Ratio Analysis
Content
Ratio Analysis
BY Gaurav Bagra Lecturer(Finance)
Brief Introduction to Some Key Points
Balance Sheet
It represents the financial affairs of the company and is also referred to as “Assets and Liabilities” statement and is always as on a particular date and not for a period.
Profit and Loss Account
It represents the summary of financial transactions during a particular period and depicts the profit or loss for the period along with income tax paid on the profit and how the profit has been allocated (appropriated).
Net worth
It means total of share capital and reserves and surplus. This includes preference share capital unlike in Accounts preference share capital is treated as a debt. For the purpose of debt to equity ratio, the necessary adjustment has to be done by reducing preference share capital from net worth and adding it to the debt in the numerator.
Reserves and Surplus
It represent the profit retained in business since inception of business. “Surplus” indicates the figure carried forward from the profit and loss appropriation account to the balance sheet, without allocating the same to any specific reserve. Hence, it is mostly called “unallocated surplus”. The company wants to keep a portion of profit in the free form so that it is available during the next year for appropriation without any problem. In the absence of this arrangement during the year of inadequate profits, the company may have to write back a part of the general reserves for which approval from the board and the general members would be required.
Secured loans
It represent loans taken from banks, financial institutions, debentures (either from public or through private placement), bonds etc. for which the company has mortgaged immovable fixed assets (land and building) and/or hypothecated movable fixed assets (at times even working capital assets with the explicit permission of the working capital banks)
Unsecured loans
It represent fixed deposits taken from public (if any) as per the provisions of Section 58 (A) of The Companies Act, 1956 and in accordance with the provisions of Acceptance of Deposit Rules, 1975 and loans, if any, from promoters, friends, relatives etc. for which no security has been offered. Such unsecured loans rank second and subsequent to secured loans for settlement of claims against the company. There are other unsecured creditors also, forming part of current liabilities, like, creditors for purchase of materials, provisions etc.
Investments
Investment made in shares/bonds/units of Unit Trust of India etc. This type of investment should be ideally from the profits of the organisation and not from any other funds, which are required either for working capital or capital expenditure.
Miscellaneous expenditure not written off can be one of the following –
Company incorporation expenses or public issue of share capital, debenture etc. together known as “preliminary expenses” written off over a period of 5 years as per provisions of Income Tax. Misc. expense could also be other deferred revenue expense like product launch expenses.
There is a significant difference between the way in which the statements of accounts are prepared as per Schedule VI of the Companies Act and the manner in which these statements, especially, balance sheet is analysed by a finance person or an analyst. For example, in the Schedule VI, the current liabilities are netted off against current assets and only net current assets are shown. This is not so in the case of financial statement analysis. Both are shown fully and separately without any netting off.
At the end of any financial year, there are certain adjustments to be made in the books of accounts to get the proper picture of profit or loss, as the case may be, for that particular period. For example, if stocks of raw materials are outstanding at the end of the period, the value of the same has to be deducted from the total of the opening stock (closing stock of the previous year) and the current year’s purchases. This alone would show the correct picture of materials consumed during the current year. Ratio analysis
It is to determine the relationship between any set of two parameters and compare it with the past trend. In the statements of accounts, there are several such pairs of parameters and hence ratio analysis assumes great significance. The most important thing to remember in the case of ratio analysis is that you can compare two units in the same industry only and other factors like the relative ages of the units, the scales of operation etc. come into play.
Types of Ratios
Liquidity ratios Turnover ratios Profitability ratios Investment on capital/return ratios
Liquidity Ratios
CURRENT RATIO
Formula = Current assets/Current liabilities.
Min. Expected even for a new unit in India = 1.33:1.(Ideal Ratio is 2 : 1)
Significance = Net working capital should always be positive. In short, the higher the net working capital, the greater is the degree of overall short-term liquidity. Means current ratio does indicate liquidity of the enterprise. Too much liquidity is also not good, as opportunity cost is very high of holding such liquidity. This means that we are carrying either cash in large quantities or inventory in large quantities or receivables are getting delayed. All these indicate higher costs. Hence, if you are too liquid, you compromise with profits and if your liquidity is very thin, you run the risk of inadequacy of working capital.
