Financial

Statement Analysis UNIT13 RATIO ANALYSIS

Objective
 Understand the meaning and rationale of ratio analysis
 Provide a broad classification of ratios
 Identify ratios which are appropriate for control of particular activity
 Discuss and interpret various ratios

Structure
13.1 Introduction
13.2 Type of Ratios
13.3 Profitability Ratios:
13.4 Liquidity Ratios
13.5 Leverage Ratios
13.6 Coverage Ratios
13.7 Efficiency (or Activity) Ratios
13.8 Investment Ratios (or Valuation Ratios)
13.9 Summary
13.10 Keywords
13.11 Self Assessment Questions
13.12 Additional Readings

13.1 INTRODUCTION
The financial information relating to any business firm is included in the
three fundamental financial statements – the Balance Sheet, Income
Statement (or Profit & Loss Account), and Cash flow statement. The Balance
sheet focuses on the resources (or Assets) that are at the firm’s disposal and
the obligations (or Liabilities) of the business firm. It is, thus, a statement of
what the firm ‘owns’ and what the firm ‘owes’, as on a particular date. The
Balance sheet is a ‘snapshot’ of the assets and liabilities of the firm at a point
in time. The Income Statement summarises the revenues earned, the expenses
incurred to earn those revenues, and finally, the profits generated (or losses
incurred) during an accounting year. The profit is the surplus of revenues
over the expenses incurred. It thus depicts the profitability position of a firm
during an accounting period. The third financial statement prepared is the
Cash flow statement, which reflects the sources and uses of cash or the flow
of cash during an accounting period. It is also called the statement of changes
in Financial Position.
These financial statements summarise the transactions carried by a business
enterprise over an accounting period in financial terms. These financial
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statements need to be analysed to gain better insights into the strengths and Ratio Analysis
weaknesses of the firm. Such an analysis is undertaken by establishing
relationships between different items of the balance sheet, income statement
and cash flow statement. Besides the management, other stakeholders
interested in such an analysis are the shareholders, prospective investors,
creditors, customers, suppliers, lenders, and the government. Shareholders
and the prospective investor want to know if the money they have invested or
intend to invest would grow in value over a period of time or not. Creditors
who have lent funds want to know if the money they have lent to the firm is
safe or not. Even employees who work for the firm want to know if the
company is profitable or not so that they receive the compensation and other
benefits regularly. The government also wants to know if the firm would be
able to pay taxes or not. One of the ways to do find answers to such concerns
is by conducting a Ratio Analysis.

Ratio Analysis:
Ratio analysis is an important tool used in the analysis of financial
statements. A ratio is simply the relationship between any two or more
things. In the context of financial statements, when any two or more items of
the financial statements are expressed as a ratio, it is called a financial ratio.
We can comment on the performance of a student only when the marks
obtained by him are seen in conjunction with the maximum marks. Similarly,
to evaluate the performance of a firm, say in terms of its profits, just knowing
the quantum of profits earned by the firm is not enough. We can comment on
the performance only when the profits are compared with either the
investment made or the sales.

13.2 TYPES OF RATIOS

Any business has many stakeholders. Different stakeholders in a business
firm want to evaluate the financial performance of firms from their
perspective. Shareholders or the owners want to evaluate if the business
enterprise is profitable and financially strong or not. They want to know if the
money invested by them has grown over the years or has the investment
eroded. Short-term creditors and suppliers of raw materials want to know if
the company would be able to repay the short-term credit, which they have
provided. They are therefore interested in knowing about the short-term
liquidity position of the firm

Similarly, lenders of long-term finance are interested in the long-term

solvency and profitability of the firm. Management is interested in the overall
performance of the firm. Thus, each stakeholder wants to examine and
evaluate the financial statements from their perspective. Thus, we may
categorise the financial ratios in the following categories:

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Financial
Statement Analysis
Types of
Financial Ratios

Profitabilty Leverage Coverage Efficiency Valuation

Liquidity Ratios
Ratios Ratios Ratios Ratios Ratios

As the name suggests, the profitability ratios assess the firm on its profit-
earning capacity. The liquidity ratio measures the firm’s ability to meet its
short-term liabilities. Leverage ratios analyse the proportion of debt and
equity in the firm’s capital structure. The valuation ratios are used to value
the investment made by the shareholders. These ratios are discussed in detail
for which the following Balance sheet and the Income statement of a
hypothetical firm are considered.

ABC Enterprises Limited

Balance Sheet
As on March 31, (Rs. Lacs)
2016 2017 2018 2019 2020

A. Liabilities:

Share Capital 374.56 374.56 374.56 374.56 374.56

Reserves & Surplus 286.13 446.70 586.26 759.94 931.84

Net worth 660.69 821.26 960.82 1,134.50 1,306.40

B. Borrowings:
Long-Term
Debentures 148.56 242.00 418.43 697.52 721.93

Other Borrowings 461.55 697.89 788.16 768.37 1,175.48

Short-Term Bank
Borrowings 342.92 605.94 1,053.73 1,145.40 1,185.49

Total Borrowings 953.03 1,545.83 2,260.32 2,611.29 3,082.90

Total Liabilities (A +
C. B) 1,613.72 2,367.09 3,221.13 3,745.79 4,389.30

D. Fixed Assets:

Gross Block 653.49 1,154.72 2,008.05 2,182.75 2,259.15

Less: Accumulated
Depreciation 159.55 194.01 231.84 271.80 317.03

Net Block 493.94 960.71 1,776.21 1,910.95 1,942.12

Other Non-Current
Assets 52.76 56.84 72.97 80.62 94.20

Net Fixed Assets 546.70 1,017.55 1,849.18 1,991.57 2,036.32

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E. Current Assets Ratio Analysis

