Financial Ratio Intrepretation

8/22/2019 Financial Ratio Intrepretation

1/47

COMPANY OVERVIEW

HCL is a leading global Technology and IT Enterprise with annual revenues of

US$ 6.3 billion. The HCL Enterprise comprises two companies listed in India,

HCL Technologie(www.hcltech.com ) and HCL Infosystems

(www.hclinfosystems.in)

The 35 year old enterprise, founded in 1976, is one of India's original IT garage

start ups. Its range of offerings span R&D and Technology Services, Enterprise

and Applications Consulting, Remote Infrastructure Management, BPO services,

IT Hardware, Systems Integration and Distribution of Technology and Telecom

products in India. The HCL team comprises 92,000 professionals of diverse

nationalities, operating across 31 countries including 505 points of presence in

India. HCL has global partnerships with several leading Fortune 1000 firms,

including several IT and Technology majors.
http://www.hcltech.com/http://www.hcltech.com/http://www.hcltech.com/http://www.hclinfosystems.in/http://www.hcltech.com/http://www.hclinfosystems.in/


2/47


3/47

RATIO ANALYSIS

INTRODUCTION

The ratio analysis is one of the most important and powerful tools of financial

analysis. It is the process of establishing and interpreting various ratios. It is with

the help of ratios that the ratios that the financial statement can be analyzed more

clearly and decisions made from such analysis.

CONCEPT OF RATIO

A ratio is a simple arithmetical expression of the relationship of one number to

another. It may be defined as the indicated quotient of two mathematical

expressions. According to Accountants handbook by Wixonkell and Bedford, a

ratio is an expression of the quantitative relationship between two numbers.

RATIO ANALYSIS

Ratio analysis is the technique of calculation of number of accounting ratios from

the data found in the financial statements, the comparison of the accounting ratios

with those of the previous years or with those of other concerns engaged in similar

line of activities or with those of standard ratios and the interpretation of the

comparison.

CLASSIFICATION OF ACCOUNTING RATIOS

The use of ratio analysis is not confined to financial manager only. There are

different parties interested in the ratio analysis for knowing the financial position

of a firm for different purposes. In view of various users of ratio which can be

calculated from the information given in the financial statement.


4/47

Ratios

Traditional classification Functional classification Significance ratios

CLASSIFICATION ACCORDING TO TESTS

Liquidity ratios Long-term solvency ratios Activity ratios Probability ratio

1. Balance sheet ratios

2. Revenue statementratios

1. Liquidity ratios

2. Leverage ratios

3. Activity ratios

1. Primary ratios

2. Secondary ratios

1. Currentratio

2. Acid testratio

1. Debt equity ratio2. Proprietory ratio3. Capital gearing

ratio4. Fixed assets to

net worth5. Current assets to

1. Gross profitratio

2. Net profit ratio3. Operating profit

ratio4. Return on

capital employed5. Return on total

1. Stock turn overratio

2. Debtors turnoverratio

3. Debt-collection

period4. Creditors turnover

ratio5. Debt-payment

period6. Fixed assets

turnover ratio7. Total assets


5/47

Liquidity Ratios

A. Current Ratio

The current ratio is an indication of a firm's market liquidity and ability to meet

creditor's demands. Acceptable current ratios vary from industry to industry and

are generally between 1.5 and 3 for healthy businesses. If a company's current ratio

is in this range, then it generally indicates good short-term financial strength. If

current liabilities exceed current assets (the current ratio is below 1), then the

company may have problems meeting its short-term obligations. If the current ratio

is too high, then the company may not be efficiently using its current assets or its

short-term financing facilities. This may also indicate problems in working capitalmanagement. Low values for the current or quick ratios (values less than 1)

indicate that a firm may have difficulty meeting current obligations. Low values,

however, do not indicate a critical problem. If an organization has good long-term

prospects, it may be able to borrow against those prospects to meet current

obligations. Some types of businesses usually operate with a current ratio less than

one. For example, if inventory turns over much more rapidly than the accounts

payable become due, then the current ratio will be less than one. This can allow a

firm to operate with a low current ratio. Anything that increases or decreases

current assets or current liabilities can affect working capital and the current ratio.

1) A buildup or decline in inventory or A/R

2) A change in available cash

3) A reduction in short-term debt

4) A backlog of bills to pay

The more quickly Inventory and Accounts Receivable can be converted to cash,

the more secure your cushion.


6/47

To improve your current ratio, these things may help:

collect outstanding accounts receivable

pay off some current liabilities

convert fixed assets to cash: sell unused equipment

increase current assets with new equity investments

take fewer owner withdrawals and reinvest profits back into the

business

increase your cash balance with a long-term loan

Current assetsCurrent Ratio = ________________

Current liabilities

Significance:

Current ratio is the primary measure of a company's liquidity. Minimum levels of

current ratio are often defined in loan covenants to protect the interest of the

lenders in the event of deteriorating financial position of the borrowers. Financialregulations of various countries also impose restrictions on financial institutions to

lend credit facilities to potential borrowers that have a current ratio which is lower

than the defined limits.

Limitations of current ratio

Current ratio suffers from a number of limitations. Some are given below:

1) Some businesses have different trading activities in different seasons. Such

businesses may show low or high current ratio in certain periods during the year.


7/47

2) To compare the ratio of two companies it is necessary that both the companies use

same inventory valuation method. For example, comparing current ratio of two

companies would be like comparing apples to oranges if one uses fast-in, first-out

(FIFO) method and the other uses Last-in, first-out (LIFO) method for the valuation of

inventory. So the analyst would not be able to compare the ratio of two companies

even in the same industry.

