Financial Analysis
Introduction
A ratio is a simple mathematical expression of figures in a Balance Sheet and Profit & Loss Account. (A relationship between two figures)
What Is a……….?????
Balance Sheet….
A snap shot of the Firms Financial Position taken on a particular date.
Profit & Loss A/C
The Financial performance of a Firm over a period of time.
Ways of Expressing These
Relationships….
As a fraction (1/3 )
As a percentage ( 33% )
Express in words ( Gross profit of Rs1/- for every Rs3/- )
Interpretation of Ratios.
Interpretation is done by comparison of a ratio with…….
…the same ratio derived in another period of time.
…a result of a ratio which has been benchmarked as normal.
Basic Types of Financial Ratios.
Liquidity Ratios – Firms ability to meet obligations which are maturing on a short term.
Gearing Ratios – The extent to which the firm has been financed by Debt.
Activity Ratios – How effective has been the firm in using its resources.
Performance Ratios – Firm’s overall effectiveness shown by the profits generated on
sales and capital employed.
Liquidity Ratios
Current Assets
Current Ratio = ----------------------
Current Liabilities
Current Assets - Stocks
Quick Ratio = ---------------------------------
Current Liabilities
Current Ratio
Current Assets
Current
Ratio = ----------------------
Current Liabilities
1. Measure of short term solvency. (The extent to which, short term creditors are covered by current liabilities)
2. Usually mentioned as a simple ratio.
3. Rule of the thumb is 2:1
4. How ever if the ratio is lower that above it does not mean that their solvency is impaired.
5. If the ratio falls below 1:1, it should cause to be concern.
For example, if WXY Company's current assets are Rs50,000. and its current liabilities are Rs40,000. then its current ratio would be Rs50,000. divided by Rs40,000. Which equals 1.25. It means that for every rupee the company owes it has Rs1.25 available in current assets. A current ratio of assets to liabilities of 2:1 is usually considered to be acceptable (your assets are twice your liabilities).
The current ratio is an indication of a firm's market liquidity and ability to meet creditor's demands. Acceptable current ratios vary from industry to industry. If current liabilities exceed current assets (the current ratio is below 1), then the company may have problems meeting its short-term obligations. If the current ratio is too high, then the company may not be efficiently using its current assets.
Quick Ratio
Current Assets - Stocks
Quick
Ratio =
---------------------------------
Current
Liabilities
Current ratio itself is not adequate to gauge the solvency of a firm. Quick ratio is acid test / checking margin of safety.
The firm must hold adequate liquid assets to pay off current liabilities as and when they fall due.
If the current ratio is high and quick ratio remains low it indicates a higher inventory.
Rule of the thumb is 1:1
In finance the Acid-test or quick ratio or liquid ratio measures the ability of a company to use its near cash or quick assets to immediately extinguish its current liabilities. Quick assets include those current assets that presumably can be quickly converted to cash Such items are cash, marketable securities, and some accounts receivable. This ratio indicates a firm's capacity to maintain operations as usual with current cash or near cash reserves in bad periods.
Gearing Ratios
Total Debt (Long/short)
Debt/
Equity Ratio= ---------------------------------
Equity (share holding+ Retained Profits+
Reserves)
Total external debts
Gearing = ---------------------------------------
Equity (share holding+ Retained Profits+
Reserves)
Equity = Tangible Net worth
Debt / Equity Ratio
Total Debt (Long/short)
Debt/
Equity Ratio= ---------------------------------
Equity (share holding+ Retained Profits+
Reserves)
Provides a measure of protection to share holders and other parties who contribute funds such as creditors / Banks.
When this ratio is above 1 – We call the firm High Geared.
When this ratio is below 1 – We call the firm Low geared.
Lending to high geared firms has a inherited financial risk.
The debt
to equity ratio (D/E) is a financial ratio indicating the relative proportion
of equity and debt used to finance a company's assets. This ratio is also known
as Risk or Gearing. It is equal to total debt divided by shareholders' equity.
The two components are often taken from the firm's balance sheet. The debt
usually includes only the Long Term Debt.
Financial
analysts quotes will generally not include other types of liabilities, such as
accounts payable, although some will make adjustments to include or exclude
certain items from the formal financial statements. Adjustments are sometimes
also made to, for example, exclude intangible assets (such as revaluation
reserve), and this will affect the formal equity; debt to equity will therefore
also be affected.
Gearing Ratio
Total external debts including creditors
Gearing =
---------------------------------------------------------------
Equity (share holding+ Retained Profits+
Reserves)
A measure of relative exposure / risk to the external providers of funds and shareholders.
High Geared firms a more vulnerable to downfall due to heavy burden of interest cost.
Increase in gearing could be due to the following. Incurring losses eroding equity.
Incurring Losses there by eroding Equity
The firm growing faster than the growth of equity.
If the assets of the company is on the rise. Check for over trading.
Activity Ratios
Trade Debtors
Debt
Collection Period = ---------------------- X 365
Sales
Trade
Creditors
Creditors
Payment Period = ----------------------- X 365
Cost
of Sales
Stocks & WIP
Stock
Turnover Period = ------------------------ X 365
Cost of Sales
Debt Collection Period
Trade
Debtors
Debt
Collection Period = ---------------------- X 365
Sales
This ratio is an indication how long it take the firm to collect it’s dues from their debtors.
If the ratio is high……
Any increase in the ratio is a poor sign.
Longer credit extended.
Relaxed credit control.
Bad debts.
If the Ratio is low…….
Check whether the bills are discounted.
Creditors Payment Period
Trade Creditors
Creditors
Payment Period = ----------------------- X 365
Cost of Sales
This ratio is an indication of how long it takes for the firm to repay it’s dues to creditos.
Increase ratio – Firm enjoying longer credit period.
Increased ratio might be a warning sign – due to liquidity constrains stretching payment to creditors.
New Firms might not enjoy longer credit - Low ratio.
Low ratio may mean firm being liquid and less reliance on creditors. Or some times they might be paying off the creditors faster , not taking the full advantage of the suppliers credit.
Sudden change in the ratio might be a change of the supplier or trade terms.
Stock Turnover Period
Stocks & (RM+WIP+FG)
Stock
Turnover Period =
---------------------------------- X 365
Cost of Sales
This ratio is an indication of how long the firm take to convert it’s inventories to cash or debtors.
Firms with large distribution net works may have higher ratios.
If the ratio is high…Denotes larger stock holding / longer rotation period.
If the ratio is high…Obsolete stocks.
Ratio being very low – the firm may not be holding adequate stocks.
Inefficient production might pile up work in progress.
Performance Ratios
Gross Profit
Gross
Profit Margin =
-------------------- X 100
Sales
Operating Profit
Operating
Profit Margin =
--------------------- X 100
Sales
Net Profit
Net
Profit Margin =
--------------------- X 100
Sales
Profit before Interest & Tax
Interest
Cover =
---------------------------------------
Interest
Profit before tax
Return
On Capital Employed =
-------------------------------------
Capital Employed
Gross Profit Margin
Gross Profit
Gross
Profit Margin =
-------------------- X 100
Sales
Gross Profit = Revenue − Cost of Goods Sold
Cost of goods sold includes variable and fixed costs directly linked to the product, such as material and labor. It does not include indirect fixed costs like office expenses, rent, administrative costs, etc.
Higher gross margins for a manufacturer reflect greater efficiency in turning raw materials into income. For a retailer it will be their mark up. Larger gross margins are generally good for companies,
1. Falling ratio – Cost of production / material has increased. This has not been passed to the customer.
2. Weakening of the local currency which has resulted increased cost of materials. This has not been passed on to the client.
3. Competition in the market has forced the firm to accept lower margins.
4. Low margin – under cutting the competitors.
5. Increase of production.
6. Alternative cheaper material / labor.
Operating Profit Margin
Operating Profit
Operating
Profit Margin = ----------------------- X 100
Sales
It is a measurement of what proportion of a company's revenue is left over, before taxes, after paying for variable costs of production as wages, raw materials, etc. A good operating margin is needed for a company to be able to pay for its fixed costs, as interest on debt.
Operating Profit = Profit after Distribution , Administrative , Selling expenses.
Will be a parameter to check behavior of the Distribution , Administrative , Selling costs.
If the ratio changes in line with the gross margin , there is no need for further investigation.
Observe change in comparative years. Any change will be due to the changes in the above.
Net Profit Margin
Net Profit
Net
Profit Margin = ---------------------
X 100
Sales
The profit margin is mostly used for internal comparison. It is difficult to accurately compare the net profit ratio for different entities. Individual businesses' operating and financing arrangements vary so much that different entities are bound to have different levels of expenditure, so that comparison of one with another can have little meaning.
The final out come of the business which is to be carried forward or appropriated.
Check whether the profits have been pulled out of the business.
With the analysis of the Operating Profit Margin and the Interest Cover you will be able to determine the behavior of the Net Margin.
Interest Cover
Profit before Interest & Tax
Interest
Cover = ---------------------------------------
Interest
To measure the extent of profits being generated to cover the interest.
This should be above 1.
If below 1, the firm can not service the interest – Warning.
If the ratio is falling – Fall of sales volume / margins. Increase in borrowings or interest rates & other costs.
Return On Capital Employed
Profit before tax
Return
On Capital Employed =
------------------------------------- X 100
Capital Employed
Return on Capital Employed (ROCE) is used in finance as a measure of the returns that a company is realizing from its capital employed. It is commonly used as a measure for comparing the performance between businesses and for assessing whether a business generates enough returns to pay for its cost of capital. It would be ideal if this is above the current market interest rates.
By
Sanjeeva Pieris
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