Range – No fixed range is possible. Unless the activity is very profitable and there are no
immediate means of reinvesting the excess profits in fixed assets, any current ratio above 2.5:1 calls for an examination of the profitability of the operations and the need for high level of current assets. Reason = net working capital could mean that external borrowing is involved in this and hence cost goes up in maintaining the net working capital. It is only a broad indication of the liquidity of the company, as all assets cannot be exchanged for cash easily and hence for a more accurate measure of liquidity, we see “quick asset ratio” or “acid test ratio”.
Acid Test Ratio or Quick Asset Ratio
Formula = Quick Assets / Current liabilities.
Quick assets = Current assets (-) Inventories + Prepaid Expenses (which cannot be easily converted into cash). Significance = coverage of current liabilities by quick assets. As quick assets are a part of current assets, this ratio would obviously be less than current ratio. This directly indicates the degree of excess liquidity or absence of liquidity in the system and hence for proper measure of liquidity, this ratio is preferred. The minimum should be 1:1. This should not be too high as the opportunity cost associated with high level of liquidity could also be high. What is working capital gap? The difference between all the current assets known as “Gross working capital” and all the current liabilities other than “bank borrowing”. This gap is met from one of the two sources, namely, net working capital and bank borrowing. Net working capital is hence defined as medium and long-term funds invested in current assets.
Turnover Ratios
Generally, Turn Over Ratios indicate the Operating Efficiency. The higher the ratio, the higher the degree of efficiency and hence these assume significance. Further, depending upon the type of turn over ratio, indication would either be about liquidity or profitability also. For example, inventory or stocks turn over would give us a measure of the profitability of the operations, while receivables turn over ratio would indicate the liquidity in the system.
Debtors Turn Over Ratio / Receivable Turnover Ratio
This indicates the efficiency of collection of receivables and contributes to the liquidity of the system. Formula = Total Credit Sales / Average debtors outstanding during the year. Hence the Minimum would be 3 to 4 times. This depends upon so many factors such as type of industry like capital goods, consumer goods – capital goods, this would be less and consumer goods, this would be significantly higher; Conditions of the market – monopolistic or competitive – monopolistic, this would be higher and competitive it would be less as you are forced to give credit; Whether new enterprise or established – new enterprise would be required to give higher credit in the initial stages while an existing business would have a more fixed credit policy evolved over the years of business
Average Collection Period / Debtors Velocity
Inversely related to Debtors Turn Over Ratio Formula = 360 / Receivables Turn Over Ratio. For example debtors turn over ratio is 4. Then considering 360 days in a year, the average collection period would be 90 days. In case the debtors turn over ratio increases, the average collection period would reduce, indicating improvement in liquidity.
Creditors Turnover Ratio
Meaning – This ratio is used to establish a relationship between net credit purchases and average trade creditors Objective – The objective of calculating this ratio is to determine the efficiency with which the creditors are managed.
Formula = Net Credit Purchase / Average Payables Net Credit Purchases = Gross Credit Purchases – Purchase Return Average Payables = (Opening Creditors & B/P + Closing Creditors & B/P) / 2
Average Credit Period or Creditor’s Velocity It shows an average period for which the credit purchases remain outstanding.
Formula = Months or Days in a year / Credit Turnover
Inventory Turn Over Ratio
Formula = Cost of Goods Sold/Average inventory held during the year The inventory should turn over at least 4 times in a year, even for a capital goods industry. But there are capital goods industries with a very long production cycle and in such cases, the ratio would be low. While receivables turn over contributes to liquidity, this contributes to profitability due to higher turn over. The less the production cycle, the better the ratio and vice-versa. The higher the level of stocks, the lower would be the ratio and vice-versa. Cost of goods sold = Sales – profit – Interest charges. Current Assets Turn Over Ratio Not much of significance as the entire current assets are involved. However, this could indicate deterioration or improvement over a period of time. Indicates operating efficiency. Formula = Cost of goods sold/Average current assets held in business during the year. There is no min. Or maximum. Again this depends upon the type of industry, market conditions, management’s policy towards working capital etc.
Profitability Ratios
Profitability Ratios
a) Profit in Relation to Sales
This indicates the Margin Available on Sales b) Profit in Relation to Assets This indicates the degree of return on the capital employed in business that means the earning efficiency. Please appreciate that these two are totally different.
