FINANCIAL MANAGEMENT

FINANCIAL MANAGEMENT

Financial Ratio Analysis

SIGNIFICANCE OF RATIO ANALYSIS CSD ‘A’ earns Rs 50,000 CSD ‘B’ earns Rs 40,000 Which is more efficient? A or B CSD ‘A’ has emp Rs 4,00,000 CSD ‘B’ has emp Rs 3,00,000 Profit as a % of Capital emp ‘A’ = (50,000/ 4,00,000) * 100 =12.50% ‘B’ = (40,000/ 3,00,000) * 100 =13.33%

RATIO A ratio is a statistical yardstick that provides a measure of the relationship between two variables or figures.

BALANCE SHEET ABC COMPANY AS AT 31 MAR2008

INCOME STATEMENT OF ABC COMPANY FOR YEAR ENDED 31 MAR 08

WHY BOTHER WITH RATIOS? • A comparison is more useful than mere Nos • Analysis of financial ratios involves two types of comparisons: • Present ratio with the past ratios & expected future ratios • Ratios of one firm with those of similar firms or with industry averages at same point of time • Essential to consider nature of business (apples cannot be compared with oranges)

CLASSIFICATION OF RATIOS • Liquidity ratios • Leverage / Solvency ratios • Turnover / Activity ratios • Profitability ratios • Valuation ratios

LIQUIDITY RATIOS • Shows ability of company to pay its current financial obligations • Company should not be selling its assets at a loss to meet its financial obligations; worst scenario be forced into liquidation • Current ratio • Quick / Acid test ratio

CURRENT RATIO (CR) • Measure of company’s ability to meet short term requirements • Indicates whether current liabilities are adequately covered by current assets • Measures safety margin available for short term creditors • CR = Current assets/Current liabilities • If Net Working Capital is to be positive, CR >1 • Indian avg for non banking industries is 2 • Current assets = 681 • Current liabilities = 399 • CR = 681/399 = 1.71

CURRENT RATIO (CR) - IMPORTANCE • Higher ratio ensures firm does not face problems in meeting increased working capital requirements • Low ratio implies repeated withdrawls from bank to meet liquidity requirements • High CR as compared to other firms implies advantage of lower int rates from banks

ACID TEST RATIO/QUICK RATIO(QR) • 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 • Measures position of liquidity at a point of time • QR = Quick Assets / Current Liabilities • Quick assets = Current assets – (inventories + prepaid expenses) = 681–(355+64) = 262 • Current liabilities = 399 • QR = 262/399 = 0.66 • As a thumb rule ideal QR = 1; should not be less than 1

LEVERAGE RATIOS • Shows dependence of firm on outside long term finance • Shows long term financial solvency & measures firm’s ability to pay interest & principle regularly when due • To assess extent to which the firm borrowed money vis-à-vis funds supplied by owners; Use of debt finance • Companies whose EBIT <= Interest payments are risky • Debt - Equity ratio • Debt - Total fund ratio • Debt - Assets ratio • Interest coverage ratio • Liability coverage ratio

DEBT EQUITY RATIO • Measures relative proportion of debt & equity in financing assets of a firm • Company can have good current ratio and liquidity position, however liquidity may have come from long term borrowed funds, the repayment of which along with interest will put liquidity under pressure • DER = Long term debt / Share holders funds • Creditors would like this to be low; Lower ratio implies larger credit cushion (margin of protection to creditors) • IDB expects DER of 2:1 in respect of SMEs

DEBT EQUITY RATIO • Debt (loans) = Secure loans + Unsecure loans = 151+30=181 • Share holders funds = (equity+ preference capital + res & surplus – fictitious assets & accumulated losses not written off ) = 120+50+215 = 385 • DER = 181/385 = 0.47 = (0.47:1) • Creditors are providing Rs 0.47 financing for each rupee provided by shareholders

DEBT – TOTAL FUND RATIO • DTF ratio= Long term debt / Total fund • Debt (long term) = 181 • Total funds (debt + sh holders’ funds) = 181+(170+215-35) = 531 • DTF ratio = 181/531 = 0.34 • 34% of the firms funds are debt (of various types) remaining 66% is financed by owners/ share holders • Higher the debt - total funds ratio, greater the financial risk

