Accounting

&
Finance
MBA 1st Semester
Amity Global Business School
Ms. Kavitha Menon
 Module III –

Analyzing Financial Position

 Snapshot of Module I
• Financial Analysis
• Purpose of Financial Analysis
• Limitations of Financial Analysis
• Tools for Financial Analysis
• Ratio Analysis
• Advantages & Limitations of Ratio Analysis
• Classification of Ratios
 Liquidity Ratios
 Solvency Ratios
 Profitability Ratios
 Turnover Ratios
 Financial Analysis
• “A systematic process of critical
examination of the financial information
contained in the financial statements in
order to understand and make decisions
regarding the operations of the firm”
• Process of dissection, establishing
relationships and interpretation thereof to
understand the working and financial
position of a firm
 Objects of Financial Analysis
• To present complex data contained in
financial statements in simple &
understandable form
• To classify items contained in financial
statements in convenient & rational groups
• To make comparisons between various
groups to draw various conclusions
 Purpose of Financial Analysis
• Earning capacity or profitability
• Short-term and long-term solvency
• Financial strength
• Inter-firm comparison
• Capability of payment of interest & dividend
• Trend of the business
• Managerial efficiency
• Making forecasts and preparing budgets
Limitations of Financial Analysis
• Historical analysis
• Limitations of Financial Statements
• Affected by Window-dressing
• Do not reflect price level changes
• Variation in accounting practices
• Effect of personal ability & bias of the analyst
• Difficulty in forecasting
• Qualitative aspect ignored
• Limited use of single year’s analysis of financial
statements
 Tools for Financial Analysis
• Comparative Statements
• Common Size Statements
• Trend Analysis
• Accounting Ratios
• Cash Flow Statements
• Funds Flow Statements
 What is a Ratio?
• A ratio is an arithmetical and logical
relationship between two figures
• 4 types:
Pure ratio or Simple ratio – e.g. 2:1
Rate or ‘So many times’ – e.g. 5 times
Percentage – e.g. 20%
Fraction – one-tenth
 Ratio Analysis
• A method of calculating and interpreting
financial ratios in order to assess the strengths
and weaknesses underlying the performance of
an enterprise
• Objective: To judge
 Earning capacity
 Financial soundness
 Operating efficiency
 Advantages of Ratio Analysis
• Helpful in analysis of financial statements
• Simplification of Accounting figures
• Helpful in Comparative Study – inter & intra-firm
• Helpful in locating weaknesses
• Useful in forecasting
• Estimate about trend of the business
• Fixation of ideal standards
• Effective control
• Study of Financial Soundness
 Limitations of Ratio Analysis
• False accounting data gives false ratios
• Comparison not possible if different firms adopt
different accounting policies
• Less effective when there are price level changes
• May be misleading in the absence of absolute data
• Window- dressing
• Lack of proper standards
• Ratios alone not adequate for proper conclusions
• Effect of personal ability & bias of the analyst
• Ignores qualitative factors
 Benchmarks
• To comment on the quality of a ratio
one has to make a comparison with
some standard or benchmark.
• Types:
 Past ratio
 Ratio of similar firms or industry
average
 Rule of thumb : e.g. current ratio is
2:1, meaning current assets should
be twice the current liabilities.
 Classification of Ratios
Liquidity Ratios
 Solvency/ Capital Structure/
Leverage Ratios
 Profitability Ratios
 Activity/Turnover/ Efficiency Ratios
 Liquidity Ratios
 The ability of a firm to satisfy its short-term
obligations as they become due for payment
 Helps users in knowing the extent of short-term debt
paying ability of a firm.
 Proper balance between liquidity and profitability is
required for efficient financial management
 Types:
Net Working Capital
Current Ratio
Quick Ratio/Acid Test Ratio/Liquid Ratio
Absolute Liquidity Ratio
 Net Working Capital
• Excess of current assets over current
liabilities
• Not really a ratio but frequently used as a
measure of company’s liquidity position.
• An enterprise should have sufficient NWC to
meet the claims of creditors and the day-to-day
need of the business.
• Inadequate working capital is the first sign of
financial problems for a firm.
 COLLECTIONS CASH

