FINANCIAL STATEMENTS

ANALYSIS -II
 Financial Ratio Analysis

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 RATIO

A ratio is a statistical yardstick that provides a

measure of the relationship between two
variables or figures.

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 Ratios
Ratios can be expressed in three different
ways:
1. Ratio (e.g., current ratio of 2:1)
2. % (e.g., profit margin of 2%)
3. (e.g., EPS of 2.25)

CAUTION!
“Using ratios and percentages without
considering the underlying causes may lead
to incorrect conclusions.”
 WHY BOTHER WITH RATIOS?

• A comparison is more useful than mere Nos

• Analysis of financial ratios involves two types of comparisons:
– Present ratio with the past ratios & expected future ratios
– Ratios of one firm with those of similar firms or with industry averages
at same point of time
• Essential to consider nature of business
(apples cannot be compared with oranges)

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 Categories of Ratios
• Liquidity Ratios
Indicate a company’s short-term
debt-paying ability
• Equity (Long-Term Solvency) Ratios
Show relationship between debt and equity
financing in a company
• Profitability Tests
Relate income to other variables
• Market Tests
Help assess relative merits of stocks in the
marketplace
 Building Blocks of Analysis

Ability to meet Ability to

short-term
Liquidity generate future
obligations and to
and Solvency revenues and
efficiently generate meet long-term
revenues Efficiency
obligations

Ability to provide
financial rewards Ability to
sufficient to attract generate
and retain Profitability Market positive market
financing expectations
 Financial Ratio Analysis
Financial ratio analysis is the use of relationships among
financial statement accounts to gauge the financial condition and
performance of a company.
We can classify ratios based on the type of information the ratio
provides:
 SIGNIFICANCE OF RATIO ANALYSIS
Company‘A’ earns Rs 50,000
Company ‘B’ earns Rs 40,000

Which is more efficient? A or B

‘A’ has invested capital Rs 4,00,000

‘B’ has invested capital Rs 3,00,000
Profit as a % of Capital Employed
‘A’ = (50,000/ 4,00,000) * 100 =12.50%
‘B’ = (40,000/ 3,00,000) * 100 =13.33%

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 Solvency Ratios
The capacity of a company to discharge its long-
term obligation indicates its financial strength
and solvency position.
Under this group, the following ratios are
computed.
1. Debt-Equity ratio
2. Interest coverage ratio
3. Debt-service coverage ratio
 Solvency Ratio- D / E Ratio
The debt-to-equity ratio (debt/equity ratio, D/E) is a financial ratio indicating the relative proportion of entity's
equity and debt used to finance an entity's assets. This ratio is also known as financial leverage. Debt-to-equity
ratio is the key financial ratio and is used as a standard for judging a company's financial standing. It is also a
measure of a company's ability to repay its obligations. When examining the health of a company, it is critical to
pay attention to the debt/equity ratio. If the ratio is increasing, the company is being financed by creditors rather
than from its own financial sources which may be a dangerous trend. Lenders and investors usually prefer low debt-
to-equity ratios because their interests are better protected in the event of a business decline. Thus, companies
with high debt-to-equity ratios may not be able to attract additional lending capital.

Calculation Formula:
Long term debt
-------------------------------------------------------------------
Total net worth( Eq. shareholders’ funds+Pref. cap)

Norms and Limits

•Optimal debt-to-equity ratio is considered to be about 1, i.e. liabilities = equity, but the ratio is very industry
specific because it depends on the proportion of current and non-current assets. The more non-current the assets
(as in the capital-intensive industries), the more equity is required to finance these long term investments.
•For most companies the maximum acceptable debt-to-equity ratio is 1.5-2 and less. For large public companies
the debt-to-equity ratio may be much more than 2, but for most small and medium companies it is not acceptable.
•In general, a high debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy
its debt obligations. However, a low debt-to-equity ratio may also indicate that a company is not taking advantage
of the increased profits that financial leverage may bring.
 Solvency Ratios -ICR
The interest coverage ratio (ICR) is a measure of a company's ability to meet its interest payments.The
interest coverage ratio is a measure of the number of times a company could make the interest
payments on its debt with its EBIT. It determines how easily a company can pay interest expenses on
outstanding debt.
Calculation (formula)

