Financial Analysis and Planning - Ratio Analysis PDF

CHAPTER 3 FINANCIAL ANALYSIS AND PLANNING– RATIO ANALYSIS LEARNING OUTCOMES  Discuss Sources of financial data for Analysis  Discuss financial ratios and its Types  Discuss use of financial ratios to analyse the financi...

CHAPTER 3 FINANCIAL ANALYSIS AND PLANNING– RATIO ANALYSIS LEARNING OUTCOMES  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  3.2 FINANCIAL MANAGEMENT RATIO ANALYSIS Application of Ratio Analysis Types of Ratios in decision making ♦ Liquidity Ratios/Short- term solvency ratios Relationship of Financial Management with other ♦ Leverage Ratio/Long disciplines of accounting. term solvency Ratios ♦ Activity Ratios/Efficiency Ratios/Performance Ratios/Turnover ratios Profitability Ratios 3.1 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 and the balance sheet depicts the balance value of the acquired assets and of liabilities 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 tool is Ratio Analysis. Let us discuss the Ratio Analysis. © The Institute of Chartered Accountants of India FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.3 3.2 RATIOS AND RATIO ANALYSIS Let us first understand the definition of ratio and meaning of ratio analysis 3.2.1 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 accounting figures. 3.2.2 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; and  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; and  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, other companies, the industry, or even the economy in general for the purpose of financial analysis. 3.2.3 Sources of Financial Data for Analysis The sources of information for financial statement analysis are: 1. Annual Reports © The Institute of Chartered Accountants of India  3.4 FINANCIAL MANAGEMENT 2. Interim financial statements 3. Notes to Accounts 4. Statement of cash flows 5. Business periodicals. 6. Credit and investment advisory services 3.3 TYPES OF RATIOS Liquidity Ratios*/ Short- term Solvency Ratios Capital Structure Ratios Leverage Ratios/ Long term Solvency Ratios Coverage Ratios Types of Ratios Activity Ratios/ Efficiency Ratios/ Realted to Sales Performance Ratios/ Turnover Ratios* Related to overall Return 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. 3.3.1 Liquidity Ratios The terms ‘liquidity’ and ‘short-term solvency’ are used synonymously. © The Institute of Chartered Accountants of India FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.5 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 Ratio (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?" Current Assets Current Ratio = Current Liabilitie s Where, Current Assets = Inventories + Sundry Debtors + Cash and Bank Balances + Receivables/ Accruals + Loans and Advances + Disposable Investments + Any other current assets. 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. © The Institute of Chartered Accountants of India  3.6 FINANCIAL MANAGEMENT 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?" 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. (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: © The Institute of Chartered Accountants of India FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.7 Cash and Bank balances + Marketable Securities Cash Ratio = Current Liabilities Or, Cash and Bank balances + 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 + Marketable Securities Basic Defense Interval = Opearing Expenses÷ No. of days (say 360) Or Current Assets - Inventories Interval Measure = Daily Operating Expenses Cost of GoodsSold+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. (e) Net Working Capital Ratio: Net working capital is more a measure of cash flow than a ratio. The result of this calculation must be a positive number. It is calculated as shown below: Net Working Capital Ratio = Current Assets-Current Liabilities (Excluding short-term bank borrowing) © The Institute of Chartered Accountants of India  3.8 FINANCIAL MANAGEMENT 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. 3.3.2 Long-term Solvency Ratios /Leverage Ratios The leverage ratios may be defined as those financial ratios which measure the long term stability and 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 2. Coverage Ratios (a) Debt-Service Coverage Ratio (DSCR) (b) Interest Coverage Ratio (c) Preference Dividend Coverage Ratio (d) Fixed Charges Coverage Ratio 3.3.2.1 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. © The Institute of Chartered Accountants of India FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.9 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: Shareholders' Equity Equity Ratio = CapitalEmployed This ratio indicates proportion of owners’ fund to total fund invested in the business. Traditionally, it is