Ratio Analysis – MAC – 29-June-2008

Ratio Analysis : – Ratio of selected values based on the company’s financial statement. There are many standard ratios used to evaluate the overall financial condition of a corporation or other organization.

Who Uses the Ratios : – Corporate Finance Managers, Current/Potential Shareholders, Creditors

Common Size Analysis – Ratio comparisons are done on Past performances, Competing Firms, Absolute Standards, Industry Trends, Budgets – Planning/Control

Profitability	For shareholders, employees, creditors, investors, management.
Liquidity	For shareholders, management, suppliers, creditor and competitors.
Efficiency	For management, shareholders, creditors and competitors.
Gearing	For shareholders, lenders, creditor and potential investors.
Investment	For shareholders, potential investors, management.

Ideally companies should be Liquid and Profitable, and hence we pay more attention to the Liquidity Ratios and the Profitability Ratios.

Key Liquidity Ratios

		Current Assets
	Current Ratio =	————————
		Current Liabilities

		Quick Assets
	Quick Ratio =	———————-
		Current Liabilities

Quick Assets = Current Assets – Inventories

Quick Ratio is significant in Industries where Inventory is more or less the finished product. e.g. Pen Industry.

Case Study on HUL, MARICO and Doctors Soap, and discussion about Monopoly (Market)  and Monopsony(Creditors). HUL though having lesser ratio has higher Monopoly and Monopsony, indicating there are no benchmarks for these numbers and are dependent on the Industry/Competetive positions.

Long Term Solvency Ratios

		Total Liabilities
	Debt to Equity Ratio =	———————————-
		Total Stockholders’ Equity

		Long Term Liability
	LT Debt Equity Ratio =	——————————————————-
		Networth/ Total Stockholder’s Equity

Times Interest Earned Ratio (TIE Ratio)

		PBIT (Before Interest and Tax)
	TIE	———————————-
		Interest Expense

TIE Ratio of > 1 is necessary to pay bare interest necessities

A ratio of > 10 is considered a very safe position.

Inventory Turnover Ratio : – A ratio showing how many times a company’s inventory is sold and replaced over a period.

		Cost Of Goods Sold
	Inventory Turnover Ratio	—————————-
		Average Inventory

A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort. A high turnover rate may indicate inadequate inventory levels, which may lead to a loss in business.

Effeciency Ratios : – Inventory Collection Period, Average Collection Period, Average Payment period

Inventory Collection Period : – (Inventory * 365)/Cost of Goods Sold

Average Collection Period :-  (Acc. recievable * 365)/ Credit Sales (The collection period or average collection period must be compared to competitors to see whether the credit given, and customer risk, is in line with the industry. A high collection period shows a high cost in extending credit to customers). Lower ACP means more Monopoly.

Average Payment Period :- (Acc. Payable * 365) / Purchases. Lesser APP means lower Monopsony.

e.g. ICP = 70 Days, ACP = 85 Days, APP = 45 Days. Deduction Cycle = 155 days on which the company has to self finance for 110 days.

Profitability Analysis Ratios

		PAT + Interest + Taxes
	Return on Assets (ROA) =	———————————-
		Average Total Assets

Average Total Assets = (Beginning Total Assets + Ending Total Assets) / 2

		PAT
	Return on Equity (ROE) =	————————
		Stockholders’ Equity

		PAT + Interest
	Return on Common Equity (ROCE) =	——————————————–
		Stockholders’ Equity

		Net Income
	Profit Margin =	—————–
		Sales

		Net Income
	Earnings Per Share (EPS) =	———————————————
		Number of Common Shares Outstanding

Return on Equity (ROE)

		PAT                 Sales                          Total Assets
	Return on Equity (ROE) =	——–  *      ———————-  *     ————————
		Sales           Total Assets                      Networth

In essence ROE = Margin * Asset Turnover Ratio * Leverage

Things to remember about Asset Turnover Ratio

• Companies with low profit margins tend to have high asset turnover, those with high profit margins have low asset turnover – it indicates pricing strategy.
• This ratio is more useful for growth companies to check if in fact they are growing revenue in proportion to sales.

Market Ratios

		Market Price of Common Share            Mkt Cap
	PE Ratio =	————————————– =                  ———————–
		Earnings Per Share                              Profit After Tax

		Annual Dividends Per Common Share
	Dividend Yield =	————————————–
		Market Price Per Share