L.

Shivakumar
Financial Statement Analysis


Ratio Analysis

1. Financial statements provide absolute amounts that may not by themselves be meaningful
indicators of good or bad performance (since good or bad is relative to something). For e.g.,
a firms current asset of 100,000 and current liabilities of 50,000 do not tell much by
themselves. However, if they are related to one another as a ratio, we can tell that current
assets are twice as much as current liabilities and then we can comment on whether the firm
has sufficient short-term funds to pay its short-term liabilities.

2. We could come up with any number of ratios - but there are a few key ratios that are
generally helpful in financial analysis. These key ratios have been developed keeping in
mind the logical relationship between the items in the profit and loss accounts and the
balance sheets. For instance, we can expect sales and debtors to be positively related and
hence, can have a ratio which relates these items. Ratios that do not have a logical
relationship between the items may not be useful for financial analysis. Example, trying to
relate cost of goods sold to the financial investments made by a firm is not helpful.

3. There are no standards for ratio definitions. We need to keep in mind the precise way in
which we define the ratios before interpreting the ratios

4. Ratio analysis can help us answer questions on a firms: (1) performance (2) efficiency of
utilisation of its resources (3) liquidity and (4) long-term solvency

5. Ratio analysis involves comparing one set of ratios against another - either time-series or
cross-sectional.

6. Since ratios are based on accounting numbers it will be useful to read through the
accompanying notes to financial statements to understand the assumptions and accounting
choices underlying these numbers. Such an understanding is helpful to maintain
comparability between firms or time periods, since the assumptions may vary over time and
may also vary across the firms that are being compared.

7. Ratios have several limitations: Most ratios assume a linear relationship between the
numerator and denominator. This may be incorrect in some cases. Also, accounting ratios
can be manipulated by appropriately timing the firms activities. (For e.g., managers can
change a firms current ratio by either advancing or postponing payments to creditors
discussed in detail later.)


Profitability ratios

Three of the highly used ratios in financial analysis are the following return on investment
measures:
(1) Return on Equity
(2) Return on capital employed
(3) Return on Total assets


(1) Return on equity = Net income
(ROE) Average shareholders funds

(a) The numerator is normally the net income before extra-ordinary items. Denominator can
either be average of opening and closing balances or just the closing balance in shareholders
funds.
(b) The ROE can be used as a starting point for systematic financial analysis of a firms
performance. ROE is a comprehensive indicator of a firms performance because it
provides an indication of how well managers are employing shareholders funds. ROE
measures the returns that a firm generates for its shareholders.
(c) In the long run, the value of the firms equity is determined by the relationship between its
ROE and its cost of equity capital. That is, those firms earnings ROEs (and those expected
to earn ROEs) in excess of the cost of equity capital will have market values in excess of
book value and vice versa.
(d) A comparison of ROE with the cost of capital is useful not only for contemplating the value
of the firm, but also in considering the path of future profitability. The generation of
consistent supernormal profitability will, absent significant barriers to entry, attract
competition. For that reason, ROEs tend over time to be driven by competitive forces
towards a normal level (typically, the cost of equity capital). Abnormal ROEs may arise
either because of industry conditions and competitive strategy or because of distortions in the
ratio from accounting assumptions.


(2) Return on total assets = trading profit before interest paid, taxation and exceptional items
(ROA) Average total assets for the period

(a) The numerator is the PBIT (Profit Before Interest and Taxes) and is a measure of the firms
profit available for distribution to all capital providers. The denominator is the average of
the opening and closing book values of total assets, although the closing balance may
sometimes be substituted for the average.

(b) The ROA measures the returns that a firm earns on all its resources (assets). Since total
assets equals sum of liabilities and shareholders funds, it can also be viewed as the return
earned by a firm to all providers of capital (short-term as well as long-term investors; debt as
well as equity investors).

