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

Is it right to compare only the returns of the fund with the benchmark?

No. as we have seen earlier, returns have to be studied along with the risk. This means, a fund could have earned higher return than the benchmark. But such higher return may be accompanied by higher risk. Therefore, we have to compare funds with the benchmarks, on a risk-adjusted basis. In order to do this, we compute the return and risk for both the fund and the benchmark, and find out what is the return per unit of risk, earned by each of them. For example, over the same period of a1 year, the risk and return are as follows:
Benchmark:
Return: 12%
Risk (Standard deviation) = 9%
Fund:
Return: 16%
Risk: 11%
We find that the fund has outperformed the be4nchmark in terms of the return that it has earned. However, we also notice that the return is accompanied by a higher level of risk. We can then compute return per unit of risk as follow:
Benchmark: 12/9
Return per unit of risk: 12/9 = 1.33
Fund 16/11
Return per unit of risk: 16/11 = 1.45
We find that the return per unit of risk for the fund is higher. This means that on a risk-adjusted basis, the fund has performed better than the market.

What is the Treynor ratio?

In the example of Sharp ratio, we measures return per unit of standard deviation. Instead if we measured return per unit of beta, we have the Treynor measure of performance. Treynor measure uses the market risk to rank funds, while Sharpe measure uses total return to rank funds.

What is the Sharpe Ratio?

William Sharpe created a metric for fund performance, which enables the ranking of funds on a risk-adjusted basis. This measure is based on the comparison of “excess return” per unit of risk, risk being measure4d by standard deviation. Excess return is defined as the actual return of the fund less the risk free rate. The return on the 90-day treasury bill of the government is taken as the risk-free reat.using the figures as in the example above, and assuming a risk free of 7%. We will be able to compute the Sharpe ratio as follows:
Benchmark:
(12 – 7)/9
0.55

Mutual fund:
(16 – 7) 11
0.75
Since the fund delivering a superior return compared to the benchmark, it is ranked as an out-performer.

Benefits of Investing in Mutual Funds

Mutual Funds provide the services of experienced and skilled professionals, backed by a dedicated investment research team that analyses the performance and prospects of companies and selects suitable investments to achieve the objectives of the scheme.

• Diversification
  

Mutual Funds invest in a number of companies across a broad cross-section of industries and sectors. This diversification reduces the risk because seldom do all stocks decline at the same time and in the same proportion. You achieve this diversification through a Mutual Fund with far less money than you can do on your own.

• Convenient Administration
  

Investing in a Mutual Fund reduces paperwork and helps you avoid many problems such as bad deliveries, delayed payments and follow up with brokers and companies. Mutual Funds save your time and make investing easy and convenient.

• Return Potential
  

Over a medium to long-term, Mutual Funds have the potential to provide a higher return as they invest in a diversified basket of selected securities.

• Low Costs
  

Mutual Funds are a relatively less expensive way to invest compared to directly investing in the capital markets because the benefits of scale in brokerage, custodial and other fees translate into lower costs for investor.

• Liquidity
  

In open-end schemes, the investor gets the money back promptly at net asset value related prices from the Mutual Fund. In closed-end schemes, the units can be sold on a stock exchange at the prevailing market price or the investor can avail of the facility of direct repurchase at NAV related prices by the Mutual Fund.

• Transparency
  

You get regular information on the value of your investment in addition to disclosure on the specific investments made by your scheme, the proportion invested in each class of assets and the fund manager's investment strategy and outlook.

• Flexibility
  

Through features such as regular investment plans, regular withdrawal plans and dividend reinvestment plans, you can systematically invest or withdraw funds according to your needs and convenience.

• Affordability
  

Investors individually may lack sufficient funds to invest in high-grade stocks. A mutual fund because of its large corpus allows even a small investor to take the benefit of its investment strategy.

• Choice of Schemes
  

Mutual Funds offer a family of schemes to suit your varying needs over a lifetime.

• Well Regulated
  

All Mutual Funds are registered with SEBI and they function within the provisions of strict regulations designed to protect the interests of investors. The operations of Mutual Funds are regularly monitored by SEBI.

Rights of a Mutual Fund Unit holder

A unit holder in a Mutual Fund scheme governed by the SEBI (Mutual Funds) Regulations, is entitled to:

• Receive unit certificates or statements of accounts confirming the title within 6 weeks from the date of closure of the subscription or within 6 weeks from the date of request for a unit certificate is received by the Mutual Fund.
  

• Receive information about the investment policies, investment objectives, financial position and general affairs of the scheme.
  

• Recive dividend within 42 days of their declaration and receive the redemption or repurchase proceeds within 10 days from the date of redemption or repurchase.
  

• Vote in accordance with the Regulations to:-
  

1. Approve or disapprove any change in the fundamental investment policies of the scheme, which are likely to modify the scheme or affect the interest of the unit holder. The dissenting unit holder has a right to redeem the investment.
2. Change the Asset Management Company.
3. Wind up the schemes.

• Inspect the documents of the Mutual Funds specified in the scheme's offer document.