Financial Analysis and Planning – Ratio Analysis PDF

CHAPTER a 3 2 FINANCIAL ANALYSIS AND PLANNING– RATIO ANALYSIS LEARNING OUTCOMES. After studying this chapter,...

CHAPTER a 3 2 FINANCIAL ANALYSIS AND PLANNING– RATIO ANALYSIS LEARNING OUTCOMES. After studying this chapter, you would be able to -  Discuss Sources of financial data for Analysis.  Discuss financial ratios and its types.  Discuss use of financial ratios to analyse the financial statement.  Analyse the ratios from the perspective of investors, lenders, suppliers, managers etc. to evaluate the profitability and financial position of an entity.  Describe the users and objective of Financial Analysis - A Birds Eye View  Discuss Du Pont analysis.  State the limitations of Ratio Analysis. @The Institute of Chartered Accountants of India a 3.2 FINANCIAL MANAGEMENT CHAPTER OVERVIEW RATIO ANALYSIS Application of Ratio Analysis Types of Ratios in decision making  Liquidity Ratios/Short-term Solvency Ratios Relationship of Financial  Leverage Ratio/Long-term Management with other Solvency Ratios disciplines of accounting  Activity Ratios/Efficiency Ratios/Performance Ratios/ Turnover Ratios  Profitability Ratios 1. INTRODUCTION The basis for financial analysis, planning and decision making is financial statements which mainly consist of Balance Sheet and Profit and Loss Account. The profit & loss account shows the operating activities of the concern over a period of time and the balance sheet depicts the balance value of the acquired assets and of liabilities or in other words, financial position of an organization at a particular point of time. However, the above statements do not disclose all of the necessary and relevant information. For the purpose of obtaining the material and relevant information necessary for ascertaining the financial strengths and weaknesses of an enterprise, it is necessary to analyse the data depicted in the financial statement. The financial manager has certain analytical tools which help in financial analysis and planning. One of the main tools is Ratio Analysis. Let us discuss the Ratio Analysis in this chapter. @The Institute of Chartered Accountants of India  FINANCIAL ANALYSIS AND PLANNING– 3.3 3.3 RATIO ANALYSIS 2. RATIO AND RATIO ANALYSIS Let us first understand the definition of ratio and meaning of ratio analysis. 2.1 Definition of Ratio A ratio is defined as “the indicated quotient of two mathematical expressions and as the relationship between two or more things.” Here, ratio means financial ratio or accounting ratio which is a mathematical expression of the relationship between two accounting figures. 2.2 Ratio Analysis The term financial ratio can be explained by defining how it is calculated and what the objective of this calculation is? a. Calculation Basis (Basis of Calculation): A relationship expressed in mathematical terms Between two individual figures or group of figures Connected with each other in some logical manner Selected from financial statements of the concern b. Objective for financial ratios is that all stakeholders (owners, investors, lenders, employees etc.) can draw conclusions about the: Performance (past, present and future) Strengths & weaknesses of a firm Can take decisions in relation to the firm Ratio analysis is based on the fact that a single accounting figure by itself may not communicate any meaningful information but when expressed relative to some other figure, it may definitely provide some significant information. Ratio analysis is not just comparing different numbers from the balance sheet, income statement, and cash flow statement. It is comparing the number against previous years (intra-firm comparison) and, other companies (inter-firm comparison), the industry, or even the economy in general for the purpose of financial analysis. @The Institute of Chartered Accountants of India  a 3.4 FINANCIAL MANAGEMENT 2.3 Sources of Financial Data for Analysis The sources of information for financial statement analysis are: i. Annual Reports ii. Interim financial statements iii. Notes to Accounts iv. Statement of cash flows v. Business periodicals. vi. Credit and investment advisory services 3. TYPES OF RATIOS Liquidity Ratios*/ Short-term Solvency Ratios Leverage Ratios/ Capital Structure Ratios Long-term Solvency Ratios Coverage Ratios Types of Ratios Activity Ratios/ Efficiency Ratios/ Related to Sales Performance Ratios/ Turnover Related to overall Return Ratios* on Investment (Assets/ Capital Employed/ Equity) Profitability Ratios Required for analysis from Owner's point of view Related to Market/ Valuation/ Investors Classification of Ratios *Liquidity ratios should be examined taking relevant turnover ratios into consideration. @The Institute of Chartered Accountants of India  FINANCIAL ANALYSIS AND PLANNING– 3.5 3.5 RATIO ANALYSIS 3.1 Liquidity Ratios The terms ‘liquidity’ and ‘short-term solvency’ are used synonymously. Liquidity or short-term solvency means ability of the business to pay its short- term liabilities. Inability to pay-off short-term liabilities affects its credibility as well as its credit rating. Continuous default on the part of the business leads to commercial bankruptcy. Eventually such commercial bankruptcy may lead to its sickness and dissolution. Short-term lenders and creditors of a business are very much interested to know its state of liquidity because of their financial stake. Both lack of sufficient liquidity and excess liquidity is bad for the organization. Various Liquidity Ratios are: (a) Current Ratio (b) Quick Ratio or Acid test Ratio (c) Cash Ratio or Absolute Liquidity Ratio (d) Basic Defense Interval or Interval Measure Ratios (e) Net Working Capital (a) Current Ratio: The Current Ratio is one of the best known measures of short-term solvency. It is the most common measure of short-term liquidity. The main question this ratio addresses is: "Does your business have enough current assets to meet the payment schedule of its current debts with a margin of safety for possible losses in current assets?" In other words, current ratio measures whether a firm has enough resources to meet its current obligations. Current Assets Current Ratio = Current Liabilities Where, Current Asset = Inventories + Sundry Debtors + Cash and Bank Balances + Receivables/ Accruals + Loans and Advances + Disposable Investments + Any other current assets. @The Institute of Chartered Accountants of India a 3.6 FINANCIAL MANAGEMENT Current Liabilities = Creditors for goods and services + Short-term Loans + Bank Overdraft + Cash Credit + Outstanding Expenses + Provision for Taxation + Proposed Dividend + Unclaimed Dividend + Any other current liabilities. Interpretation A generally acceptable current ratio is 2:1. But whether or not a specific ratio is satisfactory depends on the nature of the business and the characteristics of its current assets and liabilities. (b) Quick Ratio: The Quick Ratio is sometimes called the "acid-test" ratio and is one of the best measures of liquidity. Quick Assets Quick Ratio or Acid Test Ratio = Current Liabilities Where, Quick Assets = Current Assets − Inventories − Prepaid expenses Current Liabilities = As mentioned under Current Ratio. The Quick Ratio is a much more conservative measure of short-term liquidity than the Current Ratio. It helps answer the question: "If all sales revenues should disappear, could my business meet its current obligations with the readily convertible quick funds on hand?" Quick Assets consist of only cash and near cash assets. Inventories are deducted from current assets on the belief that these are not ‘near cash assets’ and also because in times of financial difficulty, inventory may be saleable only at liquidation value. But in a seller’s market, inventories are also near cash assets. Interpretation An acid-test of 1:1 is considered satisfactory unless the majority of "quick assets" are in