believed that higher the proportion of owners’ fund lower is the degree of risk. (b) Debt Ratio: Debt Ratio = Total outside liabilities Total Debt+ Net worth Or, Debt Ratio = Total Debt Net Assets 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. (c) Debt to Equity Ratio: Total Outside Liabilities Total Debt * Debt to Equity Ratio = = Shareholders'Equity Shareholders'Equity Or, = Long- term Debt * * Shareholders'equity *Not merely long-term debt. ** Sometimes only interest-bearing, long term debt is used instead of total liabilities (exclusive of current liabilities) © The Institute of Chartered Accountants of India  3.10 FINANCIAL MANAGEMENT The shareholders’ equity is equity and preference share capital + post accumulated profits (excluding fictitious assets etc). 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 referred in capital structure decision as well as in the legislation dealing with the capital structure decisions (i.e. issue of shares and 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 Debt to Total Assets Ratio = Total Assets Or, = Total Debt Total Assets (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. (Preference Share Capital + Debentures + OtherBorrowedfunds) 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 + Reserve & Surplus. Total assets exclude fictitious assets and losses. Interpretation It indicates the proportion of total assets financed by shareholders. © The Institute of Chartered Accountants of India FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.11 3.3.2.2 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 + Instalments Earning 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 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: Earningsbeforeinterest andtaxes(EBIT) Interest Coverage Ratio = Interest © The Institute of Chartered Accountants of India  3.12 FINANCIAL MANAGEMENT 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. This ratio indicates the extent to which earnings may fall without causing any embarrassment to the firm regarding the payment of interest charges. 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: Preference Dividend Coverage Ratio = Net Profit / Earning after taxes (EAT) Preference dividend liability Earnings after tax is considered because unlike debt on which interest is charged on the profit of the firm, the preference dividend is treated as appropriation of profit. 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 taking (EAT – Pref. Dividend) and equity fund figures into consideration. (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. Fixed Charges Coverage Ratio = EBIT+Depreciation Repayment of loan Interest+ 1-taxrate 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) © The Institute of Chartered Accountants of India FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.13 2. Ratios shall be calculated based on requirement and availability and may deviate from original formulae. 3. Numerator should be taken in correspondence with the denominator and vice-versa. 3.3.3 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 ‘Asset management ratios’. These ratios usually indicate the frequency of sales with 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 (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. Asset Turnover Ratios: Based on different concepts of assets employed, it can be expressed as follows: (a) Total Asset Turnover Ratio: This ratio measures the efficiency with which the firm uses its total assets. This ratio is computed as: Sales / Cost of GoodsSold Total Asset Turnover Ratio = TotalAssets © The Institute of Chartered Accountants of India  3.14 FINANCIAL MANAGEMENT (b) Fixed Assets Turnover Ratio: It measures the efficiency with which the firm uses its fixed assets. Fixed Assets Turnover Ratio = Sales / Cost of Goods Sold Fixed Assets 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 GoodsSold Capital Turnover Ratio = Net Assets Interpretation 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. Net Assets includes Net Fixed Assets and Net Current Assets (Current Assets – Current Liabilities). Since Net Assets equals to capital employed it is also known as Capital Turnover Ratio. (d) Current Assets Turnover Ratio: It measures the efficiency using the current assets by the firm. Sales / Cost of GoodsSold Current Assets Turnover Ratio = Current Assets (e) Working Capital Turnover Ratio: Sales / Cost of GoodsSold Working Capital Turnover Ratio = Working Capital Interpretation 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 Capita also can be taken. (i) Inventory/ Stock Turnover Ratio: This ratio also known as stock turnover ratio establishes the relationship between the cost of goods sold during the © The Institute of Chartered Accountants of India FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.15 