(Self Study) Financial Statement and Analysis (Part of Fundamental Analysis)

Financial Statements and
Analysis
S.B.Khatri - KUSOM 1
Financial Statements and
Cash Flow
Functions of Financial
Statements
Financial Statements:
Provide information to the owners &
creditors of a firm about the current
status and past performance
Provide a convenient way for owners &
creditors to set performance targets & to
impose restrictions of the managers of
the firm
Provide a convenient templates for
financial planning
Balance Sheet
Snapshot of firms accounting value at a particular date
Components of balance sheet
Current liabilities
Current assets
Net working capital
Fixed assets Long-term debt

( tangible )
( intangible ) Shareholders equity
Assets = Liability + stock holders Equity
Balance Sheet (continue)
A convenient means of organizing and

summarizing what a firm owns (its assets), what
a firm owes (its liabilities), and the difference
between the two (the firms equity) at a given
point of time.
Assets are listed in the order of accounting liquidity

Assets : Current or Fixed
Fixed Assets : Tangible or Intangible
Balance Sheet (continue)
Liabilities and equity are listed in the order in which

they must be repaid
Liabilities: Current or Long-Term
Long-Term Liabilities: Bond and Bondholders
Debt service is contracted payments of principle and

interest on debt
- put the firm in default if not paid
Accounting value (historical cost of assets) does not

reflect market value of assets
Many valuable assets do not appear in the balance sheet :

- good managementS.B.Khatri
practice, good reputation, etc. 6
- KUSOM
[Table 1] Balance Sheet of US Composite Corp. 19x2 and 19x1 ($million)
19X2 19X1
Assets
Current assets :
Cash and equivalents 140 107
Accounts receivable 294 270
Inventories 269 280
Other 58 50
Total current assets 761 707
Fixed assets :
Property, plant, equipment 1423 1274
Less accumulated depreciation -550 -460
Net property, plant, equipment 873 814
Intangible and other assets 245 221
Total fixed assets 1118 1035
Total assets 1879 1742
[Table 1] Balance Sheet (continue)
19X2 19X1
Liabilities and shareholders' equity
Current liabilities :
Accounts payable 213 197
Notes payable 50 53
Accrued expenses 223 205
Total current liabilities 486 455
Long-term liabilities :
Deferred taxes 117 104
Long-term debt 471 458
Total long-term liabilities 588 562
Stockholders equity :
Preferred stock 39 39
Common stock ($1 par value) 55 32
Capital surplus 347 327
Accumulated retained earnings 390 347
Less treasury stock -26 -20
Total equity 805 725
Total liabilities and shareholders' equity 1879 1742
Balance Sheet
Assets Liabilities & Owners Equity
Current Assets Current Liabilities

Cash Accounts Payable
Marketable Securities Notes Payable
Accounts Receivable Accrued Salaries
Inventories
Long-Term Liabilities
Fixed Assets Mortgage Debt
Land Debentures
Plant & Equipment
less: depreciation Owners Equity
Common Stock ($1 Par)
Addl Paid In Capital
Retained Earnings
Net Working Capital (NWC)
Difference between a firms current assets and its current
liabilities.
NWC is generally positive in a healthy firm
This means that the cash that will become available over the next
12 months exceeds the cash that must be paid over the same
period.
The structure of the assets of a particular firm reflects the line of

business that that firm is in and also managerial decisions about
how much cash and inventory to have and about credit policy,
fixed assets acquisition, and so on.
The liabilities side of the balance sheet reflects managerial
decisions about capital structure and the use of short-term debt.
Liquidity
Refers to the speed and ease with which an assets can be
converted to cash.
Liquidity has two dimensions:
Ease of conversion
Loss of value
A highly liquid asset is the one that can be quickly sold
without significant loss of value
An illiquid asset is one that cannot be quickly converted
to cash without a substantial price reduction.
Liquidity, is valuable. The more liquid a business is, the
less likely it is to experience financial distress.
Unfortunately, liquid assets are generally less profitable
to hold, eg Cash holdings.
There is therefore a trade-off between the advantages of
liquidity and foregoneS.B.Khatri
profits.
- KUSOM 11
Income Statement
Measures performance of the firm over a specific period
Accounting definition of income
Income = Revenue - Expenses
Revenue is recorded upon an exchange of goods or services not

counting unrealized appreciation of tangible assets. GAAP
Expenses include some non-cash items
- Depreciation - change in value of existing assets and allowances
for asset replacement or repair
- Deferred taxes - results from differences between accounting

income and taxable income
Income Statement (continue)
Costs are classified into
product costs
total production cost
raw material, labor, manufacturing overhead
reported as cost of goods sold
period costs
allocated to a time period, for example, salaries
reported as selling, general and administrative expenses
Do not distinguish between variable (long run) costs and
fixed (short run) costs
The distinction between fixed and variable
costs is important, at times, to the financial
manager, but the way costs are reported on
the income statement is not a good guide as
to which costs are which.
?
THE FIGURES SHOWN ON THE
INCOME STATEMENT MAY NOT BE
ALL REPRESENTATIVE OF THE
ACTUAL CASH INFLOWS AND
OUTFLOWS THAT OCCURRED
DURING A PARTICULAR PERIOD.
TRUE ? WHY ?
Accrual Principle, Matching Principle and Non-cash items

For the financial manager, the actual timing
of the cash inflows and outflows is critical
in coming up with a reasonable estimate of
market value
So we need to learn how to separate the

cash flows from the non-cash accounting
entries.
[Table 2] Income Statement of US Composite Corp. ($million)
19X2
Total operating revenues 2262
Costs of goods sold -1655
Selling, general and administrative expenses -327
Depreciation -90
Operating income 190
Other income 29
Earnings before interest and taxes (EBIT) 219
Interest expense -49
Pre-tax income 170
Taxes -84
(Current) 71
(Deferred) 13
Net income 86
(Retained earnings) 43
(Dividends) 43
REVENUE Income Statement
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses
NET OPERATING INCOME (NOI ) or
EARNINGS BEFORE INTEREST &
TAXES (EBIT)
- Interest Expense
- Income Taxes
NET INCOME
- Dividends on Common & Preferred Stock
RETAINED EARNINGS
Financial Cash Flow
Firm issues securities
Financial Markets
Firm Dividend & debt payments
short term debt

current assets
Retained long term debt
fixed assets
cash flow equity shares
Taxes
Total Government Total value of

firm to investors
value of in financial
assets markets
Financial Cash Flow (continue)
total cash flow = cash flow to debt + cash flow to equity
cash flow to debt = debt service costs - new debt
= ( interest + principle repaid ) - new debt
cash flow to equity = dividends + stock repurchased - new stock issues
Value created if total cash flow > money raised
Cash flow is not equal to working capital
working capital = current assets - current liabilities
- If you use cash to increase inventories, then

cash decreases but working capital increases
[Table 3] Financial Cash Flow of US Composite Corp. 19x2 ($million)
Cash flow of the firm