DEBT – ASSETS RATIO • Debt - Assets ratio = Debt / Net assets • Debt = 181 • Net assets (less fictitious assets & losses) = 930 • Ratio = 181/930 = 0.19 • 19% of the firms assets are financed with debt (of various types). • Shows coverage provided by the assets to total debt

INTEREST COVERAGE RATIO • Gives ability of company to pay back long term loans along with interest or other charges from generation of profit from its operations • Interest coverage ratio = EBIT / Debt interest • EBIT = 143 • Interest = 29+4 = 33 • Ratio = 143/33=4.33 • EBIT should be 6 – 7 times of debt interest • Shows margin of cover to lenders; of prime imp

LIABILITY COVERAGE RATIO • Calculated to determine time a company would take to pay off all its liabilities from internally generated funds • Assumes that liabilities will not be liquidated from additional borrowings or from sale of assets • LCR = Internally generated funds / Total liabilities • Internally gen funds = Equity + Pref + R&S = 385 • Total liabilities = 965 • LCR = 385/965 = 0.399 • Firm will take 2.5 yrs (1/.399) to repay all its liabilities

ACTIVITY / TURN OVER RATIOS • Allows to examine whether total amount of each type of asset a company owns is reasonable, too high or too low in light of current and forecast operating needs • In order to purchase / acquire assets, companies need to borrow or obtain Capital from elsewhere :- • More assets acquired implies high int and low profits • Lesser assets implies operations not as efficient as possible • Activity turn over ratios used to assess efficiency with which company utilizing its assets • Relates to level of activity represented by sales or cost of goods sold • Inventory turnover ratio • Average collection period • Fixed assets turn over ratio

INVENTORY TURN OVER RATIO • Measures No of times inventory turned over in a year OR No of days of inventory held by company to sp sales • Times Inventory turned over = Net sales OR COGS Avg inventory Avg stocks • Inventory measured in days of sale = 365 x Avg inventory Net Sales

INVENTORY TURN OVER RATIO • A ratio of 6 times indicates inventory turned over six times in a year OR Ratio of 60 days indicates enough inventory to support sales for 60 days held by company • Excessive inventories unproductive; represent investment with zero rate of return • Conversely less inventory results in loss of customers • ABC’s ratio = 904/355 = 2.54 • ABC’s Days of Inv = (355 x 365)/904 = 143.33 days

AVERAGE COLLECTION PERIOD • Represents duration a company must wait after making sales, before it actually receives cash from its customers • ACP = Avg receivables OR Average sales per day = Avg receivables x 365 Sales • Imp • For assessing effectiveness of credit policy of firm • Enables mgmt to take timely measures to effectively manage credit • Too high value - firm facing difficulties in collecting debts • Too low value - restrictive credit policy Receivables = 189 Sales = 904 ACP = (189 x 365)/ 904 = 76.2 days say 76 days

FIXED ASSETS TURNOVER RATIO • Measures effectiveness of utilization of fixed assets by company • Used to compare fixed assets utilization of two firms • Not truly reflective of performance / efficiency • High ratio (depreciation) if old assets • Low ratio if capital assets procured recently • FATR = Net sales (or COGS)/ Fixed assets • Higher ratio indicates better utilisation of assets (with a caution on age of assets) Fixed Assets = 229 Net Sales = 904 FATR = 904 / 229 = 3.95

PROFITABILITY RATIOS • Profitability ratios indicate • Company's profitability in relation to other companies • Internal comparison with last yrs profits • Managements effectiveness as shown by returns generated on sales and investments • Gross profit margin ratio (GPMR) • Net profit margin ratio (NPMR) • Return on investment

GROSS PROFIT MARGIN RATIO(GPMR) • Represents cost of production • Helps in understanding proportion of raw materials used and direct expenses incurred in overall production process • Reflects income being generated which can be apportioned by promoters • Reflects efficiency of firm’s operations as well as how products are priced • GPMR = Gross profit/ Net sales Net Sales = 904 Gross Profit = Net sales - COGS = 904 - 714 = 190 GPMR = Gross Profit / Net sales = 190 / 904 = 0.21 = 21% Implies 79% (100-21%) of sales contribute towards direct expenses and raw mtrl

