8. Financial Statement Analysis

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Financial Statement Analysis

Financing Module


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Topics Covered

Financial Ratios DuPont System

Using Financial ratios

Measuring Company Performance

The Role of Financial Ratios


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Analyzing Financial StatementsFinancial Ratio:

A) ANALYZING FINANCIAL STATEMENTSI. Common-Size Financial StatementsCommon-size balance sheets and income statements are used to comparethe performance of different companies or a company's progress overtime.

Common-Size Balance Sheet is a balance sheet where every dollar amounthas been restated to be a percentage of total assets.

Common-Size Income Statement is an income statement where every dollaramount has been restated to be a percentage of sales.

Example: FedEx Common Size Balance Sheet and Income StatementAt first glance, all numbers stated within FedEx's income statement in figure 7.1,can seem daunting. It requires close examination to determine whetheroperating expenses are increasing or decreasing, or which particular expensecomprises the highest percentage total operating expenses.


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Income Statement


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Classification of Financial Ratios

B) Classification of Financial Ratios

Ratios were developed to standardize a companys results. They allow analyststo quickly look through a companys financial statements and identify trends and

anomalies. Ratios can be classified in terms of the information they provide tothe reader.There are four classifications of financial ratios:Internal liquidity The ratios used in this classification were developed to

analyze and determine a companys financial ability to meet short-term liabilities.Operating performance - The ratios used in this classification were developedto analyze and determine how well management operates a company. The ratiosfound in this classification can be divided into operating profitability and

operating efficiency. Operating profitability relates the companys overall

profitability, and operating efficiency reveals if the companys assets were utilized

efficiently.Risk profile - The ratios found in this classification can be divided into businessrisk and financial risk. Business risk relates the companys income variance, i.e.

the risk of not generating consistent cash flows over time. Financial risk is therisk that relates to the companys financial structure, i.e. use of debt.

Growth potential - The ratios used in this classification are useful to

stockholders and creditors as it allows the stockholders to determine what thecompany is worth, and allows creditors to estimate the companys ability to pay


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Internal Liquidity Ratios

1. Current Ratio: This ratio is a measure of the ability of a firm to meet its short-term obligations. In general, a ratio of 2 to 3 is usually considered good. Too small a

ratio indicates that there is some potential difficulty in covering obligations. A highratio may indicate that the firm has too many assets tied up in current assets and isnot making efficient use to them.

Current ratio = current assets / current liabilities2. Quick RatioThe quick (or acid-test) ratio is a more stringent measure of liquidity. Only liquid

assets are taken into account. Inventory and other assets are excluded, as they maybe difficult to dispose of

Quick ratio = (cash+ marketable securities + accounts receivables)current liabilities

3. Cash RatioThe cash ratio reveals how must cash and marketable securities the company hason hand to pay off its current obligations.

Cash ratio = (cash + marketable securities)/current liabilities

4. Working Capital Ratio

Working Capital Ratio = CA CL / Sales


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Efficiency / Turnover Ratios5. Receivable Turnover Ratio

This ratio provides an indicator of the effectiveness of a company's credit policy. Thehigh receivable turnover will indicate that the company collects its dues from itscustomers quickly. If this ratio is too high compared to the industry, this may indicatethat the company does not offer its clients a long enough credit facility, and as aresult may be losing sales. A decreasing receivable-turnover ratio may indicate thatthe company is having difficulties collecting cash from customers, and may be a signthat sales are perhaps overstated.

Receivable turnover = net annual sales / average receivablesWhere:Average receivables = (previously reported account receivable + current accountreceivables)/2

6. Average Number of Days Receivables Outstanding (Average CollectionPeriod)This ratio provides the same information as receivable turnover except that itindicates it as number of days.

Average number of days receivables outstanding = 365 days_receivables turnover


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7. Inventory Turnover RatioThis ratio provides an indication of how efficiently the company's inventory isutilized by management. A high inventory ratio is an indicator that thecompany sells its inventory rapidly and that the inventory does not languish,which may mean there is less risk that the inventory reported has decreasedin value. Too high a ratio could indicate a level of inventory that is too low,perhaps resulting in frequent shortages of stock and the potential of losingcustomers. It could also indicate inadequate production levels for meetingcustomer demand

Inventory turnover = cost of goods sold / average inventoryWhere:Average inventory = (previously reported inventory + current inventory)/28. Average Number of Days in StockThis ratio provides the same information as inventory turnover except that itindicates it as number of days.

Average number of days in stock = 365 / inventory turnover9. Payable Turnover RatioThis ratio will indicate how much credit the company uses from its suppliers.Note that this ratio is very useful in credit checks of firms applying for credit.Payable turnover that is too small may negatively affect a company's creditrating.

Payable turnover = Annual purchases / average payables


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Where:Annual purchases = cost of goods sold + ending inventory beginninginventoryAverage payables = (previously reported accounts payable + current

accounts payable) / 210. Average Number of Days Payables Outstanding (Average Age ofPayables)This ratio provides the same information as payable turnover except that itindicates it by number of days.Average number of days payables outstanding = 365_____

payable turnover

II. Other Internal-Liquidity Ratios11.Cash Conversion CycleThis ratio will indicate how much time it takes for the company to convertcollection or their investment into cash. A high conversion cycle indicates that thecompany has a large amount of money invested in sales inprocess.Cash conversion cycle = average collection period + average number of

days in stock - average age of payablesCash conversion cycle = average collection period + average number of daysin stock - average age of payables12.Defensive IntervalThis measure is essentially a worst-case scenario that estimates how many daysthe company has to maintain its current operations without any additional sales.


