Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

Module I: Basics of Credit and Credit Process

Chapter 3: Financial Statements Analysis

Dr. M. Manickaraj

Objectives
The objective of this chapter is to analyze the financial statements using various tools.
Structure
3.1 Why financial statement analysis?
3.2 Tools for financial statement analysis
3.2.1 Common-size statements
3.2.2 Trend analysis
3.2.3 Ratio analysis
3.3 Ratios important for lending decisions
3.4 Conclusion

3.1 Why financial statement analysis?

All business transactions that can be measured in monetary terms are entered in to the
books of accounts. At the end of every year, two statements, namely, profit and loss (P&L)
account and balance sheet are prepared. These statements report the effect of all the
transactions that took place during the accounting year, in a summarised form. The P&L
account reports the profit or loss made by a business firm during the period and the
balance sheet shows the assets and liabilities of the firm as on the last day of the
accounting year.
Accounting practices are governed by globally accepted accounting standards and the
financial statements are presented in a standard format which is more or the less the
same across the entire world. One feature of financial statements is that irrespective of
size and nature of business of a firm, balance sheet and P&L account are presented in one
page each. Therefore, if one can read and analyze the financial statements of a company
one can analyse the financial statements of any firm in the world.
Performance of business firms is influenced by innumerable factors both external and
internal to a firm. External factors may include developments in global and domestic
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Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

economies, government policy, political and social conditions, nature, etc. Internal
factors, on the other hand, may include management, human resource, financial
condition, marketing capabilities, technology and so on. The impact of all these factors
will influence business operations and will reflect in the financial statements of the firm.
Moreover, the effect of all actions and inactions of the management and their efficiency
or inefficiency too will be reflected in financial statements. Therefore, financial
statements are an indispensable source of information and hence analysing the same is a
must for managerial decisions, investment decisions and also for lending decisions.
Lenders are generally keen on ascertaining the funding requirements and repayment
capacity of a borrowing firm. Both can be ascertained from the financial statements of the
borrower.

Financial statements include:

· Profit and Loss Account
· Balance sheet
· Cash flow statement

Profit and Loss Account :

It is the Income and Expenses statement, generally, for one accounting year and reflects
the performance of the business entity giving information on the sales, production
expenses, Gross profit, Sales expenses and other costs, Net profit and how the net profit
is appropriated and what is transferred as reserves for future business.
Balance sheet : It is the statement of the Assets and Liabilities of a Business entity on a
particular date, generally the last date of an accounting year. It reflects all the funds
pooled for the Business which may be owned funds, long term loans, current liabilities
and how the same have been used by the business entity viz., Fixed Assets, Investment,
Current assets etc.
A sample balance sheet format is given below:

Liabilities (Sources of fund for the Assets (Uses of fund in the

Business) Business)
I-Owned Fund IV -Fixed Assets
v Capital/Paid up capital v Land
v Reserve & Surplus v Building & Structure
v Share Premium v Plant & Machinery
v Share Application money v Furniture & fixture
v Vehicle
II- Long Term Liabilities v Equipment
v Term Loans v Others Fixed Assets
v Unsecured loans v Capital work in progress
v Other Long term Liabilities
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V -Non-Current Assets
III- Current Liabilities v Investment
v Short Term borrowing-Working v Other non-current assets
capital
v Sundry Creditors VI - Current Assets
v Provisions v Cash & Bank Balance
v Installment of TL v Stock
v Other short term Liabilities v Trade Receivables
v Loans & Advances –short
term

VII-Intangible Assets
v Goodwill
v Patent
v Copyright
v Trade Marks
v Preliminary Expenses not
written off
Contingent Liabilities:- These are shown below the balance sheet and are
called off-balance sheet items.

Liabilities in I & II are Long term in nature and items under III, Current Liabilities are
short term in nature. Current liabilities are obligations that are due within the next
one year from the date of balance sheet.

Similarly in the Assets side, IV are long term in nature. Items in V are not immediately
convertible as cash and VII –Intangible assets are non-physical in nature. However,
preliminary expenses not written off are not assets at all. Any expenses not-written off
will appear on the asset side of the balance sheet and these are fictitious in nature.

Current assets are assets which are expected to be converted to cash within the next
one year.

3.2 Tools for financial statement analysis

There are many tools for analyzing financial statements. Commonly used tools for
financial analysis are:
• Common-size statements
• Trend statements
• Ratio analysis
• Cash flow analysis
In the following sections, financial statements of Bajaj Auto Ltd and TVS Motor Company
Ltd are used to illustrate financial statement analysis. Both companies are market leaders
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Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

in the two wheeler industry in India. The balance sheet of both the companies for the
financial years 2014-15 and 2015-16 are presented in Annexure 1 and the P&L account
of these two companies are presented in Annexure 2.

3.2.1 Common-Size Statements

One simple approach for evaluating the performance of a firm is by comparing the
financials of the firm with that of its peers. Financial statements provide absolute value
of different items which cannot easily be compared with other firms nor with
benchmarks. Besides, absolute values cannot easily be compared across time. Therefore,
all figures shown in profit and loss account and balance sheet may be converted into
percentages.
Common-size profit and loss account presents sales of each year and each company as
100 and all the items of the income statement as percentage to sales and as all the values
in the profit and loss account have a common denominator the statement is referred to
as common-size profit and loss account.
Table 1 is the common size profit and loss account of Bajaj Auto and TVS Motor for the
financial years 2014-15 and 2015-16 (refer Annexure 1 and Annexure 2 for the absolute
values). The table shows the cost structure of a business firm and profit margins. The
figures in the table are comparable across years and also across companies.

