238141Fm03 Fin Analysis3

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WELCOME TO
CHAPTER 3:
FINANCIAL ANALYSIS
Copyright © by R. S. Pradhan All rights reserved.

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CHAPTER 3: FINANCIAL ANALYSIS
 Difficult to directly compare the financial
statements of two firms because of size
differences.
 Difficult if it is to be compared with a foreign
firm.
Common size statements
 Common size analysis consists of computing
percentages of each item over total assets in
case of balance sheet.
 In case of income statement, percentages are
computed over sales.

The Balance Sheet : 3-3
NEPAL BRICK FACTORY LTD. (‘000 Rs.)
Liabilities and equity Year 2 % of TA
Accounts payable 2,00010
Notes payable 400 2
Accrued wages 800 4
Other accruals 800 4
Current Liabilities 4,00020
Long-term debt 6,00030

Preferred stock 0 0
Stockholder’s equity:
Com. Stock (Par Rs.100) 2,00010
Paid in Capital 2,00010
Retained Earnings 6,00030
Total Stockholders’ eq. 10,00050
Total liab.& eq. 20,000 100
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 Assets Year 2 % of TA
Cash 1,0005
Marketable securities 1,0005
A/cs. receivables, net 2,400 12
Inventories 3,600 18
Prepaid expenses 00
Current assets 8,000 40
Gross Fixed Assets:
Land 1,0005
Building 5,500 27.5
Machinery & equip. 9,500 47.5
Other fixed assets 4,000 20
Total Fixed Assets 20,000 100
Less Depreciation -8,000 40
Net Fixed Assets 12,000 60
Total Assets 20,000 100
The Income Statement 3 - 5
Particulars Year 2 % of S.
Revenues 24,000 100
Cost of sales -13,600 56.7
Gross income 10,400 43.3
Marketing expense -6,000 25
General & adm. Exps. -1,200 5
EBDIT 3,200 13.3
Depreciation -1,000 4.2
Net ope.income (NOI) 2,200 9.1
Other income, net +240 +1.0
EBIT 2,440 10.1
Interest expenses -440 1.8
EBT 2,000 8.3
Income taxes @ 40% -800 3.3
Net income 1,200 5.0
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Financial Ratio Analysis
 Why bother with a ratio? Why not simply look at
the raw numbers. Raw numbers are not very
informative.
 Ratios prove more useful than the raw numbers.
Net profit of Rs. 1 million?
 A ratio is simply a one number divided by
another number. Hence, one may compute a
large number of financial ratios.
 Why compute ratios?
- assess the financial strengths & weaknesses of
the firm
- serve as a basis for decision-making - whether to
extend the loan to a firm?
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 Different groupings of financial ratios. Actual
ratios would remain the same.
A. Liquidity ratios
B. Asset mgmt. or efficiency ratios
C. Debt mgmt. or leverage ratios
D. Profitability ratios
E. Market value ratios
 Compute ratios for Nepal Brick (Year 2):
 (A) Liquidity ratios
1. Current ratio = CA/CL =Rs.8,000/Rs.4,000 =2x.
(Ind. Aver. Or Comp. Co. = 2x). Comment: ?
2. Quick, or acid test =(CA - Inv.)/ CL
=(Rs.8000-3600)/4000 =1.1x.
(IA or CC=1.0x) Comment: ?
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(B) Asset Management (Efficiency or Turnover )
ratios
3. Inventory turnover = Sales or COGS/ Inv.
= Rs. 24,000/ 3,600 = 6.67x.
(IA or CC=8x). Comment: ?
4. Days sales outstanding (DSO)
= Receivables/ (Annual sales/360)
= Rs.2,400/(Rs.24,000/360) = 36 Days.
(IA or CC = 30 days). Comment: ?
5. Fixed assets turnover = Sales/Net fixed
assets = Rs. 24,000/Rs. 12,000 = 2x.
(IA or CC = 2x). Comment: ?
6. Total assets turnover = Sales/ Total assets
= Rs. 24,000/Rs. 20,000 =1.2x.
(IA or CC=1.5x). Comment: ?
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7. Capital requirement = Operating capital / Sales =
(Rs.15,400)/ Rs.24,000 = 64.2%
(IA or CC =40%). Comment: ?
 (C) Debt Mgmt. or Leverage ratios
8. Total debt to total assets = Total debt/Total
assets = Rs.10,000 /Rs.20,000 =50%
(IA or CC = 40%). Comment: ?
9. Long-term debt to total assets = Long-term
debt/Total assets = Rs.6,000/20,000 =30%
10.Times-interest-earned (TIE) = EBIT/ Interest
charges = Rs.2,440/Rs.440 = 5.5x.
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 (D) Profitability ratios
11.Net profit margin = Net income/ Sales
= Rs.1,200/24,000 = 5%.
12. Basic earning power = EBIT/Total assets
=Rs.2,440/20,000 =12.2%.
13. Return on total assets (ROA) =Net income/
total assets =1,200/20,000 = 6%.
(IA or CC = 9%). Comment: ?