accounts receivable, and the pattern of accounts receivable collection lags behind the schedule for paying current liabilities. @The Institute of Chartered Accountants of India  FINANCIAL ANALYSIS AND PLANNING– 3.7 3.7 RATIO ANALYSIS (c) Cash Ratio/ Absolute Liquidity Ratio: The cash ratio measures the absolute liquidity of the business. This ratio considers only the absolute liquidity available with the firm. This ratio is calculated as: Cash and Bank balances + Marketable Securities Cash Ratio = Current Liabilities Or, Cash and Bankbalances + Current Investments = Current Liabilities Interpretation The Absolute Liquidity Ratio only tests short-term liquidity in terms of cash and marketable securities/ current investments. (d) Basic Defense Interval/ Interval Measure: Cash and Bank balances + Net Receivables + Marketable Securities Basic Defense Interval = Operating Expenses÷ No. of days (say 360) Or Current Assets – Prepaid expenses – Inventories = Daily OperatingExpenses Cost of Goods Sold + Selling Administartion and other General expenses - Depreciationand other non cash expenditure Daily Operating Expenses= No. of days in a year Interpretation If for some reason all the company’s revenues were to suddenly cease, the Basic Defense Interval would help determine the number of days for which the company can cover its cash expenses without the aid of additional financing. @The Institute of Chartered Accountants of India a 3.8 FINANCIAL MANAGEMENT (e) Net Working Capital: Net working capital is more a measure of cash flow than a ratio. The result of this calculation must be a positive number. However, in certain business models it may be negative. It is calculated as shown below: Net Working Capital = Current Assets - Current Liabilities (Excluding short-term bank borrowing) Interpretation Bankers look at Net Working Capital over time to determine a company's ability to weather financial crises. Loans are often tied to minimum working capital requirements. 3.2 Long-term Solvency Ratios/ Leverage Ratios The leverage ratios may be defined as those financial ratios which measure the long-term stability and capital structure of the firm. These ratios indicate the mix of funds provided by owners and lenders and assure the lenders of the long- term funds with regard to: (i) Periodic payment of interest during the period of the loan and (ii) Repayment of principal amount on maturity. Leverage ratios are of two types: 1. Capital Structure Ratios (a) Equity Ratio (b) Debt Ratio (c) Debt to Equity Ratio (d) Debt to Total Assets Ratio (e) Capital Gearing Ratio (f) Proprietary Ratio @The Institute of Chartered Accountants of India  FINANCIAL ANALYSIS AND PLANNING– 3.9 3.9 RATIO ANALYSIS 2. Coverage Ratios (a) Debt-Service Coverage Ratio (DSCR) (b) Interest Coverage Ratio (c) Preference Dividend Coverage Ratio (d) Fixed Charges Coverage Ratio 3.2.1 Capital Structure Ratios These ratios provide an insight into the financing techniques used by a business and focus, as a consequence, on the long-term solvency position. From the balance sheet, one can get only the absolute fund employed and its sources but only capital structure ratios show the relative weight of different sources. Various capital structure ratios are: (a) Equity Ratio: Shareholder's Equity Equity Ratio = Net Assets The shareholder's equity is Equity share capital and Reserves & Surplus (excluding fictitious assets etc). Net Assets or Capital employed includes Net Fixed Assets and Net Current Assets (Current Assets – Current Liabilities). This ratio indicates proportion of owner's fund to total fund invested in the business. Traditionally, it is believed that higher the proportion of owner's fund, lower is the degree of risk for potential lenders. (b) Debt Ratio: Total Debt Debt Ratio = Net Assets @The Institute of Chartered Accountants of India a 3.10 FINANCIAL MANAGEMENT Total debt or total outside liabilities includes short and long term borrowings from financial institutions, debentures/bonds, deferred payment arrangements for buying capital equipment, bank borrowings, public deposits and any other interest bearing loan. Interpretation This ratio is used to analyse the long-term solvency of a firm. A ratio greater than 1 would mean greater portion of company assets are funded by debt and could be a risky scenario. (c) Debt to Equity Ratio: Total Outside Liabilities Total Debt* Debt to Equity Ratio = = Shareholders' Equity Shareholder's Equity Long-term Debt * * = Shareholders' equity *Not merely long-term debt i.e. both current & non-current liabilities. ** Sometimes only interest-bearing, long-term debt is used instead of total liabilities (exclusive of current liabilities) Interpretation A high debt to equity ratio here means less protection for creditors, a low ratio, on the other hand, indicates a wider safety cushion (i.e., creditors feel the owner's funds can help absorb possible losses of income and capital). This ratio indicates the proportion of debt fund in relation to equity. This ratio is very often used for making capital structure decisions such as issue of shares and/ or debentures. Lenders are also very keen to know this ratio since it shows relative weights of debt and equity. Debt equity ratio is the indicator of firm’s financial leverage. (d) Debt to Total Assets Ratio: This ratio measures the proportion of total assets financed with debt and, therefore, the extent of financial leverage. Total Outside Liabilities Total Debt Debt to Total Assets Ratio = Or = Total Assets Total Assets Higher the ratio, indicates that assets are less backed up by equity and hence higher financial leverage. @The Institute of Chartered Accountants of India  FINANCIAL ANALYSIS AND PLANNING– 3.11 3.11 RATIO ANALYSIS (e) Capital Gearing Ratio: In addition to debt-equity ratio, sometimes capital gearing ratio is also calculated to show the proportion of fixed interest (dividend) bearing capital to funds belonging to equity shareholders i.e. equity funds or net worth. Again, higher ratio may indicate more risk. Preference Share Capital + Debentures + Other Borrowed funds Capital Gearing Ratio = Equity Share Capital + Reserves & Surplus - Losses (f) Proprietary Ratio: Proprietary Fund Proprietary Ratio = Total Assets Proprietary fund includes Equity Share Capital, Preference Share Capital and Reserve & Surplus. Total assets exclude fictitious assets and losses. Interpretation It indicates the proportion of total assets financed by shareholders. Higher the ratio, less risky scenario it shall be. 3.2.2 Coverage Ratios The coverage ratios measure the firm’s ability to service the fixed liabilities. These ratios establish the relationship between fixed claims and what is normally available out of which these claims are to be paid. The fixed claims consist of: (i) Interest on loans (ii) Preference dividend (iii) Amortisation of principal or repayment of the instalment of loans or redemption of preference capital on maturity. The following are important coverage ratios: (a) Debt Service Coverage Ratio (DSCR): Lenders are interested in debt service coverage to judge the firm’s ability to pay off current interest and instalments. Earnings available for debt services Debt Service Coverage Ratio = Interest + Installments @The Institute of Chartered Accountants of India a 3.12 FINANCIAL MANAGEMENT Earnings available for debt service* = Net profit (Earning after taxes) + Non-cash operating expenses like depreciation and other amortizations + Interest + other adjustments like loss on sale of Fixed Asset etc. *Fund from operations (or cash from operations) before interest and taxes also can be considered as per the requirement. Interpretation Normally DSCR of 1.5 to 2 is satisfactory. You may note that sometimes in both numerator and denominator lease rentals may also be added. (b) Interest Coverage Ratio: This ratio also known as “times interest earned