Table 1: Common-Size Profit and Loss Accounts of Bajaj Auto Ltd and
TVS Motor Co Ltd

Bajaj Auto Ltd TVS Motor Company Ltd

2015-16 2014-15 2015-16 2014-15
Net sales 100.0% 100.0% 100.0% 100.0%
Raw material cost 66.4% 68.8% 71.4% 72.7%
Employee cost 3.9% 4.0% 5.9% 5.9%
Power and fuel 0.5% 0.5% 0.8% 0.9%
Other Manufacturing Expenses 5.1% 4.9% 5.1% 5.2%
Depreciation 1.1% 1.2% 1.7% 1.5%
Cost of Goods Sold 77.0% 79.4% 84.8% 86.2%
Gross Profit 23.0% 20.6% 15.2% 13.8%
General and Administration
Expenses 0.5% 0.5% 3.8% 3.8%
Selling and Distribution Expenses 2.8% 2.3% 6.4% 5.5%

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Total operating cost 80.3% 82.2% 95.0% 95.5%

Operating Profit (EBIT) 19.7% 17.8% 5.0% 4.5%
Interest 0.0% 0.0% 0.4% 0.3%
Other income/expenses 4.0% 2.7% 0.5% 0.3%
PBT and extraordinary items 23.7% 20.5% 5.0% 4.5%
Exceptional income/expenses 0.0% -1.6% 0.0% 0.0%
Profit Before Tax (PBT) 23.7% 18.9% 5.0% 4.5%
Tax 7.6% 5.9% 1.2% 1.1%
Profit After Tax (PAT) 16.1% 13.0% 3.8% 3.5%

Analysis of Table 1 provides the following inferences:

· The largest cost item for both the companies is raw material. However, Bajaj auto
has incurred raw material cost equivalent to 66.4% of net sales during 2015-16.
Whereas, the raw material cost for TVS Motor was 71.4% of its net sales during
the same year which was significantly higher than that of Bajaj Auto.
· The other major items of cost including employee cost, general and administration
expenses, and selling and distribution expenses too were higher for TVS Motor
resulting in very low operating profit margin (EBIT) of 5.0% compared to 19.7%
for Bajaj Auto.

Due to higher costs TVS Motor’s net profit margin was substantially lower at 3.8%
compared to 16.1% of Bajaj Auto.

Common-size profit and loss account also enables comparison of performance of

companies across time on each and every item of the P&L account. However, the
comparisons are made in reference to net sales only. That is, one can see whether a cost
item has increased or decreased as a percentage of sales. For instance, the raw material
cost of Bajaj Auto has decreased from 68.8% of net sales in 2014-15 to 66.4% in 2015-16.
Similarly, TVS Motor’s raw material cost has declined from 72.7% to 71.4% during the
same period.

Common-size balance sheet is a statement where all the assets and liabilities of a
company are expressed as percentage to total assets of the company. Total assets,
therefore, will always be shown as 100. Table 2 presents the common-size balance sheets
of TVS Motor and Bajaj Auto. It shows the share of various assets and liabilities in total
assets of the two companies. The inferences that emerge from the analysis of the table
are as follows:

· Net worth of Bajaj Auto is very high at 78.4% of its total assets against TVS Motor’s
net worth of 38.1%. It indicates the fact that Bajaj Auto uses mostly equity capital
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whereas TVS Motor relies on substantial amount of outsiders’ money including

trade credit, and borrowings.
· The asset side of the common-size statement shows that Bajaj Auto has a huge
amount of investments (60.7% of total assets) and is using a very limited amount
of fixed assets and current assets. Bajaj Auto has also substantial cash and bank
balance (5.5% of total assets) compared to TVS Motor’s cash and bank balance of
0.7%.
· Notably, TVS Motor’s inventory and receivables are very high indicating a
substantial amount of capital is locked up in those current assets. Probably
because of lower level of assets Bajaj Auto does not need loans and its profitability
is very high.
Table 2: Common Size Balance Sheets of Bajaj Auto Ltd and
TVS Motor Company Ltd

Bajaj Auto Ltd TVS Motor Company Ltd

Mar-16 Mar-15 Mar-16 Mar-15
Share capital 1.8% 1.9% 1.0% 1.0%
Reserves 76.6% 66.8% 38.1% 34.7%
Net Worth 78.4% 68.7% 39.0% 35.7%
Long-term borrowings 1.0% 0.7% 12.9% 12.3%
Deferred tax liability 0.2% 0.4% 3.5% 3.3%
Other long-term liabilities 1.2% 0.9% 0.0% 0.0%
Current Liabilities and Provisions: 19.1% 29.3% 44.6% 48.7%
Short-term borrowings 0.0% 0.0% 5.3% 8.7%
Trade creditors 12.9% 11.3% 31.1% 32.1%
Other current liabilities 3.9% 5.2% 6.2% 4.7%
Provisions 2.4% 12.8% 2.0% 3.2%
Total 100.0% 100.0% 100.0% 100.0%

Net Fixed Assets 12.9% 12.3% 32.1% 28.9%

Capital work-in progress 0.3% 1.6% 0.6% 1.9%
Investments 60.7% 58.8% 23.9% 22.0%
Other non-current assets 0.6% 0.4% 0.0% 0.0%
Current assets & Loans and
advances: 25.4% 26.8% 43.4% 47.2%
Inventory 4.6% 5.2% 16.6% 17.8%

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- Raw material 2.8% 2.9% 12.7% 12.2%

- Work-in-process 0.3% 0.2% 1.3% 1.1%
- Finished goods 1.5% 2.1% 2.6% 5.1%
Receivables 4.6% 4.6% 11.7% 10.9%
Cash and bank balance 5.5% 3.8% 0.7% 0.1%
Loans and advances 4.6% 3.5% 6.4% 12.2%
Other current assets 6.2% 9.7% 8.0% 6.2%
Total assets 100.0% 100.0% 100.0% 100.0%