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 GoodsSold / Sales Inventory Turnover Ratio = Average Inventory * OpeningStock+ClosingStock *Average Inventory = 2 In the case of inventory of raw material the inventory turnover ratio is calculated using the following formula : Raw Material Inventory Turnover Ratio= Raw Material Consumed 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: Receivable (Debtor) Turnover Ratio = Credit Sales Average AccountsReceivable Receivables (Debtors’) Velocity: Debtors’ turnover ratio indicates the average collection period. However, the average collection period can be directly calculated as follows: © The Institute of Chartered Accountants of India  3.16 FINANCIAL MANAGEMENT Receivable Velocity/ Average Collection Period = Average Accounts Receivables Average Daily Credit Sales Or, = 12 months / 52 weeks / 360 days Receivable TurnoverRatio Average Daily Credit Sales = Average Daily Credit Sales Credit Sales = No.of daysinyear (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. (iii) Payables Turnover Ratio: This ratio is calculated on the same lines as receivable turnover ratio is calculated. This ratio 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 = Average Daily Credit Purchases Or, = 12months / 52 weeks / 360 days Payables Turnover Ratio In determining the credit policy, debtor’s turnover and average collection period provide a unique guidance. 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 Institute of Chartered Accountants of India FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.17 The above three ratios i.e. Inventory Turnover Ratio/ Receivables 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 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 calculating the above ratios. Infact 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 and may deviate from original formulae. 3.3.4 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 firm 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 (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: 1. Profitability Ratios based on Sales (a) Gross Profit Ratio (b) Net Profit Ratio (c) Operating Profit Ratio © The Institute of Chartered Accountants of India  3.18 FINANCIAL MANAGEMENT (d) Expenses Ratio 2. 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) 3. Profitability Ratios required for Analysis from Owner’s Point of View (a) Earnings per Share (EPS) (b) Dividend per Share (DPS) (c) Dividend Payout Ratio (DP) 4. 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 (MVBV) (d) Q Ratio 3.3.4.1 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 price/ sales, 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: NetProfit Earningsafter taxes (EAT) (i) Net Profit Ratio = ×100 or ×100 Sales Sales © The Institute of Chartered Accountants of India FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.19 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. A high net profit ratio will ensure positive returns of 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 or, Earnings before interest and taxes (EBIT) ×100 Sales Where, Operating Profit = Sales – Cost of Goods Sold (COGS) – 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 (ii) Operating Expenses Ratio = Administrative exp.+ Selling & Distribution OH ×100 Sales COGS+Operating expenses (iii) Operating Ratio = ×100 Sales Financialexpenses * (iv) Financial Expenses Ratio = ×100 Sales *It excludes taxes, loss due to theft, goods destroyed by fire etc. © The Institute of Chartered Accountants of India  3.20 FINANCIAL MANAGEMENT Administration Expenses Ratio and Selling & Distribution Expenses Ratio can also be calculated in similar ways. 3.3.4.2 Profitability Ratios related to Overall Return on Assets/ Investments (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 Return /Profit /Earnings = Profitability Ratio Sales Sales Investment Turnover Ratio = Investments So, ROI = Profitability Ratio × Investment Turnover Ratio. 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. (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. © The Institute of Chartered Accountants of India FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.21 (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 Net Profit after taxes ROA= or or Average Total Assets Average Tangible Assets Average Fixed Assets Here net profit is exclusive of interest. As Assets are also financed by lenders, hence ROA can be calculated as: NetProfit after taxes+Interest = Average TotalAssets / Average Tangible Assets / AverageFixed 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 (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 Sometime it is calculated as Net Profit after taxes(PAT /EAT)+Interest = ×100 Capital Employed Where, Capital Employed = Total