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Interpreting Financial Statements

• Income statement
Ratio Analysis • Indicates firm’s revenue, costs, and earnings over a
period of time.
• Balance sheet
Nikunj Patel • Reports book value of all the firm’s assets, liabilities, and
Assistant Professor
owner’s equity at a given point of time.
Institute of Management,
Nirma University,
Ahmedabad

Ratio Objectives of Ratio Analysis

• Ratios are simply relationships between two or more • Standardize financial information for comparisons
financial balances or financial calculations. • Evaluate current operations
• These relationships establish our references so we • Compare performance with past performance
can understand how well we are performing
financially. • Compare performance against other firms or
industry standards
• Study the efficiency of operations
• Study the risk of operations

Rationale Behind Ratio Analysis Ratio Analysis

• A firm has resources • Comparing ratios
• It converts resources into profits through • Evaluate how a firm’s financial condition compares to other firms in
the industry.
• production of goods and services
• sales of goods and services • Limitations of ratio analysis
• Firms might operate in more than one industry - makes comparisons
• Ratios difficult.
• Measure relationships between resources and financial • Accounting practices vary among firms
flows
• Seasonality can impact ratios
• Show ways in which firm’s situation deviates from
• Its own past
• Other firms
• The industry
• All firms

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Major Balance Sheet Items Liquidity Ratios

Liabilities and Equity Assets Liquidity – the ability of the firm to pay
 Fixed assets:
 Shareholders' equity its way
 Long-term liabilities – Tangible assets
 Current liabilities:
– Intangible assets
– Payables  Current assets:
– Short-term debt – Cash & securities
– Receivables
– Inventories

Current Ratio Acid Test

• Looks at the ratio between Current Assets and Current • Also referred to as the ‘Quick ratio’
Liabilities
• (Current assets – stock) : current liabilities
• Current Ratio = Current Assets : Current Liabilities
• 1:1 seen as ideal
• Ideal level? – 2 : 1
• A ratio of 3:1 therefore would suggest the firm has 3 times
• available to cover every 1 it owes
as much cash as it owes – very healthy!
• Too high – Might suggest that too much of its assets are tied
up in unproductive activities – too much stock, for example? • EXAMPLE — Cash is 5,000, Marketable Securities are
15,000, Accounts Receivable are 40,000, and Current
• Too low - risk of not being able to pay your way Liabilities are 80,000. The Acid Test Ratio is ( 5,000 +
• EXAMPLE — Current Assets are 200,000 and Current 15,000 + 40,000) / 80,000 or .75. We have .75 in liquid
Liabilities are 80,000. The Current Ratio is 200,000 / assets for each 1.00 in current liabilities.
80,000 or 2.5. We have 2.5 times more current assets than
current liabilities.

The Cash Ratio Leverage or Gearing Ratios

Cash + Cash Equivalents • Another important group of detail ratios are
𝐶𝑎𝑠ℎ 𝑅𝑎𝑡𝑖𝑜 =
Current Liabilities Leverage Ratios. Leverage Ratios measure the use of
debt and equity for financing of assets.

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Debt to Equity Debt Ratio

• Debt to Equity is the ratio of Total Debt to Total Equity. It • The Debt Ratio measures the level of debt in relation
compares the funds provided by creditors to the funds provided
by shareholders. As more debt is used, the Debt to Equity Ratio to our investment in assets. The Debt Ratio tells us
will increase. Since we incur more fixed interest obligations with the percent of funds provided by long term fund
debt, risk increases. Three variants are suggested in several suppliers and to what extent our assets protect us
references. Generally, the first is used to refer D/E and later is from them. A low Debt Ratio would indicate that we
used as total debt to equity.
have sufficient assets to cover our debt load.
= Total Liabilities / Shareholders’ Equity -- I includes all liabilities Creditors and management favor a low Debt Ratio.
= Total Long Term Liabilities / Shareholders’ Equity -- II Excludes CL • = Total Liabilities / Total Assets
= Total LT Borrowings / Shareholders’ Equity -- III Only LT Debt • EXAMPLE — Total Liabilities are 75,000 and Total Assets
• EXAMPLE — We have total Long term liabilities of 75,000 and total
are 500,000. The Debt Ratio is 15%, 75,000 / 500,000 = .15.
shareholders equity of 200,000. The Debt to Equity Ratio is 37.5%, 75,000 15% of our funds for assets comes from debt.
/ 200,000 = .375. When compared to our equity resources, 37.5% of our
resources are in the form of debt.

