UNIT-5

FINANCIAL RATIO ANALYSIS AND CAPITAL BUDGETING

1. Define Ratio analysis. Explain the objectives and importance of ratio analysis.
Ans). Ratio Analysis is a financial analysis tool that involves evaluating the relationships between various
financial statement items to assess the financial health, performance, and efficiency of a business. This
analysis involves calculating ratios from the balance sheet, income statement, and cash flow statement to draw
insights into areas such as liquidity, profitability, solvency, and efficiency. Ratios can be used to benchmark a
company’s performance against industry standards, track its financial performance over time, and identify
areas that need improvement.

Objectives of Ratio Analysis

1. Evaluate Financial Performance: Ratio analysis helps in assessing a company's profitability,

liquidity, and overall financial health. By analyzing trends, stakeholders can gauge the company's
performance over time.
2. Decision Making: Ratios provide a basis for management and investors to make informed decisions.
For instance, profitability ratios can help investors decide whether to invest, and liquidity ratios can
guide management on cash flow needs.
3. Compare with Industry Standards: By comparing ratios with industry benchmarks, a company can
determine its competitive position within the industry, helping it to identify strengths, weaknesses, and
improvement areas.
4. Assess Financial Health: Ratios like debt-to-equity and interest coverage help in assessing the
financial stability of a company, identifying whether the company is too leveraged or has sufficient
capital structure.
5. Aid in Planning and Forecasting: Historical trends from ratio analysis can help management in
setting financial goals, planning strategies, and forecasting future performance.

Importance of Ratio Analysis

1. Simplifies Financial Statements: Ratios condense vast amounts of financial data into key figures that
are easy to understand, making it simpler for stakeholders to assess financial health quickly.
2. Enhances Comparability: Ratios standardize financial data, allowing comparison across different
periods, companies, or industries, regardless of size or scale, which is crucial for benchmarking and
performance evaluation.
3. Improves Operational Efficiency: Efficiency ratios, such as inventory turnover or asset turnover,
reveal how well a company uses its assets, guiding management in improving resource allocation.
4. Identifies Risk Areas: Solvency and liquidity ratios help identify financial risks, allowing the
company to manage potential issues like liquidity crunches or excessive debt before they impact
operations.
5. Supports Investment Analysis: Investors and analysts heavily rely on ratio analysis to assess a
company's profitability, growth potential, and risks, making it essential for evaluating stock
investments and creditworthiness.
6. Facilitates Communication with Stakeholders: Ratio analysis provides a standard language for
financial performance, enhancing transparency and trust in communications with investors, creditors,
and regulatory bodies.

In summary, ratio analysis is an essential tool for assessing and improving financial performance, guiding
strategic decisions, and enhancing transparency with stakeholders.
2. Define Ratio Analysis. How do you classify different types of Ratios?

Ans). Ratio Analysis is a technique used to assess a company's financial health by analyzing relationships
between various figures in its financial statements, such as the balance sheet, income statement, and cash flow
statement. By comparing these relationships, ratios provide insights into areas like profitability, liquidity,
efficiency, and solvency, allowing stakeholders to understand the company’s performance over time, compare
it to industry standards, and identify areas for improvement.

Classification of Ratios

Ratios can be broadly classified into the following main types based on the aspect of financial performance
they evaluate:

1. Liquidity Ratios
2. Profitability Ratios
3. Efficiency (or Activity) Ratios
4. Solvency (or Leverage) Ratios
5. Market Ratios

Let's go over each type in more detail.

1. Liquidity Ratios

Liquidity ratios measure a company's ability to meet its short-term obligations and assess its financial
flexibility. They help determine if the company can cover its current liabilities using its current assets.

 Current Ratio: Current Assets/Current Liabilities

 Quick Ratio (Acid-Test Ratio): (Current Assets−Inventory)/Current Liabilities
 Cash Ratio: Cash and Cash Equivalents/Current Liabilities

2. Profitability Ratios

Profitability ratios assess a company's ability to generate profits relative to its sales, assets, equity, or other
financial elements. These ratios are crucial for evaluating the effectiveness of management in generating
returns.

 Gross Profit Margin: Gross Profit/Net Sales

 Operating Profit Margin: Operating Income/Net Sales
 Net Profit Margin: Net Income/Net Sales
 Return on Assets (ROA): Net Income/Total Assets
 Return on Equity (ROE): Net Income/Shareholders’ Equity

3. Efficiency (or Activity) Ratios

Efficiency ratios, also known as activity or asset management ratios, measure how well a company uses its
assets and liabilities to generate sales and profits. They reflect the efficiency of resource utilization within the
company.