Assets – Current Liabilities © The Institute of Chartered Accountants of India  3.22 FINANCIAL MANAGEMENT Or = Fixed Assets + Working Capital 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 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: ROE = Net Profit after taxes-Preferencedividend (if any) ×100 Net worth equity shareholders'fund 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 is calculated then Net Profit after taxes (before preference dividend) shall be divided by total shareholders’ fund includes 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. (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 © The Institute of Chartered Accountants of India FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.23 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. Profitability Profit Sales = ÷ Net profit margin Net Income Revenue Net profit margin is a safety cushion; the lower the margin, the less room for error. A business with 1% margins 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., the higher the net profit margin, the lower the asset turnover. 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: Equity Multiplier = Investment /Assets /Capital ÷ 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) (Investment Turnover / Asset Turnover / Capital Turnover) Equity Multiplier) Example: XYZ Company’s details are as under: © The Institute of Chartered Accountants of India  3.24 FINANCIAL MANAGEMENT Revenue: `29,261; Net Income: `4,212; Assets: `27,987; Shareholders’ Equity: `13,572. CALCULATE return on equity. Solution 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: (` 27,987) 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%. 15.04% of the return on equity was due to profit margins and sales, while 15.96% was due to returns earned on the debt at work in the business. If you found 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. 3.3.4.3 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 n per share basis. This is known as Earnings per share. It is calculated as follows: Netprofit available to equity shareholders Earnings per Share (EPS) = Number of equity sharesoutstanding (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 (c) Dividend Payout 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: © The Institute of Chartered Accountants of India FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.25 Dividendper equity share(DPS) Dividend payout Ratio = Earning per Share(EPS) 3.3.4.4 Profitability Ratios related to market/ valuation/ Investors These ratios involve measures that consider the market value of the company’s shares. 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. (b) Dividend and Earning Yield: Dividend ±Change in share price Dividend Yield = ×100 Initial share price Sometime it is calculated as Dividendper Share(DPS) ×100 Market Priceper Share(MPS) 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. Earning Yield also can be calculated as Earnings Yield = Earningsper Share(EPS) ×100 Market Price per Share(MPS) Also known as Earnings Price (EP) Ratio. © The Institute of Chartered Accountants of India  3.26 FINANCIAL MANAGEMENT (c) Market Value /Book Value per Share (MVBV): It provides evaluation of how investors view the company’s past and future performance. Market valueper share Averageshareprice = Book valueper share Net worth÷No.of equity shares Or, Closingshareprice Net worth÷No.of equity shares Interpretation This ratio indicates market response of the shareholders’ investment. Undoubtedly, higher the ratios 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 Estimated replacement cost of assets 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. 3. Ratios shall be calculated based on requirement and availability and may deviate from original formulae. 4. Numerator should be taken in correspondence with the denominator and vice-versa. © The Institute of Chartered Accountants of India FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.27 3.4 USERS AND OBJECTIVE OF FINANCIAL ANALYSIS:- A BIRDS 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 Ratio [In particular interested to know about Earning per share profitability and growth of (EPS), Dividend the organization per share (DPS), Price Earnings (P/E), Dividend Payout ratio (DP)] 2. Investors They are interested to ♦ Profitability Ratios know overall financial ♦ Capital structure health of the organisation Ratios particularly future ♦ Solvency Ratios perspective of the ♦ Turnover Ratios organisations. 