Financial Management

Prof. Sapna U. Malya

Analysis of Financial Statements using RATIOS
Topics covered:  Meaning of Ratio  Why Ratio?  Different types of ratios: • Liquidity Ratios • Asset Management Ratios • Debt Management Ratios • Profitability Ratios • Market Value Ratios  Du pont Equation  Limitation of Ratio Analysis

Different Types of Ratios:
Current Assets / Current Liabilities Sales / Inventories

Sales / Net Fixed Assets

EBIT / Interest

EBIT / Total Assets

Price per share / Earnings per share

Liquidity Ratios  Current Ratio = Current Assets / Current Liabilities  Quick/ Acid Test Ratio = (Current Assets less inventories) / Current Liabilities .

Asset Management Ratio  Inventory turnover ratio = Sales / Inventory Debtors turnover ratio = Sales / Debtors   Days Sales Outstanding (DSO) = Receivables / Average sales per day Creditors turnover = Purchases / Creditors   Fixed Assets turnover = Sales / Net fixed assets Total Assets turnover = Sales / Total assets  .

Debt Management Ratios  Debt Ratio = Total Debt / Total Assets Debt Equity = Debt / Equity or Debt / (Debt + Equity)   Interest Coverage Ratio = EBIT / Interest charges Debt Service Coverage Ratio (DSCR) =  EBIDTA + Lease payments / Interest + Principal payments + Lease payments .

Profitability Ratios  Profit margin = NPAT / Sales Basic Earning Power ( BEP) = EBIT / Total Assets   Return on Total Assets = Net income available to Equity / Total Assets Return on Equity = Net income available to Equity / Equity  .

Market Value Ratios  Price earnings ratio = Market price per share / Earnings per share Price / Cash flow ratio = Price per share / Cash profit per share   Market / Book ratio = Market price per share / Book value per share .

Du Pont equation  ROA = Net profit / Total Assets ROA = Net profit * Sales Sales Total Assets ROA = Profit margin * Total Assets Turnover   OR  ROA = Net profit / Capital Employed .

Du Pont equation…. Other side to it  ROE = Net profit / Equity( or Total Assets) ROE = Net profit * Sales Sales Total Assets * Total assets Equity   ROE = Net profit * Sales Sales Total Assets Equity multiplier = Total assets / Equity Therefore ROE = ROA * Equity multiplier   ..

However. the company’s sales. does this mean that shareholder wealth will also increase?  .Certain questions to ponder over……  Is a high inventory turnover always better? Why would the inventory turnover ratio be more important when analysing a grocery chain than an insurance company?   There is an increase in current ratio and a drop in its total assets turnover ratio. DSO and fixed assets turnover ratio have remained constant. What explains these changes? If a firm takes steps to improve its ROE. cash and marketable securities.

Limitations of Ratio Analysis  Benchmarking required for analysis Inflation may distort comparative analysis   Window dressing techniques can be adopted to make ratios look stronger Different accounting practices can distort comparison Difficult to generalise whether a ratio is good or bad   .

Time Value of Money Topics covered:  Concept of Time Value of Money  Present Value Future Value   Annuity Present Value Annuity Future Value  .

Concept of Time Value A Rupee today is more valuable than a rupee a year hence. Thus rupee discounts from time to time…… . •Purchasing power of money is greater today than a year hence due to inflation. Why ? •Current consumption is preferred to future consumption. •Capital can be employed productively to generate positive returns.

Concept of Time Value Time value thus brings to light two important values: Present Value Future Value .

Future Value therefore is the value of money in future…..  .Present Value & Future Value  Value of money at present that is at this point of time is said to be the present value…..

1 = Present Value + Interest FV of Re.1 received a year later if the rupee discounts at 10%? Future Value of Re.Present Value & Future Value What is the value of Re.1 = PV of Re.1 FV = 1 + 1(10/100) FV = PV + 1(10/100) FV = PV + PV(10/100) FV = PV (1+ 10/100) FV = PV (1 + r ) .1 + 10% on Re.

Present Value & Future Value Similarly PV = FV / (1+r) And if this is to be calculated for the nth year it will be PV = FV / (1+r)n PV = FV * 1 /(1+r)n .

