Financial Analysis

Session 4 & 5
 Key Concepts

• There are two primary tools in financial analysis:

– Ratio analysis – to assess how various line items in

financial statements relate to each other and to
measure relative performance.

– Cash flow analysis – to evaluate liquidity and the

management of operating, investing, and financing
activities as they relate to cash flow.
 Determinants of Firm Value
and Ratio Analysis
• Profitability and growth drive firm value.
• Managers can employ four levers to achieve
growth and profit targets:
– Operating management
– Investment management
– Financing strategy
– Dividend policy

• Ratio analysis seeks to evaluate the firm’s

effectiveness in these areas.
 Ratio Analysis

• While ratio analysis may not give all the answers to an analyst regarding the
firm’s performance, it will help the analyst frame questions for further
probing.
• 1)Compare ratios for a firm over several years (a time-series comparison).
• 2) Compare ratios for the firm and other firms in the industry (cross-
sectional comparison).
• 3) Compare ratios to some absolute benchmark
 Ratio Analysis
• Evaluating ratios requires comparison against
some benchmark. Such benchmarks include:
– Ratios over time from prior periods (time series)
– Ratios of other firms in the industry (cross-sectional)
– Some absolute benchmark
• Effective ratio analysis must attempt to relate
underlying business factors to the financial
numbers
• The text illustrates ratio analysis by applying it to
H&M stores.
 Measuring Overall Profitability

• ROE is a comprehensive measure of and is a

good starting point to systematically analyze firm
performance.

ROE = Net Income / Shareholders’ equity

 Decomposing Profitability:
Traditional Approach
ROE = Net income
Shareholders Equity
• Or ROA * Financial leverage(Equity Multiplier)
= Net income * Assets
Assets Shareholders’ equity
ROE- Decomposition
 Assessing Operating Management:
Income Statement Ratios
• Common-sized income statements facilitate
comparisons of key line items across time and
different firms.
• Additionally, the following ratios are also helpful:
– Gross profit margin
– Net profit margin
– Operating profit margin
– NOPAT margin
– EBITDA margin
 Questions to be answered

1. Are the company’s margins consistent with its stated

competitive strategy? For example, a differentiation
strategy should usually lead to higher gross margins than
a low-cost strategy.

2. Are the company’s margins changing? Why? What are

the underlying business causes-changes in competition,
changes in input costs, or poor overhead cost
management?

3. Is the company managing its overhead and

administrative costs well? What are the business
activities driving these costs? Are these activities
necessary?
 Gross Profit Margin

• Measures the profitability of sales, less direct

costs of sales:
Gross profit margin = Sales – Cost of sales
Sales

The gross profit margin is an indicator of:

– The price premium that a firm’s product commands in the market
– The efficiency of a firm’s procurement and/or production process
– The price premium a firm’s products or services can command is
influenced by the degree of competition and the extent to which its
products are unique.
– The firm’s cost of sales can be low when it can purchase its inputs at a
lower cost than competitors and/or run its production processes more efficiently
 NOPAT and EBITDA Margins

• The NOPAT margin provides a comprehensive measure

of operations:
NOPAT margin = NOPAT
Sales

• The EBITDA margin eliminates the significant non-cash

expenses of depreciation and amortization along with
interest and taxes:
EBITDA =
Earnings before interest, taxes, depreciation, and amortization
Sales
 Selling and Admin expenses/sales

• One factor that potentially explains the increase

in the SG&A-to-sales ratio is the stickiness of
SG&A expenses.
• In particular, in periods during which sales per
store decline, changes in selling expenditures
typically lag behind sales changes, thus
increasing the ratio of these costs to sales.
• This is because it is costly for firms to temporarily
cut capacity in down periods and bring back
capacity when sales recover
 Investment Management ratios/Asset
turnover ratios/Efficiency Ratios
• Since firms invest considerable resources in their assets,
using them productively is critical to overall profitability.
• A detailed analysis of asset turnover allows the analyst
to evaluate the effectiveness of a firm’s investment
management
• There are two primary areas of asset management:
• (1) working capital management and
• (2) management of non-current operating assets.
 Working Capital defined

• Working capital is defined as the difference between a firm’s current assets

and current liabilities. (CA-CL)
• However, this definition does not distinguish between operating components
(such as trade receivables, inventories, and trade payables) and the
financing and investment components (such as excess cash, marketable
securities, and notes payable).
 What does operating working capital
indicate
• The components of operating working capital that analysts primarily
focus on are trade/account receivables, inventories, and account
payables
• For example, a firm’s credit policies and distribution policies
determine its optimal level of trade receivables.
• The nature of the production process and the need for buffer stocks
determine the optimal level of inventories.
• Finally, trade payables are a routine source of financing for the
firm’s working capital, and payment practices in an industry
determine the normal level of trade payable.
 Operating working capital ratio

How much Operating working capital turnover indicates how many

euros/rupees of sales a firm is able to generate for each euro/rupee invested
in its operating working capital.
Operating working capital = (Current assets -Excess cash and
marketable securities) - (Current liabilities - Current debt)
 Stock turnover/Inventory turnover

• Inventories turnover = Cost of sales(cost of goods

sold) /Inventories or
• Cost of materials /Inventories

• Inventory turnover measures how fast a

company sells inventory and how analysts
compare it to industry averages. ... It
may indicate a problem with the goods being
offered for sale or be a result of too little
marketing
 Trade receivable turnover

• Trade receivables turnover = Sales/Trade

receivables
 Trade payables turnover

• Trade payables turnover = Purchases/Trade

payables or Cost of sales/Trade payables or
Cost of materials/Trade payables
Calculations as Days turnover
Non current asset management/Non current
efficiency ratio
Asset turnover/ Efficiency Ratios
 Financial Leverage Analysis

• Borrowing allows a firm to access to capital, but

increases the risk of ownership for equity holders
• Analysis of leverage can be performed on both
short- and long-term debts:
– Liquidity analysis relates to evaluating current liabilities
– Solvency analysis relates to longer term liabilities
• 1) Current Liabilities and Short term Liquidity
• 2) Debt and Long Term Solvency
 Liquidity Analysis

• There are several ratios useful to evaluate a

firm’s liquidity, including:
– Current ratio
– Quick ratio
– Cash ratio
– Operating cash flow ratio
• Each of these ratios attempts to measure the
ability of a firm to pay its current obligations.
 Liquidity Analysis
• Knowing how the liquidity ratios are calculated allows the user to
understand how to interpret them:

Current ratio = Current assets / Current liabilities

Current liabilities

Quick ratio = Cash + Short-term investments + Accts. receivable

Current liabilities

Cash ratio = Cash + Marketable securities

Current liabilities

Operating cash flow ratio = Cash flows from operations

Current liabilities
Comparison of Ratios
 Debt and Solvency Ratios
• Beyond short-term survival, solvency measures the ability of a firm to
meet long-term obligations.

• Several useful ratios are used to analyze solvency. Three using only
shareholders’ equity as a denominator are:

Liabilities-to-equity ratio = Total liabilities

Shareholders’ equity

Debt-to-equity ratio = Short-term debt + Long-term debt Shareholders’

equity

Net-debt-to-equity ratio =
Short-term debt + Long-term debt – Cash and marketable securities
Shareholders’ equity
 More Debt and Coverage Ratios
• Ratios that use debt as a proportion of total capital are:
Debt-to-capital ratio =

Short-term debt + Long-term debt

Short-term debt + Long-term debt + Shareholders’ equity
Interest Coverage Ratio
H& M Debt and Solvency ratios