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Module 1

Analysis of composite cash flows, Leverage, Ownership structures, ROE, P/E ratios, Dividend payout, Dividend yields, and other financial characteristics of Sensex and Nifty firms.

The financial statement analysis is a process of evaluating the relationship between component parts of financial statements to obtain a better understanding of the firms position and performance. The focus of financial analysis is on key figures in the financial statements and the significant relationship between them. Financial statements provide an insight into the performance of the company and helps in inter-firm and intra-firm comparison. It is an ongoing exercise used by various stake holders such as the management, investors, financial analysts, lending institutions and others. Firm management use the measurements to compare the actual performance against the projected performance.

The process involves selecting information relevant to the decision under consideration from the financial statements, arrange the information in a way to highlight the significant relationships and finally drawing inferences and interpretation of the analysis. In brief, financial analysis is the process of selection, relation and evaluation. Analysing the financial performance though termed as a post mortem, it is an essential part of the investment strategy. The assessment of the actual performance Vs. expectations gives the required insight as a measuring yard- stick. A good investment creates value for the firm by earning a return that is greater than its hurdle rate. The actual performance is likely to be different from the expected performance as some investments do better than expected and some investment do worse.

The type of analysis varies according to the specific interests of the party involved. Trade Creditors are interested in the short term liquidity of the firm to pay their claims judged by analysis of liquidity. The Debt holders are interested in long term who evaluate the cash flow ability of the firm to service debt over long run. The Debt holders evaluate the capital structure of the firm, the major sources and uses of funds, its profitability over time and projections of future profitability.

Equity investors are concerned primarily with the present and expected future earnings and the stability of these earnings, trend of these earnings, co-variance of earnings of other companies. Their analysis will focus on the ability of the company to pay dividends and to avoid bankruptcy. Management would be interested in all aspects of financial analysis that suppliers of capital use in evaluating the firm. Management also employs financial analysis for the purpose of internal control and in particular with profitability of investment in the various assets and in efficiency of asset management.

Typical Income Statement

Total Revenue Less Variable Costs Contribution

Less Fixed Costs


Operating Income

Earnings before interest and tax (EBIT) Less Interest on Debt Profit Before tax (EBT or PBT) Less Corporate Tax Profit After Tax (EAT or PAT) Less Preference Dividend (if any) Equity Earnings

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Typical Income Statement

Total Revenue

Less Cost of Goods Sold (COGS)


Gross Profit Less Operating Costs (Salaries, rents, administrative expenses, D&A & other expenses) Operating Profit (EBIT) Less Interest on Debt Profit Before tax (EBT or PBT)

Less Corporate Tax


Profit After Tax (EAT or PAT) Less Preference Dividend (if any) Equity Earnings
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While short term creditors are interested in short term liquidity, the long term creditors like debenture holders, term lending institutions etc., are concerned with the firms long-term financial position. The process of magnifying the shareholders' return through the use of debt is called financial leverage or financial gearing or trading on equity. Leverage ratios help to measure the financial risk and the firms ability of using debt to shareholders' advantage.

Risk attached to a firm can be divided into two categories Business Risk and Financial Risk. Business Risk arises because of the variability of EBIT. EBIT is also referred to the operating profit. It results from internal and external environment (business cycle, technological obsolescence) in which the firm operates. It is associated with the investment activities of the firm. It is measured by calculating operating leverage. Its degree does not differ with the use of different forms of financing.
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Financial Risk arises because of the variability of EAT. It results from use of financial leverage source of funds bearing fixed returns like debt. It is associated with the financing activities of the firm. It refers to the capital structure decision and the degree varies with use of different forms of financing.

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Leverage refers to use of funds bearing fixed financial payments like debt in the capital structure. Operating Leverage affects a firms Operating Profit (EBIT) while the Financial Leverage affects Profit After tax (EAT / PAT) or EPS. Degree of Operating Leverage is defined as the percentage change in the EBIT relative to a given percentage change in sales. It exists because of fixed costs. Example: DOL of 1.5 means for a 1% increase in sales will result in 1.5% increase in EBIT. % change in EBIT OR EBIT /EBIT DOL = % change in Sales Sales/Sales
Q (S-V) Q (S-V) F OR Contribution EBIT
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DOL =

Financial Leverage is a measure of Financial Risk. Degree of Financial Leverage is defined as the percentage change in the EPS due to a given percentage change in EBIT % change in EPS EPS/EPS DFL = % change in EBIT OR EBIT/EBIT EBIT Q (S-V) F If no pref .dividend = EBT DFL = Q(S-V) - F - I EBIT If preference dividend exists = EBT ( Pref. Dvd / 1-t)
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Combined Leverage : Operating and Financial Leverages together cause wide fluctuations in EPS for a given change in sales. If a firm employs a high level of Operating and Financial Leverage, a small change in the level of sales will have a dramatic effect on EPS.

