You are on page 1of 62

Interpretation and Analysis of Financial Statement

CA N Maheswara Rao

Apr 22, 2012

CA N Maheswara Rao

Financial Analysis
Assessment of the firms past, present and

future financial conditions Done to find firms financial strengths and weaknesses Primary Tools:
Financial Statements Comparison of financial ratios to past performance , industry, sector and all firms
Apr 22, 2012 CA N Maheswara Rao 2

Financial Statements

Balance Sheet Income Statement Cashflow Statement


Apr 22, 2012 CA N Maheswara Rao 3

Review: Major Balance Sheet Items


Assets Current assets:
Cash & securities Receivables Inventories

Liabilities and Equity Current liabilities:


Payables Short-term debt

Long-term liabilities Shareholders' equity

Fixed assets: Tangible assets Intangible assets

Apr 22, 2012

CA N Maheswara Rao

Financial Perspective of the Firm

Debt Operating Assets


I n t e r e s t

Equity
Retained Profit

Revenues Operating Expenses


Apr 22, 2012

Net Operating Profit

Net Income
CA N Maheswara Rao

Dividends

Review: Major Income Statement Items


Gross Profit = Sales - Costs of Goods Sold EBITDA

= Gross Profit - Cash Operating Expenses EBIT = EBDIT - Depreciation - Amortization EBT = EBIT - Interest NI or EAT = EBT- Taxes Net Income is a primary determinant of the firms cashflows and, thus, the value of the firms shares
Apr 22, 2012 CA N Maheswara Rao 6

An Example: Abbreviated Income Statement


Sales Rs.25,265.00 Costs of Goods Sold Rs.19,891.00 Gross Profit Rs.5,374.00 Cash operating expense Rs.2,761.00 EBITDA Depreciation & Amortization Rs.156.00 Other Income (Net) EBIT Apr 22, 2012 CA N Maheswara Rao Rs.2,451.00 -

2,613.00 -Rs.6.00
7

Apr 22, 2012

CA N Maheswara Rao

Financial Statement Analysis


1. Horizontal Analysis 2. Vertical Analysis 3. Common Size Statement 4. Ratio Analysis 5. Proforma Financial Statement 6. Measure Economic Value Added

& Market Value Added

1. Horizontal Analysis
Increase/(Decrease) 2005 2004 Amount Percent Rs.41,500 Rs.37,850 Rs.3,650 9.6% 40,000 36,900 3,100 8.4% 1,500 950 550 57.9%

Sales Expenses Net income

Apr 22, 2012

CA N Maheswara Rao

Trend Percentages...
are computed by selecting a base year

whose amounts are set equal to 100%. The amounts of each following year are expressed as a percentage of the base amount. Trend % = Any year Rs. Base year Rs.
Apr 22, 2012 CA N Maheswara Rao 10

2. Vertical Analysis...
compares each item in a financial statement

to a base number set to 100%. Every item on the financial statement is then reported as a percentage of that base.

Apr 22, 2012

CA N Maheswara Rao

11

2. Vertical Analysis
Revenues Cost of sales Gross profit Total operating expenses Operating income Other income Income before taxes Income taxes Net income
Apr 22, 2012

2005 Rs.38,303 19,688 Rs.18,615 13,209 Rs. 5,406 2,187 Rs. 7,593 2,827 Rs. 4,766

% 100.0 51.4 48.6 34.5 14.1 5.7 19.8 7.4 12.4


12

CA N Maheswara Rao

2. Vertical Analysis ..
Assets Current assets: Cash Receivables net Inventories Prepaid expenses Total current assets Plant and equipment, net Other assets Total assets
Apr 22, 2012

2005 Rs. 1,816 10,438 6,151 3,526 Rs.21,931 6,847 9,997 Rs.38,775

% 4.7 26.9 15.9 9.1 56.6 17.7 25.7 100.0


13

CA N Maheswara Rao

3. Common-size Statements
On the income statement, each item is

expressed as a percentage of net sales. On the balance sheet, the common size is the total on each side of the accounting equation. Common-size statements are used to compare one company to other companies, and to the industry average.
Apr 22, 2012 CA N Maheswara Rao 14

