Financial Analysis for the Non-Finance Executives


By
D. Aruna Kumar
Assistant Professor (Finance & Accounting Area)
Lokamanya Tilak PG College of Management
Ibrahimpatnam, Hyderabad-501 506
 


The focus of this paper is on Ratio Analysis as the most widely used technique of financial statement analysis. It briefly discusses about the standards of comparison and various types of Ratios, which are widely used by the corporates, with brief interpretations and conclusions.

Introduction:

Management should be particularly interested in knowing financial strengths of the firm to make their best use and to be able to spot out financial weaknesses of the firm to take suitable corrective actions.

Financial analysis is the process of identifying the financial strengths and weaknesses of the firm by properly establishing relationships between the items of the balance sheet and the profit and loss account.  Financial analysis can be undertaken by management of the firm or by parties outside the firm like owners, creditors, investors and others.

Ratio Analysis is a powerful tool of financial analysis.  A ratio is defined as "the indicated quotient of two mathematical expressions" and as "the relationship between two or more things".  The relationship between two accounting figures expressed mathematically is known as 'financial ratio'.  Rations help to summarise large quantities of financial data and to make qualitative judgement about the firm's financial performance.  It measures the firm's liquidity.   The greater the ratio the greater the firm's liquidity and vice-versa.   The point to note is that a ratio reflecting a quantitative relationship, helps to form a qualitative judgement.

STANDARDS OF COMPARISION:

The ratio analysis involves comparison for a useful interpretation of the financial statements.  A single ratio is itself does not indicate favourable or unfavourable condition.  It should be compared with some standard.  It consists of:

  • PAST RATIOS: Rations calculated from past financial statements of the same firm.
  • COMPETITORS RATIOS: Ratios of some selected firms, especially most progressive and successful competitor, at the same point of time.
  • INDUSTRY RATIOS: Ratios of industry to which the firm belongs.
  • PROJECTED RATIOS: Ratios developed using the projected or proforma, financial statements of the same firm.

CLASSIFICATION OF RATIOS:

The parties interested in financial analysis are short and long term creditors, owners and management.  Short term creditors main interest is I the liquidity position or short term solvency of the firm.  Long term creditors on the other hand are more interested in the long term solvency and profitability of the firm.  Similarly, owners concentrate on the firm's profitability and financial condition.  Management is interested in evaluating every aspect of the firm's performance.  They are classified into 4 categories:

  • Liquidity ratios
  • Liverage ratios
  • Activity ratios
  • Profitability ratios

LIQUIDITY RATIOS:

Liquidity ratios measure the firms ability to meet current obligations.  It is extremely essential for a firm to be able to meet its obligations as they become due liquidity ratio's measure.  The ability of the firm to meet its current obligations.  In fact analysis is of liquidity needs in the preparation of cash budgets and cash and funds flow statements, but liquidity ratios by establishing a relationship between cash and other current assets to current obligations provide a quick measure of liquidity.

A firm should ensure that it does  not suffer from lack of liquidity and also that it does not have excess liquidity.  The failure of the company to meet its obligations due to the lack of sufficient liquidity will result in a poor credit worthiness, loss of creditors confidence or even in legal tangles resulting in the closure of company.  A very high degree of liquidity is also bad, idle assets earn nothing.  The firm's funds will be unnecessarily tied up to current assets.  Therefore, it is necessary to strike a proper balance between high liquidity and lack of liquidity.

  • Current ratio
  • Quick ratio
  • Interval measure
  • Net working capital ratio

CURRENT RATIO:

Current ratio is calculated by dividing current assets by current liabilities:  Current assets include cash and those assets which can be converted into cash with in a year, such as marketable securities, debtors and inventories.  Current liabilities include creditors, bills payable, accrued expenses, short term back loan, income tax liability and long term debt maturing in current year.  The current ratio is a measure of firm's short term solvency.

As a conventional rule a current ratio of 2:1 or more is considered satisfactory.  The current ratio represents margin of safety for creditors

CURRENT RATIO = CURRENTS ASSETS/CURRENT LIABILITIES

QUICK RATIO:

Quick ratio establishes a relationship between quick or liquid, assets and current liabilities.  Cash is the most liquid asset, other assets which are considered to be relatively liquid and included in quick assets are debtors and bills receivables and marketable securities.  Inventories are considered to be less liquid.

Generally a quick ratio of 1:1 is considered to represent a satisfactory current financial condition

QUICK RATIO: CURRENT  - INVENTORIES
                     CURRENT LIABILITIES

INTERVAL MEASURE:

The ratio which assesses a firm's ability to meet its regular cash expenses is the interval measure.  Interval measure relates the liquid assets to average daily operating cash outflows.  The daily operating expenses will be equal to cost of goods sold plus selling, administrative and general expenses  less depreciation divided by number of days in the year.

