CHAPTER 2

2.1 Ratio analysis

Ratio analysis is a quantitative method of gaining insight into a company's liquidity, operational
efficiency, and profitability by studying its financial statements such as the balance sheet and
income statement. Ratio analysis is a cornerstone of fundamental equity analysis. Ratio
analysis can mark how a company is performing over time, while comparing a company to
another within the same industry or sector. Investors and analysts employ ratio analysis to
evaluate the financial health of companies by scrutinizing past and current financial statements.

Significance of ratio analysis

1.Forecasting and Planning :

By calculating ratios of pertinent accounting numbers from the most recent several years, it is
possible to determine the trend in costs, sales, profits, and other facts. Ratio based trend
analysis may be helpful for forecasting and organizing upcoming company activity.

2. Communication:

In informing the owners or other parties about the situation and progress of business concern,
ratios are an excellent communication tools.

3.Decision Making:

When deciding whether to offer a firm credit for the supply of goods or whether to make bank
loans available, among other things.

4.Budgeting:

It is a process of projecting future actions based on information from the past, Budgeted
amounts can be launched using accounting ratios.
5. Efficiency:

Ratio analysis reveals the efficiency level in managing and utilizing its assets, This is how
operating efficiency is measured.

6. Indication of Liquidity position:

Ratio analysis aids in determining a company’s liquidity position or capacity to pay the short
term debts.

7. Inter-firm comparision:

Comparing the performance of two or more businesses exposes which ones efficient and which
ones are not, allowing the latter to take necessary steps to become more efficient.

8. Indicates overall profitability:

Ratios helps the management about profitability of business.

9. Simplify Financial statements:

Ratio analysis makes it simple to understand the connections between different things and aids
in the comprehension of financial statements.

10. Proactive approach:

An organization is sick when it experiences a severe liquidity crisis and consistently fails to earn
a profit. Proper ratio analysis can detect corporate sickness early on, allowing for the prompt
implementation of preventive measures.
2.2 Profitability ratios

Profitability ratios assess a company's ability to earn profits from its sales or operations,
balance sheet assets, or shareholders' equity. They indicate how efficiently a company
generates profit and value for shareholders. These ratios are used to assess a company's
current performance compared to its past performance, the performance of other companies
in its industry, or the industry average. Investors can use them, along with other research, to
determine whether or not a company might be a good investment. Higher profitability ratios
can point to strengths and advantages that a company has.

The two primary groups of profitability ratios are margin and return ratios.

a)MARGIN RATIOS

Gross profit margin

The gross profit margin ratio helps measure how much profit a company generates from its
sales of goods and services after deducting direct costs or the cost of goods sold. Also, a higher
gross profit is a positive indication that the company can cover operating expenses, fixed costs,
depreciation, etc., and generate net income for the company. In contrast, a low gross profit
margin reflects poorly on the company, indicating high selling price, low sales, high costs,
severe market competition etc.

Gross Profit Margin = Gross Profit/ Net Sales

Operating profit margin

Operating margin measures, or a per dollar of sales basis, how much a company makes or loses
from its primary business. As this metric considers not only the loss of sales, but other
components of operating income, such as marketing and overhead, it is considered to be more
complete and a more accurate indicator of a company's ability to generate profit than gross
margin.

Operating Margin = (Operating Income or Loss) / Sales

Net profit margin

The net profit margin measures the company’s overall profitability from its sales after
deducting all direct and indirect expenses. Also, it is the percentage of revenue that remains
after deducting all expenses, interest and taxes.

Net profit margin = Net Income/Sales

Profit before Depreciation, Interest and Tax

PBDIT margin is a measurement of a company’s operating profitability as apercentage of its

total revenue. Because PBDIT excludes interest, depreciation and taxes this can provide an
investor with a clear view of a company’s profitability and cash flow.

PBDIT= Revenue-Expenses (excluding tax, interest, depreciation and amortization)

Profit before Interest and Tax

PBIT is a financial metric that evaluates a company's operating profitability before any tax
charges or interest are deducted. The PBIT meaning is a crucial indicator that assists businesses
in determining their profitability by focusing solely on revenue generated by operations rather
than on external considerations such as tax liabilities and interest payments.

