Financial Analysis -Tata Steel- For Students

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Financial Analysis of Tata Steel

1.0 Introduction:

An attempt has made to analyse Tata Steel‟s overall performance and assess its current

financial standing. The purpose of this analysis is to assess company‟s financial health and

performance. Effective decision making requires evaluation of the past performance of the

companies and assessment of the future prospects. The starting point in analysis is to look

at the past record. Information about past performance is useful in judging future

performance. An assessment of the current status will show where the company stands at

present. To a large extent ,the expectations of investors and creditors about future

performance are shaped by their evaluation of past performance and current position.

Investors and creditors use information about past to assess the prospects of a company.

Investors expect an adequate return from the company in the form of the dividends and

market price appreciation. Creditors expect the company to pay interest and repay the

principal in accordance with the terms of lending. Therefore they are interested in

predicting the earning power and debt paying ability of the company. Investors and

creditors try to balance expected risks and return.

Needless to mention comparisons are essentially intended to throw light on how well a

company is achieving its objectives. In order to decide the types of comparisons that are

useful, we need first to consider what a business is all about? What its objectives are. A

generalization that the overall objective of a business is to create value for its shareholders

while maintaining a sound financial position; implicit to this statement is the assumption is

that value creation can be measured.

Our approach to financial analysis followed a comprehensive framework of looking at

various parameters of company performance and use different ratio‟s to substantiate the

analysis. The framework will be as under:

Top Line Growth

Profit and Profitability

Liquidity Analysis

Assets Growth

Capital Structure Analysis

Assets Utilisation Ratio‟

Fund Flow Statements

Market Perception

Here ratios and other qualitative aspects have been considered in a sequence intended to

facilitate an understanding of the total business. As an analyst first one has to look at analyst

the firm‟s performance in the broadest terms and then worked down through various

levels of detail in order to identify the significant factors that accounted for the overall

results. If the values of the ratios used in this analysis are compared with their values for

other time periods, the comparison is called a longitudinal, or trend analysis.

Dozens of ratios can be computed from a single set of financial statements. Each analyst

tend to have a set of favorite ratios selected from those described below and probably from

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some which has not been described. Although here many frequently used ratios been

described, the best analytical procedure is not to compare all of them mechanically but

rather to describe first which ratios might be relevant in the particular type of investigation

to expertise the trend and its significance.

2.0 Top-line Growth

Growth rate of Sales and Income indicates whether a company is able to drive its top line

up so that its market presence, share and aspects of control is retained. Higher growth rate

in sales and income implicitly indicates that company will be able increase its profit at

much higher rate and hence boost up its bottom line. Analysts are also interested in the

growth rate of certain key products of the company to assess the potential of retaining

market share of the company on its various lines of product. These growth rates are

compared with the rate of growth in that particular industry or with similar product lines of

other companies. For example growth of cement sales at Ultratech Ltd may be compared

with Cement sales of ACC etc. Common growth rate calculations include average growth

rate and compound growth rate.

From the Profit and Loss Account we observe Tata Steel has registered a topline growth of

5.08 per cent in 2009-10 compared to 2008-09. In absolute terms it has achieved a topline

of Rs 25875.77 crores in 2090-10 compared to Rs 24624.04 crores in the previous period.

Top line of Tata Steel comprises of Sales and Other Operating Income and Other

Income. Both the components have grown at different rates as could be seen from the

Table-1 below.

Table -2.1 (Rs in crores)

2008-09 2009-10 %

growth

A. Income (D+E) 24624.04 25875.77 5.08

B. Sales and Other Operating Income 26843.73 26757.80

C. Excise Duty 2527.96 1735.82

D. Sales and Other Operating Income net of Excise

Duty

24315.77 25021.98 2.90

E. Other Income 308.27 853.79 176.96

Sales and Other Operating Income comprise of Sale of Products , Sale of Power and

Water,Income from Town Medical and Other Services and Other operating income.

Table -2 below shows how all these components of sales and Other operating income has

increased or decreased compared to last year.

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Table - 2 .2

(Rs in Crores)

2008-09 2009-10 % growth

A.Sale of Products 25945.45 25755.52 (0.74)

B.Sale of Power and Water 566.31 656.80 15.98

C. Income from town , medical and other services 40.65 40.32 (0.82)

D. Other Operating Income 291.32 305.16 4.75

E.Total (A to D) 26843.73 26757.80 (0.32)

A further analysis of the sales portfolio indicates that four products dominate in the

product portfolio of Tata Steel, they are: Salable Steel (finished), Semi finished Steel and

Scrap, Welded Steel Tubes and some categories of Raw Materials. In 2009-10 they formed

around 95 percent of the total products sales portfolio. All these products have suffered

from certain anomalies in terms of either price reduction or quantity reduction during the

period. Except one or two products most of the products faced pressures on the price

front as could be scan from the Table-2.3 below:

Table – 2. 3:Break up sales and average unit price realized

Tata Steel

Value

Rs in

crores Qty

Value

Rs in

crores Qty

Unit Price

Realised(Rs

)

Unit Price

Realised(Rs

)

2009 2009 2010 2010 2009 1010

Saleable Steel

(Finished)

19313.4

2 4760572

19333.4

9 5518047 40569.54 35036.83

Agrico Products 116.21 126.86

Semi Finished 1004.86 446069 1554.88 768127 22527.01 20242.49

Welded Steel Tubes 1130.92 227156 1110.28 253802 49786.05 43745.91

By Products 166.07 237.44

Raw Materials

Ferro Manganese 290.73 34515 183.47 38976 84232.94 47072.56

Charge Chrome 1251.47 177029 733.21 145899 70692.94 50254.63

Other raw

Materials 1879.93 1802.44

Other Products 465.52 382.58

Bearings 144

2633966

0 166.15

3133885

2 54.67041 53.01726

Metallurgical

Machinery 165.17 116.95

Others 17.08 7.77

Alloy Steel Ball

Bearing 0.07 0

Total

25945.4

5

25755.5

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Table -3 shows that average price realization in the year 2009-10 for Saleable Steel,

Semi finished Steel, Welded Steel Tubes and among raw materials Ferro Manganese

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and Charge Chrome were lower. Since all these items taken together form 95 per cent

of sales undoubtedly lesser realization would have impact on the bottom line of the

company.