Operating cash flow 238
EBIT + depreciation - current taxes (219 + 90 -71)
Capital spending -173
acquisitions of fixed assets - sales of fixed assets (1118-1035+90)
Addition to net working capital (761-486)-(707-455) -23
Total 42
Cash flow to investors
Debt 36
interest + retirement of debt - new long term debt [49-(471-458)]
Equity 6
dividends + repurchase of stock - proceeds from new stock sales
[43-{(39-39)+(55-32)+(347-327)+(-26-(-20))}]
Total 42
Financial cash flow = cash flow
S.B.Khatri to debt + cash flow to equity
- KUSOM 21
[Table 4] Statement of Cash Flows of US Composite Corp. 19x2
Operating activities
Net income 86
Depreciation 90
Deferred taxes 13
Changes in assets and liabilities = - investment in current net assets 10
Total cash flow from operating activities 199
Investing activities
Acquisition of fixed assets -198
Sales of fixed assets 25
Total cash flow from investing activities -173
Financing activities
Retirement of debt -73
Preceeds from long term debt 86
Dividends -43
Repurchase of stock -6
Proceeds from new stock sales [(55-32)+(347-327)] 43
Total cash flow from financing activities 7
Change in cash (on the balance sheet) 33
Financial Cash Flow (continue)
Interest expense on income statement
= Total financial cash flow + Total cash flow from financing
activities
= 42 (Table 3) + 7 (Table 4)
= 49 (Table 2)
Net investment in current assets (-10)

= change in accounts receivable (24)
+ change in inventories (-11)
+ change in accounts payable (-16)
+ change in accrued expenses (-18)
+ change in notes payable (3)
+ change in other S.B.Khatri - KUSOM (8) 23
Cash Flow Statement
Cash collected from customers
- Cash paid to suppliers
- Operating Cash Outflows (marketing,
administrative and interest payments)
- Cash Tax Payments
+/- Cash Flow from Investments acquired or sold
+ Receipts from new stock issue
+ Increased borrowing
- Repayment of debt principal
- Common Stock Dividend Payments
Cash Flow GeneratedS.B.Khatri - KUSOM 24
Cash Flow Statement
- Cash Tax Payments
Cash Flow Statement
- Cash Tax Payments
Standardized Financial Statements
Common-Size Statements
Common Base Year Statements
Combined Common-Size and Base-year Analysis
Common-size Income Statements
A common-size income statement restates all
expenses as a percentage of sales
Tells us what happens to each dollar in

SALES.
This allows the analyst to quickly and easily

see which expenses have increased or
decreased relative to sales
Elvis Products International
Common-size Income Statement
For the Year Ended Dec. 31, 1997 ($ 000's)
1997% 1997 1996% 1996
Sales 100.00% 3900.00 100.00% 3500.00
Cost of Goods Sold 83.33% 3250.00 81.83% 2864.00
Gross Profit 16.67% 650.00 18.17% 636.00
Selling and G&A Expenses 8.47% 330.30 6.86% 240.00
Fixed Expenses 2.56% 100.00 2.86% 100.00
Depreciation Expense 0.51% 20.00 0.54% 18.90
EBIT 5.12% 199.70 7.92% 277.10
Interest Expense 1.95% 76.00 1.79% 62.50
Earnings Before Taxes 3.17% 123.70 6.13% 214.60
Taxes @ 40% 1.27% 49.48 2.45% 85.84
Net Income 1.90% 74.22 3.68% 128.76
Common-size Balance Sheets
A common-size balance sheet restates all
assets and liabilities as a percentage of total
assets
This allows the analyst to quickly and easily

see which accounts have increased or
decreased relative to total assets
Elvis Products International
Common-size Balance Sheet
As of Dec. 31, 1997 ($ 000's)
Assets 1997% 1997 1996% 1996
Cash and Equivalents 3.03% 50.00 3.92% 57.60
Accounts Receivable 24.35% 402.00 23.91% 351.20
Inventory 50.76% 838.00 48.69% 715.20
Total Current Assets 78.14% 1290.00 76.53% 1124.00
Plant & Equipment 31.92% 527.00 33.43% 491.00
Accumulated Depreciation 10.07% 166.20 9.95% 146.20
Net Fixed Assets 21.86% 360.80 23.47% 344.80
Total Assets 100.00% 1650.80 100.00% 1468.80
Liabilities and Owner's Equity
Accounts Payable 10.61% 175.20 9.91% 145.60
Short-term Notes Payable 13.63% 225.00 13.62% 200.00
Other Current Liabilities 8.48% 140.00 9.26% 136.00
Total Current Liabilities 32.72% 540.20 32.79% 481.60
Long-term Debt 25.72% 424.61 22.02% 323.43
Total Liabilities 58.45% 964.81 54.81% 805.03
Common Stock 27.87% 460.00 31.32% 460.00
Retained Earnings 13.69% 225.99 13.87% 203.77
Total Shareholder's Equity 41.55% 685.99 45.19% 663.77
Total Liabilities and Owner's Equity 100.00%
S.B.Khatri - KUSOM 1650.80 100.00% 1468.80
31
BALANCE SHEET
Horizontal Form
Liabilities + Equity Assets
Share capital Fixed assets
Reserves and surplus Investments
Secured loans Current assets, loans and
Unsecured loans advances
Current liabilities and provisions Miscellaneous expenditures
and losses
BALANCE SHEET
Vertical (or Report) Form
I. Sources of Funds
(1) Shareholders funds:
(a) Capital
(b) Reserves and Surplus
(2) Loan funds:
(a) Secured loans
(b) Unsecured loans
II. Application of funds
(1) Fixed assets
(2) Investments
(3) Current assets, loans and advances
Less: Current liabilities and provisions:
Net current assets
(4) Miscellaneous expenditures and losses
BALANCE SHEET OF HORIZON LIMITED AS ON
MARCH 31, 20 X 1
A. Account Form Rs.in million
Liabilities 20 x 1 20 x 0 Assets 20 x 1 20 x 0
Share capital 150 150 Fixed assets 330 322
Equity 150 Investments*** 15 15

Preference Current assets, loans
Reserves & surplus 112 106 and advances 234 156
Secured loans* 143 131 Miscellaneous
Unsecured loans** 69 25 expenditures and losses
Current liabilities
and provisions 105 81
579 493 579 493
* Rs. 35 million of secured loans are due within 1 year, the balance being due after 1 year.
** Rs.40 million of unsecured loans are due within 1 year, the balance being due after 1 year.
*** Rs.3 million out of Rs.15 million represent current investments.
BALANCE SHEET OF HORIZON LIMITED AS ON
MARCH 31, 20 X 1 Rs.in million
20 x 1 20 x 0
I. Sources of Funds
(1) Shareholders funds: 262 256
(a) Capital 150
(b) Reserves and surplus 112
(2) Loan funds: 212 156
(a) Secured loans 143
(b) Unsecured loans 69
474 412
II. Application of Funds
(1) Fixed assets 330 322
(2) Investments 15 15
(3) Current assets, loans and advances 234 156
Less: Current liabilities and provisions: 105 81

