LECTURE – 06

UNDERSTANDING ANNUAL REPORT & FINANCIAL STATEMENT

Ratio Analysis

A tool used by individuals to conduct a quantitative analysis of information in a company's

financial statements. Ratios are calculated from current year numbers and are then compared
to previous years, other companies, the industry, or even the economy to judge the
performance of the company. Ratio analysis is predominately used by proponents of
fundamental analysis.

Ratio Analysis enables the business owner/manager to spot trends in a business and to
compare its performance and condition with the average performance of similar businesses in
the same industry. To do this compare your ratios with the average of businesses similar to
yours and compare your own ratios for several successive years, watching especially for any
unfavorable trends that may be starting. Ratio analysis may provide the all-important early
warning indications that allow you to solve your business problems before your business is
destroyed by them.

A ratio is a mathematical relation between one quantity and another. Suppose you have 200
apples and 100 oranges. The ratio of apples to oranges is 200 / 100, which we can more
conveniently express as 2:1 or 2. A financial ratio is a comparison between one bit of financial
information and another. Consider the ratio of current assets to current liabilities, which we
refer to as the current ratio. This ratio is a comparison between assets that can be readily
turned into cash -- current assets -- and the obligations that are due in the near future -- current
liabilities. A current ratio of 2:1 or 2 means that we have twice as much in current assets as we
need to satisfy obligations due in the near future.

Ratios can be classified according to the way they are constructed and their general
characteristics. By construction, ratios can be classified as a Activity ratio, a Liquidity ratio, a
Solvency ratio, a Profitability ratio and Valuations ratio:
 Financial
Ratio

Activity Liquidity Solvency Profitability Valuations

Ratio Ratio Ratio Ratio Ratio

Receivable Current Ratio Debt to Equity Net profit Earnings per

turnover margin Share (Basic)

Days of sales Quick ratio Gross profit

Debt to capital Earnings per
Outstanding margin share
(Diluted)

Inventory Cash ratio Operating profit

Debt to Assets Price earning
turnover margin
(P/E) ratio

Days of Defensive Pretax Margin

Financial Dividend
inventory on Interval
Leverage payout ratio
hand

Payables Cash Interest Return on Dividend yield

turnover conversion coverage ratio Assets
cycle

Number of
Fixed charge Operating
days of
coverage return on Assets
payables

Total asset Return on Total

Cash flow to
turnover Capital
debt ratio

Fixed asset Return on

turnover Equity

Working Return on
capital common equity
turnover
XYZ Company Ltd

Balance Sheet
XYZ Company Ltd

Income Statement
 XYZ Company Ltd

Cash Flow Statement

Activity ratio

Activity ratios are measures of how well assets are used. Activity ratios -- which are, for the
most part, turnover ratios -- can be used to evaluate the benefits produced by specific assets,
such as inventory or accounts receivable. Or they can be use to evaluate the benefits produced
by all a company's assets collectively.
These measures help us gauge how effectively the company is at putting its investment to work.
A company will invest in assets – e.g., inventory or plant and equipment – and then use these
assets to generate revenues. The greater the turnover, the more effectively the company is at
producing a benefit from its investment in assets. The most common turnover ratios are the
following:

1. Receivable turnover

Accounts receivable turnover is the ratio of net credit sales to accounts receivable. This ratio
indicates how many times in the period credit sales have been created and collected on. it is
considered desirable to have a receivable turnover figure close to the industry norm.
Receivable turnover = Annual Sales/Average receivables
=24,623/ ((798+615)/2)
=34.9 Times

2. Days of sales Outstanding

The inverse of the receivables turnover times 365 is the average collection period, or days of
sales outstanding, which is the average number of days it takes for the company's customers to
pay their bills:

Days of sales Outstanding = 365/ Receivable turnover

=365/34.9
=10.5 Days

It is considered desirable to have a collection period (and receivables turnover) close to the
industry norm. The firm's credit terms are another important benchmark used to interpret this
ratio. A collection period that is too high might mean that customers are too slow in paying
their bills, which means too much capital is tied up in assets. A collection period that is too low
might indicate that the firm's credit policy is too rigorous, which might be hampering sales.