 Inventory Turnover Ratio: Cost of Goods Sold/Average Inventory

 Receivables Turnover Ratio: Net Credit Sales/Average Accounts Receivable
 Total Asset Turnover Ratio: Net Sales/Average Total Assets
 Fixed Asset Turnover Ratio: Net Sales/Net Fixed Assets
4. Solvency (or Leverage) Ratios

Solvency ratios assess a company’s long-term financial stability and its ability to meet long-term obligations.
These ratios measure the extent to which a company relies on debt financing compared to equity financing.

 Debt-to-Equity Ratio: Total Debt/Shareholders’ Equity

 Debt-to-Assets Ratio: Total Debt/Total Assets
 Interest Coverage Ratio: Operating Income/Interest Expense
 Equity Ratio: Shareholders’ Equity/Total Assets

5. Market Ratios

Market ratios evaluate a company's stock performance and are primarily used by investors to determine
whether a stock is over- or undervalued. These ratios help analyse the market perception of the company’s
value and profitability potential.

 Earnings Per Share (EPS): Net Income/Number of Outstanding Shares

 Price-to-Earnings Ratio (P/E Ratio): Market Price per Share/Earnings per Share
 Dividend Yield: Annual Dividends per Share/Market Price per Share
 Book Value per Share: Total Shareholders’ Equity/Total Outstanding Shares

Summary of Ratio Classification

 Liquidity Ratios assess the company’s short-term financial health and ability to pay off current
liabilities.
 Profitability Ratios measure the company’s ability to generate profit relative to sales, assets, and
equity.
 Efficiency Ratios analyse how effectively the company uses its resources to generate sales and
manage assets.
 Solvency Ratios evaluate the company’s long-term financial stability and its dependence on debt.
 Market Ratios provide insights into the company’s stock performance and overall market valuation.

Each category of ratios provides a unique perspective on the company’s financial standing, which, when
analysed together, offers a comprehensive understanding of the company's overall financial health.

3. Define Ratio Analysis. Explain the Limitations of Ratio analysis.

Ans). Ratio Analysis is a financial analysis tool used to assess a company's financial health, performance,
and operational efficiency by examining relationships between various financial statement items. This process
involves calculating ratios using data from the balance sheet, income statement, and cash flow statement to
analyse aspects like liquidity, profitability, solvency, and efficiency. These ratios offer insights into the
company's financial standing, enable comparisons with industry standards, and highlight trends over time that
may indicate strengths or areas for improvement.

Limitations of Ratio Analysis

While ratio analysis is a valuable tool, it has several limitations:

1. Historical Data: Ratios are based on past financial data, which may not accurately predict future
performance. External factors such as economic conditions or industry shifts can change rapidly,
making historical ratios less relevant.
2. Different Accounting Policies: Companies may use different accounting methods (e.g., FIFO vs.
LIFO for inventory valuation, straight-line vs. declining-balance for depreciation), leading to
inconsistencies in ratios across companies, even within the same industry.
 3. Lack of Standardization: Ratios often lack standard definitions, leading to potential confusion or
misinterpretation. For instance, companies may define current assets or operating income differently,
affecting liquidity and profitability ratios.
4. Ignores Qualitative Aspects: Ratio analysis focuses solely on quantitative aspects and ignores
qualitative factors like management quality, brand strength, employee skills, or customer satisfaction,
which also impact a company’s long-term success.
5. Subject to Window Dressing: Companies might use accounting adjustments to present a more
favourable financial position (e.g., delaying payments to improve the current ratio or selling off assets
to boost liquidity). Such "window dressing" can distort ratios and mislead stakeholders.
6. Influence of Inflation: Financial statements prepared during periods of inflation may not reflect the
true value of assets, liabilities, or equity. Inflation can distort ratios, making older figures less
comparable to current data.
7. Limited Usefulness in Isolation: Individual ratios often provide limited information on their own. For
example, a high current ratio may suggest liquidity, but it might also indicate inefficient asset use.
Ratios are most useful when analysed together to get a complete picture.
8. Industry-Specific Comparability Issues: Some ratios have limited relevance across industries. For
instance, inventory turnover may be crucial for a retail company but is less meaningful for a service-
based business, making cross-industry comparisons challenging.
9. Difficulty in Defining Benchmarks: While ratio analysis often involves comparing a company's
ratios to industry benchmarks, defining a relevant and consistent benchmark is sometimes difficult due
to differences in company size, market share, or regional focus.
10. Doesn’t Reflect Seasonal Variations: Ratios calculated at a single point in time may not capture
seasonal fluctuations that affect sales, expenses, or inventories, leading to skewed interpretations of a
company’s performance.
11. Potential for Overemphasis on Ratios: Too much reliance on ratios can lead to overlooking other
critical factors affecting a company’s performance. Management may focus on improving specific
ratios rather than overall operational efficiency.