Relationship between ROA and ROE to providers of investment base

+
Operating Income - Interest = Net Income
Equity
Debt
Assets
ROA
ROE


ROA measures the total returns generated by a firm for all providers of capital (equity and
debt). Since, debt holders get paid a fixed interest, ROE measures the residual return generated
by a firm for providers of equity.
2


(3) Return on capital employed = Operating income before exceptional items
(ROCE) Capital Employed

Capital employed is the total of all liabilities and shareholders funds arising from a companys
conscious financial decision. It includes long-term debt, bank loans, equity & preference
shareholders funds, but generally does not include trade creditors, accruals, deferred revenue,
etc.

This ratio is a modification of the ROA and focuses only on the returns generated from non-
operating sources of funds. In other words, it focuses only on returns to capital raised through a
conscious financial decision. Hence, the ROCE may actually be a better measure of the returns
of a firm to providers of capital than ROA.

This ratio is also referred to as the return on net assets.


(4) Profit margin or Net margin = Net income before extra-ordinary items
Sales

This ratio measures the net profit earned for every pound of sales by a firm. A highly efficient
firm that is able to keep its costs low will have a high profit margin. However, it should be
noted that profit margins vary significantly across industries. A few industries like
pharmaceuticals and health care enjoy high levels of profit margins, while other highly
competitive industries such as airlines and food retailing have relatively low profit margins.

Apart from industry effects, this ratio is also influenced by a firms choice of competing
strategy. For example, the profit margin for a discounter would be lower than that of a firm
selling premium/luxury products.

The profit margin is affected by a firms financial decision as well as by the tax laws of the
government since net income is computed after considering interest and taxes. In order to
measure the operating efficiency of a firm without having government decisions impact the
analysis, we may consider the following ratio:



(5) Operating margin = Operating income before interest and taxes
Sales

Both the profit margin and the operating margin assume that sales and profit are directly
proportional. However, this is not always the case since operating profit (as well as pre-tax
profits and net income) is computed after considering expenses that are not directly related to
sales. For instance, most administrative expenses (such as rent, managers salary, etc.) do not
directly vary with sales, but are included in the computations of operating profit. Hence, these
ratios do not measure the marginal contribution (increase in profits) earned from an extra dollar
of sales.


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(6) Gross margin = Gross Profit
Sales

To determine the marginal contribution of an extra dollar of sales, the Gross margin ratio is
used. Since cost of sales is an expense that directly increases with sales, it can be argued that
gross profit is more or less directly proportional to sales. By relating gross profit to sales, the
gross margin ratio estimates the contribution from an extra dollar of sales, that can be used to
meet the firms administrative and distribution expenses.

Efficiency and Effectiveness ratios

Efficiency ratios concentrate on a companys performance in terms of utilisation of specific
resources such as stocks, debtors, employees, etc. In contrast to profitability ratios, which focus
on the ability of a firm to generate profits, the focus here is not on profits. The efficiency ratios
measure the level of resources needed to maintain a given level of operations (normally, a given
level of sales).

The efficiency ratios can be calculated in two ways: (1) relative terms; or (2) in periods.


(1) Debtors turnover

Relative terms: Debtors turnover = Sales
Average debtors

In periods: Average collection period = 365
Debtors turnover

The denominator in all turnover ratios can be substituted by closing balances instead of using
averages.

The numerator for this ratio should ideally be the credit sales, but companies almost never
report the fraction of sales done for credit and, hence, we may be forced to use the total sales as
approximation for credit sales.

The debtors turnover measures a firms efficiency with regard to utilisation of its debtors. It
computes the amount of sales that can be maintained with one dollar of debtors. Another way to
interpret this ratio is that it measures the number of times, debtors is turned around in one
accounting period. That is, if we consider the sale of a product on credit and the later collection
of cash from this sale as one cycle, then the debtors turnover computes the average number of
cycles in a given accounting period. A higher turnover indicates better utilisation of the firms
investment in debtors.