PBIT = Revenue - Operating Expenses

Profit before Tax

Profit Before Tax (PBT) is the measure of the company's profit before the payment of corporate
income tax. It is listed on the income statement of the company.

Profit before tax = revenue – expenses(excluding tax)

Return on Equity

ROE measures how well a company can use its shareholders’ money to generate profits. Also, it
indicates the returns on the sum of money the investors have invested in the company.
Furthermore, ROE is usually watched by investors and analysts. Moreover, a higher ROE ratio
can be one of the reasons to buy a company’s stock. Companies with a high return on equity
can generate cash internally, and thus they will be less dependent on debt financing.

Return on Equity= Net income after taxes/Shareholders Equity x 100

Return on assets

ROA measures how well a company uses its assets to generate profits. In other words, it
focuses on how much profit it generates on every rupee invested. Also, it measures the asset
intensity of the company. Thus, a lower ROA indicates a more asset-intensive company.

Return on assets= Net profit after taxes/Total assets x 100

Return on Capital Employed

ROE measures the company’s overall return against the overall investment of both
shareholders and bondholders. This ratio is very similar to ROE, but it is more comprehensive as
it includes the returns generated from bond holder’s capital investments.

Return on capital employed = EBIT/Capital employed

Asset turnover Ratio

The asset turnover ratio measures the value of a company's sales or revenues relative to the
value of its assets. The asset turnover ratio can be used as an indicator of the efficiency with
which a company is using its assets to generate revenue.

The higher the asset turnover ratio, the more efficient a company is at generating revenue from
its assets. Conversely, if a company has a low asset turnover ratio, it indicates it is not efficiently
using its assets to generate sales.

Asset Turnover= Total Assets/(beginning assets + ending assets/2)

2.3 Liquidity Ratios

A liquidity ratio is a type of financial ratio used to determine a company’s ability to pay its
short-term debt obligations. The metric helps determine if a company can use its current, or
liquid, assets to cover its current liabilities. In other words, we can say this ratio tells how
quickly a company can convert its current assets into cash so that it can pay off its liability on a
timely basis. The liquidity ratio affects the credibility of the company as well as the credit rating
of the company. Hence this ratio plays important role in the financial stability of any company
and credit ratings.

Current Ratio

The current ratio measures a company's ability to pay off its current liabilities (payable within
one year) with its total current assets such as cash, accounts receivable, and inventories. The
higher the ratio, the better the company's liquidity position. A higher ratio indicates the
company has enough liquid assets to cover its short-term debts. In comparison, a low ratio
suggests that the company may not have enough cash or other liquid assets to cover its
immediate liabilities. In general, a Current Ratio of 1:1 or greater is considered healthy.

Current Ratio= Current Assets/Current Liabilities

Quick Ratio

The quick ratio measures a company's ability to meet its short-term obligations with its most
liquid assets and therefore excludes inventories from its current assets. It is also known as
the acid-test ratio. A higher ratio indicates the company has enough liquid assets to cover its
short-term obligations. Comparatively, a lower ratio suggests that the company may be unable
to meet these obligations.

Quick Ratio= (current assets-inventory)/current liabilities

Cash Ratio

The cash ratio is the most stringent of all Liquidity Ratios and measures a company’s ability to
pay off its short-term debt with only cash or cash equivalents. Here, a higher ratio indicates that
the company has enough liquid assets to cover all its short-term obligations without selling any
other assets. A cash ratio of 1:1 or greater is generally considered healthy.

Cash Ratio= cash and cash equivalents/current liabilities

Inventory turnover Ratio

Inventory turnover refers to the amount of time that passes from the day an item is purchased
by a company until it is sold. One complete turnover of inventory means the company sold the
stock that it purchased, less any items lost to damage or shrinkage. The inventory turnover ratio
is the number of times a company has sold and replenished its inventory over a specific amount
of time. The formula can also be used to calculate the number of days it will take to sell the
inventory on hand. Ultimately, the inventory turnover ratio measures how well the company
generates sales from its stock. A higher ratio tends to point to strong sales and a lower one to
weak sales. Conversely, a higher ratio can indicate insufficient inventory on hand, and a lower
one can indicate too much inventory in stock.

