JS

Financial Accounting &

Analysis

Union Bank Staff Training College

Shankar Jaganathan
April 2, 2011
Ratio Analysis or Competitive View of Financial
Performance
Financial Accounting & Analysis
-Topics JS
1. Introduction (March 6)
• Course structure, methodology and evaluation
• A brief history of accountancy
2. Accounting concepts, conventions & Double entry (March 12)
• Accounting concepts, Conventions, Double entry accounting
3. Financial Statements (March 19)
• Balance Sheet, Profit and Loss Account & Cash Flow Statements
4. Important Accounting Standards (March 26)
• Need for Accounting Standards and key standards
5. Ratio Analysis or Comparative view (April 2)
• Dupont Analysis, Altman Score and Equity Ratios
6. Accounting for Internal decision making (April 9)
• Cost accounting and management accounting systems
7. Accounting for Equity Markets (April 13)
• Share premium, EPS, Book value, Bonus issue, Stock split, US
GAAP and IFRS
8. Project Presentation (April 24)

2
Accountancy: The
Sequence JS
Financial
Bookkeeping Financial
Analysis &
Statements
Interpretation

Ratio Analysis
Dupont Analysis
Altman’s Score
Equity Valuation

3
 JS

A. Dupont Analysis

4
DuPont Model Origin JS
• DuPont took 23% stake in General Motors
• Donaldson Brown, in the Treasury Department of
DuPont given the job of cleaning up the Finance
• Brown an electrical engineer, developed the model in
1919
• A Generic model to analyzes Value creation in an
industry
• Useful for both intra-industry and inter-industry
comparison
5
DuPont Model JS
Return on Equity
PAT/Average Networth
Financial
Operating Asset Utilization
Leverage or
Leverage or or Efficiency
Gearing Analysis
Profitability Analysis
Analysis
Avg. Assets/ Avg.
PAT/Sales Sales/ Avg.Assets
Networth

6
DuPont Model –Detailed JS
Generic Business Industry Level Company Specific
Operating Leverage Gross Margin
Net Margin
Profit before Tax
Profit After Tax
Asset Utilization Total Asset Turnover
Fixed Asset Turnover
Return On Equity Current Asset Turnover
Inventory Turnover
Receivable Turnover
Financial Leverage Total Debt Equity Ratio
Long term debt to Equity
Current Ratio
Acid Ratio

7
Performance in 2007 JS
      $m

Description Pfizer Walmart Citibank

Revenue 48,418 348,650 146,558
Net Income 8,144 11,284 21,538
Total Assets 115,268 151,191 2,182,706
Net Worth 65,010 61,573 113,598
Debt 13,139 39,018 1,399,797
Liabilities 37,005 48,442 669,311
Minority Interest 114 2,160 -
Capital & Liabilities 115,268 151,193 2,182,706

• Pfizer: World’s largest Pharmaceutical company

• Walmart: World’s largest Retailer
• Citibank: World’s largest Bank
8
2008 Was An Abnormal Year
Three Routes to RoE
Using The DuPont Model JS
      $m
Description Pfizer Walmart Citibank
Revenue 48,418 348,650 146,558

Net Income 8,144 11,284 21,538

Total Assets 115,268 151,191 2,182,706

Net Worth 65,010 61,573 113,598

Debt 13,139 39,018 1,399,797

Liabilities 37,005 48,442 669,311

Minority Interest 114 2,160 -

Capital & Liabilities 115,268 151,193 2,182,706

Asset Turnover ratio 0.42 2.41 0.07

Profit Margin 16.8% 3.2% 14.7%

Leverage -Quantum 1.69 2.52 17.43

ROE 11.94% 19.67% 18.46%

9
Where is the Sweet Spot
An Exercise JS
• Can you individually calculate the following ratios
for your companies

– ROE
– PAT/ Sales
– Sales/ Avg. Assets
– Avg. Assets / Avg. Networth

10
Operating Leverage: The Sources
of High Margin JS
• High Margin a result of an ‘Unique Selling Proposition’
– Resource Control:
• Oil companies, Mines, Plantations,
– Talent Farming
• People oriented Services businesses
– Process Control
• Transaction oriented Volume businesses
– Legal Protection:
• Brand, Patent, Copyright, Monopoly