3. Lenders They will keep an eye on ♦ Coverage Ratios the safety perspective of ♦ Solvency Ratios their money lent to the ♦ Turnover Ratios organisation ♦ Profitability Ratios 4. Creditors They are interested to ♦ Liquidity Ratios know liability position of ♦ Short term the organisation solvency Ratios/ particularly in short term. Liquidity Ratios Creditors would like to know whether the organisation will be able to pay the amount on due date. © The Institute of Chartered Accountants of India  3.28 FINANCIAL MANAGEMENT 5. Employees They will be interested to ♦ Liquidity Ratios know the overall financial ♦ Long terms wealth of the organisation solvency Ratios and compare it with ♦ Profitability Ratios competitor company. ♦ Return of investment 6. Regulator / They will analyse the Profitability Ratios Government financial statements to determine taxations and other details payable to the government. 7. Managers:- (a) Production They are interested to ♦ Input output Ratio Managers know about data ♦ Raw material regarding input output, consumption production quantities etc. ratio. (b) Sales Data related to units sold ♦ Turnover ratios Managers for various years, other (basically associated figures and receivable predicted future sales turnover ratio) figure will be an area of ♦ Expenses Ratios interest for them (c) Financial They are interested to ♦ Profitability Ratios Manager know various ratios for (particularly their future predictions of related to Return financial requirement. on investment) ♦ Turnover ratios ♦ Capital Structure Ratios Chief Executive/ They will try to assess the ♦ All Ratios General complete perspective of Manager the company, starting from Sales, Finance, Inventory, Human resources, Production etc. © The Institute of Chartered Accountants of India FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.29 8. Different Industry (a) Telecom ♦ Ratio related to ‘call’ ♦ Revenue and expenses per customer (b) Bank ♦ Loan to deposit Ratios ♦ Operating Finance Manager /Analyst expenses and will calculate ratios of their income ratios company and compare it (c) Hotel ♦ Room occupancy with Industry norms. ratio ♦ Bed occupancy Ratios ♦ Passenger - kilometre ♦ Operating cost - per passenger kilometre. 3.5 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. Ratio analysis is relevant in assessing the performance of a firm in respect of following aspects: © The Institute of Chartered Accountants of India  3.30 FINANCIAL MANAGEMENT 3.5.1 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 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 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. © The Institute of Chartered Accountants of India FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.31 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. It helps in budgeting. 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. 3.6 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. © The Institute of Chartered Accountants of India  3.32 FINANCIAL MANAGEMENT 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 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. (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. 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. 3.7 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 © The Institute of Chartered Accountants of India FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.33 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. 3.8 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: Ratio Formulae Interpretation Liquidity Ratio Current Ratio Current Assets A simple measure that CurrentLiabilities estimates whether the business can pay short term debts. Quick Ratio Quick Assets It measures the ability to CurrentLiabilities meet current debt immediately. Ideal ratio is 1 Cash Ratio  CashandBank balances +  It measures absolute    Marketable Securities  liquidity of the business. Current Liabilities Basic Defense  CashandBank balances +  It measures the ability of Interval Ratio   the business to meet  Marketable Securities  Opearing Expenses÷ No.of days regular cash expenditures. Net Working Current Assets – Current It is a measure of cash Capital Ratio Liabilities flow to determine the ability of business to survive financial crisis. Capital Structure Ratio Equity Ratio Shareholders' Equity It indicates owner’s fund in CapitalEmployed companies to total fund invested. © The Institute of Chartered Accountants of India  3.34 FINANCIAL MANAGEMENT Debt Ratio Totaloutsideliabilities It is an indicator of use of TotalDebt+Net worth outside funds. Debt to equity TotalOutsideLiabilities It indicates the Ratio Shareholders'Equity composition of capital structure in terms of debt and equity. Debt to Total TotalOutsideLiabilities It measures how much of Assets Ratio TotalAssets total assets is financed by the debt. Capital Gearing  Preference Share Capital +Debentures  It shows the proportion of Ratio  + OtherBorrowedfunds  fixed interest bearing   capital to equity  Equity Share Capital +   Reserves & Surplus - Losses  shareholders’ fund. It