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Interpretation and Analysis of Financial Statement

CA N Maheswara Rao

Apr 22, 2012

CA N Maheswara Rao

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Financial 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 performance , industry, sector and all firms
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Financial Statements

Balance Sheet Income Statement Cashflow Statement
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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 4 .

2012 Net Operating Profit Net Income CA N Maheswara Rao Dividends 5 .Financial Perspective of the Firm Debt Operating Assets I n t e r e s t Equity Retained Profit Revenues Operating Expenses Apr 22.

the value of the firm’s shares Apr 22. 2012 CA N Maheswara Rao 6 .Depreciation .Amortization  EBT = EBIT .Review: Major Income Statement Items  Gross Profit = Sales .Cash Operating Expenses  EBIT = EBDIT . thus.Interest  NI or EAT = EBT.Taxes  Net Income is a primary determinant of the firm’s cashflows and.Costs of Goods Sold  EBITDA = Gross Profit .

00 - 2.00 Cash operating expense Rs.00 Gross Profit Rs.156.00 7 .2.761.00 -Rs.00 EBITDA Depreciation & Amortization Rs. 2012 CA N Maheswara Rao Rs.2.25.5.891.451.19.374.6.265.00 Costs of Goods Sold Rs.00 Other Income (Net) EBIT Apr 22.An Example: Abbreviated Income Statement Sales Rs.613.

Proforma Financial Statement 6. Common Size Statement 4. Vertical Analysis 3. Measure Economic Value Added & Market Value Added . 2012 CA N Maheswara Rao 8 Financial Statement Analysis 1. Ratio Analysis 5.Apr 22. Horizontal Analysis 2.

2012 CA N Maheswara Rao 9 .3.500 950 550 57. Horizontal Analysis Increase/(Decrease) 2005 2004 Amount Percent Rs.1.100 8.000 36.37.6% 40.4% 1.9% Sales Expenses Net income Apr 22.650 9.900 3.500 Rs.41.850 Rs.

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

.  Every item on the financial statement is then reported as a percentage of that base. Apr 22. 2012 CA N Maheswara Rao 11 . – compares each item in a financial statement to a base number set to 100%.. Vertical Analysis.2.

2012 2005 Rs.18. Vertical Analysis… Revenues Cost of sales Gross profit Total operating expenses Operating income Other income Income before taxes Income taxes Net income Apr 22.4 12.688 Rs.209 Rs.4 12 CA N Maheswara Rao .4 48.593 2. 4.303 19.5 14.2.187 Rs.827 Rs.1 5.8 7. 7.406 2.766 % 100.7 19.615 13.6 34.0 51.38. 5.

0 13 CA N Maheswara Rao .9 15. Vertical Analysis .2.151 3.526 Rs.816 10.38.847 9.6 17.997 Rs. 2012 2005 Rs.438 6.7 26.21.931 6.. Assets Current assets: Cash Receivables net Inventories Prepaid expenses Total current assets Plant and equipment.7 25. net Other assets Total assets Apr 22.775 % 4. 1.1 56.7 100.9 9.

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

4% 28.4% 51.4% 7.0% 10.. Common-size Statements. Benchmarking Percent of Net Sales Lucent Technologies 12.8% MCI s Cost of goods sold s Income tax Apr 22.2% 8. 2012 s Operating expenses s Net income 15 CA N Maheswara Rao .3.8% 38.0% 43.

4. 2012 CA N Maheswara Rao 16 . Financial Ratios Apr 22.

2012 CA N Maheswara Rao 17 .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 firm’s situation deviates from • • • • Its own past Other firms The industry All firms- Apr 22.

2012 CA N Maheswara Rao 18 .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.

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 .

Measuring profitability 1. 2012 CA Maheswara Rao 20 .Ratio Classification 1. Measuring ability to sell inventory and collect receivables 1. Measuring ability to pay current liabilities 1. Measuring Assets Utilization. 2. Measuring ability to pay short-term and long-term debt 1. Analyzing stockNas an investment Apr 22.

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

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.
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Measuring Ability to Pay Current Liabilities
The current ratio measures The current ratio measures the company’s ability to pay the company’s 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
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Measuring Ability to Pay Current Liabilities
The acid-test ratio shows the company’s The acid-test ratio shows the company’s 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
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2012 .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. CA N Maheswara Rao 25 Apr 22. q A high turnover is preferred to a low one.

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. 2012 . CA N Maheswara Rao 26 Apr 22.Measuring Ability to Collect Receivables Accounts receivable turnover measures a company’s Accounts receivable turnover measures a company’s ability to collect cash from credit customers.

