FSS: RATIO ANALYSIS

Financial statement analysis consists of applying analytical tools and techniques to financial statements and other relevant data to obtain useful information. This information is shown as significant relationship between data and trends in those date that asses the company’s past performance and current financial position. The information shows the results or consequences of prior management decisions. In addition, the information is used to make predictions that may have a direct effect on decisions made by users of financial statements.

Present investors and potential investors are both interested in the future ability of a company to earn profits. These invertors wish to predict future dividends and changes in the marker price of the company’s common stock. Since both dividends and price changes are likely to be influenced by earnings, investors may seek to predict earnings.

Sometimes outside parties, such as creditors, are interested in predicting a company’s solvency rather than its profitability. The liquidity of company affects its short-term solvency. The company’s liquidity is its state of possessing liquid assets, such as (1) cash and (2) other assets that will soon be converted to cash.

Long-term creditors are interested in a company’s long-term solvency, which is usually determined by the relationship of a company’s assets to its liabilities. Generally a company is considered solvent when its assets exceed its liabilities so that the company has a positive stockholders’ equity.

Several types of analyses can be performed on a company’s financial statements. All of these analyses rely on comparisons or relationships of data because comparisons and relationships enhance the utility or practical value of accounting information. Example: a company’s net income last year was Tk. 100,000 may or may not, by itself, be useful information. Some usefulness is added when we know that the prior year’s net income was tk. 25,000. And even more useful information is gained if we know the amounts of sales and assets of the company. Such comparisons or relationships may be expressed as:

1. Absolute increases and decreases for an item from one period to the next.

2. Percentage increases and decreases for an item from one period to the next.

3. Trend percentages.

4. Percentages of single items to an aggregate total.

5. Ratios.

Ratio analysis is the most widely used tool of financial analysis. The term ratio refers to the numerical or quantitative relationship between two items or variables. This relationship can be expressed as in percentage, say, gross profit ratio is 30%, or in fractions, say, net profit is one fourth of sales, or in proportion of numbers, say, current ratio is 2:1.These alternative methods of expressing items, which are related to each other, referred to as ratio analysis. Ratios reveal the relationship in a more meaningful way so as to enable us to draw conclusions from them.

The rationale of ratio analysis lies in the fact that it makes related information comparable. Relationship between financial statement items become more meaningful when standards are available for comparison. Comparison with standards provide a starting point for the analyst’s thinking and lead to further investigation and ultimately to conclusions and business decisions. Such standards of comparison are:

a) Intra-company comparison: One way of comparison is to compare the calculated ratios of the company over the period of time.

b) Inter-company transaction: Another way of comparison is to compare the ratios of one firm with some selected firms in the same industry at the same point of time.

c) Industry average: Calculated ratios may be compared with average ratios of the industry of which the firm is a member.

d) Ideal Ratio: Experts has laid down some standard after making numerous experiments in various companies and at various places. The calculated ratios are compared with those ideal ratios.

According to financial spread sheet (FSS) there are six types of ratios, which are as follows:

a) Growth ratio: Growth ratios measures the company’s potentiality, performance. It also measures whether the company will survive. Example of the growth ratios are sales growth, assets growth etc.

b) Profitability ratio: Profitability indicates the efficiency of the unit in generating surplus. In order to have a ratio, we can compare profit to the factors which regulate the quantum of profit directly, like sales and the total assets or equity. Profitability ratios measure the income or operating success of an enterprise for a given period of time e.g., gross profit margin, operating profit margin etc.

c) Coverage ratio: These ratios measure the ability of a company to generate cash to pay interest and principal repayments e.g., interest coverage ratio.

d) Activity ratio: It has been widely accepted that the profitability of an enterprise to a large extent depends on its efficient asset utilization or activity performed. Activity ratios measure how efficiently the assets are employed by the firm. These ratios are also called efficiency ratios or asset management ratios. For examples , inventory turnover, total assets turnover etc.

e) Liquidity ratio: The liquidity or short-term solvency of an organization can be measured with the help of current ratio and quick ratio. Liquidity implies to the ability of an organization to pay off its short-term obligations with the current assets.

f) Leverage ratio: Ratio, which measures the extent to which a firm has been financed by debt. It is also known as debt management ratios. Examples of leverage ratios are debt ratio, etc.

