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Module 1: Ratio Analysis and Return on Equity

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Namaste.In last few sessions, we are discussing the case of Shipping Corporation of India we haveseen how to do horizontal analysis by preparing a comparative statement where we compare thecurrent figures with last year.Then we have also seen how to prepare a common size statement to go for vertical analysiswhere we convert all figures into percentages of 100 and then we can compare either withthe same company in earlier years or we can compare across different players in the pairgroup.So, within the same industry, who are the competitors and how their balance sheet orP and L looks like.It can also be compared with industry average or with the particular segment in case ofa broader companies ok.So, I am requesting you to study your own company once again and compare it with theirother pairs.You can go to websites like money control where they will give you all the data in thebalance sheet in the excel format ok.Now, let us go to one more analysis in today session.So, here again we have got the data for shipping corporation, but now it is a long term data,it is a 5 year data.In earlier sessions, we only compare 16 and 17.Today we will compare 5 years figures.So, what we are going to calculate is known as trend analysis.So, we will take March 13 figure as 100 and compare other figures as a percentage thatto that base.So, we will know over the period how is the movement?This is known as trend analysis we can also calculate CAGR cumulative growth rates, butright now we will just do the trend.So, we have just seen how to calculate it we have taken the base as 100.So, that is a figure for March 17, so for sorry March 13.So, March 14 figure is calculated as E7 upon F7.Now for March 15 it is D7 upon F7.Are you getting me?So, March 16 C7 upon F7 and for the March 17, we will compare the current figure thatis March 17 figure with March 13 figure.So, if you look at the revenue trends you will realize that March 17 what was 100 ismore or less up and down and it is at the same position.It slightly went down and now it has slightly increased the sorry this is for reserves andsurplus.Now, I will just hide this ok.So, we can also do it for share capital although it would not make much sense because sharecapital is unchangedconverting into percentage.So, share capital is same 100 percent in each year for other figures like reserves havealso not changed much.In the first 2 years, the company that is in earlier years the company was in loss.I think this also got converted into percentage; it is not changing, but we leave it.So, are you getting me?So, company was reducing its reserves.Now its reserves have slightly increased and again they are slightly decreasing look attrends in borrowings.You will realize that borrowings are slowly going down from 100, company is systematicallyrepaying its long term borrowings and becoming relatively debt free.Short term borrowings earlier it went up, then it went down.Now they have again gone up.Trade payables where slowly going up down again they have increased substantially.If you look at the trends of total current liabilities it shows slightly rising trendwhich is very some because their revenue is more or less constant.So, no reason for that to go up, tangible assets are again more or less constant.Capital WIPs you can see in one of the years the capital WIP was high maybe they were inthe process of building new ship now again it has gone down.Total noncurrent assets have shown a significant rise in the current year.If you look at current assets, you will realize that current investments are slowly goingdown perhaps they are disposing of their investments.Inventory is anyway have very small amount, but the trade receivables are slowly goingdown because their business is also shrinking.Cash and cash equivalent is more or less constant, it had gone down in one of the years, shortterm loans and advances had shot up in between, they went down that again they have bit increased.So, this needs to be investigated and if you look at total assets there is somewhat stinkingof total assets over the period of time.So, like this in trend what is done is for the earliest year we take as 100 and overthe years we go for the comparison.Now let us do it for P and L items, it might make more sense for P and L items to you.So, we have already seen the P and L earlier.So, let us hide the figures or maybe I will keep 1 year figures.Now if you look at the revenue, you will realize that first 3 years it was constant, but inlast 2 years; there is a fall.Other income anyway it is a small amount, but it is slowly going down because theirinvestments are also getting disposed of perhaps.Operating and direct expenses they are going down because the revenue itself is going down.There is a fall in the operating and other expenses; it is a positive sign because youcan see more fall than the fall in the revenue.Employee expenses are more or less constant, finance cost is also not changed much actuallyit should have substantially reduced because they are repaying their loans compared toearlier years.Depreciation figures are going down perhaps because their assets are becoming older; otherexpenses anyway negligible about.If you look at the profit; now there is a significant fall in the profit over the periodof time.Tax