3.0 Profit and Profitability Ratios

The ability to generate profit on capital invested is a key determinant of a company's

overall value and the value of the securities it issues. Consequently, many equity

analysts would consider profitability to be a key focus of their analytical efforts.

Profitability ref1ects a company's competitive position to the market, and by extension,

the quality of its management. The income statement reveals the sources of earnings

and the components of revenue and expenses. Earnings can be distributed to

shareholders or reinvested in the company. Reinvested earnings' enhance solvency and

provide a cushion against short-term problems.

Table 3 .1 : Categorization of different types of Profit

(Rs in crs)

………………………………………………………………………………………. 2008-09 2009-10

A. Income 24624.04 25876.77

Expenditure

B. Manufacturing and Other Expenses 15525.99 16396.00

C. Depreciation 973.40 1083.18

D. Capitalisation of Expenditure (343.65) (326.11)

E.Net Finance Charges 1152.69 1508.40

F. Total 17308.43 18661.47

G. Profit Before Taxes(PBT) 7315.61 7214.30

H.EBDITA (G+E+C) 9441.7 9805.88

I. less: Depreciation 973.40 1083.18

J.EBIT (H-I) 8468.30 8722.7

K. Interest 1152.69 1508.40

L. PBT (J-K) 7315.61 7214.3

M. Tax 2113.87 2167.50

N. Profit After Tax(PAT) (L-M) 5201.74 5046.80

3.1 Calculation of Profitability Ratios

Profitability ratios measure the return earned by the company during a period. Exhibit

12 provides the definitions of a selection of commonly used profitability ratios.

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Table 3.2 :Definitions of Commonly used Profitability Ratios

Profitability Ratios Numerator Denominator

Return on Sales

EBDITA margin

EBDITA Income

EBIT Margin EBIT Income

Pretax margin

PBT (Profit before tax

but after interest)

Income

Net profit margin

Profit After Tax Income

Return on Investment

ROA EBIT Average total assets

Return on total capital

Employed (ROCE)

EBIT Short and long-term

debt and equity

ROE PAT Average total equity

Return-on-sales profitability ratios express various subtotals on the income statement

(e.g., EBITA,EBIT,PBT,PAT) as a percentage of Income/(Revenue). Return on

investment profitability ratios measure income relative to assets, equity, or total

capital employed by the company. For ROE, return is measured as PAT (net

income i.e., after deducting interest paid on debt capital as also tax ).

Interpretation of Profitability Ratios

In the following, we discuss the interpretation of the profitability ratios presented in

Table - 5. For each of the profitability ratios, a higher ratio indicates greater

profitability.

3.2 EBDITA Margin

EBDITA margin indicates the percentage of revenue available to cover operating

and policy related expenditures. Higher EBDITA margin indicates some

combination of higher product pricing and lower product costs. The ability to charge

a higher price is constrained by competition, so EBDITA profit are affected by

(and usually inversely related to) competition. If a product has a competitive

advantage (e.g., superior branding, better quality, or exclusive technology), the

company is better able to charge more for it. On the cost side, higher gross profit

margin can also indicate that a company has a competitive advantage in product

costs.

3.3 EBIT Margin

This is calculated EBDITA minus operating costs in this case is only depreciation. So,

EBIT margin increasing faster than the EBDITA margin can indicate improvements in

controlling operating costs. In contrast, a declining/ EBIT margin could be an indicator of

deteriorating control over operating costs.

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3.4 Profit Before Tax Margin

Profit Before Tax (also called "earnings before tax") is calculated as EBIT minus interest,

so this ratio reflects the effects on profitability of leverage and other (non-operating) income

and expenses. If a company's pretax margin is rising primarily as a result of increasing

non-operating income, then we should evaluate whether this increase reflects a

deliberate change in a company's business focus and, therefore, the likelihood that

the increase will continue.

3.5 PAT Margin

Net profit, or net income, is calculated as revenue minus all expenses. Net profit includes

both recurring and nonrecurring components. Generally, the net profit margin adjusted for

nonrecurring items offers a better view of a company's potential future profitability.

3.6 Return on Total Capital

Return on total capital measures the profits a company earns on all of the capital that it

employs (short-term debt, long-term debt, and equity). As with ROA, returns are measured

prior to deducting interest on debt capital (i.e., as operating income or EBIT).

3.7 ROE

ROE measures the return earned by a company on its equity capital, including minority

shares, preference shares, and ordinary shares. As noted, return is measured as PAT or net

profit (i.e., interest on debt capital is not included in the return on equity capital). A

variation of ROE is return on ordinary shares, which measures, the return earned by a

company only on its common equity.

Both ROA and ROE are important measures of profitability and will be explored in

more detail below. As with other ratios, profitability ratios should be evaluated

individually and as a group to gain an understanding of what is driving profitability

(operating versus non-operating activities).

Extended Example of Tata Steel:Evaluation of Profitability Ratios

In evaluating the profitability of Tata Steel over last two years we find the flowing a

recent three-year period and collects the following profit-ability ratios:

Table :3.3- Different Types of Margin (Percentage)

………………………………………

……………..

2008-09

0909..…09……………………………….. 2009-10

EBDITA margin 38.34 37.89

EBIT margin 34.39 33.71

Profit Before Tax Margin 29.70 27.88

Profit After Tax Margin 21.12 19.50

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3.7 DuPont Analysis: The Decomposition of ROE

As noted earlier, ROE measures the return a company generates on its equity capital.