Interest coverage ratio = EBIT / Interest expenses

Interpretation
•The lower the interest coverage ratio, the higher the company's debt burden and the greater the
possibility of bankruptcy or default. A lower ICR means less earnings are available to meet interest
payments and that the business is more vulnerable to increases in interest rates. When a company's
interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable. An
interest coverage ratio below 1.0 indicates the business is having difficulties generating the cash
necessary to pay its interest obligations (i.e. interest payments exceed its earnings (EBIT)).

•A higher ratio indicates a better financial health as it means that the company is more capable to
meeting its interest obligations from operating earnings. On the other hand, a high ICR may suggest a
company is "too safe" and is neglecting opportunities to magnify earnings through leverage.
 Solvency Ratios -DSCR
The Debt Service Coverage Ratio (DSCR) helps in assessing whether a company has the
ability to service its instalments of the principal due and the interest obligations out of the
revenues generated. Higher the ratio, greater is the ability.

Calculation (Formula)
•DSCR = (PAT+ Interest Expense + Amortization & Depreciation )/ (Principal Repayment +
Interest Payments + Lease Payments)

Interpretation
•A debt service coverage ratio which is below 1 indicates a negative cash flow. For example,
a debt service coverage ratio of 0.92 indicates that the company’s net operating income is
enough to cover only 92% of its annual debt payments . The lenders, however, usually
frown on a negative cash flow while some might allow it if, in case, the borrower is having
sound income outside.
• The debt service coverage ratio is, therefore, a benchmark used to measure the cash
producing ability of a business entity to cover its debt payments. A higher debt service
coverage ratio makes it easier to obtain a loan.
 LIQUIDITY RATIO
Liquidity refers to the capacity a company to meet its day
to day expenses and discharge short-term obligations of
suppliers and other creditors smoothly.

Following ratios are calculated under this head.

1. Current Ratio
2. Quick Ratio
3. Collection period
4. Suppliers Credit
5. Inventory Holding period
 Liquidity Ratio
Liquidity ratios are the ratios that measure the ability of a company to meet its short term debt obligations.
These ratios measure the ability of a company to pay off its short-term liabilities when they fall due.The
liquidity ratios are a result of dividing cash and other liquid assets by the short term borrowings and current
liabilities. They show the number of times the short term debt obligations are covered by the cash and liquid
assets. If the value is greater than 1, it means the short term obligations are fully covered.
Generally, the higher the liquidity ratios are, the higher the margin of safety that the company posses to
meet its current liabilities. Liquidity ratios greater than 1 indicate that the company is in good financial health
and it is less likely fall into financial difficulties.
Most common examples of liquidity ratios include current ratio, acid test ratio (also known as quick ratio),
cash ratio and working capital ratio. Different assets are considered to be relevant by different analysts. Some
analysts consider only the cash and cash equivalents as relevant assets because they are most likely to be
used to meet short term liabilities in an emergency. Some analysts consider the debtors and trade
receivables as relevant assets in addition to cash and cash equivalents. The value of inventory is also
considered relevant asset for calculations of liquidity ratios by some analysts.
The concept of cash cycle is also important for better understanding of liquidity ratios. The cash continuously
cycles through the operations of a company. A company’s cash is usually tied up in the finished goods, the
raw materials, and trade debtors. It is not until the inventory is sold, sales invoices raised, and the debtors’
make payments that the company receives cash. The cash tied up in the cash cycle is known as working
capital, and liquidity ratios try to measure the balance between current assets and current liabilities.
A company must posses the ability to release cash from cash cycle to meet its financial obligations when the
creditors seek payment. In other words, a company should posses the ability to translate its short term assets
into cash. The liquidity ratios attempt to measure this ability of a company.
 Liquidity Ratio-CR
The current ratio (CR) indicates a company's ability to meet short-term debt obligations. The current ratio
measures whether or not a firm has enough resources to pay its debts over the next 12 months. Potential
creditors use this ratio in determining whether or not to make short-term loans. The current ratio can also give a
sense of the efficiency of a company's operating cycle or its ability to turn its product into cash. The current ratio
is also known as the working capital ratio.

