FINANCIAL RATIO ANALYSIS

BY.DR.SAYLEE GHARGE

Reference: Financial Management (Theory and practice) by Prasanna Chandra

 Introduction
 Financial statements is often not enough to form conclusive judgments about firm
performance, financial statements do provide important clues about what needs to be
examined in greater detail.
 Analysis of financial statements is of interest to lenders (short-term as well as long-
term), investors, security analysts, managers, corporate boards, regulators etc.
 Financial statement analysis may be done for a variety of purposes, which may range
from a simple analysis of the short-term liquidity position of the firm to a
comprehensive assessment of the strengths and weaknesses of the firm in various areas.
 It is helpful in assessing corporate excellence, judging creditworthiness, forecasting bond
ratings, predicting bankruptcy, and assessing market risk.
 Introduction
 A ratio is an arithmetical relationship between two figures.
 Financial ratio analysis is a study of ratios between various items or groups of
items in financial statements. Ratio analysis refers to the analysis of various
pieces of financial information in the financial statements of a business.
 They are mainly used by external analysts to determine various aspects of a
business, such as its profitability, liquidity, and solvency.
 Analysts rely on current and past financial statements to obtain data to evaluate
the financial performance of a company.
 They use the data to determine if a company’s financial health is on an upward or
downward trend and to draw comparisons to other competing firms.
 Ratio Analysis
Utility of the Ratio Analysis are:
1.Easy to understand the financial position of the firm: The ratio analysis facilitates the
parties to read the changes taken place in the financial performance of the firm from
one time period to another.
2.Measure of expressing the financial performance and position: It acts as a measure
of financial position through Liquidity ratios and Leverage ratios and also a measure of
financial performance through Profitability ratios and Turnover Ratios.
3.Intra-firm analysis on the financial information over many number of years: The
financial performance and position of the firm can be analyzed and interpreted with in
the firm in between the available financial information of many number of years; which
portrays either increase or decrease in the financial performance.
 Ratio Analysis
4.Inter-firm analysis on the financial information within the industry: The
financial performance of the firm is studied and interpreted along with the
similar firms in the industry to identify the presence and status of the respective
firm, among others.
5.Possibility for Financial planning and control: It not only guides the firm to
earn in accordance with the financial forecasting but also facilitates the firm to
identify the major source of expense which drastically has greater influence on
the earnings.
 Limitations of the Ratio Analysis
1.It is dependent tool of analysis: The perfection and effectiveness of the analysis
mainly depends upon the preparation of accurate and effectiveness of the financial
statements. It is subject to the availability of fair presentation of data in the financial
statements.
2. Ambiguity in the handling of terms: If the tool of analysis taken for the study of inter
firm analysis on the profitability of the firms lead to various complications. To study the
profitability among the firms, most required financial information are profits of the
enterprise.
 Limitations of the Ratio Analysis
The profit of one enterprise is taken for analysis is Profit After Taxes (PAT) and
another is considering Profit Before Interest and Taxes (PBIT) and third one is
taking Net profit for study consideration. The term profit among the firms for the
inter firm analysis is getting complicated due to ambiguity or poor clarity on the
terminology.
3.Qualitative factors are not considered: Under the ratio analysis, the quantitative
factors only taken into consideration rather than qualitative factors of the
enterprise. The qualitative aspects of the customers and consumers are not
considered at the moment of preparing the financial statements but while granting
credit on sales is normally considered.
 Limitations of the Ratio Analysis
4.Not ideal for the future forecasts: Ratio analysis is an outcome of analysis of
historical transactions known as Postmortem Analysis. The analysis is mainly based
on the yester performance which influences directly on the future planning and
forecasting ; it means that the analysis is mainly constructed on the past information
which will also resemble the same during the future analysis.
5.Time value of money is not considered: It does not give any room for time value of
money for future planning or forecasting of financial performance; the main reason is
that the fundamental base for forecasting is taken from the yester periods which
never denominate the timing of the benefits
Financial ratios have been classified in several ways. We divide
them into five broad categories as follows:
■ Liquidity ratios
■ Solvency/Leverage ratios
■ Activity/Turnover ratios
■ Profitability ratios
■ Valuation ratios
To facilitate the
discussion of
various ratios the
financial statement of
Horizon Limited, shown
in Exhibits 4.1 and 4.2,
will be used

.
 Liquidity Ratios
Liquidity refers to the ability of a firm to meet its obligations in the short run, usually
one year. Liquidity ratios are generally based on the relationship between current assets
(the sources for meeting short-term obligations) and current liabilities (the obligations
which will mature in the short-run).