To understand what drives a company's ROE, a useful technique is to decompose

ROE into its component parts. (Decomposition of ROE is sometimes referred to as

DuPont analysis because it was developed originally at that company.) Decomposing

ROE involves expressing the basic ratio (i.e., net income divided by average

shareholders' equity) as the product of component ratios. Because each of these

component ratios is an indicator of a distinct aspect of a company's performance that

affects ROE, the decomposition allows us to evaluate how these different aspects of

performance affected the company's profitability as measured by ROE.

Decomposing ROE is useful in determining the reasons for changes in ROE over time

for a given company and for differences in ROE for different companies in a given

time period. The information gained can also be used by management to determine

which areas they should focus on to improve ROE. This decomposition will also show

why a company's overall profitability, measured by ROE, is a function of its efficiency,

operating profitability, taxes, and use of financial leverage. DuPont analysis shows the

relationship between the various categories of ratios discussed in this reading and how

they all influence the return to the investment of the owners.

Analysts have developed several different methods of decomposing ROE. The

decomposition presented here is one of the most commonly used and the one found

in popular research databases, such as Bloomberg. Return on equity is calculated as:

ROE = PAT(i.e. net income)/Average shareholders‟ equity

The decomposition of ROE makes use of simple algebra and illustrates the

relationship between ROE and ROA. Expressing ROE as a product of only two of its

components, we can write:

equityrsshareholdeAverage

incomeNetROE

'


assetstotalAverageX

assetstotalAverage

incomeNet

'

Which can be interpreted as:

ROE = ROA x Leverage

In other words, ROE is a function of a company's ROA and its use of financial

leverage ("leverage" for short, in this discussion). A company can improve its ROE by

improving ROA or making more effective use of leverage. Consistent with the

definition given earlier, leverage is measured as average total assets divided by average

shareholders' equity. If a company had no leverage (no liabilities), its leverage ratio

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would equal 1.0 and ROE would exactly equal ROA. As a company takes on

liabilities, its leverage increases. As long as a company is able to borrow at a rate lower

than the marginal rate it can earn investing the borrowed money in its business, the

company is making an effective use of leverage and ROE would increase as leverage

increases. If a company's borrowing cost exceeds the marginal rate it can earn on

investing, ROE would decline as leverage increased because the effect of borrowing

would be to depress ROA.

Just as ROE can be decomposed, the individual components such as ROA can be

decomposed. Further decomposing ROA, we can express ROE as a product of three

component ratios:


assetstotalAveragex

assetstotalAverage

venuex

venue

incomeNet


incomeNet

'

Re

Re'


ROE = Net profit margin x Asset turnover x Leverage

To separate the effects of taxes and interest, we can further decompose the net profit

margin and write:

venue

EBITx

EBIT

EBTx

EBT

incomeNet


incomeNet

Re'


assetstotalAveragex

assetstotalAverage

venuex

'

Re


LeveragexturnoverAssetxinmEBITxrdenInterestbuxTaxburdenROE arg

This five-way decomposition is the one found in financial databases such as

Bloomberg. The first term on the right-hand side of this equation measures the effect

of taxes on ROE. Essentially, it reflects one minus the average tax rat~, or how much

of a company's pretax profits it gets to keep. This can be expressed in decimal or

percentage form. So, a 30 percent tax rate would yield a factor of 0. 70 or 70 percent

A higher value for the tax burden implies that the company can keep a higher

percentage of its pretax profits, indicating a lower tax rate. A decrease in the tax

burden ratio implies the opposite (i.e., a higher tax rate leaving the company with less

of its pretax profits).

The second term on the right-hand side captures the effect of interest on ROE.

Higher borrowing costs reduce ROE. Some analysts prefer to use operating income

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instead of EBIT for this factor and the following one (consistency is required), In

such a case, the second factor would measure both the effect of interest expense and

non operating income.

The third term on the right-hand side captures the effect of operating margin (if

operating income is used in the numerator) or EBIT margin (if EBIT is used) on

ROE. In either case, this factor primarily measures the effect of operating profitability

on ROE.

The fourth term on the right-hand side is again the asset turnover ratio, an indicator

of the overall efficiency of the company (i.e., how much revenue it generates per unit

of assets), The fifth term on the right-hand side is the financial leverage ratio

described above-the total amount of a company's assets relative to its equity capital.

This decomposition expresses a company's ROE as a function of its tax rate, interest

burden, operating profitability, efficiency, and leverage. An analyst can use this

framework to determine what factors are driving a company's ROE. The

decomposition of ROE can also be useful in forecasting ROE based upon expected

efficiency, profitability, financing activities, and tax rates. The relationship of the

individual factors, such as ROA to the overall ROE, can also be expressed in the form

of an ROE tree to study the contribution of each of the five factors, as shown in below

for Tata Steel.

Exhibit below shows that Tata Steels‟ ROE of 13.65 percent in 2009-10 can be

decomposed into ROA of 7.86 percent and leverage of 1.7378. ROA can further be

decomposed into a net profit margin of 19.50 percent and total asset turnover of

.4028. Net profit margin can be decomposed into a tax burden of 69.96 (an average

tax rate of 30 percent), an interest burden of 40.21, and an EBIT margin of 33.71

percent. Overall ROE is decomposed into five components.

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DuPont Analysis of Tata Steel‟

ROE:2010

The most detailed decomposition of ROE that we have presented is a five way

decomposition. Nevertheless, an analyst could further decompose individual

components of a five-way analysis. For example, EBIT margin (EBIT /Revenue)

could be further decomposed into a non-operating component (EBIT/Operating

income) and an operating component (Operating income/Revenues). The analyst can

also examine which other factors contributed to these five components. For example,

an improvement in efficiency (total asset turnover) may have resulted from better

management of inventory or better collection of receivables .