However, a more direct approach for assessing the efficiency of debtors utilisation is to express
debtors turnover ratio in terms of periods. This is what the average collection period does. The
average collection period is an indicator of the average credit that is given for each credit sales -
that is the average number of days between the sale and the eventual cash collection from this
sale. A smaller number for the average collection period would be preferable since that
indicates the ability of a firm to generate revenues with fewer resources tied-up under debtors.

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(2) Stock turnover or Inventory turnover

Relative terms: Stock turnover = Cost of Sales
Average stock

In periods: Average days stock in inventory = 365
Stock turnover

An important aspect of the management of a company concerns the levels of stocks that a firm
should carry. Very often a considerable amount of capital is tied up in the financing of raw
materials, work in progress and finished goods. It is therefore important to ensure that the level
of stocks is kept as low as possible and at the same time avoid stock-out situations. The
appropriate level of stocks for a firm depends on several factors, including the operating
strategy (Just-in-time concept), marketing strategy (immediate supply vs. delayed supply), type
of product (perishable Vs durable), type of production system (mass production Vs made to
order), etc.

The stock turnover calculates the efficiency with which a firm uses its stock. At times, the
closing stock may be used instead of average stock for the denominator of this ratio. It is
important to use cost of sales rather than sales in the numerator so as to be consistent with the
denominator, which is valued at cost.

The optimal level of stock turnover varies from industry to industry. For instance,
manufacturing firms generally have lower stock turnovers, than retailing companies. However,
systematic changes over time or deviations from ratios of similar companies can be used to
identify improving/deteriorating stock situations.


(3) Creditor turnover or Payables turnover

Relative terms: Creditors turnover = Purchases
Average creditors

In periods: Average days creditors outstanding = 365/ creditors turnover

The numerator in the creditors turnover should ideally be credit purchases. However,
information on credit purchases is almost never provided in the financial statements. Even
information on total purchases (i.e., both cash and credit purchases) is rarely provided in the
financial statements. But, this number can often be estimated as follows:

Total purchases = cost of sales + closing stock - opening stock

The total purchases is then used in the numerator of the creditors turnover ratio.

Often firms get credit from their suppliers for stock purchases. The creditors turnover calculates
the degree of this credit available to a firm. A greater number for this ratio indicates relatively
faster payment to (or relatively less credit from) suppliers.

The number of days of credit that a firm enjoys from its suppliers is more clearly seen from the
average days creditors outstanding ratio. A larger number for this ratio generally indicates
longer credit facilities from suppliers. However, it should be kept in mind, that a large number
for this ratio will also be observed if a firm is unable to pay its creditors on time. The latter
explanation is more relevant for firms facing cash flow difficulties.
5

(4) Fixed asset turnover and Total asset turnover

Fixed asset turnover = Sales
Average fixed assets

Total asset turnover = Sales
Average total assets

These turnover ratios measure the efficiency of a firms long term activities. For instance, the
fixed asset turnover ratio measures the sales which a firm is able to generate using 1 of fixed
assets. The denominator for the fixed asset turnover ratio is the net book value of fixed assets.
Only the book value of operating fixed assets should be considered for this ratio.

The total asset turnover ratio can be interpreted as the sales (or revenue) that a firm can generate
with 1 of total assets.

A higher number for these two turnover ratios indicates a more efficient use of the companys
resources. However, it is important to recognise the following limitations of these ratios.

First, the assumption of a linear relationship between the numerator and the denominator may
not be completely valid for these ratios. While the numerator in these ratios (i.e., sales) can
vary freely from year to year, the yearly variation in fixed assets and total assets would be much
less. This is because productive capacity can be increased only on a discrete basis (for
instance, it is meaningless to increase fixed assets by half a machine), while sales can vary at a
continuos rate. Hence, changes in fixed assets will not be proportional to sales growth.

