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A NOTE ON FINANCIAL RATIO ANALYSIS

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VALUATION RATIOS

Valuation ratios indicate the performance of the equity stock of a company in the stock market. Since the market value of equity reflects the combined influence of risk and return, valuation ratios play an important role in assessing a company's performance in the stock market. The important valuation ratios are the Price-Earnings Ratio and the Market Value to Book Value Ratio.

Price-Earnings (P/E) Ratio :

The P/E ratio is the ratio between the market price of the shares of a firm and the firm's earnings per share. The formula for calculating the P/E ratio is:

P/E ratio = Market Price of Share / Earnings per Share


The price-earnings ratio indicates the growth prospects, risk characteristics, degree of liquidity, shareholder orientation, and corporate image of a company.

Market Value to Book Value Ratio :

This is the ratio between the market price per share (MPS) and actual book value per share. It can be calculated as follows:

Market Value to Book Value Ratio = Market Price per Share / Book Value per Share


This ratio reflects the contribution of a company to the wealth of its shareholders. When this ratio exceeds 1, it means that the company has contributed to the creation of wealth of its shareholders.

DUPONT ANALYSIS

Dupont Analysis is a technique that breaks ROA and ROE measures down into three basic components that determine a firm's profit efficacy, asset efficiency and leverage. The analysis attempts to isolate the factors that contribute to the strengths and weaknesses in a company's financial performance. Poor asset management, expenses getting out of control, production or marketing inefficiency could be potential weaknesses within a company. Expressing these individual components rather than interpreting ROE, may help the company identify these weaknesses in a better way. This model was developed by the US based DuPont company. The model breaks down return on networth (RONW) into three basic components, reflecting the quality of earnings along with possible risk levels.

RONW = PAT / NW

Where,

PAT = Profit after Tax
NW = Networth

The above formula can be further broken down into:

RONW = PAT / Sales * Sales / CE * CE / NW

Where, CE = Capital Employed.  

COMMON SIZE STATEMENTS

TA common size statement is an extension of ratio analysis. In a common size statement, each individual asset and liability is shown as a percentage of total assets and liabilities respectively. Such a statement prepared for a firm over a number of years would give insights into the relative changes in expenses, assets and liabilities. In a common size income statement gross sales/net sales are taken as 100 per cent and each expense item is shown as a percentage of gross sales/net sales.

CALCULATING FINANCIAL RATIOS OF HLL

COMMON SIZE INCOME STATEMENT OF HLL


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