Comments: To deter-mine whether these receivable collection numbers are good or bad, it is
essential that they be related to the firm’s credit policy and to comparable collection figures for
other firms in the industry. The point is, the receivable collection period value varies
dramatically for different firms (e.g., from 10 to over 60) and it is mainly due to the product and
the industry.
3. Inventory turnover

A measure of a firm's efficiency with respect to its processing and inventory management is
inventory turnover:

Inventory turnover=Cost of goods sold/Average Inventory

=18,049/ ((3482+2831)/2)
= 5.7 Times

This ratio indicates how many times inventory is created and sold during the period. For
inventory turnover, be sure to use cost of goods sold as enumerator not sales.

4. Days of inventory on hand

The inverse of the inventory turnover times 365 is the average inventory processing period, or
days of inventory on hand:

Days of inventory on hand = 365/ Inventory turnover

=365/5.7
=64 Days

Comments: As is the case with accounts receivable, it is considered desirable to have days of
inventory on hand (and inventory turnover) close to the industry norm. A processing period
that is too high might mean that too much capital is tied up in inventory and could mean that
the inventory is obsolete. A processing period that is too low might indicate that the firm has
inadequate stock on hand, which could hurt sales.

5. Payables turnover

A measure of the use of trade credit by the firm is the payables turnover ratio

Payables turnover = Purchases or COGS/Average trade payables

=18,049/ ((1547+1364)/2)
=12.4 Times

6. Number of days of payables

The inverse of the payables turnover ratio multiplied by 165 is the payables
payment period or number of days of payables, which is the average amount of
times it takes the company to pay its bills
Number of days of payables = 365/ Payables turnover

=365/12.4

=29 Days

Note: We have shown day’s calculation for payables, receivables, and inventory based on
annual turnover and a 365-day a year. If turnover ratios are for a quarter rather than a year, the
number of days in the quarter should be divided by the quarterly turnover ratios in order to get
the "days” from of these ratios.

7. Total asset turnover

The effectiveness of the firm's use of its total assets to create revenue is measured by its total
asset turnover:

Total asset turnover=Revenue/Average total assets

=24,623/ ((8834+7104)/2)

=3.09 Times

Comments: Different types of industries might have considerably different turnover ratios.
Manufacturing businesses that are capital-intensive might have asset turnover ratios near one,
while retail businesses might have turnover ratios near 10. As was the case with the current
asset turnover ratios discussed previously, it is desirable for the total asset turnover ratio to be
close to the industry norm. Low asset turnover ratios might mean that the company has too
much capital tied up in its asset base. A turnover ratio that is too high might imply that the firm
has too few assets for potential sales, or that the asset base is outdated.

8. Fixed asset turnover

The utilization of fixed assets is' measured by the fixed asset turnover ratio

Fixed asset turnover=Revenue/Average net fixed assets

=24623/ ((4345+3428)/2)

=6.3 Times

Comments: As was the case with the total asset turnover ratio, it is desirable to have a fixed
asset turnover ratio close to the industry norm. Low fixed asset turnover might mean that the
company has too much capital tied up in its asset base or is using the assets it has inefficiently.
A turnover ratio that is too high might imply that the firm has obsolete equipment, or at a
minimum, that the firm will probably have to incur capital expenditures in the near future to
increase capacity to support growing revenues. Since "net" here refers to net of accumulated
depreciation, firms with more recently acquired assets will typically have lower fixed asset
turnover ratios.

9. Working capital turnover

How effectively a company is using its working capital is measured by the working capital
turnover ratio.

Working capital turnover=Revenue/Average working capital

=24623/ ((1292+1246)/2)

=19.40

Comments: Working capital (sometimes called net working capital) is current assets minus
current liabilities. The working capital turnover ratio gives us information about the utilization
of working capital in terms of dollars of sales per dollar of working capital. Some firms may have
very low working capital if outstanding payables equal or exceed inventory and receivables. In
this case the working capital turnover ratio will be very large, may vary significantly from period
to period, and is less informative about changes in the firm's operating efficiency.

Liquidity Ratio
Liquidity ratios provide a measure of a company’s ability to generate cash to meet its
immediate needs. Its ability to turn short-term assets into cash to cover debts is of the utmost
importance when creditors are seeking payment. Bankruptcy analysts and mortgage originators
frequently use the liquidity ratios to determine whether a company will be able to continue as a
going concern. There are three commonly used liquidity ratios.