Raw Material 105.87 116.56 120.69 354.82 403.73

Work-in-Progress 85.74 156.07 120.69 102.35 169.00

Finished Goods 600.59 664.12 848.77 749.80 986.54

Inventories 792.20 936.75 1,090.15 1,206.97 1,559.28

Debtors 435.59 519.29 528.94 850.31 1,076.72

Cash & Bank
Balance 160.69 177.80 169.25 173.52 171.39

Other Current Assets 28.27 86.21 92.45 125.76 157.34

Current Assets 1,416.75 1,720.04 1,880.78 2,356.57 2,964.72

Less: Current
F. Liabilities:

Trade Creditors 226.86 199.53 305.94 354.82 356.78

Provisions & Others 122.87 170.97 202.89 247.53 254.95

Current Liabilities 349.73 370.50 508.83 602.35 611.74

Net Current Assets
G. (E-F) 1,067.02 1,349.54 1,371.95 1,754.22 2,352.98

H. Total Assets 1,613.72 2,367.09 3,221.13 3,745.79 4,389.30

Market Price per

Share 114.60 176.65 223.85 229.25 335.25

ABC Enterprises Limited

Income Statement
(Rs.
For the Year ended March 31, Lacs)
2016 2017 2018 2019 2020

1 Sales (Net) 1,890.50 1,975.57 2,109.91 2,274.48 2,347.27

1 Raw Material 1,071.91 1,120.15 1,196.32 1,289.63 1,330.90

2 Direct Labour 138.38 170.53 154.45 166.49 171.82

3 Depreciation 33.07 34.46 37.84 39.95 45.23

4 Other Manufacturing Expenses 205.34 255.72 205.34 255.72 329.44

1,448.71 1,580.86 1,593.94 1,751.80 1,877.39

5 Add: Opening Stock (WIP) 59.85 85.74 96.74 88.23 137.98

1,508.56 1,666.60 1,690.68 1,840.03 2,015.37
6 Less: Closing Stock (WIP) 130.83 347
Financial 85.74 76.55 96.74 97.55
Statement Analysis
7 Cost of Production 1,422.82 1,590.05 1,593.94 1,742.48 1,884.54

8 Add: Opening Stock (Finished Goods) 160.54 167.12 180.93 197.12 244.26

1,583.36 1,757.17 1,774.87 1,939.60 2,128.80

9 Less: Closing Stock (Finished Goods) 147.12 244.26 147.12 244.26 461.81
10 Cost of Goods Sold 1,436.24 1,512.91 1,627.75 1,695.34 1,666.99

3 Gross Profit (1-2) 454.26 462.66 482.16 579.14 680.28

4 Selling & Adm. Expenses 139.72 162.10 189.72 192.10 257.87

5 Operating Income (3-4) 314.54 300.56 292.44 387.04 422.41

6 Other Income 15.24 25.38 27.87 28.37 34.89

Earnings Before Interest & Taxes
7 (5+6) 329.78 325.94 320.31 415.41 457.30

8 Interest 59.84 94.98 112.84 144.20 166.70

9 Profit Before Taxes (7-8) 269.94 230.96 207.47 271.21 290.60

10 Provision for Taxes 51.29 48.50 48.88 64.44 85.96

11 Profit After Taxes (9-10) 218.65 182.46 158.59 206.77 204.64

12 Dividend Distributed 26.24 21.90 19.03 33.08 32.74

13 Retained Earnings 192.41 160.57 139.56 173.69 171.90

13.3 PROFITABILITY RATIOS

Profit is the surplus of the revenue earned by a firm by selling its products or
services over the cost incurred to produce those products (or render the
services). It is imperative for a firm to earn profits to sustain its operations in
the future and reward its shareholders who have invested their funds in the
firm. Creditors would also like to see the firm to whom they have provided
funds to make profits so that the firm is in a position to repay the loan and
pay interest as promised. Employees and workers would want the company
to be earning profits so that they receive salary and incentives regularly and
on time. A loss-making firm would not be in a position to pay taxes to the
government either. Hence, it is important to evaluate the profitability position
of a firm. There are various profitability ratios that are usually calculated.
Gross Profit Margin (or Gross Margin) is the ratio of gross profit earned
during a year to the sales of the firm during the same period. This ratio
indicates the gross profit earned by the firm on every rupee of sales; hence is
indicative of the efficiency with which the firm produces each unit of output.
Gross profit is defined as the difference between the sales revenue (net of
taxes, GST, and sales return) and the cost of goods sold (COGS).

