Financial Statement Analysis

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 Financial Statement Analysis

• Assessment of the firm’s past, present and

future financial conditions
• Done to find firm’s financial strengths and
weaknesses
• Primary Tools:
– Financial Statements
– Comparison of financial ratios to past,
industry, sector and all firms
 Objectives of Ratio Analysis
• Standardize financial information for
comparisons
• Evaluate current operations
• Compare performance with past
performance
• Compare performance against other
firms or industry standards
• Study the efficiency of operations
• Study the risk of operations
 Uses for Ratio Analysis

• Evaluate Bank Loan Applications

• Evaluate Customers’ Creditworthiness
• Assess Potential Merger Candidates
• Analyze Internal Management Control
• Analyze and Compare Investment
Opportunities
 Horizontal, Vertical, & Trend
Analysis
• Horizontal Analysis = calculating the Rupee
change and % change in financial statement
amounts across time
• Vertical Analysis (Common Size Analysis) =
changing all Rupee values for accounts to %
values.
• Trend Analysis = Using the “first” year as a
base year, calculate future year Rupee values as
a ratio.
 Types of Ratio Analysis

• Time Series Analysis or Trend Analysis

– Measures a firm’s performance over time
• Cross Sectional Analysis
– Compares the firm’s ratios with an industry
standard or with its competitor’s ratios.
– Sources:
• U.S. Department of Commerce
• Dun & Bradstreet
• Robert Morris Associates
 Types of Ratios

• Financial Ratios:
– Liquidity Ratios
• Assess ability to cover current obligations
– Leverage Ratios
• Assess ability to cover long term debt obligations
• Operational Ratios:
– Activity (Turnover) Ratios
• Assess amount of activity relative to amount of
resources used
– Profitability Ratios
• Assess profits relative to amount of resources
used
• Valuation Ratios:
• Assess market price relative to assets or earnings
 Liquidity Ratios

• Current Ratio
– Current Assets / Current Liabilities
• Current Assets include Cash, Marketable Securities, Accounts
Receivable and Inventory
• Current Liabilities include Accounts Payable, Debt Due within one
year, and Other Current Liabilities

Current Assets 1870.92

Current Ratio = = = 1.2 : 1
Current Liabilities 1555.75
 Liquidity Ratios

• Quick Ratio or Acid Test

– Current Assets minus Inventory / Current Liabilities
– A more precise measure of liquidity, especially if
inventory is not easily converted into cash.

Current Assets - Inventory 720.53

Quick Ratio = = = 0.46 : 1
Current Liabilities 1555.75
 Liquidity Ratios

• Cash Ratio
Cash + Marketable Securities 26.08
Cash Ratio = = = 0.17
Current Liabilities 1555.75
 Liquidity Ratios

•Interval Measure

•Calculated to assess a firm's ability to meet its regular

cash outgoings

Current Assets − Inventory

Interval Measure =
Average Daily operating expenses
1,870.92 − 1,150.39
= = 77 Days
3,369.94 / 365
 Leverage Ratios
– Leverage ratios measure the extent to which a firm has
been financed by debt.

– Leverage ratios include:

– Debt Ratio
– Debt--Equity Ratio

– Generally, the higher this ratio, the more risky a creditor

will perceive its exposure in your business. Thus, high
leverage ratios make it more difficult to obtain credit
(loans).
 Leverage Ratios Cont.
▪ Leverage ratios also include the Interest-
coverage Ratio, Fixed coverage Ratio etc,.

▪ In contrast to the leverage ratios discussed on

previous slide, the higher the Interest
Coverage Ratio (Times-Interest-Earned Ratio),
the more credit worthy the firm is, and the
easier it will be to obtain credit (loans).
 Total Debt Ratio

– Proportion of interest bearing debt in the

Capital structure.
– In general, the lower the number, the better.

Total Debt
Debt Ratio =
Net Assets
1,229.06
= = 0.646
1901.87
 Debt-Equity Ratio

– The Debt-Equity Ratio indicates the percentage of total

funds provided by creditors versus by owners.

– This ratio indicates the extent to which the business relies

on debt financing (creditor money versus owner’s equity).

Total Debt 1,229.06

Debt − Equity Ratio = = = 1.83
Net Worth 972.81
 Interest Coverage Ratio

– interest coverage ratio indicates the extent to which

earnings can decline without the firm becoming unable
to meet its annual interest costs.
– Also called the Times-Interest-Earned Ratio, this
calculation shows how many times the firm could pay
back (or cover) its annual interest expenses out of
earnings before interest and taxes (EBIT).