ACCOUNTS
PURCHASES
RECEIVABLE

The working
SALES capital cycle RAW
MATERIALS

FINISHED ACCOUNTS
STOCK PAYABLE
PRODUCTION
 Limitation –
Size of NWC not an appropriate
measure of the liquidity position

Company A Company B
Total Current Assets 180,000 30,000
Total Current liabilities 120,000 10,000
NWC 60,000 20,000
 Limitation –
Change in NWC does not necessarily
reflect change in liquidity position

Year 1 Year 2
Total Current Assets 100,000 200,000
Total Current liabilities 25,000 100,000
NWC 75,000 100,000
 Current Ratio
• Current Ratio = Current Assets
Current Liabilities
• Indicates the relationship between current assets
and current liabilities
• Indicates a firm’s ability to meet its short-term
liabilities promptly
 Rationale
• Measure of safety margin to creditors
• Higher the CR, larger is the amount of rupees
available per rupee of current liability, the
more is the form’s ability to meet current
obligations and greater is the safety of funds
of short-term creditors.
• Need arises due to inevitable unevenness in
the flow of funds through current assets and
liabilities.
 Interpretation
Co. A Co. B
Current Assets 180,000 30,000
= =
Current liabilities 120,000 10,000
Current Ratio = = 1.5:1 = 3:1
 The liquidity position of Co. B is better as compared
to Co. A as it has a higher current ratio
 Very high ratio may indicate slack management
practices - Excessive inventories, idle cash, poor
credit management, not making full use of its current
borrowing capacity
 Interpretation
• Ideal ratio – 2:1 – but no hard & fast rule
• Higher ratio considered adverse
- stock piling up because of poor sales
- obsolete stock
- large amount locked up in debtors due to inefficient
collection policy
- defaulting debtors
- cash or bank balances lying idle , no proper
investment opportunities are available
• What is satisfactory depends on development of the
capital market and the availability of long-term funds to
finance current assets, the nature of the industry
 Limitations
It is a quantitative index rather than a
qualitative one.
Does not tell us how liquid are the receivables
and inventory are.
What effect does the omission of inventory
and prepaid expenses have on the liquidity ?
Quick Ratio/Acid Test Ratio/Liquid Ratio
• Quick Ratio = Liquid Assets
Liquid Liabilities