The important liquidity ratios are:

 Current ratio
 Acid-test ratio/ Quick ratio
 Cash ratio
 Liquidity Ratios
1.Current Ratio: A very popular ratio, the current ratio is defined as:

Current assets include cash, current investments, debtors, inventories

(stocks), loans and advances, and pre-paid expenses.
Current liabilities represent liabilities that are expected to mature in the
next twelve months. These comprise (i) loans, secured or unsecured, that
are due in the next twelve months and (ii) current liabilities and provisions.
Horizon Limited's current ratio for 20X1 is 237/180 = 1.32
 Liquidity Ratios
 The current ratio measures the ability of the firm to meet its current liabilities –
current assets get converted into cash during the operating cycle of the firm and
provide the funds needed to pay current liabilities. Apparently, the higher the
current ratio, the greater the short-term solvency. However, in interpreting the
current ratio the composition of current assets must not be overlooked.
 A firm with a high proportion of current assets in the form of cash and debtors is
more liquid than one with a high proportion of current assets in the form of
inventories even though both the firms have the same current ratio.
 The general norm for current ratio in India is 1.33. Internationally it is 2.
 Liquidity Ratios
2. Acid-test Ratio Also called the quick ratio, the acid-test ratio is defined as:

Quick assets are defined as current assets excluding inventories.

Horizon's acid-test ratio for 20X1 is: (237-105)/180 = 0.73
The acid-test ratio is a stringent measure of liquidity. It is based on those current
assets which are highly liquid - inventories are excluded from the numerator of this
ratio because inventories are deemed to be the least liquid component of current
assets.
 Liquidity Ratios
3. Cash Ratio : Because cash, bank balances and short-term marketable securities are the
most liquid assets of a firm, financial analysts look at cash ratio, which is defined as:

Horizon's cash ratio for 20X1 is: (10+3)/180 = 0.07

Clearly, the cash ratio is perhaps the most stringent measure of liquidity.
Indeed, one can argue that it is overly stringent. Lack of immediate cash may not
matter if the firm can stretch its payments or borrow money at short notice.
 Net Working Capital Ratio

 The difference between current assets and current liabilities excluding short-term bank
borrowing is called net working capital (NWC) or net current assets (NCA).
 NWC is sometimes used as a measure of a firm’s liquidity. It is considered that, between
two firms, the one having the larger NWC has the greater ability to meet its current
obligations. This is not necessarily so; the measure of liquidity is a relationship, rather
than the difference between current assets and current liabilities.
 NWC, however, measures the firm’s potential reservoir of funds. It can be related to net
assets (or capital employed):
 Solvency/Leverage Ratios
Financial leverage refers to the use of debt finance. While debt capital is a cheaper
source of finance, it is also a riskier source of finance. Leverage ratios help in assessing
the risk arising from the use of debt capital.
Two types of ratios are commonly used to analyze financial leverage:
 Structural ratios
 Coverage ratios
Structural ratios are based on the proportions of debt and equity in the financial
structure of the firm. The important structural ratios are:
 Debt-equity ratio
 Debt-assets ratio
 Equity Multiplier
 Solvency/Leverage Ratios
Coverage ratios show the relationship between debt servicing commitments and the
sources for meeting these burdens. The important coverage ratios are:
 Interest coverage ratio,
 Fixed charges coverage ratio,
 Debt service coverage ratio.