Measuring Ability to Collect Receivables Days’ sales in receivable ratio measures how Days’ sales in receivable ratio measures how many day’s sales remain in Accounts Receivable. 2012 CA N Maheswara Rao 27 . One day’s sales = Net sales ÷ 365 days One day’s sales = Net sales ÷ 365 days Days’ sales in Accounts Receivable = Days’ sales in Accounts Receivable = Average net Accounts Receivable ÷ One day’s sales Average net Accounts Receivable ÷ One day’s sales Apr 22. many day’s sales remain in Accounts Receivable.

Measuring Ability to Pay Debt The debt ratio indicates the proportion The debt ratio indicates the proportion of assets financed with debt. 2012 CA N Maheswara Rao 28 . of assets financed with debt. Total liabilities ÷ Total assets Total liabilities ÷ Total assets Apr 22.

Times-interest-earned Times-interest-earned = Income from operations = Income from operations ÷ Interest expense ÷ Interest expense Apr 22. 2012 CA N Maheswara Rao 29 . operating income can cover interest expense.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.

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. 2012 CA N Maheswara Rao 30 . Apr 22.  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. – A firm is said to be highly leveraged when this ratio is large.

Measures of Long-Term Risk (Cont. 2012 CA N Maheswara Rao 31 .)  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.

but not as fast. 2012 CA N Maheswara Rao 32 . Apr 22.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.  A high profit margin ratio is preferred to a low one.

2012 .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. CA N Maheswara Rao 33 Apr 22. and Retained earnings. Additional paid in capital.  The denominator is the average amount contributed by common shareholders which includes – – – Common stock at par.

 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 .ROCE  The first two have been previously defined.

Earnings Per Share  EPS does not consider the amount of assets or capital required to generate earnings.  For investment purposes. 2012 CA N Maheswara Rao 35 .  EPS is of limited use in comparing two firms. – – P/E = (market price of a share of stock)/(EPS) A low P/E is preferred to a high P/E. the price to earnings ratio is sometimes used (P/E ratio).  This is the return to the purchaser of a share. Apr 22. same earnings at a lower price.

2012 CA N Maheswara Rao 36 . 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.Analyzing Stock as an Investment Dividend yield shows the percentage Dividend yield shows the percentage of a stock’s market value returned as of a stock’s market value returned as dividends to stockholders each period.

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 .

2012 CA N Maheswara Rao 38 .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.

Limitations of Ratio Analysis  A firm’s 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. 2012 CA N Maheswara Rao 40 . Financial Forecasting Apr 22.

Ratios and Forecasting  Common stock valuation based on – Expected cashflows to stockholders – ROE and ρ 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 .

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

2012 CA N Maheswara Rao 43 .6. Measure Economic Value & Market Value Added Apr 22.

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 .

2012 CA N Maheswara Rao 45 .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.

80 (calc’ed) Current Stock Price Assumed Cost of Equity Constant Future Dividend Growth Rate Apr 22. 2012 Rs. 10.Information Used in Calculating MVA and EVA (to equity owners) Equity Information as of the End-of-Period Net Income for Past Year Rs. 25.080 (known) Number of Shares 100 (known) Book Value per Share Rs. 200 (known) Total Equity Book Value Rs.92 (assumed) 13% 8% (assumed) (assumed) 46 CA N Maheswara Rao .1.

592 Total Equity Book Value Rs.) .25.2.92 times 100 shares) minus Rs. this is equal to the summation of all Net Present Values of projects in which the firm has invested.080 Market Value Added Apr 22.512 47 (Conceptually.1.MVA Calculation Equity “Capitalization” (Rs. 2012 CA N Maheswara Rao Rs.1.

130 Economic Value Added Apr 22. 2012 CA N Maheswara Rao Rs.200 minus Period Rs. 70 48 (Conceptually.EVA Calculation Net Income During the Period Rs.) . Cost of Capital Rs. this is the true economic profit created during the year.000 capital invested (until period end) times 13% cost of equity Rs.1. income above capital cost.

Reconciliation of MVA & EVA MVA is the present value of expected future EVA’s. If the past year’s EVA is expected to grow by 8% and the cost of equity is 13%.512 (This is an application of the constant growth valuation model that is discussed later in the course) Apr 22.08)] / [0. MVA = [Rs.0. 2012 CA N Maheswara Rao 49 .70 (1.1.08] = Rs.13 .