1. Current Ratio

The current ratio is the best-known measure of liquidity

Current Ratio=Current Assets/Current Liabilities

=4304/3012

=1.42
Comments: The higher the current ratio, the more likely it is that the company will be able to
pay its short-term bills. A current ratio of less than one means that the company has negative
working capital and is probably facing a liquidity crisis. Working capital equals current assets
minus current liabilities.

2. Quick ratio

The quick ratio is a more stringent measure of liquidity because it does not include inventories
and other assets that might not be very liquid.

Quick ratio= cash + marketable securities + receivables/ current liabilities

= 815/3012

= 0.27

Comments: The higher the quick ratio, the more likely it is that the company will be able to pay
its short-term bills. Marketable securities are short-term debt instruments, typically liquid and
of good credit quality. As before, you should compare these values relative to other firms in the
industry and to the aggregate economy. When possible, you should question management
regarding the reason for these relatively low liquidity ratios (e.g., small receivables due to heavy
cash sales?).

3. Cash ratio

The most conservative liquidity measure is the cash ratio

Cash ratio= cash + marketable securities/ Current Liabilities

= 17/3012

= .01

Comments: The higher the cash ratio, the more likely it is that the company will be able to pay
its short-term bills. The cash ratios during the years have been quite low and they would be
cause for concern except that such cash ratios are typical for a fast-growing retailer with larger
inventories being financed by accounts payable to its suppliers. In addition, the firm has strong
lines of credit available on short notice at various banks. Still, as an investor, you would want to
confirm how the firm can justify such a low ratio and how it is able to accomplish this.

The current, quick, and cash ratios differ only in the assumed liquidity of the current assets that
the analyst projects will be used to pay off current liabilities.
4. Defensive Interval

The defensive interval ratio is another measure of liquidity that indicates the number of days of
average cash expenditures the firm could pay with its current liquid assets.

Defensive Interval= cash + marketable securities + receivables/ average daily expenditures

Expenditures here include cash expenses for costs of goods, SG&A, and research and
development. If these items are taken from the income statement, noncash charges such as
depreciation should be added back just as in the preparation of a statement of cash flows by
the indirect method.

5. Cash conversion cycle

The cash conversion cycle is the length of time it takes to turn the firm's cash investment in
inventory back into cash, in the form of collections from the sales of that inventory. The cash
conversion cycle is computed from day’s sales outstanding, days of inventory on hand, and
number of days of payables.

Cash conversion cycle = Days of sales outstanding + Days of Inventory on hand - Number of
days of payables

= 10+64-29

= 45 Days

Comments: High cash conversion cycles are considered undesirable. A conversion cycle that is
too high implies that the company has an excessive amount of capital investment in the sales
process. To determine standard cash conversion cycle it should be compared with industry
norm as it varies industry to industry.

Solvency Ratios
1. Debt to Equity

A measure of the firm's use of fixed-cost financing sources is the debt-to-equity ratio.

Debt to Equity= Total Debt/ Total Share holders’ Equity

= (478+137+6710)/5207

= 140.68%
Comments: Increases and decreases in this ratio suggest a greater or lesser reliance on debt as
a source of financing. Total debt is calculated differently by different analysts and different
providers of financial information. Here, we will define it as long-term debt plus interest-
bearing short-term debt. A lower the percentage means that a company is using less leverage
and has a stronger equity position.

2. Debt to capital

Another way of looking at the usage of debt is the debt-to-capital ratio

Debt to capital= Total debt/ total debt +total shareholders' equity

= 3627/ (3627+5207)

= 41.06%

Comments: Capital equals all long-term debt plus preferred stock and equity. Increases and
decreases in this ratio suggest a greater or lesser reliance on debt as a source of financing.

3. Debt to Assets

A slightly different way of analyzing debt utilization is the debt-to-assets ratio

Debt to Assets= Total debt/Total Assets

= 3627/8834

=41.06%

Comments: Increases and decreases in this ratio suggest a greater or lesser reliance on debt as
a source of financing.