3. Common-size Statements.. Benchmarking


Percent of Net Sales Lucent Technologies
12.4% 7.4% 51.4% 28.8% 38.2% 8.0% 43.0% 10.8%

MCI

s Cost of goods sold s Income tax


Apr 22, 2012

s Operating expenses s Net income


15

CA N Maheswara Rao

4. Financial Ratios

Apr 22, 2012

CA N Maheswara Rao

16

Rationale Behind Ratio Analysis


A firm has resources It converts resources into profits through production of goods and services sales of goods and services Ratios Measure relationships between resources and financial flows Show ways in which firms situation deviates from
Its own past Other firms The industry All firms-

Apr 22, 2012

CA N Maheswara Rao

17

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
Apr 22, 2012 CA N Maheswara Rao 18

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
Apr 22, 2012

Valuation Ratios:

Assess profits relative to amount of resources used


CA Assess market price N Maheswara Rao relative to assets or earnings 19

Ratio Classification
1. Measuring Assets Utilization. 2. Measuring ability to pay current liabilities 1. Measuring ability to sell inventory and

collect receivables 1. Measuring ability to pay short-term and long-term debt 1. Measuring profitability 1. Analyzing stockNas an investment Apr 22, 2012 CA Maheswara Rao

20

Total Assets Turnover

Total assets turnover measures a firm's ability to

generate sales from a given level of assets. A large asset turnover is preferred to a low one. Total assets turnover is related to three similar ratios
a. Accounts receivable turnover b. Inventory turnover c. Fixed asset turnover
Apr 22, 2012 CA N Maheswara Rao 21

Fixed Asset Turnover


Measures the relation between investment in long-term

or fixed assets (such as property, plant, equipment) and sales. Efficient use of fixed assets would be associated with high sales. If fixed assets turn over every four years, then each Rupees invested in fixed assets is generating a quarter of a Rupees in sales per year. A high turnover is preferred to a low one.
Apr 22, 2012 CA N Maheswara Rao 22

Measuring Ability to Pay Current Liabilities


The current ratio measures The current ratio measures the companys ability to pay the companys ability to pay current liabilities with current assets. current liabilities with current assets. Current ratio = Current ratio = Total current assets Total current liabilities Total current assets Total current liabilities
Apr 22, 2012 CA N Maheswara Rao 23

Measuring Ability to Pay Current Liabilities


The acid-test ratio shows the companys The acid-test ratio shows the companys ability to pay all current liabilities ability to pay all current liabilities if they come due immediately. if they come due immediately. Acid-test ratio = Acid-test ratio = (Cash + Short-term investments (Cash + Short-term investments + Net current receivables) + Net current receivables) Total current liabilities Total current liabilities
Apr 22, 2012 CA N Maheswara Rao 24

Measuring Ability to Sell Inventory


Inventory turnover is aameasure Inventory turnover is measure of the number of times the average of the number of times the average level of inventory is sold during aayear. level of inventory is sold during year.

Inventory turnover = Cost of goods sold Inventory turnover = Cost of goods sold Average inventory Average inventory
q

Holding inventory is costly because the funds invested in inventory can be used elsewhere.
q

A high turnover is preferred to a low one.


CA N Maheswara Rao 25

Apr 22, 2012

Measuring Ability to Collect Receivables


Accounts receivable turnover measures a companys Accounts receivable turnover measures a companys ability to collect cash from credit customers. ability to collect cash from credit customers. Accounts receivable turnover = Accounts receivable turnover = Net credit sales Average accounts receivable Net credit sales Average accounts receivable
q

A high turnover is preferred to a low one.


CA N Maheswara Rao 26

Apr 22, 2012

Measuring Ability to Collect Receivables


Days sales in receivable ratio measures how Days sales in receivable ratio measures how many days sales remain in Accounts Receivable. many days sales remain in Accounts Receivable. One days sales = Net sales 365 days One days sales = Net sales 365 days Days sales in Accounts Receivable = Days sales in Accounts Receivable = Average net Accounts Receivable One days sales Average net Accounts Receivable One days sales
Apr 22, 2012 CA N Maheswara Rao 27

Measuring Ability to Pay Debt


The debt ratio indicates the proportion The debt ratio indicates the proportion of assets financed with debt. of assets financed with debt. Total liabilities Total assets Total liabilities Total assets

