Unit 28_Financial Analysis Techniques_2013

5/19/2018 Unit 28_Financial Analysis Techniques_2013

1/18

www.proschoolonline.com/ 1

Financial Analysis

TechniquesReading - 28

FINANCIAL REPORTING AND ANALYSIS
http://proschool.imsindia.com/http://proschool.imsindia.com/


2/18

www.proschoolonline.com/ 2

Activity Ratios

Activity ratios are also known as asset utilization ratios andthey measure how efficiently a company performs day to day

tasks such as collection of receivables and management of

inventory. Various activity ratios are :-

a. Inventory turnover ratio : It is a measure of a firms effectiveinventory management . Higher the ratio, shorter the period

that inventory is held.

b. Days of inventory on hand (DOH) : It is the average inventory

processing period or the number of days of inventory on

hand.

Cost of goods sold

Average Inventory

Inventory turnover ratio =

Number of days in period

Inventory TurnoverDays of inventory on hand =
http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/


3/18www.proschoolonline.com/ 3

Activity Ratios

c. Payable turnover ratio : It is the measure of company making

use of available credit facilities.

d. Number of days of payables : It is the average number of

days the company takes to pay its suppliers .

e. Total Asset turnover ratio : It measures the companys

overall ability to generate revenue with a given level of

assets.

purchases

average rade payablesPayables turn over =

365

payable turnover ratioNumber of days of payables =

revenue

average total assets

Total asset turnover =
http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/



Activity Ratios

f. Fixed asset turnover : It indicates the companys use of fixedassets in generating revenue.

g. Working capital turnover ratio : It indicates the companys

efficient use of working capital in generating revenue .

revenue

average net fixed assets

Fixed asset turnover =

revenue

average working capitalWorking capital turnover =
http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/



Liquidity Ratios

Liquidity ratios measure the companys ability to meet itsshort term cash requirements. Various liquidity ratios are :

a. Current ratio : It is the ratio of current assets to current

liabilities.

Working capital equals current assets minus current liabilities.

b. Quick ratio (Acid test ratio) is the ratio of quick assets to

current liabilities where quick assets are those assets whichcan be readily converted to cash.

Current AssetCurrent Liabilities

CurrentRatio =

cash + short term marketable securities + receivables

current liabilitesQuick Ratio =
http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/



Liquidity Ratios

c. The Cash conversion cycle or net operating cycle is ameasure of the time it takes to turn the firms cash

investment from paying suppliers for materials to

collecting cash from sales of inventory.

A conversion cycle that is too high shows that the

company has its excess amount invested as working

capital.

d. Defensive interval ratio : It indicates the number of days

the company can pay its expenditures with its existing

liquid assets .

Number of Number of Number ofdays of inventory days of receivables days of payables

Net operating cycle = + -

cash + short term marketable investments + receivables

daily cash expenditures=Defensive interval ratio



Solvency Ratios

a. Debt-to-assets ratio: This ratio measures the percentageof total assets financed with debt, thus a higher ratio

means a weaker solvency.

b. Debt-to-capital ratio : This ratio measures the percentageof a companys capital (debt plus equity) represented by

debt.

c. Debt-to-equity ratio : This ratio measures the amount ofdebt capital relative to equity capital.

total debt

total assetsDebt to Assets =

total debt

total debt + total shareholders equityDebt-to-capital =

total debt

total shareholders equityDebt-to-equity ratio =
http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/



Solvency Ratios

d. Financial leverage ratio: This ratio is defined in terms of average of totalassets and average total equity. It is also known as leverage ratio.

e. Interest coverage ratio : This ratio determines the firms ability to repay

its debt obligations.

f. Fixed charge coverage ratio : This ratio measures the number of times a

companys earnings can cover the companys interest and leasepayments.


average total equityFinancial leverage =

EBIT

interst paymentsInterestcoverage =

EBIT + lease payments

interest payments + lease paymentsFixed charge coverage =
http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/



Profitability Ratios

Profitability ratios measure the companys ability to generateprofitable sales from its assets. Various ratios are :

a. Gross profit margin : It indicates the available revenue to cover up

the operating expenditures.

b. Operating profit margin : It is the ratio of operating profit to

revenue or sales.

c. Pretax margin : Pretax income is calculated as operating profit

minus interest.

gross profitrevenue

Gross profit margin =

operating income

revenueOperating profit margin =

EBT

revenuePretax margin =
http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/




d. Net profit margin: It is a ratio of net income to revenue. It isrevenue minus all expenses.

e. Return on assets : It measures the return earned by acompany on its assets.

f. Operating return on assets : It measures the return on all

assets invested in the company financed with liabilities debt

or equity.

net income

revenueNet profit margin =

netincome

average total assetsReturn on assets(ROA) =

EBIT


Operating return on assets =
http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/




g. Return on total capital : It measures the profits a companyearns on all the capital that it employs be it short term or

long term debt.

h. Return on equity (ROE) : It is the ratio of net income to

average total equity (including preferred stock).

EBIT

average total capitalReturn on total capital =

net incomeaverage total equity

Return on Equity =



Valuation Ratios

a. Price to Earnings (P / E) ratio : This ratio expresses therelationship between price per share and the earnings per

share. It is expressed as

b. Price to cash flow ratio :

c. Price to sales ratio : It is used as a comparative price metric

when a company does not have positive net income.

price per share

earnings per shareP/E =

price per share

cash flow per shareP / CF =

price per share

sales pershareP / S =



Valuation Ratios

d. Price to book value ratio : It is a ratio of price per share tobook value per share and it indicates the relationship

between a companys required rate of return and its actual

rate of return.

price per share

book value per shareP / BV =
http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/



DuPont Expression

DuPont analysis is a tool used by analysts to make inferences

about a companys performance and target the areas of

concern.

The break down of return on assets into a two component

model is simplest form of the DuPont approach.

Return onassets

Net profitmargin

Total assetturnover



DuPont Expression . .

Return on assets ratio is net income divided by

the average of total assets of the company and

it is extended into two components as shown :

Net income Net income Revenue

Average total assets Revenue Average total assets

Return on Assets = = *

*=Return on Assets Net Profit margin Total asset turnover
http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/




The return on shareholders equity can be represented as athree-component DuPont model as shown :

Net income Net income Revenues Average total assets

Average shareholders equity Revenues Average total assets Average shareholders equity

* financial leverage

Return on Equity = = * *

ROE = Net Prof it Mragin * Total asset turnover
http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/




The extended DuPont expression which is a 5- partdecomposition of ROE has the effect of non

operating income items as one of the components as

shown :

operating income income before taxes taxes revenues average total assetsrevenues operating income income before taxes average total assets average shareholders equity

* *( )ROE = * * 1 -

Tax effect * Total asset turnover * Financial leverageROE = Operating profit margin * Effect of nonoperating items *
http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/http://proschool.imsindia.com/


18/18www proschoolonline com/ 18

Dividend related Quantities

It measures the percentage of earnings that the companypays out as dividends to shareholders.

Dividendpayout

ratio

It is the percentage of earnings that a company retains.

It is complement of the payout ratio (1- payout ratio).

Retentionratio

The companys growth rate is a function of its profitability

and its ability to finance itself without external equity issues .

Here growth rate g = RR* ROE

Sustainablegrowth rate

Unit 28_Financial Analysis Techniques_2013

Documents

Transcript of Unit 28_Financial Analysis Techniques_2013