Chapter 6

Financial Statements Analysis

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 FINANCIAL STATEMENTS
ANALYSIS

Ratio Analysis

Common Size Statements

Importance and Limitations of

Ratio Analysis

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 Ratio Analysis

Ratio analysis is a widely used tool of financial analysis. It is

defined as the systematic use of ratio to interpret the
financial statements so that the strengths and
weaknesses of a firm as well as its historical
performance and current financial
condition can be determined.

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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6-3
 Basis of Comparison
1) Trend Analysis involves comparison of a firm over a
period of time, that is, present ratios are compared with
past ratios for the same firm. It indicates the direction of
change in the performance – improvement, deterioration
or constancy – over the years.

2) Interfirm Comparison involves comparing the ratios of a

firm with those of others in the same lines of business or
for the industry as a whole. It reflects the firm’s
performance in relation to its competitors.

3) Comparison with standards or industry average.

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 Types of Ratios

Liquidity
LiquidityRatios
Ratios Capital
CapitalStructure
StructureRatios
Ratios

Profitability
ProfitabilityRatios
Ratios Efficiency
Efficiencyratios
ratios

Integrated
Integrated Growth
GrowthRatios
Ratios
Analysis
AnalysisRatios
Ratios

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 Net Working Capital
Net working capital is a measure of liquidity calculated by
subtracting current liabilities from current assets.

Table 1:  Net Working Capital

Particulars Company A Company B
Total current assets Rs 1,80,000 Rs 30,000
Total current liabilities 1,20,000 10,000
NWC 60,000 20,000
Table 2:  Change in Net Working Capital
Particulars Company A Company B
Current assets Rs 1,00,000 Rs 2,00,000
Current liabilities 25,000 1,00,000
NWC 75,000 1,00,000

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 Liquidity Ratios

Liquidity ratios measure the ability

of a firm to meet its short-term
obligations

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 Current Ratio
Current Ratio is a measure of liquidity calculated dividing
the current assets by the current liabilities

Current Assets
Current Ratio =
Current Liabilities

Particulars Firm A Firm B

Current Assets Rs 1,80,000 Rs 30,000
Current Liabilities Rs 1,20,000 Rs 10,000
Current Ratio = 3:2 (1.5:1) 3:1

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 Acid-Test Ratio
The quick or acid test ratio takes into consideration
the differences in the liquidity of the
components of current assets

Quick Assets
Acid-test Ratio =
Current Liabilities

Quick Assets = Current assets – Stock –

Pre-paid expenses

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 Example 1: Acid-Test Ratio

Cash Rs 2,000
Debtors 2,000
Inventory 12,000
Total current assets 16,000
Total current liabilities 8,000
(1) Current Ratio 2:1
(2) Acid-test Ratio 0.5 : 1

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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 10
 Supplementary Ratios for
Liquidity

Inventory
Inventory Turnover
Turnover Debtors
Debtors Turnover
Turnover Ratio
Ratio
Ratio
Ratio

Creditors
Creditors Turnover
Turnover Ratio
Ratio

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 Inventory Turnover Ratio

The ratio indicates how fast inventory is sold. A high ratio is good
from the viewpoint of liquidity and vice versa. A low ratio
would signify that inventory does not sell fast and stays
on the shelf or in the warehouse for a long time.

Cost of goods sold

Inventory turnover ratio =
Average inventory

The cost of goods sold means sales minus gross profit.

The average inventory refers to the simple average of the opening

and closing inventory.
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 Example 2: Inventory Turnover Ratio

A firm has sold goods worth Rs 3,00,000 with a gross profit margin of
20 per cent. The stock at the beginning and the end of the year
was Rs 35,000 and Rs 45,000 respectively. What is the
inventory turnover ratio?

(Rs 3,00,000 – Rs 60,000)

Inventory 6 (times per
= =
turnover ratio (Rs 35,000 + Rs 45,000) ÷ 2 year)

12 months
Inventory
= = 2 months
holding period Inventory turnover ratio, (6)

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 Debtors Turnover Ratio
The ratio measures how rapidly receivables are collected. A high
ratio is indicative of shorter time-lag between credit sales and
cash collection. A low ratio shows that debts are not
being collected rapidly.

