 Dear students, in our last session, we had started the discussion on analysis of financial statements. . To recap, in few minutes, which are the important financial statements, do you remember? One of the important statements is balance sheet, it gives us the financial position as on a particular day, there is another important statement known as P and L account, profit and loss account tells you about incomes, expenses and the profitability. Then we have also seen learned cash flow statement, which tells about the flows inflows and outflows of to and out of an entity. Though this financial statements are very important and they give lot of data, it remains as a raw data largely, because we do not actually get relevant information from the view point of a particular stakeholder. Let us say you are an equity shareholder, you may like to know how much are the profits available to me on my share, you may like to know what are the future prospects of the company. So, there is a banker, banker may be interested in knowing how much are the likely the chances of default in repayment of my loan. So, for getting such relevant information, it becomes very important to analyze the financial statement and exactly get what you want and that is what we are learning when we are learning interpretation and analysis of financial statements. In our last session, we have discussed comparative and common size statements, which are the tools for vertical analysis and horizontal analysis. Then we are also done some study of ratios and also applied it in a real life situation. Today, let us learn few more ratios, which will be followed again by some practical cases. Let us have now a recap of some ratios, which we have done last time. As we seen last time, ratio is essentially a relationship between the two items. So, here you can see profits and sales. To calculate net profit ratio, we try to find the relationship between these two items. I will skip this, because we have done it last time. Then we had seen that there are variety of ratios, but important ones are liquidity ratios, capital structure ratios, activity ratio, profitability ratio and return ratios. This is about the liquidity ratios. One of the most important liquidity ratios is current ratio, which is a relationship between current assets upon current liabilities. You all know what is current assets and what is current liability. So, this ratio helps you to find out. Because the company has enough current assets to pay for its current liabilities. So, the first important ratio for liquidity is current ratio. There is another important ratio that we have seen again last time, that is known as quick ratio, asset test ratio, it is sometimes also called as a liquid ratio, which is a relationship between current assets and current liabilities. Now, this is more specific measure and tries to measure whether company has enough money to pay for its day to day liabilities. The next one is capital structure ratio. Now, in liquidity ratios, we were trying to find whether company can pay its immediate liabilities. In case of capital structure ratios or leverage ratios, we are looking at the long term solvency of the company. So, whether company can survive, sustain for a long time. So, we try to find the relationship between the equity funds or the owners funds of the company to the loan funds. So, one of the important ratio, again we have seen it last time, is a equity ratio where we find the shareholders equity upon total capital employed. So, we try to see what percentage of the total funds are financed by the owners. Now, if this ratio is high, what does it mean? So, if the ratio is high, it will mean that good amount of funds are financed by the owners, which means that company does not have to too much depend or too much worry about repaying the outsider's liabilities. So, it increases the longevity of the company, it increases the long term solvency of the company. Opposite to this, there is another ratio known as debt ratio. This tries to calculate what percentage of funds are financed by debt. So, here again what will happen is, if this ratio is high, it will increase the financial risk of the company. However, a high debt ratio provides the benefit of leverage. In a sense that company will be able to expand fast, because it is getting the debt funds. It will also be able to increase its profitability. So, a reasonably high debt ratio could be good, but if it is too high, then the risk levels really go high. There is third ratio, debt equity ratio, wherein which we try to see the debt funds to equity funds. There are also ratios, which try to see the capacity of the company or entity to repay its loans or to service its debt, known as debt service coverage ratio, where we look at the earnings, which are available for debt service divided by interest plus installments due. There is also another ratio, which is known as interest coverage ratio, which tries to look at the capability to repay the interest. So, it is EBIT upon interest. In the same manner, there is also ratio, which tries to find the funds available for payment of preference dividend. So, it is earnings or profit after tax divided by preference dividend. There is also important ratio known as capital gearing ratio, which is very similar to debt equity ratio, where we are trying to find the total money on which there is a firm liability to repay either the installment or the interest. So, preference capital plus debt funds or debentures divided by