3.2.2 Trend Analysis

Trend statement is another tool for analysing financial statements. Trend statements
show the trend in all the items by indexing the values to the values of a base year. This is
done by treating all the items of the base year as 100 and the values of the items in the
following years as percentage to the base year value of the respective items. Normally,
the oldest period is taken as the base year. In the illustration in Table 3 (showing items
of income, expenses and profits of both Bajaj Auto and TVS Motor) only two years data
have been used and the year 2014-15 is the base year and all the items are indexed to the
values of the respective items in the year 2014-15. For example, net sales of both the
companies in 2014-15 is shown as 100% and the 2015-16 sales is expressed as
percentage of 2014-15 sales.
Table 3: Trend Profit and Loss Account of Bajaj Auto Ltd and
TVS Motor Company Ltd

Bajaj Auto Ltd TVS Motor Company Ltd

2015-16 2014-15 2015-16 2014-15
Net sales 105.0% 100.0% 112.0% 100.0%
Raw material cost 101.3% 100.0% 110.0% 100.0%
Employee cost 102.3% 100.0% 112.1% 100.0%
Power and fuel 105.2% 100.0% 96.7% 100.0%
Other Manufacturing Expenses 109.3% 100.0% 108.5% 100.0%
Depreciation 98.2% 100.0% 123.8% 100.0%
Cost of Goods Sold 101.8% 100.0% 110.1% 100.0%
Gross Profit 117.0% 100.0% 123.4% 100.0%
General and Administration Expenses 109.5% 100.0% 113.7% 100.0%
Selling and Distribution Expenses 123.9% 100.0% 129.6% 100.0%
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Total operating cost 102.5% 100.0% 111.4% 100.0%

EBIT 116.3% 100.0% 123.7% 100.0%
Interest 7.4% 100.0% 164.2% 100.0%
Other income/expenses 155.6% 100.0% 165.3% 100.0%
PBT and extraordinary items 121.7% 100.0% 124.1% 100.0%
Exceptional income/expenses 0.0% 100.0% --- ---
PBT 131.8% 100.0% 124.1% 100.0%
Tax 136.3% 100.0% 123.5% 100.0%
PAT 129.8% 100.0% 124.2% 100.0%

If such a statement is prepared for many years the trend in incomes and expenses will be
clearer. The table provides the following information:
· Bajaj Auto’s sales in 2015-16 was 105.0% of 2014-15 sales indicating 5% growth
in sales (105 - 100) during the year 2015-16. TVS Motor’s sales have grown by 12
percent during the same year.
· Raw material cost of TVS Motor has increased by 10 percent only compared to 1.3
percent for Bajaj Auto during 2015-16.
· Cost of power and fuel of Bajaj Auto has declined by 3.3% and that of TVS Motor
has increased by 5.2%
· Other manufacturing expenses of Bajaj Auto has grown at a higher rate of 9.3%
compared to TVS Motor’s 8.5%
· General and administration expenses and also selling and distribution expenses of
TVS Motor have grown at a higher rate than that of Bajaj Auto.
Interest expense of TVS has grown at a very high rate of 64.2%. Whereas, Bajaj Auto’s
interest expense declined sharply by 92.6%.
Balance sheet shows many non-recurring items like capital, long term borrowings, fixed
assets, investments and the like. Therefore, analysing the trend in balance sheet items
would not provide any meaningful information.
Common-size statements and trend statements enable comparison of financial
performance of business firms and they are also highly useful for preparing projected
financial statements.
3.2.3 Ratio Analysis
Ratio is a fraction and the result of one number or quantity divided by another number
or quantity respectively. Financial ratios are the simplest mathematical tools that reveal
relationships hidden in mass of data, and allow making meaningful comparisons.

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Financial ratios are the most widely used tool for financial statements analysis. Various
ratios under the following headings are discussed in this chapter:
· Profitability ratios
· Turnover/Efficiency ratios
· Leverage/Solvency ratios
· Liquidity ratios
· Holding periods
· Operating cycle
· Equity ratios
Ratios are expressed in several ways. Some ratios are expressed as numbers, some in
number of days and some as percentages. Profitability ratios are expressed in percentage,
turnover ratios, liquidity ratios and few equity ratios are expressed in numbers. Leverage
ratios are expressed in proportion, and holding periods like inventory period, receivables
period, operating cycle and the like are expressed in number of days or in months.

Profitability Ratios
Profitability of a firm can be analysed from two points of view – (1) profit per every rupee
of income; and (2) return on investment. The former set of ratios including gross profit
margin, cash profit margin, operating profit margin and net profit margin are referred to
as profit margin ratios. The latter including return on total assets, return on capital
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employed and return on equity are ratios which show the profit earned on investment.
The later three ratios show the profitability from three different points of view. Return
on total assets is the profit on total investment made in the firm (including owners’ funds
and outsiders’ funds), return on capital employed is the profitability on total long-term
capital employed and return on equity is the profit made on equity investment.
The profitability ratios are classified under the three heads, namely, profit margins,
return on investment and coverage ratios.

Profit margin ratios:

Gross Profit
Gross Profit Margin = ´ 100 ........................ (1)
Net Sales
EBITDA
Cash Profit Margin = ´ 100 ........................ (2)
Net Sales
EBIT
Operating Profit Margin = ´ 100 ...................... (3)
Net Sales
Profit After Tax
Net Profit Margin = ´ 100........................ (4)
Net Sales

Return on Investment Ratios:

EBIT
Return on Assets = ´ 100 .......... .......... ... (5)
Average Total Assets
EBIT
Return on Capital Employed = ´ 100 .......... ...... (6)
Average Long Term Capital Employed
Profit After Tax
Return on Equity = ´ 100 .......... .......... ... (7)
Average Tangible Net Worth

Profitability ratios are expressed in percentage and the results for the two companies,
TVS Motor and Bajaj Auto, for the year 2015-16 are shown in Table 4. The results show
that Bajaj Auto’s performance is much better than TVS Motor on all the parameters.
Return on equity (ROE) of Bajaj Auto, for instance is 31.80 percent compared to TVS
Motor’s24.10 percent.

