Financial Analysis

Financial Statements

Balance Sheet

A balance sheet mirrors the financial position of a firm on a particular date in terms of the structure of assets, liabilities and owners equity, and so on.

Balance Sheet
Liabilities & Owners Equity Long-Term Liabilities
Long term Debt (Term Loans) Debentures

Assets Fixed Assets

Land Plant & Equipment less: depreciation

Owners Equity
Common Stock Retained Earnings Reserves & Surplus

Current Assets
Cash Marketable Securities Accounts Receivable/ Debtors Inventories

Current Liabilities
Accounts Payable/ Creditors Notes Payable Trade Advance

The profit and loss account or the income statement shows the results of operations during a certain period of time in terms of the revenues obtained and the cost incurred during the year.

REVENUE - Cost of Goods Sold

Income Statement

GROSS PROFIT
- Operating Expenses NET OPERATING INCOME (NOI ) or EARNINGS BEFORE INTEREST & TAXES (EBIT) - Interest Expense - Income Taxes NET INCOME - Dividends on Preferred Stock - Dividends on Common Stock RETAINED EARNINGS

We will want to answer questions about the firms

Are

the profits adequate? Are the assets being used efficiently? Is the firm solvent? Can the firm meet its current obligations?

Financial Statement Analysis

The

analysis of financial statements is a process of evaluating the relationships between component parts of financial statements to obtain a better understanding of the firms position and performance.

Financial Ratios
Tools

that help us determine the financial health of a company. We can compare a companys financial ratios with its ratios in previous years (trend analysis). We can compare a companys financial ratios with those of its industry.

Liquidity Ratios : Liquidity ratio measures the ability of the firm to meet its current obligations (liabilities). Turnover or Activity Ratios : shows the efficiency with which the firms manages and utilises its assets.

Funds of creditors and owners are invested in various assets to generate sales and profits. The better the management of assets, the larger the amount of sales. These ratios are also called turnover ratios because they indicate the speed with which assets are being converted or turned over into sales.

Leverage Ratios : debt-paying ability.

Profitability Ratios : Profit is difference between revenues and expenses over a period of time.

Liquidity Ratio

Liquidity ratio measures the ability of the firm to meet its current obligations (liabilities).

Current ratio Quick ratio Cash ratio Interval measures

Current ratio
Current ratio= current assets/current liabilities Current assets include cash and those assets that can be converted into cash within a year, such as marketable securities, debtors and inventories. All obligations maturing within a year are included in current liabilities. Like creditors, bills payable, short term bank loan, income tax liability and long term debt maturing in the current year.

Quick ratio
Quick ratio, also called acid test ratio, establishes a relationship between quick, or liquid assets and current liabilities. An assets is liquid if it can be converted into into cash immediately or reasonably soon without a loss of value. Cash is the most liquid assets. Quick ratio= current assets-inventories/ current liabilities

Cash ratio

Since cash is the most liquid assets, a financial analyst may examine cash ratio and its equivalent to current liabilities.

Cash ratio= cash+ marketable securities/ current liabilities Marketable securities are also equivalent to cash ; therefore, they may be included in the computation of cash ratio.

Interval Measure
Interval measure assesses a firms ability to meet its regular cash expenses. Interval measure relates liquid assets to average daily operating cash outflows. The daily operating expenses will be equal to cost of goods sold plus selling, administrative and general expenses less depreciation divided by no. of days in a year. Interval measure= current assests-inventory/ average daily operating expenses

Leverage Ratios

The short-term creditors, like bankers and suppliers of raw material, are more concerned with the firms current debt-paying ability. On the other hand, long-term creditors, like debenture holders, financial institutions etc. are more concerned with the firms long term financial strength. In fact, a firm should have a strong short as well as long-term financial position. To judge the longterm financial position of the firm, financial leverage, or capital structure ratios are calculated. These ratios indicate mix of funds provided by owners and lenders. As a general rule, there should be an appropriate mix of debt and owners equity in financing the firms assets.

Debt ratio
Several debt ratios may be used to analyse the long-term solvency of a firm. The firm may be interested in knowing the proportion of the interest-bearing debt in the capital structure. Therefore, it may compute debt ratio Debt ratio=total debt/ capital employed or net assets. Total debt will include short and long term borrowings from financial institutions, debentures/bonds, deffered payment arrangements for buying capital equipments, bank borrowings, public deposits and any other interest-bearing loan. Capital employed will include total debt and Net worth.