Debt-equity Ratio: The debt-equity ratio shows the relative contributions of creditors and
owners. It is defined as: Debt/Equity
Horizon's debt-equity ratio for the 20X1 year-end is: 212 / 262 = 0.809

The numerator of this ratio consists of all debt, short-term as well as long-term, and the
denominator consists of net worth plus preference capital, plus deferred tax liability.
 Leverage Ratios

In general, the lower the debt-equity ratio, the higher the degree of protection enjoyed by
the creditors. In using this ratio, however, the following points should be borne in mind:
■ The book value of equity may be an understatement of its true value in a period of rising
prices. This happens because assets are carried at their historical values less depreciation,
not at current values.
■Some forms of debt (like term loans, secured debentures, and secured short-term bank
borrowing) are usually protected by charges on specific assets and hence enjoy superior
protection.
 Leverage Ratios
Debt-asset Ratio: The debt-asset ratio measures the extent to which borrowed funds
support the firm's assets. It is defined as:

The numerator of this ratio includes all debt, short-term as well as long-term, and the
denominator of this ratio is the total of all assets (the balance sheet total).
Horizon's debt-asset ratio for 20X1 is: 212 / 488 = 0.43

This ratio is related to the debt-equity ratio as follows:

In view of the above relationship, the interpretation of the debt ratio is similar to that
of the debt equity ratio.
 Leverage Ratios
Equity Multiplier: Equity Multiplier: Total Assets/Equity
With debt ratio of 50%,equity will be 0.5 times the total assets and so equity multiplier
will become 2(1/0.5).The interpretation of equity multiplier is the same as that of debt
ratio and debt equity ratio.

Problem:
A company has total assets worth 58 lakh. The equity capital including reserves
amounts to 28 lakh and debt portion is 30 lakh.
Find Debt Equity ratio and equity multiplier.
 Leverage Ratios
Interest Coverage Ratio (Times Interest Earned-TIE) is defined as:

Horizon's interest coverage ratio for 20X1 is: 89/21 = 4.23

Note that profit before interest and taxes is used in the numerator of this ratio because the
ability of a firm to pay interest is not affected by tax payment, as interest on debt funds is a
tax-deductible expense.
A high interest coverage ratio means that the firm can easily meet its interest burden
even if profit before interest and tax suffers a considerable decline.
 Leverage Ratios
A low interest coverage ratio may result in financial embarrassment when profits
before interest and tax declines. This ratio is widely used by lenders to assess a firm's
debt capacity. Further, it is a major determinant of bond rating.

Though widely used, this ratio is not a very appropriate measure of interest coverage
because the source of interest payment is cash flow before interest and taxes, not
profit before interest and taxes. In view of this, we may use a modified interest
coverage ratio:

Horizon's modified interest coverage ratio for 20X1 is; 119 / 21 = 5.67.
 Leverage Ratios
Fixed Charges Coverage Ratio: This ratio shows how many times the cash flow before
interest and tax covers all fixed financing charges. It is defined as:

In the denominator of this ratio only the repayment of loan is adjusted upwards for the
tax factor because the loan repayment amount, unlike interest, is not tax deductible.
Horizon’s tax rate has been assumed to be 50 percent.

Horizon's fixed charges coverage ratio for 20X1 is:

 Leverage Ratios
This ratio measures debt servicing ability comprehensively because it considers
both the interest and the principal repayment obligations. The ratio may be
amplified to include other fixed charges like lease payment and preference
dividends.
The fixed charge coverage ratio has to be interpreted with care because short-
term loan funds like working capital loans and commercial paper tend to be
self-renewing in nature and hence do not have to be ordinarily repaid from
cash flows generated by operations. Hence, a fixed charge coverage ratio of less
than 1 need not be viewed with much concern.
 Leverage Ratios
Debt Service Coverage Ratio: Used by financial institutions in India, the debt
service coverage ratio (DSCR) is defined as:

Financial institutions calculate the average DSCR for the period during which
the term loan for the project is repayable and regard a DSCR of 1.5 to 2.0 as
satisfactory.
 Turnover Ratios/Activity Ratios/Efficiency Ratios
Turnover ratios, also referred to as activity ratios or asset management ratios,
measure how efficiently the assets are employed by a firm. These ratios are based
on the relationship between the level of activity, represented by sales or cost of
goods sold, and the levels of various assets. The important turnover ratios are:
 Inventory turnover,
 Average collection period,
 Receivables turnover,
 Fixed assets turnover,
 Total assets turnover
 Turnover Ratios/Activity Ratios/Efficiency Ratios
Inventory Turnover or stock turnover, measures how fast the inventory is moving
through the firm and generating sales.
It is defined as:

Horizon's inventory turnover for 20X1 is:

The inventory turnover reflects the efficiency of inventory management. The higher the
ratio, the more efficient the management of inventories and vice versa. However, this
may not always be true.
 Turnover Ratios/Activity Ratios/Efficiency Ratios

 A high inventory turnover may be caused by a low level of inventory

which may result in frequent stockouts and loss of sales and customer
goodwill.
 Since inventories tend to change over the year, we use the average of
the inventories at the beginning and the end of the year.
 In general, averages may be used when a flow figure (such as cost of
goods sold) is related to a stock figure (such as inventories).
 Turnover Ratios/Activity Ratios/Efficiency Ratios
Debtors' Turnover: This ratio shows how many times sundry debtors (accounts
receivable) turn over during the year. It is defined as:

If the figure for net credit sales is not available, one may have to make do with the net
sales figure.
Horizon's debtors' turnover for 20X1 is: 701 / [(114 +68) / 2] = 7.70
Obviously, the higher the debtors' turnover the greater the efficiency of credit
management
 Turnover Ratios/Activity Ratios/Efficiency Ratios
Average Collection Period The average collection period represents the number of days'
worth of credit sales that is locked in sundry debtors. It is defined as:

If the figure for credit sales is not available, one may have to make do with the net sales
figure.
 Turnover Ratios/Activity Ratios/Efficiency Ratios
 The average collection period may be compared with the firm's credit terms to
judge the efficiency of credit management.
 For example, if the credit terms are 2/10, net 55, an average collection period of 55
days means that the collection is slow, and an average collection period of 40 days
means that the collection is prompt.
 An average collection period which is shorter than the credit period allowed by the
firm needs to be interpreted carefully.
 It may mean efficiency of credit management or excessive conservatism in credit
granting that may result in the loss of some desirable sales.
NOTE: 2/10 net 55 means that if the amount due is paid within 10 days, the customer will
enjoy a 2% discount. Otherwise, the amount is due in full within 55 days.
 Turnover Ratios/Activity Ratios/Efficiency Ratios
Fixed Assets Turnover: This ratio measures sales per rupee of investment in fixed
assets. It is defined as:

This ratio is supposed to measure the efficiency with which fixed assets are employed - a
high ratio indicates a high degree of efficiency in asset utilisation and a low ratio reflects
inefficient use of assets. However, in interpreting this ratio, one caution should be borne
in mind. When the fixed assets of the firm are old and substantially depreciated, the fixed
assets turnover ratio tends to be high because the denominator of the ratio is very low.
 Turnover Ratios/Activity Ratios/Efficiency Ratios
Total Assets Turnover: It is the output-capital ratio in economic analysis, the
total assets turnover is defined as:

This ratio measures how efficiently assets are employed, overall.

 Profitability Ratios
Profitability reflects the result of business operations.
There are two types of profitability ratios:
 Profit margins ratios
 Rate of return ratios
Profit margin ratios show the relationship between profit and sales. Since profit
can be measured at different stages, there are several measures of profit margin.
The most popular profit margin ratios are:
 Gross profit margin ratio,
 Operating profit margin ratio,
 Net profit margin ratio.
 Profitability Ratios

Rate of return ratios reflect the relationship between profit and

investment. The important rate of return measures are:
 Return on assets
 Earning power
 Return on capital employed
 Return on equity.
 Profitability Ratios
Gross Profit Margin Ratio :
The gross profit margin ratio is defined as:

Gross profit is defined as the difference between net sales and cost of goods sold.
Horizon's gross profit margin ratio for 20X1 is:
149 / 701 = 0.213 or 21.3 percent
This ratio shows the margin left after meeting manufacturing costs. It measures
the efficiency of production as well as pricing. To analyse the factors underlying
the variation in gross profit margin the proportion of various elements of cost
(labour, materials, and manufacturing overheads) to sales may be studied in detail.
 Profitability Ratios

Operating Profit Margin Ratio The operating profit margin ratio is defined as:

Horizon's operating profit margin ratio for 20 x 1 is: 89/701 = 0.127 or 12.7 percent
This ratio shows the margin left after meeting manufacturing expenses, selling, and
administration expenses (SG&A), and depreciation charges.
It reflects the operating efficiency of the firm.
 Profitability Ratios
Net Profit Margin Ratio The net profit margin ratio is defined as:

Horizon's net profit margin ratio for 20X1 is: 34 / 701 = 0.049 or 4.9 percent
 This ratio shows the earnings left for shareholders (both equity and preference) as a
percentage of net sales.
 It measures the overall efficiency of production, pricing, administration, selling,
financing, and tax management.
 Jointly considered, the gross and net profit margin ratios provide a valuable
understanding of the cost and profit structure of the firm and enable the analyst to
identify the sources of business efficiency/ inefficiency
 Profitability Ratios

Return on Assets The return on assets (ROA) is defined as:

Horizon's ROA for 20X1 is:

Though widely used, ROA is an odd measure because its numerator measures the
return to shareholders (equity and preference) whereas its denominator represents
the contribution of all investors (shareholders as well as lenders).
 Profitability Ratios
Earning Power, The earning power is defined as:

Horizon's earning power for 20X1 is:

Earning power is a measure of business performance which is not affected by
interest charges and tax burden. It abstracts away the effect of capital structure and
tax factor and focuses on operating performance. Hence it is eminently suited for
inter-firm comparison. Further, it is internally consistent. The numerator represents
a measure of pre-tax earnings belonging to all sources of finance and the
denominator represents total financing.
 Earnings per Share (EPS)
The earnings per share (EPS) is calculated by dividing the profit after taxes by the total
number of ordinary shares outstanding

Dividend per Share (DPS or DIV)

The net profits after taxes belong to shareholders. But the income, which they really
receive, is the amount of earnings distributed as cash dividends. Therefore, a large
number of present and potential investors may be interested in DPS, rather than EPS.
DPS is the earnings distributed to ordinary shareholders divided by the number of
ordinary shares outstanding:
Dividend Pay out Ratio
 Profitability Ratios
Return on Capital Employed (ROCE) The return on capital employed is defined as:

The numerator of this ratio is profit before interest and tax (1-tax rate), is also called net
operating profit after tax (NOPAT).
Horizon's ROCE for 20X1 is:
ROCE is the post-tax version of earning power. It is also referred to as the return on
invested capital (ROIC). It considers the effect of taxation, but not the capital structure. It
is internally consistent. Its merit is that it is defined in such a way that it can be compared
directly with the post-tax weighted average cost of capital of the firm.
 Profitability Ratios
Return on Equity A measure of great interest to equity shareholders, the return on
equity (ROE) is defined as:

The numerator of this ratio is equal to profit after tax less preference dividends. The
denominator includes all contributions made by equity shareholders (paid-up capital +
reserves and surplus). This ratio is also called the return on net worth.
Horizon's return on equity for 20X1 is:
The return on equity measures the profitability of equity funds invested in the firm.
Because maximizing shareholder wealth is the dominant financial objective, ROE is the
most important measure of performance in an accounting sense.
 Profitability Ratios
 It is influenced by several factors: earning power, debt-equity ratio, average cost of
debt funds, and tax rate. ROA and ROE are commonly used measures. Hence these
measures may be properly referred to as return on book assets and return on book
equity.
 The historical valuation of assets imparts an upward bias to profitability measures
during an inflationary period. This happens because the numerator of these
measures represents current values, whereas the denominator represents
historical values.
 Valuation Ratios
Valuation ratios (Market ratios) indicate how the equity stock of the company is
assessed in the capital market. Since the market value of equity reflects the combined
influence of risk and return, valuation ratios are the most comprehensive measures of
a firm's performance.
The important valuation ratios are:
 Yield
 Price-earnings ratio,
 Market value to book value ratio
 զ ratio.
 Valuation Ratios
Yield : A measure of total return to equity shareholders,

