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, & Trend Analysis 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 Financial Statement Analysis Time Series Analysis or Trend Analysis –Measures a firm’s performance over time Cross Sectional Analysis –Compares the firm’s ratios with an industry standard or with its competitor’s ratios. –Sources: U.S. Department of Commerce Dun & Bradstreet Robert Morris Associates

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

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.

Liquidity Ratios Cash Ratio

Liquidity Ratios 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.

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).

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).

Interest Coverage Ratio DA = Depreciation and Amortization expenses

Fixed Coverage Ratio (OR) Debt Service Coverage Ratio (DSCR) –Principal repayments are added to interest payments

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.

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.

Average Collection Period –The average collection period is the average length of time (in days) it takes a firm to collect on credit sales.

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

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.

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.

Net Profit Margin –The net profit margin shows the after-tax profits per rupee of sales. –The higher the ratio, the better.

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.

Return on Shareholders’ Equity –The net profit margin shows the after-tax profits per rupee of sales. –The higher the ratio, the better.

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

Dividends Per Share (DPS) –Earnings distributed to the shareholders’ as cash dividends. –The higher the ratio, the better. –.

Dividend Payout Ratio & Retention Ratio 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

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 =

The DuPont System ROE ROI Profit Margin Total Asset Turnover Equity Multiplier

The DuPont System ROE ROA Profit Margin Total Asset Turnover Equity Multiplier

The DuPont System ROE ROA Profit Margin Total Asset Turnover Equity Multiplier

The DuPont System ROE ROA Profit Margin Total Asset Turnover Equity Multiplier