Apr 22, 2012

CA N Maheswara Rao

28

Measuring Ability to Pay Debt


Times-interest-earned ratio Times-interest-earned ratio measures the number of times measures the number of times operating income can cover interest expense. operating income can cover interest expense. Times-interest-earned Times-interest-earned = Income from operations = Income from operations Interest expense Interest expense
Apr 22, 2012 CA N Maheswara Rao 29

Measures of Long-Term Risk


Debt-to-equity ratio (total liabilities)/(total equities) total equities = total liab. + shareholders equity Percentage of total financing provided by debtors or creditors. A firm is said to be highly leveraged when this ratio is large. Cash from operations to total liabilities ratio Measures the ability of the firm to pay all liabilities from cash without new debt or additional investment.
Apr 22, 2012 CA N Maheswara Rao 30

Measures of Long-Term Risk (Cont.)


Interest coverage ratio =

(interest before interest and income tax) (interest expense) Number of times interest is covered by income Indicates the relative protection that operating profitability provides to debtors Some analysts use cash flows instead of income
Apr 22, 2012 CA N Maheswara Rao 31

Profit Margin Ratio

Profit margin ratio measures a firm's ability to

control its expenses relative to its sales.


We expect expenses to grow as sales grow, but not

as fast. A high profit margin ratio is preferred to a low one.


Apr 22, 2012 CA N Maheswara Rao 32

Return on Equity

The numerator measures return as net income reduced by

any payments to preferred shareholders as these dividends are not available to the common shareholder and have not been deducted from net income. The denominator is the average amount contributed by common shareholders which includes
Common stock at par, Additional paid in capital, and Retained earnings.
CA N Maheswara Rao 33

Apr 22, 2012

ROCE
The first two have been previously defined. Leverage ratio indicates the relative proportion of

capital provided by common shareholders as distinct from that provided by creditors (debtors) or preferred shareholders.

Apr 22, 2012

CA N Maheswara Rao

34

Earnings Per Share


EPS does not consider the amount of assets or capital required

to generate earnings.
EPS is of limited use in comparing two firms. For investment purposes, the price to earnings ratio is

sometimes used (P/E ratio). This is the return to the purchaser of a share.
P/E = (market price of a share of stock)/(EPS) A low P/E is preferred to a high P/E, same earnings at a lower price.

Apr 22, 2012

CA N Maheswara Rao

35

Analyzing Stock as an Investment

Dividend yield shows the percentage Dividend yield shows the percentage of a stocks market value returned as of a stocks market value returned as dividends to stockholders each period. dividends to stockholders each period. Dividend per share of common Dividend per share of common (or preferred) stock Market price per share (or preferred) stock Market price per share of common (or preferred) stock of common (or preferred) stock
Apr 22, 2012 CA N Maheswara Rao 36

Analyzing Stock as an Investment

Book value per share of common stock Book value per share of common stock = (Total stockholders equity Preferred equity) = (Total stockholders equity Preferred equity) Number of shares of common stock outstanding Number of shares of common stock outstanding

Apr 22, 2012

CA N Maheswara Rao

37

Summary of Financial Ratios


Ratios help to: Evaluate performance Structure analysis Show the connection between activities and performance Benchmark with Past for the company Industry Ratios adjust for size differences
Apr 22, 2012 CA N Maheswara Rao 38

Limitations of Ratio Analysis


A firms industry category is often difficult to

identify Published industry averages are only guidelines Accounting practices differ across firms Sometimes difficult to interpret deviations in ratios Industry ratios may not be desirable targets Seasonality affects ratios

Apr 22, 2012

CA N Maheswara Rao

39

5. Financial Forecasting

Apr 22, 2012

CA N Maheswara Rao

40

Ratios and Forecasting


Common stock valuation based on Expected cashflows to stockholders ROE and are major determinants of cashflows to stockholders Ratios influence expectations by: Showing where firm is now Providing context for current performance Current information influences expectations by: Showing developments that will alter future performance

Apr 22, 2012

CA N Maheswara Rao

41

Pro Forma Financial Statements


Pro forma refers to a projection of what the financial

statements might look like if certain future conditions prevail. Of course, a pro forma statement is only as good as the forecast of the future conditions. In order to prepare a set of pro forma statements:
1. Project operating revenues 2. Project operating expenses given the level of revenues 3. Project assets required to support the revenues 4. Project financing for the additional assets 5. Project the cost of the financing 6. Project the cash flow statement based on assumptions about the timing of revenues and payments on debt and for expenses.
Apr 22, 2012 CA N Maheswara Rao 42

