Ratio analysis

 Is a method or process by which the relationship of

items or groups of items in the financial statements are
computed, and presented.
 Is an important tool of financial analysis.
 Is used to interpret the financial statements so that the
strengths and weaknesses of a firm, its historical
performance and current financial condition can be
determined.
Ratio
‘A mathematical yardstick that
measures the relationship between two
figures or groups of figures which are
related to each other and are mutually
inter-dependent’.
It can be expressed as a pure ratio,
percentage, or as a rate
 Words of caution
A ratio is not an end in itself. They are only a means to get
to know the financial position of an enterprise.
Computing ratios does not add any information to the
available figures.
It only reveals the relationship in a more meaningful way
so as to enable us to draw conclusions there from.
Utility of Ratios
Accounting ratios are very useful in
assessing the financial position and
profitability of an enterprise.

However its utility lies in comparison

of the ratios.
Utility of Ratios
Comparison may be in any one of the following
forms:
For the same enterprise over a number of years
For two enterprises in the same industry
For one enterprise against the industry as a whole
For one enterprise against a pre-determined
standard
For inter-segment comparison within the same
organisation
Classification of Ratios
Ratios can be broadly classified into four groups namely:
 Liquidity ratios
 Capital structure/leverage ratios
 Profitability ratios
 Activity ratios
Liquidity ratios
These ratios analyse the short-term financial
position of a firm and indicate the ability of the
firm to meet its short-term commitments
(current liabilities) out of its short-term resources
(current assets).
These are also known as ‘solvency ratios’. The
ratios which indicate the liquidity of a firm are:
 Current ratio
 Liquidity ratio or Quick ratio or acid test ratio
Current ratio

It is calculated by dividing current assets by current

liabilities.
Current ratio = Current assets where
Current liabilities
Conventionally a current ratio of 2:1 is considered
satisfactory
 CURRENT ASSETS
include –
Inventories of raw material, WIP, finished goods,
stores and spares,
sundry debtors/receivables,
short term loans deposits and advances,
cash in hand and bank,
prepaid expenses,
incomes receivables and
marketable investments and short term securities.
CURRENT LIABILITIES
include –
sundry creditors/bills payable,
outstanding expenses,
unclaimed dividend,
advances received,
incomes received in advance,
provision for taxation,
proposed dividend,
instalments of loans payable within 12 months,
bank overdraft and cash credit
Quick Ratio or Acid Test Ratio
This is a ratio between quick current assets and
current liabilities (alternatively quick liabilities).
It is calculated by dividing quick current assets by
current liabilities (quick current liabilities)
Quick ratio = quick assets
where
Current liabilities/(quick liabilities)

Conventionally a quick ratio of 1:1 is considered

satisfactory.
 Consider 3 competitors - Procter & Gamble, Johnson & Johnson, and Kimberly-
Clark Corp - with the following current assets on their balance sheets for the fiscal
year ended 2017.

Kimberly-
Procter & Johnson &
(in millions) Clark
Gamble Johnson
Corporation
Current Assets $26,494 $65,032 $5,115
minus
$4,624 $8,144 $1,679
Inventories
Quick Assets $21,870 $56,888 $3,436 CA - Inv.
Current
$30,210 $26,287 $5,846
Liabilities
Quick Ratio 0.7239 2.16 0.5878 QA / CL
Johnson & Johnson has $2.16 of very liquid assets available to cover each dollar of
short-term debt, thus, the company is in a good liquidity position. However,
Procter & Gamble and Kimberly-Clark may not be able to pay off their current
debts using only quick assets since both companies have a quick ratio below 1.
QUICK ASSETS & QUICK
LIABILITIES
QUICK ASSETS are current assets (as stated earlier)
less prepaid expenses and inventories.