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Table 4: Profitability Ratios of Bajaj Auto Ltd and TVS Motor Company Ltd

Bajaj Auto Ltd TVS Motor Company Ltd

Margin Ratios:
Gross Profit Margin 23.0% 15.2%
Cash Profit Margin 20.9% 6.7%
Operating Profit Margin 19.7% 5.0%
Net Profit Margin 16.1% 1.1%
Return on Investment Ratios:
ROA 28.6% 11.7%
ROE 31.8% 24.1%
ROE(NNOI)# 23.8% 21.2%
#: ROE (NNOI) = ROE, net of non-operating items

It may be noted that ROE is calculated based on the profit after tax which includes non-
operating incomes and gains as well as non-operating expenses and losses. Such non-
operating items like gain or loss on sale of assets and investments cannot be expected to
happen every year. Other income/expenses and exceptional income/expenses are the
two non-operating items in the profit and loss account of the two companies (Annexure
2). Therefore, such items shall be ignored while calculating ROE. The ROE excluding non-
operating items also has been calculated for both the companies and the same too have
been presented in Table 4. The table shows that the ROE adjusted for non-operating
items is lower than unadjusted ROE for both TVS Motor and Bajaj Auto.
Turnover Ratios
Turnover ratios measure how efficiently the assets have been turned over into sales.
Some of the turnover ratios used for analysis are total assets turnover ratio, fixed assets
turnover ratio and current assets turnover ratio. In all the three ratios net revenue from
operations (net sales) is the numerator. Every business firm uses various types of assets
to produce goods or services and then to sell them to customers. However, business firms
can differ in their efficiency in utilising their assets to generate income (i.e. sales). Higher
the turnover ratio, higher is the efficiency of the firm. Formulae for the three different
turnover ratios are:

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Net Sales
Total Assets Turnover = .......................... (9)
Average Total Assets
Net Sales
Fixed Assets Turnover = .........................(10)
Average Fixed Assets
Net Sales
Current Assets Turnover = ..............(11)
Average Total Current Assets

Turnover ratios of TVS Motor and Bajaj Auto for the year 2015-16 are shown in Table 5.
Total assets turnover ratio of TVS Motor is 2.4 which is greater than Bajaj Auto’s ratio of
1.5. One has to note here that total assets of a firm include all assets used in its operations
and also investments made outside the business. Bajaj Auto has substantial investment
(Rs. 9512.66 crore) as can be seen in Annexure [Link] made in subsidiaries and
marketable securities do not contribute to sales and therefore, total assets turnover ratio
may not be comparable. Fixed assets turnover ratio, hence, is a better indicator of
efficiency and is comparable across firms. However, two other factors which would make
the turnover ratios (both total assets turnover and fixed assets turnover) not comparable
is the level of outsourcing and vertical integration. If one firm produces most of its
requirements in-house and another procures mostly from outside, the ratios of the two
firms cannot be compared.
Table 5 shows that Bajaj Auto is more efficient than TVS Motor in terms of both fixed
assets turnover and current assets turnover.
Table 5: Turnover Ratios of Bajaj Auto Ltd and TVS Motor Company Ltd

Bajaj Auto Ltd TVS Motor Company Ltd

Total Assets Turnover 1.5 2.4
Fixed Assets Turnover 11.5 7.7
Current Assets Turnover 5.6 5.2

Profit Margins Vs Return on Investment: Business managers and investors would be

particularly interested in return on investment. They would be eager to know how much
return has been made out of the investment made in the business. Moreover, return on
investment ratios are inclusive of profit margins. For instance, return on assets ratio
(equation 5) can be rewritten as follows:
EBIT Net Sales
Return on Assets = ´ ´ 100 ........................... (8)
Net Sales Average Total Assets

The above equation captures operating profit margin as well as the efficiency with which
the assets have been utilised. Therefore, return on investment ratios are more
informative and important than profit margins.
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Leverage Ratios
Two most widely used leverage ratios are Debt-to-Equity ratio and Total Outside
Liabilities to-Equity ratio (TOL/TNW)1. Both the ratios take tangible net worth (TNW) in
the denominator. The difference between the two ratios is the numerator. While the
former takes long-term debt in the numerator the later uses total outside liabilities in the
numerator. Both the ratios show the relationship between owners’ funds and outsider’s
funds. Higher the ratio higher the leverage indicating greater dependence on outsiders’
funds. Therefore, in times of distress the creditors will not be able to recover their dues
fully from the sale of the firm’s assets. Besides, the interest on borrowings is a fixed cost
and is payable irrespective of the amount of profit earned. Therefore, during years when
a business firm has made very low profit or loss it will not be able to service debt. Use of
borrowings thus increases the risk of business firms. The risk arising due to use of debt
funds is called the financial risk. If owner’s funds are large the risk will be less. Between
the two ratios TOL/TNW is more important because it takes all the liabilities of a firm
into account.

