Ratio Analysis

Professor Rajendra K. LaguDepartment of Electrical Engineering

e-mail: rklagu@ee.iitb.ac.inWebpage:

http://www.ee.iitb.ac.in/~rklagu

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Balance Sheet• Shows the status of company’s financial position.

It is actually a snap shot at the instant it is prepared, what the company owns and owes.

• Not duration specific, such as P&L statement is.

• Ideally, can be calculated every day; however companies usually calculate on a quarterly basis.

• Shows the sources and applications of funds.

• Numbers by themselves are not important; ratios are.

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Balance Sheet continued…

• Double entry accounting system: Assets and Liabilities must balance

• Every transaction gets entered at two places under different heads so that accounts are “balanced”.

• Credit / Debit or Assets / Liabilities

• Compare the movement across the quarters or years

• Scope for manipulation: Asset valuation, payment realization (GAAP)

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Balance Sheet Structure

Assets Liabilities

Fixed Assets Long Term Liabilities

Land, Buildings, Vehicles, Equipment

Equity, Term Loans, Debentures

Current Assets Current Liabilities

Cash, Accounts Receivable

Accounts Payable

Inventory: WIP, Finished Goods

Short Term Loans

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Financial Management Decisions

Assets LiabilitiesFixed Assets Long Term

Liabilities

Land, Buildings, Vehicles, Equipment

Equity, Term Loans, Debentures

Current Assets Current Liabilities

Cash, Accounts Receivable, Marketable

Securities

Accounts Payable

Inventory: WIP, Finished

Goods

Short Term Loans

Operating policy decisions

Capital budgeting decisions

Capital structure decisions

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Assets

• You pay for them to acquire them and so you “own” them

• They generate revenues later in short or long term

• Liquidity of an asset: Length of the time it takes to generate revenue

• Their value generally depreciates over time

• They can be revalued on some events• They can be tangible or intangible

(goodwill, monopoly)

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Examples of Assets

• Cash in bank and in hand (bank balance, physical cash)

• Marketable Securities (parked funds)• Accounts Receivables• Inventory (Work In Progress)• Inventory (Finished goods)• Land, Building, Plants, Offices, Vehicles• Equipment (PCs, Office equipment, Test jigs)• Patents, Copyrights, Trademarks• Goodwill, Brand Position

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Liabilities

• Money that has been made available to the firm, received from outside sources.

• The firm owes them to outside agents including the shareholders

• Liabilities can have short term, long term, or no term repayment schedules

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Examples of Liabilities

• Accounts payable (supplier credit)• Accrued corporate tax• Short term loans• Debentures• Long term loans• Equity (common stock + preferred

stock)• Retained earnings

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Balance Sheet of a Prototype Company

• Frequency of P&L statement calculation

• Operating Cycle duration: 2 weeks, 2 months, 1 year

• Inventory turns and profit margins are closely linked to the operating cycle

• Traders, Manufacturers, Knowledge-based companies

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A Typical Manufacturing Company Starts Operation

Assets Liabilities

Cash 5,00,000 Equity 5,00,000

Total 5,00,000 Total 5,00,000

Two promoters deposit Rs 5 lakhs in the company account as equity

XYZ Private Limited

Balance Sheet at April 1, 2001

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A lathe is bought on cash basis

Assets Liabilities

Cash 2,00,000 Equity 5,00,000

Plant 3,00,000

Total 5,00,000 Total 5,00,000

Owner pays Rs 3 lakhs from the bank acount

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Raw material worth Rs 80,000 bought on a 60 day credit basis

Assets Liabilities

Cash 2,00,000 Equity 5,00,000

Plant 3,00,000 Account Payable

80,000

Inventory 80,000

Total 5,80,000 Total 5,80,000

No payment is done so cash position does not change

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Raw material worth Rs 40,000 processed and sold for Rs 50,000 with a 30 day credit

Assets Liabilities

Cash 2,00,000 Equity 5,00,000

Plant 3,00,000 Accounts Payable

80,000

Inventory 40,000 Retained Earnings

10,000

Accounts Receivable

50,000

Total 5,90,000 Total 5,90,000

No payment is done so cash position does not change, but inventory is reduced

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Customer pays up after 20 days

Assets Liabilities

Cash 2,50,000 Equity 5,00,000

Plant 3,00,000 Accounts Payable 80,000

Inventory 40,000 Retained Earnings 10,000

Accounts Receivable

00,000

Total 5,90,000 Total 5,90,000

Payment deposited in bank so cash position changes

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Supplier credit period is over and raw material is paid for after 60 days