11
What does DuPont model tell us? JS
Ratio Operating Leverage:
Net Profit / Sales

Inter-industry Inherent Competitive Advantage,

indicator Entry / Exit barriers

Intra-industry Brand strength, Operational efficiency,

indicator Unique resource control

Directional move Higher Operating Leverage improves ROE

12
High Asset Turnover: The Source JS
• Total Asset Turnover
– Management effectiveness
• Fixed Asset Turnover
– Value add, Technology, Integration, Scale,
Centralization
• Current Asset Turnover
– Process maturity, Efficiency, Business philosophy
• % of Intangible Assets /Investments
– Choice of Growth Strategy –Organic or Inorganic

13
What does DuPont model tell us? JS
Ratio Asset Utilization
Sales/ Avg. Assets
Inter-industry indicator Vertical integration, Extent of
Outsourcing, Scale of Operations

Intra-industry indicator Technology base,

Managerial quality

Directional move Higher utilization improves ROE

14
Financial Leverage: The Source
JS
• Age of Industry

• Nature of Assets

• Equity base

• Profitability track record

15
What does DuPont model tell
us? JS
Ratio Financial Leverage
Avg. Assets/ Avg. Net Worth
Inter-industry indicator Attractiveness to Debt, Tangible asset
base, Industry maturity & predictability

Intra-industry indicator Risk appetite

Directional move Higher Leverage may improve ROE,

only if Debt Cost is lower than ROCE

16
 JS

B. Altman’s Score

17
Can Financial Statements
Predict the Future? JS
• Extensive Research in USA, the bankruptcy capital
• Research on
– Distance to Default or how early we can see it
– Default probability or certainty of prediction
• Used for
– Bankruptcy filings
– Bond Defaults
– Credit rating efficiencies

18
Initial Research Triggered by Great Depression of 1930s
 Predicting Bankruptcies
Altman’s Z Score JS
• Edward Altman’s model in 1968
• Picked 33 companies that
– Filed for bankruptcy between 1946-65
– Publicly listed manufacturing companies
– With asset size of $ 1 m to $25 m
• Picked a paired sample of 33 solvent companies
– Stratified for industry and size, random sample
– Asset size between $1 m to $25 m
– Data used for the years matched with bankruptcy
companies

19
Most Popular Predictive Model Using Financial Statements
 Reliability of Model JS
• One
Two years prior to Brust
Burst
• 83%
95% accuracy
accuracy

Burst
Burst
32 9/32 23/32
33 2/33 31/33

Actual
Actual
31/33 2/33
32/33 1/33
33
33

Solvent Burst
Solvent Burst
Predicted
Predicted

Model Validated in 30 years with 80% accuracy Level20

Z Score Model –The Basis JS
• Liquidity Ratios
– Working Capital / Total Assets, designated A
– Proportion of liquid capital
• Solvency Ratios
– Retained Earnings / Total Assets, designated B
– Age and preference for debt
• Profitability Ratios
– EBIT / TA, designated C
– Earning power; tax and debt not critical
• Leverage Ratios
– Market Cap / Book value of total liability, designated D
– Cushion Available
• Activity Ratios
– Sales / Total Assets, designated E
– Level of activity; not valuable by itself; by in combination

21
Picked One from the Five distinct Pools
Z Score Computed JS
• For Public Manufacturing Companies
Z score = 1.24 A + 1.4 B + 3.3 C + 0.6 D + .999 E
>2.99: Safe zone; 1.8-2.99: Grey zone; <1.8: Distress zone
• For Private Companies
Instead of Market value of equity book value of equity used
Z’ Score = 0.717 A +0.847 B +3.107 C +0.420 D +0.998 E
>2.9: Safe zone; 1.23-2.9: Grey zone; <1.23: Distress zone
• For non-manufacturing firms
Z’’ Score =6.56 A +3.26 B+ 6.72 C+ 1.05D
>2.6: Safe zone; 1.1-2.6: Grey zone; <1.1: Distress zone