14. Return on equity (ROE) = Net Income / Equity
= Rs.1,200/Rs.10,000 = 12%.
3 - 11
 (E) Market value ratios
15. EPS = NI/ No. of shares = Rs. 1200/20
= Rs.60. (IA or CC = Rs.75). Comment: ?
16. Price-earning (P/E) = MPS/ EPS
= Rs.200/Rs. 60 =3.33x. (Assume MPS=Rs. 200)
17. Book value per share = Book equity/ No. of
shares = Rs. 10,000/ 20 = Rs. 500.
(IA or CC = Rs.700). Comment: ?
18. Market/Book values = MPS/ Book value per
share = Rs. 200/ Rs. 500 =0.4x.
(IA or CC = 1.5 times). Comment: ?
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The Du Pont Identity
 The two measures of profitability, ROA and ROE,
is the reflection of use of debt financing, or
financial leverage.
 Du Pont Corporation developed a famous way of
decomposing ROE into its component parts.
 It tells us that if our ROE is low, what could be
the reasons.
Net income
ROE= ----------------------- = 12 percent.
Total Equity
Multiply the ratio by Total Assets/ Total Assets
Net income Total Assets
ROE = -------------------- x --------------------------
Total Equity Total Assets
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Net income Total Assets
ROE = ------------------- x ------------------------
Total Assets Total Equity
ROE = ROA x Equity Multiplier
Rs.1200 Rs.20,000
= ------------ x ----------------
Rs.20,000Rs.10,000
=0.06 x 2.0 = 0.12 or 12%. Same as before.
 Further decompose ROE by multiplying
numerator and denominator by sales:
Sales NI Total Assets
ROE=------------ x ------------------- x -------------------
Sales Total Assets Total Equity
NI Sales Total Assets
= --------- x ------------------- x -------------------
Sales Total Assets Total Equity
= NPM x TAT x EM
= 0.05 x 1.2 x 2 = 0.12 or 12.0%
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ROE = NPM x TAT x EM
Firm : 0.05 x 1.2 x 2.0 = 0.12 or 12.0%
Ind. Ave.: 0.08 x 1.5 x 1.67 = 0.20 or 20.0%
Remarks: Poor Poor Risky
(Note: How to find industry average EM? IA debt ratio
= 40%. It means equity ratio is 60%. TE/TA = 60%
means TA/TE=100/60=1.67)
 Again, ROE is the same as before.
 Firm is deficient in all ROE determinants.
 Du Pont Identity tells us that ROE is affected by
three things:
1.Operating efficiency as measured by profit margin.
2. Asset use efficiency as measured by assets
turnover.
3. Financial leverage as measured by equity multiplier.
 If ROE is unsatisfactory, the Du Pont Identity tells us
where to start looking for the reasons.
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Empirical evidence:
Prediction of corporate bankruptcy
 Altman (1968) used discriminant analysis of fin.
ratios in the prediction of corp. bankruptcy.
 Only 5 out of 22 ratios were finally considered
as predictors. Altman’s model appeared as
follows:
Z=0.012 X1 +0.014 X 2 +0.033 X3+0.006 X4+0.999 X5
X1 = (CA-CL)/ TA, %
X2 = Retained Earnings/ Total Assets, %
X3 = EBIT / Total Assets, %
X4 = ME / Book Value of Total Debt (market value
of equity includes both pref. & com. shares,
and debt includes CL + LTL), %
X5 = sales/total assets, times
 A Z-score of less than 1.8 indicates a3 -very 16 high
probability of failure, while a Z-score larger than 3
indicates a high probability of nonfailure.
 Z-scores between 1.8 & 3 fall in the “gray zone”
where it is not possible to predict with confidence
whether the firm will or will not fail.
Group means
Ratio Bankrupt Nonbankrupt
X1 - 6.1% 42.4%
X2 - 62.6% 35.5%
X3 - 31.8% 15.4%
X4 40.1% 247.7%
X5 1.5 times 1.9 times
A case of Nepal Brick Factory:
(Assume dividend paid is Rs. 400 & MPS=Rs.200).
X1=20%, X2=4%, X3=12.2%, X4=40%, X5=1.2 times
Z = 0.012(20%) + 0.014(4%) + 0.033(12.2%) + 0.006(40%)
+Copyright
0.999(1.2) = 2.1 (Gray zone)
© by R. S. Pradhan All rights reserved.
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SOLVE PROBLEMS
Page 73 Self-test Problems: SP 3 & 7
Page 77-80 Problems: P1 to 3, & 5.
 Quiz
Case Presentation date: ???
 Group report be submitted first one day
before.
 Each member must give the presentation.
 Quiz on the case.
Thanking you

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Copyright © by R. S. Pradhan All rights reserved.

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Long-term debt 6,00030

Copyright © by R. S. Pradhan All rights reserved.

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