As per CRG score sheet, a bank officer must calculate the following four ratios for understanding the financial risk of a business.

Types	Formula	Implications
Leverage: Debt equity ratio (times)	Total liabilities to tangible net worth.	Highest score (15) if it is less than 0.25. Lowest score (0) if it is more than 2.75.
Liquidity: Current ratio(times)	Current assets to current liabilities.	Highest score (15) if it is greater than 2.74. Lowest score (0) if it is less than 0.70.
Profitability Operating Profit margin (%)	Operating profit to net sales.	Highest score (15) if it is greater than 25%. Lowest score (0) if it is less than 1%.
Coverage: Interest coverage (times)	EBIT/Interest on debt.	Highest score (5) if it is greater than 2. Lowest score (0) if it is less than 1.

Ratio analysis

1. Growth Ratios

Name of ratio	Components of formula	Use
Sales growth, Sales %	[(CY.S-PY.S)/PY.S]*100	Rule of Thumb=Higher is better, comparing with previous years or industry average.
Net sales growth, Composite %	[(CY.NS-PY.NS)/PY.NS]*100	Rule of Thumb=Higher is better, comparing with previous years or industry average.
Net income growth, %	[(CY.NI-PY.NI)/PY.NI]*100	Rule of Thumb=Higher is better, comparing with previous years or industry average.
Total assets growth, %	[(CY.A-PY.A)/PY.A]*100	Rule of Thumb=Higher is better, comparing with previous years or industry average.
Total liabilities growth,%	[(CY.L-PY.L)/PY.L]*100	Rule of Thumb=Lower is better, comparing with previous years or industry average.
Net worth growth, %	[(CY.W-PY.W)/PY.W]*100	Rule of Thumb=Higher is better, comparing with previous years or industry average.

Note: CY=Current Year, PY= Previous Year, N=Net, S= Sales, A=Total Assets, L=Total Liabilities, W= Net Worth.

2. Profitability ratios

Name of ratio	Components of formula	Use
Gross margin, Composite %	(GP/Sales)*100	Indicates the efficiency of management in turning over the company’s goods at a profit. Rule of Thumb=25% to 30%, higher is better.
SG & A, %	(SG & A /Sales)x100	Rule of Thumb=Lower is better, comparing with previous years.
Cushion (GP-SG&A), %	{(GP-SG&A)/Sales}x100	Rule of Thumb= Higher is better
Depreciation. Amortization, %	(Depreciation/Sales)x100	Rule of Thumb= Lower is better
Operating profit margin, %	(EBITDA/Sales)x100	It is used to discuss the general profitability of the concern. Rule of Thumb=-20% to 25%, higher is better
Interest Expense, %	(Interest/Sales) x 100	Rule of Thumb= Lower is better.
Operating Margin, %	(Profit before tax & Extra income/Sales)x100	Rule of Thumb= Higher is better
Net Margin, %	(NP/Sales) x 100	This ratio is used to measure the overall profitability. Rule of Thumb= Higher is better.
Return on assets, %	(NP/Assets) x 100	It measures the profitability of investments. Rule of Thumb= Higher is better.
Return on Equity, %	(NP/Net Worth) x 100	Measures earning power of shareholders’ equity. Rule of Thumb= Higher is better.
Dividend payout rate, %	(Dividend /NP) x 100	Rule of Thumb= Lower is better to long term creditors.

Note: EBITDA= Earning Before Interest, Tax, Depreciation & Amortization, SG & A =Selling, General & Administrative Exp.

3. Coverage Ratios:

Name of Ratio	Components or Formula	Use
Interest Coverage	(EBIT/Total Interest)	This ratio shows how many times the interest charges are covered by EBIT. Rule of Thumb= Higher is better.
Debt Service Coverage	[EBITDA/(Total Interest + CMLTD)]	It reflects the company’s ability to serve long-term debt. Rule of Thumb=Must be greater than one.

Note: EBIT = Earning Before Interest & Tax, CMLTD = Current Funded Portion of Term Debts.