Net current assets 129 75
(4) Miscellaneous expenditures and losses
474 412
LIABILITIES
Share Capital
Reserves & Surplus
Secured Loans
Unsecured Loans
Current Liabilities and Provisions
ASSETS
Fixed Assets
Investments
Current Assets, Loans, & Advances
Miscellaneous Expenditure & Losses
PROFIT & LOSS ACCOUNT OF HORIZON LTD, FOR
THE YEAR ENDING ON MARCH 31, 20 X 1
(Rs.in million)
Income
Sales 701
Other income
701
Expenditure
Material and other expenditure 582
Interest 21
Depreciation 30
Provision for tax 34
Profit after tax 34
PROFIT & LOSS ACCOUNT OF HORIZON LTD, FOR
THE YEAR ENDING ON MARCH 31, 20 X 1
(Rs. in million)
20 x 1 20 x 0
Net sales 701 623
Cost of goods sold 552 475
Stocks 421
Wages and salaries 68
Other manufacturing expenses 63
Gross profit 149 148
Operating expenses 60 49
Depreciation 30
General administration 12
Selling 18
Operating profit 89 99
Other income (expense) 06
Profit before interest and tax 89 105
Interest 21 22
Profit before tax 68 83
Provision for tax 34 41
Profit after tax 34 42
PROFIT AND LOSS ACCOUNT ITEMS
Net Sales
Cost of Goods Sold
Gross Profit
Operating Expenses
Operating Profit
Non-operating Gains and Losses
Profit Before Interest and Taxes
Interest
Profit before Tax
Income Tax Provision
Profit After Tax
Prior Period Adjustments
Amount Available for Appropriation
Appropriations
Balance Carried Forward
NET CASH FLOW
Net cash Profit after Non cash Non cash

= +
flow tax revenues expenses
In practice, analysts use the following approximation:
Net cash Profit after + Depreciation + Amortisation

=
Flow tax
STATEMENT OF CASH FLOW
Sources of Cash
Increase in liabilities and owners equity
Decrease in assets (other than cash)
Uses of Cash
Decrease in liabilities and owners equity
Increase in assets (other than cash)
STATEMENT OF CASH FLOWS
Operating Cash inflows Cash outflows Cash flow

from operations = from operations
from operations
+
Cash inflows Cash outflows Cash flow
Investing from investing from investing = from investing
activities activities activities
+
Cash inflows Cash outflows Cash flow

Financing from financing from financing = from financing
activities activities activities
Net cash flow

for the period
SOURCES USES
FINANCING CAPITAL CAPITAL
OPERATING RES. & SURPLUS RES. & SURPLUS
FINANCING LOANS LOANS
OPERATING CURRENT LIABILITIES CURRENT LIABILITIES

& PROVISIONS & PROVISIONS
INVESTMENT FIXED ASSETS FIXED ASSETS
INVESTMENT INVESTMENTS INVESTMENTS
OPERATING INVENTORIES INVENTORIES
OPERATING DEBTORS DEBTORS

CASH FLOW STATEMENT FOR HORIZON LTD, FOR
THE PERIOD 1.4.20X0 TO 31.3.20X1
(Rs. in million)
(A) Cash Flow from Operating Activities
Net profit before tax and extraordinary items 68
Adjustments for
Interest paid 21
Depreciation 30
Operating profit before working capital changes 119
Adjustments
Debtors (46)
Inventories (33)
Advances 05
Trade credit 15
Advances 07
Provisions 02
Cash generated from operations 69
Income tax paid 34
Cash flow before extraordinary items 35
Extraordinary item
Net cash flow from operating activities 35
(Contd.)
(Contd.)
(Rs.in million)
(B) Cash Flow from Investing Activities
Purchase of fixed assets (38)
Net cash flow from investing activities (38)
(C) Cash Flow from Financing Activities
Proceeds from term loans 12
Proceeds from inter-corporate deposits 44
Interest paid (21)
Dividend paid (28)
Net cash flow from financing activities 07
(D) Net Increase in Cash and Cash Equivalents (A) + (B) + (C) 04
Cash and cash equivalents as on 1.04.20x0 06
Cash and cash equivalents as on 31.03.20x1 10
MANIPULATION OF THE BOTTOM LINE
1. INFLATE THE SALES FOR THE CURRENT YEAR BY ADVANCING THE SALES FROM THE
FOLLOWING YEAR
2. ALTER THE OTHER INCOME FIGURE BY PLAYING WITH NON-OPERATIONAL ITEMS
3. FIDDLE WITH THE METHOD & RATE OF DEPRN
4. DEFER CERTAIN DISCRETIONARY EXPENSES TO THE FOLLOWING YEAR.
5. MAKE INADEQUATE PROVISIONS . . LIABILITIES
6. MAKE EXTRA PROVISIONS . . PROSPEROUS PERIODS . . WRITE THEM BACK . . LEAN PERIODS
7. USE TOTALLY UNACCEPTABLE ACCOUNTING PRACTICES.
8. REVALUE ASSETS . . CREATE . . IMPRN . . RESERVES
9. LENGTHEN ACCOUNTING YEAR . . ATTEMPT COVER POOR PERFORMANCE.
WHY ? PROJECT IMAGE OF LOW RISK

PROMOTE PERCEPN . . COMPETENT MGT
INCREASE MGRL COMPENN
QUALITY PROMPTNESS
OF CANDOUR IN ANALYSING PAST PERFORMANCE
REPORTING MEANINGFUL DISCUSSION . . PROSPECTS
Financial Statement Analysis
Areour decisions maximizing

shareholder wealth?
Ratio Analysis
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
competitors and industry.
Financial Ratios
Financial ratios are the analysts microscope; they
allow us to get a better view of the firms financial
health than just looking at the raw financial
statements
Ratios are used by both internal and external
analysts
Internal uses
planning
evaluation of management
External uses
credit granting
performance monitoring
investment decisions
Questions to be answered
How is it computed ?
What is it intended to measure, and why
might we be interested ?
What is the unit of measurement ?
What might a high or low value be telling
us ? How might such values be misleading ?
How could this measure be improved ?
Categories of Financial Ratios
Financial ratios are often divided into

categories based on the information that
they provide:
Liquidity Ratios
Efficiency Ratios
Leverage Ratios
Coverage Ratios
Profitability Ratios
Market valuation Ratios
Example:
CyberDragon
Corporation
CyberDragons
Balance Sheet ($000)
Assets: Liabilities & Owners' Equity:
Cash $2,540 Accounts Payable 9,721
Marketable securities 1,800 Notes Payable 8,500
Accounts Receivable 18,320 Accrued taxes payable 3,200
Inventories 27,530 Other current liabilities 4,102
Total Current Assets 50,190 Total Current Liabilities 25,523
Plant and Equipment 43,100 Long-term debt (bonds) 22,000
less accum deprec. 11,400 Total Liabilities 47,523
Net Plant & Equip. 31,700 Common Stock ($10 par) 13,000
Total Assets 81,890 Paid in capital 10,000
Retained earnings 11,367
Total stockholders' equity 34,367
S.B.Khatri -Total
KUSOMliabilities & equity 81,890
54
Sales (all credit) $112,760
Cost of Goods Sold (85,300)
Gross Profit 31,500
Operating Expenses:
Selling (6,540)
General & Administrative (9,400)
Total Operating Expenses (15,940)
Earnings before interest and taxes (EBIT) 11,520
Interest charges:
Interest on bank notes: (850)
Interest on bonds: (2,310)
Total Interest charges (3,160)
Earnings before taxes (EBT) 8,600
Taxes (3,344)
Net Income S.B.Khatri - KUSOM 5,016
55
CyberDragon
Other Information
Dividends paid on common stock $2,800

