FINANCIAL STATEMENT

ANALYSIS
Module III
 OBJECTIVE OF THIS MODULE
The goals of this section is to understand the financial
statements through:
a. Interpreting P&L and Balance sheet
b. Preparing Cash Flow Statements
c. Fundamental Accounting Concepts
d. Depreciation Methods
e. DuPont Analysis
f. Working Capital
g. Ratio Analysis
h. Common-sizing
 MAJOR COMPONENTS OF A MODEL
It is recommended that a financial model be built in six major
components:
1. Income statement
2. Cash flow statement
3. Balance sheet
4. Depreciation schedule
5. Working capital
6. Debt schedule

The first three are the major statements: income statement, cash
flow statement, and balance sheet. The latter three help support
the flow and continuity of the first three.
 ANNUAL REPORT
• The Annual Report (AR) of a company is an official
communication from the company to its investors and other
stakeholders.

• The AR is the best source to get information about the

company; hence AR should be the default choice for the
investor to source company related information.

• The AR contains many sections, with each section highlighting

certain aspect of the business.

• The AR is also the best source to get information related to

the qualitative aspects of the company.
 ANNUAL REPORT
• The management discussion and analysis is one of the most
important sections in the AR. It has the management’s perspective
on the overall economy of the country, their outlook on the industry
they operate in for the year gone by (what went right and what went
wrong), and what they foresee for the year ahead.

• The AR contains three financial statements – Profit & Loss

statement, Balance Sheet, and Cash Flow statement.

• The standalone statement contains the financial numbers of only

the company in consideration. However the consolidated numbers
contains the company and its subsidiaries financial numbers.
 INCOME STATEMENT

o The Income Statement is one of a company’s core financial

statements that shows their profit and loss over a period of time.

o The profit or loss is determined by taking all revenues and

subtracting all expenses from both operating and non-operating
activities.
 COMPONENTS OF AN
INCOME STATEMENT
An income statement can be divided into nine major line items :
1. Revenue (sales)
2. Cost of goods sold
3. Operating expenses
4. Other income
5. Depreciation and amortization
6. Interest
7. Taxes
8. Non-recurring and extraordinary items
9. Distributions
 BALANCE SHEET
o A balance sheet gives a statement of a business’s assets, liabilities
and shareholders equity at a specific point in time.

o They offer a snapshot of what your business owns and what it owes
as well as the amount invested by its owners, reported on a single
day.

o A balance sheet is important because it provides insights about the

business w.r.t. efficiency, leverage and liquidity.

o A balance sheet tells you a business’s worth at a given time, so you

can better understand its financial position.
 BALANCE SHEET
ASSETS

o The assets section of the balance sheet breaks down what your business
owns of value that can be converted into cash. There are two main
categories of assets included on your balance sheet:

o Long-Term Assets: Long-term assets won’t be converted to cash within a

year.

o They can be further broken down into:

Fixed assets: Includes property, buildings, machinery and equipment like
computers
Long-term securities: Investments that can’t be sold within one year
Intangible assets: Assets that aren’t physical objects, such as copyrights,
franchise agreements and patents
 BALANCE SHEET
o Current Assets: Current assets can easily be converted to cash within a
year or less. Current assets are further broken down on the balance sheet
into these accounts:
• Cash and cash equivalents: These are your most liquid assets, including
currency, checks and money stored in your business’s checking and
savings accounts
• Marketable securities: Investments that you can sell within a year
• Accounts receivable: Money that your clients owe you for your services that
will be paid in the short term
• Inventory: For businesses that sell goods, inventory includes finished
products and raw materials
• Prepaid expenses: Things of value that you’ve already paid for, like your
office rent or your business insurance.
 BALANCE SHEET
LIABILITIES

o The next section of a balance sheet lists a company’s liabilities. Your

liabilities are the money that you owe to others, including your recurring
expenses, loan repayments and other forms of debt. Liabilities are further
broken down into current and long-term liabilities.

o Current liabilities include rent, utilities, taxes, current payments toward

long-term debts, interest payments and payroll.

o Long-term liabilities include long-term loans, deferred income taxes and

pension fund liabilities.
CASH FLOW
STATEMENT
 CFS: MEANING
The cash flow statement is a measure of how much cash a company
has produced or spent over a period of time.

Although an income statement shows profitability, that profit may or

may not result in actual cash gain.