These relationships suggest the two fundamental ways that the ROI can be improved. First

it can be improved by increasing the profit margin-by earning more profit per rupee of

income sales. Second, it can be improved by increasing the asset turnover. In turn the asset

turnover can be increased in either of the two ways: (1) by generating more sales volume

Return on Equity:

PAT

Average shareholders’

equity

= 13.65%

Return on Assets:

PAT

Average total assets

= 7.86%

Leverage:


Average shareholder’s

equity

= 1.7378

Net Profit Margin

PAT

Revenues

=19.50%

Total Asset Turnover

Revenues/


=.4028

Tax Burden:

PAT

PBT

=0.6996

Interest Burden:

PBT

EBIT

=0. 8271

EBIT Margin:

EBIT

Income

=.3371%

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with the same amount of investment or (2) by reducing the amount of investment in assets

required for a given level of sales volume.

These two factors can be further decomposed into elements that can be looked at

individually. The point of this decomposition is that no one manager can significantly

influence the overall ROI measure, simply because an overall measure reflects the

combined effects of a number of factors. For example the manager who is responsible for

the firm‟s credit policies and procedures influences the level of accounts receivable. Thus,

the outside analyst, as well as the firm‟s management can use the ROI chart to identify the

potential problem areas in the business.

4.0 Liquidity Analysis

Liquidity refers to the company‟s ability to meet its current obligations. Thus liquidity tests

focus on the size of, and relationships between current liabilities and current assets.

(Current assets presumably will be converted into cash in order to pay the current

liabilities.) The importance of adequate liquidity in the sense of the ability of a firm to meet

current/short-term obligations when they become due for payment can hardly be

overstressed. In fact, liquidity is a prerequisite for the very survival of a firm. The short-

term creditors of the firm are interested in the short-term solvency or liquidity of a firm.

But illiquidity implies, from the viewpoint of utilization of the funds of the firm, that funds

are idle or they earn very little. A proper balance between the two contradictory

requirements, that is, liquidity and profitability is required for efficient financial

management. The liquidity ratios measure the ability of a firm to meet its short-term

obligations and reflect the short-term financial strength/solvency of a firm. The ratios

which indicate the liquidity of a firm are: (i) Net working capital, (i) Current ratios, (iii) Acid

test/quick ratios.

Let‟s at operating cycle of a firm which indicates the pattern of liquidity and its

management which gets extended from working capital management. Working capital is an

operational necessity. A firm needs to invest in short term current asset such as inventory

(raw materials, work in progress and finished product) and also needs debtors to allow it to

perform its day to day operations. This investment in current assets is for the short term, as

raw materials will be bought, converted into finished product and sold to customers who

ultimately will pay. For many business this cycle will be completed within a short time

frame and will be repeated many times over during the year; for some other this cycle may

become considerably extended. Liquidity, or solvency, means being able to satisfy financial

obligations, without difficulty, as and when they become due.

A firm is considered technically insolvent if it is unable to settle its debts when they become

due for payment. Liquidity is a measure of how easily or speedily an asset can be converted

into cash without any significant loss of value. In liquidity management the concern is how

the business manages its short-term funds. These are the funds which are continuously

circulating through the business and of which it needs to have a constant flow to keep it

running smoothly on a day-to-day basis. By comparison, gearing or capital structure

management, is to do with managing the firm‟s long-term funding and solvency.

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Profitability measures focus on assessing the firm‟s return, actual or potential, in contrast

liquidity measures focus more on risk assessment. Profitability ratios tell us something

about a firm‟s financial performance, what it has actually achieved. Liquidity ratios are

indicative of a firm‟s financial condition, the financial state it is in. Like an athlete,

performance and condition are closely related: an athlete in poor physical condition is

unlikely to achieve an outstanding performance. Effective liquidity management is of

paramount importance for the survival and future development of any organization, profit-

making or not-for-profit. While profitability is clearly extremely important for a

commercial enterprise, it is more often a lack of liquidity rather than a lack of profitability

which causes a business to fail.

For example, even though a company may be generating profitable sales, it can run into

liquidity problems if credit control is weak and the cash is not being collected from

customers and/or if too much money is tied up in stocks (raw materials, work-in-progress

and finished goods.).

In contrast, it is possible for a company to survive – at least in the short-term-and weather

periodic economic storms, even if it is not making profits, by exercising good liquidity

management. This can be done, for example, by managing stocks and debtors efficiency

and keeping the levels of both under tight control. Clearly, survival and growth in the

longer term require a combination of good profitability and sound liquidity.

Working capital

A firm‟s total capital is found from its balance sheet by subtracting its total liabilities from its

total assets. This is represented by the balance sheet equation:

Assets(A) – Liabilities(L) = Capital (C)

Working capital can similarly be found by subtracting current liabilities from current assets:

Current assets – Current liabilities = Working capital

CA – CL = WC

Technically the difference between the current assets and current liabilities is a firm‟s net

working capital, or net current assets, assuming current assets exceed current liabilities.

However, in practice, the difference between current assets and current liabilities is often

simply referred to as working capital.

Tata Steel‟s working capital at the end of 2009-10.

Current assets Rs.12246.69 crs

Current liabilities Rs. 8999.61 crs

Working Capital Rs. 3247.08 crs.

Tata Steel‟s working capital at the end of 2008-09.

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Current assets Rs. 10268.09 crs

Current liabilities Rs. 8957.05 crs

Working Capital Rs. 1311.04 crs

Working capital, also known as circulating capital, is the amount of money which a

business needs to survive on a day-to-day basis. It should be sufficient to cover:

1. Paying creditors (without difficulty);

2. Allowing trade credit to debtors;

3. Carrying adequate stocks.

The key questions are: is the level of working capital positive? Is it sufficient in relation to

current liabilities? Sufficient working capital is needed, not only to be able to pay bills on

time (e.g. wages and suppliers) but also to be able to carry sufficient stocks and also to allow

debtors a period of credit to pay what they owe. Working capital is the kind of short-term

capital required to finance a firm on a day-to-day basis. It is a key measure of business

liquidity. The more working capital a firm has, the less risk there is of the firm not being

able to pay its creditors when the bills become due. Conversely the less working capital a

firm has, the greater the risk of the firm not being able to pay its creditors when the bills are

due.