% change in EBIT X % change in EPS DCL = % change in Sales % change in EBIT = % change in EPS OR % change in Sales Contribution Profit before tax
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Total Debt Debt/equity Ratio = --------------Net worth Where Total Debt means all long term debts outstanding and Net worth include Equity Capital + Reserves & Surplus intangibles (goodwill etc) accumulated losses if any. Lending institutions and investors consider Preference shares also as a part of Equity if they are of long tenor, say > 12 years.
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Total outside liability Total outside Liability (ST+LT) to Net worth = -----------------------------------------Net worth The ratio indicates the margin of safety available to all the outside creditors both short term and long term. Depending on the purpose for which the leverage ratios are worked out, preference share capital is either included as a part of debt or equity. Since the ratio is intended to know the financial risk i.e. bankruptcy risk, preference share capital is included as a part of Net worth.
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A high debt ratio implies that the claims of creditors are greater than the owners. The company will have several restrictive covenants from the lenders. The company may have to maintain a minimum current ratio, limits on management remuneration, restrictions on dividend payout, restriction on further borrowing, etc. Due to the pressures and constraints imposed by the creditors, the managements independence on several critical decisions will be impinged. If the company does not rectify the situation either by improving the profitability and retention or infusing fresh equity, the company may slip into a debt trap. (current example of Kingfisher Airlines)
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A company with a lower debt equity ratio, say less than 1 implies that creditors enjoy a comfortable cushion with lower financial risk. The company will be able to command favourable terms in raising long term funds with finer pricing terms and covenants. Even during periods of lower profits, the company may not face difficulty in servicing the debt periodic interest and repayment of the principal. Higher the debt ratio, the larger the shareholders earnings when the cost of debt is lower than the firms overall rate of return on investment. There is a need to strike a proper balance between the use of debt and equity. The most appropriate combination would involve a trade off between risk and return. (Trade off Theory)

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The ROCE is a metric where the profits are related to the total capital employed. Capital employed refers to long-term funds supplied by the lenders and owners of the firm. (Debt + Equity) Long term funds can be worked out in two ways it is equal to Noncurrent Liabilities (long-term liabilities) plus Owners equity. Alternatively, it is equivalent to Net working capital plus Fixed Assets. A comparison of the ratio with similar firms and industry average provides an insight into how efficiently the long term funds of owners and lenders have been used. The higher the ratio, the more efficient is the use of the capital employed.
EBIT ROCE = ---------------------------------------------------------------------BV of Debt + BV of Equity (total capital employed) OR Net Profit after taxes + Interest - Tax advantage on interest ROCE = ---------------------------------------------------------------------------------------Total capital employed
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Net Profit After taxes* TSR =


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Total Shareholders Equity *Net profit after taxes and Preference Dividend (preference capital if any).

While ROCE expresses profitability of a firm in relation to the funds supplied by the lenders and owners taken together (Debt + Equity), the TSR measures exclusively the return on the owners funds. Shareholders of a firm fall into two groups preference shareholders and equity shareholders and in this metrics both are considered to arrive at the profitability including share premium and reserves & surplus less accumulated losses (Net worth + preference capital).

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Unlike debt holders, Equity shareholders have no fixed claim. The earnings after taxes represent the equity earnings.
Net profit after taxes preference dividend Return on Equity (ROE) = -------------------------------------------------------------Ordinary shareholders' equity or Net Worth Net worth = Equity Capital +Share Premium + Reserves & Surplus accumulated losses-Intangibles

ROE indicates how well the firm has used the resources of owners. This metrics is of great interest to the present as well as the prospective shareholders. This metrics cause great concern to the management as it is an indicator whether the company has met the expectations of equity shareholders.
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The earnings may be distributed to the shareholders or retained in the business, but irrespective of how the earnings are used, the earnings after taxes (PAT) belong to equity shareholders representing their earnings. The ROE is compared with other similar companies and the industry average. This gives an indication of relative performance and strength of the company in attracting future investments.

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Debt-equity ratios only indicate the proportions in which debt and equity have been used in the funding of the long term requirements of the company. Debt-equity fail to indicate the ability to service the debt periodic interest and repayment on due dates. Interest Coverage Ratio and Debt Service Coverage Ratio (DSCR) helps in analysing the ability to service the debts. The servicing of the debt needs adequate cash flows from the project/purpose for which the debts have been raised. These calculations indicate the amount of cushion that is available to the company from the periodic cash flows.