ratio” indicates the firm’s ability to meet interest (and other fixed charges) obligations. This ratio is computed as: Earnings before interest and taxes(EBIT) Interest Coverage Ratio = Interest Interpretation Earnings before interest and taxes are used in the numerator of this ratio because the ability to pay interest is not affected by tax burden as interest on debt funds is deductible expense. It measures how many times a company can cover its current interest payment with its available earnings? In other words, it reflects the margin of safety a company has for paying interest on its debt during a given period. A high interest coverage ratio means that an enterprise can easily meet its interest obligations even if earnings before interest and taxes suffer a considerable decline. A lower ratio indicates excessive use of debt or inefficient operations. (c) Preference Dividend Coverage Ratio: This ratio measures the ability of a firm to pay dividend on preference shares which carry a stated rate of return. This ratio is computed as: Net Profit/Earning after taxes (EAT) Preference Dividend Coverage Ratio = Preference dividend @The Institute of Chartered Accountants of India  FINANCIAL ANALYSIS AND PLANNING– 3.13 3.13 RATIO ANALYSIS Interpretation This ratio indicates margin of safety available to the preference shareholders. A higher ratio is desirable from preference shareholders point of view. Similarly, Equity Dividend coverage ratio can also be calculated as: Earning after taxes (EAT) - Preference dividend Equity Dividend Coverage Ratio = Equity dividend (d) Fixed Charges Coverage Ratio: This ratio shows how many times the cash flow before interest and taxes covers all fixed financing charges. This ratio of more than 1 is considered as safe. "EBIT + Depreciation" Fixed Charges Coverage Ratio = "Interest + Repayment of Loan" Notes for calculating Ratios: 1. EBIT (Earnings before interest and taxes) = PBIT (Profit before interest and taxes), EAT (Earnings after taxes) = PAT (Profit after taxes) EBT (Earnings before taxes) = PBT (Profit before taxes) 2. Ratios shall be calculated based on requirement and availability of information and may deviate from original formulae. If required, assumptions should be given. 3. Numerator should be taken in correspondence with the denominator and vice-versa. 3.3 Activity Ratios/ Efficiency Ratios/ Performance Ratios/ Turnover Ratios These ratios are employed to evaluate the efficiency with which the firm manages and utilises its assets. For this reason, they are often called as 'Asset management ratios’. These ratios usually indicate the frequency of sales with @The Institute of Chartered Accountants of India a 3.14 FINANCIAL MANAGEMENT respect to its assets. These assets may be capital assets or working capital or average inventory. Activity Ratios/ Efficiency Ratios/ Performance Ratios/ Turnover Ratios: (a) Total Assets Turnover Ratio (b) Fixed Assets Turnover Ratio (c) Capital Turnover Ratio/ Net Assets Turnover Ratio (d) Current Assets Turnover Ratio (e) Working Capital Turnover Ratio (i) Inventory/ Stock Turnover Ratio (ii) Receivables (Debtors) Turnover Ratio (iii) Payables (Creditors) Turnover Ratio These ratios are usually calculated with reference to sales/cost of goods sold and are expressed in terms of rate or times. (a) Total Asset Turnover Ratio: This ratio measures the efficiency with which the firm uses its total assets. Higher the ratio, better it is. This ratio is computed as: Sales/ Costof GoodsSold Total Asset Turnover Ratio = TotalAssets Interpretation A high total assets turnover ratio indicates the efficient utilisation of total assets in generation of sales. Similarly, a low asset turnover ratio indicates total assets are not efficiently used to generate sales. (b) Fixed Assets Turnover Ratio: It measures the efficiency with which the firm uses its fixed assets. Sales/ Costof Goods Sold Fixed Assets Turnover Ratio = FixedAssets @The Institute of Chartered Accountants of India  FINANCIAL ANALYSIS AND PLANNING– 3.15 3.15 RATIO ANALYSIS Interpretation A high fixed assets turnover ratio indicates efficient utilisation of fixed assets in generating sales. A firm whose plant and machinery are old may show a higher fixed assets turnover ratio than the firm which has purchased them recently. (c) Capital Turnover Ratio/ Net Asset Turnover Ratio: Sales/ Cost of Goods Sold Capital Turnover Ratio = Net Assets Interpretation Since Net Assets equals to capital employed it is also known as Capital Turnover Ratio. This ratio indicates the firm’s ability of generating sales/ Cost of Goods Sold per rupee of long-term investment. The higher the ratio, the more efficient is the utilisation of owner’s and long-term creditors’ funds. (d) Current Assets Turnover Ratio: It measures the efficiency of using the current assets by the firm. Sales/ Costof Goods Sold Current Assets Turnover Ratio = Current Assets Interpretation The higher the ratio, the more efficient is the utilisation of current assets in generating sales. (e) Working Capital Turnover Ratio: It measures how effective a company is at generating sales for every rupee of working capital put to use. Sales/ Cost of Goods Sold Working Capital Turnover Ratio = Working Capital Interpretation Higher the ratio, the more efficient is the utilisation of working capital in generating sales. However, a very high working capital turnover ratio indicates that the company needs to raise additional working capital for future needs. @The Institute of Chartered Accountants of India a 3.16 FINANCIAL MANAGEMENT Working Capital Turnover is further segregated into Inventory Turnover, Debtors Turnover, and Creditors Turnover. Note: Average of Total Assets/ Fixed Assets/ Current Assets/ Net Assets/ Working Capital also can be taken in the denominator for the above ratios. (i) Inventory/ Stock Turnover Ratio: This ratio also known as stock turnover ratio establishes the relationship between the cost of goods sold during the year and average inventory held during the year. It measures the efficiency with which a firm utilizes or manages its inventory. It is calculated as follows: Cost of Goods Sold / Sales Inventory Turnover Ratio = Average Inventory Opening Stock + Closing Stock Average Inventory = 2 In the case of inventory of raw material, the inventory turnover ratio is calculated using the following formula : Raw Material Consumed Raw Material Inventory Turnover Ratio = Average Raw Material Stock Interpretation This ratio indicates that how fast inventory is used or sold. A high ratio is good from the view point of liquidity and vice versa. A low ratio would indicate that inventory is not used/ sold/ lost and stays in a shelf or in the warehouse for a long time. (ii) Receivables (Debtors) Turnover Ratio: In case firm sells goods on credit, the realization of sales revenue is delayed and the receivables are created. The cash is realised from these receivables later on. The speed with which these receivables are collected affects the liquidity position of the firm. The debtor’s turnover ratio throws light on the collection and credit policies of the firm. It measures the efficiency with which management is managing its accounts receivables. It is calculated as follows: @The Institute of Chartered Accountants of India  FINANCIAL ANALYSIS AND PLANNING– 3.17 3.17 RATIO ANALYSIS Credit Sales Receivables (Debtors) Turnover Ratio = Average Accounts Receivable A low debtors’ turnover ratio reflects liberal credit terms granted to customers, while a high ratio shows that collections are made rapidly. Receivables (Debtors) Velocity/Average Collection Period: Debtor's turnover ratio indicates the average collection period. However, the average collection period can be directly calculated as follows: Average Accounts Receivables 12 months/52 weeks/360 days = Or Average Daily Credit Sales Receivable Turnover Ratio Credit Sales Average