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 Ratio Analysis

Gross profit margin assesses the efficiency with which the firm produces its
products. A higher gross profit margin implies that the firm is able to
generate better price for its output, produce goods at relatively lower costs, or
both. If the gross profit margin is low, it indicates that the firm produces its
product inefficiently. The management would need to investigate its sales
policy and marketing efforts, purchasing policy, or producing goods more
efficiently.
Net Profit Margin (or Net Margin) relates net profits to the sales of the firm.
Net profit (or Profit After Taxes) is calculated after deducting operating
expenses, Interest on capital, and taxes paid to the government from the
Gross Profit. It relates the profit after taxes to the sales revenue.

Like the gross profit margin, the net profit margin also indicates the overall
efficiency of the management from producing the goods to selling them.
Both the gross profit margin and net profit margin need to be evaluated in
combination with each other. Consider a situation where although the gross
margin has been increasing over the years, the net profit margin is not
increasing at the same rate. This might indicate that although the efficiency
of the firm in manufacturing the goods is improving, it’s operating expenses
or interest expenses are increasing, which is suppressing the net margin.
Hence, each expense head needs to be examined to find the cause(s) of the
falling trend in the performance.

NOPAT Margin relates the Operating profits to the sales of the firm. Net
profit margin is calculated by relating the profit after taxes to the sales
revenue. In calculating the profit after taxes, interest on long-term debt is
deducted, hence two firms, although similar in their operations but differ in
their capital structure, and their net profit margin would not be comparable.
Therefore, a better measure of profit that omits the effect of financial
leverage is the net operating profit after taxes (NOPAT) computed as
EBIT*(1-tax rate). So, the NOPAT margin is computed by relating NOPAT
with sales.

EBITDA Margin relates the Earnings before Interest, Taxes, Depreciation

and Amortisation (EBITDA) to the sales of the firm. As mentioned earlier,
EBITDA is a broader measure of profits. It is usually considered as a proxy
estimate of the Cash profits from the operations as it excludes Interests,
Taxes, and even depreciation and other non-cash items. EBITDA measures
the operating profits of the firm. As EBITDA excludes interests, taxes, and
Depreciation, it is not affected by differences in capital structure,
depreciation policy, and impact of taxes due to these differences, which
makes the comparison more effective.

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Financial
Statement Analysis

So far, we have compared different measures of profits - Gross profit, net

profit, operating profit, and EBITDA with sales revenue of the firm. Profits
may also be compared with the investment made by the different suppliers of
funds – equity shareholders and debt holders

Return on Assets (ROA) relates the NOPAT with the total assets. NOPAT, as
defined earlier, is EBIT*(1-tax rate) while the total assets are the aggregate of
current and non-current assets.

Total Assets EBITDA is a wider measure of profits and is usually considered

as a proxy estimate of the Cash profits from the operations as it excludes
Interests, Taxes and even depreciation and other non-cash items.
Return on Capital Employed (ROCE) relates NOPAT with the amount of
funds - both debt and equity.

ROCE may also be calculated on a pre-tax basis as follows:

Return on Equity (ROE) relates the profit after taxes with the funds provided
by shareholders.

The shareholders’ funds (or net worth) consist of paid-up equity capital and
reserves and surplus (net of accumulated losses, if any). Paid-up equity
capital is the funds that has been invested by the equity shareholders, while
reserves and surpluses are the retained earnings that belong to the equity
shareholders. Equity shareholders are entitled to profits after paying all other
stakeholders, i.e., profit after taxes – the residual profits. Hence, PAT is
related to the funds brought in, or that belong to the equity shareholders.
ROE indicates how well the firm has deployed the resources provided by the
shareholders and is an essential financial ratio calculated by equity analysts.

Earnings per Share (EPS) indicates the Earnings of the firm on a per-share
basis. It is calculated by dividing the Profit after taxes by the no. of equity
shares outstanding.

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EPS reflects the amount that the company has earned in a year on each share. Ratio Analysis
However, the shareholders do not receive the entire earnings. They receive
only a part of the earnings, which is called the dividends. Hence, another
ratio calculated is the Dividends per Share.
Dividends per Share (DPS) indicates the dividends of the firm on a per-share
basis. It is calculated by dividing total dividends paid by the no. of equity
shares outstanding.

Dividend Pay-out ratio (DPS) indicates what percentage of the earnings are
paid out to the shareholders as dividends. Hence it is calculated by dividing
earnings per share with the earnings per share, or the total dividends by profit
after taxes.

Dividends are the return which an investor receives when he buys shares of
the firm. From the perspective of an investor or a prospective investor, it
would be important to evaluate how the returns (i.e., dividends) compare with
the investment (i.e., the market price) made by him in the shares of the firm.
Dividend Yield relates the dividends per share with the market price of the
shares.

It indicates the amount of dividends that the investor would receive per rupee
of investment. Similarly, earnings may also be related to the market price to
arrive at the Earnings Yield.

13.4 LIQUIDITY RATIOS

Creditors, in particular, are concerned about the firm’s ability to pay their
dues. Therefore, they try to analyse the liquidity position of the firm with
respect to current assets and current liabilities – that is, to know if the firm’s
current assets are adequate to pay–off their current liabilities. This is
assessed by comparing the current assets with the current liabilities. If a firm
is unable to meet its current obligations due to lack of liquidity, it will result
in poor creditworthiness, loss of business reputation, and, in extreme cases,
legal actions against the firm. At the same time, a high level of liquidity
would mean that the funds are invested in low-yielding current assets.
Therefore, a proper trade-off must be maintained between too low and too
high liquidity in the business.
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Financial The current Ratio is the most commonly calculated measure of liquidity. It
Statement Analysis
simply compares the current assets with the current liabilities of the firm.