QUICK LIABILITIES are current liabilities (as stated

earlier)
less bank overdraft and incomes received in advance.
( (c) There is also a negotiation going on for
discounting the debtors of Rs. 350,000 for Rs.
3,15,000 to a collection agency for immediate cash.
Also obsolete stocks worth Rs. 1,25,000 are being sold
for Rs. 80,000. Of the cash to be realised by the two
transactions, the bank loan is proposed to be reduced
to Rs. 1,00,000. Calculate the current ratio after the
transactions are put through.
Capital structure/ leverage ratios

These ratios indicate the long term solvency of a

firm and indicate the ability of the firm to meet its
long-term commitment with respect to
(i) repayment of principal on maturity or in
predetermined instalments at due dates and
(ii) periodic payment of interest during the period of the
loan.
Capital structure/ leverage ratios

The different ratios are:

 Debt equity ratio
 Proprietary ratio
 Debt to total capital ratio
 Interest coverage ratio
 Debt service coverage ratio
Debt equity ratio
This ratio indicates the relative proportion of debt and
equity in financing the assets of the firm. It is
calculated by dividing long-term debt by shareholder’s
funds.
Debt equity ratio = long-term debts where
Shareholders funds
Generally, financial institutions favour a ratio of 2:1.

However this standard should be applied having regard

to size and type and nature of business and the degree of
risk involved.
LONG-TERM FUNDS are long-term loans
whether secured or unsecured like – debentures,
bonds, loans from financial institutions etc.

SHAREHOLDER’S FUNDS are equity share

capital plus preference share capital plus reserves
and surplus minus fictitious assets (eg. Preliminary
expenses, past accumulated losses, discount on
issue of shares etc.)
Proprietary ratio
This ratio indicates the general financial strength of
the firm and the long- term solvency of the business.
This ratio is calculated by dividing proprietor’s
funds by total funds.
Proprietary ratio = proprietor’s funds
where Total funds/assets

As a rough guide a 65% to 75% proprietary ratio is

advisable
PROPRIETOR’S FUNDS are same as explained in
shareholder’s funds

TOTAL FUNDS are all fixed assets and all current

assets.
Alternatively it can be calculated as proprietor’s funds
plus long-term funds plus current liabilities.
Debt to total capital ratio
In this ratio the outside liabilities are related to the total
capitalisation of the firm. It indicates what proportion of
the permanent capital of the firm is in the form of long-
term debt.
Debt to total capital ratio =long- term debt
Shareholder’s funds + long- term debt
Conventionally a ratio of 2/3 is considered satisfactory.
Profitability ratios

These ratios measure the operating efficiency of the firm

and its ability to ensure adequate returns to its shareholders.
The profitability of a firm can be measured by its
profitability ratios.

Further the profitability ratios can be determined (i) in

relation to sales and
(ii) in relation to investments
Profitability ratios
Profitability ratios in relation to sales:
gross profit margin
Net profit margin
Expenses ratio
Profitability ratios
Profitability ratios in relation to investments
Return on assets (ROA)
Return on capital employed (ROCE)
Return on shareholder’s equity (ROE)
Earnings per share (EPS)
Dividend per share (DPS)
Dividend payout ratio (D/P)
Price earning ratio (P/E)
Gross profit margin

This ratio is calculated by dividing gross profit by sales.

It is expressed as a percentage.