EBIT 342.61
Interest Coverage Ratio = = = 2.4
Interest 143.46
 Interest Coverage Ratio

EBITDA 342.61 + 41.59

Interest Coverage Ratio = = = 2.7
Interest 143.46

DA = Depreciation and Amortization expenses

 Fixed Coverage Ratio (OR)
Debt Service Coverage Ratio (DSCR)
– Principal repayments are added to interest payments

•
EBITDA
Fixed Coverage Ratio =
Interest + Loan repayment
1-Tax Rate

EBITDA
Fixed Coverage Ratio = + Pref. Dividend
Interest + Lease rentals + Loan repayment
1-Tax Rate
 Activity Ratios

– Activity ratios measure how effectively a firm is using its

resources, or how efficient a company is in its operations
and use of assets.
– In general, the higher the ratio, the better.
– Activity ratios include:
▪ Inventory turnover
▪ Accounts receivable turnover
▪ Average collection period.
▪ Total assets turnover
▪ Fixed assets turnover
 Inventory Turnover Ratio

– The inventory turnover ratio indicates how fast a firm is

selling its inventories
– This ratio indicates how well inventory is being managed,
which is important because the more times inventory can
be turned (i.e., the higher the turnover rate) in a given
operating cycle, the greater the profit.

Cost of Goods Sold 3,053.66

Inventory Turnover Ratio = = = 8.6
Avg Inventory (244.26 + 7461.81) / 2

365
Days of Inventory Holding = = 42 days
Inventory Turnover
 Inventory Turnover Ratio Cont.
– In the absence of information. Instead of CGS
we can use Sales
– In the case of CGS and Inventory both are
valued at cost. While the sales are valued at
market prices
– Therefore better to use CGS
 Accounts Receivable Turnover

– The accounts receivable turnover ratio, indicates the

average length of time it takes a firm to collect credit sales
(in percentage terms), i.e., how well accounts receivable
are being collected.
– If receivables are excessively slow in being converted to
cash, liquidity could be severely impaired.

Credit Sales
A R Turnover =
Avg AR

Sales 3,717.23
= = = 7.7
Avg AR 483.18
 Average Collection Period

– The average collection period is the average length of

time (in days) it takes a firm to collect on credit sales.

365
ACP = = 47 days
AR Turnover
Accounts Payable Turnover
Days Payable Ratio
 Cash Conversion Cycle
• Cash Conversion Cycle =

• Days Holding Period(Time for converting

Inv into sale) +
• Average Collection Period (Time to
convert sale into cash) –
• Days Payable Period (Time give to make
payments)
• Lower the ratio, better.
 Net Assets Turnover

– The total assets turnover ratio, indicates how efficiently

a firm is using all its assets to generate revenues.
– This ratio helps to signal whether a firm is generating a
sufficient volume of business for the size of its asset
investment

Sales 3,717.23
Net Assets Turnover = = = 1.95 times
Net Assets 1901.87
 Profitability Ratios

– Profitability ratios measure management’s

overall effectiveness as shown by returns
generated on sales and investment.

Profitability ratios include

– Gross profit margin
– Operating profit margin
– Net profit margin
– Return on total assets (ROA)
– Return on stockholders’ equity (ROE)
Gross Profit Margin

– The gross profit margin is the total margin available to cover

operating expenses and yield a profit. This ratio indicates
how efficiently a business is using its labor and materials in
the production process, and shows the percentage of net
sales remaining after subtracting cost of goods sold.
– The higher the ratio, the better. A high gross profit margin
indicates that a firm can make a reasonable profit on sales,
as long as it keeps overhead costs under control.
Gross Profit 663.57
GP Margin = = = 0.179 or 17.9%
Sales 3,717.23
Operating Profit Margin

– The Operating Profit Margin measures profitability without

concern for taxes and interest.
– The higher the ratio, the better. A high operating profit
margin indicates that a firm can make a reasonable profit
on sales, as long as it does good tax planning.

EBIT 342.61
OP Margin = = = 0.092 or 9.2%
Sales 3,717.23
Net Profit Margin

– The net profit margin shows the after-tax profits per rupee of
sales.
– The higher the ratio, the better.