Current assets typically include cash and bank balance and those assets that
can be converted into cash within one year. These would include inventories
of finished goods, work-in-progress and raw material, debtors or receivables,
and prepaid expenses. Similarly, current liabilities are those obligations of the
firm that need to be paid within a year, which would include trade creditor or
payables, accrued expenses, short-term loans, and tax liabilities. Current
liabilities also include that portion of the long-term loans, which are falling
due in the current year.

As the current ratio compares the current assets with the current liabilities,
the ratio indicates the quantum of current assets which the firm holds for
every rupee of current liabilities. Hence, a higher current ratio is indicative of
a better liquidity position. Typically, a current ratio of 2:1, although there is
no hard and fast rule. This is based on the reasoning that even if the value of
current assets declines by 50%, they would still be sufficient to meet the
current liabilities.

Quick ratio (or Acid-test ratio) A stricter measure of the liquidity position of
a firm is the Quick ratio (or the Acid-test ratio), which considers only liquid
current assets, i.e., it excludes those current assets which cannot be easily
converted into cash within a short period of time. As inventory is relatively
difficult to be converted into cash, it is excluded from current assets for the
purpose of estimating Quick ratio.

Conventionally, a quick ratio of 1:1 is considered adequate, although it may

still not be adequate if the assets are debtors are not liquid enough. Hence it
also needs to be viewed cautiously, just like the current ratio.

An even stricter measure of liquidity is the Cash ratio which compares only
the amount of Cash & Bank balances and short-term investments held by the
firm to its Current Liabilities.

Another measure of liquidity is the Net Working Capital (NMC) which is

defined as the difference between current assets and current liabilities. The
net working capital or net current assets (NCA) are compared with the net
assets.

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13.5 LEVERAGE RATIOS Ratio Analysis

Leverage ratios are designed to assess what proportion of Debt and Equity
has been employed by the firm in financing its operations. Debt funds being
the funds made available by lenders who require to be compensated by way
of interest. Interest on borrowed funds is required to be paid irrespective of
the profitability of the firm. Hence the use of debt is considered more risky
than equity funds. In fact, the use of debt is considered a double-edged
sword. It entails paying a fixed interest expense out of the profits of the firm.
The balance profits belong to the shareholders. When the firm is earning
more than the cost of borrowed funds, it will magnify the returns to the
shareholders. This is called ‘trading on equity’ or financial leverage. If the
firm’s cost of borrowed funds is more than the rate of earnings, then the use
of debt would reduce the earnings available to equity shareholders. Hence,
there is a need to assess the proportion of Debt and Equity in the capital of
the firm. Leverage ratios help to assess the long-term financial position of the
firm.

Debt – Equity (D/E) ratio: One of the most common leverage ratios is the
Debt-Equity ratio. It compares the amount of borrowed funds (or debt) with
the amount of owners’ funds (or equity) of a firm. Debt consists of interest-
bearing long-term borrowings. Sometimes, both long-term and short-term
borrowings are considered as debt. Shareholders’ funds consist of Share
capital and free reserves, i.e., the funds provided by equity shareholders or
available for distribution to them.

The debt-Equity ratio indicates the amount of borrowed funds employed for
each rupee of shareholders’ funds. The higher the ratio, the higher the
amount of debt for a given amount of shareholders’ funds, which would
mean higher use of financial leverage. Generally speaking, use of higher
leverage would mean that the firm is riskier, in most cases. For firms like
banks and finance companies, a debt-equity ratio of 10:1 is also allowed, as
money is the raw material for such firms.

A variant of the Debt-Equity ratio is the Debt ratio which is defined as

follows:

This ratio compares the Debt with the total Assets of the firms; hence it
measures the extent to which the assets have been financed by Debt or
borrowings. This ratio is also referred to as Debt–to -Capital employed ratio.

13.6 COVERAGE RATIOS

The leverage ratios such as the Debt ratio or Debt-Equity ratio, discussed
353
Financial above, which study the proportion of debt and equity in the capital structure.
Statement Analysis
Besides them, analysts also calculate another set of ratios called the Coverage
ratios, which assess the adequacy or otherwise of the profits to pay the
interest obligations. The leverage ratios simply comment on the mix between
debt and equity in the capital structure of a firm. These ratios did not throw
much light on the firm’s ability to meet its obligations arising out of the
capital structure, i.e., the obligation to pay the interest. Coverage ratios help
access the adequacy or otherwise of the profits/ cash flows in paying the
interest obligations.
Interest Coverage ratio:

It shows the number of times the funds cover the interest obligations out of
which they are to be paid; hence a higher interest coverage ratio would
indicate a better liquidity position for the firm. A variant of this ratio is the
EBITDA to Interest ratio. EBITDA is considered to be a proxy indicator of
cash flow availability. A higher ratio indicates superior position as regards
the firm’s position to meet its interest charges is concerned.