Earnings retained in the firm 2,216
Shares outstanding (000) 1,300
Market price per share 20
Book value per share 26.44
Earnings per share 3.86
Dividends per share 2.15
1. Liquidity / Short Term
Solvency Ratios
Dowe have enough liquid assets
to meet approaching obligations?
Liquidity Ratios
Liquidity refers to the speed with which
an asset can be converted to cash
Liquidity ratios describe the ability of a firm
to meet its current obligations
There are three common liquidity ratios:
The Current Ratio
The Quick Ratio or Acid-Test Ratio
The Cash Ratio
NWC to Total Assets
Interval Measure
Who are interested with these ratios ?
Bill !! When are you

going to pay the
BILL ?
Short Term Creditors
The Current Ratio
Current Assets
CR
Current Liabilities
For EPI the current ratio in 1997 is:
1290
CR 2.39
540.20
What is CyberDragons Current
Ratio?
50,190
= 1.97
25,523
CyberDragon has $ 1.97 in current assets for
every $ 1 in credit, or,
Cyberdragon has its current liabilities covered
1.97 times over.
If the average current ratio for the

industry is 2.4, is this good or not?
What does it tell ?
Measure of Short-Term Liquidity.
It tells by how much multiple the current
liabilities of a firm is covered by current assets
of it.
For short-term creditor, higher the current
ratio, the better it is.
To the firm, high current ratio indicates
liquidity.
We would expect to see a current ratio of at
least 1.
Flip Side of it..
But, it also may indicate an inefficient use of
cash and other short-term assets.
If a firm borrows over the long term to raise
money ? How would it effect current ratio ?
Current Assets will increase and Current Liabilities
would not be affected.
Apparently low current ratio may not be a bad
sign for a company with a large reserve of
untapped borrowing power.
The Quick Ratio
Current Assets Inventories

QR
Current Liabilities
For EPI the quick ratio in 1997 is:
1290 838
QR 0.84
540.20
What is the CyberDragons Acid Test
Ratio?
50,190 - 27,530
= .89
25,523
Spose the industry average is .92

What does this tell us?
What does it tell ?
Relatively large inventories are often a sign
of short-term trouble.
Inventory is often the least liquid current
asset.
Its also the one for which the BV are least
reliable measures of MV.
WHY ?
Some of the inventory may later turn out to
be damaged, obsolete, lost.
Does using cash to buy inventory affect the
current ratio ?
NO
The Quick Ratio tells a somewhat different

story than the Current Ratio, because, inventory
accounts for more than half of Elvis and
CyberDragon.
The Cash Ratio
Cash
Cash Ratio
Current Liabilities
For EPI the cash ratio in 1997 is:
50
Cash Ratio 0.09256
540.20
How much cash is available to pay the liabilities ?

NWC to Total Assets
Current Assets - Current Liabilitie s
NWC to Total Assets
Total Assets
For EPI the NWC to Total Assets Ratio in 1997 is:
1290 540.20
NWC to Total Assets 0.45
1650.80
Higher value indicates higher liquidity

Interval Measure
Current Assets
Interval Measure
Average Daily Operating Cost
For EPI the NWC to Total Assets Ratio in 1997 is:
1290
Interval Measure 142 days
3250/360
Imagine that EPI was facing a strike and

cash inflows began to dry up. How long
could the business keep running ?
2. Efficiency Ratios or Assets
Management or Turnover Ratios
The efficiency ratios (A.K.A. assets utilization ratios)
describe how well a firm is using its investment in
various asset classes to generate sales.
Measure how efficiently the firms assets generate
operating profits.
Operating Income Return on Investment (OIROI)

= EBIT / Total Assets
Inventory Turnover Ratio
Accounts Receivable Turnover Ratio
Average Collection Period
Fixed Asset Turnover Ratio
Total Asset TurnoverS.B.Khatri
Ratio- KUSOM 71
HOW EFFICIENTLY MY ASSETS
ARE GENERATING SALES
What is the CyberDragons Operating Income
Return on Investment (OIROI)?
11,520
= 14.07%
81,890
Slightly below the industry average of 15%.
The OIROI reflects product pricing and

the firms ability to keep costs down.
The Inventory Turnover Ratio
Cost of Goods Sold

Inventory Turnover
Inventory
For EPI the inventory turnover ratio in 1997 is:
3250
Inventory Turnover 388
.
838
What is the CyberDragons Inventory
Turnover?
85,300
= 3.10 times
27,530
CyberDragon turns their inventory over 3.1
times per year. The industry average
is 3.9 times. Is this efficient?
Tells us by how many times did we turn over or sold

off the entire inventory
As long as we are not running out of stock and thereby
forgoing sales, the higher the ratio is, the more
efficiently we are managing inventory.
Low inventory turnover:
The firm may have too much inventory,

which is expensive because:
Inventorytakes up costly warehouse

space. (Holding Cost)
Some items may become spoiled or

obsolete. (Set-up or Ordering Cost)
Days Sales in Inventory
360 days
Day ' s sales in inventory
Inventory Turnover
For EPI the Days Sales in Inventory in 1997 is:
36 0
Days ' Sales in inventory 93 days
3.88
Inventory sits 93 days on average before it is
sold.
It will take about 93 days to work off our
inventory.
A variation of it
Average of Opening and Ending Inventory can be
used too.
It depends upon the purpose of the calculation.
If we are interested in how long will it take us to
sell our current inventory, then using ending figure
(as we did initially) is better.
It depends on whether we are worried about the
past, in which case average is appropriate, or the
future, in which case, ending figures might be better.
The A/R Turnover Ratio
Annual Credit Sales

A / R Turnover
Accounts Re ceivable
For EPI the accounts receivable turnover ratio in 1997 is:
3900
A / R Turnover 9.70
402
What is the CyberDragons Accounts
Receivable Turnover?
112,760
= 6.16 times
18,320
CyberDragon turns their A/R over 6.16
times per year. The industry average
is 8.2 times. Is this efficient?
Answers, how many times the firm collected its outstanding
credit accounts and re-loaned the money.
Higher the ratio, the better it is.
The Average Collection Period or
Days Sales in Receivables
Accounts Re ceivable
Average Collection Period
Annual Credit Sales 360
For EPI the average collection period in 1997 is:
402
Average Collection Period 37.11
3900 360
What is the firms Average Collection
Period?
18,320
= 59.3 days
112,760 / 365
If the industry average is 47 days, what
does this tell us?
Answer to : How many days does it take to the
firm to collect the credit on sales ? using avg
What worth of uncollected sales do we have
currently ? using ending fig
The Fixed Asset Turnover Ratio
Sales
Fixed Asset Turnover
Net Fixed Assets
For EPI the fixed asset turnover ratio in 1997 is:
3900
Fixed Asset Turnover 10.81
360.80
What is the CyberDragons Fixed
Asset Turnover?
112,760
= 3.56 times
31,700
If the industry average is 4.6 times, what
does this tell us about CyberDragon?
How much work we get out of our Fixed
Assets.
How efficiently are we using our Fixed Assets
to generate Sales ?
The Total Asset Turnover Ratio
Sales
Total Asset Turnover
Total Assets
For EPI the total asset turnover ratio in 1997 is:
3900
Total Asset Turnover 2.36
1650.80
What is their Total Asset Turnover?
112,760
= 1.38 times
81,890
The industry average is 1.82 times.
The firm needs to figure out how to squeeze

more sales dollars out of its assets.
Co A had a total asset turnover of 0.76
as compared to 1.00 of Co X of the
same industry.
However, Co As fixed assets turnover
is 0.89 while that of Co X is 1.99
What can you infer from this data ?