Calculation (formula)
Current Ratio = Current Assets / Current Liabilities
Interpretation
•The higher the ratio, the more liquid the company is. Commonly acceptable current ratio is 2; it's a comfortable
financial position for most enterprises. Acceptable current ratios vary from industry to industry. For most
industrial companies, 1.5 may be an acceptable current ratio.
•Low values for the current ratio (values less than 1) indicate that a firm may have difficulty meeting current
obligations. However, an investor should also take note of a company's operating cash flow in order to get a
better sense of its liquidity. A low current ratio can often be supported by a strong operating cash flow.
•If the current ratio is too high (much more than 2), then the company may not be using its current assets or its
short-term financing facilities efficiently. This may also indicate problems in working capital management.All other
things being equal, creditors consider a high current ratio to be better than a low current ratio, because a high
current ratio means that the company is more likely to meet its liabilities which are due over the next 12 months.
 Liquidity Ratio- QR
The Quick Ratio (QR) is a measure of a company's ability to meet its short-term obligations using its
most liquid assets (near cash or quick assets). Quick assets include those current assets that
presumably can be quickly converted to cash at close to their book values. Quick ratio is viewed as a
sign of a company's financial strength or weakness; it gives information about a company’s short term
liquidity. The ratio tells creditors how much of the company's short term debt can be met by selling all
the company's liquid assets at very short notice.The quick ratio is also known as the acid-test ratio or
quick assets ratio.
Calculation (formula)
Quick ratio = (Current Assets - Inventories) / Current Liabilities

Calculating liquid assets inventories are deducted as less liquid from all current assets (inventories are
often difficult to convert to cash). All of those variables are shown on the balance sheet

Alternative and more accurate formula for the quick ratio is the following:
Quick ratio = (Cash and cash equivalents + Marketable securities + Accounts receivable) / Current
Liabilities
Interpretation
The higher the quick ratio, the better the position of the company. The commonly acceptable current
ratio is 1, but may vary from industry to industry. A company with a quick ratio of less than 1 can not
currently pay back its current liabilities; it's the bad sign for investors and partners.
 Liquidity Ratio Contd..
Collection Period ( days )

The ratio measures how fast the company is able

to realise the dues from the customers on credit sales.
It helps to understand the credit policy of the company.

Formula: Receivables *365 / Credit sales

 Liquidity Ratio Contd..
Suppliers’ Credit ( days )
The ratio measures the average credit period
enjoyed by the company from its suppliers. It also helps
to understand the credit policy extended to a company
by the suppliers.
Formula:
Payables*365/Credit Purchases
 Liquidity Ratio Contd..
• Inventory Holding Period( days )
The ratio measures the average period for which cash is
blocked in inventory. In other words the ratio
explains how fast the company is able to convert its
inventory into cash.
Formula:
Inventory*365
--------------------
Cost of goods sold
 Asset Management Ratios
(Turnover Ratios)
These ratios indicate how efficiently the assets of the
company are used to generate revenue .
Following ratios are calculated under this group.
1. Fixed Assets Turnover Ratio
2. Debtors Turnover Ratio
3. Inventory Turnover Ratio
4. Accounts Payble Turnover Ratio
 Asset Management Turnover Ratios
Asset management (turnover) ratios compare the assets of a company to its sales revenue. Asset management ratios
indicate how successfully a company is utilizing its assets to generate revenues. Analysis of asset management ratios
tells how efficiently and effectively a company is using its assets in the generation of revenues. They indicate the ability
of a company to translate its assets into the sales. Asset management ratios are also known as asset turnover ratios and
asset efficiency ratios.