Gross profit is the result of relationship between prices,

sales volume and costs.
Gross profit margin = gross profit x 100

Net sales
Gross profit margin
A firm should have a reasonable gross profit margin to
ensure coverage of its operating expenses and ensure
adequate return to the owners of the business ie. the
shareholders.
To judge whether the ratio is satisfactory or not, it
should be compared with the firm’s past ratios or with
the ratio of similar firms in the same industry or with
the industry average.
Net profit margin
This ratio is calculated by dividing net profit by sales. It is
expressed as a percentage.
This ratio is indicative of the firm’s ability to leave a margin
of reasonable compensation to the owners for providing
capital, after meeting the cost of production, operating
charges and the cost of borrowed funds.
Net profit margin =
net profit after interest and tax x 100
Net sales
Net profit margin
Another variant of net profit margin is operating profit
margin which is calculated as:
Operating profit margin =
net profit before interest and tax x 100
Net sales
Higher the ratio, greater is the capacity of the firm to
withstand adverse economic conditions and vice versa
Expenses ratio
These ratios are calculated by dividing the various expenses by
sales. The variants of expenses ratios are:
Material consumed ratio = Material consumed x 100
Net sales
Manufacturing expenses ratio = manufacturing expenses x
100
Net sales
Administration expenses ratio = administration expenses x 100
Net sales
Selling expenses ratio = Selling expenses x 100
Net sales
Operating ratio = cost of goods sold plus operating expenses x
100
Net sales
Financial expense ratio = financial expenses x 100
Net sales
Expenses ratio
The expenses ratios should be compared over a period
of time with the industry average as well as with the
ratios of firms of similar type. A low expenses ratio is
favourable.
The implication of a high ratio is that only a small
percentage share of sales is available for meeting
financial liabilities like interest, tax, dividend etc.
Return on assets (ROA)
This ratio measures the profitability of the total funds
of a firm. It measures the relationship between net
profits and total assets. The objective is to find out
how efficiently the total assets have been used by the
management.
Return on assets =
net profit after taxes plus interest x
100
Total assets
Total assets exclude fictitious assets. As the total
assets at the beginning of the year and end of the year
may not be the same, average total assets may be
used as the denominator.
 Return on capital employed (ROCE)
This ratio measures the relationship between net profit and
capital employed. It indicates how efficiently the long-term
funds of owners and creditors are being used.
Return on capital employed =
net profit after taxes plus interest x 100
Capital employed
CAPITAL EMPLOYED denotes shareholders funds and long-
term borrowings.
To have a fair representation of the capital employed, average
capital employed may be used as the denominator.
Return on shareholders equity
This ratio measures the relationship of profits to owner’s
funds. Shareholders fall into two groups i.e. preference
shareholders and equity shareholders. So the variants of
return on shareholders equity are

Return on total shareholder’s equity =

net profits after taxes x 100
Total shareholders equity
.
TOTAL SHAREHOLDER’S EQUITY includes
preference share capital plus equity share capital plus
reserves and surplus less accumulated losses and
fictitious assets. To have a fair representation of the
total shareholders funds, average total shareholders
funds may be used as the denominator
Return on ordinary shareholders equity =
net profit after taxes – pref. dividend x 100
Ordinary shareholders equity or net worth
ORDINARY SHAREHOLDERS EQUITY OR NET
WORTH includes equity share capital plus reserves and
surplus minus fictitious assets.
From the following annual accounts of New Horizontal Limited you are required to
calculate the following ratios and comment on the results, indicating what other
information you require:

(i) Gross profit percentage,

(ii) Net profit percentage,
(iii) Return on total assets,
(iv) Quick asset ratio,
(v) Debtors collection period,
(vi) Stock turnover,
(vii) Fixed assets turnover,
(viii) Return on shareholders’ funds,
(ix) Current ratio, and
(x) Debt ratio.
From the following Balance Sheet –Calculate Current Ratio, Liquid Ratio,
Debt Equity Ratio and Fixed Assets to turnover ratio

Liabilities and Capital Amount

Equity Share Capital 100000
Reserves 20000
P&L 30000
Secured Loan 80000
Sundry creditors 50000
Provision for Tax 20000
Total 3,00,000
Assets Amount
Goodwill 60000
Fixed Assets 140000
Stock 30000
Sundry Debtors 30000
Advance 10000
Total 3,00,000

Sales for the year is 560000/-

 Very few ratios have an absolute value but they are used in a
relative way in intra-and inter- firm comparisons. Both gross and
net margins are calculated using the profit before tax and interest
to identify the trading profit, irrespective of the capital structure in
force.
 Both these figures seem satisfactory but knowledge of the
industry is necessary. Also the returns on shareholders’ funds and
on total assets both appear quite satisfactory.
 The quick ratio exceeds the 1: 1 norm and the current ratio is near
the 2: 1 norm, but this requirement varies widely. On the other
hand the debt ratio seems high, as two-thirds of all assets are
financed by debt. Asset turnover rates also need comparisons to
make any judgement but the debtors collection period of 91 days
would seem too long for most industries, especially if credit is
granted on a net monthly basis.
Earnings per share (EPS)
This ratio measures the profit available to the equity
shareholders on a per share basis. This ratio is calculated
by dividing net profit available to equity shareholders by
the number of equity shares.
Earnings per share =
net profit after tax – preference dividend
Number of equity shares
Dividend per share (DPS)
This ratio shows the dividend paid to the shareholder on
a per share basis. This is a better indicator than the EPS
as it shows the amount of dividend received by the
ordinary shareholders, while EPS merely shows
theoretically how much belongs to the ordinary
shareholders
Dividend per share =
Dividend paid to ordinary shareholders
Number of equity shares
Dividend payout ratio (D/P)
This ratio measures the relationship between the
earnings belonging to the ordinary shareholders and
the dividend paid to them.
Dividend pay out ratio =
total dividend paid to ordinary shareholders x
100
Net profit after tax –preference dividend
OR
Dividend pay out ratio = Dividend per share x 100
Earnings per share
 Price earning ratio (P/E)
This ratio is computed by dividing the market price of the
shares by the earnings per share. It measures the
expectations of the investors and market appraisal of the
performance of the firm.
Price earning ratio = market price per share
Earnings per share
 Activity ratios