total taxes earlier went up, now they have gone down and the final figure reportednet profit is also showing reduction which is not a very positive sign.So this is how the trend is calculated the purpose of trend is having a long term perspectiveinstead of just looking at 2 or 3 years, we little bit take a long term perspective, butwe have to keep in mind that industry should be reasonably stable for a long term perspectiveand that for that company also there should not be major changes.So, for a company like shipping corporation, it is good because there has not been majorchanges either in their assets or in their revenue model.Getting it?Now with this, we will go to major form of analysis that is known as ratio analysis.Now, this is the data for Havells Limited.This is the consumer goods manufacturing company.I will request you to keep your ratio sheet ready because we will be calculating variousratios.I will just show you the sheet which has been shared with you.But if you are not having it we will just have a look kind of revision for you.Please keep that sheet ready because we can readily calculate the ratios.Now for liquidity ratio, we have discussed earlier cash, current and quick ratio thatis current assets by current liabilities and quick assets by quick liabilities.This ratio, in this sheet has been slightly tweaked.Here we have gone for quick ratio upon current liabilities which is a more conservative measure.There can also be a ratio called as cash ratio where we are calculating cash plus cash equivalentas a percentage of current liabilities.Now, this is even more conservative, we want to know how much cash we have for repaymentof current liabilities.One more ratio related to liquidity is inventory to net working capital, inventory upon workingcapital; working capital is CA minus CL.Now is it good to have higher ratio or lower ratio for inventory to net working capital?Higher ratio will mean that their working capital is relatively illiquid because inventoryis not so liquid asset.For other as ratios like current and quick ratio higher ratio is normally good from liquidityviewpoint although it will have a negative impact on profitability if you have two higherratio.Next ratios are profitability ratios very simple to understand.Because denominator is always total operating revenue and we take the respective profitin the numerator.Right now EBIDTA has been taken.I hope you have heard about this term EBIDTA, this is Earning Before Interest Depreciationand Amortization.This term is very much popular in US and often used by analysis to know the cash profit generatedby the business.So, here we have calculated it as a percentage of sales then EBIT or PBIT.This is the operating revenue or profit as a percentage of sales before interest andtaxes the net profit margin.We have also discussed about return ratios of them ROI is perhaps the most importantthat is EBIT upon capital employed, it can be done at a company level or at a projectlevel also.Then ROTA that is Return On Total Assets ROE EPS which is very important for shareholders.This particular ratio, we had not discussed earlier that is known as EVA Economic ValueAdded.In EVA, we take no PAT or net profit net operating profit, but we reduce taxes.So, net operating after tax and we reduce the charge for the capital.So, capital into cost of capital because you will have to compensate the capital in theform of interest or dividend we calculate a weighted average rate of cost of cal capitaland apply it on all the capital.Here the capital does not refer only to equity, but the total capital employed.So, no pat minus capital into cost of capital gives you another major of profitability knownas EVA ok.So, we will not necessarily go for all the ratios, but keep the sheet ready.Now, the next type of ratios are activity ratios.We have discussed them extensively.So, I will not repeat, but these are the formulas in short, it is also given where to find theseitems.You remember return ratios and turnover ratios are composite; one figure is from P and Lother figure is from balance sheet.Next are leverage ratios the most popular being debt to equity or debt equity ratio.You can also go for debt to asset ratio, interest coverage ratio.And the last three ratios are particularly useful for shareholders which are in the formof PE ratio dividend yield and so on.I think dividend yield we have not discussed.So, dividend yield refers to DPS or Dividend Per Share divided by market price.Now from investor angle, it seeks to find out what percentage of return does the dividendgive that is why it is called as Dividend Yield.Dividend Payout Ratio is DPS upon EPS.So, we will come to know what percentage of their earning is being distributed by wayof dividend.Higher is good or lower is good?Not necessarily higher will mean that companies share holders are getting more cash dividend;lower we will mean that company is investing that amount and is more of a growth orientedcompany.So, according to stage of comp industry and company, companies have to decide the payoutratio many times companies try to keep it constant ok.So, this was a summary sheet for various ratios, now let us go to actual figures for Havellsand try to calculate the important ratios.Now, we have got balance sheet and P and L both so, that we can calculate the compositeratios as well first try to have a view in the balance sheet.So, you can see the capital is