Financial Statement Analysis

Ratio Analysis

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Introduction
Purpose:
To identify aspects of a businesss performance to aid decision making
Quantitative process may need to be supplemented by qualitative factors to get a complete
picture
Broadly it focuses on 6 major areas:
Liquidity Aspect the ability of the firm to pay its way
Financing Aspect information on the relationship between the exposure of the business to loans as opposed
to share capital
Efficiency Aspect/Asset Utilisation Aspect the rate at which the company sells its stock and the efficiency
with which it uses its assets
Profitability Aspect how effective the firm is at generating profits given sales and or its capital assets
Investment/shareholders Information Aspect information to enable decisions to be made on the extent of
the risk and the earning potential of a business investment

Stock Market Performance Aspect- information regarding the stock market performance
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Liquidity Aspect
Liquidity Ratios Measure of companys ability to meet short term requirements. Indicates whether current
liabilities are adequately covered by current assets. Measures safety margin available for short term creditors.

Current Ratio
= Current Assets
Current Liabilities

Quick Ratio
= Quick Assets
Current Liabilities
Note: Quick assets = Current assets (inventories
+ prepaid expenses)

Current Ratio: As compared to industry average, Too

high Might suggest that too much of company assets are
tied up in unproductive activities i.e., too much inventory,
(for example). Too low indicates a risk of not being able to
meet its liability.
Quick Ratio or Acid Test Ratio is used to examine
whether firm has adequate cash or cash equivalents to
meet current obligations without resorting to liquidating
non cash assets such as inventories or prepaid expenses.
1:1 seen as ideal. should not be less than 1.

Gross Working Capital = Total Current Assets

Net Working Capital = Total Current Assets Total Current Liabilities
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Liquidity Aspect
Working Capital Turnover Ratio
Net sales
Average Net Working Capital
Note-1: Average Net Working Capital =
Beginning net working capital + Ending net working capital) / 2
Note-2: If data for two years is not available, then it can be calculated
using one year net working capital data.

A high working capital turnover ratio

can potentially give you a competitive
edge in your industry. It indicates you
use up your working capital more times
per year, which suggests that money is
flowing in and out of your small
business smoothly. This gives you more
spending flexibility and can help avoid
financial trouble.

Working Capital Productivity

Net Sales
Total Working Capital

Days Working Capital

= Average Net Working Capital * (365/
Annual Sales Revenue)
Note: If data for two years is not available, then it can be calculated
using one year net working capital data.
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Days working Capital: It indicates

how many days it will take for a
company to convert its working capital
into revenue. The faster a company
does this, the better.
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Financing Aspect

There is both advantage and disadvantage of debt financing. Advantages might be Tax benefit, discipline the manager. The
dis advantage of debt financing is related to bankruptcy cost, agency cost and loos of future flexibility. The use of financial
leverage can positively - or negatively - impact a company's return on equity as a consequence of the increased level of risk.

Debt to Equity Ratio

Long-term debt + Short-term debt
Share Holders Equity
Note: Share Holders Equity or Equity capital or Total
equity, meaning is same. It includes equity share capital
and retained earnings. Preference share capital is not
considered.

Equity multiplier
= Total assets
Share Holders equity
Note: Share Holders Equity or Equity capital or Total
equity, meaning is same. It includes equity share capital
and retained earnings. Preference share capital is not
considered. Total asset includes all kind of assets.

Debt to equity ratio is otherwise called as leverage ratio. High

leverage effect magnifies profits when the returns from the asset
more than offset the costs of borrowing, losses are magnified when
the opposite is true. High leverage effect is considered as high risk
for the firm. It is important to compare with the industry for a
meaningful conclusion. The addition of long term debt with short
term debt also mentioned as total liability.
The equity multiplier is a way of examining how a company uses
debt to finance its assets. Also known as the financial leverage or
financial leverage multiplier. It is used in Due Pont Analysis. Also
called the assets-to-equity ratio. Analysts use the ratio to measure
how efficiently a company uses debt to finance its assets. A higher
equity multiplier indicates higher financial leverage, which means
the company is relying more on debt to finance its assets. A high
multiplier, in comparison to the results for the same industry,
implies that a it may have incurred more debt than is the norm.