Debt- Equity Ratio

Debt equity ratio is directly computed by dividing total debt by net worth.

D/E ratio = TD/NW

Coverage Ratios
Debt ratios described are static in nature, and fail to indicate the firms ability to meet interest (and other fixed charges) obligations. The interest coverage ratio or the times-interest-earned is used to test the firms debt-servicing capacity. The interest coverage ratio is computed by dividing earnings before interest and taxes (EBIT) by interst charges. Interest coverage= EBIT or EBITDA / interest

Activity Ratio

Activity ratios are employed to evaluate the efficiency with which the firms manages and utilises its assets. Funds of creditors and owners are invested in various assets to generate sales and profits. The better the management of assets, the larger the amount of sales. These ratios are also called turnover ratios because they indicate the speed with which assets are being converted or turned over into sales. Activity ratios show a relationship between sales and assets.

Inventory ratio
Inventory ratio indicates the efficiency of the firm in producing and selling its product. Inventory ratio=cost of good sold/ average inventory The manufacturing firms inventory consists of two more components: Raw material and work in process. We examine the efficiency with which the firm converts raw materials into work in process into finished goods. So it is necessary to know the levels of raw materials inventory and work in process inventory. The raw material should be related to materials consumed, and work in process to the cost of production.

Account Receivable Turnover or Debtor turnover

Debtors turnover=credit sales/ average debtors Total assets turnover= sales/ total assets

Working capital turnover: Net current assets turnover= sales/net current assets.

Profitability Ratios
Profit is difference between revenues and expenses over a period of time. Gross margin profit=sales cost of goods sold / sales.

Net profit margin= profit after tax / sales.

Operating expense ratio = operating expenses / sales. Earning per share= profit after tax / no. of share outstanding

Example: Cyber-Dragon Corporation

Cyber-Dragons Balance Sheet (Rs000)

Liabilities & Owners' Equity:
Accounts Payable Notes Payable Accrued taxes payable Other current liabilities Total Current Liabilities Long-term debt (bonds) Total Liabilities Common Stock Retained earnings Total stockholders' equity Total liabilities & equity 9,721 Cash 8,500 Marketable securities 3,200 Accounts Receivable 4,102 Inventories 25,523 Total Current Assets 22,000 Plant and Equipment 47,523 less accum deprec. 23,000 Net Plant & Equip. 11,367 Total Assets 34,367 81,890

Assets:
2,540 1,800 18,320 27,530 50,190 43,100 11,400 31,700 81,890

Cyber-Dragons Income Statement

Sales (all credit) Cost of Goods Sold Gross Profit Operating Expenses: Selling General & Administrative Total Operating Expenses Earnings before interest and taxes (EBIT) Interest charges: Interest on loan: Interest on bonds: Total Interest charges Earnings before taxes (EBT) Taxes 112,760 85,300 27,460 6,540 9,400 15,940 11,520 850 2,310 3,160 8,360 3,344

Net Income

5,016

Cyber-Dragon
Other Information

Dividends paid on common stock Earnings retained in the firm Shares outstanding (000) Market price per share Book value per share Earnings per share Dividends per share

2,800 2,216 1,300 20

Cyber-Dragon
Other Information

Dividends paid on common stock Earnings retained in the firm Shares outstanding (000) Market price per share Book value per share Earnings per share Dividends per share

2,800 2,216 1,300 20 26.44 3.86 2.15

1. Liquidity Ratios
Do

we have enough liquid assets to meet approaching obligations?

Liquidity
Measures the ability of the firm to meet its short-term liabilities as they come due

Net Working capital:

Current assets - Current liabilities company A Rs. 1,80,000 1,20,000 60,000 company B 30,000 10,000 20,000

Current assets Current Liabilities NWC

Current ratio:A higher current ratio indicates greater liquidity (2 : 1 considered satisfactory)
Current assets / Current liabilities
Company A Rs. 1,80,000 1,20,000 1.5 : 1 Company B 30,000 10,000 3:1

Current assets Current Liabilities CR

What is Cyber-Dragons Current Ratio?

50,190 25,523 = 1.97

What is CyberDragons Current Ratio?

50,190 25,523 = 1.97

If the average current ratio for the industry is 2.4, is this good or not? Higher the current ratio, the greater the ability of the firm to pay its bills.

Acid-Test (Quick) ratio: Quick Assets / Current Liabilities Quick assets = Current assets inventories
Quick ratio determines firms ability to pay off current liabilities without relying on the sale of inventories.