Second, the fixed asset turnover ratio and the total asset turnover ratio can be affected by the
managements discretion over timing, form and financial reporting of the asset acquisitions.

The combination of these factors can cause erratic changes in the turnover ratios as detailed
below.

The asset turnover ratios for a company are likely to depend on its life cycle. The life cycle of a
company (or of a product) includes a number of stages: Start-up, growth, maturity and decline.
The initial turnover of start-up companies may be low, as their level of operations is below their
productive capacity. As sales grow, turnover will improve continually until the limits of the
firms initial capacity are reached (see figure 1). Subsequent increases in capital investment
decrease the turnover ratio until the firms sales growth catches up to the increased capacity.
This process continues until maturity, when sales and capacity level off, only to reverse when
the firm enters its decline stage.

Additional problems can result from the timing of a firms asset purchases. To see this,
consider two firms with similar operating efficiency, productive capacity, level of sales and
accounting estimates. The turnover ratios for these firms will be different depending on when
their assets were acquired. The firm with older assets would have depreciated its assets for a
longer period, resulting in lower book values of assets and a higher turnover ratio. Because of
depreciation, the turnover ratios would appear to improve over time even if there is no real
improvement in the firms efficiency. The use of gross numbers (i.e., numbers before
depreciation) can alleviate this problem, although it is rarely done in practice.

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Figure 1
7
Liquidity Analysis

Even if a firms profitability analysis reveals a satisfactory position, it is important to analyse
the liquidity position of a firm. A problem that often faces highly profitable and rapidly-
expanding firms is that of overtrading. This situation arises when most of a firms profits are
reinvested in additional fixed assets, stocks and debtors to meet expansionary needs, while
leaving little liquid resources for meeting the firms short-term obligations. Therefore, it is
important to assess not only the profitability of a company, but also its liquidity and solvency.

Firms that continuously face shortages of internally generated funds to meet their financial
obligations are at a particularly high risk of being bankrupt. In the short-run such firms may be
able to survive by raising funds externally, but sooner or later these firms would be forced to
rely on their internally generated funds. Hence, it is important to analyse the ability of a
company to generate sufficient cash flows to meet its short-term and long-term obligations. The
liquidity analysis focuses on the firms immediate ability to pay short-term obligations. On the
other hand, solvency analysis investigates the ability of a firm to generate cash for meeting its
long-term obligations and measures the chances of a financial crisis in the long-run. This
section deals with liquidity analysis, while the next section discusses solvency analysis.


(1) Cash Cycle

Cash cycle = days in inventory + days debtors outstanding - days creditors outstanding

The following figure is a schematic representation of the operating cycle of a firm.
Buy stock on credit
Sell stock
on credit
Pay creditors
Cash collection from
customer
}
days in inventory
}
days debtors
outstanding
{
days creditors
outstanding
{
Cash cylce


Cash cycle measures the number of days cash is tied up in inventory and receivables. So, this is
the average amount of cash that the company keeps invested in its operating cycle.

8
Example: Suppose today is day 0, and a company buys goods for 100. The company sells the
goods after 20 days for 150. Assume that the supplier gives 10 days credit, and the company
gives its customer 10 days credit. Hence,
Cash will be paid to the suppliers on day 10
Cash will be collected from customer on: day 30 (20 days in inv. + 10 days customer
credit)

The cash cycle is the difference between the payment of cash to suppliers and the receipt of cash
from customers. So in the above example, cash cycle = 20 days. In words, the company has to
invest its own capital for 20 days (in stocks and debtors), before it receives cash from
customers.

If the cash cycle is negative then it indicates that, on average, the company receives cash from
its debtors before it needs to pay its creditors. So, the company can enjoy the cash it has
received from its customers for some time before paying the creditors.


(2) Current Ratio

Current ratio = Current assets
Current liabilities

The current ratio relates current assets of a company to its current liabilities. Current assets are
cash plus items that can normally be converted into cash in the near future (or during the normal
operations of the business). Current assets can also be viewed as the liquid resources needed to
meet a firms current liabilities (i.e., liabilities due within one year).