3) It is not exact science to test the liquidity of a company because the quality of each

Individual asset is not taken into account while computing this ratio.

4) It can be easily manipulated by equal increase or decrease in current assets and

current liabilities. For example, if current assets of a company are $10,000 and current

liabilities are $5,000, the current ratio would be 2:1 as computed below:

$10,000 / $5,000

2:1

If both current assets and current liabilities are reduced by $1,000, the ratio would be

increased to 2.25:1 as computed below:

$9,000 / $4,000

2.25:1

Table: 5.1 CURRENT RATIO


8/47

Year

Current

Assets

Rs. in

crores

Current

Liabilities

Rs. incrores

Ratio

2011

2012

3974.08

4009.97

2349.39

2654.49

1.6:1

1.5:1

Interpretation:

The current ratio has been decreasing year after year which shows

decreasing working capital.

But still the situation of company is under control and assets can easily handlethe liabilities.

a) Satisfactory level

b) There is increase in Fixed assets means the cash has been utilized for fixed

assets

c) Some thing might have invested in inventories

Chart no.: 5.1 CURRENT RATIO


9/47

Current assets Curent liablities Current ratio

2011 3974.08 2349.39 1.6

2012 4009.97 2654.49 1.5

0

500

10001500

2000

2500

3000

3500

4000

4500

AxisTitle

B. Quick Ratio

Measures assets that are quickly converted into cash and they are compared

with current liabilities. This ratio realizes that some of current assets are not easily

convertible to cash e.g. inventories. Quick ratio or Acid Test ratio is the ratio of the

sum of cash and cash equivalents, marketable securities and accounts receivable to

the current liabilities of a business. It measures the ability of a company to pay its

debts by using its cash and near cash current assets.

The quick ratio, also referred to as acid test ratio, examines the ability of the

business to cover its short-term obligations from its quick assets only (i.e. it

ignores stock). The quick ratio is calculated as follows

Quick assetsQuick Ratio = ____________________

Current liabilities

Significance:


10/47

The standard liquid ratio is supposed to be 1:1 i.e., liquid assets should be equal tocurrent liabilities. If the ratio is higher, i.e., liquid assets are more than the currentliabilities, the short term financial position is supposed to be very sound. On theother hand, if the ratio is low, i.e., current liabilities are more than the liquid assets,the short term financial position of the business shall be deemed to be unsound.When used in conjunction with current ratio, the liquid ratio gives a better pictureof the firms capacity to meet its short-term obligations out of short-term assets.Aquick ratio of 1.00 means that the most liquid assets of a business are equal to itstotal debts and the business will just manage to repay all its debts by using its cash,marketable securities and accounts receivable. A quick ratio of more than oneindicates that the most liquid assets of a business exceed its total debts. On theopposite side, a quick ratio of less than one indicates that a business would not beable to repay all its debts by using its most liquid assets. Thus we conclude that,generally, a higher quick ratio is preferable because it means greater liquidity.However a quick ratio which is quite high, say 4.00 is not favorable to a businessas whole because this means that the business has idle current assets which couldhave been used to create additional projects thus increasing profits. In other words,

very high value of quick ratio may indicate inefficiency.

Table: 5.2 QUICK RATIO

Year

Quick

Assets

Rs. in

crores

Current

Liabilities

Rs. in crores

Ratio

2011

2012

3387.83

3351.02

2349.39

2654.49

1.44

1.26

Interpretation:


11/47

As a quick ratio of 1:1 is considered satisfactory as a firm can easily meet all

current claims. It is a more rigorous and penetrating test of the liquidity position of

a firm. But the liquid ratio has been decreasing year after year which indicates a

high operation of the business. From the above statement, it is clear that the

liquidity position of the HCL is satisfactory.

a) Stock turnover has increased hence increasing the stock turnover ratio

b) Sales have reduced hence reducing sales turnover ratio

c) COGS have increased hence increasing the cost can be the reason of

reduction in sales as the selling cost will be high

d) Company can easily cover its current liabilities with its quick assets

Chart no.: 5.2 QUICK RATIO

Quick assets Curent liablities Current ratio

2011 3387.83 2349.39 1.26

2012 3351.02 2654.49 1.44

0

500

1000

1500

2000

2500

3000

3500

4000

AxisTitle

C. Cash ratio:


12/47

This is also known as cash position ratio or super quick ratio. It is a variation of

quick ratio. This ratio establishes the relationship between absolute liquid assets

and current liabilities. Absolute liquid assets are cash in hand, bank balance and

readily marketable securities. Both the debtors and the bills receivable are exclude

from liquid assets as there is always an uncertainty with respect to their realization.

In other words, liquid assets minus debtors and bills receivable are absolute liquid

assets. The cash ratio is calculated as follows

Cash in hand & at bank + Marketable securitiesCash Ratio = ________________________________________

Current liabilities

Significance:

This ratio gains much significance only when it is used in conjunction with the first

two ratios. The accepted norm for this ratio is 50% or 0.5:1 or 1:2(i.e.,) Re. 1 worth

absolute liquid assets are considered adequate to pay Rs.2 worth current liabilities

in time as all the creditors are not expected to demand cash at the same time and

then cash may also be realized from debtors and inventories. This test is a more

rigorous measure of a firms liquidity position. This type of ratio is not widely used

in practice. Quick ratio is an indicator of solvency of an entity and must be

analyzed over a period of time and also in the context of the industry the company

operates in. Generally, companies should aim to maintain a quick ratio that

provides sufficient leverage against liquidity risk given the level of predictability

and volatility in a specific business sector among other considerations. The more

uncertain the business environment, the more likely that companies would

maintain higher quick ratios. Conversely, where cash flows are stable and

predictable, companies would seek to keep quick ratio at relatively lower levels. In

any case, companies must achieve the right balance between liquidity risk arising

from a low quick ratio and the risk of loss resulting from a high quick ratio. A


13/47

quick ratio that is greater than industry average may suggest that the company is

investing too many resources in the working capital of the business which may

more profitably be used elsewhere. If a company has too much spare cash, it may

consider investing the surplus funds in new ventures and in case company is out of

investment options it may be prudent to return the excess funds to shareholders in

the form of increased dividend payments. Acid test ratio which is lower than the

industry average may suggest that the company is taking too much risk by not

maintaining an appropriate buffer of liquid resources. Alternatively, a company

may have a lower quick ratio due to better credit terms with suppliers than the

competitors. When analyzing the quick ratio over several periods, it is important to

take into account seasonal variations in some industries which may cause the ratio

to be traditionally higher or lower at certain times of the year as seasonal

businesses experience irregular bursts of activities leading to varying levels current

assets and liabilities over time. -

Table: 5.3 CASH RATIO

Year

Cash in

Hand & at

Bank

Rs. in

crores

Current

Liabilities

Rs. incrores

Ratio

2011

2012

655.97

853.12

2654.49

2349.39

0.24

0.36

Interpretation:


14/47

a) The cash ratio is below the accepted norm.

b) So the cash position is not utilized effectively and efficiently.

c) It is also not healthy sign because cash has been used for paying off long tem

debts and increasing fixed assets.

Chart no.: 5.3 CASH RATIO

cash equilents and

cashCurent liablities Current ratio

2011 655.97 2349.39 0.24

2012 853.12 2654.49 0.36

0

500

1000

1500

2000

2500

3000

AxisTitle

5.2.2 Activity Ratio

A. Inventory Turnover Ratio:

This ratio measures the stock in relation to turnover in order to determine

how often the stock turns over in the business.

It indicates the efficiency of the firm in selling its product. It is calculated by

dividing he cost of goods sold by the average inventory.

A business can take a range of actions to improve its stock turnover:

Sell-off or dispose of slow-moving or obsolete stocks Introduce lean production techniques to reduce stock holdings Rationalize the product range made or sold to reduce stock-holding

requirements


15/47

Negotiate sale or return arrangements with suppliers so the stock is onlypaid for when a customer buys it

Cost of goods soldInventory Turnover Ratio = ___________________

Average Inventory

a) Cost of goods sold figure is obtained from the income statement of a business

b) Average inventory is calculated as the sum of the inventory at the beginning and

at the end of the period divided by 2. The values of beginning and ending

inventory are obtained from the balance sheets at the start and at the end of the

accounting period.

Significance:

This ratio is calculated to ascertain the number of times the stock is turned overduring the periods. In other words, it is an indication of the velocity of the

movement of the stock during the year. In case of decrease in sales, this ratio willdecrease. This serves as a check on the control of stock in a business. This ratiowill reveal the excess stock and accumulation of obsolete or damaged stock. Theratio of net sales to stock is satisfactory relationship, if the stock is more thanthree-fourths of the net working capital. This ratio gives the rate at whichinventories are converted into sales and then into cash and thus helps indetermining the liquidity of a firm.Inventory turnover ratio is used to measure theinventory management efficiency of a business. In general, a higher value ofinventory turnover indicates better performance and lower value meansinefficiency in controlling inventory levels. A lower inventory turnover ratio may

be an indication of over-stocking which may pose risk of obsolescence andincreased inventory holding costs. However, a very high value of this ratio may beaccompanied by loss of sales due to inventory shortage. Inventory turnover isdifferent for different industries. Businesses which trade perishable goods havevery higher turnover compared to those dealing in durables. Hence a comparisonwould only be fair if made between businesses of same industry.


16/47

Table: 5.4 INVENTORY TURNOVER RATIO

Year

Cost of goods

sold

Rs. in crores

Average

Inventory

Rs. in crores

Ratio

2011

2012

9223.08

8890.88

622.6

622.6

14.8

times

14.2

times

Interpretation:

A higher turnover ratio is always beneficial to the concern. In this the number

of times the inventory is turned over has been increasing from one year toanother year. This increasing turnover indicates immediate sales. And in turn

activates production process and is responsible for further development in the

business. This indicates a good inventory policy of the company.

Chart no.: 5.4 INVENTORY TURNOVER RATIO

COGS Average InventoryInventory

turnover ratio

2011 9223.08 622.6 14.80%

2012 8890.88 622.6 14.20%

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

AxisTitle

B. Fixed Assets Turnover Ratio:


17/47

The fixed assets turnover ratio measures the efficiency with which the firm

has been using its fixed assets to generate sales. Asset turnover ratio is the ratio of

a company's sales to its assets. It is an efficiency ratio which tells how successfully

the company is using its assets to generate revenue. It is calculated by dividing the

firms sales by its net fixed assets as follows:

SalesFixed Assets Turnover =________________

Fixed assetsSignificance:

This ratio gives an ideal about adequate investment or over investment or under

investment in fixed assets. As a rule, over-investment in unprofitable fixed assets

should be avoided to the possible extent. Under-investment is also equally bad

affecting unfavorably the operating costs and consequently the profit. In

manufacturing concerns, the ratio is important and appropriate, since sales are

produced not only by use of working capital but also the capital invested in fixed

assets. An increase in this ratio is the indicator of efficiency in work performance

and a decrease in this ratio speaks of unwise and improper investment in fixed

assets. If a company can generate more sales with fewer assets it has a higher

turnover ratio which tells it is a good company because it is using its assets

efficiently. A lower turnover ratio tells that the company is not using its assets

optimally. Total asset turnover ratio is a key driver of return on equity as discussed

in the DuPont analysis

Table: 5.5 FIXED ASSETS TURNOVER RATIO

Year Sales

Rs. incrores

Fixed

Assets

Rs. in

crores

Ratio

2011 11062.40 250.55 44.152


18/47

2012 10380.81 298.22 34.809

Interpretation:

The fixed assets turnover ratio is maintained year after year. The overall higher

ratio indicates the efficient utilization of the fixed assets. There is little decrease of

9.343 in FATR this may be due to

a) Increase in Fixed assets

b) Reduction in sales

c) The proportion is not same

Chart no.: 5.5 FIXED ASSETS TURNOVER RATIO


19/47

Sales Fixed assets FATR

2011 11062.4 250.55 44.152

2012 10380.81 298.22 34.809

0

2000

4000

6000

8000

10000

12000

AxisTitle

5.2.3 Financial Leverage (Gearing) Ratios

A.Proprietary Ratio:

This ratio is also known as Owners fund ratio (or) Shareholders equity ratio

(or) Equity ratio (or) Net worth ratio. This ratio establishes the relationship

between the proprietors fund and total tangible assets. The formula for this ratio

may be written as follows.

Shareholders fundsProprietary Ratio = _____________________

Total assets

Significance:

This ratio represents the relationship of owners funds to total tangible assets,

higher the ratio or the share of the shareholders in the total capital of the company,

better is the long term solvency position of the company. This ratio is of


20/47

importance to the creditors who can ascertain the proportion of the shareholders

funds in the total assets employed in the firm. A ratio below 50% may be alarming

for the creditors since they may have to lose heavily in the event of companys

liquidation on account of heavy losses.

Depends on Risk Appetite: The ideal value of the proprietary ratio of the

company depends on the risk appetite of the investors. If the investorsagree to take a large amount of risk, then a lower proprietary ratio ispreferred. This is because, more debt means more leverage means profitsand losses both will be magnified. The result will be highly uncertain

payoffs for the investors.

On the other hand, if investors are from the old school of thought, theywould prefer to keep the proprietary ratio high. This ensures lessleverage and more stable returns to the shareholders.

Depends on Stage of Growth: The ideal value of the proprietary ratio

also depends upon the stage of growth the company is in. Mostcompanies require a lot of capital when they are at the early stages.Issuing too much equity could dilute the earnings potential at this stage.Therefore a lower proprietary ratio would be desirable at such a stageallowing the firm to access the capital it wants at a lower cost.

Depends on Nature of Business: The firm has to undertake many risksand balance them out. There are market risks which are external to thefirm and there are capital structure risks that are internal to the firm. Ifthe external risks are high, the firm must not undertake aggressive

financing because this could lead to a complete washout of the firm. Onthe other hand, if the external environment is stable, the firm can affordto take more risks.

Table: 5.6 PROPRIETARY RATIO

Year

Shareholders

Fund

Rs. in crores

Total Assets

Rs. in crores Ratio

2011 1947.04 4565.87 42.64%


21/47

2012 1917.16 4867.20 39.38%

Interpretation:

This ratio is particularly important to the creditors and it focuses on the general

financial strength of the business.

a) There is decrease in ratio of 3.26%

b) There is rise in fixed assets

c) Parallely a fall in Shareholders fund

Chart no.: 5.6 PROPRIETARY RATIO


22/47

Shareholder fund Fixed assets Propritor ratio

2011 1947.04 4565.87 42.64%

2012 1917.16 4867.2 39.38%

0

1000

2000

3000

4000

5000

6000

AxisTitle

B. Debt RatioA debt ratio of greater than 1 indicates that a company has more debt than assets,meanwhile, a debt ratio of less than 1 indicates that a company has more assetsthan debt. Used in conjunction with other measures of financial health, the debtratio can help investors determine a company's level of risk.

Significance

Debt ratiois a ratio that indicates the proportion of a company's debt to its totalassets. It shows how much the company relies on debt to finance assets. The debtratio gives users a quick measure of the amount of debt that the company has on its

balance sheets compared to its assets. The higher the ratio, the greater the riskassociated with the firm's operation. A low debt ratio indicates conservativefinancing with an opportunity to borrow in the future at no significant risk. Thedebt ratio of a company is highly subjective. There is no such thing as an ideal debt

ratio. Neither are industry wide comparisons very helpful because the capitalstructure of a company is an internal decision. Here is how to interpret the debtratio of a company.

Certainty: Debt is not harmful as long as the revenues in question arefairly certain. Debt becomes a problem when the revenues of thecompany are wildly fluctuating. This is when there arise situations when


23/47

the company may not have enough cash on hand to meet its interestobligations. Hence while looking at the debt ratio analysts usually alsolook at the revenues with regards to how certain they are to gauge theriskiness. Whether these revenues are converted to cash fast enough tomeet the interest obligations is also under consideration.

Tax Shield Advantages: Debt is a tax deductible expense. Hence theamount of interest paid reduces the tax bill of the company. One of the

advantages of having a higher debt ratio is that you have to pay less tothe government in taxes.