What is the firms Acid Test Ratio?

What is the firms Acid Test Ratio?

50,190 - 27,530 = 25,523 .89

What is the firms Acid Test Ratio?

50,190 - 27,530 = 25,523 .89

Suppose the industry average is .92. What does this tell us? It shows a firms ability to meet current liabilities with its most Liquid assets.

Activity ratios/ Turnover ratios

Measure how effectively the firms assets are being managed The efficiency with which the assets are used would be reflected in the speed and rapidity with which the assets are converted into cash.

Inventory turnover =

Cost of Goods Sold Average Inventory

Days in period (i.e.365) = Inventory holding period Inventory turnover

These ratios provide information on how well the firm manages its inventory. It indicates the number of times inventory is replaced during a year/ how quickly the inventory is sold

Receivable s/ / Debtors = turnover

Credit Sales Average receivable s

Days in period (i.e.365) = Debt collection period Receivables turnover

These ratios measures how rapidly debts are collected.

Payables turnover =

Credit Purchases Average Creditors

Days in period (i.e.365) = Creditors Payment period Payables turnover

These ratios provide information on the extent to which trade creditors are willing to wait for payment.

What is the firms Accounts Receivable Turnover?

112,760 18,320

= 6.16 times

What is the firms Accounts Receivable Turnover?

112,760 18,320

= 6.16 times

CyberDragon turns their A/R over 6.16 times per year. The industry average is 8.2 times. Is this efficient?

What is the firms Average Collection Period?

18,320 112,760 / 365

= 59.3 days

What is the firms Average Collection Period?

18,320 112,760 / 365

= 59.3 days

If the industry average is 47 days, what does this tell us?

What is the firms Inventory Turnover?

85,300 27,530

= 3.10 times

What is the firms Inventory Turnover?

85,300 27,530

= 3.10 times

CyberDragon turns their inventory over 3.1 times per year. The industry average is 3.9 times. Is this efficient?

Low inventory turnover:

The firm may have too much inventory, which is expensive because:
Inventory

takes up costly warehouse

space.
Some

items may become spoiled or obsolete.

Exercise

The following data relate to Satyam and Co:

Rupees in Millions
Cash & Marketable Securities Fixed Assets Sales Net Income (100% Retained earnings) Common Equity Quick Ratio Current Ratio Average Collection Period 100.00 283.50 1000.00 50.00 366.667 2.0 times 3.0 times 40 days

Prepare the Balance Sheet of the Company. Assume 360 days in a year. The company has no preferred stock only common equity, current liabilities and long-term debt.

Solution

Average Collection Period = 360/ Accounts Receivable Turnover (ART) ART = 360/40 = 9 Accounts receivables = Credit Sales/ ART = 1000/9 = 111.11 million Quick Ratio = Quick Assets/ CL = (100 + 111.11)/CL 2 = 211.11/CL CL = 105.55 millions Current Ratio = Current Assets/ CL CA = 3*105.55 = 316.665 millions Inventory = CA QA = 316.665-211.11 = 105.55 millions Total Assets = FA + CA = 283.50 +316.665 = 600.165 millions Long Term Debt = 600.165 common Equity Retained Earnings CL = 600.165 366.667 50 105.55 = 77.943 millions

Solution - Balance Sheet

Owners Equity and Liabilities
Common Equity Retained Earnings Long Term Debt CL 366.67 50 77.943 105.55

Assets (in Rs. Millions)

Fixed Assets Inventory Debtors Cash and Sec 283.50 105.55 111.11 100.00

Total

600.165

Total

600.165

Total asset turnover =

sales Average total assets

Capital Turnover = Sales/ Capital Employed Capital includes (Owners equity + R&S + Long-term liabilities) Fixed Assets Turnover = Sales/ Fixed Assets

Measures the efficiency of a firm in managing and utilizing its assets. Higher is the ratio more efficient is the utilization, whereas a low ratio indicates underutilization of available resources and presence of idle capacity.

What is the firms Fixed Asset Turnover?

112,760 31,700 = 3.56 times

What is the firms Fixed Asset Turnover?

85,300 31,700 = 2.69 times

If the industry average is 3.7 times, what does this tell us about CyberDragon?

What is their Total Asset Turnover?

112,760 81,890

= 1.38 times

What is their Total Asset Turnover?