Interest Coverage Ratio Activity (Efficiency, turnover) Ratios

• ICR or Times Interest Earned is the number of times
our earnings (before interest and taxes) covers our
• Shows the efficiency of its resources
interest expense. It represents our margin of safety in
making fixed interest payments. A high ratio is
desirable from both creditors and management.
• = Earnings Before Interest and Taxes / Interest Expense
• EXAMPLE — Earnings Before Interest Taxes is 100,000
and we have 10,000 in Interest Expense. Times Interest
Earned is 10 times, 100,000 / 10,000. We are able to cover
our interest expense 10 times with operating income.

Inventory Turnover Days in Inventory

• Inventory Turnover is similar to accounts receivable • Days in Inventory is the average number of days we held our
turnover. We are measuring how many times did we turn our inventory before a sale. A low number of inventory days is
inventory over during the year. Higher turnover rates are desirable. A high number of days implies that management is
desirable. A high turnover rate implies that management unable to sell existing inventory stocks.
does not hold onto excess inventories and our inventories are
360
highly marketable. 𝐷𝑎𝑦𝑠 𝑖𝑛 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦=
Inventory Turnover
Cost of Goods Sold
Inventory Turnover =
Average Inventory • EXAMPLE — If we refer back to the previous example and
• Cost of Goods Sold were 192,000 and the average inventory we use the entire calendar year for measuring inventory, then
balance during the year was 120,000. The Inventory on average we are holding our inventories 225 days before a
Turnover Rate is 1.6 or we were able to turn our inventory sale. 360 / 1.6 = 225 days.
over 1.6 times during the year.

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The Debtors Turnover Ratio The Average Collection Period

• Debtors Turnover measures the number of times we were • The Number of Days in Accounts Receivable is the average
able to convert our receivables over into cash. Higher length of time required to collect our receivables. A low
turnover ratios are desirable. number of days is desirable.
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 Average Accounts Receivable
𝐷𝑒𝑏𝑡𝑜𝑟𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = Average Collection Period=
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 Re𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 Annual Credit SalesΤ360

• EXAMPLE — Credit Sales are 480,000, the average • EXAMPLE — If we refer to our previous example and we
receivable balance during the year was 40,000 and we have a base our calculation on the full calendar year, we would
20,000 allowance for sales returns. Debtors Turnover is require 32 days on average to collect our receivables. 360/
(480,000 - 20,000) / 40,000 or 11.5. We were able to turn 11.5 = 31.30 days.
our receivables over 11.5 times during the year.

The Fixed Asset Turnover Ratio The Total Asset Turnover Ratio

Sales Sales
Fixed Asset Turnover = Total Asset Turnover =
Average Net Fixed Assets Average Total Assets

Profitability Ratio Profitability

Profitability – how effective the firm is at • Profitability measures look at how much profit the
firm generates from sales or from its capital assets
generating profits given sales and or its capital
assets • Different measures of profit – gross and net
• Gross profit – effectively total revenue (turnover) –
variable costs (cost of Goods Sold)
• Net Profit – effectively total revenue (turnover) – variable
costs and fixed costs (overheads)

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Gross Profit Margin Net Profit Margin

• Gross Profit Margin = Gross profit / turnover x • Net Profit Margin = Net Profit / Turnover x 100
100
• Net profit takes into account the fixed costs involved in
• The higher the better production – the overheads
• Enables the firm to assess the impact of its sales and
how much it cost to generate (produce) those sales
• A gross profit margin of 45% means that for every 1
of sales, the firm makes 45p in gross profit

Return on Total Assets Return on Net Assets or Capital Employed

• Return on Assets measures the net income returned on each • Return on Net Assets measures the net income returned on
of assets. This ratio measures overall profitability from our net assets. This ratio measures overall profitability from our
investment in assets. Higher rates of return are desirable. investment in net assets. Higher rates of return are desirable.