INTERVAL MEASURE: CURRENT ASSETS – INVENTORY
                            AVERAGE DAILY OPERATING EXPENSES

NET WORKING CAPITAL RATIO:

The difference between current assets and current liabilities excluding short term bank borrowing is called net working capital or net current assets.  Net working capital is some times used as measure of firm's liquidity.

NET W.C RATIO: NET WORKING CAPITAL
                       NET ASSETS

LIVERAGE RATIOS:

The short term creditors, like bankers and suppliers of raw material are more concerned with the firms current debt paying ability.  On the other hand, long term creditors like debenture holders, financial institutions etc. are more concerned with firms long term financial strength.  In fact a firm should have short as well as long term financial position.  To judge the long term financial position of the firm, financial leverage or capital structure, ratios are calculated.  These ratios indicate mix of funds provided by owners and lenders.  As a general rule, there should be an appropriate mix of debt and owners equity in financing the firm's assets.

  • Debt Ratio
  • Debt Equity Ratio
  • Capital employed to net worth ratio
  • Other Debt Ratios

DEBT RATIO:

Several debt ratios may be used to analyse the long term solvency of the firm.  It may therefore compute debt ratio by dividing total debt by capital employed or net assets.

Net assets consist of net fixed assets and net current assets:

DEBT RATIO: TOTAL DEBT
                  NET ASSETS

DEBT EQUITY RATIO:

It is computed by dividing long term  borrowed capital or total debt by Share holders fund or net worth.

DEBT EQUITY RATIO: TOTAL DEBT
                             NET WORTH

DEBT EQUITY RATIO: Long term  borrowed capital
                             Share holders fund

CAPITAL EMPLOYED TO NET WORTH RATIO:

There is an another alternative way of expressing the basic relationship between debt and equity.  It helps in knowing, how much funds are being contributed together by lenders and owners for each rupee of owner's contribution.  This can be found out by calculating the ratio of capital employed or net assets to net worth

Capital Employed to Net WORTH RATIO:       CAPITAL EMPLOYED
                                                            NET WORTH

OTHER DEBT RATIOS:

To assess the proportion of total funds – Short and Long term provided by outsiders to finance total assets, the following ratio may be calculated

TL to TA RATIO: TOTAL LIABILITIES
                       TOTAL ASSETS

ACTIVITY RATIOS:

Funds of creditors and owners are invested in various assets to generate sales and profits.  The better the management of assets, the larger is an amount of sales.  Activity ratios are employed to evaluate the efficiency with which the firm manages and utilizes its assets these ratios are also called turnover ratios because they indicate the speed with which assets are being converted or turned over into sales.  Activity ratios, thus, involve a relationship between sales and assets.  A proper balance between sales and assets generally reflects that assets are managed well.

  • Inventory turnover ratio
  • Debtors turnover ratio
  • Collection period
  • Net assets turnover ratio
  • Working Capital turnover ratio

INVENTORY TURNOVER RATIO:

Inventory turnover ratio indicates the efficiency of the firm in producing and selling its product.  It is calculated by dividing cost of goods sold by average inventory.  Average inventory consists of opening stock plus closing stock divided by 2.

INVENTORY TURNOVER RATIO: COST OF GOODS SOLD
                                         AVERAGE INVENTORY

DEBTORS TURNOVER RATIO:

Debtors turnover ratio is found out by dividing credit sales by average debtors.  Debtors turnover indicates the number of times debtors turnover each year.  Generally the higher the value of debtors turnover, the more efficient is the management of credit

DEBTORS TURNOVER TATIO= CREDIT SALES
                                       AVERAGE DEBTORS

COLLECTION PERIOD:

The average number of days for which debtors remain outstanding is called the average collection period.

AVERAGE COLLECTION PERIOD= NO. OF DAYS IN A YEAR
                                           DEBTORS TURNOVER

NET ASSETS TURNOVER RATIO:

A firm should manage its assets efficiently to maximise sales.  The relationship between sales and assets is called net assets turnover ratio.  Net assets include net fixed assets and net current assets

NET ASSETS TURNOVER RATIO= SALES
                                            NET ASSETS

WORKING CAPITAL TGURNOVER RATIO:

A firm may also like to relate net current assets to sales.  It may thus compute net working capital turnover by dividing sales by net working capital

WORKING CAPITAL TURNOVER RATIO= SALES
                                                   NET CURRENT ASSETS

PROFITABILITY RATIOS:

A company should earn profits to survive and grow over a long period of time.  Profits are essential but it would be wrong to assume that every action initiated by management of a company should be aimed at maximizing profits, irrespective of social consequences.

Profit is the difference between revenues and expenses over a period of time.  Profit is the ultimate output of a company and it will have no future if it fails to make sufficient profits.  Therefore, the financial manager should continuously evaluate the efficiency of the company in terms of profits.  The profitability ratios are calculated to measure the operating efficiency of the company.