Assets Liabilities

Cash 1,70,000 Equity 5,00,000

Plant 3,00,000 Accounts Payable 00,000

Inventory 40,000 Retained Earnings 10,000

Accounts Receivable

00,000

Total 5,10,000 Total 5,10,000

Payment done from bank so cash balance reduces

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A new promoter buys 10,000 shares of Rs 10 face value at a premium of Rs 20

Assets Liabilities

Cash 4,70,000 Equity 6,00,000

Plant 3,00,000 Accounts Payable 00,000

Inventory 40,000 Retained Earnings 10,000

Accounts Receivable

00,000 Share Premium a/c 2,00,000

Total 8,10,000 Total 8,10,000

Payment done to bank so cash balance increases

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Profit & Loss Account (Income Statement)

Sales Revenues 4,00,000

Other Revenues 1,00,000

Total Revenues 5,00,000 100 %

Cost of Goods Sold 2,00,000 40 %

Gross Profit 3,00,000 60 %

Operating Expenses 1,50,000 30 %

PBITD 1,50,000 30 %

Interest + Tax + Depreciation

25,000 5 %

Net Profit 1,25,000 25 %

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Cash Flow / Funds Flow Statement

• Differences in successive balance sheets

• Sources of FundsNet profitIssue of new share capitalSale of fixed assetsNew loans

• Use of FundsPayment of dividendsPurchase of fixed assetsRepayment of loans

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Ratio Analysis

• Compare the performance of the company for three successive years

• The absolute numbers change so compare ratios

• Compare two companies of differing size but from the same industry, e.g, Infosys and Mastek

• Calculate industry-wide numbers (net profit margins for automobile companies)

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Liquidity Ratios

• Measure a firm’s ability to meet its short term obligations

• Show trends early and so corrective actions can be taken in the working capital management

• Current Ratio: Current Assets / Current Liabilities

• Acid Test Ratio or Quick Ratio: (Current Assets – Inventory) / Current Liability (Cash or cash equivalent) / Current Liability

A firm is “solvent” if its assets are greater than outside liabilities. A firm is “liquid” if its current assets are greater than its current liabilities

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Gearing Ratios

• Leverage of a firm: Proportion of its long term liabilities that are debts

• Long term liabilities = Debts + Equity• Debt/Equity ratio

Loan Capital / Share holder’s funds

Gears, Leverage: Mechanical Engg terms

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Asset Utilization Ratios

• Return on Total Investment: management’s skill in exploiting the funds made available ROI = PBT / (Shareholders’ funds + Long term loans)

• Return on Shareholders’ Equity ROE =

PBT / (Shareholders’ funds)Sales / Total Capital Employed

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Profitability Ratios

• Net Profit Margin = NP / Sales

• Gross Profit Margin = GP / Sales

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Market Value related Ratios

• EPS (Earning Per Share) : NP / Total outstanding shares

• P/E : Market Price / Earning Per Share

• Revenue Multiple: Revenues / Assets

• Market to Book: Market Value / Book Value

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Limitations of Financial Statements

• They are backward looking: Accrued results of the past year / quarter

• Company’s value depends on its future profitability which depends on many factors not reflected in the balance sheet, which are non-monetary

Nature and innovativeness of it products Technology landscape (product obsolescence) Competitors Economic conditions (recession / boom),

government policies Staff and management morale

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Balance Sheet of Three IT Companies at 31.03.2001 (in Rs Cr) (http://www.indiainfoline.com)

Company Infosys Wipro Satyam

Equity 33.0 47.0 56.0

Share premium 320.0 592.0 87.0

Retained earnings

1030.0 1300.0 670.0

Net Worth 1383.0 1965.0 813.0

Debt 0.0 45.0 172.0

Capital employed

1383.0 2010.0 985.0

Fixed Assets 600.0 902.0 288.0

Account receivable

430.0 600.0 475.0

Cash & bank balance

385.0 446.0 151.0

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Profit and Loss Statement of Three IT Companies for 12 Months Ending 31.03.2001 (in Rs Cr)

Company Infosys Wipro Satyam

Sales 1900.0 3054.0 1220.0

Other income 59.0 69.0 22.0

Total income 1959.0 3123.0 1242.0

Cost of material 238.0 380.0 128.0

Comm + traveling cost

190.0 633.0 128.0

Employee cost 718.0 422.0 486.0

Total cost of sales 1151.0 2252.0 776.0

PBIDT 808.0 870.0 466.0

PAT 629.0 668.0 Prior year

adjusted