Table: 5.7 DEBT RATIO

Interpretation

a) The ratio is maintained

b) But the significant rise in Long term debts

c) The rise in Total assets is there but not much significant

d) Thus giving a little decrease in ratio

Year

Total

Assets

Rs. incrores

Long term

debt

Rs. incrores

Ratio

2011

2012

4565.87

4867.20

269.44

295.55

16.94

16.46


24/47

Chart5.7 Debt Ratio

Total assets Long term debt Propritor ratio

2011 4565.87 269.44 16.94

2012 4867.87 295.55 16.46

0

1000

2000

3000

4000

5000

6000

AxisTitle

C. Debt to Equity ratio

This ratio indicates the extent to which debt is covered by shareholders funds.

It reflects the relative position of the equity holders and the lenders and indicates

the companys policy on the mix of capital funds. The debt to equity ratio is the

most important of all capital adequacy ratios. It is seen by investors and analysts

worldwide as the true measure of riskiness of the firm. This ratio is often quoted in

the financials of the company as well as in discussions pertaining to the financial

health of the company in TV shows newspapers etc. The debt to equity ratio tellsthe shareholders as well as debt holders the relative amounts they are contributing

to the capital. It needs to be understood that it is a part to part comparison and not a

part to whole comparison. The debt to equity ratio is calculated as follows:


25/47

Total debtDebt to Equity Ratio = ____________

Total equity

Significance:

The importance of debt-equity ratio is very well reflected in the words ofWeston and brigham which are reproduced here: Debt-equity ratio indicates towhat extent the firm depends upon outsiders for its existence. For the creditors, this

provides a margin of safety. For the owners, it is useful to measure the extent towhich they can gain the benefits of maintaining control over the firm with a limitedinvestment: The debt-equity ratio states unambiguously the amount of assets

provided by the outsiders for every one rupee of assets provided by theshareholders of the company. Debt to equity ratio provides two very important

pieces of information to the analysts. They have been listed below.

Interest Expenses: A high debt to equity ratio implies a high interestexpense. Along with the interest expense the company also has to redeemsome of the debt it issued in the past which is due for maturity. Thismeans a huge expense. Moreover this expense needs to be paid in cash,which has the potential to hurt the cash flow of the firm. Investors arenever keen on investing in cash strapped firm and therefore have a keeneye on this ratio.

Liquidation Scenario: Another interpretation of the debt equity ratio isthe event of a liquidation of the company. Shareholders as well as debtholders want to know what the maximum downside is and debt to equityratio helps them understand what they would end up with if the companywere to stop functioning as a going concern.

Table: 5.8 DEBT TO EQUITY RATIO


26/47

Interpretation:

The debt to equity ratio is decreasing year after year. A low debt equity ratio is

considered favorable from management. It means greater claim of shareholders

over the assets of the company than those of creditors. For the company also, the

servicing of debt is less burdensome and consequently its credit standing is not

adversely affected. Therefore debt to equity ratio is satisfactory to the company.

There is little increse due to

a) Fall in value of equity

b) Rise in Debt

c) Not convincing for shareholders

Year

Total

Debt

Rs. in

crores

Total

Equity

Rs. incrores

Ratio

2011

2012

269.44

295.55

1947.04

1917.16

0.14

0.15


27/47

Chart no.: 5.8 DEBT TO EQUITY RATIO

Total debt Totla equity Propritor ratio

2011 269.33 1947.04 0.14

2012 295.55 1917.16 0.15

0

500

1000

1500

2000

2500

AxisTitle

D. Interest coverage ratio

The times interest earned shows how many times the business can pay its

interest bills from profit earned. Present and prospective loan creditors such as

bondholders, are vitally interested to know how adequate the interest payments on

their loans are covered by the earnings available for such payments. Owners,

managers and directors are also interested in the ability of the business to service

the fixed interest charges on outstanding debt. The ratio is calculated as follows:

EBITInterest Coverage Ratio = _______________

Interest charges

Significance:


28/47

It is always desirable to have profit more than the interest payable. In case

profit is either equal or lesser than the interest, the position will be unsafe. It will

show that there this nothing left for the shareholders and the position of the lendors

is also unsafe. A high ratio is a sign of low burden of dept servicing and lower

utilization of borrowing capacity. From the points of view of creditors, the larger

the coverage, the greater the ability of the firm to handle fixed charges liabilities

and the more assessed the payment of interest to the creditors. In contrast the low

ratio signifies the danger the signal that the firm is highly dependent on borrowings

and its earnings cannot meet obligations fully. The standard for this ratio for an

industrial undertaking is 6 to 7 times.

Higher Ratio Means Solvent: The higher the interest coverage ratio ofany firm, the more solvent it is. If an organization, under normal

circumstances, earns way more than what its interest costs are, then it isfinancially secure. This is because earnings would have to take a real

beating for the firm to default on its obligations. Hence, interest coverageratio is of prime importance to lenders like banks and bond traders.Credit rating agencies also pay close attention to this number before theyrate the company.

Tolerance Depends On Variability: In industries where sales are verystable, such as utilities companies, a lower interest coverage ratio shouldsuffice. This is because, these industries, by nature record stable

revenues. Hence the sales and profits of the company are unlikely towitness wild fluctuation. This means that even in tough times thecompany will most probably be able to make good its interest obligations

because its performance is not affected by the business cycle.

On the other hand, companies with highly variable sales, like technologyand apparel companies, need to have a high interest coverage ratio. Theseindustries are prone to wild fluctuations is sales and investors want toensure that their cash flow is not interrupted as a result. Hence theydemand a higher interest coverage ratio before they give out their money.

Ability To Take On More Credit: This is a corollary of the fact that highinterest coverage ratio means the company is solvent. Lenders want tolend money to people who are solvent. This ensures that they get repaidon time and the risks of business are assumed by the owner. Thus,companies with high interest coverage ratios are more likely to get crediteasily and on more favorable terms.


29/47

Table: 5.9 INTEREST COVERAGE RATIO

Year

EBIT

Rs. incrores

Interest on Fixed

Loans

Rs. in crores

Ratio

2011

2012

311.07

141.63

15.74

33.08

19.7

4.28

Interpretation:

The Interest coverage ratio is increasing year after year. A high ratio is a sign

of low burden of dept servicing and lower utilization of borrowing capacity.

Therefore this ratio is satisfactory to the company.

a) EBIT has reduced

b) Interest rate has increased

c) Ultimately ratio has decreased


30/47

Chart no.: 5.9 INTEREST COVERAGE RATIO

EBIT Intrest expenses Propritor ratio

2011 311.07 15.74 19.7

2012 141.63 33.08 4.28

0

50

100

150

200

250

300

350

AxisTitle


31/47

5.2.4 Profitability Ratios

Profitability is the ability of a business to earn profit over a period of time.

Although the profit figure is the starting point for any calculation of cash flow, as

already pointed out, profitable companies can still fail for a lack of cash.

A company should earn profits to survive and grow over a long period of

time.

Profits are essential, but it would be wrong to assume that every action

initiated by management of a company should be aimed at maximizing

profits, irrespective of social consequences.

The ratios examined previously have tendered to measure management efficiency

and risk.

A. Gross Profit Margin

Normally the gross profit has to rise proportionately with sales.

It can also be useful to compare the gross profit margin across similar

businesses although there will often be good reasons for any disparity.

Gross profit

Gross Profit Margin = ________________ *100

Sales

Significance:


32/47

The gross profit ratio helps in measuring the results of trading or

manufacturing operations. It shows the gap between revenue and expenses at a

point after which an enterprise has to meet the expenses related to the non-

manufacturing activities, like marketing, administration, finance and also taxes and

appropriations.

The gross profit shows the gap between revenue and trading costs. It,

therefore, indicates the extent to which the revenue have a potential to generate a

surplus. In other words, the gross profit reveals the mark up on the sales. Gross

profit ratio reveals profit earning capacity of the business with reference to its sale.

Increase in gross profit ratio will mean reduction in cost of production or direct

expenses or sale at a reasonably good price and decrease in the will mean increased

cost of production or sales at a lesser price. Higher gross profit ratio is always in

the interest of the business. Gross margin ratio measures profitability. Higher

values indicate that more cents are earned per dollar of revenue which is favorable

because more profit will be available to cover non-production costs. But gross

margin ratio analysis may mean different things for different kinds of businesses.

For example, in case of a large manufacturer, gross margin measures the efficiency

of production process. For small retailers it gives an impression of pricing strategy

of the business. In this case higher gross margin ratio means that the retailer

charges higher markup on goods sold.


33/47

Table: 5.10 GROSS PROFIT MARGIN

Year Gross

Profit

Rs. in

corers

Net Sales

Rs. incorers

Ratio

2011

2012

1695.28

1051.08

10918.36

10918.36

15.52%

10.57%

Interpretation:

In the year 2011, the Gross Profit Ratio was 15.52% but then it decreased to10.57%, which does not shows a good profit earning capacity of the business withreference to its sales.There is decrease in the percentage of gross profit ascompared to the previous year; it is indicator of one or more of the followingfactors.

a) There may be decrease in the selling rate of the goods sold withoutcorresponding decrease in the cost of goods sold.

b) There may be increase in the cost of goods sold without corresponding increase

in the selling price of the goods sold.c) There may be omission of sales.d) Increase in direct expensese) Sales have not increased proportionally

Chart no.: 5.10 GROSS PROFIT MARGIN


34/47

gross profit Net sales Current ratio

2011 1695.28 10918.36 15.52

2012 1051.08 9914.96 10.57

0

2000

4000

6000

8000

10000

12000

AxisTitle

B. Net Profit Margin

This is a widely used measure of performance and is comparable across

companies in similar industries. The fact that a business works on a very low

margin need not cause alarm because there are some sectors in the industry that

work on a basis of high turnover and low margins, for examples supermarkets and

motorcar dealers. What is more important in any trend is the margin and whether it

compares well with similar businesses.

Earnings after interest and taxesNet Profit Margin =______________________________ *100

Net Sales

Significance:

An objective of working net profit ratio is to determine the overall efficiency

of the business. Higher the net profit ratio, the better the business. The net profit

ratio indicates the managements ability to earn sufficient profits on sales not only

to cover all revenue operating expenses of the business, the cost of borrowed funds


35/47

and the cost of merchandising or servicing, but also to have a sufficient margin to

pay reasonable compensation to shareholders on their contribution to the firm. A

high ratio ensures adequate return to shareholders as well as to enable a firm to

with stand adverse economic conditions. A low margin has an opposite

implication. Net profit ratio is used to measure the overall profitability and hence it

is very useful to proprietors. The ratio is very useful as if the net profit is not

sufficient, the firm shall not be able to achieve a satisfactory return on its

investment. This ratio also indicates the firm's capacity to face adverse economic

conditions such as price competition, low demand, etc. Obviously, higher the ratio

the better is the profitability. But while interpreting the ratio it should be kept in

mind that the performance of profits also be seen in relation to investments or

capital of the firm and not only in relation to sales.

Table: 5.11 NET PROFIT MARGIN

Year

Net Profit

Rs. incrores

Sales

Rs. incrores

Ratio

2011

2012

237.10

61.54

10918.36

9941.96

2.17%

0.6%

Interpretation:

In the year 2011 the Net Profit margin is 2.17%, but in the year 2012 it was

decreased to 0.6% which may due to

a) Excessing selling and distribution expenses.

b) Increase in finance cost

c) Increase in Depreciation cost


36/47

d) Reduction in interest income

Chart no.: 5.11 NET PROFIT MARGIN

Net profit Net sales Net profit margin

2011 237.1 10918.36 2.17%

2012 61.54 9914.96 0.60%

0

2000

4000

6000

8000

10000

12000

AxisTitle

C. Operating Profit Margin

Operating margin is a measurement of what proportion of a company's revenue is

left over after paying for variable costs of production such as wages, raw materials,

etc. A healthy operating margin is required for a company to be able to pay for its

fixed costs, such as interest

Also known as "operating profit margin" or "net profit margin". Operating margin

is used to measure company's pricing strategy and operating efficiency. It gives an

idea of how much a company makes (before interest and taxes) on each dollar of

sales. Operating margin ratio shows whether the fixed costs are too high for the

production or sales volume. A high or increasing operating margin is preferred

because if the operating margin is increasing, the company is earning more per

dollar of sales. Operating margin can be used to compare a company with its

competitors and with its past performance. It is best to analyze the changes of


37/47

operating margin over time and to compare company's figure to those of its

competitors. Operating margin shows the profitability of sales resulting from

regular business. Operating income results from ordinary business operations and

excludes other revenue or losses, extraordinary items, interest on long term

liabilities and income taxes. Operating margin gives analysts an idea of how

much a company makes (before interest and taxes) on each dollar of sales. When

looking at operating margin to determine the quality of a company, it is best to

look at the change in operating margin over time and to compare the company's

yearly or quarterly figures to those of its competitors. Ifa company's margin is

increasing, it is earning more per dollar of sales. The higher the margin, the better

Significance

Operating income is revenue less operating expenses for a given period of time,

such as a quarter or year. Operating margin is a percentage figure usually given as

operating income for some period of time divided by revenue for the same time

period. Operating margin is the percentage of revenue that a company generatesthat can be used to pay the company's investors (both equity investors and debt

investors) and the tax man. It is a key measure in analyzing a stock's value. Other

things being equal, the higher the operating margin, the better. Using a percentage

figure is also very useful for comparing companies against or analyzing the

operating results of one company over various revenue scenarios. Operating

margin ratio of 9% means that a net profit of $0.09 is made on each dollar of sales.

Thus a higher value of operating margin ratio is favorable which indicates that

more proportion of revenue is converted to operating income. An increase in

operating margin ratio overtime means that the profitability is improving. It is also

important to compare the gross margin ratio of a business to the average gross


38/47

profit margin of the industry. In general, a business which is more efficient is

controlling its overall costs will have higher operating margin ratio. Operating

profit is important because it is an indirect measure of efficiency. The higher the

operating profit, the more profitable a company's core business is. Several things

can affect operating profit, such as pricing strategy, prices for raw materials, or

labor costs, but because these items directly relate to the day-to-day decisions

managers make, operating profit is also a measure of managerial flexibility and

competency, particularly during rough economic times. It is also important to note

that some industries have higher labor or materials costs than others. This is why

comparing operating profits or operating margins is generally most meaningful

among companies within the same industry, and the definition of a "high" or "low"

profit should be made within this context.

Year

Operating income

Rs. in crores

Net sales

Rs. in

crores

Ratio

2011

2012

18.12

183.55

11062.40

10380.81

0.16%

1.76%

Interpretation

a) Rise in Operating income

b) Fall in net sales

c) Ultimately increasing the ratio

Chart no.: 5.12 Operating profit margin


39/47

Operating income Net salesOperating profit

margin

2011 18.12 11062.4 0.16%

2012 183.55 10380.81 1.76%

0

2000

4000

6000

8000

10000

12000

AxisTitle

D. Return on Equity (ROE)

This ratio shows the profit attributable to the amount invested by the owners of

the business. It also shows potential investors into the business what they might

hope to receive as a return. The stockholders equity includes share capital, share

premium, distributable and non-distributable reserves. Return on equity or return

on capital is the ratio of net income of a business during a year to its stockholders'

equity during that year. It is a measure of profitability of stockholders' investments.

It shows net income as percentage of shareholder equity. The ratio is calculated as

follows:

Net profit after taxes and preference dividendReturn on Equity =__________________________________________

Equity capital

a) Net income is the after tax income


40/47

b) Average shareholders' equity is calculated by dividing the sum of shareholders'

equity at the beginning and at the end of the year by 2. The net income figure is

obtained from income statement and the shareholders' equity is found on balance

sheet.

Significance:

This ratio measures the profitability of the capital invested in the business by

equity shareholders. As the business is conducted with a view to earn profit, return

on equity capital measures the business success and managerial efficiency. It

reveals whether the firm has earned a reasonable profit to its equity shareholders or

not by comparing it with its own past records, inter-firm comparison and

comparison with the overall industry average. This ratio is of significant use in the

ratio analysis from the standpoint of the owners of the firm. Return on equity is an

important measure of the profitability of a company. Higher values are generally

favorable meaning that the company is efficient in generating income on new

investment. Investors should compare the ROE of different companies and also

check the trend in ROE over time. However, relying solely on ROE for investment

decisions is not safe. It can be artificially influenced by the management, for

example, when debt financing is used to reduce share capital there will be an

increase in ROE even if income remains constant.

