APPROACH TO RATIO ANALYSIS

(E PMBA Course, Sem IV)

1

PROF. RAJKUMAR SINGH 04.06.2011 05.06.2011

Classification of Ratios
2

Ratios can be broadly classified into four groups namely: y Profitability ratios y Liquidity ratios y Capital structure/leverage ratios y Activity ratios

Profitability ratios
3

Profitability ratios in relation to sales: y Gross profit margin y Net profit margin y Expenses ratio

Profitability ratios
4

Profitability ratios in relation to investments y Return on assets (ROA) y Return on capital employed (ROCE) y Return on shareholders equity (ROE) y Earnings per share (EPS) y Dividend per share (DPS) y Dividend payout ratio (D/P) y Price earning ratio (P/E)

Gross profit margin

5

This ratio is calculated by dividing gross sales. It is expressed as a percentage. Gross profit is the result of relationship prices, sales volume and costs. Gross profit margin = Gross Profit x 100 Net sales

profit by

between

Net profit margin

6

This ratio is calculated by dividing net profit by sales. It is expressed as a percentage. This ratio is indicative of the firms ability to leave a margin of reasonable compensation to the owners for providing capital, after meeting the cost of production, operating charges and the cost of borrowed funds. Net profit margin = Net Profit After Interest and Tax x 100 Net sales

Net profit margin

7

Another variant of net profit margin is operating profit margin which is calculated as: Operating profit margin = Net Profit Before Interest and Tax x 100 Net sales Higher the ratio, greater is the capacity of the firm to withstand adverse economic conditions and vice versa

Expenses ratio
8

These ratios are calculated by dividing the various expenses by sales. The variants of expenses ratios are: Material Consumed x 100 Net sales Manufacturing expenses ratio = Manufacturing Expenses x 100 Net sales Administration expenses ratio = Administration Expenses x 100 Net sales Selling expenses ratio = Selling Expenses x 100 Net sales Operating ratio = Cost of Goods Sold plus Operating Expenses x 100 Net sales Financial expense ratio = Financial Expenses x 100 Net sales Material consumed ratio =

Return on assets (ROA)

9

This ratio measures the profitability of the total funds of a firm. It measures the relationship between net profits and total assets. The objective is to find out how efficiently the total assets have been used by the management. Return on assets = Net Profit After Taxes plus Interest x 100 Total assets Total assets exclude fictitious assets. As the total assets at the beginning of the year and end of the year may not be the same, average total assets may be used as the denominator.

Return on capital employed (ROCE)

10

This ratio measures the relationship between net profit and capital employed. It indicates how efficiently the long-term funds of owners and creditors are being used. Return on capital employed = net profit after taxes plus interest x 100 Capital employed CAPITAL EMPLOYED denotes shareholders funds and long-term borrowings. To have a fair representation of the capital employed, average capital employed may be used as the denominator.

Return on shareholders equity

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This ratio measures the relationship of profits to owners funds. Shareholders fall into two groups i.e. preference shareholders and equity shareholders. So the variants of return on shareholders equity are Return on total shareholders equity = Net Profits After Taxes x 100 Total shareholders equity

Return on shareholders equity

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Return on ordinary shareholders equity = Net Profit After Taxes Pref. Dividend Ordinary shareholders equity or net worth

x 100

ORDINARY SHAREHOLDERS EQUITY OR NET WORTH includes equity share capital plus reserves and surplus minus fictitious assets.

Earnings per share (EPS)

13

This ratio measures the profit available to the equity shareholders on a per share basis. This ratio is calculated by dividing net profit available to equity shareholders by the number of equity shares. Earnings per share = Net Profit After Tax Preference Dividend Number of equity shares

Dividend per share (DPS)

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This ratio shows the dividend paid to the shareholder on a per share basis. This is a better indicator than the EPS as it shows the amount of dividend received by the ordinary shareholders, while EPS merely shows theoretically how much belongs to the ordinary shareholders Dividend per share = Dividend paid to ordinary shareholders Number of equity shares

Dividend payout ratio (D/P)

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This ratio measures the relationship between the earnings belonging to the ordinary shareholders and the dividend paid to them. Dividend pay out ratio = Total Dividend paid to ordinary shareholders x 100 Net profit after tax preference dividend OR Dividend pay out ratio = Dividend per share x 100 Earnings per share

Price earning ratio (P/E)

16

This ratio is computed by dividing the market price of the shares by the earnings per share. It measures the expectations of the investors and market appraisal of the performance of the firm. Price earning ratio = Market Price Per Share Earnings per share

Income Statement Analysis

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y Case Study on Infosys.