These ratios are also called efficiency ratios / asset

utilization ratios or turnover ratios. These ratios
show the relationship between sales and various
assets of a firm. The various ratios under this group
are:
 Inventory/stock turnover ratio
 Debtors turnover ratio and average collection period
 Asset turnover ratio
 Creditors turnover ratio and average credit period
Inventory /stock turnover ratio
This ratio indicates the number of times inventory is
replaced during the year. It measures the relationship
between cost of goods sold and the inventory level.
There are two approaches for calculating this ratio,
namely:
Inventory turnover ratio = cost of goods sold
Average stock
AVERAGE STOCK can be calculated as
Opening stock + closing stock
2
Alternatively
Inventory turnover ratio = sales_________
Closing inventory
Inventory /stock turnover ratio
A firm should have neither too high nor too low
inventory turnover ratio. Too high a ratio may indicate
very low level of inventory and a danger of being out
of stock and incurring high ‘stock out cost’. On the
contrary too low a ratio is indicative of excessive
inventory entailing excessive carrying cost.
Debtors turnover ratio and average collection
period

This ratio is a test of the liquidity of the debtors of a firm. It

shows the relationship between credit sales and debtors.
Debtors turnover ratio =
Credit sales

Average Debtors and bills receivables

Average collection period =
Months/days in a year
Debtors turnover
Debtors turnover ratio and average collection
period
These ratios are indicative of the efficiency of the trade
credit management. A high turnover ratio and shorter
collection period indicate prompt payment by the
debtor. On the contrary low turnover ratio and longer
collection period indicates delayed payments by the
debtor.
In general a high debtor turnover ratio and short
collection period is preferable.
 Asset turnover ratio

Depending on the different concepts of assets employed, there

are
many variants of this ratio. These ratios measure the efficiency
of a firm in managing and utilising its assets.
Total asset turnover ratio = sales/cost of goods sold
Average total assets
Fixed asset turnover ratio = sales/cost of goods sold
Average fixed assets
Capital turnover ratio = sales/cost of goods sold
Average capital employed
Working capital turnover ratio = sales/cost of goods sold
Net working capital
Asset turnover ratio

Higher ratios are indicative of efficient management

and utilisation of resources while low ratios are
indicative of under-utilisation of resources and
presence of idle capacity.
Creditors turnover ratio and average credit
period
This ratio shows the speed with which payments are made to
the suppliers for purchases made from them. It shows the
relationship between credit purchases and average creditors.
Creditors turnover ratio =
credit purchases
Average creditors & bills payables
Average credit period = months/days in a year
Creditors turnover ratio
Creditors turnover ratio and average
credit period

Higher creditors turnover ratio and short credit period

signifies that the creditors are being paid promptly and
it enhances the creditworthiness of the firm.
Problem
1. Also known as
a) Du Pont Identity
b) Du Pont Equation
c) Du Pont Model
d) Du Pont Method
2. Pioneered by DU PONT Company of United
States
3. It is a system of financial analysis which
received wide spread recognition and
acceptance
4. It was developed by DU PONT company for
analyzing and controlling financial performance
5. It is an expression which breaks Return on
Equity into three parts :
a) Profitability (Measured by Profit Margin)
b) Operating Efficiency (Measured by Asset Turnover)
c) Financial Leverage (Measured by Equity Multiplier)
Profit Margin
Net Profit = Net Sales – Total
Profit Margin = Net Profit
Cost
Sales

