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Financial Statement Analysis
Financial Statement Analysis
• Assessment of the firm’s past, present and future financial conditions
• Done to find firm’s financial strengths and weaknesses
• Primary Tools:– Financial Statements– Comparison of financial ratios to past,
industry, sector and all firms
Objectives of Ratio Analysis
• Standardize financial information for comparisons
• Evaluate current operations• Compare performance with past
performance• Compare performance against other
firms or industry standards• Study the efficiency of operations• Study the risk of operations
Uses for Ratio Analysis
• Evaluate Bank Loan Applications
• Evaluate Customers’ Creditworthiness
• Assess Potential Merger Candidates
• Analyze Internal Management Control
• Analyze and Compare Investment Opportunities
Horizontal, Vertical, & TrendAnalysis
• Horizontal Analysis = calculating the Rupee change and % change in financial statement amounts across time
• Vertical Analysis (Common Size Analysis) = changing all Rupee values for accounts to % values.
• Trend Analysis = Using the “first” year as a base year, calculate future year Rupee values as a ratio.
Types of Ratios
• Financial Ratios:– Liquidity Ratios
• Assess ability to cover current obligations
– Leverage Ratios• Assess ability to cover long term debt obligations
• Operational Ratios:– Activity (Turnover) Ratios
• Assess amount of activity relative to amount of resources used
– Profitability Ratios• Assess profits relative to amount of resources used
• Valuation Ratios:• Assess market price relative to assets or earnings
Liquidity Ratios
• Current Ratio – Current Assets / Current Liabilities
• Current Assets include Cash, Marketable Securities, Accounts Receivable and Inventory
• Current Liabilities include Accounts Payable, Debt Due within one year, and Other Current Liabilities
1:2.175.1555
92.1870
sLiabilitieCurrent
AssetsCurrentRatioCurrent
Liquidity Ratios
• Quick Ratio or Acid Test– Current Assets minus Inventory / Current Liabilities– A more precise measure of liquidity, especially if
inventory is not easily converted into cash.
1:46.075.1555
53.720
Inventory -
sLiabilitieCurrent
AssetsCurrentRatioQuik
Liquidity Ratios
• Cash Ratio
17.075.1555
08.26
Securities Marketable
sLiabilitieCurrent
CashRatioCash
Liquidity Ratios
Days 77360 /94.369,3
39.150,192.870,1
expenses operatingDaily
Inventory As Measure
Average
setsCurrentInterval
•Interval Measure
•Calculated to asses a firms ability to meet its regular cash outgoings
Leverage Ratios
– Leverage ratios measure the extent to which a firm has been financed by debt.
– Leverage ratios include:– Debt Ratio– Debt--Equity Ratio
– Generally, the higher this ratio, the more risky a creditor will perceive its exposure in your business. Thus, high leverage ratios make it more difficult to obtain credit (loans).
Leverage Ratios Cont.
Leverage ratios also include the Interest-coverage Ratio, Fixed coverage Ratio etc,.
In contrast to the leverage ratios discussed on previous slide, the higher the Interest Coverage Ratio (Times-Interest-Earned Ratio), the more credit worthy the firm is, and the easier it will be to obtain credit (loans).
Total Debt Ratio
– Proportion of interest bearing debt in the Capital structure.
– In general, the lower the number, the better.
0.646 87.1901
06.229,1Assets
Net
DebtTotalRatioDebt
Debt-Equity Ratio
– The Debt-Equity Ratio indicates the percentage of total funds provided by creditors versus by owners.
– This ratio indicates the extent to which the business relies on debt financing (creditor money versus owner’s equity).
1.83 81.972
06.229,1
Worth
Equity
Net
DebtTotalRatioDebt
Interest Coverage Ratio
– interest coverage ratio indicates the extent to which earnings can decline without the firm becoming unable to meet its annual interest costs.
– Also called the Times-Interest-Earned Ratio, this calculation shows how many times the firm could pay back (or cover) its annual interest expenses out of earnings before interest and taxes (EBIT).
