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# Ratio Analys sis

Ratio Analysis

## Private and Confidential Not for Circulation

Discussion topics p
How to analyze a company?
Analytical techniques for Financial Statement Analysis

## Horizontal i l Analysis l i Trend Analysis Vertical Analysis Ratio Analysis

Solvency
Current Ratio /Quick Ratio / Cash ratio Receivables turnover / Inventory turnover / Payables turnover / Cash Conversion Cycle

## Ratio Analys sis

Operating
Operating Efficiency ratios Operating Profitability DuPont Formula Extended DuPont Formula

Risk
Business Risk Financial risk External liquidity risk

Growth

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## Analytical y techniques q for FSA

Purpose of Financial Statement Analysis is to evaluate management performance in
Profitability Effi i Efficiency Risk

## Although financial statement information is historical, it is used to project future performance

Compares two financial statements to determine dollar and percentage changes Compute dollar changes and percentage changes

## Horizontal and Trend Analysis

Vertical Analysis

Shows relationship p of each item to a base amount on financial statements Income statement (each item expressed as percentage of net sales) Balance sheet (each item expressed as percentage of total assets)

## Which method is the Best?

Ratio Analysis

Puts numbers in perspective with other numbers Helps control for different sizes of firms Ratios provide meaningful relationships between individual values in the financial statements

## An Analyst is expected to do a complete synthesis using all three methods

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Horizontal Analysis y
Horizontal analysis shows the changes between years in the financial data in both dollar and percentage form Horizontal analysis on the income statement
GKSR Income Statement Rental Operations Direct Sales Net Revenues C t of Cost f rental t l operations ti Cost of direct sales Selling and administrative costs Operating Expenses Ebitda Depreciation Amortization of intangibles Ebit Interest Expense Income before income taxes Provision for taxes PAT Basic EPS Diluted EPS 2006 801,240 79,603 \$880,843 (518 543) (518,543) (57,522) (186,652) (\$762,717) \$118,126 (32 479) (32,479) (10,784) \$74,863 (13,226) \$61,637 (19,786) \$41,851 \$ , \$1.98 \$1.97 2007 847,401 82,141 \$929,542 (541 392) (541,392) (59,579) (203,614) (\$804,585) \$124,957 (34 789) (34,789) (10,806) \$79,362 (13,901) \$65,461 (22,271) \$43,190 \$ , \$2.03 \$2.02 Increase (\$) 46,161 2,538 \$48,699 (22 849) (22,849) (2,057) (16,962) (\$41,868) \$6,831 (2 310) (2,310) (22) \$4,499 (675) \$3,824 (2,485) \$1,339 \$ , \$0.05 \$0.05 % YoY change 5.8% 3.2% 5.5% 4 4% 4.4% 3.6% 9.1% 5.5% 5.8% 7 1% 7.1% 0.2% 6.0% 5.1% 6.2% 12.6% 3.2% 2.5% 2.4%
[Current year Base year] / [Base year]

## Ratio Analys sis

Why provision for tax has increased by 12.6%, while the revenues increased by only 5.5%? Why there is an increase of 9.1% in Selling and administrative cost?

Horizontal analysis can also be done on the liabilities or shareholders shareholder s equity

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Trend Analysis y
Trend percentages state several years financial data in terms of a base year, which equals 100% In the example below, below we have taken base year as 2002
Income Statement Net Revenues Operating Expenses PAT Trend Analysis Net Revenues Operating Expenses PAT 2002 677,591 565,077 38,267 2002 100.0% 100.0% 100.0% 2003 705,588 598,974 33,689 2003 104.1% 106.0% 88.0% 2004 733,447 625,064 35,384 2004 108.2% 110.6% 92.5% 2005 788,775 674,566 38,179 2005 116.4% 119.4% 99.8% 2006 880,843 762,717 41,851 2006 130.0% 135.0% 109.4% 2007 929,542 804,585 43,190 2007 137.2% 142.4% 112.9%

## [Current year ] / [Base year] * 100

We can use the trend percentages to construct a graph so we can see the trend over time
TrendAnalysis 160% 140% 120% 100% 80% 60% 2002 2003
Net Revenues

While Operating cost has increased by 42% since 2002, Net income grew marginally by 13% during the corresponding period

