Financial Ratio Analysis

Manu

Hi Vinu, Why are looking sad?

Vinu

Manu, Yesterday I’ve gone to the Commercial Bank where our Company has various loans.

Manu

Ok

Vinu

Credit Officers in the Bank have thrashed me into pieces!  

Manu

 Why, what happened?

Vinu

They just took our Company’s Balance Sheet, scanned them for 5 - 10 minutes and said

- Our Company is not doing well;

- We are having liquidity problems and won’t pay short term creditors on time;

- Our Assets are not utilized effectively (how do they know?);

- We are highly leveraged (which of course, I didn’t understand);

- We are going to face severe problems in the downturn (how they can say that?);

- We may have to book huge losses, if certain cases go against us;

And hell a lot….

Manu

Be Cool Vinu…

Vinu

When they said,

a) We are having liquidity problems and won’t pay short term creditors on time;

I thought some of our creditors would have told them.

b)Our Assets are not utilised effectively

I thought how they know this even without seeing our assets?;

c) We are highly leveraged!

I thought what the hell that was?

d) We are going to face severe problems in the downturn

I thought how they can say that?;

e) We may have to book huge losses, if certain cases go against us;

I thought who gave them details about our cases??

Manu

Ohhh…!!!

Vinu

I was wondering how they can say all these in just 5-10 minutes just by reading Balance Sheet?

Manu

Vinu! If not for answering all these, then for what purpose Balance Sheet – aka- Financial Statements are prepared?

Vinu

I am sorry Manu. I couldn’t understand.

Mau

Vinu! Please understand the very purpose of preparing financial statements is to provide information like these to the stake holders.

Vinu

But I have also read the Balance Sheets. I have never seen these stuffs in Balance Sheets.

Manu

It means, you have NOT understood Financial Analysis.

Or, I would say, you don’t know how to read Balance Sheet

Vinu

Manu, please don’t say that. In Accounting papers, always I have been correct in preparing Financial Statements. Always my Balance sheet will tally and I used to score good marks too….L

Manu

But, that is Accounting!!!

Vinu

What?

Manu

Yes! That is Accounting. There your focus is preparing Financial Statements by following Generally Accepted Accounting Principles and Practices.

By being an Accountant you will focus on Accounting Procedures, Presentations, Disclosures, etc.

But, what for these all?

Vinu

Yes? What for these all?

Manu

It’s all for reading by stake holders.

Stake holders like Investors, Lenders, Creditors, Employees, etc. are going to read your Balance Sheet.

They read your Balance Sheet to assess your Company!

They read your Balance Sheet to understand risk involved!

They read your Balance Sheet to understand your

- Efficiency;

- Cash generating capacity;

- Profitability;

- Liquidity;

- Solvency;

- Return on Investments;

- Debt Repayment Capacity;

- Owners Contribution to the Business;

- Extent of dependence on Outsiders for running your Business;

- Income which you make from your Operating and Non-Operating Activities;

- Expenses incurred on your Operating and Non-Operating Activities;

-Litigations;

-Future directions;

Vinu

OMG!!!

Manu

Yes Vinu!

You know, there is a saying called “Face is the Index of the Mind”

In case of Business Entities, Balance Sheet is their Face.

Vinu

Agreed!

How I can develop Balance Sheet reading ability?

Already I know, how to prepare Balance Sheet. Will that be sufficient?

Manu

Vinu! Actually for reading Balance Sheet, you need not be an Accountant.

Imagine from those Bankers point of view.

Most of them would be Non Finance Executives may be even Engineering or Science graduates.

But they were able to read your balance sheet and tear you into pieces.

How did this happened?

It’s because, they have developed their skill to read Balance Sheet.

Vinu

Skill?

Manu

Yes! Balance Sheet reading is a skill which any one can develop through practice.

Vinu

Oh…

Manu

There are various Financial Ratios which will help you to read the Balance Sheet.

Vinu

Is it?