2.4 46.143
61.342 Coverage
Interest
EBITRatioInterest
Interest Coverage Ratio
2.7 46.143
59.4161.342 Coverage
Interest
EBITDARatioInterest
DA = Depreciation and Amortization expenses
Fixed Coverage Ratio (OR)Debt Service Coverage Ratio (DSCR)
– Principal repayments are added to interest payments
•
RateTax -1Dividend Pref.repaymentLoan
RateTax -1repaymentLoan
rentals Lease Coverage
Coverage
Interest
EBITDARatioFixed
Interest
EBITDARatioFixed
Activity Ratios
– Activity ratios measure how effectively a firm is using its resources, or how efficient a company is in its operations and use of assets.
– In general, the higher the ratio, the better.– Activity ratios include:
Inventory turnover Accounts receivable turnover Average collection period. Total assets turnover Fixed assets turnover
Inventory Turnover Ratio
– The inventory turnover ratio indicates how fast a firm is selling its inventories
– This ratio indicates how well inventory is being managed, which is important because the more times inventory can be turned (i.e., the higher the turnover rate) in a given operating cycle, the greater the profit.
days
Avg
CostRatioInventory
42TurnoverInventory
360 HoldingInventory of Days
8.6 2 / )81.7461 26.244(
66.053,3
Inventory
Sold Goods of Turnover
Inventory Turnover Ratio Cont.
– In the absence of information. Instead of CGS we can use Sales
– In the case of CGS and Inventory both are valued at cost. While the sales are valued at market prices
– Therefore better to use CGS
Accounts Receivable Turnover
– The accounts receivable turnover ratio, indicates the average length of time it takes a firm to collect credit sales (in percentage terms), i.e., how well accounts receivable are being collected.
– If receivables are excessively slow in being converted to cash, liquidity could be severely impaired.
7.7 18.483
23.717,3
AR
AR
Turnover R
Avg
Sales
Avg
SalesCreditA
Average Collection Period
– The average collection period is the average length of time (in days) it takes a firm to collect on credit sales.
days 47 Turnover
360CP
ARA
Net Assets Turnover
– The total assets turnover ratio, indicates how efficiently a firm is using all its assets to generate revenues.
– This ratio helps to signal whether a firm is generating a sufficient volume of business for the size of its asset investment
times1.95 1901.87
3,717.23
Turnover
AssetsNet
SalesAssetsNet
Profitability Ratios
– Profitability ratios measure management’s overall effectiveness as shown by returns generated on sales and investment.
Profitability ratios include– Gross profit margin– Operating profit margin– Net profit margin– Return on total assets (ROA)– Return on stockholders’ equity (ROE)
Gross Profit Margin
– The gross profit margin is the total margin available to cover operating expenses and yield a profit. This ratio indicates how efficiently a business is using its labor and materials in the production process, and shows the percentage of net sales remaining after subtracting cost of goods sold.
– The higher the ratio, the better. A high gross profit margin indicates that a firm can make a reasonable profit on sales, as long as it keeps overhead costs under control.
17.9%or 0.179 3,717.23
663.57
Profit Margin
Sales
GrossGP
Operating Profit Margin
– The Operating Profit Margin measures profitability without concern for taxes and interest.
– The higher the ratio, the better. A high operating profit margin indicates that a firm can make a reasonable profit on sales, as long as it does good tax planning.
9.2%or 0.092 3,717.23
342.61 Margin
Sales
EBITOP
Net Profit Margin
– The net profit margin shows the after-tax profits per rupee of sales.
– The higher the ratio, the better.
3.6%or 0.036 3,717.23
134.86 Margin
Sales
PATNP
Return on Investment (ROI) OR Return on Capital Employed (ROCE)
– The return on total assets ratio shows the after-tax profits per dollar of assets; this is also called return on investment (ROI).
– The ROI is perhaps the most important ratio of all. It is the percentage of return on money invested in the business. The ROI should always be higher than the rate of return on an alternative, risk-free investment.
– The higher the ratio, the better.
18%or 0.18 1,901.87
342.61
EmployedCapital
EBITROI
Return on Shareholders’ Equity
– The net profit margin shows the after-tax profits per rupee of sales.