This is because many income statement items that are recorded do

not necessarily result in an effect on cash.
 CFS: USAGE
A Cash Flow statement allows you to:

o See where your money came from

o See where your money is being spent
o Understand the “cash reality” of your business, rather than the
abstract accounting
o Help you plan your future cash flows more intelligently (you’ll need
to do some cash flow projection for that)
o See a simple “cash balance” for the month
 CASH & CASH EQUIVALENTS
Cash includes legal tender, coins, cheques received but not deposited,
and savings accounts.

Cash equivalents are any short-term investment securities with

maturity periods of 90 days or less. They include bank certificates of
deposit, Treasury bills, commercial paper, and other money market
instruments.

Investments in liquid securities, such as stocks, bonds, and

derivatives, are not included in cash and equivalents. Even though
such assets may be easily turned into cash (typically with a three-day
settlement period), they are still excluded.
SEGMENTS IN CASHFLOW STATEMENT

OPERATING INVESTING FINANCING

ACTIVITIES ACTIVITIES ACTIVITIES
 CASHFLOW FROM OPERATING ACTIVITIES

Activities that are directly related to the daily core business operations
are called operational activities.

Typical operating activities include sales, marketing, manufacturing,

technology upgrade, resource hiring etc.

A company which has a positive cash flow from operating activities is

always a sign of financial well being.
 CASHFLOW FROM OPERATING ACTIVITIES

Cash from Operating Activities =

Net Income
+Changes in Working Capital
+Depreciation
+Other Non-Cash Items
+Deferred Taxes
 CASHFLOW FROM INVESTING ACTIVITIES

Activities pertaining to investments that the company makes with an

intention of reaping benefits at a later stage.

Examples include parking money in interest bearing instruments,

investing in equity shares, investing in land, property, plant and
equipment, intangibles and other non current assets etc.

Healthy investing activities foretells the investor that the company is

serious about its business expansion.
 CASHFLOW FROM FINANCING ACTIVITIES

Cash from financing activities is defined as cash generated or spent

from equity or debt. More specifically:

■ Raising or buying back equity or preferred securities

■ Raising or paying back debt
■ Distributions to equity holders (non-controlling interests and
dividends)
 CFS: RULES
Four simple rules to remember:-

Increase in assets treated as cash outflow.

Decrease in assets treated as cash inflow.
Increase in liability treated as cash inflow.
Decrease in liability treated as cash outflow.
 A FEW
FUNDAMENTAL
CONCEPTS
 EBITDA
o Earnings before interest, taxes, depreciation, and amortization
(EBITDA) is a very important measure among analysts.

o It is a measure of a company's overall financial performance and is

used as an alternative to net income in some circumstances.

o EBITDA=Net Income + Interest + Taxes + Depreciation

o EBITDA is useful when comparing companies with different capital

investment, debt, and tax profiles.
 Is ‘Other Income’ part of EBITDA?
o It is debatable whether ‘Other Income’ should be included in EBITDA
or not. There are two sides to the argument.

o Argument 1: Other income, although not core to revenue, is still in

fact operating and should be represented as part of the company’s
operations. For example, a car manufacturing company having
income from financing activities, although not core to revenue, are
essential enough to the overall profitability to be considered as part
of EBITDA.

o Argument 2: Although it is a part of the company’s profitability, it is

not core enough to the operations to be incorporated as part of the
company’s core profitability.
 EBITDA MARGIN
o EBITDA margins provide investors a snapshot of short-term
operational efficiency. Because the margin ignores the impacts of
non-operating factors such as interest expenses, taxes, or
intangible assets, the result is a metric that is a more accurate
reflection of a firm's operating profitability.

EBITDA margin = EBITDA / Total Revenue

o The EBITDA margin calculated using this equation shows the cash
profit a business makes in a year. The margin can then be
compared with another similar business in the same industry.
 EBITDA MARGIN
o For example, Company A has an EBITDA of Rs.8,00,000 while their
total revenue is Rs.80,00,000. The EBITDA margin is 10%. Company
B has an EBITDA of Rs.960,000 and total revenue of
Rs.1,20,00,000.

o This means that while Company B demonstrates higher EBITDA, it

actually has a smaller margin than Company A (8% against 10%).
Therefore, an investor will see more potential in Company A.
 P/E RATIO
o The PE ratio is significant because, by combining it with a forecast
of company earnings, analysts can decide whether the shares are
currently over- or undervalued.

o The PE ratio is calculated by dividing the market price of a share by

the earnings that the company generated for that share.

o P/E ratio = Market price per share/Earnings per share

 P/E RATIO
o Alternatively, the PE figure may be seen as a multiple of the
earnings per share, where the multiple represents the number of
years’ earnings required to recoup the price paid for the share.