Profit Margin On Sales a) Gross profit margin on sales and net profit margin ratio – Gross profit margin :Formula = Gross Profit / Net Sales. Gross Profit = Net sales (-) Cost of production before selling, general, administrative expenses and interest charges. Net Sales = Gross sales (-) Excise duty. This indicates the efficiency of production and serves well to compare with another unit in the same industry or in the same unit for comparing it with past trend. For example in Unit A and Unit B let us assume that the sales are same at Rs.100lacs. Parameter Unit A Unit B Sales 100 Lacs 100 Lacs Cost of production 60 Lacs 65 Lacs Gross profit 40 Lacs 35 Lacs Deduct: Selling General Administrative expenses and interest 35 Lacs 30lacs Net profit 5 Lacs 5 Lacs While both the units have the same net profit to sales ratio, The significant difference lies in the fact that while Unit A has less cost of production and more office and selling expenses, Unit B has more cost of production and less of office and selling expenses. This ratio helps in controlling either production costs if cost of production is high or selling and administration costs, in case these are high.
=> Net Profit To Sales Ratio Net profit means profit after tax but before distribution in any form. Formula = Net Profit / Net Sales. Tax rate being the same, this ratio indicates operating efficiency directly in the sense that a unit having higher net profitability percentage means that it has a higher operating efficiency. In case there are tax concessions due to location in a backward area, export activity etc. available to one unit and not available to another unit, then this comparison would not hold well. b) Investment on Capital Ratios or Earnings Ratios
i) Return On Net Worth
Formula = Profit After Tax (PAT) / Net Worth This is the return on the shareholders’ funds including Preference Share capital. Hence Preference Share capital is not deducted. There is no standard range for this ratio. If it reduces it indicates less return on the net worth. ii) Return On Equity Formula = Profit After Tax (PAT) – Dividend on Preference Share Capital / Net worth – Preference share capital. Although reference is equity here, all equity shareholders’ funds are taken in the denominator. Hence Preference dividend and Preference share capital are excluded. There is no standard range for this ratio. If it comes down over a period it means that the profitability of the organisation is suffering a setback.
Return on Capital Employed (pre-tax)
Formula = Earnings Before Interest and Tax (EBIT) / Net worth + Medium and long-term liabilities. This gives return on long-term funds employed in business in pre-tax terms. Again there is no standard range for this ratio. If it reduces, it is a cause for concern. Earning Per Share (EPS) Dividend per share (DPS) + Retained earnings per share (REPS). (Here the share refers to equity share and not preference share.
Formula = Profit after tax (-) Preference dividend (-) Dividend tax both on preference and equity dividend / number of equity shares.
This is an important indicator about the return to equity shareholder.
In terms of percentage anything less than 40% to 50% of the face value of the shares would not go well with the market sentiments. In fact P/E ratio is related to this, as P/E ratio is the relationship between “Market value” of the share and the EPS. The higher the PE the stronger is the recommendation to sell the share and the lower the PE, the stronger is the recommendation to buy the share. This is only indicative and by and large followed. There is something known as industry average EPS. If the P/E ratio of the unit whose shares we contemplate to purchase is less than industry average and growth prospects are quite good, it is the time for buying the shares, unless we know for certain that the price is going to come down further. If on the other hand, the P/E ratio of the unit is more than industry average P/E, it is time for us to sell unless we expect further increase in the near future.
What is the objective behind analysis of financial statements?
1) Objective (To know about) Financial position of the company Relevant indicator/Remarks Net worth, i.e., share capital, reserves and unallocated surplus in balance sheet carried down from profit and loss appropriation account. For a healthy company, it is necessary that there is a balance struck between dividend paid and profit retained in business so much that the net worth keeps on increasing.
2. Objective (To know about)
Liquidity of the company, i.e., whether the company is in a position to meet all its short-term liabilities (also called “current liabilities”) with the help of its current assets Relevant Indicator/Remarks Current Ratio and Quick Ratio or Acid Test Ratio.
Current Ratio = Current Assets / Current Liabilities.
Quick ratio = Current assets (-) inventory / current liabilities. Current ratio should not be too high like 4:1 or 5:1 or too low like less than 1.5:1. This means that the company is either too liquid thereby increasing its opportunity cost or not liquid at all, both of which are not desirable. Quick ratio could be at least 1:1. Quick ratio is a better indicator of liquidity position.