................................ (12)
Long Term Borrowings
Debt to Equity Ratio =
TNW
(Long Term Debt + Short Term Debt)
Total Debt to Equity Ratio = ..................................(13)
TNW
TOL
Total Outside Liabilitie s to Equity Ratio = ................................ (14)
TNW

The results of the three ratios of our sample companies are given in Table 6. The ratios
show clearly that TVS Motor is using more long-term debt/outsiders’ funds than Bajaj
Auto. Nevertheless, the leverage in both the companies is very less and hence their
solvency position is good.
Table 6: Leverage Ratios of Bajaj Auto Ltd and TVS Motor Company Ltd

Bajaj Auto Ltd TVS Motor Company Ltd

Debt to Equity 0.0 0.3
Total Debt to Equity 0.01 0.47
TOL/TNW 0.3 1.6

Coverage Ratios: Lending institutions are particularly interested in knowing whether a

borrower will be able to service the loan given to them or not and hence Interest Cover
Ratio and Debt Service Cover Ratio (DSCR) are the two ratios they are especially
interested in. The former ratio measures the ability of the borrower in paying interest

1
TOL is nothing but total assets minus net worth.
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from out of his operating profit. The later ratio indicates the borrower’s ability to pay
interest and loan instalments from out of his operating profit.
Three different methods are given hereunder for finding out interest cover and three
methods are given for DSCR. According to the author, equations 15 and 18 are the
prudent ones for determining interest coverage and DSCR respectively. Accordingly the
ratios given in Table 7 have been calculated.
EBIT - Tax
Interest Cover = .......... .......... .......... ......... (15 )
Interest

( or )

EBITDA - Tax
Interest Cover = .......... .......... .......... .........( 16 )
Interest

(or )

PAT + Depreciati on + Interest

Interest Cover = .......... .......... .(17 )
Interest

EBITDA- Tax
DSCR= ..................(18)
Interest+ CurrentPortionof LongTermDebt

(Or)

EBITDA- Tax- Intereston WorkingCapitalCredit

DSCR= ................(19)
Intereston TermLoans+ CurrentPortionof LongTermDebt

(Or)

PAT+ Depreciati
on + Intereston TermLoans
DSCR= ................(20)
Intereston TermLoans+ CurrentPortionof LongTermDebt

The interest cover ratio of TVS Motor and Bajaj Auto are given in Table 7. The
interpretations of the results in the table are as follows:
· The ratio of Bajaj Auto is very high at 5707.5 because of very small amount of
borrowings used by the company and hence the interest burden. Besides, the
company’s profitability is very high compared to TVS Motor.
· Interest cover ratio of TVS Motor, on the other hand, is 8.90.
· Though the ratio for TVS Motor is very low compared to Bajaj Auto the ability of
the company to service its loans is more than adequate.
· Similarly, DSCR of Bajaj Auto is very high at 6247.8 compared to TVS Motor’s 3.20.

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· It may be noted that though the coverage ratios of TVS Motor is substantially lower
than that of Bajaj Auto it can comfortably service its loans. For instance, the DSCR
of TVS Motor reveals the fact that the company’s profit is 3.2 times the amount of
interest and principal of loan repayable during the year.

Table 7: Coverage Ratios of Bajaj Auto Ltd and TVS Motor Company Ltd

Bajaj Auto Ltd TVS Motor Company Ltd

Interest Coverage 5707.5 8.9
DSCR 6247.8 3.2

Liquidity Ratios
Another aspect different stakeholders in a business would be interested in is liquidity.
Three commonly used liquidity ratios are current ratio, quick ratio, and cash ratio2. The
ratios measure the ability of a firm to meet its current obligations (current liabilities)
from its current assets. While current ratio relates current assets to current liabilities the
quick ratio relates quick assets (current assets excluding inventory) to current liabilities.
Current assets are those which can be converted into cash within a period of one year and
current liabilities are obligations to be settled within one year. Amongst the various
current assets inventory cannot easily be converted into cash during times of distress and
hence it is not considered as a quick asset. To elaborate, if a business firm faces severe
crisis and could not run its business its ability to sell its inventory will be difficult. If at all
it can sell, it can do so at a substantially low price. On the other hand, sundry debtors,
another major current asset for any business firm, can be realised into cash quite easily
because the customers who have bought goods have to necessarily pay for it.
Current Assets
Current Ratio = .......... .......... ....... (21)
Current Liabilitie s
Current Assets - Inventory
Quick Ratio = .......... ........(2 2)
Current Liabilitie s
Cash and Bank Balance
Cash Ratio = .......... .......... ......(23)
Current Liabilitie s

Current ratio of TVS Motor is 0.97 (Table 8) compared to Bajaj Auto’s ratio of 1.33. The
ratio indicates clearly that Bajaj Auto has higher liquidity Than TVS Motor. The cash ratio
of Bajaj Auto (0.29) too is significantly greater than TVS Motor’s (0.01). All the three ratios
thus show that the liquidity position of Bajaj Auto is significantly higher than TVS Motor.

2
Current assets and current liabilities used for these ratios are current assets and loans and advances and
current liabilities and provisions respectively.
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Liquidity ratios should be interpreted from two different points of views. One is liquidity
and another important aspect is efficiency. Universally, business firms are working hard
to improve their working capital management such that they can run the business with
minimum amount of current assets. Just-in-time (JIT) is one approach to achieve this.
These two companies could probably be using all possible techniques including JIT to
minimise the level of their current assets.
Current ratio is also believed to show the proportion of current assets being funded by
equity capital. It is referred to as margin for working capital by banks and other lending
institutions. This is a wrong notion. Current ratio shows how much of the current assets
is funded by long term sources of finance and not by equity capital alone.

Note: It may be noted that the original balance sheets of both the companies have
reported the figures as per the revised format given in Schedule VI of Companies Act.
Under the revised format current investments will be shown under current assets.
Whereas, under the old format investments were being reported separately and as a
single item. Similarly, current maturities of long-term loans are shown under current
liabilities under the new format which was not the case earlier. Current ratio and quick
ratio of TVS Motor and Bajaj Auto have been calculated excluding investments from
current assets and current maturities of long-term loans from current liabilities.
Moreover, total provisions including noncurrent and current, total trade creditors
including noncurrent and current have been treated as current liabilities and total loans
and advances including noncurrent and current have been treated as current assets.

