Interpretation of Financial Statements Ratio Analysis Ratio analysis has gained wide acceptance as a quantitative technique of financial management

t and is used widely by banks and financial institutions all over the world. This tool helps in assessing the financial health of a unit and is also considered as an important tool for credit/project appraisal by banks and financial institutions. This tool helps in measuring the past performance of an organization and helps in projecting future trends. Analysis and interpretation of various ratios, gives the credit analyst a better understanding of the financial condition and performance of the firm than what the analyst would have obtained from the analysis of the financial data alone. Bankers generally compute and evaluate the following ratios: I) Liquidity Ratio, II) Solvency Ratio, III) Gearing Ratio, IV) Profitability Ratio, V) Activity Ratio and VI) Misc.Ratio I) Liquidity Ratios.

The basic objective in computing this ratio is to find out whether the business concern will have sufficient cash and other resources to meet the liabilities as and when they arise. An organization is said to have liquidity if it is in a position to meet its current liability out of its current assets. The two liquidity ratios which are generally computed are (a) Current Ratio and (b) Quick or Acid test ratio. (a) Current Ratio (C/R) This indicates the extent to which the organization can meet its Current Liabilities out of its Current Assets. It is found out as under. Current Ratio = Current Assets Current Liabilities Though the ideal current ratio is 2:1, practically a credit officer sees such ideal ratio. As per II Method of lending minimum current ratio suggested is 1.33:1. In any case a banker must ensure that current ratio is at least 1:1.

What does a higher current ratio say 3:1 or 4: 1 indicate? A Comfortable position for short-term lenders. The firm is having more long term fund than required and is utilizing this excess fund for holding flabby current assets. Low Current Liabilities say low Sundry Creditors, Bills payable, short-term advances etc. that are generally cheap finance available in the market.

The higher current ratio affects profitability of the organization. Composition of various types of current assets is to be seen while interpreting this ratio. What does a lower current ratio say less than 1.33:1 or 1 indicate? The organization liquidity is under strain. The persistent trend of less than 1 over a period of time is a sure indicator of sickness of the organization.

The lower current ratio affects the liquidity of the firm. The firm will face problem of meeting its short-term liabilities. Composition of various types of current assets and current liabilities should be strictly as per RBI guidelines while calculating this ratio. To improve the poor current ratio the banker will always advise the borrower to bring in fresh long-term funds or by ploughing back profits. (b) Quick or Acid test ratio. This indicates the extent to which liquid assets are available to meet the current liabilities (obligations) immediately/quickly. It is found out as under. Quick Ratio = Quick Assets Current Liabilities = Current Assets - Inventory Current Liabilities

The ideal Quick ratio is 1:1

This ratio should be studied along with Current ratio and not in isolation. A higher C/R but low Q/R may indicate large stock of inventory. The banker then probes into the reasoning of such large build up of stocks/inventory to get a satisfactory answer from the borrower. The liquidity of the organization is also found out by calculating Net Working Capital (NWC). Excess of Current Assets over Current Liabilities is known as Net Working Capital. A positive NWC indicates liquidity and for this reason NWC is also known as Liquid Surplus, Current Surplus or Working Capital Surplus. NWC, excess of current assets over current liabilities, is to be funded out of surplus of Long Term Source of funds after meeting Long Term Uses. II) Solvency Ratio

The basic objective in computing this ratio is to find out whether the business concern has sufficient tangible assets to meet its all its liabilities both short term as well as long term. An organization is said to be solvent if its Tangible Net Worth (TNW) is positive. (TNW = Net Worth Intangible Assets). Two important ratios which are computed under this are : 1) Total Outside Liabilities/Equity (TOL/TNW) and 2) Funded Debt/Equity. 1) The ratio TOL/TNW is commonly known as debt/equity ratio (DER) and is calculated as under. DER = TOL/TNW. TOL = includes both short term as well as long-term liabilities of the organization. Normally the banker accepts if the ratio is 3:1 for SSI units and 2: 1 for large concerns. 2) Funded Debt/Equity ratio (FDER) is calculated as under. FDER = Long Term Debts Tangible Net Worth.