V.V.51 Total 105.V(1+r) (1+r) = P.25 5.V.79 6.1( 1 + r ) = P.Annuity Future value 0 1 2 3 4 5 6 -100 Interest 5 5.38 121.(n) = P.08 6.76 F.V2 = F.25 115.55 127. (1+r)^n 5.V.63 134. (1+r)^2 Therefore F.00 110.01 .

Finding the interest rate.Applications of Present Value in Business  How much can you borrow for an asset? Period of Loan amortisation.   .

Applications of Future Value in Business  Knowing what lies in store for you How much should you save annually   Finding the interest rate Annual deposit in the sinking fund  .

Higher the Discounting rate………. Lower the Present Value factor……….Conclusion Present Value and Annuity Value is calculated assuming that the discounting is done at the end of each year and not any time during the year... .

Stock Valuation Concepts to be known:  Common Stock / Equity  Preferred Stock  Pre-emptive right  Closely held company  Publicly owned company  Primary market (IPO)  Secondary market .

Valuation of Common stock / Equity Models used for valuation:  Zero Growth or Constant Dividend Model  Constant Growth Model / Gordon Model  Valuation of stocks with non constant growth  Capital Asset Pricing Model Other Approaches to valuing Equity:  P/E Multiple  EVA Approach .

Zero Growth or Constant Dividend Model Dividends received annually Dividends received in perpetuity No growth in dividends There is an expectation of the investor from the company P0 = D1/ ke P0 = Price of the stock today D1 = Dividend received in future ke = expected return by the investor .

Constant Growth Model / Gordon Model Dividends received annually Dividends received in perpetuity There is a growth in dividends which is constant There is an expectation of the investor from the company P0 = D1/ (ke – g) P0 = Price of the stock today D1 = Dividend received in future ke = expected return by the investor .

Valuation of stocks with non constant growth Dividends received annually Dividends received for n periods There is a change in dividends which is not constant There is an expectation of the investor from the company  P0 = D1 + D2 + …………… Dn (1+ke)^1 (1+ke)^2 (1+ke)^n P0 = Price of the stock today D1 = Dividend received in future ke = expected return by the investor .

MVA & EVA as a valuation technique  MVA( Market Value Added) Market value of stock – Equity share capital  EVA (Economic Value Added) NOPAT – (Capital Employed * Cost of capital) = EBIT(1 – T) – (Capital Employed * Cost of capital) .

Cost of Capital Types of Capital  Debt  Preference Capital  Retained Earnings  Equity Capital .

then the value of debt is the YTM of that debt which is: rd = I + ( Face value ‘F’ – Current market price ‘P0’ ) / n  0.6 P0 + 0.Cost of Capital – Debt (kd) Debt is long term in nature Interest is paid on debt at a fixed rate Interest is tax deductible kd = I (1 – T) But if the debt is traded and has a different market price with maturity period.4 F kd = rd (1-t) .

then the value of preference is the YTM of that preference which is: rp = I + ( Face value ‘F’ – Current market price ‘P0’ ) / n  0.6 P0 + 0.4 F .Cost of Capital – Preference kp Preference capital forms a part of owners funds Dividends at a fixed rate are paid to these financers Dividends are always paid after tax kp = D / P But if the preference is traded and has a different market price with maturity period.

tax and preference dividend Profits belonging to the owner  ks = ke (except ke at times increases due to floatation cost) .Cost of Capital – Retained Earnings (Ks)    Profits accumulated every year Profits accumulated are after payment of interest.

Cost of Capital – Retained Earnings (Ks) Various approaches used for valuation are: CAPM Bond Yield Plus Risk Premium Approach Dividend Yield Plus Growth Rate Approach .

Cost of Capital – Equity (ke)  P0 = D1/ (ke – g) ke = (D1 / P0) + g ke = (D1 / P0 – f) + g   .

kf = Market risk premium β = Stocks Beta .Capital Asset Pricing Model ( CAPM) ke = kf + (km-kf)β ke = Expected rate of return from equity kf = Risk free rate of return ( Treasury bills. PPF account) km .

Weighted Average Cost of Capital – WACC WACC = wdkd+ wpkp + weke Weights can be according to book values or market values. However market values are more relevant for new issues of capital/ new sources of finance .

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