Current ratio

The ratio, also called the working capital ratio1

, measures the relationship between current

assets and current liabilities. As current liabilities should technically be paid from current

assets, this ratio highlights the firm‟s ability to meet its short-term liabilities from its short-

term assets. In other words the firm should not have to sell fixed assets to pay suppliers for

raw materials: if it does then it is clearly in trouble.

The current ratio will be very important to anyone who is supplying short-term funds to the

firm such as banks and trade creditors. It is usually shown in the following way:

Current assets: Current liabilities e.g.1.5:1

Tata Steel‟s current ratio is: 1.36 : 1 2009-10

1.15 : 1 2008-09

It is difficult to say what the „ideal‟ current ratio should be, and this can be a contentious

area, but a 1.33:1 ratio – where current assets are 1.33 times two times the level of current

liabilities – is commonly cited as desirable.2

However, a ratio less than this does not

necessarily suggest that a firm is in financial trouble. It depends on the circumstances of the

1 See Mc Menamin Jim- Financial Management –An introduction Pg -310

2 It may not be out of place to mention here that the Tandon Committee (1974) had prescribed in India the minimum scale of current

asset financing by long-term funds. However business environment has charged substantially now, hence banks also do not follow

those norms very strictly.

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individual firm and the normal parameters of the business sector in which the firm

operates.

Current ratios tend to be sector-specific, that is, different business sectors are likely to have

different „typical‟ current ratios. For example, what is considered a normal or typical

current ratio for a steel company, is likely to be different from a FMCG Company.

Therefore care needs to be taken to ensure that like is being compared with like and that

individual ratios are not being considered in isolation.

It is also possible that an apparently healthy current ratio could actually indicate inefficient

management of stocks and debtors as these may have been allowed to accumulate.

Conversely an apparently low current ratio may be the result of efficient stock and debtor

management, as these current assets are being turned over quickly and stock management

systems, such as Just in Time (JIT), may be in operation.3

A firm with a higher percentage of this current assets in the form of cash would be more

liquid, in the sense of being able to meet obligations as and when they become due, than

one with a higher percentage of slow moving and un-saleable inventory and /or slow-paying

receivables, even though both have the same current ratio. In fact, the latter type of firm

may encounter serious difficulties in paying its bills even though it may have a current ratio

of 2:1, whereas the former may do well with a ratio lower than the conventional norm.

Besides, a higher current ratio may indicate two aspects: (a) more deployment of the long

term fund of the company which is costly proposition in real sense; (b) company may not

be able to draw more support from its creditors to build its current assets – may be due to

its creditworthiness. Thus, the current ratio is not a conclusive index of the real liquidity of

a firm. It fails to answer questions, such as, how liquid are the receivables and the

inventory? What effect does the omission of inventory have on the liquidity of a firm? To

answer these and related questions, an additional analysis of the quality of current assets is

required. This is known in Acid-Test or Quick Ratio.

Quick Ratio or Acid Test ratio

This is a more stringent test of liquidity than the current ratio. It is „the acid test‟ of

liquidity and compares the firm‟s quick assets (i.e. current assets less stocks) to its current

liabilities. By stripping the stock figures out of the equation, it is suggested that this ratio

3 The current ratio, though superior to NWC in measuring short-term financial solvency, is rather a crude

measure of the liquidity of a firm. The limitation of current ratio arises from the fact that it is a quantitative

rather than a qualitative index of liquidity. The term quantitative refers to the fact that it takes into account the

total current assets without making any distinction between various types of current assets such as cash,

inventories and so on. A qualitative measures takes into account the proportion of various types of current

assets to the total current assets. A satisfactory measure of liquidity should consider the liquidity of the various

current assets per se. While current liabilities are fixed in the sense that they have to be paid in full in all

circumstances, the current assets are subject to shrinkage in value, for example, possibility of and debts, un-

sale-ability of inventory, and so on. Moreover, some of the current assets are more liquid than others; cash is

the most liquid of all; receivables are more liquid than inventories, the last being the least liquid as they have

to be sold before they are converted into receivables and, then, into cash.

15

gives a more immediate indication of the firm‟s ability to settle its current debts. The acid

test ratio is shown in a similar manner to the current ratio: Quick assets4

: current

liabilitiee.g. 1:1

Table :4. 1

(Rs in crores)

2008-09 2009-10

1.Current Assets …………………………… Rs. 10268.09 Rs. 12246.69

2.Inventory and Spare Parts Rs 3480.47 Rs 3077.75

3.Quick Assets (1-2) Rs 6787.62 Rs 9168.94

4.Current Liabilities Rs 8957.05 Rs 8999.61

5. Quick Ratio (3 / 4) [Times] .76 1.02

The acid test ratio for Tata Steel is: 1.02 : 1 2009-10

.76 : 1 2008-09

The rationale for omitting stock figures is that they are generally considered to be the

current assets which take longest to convert into cash. Stocks (raw materials, work-in-

progress and finished goods) are needed to produce saleable products, which in turn are

billed to customers, the customers then usually take a period of credit to pay. This

conversion process – of turning stocks into cash – especially for a manufacturing concern

can sometimes be very protracted. It should be noted that the use of different stock

valuation methods (e.g. LIFO and FIFO) can distort comparison of the current ratio.

Again it is difficult to give a norm for what this ratio should be, but a 1:1 ratio is commonly

considered desirable: it depends on the characteristics and circumstances of the individual

firm.