Company Price PE ratio

A 453 12.6
B 340 39.3
C 1,125 19.6
o For example, it would take a shareholder in Company B just under
forty years to recoup her outlay if all earnings were to be
distributed, whereas it would take a shareholder in Company A just
over twelve years to recoup his outlay, and one in Company C just
under twenty years.
 P/E RATIO
o It is difficult to interpret a PE ratio in isolation without a certain
amount of information about the company, its competitors and the
industry within which it operates.

o The PE ratio for a company will reflect investors’ confidence and

hopes about the international scene, the national economy and the
industry sector, as well as about the current year’s performance of
the company as disclosed in its financial report.
 P/E RATIO
o A high PE ratio might reflect investor confidence in the existing
management team: people are willing to pay a high multiple for
expected earnings because of the underlying strength of the
company.

o A low PE ratio might indicate a lack of confidence in the current

management or a feeling that even a new management might find
problems that are not easily surmounted.
 Taxes
Compute effective tax rate from the historical year using the equation:

Eff. Tax rate = Reported Tax expense/Profit Before Tax

While making forecast, multiply the effective tax rate with the PBT of
the corresponding years.
DEPRECIATION
METHODS
 DEPRECIATION
o Depreciation is the systematic allocation of an asset’s cost over
time.

o It forms a significant portion of operating expenses.

o The analyst must decide whether the reported depreciation

expense is more or less than economic depreciation, which is the
actual decline in the value of the asset over the period.

o Depreciation methods include the straight-line method, accelerated

methods, and the units-of- production method.
 STRAIGHT LINE METHOD
o Under the straight-line method, the cost of the asset is allocated
evenly across its estimated useful life. Depreciation is the same
amount each year over the asset’s estimated life. It is calculated as
depreciable cost divided by estimated useful life.

Depreciation expense = (Cost - Residual value)/ Useful Life

o Depreciable cost is the historical cost of the tangible asset minus

the estimated residual (salvage) value.

o The residual value is the estimated amount that will be received

from disposal of the asset at the end of its useful life.
 STRAIGHT LINE METHOD
Example
Cost =$12,000,
Residual value =$2,000,
Useful life =5 years.
Calculate depreciation using SLM.

Solution: Depreciation =(12000-2000)/5 = $2,000

 DOUBLE DECLINING BALANCE METHOD
Under this method, more depreciation expense is recognized in the early
years of an asset’s life and less depreciation expense in the later years.

Thus, it results in lower net income in the early years of an asset’s life
and higher net income in the later years, compared to straight-line
depreciation.

DDB depreciation = 2/depreciable life in years x book value at beginning

of year

Note: Salvage value is not deducted for DDB depreciation. However,

once the carrying (book) value of the asset reaches the salvage value,
no additional depreciation expense is recognized.
 DOUBLE DECLINING BALANCE METHOD
Example: Cost =$12,000, Residual value =$2,000, Useful life =5 years.
Calculate depreciation using DDB.

Solution:
Year Op. Bal Depreciation Cl. Bal
1 12000 12000x2/5=4800 7200
2 7200 7200x2/5=2880 4320
3 4320 4320x2/5=1728 2592
4 2592 592* 2000

* Depreciation restricted to 2592x2/5=1036 or 592 w.i. lower.

 SUM OF THE YEARS’ DIGITS METHOD
Sum of the years’ digits method of depreciation is one of the
accelerated depreciation techniques which are based on the
assumption that assets are generally more productive when they are
new and their productivity decreases as they become old.

SYD Depreciation = Depreciable Base × Remaining Life/SYD

SYD = n(n+1)/2
 SUM OF THE YEARS’ DIGITS METHOD
Example
Cost $45,000
Salvage Value $5,000
Useful Life in Years 4
Asset is Depreciated Yearly

Solution:
Sum of the Years' Digits
=1+2+3+4
= 4 × (4 + 1) ÷ 2
= 10
 SUM OF THE YEARS’ DIGITS METHOD
Depreciable Base
= $45,000 − $5,000
= $40,000

Year Base Depr Factor Depr Expense Acc. Depr

1 $40,000 4/10 4/10 × 40,000 =16,000 $16,000
2 $40,000 3/10 3/10 × 40,000 =12,000 $28,000
3 $40,000 2/10 2/10 × 40,000 =8,000 $36,000
4 $40,000 1/10 1/10 × 40,000 =4,000 $40,000
 UNITS OF PRODUCTION METHOD
• Depreciation under the units-of-production method is based on
usage rather than time.