The current ratio measures a firms margin of safety for meeting its short-term obligations.

Although it is not possible to categorically state what number is ideal for this ratio, a ratio of
less than 1.0, generally speaking, might give cause for concern. This is because a ratio of less
than 1.0 suggests that the firms liquid resources are insufficient to cover its short-term
payments. Bearing in mind the time lag for converting debtors and stock into cash, this ratio
should ideally be greater than one. However, too high a ratio might indicate too much assets
being invested in liquid resources (which generally yield low returns) and this would indicate
bad working capital management. (Note: working capital or net current assets is the capital that
is needed for operating a business and is defined as current assets less current liabilities).

A problem with the current ratio is that it is susceptible to window dressing as shown below:

Consider a firm which has the following balances on the day just before the financial accounts
are closed for a particular period (say, on 30
th
December, 1996):

Stock 4,000
Debtors 10,000
Cash 6,000
Creditors 12,000

On this day, the firms current ratio = 20,000/12,000 = 1.67

Now, suppose that on 31
st
December 1996 (the last day of the accounting period), the manager
wants to raise the current ratio. One way the manager can achieve this is by prematurely
repaying some of the creditors. Suppose on 31
st
December the manager pays off 4000 of
creditors, then the new balances for current assets and current liabilities would be 16,000 and
8,000 respectively and the new current ratio will be 2 (=16,000/8,000). Thus, the manager has
been able to increase the firms current ratio, even though the net current asset position remains
unchanged.
9

Exercise: Try and work out an example where current ratio before the financial year end is less
than 1.0. Then find out the impact of a manager prematurely paying creditors.


(3) Quick ratio ( or acid test ratio) = Cash + Short-term investments + Trade debtors
Current liabilities

Sometimes, quick ratio is also defined as: Current assets - stock
Current liabilities

The quick ratio is intended to give a more conservative estimate of a firms liquidity than the
current ratio.

Since the current assets of a firm include items such as stock, that may not be readily
convertible into cash, the current ratio gives a somewhat exaggerated picture of the firms
ability to pay creditors at short notice. This is particularly true for firms with severe financial
problems, where the ability of a firm to sell its stock at short notice is questionable. The quick
ratio overcomes this limitation by excluding from the numerator, stock and other items that are
not easily convertible into cash. By concentrating on assets that are more readily convertible
into cash, the quick ratio provides a much stricter test of liquidity than does the current ratio.

Although the ideal range for this ratio depends on several factors idiosyncratic to a firm,
generally speaking, this ratio should not be too much lower than 1.0.

Unlike the current ratio, the quick ratio is not affected by the distortions of stock valuation
practices and accounting choices for stocks. However, this ratio can still be affected by window
dressing of the nature discussed earlier (see example given for current ratio).


(4) Cash ratio = cash + short-term investments
current liabilities


This is an even more conservative estimate of a firms liquidity position than the quick ratio.
The quick ratio assumes that the debtors are liquid and can be realised in cash at short notice.
This is a reasonable assumption in industries where the credit-worthiness of the customers is
beyond dispute or when debtors are collected in a very short period. However, when these
conditions do not prevail, the cash ratio, which considers only cash and marketable securities in
its numerator, is a better indication of a firms ability to cover its current liabilities in an
emergency.

The current ratio, quick ratio and the cash ratio assume that, in emergency, the firms assets are
the only resources for paying creditors. This, however, is not true. One of the most important
factors concerning liquidity appraisal is the extent to which loan and overdraft facilities are
available to a firm. If a firm has unused overdraft facilities that could be drawn on, then this
resource could be used to meet the firms short-term obligations. The availability of unused
overdraft facilities can act as a cushion to compensate for a low quick ratio or cash ratio.