4. Financial Leverage

Another measure that is used as an indicator of a company's use of debt financing is the
financial leverage ratio (or leverage ratio)

Financial Leverage= Average total assets/Average total liabilities

= 7969/3249

= 2.45%
Comments: Average here means the average of the values at the beginning and at the end of
the period. Greater use of debt financing increases financial leverage and typically, risk to
equity holders and bondholders alike.

5. Interest coverage ratio

The remaining risks ratios help determine the firm's ability to repay its debt obligations. The
first of these is the interest coverage ratio

Interest coverage ratio= earnings before interest and taxes/ Interest payments

= 886+537+ (3+461)/(3+461)

= 4.07 Times

Comments: The lower this ratio, the more likely it is that the firm will have difficulty meeting
its debt payments. When a company's interest coverage ratio is only 1.5 or lower, its ability to
meet interest expenses may be questionable.

6. Fixed charge coverage

A second ratio that is an indicator of a company's ability to meet its obligations is the fixed
charge coverage ratio.

Fixed charge coverage= earnings before interest and taxes + lease payments/ Interest
payments + lease payments

= (1398+461)/ (3+461)

= 4.01 Times

Comments: Here, lease payments are added back co operating earnings in the numerator and
also added to interest payments in the denominator. Significant lease obligations will reduce
this ratio significantly compared to the interest coverage ratio. Fixed charge coverage is the
more meaningful measure for companies that lease a large portion of their assets, such as
some airlines.

7. Cash flow to debt ratio

This coverage ratio compares a company's operating cash flow to its total debt, which, for
purposes of this ratio, is defined as the sum of short-term borrowings, the current portion of
long-term debt and long-term debt. This ratio provides an indication of a company's ability to
cover total debt with its yearly cash flow from operations.
Cash flow to debt ratio= Operating cash flow/Total debt

= 719/3627

= 19.82%

Comments: The higher the percentage ratio, the better the company's ability to carry its total
debt.

Profitability ratio
Profitability ratios (also referred to as profit margin ratios) compare components of income
with sales. They give us an idea of what makes up a company's income and are usually
expressed as a portion of each dollar of sales. The objective of margin analysis is to detect
consistency or positive/negative trends in a company's earnings. Positive profit margin analysis
translates into positive investment quality. To a large degree, it is the quality, and growth, of a
company's earnings that drive its stock price. The profit margin ratios we discuss here differ
only by the numerator. It's in the numerator that we reflect and thus evaluate performance for
different aspects of the business:

1. Net profit margin

The net profit margin is the ratio of net income to revenue:

Net profit margin=Net income/ revenue

= 886/24623

= 3.6%

Comments: Analysts should be concerned if this ratio is too low. The net profit margin should
be based on net income from continuing operations, because analysts should be primarily
concerned about future expectations, and "below the line" items such as discontinued
operations will not affect the company in the future.

2. Gross profit margin

The gross profit margin is the ratio of gross profit (sales less cost of goods sold) to sales:

Gross profit margin= gross profit/Revenue

 = 6574/24623

= 26.7%

Comments: This ratio indicates the basic cost structure of the firm. An analysis of this ratio over
time relative to a comparable industry figure shows the firm’s relative cost-price position. As
always, it is important to compare these margins and any changes with the industry and strong
competitors. Analyst should be concerned if this ratio is too low.

3. Operating profit margin

The operating profit margin is the ratio of operating profit (gross profit less selling, general, and
administrative expenses) to sales; Operating profit is also referred to as earnings before interest
and taxes (EBIT):

Operating profit margin= Operating income/revenue

or

EBIT/Revenue

= 1398/24623

= 5.7%

Comments: Strictly speaking, EBIT includes some non operating items, such as gains on
investment. The analyst, as with other ratios with various formulations, must be consistent in
his calculation method and know how published ratios are calculated. Analysis should be
concerned if this ratio is too low. Some analysts prefer to calculate the operating profit margin
by adding back depreciation and any amortization expense to arrive at earnings before interest,
taxes, depreciation, and amortization (EBITDA).

4. Pretax Margin

Sometimes profitability is measured using earnings before tax (EBT), which can be calculated by
subtracting interest from EBIT or from operating earnings. The pretax margin is calculated as:

Pretax margin= EBT/Revenue

= 1422/24623

= 5.78%
5. Return on Assets

Another set of profitability ratios measure profitability relative to funds invested in the
company by common stockholders, preferred stockholders, and suppliers of debt financing.