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EBIDTA Interest Coverage = ---------------------Interest EBIDTA and Interest should be for the similar periods under consideration. Interest being a charge to P/L account before tax, EBIT is considered. Depreciation being a non-cash item is included in the calculation. The ratio shows the number of times the interest charges are covered by funds that are available for payment. It indicates the extent to which the earnings may fall without causing difficulty for the company to service interest. A very high ratio indicates that the company is highly conservative and not using financial leverage to the advantage of the shareholders.

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EBIDTA Debt Service Coverage = ------------------------------------Interest + Loan repayment 1- tax rate

As only the after tax earnings are available to repay the principal amount, the principal repayment is converted to a before tax basis by dividing it by 1-tax rate. Depreciation and other non-cash items are added to the numerator to provide coverage measure in terms of cash flow rather than earnings.

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The ROCE is a metric where the profits are related to the total capital employed. Capital employed refers to long-term funds supplied by the lenders and owners of the firm. (Debt + Equity) Long term funds can be worked out in two ways it is equal to Noncurrent Liabilities (long-term liabilities) plus Owners equity. Alternatively, it is equivalent to Net working capital plus Fixed Assets. A comparison of the ratio with similar firms and industry average provides an insight into how efficiently the long term funds of owners and lenders have been used. The higher the ratio, the more efficient is the use of the capital employed.
EBIT ROCE = ---------------------------------------------------------------------BV of Debt + BV of Equity (total capital employed) OR Net Profit after taxes + Interest - Tax advantage on interest ROCE = ---------------------------------------------------------------------------------------Total capital employed
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Net Profit After taxes* TSR =


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Total Shareholders Equity *Net profit after taxes and Preference Dividend (preference capital if any).

While ROCE expresses profitability of a firm in relation to the funds supplied by the lenders and owners taken together (Debt + Equity), the TSR measures exclusively the return on the owners funds. Shareholders of a firm fall into two groups preference shareholders and equity shareholders and in this metrics both are considered to arrive at the profitability including share premium and reserves & surplus less accumulated losses (Net worth + preference capital).

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EPS measures the profits available to the equity shareholders on a per share basis, the amount that they can get on every share held. EPS = Net Profit available to equity shareholders Number of equity shares outstanding

The Net Profit is the PAT less preference dividends if any. EPS calculations made over the years indicate whether or not the firms earnings power on per-share basis has changed over the period.

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EPS

EPS is a good measure of profitability from the shareholders point of view which can be compared with the past years, between firms and the industry. An increase in the EPS does not necessarily mean that profitability has improved since it does not consider the enlarged capital resulting from retention of earnings of previous years as it takes into account only the number of shares as the basis. EPS only indicates how much of the earnings belong to the equity shareholders and does not reveal how much has been paid out as dividend or retained in the business.

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The PAT belong to equity shareholders. But what they actually receive is the amount of earnings distributed as cash dividends. Many investors may be interested in DPS rather than EPS.
Dividend amount paid DPS = ----------------------------------------------Number of Equity shares outstanding

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Dividend

payout ratio indicates what is the extent of equity earnings (PAT) that has been paid out as dividend.
Equity Dividend DPS Payout = -------------------------- = ------Profit After Tax EPS Earnings not distributed to shareholders are retained in the business. The Retention ratios is 1- Dividend Payout Ratio

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Dividend Yield is the dividends per share divided by the market value per share. Earnings Yield is the EPS divided by the market value per share. Dividend per Share Dividend Yield = -------------------------------Market value per share

Earnings Per Share Earnings Yield = ---------------------------------Market Value per share These metrics evaluate shareholders return in relation to the market value of the share. Earnings Yield is also called Earnings-Price (E/P) ratio.
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The P/E ratio is widely used by investors to value the firms performance. It indicates investors expectations about the firms performance. Management is interested in this metric which indicates the market appraisal of the firms performance and its future prospects and growth in the future earnings. P/E ratio varies from industry to industry and between companies. Market Price Per share MV Price- Earnings = ------------------------------ = ------Earnings per share EPS

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William Beaver compared the financial ratios of 79 manufacturing firms that subsequently failed with the ratios of 79 that remained solvent. His study revealed 5 ratios which could discriminate between failed and non-failed firms. These ratios are:
I. II. III. IV. V.

Cash flow to Total Assets Net Income to Net Assets Total Debt to Total Assets Working Capital to Total Assets and Current ratios
The failed firms had more debt and lower return on assets. They had low current ratios : less cash , less inventory but more receivables .
(William W.H ., Financial Ratios and Predictors of Failure, Empirical Research in Accounting: Selected Studies Supplement to Journal of Accounting Research 1966)
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