Financial Statement Analysis

Financing Module

Topics Covered

Financial Ratios DuPont System Using Financial ratios Measuring Company Performance The Role of Financial Ratios

Analyzing Financial Statements

Financial Ratio:
A)

ANALYZING FINANCIAL STATEMENTS I. Common-Size Financial Statements

Common-size balance sheets and income statements are used to compare the performance of different companies or a company's progress over time.

Common-Size Balance Sheet is a balance sheet where every dollar amount

has been restated to be a percentage of total assets.

Common-Size Income Statement is an income statement where every dollar

amount has been restated to be a percentage of sales.

Example: FedEx Common Size Balance Sheet and Income Statement

At first glance, all numbers stated within FedEx's income statement in figure 7.1, can seem daunting. It requires close examination to determine whether operating expenses are increasing or decreasing, or which particular expense comprises the highest percentage total operating expenses.

Income Statement

Classification of Financial Ratios

B) Classification of Financial Ratios
Ratios were developed to standardize a companys results. They allow analysts to quickly look through a companys financial statements and identify trends and anomalies. Ratios can be classified in terms of the information they provide to the reader. There are four classifications of financial ratios: Internal liquidity The ratios used in this classification were developed to analyze and determine a companys financial ability to meet short-term liabilities. Operating performance - The ratios used in this classification were developed to analyze and determine how well management operates a company. The ratios found in this classification can be divided into operating profitability and operating efficiency. Operating profitability relates the companys overall profitability, and operating efficiency reveals if the companys assets were utilized efficiently.

Risk profile - The ratios found in this classification can be divided into business risk and financial risk. Business risk relates the companys income variance, i.e. the risk of not generating consistent cash flows over time. Financial risk is the risk that relates to the companys financial structure, i.e. use of debt.
Growth potential - The ratios used in this classification are useful to stockholders and creditors as it allows the stockholders to determine what the company is worth, and allows creditors to estimate the companys ability to pay

Internal Liquidity Ratios

1. Current Ratio: This ratio is a measure of the ability of a firm to meet its shortterm obligations. In general, a ratio of 2 to 3 is usually considered good. Too small a ratio indicates that there is some potential difficulty in covering obligations. A high ratio may indicate that the firm has too many assets tied up in current assets and is not making efficient use to them. Current ratio = current assets / current liabilities 2. Quick Ratio The quick (or acid-test) ratio is a more stringent measure of liquidity. Only liquid assets are taken into account. Inventory and other assets are excluded, as they may be difficult to dispose of Quick ratio = (cash+ marketable securities + accounts receivables) current liabilities 3. Cash Ratio The cash ratio reveals how must cash and marketable securities the company has on hand to pay off its current obligations. Cash ratio = (cash + marketable securities)/current liabilities 4. Working Capital Ratio Working Capital Ratio = CA CL / Sales

Efficiency / Turnover Ratios 5. Receivable Turnover Ratio This ratio provides an indicator of the effectiveness of a company's credit policy. The high receivable turnover will indicate that the company collects its dues from its customers quickly. If this ratio is too high compared to the industry, this may indicate that the company does not offer its clients a long enough credit facility, and as a result may be losing sales. A decreasing receivable-turnover ratio may indicate that the company is having difficulties collecting cash from customers, and may be a sign that sales are perhaps overstated.

Receivable turnover = net annual sales / average receivables Where: Average receivables = (previously reported account receivable + current account receivables)/2 6. Average Number of Days Receivables Outstanding (Average Collection Period) This ratio provides the same information as receivable turnover except that it indicates it as number of days.
Average number of days receivables outstanding = 365 days_ receivables turnover

7. Inventory Turnover Ratio This ratio provides an indication of how efficiently the company's inventory is utilized by management. A high inventory ratio is an indicator that the company sells its inventory rapidly and that the inventory does not languish, which may mean there is less risk that the inventory reported has decreased in value. Too high a ratio could indicate a level of inventory that is too low, perhaps resulting in frequent shortages of stock and the potential of losing customers. It could also indicate inadequate production levels for meeting customer demand
Inventory turnover = cost of goods sold / average inventory Where: Average inventory = (previously reported inventory + current inventory)/2 8. Average Number of Days in Stock This ratio provides the same information as inventory turnover except that it indicates it as number of days. Average number of days in stock = 365 / inventory turnover 9. Payable Turnover Ratio This ratio will indicate how much credit the company uses from its suppliers. Note that this ratio is very useful in credit checks of firms applying for credit. Payable turnover that is too small may negatively affect a company's credit rating. Payable turnover = Annual purchases / average payables

Where: Annual purchases = cost of goods sold + ending inventory beginning inventory Average payables = (previously reported accounts payable + current accounts payable) / 2 10. Average Number of Days Payables Outstanding (Average Age of Payables) This ratio provides the same information as payable turnover except that it indicates it by number of days. Average number of days payables outstanding = 365_____ payable turnover II. Other Internal-Liquidity Ratios 11.Cash Conversion Cycle This ratio will indicate how much time it takes for the company to convert collection or their investment into cash. A high conversion cycle indicates that the company has a large amount of money invested in sales in process. Cash conversion cycle = average collection period + average number of days in stock - average age of payables Cash conversion cycle = average collection period + average number of days in stock - average age of payables 12.Defensive Interval This measure is essentially a worst-case scenario that estimates how many days the company has to maintain its current operations without any additional sales.