Co A has higher investment in fixed
assets than Co X
3. Leverage Ratios
(financing decisions)
Measure the impact of using
debt capital to finance assets.
Intended to address the firms
long-run ability to meet it
obligations.
Firms use debt to lever
(increase) returns on common
equity.
Also called long-term Solvency
Ratios S.B.Khatri - KUSOM 88
How does Leverage work?
Suppose we have an all equity-
financed firm worth $100,000. Its
earnings this year total $15,000.
15,000
ROE = = 15%
100,000
(ignore taxes for this example)

How does Leverage work?
Suppose the same $100,000 firm

is financed with half equity and
half 8% debt (bonds). Earnings
are still $15,000.
15,000 - 4,000
ROE = = 22%
50,000
Can leverage make the firm more
profitable?
Yes
Can leverage make the firm riskier?
Yes
Leverage Ratios
Leverage ratios describe the amount of debt

that the firm has used to finance its
investments in assets:
Total Debt Ratio
Long-term Debt Ratio
Debt to Equity
Long-term Debt to Equity
The Total Debt Ratio
Total Liabilities
Total Debt Ratio
Total Assets
For EPI the total debt ratio in 1997 is:
964.81
Total Debt Ratio 58.45%
1650.80
What is CyberDragons Debt
Ratio?
47,523
= 58%
81,890
If the industry average is 47%, what
does this tell us?
Takes into account all debts of all maturities to all
creditors.
CyberDragon has $ 0.58 debt for every $ 1 in assets.
Measures the extent to which borrowed funds support
the firms assets. S.B.Khatri - KUSOM 94
Whether this is high or low or
whether it even makes any
difference depends on whether or not
capital structure matters.
WE SHALL STUDY ABOUT IT IN
Cost of Capital and Long-Term

Financial Policy
The Long-term Debt Ratio
Long termDebt
Long termDebt Ratio
Total Assets
For EPI the long-term debt ratio in 1997 is:
424.61
Long termDebt Ratio 25.72%
1650.80
A Variation of Debt Ratio

The Debt to Equity Ratio
Total Liabilities
Debt to Equity
Total Equity
For EPI the debt to equity ratio in 1997 is:
964.81
Debt to Equity 141
.
685.99
Shows the relative contributions of creditors

and owners
In general, the lower the debt-equity ratio, the
higher the degree of protection enjoyed by the
creditors.
In using this ratio, however, the following points
should be borne in mind:
The book value of equity may be an understatement

of its true value in a period of rising prices.
Some forms of debts (like term loans, secured

debentures, and secured short-term bank borrowings)
are usually protected by charges on specific assets and
hence enjoy superior protection.
The Long-term Debt to Equity
Ratio
Long term Debt
LTD to Equity
Total Equity
For EPI the long-term debt to equity ratio in 1997 is:
424.61
LTD to Equity 6190%
.
685.99
Equity Multiplier
Total Assets
Equity Multiplier 1 Debt - Equity Ratio
Total Equity
1
Equity Multiplier
1 Debt Ratio

4. Coverage Ratios
Coverage ratios indicate the firms ability to

pay certain expenses:
Times Interest Earned Ratio
Cash Coverage Ratio
Fixed Charge Coverage Ratio

The Times Interest Earned Ratio
EBIT
TIE
Interest Expense
For EPI the times interest earned ratio in 1997 is:
199.70
TIE 2.63
76

What is the firms Times Interest
Earned Ratio?
11,520 = 3.65
3,160 times
The industry average is 6.7 times.
Measures how well a company has its interest

obligations met.
This is further evidence that it uses more
debt financing than average.
Cash Coverage Ratio
EBIT Depreciati on
Cash Coverage Ratio
Interest
EBDIT

Interest
Measure of cash flow available to meet

financial obligations.
The Fixed Charge Coverage
Ratio
EBIT + Lease Payments
Fixed Ch arg e Coverage =
SF Payments
Int. Exp.+LeasePayments +
(1- t )
Note: SF Payments are Sinking Fund payments

which are not tax deductible. Therefore, we must
divide them by (1-t) to find out how much we
need before taxes to meet this after-tax expense.
Also, you must include preferred dividends in this
number. S.B.Khatri - KUSOM 105
5. Profitability Ratios
Profitability ratios provide a measure of the

returns that a firm is generating:
Gross Profit Margin

Operating Profit Margin
Net Profit Margin
Return on Total Assets
Return on Equity
Return on Common Equity
The Gross Profit Margin
Gross Profit
GPM
Sales
For EPI the gross profit margin in 1997 is:
650
GPM 16.67%
3900

The Operating Profit Margin
Net Operating Income

OPM
Sales
For EPI the operating profit margin in 1997 is:
199.70
OPM 512%
.
3900

The Net Profit Margin
Net Income
NPM
Sales
For EPI the net profit margin in 1997 is:
74.22
NPM 190%
.
3900

The Return on Total Assets
Net Income
ROA
Total Assets
For EPI the return on total assets in 1997 is:
74.22
ROA 4.50%
1650.80

The Return on Equity
Net Income
ROE
Total Equity
For EPI the return on equity in 1997 is:
74.22
ROE 10.82%
685.99

What is CyberDragons
Return on Equity (ROE)?
5,016
= 14.6%
34,367
The industry average is 17.54%.
Is this what we would expect, given the

firms leverage?
Another Expression of ROE
ROE ROA Equity Multiplier ROA 1 Debt - Equity Ratio
Define this expression for EPI and Cyber

Dragon.
The Difference between ROA and ROE

reflects the use of debt financing, or
financial leverage of the company
What Conclusion can
you draw by seeing
the fig of Leverage
and ROE of
CyberDragon?
Even though CyberDragon has
higher leverage than the industry
average, they are much less
efficient, and therefore, less
profitable.
The Return on Common Equity
Net Income
ROCE
Total Common Equity
For EPI the return on common equity in 1997 is:
74.22
ROCE 10.82%
685.99

6. Market Valuation Ratios
The market valuation ratios provide an

indication of the relative under- or over-
pricing of a firms stock:
Price/Earnings Ratio
Price/Book Ratio

The Price/Earnings Ratio / Multiple
Stock Pr ice
P/E
Earnings per Share
Measures how much investors are willing to

pay for the stocks, per dollar of current earnings
of the company.
It primarily reflects : growth prospects, risk
characteristics, shareholder orientation,
corporate image, and degree
S.B.Khatri - KUSOM of liquidity. 117
Be careful while looking at P/E
If a firm had no or almost no earnings, its PE
would probably be quite large
Interpret with care
Look for other figures and ratios too.

