JO JITA WAHI SIKANDER

Financial Analysis By – Rahul Jain

Effective Financial Statement Analysis To perform an effective financial statement analysis, you need to be aware of the organisation’s: –business strategy –objectives –annual report and other documents like articles about the organisation in newspapers and business reviews. These are called individual organisational factors.

Effective Financial Statement Analysis Requires that you: Understand the nature of the industry in which the organisation works. This is an industry factor. Understand that the overall state of the economy may also have an impact on the performance of the organisation. → Financial statement analysis is more than just “crunching numbers”; it involves obtaining a broader picture of the organisation in order to evaluate appropriately how that organisation is performing

USE OF FINANCIAL STATEMENTS PROVIDING INFORMATION USE OF KEY STATEMENTS AID IN DECISION MAKING TO STAKEHOLDERS INCLUDING (OWNERS, MANAGEMENT, CREDITORS)

Standardize numbers; facilitate comparisons Used to highlight weaknesses and strengths Why are ratios useful?

Liquidity: Can we make required payments as they fall due? Asset management: Do we have the right amount of assets for the level of sales? Major categories of ratios Major categories of ratios (More…)

Solvency Ratios: Do we have the right mix of debt and equity? Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA?

Profitability Ratios 3 elements of the profitability analysis: Analysing on sales and trading margin –focus on gross profit Analysing on the control of expenses –focus on net profit Assessing the return on assets and return on equity

Profitability Ratios Gross Profit % = Gross Profit * 100 Net Sales Net Profit % = Net Profit after tax * 100 Net Sales Return on Assets = Net Profit * 100 Total Assets Return on Equity = Net Profit *100 Total Equity

ROE= = = 12.8%. Net income Common equity $253.6 $1, E Ind. ROA7.2%-3.3%6.0%9.0% ROE12.8%-17.1%13.3%18.0% Both below average but improving.

© Mary Low Liquidity ratios Short-term funds management Working capital management is important as it signals the firm’s ability to meet short term debt obligations. For example: Current ratio The ideal benchmark for the current ratio is $2:$1 but a ratio below $1CA:$1CL represents liquidity riskiness as there is insufficient current assets to cover $1 of current liabilities.

Liquidity or Short-Term Solvency ratios Working Capital = Current assets – Current Liabilities Current Ratio = Current Assets Current Liabilities Quick Ratio = Current Assets – Inventory – Prepayments Current Liabilities – Bank Overdraft

Expected to improve but still below the industry average. Liquidity position is weak. Comments on CR and QR 2005E Ind. CR2.58x1.46x2.3x2.7x QR0.93x0.5x0.8x1.0x

Asset Management or Activity Ratios Efficiency of asset usage –How well assets are used to generate revenues (income) will impact on the overall profitability of the business.

Inventory turnover ratio Inv. turnover= = = 4.10x. COGS/Sales Inventories $7,036 $1, E Ind. Inv. T.4.1x4.5x4.8x6.1x

Inventory turnover is below industry average. Firm might have old inventory, or its control might be poor. No improvement is currently forecasted. Comments on Inventory Turnover

Receivables Average sales per day DSO is the average number of days after making a sale before receiving cash. DSO= = = 45.5 days. Receivables Sales/365 $878 $7,036/365

Appraisal of DSO nFirm collects too slowly, and situation is getting worse. nPoor credit policy Ind. DSO

Fixed Assets and Total Assets Turnover Ratios Fixed assets turnover Sales Net fixed assets = = = 8.41x. $7,036 $837 Total assets turnover Sales Total assets = = = 2.00x. $7,036 $3,517 (More…)

FA turnover is expected to exceed industry average. Good. TA turnover not up to industry average. Caused by excessive current assets (A/R and inventory). 2005E Ind. FA TO8.4x6.2x10.0x7.0x TA TO2.0x2.0x2.3x2.5x

© Mary Low Financial Structure or Solvency Ratios Long term funds management Measures the riskiness of business in terms of debt gearing. For example: Debt/Equity This ratio measures the relationship between debt and equity. A ratio of 1 indicates that debt and equity funding are equal (i.e. there is $1 of debt to $1 of equity) whereas a ratio of 1.5 indicates that there is higher debt gearing in the business (i.e. there is $1.5 of debt to $1 of equity). This higher debt gearing is usually interpreted as bringing in more financial risk for the business particularly if the business has profitability or cash flow problems.

Total Debt Total assets Debt ratio= = = 43.8%. $1,040 + $500 $3,517 EBIT Int. expense TIE= = = 6.3x. $502.6 $80 Calculate the debt, TIE (More…)

How do the debt management ratios compare with industry averages? 2005E Ind. D/A43.8%80.7%54.8%50.0% TIE6.3x0.1x3.3x6.2x

Credit rating Default risk ratio = Free cash Flow/Principal Payments (defined as free cash flow divided by the combined annual principal payments on all outstanding loans; free cash flow is defined as net profit plus depreciation minus dividend payments)

Market Test Ratios Based on the share market's perception of the company. For example: Price/Earnings ratio= Price/EPS The higher the ratio, the higher the perceived quality of the earnings by the share market.

Market Test Ratios Earnings per share = Net Profit after tax Number of issued ordinary shares Dividends per share = Dividends Number of issued ordinary shares Dividend payout ratio = Dividends per share *100 Earnings per share

What are some potential problems and limitations of financial ratio analysis? Comparison with industry averages is difficult if the firm operates many different divisions. “Average” performance is not necessarily good. Seasonal factors can distort ratios. (More…)

Window dressing techniques can make statements and ratios look better. Different accounting and operating practices can distort comparisons. Sometimes it is difficult to tell if a ratio value is “good” or “bad.” Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition.

Some qualitative factors For evaluating a future financial performance? Are the company’s revenues tied to a single customer? To what extent are the company’s revenues tied to a single product? To what extent does the company rely on a single supplier? (More…)

What percentage of the company’s business is generated overseas? What is the competitive situation? What does the future have in store? What is the company’s legal and regulatory environment?