3. Objective (To know about)
Profitability of the company in general and operating profits in particular, i.e., whether the main operations of the company like manufacturing have been in profit or the profit of the company is derived from other income, i.e., income from investment in shares/debentures etc.
Relevant Indicator/Remarks
Percentage of profit before tax to total income including other income, like dividend or interest income. Operating profit, i.e., profit before tax (-) other income as above as a percentage of income from the main operations of the company, be it manufacturing, trading or services.
4. Objective (To know about)
Relationship between the net worth of the company and its external liabilities (both short-term and long-term). What about only medium and long-term debts? Relevant Indicator/Remarks Debt/Equity ratio, which establishes this relationship.
Formula = External liabilities + preference share capital /net worth of the company (-) preference share capital (redeemable kind).
From the lender’s point of view, this should not exceed 3:1. Is there any sharp deterioration in this ratio? If so, please be on guard, as the financial risk for the company increases to that extent. For only medium and long-term debts, it cannot exceed 2:1.
5. Objective (To know about)
Has the company’s investments in shares/debentures of other companies reduced in value in comparison with last year? Relevant Indicator/Remarks Difference between the market value of the investments and the purchase price, which is theoretically a loss in value of the investment. Actual loss is booked upon only selling. The periodic reduction every year should warn us that at the time of actual sales, there would be substantial loss, which immediately would reduce the net worth of the company. Banks, Financial Institutions, Investment companies or NBFC’s would be required to declare their investment every year in the balance sheet at cost price or market price whichever is less.
6. Objective (To know about)
Relationship between Average Debtors (bills receivable) and Average Creditors (bills payable) during the year. Relevant Indicator/Remarks Average debtors in the year or Average creditors in the year. This should be greater than 1:1, as bills receivable are at gross value {cost of development (+) profit margin}, Whereas creditors are at purchase price for software or components, which would be much less than the final sales value. If it is less than 1:1, it shows that while receivable management is quite good, the company is not paying its creditors, which could cause problems in future. Too high a ratio would indicate that receivable management is very poor.
BY Gaurav Bagra Lecturer(Finance)
Brief Introduction to Some Key Points
Balance Sheet
It represents the financial affairs of the company and is also referred to as “Assets and Liabilities” statement and is always as on a particular date and not for a period.
Profit and Loss Account
It represents the summary of financial transactions during a particular period and depicts the profit or loss for the period along with income tax paid on the profit and how the profit has been allocated (appropriated).
Net worth
It means total of share capital and reserves and surplus. This includes preference share capital unlike in Accounts preference share capital is treated as a debt. For the purpose of debt to equity ratio, the necessary adjustment has to be done by reducing preference share capital from net worth and adding it to the debt in the numerator.
Reserves and Surplus
It represent the profit retained in business since inception of business. “Surplus” indicates the figure carried forward from the profit and loss appropriation account to the balance sheet, without allocating the same to any specific reserve. Hence, it is mostly called “unallocated surplus”. The company wants to keep a portion of profit in the free form so that it is available during the next year for appropriation without any problem. In the absence of this arrangement during the year of inadequate profits, the company may have to write back a part of the general reserves for which approval from the board and the general members would be required.
Secured loans
It represent loans taken from banks, financial institutions, debentures (either from public or through private placement), bonds etc. for which the company has mortgaged immovable fixed assets (land and building) and/or hypothecated movable fixed assets (at times even working capital assets with the explicit permission of the working capital banks)
Unsecured loans
It represent fixed deposits taken from public (if any) as per the provisions of Section 58 (A) of The Companies Act, 1956 and in accordance with the provisions of Acceptance of Deposit Rules, 1975 and loans, if any, from promoters, friends, relatives etc. for which no security has been offered. Such unsecured loans rank second and subsequent to secured loans for settlement of claims against the company. There are other unsecured creditors also, forming part of current liabilities, like, creditors for purchase of materials, provisions etc.
Investments
Investment made in shares/bonds/units of Unit Trust of India etc. This type of investment should be ideally from the profits of the organisation and not from any other funds, which are required either for working capital or capital expenditure.
