Ratio Analysis

1. Professor Rajendra K. Lagu Department of Electrical Engineering e-mail: rklagu@ee.iitb.ac.in Webpage: http://www.ee.iitb.ac.in/~rklagu Ratio Analysis

2. Balance Sheet • Shows the status of company’s financial position. It is actually a snap shot at the instant it is prepared, what the company owns and owes. • Not duration specific, such as P&L statement is. • Ideally, can be calculated every day; however companies usually calculate on a quarterly basis. • Shows the sources and applications of funds. • Numbers by themselves are not important; ratios are.

3. Balance Sheet continued… • Double entry accounting system: Assets and Liabilities must balance • Every transaction gets entered at two places under different heads so that accounts are “balanced”. • Credit / Debit or Assets / Liabilities • Compare the movement across the quarters or years • Scope for manipulation: Asset valuation, payment realization (GAAP)

4. Balance Sheet Structure

5. Financial Management Decisions Capital budgeting decisions Capital structure decisions Operating policy decisions

6. Assets • You pay for them to acquire them and so you “own” them • They generate revenues later in short or long term • Liquidity of an asset: Length of the time it takes to generate revenue • Their value generally depreciates over time • They can be revalued on some events • They can be tangible or intangible (goodwill, monopoly)

7. Examples of Assets • Cash in bank and in hand (bank balance, physical cash) • Marketable Securities (parked funds) • Accounts Receivables • Inventory (Work In Progress) • Inventory (Finished goods) • Land, Building, Plants, Offices, Vehicles • Equipment (PCs, Office equipment, Test jigs) • Patents, Copyrights, Trademarks • Goodwill, Brand Position

8. Liabilities • Money that has been made available to the firm, received from outside sources. • The firm owes them to outside agents including the shareholders • Liabilities can have short term, long term, or no term repayment schedules

9. Examples of Liabilities • Accounts payable (supplier credit) • Accrued corporate tax • Short term loans • Debentures • Long term loans • Equity (common stock + preferred stock) • Retained earnings

10. Balance Sheet of a Prototype Company • Frequency of P&L statement calculation • Operating Cycle duration: 2 weeks, 2 months, 1 year • Inventory turns and profit margins are closely linked to the operating cycle • Traders, Manufacturers, Knowledge-based companies

11. A Typical Manufacturing Company Starts Operation Two promoters deposit Rs 5 lakhs in the company account as equity XYZ Private Limited Balance Sheet at April 1, 2001

12. A lathe is bought on cash basis Owner pays Rs 3 lakhs from the bank acount

13. Raw material worth Rs 80,000 bought on a 60 day credit basis No payment is done so cash position does not change

14. Raw material worth Rs 40,000 processed and sold for Rs 50,000 with a 30 day credit No payment is done so cash position does not change, but inventory is reduced

15. Customer pays up after 20 days Payment deposited in bank so cash position changes

16. Supplier credit period is over and raw material is paid for after 60 days Payment done from bank so cash balance reduces

17. A new promoter buys 10,000 shares of Rs 10 face value at a premium of Rs 20 Payment done to bank so cash balance increases

18. Profit & Loss Account (Income Statement)

19. Cash Flow / Funds Flow Statement • Differences in successive balance sheets • Sources of Funds • Net profit • Issue of new share capital • Sale of fixed assets • New loans • Use of Funds • Payment of dividends • Purchase of fixed assets • Repayment of loans

20. Ratio Analysis • Compare the performance of the company for three successive years • The absolute numbers change so compare ratios • Compare two companies of differing size but from the same industry, e.g, Infosys and Mastek • Calculate industry-wide numbers (net profit margins for automobile companies)

21. Liquidity Ratios • Measure a firm’s ability to meet its short term obligations • Show trends early and so corrective actions can be taken in the working capital management • Current Ratio: Current Assets / Current Liabilities • Acid Test Ratio or Quick Ratio: (Current Assets – Inventory) / Current Liability (Cash or cash equivalent) / Current Liability A firm is “solvent” if its assets are greater than outside liabilities. A firm is “liquid” if its current assets are greater than its current liabilities

22. Gearing Ratios • Leverage of a firm: Proportion of its long term liabilities that are debts • Long term liabilities = Debts + Equity • Debt/Equity ratio Loan Capital / Share holder’s funds Gears, Leverage: Mechanical Engg terms

23. Asset Utilization Ratios • Return on Total Investment: management’s skill in exploiting the funds made available ROI = PBT / (Shareholders’ funds + Long term loans) • Return on Shareholders’ Equity ROE = PBT / (Shareholders’ funds) Sales / Total Capital Employed

24. Profitability Ratios • Net Profit Margin = NP / Sales • Gross Profit Margin = GP / Sales

25. Market Value related Ratios • EPS (Earning Per Share) : NP / Total outstanding shares • P/E : Market Price / Earning Per Share • Revenue Multiple: Revenues / Assets • Market to Book: Market Value / Book Value

26. Limitations of Financial Statements • They are backward looking: Accrued results of the past year / quarter • Company’s value depends on its future profitability which depends on many factors not reflected in the balance sheet, which are non-monetary • Nature and innovativeness of it products • Technology landscape (product obsolescence) • Competitors • Economic conditions (recession / boom), government policies • Staff and management morale

27. Balance Sheet of Three IT Companies at 31.03.2001 (in Rs Cr) (http://www.indiainfoline.com)

28. Profit and Loss Statement of Three IT Companies for 12 Months Ending 31.03.2001 (in Rs Cr)