Table 8: Liquidity Ratios of Bajaj Auto Ltd and TVS Motor Company Ltd

Bajaj Auto Ltd TVS Motor Company Ltd

Current Ratio 1.33 0.97
Quick Ratio 1.09 0.60
Cash Ratio 0.29 0.01

Holding Periods
Another set of financial ratios one would be interested in is the holding period of current
assets and current liabilities. The holding periods which are important especially for the
lending institutions are inventory period, receivables period and payables period
(creditors period).
Inventory period is the time taken by a company to sell the finished goods from the date
of purchase of raw material. It can be broken down into (1) raw material holding period;
(2) work-in-process holding period and (3) finished goods holding period. Raw material
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holding period shows the material in stock is equivalent to how many days consumption.
Work-in-process inventory period is the time taken by a company to convert raw material
into finished goods and the finished goods inventory period is the time taken to sell the
finished goods from the date of completion of production.
Receivable period is the credit period offered by the company to its customers. It may
also be referred to as the collection period or the time taken for collecting money from
customers. Creditors period, on the other hand, is the time taken by the company to pay
the suppliers. Creditor period is also referred to as payable period.
The length of these holding periods will vary due to nature of business and efficiency of
working capital management. For instance, a firm manufacturing heavy machinery will
have a longer manufacturing cycle and hence the work-in-process inventory period. For
a food processing unit, on the other hand, the manufacturing cycle will be very short and
hence the work-in-process inventory holding period too will be short. Receivables
holding period would depend on the bargaining power of a company with its customers
and creditors period on the other hand would depend on the company’s bargaining
power with its suppliers. Therefore, while financing working capital the acceptable level
of inventory and receivables should be determined based on nature of business amongst
others.
The equations for calculating various holding periods are as follows:

Average Inventory
Inventory Period = ......................................... (24)
Cost of Goods Sold/365

Average Inventory of Raw Material

RawMaterial Inventory Period = .......................(25)
Raw Material Cost/365
Average Inventory of W.I.P
Work - in - Process Inventory Period =
(Raw Material Cost + 50% of other Manufactur ing Expenses)/365
.......................... (26)
Average Inventory of Finished Goods
Finished Goods Inventory Period = .....................(27)
Cost of Goods Sold/365

Average Receivables
Receivables Period = ..................................................................(28)
Sales/365

Average Trade Creditors

Creditors Period = ............................................................(29)
Raw Materials Cost/365

The holding periods for TVS Motor and Bajaj Auto for the year 2015-16 are presented in
Table 9. The table provides the following facts:
· The holding periods of Bajaj Auto is significantly shorter than TVS Motor’s.

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Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

· Inventory period of Bajaj Auto is just 16 days compared to TVS Motor’s inventory
period of 31 days.
· Similarly, the receivable period of TVS Motor too is longer than that of Bajaj Auto.
· TVS Motor’s creditor period is 69 days compared to Bajaj Auto’s 46 days revealing
the fact that TVS Motor takes substantially longer time to pay its suppliers.
It may be noted that longer current assets holding periods will lead to higher capital
requirement. If only TVS Motor can reduce its inventory holding period and receivables
period it will result in substantial release of capital locked up in these two items. This
will definitely help in minimising the interest cost, insurance cost, storage cost, and the
like and will help improve its profits.

Table 9: Holding Periods of Bajaj Auto Ltd and TVS Motor Company Ltd

Bajaj Auto Ltd TVS Motor Company Ltd

Inventory Period (A) 16 31
- Raw material holding 11 27
- WIP holding 1 2
- Finished goods holding 6 7
Receivables Period (B) 12 18
Creditors Period ( C) 46 69

Operating Cycle
Holding periods that make up the operating cycle and cash cycle are mainly the ones
indicating the holding periods of different current assets and current liabilities. Holding
periods for the purpose of finding out the length of operating cycle can be calculated by
using sales as the common denominator as in equations 30, 31, and 32. Operating cycle
of a typical business firm will start with the purchase of raw material and end with
collection of cash from its customers. To elaborate, the operating cycle will start with
purchase of raw material, conversion of raw material into finished goods, sale of finished
goods and finally collecting cash from customers. The time period between purchase of
raw material and sale of finished goods is nothing but the inventory period and the time
period between sale of finished goods and collection of cash is the receivable period.
Operating cycle, therefore, is the sum of inventory period and receivable period.

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Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

Average Inventory
Inventory Period = ............................................ (30)
Net Sales/365
............................................ (31)
Average Receivable
Receivable Period =
Net Sales/365
............................................ (32)
Average Trade Creditors
Creditors Period =
Net Sales/365
Operating Cycle = Inventory Period + Receivable Period ............................................ (33)
Net Operating Cycle = Operating Cycle - Creditors Period ............................................ (34)

Longer operating cycle may be due to inefficiency in operations and hence every firm
would strive for reducing the length of operating cycle. A part of the operating cycle is
financed by suppliers of raw material and other services and the remaining part of the
operating cycle can be called as the net operating cycle or as cash cycle. It may also be
referred to as cash-to-cash cycle.
The results shown in Table 10 show that Bajaj Auto’s operating cycle is of 24 days and
TVS Motor’s operating cycle is 44 days. However, both the companies are availing credit
from their suppliers for a period longer than their operating cycle and hence they do not
need working capital. The net operating cycle of the two companies hence are negative.
Table 10: Operating Cycle of Bajaj Auto Ltd and TVS Motor Company Ltd

Bajaj Auto Ltd TVS Motor Company Ltd

Inventory Period (A) 12 27
- Raw material holding 7 19
- WIP holding 1 2
- Finished goods holding 5 6
Receivables Period (B) 12 18
Creditors Period ( C) 30 49
Operating Cycle (D = A+B) 24 44
Net Operating Cycle (D - C) -7 -5