This ratio measures the long -term solvency and ability of the organization to meet long-term liabilities. It excludes current liabilities. Acceptable ratio for the bankers is SSI 2:1 and Large Corporates - 1.5:1. III) Gearing/ Leverage Ratio

To understand this ratio, one should know the term Financial Leverage. Utilising outside borrowing (just like a lever) to increase return on shareholders fund is known as Financial Leverage. Gearing is another name of Financial Leverage. A company can arrange its funds either from sources, which carry fixed charge by way of interest or dividend, or which do not carry such fixed charge. Eg. Term loan, Preference capital, Debentures etc. are the ones which carry fixed charge under long term funding and Equity capital, Quasi Capital, other types which are classified as owners fund are the ones which will not carry fixed charge. A companys financial structure is said to be highly geared when its interest bearing (fixed charge bearing) funds are disproportionately high. Capital Gearing Ratio: (CGR) This ratio also known as Financial Leverage Ratio, measures the proportion of fixed charge bearing Long Term Fund to the Total Long Term Fund arranged by the company. CGR is calculated as under. CGR = Fixed Charge Bearing Long Term Fund* Total Long Term Fund** * Includes items under liabilities of the balance sheet like Term loan, Debentures, Fixed Deposits, Preference Capital etc. ** Includes Net Worth + Term Liabilities. A high gearing gives boost to rate of return on shareholders fund. But it is also equally risky in case the unit fails to earn enough profit in future years, as it will be difficult on its part to serve its fixed charge obligations. Non-Payment of such commitments may result in debt crisis situations including closure of business. Further such highly geared company cannot borrow more. Thus the company should be prudent enough to keep its gearing in a prudent limit.

When the company maintains a highly geared capital structure it is said to be Trading In Equity. In other words trading in equity means having a very thin equity and a high borrowing with an objective to increase return on net worth. Gearing if kept within prudent limits will result in a good dividend distribution and will help the company in times of raising capital from public at a premium.

IV)

Profitability Ratio

A credit analyst should not be complacent after seeing impressive net profit figure in the financial statement, as this does not necessarily indicate the business profit of the concern. A commercially viable concern is one, which achieves the profit at each stage of operation as detailed below. It should be able to manufacture goods at least cost and generate reasonable/sufficient profit known as Gross Profit. It should keep operating expenses under control and earn satisfactory profit known as Operating Profit. It should earn enough for its Shareholders by earning more profit known as Net Profit after Tax. (NPAT).

Operating profit and Net Profit must be adequate enough to cover: 1) Repayment of long-term debt obligations. 2) Income Tax. 3) Reasonable dividend to share holders. 4) And still leave a surplus, which can be ploughed back for building up reserves and maintain at least the minimum required net working capital. The profitability ratios are generally expressed in terms of percentage and the following are the ratios, which are normally calculated by the bankers.

(a) Gross Profit Ratio = Gross Profit X 100 Net Sales

This ratio indicates manufacturing efficiency of the concern. A higher Gross Profit Ratio indicates efficiency in production. (b) Operating Profit Ratio = Operating Profit (GP- Opg.Exp.) X 100 Net sales Higher ratio indicates operational efficiency of the concern. (c) Net Profit Ratio = Net Profit (Profit before tax) X 100 Net sales This ratio measures overall efficiency. Net Profit ratio may go up due to nonbusiness income, which should be looked into by the credit analyst. (d) Return on Net Worth = Net Profit after tax X 100 TNW (tangible Net Worth) This ratio is also known as Shareholders ratio or return on Tangible Net Worth. Investors of the company will normally be interested in this ratio.

(e) Return On Capital Employed = Profit Before Interest and tax X 100 Capital Employed (TNW+TL+CL) This ratio indicates the overall efficiency of the management in utilizing the total fund available for running the business. It is very suitable ratio for inter firm comparison. This ratio can be improved by increasing sales turnover or the selling price or both.

V)

Activity Ratios

This ratio is calculated to find out the efficiency of operation. Some of the important ratios, which are calculated by the bankers, are as follows.

Inventory Turnover Ratio = Cost of Sales/Cost of the Goods sold. Average Inventory*

* = Opening Stock of Inventory + Closing stock of Inventory 2 (For approximate calculation closing stock of inventory may be taken in place of average inventory. Similarly Net Sales may be taken in place of Cost of sales. ) This ratio indicates the number of times the inventory is rotated (turned over) during the relevant accounting year. Higher ratio (turn over) compared to past year or compared to that of units in same industry indicates better management of inventory/working capital. Lower ratio (turn over) must be viewed with concern as it may be due to depressed sales or some of the stocks may be non saleable/non- moving/slow moving. If it is due to excess (flabby) inventory, it may be due to over finance, which requires further analysis. In case it is due to slow moving/non-moving /nonsaleable inventory, there is problem of lack of demand which should be studied in detail by the analyst.