also   signifies the advantage of financial leverage to the equity shareholder. Proprietary Ratio Proprietary Fund It measures the proportion Total Assets of total assets financed by shareholders. Coverage Ratios Debt Service Earningsavailable for debt services It measures the ability to Coverage Ratio Interest+Instalments meet the commitment of (DSCR) 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 NetProfit / Earning after taxes (EAT) It measures the ability to Dividend Preferencedividendliability pay the preference Coverage Ratio shareholders’ dividend. Ideal ratio is > 1. © The Institute of Chartered Accountants of India FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.35 Fixed Charges EBIT+Depreciation This ratio shows how many Coverage Ratio Re -payment of loan times the cash flow before Interest+ 1-taxrate interest and taxes covers all fixed financing charges. The ideal ratio is > 1. Activity Ratio/ Efficiency Ratio/ Performance Ratio/ Turnover Ratio Total Asset Sales / Cost of GoodsSold A measure of total asset Turnover Ratio Average TotalAssets 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 GoodsSold This ratio is about fixed asset Turnover Ratio FixedAssets 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 GoodsSold This indicates the firm’s Ratio Net Assets ability to generate sales per rupee of long term investment. Working Capital Sales / COGS It measures the efficiency of Turnover Ratio WorkingCapital the firm to use working capital. Inventory COGS / Sales It measures the efficiency of Turnover Ratio AverageInventory the firm to manage its inventory. Debtors Turnover CreditSales It measures the efficiency at Ratio Average Accounts Receivable which firm is managing its receivables. Receivables Average Accounts Receivables It measures the velocity of (Debtors’) Average Daily Credit Sales collection of receivables. Velocity © The Institute of Chartered Accountants of India  3.36 FINANCIAL MANAGEMENT Payables AnnualNet CreditPurchases It measures the velocity of Turnover Ratio Average AccountsPayables payables payment. Profitability Ratios based on Sales Gross Profit Ratio GrossProfit This ratio tells us something ×100 Sales 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 NetProfit It measures the relationship ×100 Sales between net profit and sales of the business. Operating Profit Operating Profit It measures operating ×100 Ratio Sales performance of business. Expenses Ratio Cost of Goods COGS It measures portion of a ×100 Sold (COGS) Sales particular expenses in Ratio comparison to sales. Operating  Administrative exp. +  . Expenses Ratio  Selling & Distribution Overhead  x100  Sales      Operating Ratio COGS+Operatingexpenses ×100 Sales Financial Financialexpenses ×100 Expenses Ratio Sales Profitability Ratios related to Overall Return on Assets/ Investments Return on Return /Profit /Earnings It measures overall return of ×100 Investment (ROI) Investments the business on investment/ equity funds/capital employed/ assets. © The Institute of Chartered Accountants of India FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.37 Return on Assets Net Profit after taxes It measures net profit per (ROA) Averagetotal assets rupee of average total assets/ average tangible assets/ average fixed assets. Return on Capital EBIT It measures overall earnings ×100 Employed ROCE CapitalEmployed (either pre-tax or post tax) (Pre-tax) on total capital employed. Return on Capital EBIT(1- t) It indicates earnings ×100 Employed ROCE CapitalEmployed available to equity (Post-tax) shareholders in comparison Return on Equity  NetProfitafter taxes-  to equity shareholders’ net  Preferencedividend(if any)  worth. (ROE)   ×100 Net worth / equity shareholders'fund Profitability Ratios Required for Analysis from Owner’s Point of View Earnings per Netprofitavailabletoequity shareholders EPS measures the overall Share (EPS) Number of equity sharesoutstanding profit generated for each share in existence over a particular period. Dividend per Dividendpaidto equity shareholders Proportion of profit Share (DPS) Number of equity shares outstanding distributed per equity share. Dividend payout Dividendper equity share It shows % of EPS paid as Ratio (DP) Earningper Share(EPS) dividend and retained earnings. Profitability Ratios related to market/ valuation/ Investors Price-Earnings MarketPriceper Share(MPS) At any time, the P/E ratio is per Share (P/E Earningper Share(EPS) an indication of how highly Ratio) 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  3.38 FINANCIAL MANAGEMENT Dividend Yield Dividend±Changeinsharepeice ×100 It measures dividend paid Initialshareprice based on market price of OR shares. Dividendper Share(DPS) ×100 MarketPriceper Share(MPS) Earnings Yield Earningsper Share(EPS) ×100 It is the relationship