Miscellaneous expenditure not written off can be one of the following –
Company incorporation expenses or public issue of share capital, debenture etc. together known as “preliminary expenses” written off over a period of 5 years as per provisions of Income Tax. Misc. expense could also be other deferred revenue expense like product launch expenses.
There is a significant difference between the way in which the statements of accounts are prepared as per Schedule VI of the Companies Act and the manner in which these statements, especially, balance sheet is analysed by a finance person or an analyst. For example, in the Schedule VI, the current liabilities are netted off against current assets and only net current assets are shown. This is not so in the case of financial statement analysis. Both are shown fully and separately without any netting off.
At the end of any financial year, there are certain adjustments to be made in the books of accounts to get the proper picture of profit or loss, as the case may be, for that particular period. For example, if stocks of raw materials are outstanding at the end of the period, the value of the same has to be deducted from the total of the opening stock (closing stock of the previous year) and the current year’s purchases. This alone would show the correct picture of materials consumed during the current year. Ratio analysis
It is to determine the relationship between any set of two parameters and compare it with the past trend. In the statements of accounts, there are several such pairs of parameters and hence ratio analysis assumes great significance. The most important thing to remember in the case of ratio analysis is that you can compare two units in the same industry only and other factors like the relative ages of the units, the scales of operation etc. come into play.
Types of Ratios
Liquidity ratios Turnover ratios Profitability ratios Investment on capital/return ratios
Liquidity Ratios
CURRENT RATIO
Formula = Current assets/Current liabilities.
Min. Expected even for a new unit in India = 1.33:1.(Ideal Ratio is 2 : 1)
Significance = Net working capital should always be positive. In short, the higher the net working capital, the greater is the degree of overall short-term liquidity. Means current ratio does indicate liquidity of the enterprise. Too much liquidity is also not good, as opportunity cost is very high of holding such liquidity. This means that we are carrying either cash in large quantities or inventory in large quantities or receivables are getting delayed. All these indicate higher costs. Hence, if you are too liquid, you compromise with profits and if your liquidity is very thin, you run the risk of inadequacy of working capital.
Range – No fixed range is possible. Unless the activity is very profitable and there are no
immediate means of reinvesting the excess profits in fixed assets, any current ratio above 2.5:1 calls for an examination of the profitability of the operations and the need for high level of current assets. Reason = net working capital could mean that external borrowing is involved in this and hence cost goes up in maintaining the net working capital. It is only a broad indication of the liquidity of the company, as all assets cannot be exchanged for cash easily and hence for a more accurate measure of liquidity, we see “quick asset ratio” or “acid test ratio”.
Acid Test Ratio or Quick Asset Ratio
Formula = Quick Assets / Current liabilities.
Quick assets = Current assets (-) Inventories + Prepaid Expenses (which cannot be easily converted into cash). Significance = coverage of current liabilities by quick assets. As quick assets are a part of current assets, this ratio would obviously be less than current ratio. This directly indicates the degree of excess liquidity or absence of liquidity in the system and hence for proper measure of liquidity, this ratio is preferred. The minimum should be 1:1. This should not be too high as the opportunity cost associated with high level of liquidity could also be high. What is working capital gap? The difference between all the current assets known as “Gross working capital” and all the current liabilities other than “bank borrowing”. This gap is met from one of the two sources, namely, net working capital and bank borrowing. Net working capital is hence defined as medium and long-term funds invested in current assets.
Turnover Ratios
Generally, Turn Over Ratios indicate the Operating Efficiency. The higher the ratio, the higher the degree of efficiency and hence these assume significance. Further, depending upon the type of turn over ratio, indication would either be about liquidity or profitability also. For example, inventory or stocks turn over would give us a measure of the profitability of the operations, while receivables turn over ratio would indicate the liquidity in the system.
Debtors Turn Over Ratio / Receivable Turnover Ratio
This indicates the efficiency of collection of receivables and contributes to the liquidity of the system. Formula = Total Credit Sales / Average debtors outstanding during the year. Hence the Minimum would be 3 to 4 times. This depends upon so many factors such as type of industry like capital goods, consumer goods – capital goods, this would be less and consumer goods, this would be significantly higher; Conditions of the market – monopolistic or competitive – monopolistic, this would be higher and competitive it would be less as you are forced to give credit; Whether new enterprise or established – new enterprise would be required to give higher credit in the initial stages while an existing business would have a more fixed credit policy evolved over the years of business
Average Collection Period / Debtors Velocity
Inversely related to Debtors Turn Over Ratio Formula = 360 / Receivables Turn Over Ratio. For example debtors turn over ratio is 4. Then considering 360 days in a year, the average collection period would be 90 days. In case the debtors turn over ratio increases, the average collection period would reduce, indicating improvement in liquidity.
