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    Ratio Analysis

    Over the years, investors and analysts have developed numerous analytical tools, concepts and techniques to compare the relative strengths and weaknesses of companies. These tools, concepts and techniques form the basis of fundamental analysis. 

    Ratio analysis is a tool in quantitative analysis of the operating &financial performance of a business organization such as efficiency, solvency, profitability, etc. of a particular period from the financial statements like Balance Sheet, Profit & Loss A/c, Cash Flow Statements, etc. 

    The trend of these ratios is studied to check whether the organization is improving or deteriorating.

    What is the need of Ratio Analysis?


    In finance, they have a very significant role to play because these ratios provide an in-depth understanding of the business which cannot be understood by just looking at the standalone financial statements.


    For example, a ratio of net profit to sales indicates the percentage of net profit margin. When this ratio is compared with the industry standards, we can come to a conclusion whether the company has performed good or bad. In the other instance, if we compare it with previous year’s margins, we can assess whether the company is improving, stable or downgrading compared to its past performance. This is how financial analysis augments the worth of preparing financial statements.


    Benefits of Ratio Analysis:


    1. Analysing the financial statements
    2. Judging efficiency of the business organization


    1. Comparing performance of the organization from one period to the other or with the other company.


    1. Financial Planning
    2. 5. Establishing benchmark


    Types of Ratios:


    1. Liquidity Ratios - Liquidity ratios are calculated to find out the liquidity position of an organization. Liquidity means an ability to pay as and when some obligations are due. Liquidity is the lifeblood of any business organization because the lack of liquidity can bring bankruptcy situation for the organization.


    For calculating liquidity ratios, current assets and current liabilities are used. The important liquidity ratios are the current ratio, acid-test ratio or quick ratio, cash ratio.




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    SBS Interns' Digest                                                                                                                    


    1. Profitability/Performance Ratios - Profitability ratios are the evaluation method for an organization. Profit is the main motive of every organization and these ratios judge how well an organization has achieved its goal of profits. Profit margin ratios include gross profit margin and net profit margin and it judges the profitability at different stages.


    The rate of return ratios include return on equity, return on assets, earning power, return on capital employed.


    1. Turnover/ Activity/ Efficiency Ratios–These ratios are also known as Asset Management Ratios. Efficiency ratios judge the efficiency in the management of assets. Assets are employed to generate sales for a firm and these ratios determine how well the asset is utilized to efficiently generate or convert an asset into sales.


    Important activity / efficiency / turnover ratios are inventory turnover, average collection period, receivables turnover, fixed assets turnover and total asset turnover.


    1. Financial Leverage Ratios - It would be difficult to find a company with no debt in its capital structure. Use of debt in its capital structure is commonly known as leverage. Leverage ratios or capital structure ratios revolve around the debt of an organization. The two types of ratios are as follows:


    1. Capital Structure Ratios –
      1. Capital structure ratios assess the risk of bankruptcy for the organization.
      2. Capital structure ratios are debt-equity ratio and debt-asset ratio.
    2. Coverage Ratios –


    1. Apart from judging the bankruptcy risk, also judges the servicing capacity of payment by comparing the future debt obligations with resources used for honouring them.


    1. Coverage ratios are interest coverage ratios, fixed charge coverage ratios and debt service coverage ratios.


    1. 5. Growth Ratios – It measures the growth of a firm. Factors such as investment in fixed asset, profit margins, retention ratio etc. are responsible for the growth of a firm. Growth ratios are of two types such as internal growth rate and sustainable growth rate (when external financing is used to support growth). It is said that higher growth can be achieved when external financing used.


    1. Valuation Ratios - Valuation ratios are the mainly utilized for analysing the worth of a stock in share market or to value a company as a whole. It includes price to earnings ratio, dividend yield, market value to book value etc.


    1. DuPont Analysis - DuPont is a US based company established in 1802. It has pioneered a method of financial analysis widely used by the business organization. It has not produced any ratio but has come up with inter-relationship between some ratios to understand cause and effect of a ratio to others.









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    An insight into Annual Performance Report (“APR”) under SEZ Laws



    SBS Interns' Digest                                                                                                                     


    For example, DuPont defiznes Return on Assets as the product of Net Profit Margin and Total Asset Turnover Ratio.


    DuPont analysis tells us that ROE is affected by three things:


    1. Operating efficiency, which is measured by profit margin
    2. Asset use efficiency, which is measured by total asset turnover
    3. Financial leverage, which is measured by the equity multiplier


    ROE = Profit Margin (Profit/Sales) * Total Asset Turnover (Sales/Assets) * Equity Multiplier (Assets/Equity)


    Altman Z Score:


    ?EdwardAltman’s has developed this formula.