Liquid Assets = Current Liquid Liabilities = Current

Assets – Stock – Prepaid Liabilities – Bank Overdraft
Expenses – Cash Credit

• Measures the firm’s ability to convert its current

assets quickly into cash in order to meet its
current liabilities.
 Interpretation
• Best available test of the liquidity position
Cash 2000
Debtors 2000
Inventory 12000
Total Current Assets 16000
Total Current Liabilities 8000
(i) Current Ratio 2:1
(ii) Acid-Test Ratio 0.5:1
 Absolute Liquidity Ratio
• Also known as Super Quick Ratio or Cash Ratio
or Cash Reservoir Ratio
• Cash in hand and at bank +
Cash Ratio = Marketable securities
Total Current Liabilities
• Cash + bank balance + marketable securities
considered as highly liquid assets
• Measures the immediate amount of cash
available to satisfy short term debt.
 Limitations of Liquidity Ratios
• Current assets can be manipulated by changing
the accounting policies e.g. method of
valuation of inventories or marketable
securities
• Current liabilities manipulated by postponing
payment by a few days
• Static in nature
• Ratios show the position on the balance sheet
date
 Turnover/Activity Ratios
• Helps to determine how quickly certain current
assets are converted into cash.
• The liquidity ratios should be examined in
conjunction with the relevant turnover ratios
affecting liquidity.
 Types of Turnover Ratios
 Inventory Turnover Creditors Turnover
Ratio Ratio
Average Age of  Age of Payables
Inventory  Working Capital
Debtors/Receivables Turnover Ratio
Turnover Ratio  Fixed Assets
 Average Collection Turnover Ratio
Period
 Inventory/Stock Turnover Ratio
Cost of goods sold
Inventory Turnover Ratio Average Inventory
=
Average Inventory = Opening Stock + Closing Stock
2
Or
Average inventory = Closing Stock
Cost of goods sold = Net Sales – Gross Profit
Or
Cost of goods sold = Opening Stock + Purchases +
Carriage Inward + Wages + other direct charges –
Closing Stock
 Interpretation
• Establishes the relationship between cost of
goods sold during the year and average
inventory held during the year
• High ratio – good from the point of liquidity
• Low ratio – inventory does not sell fast and
stays on the shelf or in the warehouse for a
long time.
 Average age of Inventory
• Also known as Days of Inventory Holding (DIH)
• DIH = Days in a year
Inventory turnover ratio
• Indicates number of days that inventory is held
prior to being sold.
• Increasing age indicates a risk in the company's
inability to sell its products (lack of demand).
• Low ratio - company is not keeping enough stock
on hand to meet demands.  
 Debtors Turnover Ratio
Debtors Turnover Net Credit Sales
Ratio = Average Accounts Receivable
• Accounts receivable = Trade debtors + Bills
Receivable
• Net Credit Sales = Gross credit sales – Sales
returns.
• Provision for Bad and Doubtful debts is not
deducted from debtors
• If amount of credit sales is not given total sales
to be taken
 Interpretation
• Measures how rapidly receivables are collected
• High ratio indicates shorter collection period –
prompt payment by debtors
• Low ratio indicates a longer collection period –
delayed payments by debtors i.e. debts are not
being collected rapidly.
• To be compared with past ratios or ratios of
similar firms or industry average
 Average Collection Period
• Represents the average number of days for
which a firm has to wait before its receivables
are converted into cash
Average Debtors x No. of
Average Collection
working days/months
Period =
Net Credit Sales
Or
= 365
Debtors Turnover Ratio
• Shorter collection period- prompt payment
by debtors
 Creditors/Payable Turnover Ratio

Creditors Turnover Net Credit Purchases

Ratio = Average Accounts Payable

Accounts payable = Trade creditors + Bills

Payable
Net Credit Purchases = Gross credit purchases –
purchase
returns.

 Interpretation
 High Ratio indicates creditors are being paid
promptly, thus enhancing credit worthiness
 Low ratio indicates creditors are not paid on
time
 Average Age of Payables
Average Age of Months (or days) in a year
Payables = Creditors’ Turnover Ratio

• Indicates speed with which payments for credit

purchases are made to creditors
• To be compared with credit period allowed by
suppliers – should be approximately equal
 Working Capital Turnover Ratio
Working Capital Cost of goods sold
Turnover Ratio = Net Working Capital
• Used to analyze the relationship between the
money used to fund operations and the sales
generated from these operations. 
• Measures efficiency with which the working
capital is used by the firm
• High ratio indicates efficient utilization
 Fixed Asset Turnover Ratio
Fixed Asset Sales
Turnover Ratio = Net Fixed Assets
• Measures the efficiency in the utilization of
fixed assets
• Higher the better – efficient use of assets will
generate greater sales
• Low ratio indicates idle capacity and
excessive investment in fixed assets
Sum: XYZ Co. financial statement contain the foll.
info:Liabilities Rs. Assets Rs.
Creditors 700000 Cash 200000
Bank Overdraft 40000 Sundry debtors 320000
5 % debentures 1500000 Marketable 200000
Loan from ICICI 800000 securities
Equity Share Capital 2000000 Stock 1840000
Retained Earnings 460000 Prepaid expenses 20000
Land & Building 2200000
Furniture & 720000
fixtures