The Price/Book Ratio
or Market to Book Value Ratio
Stock Price
P/B
Book Value per Share

Rules for Memorizing Ratios
There can be an infinite number of financial
ratios, but knowing a few basic rules will
help you to memorize the formulas: The
basic rule is that the name tells you how to
calculate the ratio.
Any margin ratio is something divided by
sales. More, the better
Any turnover ratio is sales (or a variation of
sales) divided by something. More, the better
Any return on ratio is net income (or a
variation of net income) divided by something.
More, the better
Using Financial Ratios
Calculating ratios is pointless unless you know
how to use them
The most basic rule is: a single ratio provides very
little information and may be misleading
With that in mind, there are at least 4 uses of
ratios:
Trend analysis (internal and external)
Comparison to industry averages (internal and external)
Setting and evaluating company goals (internal)
Restrictive debt covenants (external)
Trend Analysis of Ratios
Trend analysis
involves the
EPI Current Ratio Trend
examination of ratios
over time 2.40 x
2.39 x
The analyst tries to 2.38 x
Curre nt Ratio
determine if the ratio 2.37 x
2.36 x
is changing in a 2.35 x
favorable, or 2.34 x
2.33 x
unfavorable, direction 2.32 x
The chart shows EPIs 2.31

2.30
x
x
current ratio for two 1996 1997
years (we really need Ye ar
more data)
Comparing to Industry Averages
Industry average ratios provide a benchmark
for comparison
We assume that if a ratio is too far from the

average something is wrong

Indus try
Ratio 1997 1997 1996
Liquidity Ratios
Current 2.70 x 2.39 x 2.33 x
Quick 1.00 x 0.84 x 0.85 x
Efficie ncy Ratios
Inventory Turnover 7.00 x 3.88 x 4.00 x
A/R Turnover 10.70 x 9.70 x 9.97 x
Average Collection Period 33.64 37.11 36.12
Fixed Asset Turnover 11.20 x 10.81 x 10.15 x
Total Asset Turnover 2.60 x 2.36 x 2.38 x
Le ve rage Ratios
Total Debt Ratio 50.00% 58.45% 54.81%
Long-term Debt Ratio 20.00% 25.72% 22.02%
LTD to Total Capitalization 28.57% 38.23% 32.76%
Debt to Equity 1.00 x 1.41 x 1.21 x
LTD to Equity 40.00% 61.90% 48.73%
Cove rage Ratios
Times Interest Earned 2.50 x 2.63 x 4.43 x
Profitabilty Ratios
Gross Profit Margin 17.50% 16.67% 18.17%
Operating Profit Margin 6.25% 5.12% 7.92%
Net Profit Margin 3.50% 1.90% 3.68%
Return on Total Assets 9.10% 4.50% 8.77%
Return on Equity 18.20% 10.82% 19.40%
Othe r Ratios
Payout Ratio 70.06%
Plowback (Retention) Ratio 29.94%
Internal Growth Rate 1.36%
Sustainable Growth Rate 3.35%
Capital Intensity Ratio S.B.Khatri -38.46%
KUSOM 42.33% 41.97% 124
Company Goals and Debt
Covenants
Company goals are often stated in terms of
financial ratios
For example, it is common for management to
set goals regarding the firms ROE
Debt covenants often contain restrictions on
certain ratios
For example, a borrower might be required to
maintain a debt to equity ratio of less than 1.0
and a current ratio greater than 2.0
The DuPont Model
Brings together:
Profitability
Efficiency
Leverage

The DuPont Model
ROE ROA Equity Multiplier ROA 1 Debt - Equity Ratio
Remember,
Net Income Net Income Total Assets
ROE
TotalEquit y Total Assets Total Equity
Further,
Net Income Sales Total Assets
ROE
Sales Total Assets Total Equity
Profit Margin Total Asset Turnover Equity Multiplier

The DuPont System
ROE
ROA Equity Multiplier
Profit Margin Total Asset Turnover

The DuPont System
ROE
ROE ROA Equity Multiplier

Net Income Total Assets

Total Assets Common Equity
The DuPont System
ROE
ROA Profit Margin Total Asset Turnover

Net Income Sales

Sales Total Assets
The DuPont System
ROE
ROE Profit Margin Total Asset Turnover Equity Multiplier


Sales Total Assets Common Equity

The DuPont Model
It can also be expressed as
ROE = Net Profit X Total Asset Debt

: ( 1 - Ratio
Margin Turnover )
=
Net Income Sales Total Debt
Sales
X
Total Assets
: ( 1- Total Assets )

The DuPont Model
ROE = Net Profit X Total Asset :(1- Debt

Margin Turnover Ratio )
=
Net Income Sales Total Debt
Sales
X
Total Assets
: ( 1- Total Assets
5,016 112,760 47,523

=
112,760
X
81,890 : ( 1- 81,890
) = 14.6%
DuPont Model
This expression polularized by Du Pont
Corporation is called Du Pont Model or Du Pont
Identity.
This Du Pont Identity tells us that ROE is
affected by three things:
Operating efficiency (as measured by profit margin)
Asset use efficiency (as measured by total assets
turnover)
Financial leverage (as measured by the equity
multiplier)
ROE
Sales Total Assets Total Equity
Profit Margin Total Asset Turnover Equity Multiplier
Financial Leverage
Assets Use Efficiency
Operating Efficiency

DU PONT CHART APPLIED TO HORIZON LIMITED
Net Sales
+/- Non operating
Surplus/Deficit
701
Net Profit
34

Net Profit
Total Costs
Margin
4.9% 667
Net Sales
701
Return on
Total Assets
7.7 % X Average
Fixed assets
Net Sales 326
701
+
Total Assets
Turnover

Average
1.58
Average Investments
Total 15
Assets 443
+
Average
Net Current
S.B.Khatri - KUSOM Assets 102
136
EXTENSION OF THE DU PONT CHART
Return of Equity
13.1%
Return of Assets Average Total Assets