Infosys 2011

Indian Information Technology Sector Vision 2020

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y Indian IT industry has envisioned to become a US$

225 bn industry by 2020.

y Over the past decade, Indian IT industry has become

the premier growth engine of Indian Economy .

y It has achieved significant milestones in terms of

revenue growth, employment generation and value creation, in addition to becoming the global brand ambassador for India.
Source: IBEF, February 2011

Study: India Advantage

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y According to a research report published by National

Association of Software and Service Companies (NASSCOM), IT-BPO Sector in India: Strategic Review 2011, the sector is estimated to aggregate revenues of US$ 88.1 billion in FY2011, with the IT software and services sector (excluding hardware) accounting for US$ 76.1 billion of revenues. y The report estimates export revenues to gross US$ 59 billion in FY2011 and contribute 26 per cent as its share in total Indian exports (merchandise plus services), employing around 2 million employees.
Source: IBEF, February 2011

Study: India Advantage

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y Within exports, IT Services segment was the fastest

growing segment, growing by 22.7 per cent over FY2010, and aggregating export revenues of US$ 33.5 billion, accounting for 57 per cent of total exports. y NASSCOM said that the domestic IT-BPO revenues excluding hardware are expected to grow at almost 16 per cent to reach US$ 17.35 billion in FY2011. Strong economic growth, rapid advancement in technology infrastructure, increasingly competitive Indian organisations, enhanced focus by the government and emergence of business models that help provide IT to new customer segments are the key drivers for increased technology adoption in India.
Source: IBEF, February 2011

Study: India Advantage

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y India is a preferred destination for companies

looking to offshore their IT and back-office functions. It also retains its low-cost advantage and is a financially attractive location when viewed in combination with the business environment it offers and the availability of skilled people.

Source: IBEF, February 2011

Latest developments in Indian IT industry

22
y

y y

Four Soft Ltd, which offers software solutions for the logistics and transportation industry, has signed a large contract with Jacobson Companies, for implementing its multimodal transport management system and business intelligent tool across Jacobson locations globally. Information technology (IT) services and solutions provider Patni Computer Systems has signed a five year contract worth over US$ 32.09 million with UK-based IT services provider 2e2. Patni will provide a range of support services to 2e2's end-user clients and in-house support services. Firstsource Solutions, a Mumbai-based business process outsourcing (BPO) provider, has announced a five-year outsourcing partnership with Barclaycard, the UK-based credit card and consumer lending business of Barclays PLC. Vertex, a global customer management outsourcing (CMO) and business process outsourcing (BPO) company, has announced a joint venture with Shell Transource to address the domestic BPO market. Vertex will own over 70 per cent in the joint venture, with Shell Transource holding the rest. Patni Computer Systems has secured outsourcing engagements from the Scandinavian insurance company Codan Group and the UK-based Serco Learning. Tata Consultancy Services Ltd (TCS) has announced the launch of its first BPO centre in the Philippines. This is also the firm's first BPO centre in the South-East Asian region.

Source: IBEF, February 2011

Road Ahead
23

y The Indian information technology sector continues to be one of the

sunshine sectors of the Indian economy showing rapid growth and promise.
y According to a report prepared by McKinsey for NASSCOM called

'Perspective 2020: Transform Business, Transform India' released in May 2009, the exports component of the Indian industry is expected to reach US$ 175 billion in revenue by 2020. The domestic component will contribute US$ 50 billion in revenue by 2020. Together, the export and domestic markets are likely to bring in US$ 225 billion in revenue, as new opportunities emerge in areas such as public sector and healthcare and as geographies including Brazil, Russia, China and Japan opt for greater outsourcing.

Source: IBEF, February 2011

Analysis: Infosys Case FY11 P&L Statement

24

y Q-o-q Revenue has marginally risen by 2% indicating y

y y y

sluggish market conditions during the quarter. Y-o-y revenue has registered a strong growth of 20% on account of 19.2% y-o-y growth in Software Services globally and 38.9% y-o-y growth in Software products globally. GPM has been consistent at 44% q-o-q and y-o-y. NPM has also been consistent at 25% q-o-q and y-oy. SG&A has been consistent at 11% q-o-q and y-o-y.