Defensive interval = 365 * (cash + marketable securities + accounts receivable) projected expenditures

Where: Projected expenditures = projected outflow needed to operate the company 7.3 - Operating Profitability Ratios Operating Profitability can be divided into measurements of return on sales and return on investment Return on Sales

1. Gross Profit Margin This shows the average amount of profit considering only sales and the cost of the items sold. This tells how much profit the product or service is making without overhead considerations. As such, it indicates the efficiency of operations as well as how products are priced. Wide variations occur from industry to industry. Gross profit margin = gross profit / net sales
Gross profit = net sales cost of goods sold

2. Operating Profit Margin

This ratio indicates the profitability of current operations. This ratio does not take into account the company's capital and tax structure. Operating profit margin = operating income/net sales 3. Per-Tax Margin (EBT margin) This ratio indicates the profitability of Company's operations. This ratio does not take into account the company's tax structure. Pre-tax margin = Earning before tax/sales 4. Net Margin (Profit Margin) This ratio indicates the profitability of a company's operations. Net margin = net income/sales 5. Contribution Margin This ratio indicates how much each sale contributes to fixed expenditures.

Contribution margin = contribution / sales Where: Contributions = sales - variable cost

Return on Investment Ratios

1.

Return on Assets (ROA) This ratio measures the operating efficacy of a company without regards to financial structure Return on assets = (net income + after-tax cost of interest) average total assets OR Return on assets = earnings before interest and taxes average total assets 2. Return on Common Equity (ROCE) This ratio measures the return accruing to common stockholders and excludes preferred stockholders. Return on common equity = (net income preferred dividends) average common equity 3. Return on Total Equity (ROE) This is a more general form of ROCE and includes preferred stockholders. Return on total equity = net income/average total equity

Operating Efficiency Ratios

1.

Total Asset Turnover This ratio measures a company's ability to generate sales given its investment in total assets. A ratio of 3 will mean that for every dollar invested in total assets, the company will generate 3 dollars in revenues. Capitalintensive businesses will have a lower total asset turnover than non-capitalintensive businesses. Total asset turnover = net sales / average total assets Fixed-Asset Turnover This ratio is similar to total asset turnover; the difference is that only fixed assets are taken into account. Fixed-asset turnover = net sales / average net fixed assets Equity Turnover This ratio measures a company's ability to generate sales given its investment in total equity (common shareholders and preferred stockholders). A ratio of 3 will mean that for every dollar invested in total equity, the company will generate 3 dollars in revenues. Equity turnover = net sales / average total equity

2.

3.

FINANCIAL RISK RATIOS

Financial Risk This is risk related to the company's financial structure. Analysis of a Company's Use of Debt 1.Debt to Total Capital This measures the proportion of debt used given the total capital structure of the company. A large debt-to-capital ratio indicates that equity holders are making extensive use of debt, making the overall business riskier. Debt to capital = total debt / total capital Where: Total debt = current + long-term debt Total capital = total debt + stockholders' equity

2. Debt to Equity This ratio is similar to debt to capital. Debt to equity = total debt / total equity Analysis of the Interest Coverage Ratio
3. Times Interest Earned (Interest Coverage ratio) This ratio indicates the degree of protection available to creditors by measuring the extent to which earnings available for interest covers required interest payments. Times interest earned = earnings before interest and tax interest expense

Market Ratios

1. Sustainable Growth Rate G = RR * ROE Where: RR = retention rate = % of total net income reinvested in the company or, RR = 1 (dividend declared / net income) ROE = return on equity = net income / total equity Note that dividend payout is the residual portion of RR. If RR is 80% then 80% of the net income is reinvested in the company and the remaining 20% is distributed in the form of cash dividends. Therefore, Dividend Payout = Dividend Declared/Net Income

Let's consider an example:

Market Ratios
Dividend Yield: It is the return on dividend on the investment, expressed in percentage and can be calculated as follows: Dy = D / price P/E Multiple = Price / Earning This ratio show how much will you willing to pay for a stock against a single rupee earning of a company. Payout Ratio: This show how mush you pay for dividends out of the total income. And can be calculated as follows: DPS / EPS

DuPont System
A system of analysis has been developed that focuses the attention on all three critical elements of the financial condition of a company: the operating management, management of assets and the capital structure. This analysis technique is called the "DuPont Formula". The DuPont Formula shows the interrelationship between key financial ratios. It can be presented in several ways. The first is:
Return on equity (ROE) = net income / total equity If we multiply ROE by sales, we get:

Return on equity = (net income / sales) * (sales / total equity) Said differently:
ROE = net profit margin * return on equity The second is: Return on equity (ROE) = net income / total equity If in a second instance we multiply ROE by assets, we get: ROE = (net income / sales) * (sales / assets) * (assets / equity) Said differently: ROE = net profit margin * asset turnover * equity multiplier