4. Activity Ratios:

Name of Ratio	Components or Formula	Use
Receivable in Days	(AR/Sales) x 365	Shows average number of days receivables are outstanding before being collected. Rule of Thumb= Lower is better. Should not more than 1/3^rd greater than the company’s term of sales.
Payable in Days	(AP/COGS) x 365	Indicates the average length of time trade debt is outstanding. Rule of Thumb=Higher indicates the creditors are not paid in time and lower shows that the business is not taking the full advantage of credit period allowed by the creditors.
Inventory in Days	(Inventory/COGS) x 365	Shows the average no. of days the inventory is held before it is turned into accounts receivable through sales. Rule of Thumb= Lower is better compare with previous years.
Sales to Total Assets	(Sales/Total Assets)	Shows how efficiently assets are used to generate sales. Rule of Thumb= Higher is better.

Note: Sales= Total Sales Revenue, AR= Accounts Receivable, AP= Accounts payable, COGS= Cost of Goods Sold.

5. Liquidity Ratios:

Name of Ratio	Components or Formula	Use
Working Capital	CA-CL	It is a measure of company’s liquidity position. Rule of Thumb= Larger is better.
Quick Ratio	Cash & Cash Equivalent+ Receivables/CL	Measures ability to meet current debts with most liquid (quick) assets. Rule of Thumb=1:1, higher is better.
Current Ratio	CA/CL	Measures ability to meet current debts with current assets. Rule of Thumb=2:1, higher is better.
Sales to Net Working Capital	Sales/Net Working Capital	Rule of Thumb= Higher is better.

Note: CA= Current Assets, CL= Current Liability.

6. Leverage Ratios

Name of Ratio	Components or Formula	Use
TL/NW	TL/NW	Indicates the extent to which debt financing is used relative to equity financing. Rule of Thumb=1:1, higher indicates less protection for lender.
Affiliate Exposure/NW,%	(Affiliate Exposure/NW) x 100
TL/(NW-Affiliates)	TL/(NW-Affiliates)

Note: TL=Total Liabilities, NW= Net Worth.

ABC Limited

Income Statement

Particulars	Amounts
	2006	2007	2008
	in (000) Taka	in (000) Taka	in (000) Taka
Net Sales	1,132	1,245	1,325
Less :Cost of Goods Sold	681	676	642
GROSS PROFIT/REVENUE	451	569	683
Less: Selling. Gen. & Admin. Expenses	37	44	47
TOTAL OPERATING PROFIT (EBITDA)	414	525	636
Less: Depreciation	287	362	436
Less: Interest Expense	13	13	14
PROFIT BEFORE TAXES & EXTR ITEM	114	150	186
Income Taxes	11	15	20
NET PROFIT	103	135	166
Reserve	23	29	36
Cash Withdrawals/Dividend	17	26	36
TOTAL CHANGES IN RETAINED EARNINGS	63	80	94

Balance Sheet

Particulars	Amounts
	2006	2007	2008
	in (000) Taka	in (000) Taka	in (000) Taka
CURRENT ASSETS
Cash/Bank Balances	7	33	147
L/C Margin	5	32	35
Fixed Deposits/Marketable Securities	0	40	76
Acc. Receivables-Trade	25	70	200
Inventory	88	88	90
TOTAL CURRENT ASSETS	125	263	548
FIXED ASSETS
Gross Fixed Assets	3,766	3,818	3,892
Less: Accumulated Depreciation	528	890	1,326
NET FIXED ASSETS	3,238	2,928	2,566
NON-CURRENT ASSETS
Due from Principal, Affiliate, & Investment	40	40	150
Deferred Charges, Pre-payments & Adv.	10	14	16
TOTAL NON-CURRENT ASSETS	3,288	2,982	2,732
TOTAL ASSETS	3,413	3,245	3,280
CURRENT LIABILITIES
Short Term Bank Borrowings	300	142	161
Current Funded Portion of Term Debt (CMLTD)	100	100	100
Account Payable - Trade	29	9	21
Accrued Items (Exp + Dues to Directors)	60	48	7
Provision for Income Tax/Def. I/T Liabilities	11	15	20
Dividends Payable	17	26	36
TOTAL CURRENT LIABILITIES	517	340	345
LONG TERM LIABILITIES
Term Loan	1,450	1,350	1,250
TOTAL LIABILITIES	1,967	1,690	1,595
NET WORTH
Paid up Capital	1,250	1,250	1,250
Retained Earnings	100	180	274
Reserves	96	125	161
NET WORTH	1,446	1,555	1,685
TOTAL LIABILITIES & NET WORTH	3,413	3,245	3,280