Daily Credit Sales = No. of days in year (say 360) Interpretation The average collection period measures the average number of days it takes to collect an account receivable. This ratio is also referred to as the number of days of receivable and the number of day’s sales in receivables. In determining the credit policy, debtor’s turnover and average collection period provide a unique guidance. (iii) Payables Turnover Ratio: This ratio is calculated on the same lines as receivable turnover ratio is calculated. It measures how fast a company makes payment to its creditors. It shows the velocity of payables payment by the firm. It is calculated as follows: Annual Net Credit Purchases Payables Turnover Ratio = Average Accounts Payables A low creditor’s turnover ratio reflects liberal credit terms granted by suppliers, while a high ratio shows that accounts are settled rapidly. Payable Velocity/ Average payment period can be calculated using: Average Accounts Payable 12months/52weeks/360days = Or Average Daily Credit Purchases PayablesTurnoverRatio @The Institute of Chartered Accountants of India a 3.18 FINANCIAL MANAGEMENT Interpretation The firm can compare what credit period it receives from the suppliers and what it offers to the customers. Also, it can compare the average credit period offered to the customers in the industry to which it belongs. The above three ratios i.e. Inventory Turnover Ratio/ Receivables Turnover Ratio/Payables Turnover Ratio are also relevant to examine liquidity of an organization. Notes for calculating Ratios: 1. Only selling & distribution expenses differentiate Cost of Goods Sold (COGS) and Cost of Sales (COS). In its absence, COGS will be equal to Cost of Sales. 2. We can consider Cost of Goods Sold/ Cost of Sales to calculate turnover ratios eliminating profit part. 3. Average of Total Assets/ Fixed Assets/ Current Assets/ Net Assets/ Working Capital also can be taken in denominator while calculating the above ratios. In fact, when average figures of total assets, net assets, capital employed, shareholders’ fund etc. are available it may be preferred to calculate ratios by using this information. 4. Ratios shall be calculated based on requirement and availability of information and may deviate from original formulae. If required, assumptions should be given. 3.4 Profitability Ratios The profitability ratios measure the profitability or the operational efficiency of the firm. These ratios reflect the final results of business operations. They are some of the most closely watched and widely quoted ratios. Management attempts to maximize these ratios to maximize the firm’s value. The results of the firm can be evaluated in terms of its earnings with reference to a given level of assets or sales or owner’s interest etc. Therefore, the profitability ratios are broadly classified in four categories: (i) Profitability Ratios related to Sales (ii) Profitability Ratios related to overall Return on Investment @The Institute of Chartered Accountants of India  FINANCIAL ANALYSIS AND PLANNING– 3.19 3.19 RATIO ANALYSIS (iii) Profitability Ratios required for Analysis from Owner’s Point of View (iv) Profitability Ratios related to Market/ Valuation/ Investors Profitability Ratios are as follows: (i) Profitability Ratios based on Sales (a) Gross Profit Ratio (b) Net Profit Ratio (c) Operating Profit Ratio (d) Expenses Ratio (ii) Profitability Ratios related to Overall Return on Assets/ Investments (a) Return on Investments (ROI) (i) Return on Assets (ROA) (ii) Return of Capital Employed (ROCE) (iii) Return on Equity (ROE) (iii) Profitability Ratios required for Analysis from Owner’s Point of View (a) Earnings per Share (EPS) (b) Dividend per Share (DPS) (c) Dividend Pay-out Ratio (DP) (iv) Profitability Ratios related to Market/ Valuation/ Investors (a) Price Earnings (P/E) Ratio (b) Dividend and Earning Yield (c) Market Value/ Book Value per Share (MV/BV) (d) Q Ratio @The Institute of Chartered Accountants of India a 3.20 FINANCIAL MANAGEMENT 3.4.1 Profitability Ratios based on Sales (a) Gross Profit (G.P) Ratio/ Gross Profit Margin: It measures the percentage of each sale in rupees remaining after payment for the goods sold. Gross Profit Gross Profit Ratio = ×100 Sales Interpretation Gross profit margin depends on the relationship between sales price, volume and costs. A high Gross Profit Margin is a favourable sign of good management. (b) Net Profit Ratio/ Net Profit Margin: It measures the relationship between net profit and sales of the business. Depending on the concept of net profit, it can be calculated as: Net Profit (i) Net Profit Ratio = ×100 Sales Or Earnings after taxes (EAT) ×100 Sales Earnings before taxes (EBT) (ii) Pre-tax Profit Ratio = ×100 Sales Interpretation Net Profit ratio finds the proportion of revenue that finds its way into profits after meeting all expenses. A high net profit ratio indicates positive returns from the business. (c) Operating Profit Ratio: Operating profit ratio is also calculated to evaluate operating performance of business. Operating Profit Operating Profit Ratio = ×100 Sales @The Institute of Chartered Accountants of India  FINANCIAL ANALYSIS AND PLANNING– 3.21 3.21 RATIO ANALYSIS or, Earnings before interest and taxes (EBIT) ×100 Sales Where, Operating Profit = Sales – Cost of Goods Sold (COGS) – Operating Expenses Interpretation Operating profit ratio measures the percentage of each sale in rupees that remains after the payment of all costs and expenses except for interest and taxes. This ratio is followed closely by analysts because it focuses on operating results. Operating profit is often referred to as earnings before interest and taxes or EBIT. (d) Expenses Ratio: Based on different concepts of expenses it can be expresses in different variants as below: COGS (i) Cost of Goods Sold (COGS) Ratio = ×100 Sales Administrative exp. + Selling & Distribution OH (ii) Operating Expenses Ratio = ×100 Sales COGS+Operating expenses (iii) Operating Ratio = ×100 Sales Financial expenses * (iv) Financial Expenses Ratio = ×100 Sales *It excludes taxes, loss due to theft, goods destroyed by fire etc. Administration Expenses Ratio and Selling & Distribution Expenses Ratio can also be calculated in similar ways. @The Institute of Chartered Accountants of India a 3.22 FINANCIAL MANAGEMENT 3.4.2 Profitability Ratios related to Overall Return on Assets/ Investment s Return on Investment (ROI) Return on Assets Return on Capital Return on Equity (ROE) (ROA) Employed (ROCE) Return on Total Assets (ROTA) Return on Net Assets (RONA) (a) Return on Investment (ROI): ROI is the most important ratio of all. It is the percentage of return on funds invested in the business by its owners. In short, this ratio tells the owner whether or not all the effort put into the business has been worthwhile. It compares earnings/ returns/ profit with the investment in the company. The ROI is calculated as follows: Return/Profit/Earnings Return on Investment = ×100 Investment Or, Return/Profit/Earnings Sales = × Sales Investment Or, = Profitability Ratio x Investment Turnover Ratio Return/Profit/Earnings Since, Profitability Ratio = , and Sales Sales Investment Turnover Ratio= Investments ROI can be improved either by improving Profitability Ratio or Investment Turnover Ratio or by both. The concept of investment varies and accordingly there are three broad categories of ROI i.e. @The Institute of Chartered Accountants of India  FINANCIAL ANALYSIS AND PLANNING– 3.23 3.23 RATIO ANALYSIS (i) Return on Assets (ROA), (ii) Return on Capital Employed (ROCE) and (iii) Return on Equity (ROE). We should keep in mind that investment may be Total Assets or Net Assets. Further, funds employed in net assets are also known as capital employed which is nothing but Net worth plus Debt, where Net worth is equity shareholders’ fund. Similarly, the concept of returns/ earnings/ profits may vary as per the requirement and availability of information. (i) Return on Assets (ROA): The profitability ratio is measured in terms of relationship between net profits and assets employed to earn that profit. This ratio measures the profitability of the firm in terms of assets employed in the firm. Based on various concepts of net profit (return) and assets, the ROA may be measured as follows: Net Profit after taxes Net Profit after taxes ROA= or * AverageTotal Assets AverageTangible Assets Net Profit after taxes or Average Fixed Assets * Note: Sometimes, total assets may also be considered instead of average assets. Here, net profit is exclusive of interest. As Assets are also financed by lenders, hence ROA can be calculated as: Net Profit after taxes + Interest RoA = Average Total Assets/Average Tangible Assets/Average Fixed Assets Or EBIT(1-t) = {also known as Return on Total Assets (ROTA)} Average Total Assets Or EBIT(1- t) = {also known as Return on Net Assets (RONA)} Average Net Assets @The Institute of Chartered Accountants of India a 3.24 FINANCIAL MANAGEMENT (ii) Return on Capital Employed (ROCE): It is another variation of ROI. The ROCE is calculated as follows: Earnings before interest and taxes(EBIT) ROCE (Pre-tax) = ×100 Capital Employed EBIT(1-t) ROCE (Post-tax) = ×100 Capital Employed Sometimes, it is also calculated as: Net Profit after taxes (PAT/EAT)+Interest = ×100 Capital Employed Where, Capital Employed = Total Assets – Current Liabilities Or = Fixed Assets + Working Capital Or = Equity + Long Term Debt Interpretation ROCE should always be higher than the rate at which the company borrows. Intangible assets (assets which have no physical existence like goodwill, patents and trade-marks) should be included in the capital employed. But no fictitious asset (such as deferred expenses) should be included within capital employed. If information is available, then average capital employed shall be taken. (iii) Return on Equity (ROE): Return on Equity measures the profitability of equity funds invested in the firm. This ratio reveals how profitably of the owners’ funds have been utilised by the firm. It also measures the percentage return generated to equity shareholders. This ratio is computed as: @The Institute of Chartered Accountants of India  FINANCIAL ANALYSIS AND PLANNING– 3.25 3.25 RATIO ANALYSIS Net Profit after taxes - Preference dividend (if any) ROE = ×100 Net Worth/ Equity Shareholders' Funds Interpretation Return on equity is one of the most important indicators of a firm’s profitability and potential growth. Companies that boast a high return on equity with little or no debt are able to grow without large capital expenditures, allowing the owners of the business to withdraw cash and reinvest it elsewhere. Many investors fail to realize, however, that two companies can have the same return on equity, yet one can be a much better business. If return on total shareholders (i.e. equity and preference shareholder) is calculated, then Net Profit after taxes (before preference dividend) shall be divided by total shareholders’ fund including preference share capital. Return on Equity using the Du Pont Model: A finance executive at E.I. Du Pont de Nemours and Co., of Wilmington, Delaware, created the DuPont system of financial analysis in 1919. That system is used around the world today and serves as the basis of components that make up return on equity. There are various components in the calculation of return on equity using the traditional DuPont model- the net profit margin, asset turnover, and the equity multiplier. By examining each input individually, the sources of a company's return on equity can be discovered and compared to its competitors. The components are as follows: (i) Profitability/Net Profit Margin: The net profit margin is simply the after-tax profit a company generates for each rupee of revenue. Net profit margin varies across industries, making it important to compare a potential investment against its competitors. Although the general rule-of- thumb is that a higher net profit margin is preferable, it is not uncommon for management to purposely lower the net profit margin in a bid to attract higher sales. Profit/ Net Income Profitability/ Net Profit margin= Sales/ Revenue @The Institute of Chartered Accountants of India a 3.26 FINANCIAL MANAGEMENT Net profit margin is a safety cushion; the lower the margin, the less room for an error. A business with 1% margin has no room for flawed execution. Small miscalculations on management’s part could lead to tremendous losses with little or no warning. (ii) Investment Turnover/ Asset Turnover/ Capital Turnover: The asset turnover ratio is a measure of how effectively a company converts its assets into sales. It is calculated as follows: Investment Turnover/ Asset Turnover/ Capital Turnover Sales/ Revenue = Investment/ Assets/ Capital The asset turnover ratio tends to be inversely related to the net profit margin i.e. higher the net profit margin, lower the asset turnover and vice versa. The result is that the investor can compare companies using different models (low-profit, high-volume vs. high-profit, low-volume) and determine which one is the more attractive business. (iii) Equity Multiplier: It is possible for a company with terrible sales and margins to take on excessive debt and artificially increase its return on equity. The equity multiplier, a measure of financial leverage, allows the investor to see what portion of the return on equity is the result of debt. The equity multiplier is calculated as follows: Investment /Assets /Capital Equity Multiplier = Shareholders' Equity Calculation of Return on Equity To calculate the return on equity using the DuPont model, simply multiply the three components (net profit margin, asset turnover, and equity multiplier.) Return on Equity = (Profitability/ Net profit margin) x (Investment Turnover/ Asset Turnover / Capital Turnover) x Equity Multiplier Example - 1: XYZ Company’s details are as under: Revenue: ` 29,261; Net Income: ` 4,212; Assets: ` 27,987; Shareholders’ Equity: ` 13,572. @The Institute of Chartered Accountants of India  FINANCIAL ANALYSIS AND PLANNING– 3.27 3.27 RATIO ANALYSIS Here, Return on Equity as per Du Pont Model will be calculated as follows: Net Profit Margin = Net Income (` 4,212) ÷ Revenue (` 29,261) = 0.14439 or 14.39% Asset Turnover = Revenue (` 29,261) ÷ Assets (` 27,987) = 1.0455 Equity Multiplier = Assets (` 27,987) ÷ Shareholders’ Equity (` 13,572) = 2.0621 Finally, we multiply the three components together to calculate the return on equity: Return on Equity = Net Profit Margin x Asset Turnover x Equity Multiplier = (0.1439) x (1.0455) x (2.0621) = 0.3102, or 31.02% Analysis: A 31.02% return on equity is good in any industry. Yet, if you were to leave out the equity multiplier to see how much company would earn if it were completely debt-free, you will see that the ROE drops to 15.04% (0.1439 x 1.0455). 15.04% of the return on equity was due to profit margins and sales, while remaining 15.98% was due to returns earned on the debt at work in the business. If you could find a company at a comparable valuation with the same return on equity yet a higher percentage arose from internally generated sales, it would be more attractive. 