Financing Aspect
Interest Coverage ratio or Times interest earned
Earnings before interest and taxes ( i.e., EBIT)
Interest Expenses

The interest coverage ratio is used to determine

how easily a company can pay interest expenses on
outstanding debt. The interest coverage ratio (ICR)
is a measure of a company's ability to meet its
interest payments. Also known as times interest
earned, is a measure of how well a company can
meet its interest-payment obligations. Higher is
beteer.

Some Other Ratios Related to Financing Aspects are:

Debt to assets ratio = Total liabilities (i.e., Long Term Debt + Short
term Debt)/ Total assets
Cash coverage ratio = (EBIT + Depreciation)/Interest
Gearing Ratio = (Loan Capital + Preference capital) / Total Capital
Equity ratio = (Share Holder Equity Capital / Total Assets)
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Asset Utilisation Aspect

Asset turnover is a catch-all efficiency ratio
that highlights how effective management is
at using its assets. All else equal, the higher
the total asset turnover, the better.

Total Asset Turnover =

Net Sales
Total Assets
Fixed Asset Turnover =

Net Sales
Fixed Assets

Three Asset
Turnover
Ratios

Current Asset Turnover =

Net Sales
Current Assets
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Total Asset turnover ratio considers shortterm (Current asset) , long-term assets
(Fixed Assets) and Intangible assets as well.
Fixed Assets turnover ratio considers only
the long term Fixed Assets minus the
accumulated depreciation.
Current Assets turnover ratio considers
only the short term Current Assets of the
company.
If the data is available, then average value
of these total asset, fixed asset and current
assets can be considered for calculation. If
data is not available one year data can be
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taken for calculation.

Efficiency Aspect
Inventory turnover =
Cost of Goods Sold
Average Inventory
Note: If sufficient data is available you can take the
average value of two years in the denominator. If data is
not available, please take the values for the one year.

Account Receivable turnover =

Net Sales
Average Account Receivables
Note: If sufficient data is available you can take the
average value of two years in the denominator. If data is
not available, please take the values for the one year.

Account Payable turnover =

Total purchases
Average accounts payable
Note: If sufficient data is available you can take the
average value of two years in the denominator. If data is
not available, please take the values for the one year.

The Inventory turnover illustrates how well a company manages its

inventory levels. If inventory turnover is too low, it suggests that a
company may be overstocking or overbuilding its inventory or that it
may be having issues selling products to customers. All else equal,
higher inventory turnover is better. How many times inventory is
created and sold during the period.
The accounts receivable turnover ratio measures how effective the
company's credit policies are. If accounts receivable turnover is too
low, it may indicate the company is being too generous granting
credit or is having difficulty collecting from its customers. All else
equal, higher receivable turnover is better. How many times accounts
receivable are created and collected during the period.

The Accounts payable turnover is important because it measures

how a company manages paying its own bills. Measures the number
of times a company pays its suppliers during a specific accounting
period. A falling ratio is a sign that the company is taking longer to
pay off its suppliers. A rising turnover ratio means that the company is
paying off suppliers at a faster rate.
Efficiency ratios measure how effectively the company utilizes these8
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assets,
as well as how well it manages its liabilities.

Efficiency Aspect
Cash Conversion Cycle (CCC) =
Days Inventory Outstanding (DIO)
+ Days Sales Outstanding (DSO)
- Days Payable Outstanding (DPO)

The cash conversion cycle (CCC, or Operating Cycle) is the length of

time between a firm's purchase of inventory and the receipt of cash
from accounts receivable. Measured in terms of number of Days or
the length of time a company takes to turn purchases into cash
receipts from customers. In other words it is the time required for a
business
convert
resource
inputs
into
cash
flows.
CASH CONVERSION CYCLE

DIO

Accounts payable
Average
Purchase

DSO

account Receivables
Average days of revenue
Note: Average days revenue
= Net Sales/ 365

Inventory
Average Days Cost of
Goods Sold (COGS)

DPO

Note: Average days purchase

= Total Purchase/365

Note: Average days of COGS

= Total COGS/365
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Efficiency Aspect
It tells you how many
days inventory sits on
the shelf on average.

