1. Analyzing Financial Statements

2. Financial Statement and its Analysis Collective name for the tools and techniques that are intended to provide relevant information to decision makers. Objective is to assess a company’s financial health and performance. Assessment can be made by looking at past facts and figures with the latest up-to-date facts and figures for the same company. Comparisons can be made between different companies operating in the same industry and different industries

3. End Users of Financial Statements Existing and potential investors. Employees. Government. Managers. Creditors and other lenders. Banks. Trade and Worker’s Unions. Society.

4. Some purposes for financial analysis Information from past performances is useful in judging future performance. An assessment of current status will show where the company stands at present – borrowings, inventories, cash balances etc. Investment evaluations helps assess prospects for future investments patterns and also current investor’s predictions. Credit assessment is useful for creditors who are concerned with management’s compliance with loan indentures. Government’s taxation policies can be developed and formulated by assessing the industry’s financial performances.

5. Techniques used Horizontal Analysis – financial statements provide comparative information for the current year and the previous year. Idea: is to calculate amount changes and percentage change. Trend Analysis – involves calculations of percentage changes in the financial statement items for a number of successive years. Vertical Analysis – is the proportional expression of each item on a financial statement to the statement total. Example: any item as a percentage of sales. Ratio Analysis – involves establishing a relevant financial relationship between components of financial statement. It helps in identifying significant relationships between financial statement items.

6. Financial Ratios Profitability Ratios Liquidity Ratios Solvency Ratios Capital Market Ratios

7. Profitability Ratios Profitability ratios measure the degree of operating success of a company in an accounting period. Stakeholder interests in the profitability - 1)Potential and existing investors. 2)Government. 3)Employees. 4)Managers and Executive members. Some common profitability ratios: 1)Net Profit Margins, Gross Profit Margin, Operating Margin. 2)Asset Turnover Ratios. 3)Returns on Equity. 4)Inventory Turnover Ratios. 5)Creditors Payable Days

8. Profitability Ratios: Profits Margins Profits after Tax Net Sales Revenue EBITDA Net Sales Revenue Gross Profits Sales Profit Margin = Operating Margins = Gross Profit Margins =

9. Profitability Ratios: Asset Turnover Asset Turnover measures the efficiency with which the assets are utilized. It indicates the amount of sales is generated for every rupee worth of assets. Higher ratio indicates efficient utilization and lower ratio means the opposite. Lower ratio indicates that company has more assets than what is required and that it is not used optimally. It is generally observed that firm with lower profit margins tends to have higher asset turnover and vice versa. 2002 Rs. Lakhs 2001 Rs. Lakhs Total Assets 750545.26673238.44 Sales995485.301066755.69 Total Sales Average Total Assets 995485.30 (750545.26 + 673238.44)/2 AT = 1.40 times AT =

10. Profitability Ratios: Inventory Turnover Inventory turnover measures the rate at which inventories are turned over as a percentage of cost of sales. The ratio shows us the pace at which inventories are sold and replaced over a period. Inventory Cost of Sales Greater the number of days imply: 1.lack of demand. 2.It may reflect poor inventory control. 3.It may lead to inventory obsolescence and related write off. All is not bad: It may also indicate that the company is buying large inventory to benefit from possible trade discounts, or may be to avoid a possible cut or disruption in inventory supply to customer. * 365 days Inventory Turnover =

11. Profitability Ratios: Creditors Payable Days Creditors amount falling due within a year Credit Purchases Significance: Ratio is always compared with last year’s figures. A long credit period may be good as it represents a source of free finance. A long credit period may also indicate that the company is unable to pay more quickly because of liquidity problem. A company may develop a poor credit ratings/reputation. Having long credit period may discourage supplier firms from extending cash discounts as incentives and also may discontinue operations. * 365 CPD =

12. Profitability: ROE vs ROCE Profits after Interest and Tax (Net Profits) Ordinary Shareholders + Reserves and Surplus Operating Profits (EBIT) Share Capital + Reserves and Surplus + Borrowings ROE = ROCE =

13. Profitability: ROE & Du Pont Identity Du Pont Identity breaks the ROE into three important segments – Profit Margin. Total Asset Turnover. Financial Leverage. Significance of these 3 segments – Profit Margin – signifies operating efficiency. Total Asset Turnover - signifies asset use efficiency. Financial Leverage – signifies equity multiplier (assets/equity).