2004

2005

2006

2007

Operating p g Expense p

Net Income

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Vertical Analysis y
Common-size statements use percentages to express the relationship of individual components to a total within a single period is known as Vertical Analysis
Income Statement (as a percentage of Total Revenues) Balance Sheet (As a percentage of Total Asset / Total Liabilities)
2002 96.8% 3 2% 3.2% 100.0% -59.5% -2.3% -21.6% -83.4% 16.6% -4.4% -0.9% 11.3% -2.0% 9.3% -3.7% -3 7% 5.6% 2003 96.6% 3 4% 3.4% 100.0% -60.5% -2.5% -21.9% -84.9% 15.1% -4.3% -1.0% 9.8% -1.9% 7.8% -3.1% -3 1% 4.8% 2004 96.6% 3 4% 3.4% 100.0% -61.1% -2.6% -21.5% -85.2% 14.8% -4.3% -1.1% 9.4% -1.6% 7.8% -3.0% -3 0% 4.8% 2005 93.9% 6 1% 6.1% 100.0% -59.6% -4.5% -21.4% -85.5% 14.5% -4.1% -1.2% 9.2% -1.4% 7.8% -2.9% -2 9% 4.8% 2006 91.0% 9 0% 9.0% 100.0% -58.9% -6.5% -21.2% -86.6% 13.4% -3.7% -1.2% 8.5% -1.5% 7.0% -2.2% -2 2% 4.8% 2007 91.2% 8 8% 8.8% 100.0% -58.2% -6.4% -21.9% -86.6% 13.4% -3.7% -1.2% 8.5% -1.5% 7.0% -2.4% -2 4% 4.6%
Since 2004, , cost of rentals have decreased

Vertical Analysis

## Ratio Analys sis

Rental Operations Alcohol Net Revenues Cost of rental operations Cost of direct sales Selling and administrative costs Operating Expenses Ebitda Depreciation Amortization of intangibles g Ebit Interest Expense Income before income taxes Provision for taxes PAT

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Ratio Analysis

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Ratio Analysis y
Puts numbers in perspective with other numbers H l control Helps t lf for different diff t sizes i of f firms fi Ratios provide meaningful relationships between individual values in the financial statements

Ratios can be used to evaluate four different areas of companys performance and conditions

## Ratio Analys sis

Ratio Analysis

Solvency Ratios

Operating Performance

Risk Analysis

Growth

## Current/Cash /Quick Ratio

Turnover Ratios

Operating Efficiency

Operating Profitability

Financial Risk

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## Ratio Analysis y - Solvency y

Analyst employ these ratios to determine the firms ability to pay its short-term liabilities Current Ratio examines current assets and current liabilities
Higher the current ratio, more likely is that the company will be able to pay its short-term bills

Ratio Analys sis

Current Ratio =

## Current Assets Current Liabilitie s

A ratio of less than 1, means that the company has negative working capital and is probably facing li idit crisis liquidity i i

## Quick Ratio adjusts current assets by removing less liquid assets

More stringent measure of liquidity

Quick Ratio =

## Cash + Marketable Securities + Receivables Current Liabilities

Higher the quick ratio, more likely is that the company will be able to pay its short-term bills

## Cash ratio relates cash (ultimate liquid asset) to current liabilities

Higher the cash ratio, more likely is that the company will be able to pay its short-term bills

Cash Ratio =

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## Ratio Analysis y - Solvency y

Receivables turnover examines the management of accounts receivable
Balance sheet items are taken as average of the account

Ratio Analys sis

Receivables Turnover =

## Net Annual Sales Average Receivables

Average collection period is the average number of days it takes for the companys customer to p pay y their bills
It is desirable to have a collections period closer to the industry norm

## 365 Receivables Turnover

Collection period too high mean that customers are too slow in paying their bills bills, which implies too much capital is tied up in assets

Inventory turnover measures firms efficiency with respect to its processing and inventory management
Balance sheet items are taken as average of the account

Inventory Turnover =

## Cost of Goods Sold Average Inventory

Given the turnover values, you can compute the average inventory processing time
It is desirable to have a collections period closer to the industry norm

## Average Inventory Processing Period = Inventory Turnover

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## Evaluating g Solvency y Ratios

Payables turnover measures the use of trade credit by the firm
Balance sheet items are taken as average of the account

Payables Turnover =

## Cost C t of f goods d sold ld Average Payables

Given the turnover values, we can compute the average payment period processing time
It is desirable to have a collections payment closer to the industry norm

## Cash Conversion Cycle

Combines information from the receivables turnover, inventory turnover, and accounts payable turnover

## Cash Con Cycle

Receivable period

Inventory period

Payable period

High conversion cycle is undesirable Too high conversion cycle implies that company has excessive amount of capital investment in the sales process

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## Calculating g Cash Conversion Cycle y

