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Professor Rajendra K. Lagu Department of Electrical Engineering e-mail: Webpage: Ratio Analysis Balance Sheet

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Ratio Analysis

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Professor Rajendra K. Lagu

Department of Electrical Engineering



Ratio Analysis

balance sheet
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.
balance sheet continued
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)
financial management decisions
Financial Management Decisions

Capital budgeting decisions

Capital structure decisions

Operating policy decisions

  • 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)
examples of assets
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
  • 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
examples of liabilities
Examples of Liabilities
  • Accounts payable (supplier credit)
  • Accrued corporate tax
  • Short term loans
  • Debentures
  • Long term loans
  • Equity (common stock + preferred stock)
  • Retained earnings
balance sheet of a prototype company
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
a typical manufacturing company starts operation
A Typical Manufacturing Company Starts Operation

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

XYZ Private Limited

Balance Sheet at April 1, 2001

a lathe is bought on cash basis
A lathe is bought on cash basis

Owner pays Rs 3 lakhs from the bank acount

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

No payment is done so cash position does not change

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

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

customer pays up after 20 days
Customer pays up after 20 days

Payment deposited in bank so cash position changes

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

Payment done from bank so cash balance reduces

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

Payment done to bank so cash balance increases

cash flow funds flow statement
Cash Flow / Funds Flow Statement
  • Differences in successive balance sheets
  • Sources of Funds
      • Net profit
      • Issue of new share capital
      • Sale of fixed assets
      • New loans
  • Use of Funds
      • Payment of dividends
      • Purchase of fixed assets
      • Repayment of loans
ratio analysis
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)
liquidity ratios
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

gearing ratios
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

asset utilization ratios
Asset Utilization Ratios
  • Return on Total Investment: management’s skill in exploiting the funds made available


PBT / (Shareholders’ funds + Long term loans)

  • Return on Shareholders’ Equity


PBT / (Shareholders’ funds)

Sales / Total Capital Employed

profitability ratios
Profitability Ratios
  • Net Profit Margin = NP / Sales
  • Gross Profit Margin = GP / Sales
market value related ratios
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
limitations of financial statements
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
profit and loss statement of three it companies for 12 months ending 31 03 2001 in rs cr
Profit and Loss Statement of Three IT Companies for 12 Months Ending 31.03.2001 (in Rs Cr)