Equity Ratios
In addition to the ratios discussed in the previous sections various stake holders are also
interested in calculating and analysing equity ratios. The key equity ratios which are
commonly used are as follows:
Earnings per share (EPS) = Profit after tax / Number of shares outstanding…………..
(32)

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Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

Dividend per share (DPS) = Total dividends paid in a year / Number of shares
outstanding…(33)
Pay-out ratio = DPS / EPS
……………………………………………………………………………. (34)
Retention ratio = 1 – Pay-out ratio
………………………………………………………………. (35)
Book value per share = Tangible net worth / Number of shares outstanding
.………….. (36)
PE Ratio = Current Market Price of Equity Shares/ EPS
…………………………………….. (37)
PB Ratio = Current Market Price of Equity Shares / Book value per share
……………. (38)
Caution is required while interpreting ratios which are expressed as value per share. EPS,
DPS and book value per share should not be compared with other companies. In fact,
these three are not ratios. Rather, they are absolute values per share. Moreover, they are
not only influenced by the performance of the companies but also by face value of shares,
bonus issues, and stock splits. Supposing, if a company goes for splitting its shares from
say Rs. 10 per share to Rs.5 per share it will result in a sudden fall in the values of these
ratios by 50 percent because the number of shares will become double but the amount of
capital will remain the same. Bonus issue will also have the same effect. Moreover, the
book value of shares will also be influenced by the age of a firm. Longer the existence of
a company larger could be the amount of reserves and surpluses and hence the book
value. Contrarily, for a new company the book value will be less though the performance
of the company in terms of profitability and other parameters might be comparable.
The equity ratios of TVS Motor and Bajaj Auto have been calculated and the results are
presented in Table 11. EPS, DPS and book value of Bajaj Auto is much larger than TVS
Motor. This is due to better performance of Bajaj Auto and also might be due to the above
mentioned factors.
Pay out and retention of profit are determined by factors like growth potential and
requirement of capital for tapping the potential. If a firm has great potential to grow then
the need for ploughing back the profits will be very high. Such companies and those
companies in emerging sectors will pay out very less of their profits as dividends to their
shareholders. Therefore, the pay-out ratio of such companies will be very less and
retention rate will be very high. These two ratios will also be decided by the dividend
policies of the companies. Table 11 shows that TVS Motor has paid out 27 percent of its
profits earned during 2015-16 as dividends and balance is retained. Bajaj Auto, on the
other hand, has paid out 44 percent of profits as dividends and only 56 percent is
retained.

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Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

PE and PB ratios are comparable and are very widely used by the investors for valuation
and other purposes. Normally, companies whose earnings grow at very high rates will
have very high PE ratio and high PB ratio. The results shown in Table 11reveal that equity
shares of Bajaj Auto are trading at 21.1 times its earnings and 6.3 times its book value.
Whereas, TVS Motor’s shares are trading at 31.6 times its earnings and 7.1 times its book
value. The shares of TVS Motor thus are trading at a higher level. This could be because
the investors expect the performance of the company to be better in the future.
Table 11: Equity Ratios of Bajaj Auto Ltd and TVS Motor Company Ltd

Bajaj Auto Ltd TVS Motor Company Ltd

EPS 126.22 9.10
DPS 55.00 2.50
Book value per share 424.77 40.77
Pay-out ratio 44% 27%
Retention ratio 56% 73%
P/B 6.3 7.1
P/E 21.1 31.6

3.3 Ratios Important for Lending Decisions

Though many ratios have been discussed in this chapter and many more ratios can be
calculated for analysis of financial statements the following ratios are highly relevant for
making lending decisions.

For Working Capital Loan Decisions For Term Loan Decisions

· Interest coverage ratio · DSCR
· Holding periods and operating cycle · Debt/Equity Ratio
· TOL/TNW · TOL/TNW

3.4 Conclusion
Financial statement analysis is critically important for various managerial, investment
and lending decisions. While different tools help in making various decisions common-
size statements and trend statements will be more relevant while preparing projected
financial statements. Ratios are useful for variety of purposes including for projecting
financial statements.
Business firms though may be in the same line of business they may differ in their level
of forward and backward integration, etc. Besides, business firms are able to reduce the
level of assets while maintaining their level of activities and hence the standards for
various financial parameters are becoming irrelevant. For instance, adopting techniques
like JIT level of inventory can be reduced to bare minimum. Similarly, by arranging

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Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

finance for customers receivables period can be reduced. Therefore, one should be very
cautious in interpreting the ratios especially when comparing ratios of one firm with
another.
Annexure 1
Balance Sheet of Bajaj Auto Ltd and TVS Motor Company Limited
Bajaj Auto Ltd TVS Motor Company Ltd
Mar-16 Mar-15 Mar-16 Mar-15
Share capital (A) 289.37 289.37 47.51 47.51
Reserves (B) 12002.29 10402.78 1889.29 1597.85
Net Worth (C = A+B) 12291.66 10692.15 1936.80 1645.36
Long-term borrowings (D)@ 162.48 112.35 638.10 564.38
Other long-term liabilities (E ) 29.78 57.59 175.67 152.75
Deferred tax liability (F) 188.25 141.58 0.00 0.00
Current Liabilities and Provisions:
(G = H+I+J+K) 3000.59 4558.65 2212.00 2242.16
Short-term borrowings (H) 0.00 0.25 264.23 399.76
Trade creditors (I) 2027.04 1760.53 1543.71 1478.50
Other current liabilities (J) 604.53 805.86 305.60 215.14
Provisions (K) 369.02 1992.01 98.46 148.76
Total Capital and Liabilities
(C+D+E+F+G) 15672.76 15562.32 4962.57 4604.65
Net Fixed Assets (L) 2025.67 1917.24 1592.85 1329.63
Capital work-in progress (M) 52.24 254.94 30.96 89.36
Investments (N) 9512.66 9153.32 1184.57 1012.46
Other non-current assets (O) 94.28 67.23 0.00 0.00
Current Assets & Loans and
Advances: (P) 3987.91 4169.59 2154.19 2173.20
Inventory (Q = R+S+T) 719.07 814.15 825.97 819.68
- Raw material (R ) 433.90 456.28 631.62 563.95
- Work-in-process (S) 42.61 28.65 63.55 48.71
- Finished goods (T) 242.56 329.22 130.80 234.02
Receivables (U) 717.93 716.96 578.69 503.86
Cash and bank balance (V) 859.52 586.15 32.84 5.39
Loans and advances (W) 722.56 543.67 318.75 561.07
Other current assets (X) 968.83 1508.66 397.94 283.20
Total Assets (L+M+N+O+P) 15672.76 15562.32 4962.57 4604.65