Asset management ratios are computed for different assets. Common examples of asset turnover ratios include fixed
asset turnover, inventory turnover, accounts payable turnover ratio, accounts receivable turnover ratio, and cash
conversion cycle. These ratios provide important insights into different financial areas of the company and its highlights
its strengths and weaknesses.High asset turnover ratios are desirable because they mean that the company is utilizing
its assets efficiently to produce sales. The higher the asset turnover ratios, the more sales the company is generating
from its assets.

Although higher asset turnover ratios are preferable, but what is considered to be high for one industry, may be low for
another. Therefore it is not useful to compare asset turnover ratios of different industries. Different industries have
different requirements with regard to assets. It would be unwise to compare an ecommerce store which requires little
assets to a manufacturing organization which requires large manufacturing facilities, plant and equipment.

Low asset turnover ratios mean inefficient utilization of assets. Low asset turnover ratios mean that the company is not
managing its assets wisely. They may also indicate that the assets are obsolete. Companies with low asset turnover
ratios are likely to be operating below their full capacity.

Financial analyses have highlighted relationship between profit margins and asset turnover ratios. It has often been
observed that companies with high profit margins have lower asset turnover ratios. On the other hand, companies with
lower profit margins tend to have higher asset turnover ratios.Asset turnover ratios are not always very useful. Asset
turnover ratios will not give useful insights into the asset management of companies which sell highly profitable
products but not often.
 Fixed Asset Turnover Ratio
Fixed asset turnover ratio compares the sales revenue a company to its fixed assets. This ratio tells us
how effectively and efficiently a company is using its fixed assets to generate revenues. This ratio
indicates the productivity of fixed assets in generating revenues. If a company has a high fixed asset
turnover ratio, it shows that the company is efficient at managing its fixed assets. Fixed assets are
important because they usually represent the largest component of total assets.

Calculation (formula)

