Financial Analysis & Ratio Essentials

Learning Outcomes

• Explain ratio analysis, data sources, users & objectives

• Classify & compute liquidity, leverage, activity, profitability ratios

• Interpret ratios for investors, creditors, managers

• Apply Du Pont model; recognise limitations of ratios

Financial Statements & Need for Analysis

• $\text{P\&L}:$ performance over period; $\text{B/S}:$ position at date

• Single figures meaningless; ratios give relationships, allow trend / comparative (intra & inter-firm) study

Main Source Documents

• Annual report, interim statements, notes to accounts, cash-flow, periodicals, credit reports

Key Ratio Groups & Core Formulae

1 Liquidity (Short-term)

• Current $=\dfrac{CA}{CL}$ (ideal $2:1$)

• Quick / Acid $=\dfrac{CA-Inventory-Prepaids}{CL}$ (ideal $1:1$)

• Cash $=\dfrac{Cash+Mkt\,Sec}{CL}$

• Basic Defense Interval $=\dfrac{Cash+Net\,Rec+Mkt\,Sec}{Daily\,OpEx}$ (days firm can run)

• Net Working Capital $=CA-CL$

2 Leverage (Long-term Solvency)

Capital-structure

• Equity $=\dfrac{Shareholders\,Equity}{Net\,Assets}$

• Debt $=\dfrac{Total\,Debt}{Net\,Assets}$

• Debt-Equity $=\dfrac{Total\,Debt}{Shareholders\,Equity}$

• Debt-Total Assets $=\dfrac{Total\,Debt}{Total\,Assets}$

• Capital Gearing $=\dfrac{Pref+Deb+Borrowings}{Eq\,Sh\,Cap+Res-Losses}$

• Proprietary $=\dfrac{Shareholders\,Funds}{Total\,Assets}$

Coverage

• Interest Coverage $=\dfrac{EBIT}{Interest}$

• DSCR $=\dfrac{Earnings\,for\,Debt\,Svc}{Int+Instalments}$ (>$1.5$ good)

3 Activity / Turnover (Efficiency)

• Total Asset $=\dfrac{Sales}{Total\,Assets}$

• Fixed Asset $=\dfrac{Sales}{Fixed\,Assets}$

• Working Capital $=\dfrac{Sales}{WC}$

• Inventory $=\dfrac{COGS}{Avg\,Inventory}$ ⇒ days $=\dfrac{365}{Turn}$

• Debtors $=\dfrac{Credit\,Sales}{Avg\,AR}$; Collection days $=\dfrac{365}{Turn}$

• Creditors turn & payment days analogous

4 Profitability

On Sales

• Gross Margin $=\dfrac{GP}{Sales}\times100$

• Net Margin $=\dfrac{PAT}{Sales}\times100$

• Operating $=\dfrac{EBIT}{Sales}\times100$

On Investment

• ROA $=\dfrac{PAT+Interest(1-t)}{Avg\,Assets}$

• ROCE $=\dfrac{EBIT}{Capital\,Employed}$

• ROE $=\dfrac{PAT-Preference\,Div}{Equity}\times100$

Shareholders / Market

• EPS $=\dfrac{PAT_{eq}}{No. shares}$

• DPS, Dividend Payout $=\dfrac{DPS}{EPS}$

• P/E $=\dfrac{Market\,Price}{EPS}$

• Yield $=\dfrac{DPS}{Price}\times100$; Earnings Yield $=\dfrac{EPS}{Price}$

• MV/BV per share $=\dfrac{Market\,Price}{Book\,Value\,/\,share}$

• Tobin Q $=\dfrac{Mkt\,Value\,(Equity+Debt)}{Replacement\,Cost\,Assets}$ (≈1 in equilibrium)

Du Pont ROE Decomposition

$ROE=\frac{PAT}{Sales}\times\frac{Sales}{Assets}\times\frac{Assets}{Equity}$
= Net Margin × Asset Turnover × Equity Multiplier (leverage). Helps locate driver of ROE.

Users & Focus Ratios (Examples)

• Shareholders: EPS, DPS, ROE, P/E

• Lenders: Debt-Equity, DSCR, Interest Coverage, Liquidity

• Creditors: Current, Quick, Payables days

• Management: All groups for planning/budgeting

Applications

• Assess: liquidity, solvency, efficiency, profitability, inter-firm comparison, budgeting & forecasting

Limitations

• Inflation distortion; seasonal bias; window dressing; accounting policy differences; diversified segments; no single benchmark; ratios inter-related

Horizontal vs Vertical Analysis

• Horizontal: trend across years; Vertical: common-size one year (B/S % assets, P&L % sales)

Quick Reference – Ideal Benchmarks (rule of thumb)

• Current $2:1$, Quick $1:1$

• Debt-Equity ≤$1:1$ (varies by sector)

• Interest Coverage >$3$; DSCR >$1.5$

• Inventory days & AR days align with industry credit terms

Recent Disclosure (Schedule III – Companies Act)

Companies must present ratios incl. Current, Debt-Equity, DSCR, ROE, Inventory, Trade Receivable/Payable, Net Profit, ROCE, ROI.

/