2012 CA N Maheswara Rao 50 Accounting Statement of Cash Flows .Apr 22.

Cash Flows from Operations --. 2012 CA N Maheswara Rao 51 . 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 Investing Activities --.Cash Flows from Financing Activities  These categories fit well with how finance people view the firm cash flows as Apr 22.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.

780 Cash Flow from Investment: Fixed Asset Increase Operations Investment -36.50.220 4.600 .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. Increase in Inventory 44.000 101.000 25.000 64.000 29.600 Financing This balances to change in Cash Apr 22. 2012 CA N Maheswara Rao 52 .220 20.800 Net Cash Flow from Operations -73.180 -5. Rec.800 -120.Accounting Statement of Cash Flows Cash Flow from Operating Activities: Net Income Depreciation Total Increase in Accruals Increase in Accounts Payable Increase in Accts.180 -22.

bad debt allowances. 53 . 2012 CA N Maheswara Rao Cont…. goodwill.Current Liability = decrease in cash * Exclude Interest Bearing Short Term Debt Apr 22.Current Asset = increase in cash + Current Liability = increase in cash . patents.) Changes in Current Assets & Current Liabilities * which move more or less “spontaneously “ with Sales + Current Asset = decrease in cash .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. etc..

Sale or retirement of debt ---.Acquisitions of other firms or divestitures of divisions --.Sale or retirement of equity securities ---.Interest expense (after taxes) ---. Cash Flows from Investment Activities include: --.Dividend payments  Cash Flows from Financing Activities include: Cont….Purchase or sale of long-term operating assets such as plant & equipment --.. 2012 CA N Maheswara Rao 54 .Ideally separate “Operating Assets” from “Non-Operating Assets” ---. Apr 22.

land held for future use.Operating Assets  We will not treat any Non. 2012 CA N Maheswara Rao 55 .Operating Assets versus Non. deferred taxes. investment in unconsolidated subsidiaries. Goodwill recorded in an acquisition. and so forth Apr 22.Operating Assets in this set of notes Non-operating assets include items such as excess marketable securities.

Preparation of a Statement of Cash Flows Published financials will include such a statement. Thus. 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. 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 . you should know how to prepare the Statement.

000Investment Cash Flow Accum.000 Operating Cash Flow NOPAT Long Term Debt 101.600 Apr 22.000 Financing Cash Flow 45.600 Total 229.000 Financing Cash Flow Accruals 4.600229.800Operating Cash Flow Gross Fixed Assets 36.000 Adjust to Net Income Accounts Payable 29.800 Operating Cash Flow Inventory 120.600 Balancing Item in Source and Use of Funds Statement (Or Changes in Balance Sheets) .180 Financing Cash Flow 89. 2012 CA N Maheswara Rao 57 Change in Fin’l Resources Category Source Use 5. Receivable 50.600 Operating Cash Flow ST Notes Payable 25.820 Ret. Net Income 44.Cash Statement Accts.220 Interest AT Dividends 22. Depreciation 20. Earn.

000 29.600 .000 Free Cash Flow from Assets-58.580 Cash from Capital Suppliers 58 Apr 22. Rec. 2012 CA N Maheswara Rao .180 -45.600 -22.800 Net Cash Flow from Operations -22.800 -120.000 109. Increase in Inventory 89.600 5.50.000 Operations Investment Net Cash Flow from Financing 58.820 4.580 Cash Flow from Investment: Fixed Asset Increase -36.000 101.820 20.“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.580 Cash Flow from Financing: Increase in Notes Payable Increase in Long-term Debt Interest after tax Common Dividends 25.

600 Common Dividends .180 Interest after tax -45.Sources of Cash From Capital Suppliers: Increase in Notes Payable 25.000 Increase in Long-term Debt 101. 2012 CA N Maheswara Rao 59 .22.000 Net Cash Flow from Financing 58.580 Apr 22.

2012 CA N Maheswara Rao 60 .171.820 --.600 of potential cash inflow  New investment took another Rs.but Inventory & A / R absorbed Rs.000) This state of affairs can not continue Apr 22.109.36.Analysis of the Statement of Cash Flows  Operations drained cash --.000 of cash  This was financed by new debt (mainly Long-Term)  And they continued to pay dividends (Rs.22.NOPAT + Depreciation provided Rs.

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. 2012 CA N Maheswara Rao 61 . is there a problem with this? Apr 22. they need to be reduced  Notice also that Inventory & Receivables were financed with long-term debt.

2012 CA N Maheswara Rao 62 .Apr 22.