Analysis of Financial Statements

Reading # 07
Financial Analysis Techniques (Supplement)
• The Universe of Ratios
• Model Building & Forecast
• Difference between Equity Analysis and Credit Analysis
• Term Project

Disclosure: These slides and all the material in them are gathered using CFA Institute Curriculum and Schweser Notes
1 – The Universe of Ratios

• So far we have covered Key Ratios related to Income Statement, Balance Sheet, and Cash Flows in the past readings

• This reading will cover additional ratios that are helpful in analyzing financial statements

 Industry-specific Ratios

 Ratios with elements from more than one financial statements

• Key Additional Ratios:

 Combined Ratio (For Insurance Company) = Total Costs (i.e. Losses & Expenses) / Net Premium

 It is a profitability measure for insurance companies

 Example:

Comment on changes in the company’s

combined ratio over the period of 5
years:

Overall, the company’s profitability

1 2 3 4 5 worsened over the period of 5 years.

However, the profitability has been

significantly volatile. Analyst needs to
figure out the reason for this volatility
and understand nature of the business
 Categories of Financial Ratios:
 Activity Ratios: They Measure how efficiently a Company uses its resources
 Activity Ratios:

• Inventory Turnover = COGS / Avg. Inventory = 7.4 x - Higher is better.

 Activity Ratios:

• Days of Inventory on Hand (DOH) = No. of Days in Year / Inventory Turnover = 50 Days - Lower is better
 Activity Ratios:

• Receivables Turnover = Revenue / Average Receivables = 4 x - Higher is better

 Activity Ratios:

• Days Sales Outstanding (DSO) = No. of Days in Period / Receivables Turnover = 92 Days - Lower is better
 Activity Ratios:

• Payables Turnover = Purchases / Average Trade Payables = 3.4 x - Lower is better

Purchases = COGS + (Change in Stock) = 248 + (34 – 33) = 249

 Activity Ratios:

• No. of Days of Payables = No. of Days in Period / Payables Turnover = 108 Days - Higher is better
 Activity Ratios:

• Working Capital Turnover = Revenue / Avg. Working Capital = 7.6x - Higher is better
 Activity Ratios:

• Fixed Assets Turnover = Revenue / Avg. Fixed Assets = 0.35x - Higher is better
 Activity Ratios:

• Total Assets Turnover = Revenue / Avg. Total Assets = 0.28x - Higher is better
 Activity Ratios:

 Comment on the Change in the Company’s Activity Ratios over the past 4 Years:

- Inventory Turnover increased and DOH decreased. This is a

positive sign. Inventory management has become more efficient
as the company is now able to sell more while keeping lesser
inventory. It is able to sell inventory more quickly than before

- Receivables Turnover decreased and DSO increased. This means

company is now offering more credit to its customers. It might be
to support growth. However, it will negatively impact the cash
cycle

- Purchases turnover increased and Payables Days decreased. This

means Company is paying off suppliers quickly. It again have a
negative impact on cash conversion cycle

- Overall, the Company’s Working Capital management has become

less efficient. As deterioration of DSO and Payables Days has more
than offset the improvement in inventory management

- Overall, Productivity & Efficiency has deteriorated with respect to

Working Capital management. However, the efficiency &
productivity have improved with respect to Total Assets, as the
company is making more sales with every $ of investment in
Assets. This is reflected in increase in Total Asset Turnover
 Liquidity Ratios: They Measure the Company’s ability to meet short-term obligations

- Current Ratio, Quick Ratio, and

Cash Ratio have already been
discussed in previous readings

- Therefore, we will only cover

Defensive interval ratio;
Operating Cycle; and Cash
Conversion cycle (i.e. Net
Operating Cycle) in this reading
 Liquidity Ratios:

• Defensive Interval Ratio = (Cash + Marketable Securities + Receivables) / Daily Cash Expenditure

• Assume Daily Cash Expenditure = 7.5  Defensive Interval Ratio = 45 Days - Higher is better.
 Liquidity Ratios:

• Operating Cycle = DOH + DSO = 50 + 92 = 142 Days - Lower is better

• Net Operating Cycle = Cash Conversion Cycle = DOH + DSO – Payables Days = 34 Days – Lower is better
 Liquidity Ratios:

 Comment on the Change in the Company’s Defensive Interval & Operating Cycle Ratios over the past 4 Years:

- Defensive interval ratio has been almost stable and so it is not much of a concern. The Company has enough liquidity
to meet its daily spending needs

- The Company’s Cash Conversion Cycle has worsened from 2013 to 2017, reflecting a significant increase in its Working
Capital. The Company’s suppliers are asking for quicker payments, while its customers seem to be delaying payments.
One of the possible reasons for this change can be the Company’s high growth, as it may need to increase credit
period to customers. Analyst should compare cash conversion cycle with industry peers to analyze the possibility of
improvement in it. If the trend continues, the company’s working capital will significantly increase, and negatively
impact its valuation further
 Solvency Ratios: They Measure the Company’s ability to meet Long-term obligations

- Most of these ratios have

already been discussed in
previous readings

- Therefore, we will only cover

Interest Coverage, and Fixed
Charge Coverage ratios in this
reading
 Solvency Ratios:

• Interest Coverage Ratio = EBIT / Interest Expense = 1.7x - Higher is better.