However, the quality of current asset also needs to be examined while commenting on the

current assets. Sometimes in the companies balance sheet one observes huge amount of

loans and advances. These loans advances in a shorter time span can not be converted to

liquidity. This point has to be kept in mind while assessing the liquidity of any company.

In case of Tata Steel we find that the company has Rs 4561.04 crs in 2008-09 and Rs

5499.68 crs in 2009-10 and was locked up in loans and advances.

4 Here quick assets mean current Assets – Inventory. The term quick assets refers to current assets which can

be converted into cash immediately or at a short notice without diminution of value. Included in this category

of current assets are: (i) cash and bank balances, (ii) Debtors/receivables. Loans and Advances should not

form part of the quick assets, but conventionally it is kept within the quick assets. Thus, the current assets

which are excluded are – pre-paid expenses and inventory. The exclusion of inventory is based on the

reasoning that it is not easily and readily convertible into cash. Pre-paid expenses by their very nature are not

available to pay-off current debts. They merely reduce the amount of cash required in one period because of

payment in a prior period. It is a rigorous measure of a firm‟s ability to service short-term liabilities. The

usefulness of the ratio lies in the fact that it is widely accepted as the best available test of the liquidity position

of a firm. Some experts consider acid-test ratio is superior to the current ratio.

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5.0 Asset Growth

Growth in the asset indicates that the companies are making a planned effort to ensure

future revenue earning capacity as well as targeting higher profitability. Expansion or

addition of fixed assets indicates future production capacity there by indicates sustainable

top line growth. In case of addition of balancing equipment it will indicate the company is

trying to achieve competitiveness by managing its cost structure and there by enhance its

bottom line. Addition to the current asset indicates inventory and debtors build up in a

systematic manner to strengthen cash to cash cycle and making the operating cycle move

faster thereby trying to ensure top line growth for the current period. However, there are

cases in companies where current asset is growing by default that is the company is not able

to push it inventory in the market neither it is able to realize its debtors at a faster rate.

Table 5.0

(Rs in crores)

Assets Tata Steel

Fixed Assets 2008-09 2009-10

Gross Block 23544.69 26149.66

Less: Depreciation 9062.47 10143.63

Net Block 14482.22 16006.03

Investments 42371.78 44979.67

Current Assets, Loans and Advances 10268.09 12246.69

Current Liabilities and Provisions 8957.05 8999.61

Net Current Assets 1311.04 3247.08

Miscellaneous 105.07

Total 58741.77 64232.78

Total assets of Tata Steel has been gone up from Rs.58741.77 in 2008-09 crores to

Rs.64232.78 crores in 2009-10. Total asset has gone up by 9.35 percent in the current

year compared to previous year. All the categories of asset has gone up during this period.

Fixed asset has gone up from Rs.144482.22 crs in 2008-09 to Rs.16006.03 crs in 2009-10

registering a growth rate of 11.07 per cent. Needless to mentioned growth in the fixed

assets indicates that the company has increased its capacity to produce or manufacture.

The current asset of the company has gone up from Rs.10268.09 crs 2009-10 to Rs.

12246.69 crs in 2009-10 , registering a growth rate of 19.27 per cent. Current assets

growth, other things remaining same, indicates effort of the company to drive up revenue

and thereby profit. The company has certainly driven up revenue marginally and but built

up current assets in higher proportion . Silverline in the whole approach is Cash and Bank

balance has gone up by more than 200% and Loans and Advances have gone up by Rs

938.64 crores. Investments has gone up from Rs.42371.78 crores in 2008-09 to Rs

44979.67 crores in 2009-10 registering a growth rate of 6.15 per cent over the previous

year. The company had already invested huge money earlier which has gone up in the

current year also.

17

6.0 Capital Structure Analysis

Capital Structure Analysis indicates about solvency of any company. Solvency pertains to

the company‟s ability to meet the interest costs and the repayment schedules associated

with its long-term obligations. When a company borrows money, it promises to make a

series of fixed payments. Because the shareholders get only what is left over after the debt

holders have been paid, debt is said to create financial leverage. Capital Structure Ratio‟s

measures these leverage. From the company‟s standpoint the greater the proportion of its

invested capital that is obtained from shareholders ,the less worry the company has in

meeting its fixed obligations. But in return for this lessened worry, the company must

expect to pay overall cost of obtaining capital. Conversely, the more funds that are obtained

from debenture or bonds relatively low overall cost of the company. For a growing, tax

paying company higher debt ensures better return for shareholders.

A cursory look at the liabilities side of the Balance Sheet of a Company shows the leverage

position of a company. Typically an Indian Company mobilizes fund from the sources as

has happened in case of Tata Steel. As one can see the share holders fund comprises of

original capital contributed by the Shareholders and various types of reserves and surplus.

The Loan Fund composes of Secured Loans and Unsecured Loans. Below we find the

schedule of share capital and reserves and surplus for Tata Steel. The table below gives a

glimpse of the sources of long term finances of the company.

The relative amount of a company‟s capital that is obtained from various sources is a

matter of great importance in analyzing the soundness of the company‟s financial position.

In illustrating the ratio‟s intended for this purpose the following summary of the liabilities

and owners equity side of the balance sheet will be used. Attention needed to be focused

on the sources of invested capital( also called permanent capital: debt capital (loan funds)

and equity capital(shareholders fund). From the point of view of the company, debt capital

is risky because if the bond and debenture holders and other creditors are not paid

promptly, they can take legal action to obtain payment.

Table 6.0

(Rs. in crores) 2008-09 2009-10

A. Shareholders Fund

Share capital 6203.45 887.41

Reserves & Surplus 23972.81 36074.39

30176.26 36961.80

B. Loan Funds

Secured Loan 3913.05 2259.32

Unsecured Loan 23033.13 22979.88

26946.18 25239.20

Total (A+B) 57122.44 62201.00

18

Because the shareholders have less certainty receiving dividends than the bondholders have

receiving interest, investors usually are unwilling to invest in company‟s share unless they

see a possibility of making a higher return (dividends plus share price appreciation) than

they could obtain as bond holders .