Creditors Turnover Ratio
Meaning – This ratio is used to establish a relationship between net credit purchases and average trade creditors Objective – The objective of calculating this ratio is to determine the efficiency with which the creditors are managed.
Formula = Net Credit Purchase / Average Payables Net Credit Purchases = Gross Credit Purchases – Purchase Return Average Payables = (Opening Creditors & B/P + Closing Creditors & B/P) / 2
Average Credit Period or Creditor’s Velocity It shows an average period for which the credit purchases remain outstanding.
Formula = Months or Days in a year / Credit Turnover
Inventory Turn Over Ratio
Formula = Cost of Goods Sold/Average inventory held during the year The inventory should turn over at least 4 times in a year, even for a capital goods industry. But there are capital goods industries with a very long production cycle and in such cases, the ratio would be low. While receivables turn over contributes to liquidity, this contributes to profitability due to higher turn over. The less the production cycle, the better the ratio and vice-versa. The higher the level of stocks, the lower would be the ratio and vice-versa. Cost of goods sold = Sales – profit – Interest charges. Current Assets Turn Over Ratio Not much of significance as the entire current assets are involved. However, this could indicate deterioration or improvement over a period of time. Indicates operating efficiency. Formula = Cost of goods sold/Average current assets held in business during the year. There is no min. Or maximum. Again this depends upon the type of industry, market conditions, management’s policy towards working capital etc.
Profitability Ratios
Profitability Ratios
a) Profit in Relation to Sales
This indicates the Margin Available on Sales b) Profit in Relation to Assets This indicates the degree of return on the capital employed in business that means the earning efficiency. Please appreciate that these two are totally different.
Profit Margin On Sales a) Gross profit margin on sales and net profit margin ratio – Gross profit margin :Formula = Gross Profit / Net Sales. Gross Profit = Net sales (-) Cost of production before selling, general, administrative expenses and interest charges. Net Sales = Gross sales (-) Excise duty. This indicates the efficiency of production and serves well to compare with another unit in the same industry or in the same unit for comparing it with past trend. For example in Unit A and Unit B let us assume that the sales are same at Rs.100lacs. Parameter Unit A Unit B Sales 100 Lacs 100 Lacs Cost of production 60 Lacs 65 Lacs Gross profit 40 Lacs 35 Lacs Deduct: Selling General Administrative expenses and interest 35 Lacs 30lacs Net profit 5 Lacs 5 Lacs While both the units have the same net profit to sales ratio, The significant difference lies in the fact that while Unit A has less cost of production and more office and selling expenses, Unit B has more cost of production and less of office and selling expenses. This ratio helps in controlling either production costs if cost of production is high or selling and administration costs, in case these are high.
=> Net Profit To Sales Ratio Net profit means profit after tax but before distribution in any form. Formula = Net Profit / Net Sales. Tax rate being the same, this ratio indicates operating efficiency directly in the sense that a unit having higher net profitability percentage means that it has a higher operating efficiency. In case there are tax concessions due to location in a backward area, export activity etc. available to one unit and not available to another unit, then this comparison would not hold well. b) Investment on Capital Ratios or Earnings Ratios
i) Return On Net Worth
Formula = Profit After Tax (PAT) / Net Worth This is the return on the shareholders’ funds including Preference Share capital. Hence Preference Share capital is not deducted. There is no standard range for this ratio. If it reduces it indicates less return on the net worth. ii) Return On Equity Formula = Profit After Tax (PAT) – Dividend on Preference Share Capital / Net worth – Preference share capital. Although reference is equity here, all equity shareholders’ funds are taken in the denominator. Hence Preference dividend and Preference share capital are excluded. There is no standard range for this ratio. If it comes down over a period it means that the profitability of the organisation is suffering a setback.