Yield is defined as:

1.87+(21-20)/20 = 0.1435

Yield represents the rate of return actually earned by equity shareholders. It is compared
with the rate of return required by equity shareholders.

Price-earnings(P/E) Ratio Perhaps the most popular financial statistic in stock market, the
price-earnings ratio is defined as:
 Valuation Ratios
The market price per share may be the price prevailing on a certain day or the average
price over a period. The earnings per share is simply: profit after tax less preference
dividend divided by the number of outstanding equity shares.

The price-earnings ratio (or the price-earnings multiple as it is commonly referred to) is a
summary measure which primarily reflects the following factors: growth prospects, risk
characteristics, shareholder orientation, corporate image, and the degree of liquidity.
 Valuation Ratios
EV-EBITDA Ratio A widely used multiple in company valuation, the EV-EBTTDA ratio
is defined as:

EV is the sum of the market value of equity and the market value of debt. The market
value of equity is simply the number of outstanding equity shares times the price per
share. As far as debt is concerned, if it is in the form of traded debt securities, its market
value can be observed. If the debt is in the form of loans, its market value has to be
imputed. Generally, a rupee of loan is deemed to have a rupee of market value.

EV-EBTTDA is supposed to reflect profitability, growth, risk, liquidity, and corporate image.
 Valuation Ratios
Market Value to Book Value Ratio Another popular stock market statistic, the market value to
book value is defined as:

In a way, this ratio reflects the contribution of a firm to the wealth of society. When this ratio
exceeds 1 it means that the firm has contributed to the creation of wealth in the society - if
this ratio is, say, 2, the firm has created a wealth of one rupee for every rupee invested in it.
When this ratio is equal to 1, it implies that the firm has neither contributed to nor detracted
from the wealth of society.
 Valuation Ratios
It may be emphasized here that if the market value to book value ratio is equal to 1, all
the three ratios, namely, return on equity, earnings-price ratio and total yield, are equal.

Q Ratio Proposed by James Tobin, the q ratio is defined as:

The q ratio resembles the market value to book value ratio. However, there are two key
differences: (i) The numerator of the q ratio represents the market value of equity as
well as debt, not just equity, (ii) The denominator of the q ratio represents all assets.
 Working Capital Ratios
Working capital is the outlay needed to carry out the day to day operations of the
company once the broad fixed assets are in place. Thus, companies have to arrange for
funds in respect of cash balance required to carry on operations, the stock of inventory
and the amount locked up because customers take sometime to pay after the sale has
been made.

Number of days of inventory: It shows inventory level in terms of the number of days of
sales. At first step calculate daily sales (Annual sales/365) .The inventory is then divided by
the daily sales.

Number of days of Inventory: Inventory/Daily sales

 Working Capital Ratios
Days sales outstanding (DSO): With this ratio, companies calculate the number of
days of sale that is represented by the receivables that are to be collected.

Days sales outstanding: Receivables / (Sales/365)

Companies keep monitoring this regularly. Long delays in the receipts of dues result in loss of
interest on working capital and also the risk of the account defaulting(becoming bad debt).
It calculates the daily sales first and divides the receivables with this daily sales. If this
number exceeds the number of days stipulated in our invoice of sale as the days allowed for
payment, we have reason to be worried.
A comparison of DSO over the past few years and also with that of the competitors will
throw light on the pace of collection and the need for any action to remedy the situation.
 Working Capital Ratios

Days Payable: Calculate the number of days of purchases that remain unpaid by
us,by using the days payable ratio. This is calculated as:

Purchases/Daily sales
The ratio needs to be compared with the contracted days by which we need to
make payments against our purchases.