3.4.3 Profitability Ratios Required for Analysis from Owner’s Point of View (a) Earnings per Share (EPS): The profitability of a firm from the point of view of ordinary shareholders can be measured in terms of earnings per share basis. It is calculated as follows: Net profit available to equity shareholders Earnings per Share (EPS) = Number of equity shares outstanding (b) Dividend per Share (DPS): Earnings per share as stated above reflects the profitability of a firm per share; it does not reflect how much profit is paid as dividend and how much is retained by the business. Dividend per share ratio indicates the amount of profit distributed to equity shareholders per share. It is calculated as: Total Dividend paid to equity shareholders Dividend per Share (DPS) = Number of equity shares outstanding @The Institute of Chartered Accountants of India a 3.28 FINANCIAL MANAGEMENT (c) Dividend Pay-out Ratio (DP): This ratio measures the dividend paid in relation to net earnings. It is determined to see to how much extent earnings per share have been retained by the management for the business. It is computed as: Dividend per equity share (DPS) Dividend pay-out Ratio = Earning per Share (EPS) 3.4.4 Profitability Ratios related to market/valuation/ Investors These ratios consider the market value of the company’s shares in calculation. Frequently, share prices data are punched with the accounting data to generate new set of information. These are (a) Price- Earnings Ratio, (b) Dividend Yield, (c) Market Value/ Book Value per share, (d) Q Ratio. (a) Price- Earnings Ratio (P/E Ratio): The price earnings ratio indicates the expectation of equity investors about the earnings of the firm. It relates earnings to market price and is generally taken as a summary measure of growth potential of an investment, risk characteristics, shareholders orientation, corporate image and degree of liquidity. It is calculated as Market Price per Share (MPS) Price-Earnings per Share (P/E Ratio) = Earning per Share (EPS) Interpretation It indicates the payback period to the investors or prospective investors. A higher P/E ratio could either mean that a company’s stock is over-valued or the investors are expecting high growth rates in future. (b) Dividend and Earning Yield: Dividend ± Change in share price Dividend Yield = ×100 Initial share price Or, Dividend per Share (DPS) = ×100 Market Price per Share (MPS) @The Institute of Chartered Accountants of India  FINANCIAL ANALYSIS AND PLANNING– 3.29 3.29 RATIO ANALYSIS Earnings per Share (EPS) Earnings Yield * or EP Ratio = ×100 Market Price per Share (MPS) *Also known as Earnings Price (EP) Ratio. Interpretation This ratio indicates return on investment; this may be on average investment or closing investment. Dividend (%) indicates return on paid up value of shares. But yield (%) is the indicator of true return in which share capital is taken at its market value. (c) Market Value/ Book Value per Share (MV/BV): It provides evaluation of how investors view the company’s past and future performance. Market Value/ Book Value per Share (MV/BV) = Average share price Net worth ÷ No.of equity shares Or Closing share price = Net worth ÷ No. of equity shares Interpretation This ratio indicates market response of the shareholders’ investment. Undoubtedly, higher the ratio, better is the shareholders’ position in terms of return and capital gains. (d) Q Ratio: This ratio is proposed by James Tobin, a ratio is defined as Market Value of equity and liabilities Q Ratio = Estimated replacement cost of assets Or Market Value of a Company = Assets’ Replacement Cost Thus, this ratio represents the relationship between market valuation and intrinsic value. Equilibrium is when Q Ratio = 1 because when it is less than 1, it could mean that the stock is undervalued and when it is more than 1, it could mean that stock is overvalued. @The Institute of Chartered Accountants of India a 3.30 FINANCIAL MANAGEMENT Notes for calculating Ratios: 1. EBIT (Earnings before interest and taxes) = PBIT (Profit before interest and taxes), EAT (Earnings after taxes) = PAT (Profit after taxes), EBT (Earnings before taxes) = PBT (Profit before taxes) 2. In absence of preference dividend PAT can be taken as earnings available to equity shareholders. 3. If information is available then average capital employed shall be taken while calculating ROCE. 4. Ratios shall be calculated based on requirement and availability of information and may deviate from original formulae. If required, assumptions should be given. 5. Numerator should be taken in correspondence with the denominator and vice-versa. 4. USERS AND OBJECTIVE OF FINANCIAL ANALYSIS - A BIRD'S EYE VIEW Financial Statement analysis is useful to various shareholders to obtain the derived information about the firm. S.No. Users Objectives Ratios used in general 1. Shareholders Being owners of the Mainly Profitability organisation they are Ratios [In particular interested to know Earning per share (EPS), about profitability and Dividend per share growth of the (DPS), Price Earnings organization (P/E), Dividend Payout ratio (DP)] @The Institute of Chartered Accountants of India  FINANCIAL ANALYSIS AND PLANNING– 3.31 3.31 RATIO ANALYSIS 2. Investors They are interested to  Profitability Ratios know overall financial  Capital structure health of the Ratios organisation particularly  Solvency Ratios future perspective of  Turnover Ratios the organisations. 3. Lenders They will keep an eye  Coverage Ratios on the safety  Solvency Ratios perspective of their  Turnover Ratios money lent to the  Profitability Ratios organisation 4. Creditors They are interested to  Liquidity Ratios know liability position  Short term solvency of the organisation Ratios/ Liquidity particularly in short Ratios term. Creditors would like to know whether the organisation will be able to pay the amount on due date. 5. Employees They will be interested  Liquidity Ratios to know the overall  Long terms solvency financial wealth of the Ratios organisation and  Profitability Ratios compare it with  Return on competitor company. investment 6. Regulator / They will analyse the  Profitability Ratios Government financial statements to determine taxations and other details payable to the government. @The Institute of Chartered Accountants of India a 3.32 FINANCIAL MANAGEMENT 7. Managers (a) Production They are interested to  Input output Ratio Managers know about data  Raw material regarding input output, consumption ratio. production quantities etc. (b) Sales Data related to units  Turnover ratios Managers sold for various years, (basically receivable other associated figures turnover ratio) and predicted future  Expenses Ratios sales figure will be an area of interest for them (c) Financial They are interested to  Profitability Ratios Manager know various ratios for (particularly related their future predictions to Return on of financial requirement. investment)  Turnover ratios  Capital Structure Ratios (d) Chief They will try to assess  All Ratios Executive/ the complete General Manager perspective of the company, starting from Sales, Finance, Inventory, Human resources, Production etc. @The Institute of Chartered Accountants of India  FINANCIAL ANALYSIS AND PLANNING– 3.33 3.33 RATIO ANALYSIS 8. Different Industry (a) Telecom  Ratio related to ‘call’  Revenue and expenses per customer (b) Bank  Loan to deposit Ratios Finance Manager/ Analyst will calculate  Operating expenses ratios of their company and income ratios (c) Hotel and compare it with  Room occupancy Industry norms. ratio  Bed occupancy Ratios (d) Transport  Passenger-kilometre  Operating cost-per passenger kilometre 5. APPLICATION OF RATIO ANALYSIS IN FINANCIAL DECISION MAKING A popular technique of analysing the performance of a business concern is that of financial ratio analysis. As a tool of financial management, they are of crucial significance. The importance of ratio analysis lies in the fact that it presents facts on a comparative basis and enables drawing of inferences regarding the performance of a firm. @The Institute of Chartered Accountants of India a 3.34 FINANCIAL MANAGEMENT Ratio analysis is relevant in assessing the performance of a firm in respect of following aspects: 5.1 Financial Ratios for Evaluating Performance (a) Liquidity Position: With the help of ratio analysis one can draw conclusions regarding liquidity position of a firm. The liquidity position of a firm would be satisfactory if it is able to meet