Return on Capital Employed (pre-tax)
Formula = Earnings Before Interest and Tax (EBIT) / Net worth + Medium and long-term liabilities. This gives return on long-term funds employed in business in pre-tax terms. Again there is no standard range for this ratio. If it reduces, it is a cause for concern. Earning Per Share (EPS) Dividend per share (DPS) + Retained earnings per share (REPS). (Here the share refers to equity share and not preference share.
Formula = Profit after tax (-) Preference dividend (-) Dividend tax both on preference and equity dividend / number of equity shares.
This is an important indicator about the return to equity shareholder.
In terms of percentage anything less than 40% to 50% of the face value of the shares would not go well with the market sentiments. In fact P/E ratio is related to this, as P/E ratio is the relationship between “Market value” of the share and the EPS. The higher the PE the stronger is the recommendation to sell the share and the lower the PE, the stronger is the recommendation to buy the share. This is only indicative and by and large followed. There is something known as industry average EPS. If the P/E ratio of the unit whose shares we contemplate to purchase is less than industry average and growth prospects are quite good, it is the time for buying the shares, unless we know for certain that the price is going to come down further. If on the other hand, the P/E ratio of the unit is more than industry average P/E, it is time for us to sell unless we expect further increase in the near future.
What is the objective behind analysis of financial statements?
1) Objective (To know about) Financial position of the company Relevant indicator/Remarks Net worth, i.e., share capital, reserves and unallocated surplus in balance sheet carried down from profit and loss appropriation account. For a healthy company, it is necessary that there is a balance struck between dividend paid and profit retained in business so much that the net worth keeps on increasing.
2. Objective (To know about)
Liquidity of the company, i.e., whether the company is in a position to meet all its short-term liabilities (also called “current liabilities”) with the help of its current assets Relevant Indicator/Remarks Current Ratio and Quick Ratio or Acid Test Ratio.
Current Ratio = Current Assets / Current Liabilities.
Quick ratio = Current assets (-) inventory / current liabilities. Current ratio should not be too high like 4:1 or 5:1 or too low like less than 1.5:1. This means that the company is either too liquid thereby increasing its opportunity cost or not liquid at all, both of which are not desirable. Quick ratio could be at least 1:1. Quick ratio is a better indicator of liquidity position.
3. Objective (To know about)
Profitability of the company in general and operating profits in particular, i.e., whether the main operations of the company like manufacturing have been in profit or the profit of the company is derived from other income, i.e., income from investment in shares/debentures etc.
Relevant Indicator/Remarks
Percentage of profit before tax to total income including other income, like dividend or interest income. Operating profit, i.e., profit before tax (-) other income as above as a percentage of income from the main operations of the company, be it manufacturing, trading or services.
4. Objective (To know about)
Relationship between the net worth of the company and its external liabilities (both short-term and long-term). What about only medium and long-term debts? Relevant Indicator/Remarks Debt/Equity ratio, which establishes this relationship.
Formula = External liabilities + preference share capital /net worth of the company (-) preference share capital (redeemable kind).
From the lender’s point of view, this should not exceed 3:1. Is there any sharp deterioration in this ratio? If so, please be on guard, as the financial risk for the company increases to that extent. For only medium and long-term debts, it cannot exceed 2:1.
5. Objective (To know about)
Has the company’s investments in shares/debentures of other companies reduced in value in comparison with last year? Relevant Indicator/Remarks Difference between the market value of the investments and the purchase price, which is theoretically a loss in value of the investment. Actual loss is booked upon only selling. The periodic reduction every year should warn us that at the time of actual sales, there would be substantial loss, which immediately would reduce the net worth of the company. Banks, Financial Institutions, Investment companies or NBFC’s would be required to declare their investment every year in the balance sheet at cost price or market price whichever is less.
6. Objective (To know about)
Relationship between Average Debtors (bills receivable) and Average Creditors (bills payable) during the year. Relevant Indicator/Remarks Average debtors in the year or Average creditors in the year. This should be greater than 1:1, as bills receivable are at gross value {cost of development (+) profit margin}, Whereas creditors are at purchase price for software or components, which would be much less than the final sales value. If it is less than 1:1, it shows that while receivable management is quite good, the company is not paying its creditors, which could cause problems in future. Too high a ratio would indicate that receivable management is very poor.
