RATIO ANALYSIS

RATIO ANALYSIS
Mere statistics/data presented in the different financial statements do not reveal the true picture of a financial position of a firm. Properly analyzed and interpreted financial statements can provide valuable insights into a firm’s performance. To extract the information from the financial statements, a number of tools are used to analyse such statements. The most popular tool is the Ratio Analysis. Financial ratios can be broadly classified into three groups: (I) Liquidity ratios, (II) Leverage/Capital structure ratio, and (III) Profitability ratios.
(I) Liquidity ratios:
Liquidity refers to the ability of a firm to meet its financial obligations in the short-term which is less than a year. Certain ratios, which indicate the liquidity of a firm, are (i) Current Ratio, (ii) Acid Test Ratio, (iii) Turnover Ratios. It is based upon the relationship between current assets and current liabilities.
(i) Current ratio = Current Assets/ Current Liabilities
The current ratio measures the ability of the firm to meet its current liabilities from the current assets. Higher the current ratio, greater the short-term solvency (i.e. larger is the amount of rupees available per rupee of liability).
(ii) Acid-test Ratio = Quick Assets/ Current Liabilities
Quick assets are defined as current assets excluding inventories and prepaid expenses. The acid-test ratio is a measurement of firm’s ability to convert its current assets quickly into cash in order to meet its current liabilities. Generally speaking 1:1 ratio is considered to be satisfactory.
(iii) Turnover Ratios:
Turnover ratios measure how quickly certain current assets are converted into cash or how efficiently the assets are employed by a firm. The important turnover ratios are: Inventory Turnover Ratio, Debtors Turnover Ratio, Average Collection
Period, Fixed Assets Turnover and Total Assets Turnover
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Where, the cost of goods sold means sales minus gross profit. ‘Average Inventory’ refers to simple average of opening and closing inventory. The inventory turnover ratio tells the efficiency of inventory management. Higher the ratio, more the efficient of inventory management.
Debtors’ Turnover Ratio = Net Credit Sales / Average Accounts Receivable (Debtors)
The ratio shows how many times accounts receivable (debtors) turn over during the year. If the figure for net credit sales is not available, then net sales figure is to be used. Higher the debtors turnover, the greater the efficiency of credit management.
Average Collection Period = Average Debtors / Average Daily Credit Sales
Average Debtors
Average Collection Period represents the number of days’ worth credit sales that is locked in debtors (accounts receivable).
Average Collection Period = 365 Days / Debtors Turnover
Fixed Assets turnover ratio measures sales per rupee of investment in fixed assets. In other words, how efficiently fixed assets are employed. Higher ratio is preferred. It is calculated as follows:
Fixed Assets turnover ratio = Net. Sales / Net Fixed Assets
Total Assets turnover ratio measures how efficiently all types of assets are employed.
Total Assets turnover ratio = Net Sales / Average Total Assets
(II) Leverage/Capital structure Ratios:
Long term financial strength or soundness of a firm is measured in terms of its ability to pay interest regularly or repay principal on due dates or at the time of maturity. Such long term solvency of a firm can be judged by using leverage or capital structure ratios. Broadly there are two sets of ratios: First, the ratios based on the relationship between borrowed funds and owner’s capital which are computed from the balance sheet. Some such ratios are: Debt to Equity and Debt to Asset ratios. The second set of ratios which are calculated from Profit and Loss Account are: The interest coverage ratio and debt service coverage ratio are coverage ratio to leverage risk.
(i) Debt-Equity ratio reflects relative contributions of creditors and owners to
finance the business.
Debt-Equity ratio = Total Debt / Total Equity
The desirable/ideal proportion of the two components (high or low ratio) varies from industry to industry.
(ii) Debt-Asset Ratio: Total debt comprises of long term debt plus current liabilities. The total assets comprise of permanent capital plus current liabilities.
Debt-Asset Ratio = Total Debt / Total Assets
The second set or the coverage ratios measure the relationship between proceeds from the operations of the firm and the claims of outsiders.
(iii) Interest Coverage ratio = Earnings Before Interest and Taxes /Interest
Higher the interest coverage ratio better is the firm’s ability to meet its interest burden. The lenders use this ratio to assess debt servicing capacity of a firm.
(iv) Debt Service Coverage Ratio (DSCR) is a more comprehensive and apt to compute debt service capacity of a firm. Financial institutions calculate the average DSCR for the period during which the term loan for the project is repayable. The Debt Service Coverage Ratio is defined as follows:
DSCR - Profit after tax Depreciation Other Non-cash Expenditure Interest on term loan / Interest on Term loan Repayment of term loan
(III) Profitability ratios:
Profitability and operating/management efficiency of a firm is judged mainly by the following profitability ratios:
(i) Gross Profit Ratio (%) = Gross Profit / Net Sales * 100
(ii) Net Profit Ratio (%) = Net Profit / Net Sales * 100
Some of the profitability ratios related to investments are:
(iii) Return on Total Assets = Profit Before Interest And Tax / (Fixed Assets Current Assets)
(iv) Return on Capital Employed = Net Profit After Tax / Total Capital Employed (Here, Total Capital Employed = Total Fixed Assets + Current Assets - Current Liabilities)
(v) Return on Shareholders’ Equity = Net profit After-Tax / Average Total Shareholders Equity or Net Worth
(Net worth includes Shareholders’ equity capital plus reserves and surplus) A common (equity) shareholder has only a residual claim on profits and assets of a firm, i.e., only after claims of creditors and preference shareholders are fully met, the equity shareholders receive a distribution of profits or assets on liquidation. A measure of his well being is reflected by return on equity.
There are several other measures to calculate return on shareholders’ equity of which the following are the stock market related ratios:
(i) Earnings Per Share (EPS): EPS measures the profit available to the equity shareholders per share, that is, the amount that they can get on every share held. It is calculated by dividing the profits available to the shareholders by number of outstanding shares. The profits available to the ordinary shareholders are arrived at as net profits after taxes minus preference dividend. It indicates the value of equity in the market.
EPS = Net profit AvailableToThe Shareholder / Number of Ordinary Shares Outstanding
(ii) Price-earnings ratios = P/E Ratio = Market Pr ice per Share / EPS
Abbreviations:NSE- National Stock Exchange of India Ltd.SEBI - Securities Exchange Board of IndiaNCFM - NSE’s Certification in Financial MarketsNSDL - National Securities Depository LimitedCSDL - Central Securities Depository LimitedNCDEX - National Commodity and Derivatives Exchange Ltd.NSCCL - National Securities Clearing Corporation Ltd.FMC – Forward Markets CommissionNYSE- New York Stock ExchangeAMEX - American Stock ExchangeOTC- Over-the-Counter MarketLM – Lead ManagerIPO- Initial Public OfferDP - Depository ParticipantDRF - Demat Request FormRRF - Remat Request FormNAV – Net Asset ValueEPS – Earnings Per ShareDSCR - Debt Service Coverage RatioS&P – Standard & PoorIISL - India Index Services & Products LtdCRISIL- Credit Rating Information Services of India LimitedCARE - Credit Analysis & Research LimitedICRA - Investment Information and Credit Rating Agency of IndiaIGC – Investor Grievance CellIPF – Investor Protection FundSCRA - Securities Contract (Regulation) ActSCRR – Securities Contract (Regulation) Rules