its obligations when they become due. This ability is reflected in the liquidity ratios of a firm. The liquidity ratios are particularly useful in credit analysis by banks and other suppliers of short- term loans. (b) Long-term Solvency: Ratio analysis is equally useful for assessing the long- term financial viability of a firm. This aspect of the financial position of a borrower is of concern to the long term creditors, security analysts and the present and potential owners of a business. The long term solvency is measured by the leverage/capital structure and profitability ratios which focus on earning power and operating efficiency. The leverage ratios, for instance, will indicate whether a firm has a reasonable proportion of various sources of finance or whether it is heavily loaded with debt in which case its solvency is exposed to serious strain. Similarly, the various profitability ratios would reveal whether or not the firm is able to offer adequate return to its owners consistent with the risk involved. (c) Operating Efficiency: Ratio analysis throws light on the degree of efficiency in the management and utilisation of its assets. The various activity ratios measure this kind of operational efficiency. In fact, the solvency of a firm is, in the ultimate analysis, dependent upon the sales revenues generated by the use of its assets – total as well as its components. (d) Overall Profitability: Unlike the outside parties which are interested in one aspect of the financial position of a firm, the management is constantly concerned about the overall profitability of the enterprise. That is, they are concerned about the ability of the firm to meet its short-term as well as @The Institute of Chartered Accountants of India  FINANCIAL ANALYSIS AND PLANNING– 3.35 3.35 RATIO ANALYSIS long-term obligations to its creditors, to ensure a reasonable return to its owners and secure optimum utilisation of the assets of the firm. This is possible if an integrated view is taken and all the ratios are considered together. (e) Inter-firm Comparison: Ratio analysis not only throws light on the financial position of a firm but also serves as a stepping stone to remedial measures. This is made possible due to inter-firm comparison/comparison with industry averages. A single figure of particular ratio is meaningless unless it is related to some standard or norm. One of the popular techniques is to compare the ratios of a firm with the industry average. It should be reasonably expected that the performance of a firm should be in broad conformity with that of the industry to which it belongs. An inter-firm comparison would demonstrate the relative position vis-a-vis its competitors. If the results are at variance either with the industry average or with those of the competitors, the firm can seek to identify the probable reasons and, in the light, take remedial measures. Ratios not only perform post mortem of operations, but also serve as barometer for future. Ratios have predictor value and they are very helpful in forecasting and planning the business activities for a future. Conclusions are drawn on the basis of the analysis obtained by using ratio analysis. The decisions affected may be whether to supply goods on credit to a concern, whether bank loans will be made available, etc. (f) Financial Ratios for Budgeting: In this field ratios are able to provide a great deal of assistance. Budget is only an estimate of future activity based on past experience, in the making of which the relationship between different spheres of activities are invaluable. It is usually possible to estimate budgeted figures using financial ratios. Ratios also can be made use of for measuring actual performance with budgeted estimates. They indicate directions in which adjustments should be made either in the budget or in performance to bring them closer to each other. @The Institute of Chartered Accountants of India a 3.36 FINANCIAL MANAGEMENT 6. LIMITATIONS OF FINANCIAL RATIOS The limitations of financial ratios are listed below: (i) Diversified product lines: Many businesses operate a large number of divisions in quite different industries. In such cases ratios calculated on the basis of aggregate data cannot be used for inter-firm comparisons. (ii) Financial data are badly distorted by inflation: Historical cost values may be substantially different from true values. Such distortions of financial data are also carried in the financial ratios. (iii) Seasonal factors: It may also influence financial data. Example: A company deals in cotton garments. It keeps a high inventory during October - January every year. For the rest of the year its inventory level becomes just 1/4th of the seasonal inventory level. So, the liquidity ratios and inventory ratios will produce biased picture. Year end picture may not be the average picture of the business. Sometimes it is suggested to take monthly average inventory data instead of year end data to eliminate seasonal factors. But for external users it is difficult to get monthly inventory figures. (Even in some cases monthly inventory figures may not be available). (iv) To give a good shape to the popularly used financial ratios (like current ratio, debt-equity ratios etc.): The business may make some year-end adjustments. Such window dressing can change the character of financial ratios which would be different had there been no such change. (v) Differences in accounting policies and accounting period: It can make the accounting data of two firms non-comparable as also the accounting ratios. (vi) No standard set of ratios against which a firm’s ratios can be compared: Sometimes a firm’s ratios are compared with the industry average. But if a firm desires to be above the average, then industry average becomes a low standard. On the other hand, for a below average firm, industry averages become too high a standard to achieve. @The Institute of Chartered Accountants of India  FINANCIAL ANALYSIS AND PLANNING– 3.37 3.37 RATIO ANALYSIS (vii) Difficulty to generalise whether a particular ratio is good or bad: For example, a low current ratio may be said ‘bad’ from the point of view of low liquidity, but a high current ratio may not be ‘good’ as this may result from inefficient working capital management. (viii) Financial ratios are inter-related, not independent: Viewed in isolation one ratio may highlight efficiency. But when considered as a set of ratios they may speak differently. Such interdependence among the ratios can be taken care of through multivariate analysis (analyzing the relationship between several variables simultaneously). Financial ratios provide clues but not conclusions. These are tools only in the hands of experts because there is no standard ready-made interpretation of financial ratios. 7. FINANCIAL ANALYSIS It may be of two types: - Horizontal and vertical. Horizontal Analysis: When financial statement of one year are analysed and interpreted after comparing with another year or years, it is known as horizontal analysis. It can be based on the ratios derived from the financial information over the same time span. Vertical Analysis: When financial statement of single year is analyzed then it is called vertical analysis. This analysis is useful in inter firm comparison. Every item of Profit and loss account is expressed as a percentage of gross sales, while every item on a balance sheet is expressed as a percentage of total assets held by the firm. 8. SUMMARY OF RATIOS Another way of categorizing the ratios is being shown to you in a tabular form. A summary of the ratios has been tabulated as under: @The Institute of Chartered Accountants of India a 3.38 FINANCIAL MANAGEMENT Ratio Formulae Interpretation Liquidity Ratio Current Ratio Current Assets A simple measure that Current Liabilities estimates whether the business can pay short term debts. Ideal ratio is 2. Quick Ratio Quick Assets It measures the ability Current Liabilities to meet current debt immediately. Ideal ratio is 1. Cash Ratio  Cash and Bank balances +  It measures absolute    Marketable Securities  liquidity of the Current Liabilities business. Basic Defense  Cash and Bank balances +  It measures the ability  Net Reveivables + Marketable Securities Interval Ratio of the business to Opearing Expenses  No. of days meet regular cash expenditures. Net Working Current Assets – Current Liabilities It is a measure of cash Capital flow to determine the ability of business to survive financial crisis. Capital Structure Ratio Equity Ratio Shareholders' Equity It indicates owner’s Net Assets fund in companies to total fund invested. Debt Ratio Total Debt It is an indicator of use Net Assets of outside funds. Debt to equity Total Debt It indicates the Ratio Shareholders'Equity composition of capital structure in terms of debt and equity. @The Institute of Chartered Accountants of India  FINANCIAL ANALYSIS AND PLANNING– 3.39 3.39 RATIO ANALYSIS Debt to Total Total Debt It measures how much Total Assets Assets Ratio of total assets is financed by the debt. Capital Gearing  Preference Share Capital +  It shows the  Debentures+ Other Borrowed funds  Ratio proportion of fixed  Equity Share Capital +  interest bearing capital  Reserves & Surplus – Losses  to equity shareholders’ fund. It also signifies the advantage of financial leverage to the equity shareholder. Proprietary Ratio Proprietary Fund It measures the Total Assets proportion of total assets financed by shareholders. Coverage Ratios Debt Service Earnings available for It measures the ability to Coverage Ratio debt services meet the commitment of (DSCR) Interest+Instalments various debt services like interest, instalment etc. Ideal ratio is 2. Interest EBIT It measures the ability of Coverage Ratio Interest the business to meet interest obligations. Ideal ratio is > 1. Preference Net Profit / Earning after taxes (EAT) It measures the ability to Preference dividend liability Dividend pay the preference Coverage Ratio shareholders’ dividend. Ideal ratio is > 1. @The Institute of Chartered Accountants of India a 3.40 FINANCIAL MANAGEMENT Fixed Charges EBIT + Depreciation This ratio shows how Coverage Ratio Interest + Repayment of loan many times the cash flow before interest and taxes covers all fixed financing charges. The ideal ratio is > 1. Activity Ratio/ Efficiency Ratio/ Performance Ratio/ Turnover Ratio Total Asset Sales / Costof Goods Sold A measure of total asset Average Total Assets Turnover Ratio utilisation. It helps to answer the question - What sales are being generated by each rupee’s worth of assets invested in the business? Fixed Assets Sales / Cost of Goods Sold This ratio is about fixed Fixed Assets Turnover Ratio asset capacity. A reducing sales or profit being generated from each rupee invested in fixed assets may indicate overcapacity or poorer- performing equipment. Capital Turnover Sales / Cost of Goods Sold This indicates the firm’s Net Assets Ratio ability to generate sales per rupee of long term investment. Working Capital Sales / COGS It measures the efficiency Working Capital Turnover Ratio of the firm to use working capital. Inventory COGS / Sales It measures the efficiency Average Inventory Turnover Ratio of the firm to manage its inventory. @The Institute of Chartered Accountants of India  FINANCIAL ANALYSIS AND PLANNING– 3.41 3.41 RATIO ANALYSIS Debtors Turnover Credit Sales It measures the efficiency Average Accounts Receivable Ratio at which firm is managing its receivables. Receivables Average Accounts Receivables It measures the velocity of Average Daily Credit Sales (Debtors’) collection of receivables. Velocity Payables Annual Net Credit Purchases It measures how fast a Average Accounts Payables Turnover Ratio company makes payment to its creditors. Average Accounts Payable Payables Velocity It measures the velocity of Average Daily Credit Purchases payment of payables. Profitability Ratios based on Sales Gross Profit Ratio Gross Profit This ratio tells us ×100 Sales something about the business's ability consistently to control its production costs or to manage the margins it makes on products it buys and sells. Net Profit Ratio Net Profit It measures the ×100 Sales relationship between net profit and sales of the business. Operating Profit Operating Profit It measures operating ×100 Sales Ratio performance of business. @The Institute of Chartered Accountants of India a 3.42 FINANCIAL MANAGEMENT Expenses Ratio Cost of Goods COGS ×100 Sales Sold (COGS) Ratio Operating Administrative exp. + ( ) It measures portion of a Selling & Distribution Overhead Expenses Ratio x 100particular expenses in Sales COGS+Operating expenses comparison to sales. Operating Ratio ×100 Sales Financial Financial expenses ×100 Sales Expenses Ratio Profitability Ratios related to Overall Return on Assets/ Investments Return on Return /Profit /Earnings It measures overall return ×100 Investments Investment (ROI) of the business on investment/ equity funds/capital employed/ assets. Return on Assets Net Profit after taxes It measures net profit per Average total assets (ROA) rupee of average total assets/average tangible assets/average fixed assets. Return on Capital EBIT It measures overall ×100 Capital Employed Employed ROCE earnings (either pre-tax or (Pre-tax) post tax) on total capital employed. @The Institute of Chartered Accountants of India  FINANCIAL ANALYSIS AND PLANNING– 3.43 3.43 RATIO ANALYSIS Return on Capital EBIT (1- t) It indicates earnings ×100 Capital Employed Employed ROCE available to equity (Post-tax) shareholders in  Net Profit after taxes-  comparison to equity Return on Equity   shareholders’ net worth. (ROE)  Preference dividend (if any)  ×100 Net worth Equity shareholders' fund Profitability Ratios Required for Analysis from Owner’s Point of View Earnings per Net profit available to equity EPS measures the overall Share (EPS) shareholders profit generated for each Number of equity shares outstanding share in existence over a particular period. Dividend per Dividend paid to equity shareholders Proportion of profit Number of equity shares outstanding Share (DPS) distributed per equity share. Dividend payout Dividend per equity share It shows % of EPS paid as Earning per Share (EPS) Ratio (DP) dividend and retained earnings. Profitability Ratios related to market/ valuation/ Investors Price-Earnings Market Price per Share (MPS) At any time, the P/E ratio Earning per Share (EPS) per Share (P/E is an indication of how Ratio) highly the market "rates" or "values" a business. A P/E ratio is best viewed in the context of a sector or market average to get a feel for relative value and stock market pricing. @The Institute of Chartered Accountants of India a 3.44 FINANCIAL MANAGEMENT Dividend Yield Dividend ± Change in It measures dividend paid share peice based on market price of  100 Initial share price shares. OR Dividend per Share (DPS) ×100 Market Price per Share (MPS) Earnings Yield Earnings per Share (EPS) ×100 It is the relationship of Market Priceper Share (MPS) earning per share and market value of shares. Market Value Market value per share It indicates market /Book Value per Book value per share response of the Share shareholders’ investment. Q Ratio Market Value of equity and liabilities It measures market value Estimated replacement cost of assets of equity as well as debt in comparison to all assets at their replacement cost. Students may note that now a company is also required to disclose the following ratios in the notes to accounts while preparing Financial Statements: (a) Current Ratio, (b) Debt-Equity Ratio, (c) Debt Service Coverage Ratio, (d) Return on Equity Ratio, (e) Inventory turnover ratio, (f) Trade Receivables turnover ratio, (g) Trade payables turnover ratio, (h) Net capital turnover ratio, (i)