Net operating cycle

Number of days
or
=
of inventory
Cash conversion cycle
= Inventory
Average Days
Cost of Goods Sold

Days of Receivable tells you how

many days after the sale it takes
people to pay you on average.

Number of days
+
of receivables
+ ccount Receivables
Average days of revenue

Days of Payables Outstanding tells

you how many days the company
takes to pay its suppliers.

Number of days

of payables
- Accounts payable
Average Purchase

How many days does it take a company to pay for and generate cash from the sales of its inventory?
This is what the Cash Conversion Cycle or Net Operating Cycle tells us. The entire CCC is often referred to as the Net
Operating Cycle. It is net because it subtracts the number of days of Payables the company has outstanding from the
Operating Cycle. It gives us an indication as to how long it takes a company to collect cash from sales of inventory. Often a
company will finance its inventory instead of paying for it with cash up front. This means they owe someone money which
generates Accounts Payable. Many times they will turn around and sell that inventory on credit without getting all the cash
at the time of the sale. This means people owe them money and generates Accounts Receivable. The first two components
of the CCC, DSO namely DIO are what is called the Operating Cycle. This is how many days it takes for a company to
process raw material and/or inventory and collect cash from the sale. Source: Timothy P. Connolly, A Look at the Cash Conversion Cycle, CFA Institute.
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Continue.. An Example
Year 2014

Company A

Company B

Revenue or Sales
Purchases (all credit)
Cost of Goods Sold (COGS)
2014 Account receivable
2014 Accounts Payable
2014 Inventory
Average Dyas COST OF Goods Sold
(COGS/365)

164687 1,26,405
64,000
72,000
95,668
15,738
12786
11673
87632
8342
1346
4937
262.10

43.12

Average Days Revenue (Revenue/365)

451.20

346.32

Average days Purchases (Purchases/365)

Number of Days of Inventory (DIO)
Nummber of Days of Receivables (DSO)
Number of Days of Pyable (DPO)
Operaing cycle (DIO + DSO)
Cash Conversion Cycle (DIO+DSO-DPO)

175.34
5.14
28.34
499.78
33.47
-466.30

197.26
114.50
33.71
42.29
148.21
105.92
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Assume that, Company A and B operates in the

same industry. The cash conversion cycle (CCC)
calculation indicates that, Company A is a market
leader as compared to Company B. This is because
Company A with a negative CCC suggest that
company receives from its customers well in
advance as compared to the Company B.

If we see the Operating Cycle figure (DIO + DSO)

it suggest that, Company A is efficient enough to
convert its inventory in to sales and to collect
account receivables from its customers. Company
B is close to the efficiency level of Company A for
receivable collection, but fails to match in terms of
inventory to sale conversion.
Product demand for Company A is also good in
the market. This is because on an average product
stays in the inventory only for 5 days, while it
takes 114 days for a sale of inventory in case of
Company B.
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Continue.. HUL Analysis

Data from HUL Annual Report

2015

2014

Revenue or Sales
Purchases (Assuming all credit):

30805.62

28019.13

15565.27

14,510.00

24018.49

22107.92

Cost of
materials consumed + Purchases of stock-in-trade

Cost of Goods Sold (COGS):

Cost of materials consumed + Purchases of stock-intrade + Changes in inventories of finished goods +
Total Other expenses

Account receivable
Accounts Payable
Inventory

782.94
5,288.90
2602.68

816.43
5,623.84
2747.53

Average Dyas Cost of Goods Sold (COGS/365)

65.80

60.57

Average Days Revenue (Revenue/365)