Analysis: Infosys Case FY11 P&L Statement

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y As % of sales: y GPM has been consistent at 44% q-o-q and y-o-y. y NPM has also been consistent at 25% q-o-q and y-o-

y. y SG&A has been consistent at 11% q-o-q and y-o-y. y OPM has remained consistent at 33% q-o-q and y-oy. y Admin. Cost remained consistent at 6% q-o-q and yo-y.

Analysis: Infosys Case FY11 P&L Statement

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y Q-o-Q / Y-o-Y Growth (%): y COGS q-o-q has marginally risen by 3%. y Selling & marketing expenses y-o-y has substantially

increased by 25% resulting in new addition of 139 customers in FY11 as compared to 141 in FY10. y Administration expenses has gone up by 19% y-o-y on account of additional employees hired during FY11. Employee number has increased to 32,247 (gross) and 15,321 (net) in FY11 compared to 18,905 (gross) and 6,837 (net) in FY10. y Employee utilization rate has been impressive at 72.9% in FY11 vis--vis 67.5% in FY10.

Analysis: Infosys Case FY11 P&L Statement

27

y Gross Profit has registered substantial growth of 16%

y-o-y due to higher software development expenses incurred resulting into stronger revenues during FY11. y Operating Profit & Net Profit has gone up by 14% yo-y & 11% y-o-y respectively truly reflecting efficient and effective cost management practice followed by Infosys in this highly competitive industry.

Ratios to analyse Balance Sheet

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ASSETS Current Assets Intermediate Assets Long-Term Assets Total Assets (TA)

LIABILITIES Current Intermediate Long-Term Total Liabilities (TL) Net Worth (NW) = TATL TL + NW

Current ratio
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It is calculated by dividing current assets by current liabilities. Current ratio = Current assets Current liabilities Conventionally a current ratio of 2:1 is considered satisfactory

Quick Ratio or Acid Test Ratio

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This is a ratio between quick current assets and current liabilities (alternatively quick liabilities). It is calculated by dividing quick current assets by current liabilities (quick current liabilities) Quick ratio = Quick Assets Current liabilities/(quick liabilities) Conventionally a quick ratio of 1:1 is considered satisfactory.

Capital structure/ leverage ratios

31

These ratios indicate the long term solvency of a firm and indicate the ability of the firm to meet its long-term commitment with respect to (i) repayment of principal on maturity or in predetermined instalments at due dates and (ii) periodic payment of interest during the period of the loan.

Capital structure/ leverage ratios

32

The different ratios are:

     

Debt equity ratio Proprietary ratio Debt to total capital ratio Interest coverage ratio Debt service coverage ratio Capital Gearing Ratio

Debt equity ratio

33

This ratio indicates the relative proportion of debt and equity in financing the assets of the firm. It is calculated by dividing long-term debt by shareholders funds. Debt equity ratio = Long-term Debts Shareholders funds Generally, financial institutions favour a ratio of 2:1. However this standard should be applied having regard to size and type and nature of business and the degree of risk involved.

Proprietary ratio
34

This ratio indicates the general financial strength of the firm and the long- term solvency of the business. This ratio is calculated by dividing proprietors funds by total funds. Proprietary ratio = Proprietors Funds Total funds/assets As a rough guide a 65% to 75% proprietary ratio is advisable

Debt to total capital ratio

35

In this ratio the outside liabilities are related to the total capitalisation of the firm. It indicates what proportion of the permanent capital of the firm is in the form of long-term debt. Debt to total capital ratio =Long- term Debt
Shareholders funds + long- term debt

Conventionally a ratio of 2/3 is considered satisfactory.

Interest coverage ratio

36

This ratio measures the debt servicing capacity of a firm in so far as the fixed interest on long-term loan is concerned. It shows how many times the interest charges are covered by EBIT out of which they will be paid. Interest coverage ratio = EBIT Interest A ratio of 6 to 7 times is considered satisfactory. Higher the ratio greater the ability of the firm to pay interest out of its profits. But too high a ratio may imply lesser use of debt and/or very efficient operations

Debt service coverage ratio

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This is a more comprehensive measure to compute the debt servicing capacity of a firm. It shows how many times the total debt service obligations consisting of interest and repayment of principal in instalments are covered by the total operating funds after payment of tax. Debt service coverage ratio = EAT+ interest + depreciation + other non-cash exp Interest + principal instalment EAT is earnings after tax. Generally financial institutions consider 2:1 as a satisfactory ratio.