Table: 5.13 RETURN ON EQUITY


41/47

Year

Net Profit after

Tax and

Preference

Dividend

Rs. in crores

Equity

Capital

Rs. incrores

Ratio

2011

2012

237.10

61.54

1947.04

1917.16

12.17%

3.2%

Interpretation

In the year 2011, the return on equity ratio is 12.17% but in the year 2012 it

reduced to 3.2%, which may due to

a) Capital investment

b) Shortage in Reserve and Surplus

c) Excessing selling and distribution expenses.

d) Increase in finance cost

e) Increase in Depreciation cost

f) Reduction in interest income

Chart no.: 5.13 RETURN ON EQUITY


42/47

Net profit Equity Return on Equity

2011 237.1 1947.04 12.17%

2012 61.54 1917.16 3.20%

0

500

1000

1500

2000

2500

AxisTitle

E. Return on Assets

An indicator of how profitable a company is relative to its total assets. ROA givesan idea as to how efficient management is at using its assets to generate earnings.Calculated by dividing a company's annual earnings by its total assets, ROA isdisplayed as a percentage. Return on assets is the ratio of annual net income toaverage total assets of a business during a financial year. It measures efficiency ofthe business in using its assets to generate net income.ROA = Annual Net Income

AverageTotal Assetsa) Net income is the after tax income. It can be found on income statement.

b) Average total assets are calculated by dividing the sum of total assets at thebeginning and at the end of the financial year by 2. Total assets at the beginningand at the end of the year can be obtained from year ending balance sheets of twoconsecutive financial years.

Significance


43/47

ROA tells you what earnings were generated from invested capital (assets). ROA

for public companies can vary substantially and will be highly dependent on the

industry. This is why when using ROA as a comparative measure, it is best to

compare it against a company's previous ROA numbers or the ROA of a similar

company.Return on assets indicates the number of cents earned on each dollar of

assets. Thus higher values of return on assets show that business is more profitable.

This ratio should be only used to compare companies in the same industry. The

reason for this is that companies in some industries are most asset-insensitive i.e.

they need expensive plant and equipment to generate income compared to others.

Their ROA will naturally be lower than the ROA of companies which are low

asset-insensitive. An increasing trend of ROA indicates that the profitability of the

company is improving. Conversely, a decreasing trend means that profitability is

deteriorating.

Table 5.14 Return on Assets

Year

Net Income

Rs. in crores Total AssetsRs. in

crores

Ratio

2011

2012

237.10

61.54

4565.87

4867.20

5.19%

1.26%

Interpretation

a) Significant fall in Net income major reason of fall in Ratio

b) Rise in Assets but not much significant


44/47

c) Giving a great fall I ratio by 3.93%

Chart no. 5.14 Return onAssets

Net Income Total Assets Ratio

2011 237.1 4565.87 5.19%

2012 61.54 4867.2 1.26%

0

1000

2000

3000

4000

5000

6000

F. Return on Capital Employed

A ratio that indicates the efficiency and profitability of a company's capital

investments. ROCE should always be higher than the rate at which the company

borrows; otherwise any increase in borrowing will reduce shareholders' earnings.

Return on capital employed (ROCE) is the ratio of net operating profit of a

company to its capital employed. It measures the profitability of a company by

expressing its operating profit as a percentage of its capital employed. Capital

employed is the sum of stockholders' equity and long-term finance


45/47

Significance

By comparing net income to the sum of a company's debt and equity capital,

investors can get a clear picture of how the use of leverage impacts a company's

profitability. Financial analysts consider the ROCE measurement to be a more

comprehensive profitability indicator because it gauges management's ability to

generate earnings from a company's total pool of capital. A higher value of return

on capital employed is favorable indicating that the company generates more

earnings per dollar of capital employed. A lower value of ROCE indicates lower

profitability. A company having less assets but same profit as its competitors will

have higher value of return on capital employed and thus higher profitability.

Table 5.14 Return on Capital Employed

Year

EBIT

Rs. in crores CapitalEmployed

Rs. incrores

Ratio

2011

2012

311.07

141.63

2214.6

2241.6

0.13

0.06

Interpretation

a) Significant fall in EBIT

b) Hence reducing the Ratio by 0.07


46/47

Chart no. 5.14 Return on Capital Employed

EBIT Capital Employed Ratio

2011 311.07 2214.6 0.13

2012 141.63 2214.6 0.06

0

500

1000

1500

2000

2500


47/47

Bibliography

www.hcl.in

www.hclinfosystems.in

www.investopedia.com

http://accountingexplained.com

http://www.managementstudyguide.com

http://www.ccdconsultants.com

http://www.answers.com
http://www.hcl.in/http://www.hcl.in/http://www.hcl.in/http://www.hcl.in/http://www.hclinfosystems.in/http://www.hclinfosystems.in/http://www.hclinfosystems.in/http://www.hclinfosystems.in/http://www.investopedia.com/http://accountingexplained.com/http://www.managementstudyguide.com/http://www.ccdconsultants.com/http://www.answers.com/topic/operating-margin#ixzz2YnynnY7jhttp://www.hcl.in/http://www.hclinfosystems.in/http://www.investopedia.com/http://accountingexplained.com/http://www.managementstudyguide.com/http://www.ccdconsultants.com/http://www.answers.com/topic/operating-margin#ixzz2YnynnY7j

Documents

Financial Ratio Intrepretation