Fixed Asset Turnover Ratio = Sales Revenue / Total Fixed Assets

The fixed assets usually include property, plant and equipment. The value of goodwill, long-term
deferred tax and other fixed assets that do not belong to property, plant and equipment is usually
subtracted from the total fixed assets to present a more meaningful fixed asset turnover ratio.
Interpretation:
An increasing trend in fixed assets turnover ratio is desirable because it means that the company has
less money tied up in fixed assets for each unit of sales. A declining trend in fixed asset turnover may
mean that the company is over investing in the property, plant and equipment. This ratio is usually used
in capital-intensive industries where major purchases are for fixed assets. This ratio should be used in
subsequent years to see how effective the investment in fixed assets has been.
There is no standard guideline about the best level of asset turnover ratio. Therefore, it is important to
compare the asset turnover ratio over the years for the same company. This comparison will tell
whether the company’s performance is improving or deteriorating over the years. It is also important to
compare the asset turnover ratio of other companies in the same industry. This comparison will
indicate whether the company is performing better or worse than others.
 Debtors Turnover Ratio
The receivable turnover ratio (debtors turnover ratio, accounts receivable turnover ratio) indicates the
velocity of a company's debt collection, the number of times average receivables are turned over during
a year. This ratio determines how quickly a company collects outstanding cash balances from its
customers during an accounting period. It is an important indicator of a company's financial and
operational performance and can be used to determine if a company is having difficulties collecting sales
made on credit.
Receivable turnover ratio indicates how many times, on average, account receivables are collected during
a year (sales divided by the average of accounts receivables). A popular variant of the receivables
turnover ratio is to convert it into an Average collection period in terms of days. The average collection
period (also called Days Sales Outstanding (DSO) is the number of days, on average, that it takes a
company to collect its accounts receivables, i.e. the average number of days required to convert
receivables into cash.
Calculation (formula)
Receivables (Debtors) Turnover ratio = Net receivable sales/ Average accounts receivables
Average collection period (Days sales outstanding) = 365 / Receivables Turnover Ratio
Norms and Limits
There is no general norm for the receivables turnover ratio, it strongly depends on the industry and other
factors. The higher the value of receivable turnover the more efficient is the management of debtors or
more liquid the debtors are and the better the company is in terms of collecting their accounts
receivables. Similarly, low debtors turnover ratio implies inefficient management of debtors or less liquid
debtors. But in some cases too high ratio can indicate that the company's credit lending policies are too
stringent, preventing prime borrowing candidates from becoming customers.
 Inventory turnover
Inventory turnover is a measure of the number of times inventory is sold or used in a given time period
such as one year. It is a good indicator of inventory quality (whether the inventory is obsolete or not),
efficient buying practices, and inventory management. This ratio is important because gross profit is
earned each time inventory is turned over. Also called stock turnover.
Calculation (formula)
Inventory turnover = Cost of goods sold / Average Inventory
Another approach is: Inventory turnover = Sales / Average Inventory
The number of days in the period can then be divided by the inventory turnover formula to calculate the
number of days it takes to sell the inventory on hand or "Days inventory outstanding ":
Days inventory outstanding = 365 / Inventory turnover
Norms and Limits
There is no general norm for the inventory turnover ratio; it should be compared against industry
averages. A relatively low inventory turnover may be the result of ineffective inventory management
(that is, carrying too large an inventory) and poor sales or carrying out-of-date inventory to avoid writing
off inventory losses against income. Normally a high number indicates a greater sales efficiency and a
lower risk of loss through un-saleable stock. However, too high an inventory turnover that is out of
proportion to industry norms may suggest losses due to shortages, and poor customer-service.
A high value for inventory turnover usually accompanies a low gross profit figure. This means that a
company needs to sell a lot of items to maintain an adequate return on the capital invested in the
company.
 Accounts Payable Turnover Ratio
Accounts payable turnover ratio is an accounting liquidity metric that evaluates how fast a company pays off its
creditors (suppliers). The ratio shows how many times in a given period (typically 1 year) a company pays its average
accounts payable. An accounts payable turnover ratio measures the number of times a company pays its suppliers
during a specific accounting period. Accounts payables turnover trends can help a company assess its cash situation.
Just as accounts receivable ratios can be used to judge a company's incoming cash situation, this figure can
demonstrate how a business handles its outgoing payments.
Calculation (formula)
Accounts-payable turnover is calculated by dividing the total amount of purchases made on credit by the average
accounts-payable balance for any given period.
Accounts payable turnover ratio = Total purchases / Average accounts payable
To calculate the purchases made, the cost of goods sold is adjusted by the change in inventory as follows:
Purchases = Cost of sales + Ending inventory – Starting inventory

Again, as with the accounts receivable turnover ratios, this can also be expressed in terms of a number of days by
dividing the result into 365:
Days Payable Outstanding (DPO) = 365 /Accounts payable turnover ratio