Cost of Goods Sold = xxx

Operating Expenses = xxx
Interest and Taxes = xxx
Total Cost = xxx
Asset Turnover
Asset Turnover = Net Sales
Total Assets

Total Assets = Current Assets + Fixed Assets

Inventory = xxx
Accounts Receivables = xxx
Cash and Bank Balance = xxx
Current Assets = xxx
Equity Multiplier
Equity Multiplier = Assets
Shareholder’s Equity
Return on Equity
Return on Equity = Net Profit Margin X Asset Turnover X Equity Multiplier

Return on Equity = Net Profit Sales Assets

Sales Assets Shareholder’s Equity

Return on Equity = Net Profit (or Profit after Tax)

Shareholder’s Equity
6. Helps in understanding How the net Return on
Investment is influenced by the Net Proft Margin
and Total Asset Turnover Ratio

Return on Investment
Return on Investment = Net Profit Margin X Asset Turnover
DU PONT CHART
 ENTERPRISES

 Vendor risk management (VRM) is a comprehensive plan for identifying and

decreasing potential business uncertainties and legal liabilities regarding the
hiring of 3rd party vendors for IT products and services, as the actions of
vendors can cause significant financial and reputational impact to
organizations.
 We need to ensure that the vendor is not going to be bankrupt in the next few
years-need to analyze the credit and bankruptcy risk of the vendor
 Credit and bankruptcy risk- This occurs when a firm cannot meet its
contractual financial obligations as they come due and cannot deliver the
services the vendor was contracted to deliver.
CURRENT METHOD
 SHORTCOMINGS OF THE
CURRENT METHOD
Altman Z-score
Initially calculated for publicly-held manufacturing firms with assets
of more than $1 million
Many of the vendors we deal with are privately held, non-
manufacturing service companies – not possible to calculate the
formula for Z-score for them because
Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

D=market value of equity/total liabilities

In such cases, we rely on Quick Ratio – a very rough estimate for
credit risk as it only defines short term liquidity and ability to pay
short term liabilities
 ALTERNATIVE
 For private companies who provide documentation on their financial
statements, the Model B Altman Z-Score or Z’’ score-computed for
private non-manufacturing firms should be used which is as follows:
Z = 6.56A + 3.26B + 6.72B + 1.05D
A = working capital / total assets
B = retained earnings / total assets
C = earnings before interest and tax EBIT / total assets
D = book value of equity / total liabilities

Z>2.6 - “Safe” Zone

1.1<Z<2.6 - “Grey” Zone
Z<1.1 - “Distress” Zone
Dupont analysis Illustration
 ) The following financial statements have been extracted from the
Annual Report 2016-17 of METCALF TEXTILES Ltd., a largest
Textile Company with a strong presence in over 80 countries
worldwide.
 The company wants to keep its shareholders happy by giving them
a fair rate of return. The company is using return on equity (ROE)
as one of the metrics of performance evaluation for determining
the return for shareholders. Due to intense competition, in recent
years, its ROE has been under pressure, and to maintain the level
of ROE, the company is to change its business Model-in that, it is
varying its margin, assets utilization and leverage.
 2014 2015 2016 2017

Total revenue 7998 8992 9976 11804

Profit before tax 1855 1612 1990 2817
Profit after tax 1514 1345 1574 2110
Dividend 225 315 225 225
Tax on dividend 37 51 36 38
Retained earnings 1252 979 1313 1847
 2014 2015 2016 2017
Equity and Liabilities
Shareholders’ fund
225 225
a.Share capital 225 225
1. Reserves and Surplus
b. 8055 9034 10347 12194

2. Non-current liabilities: Loan Funds 7 617 17 1352

Current liabilities
3. Deferred Tax 251 296 324 392
8538 10172 10913 14163
Assets

1. Non - Current assets: Fixed Assets 3774 4369 4685 5276

2. Non - Current investments 371 799 1449 3642

3. Current assets 4393 5004 4779 5245
8538 10172 10913 14163