To Average Equity
7.7% Ratio 1.70

HORIZON LIMITED: PROFIT AND LOSS ACCOUNT
FOR THE YEAR ENDING 31ST MARCH 20X1
(Rs. in million)
20X1 20X0
Net sales 701 623
Stocks 421 370
Wages and salaries 68 55
Other manufacturing expenses 63 50
Depreciation 30 26
General Administration 12 11
Selling 18 12
Non-operating surplus/deficit - 6
Interest 21 22
Tax 34 41
Dividends 28 27
Retained earnings 6 15
Per share data ( in rupees)
Earning per share 2.27 2.80
Dividend per share 1.80 1.80
Market price per share 21.0 20.0
Book value per share 17.47 17.07
HORIZON LIMITED: BALANCE SHEET AS ON
31ST MARCH 20X1
(Rs. in million)
20X1 20X0
I. Sources of funds
1. Shareholders' funds 262 256
(a) Share capital 150 150
(b) Reserves and surplus 112 106
2. Loan funds
(a) Secured loans 143 131
(i) Due after 1 year 108 29
(ii) Due within 1 year 35 40
(b) Unsecured Loans 69 25
474 412
1. Fixed assets 330 322
2. Investments 15 15
(a) Long term investments 12 12
(b) Current investments 3 3
3. Current assets, loans and advances 234 156
(a) Inventories 105 72
(b) Sundry debtors 114 68
(c) Cash and bank balance 10 6
(d) Loans and advances 5 10
Less: Current liabilities and provisions 105 81
Net current assets S.B.Khatri - KUSOM 129 75 139
Total 474 412
Weakness in either operating or asset use efficiency
(or both) will show up in a diminished ROA, which
will translate into a lower ROE.
It appears that ROE could be leveraged up by
increasing the amount of debt in the firm.
It turns out this will only happen if the firms ROA
exceeds the interest rate on debt.
Explain
If ROE is unsatisfactory by some measure, then the Du
Pont Identity tells us where to start looking for reasons.
Example
In 1989, GM had an ROE of 12.1 %. By 1993,
its ROE had improved to 44.1 %, a dramatic
improvement. On closer inspection, however,
we find that, over the same period, GMs profit
margin had declined from 3.4 to 1.8 %, and
ROA had declined from 2.4 to 1.3 %. The
decline in ROA was moderated only slightly by
an increase in Total Assets Turnover from 0.71
to 0.73 over the period.
Given this information, how is it possible for GMs
ROE to have climbed so sharply
S.B.Khatri - KUSOM? 141
Answer
GMs equity multiplier increased substantially during
the period.
GMs book equity value was almost wiped out
overnight in 1992 by changes in the accounting
treatment of pension liabilities.
What happens to the equity multiplier if a companys
equity value declines sharply ?
In GMs case, the multiplier went from 4.95 in 1989 to
33.62 in 1993.
In sum, the dramatic improvement in GMs ROE
doesnt really represent an improvement in financial
performance at all.
Problems with Financial Statement
Analysis
1. Lack of underlying theory
No theory that tells us which numbers to look at and how to
interpret them.
Without such theory, it appears to be ad hoc, informal and
subjective.
2. Conglomerate firms
Difficult to analyze their consolidated financial statements
Difficult to find out the benchmark figures
3. Window dressing
Projecting favorable financial picture
Eg. Preparing balance sheet when the inventory level is low.
4. Price level changes
As a result, BS figures are distorted and misreported
Problems (contd.)
5. Variations in accounting policies
Latitude in items like depreciation, valuation of stocks,
R&D expenses, foreign exchange transactions, installment
sales, preliminary and pre-operative expenses, provision of
reserves and revaluation of assets.
Comparative financial statement analysis may be vitiated.
6. Interpretation of results
It is somewhat difficult to judge whether certain ratio is
good or bad
Eg. A high turnover of fixed assets may mean efficient
utilization of plant and machinery or continued flogging of
more or less fully depreciated, worn out, and inefficient
plant and machinery.
Several ratios might point towards different directions,
hence making it difficult to form overall judgment.
Guidelines for Financial Statement
Analysis
1. Use ratios to get clues to ask the right
questions
By themselves ratios rarely provide answers, but
they definitely help you to raise right questions
2. Be selective in the choice of ratios
Few ratios, aptly chosen, would capture most of the
information that you can derive from financial
statements.
3. Employ proper benchmarks
Average of industry , ratios of industry leaders,
historic ratios of the firm itself
Guidelines
4. Know the tricks used by accountants
Think from the point of view of criminal to
understand how they think.
5. Read the footnotes
The more difficult it is to read a footnote, the more
information laden it may be.
6. Remember that financial statement analysis is
an odd mixture of art and science.
Requires care, thought, common sense, and
business judgment a process for which there are
no mechanical substitutes.
Going beyond the numbers
Comprehensive business analysis, calls for going
beyond the conventional financial measures to
consider qualitative factors relevant for evaluating the
performance and prospects of a company.
1. Are the companys resources tied to one key customer
?
2. To what extent are the companys revenues tied to
one key product ?
3. To what extent does the company rely on a single
supplier ?
4. What percentage of companys business is generated
overseas ? S.B.Khatri - KUSOM 147
Percentage of Revenue and Net Income from
Overseas Operations for 10 Well-Known
Corporations, 2001
Company % of Revenue from % of Net Income

overseas from overseas
Coca-Cola 60.8 35.9
Exxon Mobil 69.4 60.2
General Electric 32.6 25.2
General Motors 26.1 60.6
IBM 57.9 48.4
JP Morgan Chase & Co. 35.5 51.7
McDonalds 63.1 61.7
Merck 18.3 58.1
3M 52.9 47.0
Sears, Roebuck 10.5 7.8
Going beyond numbers (contd..)
5. Competition
6. Future prospects (eg R&D investment)
7. Legal and regulatory environment

Case Analysis
Horizon Limited

HORIZON LIMITED: PROFIT AND LOSS ACCOUNT
FOR THE YEAR ENDING 31ST MARCH 20X1
(Rs. in million)
20X1 20X0
Net sales 701 623
Stocks 421 370
Wages and salaries 68 55
Other manufacturing expenses 63 50
Depreciation 30 26
General Administration 12 11
Selling 18 12
Non-operating surplus/deficit - 6
Interest 21 22
Tax 34 41
Dividends 28 27
Retained earnings 6 15
Per share data ( in rupees)
Earning per share 2.27 2.80
Dividend per share 1.80 1.80
Market price per share 21.0 20.0
Book value per share 17.47 17.07
HORIZON LIMITED: BALANCE SHEET AS ON
31ST MARCH 20X1
(Rs. in million)
20X1 20X0
I. Sources of funds
1. Shareholders' funds 262 256
(a) Share capital 150 150
(b) Reserves and surplus 112 106
2. Loan funds
(a) Secured loans 143 131
(b) Unsecured Loans 69 25
474 412
1. Fixed assets 330 322
2. Investments 15 15
(a) Long term investments 12 12
(b) Current investments 3 3
3. Current assets, loans and advances 234 156
(a) Inventories 105 72
(b) Sundry debtors 114 68
(c) Cash and bank balance 10 6
(d) Loans and advances 5 10
Less: Current liabilities and provisions 105 81
Net current assets S.B.Khatri - KUSOM 129 75 152
Total 474 412
LIQUIDITY RATIOS
Current Ratio
Current assets 237
Current liabilities = 180 =1.32
Acid-Test Ratio
Quick assets (237 105)
Current liabilities = 180 = 0.73
Cash Ratio
Cash and bank Current
balances + investments (10 + 3)
Current liabilities = 180 = 0.07
LEVERAGE RATIOS
Debt-equity Ratio
Debt 212
= = 0.809
Equity 262
Debt-asset Ratio
Debt 212
= = 0.45
Assets 474
Interest Coverage Ratio
Profit before interest and tax 89
= = 4.23
Interest 21
TURNOVER RATIOS
Inventory Turnover
Cost of goods sold 552
Average inventory = (105 + 72)/2 = 6.24
Debtors Turnover
Net credit sales 701
Average debtors = (114 + 68)/2 = 7.70
Fixed Assets Turnover
Net sales 701
Average net fixed assets = (330 + 322)/2 = 2.15
Total Assets Turnover
Net sales 701
Average total assets = (474 + 412)/2 = 1.58
PROFITABILITY RATIOS
Gross Profit Margin Ratio
Gross profit 149
= = 0.21 or 21 percent
Net sales 701
Net Profit Margin Ratio

Net profit 34
= = 0.049 or 4.9 percent
Net sales 701
Return on Assets (ROA)

Profit after tax 34
= = 0.077 or 7.7 percent
Average total assets (474 + 412)/2

PROFITABILITY RATIOS
Earning Power
Profit before interest and tax 89
= = 0.201 or 20.1
percent
Return on Capital Employed
Profit before interest and tax
(1 Tax rate) 89 (1 0.5)
= = 0.101 or 10.1
percent
Return on Equity
Equity earnings 34
Average equity = (262 + 256)/2 = 0.131 or 13.1 percent157
S.B.Khatri - KUSOM
VALUATION RATIOS
Price-earnings Ratio
Market price per share 21.0
= = 9.25
Earnings per share 2.27
Yield
Dividend Price change
+
Initial price Initial price
Dividend yield Capital gains/losses yield
1.87 1.0
= 9.35% = 5%
20.0 20.0
Market Value to Book Value Ratio
Market value per share 21.00
= = 1.20
Book value per share 17.47