• Depreciation expense is higher in periods of high usage.

Depreciation = (Original cost - Salvage value)/Total output capacity x

output units in the period
 UNITS OF PRODUCTION METHOD
Example
Cost $12,000
Salvage Value $2,000
Total Capacity 10,000 units
Output Produced 2,000

Depreciation = (12,000-2,000) x 2000/ 10,000 = $2,000

Note that regardless of the depreciation method used, the carrying

amount of the asset is not reduced below the estimated residual
value.
WORKING
CAPITAL
 WORKING CAPITAL : DEFINITION

Working capital is a measure of a company’s current assets less its

current liabilities.

Working Capital = Current Assets – Current Liabilities

Operating working capital is also defined as current assets less

Current liabilities. However, we do not include cash and cash
equivalents as part of current assets and we do not include debts as
part of current liabilities.
 CURRENT RATIO

The current ratio is the ratio of current assets to current liabilities.

CR = Current Assets/Current Liabilities

Higher the better. It shows the ability of the company to pay its short-
term bills. Current ratio<1 means that the company has negative
working capital and is probably facing a liquidity crisis.
 QUICK RATIO
The quick ratio (acid-test ratio) is the ratio of quick assets to current
liabilities.
QR = Quick Assets/Current Liabilities
Quick Assets=Cash + Short Term Marketable Securities + Receivables

Higher the better.

Quick assets are those that can be most readily converted into cash.
Inventory is not necessarily liquid and hence not included in Quick
assets. The liquidity of current assets is assumed by the analyst
depending on the circumstances.
 EXAMPLE

A company has a current and quick ratio of 2.8 and 1.6 respectively. If
the company's current liabilities amount to $120 million, the amount of
inventory that the company has is closest to:
a) $336 million. b) $192 million. c) $144 million.
 RECEIVABLES TURNOVER RATIO
RTR = Net Credit Sales/Average Receivables

• Accounts receivable turnover measures the rate at which payment

is collected from receivables.
• It measures how many times, on average, accounts receivable are
created by credit sales and collected over a given period.
• It is desirable to have an accounts receivable turnover close to the
industry average.
 NO. OF DAYS’ RECEIVABLES
= Average Receivables/Credit Sales * 365

• It is considered desirable to have a collection period close to the

industry norm.
• The firm's credit terms are another important benchmark used to
interpret this ratio.
• A collection period that is too high might mean that customers are
too slow in paying their bills, which means too much capital is tied
up in assets.
• A collection period that is too low might indicate that the firm's
credit policy is too rigorous, which might be hampering sales.
 EXAMPLE
CJ Ventures sells flying drones on credit. At the end of the year, CJ’s
balance sheet shows $20,000 in accounts receivable, $75,000 of gross
credit sales, and $25,000 of returns. Last year’s balance sheet showed
$10,000 of accounts receivable. Calculate and interpret CJ's receivables
turnover and no. of day's receivables.

Net Credit sales = $75000 - $25000 = $50000

Average receivables = $(20000+10000)/2 = $15000
Receivable's turnover ratio= $50000 / $15000 = 3.33
No. of day's receivables = 365/3.33 = 110 days.

Interpretation: CJ collects his receivables about 3.33 times a year or once

every 110 days. In other words, when a credit sale is made, it will take
him 110 days to collect the cash from that sale.
 INVENTORY TURNOVER RATIO
ITR = COGS/Average Inventory

It measures a firm's efficiency with respect to its processing and

inventory management.

No. of days of inventory = Avg. Inventory/COGS * COGS

It is considered desirable to have an inventory processing period (and

inventory turnover) close to the industry norm. A processing period
that is too high might mean that too much capital is tied up in
inventory and could mean that the inventory is obsolete. A processing
period that is too low might indicate that the firm has inadequate
stock on hand, which could hurt sales.
 EXAMPLE
LP Company sells industrial furniture for office buildings. During the current
year, LP reported cost of goods sold on its income statement of $1,000,000.
LP’s beginning inventory was $3,000,000 and its ending inventory was
$4,000,000. Calculate and interpret LP's inventory turnover ratio and no. of
day's inventory.

COGS = $1,000,000
Average inventory = $(3000000+4000000)/2 = $3500000
Inventory turnover ratio= $1,000,000 / $3500000 = 0.29
No. of day's Inventory= 365/0.29 = 1259 days ~ 3.45 years.