Average days Purchases (Purchases/365)
Number of Days of Inventory (DIO)
Nummber of Days of Receivables (DSO)
Number of Days of Pyable (DPO)
Operaing cycle (DIO + DSO)
Cash Conversion Cycle (DIO+DSO-DPO)

84.40

76.76

42.64
39.55
9.28
124.02
48.83
-75.19

39.75
45.36
10.64
141.47
56.00
-85.47

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Analysis of HULs Cash Conversion Cycle

suggest that, it collects from customers way
ahead of its payment to supplier. The negative
figure is due to the higher payment period (124
days & 141 days) to its suppliers.
HUL takes around 48 days in 2015 and 56 days
in 2014 to convert its inventory to sales and to
collect from the account receivable.

HUL takes around 9 to 10 days to collect from

its account receivable.
It takes around 40 to 45 days to convert its
inventory to sales.
Comparable figures as compared to industry can
suggest hoe HUL is doing as compared to the
industry.
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Profitability Aspect
Net Profit Margin
Net Profit after Taxes
Net Sales

Net Sales is the sales revenue minus the

excise tax and sales return if any.
Net income equals total revenues minus
total expenses and is the Net income (or
PAT) from income statement.
For calculating the Net profit after tax
the income from other sources like
interest income, dividend income
considered, because this ratio deals with
final profit figure if the company.
If the company is a loss making
company the numerator will take the
Loss or the negative value.

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The Net Profit margin ratio directly

measures what percentage of sales is made up
of net income. In other words, it measures
how much profits are produced at a certain
level of sales. This ratio also measures how
well a company manages its expenses relative
to its net sales. That is why companies strive
to achieve higher ratios. They can do this by
either generating more revenues why keeping
expenses constant or keep revenues constant
and lower expenses.

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Profitability Aspect
Gross Profit Margin
Gross Profit
Net Sales

Gross Profit margin ratio is a profitability ratio

that measures how profitable a company can sell
its inventory. It only makes sense that higher
ratios are more favourable. Higher ratios mean
the company is selling their inventory at a higher
profit percentage.

Gross Profit = Net Sales Cost of Goods Sold (COGS)

The cost of goods sold, also known as COGS, includes the expense required to
manufacture a product or provide a service.
Net Sales is the sales revenue minus the excise tax and sales return if any.
Any income under the category of other income (for e.g., interest income,
dividend income) will not be considered.

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Investment/shareholders Information Aspect

Return on assets (ROA)
= Net Profit/Total assets

Return on equity (ROE)

= Net Profit/Total equity

Cash Return on Capital Invested

= EBITDA / Capital Invested

Since income is derived from assets in use through the year, including new
plant or machinery, the value used in the calculation is an average. Return
on assets, or ROA, tests management's ability to earn a fair return on assets.
It is also can be calculated by multiplying net profit margin and asset
turnover ratio. The assets required to produce revenues will vary by industry.
Therefore, benchmarks and comparisons should only be made between
companies that produce similar products or provide essentially the same
services. How efficiently a company uses its assets to produce profits.
Return on equity (ROE) or return on capital is the ratio of net income of a
business during a year to its stockholders' equity during that year. It is a
measure of profitability of stockholders' investments. It shows net income
as percentage of shareholder equity. A measure of how well a company uses
shareholders' funds to generate a profit.

Cash return on capital invested (CROCI) is calculated by dividing the

earnings before interest, taxes, depreciation and amortization by the total
capital invested. The capital invested is defined as the equity capital and
preferred shares. Long term loans are also included in the capital employed.15

Investment/shareholders Information Aspect

Return on Invested Capital
= Net Operating Profit After Tax
Invested Capital

The return on invested capital (ROIC) is the percentage

return that a company makes over its invested capital. It is
similar to ROA, but takes into account sources of financing, so
the denominator is different. Invested capital is in the
denominator of the ROIC equation. This is calculated as the
company's fixed assets plus current assets minus current
liabilities and cash. The objective is to find out how much
capital the company has in assets that are producing net
operating profits after taxes. The important fact to remember
about ROIC is the measure filters out a lot of the noise that
limits some of the other return calculations. The focus of this
measure is the profits produced by the income-generating
assets of the company.