Conclusion

Despite these limitations, ratio analysis remains a widely used tool in financial analysis due to its ability to
simplify complex financial data and provide quick insights. However, for a complete and accurate assessment,
ratio analysis should be used alongside other qualitative and quantitative evaluations and should consider
factors like industry standards, economic conditions, and changes in accounting policies.

4. Define Capital Budgeting. Explain the capital Budgeting Process.

Ans). Capital Budgeting is the process that companies use to plan, evaluate, and make decisions on
significant investments in projects or assets that are expected to generate returns over an extended period.
These investments could include new machinery, facilities, technology upgrades, research and development,
and expansion into new markets. Capital budgeting helps organizations determine which projects are worth
pursuing by evaluating their potential costs and expected returns, ensuring that the company's resources are
used efficiently and align with its long-term strategic goals.

Capital Budgeting Process

The capital budgeting process typically involves the following steps:

1. Identification of Investment Opportunities

 The first step is to identify potential investment opportunities that could benefit the organization.
These opportunities could stem from expanding operations, replacing outdated equipment, launching
new products, or improving efficiency.
 Ideas are gathered from different departments, and the company considers its strategic goals and
market needs to develop a list of possible projects.
2. Screening and Project Classification

 Once opportunities are identified, they are screened to ensure they align with the company’s
objectives, financial capacity, and strategic vision. Projects may be classified as mandatory (e.g.,
regulatory compliance) or optional (e.g., new market entry).
 Projects are typically categorized by type (e.g., expansion, replacement, or research and development)
and by priority (essential, growth-oriented, or discretionary).

3. Estimating Cash Flows

 Accurate cash flow estimation is crucial. For each project, expected cash inflows (e.g., increased
revenue or cost savings) and cash outflows (e.g., initial investment, maintenance costs) are projected
over the project’s life.
 This step involves assessing both direct and indirect costs and any potential residual value at the end of
the project’s life.

4. Determining the Cost of Capital

 The cost of capital, or required rate of return, is determined to act as a discount rate in evaluating
projects. This rate represents the minimum acceptable return on an investment, factoring in the cost of
financing (debt and equity).
 The cost of capital reflects the risk profile of the investment and serves as a benchmark for deciding if
a project should be accepted.

5. Evaluating Project Feasibility Using Financial Metrics

 Various financial metrics are applied to assess the viability of each project. Commonly used evaluation
methods include:
o Net Present Value (NPV): Calculates the difference between the present value of cash inflows
and outflows. A positive NPV indicates a project is expected to add value.
o Internal Rate of Return (IRR): Determines the discount rate at which the project’s NPV
becomes zero. If IRR is higher than the cost of capital, the project is generally considered
acceptable.
o Payback Period: Measures the time required for the project to recoup its initial investment.
While it doesn’t consider the time value of money, it’s useful for understanding how quickly
investment can be recovered.
o Profitability Index (PI): The ratio of the present value of cash inflows to the initial
investment, indicating value per dollar invested. A PI greater than 1 indicates a potentially
profitable project.

6. Risk Analysis and Mitigation

 Before making a final decision, the company assesses potential risks, including economic changes,
competitive pressures, and project-specific uncertainties.
 Sensitivity analysis, scenario analysis, and simulation methods may be used to evaluate how changes
in key variables (e.g., sales volume or costs) impact the project’s outcome. Strategies to mitigate risks
are also developed.

7. Project Selection and Approval

 Based on the financial evaluation, risk analysis, and strategic alignment, projects are ranked and
selected. Generally, projects with higher returns, lower risk, and stronger alignment with strategic
goals are prioritized.
 Management or the board of directors reviews and approves selected projects, considering budget
constraints and available resources.
8. Implementation and Monitoring

 Once approved, the project moves into the implementation phase. A project manager and team are
assigned to ensure the project is completed on schedule and within budget.
 During implementation, progress is monitored, and actual performance is compared to projections to
identify any variances. This step helps in making real-time adjustments and improving future
budgeting processes.

9. Post-Implementation Review

 After the project’s completion, a post-implementation review is conducted to evaluate its performance
relative to initial estimates.
 Lessons learned are documented, which helps refine the capital budgeting process and improve
accuracy in future projects.