equity shareholder's money. So, this is the capital gearing ratio. Then the next type of ratios, where are the activity ratios? If you remember, in our last session, we had come up to activity ratios. These are also known as profitability or turnover ratios. The first one amongst them is capital turnover ratio, where we try to find how many times the sales are generated vis-a-vis the capital employed. So, it is sales upon capital employed. Should this ratio be high or low? Naturally, this ratio should be higher. It indicates that the entity is efficient. It is able to generate more sales by using the same amount of capital. Same way, you also have fixed asset turnover ratio, which relates sales to capital assets or the fixed assets. So, if the company is able to generate more and more sales using the same amount of fixed assets, it shows the effective utilization of fixed assets. Let us take a simple example. If you assume that you have a relatively small retail shop, which has, let us say, makes a sale of 50 lakhs in a week. There is another large size mall. It keeps lot of stock. It has a big size of showroom that also makes sale of 50 lakhs. Then, which is more efficient? It is common sense that a small shop, even with small capital asset size, if they are able to have a sale of 50 lakhs, it shows their efficiency. So, we are trying to relate the turnover generated vis-a-vis the capital employed or capital assets used. We can also look at the working capital turnover, which is sales upon working capital is tries to see how efficiently the company is able to use its working capital. It can be further subdivided into the use of inventory, debtors and so on. So, you have an important ratio, inventory turnover ratio, which shows the efficiency in use of stocks or the inventory. Since the stocks are at cost, usually we take cost of sales in the numerator divided by average inventory. If you do not have cost of sales, you can use the sales figure and divide it by average or closing inventory. This will tell you how efficiently the stock is being managed. Inventory turnover ratio can also be looked from another angle. We can convert it into stock holding period, which tries to calculate how many days of inventory an entity is keeping, which can be compared with the policy. So, that we know whether the stock policy is being added to and overall also we know how much of inventory the company has accumulated or company needs for day to day use. Similar to inventory turnover ratio, there is debtors turnover ratio or it is also known as receivable turnover ratio, which tries to relate sales vis-a-vis average accounts receivable. The ratio again can be converted into debtors velocity, which is exactly the opposite of it, which tries to find the debtors upon sales into 365 or 12 if you want in months. So, what it tries to do is, we try to find how many days of receivables an entity has. Again, we will try to see how does it compare with the policy and every entity will try to reduce the time of the debtors velocity, because company wants to recover the debts or the receivables as fast as possible. On the same lines of debtors, we also have creditors turnover, which relates credit purchases to account payable. So, here we are trying to see how many days of credit an entity is able to get from its supply. This ratio also can be converted into number of days, which is known as greatest velocity. Now, the next important types of ratios are profitability ratios. So, every stakeholder practically from the owners, bankers, employees, they are all interested in profitability. So, profitability ratios try to find how much is a profit earned by the company vis-à-vis the sales generated. So, one of the important profitability ratio is net profit ratio. It tries to find net profit after tax as a percentage of sales. You also have a gross profit ratio. Again, it links gross profit to sales. On the same lines, you also have operating profit ratio. It tries to link operating profit to sales. Now, there is the fifth category known as return ratios. These are also profitability ratios, but here profitability is computed not in relation to sales, but it is computed in relation to the capital used. So, the first ratio in this category is return on equity. Here, we are trying to find on the money of the equity shareholders. That is the net worth. What is the percentage return the company is able to earn? Now, the profit available to equity shareholders is nothing but the profit after tax. So, we take profit after tax and divide it by net worth or owner's funds to get return on equity. The second ratio in this category, which is little more broad based is return on capital employed. It is also popularly known as ROI or return on investment. So, it tries to measure return as a percentage of capital employed. Here the return relates to not profit after tax, but profit before tax. We also add back interest and we make adjustment for non-trading incomes. So, if there are non-trading incomes, which are included in profits, they will be removed because here we are interested in knowing what is the level of return the business or the operations are able to generate. So, here in the numerator, we try to look at the profit or the returns received on operations divided by the capital employed. I hope you know what is capital employed, wherein we take both the types of funds that is equity shareholders funds, preference share, capital plus long term debt and we also minus non-trade investment. So, the