6. Measure Economic Value & Market Value Added


Apr 22, 2012 CA N Maheswara Rao 43

MVA & EVA


Market Value

Added
Economic Value

Each can be viewed from Total Assets or Total Equity The examples in this set of notes consider the case of Total Equity

Added

Apr 22, 2012

CA N Maheswara Rao

44

MVA & EVA (to Equity Owners)


Market Value Added
Market Value of Equity minus Total Money Invested by Equity Owners (Book Value of Equity)
Total Value created by owning assets which have a greater return than cost of equity

Economic Value Added


Net Income for a Year minus Cost of Equity times Book Value of Equity

Value created this year by earning profits in excess of cost of equity capital

Apr 22, 2012

CA N Maheswara Rao

45

Information Used in Calculating MVA and EVA (to equity owners)


Equity Information as of the End-of-Period Net Income for Past Year Rs. 200 (known) Total Equity Book Value Rs.1,080 (known) Number of Shares 100 (known) Book Value per Share Rs. 10.80 (calced) Current Stock Price Assumed Cost of Equity Constant Future Dividend Growth Rate
Apr 22, 2012

Rs. 25.92

(assumed)

13% 8%

(assumed) (assumed)
46

CA N Maheswara Rao

MVA Calculation
Equity Capitalization
(Rs.25.92 times 100 shares) minus

Rs.2,592

Total Equity Book Value Rs.1,080 Market Value Added


Apr 22, 2012 CA N Maheswara Rao

Rs.1,512
47

(Conceptually, this is equal to the summation of all Net Present Values of projects in which the firm has invested.)

EVA Calculation
Net Income During the Period Rs.200
minus

Period Rs. Cost of Capital


Rs.1,000 capital invested (until period end) times 13% cost of equity

Rs.130

Economic Value Added


Apr 22, 2012 CA N Maheswara Rao

Rs. 70
48

(Conceptually, this is the true economic profit created during the year; income above capital cost.)

Reconciliation of MVA & EVA


MVA is the present value of expected future EVAs. If the past years EVA is expected to grow by 8% and the cost of equity is 13%, MVA = [Rs.70 (1.08)] / [0.13 - 0.08] = Rs.1,512
(This is an application of the constant growth valuation model that is discussed later in the course)

Apr 22, 2012

CA N Maheswara Rao

49

Apr 22, 2012

CA N Maheswara Rao

50

Accounting Statement of Cash Flows

Statement of Cash Flows


A relatively new financial statement Intended to highlight major areas from which cash was received

and used Until accountants began reporting the Statement of Cash Flows, financial analysts prepared a Sources & Uses of Funds statement based on published balance sheets and income statements
The Statement of Cash Flows categorizes

follows: --- Cash Flows from Operations --- Cash Flows from Investing Activities --- Cash Flows from Financing Activities These categories fit well with how finance people view the firm

cash flows as

Apr 22, 2012

CA N Maheswara Rao

51

Accounting Statement of Cash Flows


Cash Flow from Operating Activities:
Net Income Depreciation Total Increase in Accruals Increase in Accounts Payable Increase in Accts. Rec. Increase in Inventory 44,220 20,000 64,220 4,000 29,600 - 50.800 -120,800

Net Cash Flow from Operations -73,780 Cash Flow from Investment:
Fixed Asset Increase

Operations Investment

-36,000
25,000 101,180 -22,000

Cash Flow from Financing:


Increase in Notes Payable Increase in Long-term Debt Common Dividends

Net Cash Flow from Financing Total Change in Cash

104,180 -5,600

Financing This balances to change in Cash

Apr 22, 2012

CA N Maheswara Rao

52

Categories in the Statement of Cash Flows


Cash Flows from Operations include:
Net Operating Profit After Taxes Plus adjustments for non-cash expenses (amortization of depreciation, patents, goodwill, bad debt allowances, etc.) Changes in Current Assets & Current Liabilities * which move more or less spontaneously with Sales + Current Asset = decrease in cash - Current Asset = increase in cash + Current Liability = increase in cash - Current Liability = decrease in cash

