RATIO ANALYSIS

Financial ratios are the most commonly used techniques for analysis of financial statements. This technique involves the comparison of ratios across firms. Ratio is a measure of relationship between two data. Ratio analysis is used both for cross-sectional analysis and time series analysis. Ratio analysis is used for assessing credibility, profitability and operating efficiency of the organization when comparing with other enterprises or with industry standards.

Cross-sectional Analysis Using Ratios 

Ratio Analysis is also a valuable tool of cross-sectional analysis. The ratios of different firms within an industry can be compared to assess the individual performance of each firm vis-à-vis its competitors. Similarly, the ratios of a single company/firm can be compared with that of industry ratios to evolve significant conclusions.

To assess the performance of the three software companies - TCS, Infosys and Satyam, let us examine the ratios pertaining to these companies. The computation of ratios has already been explained in detail in the previous chapter. Hence, the discussion here is limited only to their analysis for cross-sectional purpose.

The ratios that are considered for analysis have been classified under the following categories:

• Short-term liquidity ratios:

• Current ratio

• Quick ratio

• Capital structure and solvency ratios:

• Long-term debt to equity

• Capital gearing ratio

• Return on investment ratios:

• Return on capital employed

• Return on net worth

• Operating performance ratios:

• Operating profit to Sales

• Profit before tax to Sales

• Profit after tax to Sales

• Operating cash flow to Sales.

The following table gives you a comprehensive picture of the ratios of the three software companies for the year 2006-07. The computation of ratios has been dealt with earlier in this chapter.

Cross-sectional Analysis using Ratios

Profitability Ratios: Profitability ratios are used to understand the operational efficiency of firms. A comparison of the profitability ratios of the software firms reveal that Infosys is the strongest among the three companies as it has a  higher operating profit to sales ratio as well as a marginally higher profit after tax to sales. Though TCS also registered an impressive operating profit ratio, its profit after tax is lower than Infosys. This could be because of a higher depreciation and tax expense.

Returns Ratios: The return ratios measure the efficiency in utilizing the firm's assets to generate the profits. While the return on total assets ratio measures the efficiency in using the firm's assets, the ratio of profit after tax to net worth expresses the efficiency in utilizing the shareholder's funds.

The return ratios of TCS have a higher margin in contrast to the other two companies thereby suggesting that TCS is more successful in efficiently utilizing its assets.

Short-term Liquidity: A firm's short-term liquidity ratios analyze the ability of the firm in meeting its short-term commitments. The current ratio measures the sufficiency of a firm's current assets in meeting its current liabilities. All the firms in our analysis have satisfactory liquidity position as their current ratio is above the ideal standard of 2:1. However, Satyam computer has a higher ratio which is   because the company has a major proportion of its assets in the form of a long-term fixed deposits. The quick ratio also confirms this fact.

The ratio of absolute cash to current liabilities is marginally below the ideal standard of 0.5:1 in case of TCS, which indicates that unless the company manages its cash properly, it may face shortage of cash resources in future. The liquidity position is ideal for Infosys Technologies.

Long-term Solvency: Long-term solvency indicates the ability of a company to honour its long-term commitments. These ratios also give valuable insight into the mode of financing of a company. All the three companies are financed mostly through internal resources; hence, the participation of outside debt is minimal or nil as is evident by the ratios. Moreover, as they do not have any outside debt, their capital gearing ratio is also minimal.

Hence, we can conclude by saying that all the three companies have satisfactory performance with TCS doing marginally better than the others in profitability, while Infosys is more consistent. Though Satyam is doing profitably it can improve its capital structure by investing its idle funds in business operations rather than in outside sources.

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