Capital Gearing Ratio

y Capital Gearing Ratio or Capitalisation Ratio or Leverage

Ratio.
Preference Shares + Long Term Borrowings X Owners Funds (Equity Share Capital + Reserves)

100

y If the ratio is 100% then, it means every rupee of equity

capital has attracted another rupee of capital (Loan) in the form of Preference shares & Long term Borrowings. y To elaborate, if the ratio is 3oo% then, it implies every rupee of equity capital has attracted 3 rupees of Preference shares & Long term Borrowings. y If the ratio is high, CAPITAL GEARING is high & viceversa

Activity ratios
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y y y y

These ratios are also called efficiency ratios / asset utilization ratios or turnover ratios. These ratios show the relationship between sales and various assets of a firm. The various ratios under this group are: Inventory/stock turnover ratio Debtors turnover ratio and average collection period Asset turnover ratio Creditors turnover ratio and average credit period

Inventory /stock turnover ratio

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This ratio indicates the number of times inventory is replaced during the year. It measures the relationship between cost of goods sold and the inventory level. There are two approaches for calculating this ratio, namely: Inventory turnover ratio = Cost of Goods Sold Average stock AVERAGE STOCK can be calculated as Opening stock + closing stock 2 Alternatively Inventory turnover ratio = Sales_________ Closing inventory

Debtors turnover ratio and average collection period

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This ratio is a test of the liquidity of the debtors of a firm. It shows the relationship between credit sales and debtors. Debtors turnover ratio = Credit sales Average Debtors and bills receivables Average collection period = Months/days in a year Debtors turnover

Asset turnover ratio

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Depending on the different concepts of assets employed, there are many variants of this ratio. These ratios measure the efficiency of a firm in managing and utilising its assets. Total asset turnover ratio = sales/cost of goods sold Average total assets Fixed asset turnover ratio = sales/cost of goods sold Average fixed assets Capital turnover ratio = sales/cost of goods sold Average capital employed Working capital turnover ratio = sales/cost of goods sold Net working capital

Creditors turnover ratio and average credit period

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This ratio shows the speed with which payments are made to the suppliers for purchases made from them. It shows the relationship between credit purchases and average creditors. Creditors turnover ratio = Credit Purchases Average creditors & bills payables Average credit period = months/days in a year Creditors turnover ratio

BALANCE SHEET
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y Case Study on Tata Steel.

Tata Steel

Components of the Statement of Cash Flows

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Cash received from Operations sale of goods and services

Cash paid for operating goods and services Cash paid for acquisition of investments Cash paid for dividends and reacquisition of debt or capital stock

cash flow from operations

+Cash received from Investing sales of investments

cash flow from investing

+=
cash flow from financing

Cash received from Financing issue of debt or capital stock

=
Figure 1
Net change in cash for the period

Cash Flow from Operating Activities (CFOA)

46

y CFOA means sources and uses of cash that arise

from the normal operations of a firm. y In general, the net cash flow from operations is computed as the net income reported on the income statement, including changes in net working capital items (i.e., receivables, inventories, and so on) plus adjustments for noncash revenues and expenses (such as depreciation).

Cash Flows from Investing Activities (CFIA)

47

y A firm makes investments in both its own noncurrent and fixed

y y y

y y

assets and the equity of other firms (which may be subsidiaries or joint ventures of the parent firm; they are listed in the investment account of the balance sheet). In Business parlance, the common element looked in here is CAPEX. Increases and decreases in these noncurrent accounts are considered investment activities. The cash flow from investing activities is the change in gross plant and equipment plus the change in the investment account. The changes are positive if they represent a source of funds (e.g., sale of some plant and/or equipment); otherwise, they are negative. The changes in these accounts are computed using the firms two most recent balance sheets. Negative cash flows from investments arise due to significant capital expenditures.

Cash Flows from Financing Activities (CFFA)

48

y Cash flow from financing activities is computed as

financing sources minus financing uses. y Cash inflows are created by actions increasing notes payable and long-term liability and equity accounts, such as bond and stock issues. Financing uses (cash outflows) include decreases in such accounts (that is, the paydown of liability and debt accounts or the repurchase of common shares). Dividend payments to equityholders are a significant financing cash outflow.