• = Profit After Tax / Avg. Total Assets x 100 • = Profit After Tax / (Total Assets – CL) x 100
• EXAMPLE — PAT is 60,000 and average total assets for
• EXAMPLE — PAT is 60,000 and average total the year are 500,000 and CL of 100000. This gives us a 15%
assets for the year are 500,000. This gives us a 12% return on Net assets, 60,000 / (500000-100000) = .15.
return on assets, 60,000 /500000= .12.

Earning Power The Return on Equity

• For publicly traded companies, the relationship of earnings

• = EBIT / Total Assets x 100 to equity or Return on Equity is of prime importance since
management must provide a return for the money invested
• EXAMPLE — EBIT is 50,000 and total assets for the year by shareholders. Return on Equity is a measure of how well
are 500,000 and CL of 100000. This gives us a 10% earning management has used the capital invested by shareholders.
power. Return on Equity tells us the percent returned for each rupee
invested by shareholders.

PAT
ROE =
Avg. Share Holders’ Equity

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Market Standing (Valuation) Ratios Earnings Per Share

• These ratios attempt to measure the economic status • Growth in earnings is often monitored with Earnings
of the organization within the marketplace. Investors per Share (EPS). The EPS expresses the earnings of
use these ratios to evaluate and monitor the progress a company on a "per share" basis. A high EPS in
of their investments. comparison to other competing firms is desirable.
• = Earnings Available to Common Shareholders / Number
of Common Shares Outstanding
• EXAMPLE — Earnings are 100,000 and preferred
stock dividends of 20,000 need to be paid. There are
a total of 80,000 common shares outstanding.
Earnings per Share (EPS) is ( 100,000 - 20,000) /
80,000 shares outstanding or 1.00 per share.

P / E Ratio Book Value per Share

• The relationship of the price of the stock in relation to EPS is • Book Value per Share expresses the Shareholders’ Equity of a
expressed as the Price to Earnings Ratio or P / E Ratio. business on a per share basis. This allows us to compare the
Investors often refer to the P / E Ratio as a rough indicator book values of a business to the stock price and gauge
of value for a company. A high P / E Ratio would imply that differences in valuations.
investors are very optimistic (bullish) about the future of the • = Shareholders’ Equity/ Outstanding Common Shares
company since the price (which reflects market value) is selling
for well above current earnings. A low P / E Ratio would • EXAMPLE — Total share holders’ Equity is 46,00,000. The
imply that investors view the company's future as poor and total number of common shares outstanding is 80,000 shares.
thus, the price the company sells for is relatively low when Book Value per Share is 46,00,000 / 80,000 or 57.50
compared to its earnings.
• = Price of Stock / Earnings per Share
• EXAMPLE — Earnings per share is 3.00 and the stock is
selling for 36.00 per share. The P / E Ratio is 36 / 3 or 12.
The company is selling for 12 times earnings.

Dividend Yield The DuPont System

• The percentage of dividends paid to shareholders in relation
to the price of the stock is called the Dividend Yield. For
investors interested in a source of income, the dividend yield ROE
is important since it gives the investor an indication of how
much dividends are paid by the company. ROA Equity Multiplier
• = Dividends per Share / Price of Stock
• EXAMPLE — Dividends per share are 2.10 and the price of Profit Margin Total Asset Turnover
the stock is 30.00 per share. The Dividend Yield is 2.10 /
30.00 or 7%

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The DuPont System The DuPont System

ROE ROE

ROA Equity Multiplier ROA Equity Multiplier

Profit Margin Total Asset Turnover Profit Margin Total Asset Turnover

ROE  ROA  Equity Multiplier ROA  Profit Margin  Total Asset Turnover
PAT Total Assets PAT Sales
   
Total Assets Net Worth Sales Total Assets

The DuPont System

ROE

ROA Equity Multiplier

Profit Margin Total Asset Turnover

ROE  Profit Margin  Total Asset Turnover  Equity Multiplier

PAT Sales Total Assets
  
Sales Total Assets Net Worth