The first of these measures is the return on assets (ROA). Typically ROA is calculated using net
income

Return on Assets (ROA) = Net Income/Average total Assets

= 886/7969

= 11.12%

Comments: This measure is a bit misleading, however, because interest is excluded from net
income but total assets include debt as well as equity. Adding interest adjusted for tax back to
net income puts the returns to both equity and debt holders in the numerator. This results in an
alternative calculation for ROA:

Return on Assets (ROA) = net income+ Interest expense (1 – tax rate)/ Average total Assets

= 886+3(1-.375)/7969

= 11.13%

6. Operating return on Assets

A measure of return on assets that includes both taxes and interest in the numerator is the
operating return on Assets.

Operating return on Assets= Operating income/Average total Assets

or

EBIT/ Average total Assets

=1398/7969

= 17.54%

7. Return on Total Capital

The return on total capital (ROTC) is the ratio of net income before interest Expense to total
capital:

Return on total capital= (Net Income+ Gross Interest expense)/Average total capital
 = (886+3)/7969

= 11.2%

Comments: Total capital includes short- and long-term debt, preferred equity, and common
equity Analysts should be concerned if this ratio is too low. Total capital is the same as total
assets. The interest expense that should be added back is gross interest expense, not net
interest expense (which is gross interest expense less interest income). An alternative method
for computing ROTC is to include the present value of operating leases on the balance sheet as
a fixed asset and as a long-term liability. This adjustment is especially important for firms that
are dependent on operating leases as a major form of financing

8. Return on Equity

This ratio indicates how profitable a company is by comparing its net income to its average
shareholders' equity. The return on equity ratio (ROE) measures how much the shareholders
earned for their investment in the company. The higher the ratio percentage, the more efficient
management is in utilizing its equity base and the better return is to investors. The return on
equity (ROE) is the ratio of net income to average total equity (Including preferred stock):

Return on equity=Net income/Average total equity

=886/(5207+4234)/2

=18.77%

Comments: Analysts should be concerned if this ratio is too low. It is sometimes called return
on total equity.

9. Return on common equity

A similar ratio to the return on equity is the return on common equity:

Return on common equity= (net income - preferred dividends)/ average common equity

or

= net income available to common/ average common equity

= 886/79.5

=11.14
Comments: This ratio differs from the return on total equity in that it only measures the
accounting profits available to, and the capital invested by, common stockholders, instead of
common and preferred stockholders. That is why preferred dividends are deducted from net
income in the numerator. Analysts should be concerned if this ratio is too low.

Cross-sectional analysis

When comparing a firm’s financial ratios to industry ratios, you may not feel comfortable using
the average (mean) industry value when there is wide variation among individual firm ratios
within the industry. Alternatively, you may believe that the firm being analyzed is not typical—
that is, it has a unique component. Under these conditions, a cross-sectional analysis may be
appropriate, in which you compare the firm to a subset of firms within the industry that are
comparable in size or characteristics. As an example, if you were interested in Kroger, you
would want to compare its performance to that of other national food chains rather than some
regional chains or specialty food chains.

Another practical problem with comparing a firm’s ratios to an industry average is that many
large firms are multiproduct and multi-industry in nature. Inappropriate comparisons can arise
when a multi-industry firm is evaluated against the ratios from a single industry. Two
approaches can help mitigate this problem. First, you can use a cross-sectional analysis by
comparing the firm against a rival that operates in many of the same industries. Second, you
can construct composite industry average ratios for the firm. To do this, the firm’s annual
report or 10-K filing is used to identify each industry in which the firm operates and the
proportion of total firm sales derived from each industry. Following this, composite industry
average ratios are constructed by computing weighted average ratios based on the proportion
of firm sales derived from each industry.