– The higher the ratio, the better.
20%or 0.20 672.81
134.86
Worth
Net
PATROE
Market Valuation Ratios
– Earnings per share (EPS)– Price-earnings ratio (P/E).– Dividend Yield– Market to Book Ratio
Earnings Per Share (EPS)
– The Profitability of the common shareholders’ Investment.
– The higher the ratio, the better.– Adjust for the bonus issues
6.00 Rs. 22.50
134.86
goutstandin
on shares No of comm
PATEPS
Dividends Per Share (DPS)
– Earnings distributed to the shareholders’ as cash dividends.
– The higher the ratio, the better. – .
2.00 Rs. 22.50
45.00
goutstandin
rsShareholde toPaid Dividends
on shares No of comm
DPS
Dividend Payout Ratio&
Retention Ratio
33%or 0.33 6
2
DPS
EPS
RatioPayout
Retention Ratio = 1- Payout Ratio
Growth in Equity = Retention Ratio * ROE
Market Valuation Measures
• Dividend Yield– Dividend / Market Value per Share
• payout declared as a percentage of the stock price
• Earnings Yield– EPS / Market Value per Share
– Dividend and Earnings yield evaluate the shareholders’ return in relation to the market value of the share
Price-Earnings Ratio
– Measure of optimism or pessimism about firm’s future.
– High PE Ratio indicates optimism– Low PE Ratio indicates pessimism
times4.88 Rs. 6
29.25
Share theof ValueMarket
Ratio /
EPS
EP
• Market Value to Book Value Ratio– Stock price / book value per share
• The number of times the market values the stock over its paid-in capital and retained earnings.
Ratio Analysis Limitations
• Financial ratios are based on accounting data, and firms differ in their treatment of such items as depreciation, inventory valuation, research and development expenditures, pension plan costs, mergers, and taxes.
• Reflects Book Value• Does not take size differences of companies into
account• Identifies problem areas, but not causes
Limitations
Seasonal factors can influence comparative ratios. A firm’s financial condition depends not only on the
functions of finance, but also on many other factors such as
Management, marketing, production/operations, R&D, and MIS decisions
Actions by competitors, suppliers, distributors, creditors, customers, and shareholders
Economic, social, cultural, demographics, environmental, political, governmental, legal, and technological trends.
Cautions in using Ratio Analysis
• Company differences
• Price Level
• Different Definitions
• Changing Situations
• Past Data
Dupont Analysis
• ROE is a closely watched number• It is a strong measure of how well the
management of a company creates value for its shareholders
• The number can be misleading• Due to its vulnerability to measures that increase
its value while making the stock risky• Without a way of breaking down the components
of ROE, investors could be duped into believing a company is a good investment when it is not.
The DuPont System
• Method to breakdown ROE into:– ROI and Equity Multiplier
• ROI is further broken down as:– Profit Margin and Asset Turnover
• Helps to identify sources of strength and weakness in current performance
• Helps to focus attention on value drivers
Components of ROE
• ROE = (Net profit margin) * (Asset Turnover) * (Equity multiplier)
• Operating Efficiency - Profit margin• Asset use efficiency – Total asset turnover• Financial leverage – Equity multiplier
Dupont Calculation
• ROE = requityShareholde
Assets
Asset
Sales
Sales
NetIncome
The DuPont System
ROE
ROI Equity Multiplier
Profit Margin Total Asset Turnover
The DuPont System
EquityCommon
Assets Total
Assets Total
IncomeNet MultiplierEquity ROAROE
ROE
ROA Equity Multiplier
Profit Margin Total Asset Turnover
The DuPont System
Assets Total
Sales
Sales
IncomeNet TurnoverAsset TotalMarginProfit ROA
ROE
ROA Equity Multiplier
Profit Margin Total Asset Turnover
The DuPont System
EquityCommon
Assets Total
Assets Total
Sales
Sales
IncomeNet MultiplierEquity TurnoverAsset TotalMarginProfit ROE
ROE
ROA Equity Multiplier
Profit Margin Total Asset Turnover