Net Operating Profit after Taxes (NOPAT) = Operating Profit x (1 - Tax Rate)
NOPAT = Net Income + Interest Expense (1-Tax Rate) - Non-Operating Income (1-Tax Rate)
Invested Capital (IC) = Fixed Assets + Non-Cash Working Capital
Non-Cash Working Capital = Current Assets - Current Liabilities - Cash
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Du Pont Analysis
Du Pont Analysis name comes from the DuPont
Corporation of US that started using this formula in the
1920s. The DuPont analysis is a way of decomposing and
examining the financial ratio return on equity (ROE).
Was it because management was efficient? Because they
had high financial leverage? What drove a high ROE
number?

Shows which variables account for profitability

Total
Equity

ROE = Net income/Total Equity

ROE= (Net income/Sales) (Sales/Total Assets) (Total Assets/Total Equity)
ROE = (Profit margin)

(Total asset turnover) (Equity multiplier)

Stock Market Performance Aspect

Earnings Per Share
= Net Profit
No. of outstanding shares
Price Earning Ratio (PE Ratio)
= Market Price Per Share
Earnings per share
Price Earnings Growth Ratio (PEG ratio)
= PE Ratio
Annual EPS Growth Rate

Market to Book Ratio (M/B Ratio)

= Market price per share
Book Value Per share
Dividend Yield
= Dividend Per share
Market Price Per share

The M/B ratio denotes how much equity investors are paying
for each dollar in net assets.

Book Value of Assets = Total Asset Intangible assets

Long term Loan Short term Loan
Dividend Rate = Dividend Paid/ Net Profit
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Retention Rate = 1-Dividend Rate

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Few Insights
Ratios
PE Ratio

PEG Ratio

High
Commanding a higher price today for the
higher future earnings
Determine if the expected growth warrants
the premium.
Compare it to its industry peers to see its
relative valuation to determine whether the
premium is the worth the cost of the
investment. High P/E ratio is expensive

Low
Can be an indication that market is yet to
factor the growth potential and hence can
be picked up for investment.
(Under Valued)

A lower PEG means the stock is more

undervalued.

Price to
Sales Ratio

How much market values every dollar of the company's sales.

Turnover is valuable only if, at some point, it can be translated into earnings
Sales dollars cannot always be treated the same way for every company.

Market to
Book Ratio

If the ratio is above 1 then the stock is If it is less than 1, the stock is overvalued.
undervalued

Enterprise Value (EV)/EBITDA

Also known as the EBITDA Multiple OR the firm multiple.
Enterprise Value = Market Capitalization +Debt +Preferred
Share Capital + Minority Interest - Cash and cash equivalents

The EV/EBITDA ratio is better as it values the worth

of the entire company.
It estimates the number of years in which the business will repay
its acquisition cost to the buyer through its earnings.
The ratio proves a great tool for valuing companies that are making
losses at the net earning level, but are profitable at the EBITDA level.

Economic value added (EVA) is an internal management performance measure

that compares net operating profit to weighted average cost of capital (WACC).
EVA = Net Operating Profit After Tax - (Capital Invested x WACC)
Economic value added asserts that businesses should create returns at a rate above their cost of capital

What is the WACC?

WACC = (D/D+E) rd (1-Tc) + (E/D+E) reL
D/D+E and E/D+E are capital structure weights evaluated at
market value, based on the firms target capital structure
Tc is the firms marginal tax bracket, but the effective tax rate
is often used as estimate
rd is the cost of debt based on the risk of the debt (which
depends on the debt ratio)
reL is the required rate of return on equity (I.e. the cost of
equity)
the cost of equity depends on the business risk of the assets
and on the debt ratio
Cost of Equity Capital = Risk-Free Rate + (Beta times Market Risk Premium).

Thank you

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