze them.

• Absolute figures given in the financial statements are dumb. They do not convey much about the health of the firm. In order to make the absolute numbers speak, we should study the inter relationship between numbers.


4

Users of Financial Analysis : These groups are the various stakeholders, who have come to be associated with the firm over a period of time with the developments in the field of trade and commerce.

Important groups are :• Proprietor – shareholders• Prospective investors• Trade creditors• Lenders• Investment analysts• Management• Employees, customers, government, society.


5

Techniques of financial statement analysis

• Horizontal analysis or comparative financial statement analysis : in this two year figures of financial statements are compared item by item taking one year as the base. Absolute and percentage change over the base period are reported and analyzed.

• Vertical analysis or common size statements : in this different figures given in the financial statements are expressed as a percentage of some important aggregate (sales in case of income statement and assets, liabilities in case of position statement).

• Ratios analysis : financial statements numbers are divided by one another to study the underlying relationship. Ratio is one number divided by another.


6

Ratio Analysis A ratio is numeric or arithmetic relation between two numbers. It is simply one number expressed in terms of another

The two numbers used in the ratio can both be taken from income statement or position statement or one number from income statement and one number from position statement.

Advantages of Ratio Analysis :• Ratio is always a pure number which is not affected by

size. We can make meaningful comparison even among the firms of different sizes.

• Ratios can be used by interested groups to make projections about future profitability, solvency or liquidity.

• Ratios help to make a qualitative judgment about the firm’s financial performance


7

Standard of Comparison : Ratios on its own do not convey much. For a meaningful analysis

we must make comparison of ratios. In ratio analysis , we make three types of comparisons :

• Time series analysis : intra-firm comparison

• Cross section analysis : Inter-firm comparison

• Comparison with industry averages


8

Types of Financial Ratios

• Liquidity ratios• Solvency ratios• Turnover ratios• Profitability ratios• Equity-related ratios


9

Liquidity Ratios

• Liquidity ratios measure a firm’s ability to meet its current obligations.

Current assetsCurrent ratio =

Current liabilitiesCurrent assets – Inventories

Quick ratio = Current liabilities

Cash + Marketable securitiesCash ratio =

Current liabilities


10

Solvency ratios : these ratios measure the dependence of a firm on borrowed funds.

• Debt – Equity Ratio = Debt / Equity Where Debt = long term borrowings Equity = proprietor funds or net worth

• Debt To total capitalization = Debt /(Debt + Equity) Where Debt + Equity = total long term funds

• Interest coverage ratio = EBIT / Annual interest


11

Turnover or activity ratios : these ratios measure the firm’s efficiency in utilizing its assets.

1. Inventory turnover ratio = cost of goods sold / average inventory

2. Inventory conversion period = 365 days/inventory turnover ratio

3. Accounts receivable turnover ratio = Net credit sales / Average account receivable

4. Accounts receivable collection period = 365 days/account receivable turnover ratio


12

5. Working capital turnover ratio = net sales / working capital

6. Fixed asset turnover ratio = net sales / fixed assets

7. Accounts payable turnover ratio = net credit purchase/average a/c

payable

8. Average payment period = 365 days/account payable turnover


13

Profitability ratios : measure a firm’s overall efficiency and effectiveness in generating profit.• Gross profit ratio = Gross Profit / Net sales

• Net profit ratio = Net Profit / Net sales

• Operating profit ratio = Operating profit / Net sales

• Operating ratio = COGS + operating exp./ Net sales

• All kinds of expense ratios – Administration, financial etc

• ROI or Return on capital employed = net profit/ capital employed where capital employed = fixed asset + w/c


14

ROI is a function of two variables – dupont analysis

• ROI = net profit ratio x investment turnover ratio = net profit/sales x sales/investment

As Investment = Fixed assets + Working capital Investment turnover can be broken down into fixed asset

turnover and working capital turnover.

Working capital turnover can be broken down into turnover of individual current assets.

Net profit ratio can be broken down into various expense ratios and operating ratio.


15

Equity-related ratios : These ratios measure the shareholders’ return and value

• EPS = (profit after tax – preference dividend) / no. of equity shares• Dividend payout ratio = dividend per share/EPS• Retention ratio = 1 – Dividend payout ratio or (EPS – Dividend per share)/EPS• Dividend yield ratio = dividend per share/market price per share• P/E ratio = market price per share/earnings per share• Earnings capitalization ratio = EPS/Ke or cost of equity.• Dividend capitalization = D/Ke• Book value per share = net worth/no of equity shares• Earnings yield ratio = EPS/market value per share.


16

Utility of Ratio Analysis

• Assessment of the firm’s financial conditions and capabilities.

• Diagnosis of the firm’s problems, weaknesses and strengths.

• Credit analysis• Security analysis• Comparative analysis• Time series analysis


17

Cautions in Using Ratio Analysis

• Financial statements are based on historic data.• Company differences : different companies may be

using different accounting policies.• Price level : financial statements are prepared on the

assumption of fixed monetary unit. Fixed assets are shown at historic cost.

• Possibility of window dressing.• Financial statements provide only financial

information and ignore the qualitative aspects or non financial information.

Documents

Presentation in Financial Ratio Analysis