5500000 5500000
 Statement of Profit for the current year
Sales 4000000
Less: Cost of goods sold 2200000
Less: office expenses 200000
Less: S & D expenses 400000
Less: Interest 160000
Net Profit 1040000
Less: Tax @ 50 % 520000
Profit after taxes 520000
Profit distributed 220000
Appraise the financial position by calculating (i)
Liquidity (ii) Profitability ratios (iii) Solvency ratios
(iv) Turnover ratios
 Solvency/Leverage/Capital
Structure Ratios
■ The long term lenders/creditors measure
soundness by the firm’s ability to
»pay interest regularly and
»pay the instalment of the
principal on due dates or in one
lumpsum.
 Types of Leverage Ratios
■ Based on the relationship between
borrowed funds and owner’s capital
» Debt-Equity Ratio
» Proprietary Ratio
» Total Assets to Debt Ratio
» Capital Gearing Ratio
■ Coverage Ratios
» Interest Coverage ratio
» Dividend Coverage ratio
» Debt Service Coverage Ratio
 Based on the relationship
between borrowed funds and
owner’s capital
» Debt-Equity Ratio
» Proprietary Ratio
» Total Assets to Debt Ratio
» Capital Gearing Ratio
• Computed from the Balance Sheet
 Debt-Equity Ratio
• D/E Ratio = Long-term debt
Shareholders’ Equity

Debt does not include current liabilities

• D/E Ratio = Total Debt

Shareholders’ equity
Debt does includes current liabilities
 Composition
• Long term debts – Debentures, bonds, bank
loan, loans from financial institutions
• Shareholder’s Funds includes Equity Share
Capital, Preference Share Capital, General
Reserve, Securities Premium and P & L a/c
(credit balance) and excludes accumulated
losses (P & L a/c debit balance) & fictitious
assets (preliminary expenses, underwriting
commission, share issue expenses, discount on
issue of shares/debentures
 Why two formulas?
• The first one excludes current liabilities while
the latter one includes them in the numerator.

The question is –
Should current liabilities be included in the
amount of debt to calculate D/E?
 Rationale
• Though individual items of current liabilities are short term
and fluctuate widely, a fixed amount of them are always in
use as that they available on a long-term footing.
• Some current liabilities like bank credit, though they are
short term, are renewed year after year and hence they
remain permanently in the business
• Current liabilities create a charge on the assets and they are
paid along with the long-term lenders at the time of
liquidation
• Short-term creditors do exercise pressure on the
management
Omission of Current Liabilities in calculating the D/E ratio
would lead to misleading results
 How should preference share
capital be treated?
• The question is –
Should it be included in debt or equity?
INCLUDE in INCLUDE in
Equity Debt

Object – to examine the Object – to show the

financial solvency of a effect of use of fixed-
firm in terms of its interest /dividend
ability to avoid financial sources of funds on the
risk earning available to the
ordinary shareholders.
 Interpretation
• Computed to ascertain the soundness of the
long-term financial policies of the firm
• Indicates the proportion of funds which are
acquired by long-term borrowings in
comparison to shareholders funds i.e. extent to
which the firm depends upon outsiders for its
existence
 Interpretation
• High ratio –
Owners putting up less money of their - danger signal
for long-term lenders
If project should fail financially – creditors would
lose heavily
Owners may indulge in speculative activities
Restrictions on borrowings
Pressure and interference of creditors in the
management
Heavy burden of interest payment specially in
adverse conditions
 Benefits of “Trading on Equity” to shareholders
 Trading of Equity
• Also known as Leverage
• Meaning - The use of borrowed funds
carrying a fixed charge in expectation of
obtaining higher returns to equity-holders
• Benefit will occur only if the firm is able to
earn on the borrowed funds at a rate higher
than the fixed charge loans
 Trading of Equity
Situations A B C D