logic of this ratio is we are trying to find what is a percentage of return on the capital used in the regular business. This ratio is very important, so I am explaining you for little more time. So, if one company wants to acquire another company, then one of the important criteria will be what is a ROI of that another company. Same way, if a particular entity is trying to evaluate its capital projects, it wants to take a number of projects. Again ROI plays a very important role, because everyone would like to know what is the likely return to be earned on the money invested in this new project. So, again ROI plays a very important role. There is also one more way to calculate ROI. As we have seen here, ROI is basically return upon capital employed. It can be broken down into two ratios. You have already have a profitability ratio. If you multiply it by capital turnover ratio, then you get ROI. This hints us that ROI can be improved in two ways. One is you improve operating profit, that is you increase the margin which you earn on your sales or you improve the capital turnover. That is you try to generate as much more sales as possible by using the same resources and of course, by doing both the things. Because both the things can go hand in hand, you also try to improve the profitability and parallely try to increase the sales which will give a higher ROI. There is one more return ratio also that is known as return on assets, where we are trying to find the profit generated by the use of fixed assets. So, it is NPAT upon average fixed assets. One more ratio could be earning per share. Now, this is not exactly linking it to capital, but it is very important ratio because equity shareholders will be very keen to know how much profit they are getting per share. So, net profit available to equity shareholders which is generally NPAT divided by number of equity shares. This gives us EPS. There is another very important ratio especially from stock market angle that is known as PE ratio, price earning ratio which tries to link the market price per share to earning per share. This ratio is extremely important because it links the profitability that is EPS to the stock market prices. So, this gives what is the expectation of the equity shareholders from a company. Now, will it be good to have high PE ratio or it is not so good to have high PE ratio. Now, here it is an interesting observation. What happens is if PE ratio high, it means that company is commanding good respect, good premium in the market. Investors are willing to buy its earnings at a higher multiple or they are willing to pay a higher price for a certain level of EPS which means that company has respect in the market. But if you are looking at yourself from the investor, then if you sit in the investor seat, too high PE ratio may indicate that these shares are very costly. It may not be it may not make a good purchase. So, we have to see from which angle you are looking to judge whether high PE is good or low PE is good, but generally high PE indicates the goodwill of the company. Just as we have found EPS, there is also another major that is known as DPS or dividend per share which tries to relate the dividend distributed to number of equity shares. So, these were all the return ratios of this EPS and PE are one of the most important. If you look at any business newspaper or even ordinary newspaper, many times you will see that market prices are quoted and PE ratios are quoted because that is where you link this market price to the performance or the profit of the company. So, we have finished our discussion on the ratios. You would have understood that this is a very important major. It can be used for variety of purposes like growth potential, risk factors, liquidity, profitability, corporate image and so on. So, the ratios can be used to judge the performance of say entity A. They are also useful to compare with the past performance of the same entity or they can be useful for comparing the performance with another entity. So, you can compare A limited with B limited or with the industry average. That is why ratios become one of the most important tools for financial statement analysis because they are very flexible. You can calculate hundreds and thousands of ratios, but I have tried to show some of the important ratios in this presentation. However, I will request you that you can find different relationships. You can take up a balance sheet or P and L account of any company. Try to find out the relationship within the same statement or with one statement, figure with another statement and then that those ratios can be compared with the different company, same ratio of different companies. That will give you lot of insight into the functioning of the company. So, I think we have discussed a lot on ratios. Now, let us look at real life case. Now, this is the financial position of Patni. I hope it is visible to you. This is the balance sheet of Patni computer systems. Profit and loss account, some important data is also given and we have been asked to calculate certain ratios which we have already learned like current ratio, quick ratio and so on. I have not shown any formulas here. Let us try to look at the figures and try to calculate each of the ratios. After that, I will request you to have a look at the balance sheet first, make a overall judgment about the company and then we will go into calculation of detail ratios. So, what do you observe by looking at the balance sheet, prima