    ?Ithelpsin predicting the bankruptcy of the company. It helps in finding the probability of the firm’s bankruptcy for the next two years period. The formula is used to measure the company defaults and the financial health of the company.


    ?Formula: Z = 1.2T1 + 1.4T2 + 3.3T4 + 0.6T4 + 0.999T5




    ?T1=Working Capital

    Total Assets


    It measures the liquid assets in relation to the size of the company.


    ?T2=Retained Earnings

    Total Assets


    It measures the profitability of the assets that reflects the company’s age and earnings power.


    ?T3=Earnings before Interest & Tax (EBIT)

    Total Assets


    It measures the Operating Efficiency apart from the tax & leveraging factors; it recognises the operating earnings as being important for being the long viability.


    ?T4=Market value of Equity

    Book Value of Total Liabilities


    It measures the market price fluctuation of the equity.



    Total Assets


    It is a Standard measure for the total sales turnover.


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    An insight into Annual Performance Report (“APR”) under SEZ Laws



    SBS Interns' Digest                                                                                                                     


    ?Interpretation of the Z score


    ?Z>2.99       Safe Zone

    ?1.81<Z< 2.99   Grey Zone

    ?Z<1.81       Distress Zone


    Conditions for use of the Altman Z Scores:


    ?Thisformula is not used for the new companies, as there are always low earnings and the Z score renders a low score.


    ?TheAltman’s Score does not directly flow with the Cash flows.


    ?Thoughacompany has high Z score but the company is unable to pay the bills then the company will be declared as the bankruptcy.


    Following are the factors where the banker/ lender looks into:


    1. Financial stability
    2. Solvency
    3. Liquidity
    4. Profitability
    5. Quality of the management
    6. Safety and security of the loans and advances


    Use of the financial parameters:


    1. The dates and duration of the financial statements being compared should be the same in order to avoid erroneous in the decision making.


    1. The accounts prepared should be calculated on the similar basis. For Eg:- Valuation of stock, method used for the calculation of depreciation .


    1. In order to judge the overall performance of the firm we need to identify the trends of the firm and that particular industry of three years.

























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    An insight into Annual Performance Report (“APR”) under SEZ Laws



    There are different standard financial ratios used in different aspects which are mentioned as below:








    Use of ratio



































    Liquidity Ratios



































    •  This ratio is used to know the company’s liquidity and working capital position, used

    Current Ratio=

    Current Assets

    in order to ascertain the whether company’s short term assets are sufficient to pay









    off the short term liabilities.




    Current Liabilities















    •  Higher the ratio, the better the performance of business organization.



















    Current Assets-Inventory

    •  It is also known as acid-test ratio. This ratio is more conservative in nature and

    Quick ratio=


    knowing the most liquid current assets to cover the current liabilities.











    Current Liabilities

    •  Higher the ratio, more the liquid position.



























    Cash ratio=

    Cash & Cash Equivalents+Invested Funds

    •  It is an indicator of a company’s liquidity to further cover the current liabilities.







    •  Higher the ratio, more the liquid position




    Current Liabilities












    Profitability / Performance Ratios



























    Gross Profit

    •  It is used to know how efficiently the company used raw materials, labour and

    Gross Profit Margin=

    manufacturing – related to fixed assets to generate profits.















    Net sales (Revenue)

    Gross Profit =Sales-Raw Materials-Labour-Manufacturing Overhead




































    Operating profit

    •  This helps in measuring the company’s pricing strategies. The higher the ratio is

    Operating Profit Margin=





















    Net sales (Revenue)

    Operating Profit= Gross Profit-Administration & Selling Expenses












































    ?Itisameasure for a company for comparing the financials with the other similar















    companies. When other profitability ratios are low and net profit margin is high, it

    Net Profit Margin=


    Net profit

    means that the company is investing more in outside.



    ?Thelower the ratio it means the indirect expenses increased, absence of non-






    Net sales (Revenue)















    operating income, low turnover, etc.















    ?NetProfit= Gross Profit+Indirect Income-Indirect Expenses























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    Net Profit

    Net Profit before Tax

    •  This ratio helps to measure how best the capital is invested & profit is generated to




    the company. The effective usage of funds made to generate a profit.



















    Net Worth




    Net Worth



    •  The greater the ratio, the effective the funds used.




































    Retained Profit


    Net Income-Dividend

    It measures about the proportion of the earning retained (reserves and surplus)by

















    the company to meet the contingent liabilities.



    Net Profit


    Net Profit









































    •  It measure the efficiency of the investment as compared with the similar industries


















    or as compared with the group of investments made by the investor in different



    Return on investment=











    The investments like the investment by the investor in equity, preference shares,










    Total Assets


















    debentures, fixed deposits, etc.

















    •  This is to evaluate the profitability of total assets employed.


































    •  The return on equity ratio or ROE is a profitability ratio that measures the ability of a


















    firm to generate profits from its shareholders investments in the company.

