Debt Service Coverage ratio (DSCR): This is a popular ratio calculated by

banks and financial institutions while granting long-term loans to companies.
While the Interest coverage ratio considers only the interest obligation to be
paid, DSCR considers the repayment of the principal loan amount also.
Further, just as interest and loan repayment are mandatory obligations, so are
the obligations to pay lease rentals and dividends of preference shares.
Hence, these are also included in the calculation of DSCR. But Interest and
lease rentals are tax-deductible, but preference dividends and principal
repayment are not; hence post-tax interest and post-tax lease rentals are
considered for the calculations. Thus, DSCR is calculated by dividing
EBITDA by post-tax interest & lease rentals, principal repayment, and
preference dividends.

13.7 EFFICIENCY (OR ACTIVITY) RATIOS

Management and the providers of funds are concerned about the proper
utilisation of the funds invested in the business. A greater amount of sales for
a given amount of capital is an indicator of better utilisation of the funds at
the disposal of the firm. Efficiency ratios (or Activity ratios) are used to
evaluate the efficiency with which a firm uses its assets. These ratios are also
referred to as Turnover ratios as they relate the various components of assets
– Inventory, Debtors, or Fixed assets with the Sales or Turnover of the firm.
Usual efficiency ratios include Inventory turnover ratio, Debtor Turnover
ratio, Creditors Turnover ratio and Assets turnover ratio.

Inventory Turnover ratio measures the speed with which the firm turns the
354
inventories into sales. It is calculated by dividing the cost of goods sold (or Ratio Analysis
sales if COGS figure is not available) with the average inventory of finished
goods.

Average inventory is calculated by taking the average of opening and closing

balances of inventory. The inventory turnover ratio indicates how fast (or
slow) the inventory is converted into cash. If the inventory turnover ratio is
high, it indicates that the firm is able to achieve its sales by maintaining a
small level of inventory and hence it is managing its inventory better. A low
inventory turnover ratio would be indicative of slow-moving inventory.
Funds are blocked in inventory, and therefore the profitability of the firms is
hampered. Inventory turnover ratio can be calculated for various stages of
inventory – inventories of finished goods, work-in-progress, or raw material,
as follows:

When a firm sells its goods for cash, it receives cash immediately. However,
when a firm sells on credit, the buyers are required to pay over a certain
period. Credit sale of goods gives rise to the creation of debtors or accounts
receivables. Gradually, when the buyers pay up, debtors are converted into
cash. So long the buyers of goods do not pay; the firm’s funds are blocked in
the form of debtors. The quality of debtors is analysed by calculating the
Debtor turnover ratio, average collection period and the ageing schedule.
Like the Inventory turnover ratio, the Debtor Turnover ratio also indicates the
speed with which the debtors are converted into cash. It is calculated as
follows:

If a firm has a higher debtor turnover ratio, it is considered more efficient

than a firm with a lower debtor turnover ratio as it rotates its debtors more
frequently.

Average Collection Period is the period taken by the firm, on an average, to

collect its debtors. It is calculated by dividing 365 days by the Debtors
turnover ratio.

The average collection period indicates the speed at which the firm is 355
Financial collecting the debtors. A short average collection period would indicate that
Statement Analysis
the firm is taking fewer days to collect the debtors. The average collection
period should be compared with the stated credit policy of the firm, which
signifies the no. of days a debtor can pay for the credit purchases made by
him. For example, if the firm’s credit policy allows a debtor a credit period of
say 45 days, and the average collection period is 40 days, then we may
conclude that the firm is efficient in managing and collecting the receivables.

Average collection period analyses the speed of collecting the debtors as a

collective group. The firm might be realising certain debtors in a short period
of time while taking more no. of days in realising from other sets of debtors.
However, the average collection period would give a figure of all the debtors
collectively. A better way to analyse the collection efforts is by way of
preparing the ageing schedule. The ageing schedule tells us the amount of
debtors outstanding for different periods. For example, if a firm has total
outstanding debtors of say Rs. 14 Lacs, as of a particular date, the ageing
schedule would indicate the amount of debtors outstanding for ‘0 to 10’ days;
11 – 20 days, 21 – 30 days, 31 – 40 days, 41 to 50 days, and more than 50
days.

Ageing Schedule

No. of Days Outstanding

Amount Outstanding (Rs) % Age
0 - 10 3,50,000 25%
11 - 20 5,75,000 41%
21 - 30 2,56,000 18%
31 -40 1,20,000 9%
41-50 59,000 4%
More than 50 40,000 3%
Total 14,00,000 100%

From the above hypothetical ageing schedule, we may conclude that a large
part of the debtors (41% to the total debtors) is outstanding for 11 to 20 days,
which need to be investigated. Only a tiny portion (7%) are outstanding for
more than 40 days.

Similarly, we may estimate the creditor’s turnover ratio as follows:

The creditors turnover ratio indicates how fast the firm is paying its creditors
from whom it has purchased goods on credit.