Manu

Yes! But before I explain you Ratios, let’s understand why we should use ratios for reading balance sheet. When I say Balance Sheet, it includes Profit and Loss also. Ok?

Vinu

Ok!

Manu

Let’s assume, there are two companies A Ltd and B Ltd and each report profit of Rs.10 Cr and Rs.5 Cr respectively.

Vinu

Ok.

Manu

If you have some cash for investment, in which company you will be investing. Would it be A Ltd or B Ltd?

Vinu

Hmmm....A Ltd makes more profit than B Ltd

So, I’ll invest in A Ltd.

Manu

Fair enough…

But what will be your decision, if A Ltd reports sales of Rs.100 Cr and B Ltd reports sales of only Rs.20 Crs.

Vinu

Let me tabulate that first.

I think I should change my mind.

Manu

Why?

Vinu

On look A Ltd’s profit is good. But, if i look at the profit margin of A Ltd, it is only 10% whereas B Ltd has a Profit margin of 25%.

Manu

Wow…how did you found that?

Vinu

I just compared profit with sales and expressed it in percentage. Like this

Manu

Perfect.

You compared Profit with Sales.

This comparison helped you to form a new ratio called Profit Margin.

And Profit Margin helped to you to take a correct decision.

I am saying correct decision, because, previously you selected A Ltd as Investment option, when you just had information about Profits.

But, when you derived a ratio called Profit Margin, you were able to make meaningful analysis and select the best one.

Vinu

True!

Manu

Whenever you derive ratios, you have to ensure, you are comparing only meaningful numbers.If you do so, the derived ratio will be meaningful and it will help you to understand various financial aspects.

Vinu

Really? I am thrilled to compute more ratios. How many ratios are there?

Manu

Hmm….Sometimes it is even left to our creativity.

But I’ll teach you the ratios which are widely used in the industry.

Vinu

Ok.

Manu

Broadly ratios can be categorised into four categories.

Vinu

Ok

Manu

They are

a)  Liquidity Ratios;

b)  Capital Structure / Leverage Ratios;

c)  Activity Ratios;

d)  Profitability Ratios.

Vinu

Ok.

Manu

First, let’s start with Liquidity Ratios.

Vinu

Ok. Why we have to find liquidity ratios? I mean, what’s the purpose?

Manu

It’s basically to know whether you have adequate liquidity!

Vinu

Liquidity means?

Manu

Hmmm….Liquidity means, whether you have adequate short term resources to pay your short term obligations.

Vinu

Can you make it little simpler?

Manu

Ok…Liquidity means, you are not strained to meet your obligations. i.e., you have more resources (can be current assets) and less obligations (current liabilities)

Vinu

Ok..ok..Understood!

Manu

So, through liquidity ratios, basically we would try to understand how comfortable the liquidity position of the business.

Vinu

But, why so much stress on liquidity?

Manu

Vinu! It’s really dangerous to have stressed liquidity position.

Let whatever be the Networth of your Business.

If liquidity is not managed, then even God cannot save that business?

Vinu

 Don’t be joking!!!

Manu

True Vinu!

Let me give you a real example!

I have seen a company which was set up at a cost of Rs.75 Crs some 15 years back.

Vinu

Ok.

Manu

Do you know, how they arranged this Rs.75 Crs?

Vinu

You have to tell meJ

Manu

Vinu

Ok

Manu

The grave mistake done by the company is arranging Rs.2 Crs of Short Term Funds for funding their long term project.

Vinu

Why?

Manu

This company would break even only after 3 years. But they have to repay short term loan of Rs.2 Crs within one year.

So sadly, this company couldn’t repay that short term loan.

Vinu

What happened then?

Manu

Short term lender has approached the court for liquidation of the company and pay back the loan.

Vinu

My God!

Manu

Court passed liquidation order and for the past 15 years, litigation is going on with no operations in the company.

Why did all these happened?

Vinu

Because, they could not pay their short term lenders.