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Defensive interval = 365 * (cash + marketable securities + accounts receivable)projected expenditures

Where:

Projected expenditures = projected outflow needed to operate the company7.3 - Operating Profitability Ratios

Operating Profitability can be divided into measurements of return on sales andreturn on investment

Return on Sales

1. Gross Profit Margin

This shows the average amount of profit considering only sales and the cost of theitems sold. This tells how much profit the product or service is making without overheadconsiderations. As such, it indicates the efficiency of operations as well as how productsare priced. Wide variations occur from industry to industry.

Gross profit margin = gross profit / net sales

Gross profit = net sales cost of goods sold


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2. Operating Profit MarginThis ratio indicates the profitability of current operations. This ratio does nottake into account the company's capital and tax structure.

Operating profit margin = operating income/net sales

3. Per-Tax Margin (EBT margin)This ratio indicates the profitability of Company's operations. This ratio doesnot take into account the company's tax structure.Pre-tax margin = Earning before tax/sales

4. Net Margin (Profit Margin)This ratio indicates the profitability of a company's operations.Net margin = net income/sales

5. Contribution MarginThis ratio indicates how much each sale contributes to fixed expenditures.

Contribution margin = contribution / salesWhere: Contributions = sales - variable cost


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Return on Investment Ratios

1. Return on Assets (ROA)

This ratio measures the operating efficacy of a company without regards tofinancial structureReturn on assets = (net income + after-tax cost of interest)

average total assetsORReturn on assets = earnings before interest and taxes

average total assets

2. Return on Common Equity (ROCE)This ratio measures the return accruing to common stockholders and excludespreferred stockholders.Return on common equity = (net income preferred dividends)

average common equity

3. Return on Total Equity (ROE)This is a more general form of ROCE and includes preferred stockholders.Return on total equity = net income/average total equity


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Operating Efficiency Ratios

1. Total Asset TurnoverThis ratio measures a company's ability to generate sales given its

investment in total assets. A ratio of 3 will mean that for every dollar investedin total assets, the company will generate 3 dollars in revenues. Capital-intensive businesses will have a lower total asset turnover than non-capital-intensive businesses.Total asset turnover = net sales / average total assets

2. Fixed-Asset TurnoverThis ratio is similar to total asset turnover; the difference is that only fixedassets are taken into account.Fixed-asset turnover = net sales / average net fixed assets

3. Equity TurnoverThis ratio measures a company's ability to generate sales given its

investment in total equity (common shareholders and preferredstockholders). A ratio of 3 will mean that for every dollar invested in totalequity, the company will generate 3 dollars in revenues.Equity turnover = net sales / average total equity


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FINANCIAL RISK RATIOS

Financial Risk This is risk related to the company's financial structure.Analysis of a Company's Use of Debt

1.Debt to Total Capital

This measures the proportion of debt used given the total capital structure of thecompany. A large debt-to-capital ratio indicates that equity holders are makingextensive use of debt, making the overall business riskier.

Debt to capital = total debt / total capitalWhere:

Total debt = current + long-term debtTotal capital = total debt + stockholders' equity

2. Debt to EquityThis ratio is similar to debt to capital.Debt to equity = total debt / total equity

Analysis of the Interest Coverage Ratio

3. Times Interest Earned (Interest Coverage ratio)This ratio indicates the degree of protection available to creditors by measuring theextent to which earnings available for interest covers required interest payments.Times interest earned = earnings before interest and tax

interest expense


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Market Ratios

1. Sustainable Growth Rate

G = RR * ROEWhere:RR = retention rate = % of total net income reinvested in the companyor, RR = 1 (dividend declared / net income)ROE = return on equity = net income / total equityNote that dividend payout is the residual portion of RR. If RR is 80% then 80%of the net income is reinvested in the company and the remaining 20% isdistributed in the form of cash dividends.

Therefore, Dividend Payout = Dividend Declared/Net Income

Let's consider an example:


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Market Ratios

Dividend Yield:It is the return on dividend on the investment,expressed in percentage and can be calculated asfollows:

Dy = D / price

P/E Multiple = Price / Earning

This ratio show how much will you willing to pay for a

stock against a single rupee earning of a company. Payout Ratio:

This show how mush you pay for dividends out of thetotal income. And can be calculated as follows: DPS

/ EPS


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DuPont SystemA system of analysis has been developed that focuses the attention on all threecritical elements of the financial condition of a company: the operatingmanagement, management of assets and the capital structure. This analysistechnique is called the "DuPont Formula". The DuPont Formula shows theinterrelationship between key financial ratios. It can be presented in severalways.The first is:

Return on equity (ROE) = net income / total equity

If we multiply ROE by sales, we get:

Return on equity = (net income / sales) * (sales / total equity)Said differently:

ROE = net profit margin * return on equity

The second is:

Return on equity (ROE) = net income / total equity

If in a second instance we multiply ROE by assets, we get:ROE = (net income / sales) * (sales / assets) * (assets / equity)Said differently:ROE = net profit margin * asset turnover * equity multiplier


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8. Financial Statement Analysis

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