of MarketPriceper Share(MPS) earning per share and market value of shares. Market Value Market valueper share It indicates market response of /Book Value per Book valueper share the shareholders’ investment. Share Q Ratio Market Valueof equity and liabilities It measures market value of Estimatedreplacement cost of assets equity as well as debt in comparison to all assets at their replacement cost. ILLUSTRATION 1 In a meeting held at Solan towards the end of 2018, the Directors of M/s HPCL Ltd. have taken a decision to diversify. At present HPCL Ltd. sells all finished goods from its own warehouse. The company issued debentures on 01.01.2019 and purchased fixed assets on the same day. The purchase prices have remained stable during the concerned period. Following information is provided to you: INCOME STATEMENTS Particulars 2018 (` ) 2019 (` ) Cash Sales 30,000 32,000 Credit Sales 2,70,000 3,00,000 3,42,000 3,74,000 Less: Cost of goods sold 2,36,000 2,98,000 Gross profit 64,000 76,000 Less: Operating Expenses Warehousing 13,000 14,000 Transport 6,000 10,000 Administrative 19,000 19,000 © The Institute of Chartered Accountants of India FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.39 Selling 11,000 14,000 49,000 57,000 Net Profit 15,000 19,000 BALANCE SHEET Assets & Liabilities 2018 (`) 2019 (`) Fixed Assets (Net Block) - 30,000 - 40,000 Receivables 50,000 82,000 Cash at Bank 10,000 7,000 Stock 60,000 94,000 Total Current Assets (CA) 1,20,000 1,83,000 Payables 50,000 76,000 Total Current Liabilities (CL) 50,000 76,000 Working Capital (CA - CL) 70,000 1,07,000 Total Assets 1,00,000 1,47,000 Represented by: Share Capital 75,000 75,000 Reserve and Surplus 25,000 42,000 Debentures − 30,000 1,00,000 1,47,000 You are required to CALCULATE the following ratios for the years 2018 and 2019. (i) Gross Profit Ratio (ii) Operating Expenses to Sales Ratio. (iii) Operating Profit Ratio (iv) Capital Turnover Ratio (v) Stock Turnover Ratio (vi) Net Profit to Net Worth Ratio, and (vii) Receivables Collection Period. © The Institute of Chartered Accountants of India  3.40 FINANCIAL MANAGEMENT Ratio relating to capital employed should be based on the capital at the end of the year. Give the reasons for change in the ratios for 2 years. Assume opening stock of ` 40,000 for the year 2019. Ignore Taxation. SOLUTION Computation of Ratios Ratio 2018 (`) 2019 (`) 1. Gross profit ratio 64,000 × 100 76,000 × 100 =21.3% =20.3% (Gross profit/sales) 3,00,000 3,74,000 2. Operating expense to 49,000×100 57,000 × 100 =16.3% =15.2% sales ratio (Operating exp/ 3,00,000 3,74,000 Total sales) 3. Operating profit ratio 15,000 × 100 19,000 × 100 =5% =5.08% (Operating profit / Total sales) 3,00,000 3,74,000 4. Capital turnover ratio 3,00,000 3,74,000 =3 = 2.54 (Sales / capital employed) 1,00,000 1,47,000 5.Stock turnover ratio (COGS 2,36,000 2,98,000 =4.72 =3.87 / Average stock) 50,000 77,000 6. Net Profit to Networth (Net 15,000 × 100 17,000 × 100 =15% =14.5% profit / Networth) 1,00,000 1,17,000 7.Receivables collection 50,000 82,000 =67.6 days =87.5 days period( Average receivables / 739.73 936.99 Average daily credit sales) (Refer to working note) Working note: 2,70,000 3,42,000 =739.73 =936.99 365 365 Average daily sales = Credit sales / 365 Analysis: The decline in the Gross profit ratio could be either due to a reduction in the selling price or increase in the direct expenses (since the purchase price has remained the same). Similarly there is a decline in the ratio of operating expenses to sales. However since operating expenses have little bearing with sales, a decline in this ratio cannot be necessarily interpreted as an increase in © The Institute of Chartered Accountants of India FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.41 operational efficiency. An in-depth analysis reveals that the decline in the warehousing and the administrative expenses has been partly set off by an increase in the transport and the selling expenses. The operating profit ratio has remained the same in spite of a decline in the Gross profit margin ratio. In fact the company has not benefited at all in terms of operational performance because of the increased sales. The company has not been able to deploy its capital efficiently. This is indicated by a decline in the Capital turnover from 3 to 2.5 times. In case the capital turnover would have remained at 3 the company would have increased sales and profits by ` 67,000 and ` 3,350 respectively. The decline in stock turnover ratio implies that the company has increased its investment in stock. Return on Net worth has declined indicating that the additional capital employed has failed to increase the volume of sales proportionately. The increase in the Average collection period indicates that the company has become liberal in