14. Profitability: Deriving Du Pont Net IncomeSales Total Assets Sales Avg Total Assets Ordinary Equity Significance, application and usefulness of Du Pont – In profit margin increases, it implies every one rupee in sales generates greater net income i.e. net income as a proportion of sales. Increase in asset turnover suggests for every one rupee invested in asset the company generates greater sales proportionally. Financial leverage indicates how a firm meets its financial obligations - is it through debt financing or equity financing ?? ** Du Pont =

15. Du Pont: Financial Leverage Increase in financial leverage indicates that the firm resorts to debt financing relative to equity financing. Financial leverage benefits diminish as the risk of defaulting on interest payments increases. So if the firm takes on too much debt, the cost of debt rises as creditors demand a higher risk premium, and ROE decreases. Increased debt will make a positive contribution to a firm's ROE only if the firm's return on assets (ROA) exceeds the interest rate on the debt significantly.

16. Du Pont Measurement. Example: Revenue (in million): $29261 Net Income: $4212 Assets: $27987 Shareholder’s Equity: $13572 Net Profit Margin: 4212/29261 = 14.39% Asset Turnover: 29261/27987 = 1.0455 Equity Multiplier: 27987/13572 = 2.0621 Du Pont ROE = (14.29%)(1.0455)(2.0621) = 31.02 % Leaving Equity Multiplier out of the equation - we get the returns on equity as a result of profit margin and sales – 15.04% It also indicates that the balance 15.96% was due to returns earned on the debt at work in the business.

17. Liquidity Ratios: Current Ratio Liquidity – ability of the company to meet its short term obligations. The company should have enough cash and other assets which can be converted into cash so that it can pay its suppliers and lenders. Current Ratio = Current Assets / Current Liabilities. Current Assets: all assets that appear in the balance sheet which can be sold or used up within one year or one business cycle. Currents Assets: Cash and Cash Equivalent. Accounts Receivables. Inventory. Prepaid Assets (used within one financial year). Short term investments. Current Liabilities: All liabilities that fall due within the current financial year.

18. Liquidity Ratios: Quick Ratio Typically, Current ratio are not a perfect tool for measuring the firm’s ability to meet short term obligations. Reasons: 1.High levels of inventory and receivables (look for work-in-progress). 2.High level of cash and cash equivalent is not necessarily a good sign ? An Acid Test/Quick Test shows the company’s ability to use its cash and cash equivalents to meets its short term obligations Current Assets include everything that can be readily and speedily converted in liquid cash. Besides the obvious cash, we can include bank deposits, marketable securities, debtors* etc etc. Quick Ratio = Quick Assets / Current liabilities.

19. Liquidity Ratios: Debtors Turnover Debtors Turnover Ratio measures the efficacy of the company’s credit and collection policy. It measures the company’s ability to collect from its credit customers the amount due from credit sales. Ratio obviously suggests that the number of days it takes a company to convert its debtor obligations into cash. Average Debtor Collection Period = Average Debtor Credit Sales / 360

20. Debtor Turnover Ratio Carphone Warehouse £000 Credit Sales1,110,678697,720 Debtors due 1 Year149,20082,826 Debtors Turnover = (149,200 + 82826) / 2 1,110,678 / 365 = 116,013 3042.95 = 38.12 days

21. Solvency Ratios: Capital Gearing Capital Gearing is the relationship between a company’s equity capital and reserves with its debt. Highly Geared Company – those that are largely financed through debt instruments and other loans. Preferential shares are included. Low Geared Company – the obvious other possibilities. No Geared Company - depends solely on equity shares for its financial needs. Earnings of a High Geared Company tend to more sensitive to profit changes. Debt – Equity Ratio = Loans + Preference Share Capital + Bank OD’s Ordinary Shares, Reserves + Minority Interest

22. Solvency Ratio: Interest Cover Interest Cover – the relationship between the EBIT and Interest Payable. Earnings before Interest and Tax (Operating Profits) Interest Payable Int Cov =