Comparison with Peer companies in the same industry:

Ratio ‘XYZ’ ‘ABC’ ‘MNO’ Industry

Average Average Average Average
Receivable turnover 34.9 Times 32.1 Times 33.2 Times 35 Times

Days of sales Outstanding 10.5 Days 8.2 Days 12.1 Days 15 Days

Inventory turnover 5.7 Times 3.3 Times 9 Days 11 Days

Days of inventory on hand 64 Days 70 Days 50 Days 72 Days

Payables turnover 12.4 Times 9 Times 6.5 Times 15 Times

Number of days of payables 29 Days 40 Days 25 Days 30 Days

Total asset turnover 3.09 Times 2.2 Times 4 Times 5 Times

Fixed asset turnover 6.3 Times 7 Times 8 Times 9.2 Times

Working capital turnover 19.40 15.1 13.2 25.3

Current Ratio 1.42 1.5 1.4 2.2

Quick ratio 0.27 .22 .28 .44

Cash ratio .01 .03 .05 .43

Cash conversion cycle 45 Days 60 Days 65 Days 59 Days

Debt to Equity 140.68% 155.3% 145.33% 160.22%

Debt to capital 41.06% 49.5% 55.2% 49.1%

Debt to Assets 41.06% 45.02% 40.12% 34%

Financial Leverage 2.45% 3.1% 1.85% 2.2%

Interest coverage ratio 4.07 Times 4.44% 3.1% 4.43%

Fixed charge coverage 4.01 Times 5.2 Times 3.77 Times 4.4 Times

Cash flow to debt ratio 19.82% 20.3% 15.3% 13%

Net profit margin 3.6% 4.2% 2.78% 5.2%

Gross profit margin 26.7% 22.9% 27.5% 30%

Operating profit margin 5.7% 4.6% 3.33% 4.9%

Pretax Margin 5.78% 6.8% 5.2% 7.2%

Return on Assets 11.12% 13.6% 8.22% 15.1%

Operating return on Assets 17.54% 18.3% 20.22% 22.3%

Return on Total Capital 11.2% 9.56% 10.2% 14.39%

Return on Equity 18.77% 15.2% 21.34% 23.5%

Return on common equity 11.14 12.6 9.36 14.22

Time-series analysis
Finally, you should examine a firm’s relative performance over time to determine whether it is
progressing or declining. This time-series analysis is helpful when estimating future
performance. For example, some analysts calculate the average of a ratio for a 5- or 10-year
period without considering the trend. This can result in misleading conclusions. For example, an
average rate of return of 10 percent can be based on rates of return that have increased from 5
per- cent to 15 percent over time, or it can be based on a series that begins at 15 percent and
declines to 5 percent. Obviously, the difference in the trend for these series would have a major
impact on your estimate for the future. Ideally, you want to examine a firm’s time series of
relative financial ratios compared to its industry and the economy.

Time series analysis of XYZ Company Ltd:

Ratio 2001 2000 1999

Receivable turnover 34.9 Times 31.1 Times 29.2 Times

Days of sales Outstanding 10.5 Days 8.2 Days 7.1 Days

Inventory turnover 5.7 Times 4.3 Times 4 Days

Days of inventory on hand 64 Days 59 Days 50 Days

Payables turnover 12.4 Times 9 Times 7 Times

Number of days of payables 29 Days 25 Days 20 Days

Total asset turnover 3.09 Times 2.2 Times 2 Times

Fixed asset turnover 6.3 Times 7 Times 8 Times

Working capital turnover 19.40 15.1 13.2

Current Ratio 1.42 1.5 1.4

Quick ratio 0.27 .21 .28

Cash ratio .01 .03 .02

Cash conversion cycle 45 Days 60 Days 35 Days

Debt to Equity 140.68% 130.3% 143.33%

Debt to capital 41.06% 49.5% 35.2%

Debt to Assets 41.06% 45.02% 40.12%

Financial Leverage 2.45% 2.1% 1.85%

Interest coverage ratio 4.07 Times 4.44% 3.1%

Fixed charge coverage 4.01 Times 5.2 Times 3.77 Times

Cash flow to debt ratio 19.82% 20.3% 13.3%

Net profit margin 3.6% 3.2% 2.78%

Gross profit margin 26.7% 22.9% 20.5%

Operating profit margin 5.7% 4.6% 3.33%

Pretax Margin 5.78% 6.8% 5.2%

Return on Assets 11.12% 13.6% 9.22%

Operating return on Assets 17.54% 18.3% 15.22%

Return on Total Capital 11.2% 9.56% 9.2%

Return on Equity 18.77% 15.2% 14.34%

Return on common equity 11.14 10.6 9.36