facie? You can see here that company has very less dependent on, company is very less dependent on loans. It is almost fully financed by its equity, which is the case for many of the software companies. If you look at the assets, you will realize that inventories are 0, again because it is into services. You will also realize that net current assets are also very low, they are only 92. Investments are relatively a high figure. So, company it looks like has a lot of excess cash, it is investing it in various investments. Also look at their profitability record. Now, after this broad view of the financials of the company, let us try to analyze in detail by going for the ratios. So, here certain ratios are given, the first one is current ratio, now how to calculate current ratio? Anybody remembers the formula for current ratio? Because we have seen in the last session, what and even today we have done a little bit of revision. So, current ratio is essentially a relationship between current assets versus current liabilities. You can see here, this is the figure of current assets of the entity and we are trying to, we are going to relate it with the total CL and provision. Do not take only the figure of current liabilities that is 535, because provisions are also a part of current liabilities in a broader sense. That is why, total CL plus provision this 940, we have to divide by 832, are you getting me? I am just going slowly, please try to solve it along with me. So that you will really understand, how we can calculate the ratios. So, in current ratio, I am going to relate current assets and divide it by current liabilities. So, you get this ratio, I will just reduce the number of decimals to make it readable for all of us. So, 1.12, so what does it mean? Is it a good ratio or bad ratio? It is a reasonably good ratio, because at least it is above 1, but it is not matching the standard of 2 is to 1. Of course, for a software company 2 is to 1 is not true, because they do not have any inventories. So, 1.12 could be good enough for them, we can just take it to the next column to get the ratio for the next year, which is 1.41. So, you can see there is an improvement in the current ratio. Have a look at the figures, you will find that the net current assets are almost doubled. And if you look at the current assets, you will realize that loans and advances have increased, cash balance have also increased. And the sundry daters have reduced, which is a good sign. That means, it is not that unnecessarily there is a accumulation of daters. The daters have come down, despite that they have improved their current asset, current ratio. So, it is a very good sign, it shows good liquidity position instead of good I think I will specifically say improvement, that will make better sense for everyone. So, there is an improvement in liquidity position, as you can see. Now, let us try to go for the next ratio, next ratio they have given quick test. What is the formula for quick test? I will try to write the formula also for your benefit. Do you remember, quick test or asset test or quick ratio or liquid ratio? It is essentially a relationship between quick assets upon quick liabilities. So, quick assets are more or less same as current assets. However, we do not include loans and advances, we also do not include stock. So, have a look now, which are the quick assets of this, inventory is anyway non-quick, but it is 0. Daters are a quick asset, I will just mark it as Q. Cash balance is definitely a quick asset, loans and advances are generally not treated as quick assets. So, these two are quick assets, we will mark them as QA. Now look at the liabilities, usually both current liabilities and provisions are treated as quick. So, we are going to take their total as Q L. So, essentially it is a linkage of this plus this, that is daters plus cash upon the total current liabilities and provisions. So, let us try to calculate. So, this is a total of current assets, we will divide it by quick liabilities. So, you get 0.89, next year if you drag you will get 0.91. So, what does it show, it is a good position, not much of a change. So, we can say good, this is known as short term solvency, I am sorry this can better be called as liquidity and current ratio we will name it as short term solvency. So, current ratio we will say improvement in liquidity or short term solvency and quick test shows good liquidity position, actually many times they are used interchangeably, but quick test focuses on more on liquid assets, whereas current ratio looks at a period of say 6 months to 1 year position. So, it could be known as short term solvency or liquidity. So, first 2 measures we are looking at the liquidity position of the concern. Now the third one they have asked for EBIT percent, it is also known as operating ratio. So, how do you find, I will just specify for your benefit. So, we are trying to look at the EBIT, so it could be find found as a bit upon sales. So, we are essentially trying to find whether what is a percentage of profit available on the sales generated, look at the profitability indicators. So, we see that PBIT is 487 and sales turnover is 1541, so we will divide PBIT upon sales and generally we multiplied by 100, because we want in percentage terms. So, we get 31.6, so what does it show, it is a good position companies and earning a good amount of profit on its revenues, we will drag it to next year, we will get we are getting 35 percent. So, the profit ratio is really