One can calculate a few types of ratio‟s to measure financial leverage of a company and the

most simple one would be Debt Ratio given by total long-term debt to total long term

capital. Indian balance sheets do not present the Loan Funds under long-term debt and

short term debt but categories them under secured and unsecured loan. Since secured and

unsecured both the loans requires to be serviced we can presume this as fixed liability to be

serviced by the companies as debt capital. Besides sometimes long-term lease agreements

also commit the firm to a series of fixed payments it makes sense to include the value of

lease obligations with a long-term debt. The debt equity ratio is an important tool to

appraise the financial structure of a firm. It has important implications from the view point

of lenders, owners and the firm itself.

Too high and too low debt-equity ratio is not desirable. In case of high debt equity lead to

inflexibility in the operations of the firm as it would face the pressures of lenders to meet its

fixed commitment of interest servicing. So the firm has to sustain ever increasing top-line

growth to service the debt. A low debt equity ratio does not help the equity investors to

maximize their return. Hence striking a balance between debt and equity is desirable.

There is no rule regarding this balance between debt and equity, however very often a 2:1

debt equity is quoted as rule of thumb in India though a large number of companies may

not maintain that. Thus for Tata Steel (with some adjustments) Debt-Equity Ratio works

out as below:

Debt Equity Ratio.

= Total Loan / Equity(i.e. Shareholders Fund).It can also written as

Total Loan

Equity

Tata Steel 2009-10 = 68.28 percent of Equity or Shareholders Fund

Tata Steel 2008-09 = 89.29 percent of Equity or Shareholders Fund

Since there is no details of lease one can safely ignore value of lease. However while

calculating debt/equity Ratio one must adjust equity to debit balances of profit and loss

account (appearing on the asset side of the balance sheet). If any revaluation reserve is

appearing under the head of reserves and surplus it is to be deducted from the

shareholders fund to arrive at the right equity.

Interest Coverage Ratio: This ratio is examined by the lenders to assess whether the

borrowing firm is having enough earnings to meet the interest payment obligation. This

can be done by comparing how much is the EBIT vs-a-vs interest payment obligation in a

period. We find in the Table 6.1 Interest coverage ratio has decreased in 2009-10

compared to 2008-09.

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Table 6.1: Interest Coverage Ratio 2008-09 2009-10

A. EBIT 8468.30 8722.70

B. Interest Payment During the period 1152.69 1508.40

C. Interest Coverage Ratio (Times) 7.35 5.78

7.0 Asset Utilisation or Turn Over Ratio‟s

Asset utilisation ratio‟s indicate how efficiently assets have been used to generate revenues

and thereby profits and is concerned with measuring the efficiency in asset management.

These ratios are also called efficiency ratios or turnover ratios. The efficiency or

productivity measures outputs of a system in relation to inputs; the greater the volume

outputs produced from a given level of inputs the more efficient the system and the

company. This also reflects the speed with which the assets are used to convert into sales.

The greater is the rate of turnover or conversion, the more efficient is the

utilization/management, other things being equal. For this reason, such ratios are also

designated as turnover ratios. Turnover is the primary mode for measuring the extent of

efficient employment of assets by relating the assets to sales. An activity ratio may,

therefore, be defined as a test of the relationship between sales (more appropriately with

cost of sales) and the various assets of a firm. Depending upon the various types of assets,

there are various types of activity ratios.

Inventory Turnover Ratio. This ratio indicates the number of times inventory is replaced

during the year. 5

It measures the relationship between the sales and the inventory level in

any period. The merit of this approach is that it is free from practical problems of

computation. The inventory turnover ratio measures how quickly inventory is sold. It is a

test of efficient inventory management. To judge whether the ratio of a firm is satisfactory

or not, it should be compared over a period of time on the basis of trend analysis. It can

also be compared with the level of other firms in that line of business as also with industry

average as a whole. In general, a high inventory turnover ratio is better than a low ratio. A

high ratio implies good inventory management. Yet a very high ratio calls for a careful

analysis. It may be indicative of under investment in, or very low level of, inventory. A very

low level of inventory has serious implications. It will adversely affect the ability to meet

customers demand as it may not cope with its requirements, that is, there is a danger of the

firm being out of stock and incurring high “stock out cost”. It is also likely that the firm

5 The ratio can be computed in two ways.

First, it is calculated by dividing the cost of goods sold by the average inventory. Alternatively

Sales

Inventory turnover = ---------------------

Inventory

Ideally it would have been cost of goods sold/Average Inventory. But, since financial statement does not

provide the cost of goods sold data Sales /Inventory is used as a surrogate measure. In theory, this

approach is not a satisfactory basis as it is not logical. For one thing, the numerator (sales) and the

denominator (inventory) are not strictly comparable, as the former is expressed in terms of market price,

the latter is based on cost. Secondly, the inventory figures are likely to be underestimates as firms

traditionally have lower inventory at the end of the year.

20

may be following a policy of replenishing its stock in too many small sizes. Apart from

being costly, this policy may retard the production process as sufficient stock of materials

may not be available.

Table : 7.0

(Rs in crores)

2008-09 2009-10

1.Sales (Net) 24315.77 25021.98

2. Inventory 3480.47 3077.75

3. Sundry Debtors 635.98 434.83

4. Working Capital 1311.04 3247.08

5. Inventory Turnover (1÷2) Times 6.98 8.12

6. Receivable Turnover (1÷3) Times 38.23 57.54

7. Working Capital Turnover (1÷4) Times 20.07 7.71

8. Days Sales blocked in Inventory 52.29 44.95

9. Days Sales in Debtors or Avg. Collection Period. 9.54 6.34

Similarly, a very low inventory turnover ratio is dangerous. It signifies excessive inventory

or over investment in inventory. Carrying excessive inventory involves cost in terms of

interest on funds locked up, rental of space, possible deterioration, and so on. A low ratio

may be the result of inferior quality goods, over-valuation of closing inventory, stock of un

saleable/obsolete goods, and deliberate excessive purchases in anticipation of future

increase in their prices, and so on. Thus, a firm should have neither too high nor too low

inventory turnover. To avoid both “stock out costs” associated with a high ratio and the

costs of carrying excessive inventory with a low ratio, what is suggested is a reasonable level

of this ratio. A company would be well advised to maintain a close watch on the trend of

the ratio and significant deviations on either side should be thoroughly investigated to

locate the factors responsible for it.