Net credit sales

Debtors turnover ratio =
Average debtors

Net credit sales consist of gross credit sales minus

returns, if any, from customers.

Average debtors is the simple average of debtors (including

bills receivable) at the beginning and at the end of year.

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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 14
 Example 3: Debtors Turnover Ratio

A firm has made credit sales of Rs 2,40,000 during the year. The
outstanding amount of debtors at the beginning and at the end
of the year respectively was Rs 27,500 and Rs 32,500.
Determine the debtors turnover ratio.

Rs 2,40,000
Debtors 8 (times per
= =
turnover ratio (Rs 27,500 + Rs 32,500) ÷ 2 year)

12 Months
Debtors 1.5
= =
collection period Debtors turnover ratio, (8) Months

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 Creditors Turnover Ratio
A low turnover ratio reflects liberal credit terms granted by
suppliers, while a high ratio shows that accounts are to be settled
rapidly. The creditors turnover ratio is an important tool of
analysis as a firm can reduce its requirement of current assets by
relying on supplier’s credit.

Net credit purchases

Creditors turnover
=
ratio Average creditors
Net credit purchases = Gross credit purchases - Returns to
suppliers.

Average creditors = Average of creditors (including bills payable)

outstanding at the beginning and at the end of the year.

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 Example 4: Creditors Turnover Ratio

The firm in previous Examples has made credit purchases of Rs

1,80,000. The amount payable to the creditors at the beginning
and at the end of the year is Rs 42,500 and Rs 47,500
respectively. Find out the creditors turnover ratio.

(Rs 1,80,000)
Creditors 4 (times
= =
turnover ratio (Rs 42,500 Rs 47,500) ÷ 2 per year)

12 months
Creditor’s
= = 3 months
payment period Creditors turnover ratio, (4)

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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 17
 The summing up of the three turnover ratios (known as a cash
cycle) has a bearing on the liquidity of a firm. The cash cycle
captures
the interrelationship of sales, collections from debtors
and payment to creditors.
The combined effect of the three turnover ratios
is summarised below:

Inventory holding period 2   months

Add: Debtor’s collection period + 1.5 months
Less: Creditor’s payment period – 3   months
0.5 months
As a rule, the shorter is the cash cycle, the better are the liquidity
ratios as measured above and vice versa.

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 DEFENSIVE INTERVAL RATIO

Defensive interval ratio is the ratio between quick

assets and projected daily cash requirement.

Liquid assets
Defensive-
=
interval ratio Projected daily cash requirement

Projected cash operating expenditure

Projected daily
=
cash requirement Number of days in a year (365)

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 Example 5: Defensive Interval Ratio

The projected cash operating expenditure of a firm from the

next year is Rs 1,82,500. It has liquid current assets
amounting to Rs 40,000. Determine the
defensive-interval ratio.

Rs 1,82,500
Projected daily cash requirement = = Rs 500
365
Rs 40,000
Defensive-interval ratio = = 80 days
Rs 500

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 Cash-flow From Operations Ratio

Cash-flow from operation ratio measures liquidity of a

firm by comparing actual cash flows from operations
(in lieu of current and potential cash inflows from
current assets such as inventory and debtors)
with current liability.

Cash-flow from operations

Cash-flow from
=
operations ratio Current liabilities

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 Leverage Capital Structure Ratio
There are two aspects of the long-term solvency of a firm:
(i) Ability to repay the principal when due, and
(ii) Regular payment of the interest .
Capital structure or leverage ratios throw light on the
long-term solvency of a firm.

Accordingly, there are two different types of leverage ratios.

First type: These ratios are Second type: These ratios are
computed from the balance computed from the Income
sheet Statement
(a) Debt-equity ratio (a) Interest coverage ratio
(b) Debt-assets ratio (b) Dividend coverage ratio
(c) Equity-assets ratio
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 I. Debt-equity ratio
Debt-equity ratio measures the ratio of long-term or total
debt to shareholders equity.