* Exclude Interest Bearing Short Term Debt


Apr 22, 2012 CA N Maheswara Rao

Cont..
53

Cash Flows from Investment Activities include:

--- Purchase or sale of long-term operating assets such as plant & equipment --- Acquisitions of other firms or divestitures of divisions --- Ideally separate Operating Assets from Non-Operating Assets ---- Sale or retirement of debt ---- Interest expense (after taxes) ---- Sale or retirement of equity securities ---- Dividend payments

Cash Flows from Financing Activities include:

Cont..
Apr 22, 2012 CA N Maheswara Rao 54

Operating Assets versus Non- Operating Assets


We will not treat any Non- Operating Assets in this set of

notes

Non-operating assets include items such as excess marketable securities, Goodwill recorded in an acquisition, deferred taxes, land held for future use, investment in unconsolidated subsidiaries, and so forth

Apr 22, 2012

CA N Maheswara Rao

55

Preparation of a Statement of Cash Flows


Published financials will include such a statement. But many times you will not be working with audited financials or will have to adjust published statements to organize them in a more meaningful way. Thus, you should know how to prepare the Statement.

1 Start by subtracting one balance sheet from another 2 Arrange balance sheet changes into two columns

Sources of Cash Uses of Cash 3 Be sure the two columns balance (total to the same value) 4 Rearrange the data into the three categories used in the Statement of Cash Flows
Apr 22, 2012 CA N Maheswara Rao 56

Cash Statement Accts. Receivable 50,800 Operating Cash Flow Inventory 120,800Operating Cash Flow Gross Fixed Assets 36,000Investment Cash Flow Accum. Depreciation 20,000 Adjust to Net Income Accounts Payable 29,600 Operating Cash Flow ST Notes Payable 25,000 Financing Cash Flow Accruals 4,000 Operating Cash Flow NOPAT Long Term Debt 101,180 Financing Cash Flow 89,820 Ret. Earn. Net Income 44,220 Interest AT Dividends 22,000 Financing Cash Flow 45,600 Total 229,600229,600
Apr 22, 2012 CA N Maheswara Rao 57

Change in Finl Resources Category Source Use 5,600 Balancing Item in

Source and Use of Funds Statement (Or Changes in Balance Sheets)

Financial Statement of Free Cash Flows


Cash Flow from Operating Activities:
Net Operating Profit Depreciation Total Increase in Accruals Increase in Accounts Payable Decrease in Cash Increase in Accts. Rec. Increase in Inventory 89,820 20,000 109,820 4,000 29,600 5,600 - 50.800 -120,800

Net Cash Flow from Operations -22,580 Cash Flow from Investment: Fixed Asset Increase -36,000 Free Cash Flow from Assets-58,580 Cash Flow from Financing:
Increase in Notes Payable Increase in Long-term Debt Interest after tax Common Dividends 25,000 101,180 -45,600 -22,000

Operations Investment

Net Cash Flow from Financing

58,580

Cash from Capital Suppliers


58

Apr 22, 2012

CA N Maheswara Rao

Sources of Cash From Capital Suppliers:


Increase in Notes Payable 25,000 Increase in Long-term Debt 101,180 Interest after tax -45,600 Common Dividends - 22,000 Net Cash Flow from Financing 58,580

Apr 22, 2012

CA N Maheswara Rao

59

Analysis of the Statement of Cash Flows


Operations drained cash
--- NOPAT + Depreciation provided Rs.109,820 --- but Inventory & A / R absorbed Rs.171,600 of potential cash inflow

New investment took another Rs.36,000 of cash This was financed by new debt (mainly Long-Term) And they continued to pay dividends (Rs.22,000)

This state of affairs can not continue


Apr 22, 2012 CA N Maheswara Rao 60

Implications of the Statement of Cash Flows


There might be a problem with excess Inventory &

Accounts Receivable
Unless sales increase substantially to warrant higher

Inventory & Receivables, they need to be reduced


Notice also that Inventory & Receivables were financed

with long-term debt, is there a problem with this?


Apr 22, 2012 CA N Maheswara Rao 61

Apr 22, 2012

CA N Maheswara Rao

62