The inventory turnover ratio for Tata Steel has gone up from 6.98 times in 2008-09 to

8.12 times in 2009-10 indicating higher turnover in 2009-10 with lesser inventory holding.

How many days sales equivalent is blocked in the inventory can be calculated by dividing

365 days in a year by inventory turnover ratio. We can see from the Table 7.0 that last year

52.29 days equivalent of sales were blocked in inventory which has gone down to 44.95

days in 2009-10 which shows better utilization of inventory.

Receivable (Debtors) Turnover Ratio and Average Collection Period. The second major

activity ratio is the receivables or debtors turnover ratio. Allied and closely related to this is

the average collection period. It shows how quickly receivables or debtors are converted

into cash. In other words, the debtors turnover ratio is a test of the liquidity of the debtors

of a firm. The liquidity of a firm‟s receivables can be examined in two ways: (i) Debtors or

receivables turnover; (ii) Average collection period. The debtors turnover shows the

relationship between the sales and debtors of a firm. Average Collection period for Tata

Steel were 9.54 days in 2008-09 and in 2009-10 it has reduced to 6.34 days.. This ratio also

measures the liquidity of a firm‟s debtors is the average collection period ratio, which has

also improved.

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8.0 Funds Flow Management

Companies mobilize funds during the year to create assets, to finance operations and to

retire obligations. Sources of funds are from operation, raising of equity, debt or disposal

of assets. It is possible to have an understanding and command on how the companies

have mobilize resources and deployed them during a period of year. Below we have

prepared sources and utilization of funds statement for Tata Steel. We find that the

company has generated substantial resources from operations manifested in high growth of

reserves and surplus, but substantial amount has been utilized in retiring preference shares

and loans. Company did not create enough of fixed assets with long term funds , rather

preferred to invest in subsidiaries and in the market. High amount of current asset has

been created from its own fund , and less provided by the current liabilities.

Fund Flow management Rs in Crores

Sources of Fund

Reserves and Surplus 12101.58

Defered Tax Liability 281.94

Forex Translation Diff. 206.95

Forex Translation Differnce 471.66

Reduction in Misc Expenses 105.07

Current Liabilities 613.23

Prov. 570.67

Total 13780.43

Utilisation of Funds

Conversion of Share 5316.04

Repayment of Secured Loans 1653.73

Repayment of Unsecured Loans 53.25

Net Block 1523.81

Investments 2607.89

Current Assets 1978.6

Provision 570.67

Employee Separation 76.44

Total 13780.43

9.0 Market Perception

How a company‟s performance is viewed by investors is reflected in its (actual and

potential) market price of share. How a company has done is reflected in its earnings per

share.

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Earning per Share:The earnings per share figure is one of the most important ratios used

by investment analysis, yet it is one of the most deceptive. If no dilutive securities are

present in the capital structure, then earnings per share is simply computed by dividing

PAT by number of ordinary shares. IF, however, convertible securities, stock options,

warrants, or other dilutive securities are included in the capital structure, (1) earnings per

equity and equity equivalent shares and (2) fully diluted earnings per share figures may have

to be used. For Tata Steel basic earnings per share in 2008-09 were Rs.69.45 for 10 rupee

fully paid up share, decreased to Rs.60.26 in 2009-10.

Certain problems exist when the earnings per share ratio is computed. Often earnings per

share can be increased simply by reducing the number of shares outstanding through

buying back own share of the company. In addition, the earnings per share figure fails to

recognize the probable increasing base of the stockholders‟ investment. That is, earnings

per share, all other factors being equal, will probably increase year after year if the

corporation reinvests earnings in the business because a larger earnings figure is generated

without a corresponding increase in the number of shares outstanding. Because even-well

informed investors attach such importance to earnings per share, caution must be

exercised, and it should not be given more emphasis than it deserves. The common

problem is that the per-share figure draws the investor‟s attention away from the enterprise

as a whole – which involves differing magnitudes of sales, costs volumes, and invested

capital and concentrates too much attention on the single share of stock.

P/E Ratio:The price earnings (P/E) ratio is an oft-quoted statistic used by analysts in

discussing the investment possibility of a given enterprise. It is computed by dividing the

market price of the stock by its earnings per share. A steady drop in a company‟s price

earnings ratio indicates that investors are wary of the firm‟s growth potential. Some

companies have high P/E multiples, while others have low multiples. This measure

involves an estimation not directly controlled by the company: the market price of its

ordinary shares. Thus the P/E ratio is the best indicator of how investors judge the future

performance (We say future performance because, conceptually the market price indicates

shareholders‟ expectations about future returns dividend and share price increases-

discounted to a present value at a rate reflecting the riskiness of these returns.)

Management is of course interested in this market appraisal, and a decline in the

company‟s P/E ratio, if not explainable by a general decline in stock market prices is a

course for concern. Also, management compares its P/E ratio with those of similar

companies to determine the market place‟s relative rankings of the firms.

P/E ratio‟s of industries vary, reflecting differing expectations about the relative rate of

growth in earnings in those industries. At times, the P/E ratios for virtually all companies

decline, predictions of general economic conditions suggest that corporate profits will

decrease and/or interest rates will rise.

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Financial Analysis -Tata Steel- For Students