Long-term Debt + Short

Debt-equity ratio measures
Totalthe ratio of long-term debt + Other Current
Debt
Debt-equity ratiode3bt
term or total = to shareholders equity Liabilities = Total external
Shareholders’ equity Obligations

If the D/E ratio is high, the owners are putting up relatively less
money of their own. It is danger signal for the lenders and
creditors. If the project should fail financially, the
creditors would lose heavily.

A low D/E ratio has just the opposite implications. To the creditors, a
relatively high stake of the owners implies sufficient safety
margin and substantial protection against
shrinkage in assets.
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 23
For the company also, the servicing of debt is less
burdensome and consequently its credit standing
is not adversely affected, its operational flexibility
is not jeopardised and it will be able to
raise additional funds.

The disadvantage of low debt-equity ratio is that

the shareholders of the firm are deprived
of the benefits of trading on equity
or leverage.

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 Trading on Equity
Trading on equity (leverage) is the use of borrowed funds in
expectation of higher return to equity-holders.

Trading on Equity (Amount in Rs thousand)

Particular A B C D   
(a) Total assets 1,000 1,000 1,000 1,000
  Financing pattern:
    Equity capital 1,000 800 600 200
    15% Debt —  200 400 800
(b)Operating profit (EBIT) 300 300 300 300
  Less: Interest —  30 60 120
Earnings before taxes 300 270 240 180
Less: Taxes (0.35) 105 94.5 84 63
Earnings after taxes 195 175.5 156 117
Return on equity (per cent) 19.5 21.9 26 58.5
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 II. Debt to Total Capital
The relationship between creditors’ funds and
owner’s capital can also be expressed using
Debt to total capital ratio.

Total debt
Debt to total capital ratio =
Permanent capital

Permanent Capital = Shareholders’ equity +

Long-term debt.

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 III. Debt to total assets ratio
Total debt
Debt to total assets ratio =
Total assets
Proprietary Ratio
Proprietary ratio indicates the extent to which assets
are financed by owners funds.

Proprietary funds
Proprietary ratio = X 100
Total assets

Capital Gearing Ratio

Capital gearing ratio is used to know the relationship between equity
funds (net worth) and fixed income bearing funds (Preference
shares, debentures and other borrowed funds.

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 Coverage Ratio
Interest Coverage Ratio
Interest Coverage Ratio measures the firm’s ability to make
contractual interest payments.

EBIT (Earning before interest and

Interest coverage ratio = taxes)
Interest

Dividend Coverage Ratio

Dividend Coverage Ratio measures the firm’s ability to pay dividend
on preference share which carry a stated rate of return.

EAT (Earning after taxes)

Dividend coverage ratio =
Preference dividend

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Total fixed charge coverage ratio
Total fixed charge coverage ratio measures the firm’s ability to meet all fixed
payment obligations.

Total fixed charge EBIT + Lease Payment

coverage ratio = Interest + Lease payments + (Preference dividend
+ Instalment of Principal)/(1-t)

Total Cashflow Coverage Ratio 

However, coverage ratios mentioned above, suffer from one major
limitation, that is, they relate the firm’s ability to meet its various
financial obligations to its earnings. Accordingly, it would be
more appropriate to relate cash resources of a firm to its
various fixed financial obligations.

EBIT + Lease Payments + Depreciation + Non-cash expenses

Total cashflow
=
coverage ratio (Principal repayment) (Preference dividend)
Lease payment +
+
+ Interest (1– t) (1 - t)

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 Debt Service Coverage Ratio
Debt-service coverage ratio (DSCR)  is considered a more
comprehensive and apt measure to compute debt
service capacity of a business firm.

n
∑ EATt + Interestt + Depreciationt + OAt
t=1
DSCR = n
∑ Instalmentt
t=1

DEBT SERVICE CAPACITY

Debt service capacity is the ability of a firm to make the
contractual payments required on a scheduled
basis over the life of the debt.
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 30
 Example 6: Debt-Service Coverage Ratio
Agro Industries Ltd has submitted the following projections. You are
required to work out yearly debt service coverage ratio (DSCR)
and the average DSCR.
(Figures in Rs lakh)
Year Net profit for the Interest on term loan Repayment of term
year during the year loan in the year
1 21.67 19.14 10.70
2 34.77 17.64 18.00
3 36.01 15.12 18.00
4 19.20 12.60 18.00
5 18.61 10.08 18.00
6 18.40 7.56 18.00
7 18.33 5.04 18.00
8 16.41 Nil  18.00
The net profit has been arrived after charging depreciation of Rs 17.68 lakh
every year.
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 31
Solution
Table 3:  Determination of Debt Service Coverage Ratio
(Amount in lakh of rupees)
Ye Net Depreciation Interest Cash  Principal  Debt DSCR [col. 5
ar profit available instalment obligation ÷ col. 7
(col. (col. 4 + col. 6) (No. of times)]
2+3+4)
1 2 3 4 5 6 7 8
1 21.67 17.68 19.14 58.49 10.70 29.84 1.96
2 34.77 17.68 17.64 70.09 18.00 35.64 1.97
3 36.01 17.68 15.12 68.81 18.00 33.12 2.08
4 19.20 17.68 12.60 49.48 18.00 30.60 1.62
5 18.61 17.68 10.08 46.37 18.00 28.08 1.65
6 18.40 17.68 7.56 43.64 18.00 25.56 1.71
7 18.33 17.68 5.04 41.05 18.00 23.04 1.78
8 16.41 17.68 Nil  34.09 18.00 18.00 1.89
  Average DSCR (DSCR ÷ 8) 1.83

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 Profitability Ratio
Profitability ratios can be computed either from
sales or investment.

Profitability Ratios Profitability Ratios

Related to Sales Related to Investments
(i) Profit Margin (i) Return on Investments

(ii) Expenses Ratio (ii) Return on Shareholders’

Equity

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 Profit Margin

Gross Profit Margin

Gross profit margin measures the percentage of each sales

rupee remaining after the firm has paid for its goods.

Gross profit margin = Gross Profit

X 100
Sales

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 Net Profit Margin
Net profit margin measures the percentage of each sales rupee
remaining after all costs and expense including interest
and taxes have been deducted.

Net profit margin can be computed in three ways

Earning before interest and taxes

i. Operating Profit Ratio =
Net sales

Earnings before taxes

ii. Pre-tax Profit Ratio =
Net sales

Earning after interest and taxes

iii. Net Profit Ratio = Net sales

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Example 7: From the following information of a firm,
determine (i) Gross profit margin and (ii) Net profit
margin.
1. Sales Rs 2,00,000
2. Cost of goods sold 1,00,000
3. Other operating expenses 50,000

Rs 1,00,000
(1) Gross profit margin = = 50 per cent
Rs 2,00,000

Rs 50,000
(2) Net profit margin = = 25 per cent
Rs 2,00,000

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 Expenses Ratio
Cost of goods sold
i. Cost of goods sold = X 100
Net sales
Administrative exp. + Selling exp.
ii. Operating expenses = X 100
Net sales
Administrative expenses
iii. Administrative expenses = X 100
Net sales
Selling expenses
iv. Selling expenses ratio = X 100
Net sales
Cost of goods sold + Operating expenses
v. Operating ratio = X 100
Net sales
Financial expenses
vi. Financial expenses = X 100
Net sales
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 37
 Return on Investment
Return on Investments measures the overall effectiveness
of management in generating profits with
its available assets.

i. Return on Assets (ROA)

EAT + (Interest – Tax advantage on interest)
ROA =
Average total assets

ii. Return on Capital Employed (ROCE)

EAT + (Interest – Tax advantage on interest)
ROCE =
Average total capital employed

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 Return on Shareholders’ Equity
Return on shareholders equity measures the return on the
owners (both preference and equity shareholders )
investment in the firm.

Return on total shareholders’ equity =

Net profit after taxes
X 100
Average total shareholders’ equity

Return on ordinary shareholders’ equity (Net worth) =

Net profit after taxes – Preference dividend
X 100
Average ordinary shareholders’ equity

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 Efficiency Ratio
Activity ratios measure the speed with which various
accounts/assets are converted into sales or cash.
Inventory turnover measures the efficiency of various types
of inventories.

i. Inventory Turnover Cost

measures theof goods sold
activity/liquidity of
Inventory Turnover Ratio =
Average
inventory of a firm; the speed with whichinventory
inventory is sold

i. Inventory Turnover Cost

measures theofactivity/liquidity
raw materials used
of
Raw materials turnover =
inventory of a firm; the speed with which
Average inventory
raw material is sold
inventory

i. Inventory Turnover measuresCost of goods manufactured

the activity/liquidity of
Work-in-progress turnover =
Average
inventory of a firm; the speed work-in-progress
with which inventory isinventory
sold
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 40
 Debtors Turnover Ratio
Liquidity of a firm’s receivables can be examined
in two ways.

i. Debtors
Inventoryturnover
Turnover Credit sales
i. = measures the activity/liquidity of inventory
of a firm; the speedAverage
with which
debtors
inventory
+ Average
is soldbills receivable (B/R)

Months (days) in a year

2. Average collection period =
Debtors turnover

i. Inventory Months (days)

Turnover in a year
measures the (x) (Average Debtors
activity/liquidity of + Average
inventory of (B/R)
a
Alternatively =
firm; the speed with which inventoryTotal
is credit
sold sales

Ageing Schedule enables analysis to identify

slow paying debtors.
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 41
 Assets Turnover Ratio
Assets turnover indicates the efficiency with which firm
uses all its assets to generate sales.

i. Inventory Turnover measures Cost

the of goods sold of inventory
activity/liquidity
i. Total assets turnover =
of a firm; the speed with which
Average
inventory
total
is assets
sold
Cost of goods sold
ii. Fixed assets turnover =
Average fixed assets
Cost of goods sold
i. Inventory Turnover
iii. Capital turnover = measures the activity/liquidity of inventory
of a firm; the speed with whichAverage
inventorycapital employed
is sold
Cost of goods sold
iv. Current assets turnover =
Average current assets

i. Inventory Turnover measures Cost

the of goods sold of inventory
activity/liquidity
v. Working capital turnover =
of a firm; the speed with which Net working
inventory is capital
sold

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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 42
1) Return on shareholders’ equity = EAT/Average total shareholders’ equity.

2) Return on equity funds = (EAT – Preference dividend)/Average ordinary

shareholders’ equity (net worth).

3) Earnings per share (EPS) = Net profit available to equity shareholders’

(EAT – Dp)/Number of equity shares outstanding (N).

4) Dividends per share (DPS) = Dividend paid to ordinary

shareholders/Number of ordinary shares outstanding (N).

5) Earnings yield = EPS/Market price per share.

6) Dividend Yield = DPS/Market price per share.

7) Dividend payment/payout (D/P) ratio = DPS/EPS.

8) Price-earnings (P/E) ratio = Market price of a share/EPS.

9) Book value per share = Ordinary shareholders’ equity/Number of equity

shares outstanding.
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 43
 Integrated Analysis Ratio
Integrated ratios provide better insight about financial and
economic analysis of a firm.

(1) Rate of return on assets (ROA) can be decomposed in to

(i) Net profit margin (EAT/Sales)
(ii) Assets turnover (Sales/Total assets)
(2) Return on Equity (ROE) can be decomposed in to
(i) (EAT/Sales) x (Sales/Assets) x (Assets/Equity)
(ii) (EAT/EBT) x (EBT/EBIT) x (EBIT/Sales) x (Sales/Assets) x
(Assets/Equity)

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 Rate of Return on Assets

EAT as percentage of Assets

sales turnover

EAT Divided by Sales Sales Divided by Total Assets

Fixed assets Plus Current assets

Gross profit = Sales less
cost of goods sold Alternatively
Minus Shareholder equity
Expenses: Selling Plus
Administrative Interest
Long-term borrowed
Minus funds

Income-tax Plus
Current liabilities

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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 45
 Return on Assets
Earning Power
Earning power is the overall profitability of a firm; is computed
by multiplying net profit margin and
assets turnover.