extending credit on sales. However, there is a corresponding increase in the current assets due to such a policy. It appears as if the decision to expand the business has not shown the desired results. ILLUSTRATION 2 Following is the abridged Balance Sheet of Alpha Ltd. :- Liabilities ` Assets ` ` Share Capital 1,00,000 Land and Buildings 80,000 Profit and Loss Account 17,000 Plant and Machineries 50,000 Current Liabilities 40,000 Less: Depreciation 15,000 35,000 1,15,000 Stock 21,000 Receivables 20,000 Bank 1,000 42,000 Total 1,57,000 Total 1,57,000 With the help of the additional information furnished below, you are required to PREPARE Trading and Profit & Loss Account and a Balance Sheet as at 31st March, 2019: (i) The company went in for reorganisation of capital structure, with share capital remaining the same as follows: © The Institute of Chartered Accountants of India  3.42 FINANCIAL MANAGEMENT Share capital 50% Other Shareholders’ funds 15% 5% Debentures 10% Payables 25% Debentures were issued on 1 April, interest being paid annually on 31st March. st (ii) Land and Buildings remained unchanged. Additional plant and machinery has been bought and a further ` 5,000 depreciation written off. (The total fixed assets then constituted 60% of total fixed and current assets.) (iii) Working capital ratio was 8 : 5. (iv) Quick assets ratio was 1 : 1. (v) The receivables (four-fifth of the quick assets) to sales ratio revealed a credit period of 2 months. There were no cash sales. (vi) Return on net worth was 10%. (vii) Gross profit was at the rate of 15% of selling price. (viii) Stock turnover was eight times for the year. Ignore Taxation. SOLUTION Particulars % (` ) Share capital 50% 1,00,000 Other shareholders funds 15% 30,000 5% Debentures 10% 20,000 Payables 25% 50,000 Total 100% 2,00,000 Land and Buildings Total liabilities = Total Assets ` 2,00,000 = Total Assets Fixed Assets = 60% of total fixed assets and current assets = ` 2,00,000 × 60/100 = ` 1,20,000 Calculation of additions to Plant & Machinery © The Institute of Chartered Accountants of India FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.43 ` Total fixed assets 1,20,000 Less: Land & Buildings 80,000 Plant and Machinery (after providing depreciation) 40,000 Depreciation on Machinery up to 31-3-20X8 15,000 Add: Further depreciation 5,000 Total 20,000 Current assets = Total assets – Fixed assets = ` 2,00,000 – ` 1,20,000 = ` 80,000 Calculation of stock Current assets - stock Quick ratio: = =1 Current liabilities ` 80,000 - stock = =1 ` 50,000 ` 50,000 = ` 80,000 – Stock Stock = ` 80,000 - ` 50,000 = ` 30,000 Receivables = 4/5th of quick assets = (` 80,000 – 30,000)× 4/5 = ` 40,000 Receivables turnover ratio Receivables = ×12 Months = 2 months CreditSales 40,000 ×12 = = 2 months Credit Sales 2 × credit sales = 4,80,000 Credit sales = 4,80,000/2 = ` 2,40,000 © The Institute of Chartered Accountants of India  3.44 FINANCIAL MANAGEMENT Gross profit (15% of sales) ` 2,40,000 × 15/100 = ` 36,000 Return on net worth (net profit) Net worth = ` 1,00,000 + ` 30,000 = ` 1,30,000 Net profit = ` 1,30,000 × 10/100 = ` 13,000 Debenture interest = ` 20,000 × 5/100 = ` 1,000 Projected profit and loss account for the year ended 31-3-2019 To cost of goods sold 2,04,000 By sales 2,40,000 To gross profit 36,000 ________ 2,40,000 2,40,000 To debenture interest 1,000 By gross profit 36,000 To administration and 22,000 other expenses To net profit 13,000 ______ 36,000 36,000 Projected Balance Sheet as at 31st March, 2019 Liabilities ` Assets ` Share capital 1,00,000 Fixed assets Profit and loss A/c 30,000 Land & buildings 80,000 (17,000+13,000) Plant & machinery 60,000 5% Debentures 20,000 Less: Depreciation 20,000 40,000 Current liabilities Current assets Stock 30,000 Trade creditors 50,000 Recivables 40,000 _ Bank 10,000 80,000 2,00,000 2,00,000 © The Institute of Chartered Accountants of India FINANCIAL ANALYSIS AND PLANNING RATIO ANALYSIS 3.45 ILLUSTRATION 3 X Co. has made plans for the next year. It is estimated that the company will employ total assets of ` 8,00,000; 50 per cent of the assets being financed by borrowed capital at an interest cost of 8 per cent per year. The direct costs for the year are estimated at `4,80,000 and all other operating expenses are estimated at ` 80,000. the goods will be sold to customers at 150 per cent of the direct costs. Tax rate is assumed to be 50 per cent. You are required to CALCULATE: (i) net profit margin; (ii) return on assets; (iii) asset turnover and (iv) return on owners’ equity. SOLUTION The net profit is calculated as follows: Particulars ` ` Sales (150% of ` 4,80,000) 7,20,000 Direct costs 4,80,000 Gross profit 2,40,000 Operating expenses 80,000 Interest changes (8% of ` 4,00,000) 32,000 1,12,000 Profit before taxes 1,28,000 Taxes (@ 50%)