 Solvency Ratios:

 Comment on change in the Company’s ability to make Interest Payments over the past 4 Years:

- The company’s ability to make interest payments have improved, as reflected in increase interest coverage ratio from
1.3x to 1.7x
 Profitability Ratios: They Measure the Company’s profitability, i.e. The income per unit of revenue or assets

- Return on Sales ratios have

already been discussed in
previous readings

- Therefore, we will only cover

Return on Investment Ratios in
this reading
 Profitability Ratios:

• Operating ROA = Operating Income / Average Total Assets = 7.7% - Higher is better.
 Profitability Ratios:

• ROA = Net Income / Average Total Assets = 2.2% - Higher is better.

 Profitability Ratios:

• Return on Equity (ROE) = Net Income / Average Equity = 7.9% - Higher is better.
 Profitability Ratios:

 Comment on the Change in the Company’s Return on Investment Ratios over the past 4 Years:

- Overall, the company’s return on investment has increased over the past four years. This reflects the
company’s ability generate higher return on per $ of investment. This further reflects that the Company
is making profitable investments and has been able to maintain the return for its investors despite
growth and expansion
 DuPont analysis: The decomposition of ROE:
 DuPont analysis: The decomposition of ROE:

Tax Interest EBIT Asset Financial

Burden Burden Margin Turnover Leverage
 DuPont analysis: The decomposition of ROE:

 Example:

 Calculate ROE using the Income Statement and Other Details provided below:

Financial Leverage = 3.6

Asset Turnover = 28%

Tax Burden = (NI / EBT) = 70%

Interest Burden = (EBT / EBIT) = 40%

EBIT Margin = (EBIT / Revenue) = 28%

Asset Turnover = 28%

Financial Leverage = 28%

ROE = 0.70 x 0.40 x 0.28 x 0.28 x 3.6 = 8%

  DuPont analysis: The decomposition of ROE:

 Example:

What might an Analyst conclude?

- Tax burden showed volatility, which is probably due
to change in tax rates. However, it hasn’t
significantly changed, and therefore it is not the
key driver of increase in ROE
2006 2007 2008 2009
- Interest burden remained almost stable

- EBIT margin improved significantly, reflecting

potential contribution to ROE

- Significant improvement in Asset Turnover was

another probably reason for significant change in
ROE

- Leverage remained almost stable

- Overall, EBIT margin and Asset Turnover have been the primary drivers of ROE. This means that improvement in operational profitability, efficiency,
and productivity have been the primary drivers of increase in ROE
 Valuation Ratios: These ratios are used in investment decision making to estimate the value

- P/E is the most commonly used

valuation ratio

- PEG is often used to support P/E ratio

- Valuation ratios can be further classified

into lagging (trailing) and leading
(forward) ratios

- Payout Ratio, Retention Ratio, and

Sustainable Growth Rate are used in
valuation models such as Gordon
Growth Model
 Valuation Ratios:

• Company X has 50% payout ratio and 8% ROE. Calculate its Sustainable Growth Rate

 g = 50% x 8% = 4%

• Assume that Company X reported an EPS of $5 last year and it is expected to report $6 EPS next year. If its
stock is currently trading at $100 per share, Calculate its Trailing and Forward P/Es

 Trailing P/E = (100 / 5) = 20x; and Forward P/E = (100 / 6) = 17x

• Assume that a Company Y is similar to Company X. However, Company Y is expected to post 8% annual
growth over the next 5 years; while Company X is expected to grow at 5% annually over the next 5 years.
Company Y’s Forward P/E is the same as Company X. Is Company Y overvalued or undervalued?

 Undervalued – Because if everything else is same then higher growth should translate into higher P/E
 Valuation Ratios:

• Calculate respective PEGs of Company X and Company Y using the data provided below.

 Company X:

• Next year’s EPS estimate = $4

• Projected 5 Year growth rate = 8%
• Price = $60

 Company Y:

• Next year’s EPS estimate = $3

• Projected 5 Year growth rate = 5%
• Price = $36

 PEG (Company X) = (60 / 4) / (8%) = 1.9

 PEG (Company Y) = 2.4

• If everything else about the two companies is same, which company is overvalued?

 Company Y is overvalued compared to Company X

 Valuation Ratios:

• Estimate the intrinsic value of Company’s share using Gordon Growth Model with following assumptions:

 The Company recently paid dividend of $5

 It is expected to increase the dividend by 15% next year
 The Company’s pay-out ratio = 60% and ROE = 8%
 Company’s cost of equity is 10%

 Value = Next Year’s Dividend / (Cost of Equity – Sustainable Growth Rate) = D1 / (r – g)

 D1 = 5 x 1.15 = $5.75
 g = Retention Ratio x ROE = 60% x 8% = 4.8%

 Value = (5.75) / (10% - 4.8%) = $110.6 per share

 Assume that the Company’s share is currently trading at $100 in the market. Using the results from
Gordon Growth Model, Should you Buy or Sell the stock?