Total Assets 1000 1000 1000 1000

Financing Pattern:
Equity Capital 1000 800 600 200
15% Debt - 200 400 800
Operating Profit 300 300 300 300
Less: Interest - 30 60 120
Earnings before taxes 300 270 240 180
Less: taxes (30%) 90 81 72 54
Earnings after taxes 210 189 168 126
Return on equity (%) 21 23.6 28 63
Rs. in ’000
 Interpretation
• Low ratio –
 Easy availability of credit
Deprived of the benefits of “Trading on
Equity”
 Sufficient safety margin and protection
 Ideal D/E Ratio
• No ideal ratio
• Depends upon the type and size of the
business, nature of industry and degree of risk
involved
 Total Assets to Debt Ratio
Total Assets to Debt Ratio = Total Assets
Long term debts
• Total Assets = Fixed assets + Current Assets
• No debit balance of P & L a/c and fictitious assets
• Measures extent to which debt is covered by assets
• High ratio – higher security to lenders, no benefits
of Trading on Equity
• Low ratio – risky financial position ; business
depends heavily on outside loans for its existence
 Proprietary Ratio
• Indicates proportion of total assets funded by
owners or shareholders.
• Proprietary Ratio = Shareholders’ Funds
Total Tangible Assets
• Total Assets exclude fictitious assets
• High ratio – indicator of financial soundness
• Low ratio – danger signal for long-term
lenders as they are less secured
 Capital Gearing Ratio
Capital Gearing Equity Share Capital
Ratio = Fixed Interest Bearing Funds
• Equity share capital - equity share capital and
all reserves and surplus – fictitious assets
• Fixed interest bearing funds includes
debentures, preference share capital and other
long-term loans
 Interpretation
• When the Equity Share Capital is lower than the
Preference Share Capital and long term loans,
the company's capital is said to be highly
geared. If the equity capital is higher than the
Preference Shares and Loans, the company's
capital is said to be lowly geared.
• High gearing ratio is not good for a new
company or a company of which future earnings
are uncertain.
 Coverage Ratios
» Interest Coverage ratio
» Dividend Coverage ratio
» Debt Service Coverage Ratio
• Computed from information available in the profit
& loss account
• Measure firm’s ability to pay certain fixed charges
-
 Interest on loans
 Preference dividend
 Amortization of principal
 Repayment of instalment of loans
 Redemption of preference share capital
 Interest Coverage ratio
• Interest Coverage = EBIT
» Interest
• Measures firm’s ability to pay fixed interest on
long term loans
• Expressed in number of times
• Higher the better
 Dividend Coverage Ratio
• Dividend Coverage = Earnings after Tax
Preference Dividend
• Measures firm’s ability to pay dividend on
preference shares which carry a fixed rate of
return
• Expressed in number of times
• Higher the better
 Debt-Service Coverage Ratio

DSCR =
PAT + Depreciation + Annual Interest on Long Term
Loans & Liabilities
Annual interest on Long Term Loans & Liabilities +
Annual Instalment
 Debt-Service Coverage Ratio
• Cashflow available for making annual interest
and principal payment of debt.
• A DSCR of less than 1 would mean a negative
cash flow.
• A DSCR of less than 1, say .95,  would mean
that there is only enough net operating income
to cover 95% of annual debt payments.
 Profitability Ratios
 For Management
To measure the profitability or operating
efficiency of the business
 For Shareholders
Adequacy of returns
 Types of Profitability Ratios
• On the basis of Sales • On the basis of
Gross Profit Ratio Investment
Net Profit Ratio Return on assets
Cost of goods sold Return on Capital
ratio Employed
Operating expenses Return on
ratio Shareholders’ Equity
Operating Ratio Earnings Per Share
Book value per Share
Dividend per Share
Dividend Pay-out Ratio
Price Earnings Ratio
 On the basis of Sales
Gross Profit Ratio
Net Profit Ratio
Cost of goods sold ratio
Operating expenses ratio
Operating Ratio
 Gross Profit Ratio
Gross Profit x 100
Gross Profit Ratio =
Net Sales
• Gross Profit = Net sales – Cost of goods sold
• Net Sales = Gross Sales (both cash and credit)
minus Sales Returns
 Interpretation
• Indicates efficiency of the concern in respect of
selling and purchasing/manufacturing operations
as well as the market conditions in which it is
operating.
• Should be analyzed and studied as a time series
• High Ratio – sign of good management – cost of
production low, indicative of higher sale price,
overvaluation/undervaluation of closing stock
• Low ratio – danger signal – high cost of
production, low selling price because of severe
competition or poor quality
 Net Profit Ratio
Net Profit x 100
Net Profit Ratio =
Net Sales
• Net profit = Earnings after tax and interest
• Shows overall efficiency in manufacturing,
administrative, selling and distributing the product
• Should be analyzed and studied as a time series
• High ratio – ensures adequate returns to owners,
enables firm to face adverse economic conditions
 Expenses Ratio
Cost of goods sold Cost of goods sold
Ratio = x 100
Net Sales