Asset turnover ratio is used to evaluate the efficiency in the usage of the
assets in generating sales. Assets are used to generate sales. Hence, in order
to maximise sales, a firm should manage its assets efficiently. A firm may
calculate the Net Assets Turnover ratio as:
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 Ratio Analysis

Net assets include the long-term assets (or non-current assets) and net
Current assets (i.e., Current assets less Current Liabilities). If this ratio is
high, it would indicate that with a given amount of net assets, the firm can
generate high sales; hence the firm is using its assets productively. As net
assets also represent the amount of capital employed in the firm, this ratio is
also referred to as the Capital employed turnover ratio. Similarly, we may
calculate the Fixed Assets turnover ratio and current assets turnover ratio in
order to evaluate the efficiency of its usage of fixed assets and current assets
in generating sales.

13.8 INVESTMENT RATIOS (OR VALUATION

RATIOS):
Valuation is the process of estimating the worth of a company. Valuation
ratios are a helpful tool for evaluating the investment potential of a firm. Here
is a list of principle valuation ratios.

Price – Earnings Ratio (P/E ratio): The Price – Earnings ratio relates the
current market company’s equity shares with the Earnings per Share.

It indicates what the market expects to pay for each rupee of earnings. This
ratio is extensively used by financial analysts to value a firm by multiplying
the earnings per share with the P/E ratio of comparable firms or pre-decided
P/E ratio.

Market-to-Book Value ratio: This ratio relates the market price to the book
value per share.

Book value is estimated by dividing the net worth of the firm by the number
of equity shares outstanding. Book value signifies the aggregate worth of the
funds invested by the equity shareholders. This ratio, therefore, indicates who
much more (or less) is the shareholders’ money is worth. If the M/B ratio is
greater than 1, it indicates that the shareholders’ funds are worth more than
their investment, while an M/B ratio less than 1 signifies erosion of
shareholders’ investment in the firm.

Enterprise Value to EBITDA: This ratio relates the Enterprise Value (EV) to
the Earnings before Interest, Taxes, Depreciation and Amortisation
(EBITDA).

Enterprise value is the value of the entire firm (whether financed by Debt or
357
Financial Equity), less non-operational (excess) Cash and short-term investments.
Statement Analysis
EBITDA, as mentioned earlier, is the Earnings before Interest, Taxes, and
Depreciation &Amortisations. While the P/E ratio considers only the market
value of equity with the profit after taxes, the EV to EBITDA ratio compares
the value of the entire firm to the earnings. It is considered a better indicator
than the P/E ratio as it is not influenced by the financing decision (capital
structure), taxes or the method of depreciation adopted by firms.
Tobin’s Q: Popularised by Nobel laureate James Tobin, the ratio relates the
market value of a firm’s assets to the replacement cost of these assets.

The replacement cost of assets is the cost a firm would have to incur today if
it was required to recreate those assets of the firm. The replacement cost is
therefore based on the subjective assessment of an analyst. If the ratio is
greater than 1, it would indicate that in present-day money terms, the cost of
setting up similar facilities is less than the market value of the firm’s assets,
which implies that the stock is overvalued. On the other hand, if the ratio is
less than 1, it would mean that the cost of setting up the facilities/assets
similar to what the company has is more than the market value of these
assets, which implies that the stock is undervalued.

Ratio 2016 2017 2018 2019 2020

A Profitability
. Ratios:
Gross Profit Gross
1
Margin Profit 454.26 462.66 482.16 579.14 680.28
Sales
1,890.50 1,975.57 2,109.91 2,274.48 2,347.27

24.03% 23.42% 22.85% 25.46% 28.98%

Net Profit Net Profit
2
Margin 218.65 182.46 158.59 206.77 204.64
Sales
1,890.50 1,975.57 2,109.91 2,274.48 2,347.27

11.57% 9.24% 7.52% 9.09% 8.72%

EBIT (1-t)
=NOPAT 224.25 221.64 217.81 282.48 310.97
Sales
1,890.50 1,975.57 2,109.91 2,274.48 2,347.27

11.86% 11.22% 10.32% 12.42% 13.25%

Operating Operating
3
Expense Ratio Expenses 1,575.96 1,675.01 1,817.47 1,887.44 1,924.86
Sales
1,890.50 1,975.57 2,109.91 2,274.48 2,347.27

83.36% 84.79% 86.14% 82.98% 82.00%

Return on EBIT (1-t)
4 Investment
(ROI) 224.25 221.64 217.81 282.48 310.97
Total
Assets 1,963.45 2,737.59 3,729.96 4,348.14 5,001.04
358
 11.42% 8.10% 5.84% 6.50% 6.22% Ratio Analysis
EBIT (1-t)
224.25 221.64 217.81 282.48 310.97
Net Assets
1,613.72 2,367.09 3,221.13 3,745.79 4,389.30

13.90% 9.36% 6.76% 7.54% 7.08%

Profit
Return on
5 After
Equity (ROE)
Taxes 218.65 182.46 158.59 206.77 204.64
Net Worth
660.69 821.26 960.82 1,134.50 1,306.40

33.09% 22.22% 16.51% 18.23% 15.66%

Profit
Earnings Per
6 After
Share
Taxes 218.65 182.46 158.59 206.77 204.64
No. of
Shares O/s 37,45,600 37,45,600 37,45,600 37,45,600 37,45,600

5.84 4.87 4.23 5.52 5.46

Dividend Per Equity
7
Share Dividends 26.24 21.90 19.03 33.08 32.74
No. of
Shares O/s 37,45,600 37,45,600 37,45,600 37,45,600 37,45,600