Norms and Limits

Payment requirements will usually vary from supplier to supplier, depending on its size and financial capabilities. A
high ratio means there is a relatively short time between purchase of goods and services and payment for them.
Conversely, a lower accounts payable turnover ratio usually signifies that a company is slow in paying its suppliers.
But a high accounts payable turnover ratio is not always in the best interest of a company. Many companies extend
the period of credit turnover (i.e. lower accounts payable turnover ratios) getting extra liquidity.
 PROFITABILITY RATIOS
The purpose of study of these ratios is to assess the
adequacy or otherwise of the profit earned by the
company. The following ratios are calculated under
this group.
1. Multi-step Profit Margin to Sales
2. Individual Cost and Expense to Sales
3. Other Income , Extraordinary Items and Prior
Period Adjustments to PBT or Sales
4. Effective Tax Rate
 Profitability Ratios Contd..
Multi-step Profit Margin to Sales Ratios(%)
These ratios measure several profit margin indicators. All these
ratios are computed in relation to Sales.
1.Gross Profit Margin-GP
2.Operating Profit-OP
3.Net Profit Margin-PAT
4.Return on Equity (ROE)
5.Return on Capital Employed (ROCE)
 Profitability Ratios -GPM
• Gross Profit Margin (GPM)
This reflects the efficiency with which management
produces each unit of output. It also indicates the
spread between the cost of goods sold and the sales
revenue.
Formula:
Sales-Cost of Goods Sold
------------------------------------- x 100
Sales
 Profitability Ratios -OPM
• Operating Profit Margin (OPM)
This ratio indicates profitability from operating
activities. A higher margin implies better sales
realisation and effective cost control.
Formula:
Operating Profit
---------------------- X 100
Sales
 Profitability Ratios -NPM
• Net Profit Margin( NPM )
The ratio is the overall measure of the firm’s ability to
earn profit per rupee of sales. It also establishes
relationship between manufacturing, administering
and selling the products.
Formula:
Profit After Tax
--------------------- x100
Sales
 Profitability Ratios -ROE
Return on Equity or Return on Net Worth (ROE)
The ratio measures the net profit earned on equity
shareholders’ funds. It is the measure of overall profitability of a
company. Higher the ratio, greater is the financial security for
investors.

Formula:
(PAT- Pref.dividend)*100
-----------------------------------------------------------
Net Worth (Equity capital + Reserves & Surplus-Misc. expenditure
not written off)
 DuPont formula
DuPont formula (also known as the DuPont analysis, DuPont Model, DuPont equation or the
DuPont method) is a method for assessing a company's return on equity (ROE) breaking its
into three parts. The name comes from the DuPont Corporation that started using this
formula in the 1920s.

Calculation (formula)

ROE (DuPont formula) = (Net profit / Revenue) * (Revenue / Total assets) * (Total assets /
Equity) = Net profit margin * Asset Turnover * Financial leverage

DuPont model tells that ROE is affected by three things:

Operating efficiency, which is measured by net profit margin;

Asset use efficiency, which is measured by total asset turnover;
Financial leverage, which is measured by the equity multiplier;

If ROE is unsatisfactory, the DuPont analysis helps locate the part of the business that is
underperforming. Helps to identify sources of strength and weakness in current
performance. This ratio help to focus attention on value drivers
 The DuPont System
Net Income Sales Total Assets
ROE   
Sales Total Assets Common Equity
 Profit Margin  Total Asset Turnover  Equity Multiplier
 ROA  Equity Multiplier

$1,666.00 $25,265.00 $11,471.00

ROE   
$25,265.00 $11,471.00 $5,308.00
 0.0659  2.2025  2.1611
ROE  Profit Margin  Total Asset Turnover  Equity Multiplier
 0.1452
Net  2.1611 Sales
Income Total Assets
  
 31.39%
Sales Total Assets Common Equity
34
 The DuPont System: Dell
Net Income Sales Total Assets
ROE   
Sales Total Assets Common Equity
 Profit Margin  Total Asset Turnover  Equity Multiplier
 ROA  Equity Multiplier

$1,666.00 $25,265.00 $11,471.00

ROE   
$25,265.00 $11,471.00 $5,308.00
 0.0659  2.2025  2.1611
 0.1452  2.1611
 31.39%
35
 Profitability Ratios - ROCE
• Return on capital employed (ROCE) is a measure of the returns that a business
is achieving from the capital employed, usually expressed in percentage terms.
Capital employed equals a company's Equity plus Non-current liabilities (or
Total Assets − Current Liabilities), in other words all the long-term funds used
by the company. ROCE indicates the efficiency and profitability of a company's
capital investments.
• ROCE should always be higher than the rate at which the company borrows
otherwise any increase in borrowing will reduce shareholders' earnings, and
vice versa; a good ROCE is one that is greater than the rate at which the
company borrows.
• Calculation (formula)
• ROCE = EBIT / Capital Employed = EBIT / (Equity + Non-current Liabilities) =
EBIT / (Total Assets - Current Liabilities)
• One limitation of ROCE is the fact that it does not account for the depreciation
and amortization of the capital employed. Because capital employed is in the
denominator, a company with depreciated assets may find its ROCE increases
without an actual increase in profit.
 Market Ratios

Following ratios are computed under this group.