Debtors Turnover Ratio/ Debtors Velocity Ratio.

This ratio is also known as Average Collection Period or Period of credit given by the borrower and is calculated as under. = Average Outstanding of Receivables* Credit Sales per day** (For approximate calculation closing figure of Receivables can be taken in the numerator in the place of average outstanding receivables and total sales figure may be taken instead of credit sales in the denominator) * Includes Sundry Debtors, Bills Receivables and Bills Discounted. ** Is calculated by dividing total credit sales during the year by 365 days. This ratio can also be expressed in weeks or months by replacing 365 days by 52 weeks or 12 months. The period so calculated represents the average time lags in days/weeks/months between sales (in credit) and its realization in cash.

This ratio is studied by comparing it with the past years and also of similar units in the industry. Lower the period, quicker is the realization of cash and better efficiency. Higher period indicates inefficiency in the receivable s management. It results in expansion of operating cycle and accordingly requirement of working capital goes up. A prudent banker probes further in such cases and ensures that bad and doubtful receivables if any are not financed, since continuance of such trend will lead to the concern facing liquidity problems and erosion of profits.

Creditors Turnover Ratio/ Creditors Velocity Ratio.

This ratio is also known as Average Payment Period or Period of credit enjoyed by the borrower and is calculated as under. = Average Outstanding of Payables* Credit Purchases per day** (For approximate calculation closing figure of all the payables can be taken in the numerator in the place of average outstanding payables and total purchases figure may be taken instead of credit purchases in the denominator)

* Includes Sundry Creditors, Bills Payables. ** Is calculated by dividing total credit purchases during the year by 365 days. This ratio can also be expressed in weeks or months by replacing 365 days by 52 weeks or 12 months. The period so calculated represents the average time lags in days/weeks/months between purchases (in credit) and its payment in cash. i.e. the period of credit enjoyed by the concern.

Sundry creditors is a cheap source of fund and should be availed by the concern to the extent possible as it reduces the dependence on Banks working capital finance which has a higher cost. A higher period (compared to earlier years or to the industry average) may be due to either of the following: The concern is facing a liquidity crunch (cash shortage) and is unable to honour its commitments in time. It may be due to diversion of fund, non-realisation of debtors or reduction in sales each being danger signal. Delayed payments not only spoils the creditworthiness of the concern, it also costs by way of payment of penal interest & scarcity in supply of raw materials. The high period of credit may also be due to the exceptional strength of the concern to dictate terms to the suppliers to extend more credit than given in the market. A low period may be due to the following: The concern due to its low creditworthiness is not in apposition to enjoy credit or it is cash rich and does not want to borrow and it wants to avail cash discount and reduce cost of production instead of enjoying credit and pay interest there on. VI) Misc.Ratio

Besides the above-mentioned ratios, a banker also calculates another important ratio known as Debt Service Coverage Ratio (DSCR). This ratio is normally calculated on term loan assessment and is based on the projected financial statement submitted by the borrower. This is calculated to ascertain the repaying capacity of the concern. This ratio is to be computed only after thoroughly scrutinizing various financial statements and necessary revision/corrections are made in the projections. (In short only after the projected profits are accepted/revised and accepted by the banker, the ratio will be computed.) The ratio is calculated as under. =* Net Profit after tax + Depreciation + Interest on Term loan Installments on term loan + Interest on Term Loan * Before appropriation of dividends.

If there are any existing obligations like installments of term loans/DPG/Lease rentals, such amounts should also be added up with installments of proposed term loan while calculating the ratio. The DSCR will have to be calculated on a yearly basis from the year of commercial production to the last year of proposed repayment. The ratio helps to fix the holiday period, repayment period and the amount of each installment. Where the DSCR is low, repayment can be extended and where it is high, the repayment period can be reduced. The ideal ratio is 2:1. Normally average ratio of 2:1 and in each year not below 1.5:1 is acceptable ratio for any banker. Summary 1) All the ratios within the group are linked to each other and must be studied together. 2) Meaningful interpretation is possible only when ratios are computed for a period of 3 to 5 years and compared. 3) The ratios are to be used for further investigation rather than to make final judgments. The findings based on the ratio analysis have to be studied along with other findings like Fund flow analysis, other financial data like notes to balance sheet, Directors Report, Auditors report and non-financial data having a bearing on financial events.

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