Suppose the average invoice period for our purchases in 30 days and we have the
above ratio as 22,then it would suggest that we are paying faster than strictly
necessary.
Horizon Limited has a favorable liquidity position. All the liquidity ratios of Horizon
Limited are higher than the industry average.
Leverage ratios of Horizon Limited are a shade lower than the industry
average.
Turnover ratios of Horizon Limited are more or less comparable with the industry average.
Profit margin ratios of Horizon Limited are somewhat higher than the industry average.
The rate of return measures of Horizon Limited are also higher than the industry average.
Valuation ratios of Horizon Limited compare slightly favorably in relation to industry
average.
Exhibit 4.4 presents certain selected ratios for Horizon Limited for a period of five years.
■ The debt-equity ratio improved for 2 years in succession but deteriorated in the last year.
■ The total assets turnover ratio remained more or less the same.
■ The net profit margin ratio improved impressively in the second year but subsequently
declined somewhat steeply over the remaining three years.
■ The return on equity followed the pattern of the net profit margin ratio.
■ The price-earnings ratio deteriorated steadily over time except in the last year.
 DuPONT ANALYSIS

 Such a decomposition helps in understanding how the return on total assets is

influenced by the net profit margin and the total assets turnover ratio.
 The upper side of the DuPont chart shows the details underlying the net profit
margin ratio.
 An examination of this side may indicate areas where cost reductions may be
affected to improve the net profit margin.
 If this is supplemented by comparative common size analysis, it becomes relatively
easier to understand where cost control efforts should be directed.
 DuPONT ANALYSIS
 The lower side of the DuPont chart throws light on the determinants of the total
assets turnover ratio.
 If this is supplemented by a study of component turnover ratios (inventory turnover,
debtors' turnover, and fixed assets turnover), a deeper insight can be gained into
efficiencies/inefficiencies of asset utilisation.
 The basic DuPont analysis may be extended to explore the determinants of the
return on equity (ROE).

Total Assets turn over ratio

 DuPONT ANALYSIS
The extension of DuPont chart as applicable to Horizon Limited is shown in Exhibit 4.6.
 SUMMARY

 Financial ratio analysis, the principal tool of financial statement analysis, is a study
of ratios between items or groups of items in financial statements.
 Financial ratios may be divided into five broad types: liquidity ratios, leverage ratios,
turnover ratios, profitability ratios, and valuation ratios.
 Liquidity refers to the ability of the firm to meet its obligations in the short run,
usually one year.
 Current ratio and acid-test ratio are the important liquidity ratios.
 Leverage refers to the use of debt finance. Debt-equity ratio, interest coverage
ratio, and fixed charges coverage ratio are the important leverage ratios.
 SUMMARY
 Turnover refers to the efficiency of asset use. Inventory turnover ratio, receivables
turnover ratio, fixed assets turnover ratio, and total assets turnover ratio are the
important turnover ratios.
 Profitability reflects the final result of business operations. Gross profit margin
ratio, net profit margin ratio, return on assets, earning power, return on capital
employed, and return on equity are the most important profitability ratios.
 Valuation refers to the assessment of the firm by the capital market. Price-earnings
ratio and market value - book value ratio are the most important valuation ratios.
 For judging whether the ratios are high or low, cross-section analysis and time-
series analysis are used.
 SUMMARY
In common size analysis, the items in the balance sheet are stated as percentages of total assets
and the items in the profit and loss account are stated as percentages of sales.
■According to DuPont analysis, return on equity is expressed as a product of net profit margin,
total asset turnover, and asset-equity ratio.
■Properly combined, financial ratios may be used to assess corporate excellence, judge
creditworthiness, predict bankruptcy, value equity shares, predict bond ratings, and measure
market risk.
■While financial statement analysis can be a very useful tool, there are certain problems and
issues encountered in such analysis that call for care, circumspection, and judgment.
■Comprehensive business analysis calls for going beyond conventional financial measures to
consider qualitative factors relevant for evaluating the performance and prospects of a
company.