Conclusion

The capital budgeting process is essential for ensuring that a company makes well-informed investment
decisions. By evaluating potential projects thoroughly, the company can maximize shareholder value, improve
operational efficiency, and position itself strategically for long-term growth.

5. Define Capital Budgeting Techniques. How do you classify different types of Capital
Budgeting Techniques ?

Ans). Capital Budgeting Techniques are financial tools and methods used to evaluate investment projects
and make decisions on which projects a company should undertake. These techniques analyse the potential
profitability and risks of projects by assessing the cash flows they are expected to generate and comparing
them with the initial and ongoing investments required. By using these techniques, businesses can prioritize
projects that will likely enhance shareholder value and support strategic growth.

Classification of Capital Budgeting Techniques

Capital budgeting techniques can be broadly classified into two categories:

1. Traditional (or Non-Discounting) Techniques

2. Discounted Cash Flow (DCF) Techniques

Each of these categories includes specific methods that approach project evaluation differently.

1. Traditional (Non-Discounting) Techniques

Traditional techniques do not account for the time value of money, meaning they treat all cash flows as if they
occur in the present. These methods are simpler and often used for quick, preliminary assessments.

 Payback Period: Measures the time required for the investment to recover its initial cost from the net
cash flows generated by the project. Projects with shorter payback periods are preferred, as they
indicate faster recovery of the investment.
o Formula: Payback Period=Initial Investment Annual Cash Inflow
 Average Rate of Return (ARR): Also known as, the accounting rate of return, this technique
measures the expected annual return on investment as a percentage of the average investment over the
project’s life.
o Formula: ARR=Average Annual Profit/ Average Investment×100

Advantages of Traditional Techniques: - Easy to understand and calculate. - Useful for evaluating small
projects or preliminary screening.
Disadvantages: - Ignores the time value of money. - Focuses on quick recovery rather than profitability or
long-term value.

2. Discounted Cash Flow (DCF) Techniques

DCF techniques account for the time value of money by discounting future cash flows to their present value.
These methods are more accurate and are commonly used in capital budgeting to assess a project’s true
financial impact.

 Net Present Value (NPV): NPV calculates the difference between the present value of cash inflows
and the present value of cash outflows over the project’s life. A positive NPV indicates that the project
is expected to generate value, while a negative NPV suggests it should be rejected.
o Formula: NPV=∑Cash Inflows−Cash Outflows/ (1+r) t, where r is the discount rate, and t is
the time period.
 Internal Rate of Return (IRR): The IRR is the discount rate at which the NPV of the project
becomes zero. It represents the project’s expected rate of return. If the IRR exceeds the company’s
required rate of return (cost of capital), the project is generally considered acceptable.
o Formula: 0=∑Cash Flows/(1+IRR)t
 Profitability Index (PI): Also called the benefit-cost ratio, PI is the ratio of the present value of cash
inflows to the initial investment. A PI greater than 1 indicates a viable project, as it suggests that for
every dollar invested, the project will generate more than a dollar in return.
o Formula: PI=Present Value of Cash Inflows/Initial Investment
 Discounted Payback Period: This is a modified version of the payback period that discounts future
cash flows to present value. It calculates the time required to recover the initial investment, taking into
account the time value of money.
o Formula: Calculated by summing the discounted cash inflows until they equal the initial
investment.

Advantages of DCF Techniques: - Considers the time value of money, providing a more accurate measure of
a project’s profitability. - Useful for long-term projects where cash flows occur over an extended period. -
Helps in assessing the risk-adjusted returns of a project.

Disadvantages: - Requires more complex calculations and accurate forecasting of cash flows. - Sensitive to
the discount rate, which can impact the feasibility of the project.

Summary of Capital Budgeting Techniques Classification

1. Traditional (Non-Discounting) Techniques

o Payback Period: Time needed to recover the initial investment.
o Average Rate of Return (ARR): Average return on investment as a percentage.
2. Discounted Cash Flow (DCF) Techniques
o Net Present Value (NPV): Present value of net cash inflows minus outflows.
o Internal Rate of Return (IRR): The rate that makes NPV zero.
o Profitability Index (PI): Present value of inflows divided by initial investment.
o Discounted Payback Period: Time needed to recover initial investment, accounting for time
value.

Each technique has its advantages and limitations, and the choice of method may depend on the project's size,
complexity, and strategic importance. Using multiple techniques in combination can provide a more balanced
view of a project's potential value and risks, ensuring a more informed investment decision.