 Market Price < Intrinsic Value  Therefore, the Stock is Undervalued  BUY the Stock
2 – Model Building and Forecasting:

 Forecast next 5-year Income Statement

 Forecast next 5-year Balance Sheet
 Forecast next 5-year Cash Flow Statement

 Forecast next 5-Year FCFF

 Forecast Terminal Value at the end of 5th Year, assuming an appropriate Terminal Growth Rate

 Estimate appropriate Discount Rate (WACC)

 Estimate Firm’s Value as of Today  Firm Value = Present Value of all future FCFFs and Terminal Value using WACC
 Find out Value of Equity  Equity Value = Firm Value – Debt + Cash
 Estimate Value per Share  Value per Share = Equity Value / No. of Total Outstanding Common Shares

 Find out Market Price per Share

 Find out if Company is Overvalued or Undervalued  By comparing Market Price with Intrinsic Value
 Give your Recommendation – i.e. Buy or Sell
• Possible Assumptions in Forecasting – Income Statement:

 Sales

 Past 5 year or 3 year CAGR

 Industry’s growth forecast
 Company’s target growth

 COGS

 Historical trend in Gross Margin

 Company’s Gross Margin Target
 Raw Material prices forecast
 Currency depreciation forecast – For importers of raw material
 Operating Expenses

 Historic trend in Operating Expenses as % of Sales

 Company’s plans of driving efficiency
 Benchmarking against the industry

 Interest & Taxation Costs

 Recent Interest Rate and Forecasted Loan Amount

 Current Tax Rate or Forecasted Tax Rate
• Possible Assumptions in Forecasting – Balance Sheet:

 Non-Current Assets

 Historic Trend and Expansion plans

 Working Capital

 Historic Trend in DSO; DOH; and Payables Days

 Benchmarking these ratios against the industry
 Company’s DSO; DOH; and Payables Days targets

 Loans

 Expected borrowing required for Expansion

 Expected repayment of loans
 Company’s target capital structure – and expected changes in loans to achieve the targeted structure
 Benchmarking against the industry’s capital structure
• Possible Assumptions in Forecasting – Valuation:

 Discount Rate

 Cost of Equity using CAPM

 Cost of Debt using Interest Cost
 WACC using Cost of Equity; Cost of Debt; and Target Capital Structure

 Long-term Growth / Terminal Growth

 Country’s Real GDP Growth Rate

• Performing the Valuation:

 Select the type of Cash Flow to be used

 FCFF
 FCFE
 Dividend

 (Proxies for Cash Flows for Simplification) – E.g. FCFF is approx. same as “EBITDA – Tax – Capex”
 Note: This is just a proxy for cash flow, and not the actual cash flow

 Use the appropriate Discount Rate

 WACC for FCFF

 Cost of Equity for FCFE

 Estimate Terminal Value (using similar model as Gordon Growth Model)

 Terminal Value calculation (using similar model as Gordon Growth Model)

 Calculate Present Values and Sum them up
 Subtract Net Debt (i.e. Net Debt = Debt – Cash)
• Assess Range of Possibilities:

 Sensitivity Analysis:

 Changing One Variable at a Time and Assessing its impact on the Financials
 E.g. Changing Sales Growth Assumption and finding how much does value change with 1% change in Sales

 Scenario Analysis:

 Changing More than One Variables at a Time and Assessing their Impact on the Financials
 E.g. Changing Sales Growth as well as Profitability Assumption

 Simulation:

 Computer-generated sensitivity and scenario analysis based on probability models for inputs
 E.g. Monte Carlo Simulation
3 – Difference Between Equity Analysis & Credit Analysis:

Equity Analysis Credit Analysis

For owners of the Company
More Focused on Growth
More Focused on Performance
More Focused on Income Statement
Focused on Growth & Profitability Ratios
Likes risk if supported by Higher return
For Creditors / Lenders of the Company
More Focused on Strength
More Focused on Position
More Focused on Balance Sheet & Cash
Focused on Coverage, Liquidity, and Solvency
Doesn’t like the company to take any risk
4 – Term Project:

 Submit a MS Word Document and an Excel Model:

 Excel Model:

 Income Statement Forecasting

 Balance Sheet Forecasting
 All the Discussed Ratios
 Common sized Financial Statements
 Valuation (in a Separate Sheet)
 Market Price and Recommendation

 MS Word Document:

 Perform Ratio Analysis for all the discussed Activity; Liquidity; Solvency; Profitability; and Valuation Ratios
 Not more than one page for one type of ratios
 Calculate and show all these ratios for the past-five years
 Provide commentary on each ratio trend / change in only 2 or 3 lines
 Provide valuation using Proxy approach (EBITDA) discussed
 Compare valuation with the Market Price and Recommend to Buy or Sell the stock