This means that LP only sold roughly a third of its inventory during the year. It
also implies that it would take LP approximately 3.5 years to sell his entire
inventory or complete one turn. In other words, LP does not have very good
inventory control.
 PAYABLES TURNOVER RATIO
Payables turnover ratio = Credit Purchases/Average Creditors

A measure of the use of trade credit by the firm is the payables

turnover ratio. Accounts payables turnover measures how many times
the company theoretically pays off creditors over a period. A high
payables turnover ratio might indicate that the company is not making
full use of available credit facilities. A low ratio could suggest that the
company has trouble making payments on time.

No. of days of payables = Avg. Payables/Credit Payables * 365

It means the average amount of time it takes the company to pay its
bills.
 EXAMPLE
KD’s Inc. buys robotics equipment in large scale and resells to its customers.
During the current year KD's purchased $1,000,000 worth of equipment.
According to KD’s balance sheet, his beginning accounts payable was $50,000
and his ending accounts payable was $958,000. Calculate and interpret KD's
payables turnover and no. of day's payables.

Net Credit purchases = $1,000,000

Average payables = $(50000+958000)/2 = $504000
Payable's turnover ratio= $1,000,000 / $504000 = 1.98
No. of day's payables = 365/1.98 = 185 days.

Interpretation: KD's pays its vendors back on average once every six months or
twice a year. This is not a high turnover ratio, but it should be compared to
others in the industry.
 QUESTION
Which of the following companies has the lowest creditworthiness?
a) A company with a high current ratio
b) A company with a high number of days of receivables
c) A company with a high inventory turnover
 OPERATING CYCLE
The operating cycle is the average number of days that it takes to turn raw materials
into cash proceeds from sales.

Operating cycle = Days of inventory + Days of receivables

The cash conversion cycle, or the net operating cycle, is the length of the period from
paying suppliers for materials to collecting cash from sales to customers. It can also be
calculated as the operating cycle minus the number of days of payables.

Net Operating Cycle = Days of Inventory + Days of Receivables - Days of Payables

Interpretation: Usually, shorter cycles are desirable. An operating/conversion cycle that

is too high implies that the company has an excessive amount of investment in working
capital. A company may have negative cash cycle.
 EXAMPLE
Q. Use the following information to answer Questions (i) and (ii):
($ million)
Credit sales 30,000
Cost of goods sold 25,000
Accounts receivable 4,000
Opening inventory 5,000
Closing inventory 2,500
Accounts payable 2,000

i) The operating cycle for the company is closest to:

a)74.22 days. b) 103.42 days. c) 1.67 days.

ii) The net operating cycle for the company is closest to:
a)1.67 days. b) 14.17 days. c) 70.98 days.
 Impact of WC on Share Value
The value of a company or a project is the present value of free cash flows
discounted at WACC.

 Free cash flow = NOPAT + Depreciation – Capital expenditure – NWC

 NOPAT = EBIT (1-tax rate)

Since free cash flow is a function of net working capital, reducing investment
in working capital for a given level of sales (growth) increases cash flows and,
hence, the stock price.

Value of the firm = PV of free cash flows + PV of terminal value

Value of equity = value of firm – value of debt outstanding
Value of a share = (value of equity/number of shares outstanding)
 DuPont
ANALYSIS
 DuPont Analysis
It breaks down the ROE to analyze how corporate can increase the
return for their shareholders.

ROE = PAT/Equity

ROE = Net Profit Margin * Asset Turnover Ratio * Financial Leverage

= (Net Income / Sales) * (Sales / Total Assets) * (Total Assets / Total Equity)

The company can increase its Return on Equity if it-

1. Generates a high Net Profit Margin.

2. Effectively uses its assets so as to generate more sales
3. Has a high Financial Leverage
 Components of DuPont Analysis
This analysis has 3 components to consider

1.Profit Margin– This is a very basic profitability ratio calculated by

dividing the net profit by total revenues. This resembles the profit
generated after deducting all the expenses. The primary factor
remains to maintain healthy profit margins and derive ways to keep
growing it by reducing expenses, increasing prices etc., which impacts
ROE.

For example; Company X has Annual net profits of Rs 1000 and Annual
turnover of Rs 10000. Therefore the net profit margin is calculated as

Net Profit Margin= Net profit/ Total revenue= 1000/10000= 10%

 Components of DuPont Analysis
2. Total Asset Turnover– This ratio depicts the efficiency of the
company in using its assets. This is calculated by dividing revenues by
average assets. This ratio differs across industries but is useful in
comparing firms in the same industry. If the company’s asset turnover
increases, this positively impacts the ROE of the company.