Inventory turnover ratio= Cost of goods sold/ average inventory ,

Average inventory=( beginning inventory + ending inventory)/2

Dividend Payout Ratio

The Dividend Payout Ratio (DPR) is the amount of dividends paid to shareholders in relation to
the total amount of net income the company generates .In other words, the dividend payout
ratio measures the percentage of net income that is distributed to shareholders in the form of
dividends. The amount that is not paid to shareholders is retained by the company to pay off
debt or to reinvest in core operations. It is sometimes simply referred to as simply the payout
ratio.

The dividend payout ratio can be calculated as the yearly dividend per share divided by the
earnings per share (EPS), or equivalently, the dividends divided by net income (as shown
below).

Dividend Payout Ratio=Dividends Paid/Net Income​

Dividend Payout Ratio=1−Retention Ratio​

2.4 Valuation Ratios

There are a wide array of ratios that can be used by investors to estimate the attractiveness of
a potential or existing investment and get an idea of its valuation. A valuation ratio measures
the relationship between the market value of a company or its equity and some fundamental
financial metric (e.g., earnings). The point of a valuation analysis is to show the price you are
paying for some stream of earnings, revenue, or cash flow (or other financial metric).

Price to earnings Ratio

The price-to-earnings ratio shows the relationship between the price per share and the
earnings (also known as the net income or profit, essentially the revenue minus cost of sales,
operating expenses, and taxes) per share. This is the amount a common stock investor pays for
a single dollar of earnings.

Price to book value Ratio

Price-to-book or P/B is the ratio of price to book value per share. Book value is the value of an
asset according to its balance sheet account - in other words, it is a company’s value if it
liquidated its assets and paid back all its liabilities.

Price to book value= stock price per share/shareholder’s equity per share
Retention Ratio

The retention ratio is the proportion of earnings kept back in the business as retained earnings.
The retention ratio refers to the percentage of net income that is retained to grow the
business, rather than being paid out as dividends. It is the opposite of the payout ratio, which
measures the percentage of profit paid out to shareholders as dividends. The retention ratio is
also called the plowback ratio. The retention ratio helps investors determine how much money
a company is keeping to reinvest in the company's operations. Growing companies typically
have high retention ratios as they are investing earnings back into the company to grow rapidly.

Retention ratio = Retained earnings/Net income

Or

Retention ratio = net income-dividends distributed/net income

Earnings yield Ratio

The earnings yield is a financial ratio that describes the relationship of a company’s LTM
earnings per share to the company’s stock price per share. The yield is a good ROI metric and
can be used to measure a stocks rate of return. Typically used by investors in assessing their
investment’s rate of return. The ratio can be particularly valuable when comparing potential
returns among different securities.

Earnings yield ratio = Earnings per share/ stock price per share

2.5 Earnings per share

Earnings per share, or EPS, is a standard term used to assess a company's profitability. EPS is
defined as the value of earnings per outstanding share of a company's common stock. In other
words, EPS measures a company's profitability by revealing how much money it can make per
share. Higher EPS can suggest growth and stock price increases.

Earnings per share is also a calculation that shows how profitable a company is on a share
holder basis. So a larger company’s profits per share can be compared to smaller company’s
profits per share. Obviously, this calculation is heavily influenced on how many shares are
outstanding. Thus, a larger company will have to split its earning amongst many more shares of
stock compared to a smaller company. Higher earnings per share is always better than a lower
ratio because this means the company is more profitable and the company has more profits to
distribute to its shareholders.

EPS = (Net income – Preferred dividends) /Weighted average common shares outstanding

2.6 SWOT analysis

SWOT (strengths, weaknesses, opportunities, and threats) analysis is a framework used to

evaluate a company's competitive position and to develop strategic planning. SWOT analysis
assesses internal and external factors, as well as current and future potential.

A SWOT analysis is designed to facilitate a realistic, fact-based, data-driven look at the strengths
and weaknesses of an organization, initiatives, or within its industry. The organization needs to
keep the analysis accurate by avoiding pre-conceived beliefs or gray areas and instead focusing
on real-life contexts. Companies should use it as a guide and not necessarily as a prescription.

A SWOT analysis pulls information internal sources (strengths of weaknesses of the specific
company) as well as external forces that may have uncontrollable impacts to decisions
(opportunities and threats). SWOT analysis works best when diverse groups or voices within an
organization are free to provide realistic data points rather than prescribed messaging.Findings
of a SWOT analysis are often synthesized to support a single objective or decision that a
company is facing.

Components of SWOT analysis

Every SWOT analysis will include the following four categories. Though the elements and
discoveries within these categories will vary from company to company, a SWOT analysis is not
complete without each of these elements:

Strength

Strengths are things that your organization does particularly well, or in a way that
distinguishes you from your competitors. Think about the advantages your organization
has over other organizations. These might be the motivation of your staff, access to certain
materials, or a strong set of manufacturing processes.

Your strengths are an integral part of your organization, so think about what makes it
"tick." What do you do better than anyone else? What values drive your business? What
unique or lowest-cost resources can you draw upon that others can't? Identify and analyze
your organization's Unique Selling Proposition (USP), and add this to the Strengths section.
Then turn your perspective around and ask yourself what your competitors might see as
your strengths.

Weakness

Weaknesses, like strengths, are inherent features of your organization, so focus on your
people, resources, systems, and procedures. Think about what you could improve, and the
sorts of practices you should avoid.

Once again, imagine (or find out) how other people in your market see you. Do they notice
weaknesses that you tend to be blind to? Take time to examine how and why your
competitors are doing better than you.

Opportunities

Opportunities are openings or chances for something positive to happen, but you'll need to
claim them for yourself! They usually arise from situations outside your organization, and
require an eye to what might happen in the future. They might arise as developments in
the market you serve, or in the technology you use. Being able to spot and exploit
opportunities can make a huge difference to your organization's ability to compete and
take the lead in your market.

Think about good opportunities that you can exploit immediately. These don't need to be
game-changers: even small advantages can increase your organization's competitiveness.

Threats

Threats include anything that can negatively affect your business from the outside, such as
supply-chain problems, shifts in market requirements, or a shortage of recruits. It's vital to
anticipate threats and to take action against them before you become a victim of them and
your growth stalls.

Always consider what your competitors are doing, and whether you should be changing
your organization's emphasis to meet the challenge. But remember that what they're
doing might not be the right thing for you to do. So, avoid copying them without knowing
how it will improve your position.

Be sure to explore whether your organization is especially exposed to external challenges.

Importance of SWOT analysis

SWOT Analysis can help you to challenge risky assumptions and to uncover dangerous
blind spots about your organization's performance. If you use it carefully and
collaboratively, it can deliver new insights on where your business currently is, and help
you to develop exactly the right strategy for any situation.

 A SWOT analysis makes complex problems more manageable. There may be an

overwhelming amount of data to analyze and relevant points to consider when making a
complex decision. In general, a SWOT analysis that has been prepared by paring down
all ideas and ranking bullets by importance will aggregate a large, potentially
overwhelming problem into a more digestible report.

 A SWOT analysis requires external consider. Too often, a company may be tempted to
only consider internal factors when making decisions. However, there are often items
out of the company's control that may influence the outcome of a business decision. A
SWOT analysis covers both the internal factors a company can manage and the external
factors that may be more difficult to control.

 A SWOT analysis can be applied to almost every business question. The analysis can
relate to an organization, team, or individual. It can also analyze a full product line,
changes to brand, geographical expansion, or an acquisition. The SWOT analysis is a
versatile tool that has many applications.

 A SWOT analysis leverages different data sources. A company will likely use internal
information for strengths and weaknesses. The company will also need to gather
external information relating to broad markets, competitors, or macroeconomic forces
for opportunities and threats. Instead of relying on a single, potentially biased source, a
good SWOT analysis compiles various angles.

 A SWOT analysis may not be overly costly to prepare. Some SWOT reports do not need
to be overly technical; therefore, many different staff members can contribute to its
preparation without training or external consulting.
A SWOT analysis is a great way to guide business-strategy meetings. It's powerful to have
everyone in the room discuss the company's core strengths and weaknesses, define the
opportunities and threats, and brainstorm ideas. Oftentimes, the SWOT analysis you envision
before the session changes throughout to reflect factors you were unaware of and would never
have captured if not for the group’s input.

A company can use a SWOT for overall business strategy sessions or for a specific segment such
as marketing, production, or sales. This way, you can see how the overall strategy developed
from the SWOT analysis will filter down to the segments below before committing to it. You can
also work in reverse with a segment-specific SWOT analysis that feeds into an overall SWOT
analysis.