Generally, there are two types of profitability ratios

1. Profitability in relation to sales
2. Profitability in relation to investment

    • Gross profit margin ratio
    • Net profit margin ratio
    • Operating expenses ratio
    • Return on Investment
    • Return on equity
    • Earning per share
    • Dividends per share
    • Dividend pay out ratio
    • Price earning ratio

GROSS PROFIT RATIO:

It is calculated by dividing gross profit by sales.  The gross profit margin reflects the efficiency with which management produces each unit of product.  This ratio indicates the average spread between the cost of goods sold and the sales revenue.

GROSS PROFIT RATIO= GROSS PROFIT
                               SALES

NET PROFIT RATIO:

Net profit is obtained when operating expenses, interest and taxes are subtracted from the gross profit.  The net profit margin is measured by dividing profit after tax or  net profit by sales.

NET PROFIT RATIO= NET PROFIT
                           SALES

OPERATING EXPENSE RATIO:

Operating expense ratio explains the changes in the profit margin ratio.  This ratio is computed by dividing operating expenses like cost of goods sold plus selling expenses, general expenses and administrative expenses by sales.

OPERATING EXPENSE RATIO= OPERATING EXPENSES
                                        SALES

The higher operating expenses ratio is unfavorable since it will leave operating income to meet interest dividends etc.

RETURN ON INVESTMENT:

The term investment may refer to total assets or net assets.  The conventional approach of calculating return on investment is to divide profit after tax by investment.  Investment represents pool of funds supplied by shareholders and lenders.  While PAT represent residue income of shareholders

RETURN ON INVESTMENT= PROFIT AFTER TAX
                                    INVESTMENT

RETURN ON EQUITY:

`Ordinary share holders are entitled to the residual profits.  A return on shareholders equity is calculated to see the profitability of owners investment.  Return on equity indicates how well the firm has used the resources of owners.  The earning of a satisfactory return is the most desirable objective of business.

RETURN ON EDQUITY= PROFIT AFTER TAX
                              NET WORTH

EARNINGS PER SHARE:

The measure is to calculate the earning per share.  The earning per share is calculated by dividing profit after tax by total number of outstanding.  EPS simply shows the profitability of the firm on a per share basis, it does not reflect how much is paid as dividend and how much is retained in business.

EARNINGS PER SHARE= PROFIT AFTER TAX
                               NO. OF SHARES OUTSTANDING

DIVIDENDS PER SHARE:

The net profits after  taxes belong to shareholders.  But the income which they really receive is the amount of earnings distributed as cash dividends.  Therefore, a larger number of present and potential investors may be interested in DPS rather than EPS.  DPS is the earnings distributed to ordinary shareholders divided by the number of ordinary shares outstanding.

DPS= EARNINGS PAID TO SHARE HOLDERS
        NUMBER OF SHARES OUTSTANDING

DIVIDEND PAY OUT RATIO:

The dividend pay out ratio is simply the dividend per share divided by Earnings Per Share.

DIVIDEND PAY OUT RATIO= DIVIDEND PER SHARE
                                     EARNINGS PER SHARE

PRICE EARNING RATIO:

The reciprocal of the earnings yield is called price earning ratio.  The price earning ratio is widely used by security analysts to value the firm's performance as expected by investors.  Price earning ratio reflects investors expectations about the growth of firm's earnings.  Industries differ in their growth prospects.  Accordingly, the P/E ratios for industries very widely.

PRICE EARNING RATIO= MARKET VALUE PER SHARE
                                EARNING PER SHARE

Conclusions

Ratio analysis plays an important role in the corporate world. It is a widely used tool of financial analysis. Ratio Analysis is relevant in assessing the performance of a firm in respect of liquidity position, long-term solvency, operating efficiency, overall profitability, inter-firm comparison and trend analysis. Hence, understanding the Ration Analysis is of immense helpful for the non-finance executives in today's competitive world.

References:

    1. Prasanna Chandra: Financial Management Theory and Practice, 2003
    2. I.M.Pandey: Financial Management: 2003
    3. M Y Khan and P K Jain: Financial Management –Text, Problems and Cases: 2004
    4. James C. Van Horne and John M. Wachowicz. Jr. Fundamentals of Financial Mangement. 1996.
    5. John J Hampton: Financial Decision Making, Practice Hall India, 1992.
    6. www.indiainfoline.com
     


D. Aruna Kumar
Assistant Professor (Finance & Accounting Area)
Lokamanya Tilak PG College of Management
Ibrahimpatnam, Hyderabad-501 506

About the Author:
D.Aruna Kumar, MCom, MBA,(PhD)
The Author is with Lokamanya Tilak P G College of Management as Assistant Professor in the Department of Business Management in the area of Finance and Accounting. He is working for his PhD on
"New Financing Instruments with reference to Central Public Enterprises", under the guidance of
Prof. R.K.Mishra, Director, Institute of Public Enterprise, Osmania University, Hyderabad -500 007.
 

Source: E-mail May 23, 2005

 
 

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