COMPARISON WITH INDUSTRY AVERAGES
Ratios Formula Horizon Industry
Limited Average
Liquidity
Current assets
Current ratio 1.32 1.26
Current liabilities
Quick assets
Acid-test ratio 0.73 0.69
Current liabilities
Leverage
Debt
Debt-equity ratio 0.81 1.25
Equity
Debt
Debt-ratio 0.45 0.56
Assets
PBIT
Interest coverage ratio 4.23 4.14
Interest
Turnover
Net sales
Inventory turnover 6.24 6.43
Average Inventory
Net credit sales
Accounts receivable turnover 7.70 7.50
Average accounts receivable
Net sales
Fixed assets turnover 2.15 2.23
Average net fixed assets
Net sales
Total assets turnover 1.58 1.26
Average Total assets
Ratios Formula Horizon Industry
Limited Average
Profitability
Gross profit
Gross profit margin ratio 21.0% 18.0%
Net sales
Net profit
Net profit margin ratio 4.7% 4.0%
Net sales
Net profit
Return on assets 7.7% 6.9%
Average total assets
PBIT
Earning power 20.1% 17.7%
PBIT (1T)
Return on capital employed 10.1% 8.8%
Equity earnings
Return on equity 13.1% 11.9%
Average net worth
Valuation
Market price per share
Price-earnings ratio 9.25 9.26
Earnings per share
Dividend + Price change
Yield 14. 0% 14.1%
Initial price
Market price per share
Market value to book 1.20 1.16
value ratio Book value per share
TIME SERIES OF CERTAIN FINANCIAL RATIOS
1 2 3 4 5
Debt-equity ratio 0.91 0.98 0.65 0.61 0.81
Total assets turnover ratio 1.51 1.59 1.58 1.53 1.58
Net profit margin (%) 8.8 11.6 9.8 6.6 4.9
Return on equity (%) 25.4 30.7 24.5 16.7 13.1
Price-earnings ratio 18.6 15.3 10.3 7.1 9.3

DUPONT ANALYSIS
Basic Du Pont Analysis
Net profit Net profit Net sales
= x
Average total assets Net sales Average total assets
ROA = NPM x TATR
Extended Du Pont Analysis

Net profit Net profit Sales Average total assets
= x x
Equity Sales Average total assets Average equity
ROE NPM x TATR x 1/(1 DAR)

DU PONT CHART APPLIED TO HORIZON LIMITED
Net Sales
+/- Non
operating
Surplus/Deficit
Net Profit 701
34

Net Profit
Total Costs
Margin
4.9% 667
Net Sales
701
Return on
Total Assets
7.7 % X Average
Fixed assets
Net Sales 326
701
+
Total Assets
Turnover

Average
1.58
Average Investments
Total 15
Assets 443
+
Average
Net Current
S.B.Khatri - KUSOM Assets 102
163
EXTENSION OF THE DU PONT CHART
Return of Equity
13.1%
Return of Assets Average Total Assets

To Average Equity
7.7% Ratio 1.70

COMMON SIZE FINANCIAL STATEMENTS
Part A : Profit and Loss Account
Reg ular (in million) Common Size (%)
20X0 20X1 20X0 20X1
Net sales Rs.623 Rs. 701 100 100
Cost of goods sold 475 552 76 79
Gross profit 148 149 24 21
PBIT 105 89 17 13
Interest 22 21 4 3
PBT 83 68 13 10
Tax 41 34 7 5
PAT 42 34 7 5
Part B: Balance Sheet
Regular (in million) Common Size (%)
20X0 20X1 20X0 20X1
Shareholders funds 256 262 62 55
Loan funds 156 212 38 45
Total 412 414 100 100
Fixed assets 322 330 78 70
Investments 15 15 4 3
Net current assets 75 129 18 27
Total 412 474 100 100
COMMON-BASE YEAR FINANCIAL STATEMENTS
Part A : Profit and Loss Account
Regular (in million) Common Base Year (%)
20X0 20X1 20X0 20X1
Net sales Rs.623 Rs. 701 100 113
Cost of goods sold 475 552 100 116
Gross profit 148 149 100 101
PBIT 105 89 100 85
Interest 22 21 100 95
PBT 83 68 100 82
Tax 41 34 100 83
PAT 42 34 100 81
Part B: Balance Sheet
Regular (in million) Common Size (%)
20X0 20X1 20X0 20X1
Shareholders funds 256 262 100 102
Loan funds 156 212 100 136
Total 412 414 100 115
Fixed assets 322 330 100 102
Investments 15 15 100 100
Net current assets 75 129 100 172
Total 412 474 100 115
The End ! Whats your
achievement ?

(Self Study) Financial Statement and Analysis (Part of Fundamental Analysis)

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(Self Study) Financial Statement and Analysis (Part of Fundamental Analysis)

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Financial Statements and

Snapshot of firms accounting value at a particular date

Components of balance sheet

Fixed assets Long-term debt

Assets = Liability + stock holders Equity

A convenient means of organizing and

Assets are listed in the order of accounting liquidity

Liabilities and equity are listed in the order in which

Debt service is contracted payments of principle and

Accounting value (historical cost of assets) does not

Many valuable assets do not appear in the balance sheet :

Current Assets Current Liabilities

The structure of the assets of a particular firm reflects the line of

Measures performance of the firm over a specific period

Accounting definition of income

Income = Revenue - Expenses

Revenue is recorded upon an exchange of goods or services not

- Deferred taxes - results from differences between accounting

Costs are classified into

Accrual Principle, Matching Principle and Non-cash items

So we need to learn how to separate the

Firm issues securities

short term debt

Total Government Total value of

Value created if total cash flow > money raised

Cash flow is not equal to working capital

working capital = current assets - current liabilities

- If you use cash to increase inventories, then

Cash flow of the firm

Net investment in current assets (-10)

Tells us what happens to each dollar in

This allows the analyst to quickly and easily

This allows the analyst to quickly and easily

Equity 150 Investments*** 15 15

Less: Current liabilities and provisions: 105 81

Reserves & Surplus

Current Liabilities and Provisions

Current Assets, Loans, & Advances

Miscellaneous Expenditure & Losses

Net cash Profit after Non cash Non cash

In practice, analysts use the following approximation:

Net cash Profit after + Depreciation + Amortisation

Increase in liabilities and owners equity

Decrease in assets (other than cash)

Decrease in liabilities and owners equity

Increase in assets (other than cash)

Operating Cash inflows Cash outflows Cash flow

Cash inflows Cash outflows Cash flow

Net cash flow

OPERATING RES. & SURPLUS RES. & SURPLUS

FINANCING LOANS LOANS

OPERATING CURRENT LIABILITIES CURRENT LIABILITIES

INVESTMENT INVESTMENTS INVESTMENTS

OPERATING INVENTORIES INVENTORIES

OPERATING DEBTORS DEBTORS

WHY ? PROJECT IMAGE OF LOW RISK

Areour decisions maximizing

Financial ratios are often divided into

Dividends paid on common stock $2,800

Bill !! When are you

Short Term Creditors

If the average current ratio for the

Current Assets Inventories

For EPI the quick ratio in 1997 is: