Times Series of financial Ratios

Besides looking at the ratios for one year, one would like to look at the ratios for several years. This will help in the detection of secular changes and avoidance of the bias introduced by transitory forces. Below is presented certain ratios for Horizon Limited for a period of five years (year 5 corresponds to 20X1) Looking at this we find that:

1) The debt equity ratio improved for three years in succession but deteriorated in the last year.
2) The total assets turnover ratio remained more or less the same.
3) The net profit margin ratio improved impressively in the second year but subsequently declined somewhat steeply over the remaining three years.
4) The return on equity followed the pattern of the net profit margin ratio.
5) The price earnings ratio deteriorated steadily over time except in the last year.

Comparison of ratios of Horizon Limited with Industry Average

Liquidity:

Current ratio = Current assets / Current liabilities

Acid test ratio = Quick assets / Current liabilities

Leverage:

Debt equity ratio = Debt / Equity

Debt ratio = Debt / Assets

Interest coverage ratio = PBIT / Interest

Turnover:

Inventory = Net sales / Average inventory

Accounts receivable turnover = Net credit sales / Average accounts receivables

Fixed assets turnover = Net sales / Average net fixed assets

Total assets turnover = Net sales / Average total assets

Profitability:

Gross profit margin ratio = Gross profit / net sales

Net profit margin ratio = Net profit / Net sales

Return on assets = Net profit / Average total assets

Earning power = PBIT / Average total assets

Return on capital employed = PBIT (1 – T) / Average total assets

Return on equity = Equity earnings / Average net worth

Valuation:

Price earnings ratio = Market price per share / Earnings per share

Yield = dividend+ Price change / Initial price

Market value to book value ratio = Market price per share / Book value per share

Du Pont Analysis:

The Du Pont Company of the US pioneered a system of financial analysis which has received widespread recognition and acceptance. A useful system of analysis, which considers important interrelationships based on information found in financial statements, it has adopted by many firms in some form or the other.

At the apex of the Du Pont chart is the return on assets (ROA), defined as the product of the net profit margin (NPM) and the total assets turnover ratio (TATR):

Net profit / Average total assets = net profit / net sales x
ROA NPM

Net sales / average total assets eq (1)
TATR

Such decomposition helps in understanding how the return on total assets is influenced by the net profit margin and the total assets turnover ratio.

The upper side of the Du Pont chart shows the details underlying the net profit margin ratio. An examination of this side may indicate areas where cost reductions may be effected to improve the net profit margin. If this is supplemented by comparative common size analysis, it becomes relatively easier to understand where cost control efforts should be directed.

The lower side of the Du Pont chart throws light on the determinants of the total assets turnover ratio. If this is supplemented by a study of component turnover ratios (inventory turnover, debtors’ turnover, and fixed assets turnover), a deeper insight can be gained into efficiencies / inefficiencies of asset utilization.

The basic Du Pont analysis may be extended to explore the determinants of the return on equity (ROE).

Net profit / Equity = Net profit / sales x Sales / Total assets x

ROE NPM TATR

Average total assets / Equity

1 ( 1 – DAR) ——————————–eq (2)

The third component on the right hand side of Eq (2) needs a little explanation. Average total assets dividend by average equity to 1 divided (1 – DAR). DAR stands for debt to assets ratio.