Example : Cash conversion cycle

## Ratio Analys sis

BalanceSheet Assets Cash AccountsReceivables Inventory Netproperty,plantandequipm TotalAssets Liabilities AccountsPayable MortgagePayable CommonStock Retainedearnings TotalliabilitiesandEquity

Income Statement

2006 \$156,000 312,000 936,000 2,184,000 \$3 588 000 \$3,588,000 2006 \$589,680 1,248,000 936 000 936,000 814,320 \$3,588,000

2007 \$46,800 468,000 624,000 2,293,200 \$3 432 000 \$3,432,000 2007 \$780,000 1,294,800 936 000 936,000 421,200 \$3,432,000

Net Sales COGS Salaries expenses Depreciation expense Interest expense Total Expense Pre-tax Income Income tax expense Net Income

2007 \$2,808,000 (1,560,000) (514,800) (109,200) (\$62 400) (\$62,400) (2,246,400) 561,600 (168,480) \$393,120

Calculateaveragecashconversioncycleforthecompany

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## Ratio Analysis y Operating p g Efficiency y

Operating Efficiency Ratios
Examines how management uses its assets to generate sales and it considers the relationship between various asset categories g and sales

Total Asset Turnover ratio indicates effectiveness of a firms use of its total asset base to produce sales
Different types of industries have different asset turnovers. Infrastructure business are capital intensive and may have Asset Turnover closer to 1, however, retail business might have turnover ratios in double digits

## Net Sales Average Total Net Assets

Low asset turnover may mean that the company has much capital tied up in its asset base

Net Fixed Fi ed Asset t turnover no e reflects eflects utilization tili ation of fixed fi ed assets
This number can look temporarily bad if the firm has recently added greatly to its capacity in anticipation of future sales

## Equity Turnover measures the employment of owners capital

Equity capital includes all preferred and common stock, paid-in capital and retained earnings

Equity q y Turnover =

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## Ratio Analysis y Operating p g Profitability y

Operating profitability ratios
Examines how management is doing at controlling costs so that a large proportion of the sales dollar is converted into profit p What proportion of the sales dollar is left after cost of goods sold? Is the firm buying inputs (inventory and direct labor) at good prices?

## Gross Profit Margin

Gross profit margin measures the rate of return after cost of goods sold

## Operating Profit Margin

Operating profit margin measures the rate of profit on sales after operating expenses

## Operating income can be thought of as the bottom line from operations

Net Margin
Shows the combined effect of operating profitability and the firms financing decisions (since net income is after interest and tax payments)

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## Ratio Analysis y Operating p g Profitability y

Example:OperatingRatios IncomeStatement
Sales COGS Selling and Admin expenses Interest income 2007

## Ratio Analys sis

Interest expense Gain on sale of long term invest Provision for income taxes

\$18,000 \$ , \$13,200 \$3,400 \$800 \$500 \$ \$1,200 \$1,015 2007 \$44,000 (\$12,000) \$32,000
22000

Calculate the following a) Operating Profit Margin b) Net profit Margin c) Asset Turnover d) Equity Turnover

SelectedBalanceSheetitems
Book value of total assets Accumulated depreciation Net total assets Shareholder's Equity

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## Ratio Analysis y Operating p g Profitability y

Return on total capital relates the firms earnings to all capital invested in the business
This number should not be too low as compared to the industry average

## Ratio Analys sis

Return on total equity indicates the rate of return earned on the capital provided by the stockholders t kh ld after ft paying i for f all ll other th capital it l used d
Total Equity includes preferred stock

## Return on owners equity is based only on the common shareholders equity

Preferred dividends are deducted from Net Income as they are a priority claim

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## Ratio Analysis y Operating p g Profitability y

DuPont System divides ROE into several ratios that collectively equal ROE while individually providing insight
Most important term in ratio analysis

sis Rat tio Analys

ROE =

## Basic algebra for ROE breakdown

Net Income Net Income Sales Total Assets = Common Equity Sales Total Assets Common Equity

Profit margin

Asset Turnover

Financial Leverage

## Extended DuPont System

Provides additional insights into the effect of financial leverage on the firm and pinpoints the effect of income taxes on ROE

g with the operating p gp g ( y sales) ) and introduce additional We begin profit margin (EBIT divided by ratios to derive an ROE value

Net Income Net Income Sales Total Assets = Common Equity Sales Total Assets Common Equity

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## Ratio Analysis y Operating p g Profitability y

Extended DuPont Analysis

Ratio Analys sis

Net Income EBT Sales Total Assets = ( 1 - t) Common Equity Sales Total Assets Common Equity