Earning power = Net profit margin × Assets turnover

Where, Net profit margin = Earning after taxes/Sales
Asset turnover = Sales/Total assets

i. Inventory Earning
Turnover after taxes
measures the Sales of inventory
activity/liquidity EAT
Earning Power = x x
of a firm; the speed withSales
which inventoryTotal
is sold
Assets Total assets

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EXAMPLE: 8
Assume that there are two firms, A and B, each having total assets
amounting to Rs 4,00,000, and average net profits after
taxes of 10 per cent, that is, Rs 40,000, each.

Firm A has sales of Rs 4,00,000, whereas the sales of firm B aggregate

Rs 40,00,000. Determine the ROA of firms A and B. Table 4 shows
the ROA based on two components.

Table 4: Return on Assets (ROA) of Firms A and B

Particulars Firm A Firm B
1. Net sales Rs 4,00,000 Rs 40,00,000
2. Net profit 40,000 40,000
3. Total assets 4,00,000 4,00,000
4. Profit margin (2 ÷ 1) (per cent) 10 1
5. Assets turnover (1 ÷ 3) (times) 1 10
6. ROA ratio (4 × 5) (per cent) 10 10

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 Return on Equity (ROE)
ROE is the product of the following three ratios: Net profit ratio (x)
Assets turnover (x) Financial leverage/Equity multiplier

Three-component model of ROE can be broadened further to

consider the effect of interest and tax payments.

EAT Turnover measures EBIT Net Profit

EBT the activity/liquidity
i. Inventory x x = of
Earnings
inventory before taxes
of a firm; SalesinventorySales
EBITwith which
the speed is sold
As a result of three sub-parts of net profit ratio, the ROE
is composed of the following 5 components.

EAT EBT EBIT Sales Assets

x x x x
EBT EBIT Sales Assets Equity
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 48
A 5-way break-up of ROE enables the management of a firm to analyse the effect of interest
payments and tax payments separately from operating profitability. To illustrate further assume 8
per cent interest rate, 35 per cent tax rate and other operating expense of Rs 3,22,462 (Firm A) and
Rs 39,26,462 (Firm B) for the facts contained in Example 8. Table 5 shows the ROE (based on the
5 components) of Firms A and B.

Table 5: ROE (Five-way Basis) of Firms A and B

Particulars Firm A Firm B
Net sales Rs 4,00,000 Rs 40,00,000
Less: Operating expenses 3,22,462 39,26,462
Earnings before interest and taxes (EBIT) 77,538 73,538
Less: Interest (8%) 16,000 12,000
Earnings before taxes (EBT) 61,538 61,538
Less: Taxes (35%) 21,538 21,538
Earnings after taxes (EAT) 40,000 40,000
Total assets 4,00,000 4,00,000
Debt 2,00,000 2,50,000
Equity 2,00,000 1,50,000
EAT/EBT (times) 0.65 0.65
EBT/EBIT (times) 0.79 0.84
EBIT/Sales (per cent) 19.4 1.84
Sales/Assets (times) 1 10
Assets/Equity (times) 2 1.6
ROE (per cent) 20 16
© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 49
© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 49
 Common Size Statements
Preparation of common-size financial statements is an extension
of ratio analysis. These statements convert absolute sums into
more easily understood percentages of some base amount. It is
sales in the case of income statement and totals of assets and
liabilities in the case of the balance sheet.

Limitations
Ratio analysis in view of its several limitations should be
considered only as a tool for analysis rather than as an end in
itself. The reliability and significance attached to ratios will largely
hinge upon the quality of data on which they are based. They are
as good or as bad as the data itself. Nevertheless, they are an
important tool of financial analysis.

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 50

© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 50