Manu

Yes! They are the most dangerous lenders and they have to be handled very carefully failing which they will ensure our business don’t continue longer.

Hence, the importance of Liquidity Management and the liquidity ratios.

Vinu

I got it.

Manu

There are many ratios in Liquidity. But ill confine to four ratios now.

Vinu

Ok.

Manu

They are

a)  Current Ratio

b) Quick Ratio

c) Cash Ratio

d) Defence Interval Ratio

Vinu

Current Ratio we have already discussed.

Manu

Yes Vinu.

It will be available in this link

/articles/analysis-on-current-ratio-23048.asp#.VTc860a7jYk

Vinu

What is Quick Ratio? Or Why we should calculate Quick Ratio?

Manu

That’s a good question. Why we should calculate Quick Ratio when we already calculate Current Ratio.

The answer is “Quick Ratio is an extension of Current Ratio”.

Sometimes, mere dependence of current ratio will be misleading.

Vinu

Why?

Manu

Let’s say, you have current asset of Rs.100 Crs and Current Liability of Rs.50 Crs.

Vinu

Ok

Manu

Can you calculate Current Ratio?

Vinu

Yes! It’s very simple.

Current Ratio = Current Assets / Current Liabilities

                         = 100 /50

                         = 2 Times

Manu

Great! What does it communicate?

Vinu

I have resources twice that of obligations. I should be happy.

Manu

Fine. Let me give break up of your current assets and current liabilities and let me see whether your happiness continues!

Vinu

What’s wrong in this?

Manu

You have to pay Rs.50 Crs to Sundry Creditors. i.e., your suppliers – right?

Vinu

Yes!

Manu

What are the resources you have?

Vinu

Manu

How much you can pay immediately to your suppliers?

Vinu

Hmm...Rs.10 Crs (Cash and Bank Balances)

Manu

You can also pay another Rs.15 Crs, if you are going to realise your receivables.

Vinu

Yes.

Manu

So, you can pay Rs.25 Crs quickly. But still, you may have to pay another Rs.25 Crs to settle Rs.50 Crs obligation.

Vinu

Yes!

Manu

What resources you have to pay that?

Vinu

Inventory of Rs.75 Crs.

Manu

 Will you return back Inventory of Rs.25 Crs???

Vinu

Hmmm…..i may not be ….because I need inventory for sales.

Manu

Yes! Your inventory may be in various forms.

If it is in the form of Raw Material,

-then it has to be consumed in the production process,

-converted into finished goods,

-customer should be identified,

- sales have to be made, and

- if it is credit sales, you won’t get money immediately.

All these would take time!!!

Vinu

Yes! I understand.

Manu

So, understand, Inventory, though it is a current asset, it is not a quick asset.

Vinu

True.

Manu

But many of your current liabilities may be quick liabilities. Though not separated.

Vinu

Ok!

Manu

So, this is the reason to find Quick Ratio.

i.e., Find out the quick assets out of your current assets.

Vinu

By subtracting Inventory from Current Assets?

Manu

Yes. Also subtract Prepaid Expenses. Because, it is already paid and it will only reduce future accounting expenses.

Vinu

Ok.

Manu

So Quick Assets is equal to…..

Vinu

I’ll do it.

Quick Assets = Current Assets – Inventory – Prepaid Expenses

Manu

Good! How would you compute Quick Ratio?

Vinu

Quick Ratio = Quick Assets / Current Liabilities

Manu

Good.

Vinu

How Quick Ratio should be?

Manu

For that, answer me, how current ratio should be?

Vinu

Current Ratio should be at least 1.33. Meaning, Current asset should be at least 1.33 times of Current Liability.

Manu

If Current Ratio should be at least 1.33, then Quick Ratio should be at least 1 Time. i.e., Quick asset should be at least equal to current liability.

Vinu

Yes! That makes sense.

Current assets should be greater than current liability but quick assets should be at least equal to current liability so liquidity position can be managed.

Manu

Sometimes Quick Ratio  is also calculated as

Quick Assets / Quick Liabilities.