very good and it has further improved, so you can say that very good profitability and has improved further, making sense to you. Now, what is very good we do not know, but definitely more than 30 percent is a good profitability margin for the company. Now, the next one is net profit margin also known as NPM, sometimes it is known as net profit ratio. So, what do we link in net profit ratio, we essentially try to calculate net profit as a percentage of sales. So, we will take net profit, here we generally take net profit after tax, so 25 percent, current here there is a significant improvement it has become 31 percent, remember this is after tax. So, even after paying tax they are able to earn as high as 25 percent margin on their sales and further it has improved to 31 percent. So, same remark will continue that very good profitability position, I think last time I have skipped that word very good. So, I am trying to say a very good profitability position again has improved further. So, both EBIT and NPM are trying to measure profits. However, EBIT looks it at operating level NPM or net profit margin gives you the final profitability. Next one is return on capital employed or return on investments popularly known as ROCE or ROI, here we are trying to see how much is a percentage of profit earned on the money invested in the business. So, what is a formula what we would try to link, so we are essentially try to link the PBIT which is a profit before interest and taxes to capital employed. So what is capital employed, it is a total of debt fund plus owners funds in 200 because we want in percentage. So, look at the liabilities now for capital employed and look at profitability for the profits. So, we will pick up PBIT and divide it by the total sources of funds that is net worth plus debt and multiply by 100 because we want in percentage terms. So, 19.34 percent is a profitability and if you see the current year it is almost stable it is 19.06 again a very good return about 20 percent return they are able to earn. So, the remarks are similar very good profitability and improvement instead of profitability I will say return. Everything is there is no further improvement, so company is able to earn a reasonably good amount of return. The next is ROTA return on total assets, so here we are trying to find the profitability or the profit generated by the use of total assets. So, we can link it either to net profit or we can link it to profit at operations it is more logical to do it with profit at operations that is PBIT divided by total assets that is TA. So, PBIT let us go up for more clarity PBIT you know is 487 look at the balance sheet what will be the total assets keep in mind it is not this total of 25818 it is a total of net block working capital investments plus total current assets. In other words we will not deduct current liabilities which are already deducted for this calculation are you getting clear. So, all assets are added, but we will not deduct current liabilities. So, we will not take this figure we will take the total of all assets let us try to calculate. So, in the denominator you want some total, so we are going to take, so net block plus capital WIP plus investments plus total current assets loans and advances. This is just the total amount this I will put in bracket and in the numerator what we want is capital employed sorry in the numerator we want PBIT. So, now you can see it is PBIT divided by total of all these assets we multiply by 100 because we want in percentage terms. So, you get 14 percent are you getting this is slightly less than return on capital employed because in capital employed also it was PBIT in the numerator, but we divided by the long term funds here we are dividing it by the total of assets. So, in the current year it has improved slightly it has become 16.55. So, again I will repeat the earlier remarks. So, there is a very good return and it has improved further I hope you are all getting me and agreeing to what I am saying is it ok. Now, let us go to the next ratio that is return on equity here we are trying to link the profit to the owners fund. So, what should be the formula in the numerator now I will not take PBIT I would rather take PAT or profit after tax and divide it by net worth. You know net worth is nothing but the owners fund or equity as it is called. So, this is PBAT that is 387 divided by the total of net worth in 200. So, 15.46 percent again it is a good return the current year it has increased slightly to 16 percent are you getting. So, 389 on the net worth. Now, why has this return though it is a very good return you can see it is less than ROCE why has it fallen from 19.34 to 15.46. You will observe that the denominator is more or less same capital employed and net worth there is no difference. But numerator earlier was PBIT now it is PAT since company is paying some amount as taxes PAT is lesser slightly than PBIT company does not have any debt. So, capital employed and net worth are more or less same, but the profit in the numerator has gone down now that is why there is slight less return. But still it is a very good return because 15.46 percent after taxes does show an hefty return on owners funds. The next ratio is EPS or earning per share. So, what is the formula for EPS? We essentially try to find how much profit is available per share. So, in the numerator we take PAT profit after tax which is the profit available to the owners and divide it by number of shares. So, number of shares