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Financial Ratio Analysis

Finance is life blood of the business. The financial management is the study about the process of procuring and judicious use of financial resources is a view to maximize the value of the firm. There by the value of the owners i.e. the example of equity share holders in a company is maximized. The traditional view of financial management looks into the following function that a finance manager of a business firm will perform. A financial ratio (or accounting ratio) is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios. Ratios can be expressed as a decimal value, such as 0.10, or given as an equivalent percent value, such as 10%. Some ratios are usually quoted as percentages, especially ratios that are usually or always less than 1, such as earnings yield, while others are usually quoted as decimal numbers, especially ratios that are usually more than 1, such as P/E ratio; these latter are also called multiples. Given any ratio, one can take its reciprocal; if the ratio was above 1, the reciprocal will be below 1, and conversely. The reciprocal expresses the same information, but may be more understandable: for instance, the earnings yield can be compared with bond yields, while the P/E ratio cannot be: for example, a P/E ratio of 20 corresponds to an earnings yield of 5%.

DIFINATION:-

Financial Management has been defined differently by different scholars.

Howard and Upton:- “Financial Management is the application of the planning and control function to the finance functions”

Bringham:- “Financial Management is an area of financial decision making harmonizing, individual motives and enterprise goals”

Sources of data for financial ratios:-

Values used in calculating financial ratios are taken from the balance sheet, income statement, statement of cash flows or (sometimes) the statement of retained earnings. These comprise the firm's "accounting statements" or financial statements. The statements' data is based on the accounting method and accounting standards used by the organization.

Purpose and types of ratios:-

Financial ratios quantify many aspects of a business and are an integral part of the financial statement analysis. Financial ratios are categorized according to the financial aspect of the business which the ratio measures. Liquidity ratios measure the availability of cash to pay debt.Activity ratios measure how quickly a firm converts non-cash assets to cash assets. Debt ratios measure the firm's ability to repay long-term debt.Profitability ratios measure the firm's use of its assets and control of its expenses to generate an acceptable rate of return. Market ratios measure investor response to owning a company's stock and also the cost of issuing stock. These are concerned with the return on investment for shareholders, and with the relationship between return and the value of an investment in company’s shares.

OBJECTIVES OF RATIO ANALYSIS:-

The study of financial statement of any corporate will help in knowing its present and future earning capacity.

The study of financial resources can help in knowing whether a company can pay its long-term or short-term liabilities.

It’s very use full to know how much working capital is employed in business and same effectively used.

It’s use full to measure earning capacity and its comparison to other competitive units.

Help full to known marginal efficiency.

Use full to future planning.

Financial ratios allow for comparisons

between companies
between industries
between different time periods for one company
between a single company and its industry average

Ratios generally are not useful unless they are benchmarked against something else, like past performance or another company. Thus, the ratios of firms in different industries, which face different risks, capital requirements, and competition are usually hard to compare.

Ratios:-

Profitability ratios:-

Profitability ratios measure the company's use of its assets and control of its expenses to generate an acceptable rate of return

Gross margin, Gross profit margin or Gross Profit Rate

$\frac{\mbox{Gross Profit}}{\mbox{Net Sales}}$

$\frac{\mbox{Net Sales -- COGS}}{\mbox{Net Sales}}$

Operating margin, Operating Income Margin, Operating profit margin or Return on sales (ROS)

Note: Operating income is the difference between operating revenues and operating expenses, but it is also sometimes used as a synonym for EBIT and operating profit.This is true if the firm has no non-operating income. (Earnings before interest and taxes / Sales)

Profit margin, net margin or net profit margin

Return on equity (ROE)

Return on investment (ROI ratio or Du Pont Ratio)

Return on assets (ROA)

Return on assets Du Pont (ROA Du Pont)

Return on Equity Du Pont (ROE Du Pont)

Return on net assets (RONA)

Return on capital (ROC)

Risk adjusted return on capital (RAROC)

Return on capital employed (ROCE)

Note: this is somewhat similar to (ROI), which calculates Net Income per Owner's Equity

Cash flow return on investment (CFROI)

Efficiency ratio

Net gearing

Basic Earnings Power Ratio

$\left(\frac{\mbox{Net Income}}{\mbox{Net Sales}}\right)\left(\frac{\mbox{Net Sales}}{\mbox{Average Assets}}\right)\left(\frac{\mbox{Average Assets}}{\mbox{Average Equity}}\right)$

$\frac{\mbox{Net Income}}{\mbox{Fixed Assets + Working Capital}}$

$\left(\frac{\mbox{Net Income}}{\mbox{Net Sales}}\right)\left(\frac{\mbox{Net Sales}}{\mbox{Total Assets}}\right)$

$\frac{\mbox{Net Income}}{\mbox{Average Shareholders Equity}}$

$\frac{\mbox{Cash Flow}}{\mbox{Market Recapitalisation}}$

$\frac{\mbox{Net Income}}{\mbox{Average Total Assets}}$

$\frac{\mbox{EBIT(1 − Tax Rate)}}{\mbox{Invested Capital}}$

$\frac{\mbox{Non-Interest expense}}{\mbox{Revenue}}$

$\frac{\mbox{Operating Income}}{\mbox{Net Sales}}$

$\frac{\mbox{Expected Return}}{\mbox{Economic Capital}}$

$\frac{\mbox{EBIT}}{\mbox{Capital Employed}}$

$\frac{\mbox{Expected Return}}{\mbox{Value at Risk}}$

$\frac{\mbox{Net Income}}{\mbox{Total Assets}}$

$\frac{\mbox{Net Profit}}{\mbox{Net Sales}}$

$\frac{\mbox{Net debt}}{\mbox{Equity}}$

$\frac{\mbox{EBIT}}{\mbox{Total Assets}}$

Liquidity ratios:-

Liquidity ratios measure the availability of cash to pay debt.