0.70 0.58 0.51 0.88 0.87

Dividend Equity
8
Payout Ratio Dividends 26.24 21.90 19.03 33.08 32.74
Profit
After
Taxes 218.65 182.46 158.59 206.77 204.64

12.00% 12.00% 12.00% 16.00% 16.00%

9 Dividend Yield DPS 0.70 0.58 0.51 0.88 0.87
MP 114.60 176.65 223.85 229.25 335.25

0.61% 0.33% 0.23% 0.39% 0.26%

1 EPS
Earnings Yield
0 5.84 4.87 4.23 5.52 5.46
MP 114.60 176.65 223.85 229.25 335.25

5.09% 2.76% 1.89% 2.41% 1.63%

Market
1 Price-Earnings
Price per
1 ratio (PE)
Share 114.60 176.65 223.85 229.25 335.25
EPS 5.84 4.87 4.23 5.52 5.46

19.6 36.3 52.9 41.5 61.4

1 Market Value MP per
2 to Book Value Share 114.60 176.65 223.85 229.25 335.25
Book
Value per
Share 17.64 21.93 25.65 30.29 34.88

6.50 8.06 8.73 7.57 9.61

B Leverage
. Ratios:
1 Debt Ratio Total Debt 953.03 1,545.83 2,260.32 2,611.29 3,082.90 359
Financial Total Debt
Statement Analysis + Net
worth 1,613.72 2,367.09 3,221.13 3,745.79 4,389.30

0.59 0.65 0.70 0.70 0.70

Debt -Equity Total Debt
2
Ratio 953.03 1,545.83 2,260.32 2,611.29 3,082.90
Net worth
660.69 821.26 960.82 1,134.50 1,306.40

1.44 1.88 2.35 2.30 2.36

Interest EBIT
3
Coverage Ratio 329.78 325.94 320.31 415.41 457.30
Interest
59.84 94.98 112.84 144.20 166.70

5.51 3.43 2.84 2.88 2.74

EBITDA
362.85 360.40 358.14 455.37 502.53
Interest
59.84 94.98 112.84 144.20 166.70

6.06 3.79 3.17 3.16 3.01

C
Activity ratios:
.
Inventory COGS
1
Turnover 1,512.91 1,627.75 1,695.34 1,666.99
Average
Inventory 632.35 756.44 799.29 868.17

2.39 2.15 2.12 1.92

Avg
Days Holding
2 Inventory
Period
*360 799.29 868.17
COGS
1,512.91 1,627.75 1,695.34 1,666.99

169.73 187.49
Debtors Credit
3
Turnover Sales 1,890.50 1,975.57 2,109.91 2,274.48 2,347.27
Average
Debtors (or
Closing
Debtors) 435.59 519.29 528.94 850.31 1,076.72
* Assuming
all Sales are
Credit Sales 4.34 3.80 3.99 2.67 2.18
Average Debtors *
4
Collection 360 435.59 519.29 528.94 850.31 1,076.72
Period
Sales
1,890.50 1,975.57 2,109.91 2,274.48 2,347.27

82.95 94.63 90.25 134.58 165.14

Net Asset Sales
5
Turnover 1,890.50 1,975.57 2,109.91 2,274.48 2,347.27
Net Assets
1,613.72 2,367.09 3,221.13 3,745.79 4,389.30

1.17 0.83 0.66 0.61 0.53

Total Asset Sales
6
360 Turnover 1,890.50 1,975.57 2,109.91 2,274.48 2,347.27
 Total Ratio Analysis
Assets 1,963.45 2,737.59 3,729.96 4,348.14 5,001.04

0.96 0.72 0.57 0.52 0.47

Current Asset Sales
7
Turnover 1,890.50 1,975.57 2,109.91 2,274.48 2,347.27
Current
Assets 1,416.75 1,720.04 1,880.78 2,356.57 2,964.72

1.33 1.15 1.12 0.97 0.79

D Liquidity
. ratios:
Current
1 Current ratio
Assets 1,416.75 1,720.04 1,880.78 2,356.57 2,964.72
Current
Liabilities 349.73 370.50 508.83 602.35 611.74

4.05 4.64 3.70 3.91 4.85

CA -
2 Quick ratio Inventorie
s 624.55 783.30 790.63 1,149.59 1,405.44
Current
Liabilities 349.73 370.50 508.83 602.35 611.74

1.79 2.11 1.55 1.91 2.30

Cash +
3 Cash Ratio Mktable
Sec. 164.93 190.73 183.11 192.39 194.99
Current
Liabilities 349.73 370.50 508.83 602.35 611.74

0.47 0.51 0.36 0.32 0.32

Net Working Net
4 Capital Ratio Working
Capital 724.10 743.60 318.23 608.82 1,167.49

Net Assets 1,613.72 2,367.09 3,221.13 3,745.79 4,389.30

0.45 0.31 0.10 0.16 0.27

13.9 SUMMARY
Ratio analysis is an important tool used in the analysis of financial
statements. A ratio is simply the relationship between any two or more
things. In the context of financial statements, when any two or more items of
the financial statements are expressed as a ratio, it is called a financial ratio.
Any business has many stakeholders. Different stakeholders in a business
firm want to evaluate the financial performance of firms from their
perspective. Hence, we may classify the financial ratios as Profitability ratios,
Liquidity ratios, Leverage ratios, Coverage ratios, Efficiency ratios, and
Valuation ratios. Profitability ratios assess the firm on its profit earning
capacity. The liquidity ratios measure the firm’s ability to meet its short-term
liabilities. Leverage ratios analyse the proportion of debt and equity in the
firm’s capital structure. The valuation ratios are used to value the investment
made by the shareholders.