1. EPS
2. Price Earning Ratio-P/E
3. Market Capitalisation
4. Yield to Investors
 Market Ratios Contd..
• Earning per Share ( EPS)
The ratio measures the overall profitability in
terms of per equity share of capital
contributed.This is the most widely used ratio
across industries.
Formula:
PAT-Pref.Dividend
-----------------------------------------------------------
Weighted average no. of equity shares O/S
 Market Ratios Contd..
Price Earning Ratio ( times )

P/E multiple is an important indicator of the

premium that the market wishes to put on a firm’s
earnings. It can be used to price a share and value a
firm.
Formula:
Market Price of Equity Share
------------------------------------------
EPS
 Market Ratios Contd..
Market Capitalisation (Rs.)

The ratio measures the total market value

of the number of equity shares outstanding.

Formula:
No. of Equity Shares O/S X Market Price
 Market Ratios Contd..
• Yield to Investors (%)
The ratio measures the total gain or loss
suffered by investors in relation to their
investment in equity shares of a company.
Dividend recd.+ Market Appreciation
---------------------------------------------x100
Initial Investment
 Important Considerations
• Need for comparable data
– Data is provided by Dun &
Bradstreet, Standard & Poor’s etc.
– Must compare by industry
– Is EPS comparable?

 Influence of external factors

 General business conditions
 Seasonal nature of business operations
 Impact of inflation
 Effective Use of Ratio Analysis
• In addition to ratios, an analyst should describe the company
(e.g., line of business, major products, major suppliers),
industry information, and major factors or influences.
• Effective use of ratios requires looking at ratios
• Over time.
• Compared with other companies in the same line of business.
• In the context of major events in the company (for example,
mergers or divestitures), accounting changes, and changes in
the company’s product mix.
 Summary
• Financial ratio analysis and common-size analysis help gauge the financial
performance and condition of a company through an examination of
relationships among these many financial items.
• A thorough financial analysis of a company requires examining its
efficiency in putting its assets to work, its liquidity position, its solvency,
and its profitability.
• We can use the tools of common-size analysis and financial ratio analysis,
including the DuPont model, to help understand where a company has
been.
• We then use relationships among financial statement accounts in pro
forma analysis, forecasting the company’s income statements and balance
sheets for future periods, to see how the company’s performance is likely
to evolve.
 FINANCIAL RATIOS
LIQUIDITY Solvency , Safety Margins,
NWC = CA - CL Idle Resources , Risk
CR = CA/CL
ATR = (CA –
INVENTORY)/CL Long term solvency
LEVERAGE Risk due to debt
Debt-Equity Ratio = Debt/Net Worth Owners Stake
Liab Coverage Ratio = Int gen funds / Total Liab Coverage provided
Debt to Assets Ratio = Debt/Total Assets by assets
Interest Coverage Ratio = EBIT/Debt Interest Interest burden

ACTIVITY/TURNOVER Utilisation
Inventory Turn Over Ratio = Net Sales/Inventory Credit mgt
FATR = Net Sales/Total Assets Restrictions
Efficency
Avg Collection Period = 365/ RTOR
PROFITABILITY Efficency
. Acceptability
GPMR = Gross Profit/Net Sales
NPMR = Net Profit/Net Sales Overall performance
ROI = EBIT x 100/ Capital Margin of Safety
ROE = Equity earnings/ NW Ability for PAT
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