NET PROFIT MARGIN RATIO(NPMR) • Takes into account not only cost of production but also administrative expenses like staff salary, selling & distribution overheads • Represents surplus of gross profit after meeting expenses • Net profit appropriated to meet tax liability, dividend payments and to retain part in business • NPMR = Net profit (Profit after tax)/ Net sales Net Sales = 904 Net Profit after taxes = 52 NPMR = Net Profit / Net sales = 52 / 904 = 0.057 = 5.7% Implies for every Rs 100/- of sales, Rs 5.7/- earned as profit which can be used for dividend distr and apportioned to res & surplus • Company B has outperformed Company A in total sales • However A has utilized its resources more efficiently

PROFITABILITY IN RELATION TO INVESTMENT- RETURN ON INVESTMENT (ROI) • Indicates efficiency with which company used its Capital (Equity as well as debt) • Takes into account overall returns of the company assuming company has not taken any debt • Gives overall returns including adjustments of earnings for fin leveraging • Enables one to check whether return made on investment is better than other alternatives available • Suited for inter-firm comparisons • ROI = EBIT x100 / Capital employed • EBIT = 143 • Capital employed = 566 ( (120+50+215+181)-(0+0) ) • (Eq +Pref sh +Res & surp+Debt)-(Fictitious assets + Non operating investments) • ROI = 143/566 x 100 = 25.26 %. • The company has earned a profit of 25.26 paise on every 100 Re invested

VALUATION RATIOS • Earning per share (EPS) • Price Earnings (PE) Multiple • Price Earnings Growth (PEG) Multiple • Dividend Payout Ratio • Dividend Yield • Beta of Stock

EARNINGS PER SHARE(EPS) • Represents total earnings of a company available for distribution among equity shareholders • Evaluates performance of company shares over a period of time • EPS = Net profit available for equity shareholders / No of Equity shares • EPS alone should not be basis of decision making with respect to purchase of any company share • Faulty reasons of High EPS • Less No of Equity shares • Investment in risky ventures

PRICE EARNING (PE) MULTIPLE • Simplest method of comparing different stocks at a point of time to make investment decisions • As a layman, this is the price being paid for buying one rupee of earning of a company eg If PE of Infosys share is Rs 9/- it means we are paying to the market a price of 9 for every Rs 1/- earning of the company • PE Ratio = Market Price per share/ EPS

PRICE EARNING GROWTH (PEG) MULTIPLE • An extension of PE which also takes into account growth rate of the company • PEG Multiple = PE / Growth Which company stocks to be purchased ?

DIVIDEND PAYOUT RATIO • Shows amount of dividend paid out of earnings • An indication of amount of profits put back into company • Imp ratio to assess long term prospects of company • Dividend Payout Ratio = Dividend / Net Income

DIVIDEND YIELD • Shows relationship between Dividend per share and market price • An imp ratio to compare two companies • Dividend Yield (%) = Dividend amount per share *100 Market price of share

BETA OF SECURITY • Refers to overall market risk which a security is carrying and which cannot be diversified • Responsiveness of share price of a company with respect to overall market movement • If over a period of time, market has given a return of 20%; individual share of company ‘A’ has given return of 10%; Beta of A = 10 / 20 = 0.5 • If investor is risk averse, should invest in stocks with low Beta; Even if market falls by drastic amount his investment will not take that much hit

FINANCIAL RATIOS • LIQUIDITY • NWC = CA - CL • CR = CA/CL • ATR = (CA –INVENTORY)/CL Solvency , Safety Margins, Idle Resources , Risk Long term solvency Risk due to debt Owners Stake Coverage provided by assets Interest burden • LEVERAGE • Debt-Equity Ratio = Debt/Net Worth • Liab Coverage Ratio = Int gen funds / Total Liab Debt to Assets Ratio = Debt/Total Assets Interest Coverage Ratio = EBIT/Debt Interest • ACTIVITY/TURNOVER • Inventory Turn Over Ratio = Net Sales/Inventory • FATR = Net Sales/Total Assets • Avg Collection Period = 365/ RTOR Utilisation Credit mgt Restrictions Efficency Efficency Acceptability Overall performance Margin of Safety Ability for PAT • PROFITABILITY • GPMR = Gross Profit/Net Sales • NPMR = Net Profit/Net Sales • ROI = EBIT x 100/ Capital • ROE = Equity earnings/ NW . 6/3/2014 42

FINANCIAL MANAGEMENT