Cash Flow Statement

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y The sum total of the cash flows from operating,

investing, and financing activities is the net increase or decrease in the firms cash. y The sole purpose of preparation of statement of cash flows vests in the information provided about the cash flow detail that is lacking in the balance sheet and income statement.

Components of the Statement of Cash Flows

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Cash received from Operations sale of goods and services

Cash paid for operating goods and services Cash paid for acquisition of investments Cash paid for dividends and reacquisition of debt or capital stock

cash flow from operations

+Cash received from Investing sales of investments

cash flow from investing

+=
cash flow from financing

Cash received from Financing issue of debt or capital stock

=
Figure 1
Net change in cash for the period

Classification of Cash Flows

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y Operating Activities  Cash effects of transactions on Net Income y Investing Activities  Capital investment  Salvage value  Working capital investment or recovery y Financing Activities  Debt and repayment of principal

Elements of Cash Flow (Incremental)

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y Investment in Assets y Salvage value y Working Capital

y Manufacturing,

Investment y Working Capital Release y Cash Revenues/Savings

Operating & Maintenance Costs y Leasing Expenses y Interest and Repayment of Debt y Income Taxes and Tax Credits

Cash Flows
53

Cash Outflows Initial Investment Working Capital Inv. Repairs & Maint. Inc. Man. & Op Costs Interest and Loan Pmt Income Taxes

Cash Inflows Incremental Revenue Cost Savings Allowed Tax Credits Salvage Value Working Cap Release ST & LT Loans
53

Operating Activities
54

y Sales revenue y Cost savings y Manufacturing expenses y O & M cost y Interest payments y Lease expenses y Income taxes

(inflow) (inflow) (outflow) (outflow) (outflow) (outflow) (outflow)

Investing Activities
55

y Capital investment y Salvage value y Working capital y Working capital recovery y Gains taxes

(outflow) (inflow) (outflow) (inflow) (outflow)

Financing Activities
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y Borrowed Amount y Principal repayments

(inflow) (outflow)

Developing Cash Flow Statement

57

y Use net operating income as the starting point to get

net operating cash flow y Add back any non-cash depreciation)

expense

(mainly

Net Cash Flow = Cash Inflow - Cash Outflow Net Operating Cash Flow = Income after Taxes + Depreciation

CFS - Ratios
58

y Cash Flow Coverage Ratio

y y

These ratios are an alternative to the earnings coverage ratio. The motivation is that a firms earnings and its cash flow typically will differ substantially. To have ratios that can be compared to similar values for other firms in the industry, the measure of cash flow used is the cash flow from operating activities figure contained in the cash flow statement. As such, it includes depreciation expense, deferred taxes, and the impact of all working capital changes. Again, it is appropriate to specify the ratio in terms of total interest charges including estimated leases interest expense. Cash Flow Coverage of Fixed Financial Costs = Net Cash Flow Provided by Operating Activities + Interest Expense +Estimated Lease Interest Expense Interest Expense + Estimated Lease Interest Expense

CFS - Ratios
59

y Cash Flow/Long-Term Debt Ratio

y

y y y

Beyond relating cash flow to the required financing expense, several studies have used a ratio that relates cash flow to a firms outstanding long-term debt as a predictor of bankruptcy and have found that this ratio was an excellent explanatory variable. The cash flow figure used in most of these studies was the traditional measure of cash flow (net income plus noncash expenses) that prevailed at the time the studies were done. Hence, we use the cash flow from operating activities, which goes beyond the traditional measure and also considers the effect of working capital changes. This is a more conservative measure of cash flow because working capital changes typically have a negative impact on cash flow for a growing firm. Cash Flow/Long-Term Debt = Cash Flow Provided by Operating Activities Book Value of Long-Term Debt + Present Value of Lease Obligations

CFS - Ratios
60

y Cash Flow/Total Debt Ratio

y y y

Investors also should consider the relationship of cash flow to total interest-bearing debt to check that a firm has not had a significant increase in its short term borrowing. When you compare these ratios to those with only long-term debt (that includes deferred taxes), they reflect the firms proportion of short-term debt due to short-term borrowing. As before, it is important to compare these flow ratios with similar ratios for other companies in the industry and with the overall economy to gauge the firms relative performance. Cash Flow/Total Interest-Bearing Debt = Cash Flow Provided by Operating Activities Total Long-Term Debt + Current Interest-Bearing Liabilities

Cash Flow Statement

61

y Case Study on Infosys.

Infosys

y Case Study on Tata Steel.

Tata Steel

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