For example; Company X has revenues of Rs 10000 and average

assets of Rs 200. Hence the asset turnover is as follows:

Asset Turnover= Revenues/Average Assets = 1000/200 = 5

 Components of DuPont Analysis
3. Financial Leverage- This refers to the debt usage to finance the
assets. The companies should strike a balance in the usage of debt.
The debt should be used to finance the operations and growth of the
company. However usage of excess leverage to push up the ROE can
turn out to be detrimental for the health of the company.

For example; Company X has average assets of Rs 1000 and equity of

Rs 400. Hence the leverage of the company is as

Financial Leverage = Average Assets/ Average Equity= 1000/400 = 2.5

 DuPont Analysis Example
Let’s analyze the Return on Equity of Companies- A and B. Both the
companies are into the electronics industry and have the same ROE of
45%. The ratios of the two companies are as follows-

Ratio Company A Company B

Profit Margin 30% 15%
Asset Turnover 0.5 6
Financial Leverage 3 0.5

Even though both companies have the same ROE, however, the
operations of the companies are totally different.
 DuPont Analysis Example
Company A is able to generate higher sales while maintaining a lower
cost of goods which can be seen from its high-profit margin.

On the other hand, company B is selling its products at a lower margin

but having very high Asset Turnover Ratio indicating that the company
is making a large number of sales. Moreover, company B seems less
risky since its Financial Leverage is very low.

Thus this Analysis helps compare similar companies with similar

ratios. It will help investors to measure the risk associated with the
business model of each company.
 5-step DuPont Analysis
The DuPont equation can be further decomposed to have an even
deeper insight where the net profit margin is broken down into EBIT
Margin, Tax Burden, and Interest Burden.

Return on Equity = EBIT Margin x Interest Burden x Tax Burden x Asset

Turnover Ratio x Financial Leverage

ROE = (EBIT / Sales) x (EBT / EBIT) x (Net Income / EBT) x (Sales /

Total Assets) x (Total Assets / Total Equity)
 DuPont Analysis Interpretation
• It gives a broader view of the Return on Equity of the company.

• It highlights the company’s strengths and pinpoints the area where

there is a scope for improvement.

• Say if the shareholders are dissatisfied with lower ROE, the

company with the help of DuPont Analysis formula can assess
whether the lower ROE is due to low-profit margin, low asset
turnover or poor leverage.

• Once the management of the company has found the weak area, it
may take steps to correct it.
 DuPont Analysis Interpretation
• The lower ROE may not always be a concern for the company as it
may also happen due to normal business operations.

• For instance, the ROE may come down due to accelerated

depreciation in the initial years.

• The Analysis is very important for an investor as it answers the

question what is actually causing the ROE to be what it is. If there is
an increase in the Net Profit Margin without a change in the
Financial Leverage, it shows that the company is able to increase
its profitability.
 DuPont Analysis Interpretation
• But if the company is able to increase it’s ROE only due to increase
in Financial Leverage, it’s risky since the company is able to
increase its assets by taking debt.

• Thus we need to check whether the increase in company’s ROE is

due to increase in Net Profit Margin or Asset Turnover Ratio (which
is a good sign) or only due to Leverage (which is an alarming
signal).
RATIO ANALYSIS
 IMPORTANCE OF RATIOS
• Investors and analysts employ ratio analysis to evaluate the
financial health of companies by scrutinizing past and current
financial statements.

• Comparative data can demonstrate how a company is performing

over time and can be used to estimate likely future performance.

• This data can also compare a company's financial standing with

industry averages while measuring how a company stacks up
against others within the same sector.
 LIQUIDITY RATIOS
• Liquidity is the ability to convert assets into cash quickly and
cheaply.

• Liquidity ratios measure a company's ability to pay off its short-

term debts as they become due, using the company's current or
quick assets.

• Liquidity ratios include the current ratio, quick ratio etc.

• Liquidity ratios are most useful when they are used in comparative
form. This analysis may be internal or external.
 PROFITABILITY RATIOS
Operating Margin = Operating Income/Revenue

• The operating margin shows how much profit a company makes for
each dollar in revenue.

• Since revenues and expenses are considered ‘operating’ in most

companies, this is a good way to measure a company’s profitability.

• Operating Income = Revenue – operating expenses (excluding

interest, taxes and depreciation).
 PROFITABILITY RATIOS
• Net Profit Margin: The percentage of net profit (gross profit minus
all other expenses) earned on a company’s sales.