Cash flow measure of liquidity

The above discussed liquidity ratios measure liquidity at a single point in time (balance-sheet
date) rather than over a period of time. This makes these ratios susceptible to window dressing
by transactions around the balance sheet date. Moreover, since the liquidity position of a
company can constantly change with cash inflows and outflows, these ratio fail to capture the
extremely important relationship between cash inflows and outflows. To avoid this problem,
the following ratio measures liquidity by comparing actual cash flows with current liabilities.
10

(5) Operating cash flow coverage of = Cash flow from operations after interest & taxes
current liabilities Current liabilities


The numerator for this ratio is obtained from the cash flow statement.

Because the numerator uses amounts measured over a period of time, the denominator for this
ratio should ideally be the average current liabilities for that period.

This ratio measures whether the cash generated from a companys operations are sufficient to
pay its short-term obligations.



Solvency Analysis

In addition to an assessment of the short-term liquidity position of a company, it is also
important to examine the overall means by which a company finances its operations. Most
firms use both debt and equity to fund their business and the relationship between these two
sources of funds provides the firms capital structure ratios or gearing ratios or leverage ratios.

The analysis of a firms capital structure is essential to evaluate its long-term risk and return
prospects. Since debt carries fixed-interest and repayment commitments, a highly geared firm
(i.e., a firm with large fraction of debt in its capital) has greater chances of failing on its
financial commitments and being forced into bankruptcy. Also for the same reason, the returns
for equity shareholders (who are the residual claimants in the company) become more volatile
and risky as gearing increases.

Although gearing increases the financial risk of a firm, it enjoys certain tax benefits. Unlike
dividends, interest paid to debtholders are tax deductible. By using more debt in a firm, a
company can reduce the share of profits it pays to the government (in the form of tax) and
thereby leave a larger share of profits for debtholders and shareholders.

Example: Consider two-firms each with a capital of 1000. The first firm is 100% equity
financed, whereas the second firm is financed 50% by debt and 50% by equity. Assume that the
corporate tax rate is 40% and that interest on the second firms debt is payable at 10%. In a
particular year, both firms earn profits before tax and interest of 100. Then, the returns to
shareholders in the two firms are:
11

Firm 1
(100%
equity)
Firm 2
Geared
Profit before tax and interest 100 100
Interest 0 50
Pre-tax profit 100 50
Tax @40% (40) (20)
Profit after tax 60 30

Share capital 1000 500
Debt 0 500
Total capital 1000 1000

Pre-tax return on capital employed
= Pre-tax profit
Total capital

10% 10%
After-tax return on capital employed
=After-tax profit+Interest
Total capital
6% 8%


Even though both firms have the same pre-tax ROCE, the geared firm has greater after-tax
ROCE because of the tax deductibility of interest payments.

I Capital Structure Ratios

(1) Total debt to total capital = Total debt (=Short-term debt + Long-term debt)
Total capital (=Total debt + Total Shareholders funds)


(2) Total debt to Equity = Total debt (=short-term debt + Long-term debt)
Shareholders funds

Both the ratios presented above, measure the proportion of debt in a firms capital.

The numerator generally consists only of loans and other debt arising from conscious financial
decisions of a firm. However, the definition of debt may be extended to include trade creditors
and accrued liabilities also.

It is not uncommon to find instruments (or securities) in a companys balance sheet that are
neither debt nor equity. For instance, preference shares have features of both debt and equity.
In such cases, for the purpose of computing capital structure ratios, the instruments have to be
examined on a case-by case basis and classified either as debt or equity depending on their
features.

As with other ratios, industry and economy-wide factors affect the level of capital structure
ratios. Capital intensive industries tend to incur high levels of debt to finance their property,
plant and equipment. Debt ratios also tend to be high for firms with relatively mature and
stable earnings.

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II Interest Coverage Ratios

The capital structure ratios indirectly examine the ability of a firm to meet its current debt
obligations. The interest coverage ratios discussed below provide a more direct approach to
estimating the ability of a firm to meet its interest payments.

