Analyzing the Financial Statements

FINANCIAL STATEMENT ANALYSIS

Basic Caveats
Focus of analysis depends upon the purpose in hand Analysis depends upon data availability Analysis of an entity for a period may not be adequate Inter-period comparison

Inter-firm comparison
Flexible No fixed formats / formula

Purpose of Analysis
Financial statement analysis helps users make better decisions.

Internal Users Managers Officers Internal Auditors

External Users Shareholders Lenders Customers

Performance Analysis: Four window approach

Liquidity

Efficiency Shareholders value

Profitability

Leverage
The four factors are interdependent. The overall performance of a Firm is a function of these four factors. They have a multiplier impact on the overall performance.

Purpose of Analysis
Financial measures are often used to rank corporate performance. Example measures include:
Growth in sales Return to stockholders Profit margins Return on equity

Determined by analyzing the financial statements.

Tools of Analysis
Horizontal analysis

Vertical analysis Trend analysis Ratio analysis

Horizontal Analysis
Financial Statements present comparative information for at least 2 years Horizontal Analysis calculates the amount & percentage changes from the previous year to the current year.

Vertical Analysis/Common Size Statements

Expressing various components of the financial statements as a percentage of a common denominator. Balance sheet Percentage of total of the balance sheet Profit and loss a/c Percentage of sales

Helps is understanding the relative importance of different components.

Change in weight over a period of time.

Trend Analysis

Trend analysis is used to reveal patterns in data covering successive periods.

Trend Analysis Period Amount = Percent Base Period Amount

100%

Trend Analysis
Berry Products Income Information For the Years Ended December 31,

Item Revenues Cost of sales Gross profit

2005 $ 400,000 285,000 115,000

2004 $ 355,000 250,000 105,000

2003 $ 320,000 225,000 95,000

2002 $ 290,000 198,000 92,000

2001 $ 275,000 190,000 85,000

Item Revenues Cost of sales Gross profit

2005 2004 2003 2002 2001 is the base period so 105% its 145% 129% 116% 150% 132% 118% 104% amounts will equal 100%. 135% 124% 112% 108%

2001 100% 100% 100%

(290,000 275,000) (198,000 190,000) (92,000 85,000)

100% = 105% 100% = 104% 100% = 108%

Trend Analysis/Indexed Financial Statements Expressing various components of the

balance sheet, and profit and loss a/c as a percentage of the base year.

Helps is understanding the growth/ trend of

different items in the financial statements

over a period of time.

Ratio Analysis Expressing one item of financial statement in relation to another

Profit and loss a/c ratios: Relating different numbers of profit and loss a/c Balance sheet a/c ratios: Relating different numbers of balance sheet Cross ratios: Relating a number of profit and loss a/c with a number of balance sheets.

Types of Ratios
Depending upon focus of analysis Profitability ratio

Growth
Dividend policy Asset utilization / Efficiency Liquidity Capital structure

Return
Market related

Profitability Ratios
Ratios Expressed as Comments

Gross margin ratio Gross profit / Sales Cash operating margin EBITDA / Total income Operating margin EBIT/ Total income Net margin PAT/ Total income Earnings per share PAT / Number of shares

Higher the margin, better it is. Compare with the industry average and trend over a period of time. Higher the margin, better it is. Compare with the industry average and trend over a period of time.

Higher the margin, better it is. Compare with the industry average and trend over a period of time. Higher the EPS, better it is. Compare the trend over a period of time.

Growth Ratio Compound Annual Growth Rate (CAGR)

Find the value of g using the following expression
A = P (1+g)^n

Where, A is current years number P is base years number n is number of years. CAGR can be calculated for various parameters

Growth Ratio

Year-on-year growth
(Current year Previous year) / Previous year Can be calculated for sales, income, different measures of profit Expressed as percentage.

Dividend Policy

Ratio

Expressed as

Comments

Dividend payout ratio (Dividend + Dividend tax) / PAT

Rtention ratio 1 D/P ratio

Dividend yield Dividend per share/ Current market price

As dividend attracts dividend distribution tax, the same is also considered a part of the payout. What % of profits after tax is being distributed? Growing companies have a lower payout. What % of profits after tax is being retained. Growing companies have a higher retention. Return to the shareholder by way of dividend on the current market price.

Liquidity Ratios
Ratio Expressed as Comments

Current ratio Current assets / Current liabilities and provisions

Times

Short term investments should also be included in the current assets 2:1 considered adequate; higher ratio indicates blockage of funds in unproductive assets, whereas low ratio indicated inability of companys current assets to cover its current liabilities.