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@: includes Current Portion of Long

Term Debt 0.00 0.58 143.87 45.40
Stock Price on July 27, 2016 2668.75 287.8
Face Value 10 1
Number of shares 28.937 47.51

Annexure 2
Profit and Loss Account of Bajaj Auto Ltd and TVS Motor Company Limited

Bajaj Auto Ltd TVS Motor Company Ltd

2015-16 2014-15 2015-16 2014-15
Net sales (A) 22687.59 21612.01 11243.87 10042.33
Raw material cost (B) 15060.08 14861.31 8025.48 7297.13
Employee cost (C ) 884.74 865.24 664.23 592.42
Power and fuel (D) 120.66 114.70 88.29 91.29
Other Manufacturing Expenses (E ) 1150.84 1053.10 570.56 525.73
Depreciation (F) 259.30 264.17 189.84 153.33
Cost of Goods Sold
(G = B+C+D+E+F) 17475.62 17158.52 9538.40 8659.90
Gross Profit (H = A - G) 5211.97 4453.49 1705.47 1382.43
General and Administration
Expenses (I) 112.70 102.91 428.89 377.08
Selling and Distribution Expenses
(J) 626.88 505.93 715.68 552.06
Total operating cost (K = G+H+I) 18215.20 17767.36 10682.97 9589.04
Operating Profit (EBIT) (L = A-K) 4472.39 3844.65 560.90 453.29
Interest (M) 0.48 6.49 47.94 29.20
Other income/expenses (N) 913.27 586.92 53.01 32.07
PBT and extraordinary items
(O = L-M+N) 5385.18 4425.08 565.97 456.16
Exceptional income/expenses (P) 0.00 -340.29 0.00 0.00
Profit Before Tax (PBT) (Q = O +P) 5385.18 4084.79 565.97 456.16
Tax (R ) 1732.77 1271.05 133.83 108.33
Profit After Tax (PAT) (S = Q-R) 3652.41 2813.74 432.14 347.83
Dividend 1591.54 1446.85 118.78 90.27
EBITDA (L + F) 4731.69 4108.82 750.74 606.62
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Case Exercise
Given below are the balance sheet and profit and loss account of Venus Ltd and do the
following based on the same. Calculate the ratios of the company and fill-in the blank cells
in Table 1
Balance Sheet of Venus Ltd (All figures are in INR Crore)
2015-16 2014-15
Share capital 296.5 296.5
Reserves 43612.06 33761.37
Net Worth 43908.6 34057.9
Long-term borrowings 26172.91 24530.07
Other long-term liabilities 1197.53 202.59
Current Liabilities and Provisions: 24700.2 19743.9
Short-term borrowings 16275.44 13128.72
Trade creditors 3421.19 2878.81
Other current liabilities 4915.08 2754.75
Provisions 88.52 981.59
Total Capital and Liabilities 95979.2 78534.4
Net Fixed Assets 30679.05 22125.86
Capital work-in progress 13567.15 17422.16
Investments 32461.19 26464.57
Other non-current assets 182.24 5.37
Current assets & Loans and advances: 19089.6 12516.4
Inventory 5026.14 5442.07
Receivables 1429.12 1157.69
Cash and bank balance 642.56 464.14
Loans and advances 11119.98 4500.52
Other current assets 871.8 952.02
Total assets 95979.2 78534.4

Current Portion of Long Term Debt 2856.49 2759.44

Stock Price on Nov 11, 2016 229.6
Face Value 1
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Profit and Loss Statement of Venus Ltd (All figures are in INR Crore)
2015-16 2014-15
Net sales 29810.62 32502.41
Raw material cost 18339.8 20105.77
Employee cost 603.53 650.13
Power and fuel 4541.65 4534.41
Other Manufacturing Expenses 1235.56 1099.99
Depreciation 1217.97 1011.67
General and Administration
911.23 925
Expenses
Selling and Distribution Expenses 268.02 236.04
Miscellaneous Expenses 5.01 322.43
Total operating cost 27122.77 28885.44
EBIT 2687.85 3616.97
Interest 3541.36 3655.93
PBT and extraordinary items -853.51 -38.96
Other income/expenses 8823.82 2008.86
Exceptional income/expenses -2490.41 -2.43
PBT 5479.9 1967.47
Tax 8.02 40.27
PAT 5471.88 1927.2
Dividend 1037.75 1215.65

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Table 1: Ratios of Venus Limited

Cash Profit Margin
Operating Profit Margin
Net Profit Margin
ROA
ROE
Total assets turnover
Fixed Assets Turnover
Current Assets Turnover
Current Ratio
Debt-Equity
TOL/TNW
Interest Cover
Inventory Period
Receivables Period
Creditors Period
Operating Cycle
Net Operating Cycle
Book value per share
P/B
P/E

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