(3) Times Interest Earned = Profit before interest and tax + Interest income
(or Interest cover) Interest expense

The numerator is the profit available to pay interest and so includes both operating profit and
non-operating income/losses (such as gains or losses from sale of fixed assets and interest
income.)

The denominator is the actual interest expense for the year.

This ratio relates the interest payments to the profits available for meeting these payments.
The interest cover measures the protection available to debtholders as the extent to which the
firms earnings cover interest expense.

Although, the times interest earned ratio measures the cover available to debtholders, it does not
necessarily examine a firms ability to pay its interest. If a firm has high net income, but low
cash, then the firm may have a higher interest cover and still default on its interest payments.
Hence, a better measure of a firms ability to meet its interest obligations is the cash interest
cover ratio discussed below.

(4) Cash interest cover = Net cash flow from operations before cash paid for interest and taxes
Interest paid

The numerator in this is the cash from operations (as reported under US GAAP or IFRS) minus
cash paid for interest and taxes. It is essentially the cash from operations (including cash
received from interest and dividends income, but before the cash paid for interests and taxes)
The cash paid for interest and taxes will be identified separately in the cash flow from
operations section of the cash flow statement.

The denominator is the actual cash paid for interest during the year and this can be obtained
from the cash flow from operations section of the cash flow statement.

The cash interest cover ratio states the number of times the cash flow from operations covers
interest payments to lenders. A higher ratio indicates greater solvency.

(5) Cash from operations to debt ratio =Net cash inflow from operations after interest and taxes
Total debt

This ratio measures the ability of a firm to generate sufficient cash to meet its debt repayments.
It provides an estimate of the firms ability to repay debt using its cash from operations, should
of all its debt become due immediately.

The numerator for this ratio is obtained directly from the cash flow statement.

The denominator includes all financial obligations that arise from the firms conscious financial
decision. Alternatively, trade creditors and accrued liabilities can also be included in the
definition of the denominator.

A variant of this ratio uses only the debt due in the next one year as the denominator. This is
intended to measure the ability of the firm to meet its debt obligations in the coming year using
its cash from operations (after interest and taxes).

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14
RATIOS: A PYRAMID ANALYSIS

The ratios surveyed in the above discussion measure such diverse aspects of an enterprises
performance as its efficiency of operations, liquidity, solvency and profitability. The discussion
thus far has focused on the characteristics of individual ratios. Comprehensive financial
analysis requires a review of three interrelationships among these ratios:

1. Economic relationships: Because of the inter-relationship between various aspects of a
business, a change in one dimension will result in other changes in the business. For
instance, a strong growth in sales could lead to a firm hoarding more inventory. Such inter-
relationships cause the various components of the financial statements to be interdependent.
Hence, a single economic activity can affect multiple ratios.
2. Overlap of components: The components of many ratios overlap due to the inclusion of an
identical term in the numerator or denominator, or because a term in one ratio is a subset or
component of another ratio. For example, sales is common to most turnover ratios. Thus
increase in sales may cause all turnover ratios to systematically increase.
3. Pyramid of ratios: Certain ratios can be viewed as a combination of other ratios. For
instance, the Return on equity (ROE) and Return on assets (ROA) can be disaggregated as
follows:


PYRAMID (or DUPONT) ANALYSIS
Net Income
ROE =
Shareholder' s Equity




From the above figure we see that a change in either leverage or return on assets will change the return on equity. Similarly, a change in either asset
turnover or in profit margin will change the return on assets and consequently, the return on equity. The interrelationships among ratios have important
implications for financial analysis. Disaggregation of a ratio into its component elements allows us to gain insights into factors affecting a firms
performance.
ROA =

Net Income
Assets
X
Assets

Leverage =
Shareholder' s Equity
Sales
Assets
X
Net (or PBIT)
Sales
Asset Profit
measur measur