Vinu

Quick Liabilities?

Manu

Yes! Out of Current liabilities, certain liabilities may not be quick. They are almost permanent liabilities.

Vinu

Like?

Manu

Like Bank Overdraft / Cash Credit?

Vinu

Really?

Manu

Yes! Because, you can pay them and re-avail immediately. So, those limits will roll after continuously if you have credit sanction in place.

Vinu

Ok!

Manu

In such cases, Quick liabilities are calculated as

Quick Liability = Current Liability – Bank Cash Credit – Bank Overdraft

Vinu

And Quick Ratio is calculated as

Quick Ratio = Quick Assets / Quick Liabilities

Manu

Yes!

We shall move on to the next ratio.

It is Absolute Liquidity Ratio.

Vinu

Ok.

Manu

This ratio is calculated to know absolute liquidity position of the company. i.e., if all the current liabilities have to be settled immediately, what are the cash resources available?

Vinu

Ok.

Manu

In such cases, you cannot expect stock and receivables to convert into cash immediately.

Vinu

Ya.

Manu

So, for calculating Absolute Liquidity Ratio, you should find absolute Liquid Assets.

Vinu

What are they?

Manu

They should your

a) Cash and Bank Balances

b) Marketable Securities.

c) Short Term Securities.

Vinu

Ok.

Manu

These resources should be compared with current liabilities.

Vinu

Do we have any standard or bench mark ratio for this?

Manu

There is no standard ratio as such. But if you have ratio like 1:1 or 1 Time, it would indicate you carry too much of cash resources.

Vinu

But what’s wrong in that?

Manu

You are carrying idle resources which are not going to generate any revenue for you but would only incur cost.

Vinu

Yes!

Manu

So, this ratio would depend upon the circumstances.

Vinu

And the formula?

Manu

Forgot to give that.

Absolute Liquid Ratio = (Cash + Marketable Securities) / Current Liabilities

Vinu

Fine. What was that fourth ratio?

Manu

It is Basic Defence Interval Measure.

Vinu

When we will use this ratio?

Manu

We can use this ratio for two scenarios.

One to know, how long the company can manage its operations when it is in the stages of winding up.

Two, it can also be used to measure the ability to meet cash expenses.

Vinu

Can you make it little clear.

Manu

Ok. Actually, this ratio is expressed in number of days. It would let us know, how long we will be able to manage our cash expenses with available cash resources.

Vinu

Oh…How do we calculate Cash Resources?

Manu

It’s nothing but Quick Assets.

Vinu

And what are the Cash Expenses?

Manu

It can be your Total Expenses adjusted for Non-Cash Items.

Vinu

Like?

Manu

Depreciation / Write offs etc.

Vinu

Ok. So, how do we calculate this ratio?

Manu

First, you have to find Cash expenses per day.

Vinu

Cash Expenses per day = (Total Expenses – Non Cash Expenses) / 365 days

Is that right?

Manu

Yes! Very much.

Vinu

What’s the formula for Basic Defence Interval Measure?

Manu

Basic Defence Interval Measure = Quick Assets / Cash Expenses per day.

Vinu

Ya! I can understand.

So this ratio says, how long we can manage our cash expenses with available quick assets. Good. It is also a great tool for management for plan their cash flows.

Manu

Yes Vinu.

Vinu

Who will be basically using these Liquidity Ratios?

Manu

That’s a good question.

Lenders and Creditors would checking these ratios of their customers or prospective customers. Because, they generally come under current liability category, and if these liquidity ratios are going to be weak, it’s a warning signal for them.

Vinu

Yes! Yes! What are the other ratios to be discussed?

Manu

We have to cover

b) Capital Structure / Leverage Ratios

c) Activity Ratios

d) Profitability Ratio

Vinu

Will do it now?

Manu

No Vinu!

It would become heavy now! Let’s take some time and do it little later.

Vinu

Ok! Shall wait :-)