actually tell you how many shares are there in the company and we take the total profit and distribute it to every share. So, you can take NPAT again and divide it by equity capital. Now, exactly we do not know the number of share, but if we assume that each share is of 1 rupee whatever is a equity share capital same will remain the number of shares. So, we are dividing by equity share capital. If you know the number of shares you will take that in the denominator. So, you can see more or less it is same. If you go up you will realize that capital has increased from 26 to 38, but since company could increase its profit also 389 to 543. So, more or less in the same proportion there is an increase in the profit as the number of shares have increased or the share capital has increased. So, more or less a same return. So, I cannot say whether it is good or bad, but for every share of the company you will receive about 15 rupees of profit that you get from EPS. Now, we will look at the asset turnover. So, what is the formula for asset turnover? This ratio tries to find how efficiently the assets are being used. So, we will try to link sales to total assets. So, you already know the sale turnover which is going to be the numerator for all turnover ratios and we will look at the total assets. Now, in the last formula we have we had actually calculated the total assets, but now we will have to recalculate it. So, total assets are going to include the net block plus capital WIP plus investment plus total current assets. So, B 31 that is sales divided by all these items. So, you can see that total assets are about 3000, sale generated is 1500. So, you get a ratio of 0.47 which is not a very high ratio. So, company is comparatively using large assets to generate lesser sales, but since the profitability is very good it is not bad. In the current year also same ratio is maintained because again as the sales have increased in the same proportion as assets we get the same ratio. So, it is not really a very good ratio. So, we will say ratio appears to be low showing less efficient use of assets. So, if the ratio is more it would have mean meant that there is more efficient use of asset. Now, look at the accounts receivable turnover. So, here we try to link the sales to receivables or the daters. So, sales is 1500 and daters are almost 600. So, the ratio is 2 times. So, now you get the ratio of 2.76. If you see the current year there is a significant improvement to 5. Why it has happened? Have a look at the balance sheet you will realize that company was able to reduce its daters though it could increase its sales. That is why the ratio of account receivable has nearly doubled, but still it is not so high. So, I will say ratio appears to be low. So, ratio appears to be low though it has improved significantly because you see a double growth in the ratio. Now, let us look at the average collection period. When you look at both the ratios together you will realize why I am saying it is not so high or it is low. What is the formula for average collection period? I will just write the formula for daters also I think for more clarity. So, in daters turnover it was sales upon daters that is account receivables. In case of collection period we are going to do exactly reverse. So, we will take daters in the numerator and divide it by sales and multiply it by 365. So, that we get it in terms of number of days. So, it is sales sorry it is daters upon sales turnover into 365. So, you get it 132. So, what does it show? It shows that in terms of number of days company is giving a credit of 132 days that is more than 4 months or you can say it takes more than 4 months to collect its dues which is not a very good sign that is what was reflected in a low account receivable turnover. So, you will realize that company needs to improve fast into its recovery. If you look at the current year it has significantly come down to 71. So, it is just more than 2 months now. So, there is a good improvement in the efficiency of management of daters are you getting? Let us take the next ratio that is debt equity ratio. In the debt equity ratio we find the relationship between debt to equity. So, debt that is borrowed funds we divide it by equity or the owners fund. What will be the formula? Anyone can guess? It is going to be almost 0 because if you remember you know for this company debt is nearly 0 versus the net worth. So, you can see how low it is current year also it is going to be 0. What does it show? It shows that company is fully financed by equity or by the owners fund. So, it means that it has high long term solvency are you getting me which is a good sign for the company. Now, the last ratio PE ratio what is the formula as the name suggests it tries to link price to earnings. If you go up you will realize that market price is given. So, we will link that to the earnings. So, market price divided by earning per share which we have already calculated. So, it gives 32 versus the current one is 31. So, it is more or less stable that shows the reputation of the company which appears to be reasonably good. So, let us stop here we have tried to do a select ratios for Patini computers. Next session we will do one more problem. So, that you really understand the different uses of ratio analysis. Keep in mind is one of the important tools for analyzing any financial statement and try to practice it. So, that you can really get the insights into it. Thank you so much we will stop for the day.