Asset Turnover

## Interest exp. rate

Financial leverage

## Tax retention rate

Financial leverage involves acquiring assets with funds at a fixed rate of interest
If Return on Investment in Asset > Fixed rate of borrowing = Positive financial leverage If Return on Investment in Asset < Fixed rate of borrowing = Negative financial leverage

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## Ratio Analysis y Operating p g Profitability y

Example : DuPont Analysis

PleaseevaluatethefollowingratiosforPrattscompany Preinterestprofitmargin(EBIT/S) Assetturnover(S/A) Leverage(A/E) Taxretention( (1t) ) Interestexpenseratio(I/A) Commentonthefirm'sROEtrends 2006 0.15 1.00 2.00 0.70 0.05 2007 0.10 1.50 2.50 0.70 0.05

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## Ratio Analysis y Risk

Risk analysis examines the uncertainty of income for the firm and for an investor Total firm risks can be decomposed into three basic sources 1) Business risk 2) Financial Risk 3) External Liquidity Risk Business Risk
Function of Business variability, Sales variability and Operating leverage Between five to ten years of data should be used for calculating business and sales variability

## Ratio Analys sis

Sales variability y=

## Standard Deviation (sales) Mean sales

Also critical is the measure of how much companys production costs are fixed (as opposed to variable)

Operating leverage =

## % change in Operating Earnings % change in Sales

Greater the use of fixed costs, greater the impact of a change in sales on the operating income of a company and hence, higher is the risk

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## Ratio Analysis y Financial Risk

Financial risk
The added uncertainty in a firms net income resulting from a firms financing decisions (primarily through employing p y g leverage) g ) Interest payments are deducted before we get to net income and these are fixed obligations. Similar to fixed production costs, these lead to larger earnings during good times, and lower earnings during a business decline The use of debt financing increases financial risk and possibility of default while increasing profitability when sales are high Two sets of financial ratios help measure financial risk
Balance sheet ratios Earnings or cash flow available to pay fixed financial charges

## Balance Sheet Ratios

How much debt does the firm employ in relation to its use of equity?

## Long term debt Long term equity

How much debt does the firm employ in relation to all long-term sources of funds?

Debt Ratio =

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## Ratio Analysis y Financial Risk

Earnings/Cash flow ratios
Relate operating income (EBIT) to fixed payments required from debt obligations Hi h ratio Higher ti means l lower risk i k Interest coverage ratio determines the firms ability to repay its debt obligations

## Ratio Analys sis

Interest coverage =

## EBIT Interest expense

Cash C h fl flow t to l long t term d debt bt ratio ti determines d t i th the ability bilit of f th the fi firm t to meet t it its long l term t debt d bt through th h its cash flows

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## Ratio Analysis y External Liquidity q y Risk

External liquidity risk
External market liquidity is a source of risk to investors Market M k t Liquidity Li idit i is th the ability bilit t to b buy or sell ll an asset t quickly i kl with ith littl little price i change h f from a prior i transaction assuming no new information The most important factor of external market liquidity is the dollar value of shares traded This can be estimated from the total market value of outstanding securities It will be affected by the number of security owners Numerous buyers and sellers provide liquidity

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## Ratio Analysis y Example p

Example : Ratio Analysis

Pleaseevaluatethefollowingratios CashRatio OperatingProfitMargin CurrentRatio TotalDebttoTotalCapitalRatio C hFl Cash FlowtoT Total lDebt D b Ratio R i CashConversionCycle(days) Interestcoverage NetProfitMargin DebttoEquityRatio 2006 0.84 30% 1.80 78% 66 54 3.00 10% 132% 2007 0.60 36% 1.44 74% 60 60 2.40 8% 127%

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## Ratio Analysis y Growth

Growth is important to both creditors and owners
Creditors interested in ability to pay future obligations F owners, the For th value l of f a firm fi depends d d on its it future f t growth th in i earnings, i cash h flow, fl and d dividends di id d

If the company doesnt grow, it stands a much greater chance of defaulting on its loans Sustainable growth rate is a function of two variables:
What is the rate of return on equity (which gives the maximum possible growth)? How much of that growth is put to work through earnings retention (rather than being paid out in dividends)? Growth = ROE x Retention rate

## Also remember ROE is a function of

Net profit p ofit margin ma gin Total asset turnover Financial leverage (total assets/equity)

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## Limitation of Financial Ratios

Accounting treatments may vary among firms, especially among non-U.S. firms Always consider relative financial ratios. They do not make any sense when viewed in isolation Firms may have divisions operating in different industries making it difficult to derive industry ratios Conclusions cannot be made by just looking at only one set of ratios Ratios outside an industry range may be cause for concern

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