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## Ratio Analysis

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**Objective of a Business**• Create value for its shareholders while maintaining a sound financial position. • Return on investment. • Sound financial position. • Other important objectives include: • Employee satisfaction. • Social responsibility. • Ethical considerations.**Annual Reports**Functions performed by a public company’s annual report: 1. Regulatory • provision of financial statements • declarations of accounting policies • provision of directors’ and auditor’s reports 2. Public relations based - enables public to view and understand the primary operations of the company. 3. Decision making - information contained in annual reports helps make performance, investment and credit-related decisions.**Profit and Loss Statement**Shows how profitable a firm has been over the past year. Includes: • revenues - sales, interest and dividends received • expenses • operating profit • abnormal items • income tax • extraordinary items**Balance Sheet**Provides a summary of the assets, liabilities and shareholders’ equity of the company on a nominated balance date. Includes: • assets - current and non-current • liabilities - current and non-current • shareholders’ equity - share capital, reserves, retained profits**Statement of Cash Flows**Represents a sources and uses of funds statement. Includes: • cash flows from operating activities • cash flows from investing activities • cash flows from financing activities**Need for Financial Statement Analysis**Comparison ????**Financial Statement Analysis Tools**• Trend % • Common Size • Ratio Analysis**Trend Percentages...**• are computed by selecting a base year whose amounts are set equal to 100%. • The amounts of each following year are expressed as a percentage of the base amount. Trend % = Any year Rs. ÷ Base year Rs.**Year 2012 2011 2010**Revenues Rs.27,611 Rs.24,215 Rs.21,718 Cost of sales 15,318 14,709 13,049 Gross profit Rs.12,293 Rs. 9,506 Rs. 8,669 2010 is the base year. Trend Percentages What are the trend percentages?**Year 2012 2011 2010**Revenues 127% 111% 100% Cost of sales 117% 113% 100% Gross profit 142% 110% 100% Trend Percentages These percentages were calculated by dividing each item by the base year.**Common Size**• compares each item in a financial statement to a base number set to 100%. • Every item on the financial statement is then reported as a percentage of that base.**Common Size**2012 % Revenues Rs.38,303 100.0 Cost of sales 19,688 51.4 Gross profit Rs.18,615 48.6 Total operating expenses 13,209 34.5 Operating income Rs. 5,406 14.1 Other income 2,187 5.7 Income before taxes Rs. 7,593 19.8 Income taxes 2,827 7.4 Net income Rs. 4,766 12.4**Common Size**Assets 2012 % Current assets: Cash Rs. 1,816 4.7 Receivables net 10,438 26.9 Inventories 6,151 15.9 Prepaid expenses 3,526 9.1 Total current assets Rs.21,931 56.6 Plant and equipment, net 6,847 17.7 Other assets 9,997 25.7 Total assets Rs.38,775 100.0**Ratios**• Financial analysis using ratios is useful to investors because the ratios capture critical dimensions of the economic performance of the company. • Managers use ratios to guide, measure, and reward workers. • Often companies base employee bonuses on a specific financial ratio or a combination of some other performance measure and a financial ratio.**Ratios- a double edged weapon**• Ratios mean different things to different groups. • A creditor might think that a high current ratio is good because it means that the company has the cash to pay the debt. • However, a manager might think that a high current ratio is undesirable because it could mean that the company is carrying too much inventory or is allowing its receivables to get too high.**Cont…**• GAAP does not define ratios. • Multiple equally valid approaches to ratios and analysis. • Managers (e.g., division manager, sales manager) should be measured to items that they control. • Investors and top management are most interested in overall performance or broadest measures of performance. • Understanding less broad measures of performance may give additional insight into overall performance.**Structure of analysis**• From broadest to more specific levels. • Principal value of financial analysis: • Suggests questions not answers. • Ratio comparisons start with the supposition that all other things are equal. (They rarely are.)**Evaluating Financial Ratios**• Financial ratios are evaluated using three types of comparisons. • Benchmarks - general rules of thumb specifying appropriate levels for financial ratios • Time-series comparisons - comparisons of a company’s financial ratios with its own historical ratios • Cross-sectional comparisons - comparisons of a company’s financial ratios with the ratios of other companies or with industry averages**Evaluating Financial Ratios- Benchmarks**• Experience. A feel for what is right or reasonable. • Budget. A target developed within the company. Factors to be considered: • How carefully was budget constructed? • What circumstances are different now? • Historical standards. Prior period’s results adjusted for changes in accounting methods. • External benchmarks. Competitor, industry average**Ratio Standards of Comparison-Cross-Sectional standards**• Cross-Sectional standards • Compare a firm’s financial ratios to other firms or industry average • Industry averages are published by companies such as • Moody’s • Standard & Poor’s • Fitchs • Deshaw • Copal Partners • And Lot of Indian Firms Like MotilalOswal, India Bulls etc. • Can reveal a firm’s strengths/weaknesses compared to other firms**Ratio Standards of Comparison- Time-series comparisons**• Time-Series standards • Compare a firm