Quick ratio (Current ratio Inventories) / Current liabilities and provisions

Times

Inventories are less liquid; Also called liquid ratio or acid test ratio 1 : 1 considered adequate; higher ratio indicates blockage of funds in unproductive assets.

Capital Structure Ratios

Ratios Debt equity ratio Borrowed funds / Shareholders funds Expressed as Times Comments Only long tern debts to be considered 2: 1 considered adequate; Higher ratio implies higher financial leverage; inability of the firm to meet its long term commitments attached with debt. Lower ratio means that the company is not taking advantage of financial leverage. Higher ratio implies higher financial leverage. Ability of the firms operating profits to cover its interest obligation. Higher the ratio better it is. Compare with the industry average and trend over a period of time. Often used by the banks and financial institution to ascertain the adequacy of the firms cash flows to cover its debt obligationinterest as well as principal.

Financial leverage ratio Total assets / Shareholders funds Interest coverage ratio EBIT / Interest and finance charges

Times Times

Cash flow coverage ratio (EBIT + Depreciation) / [Interest + Loan repayment/ (1-Tax Rate)]

Times

Assets Utilization Ratio

Ratios
Total assets turnover ratio Total income / Total assets

Expressed as
Times

Comments
May use average assets in the denominators i.e. (Opening + Closing)/2 Indicator of efficiency in utilization of assets, higher turnover means higher ability to generate revenue for the same set of assets.
May use average assets in the denominators i.e., (Opening + Closing)/2. Working capital means current assets less current liabilities Indicator of efficiency in utilization of working capital , higher turnover means higher ability to generate revenue for the same set of working capital.

Fixed assets turnover ratio Total income / Fixed assets Working capital turnover ratio Total income / Working capital

Times Times

Assets Utilization Ratio

Ratio Debtors turnover ratio Credit sales / Debtors Expressed as Times Comments If credit sales figure is not separately available, use the total sales figure. Indicator of efficiency in debt collection, higher turnover means better debt collection. If cost of goods sold is not available, use the total sales figure. Indicator of efficiency in managing inventories, higher turnover means better inventory management. Also called days sales outstanding. Can be calculated as Debtors / Average daily sales. Average daily sales = Total sales / Number of days in the accounting period. Can also be calculated as: Inventories / Average daily consumption or Average daily sales.

Inventory turnover ratio Cost of goods sold / Inventories

Times

Average collection period 365 / Debtors turnover ratio

Number of days

Average holding period 365 / Inventory turnover ratio Average payment period 365 x Creditors / Purchases

Number of days

Number of days

Return Ratios
Ratios Return on assets EBIT (1-Tax rate) / Total assets Expressed as % Comments EBIT (1-Tax rate) is also called the Net Operating Profit After Tax (NOPAT). Can also be calculated as PAT/ Total assets ability of the firm, to generate return on the total assets. Higher the better. Compare with industry average and past trends. Can also be calculated as PAT/ Capital employed ability of the firm, to generate return on the capital employed. Higher the better. Compare with industry average and past trends. Shareholders funds include reserve and surplus. Any accumulated losses and fictitious assets should be deducted Ability of the firm to generate return on the shareholders funds. Higher the better. Compare with industry average and past trends.

Return on Capital Employed (ROCE) % EBIT (1-Tax rate) / (Borrowed funds + Shareholders funds) Return on equity PAT / Shareholders funds %

Dupont Analysis
Ratios Expressed as Return on equityDuPont % analysis (PAT/Sales) x (Sales/Assets ) x (Assets/Shareholders funds) = Net margin x Assets turnover x Financial leverage Comments Helps in breaking down the ROE into profitability, assets utilization and financial leverage.

Market Ratios
Ratios Price earning multiple (times) Current market price / EPS Price earnings to growth ratio Price earnings ratio / Growth rate Book value per share Shareholders funds / Number of shares Expressed as Times Comments Inverse of earning yields (EPS/CMP) High growth firms/ industries normally have a higher P/E multiple PEG ratio of 1 is considered as fair price Shareholders funds include reserve and surplus. Any accumulated losses and fictitious assets should be deducted. Not much meaningful as based upon historical cost of the assets and does not consider the earning capacity of the assets.

Time `

Price to book value ratio Times Current Market Price / Book Value per Share Market capitalization ` No. of shares x Current market price

Total market value of all the shares issued by the firm higher market capitalization acts as a safeguard against hostile takeover