85,300 81,890

= 1.04 times

The industry average is 2.1 times. The firm needs to figure out how to squeeze more sales Rs. out of its assets.

Leverage Ratios (financing decisions)

Measure

the impact of using debt capital to finance assets. Firms use debt to lever (increase) returns on common equity.

How does Leverage work?

Suppose

we have an all equityfinanced firm worth Rs.100,000. Its earnings this year total Rs.15,000.

15,000
ROE =

100,000

= 15%

How does Leverage work?

Suppose

the same Rs.100,000 firm is financed with half equity and half 8% debt (bonds). Earnings are still Rs.15,000. 15,000 - 4,000 = 22%

ROE =

50,000

Debt / equity ratio:

Total Liabilities / Total Owners Equity Long-term Debt/ Total Owners Equity

Indicates the margin of safety to the creditors

Depends on type of industry.

Financial Leverage

Measure the extent to which a firm relies on debt financing . Debt ratio:
Debt / Total Assets OR Total liabilities / Total liabilities and owners equity

Interest/ Debt Coverage ratio:

Earnings before interest and taxes / Interest expense

Interest coverage ratio is directly connected to the firms ability to pay interest.

What is Cyber-Dragons Debt Ratio?

What is Cyber-Dragons Debt Ratio? 47,523 81,890 = 58%

What is Cyber-Dragons Debt Ratio? 47,523 81,890 = 58%

If the industry average is 47%, what does this tell us?

What is the firms Times Interest Earned Ratio?

What is the firms Times Interest Earned Ratio?

11,520 3,160
= 3.65 times

What is the firms Times Interest Earned Ratio?

11,520 3,160
= 3.65 times

The industry average is 6.7 times. This is further evidence that the firm uses more debt financing than average.

Profitability

Earnings per share:

Net income available to common stockholders / number of shares of common stock outstanding

Dividend payout ratio:

Annual dividend per share / earnings per share
Shows percentage of profits paid out as dividend to equity shareholders

Preferred dividend coverage ratio:

Net income / preferred dividend requirement

Profitability

Return on assets:
Net income / average investment (total assets)

Return on equity:
Net income / average owners equity
(PAT Pref. Dividend)/ Net Worth

Gross Profit ratio: Gross Profit/ Sales *100

High ratio means cost of production is less. It indicates good management as it indicates higher sales price without a increase in cost of goods sold.

Price/earning ratio:
Market price of common stock / earning per share

P/E ratio shows how much investors are willing to pay for Rs. 1 of Earnings Per Share.

It also reflects investors views of the growth potential

of different sectors.

Conclusion:

Even

though Cyber-Dragon has higher leverage than the industry average, they are much less efficient, and therefore, less profitable.

Example
From the following details, prepare the balance sheet of ABC Ltd: Capital turnover ratio 2 Fixed assets turnover ratio 4 Gross profit 20% Debt collection period 2 months Creditors payment period 73 days Stock Turnover 6 The gross profit was Rs 60,000. closing stock was Rs.5,000 in excess of the opening stock.

Gross Profit Ratio = Gross Profit/ Sales *100 20 = 60000/Sales *100 Sales = 3,00,000 Cost of goods Sold = Sales Gross profit = 2,40,000 Stock Turnover = Cost of goods Sold/ Average Stock 6 = 2,40,000/Average Stock Average Stock = 40,000 (Closing Stock + Opening Stock)/2 = 40,000 Given, Closing Stock Opening Stock = 5,000 Solving, Opening Stock = 37,500 Closing Stock = 42,500

Capital Turnover ratio = Cost of goods sold/ Capital 2 = 2,40,000/ Capital Capital = 1,20,000 Fixed Assets Turnover = Cost of goods Sold/ Fixed Assets 4 = 2,40,000/Fixed Assets Fixed Assets = 60,000 Debtors Turnover = 12/Debt collection Period = 6 Debtors Turnover = Credit Sales/ Average Debtors Debtors = 3,00,000/ 6 = 50,000 Creditors Turnover = 365/ Creditors Payment Period = 5

Cost of Goods Sold = Opening Stock + Purchases Closing Stock Purchases = 2,45,000 Creditors Turnover = Credit Purchase/ Creditors 5 = 2,45,000/Creditors Creditors = 49,000
Liabilities Assets Closing Stock 42,500

Capital

1,20,000

Creditors

49,000

Debtors
Fixed Assets Cash (balancing Figure)

50,000
60,000 16,500 1,69,000

1,69,000