361
Financial
Statement Analysis
13.10 KEY WORDS
Acid-test ratio; Aging Schedule; Average Collection Period; Capital
Employed Turnover ratio; Cash ratio; Coverage Ratios; Creditors Turnover
ratio; Current assets turnover ratio; Current Ratio; Debt – Equity (D/E) ratio;
Debt ratio; Debt Service Coverage ratio; Debtor Turnover ratio; Dividend
Pay-out ratio; Dividend Yield; Dividends per Share; Earnings per Share;
Earnings Yield; EBITDA Margin; Efficiency Ratios; Enterprise Value to
EBITDA; Fixed assets Turnover ratio; Gross Margin; Gross Profit Margin;
Interest Coverage ratio; Inventory Turnover ratio ; Investment Ratios;
Leverage Ratios; Liquidity Ratios; Market-to-Book Value ratio; Net
Margin; Net Profit Margin; Net Working Capital ratio; NOPAT Margin;
Price – Earnings Ratio ; Profitability Ratios; Quick ratio; Return on Assets;
Return on Capital Employed; Return on Equity; Tobin’s Q; Valuation Ratios.

13.11 SELF ASSESSMENT

QUESTIONS/EXERCISES
1. Briefly discuss the concept of Ratio Analysis. Give an overview of the
different types of financial ratios. How do different stakeholders use
Ratio Analysis?
2. Discuss the rationale for Liquidity ratios. What are the various liquidity
ratios?
3. Explain the different leverage ratios highlighting their benefits to the
firm.
4. What is meant by activity ratios? What are the different activity ratios?
What purpose do the activity ratios serve?
5. Explain the significance of profitability ratios. What are the different
types of profitability ratios?

Test Your Understanding:

Multiple Choice Questions

1. Given that Sales is Rs 1,20,000, and Gross Profit is Rs. 30,000, the gross
profit ratio is
a. 24%
b. 25%
c. 40%
d. 44%
2. If the selling price is fixed 25% above the cost, the Gross Profit ratio is
a. 13%
b. 28%
c. 26%
362 d. 20%
3. Which of the following is not included in current assets? Ratio Analysis

a. Debtors
b. Shares
c. Cash at bank
d. Cash in hand
4. Debt-Equity ratio compares
a. Short-term debt to Equity Capital
b. Short-term + Long-Term Debt to Shareholders’ Funds
c. Long-Term Debt to Equity
d. Short-term Debt to Equity Capital
5. Return on Equity is defined as
a. Profit After Taxes / Equity
b. Profit Before Taxes / Equity
c. EBIT/ Capital Employed
d. EBIT (1-tax rate)/Capital Employed
6. Determine Inventory turnover ratio, if Opening stock is Rs 31,000,
Closing stock is Rs 29,000, Sales is Rs 3,20,000, and Gross profit ratio is
25% on sales.
a. 31 times
b. 11 times
c. 8 times
d. 32 times
7. Quick ratio is 1.8:1, current ratio is 2.7:1, and current liabilities are Rs
60,000. Determine the value of inventory.
a. Rs 54,000
b. Rs 60,000
c. Rs 1,62,000
d. None of the above
8. Return on equity capital is calculated on the basis of:
a. Funds of equity shareholders
b. Equity capital only
c. Either a or b
d. None of the above
9. Net operating profit ratio determines ___________ while net profit ratio
determines_______________
a. Overall efficiency of the business, working efficiency of the
management 363
Financial b. Working efficiency of the management, overall efficiency of the
Statement Analysis
business
c. Overall efficiency of the external market, working efficiency of the
internal management
d. None of the above
10. If sales is Rs 10,00,000, sales returns is Rs 50,000, Profit Before Tax is
Rs 2,00,000, Income tax is 40%, Net profit ratio is
a. 12.63%
b. 20%
c. 10%
d. 50%
Answers to Multiple Choice Questions
1. b
2. d
3. b
4. b
5. a
6. c
7. a
8. c
9. b
10. a

13.12 ADDITIONAL READINGS

Richard A. Brealey, Stewart C. Myers, Franklin Allen, &PitabasMohanty,
Principles of Corporate Finance, 12th Edition, McGraw Hill, 2018.

Sheridan Titman, Arthur J. Keown, & John D. Martin, Financial

Management –Principles and Applications, 13th Edition, Pearson India, 2019.

Jonathan Berk, Peter Demarzo, &Jarrad Harford, Fundamentals of Corporate

Finance, 3rd Edition, Pearson, 2019.

RaithathaBapat,Financial Accounting a Managerial Perspective, McGraw

Hill, 2017.

Prasanna Chandra, Financial Management – Theory & Practice, 10th Edition,

McGraw Hill, 2019.

I.M. Pandey, Financial Management, 12th Edition, Pearson, 2021.

364