to its own ratios from other years • Helps highlight trends/changes that have occurred**Category of Financial Ratios**• Leverage ratios • Measure extent to which firm has been financed by creditors • liquidity ratio • Measure firm’s ability to meet short-term obligations • Profitability ratios • Measures productivity of money invested in firm • Turnover ratios • Measure rate of activity • Per share data • Examines items that affect common stock’s market price per share • Growth ratios • Measures contribution of various items to firm’s development • Risk analysis ratios • Measures variability**Making comparisons**• Finding the appropriate standard is difficult. • A high ratio (e.g., current ratio, ROI) may be good or bad. It can’t be viewed in isolation. • Is a high CR good or bad? • Is a high ROI always good? • Values of ratios compared across time trend analysis.**Leverage Ratios**Show how heavily the company is in debt.**Liquidity Ratios**Measure how easily the firm can obtain cash to pay its debts as they fall due.**Activity Ratios**Measure how different asset groups contribute to overall profitability.**Profitability Ratios**Used to judge how efficiently the firm is using its assets.**Profitability Ratios**Sh. Equity= E S Capital + reserves Net worth is E.S. Capital + P.S. Capital + Reserves and Surplus The others in this category may be ROA and ROCE**Market Value Ratios**Show how the firm is valued by investors.**Price/Earnings (PE) ratio**• Measure of overall performance. • Market price is not controlled by company; reflects all information available to the market. • Reflects how investors judge the future performance or prospects of the company. • Commonly compared to other companies in the same industry.**DuPont Identity**• The DuPont Identity is essentially just an expanded version of ROE. It is used to compare two companies’ profitability, efficiency, and leverage. • Net Income X Sales X Assets • Sales Assets Equity • By breaking down ROE into these three things, it allows you to determine exactly why one company has a better ROE than another. • While this isn’t “Security Valuation” it can prove to be a very important metric.**ROE**Return on Assets (Profitability) Financial leverage Liquidity Net profit Margin Asset turnover Solvency Sales Total assets Sales / Net income / Current assets Noncurrentassets Sales Total cost — + Cash Land Cost of goods sold Acc. Receivables Building SG&A Inventory Equipment R&D Intangibles Other Interest expense Others Income taxes**Growth measures**• Key accounting items for which growth is computed: sales, net income, earnings per share. • Average growth = (growth per year for n years)/n • Compound growth rate = based on present value concepts. • May be misleading due to abnormally high or low beginning or ending year.**Implied growth rate**=Return on shareholders’ equity X Profit retention rate = ROE X (1 – Dividend payout) • Estimates potential to grow profits without an injection of new capital.**Analysis of Growth**• Common stock price appreciation depends on various factors • Growth financed internally depends on the amount of retained earnings • A corporation’s growth rate depends on the return on equity • Growth rate = RR x ROE • Substituting the three-part DuPont ROE equation, we obtain Shows that multiple factors influence growth—one factor can rise and another fall and growth can remain unchanged.**Credit Risk Analysis**• Procedure to determine the likelihood a customer will pay its bills. Consider the customer’s previous credit history, bank or trade references, financial statements, and any other information supplied by the customer or collected. • Credit agencies provide reports on the credit worthiness of a potential customer. • Financial ratio analysis can be used to help determine a customer’s ability to pay its bills.**Credit Risk Analysis**A technique used to develop a measurement of solvency, sometimes called a Z Score. Edward Altman developed a Z Score formula that was able to identify bankrupt firms approximately 95% of the time.**Credit Risk Analysis**Example - If the Altman Z Score cut off for a credit worthy business is 2.7 or higher, would we accept the following client?**Credit Risk Analysis**Example - If the Altman Z Score cut off for a credit worthy business is 2.7 or higher, would we accept the following client? A score above 2.7 indicates good credit.**Credit Risk Analysis**• Credit analysis is only worth while if the expected savings exceed the cost. • Don’t undertake a full credit analysis unless the order is big enough to justify it. • Undertake a full credit analysis for the doubtful orders only.**Economic Value Added**• The idea behind economic value added (EVA) is that a company must earn more than it must pay for capital if it is to increase in value. • Capital is considered both debt and equity. • The cost of capital in EVA is a weighted average of interest cost and the returns required by equity investors. • If a company has positive EVA, the company is adding value; if a company has negative EVA, the company is losing value and might be better off liquidating.**EVA**• EVA can also be defined as the difference between the net operating profit before interest, but after tax (NOPAT) and a capital charge based on the WACC multiplied by the IC: • EVA = NOPAT – (WACC x IC)**EVA**• EVA is calculated as follows: • EVA = (ROIC – WACC) x IC • where • ROIC = Return on invested capital • WACC = Weighted Average Cost of Capital • IC = Invested Capital (at the beginning of the year)**MVA**• The link between MVA, the cumulative measure, and EVA, which is an incremental measure, is that MVA is equal to the present value of all future EVA to be generated by the company. • MVA = present value of all future EVA