PAT 134.86
NP Margin = = = 0.036 or 3.6%
Sales 3,717.23
 Return on Investment (ROI) OR
Return on Capital Employed (ROCE)
– The return on total assets ratio shows the after-tax
profits per dollar of assets; this is also called return
on investment (ROI).
– The ROI is perhaps the most important ratio of all. It
is the percentage of return on money invested in the
business. The ROI should always be higher than the
rate of return on an alternative, risk-free investment.
– The higher the ratio, the better.
EBIT 342.61
ROI = = = 0.18 or 18%
Capital Employed 1,901.87
Return on Shareholders’ Equity

– The net profit margin shows the after-tax profits per

rupee of sales.
– The higher the ratio, the better.

PAT 134.86
ROE = = = 0.20 or 20%
Net Worth 672.81
 Market Valuation Ratios

– Earnings per share (EPS)

– Price-earnings ratio (P/E).
– Dividend Yield
– Market to Book Ratio
Earnings Per Share (EPS)
– The Profitability of the common shareholders’
Investment.
– The higher the ratio, the better.
– Adjust for the bonus issues

PAT
EPS =
No of common shares outstanding

134.86
= = Rs. 6.00
22.50
Dividends Per Share (DPS)

– Earnings distributed to the shareholders’ as

cash dividends.
– The higher the ratio, the better.
– .

Dividends Paid to Shareholders

DPS =
No of common shares outstanding

45.00
= = Rs. 2.00
22.50
 Dividend Payout Ratio
&
Retention Ratio
DPS
Payout Ratio =
EPS

2
= = 0.33 or 33%
6

Retention Ratio = 1- Payout Ratio

Growth in Equity = Retention Ratio * ROE

 Market Valuation Measures
• Dividend Yield
– Dividend / Market Value per Share
• payout declared as a percentage of the stock
price
• Earnings Yield
– EPS / Market Value per Share

– Dividend and Earnings yield evaluate the

shareholders’ return in relation to the market
value of the share
 Price-Earnings Ratio
– Measure of optimism or pessimism about firm’s
future.
– High PE Ratio indicates optimism
– Low PE Ratio indicates pessimism

Market Value of the Share

P / E Ratio =
EPS

29.25
= = Rs. 4.88 times
6
 Price to Book Ratio (PB Ratio)

• Market Value to Book Value Ratio

– Stock price / book value per share
• The number of times the market values the stock over its
paid-in capital and retained earnings.
 Dupont Analysis
• ROE is a closely watched number
• It is a strong measure of how well the
management of a company creates value for its
shareholders
• The number can be misleading
• Due to its vulnerability to measures that increase
its value while making the stock risky
• Without a way of breaking down the components
of ROE, investors could be duped into believing
a company is a good investment when it is not.
 Components of ROE

• ROE = (Net profit margin) * (Asset Turnover) * (Equity multiplier)

• Operating Efficiency - Profit margin

• Asset use efficiency – Total asset turnover
• Financial leverage – Equity multiplier
 Dupont Calculation

NetIncome Sales Assets

 
• ROE = Sales Asset Shareholderequity
 Ratio to Predict Insolvency
Ratios Expressed Comments
as
Altman’s Z Score No. 3 or more – Financially sound
Z = 1.2 X1 + 1.4 X2 + 3.3 1.81 to 2.99 – Grey area
X3 + 0.6 X4 + 1.0 X5 Less than 1.8 – Higher chances of
X1 = Working Capital/ financial embarrassment
Total Assets
X2 = Retained Earnings /
Total Assets
X3 = EBIT / Total Assets
X4 = Market Value of
Equity / Book Value of
Total Liabilities
X5 = Sales / Total Assets
 Ratio Analysis Limitations
• Financial ratios are based on accounting data,
and firms differ in their treatment of such items
as depreciation, inventory valuation, research
and development expenditures, pension plan
costs, mergers, and taxes.
• Reflects Book Value
• Does not take size differences of companies into
account
• Identifies problem areas, but not causes
Limitations
▪ Seasonal factors can influence comparative ratios.
▪ A firm’s financial condition depends not only on the
functions of finance, but also on many other factors
such as
▪ Management, marketing, production/operations,
R&D, and MIS decisions
▪ Actions by competitors, suppliers, distributors,
creditors, customers, and shareholders
▪ Economic, social, cultural, demographics,
environmental, political, governmental, legal, and
technological trends.