constant; there is a gradual rise in reserves.So, company was be a profit making company.Their long term borrowings they have repaid and have become a zero debt company now.Short term borrowings are also repaid completely, trade payables are nearly constant, currentliabilities other current liabilities are somewhat increasing.Tangible assets have slightly gone up.So, company is investing something; their noncurrent investments had doubled earlierit has gone down.Now, cash and cash equivalents has gone up.Now you do not have to look at every figure, but we just had a overall look at the balancesheet.Now, let us try to calculate a few important ratios.So, if we start with liquidity in liquidity, what ratio you would like to calculate?Can somebody suggest what is a important ratio in liquidity?I think most of you know current ratio is the most important ratio and the formula isCA that is total current assets upon current liabilities.So, let us try to calculate the current ratio this is CA divided.So, we are taking total current assets divided by total current liabilities.So, we get 1.88 I am just reducing the unwanted decimals.So, over a period of 3 years, you can see there is a gradual rise in current asset isit a good sign?Normally yes because we know standard ratio is to 2 is to 1 and slight increase in theratio in their case and we are trying to go to the standard ratio.Any other important liquidity ratio?Sometimes you know that we calculate quick ratio now how will you calculate quick ratiosorry this was CR current ratio now we will go for quick ratio what is the formula?We take trade receivables, cash equivalent, short term loans and advances and other currentassets.In other words normally we can say its total current assets minus inventories in the numerator.So, please try to calculate along with me we will put this in bracket.Current assets minus inventory people can use variety of ratios and there can be slightdifference in the formulas and divided by quick liabilities; quick liabilities are moreor less same as current liabilities except we deduct bank over draft.Right now, you can see there is no short term borrowing as such.So, we will take total current liabilities.So, we are getting 1.2.So, it has improved from 0.81 then to 0.6 and now 1.26 is it a good sign?I think yes we have seen that normally the standard ratio is 1 is to 1.So, they are somewhere around it the liquidity position seems to be comfortable ok.So, these where the ratios which we have calculated only based on balance sheet.So, they are also known as balance sheet ratios.Now, what is, what are the other balance sheet ratios?We can also comment on their capital structure or it is known as gearing or leverage.So, the most popular ratio is debt equity ratio.What is the formula of debt equity ratio do you remember?It is the long term borrowings divided by the shareholders fund debt upon equity.So, ratio was 0.06 and it has become 0 now is it good sign ?Yes from a stability viewpoint because they are slowly repaying there debt anyway evenearlier the debts were not very high they were only 6 percent, but now even with theirrepaid.Some people instead of long term borrowing take long term plus short term borrowing thatis total borrowing in the numerator even in that case the amount is 0 ok.So, this is known as debt equity ratio.Now let us go to their profit and loss account.So, in P and L what ratios can be calculated?One typical ratios one typical ratio which we calculate is net profit ratio or varietyof profitability ratios.So, let us go to their net profit or profit for the period which is 715.So, NP ratioprofit upon sales now always the question is which figures to take.Because you have got revenue from operation less excise, revenue from operations net,other operating revenue, total operating revenue and total revenue.Normally since it is a net profit after tax, after everything it does make sense to takeeither total revenue or total operating revenue any of the figures are reasonable, but totalrevenue makes more sense.So, you are getting 0.12 we will converted into percent so, around 13 percent.So, you can see there was a rise in net profit as a percentage also it has increased from10 percent to 13 percent is it a good sign?Definitely because higher profitability is always advantageous, we can also calculatethe profitability at different level particularly profit before taxthis is known as NPBT ratio.So, from 12 percent to 17 percent CNP 80 which is found to be less because this is beforetax and we will take one more that is known as operating profit.Now, you see your revenue and you have got total expenses.They have not calculated any operating profit, but usually if we add back depreciation andfinance cost, we will get PBIT Profit Before Interest and Tax or we can also calculatePBDIT to know the cash profits.So, what we will do here is, we will calculate this is profit before depreciation and tax;this is also the cash profit for the business this is also popularly known as EBIDTA.Now we are comparing with operating revenue.So, you can see they have a very stable EBIDTA around 15 percent because their sales haveincreased their profits have increased the bit, but otherwise as a percentage it remainsconstant.So, we have now calculated both balance sheet and profitability P and L ratios.Now, we will also go for calculation of return ratios etc., but in the next session.Namaste.Thank you.