NPM = Net Profit / Sales * 100

• Gross Profit Margin: The percentage of gross profit earned on the

company’s sales.

GPM = Gross Profit * 100

• Gross profit is simply the revenue minus the cost of goods sold
(COGS). Net profit is the gross profit minus all other expenses.
 PROFITABILITY RATIOS
Return on Total Assets = Net Profit / Total Assets
• The return on assets ratio (ROA) measures how effectively assets
are being used for generating profit.
• The ROA is the product of two common ratios: profit margin and
asset turnover.
ROA = Net Profit / Sales x Sales /Total Assets

• A higher ROA is better, but there is no metric for a good or bad

ROA. An ROA depends on the company, the industry and the
economic environment.
• ROA is based on the book value of assets, which can be starkly
different from the market value of assets.
 PROFITABILITY RATIOS
• Return on Capital Employed(ROCE) determines a company’s
profitability and the efficiency the capital is applied.

• ROCE = EBIT/Capital Employed.

• Capital Employed = Total Assets – Current Liabilities.

• A higher ROCE implies a more economical use of capital; the ROCE

should be higher than the capital cost. If not, the company is less
productive and inadequately building shareholder value.

• ROCE is a long-term profitability ratio because it shows how

effectively assets are performing while taking into consideration
long-term financing.
 PROFITABILITY RATIOS

Both Company A and Company B sell computers. Company A represents the

Old Factory model; they are a distribution company that sells business to
business. Company B is the New Factory; they are also a distribution
company, but they sell on the Internet via credit card. Due to this modern
convenience, Company B is able to receive payment within two days instead
of the forty-five it takes Company A.
 PROFITABILITY RATIOS
If you were to just consider EBIT, then Company A looks like the
better investment at 7% return on sales compared to Company B’s
5%;

However, with such a large DSO number, Company A is out

$6,000,000 more than Company B at any given time.

This means Company B needs less capital invested in the company

which would result in a higher return on equity (ROE)
 EFFICIENCY RATIOS
• Efficiency ratios, also known as activity ratios, are used by analysts to
measure the performance of a company's short-term or current
performance. All these ratios use numbers in a company's current assets
or current liabilities, quantifying the operations of the business.

• An efficiency ratio measures a company's ability to use its assets to

generate income. This makes efficiency ratios important, because an
improvement in the efficiency ratios usually translates to improved
profitability.

• These ratios can be compared with peers in the same industry and can
identify businesses that are better managed relative to the others. Some
common efficiency ratios are accounts receivable turnover, fixed asset
turnover, accounts payable to sales, stock turnover ratio etc.
 EFFICIENCY RATIOS
Fixed asset turnover = Net sales / Average net fixed assets.

• The higher the ratio, the better, because a high ratio indicates the business
has less money tied up in fixed assets for each unit of currency of sales
revenue.

• A declining ratio may indicate that the business is over-invested in plant,

equipment, or other fixed assets.

• Fixed assets, also known as a non- current asset or as property, plant, and
equipment (PP&E), is a term used in accounting for assets and property
that cannot easily be converted into cash.
 EFFICIENCY RATIOS
• Total asset turnover is a financial ratio that measures the efficiency of a
company’s use of its assets in generating sales revenue.

Total assets turnover = Net sales revenue / Average total assets.

• Net sales are operating revenues earned by a company for selling its
products or rendering its services.

• Anything tangible or intangible that is capable of being owned or controlled

to produce value and that is held to have positive economic value is
considered an asset.

• Companies with low profit margins tend to have high asset turnover, while
those with high profit margins have low asset turnover.
 DEBT MANAGEMENT RATIOS
• Also called solvency or financial leverage ratios, these ratios
compare a company's debt levels with its assets, equity, and
earnings, to evaluate the likelihood of a company staying afloat
over the long haul, by paying off its long-term debt as well as the
interest on its debt.

• Examples of solvency ratios include: debt-equity ratios, debt-assets

ratios, and interest coverage ratios.
 DEBT MANAGEMENT RATIOS
• The debt ratio measures the firm’s ability to repay long-term debt by
indicating the percentage of a company’s assets that are provided via debt.

Debt ratio = Total debt / Total assets.

• The higher the ratio, the greater risk will be associated with the firm’s
operation.
 DEBT MANAGEMENT RATIOS
• Times interest earned (TIE) or Interest Coverage ratio is a measure of a
company’s ability to honor its debt payments. It may be calculated as either
EBIT or EBITDA divided by the total interest payable.

• EBIT = Revenue – Operating expenses (OPEX) + Non- operating income.