    •  Most of the time, ROE is computed for common shareholders. In this case, preferred









    Net Income


    dividends are not included in the calculation because these profits are not available



    Return on Equity=






    to common stockholders. Preferred dividends are then taken out of net income for













    Net Worth



















    the calculation.

















    Also, average common stockholder's equity is usually used, so an average of


















    beginning and ending equity is calculated.



















    Return on Assets=





    Net Income

    It is to measure the ability of the company in using the assets to generate profits.

    Opening Assets+Closing Assets



































    •  It measures the factors like assets management, profit margin & leverage.

















    •  This ratio measures the capacity of the company in generating the profits from the












    shareholder’s funds and comparison with the firms of the same industry.

    Return on Net Worth=







    An excessive high net worth may lead the company is funding its operations with the














    Shareholder’ s funds+Retained Earnings


    disproportionate amount of debt & trade payables. In this case the investor would



































    check for the debt levels to see how excessive returns are being generated.

















    •  It is also called as Return on Shareholder’s Investment.





















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    Net Operating Profit

    Return on Capital Employed=

    Capital Employed

    • It measures the efficiency of generating the profits from the capital employed in the company.


    • Capital employed = Share Capital + Reserves & Surplus + Debt – Fictitious Assets – Non-trading Investments.



















    Turnover Ratios




















    Cost of goods sold


    •  It measures the liquidity of the inventory i.e. how many times the inventory is sold


    Inventory Turnover Ratio=


    with respect to the turnover of the company.


    Average Inventory Cost

    The higher the ratio, lower the holding period of the inventory i.e. the lesser amount



















    of cash is blocked in inventory and vice versa.



















    Accounts Receivable Turnover Ratio=

    Net sales


    •  The receivables turnover ratio indicates the efficiency with which a firm manages



    the issue of credit to customers and collects on that credit.


    Average Debtors












































    •  This ratio indicates the extent of total debt turned over in achieving sales of the firm.


    Total Debt Turnover Ratio=



    Net sales



    A high ratio shows the greater efficiency.


    Total Debtors

    A low ratio shows less amount of efficiency of using the available resources or the






















    investment of amount is made on the low/ zero productive goods.






















    Net sales


    •  It measures how effectively the company is utilizing cash.


    Cash Turnover Ratio=



































    Fixed Assets Turnover Ratio=


    Net sales


    It measures the effective capacity & the utilization of the fixed assets of the






    Fixed Assets


































    Net sales

    •  This ratio helps in knowing the effective utilization of the working capital by the


    Working Capital Turnover Ratio=







    company. This is used to analyse with the similar companies in the industry about the








    Average Working Capital


    effective use of the working capital.










































    Net sales


    •  When the ratio increases, it indicates that the company is paying the suppliers in a


    Accounts Payable Turnover Ratio=



    faster rate


    Average Crditors

































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    Financial Leverage Ratios








































    •  It is used to measure an enterprise’s ability to meet its debt and other financial


    After tax net profit+Depreciation



    commitments. The solvency ratio indicates whether a company’s cash flow is

    Solvency Ratio=



    sufficient to meet its short-term and long-term liabilities.

    Short term debt+long term debt






    •  The lower a company's solvency ratio, the greater the probability that it will default








































    on its debt obligations








































    •  It measures the company’s financial leverage and proportion of debt and equity





















    portion invested in the assets of the company.




















    •  Higher the ratio, indicates lower stake and overtrading and lower the ratio, indicates
















    the company has conservative management, unable to get credit, high capital

    Debt-Equity Ratio=





























    •  But other industries that are highly capital intensive, such as services, utilities and








































    the industrial goods sector also tend to have higher debt-to-equity ratios.




















    •  The ideal ratio of Debt Equity ratio is 3







































    It measures the ability of the company’s repayment capacity of the long term

    Debt-Service Coverage Ratio=




































    •  The ideal ratio of DSCR is >1.



























































    •  It measures the ability of repayment of short term liabilities and the maintenance of

    Current Ratio=

    Current Assets









    the working capital to meet day to day commitments of a firm.

    Current Liabilities







    A company with higher ratio may not be able to






























    •  The ideal ratio of current ratio is 2.









































    The ratio measures the ability of payment of interest and timely manner of

    Interest Coverage Ratio=











    repayment of borrower to the lender.









    •  Higher the ratio, it indicates the company is at low risk and its operations are




































    producing enough cash to pay bills & vice versa.










































    DuPont Analysis



    Net Income






    •  With this method, assets are measured at their gross book value rather than at net

    DuPont Return on Assets=





    book value in order to produce a higher return on equity (ROE). It is also known as























    * Assets

    * Equity







    "DuPont identity".












































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    – Martin Luther king, Jr