Current ratio (Working Capital Ratio)

Acid-test ratio (Quick ratio)

Cash ratio

Operation cash flow ratio

$\frac{\mbox{Current Assets -- (Inventories + Prepayments)}}{\mbox{Current Liabilities}}$

$\frac{\mbox{Cash and Marketable Securities}}{\mbox{Current Liabilities}}$

$\frac{\mbox{Current Assets}}{\mbox{Current Liabilities}}$

$\frac{\mbox{Operating Cash Flow}}{\mbox{Total Debts}}$

Activity ratios (Efficiency Ratios):-

Activity ratios measure the effectiveness of the firms use of resources.

Average collection period

Degree of Operating Leverage (DOL)

DSO Ratio.

Average payment period

Asset turnover

Stock turnover ratio

Receivables Turnover Ratio

Inventory conversion ratio

Inventory conversion period (essentially same thing as above)

Receivables conversion period

Payables conversion period

Cash Conversion Cycle

Debt ratios (leveraging ratios):-

Debt ratios quantify the firm's ability to repay long-term debt. Debt ratios measure financial leverage.

Debt ratio

Debt to equity ratio

Long-term Debt to equity (LT Debt to Equity)

Times interest-earned ratio / Interest Coverage Ratio

Debt service coverage ratio

$\mbox{Inventory Conversion Period + Receivables Conversion Period - Payables Conversion Period}$

$\frac{\mbox{Percent Change in Net Operating Income}}{\mbox{Percent Change in Sales}}$

$\frac{\mbox{Accounts Payable}}{\mbox{Annual Credit Purchases ÷ 365 Days}}$

$\frac{\mbox{Long-term Debt + Value of Leases}}{\mbox{Average Shareholders Equity}}$

$\frac{\mbox{Accounts Receivable}}{\mbox{Annual Credit Sales ÷ 365 Days}}$

$\left (\frac{\mbox{Inventory}}{\mbox{Cost of Goods Sold}}\right)\mbox{365 Days}$

$\frac{\mbox{Accounts Receivable}}{\mbox{Total Annual Sales ÷ 365 Days}}$

$\frac{\mbox{Net Credit Sales}}{\mbox{Average Net Receivables}}$

$\frac{\mbox{EBIT}}{\mbox{Annual Interest Expense}}$

$\frac{\mbox{Net Income}}{\mbox{Annual Interest Expense}}$

$\left (\frac{\mbox{Receivables}}{\mbox{Net Sales}}\right)\mbox{365 Days}$

$\left (\frac{\mbox{Accounts Payables}}{\mbox{Purchases}}\right)\mbox{365 Days}$

$\frac{\mbox{Cost of Goods Sold}}{\mbox{Average Inventory}}$

$\frac{\mbox{365 Days}}{\mbox{Inventory Turnover}}$

$\frac{\mbox{Long-term Debt}}{\mbox{Total Assets}}$

$\frac{\mbox{Total Liabilities}}{\mbox{Total Assets}}$

$\frac{\mbox{Net Sales}}{\mbox{Total Assets}}$

$\frac{\mbox{Net Operating Income}}{\mbox{Total Debt Service}}$

Market ratios:-

Market ratios measure investor response to owning a company's stock and also the cost of issuing stock. These are concerned with the return on investment for shareholders, and with the relationship between return and the value of an investment in company’s shares.

Earnings per share (EPS)

$\frac{\mbox{Net Earnings}}{\mbox{Number of Shares}}$

Payout ratio

$\frac{\mbox{Dividends}}{\mbox{Earnings}}$

$\frac{\mbox{Dividends}}{\mbox{EPS}}$

Dividend cover (the inverse of Payout Ratio)

$\frac{\mbox{Earnings per Share}}{\mbox{Dividend per Share}}$

P/E ratio

$\frac{\mbox{Market Price per Share}}{\mbox{Diluted EPS}}$

Dividend yield

$\frac{\mbox{Dividend}}{\mbox{Current Market Price}}$

Cash flow ratio or Price/cash flow ratio

$\frac{\mbox{Market Price per Share}}{\mbox{Present Value of Cash Flow per Share}}$

Price to book value ratio (P/B or PBV)

$\frac{\mbox{Market Price per Share}}{\mbox{Balance Sheet Price per Share}}$

Price/sales ratio

$\frac{\mbox{Market Price per Share}}{\mbox{Gross Sales}}$

PEG ratio

$\frac{\mbox{Price per Earnings}}{\mbox{Annual EPS Growth}}$

Other Market Ratios

EV/EBITDA

$\frac{\mbox{Enterprise Value}}{\mbox{EBITDA}}$

EV/Sales

$\frac{\mbox{Enterprise Value}}{\mbox{Net Sales}}$

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