Operating Administrative
Expenses Ratio = expenses + Selling x 100
expenses
Net Sales
Cost of goods sold +
Operating Ratio = Operating Expenses x 100
Net Sales
 Interpretation
• Should be analyzed and studied as a time
series
• Should be compared over a period of time with
the industry average as well as firm’s of
similar type
• Lower the ratio, better it is.
• Higher ratio - small amount of operating
income to meet interest, tax and dividends
 On the basis of Investment
Return on assets
Return on Capital Employed
Return on Shareholders’ Equity
Earnings Per Share
Book value per Share
Dividend per Share
Dividend Pay-out Ratio
Price Earnings Ratio

• Also called “Return on Investments” (ROI)

 Return on Assets
Net Profit after taxes + Interest x 100
ROA =
Average Total assets
• Indicates what return a company is generating
on the firm's investments/assets.
• Helps management to know how efficient it
is at using its assets to generate earnings. 
Return on Capital Employed (ROCE)
Net profit after taxes + Interest
ROCE = x 100
Capital Employed

• Capital Employed = Equity Share Capital +

Preference Share Capital + Undistributed Profits
+ Reserves & Surplus + Long-term Liabilities –
Fictitious Assets
Or
Fixed assets + Current assets – Current liabilities
Return on Shareholders’ Equity
Net profit after taxes –
ROE = Preference Dividend x 100
Net Worth
• Net Worth = Equity share capital + reserves &
surplus – accumulated losses – Fictitious assets
• From the owner’s point – very crucial ratio
• Helps to judge whether the firm has earned a
satisfactory return for its equity shareholders who
bear all the risk and participate in the management
 Earnings per share (EPS)
Net Profit after Tax - Preference Dividend
EPS =
Number of Equity Shares

• Measures profit available to equity shareholders on a

per share basis
• Limitation
► Does not reveal amount paid to owners
as dividend
►Does not reveal amount retained in the
business
 Book value per share
Book value per Net Worth
share =
Number of Equity Shares

• Represents the claim of the equity

shareholders on a per share basis
• Limitation
►Cannot be used as valuation tool as it is based on
the historical cost of assets of a firm. There may be
significant difference between market value and
book value
 Dividend per share
Dividend paid to equity shareholders
DPS=
Number of Equity Shares

• Indicates dividend paid to the equity

shareholders on a per share basis
• Better indicator than EPS – shows what exactly
is received
 Dividend Pay-out ratio
DPS
D/P = x 100
EPS

• Shows what percentage share of the net profits after

taxed and preference dividend is paid out as
dividend to the equity shareholders
• Retention ratio = 100 – D/P ratio which indicates
what percentage of the net profits are retained in the
business (Ploughing back of profits)
 Price Earning (PE) ratio
Market Price per equity share
P/E Ratio =
Earnings per share
• Measures the amount investors are willing to
pay for each rupee of earnings
• Higher the ratio, larger is the investors’
confidence in the firm’s future
Prepare a statement of comparative ratios showing liquidity,
profitability, activity and financial position of two companies.
Particulars Peerless Ltd Perfect Ltd
Sales Rs 32,00,000 Rs 30,00,000
Net profit after tax 1,23,000 1,58,000
Equity capital (Rs 10 per share 10,00,000 8,00,000
fully paid)
General reserves 2,32,000 6,42,000
Long term debt 8,00,000 5,60,000
Creditors 3,82,000 5,49,000
Bank credit (short-term) 60,000 2,00,000
Fixed assets 15,99,000 15,90,000
Inventories 3,31,000 8,09,000
Other current assets 5,44,000 5,42,000