• When the interest coverage ratio is smaller than 1, the company is not
generating enough cash from its operations EBIT to meet its interest
obligations. The Company would then have to either use cash on hand to
make up the difference or borrow funds.

• Typically, it is a warning sign when interest coverage falls below 2.5x.

 DEBT MANAGEMENT RATIOS
• Debt Service Coverage Ratio measures the ability of a company to service
its debt obligations.

DSCR = EBITDA / Total Debt Service

• A DSCR greater than 1.0 means there is sufficient cash flow to cover debt
service.

• A DSCR below 1.0 indicates there is not enough cash flow to cover debt
service.

• Typically a lender will require a debt service coverage ratio higher than 1.0x
in order to provide a cushion in case something goes wrong.
DEBT MANAGEMENT RATIOS
COMMON-SIZE
ANALYSIS
 COMMON-SIZE INCOME STATEMENT
• A vertical common-size income statement expresses each category of the
income statement as a percentage of revenue.
• The common-size format standardizes the income statement by
eliminating the effects of size.
• It allows for comparison of income statement items over time (time- series
analysis) and across firms (cross-sectional analysis).

Usefulness:
• Common-size analysis can also be used to examine a firm's strategy.
• Tax expense is more meaningful when expressed as a percentage of pre-
tax income. The result is known as the effective tax rate.
 COMMON-SIZE INCOME STATEMENT
Example:
2006 2006 2007 2007
$ % $ %
Total revenue 400,000 100.00 500,000 100.00
Cost of goods sold (320,000) 80.00 (380,000) 76.00
Gross profit 80,000 20.00 120,000 24.00
Operating expenses
General expenses (28,000) 7.00 (29,000) 5.80
Depreciation (8,000) 2.00 (12,000) 2.40
Operating income 44,000 11.00 79,000 15.8
Interest income 3,000 0.75 2,000 0.40
Interest expense (400) 0.10 (1,800) 0.36
Other losses (1,800) 0.45 (4,200) 0.84
Income before income taxes 44,800 11.20 75,000 15.00
Provision for income taxes (16,000) 35.71 (21,000) 28.00
Net income 28,800 7.20 54,000 10.80
 COMMON-SIZE INCOME STATEMENT
Interpretation:

• Cost of goods sold has decreased from 80% to 76% of sales, so the gross
margin has increased.

• General expenses decreased from 7% to 6% of sales.

• The net profit margin has increased significantly from 7% to 11%.

• This implies that management is effectively controlling costs in order to

boost profitability.
 COMMON-SIZE BALANCE SHEET
• A vertical common-size balance sheet expresses each item of the balance
sheet as a percentage of total assets.

• The common-size format standardizes the balance sheet by eliminating the

effects of size.

• This allows for comparison over time (time-series analysis) and across
firms (cross-sectional analysis).
 BALANCE SHEET
Company A Company B
(’000) (’000)
ASSETS
Current assets
Cash and cash equivalents 400 3,000
Short-term marketable securities 200 1,300
Accounts receivable 500 1,000
Inventory 100 300 .
Total current assets 1,200 5,600
Property, plant, and equipment, net 2,050 2,650
Intangible assets 500 — .
Goodwill — 1,000
Total assets 3,750 9,250
 COMMON-SIZE BALANCE SHEET
ASSETS
Current assets
Cash and cash equivalents 10.7% 32.4%
Short-term marketable securities 5.3% 14.1%
Accounts receivable 13.3% 10.8%
Inventory 2.7% 3.2%
Total current assets 32.0% 60.5%
Property, plant, and equipment, net 54.7% 28.6%
Intangible assets 13.3% 0.0%
Goodwill 0.0% 10.8%
Total Assets 100.0% 100.0%
 COMMON-SIZE BALANCE SHEET
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities
Accounts payable 800 600
Total current liabilities 800 600
Long-term bonds payable 10 8,500
Total liabilities 810 9,100
Total shareholders’ equity 2,940 150
Total liabilities and shareholders’ equity 3,750 9,250

LIABILITIES AND SHAREHOLDERS’ EQUITY

Current liabilities
Accounts payable 21.3% 6.5%
Total current liabilities 21.3% 6.5%
Long-term bonds payable 0.3% 91.9%
Total liabilities 21.6% 98.4%
Total shareholders’ equity 78.4% 1.6%
Total Liabilities and Shareholders’ Equity 100.0% 100.0%
“The word accounting comes from the
word accountability. If you are going to
be rich, you need to be accountable for
your money.”