22
Multi-discriminate Analysis
Credit Rating Efficiency JS

23
Model Independently Validated
Manufacturing Companies In
India – Two Extremes JS
Rs. Crore
Tata Motors Tata Motors HUL HUL
2007-08 2008-09 2007 2009*
Altmans’ Score
Working Capital (273) (1,143) (1,834) (183)
Total Assets 15,096 26,426 1,527 2,483
Retained Earnings 7,454 11,716 1,221 1,843
EBIT 2,698 1,688 2,167 3,050
Market Cap 25,520 8,501 52,948 54,901
Total Liabilities 16,914 24,001 5,199 6,206
Sales 29,223 26,587 14,107 20,239
Liquidity Ratio A -2% -4% -120% -7%
Solvency Ratio B 49% 44% 80% 74%
Profitability Ratio C 18% 6% 142% 123%
Leverage Ratio D 151% 35% 1018% 885%
Activity Ratio E 1.94 1.01 9.24 8.15
Z Score 4.10 2.00 19.70 18.46

* Fifteen month period ended March 31, 2009

>2.99: Safe zone; 1.8-2.99: Grey zone; <1.8: Distress zone 24

Non-Manufacturing
Companies: Two Extremes JS
Infosys Infosys Jet Air Jet Air
2007-08 2008-09 2007-08 2008-09
Altmans Score
Working Capital 8,496 12,288 (56) 891
Total Assets 13,490 17,809 16,727 19,742
Retained Earnings 13,204 17,523 4,465 3,071
EBIT 5,100 6,714 (835) (2,373)
Market Cap 82,362 75,837 4,997 1,631
Total Liabilities 3,731 3,305 15,580 19,509
Sales 15,648 20,264 9,551 11,786
Liquidity Ratio A 63% 69% 0% 5%
Solvency Ratio B 98% 98% 27% 16%
Profitability Ratio C 38% 38% -5% -12%
Leverage Ratio D 2208% 2295% 32% 8%
Activity Ratio E 1.16 1.14 0.57 0.60
Z Score 33.10 34.42 0.85 0.08
As Mfg. Company 0.97 0.52

25
>2.6: Safe zone; 1.1-2.6: Grey zone; <1.1: Distress
Can U Calculate Altman’s
Score for Your Company? JS

26
 JS

C. Equity Market Valuations

27
Value and Price JS
Value based View Price based View

• Fundamental value • Technical value

• Intrinsic value • Extrinsic value
• Absolute value • Relative value
• Fair value • Market value
• True value • Traded value
• Yield based or • Asset based
• Value in use • Value in Exchange

Absolute Valuation & Relative Valuation 28

Absolute and Relative valuation JS
 Absolute valuation
 Discounted Cash flow

 You will study this in Financial Management

 Relative valuation

 Ratio based valuations

 We will take a look at this
Enterprise Valuation and
Equity Valuation JS
• Enterprise valuation
– Debt + Equity
– Market value of debt + Market value of Equity

• Equity valuation
– Market Capitalization
– Share price x # of Shares

• Shareholder Value Creation

– Increase in Market Capitalization
30
How is Value of Share price
Determined JS
• Return Based Valuation
– Paid to shareholders –Dividend based
– Earned for shareholders –Profit based
– Excess return based –EVA based
• Asset Based Valuation
– Book value based
– Adjusted book value based
• Growth Based Valuations
– Revenue growth
– Profit growth

31
Dividend based Ratios JS
• Dividend Yield
– Dividend per share/ Market Price

• Dividend Payout
– Dividend / PAT
• Dividend Growth

– Dividend of Current year / Dividend of Previous year

– Dividend per share of CY / Dividend per share of PY

32
Profit based Ratios JS
• PAT to Sales
– True measure of returns to shareholders
• PBT to Sales
– Used to measure comparable long term returns, when limited
period tax advantages exist
• PBIT to Sales
– Used to measure comparable returns when debt levels used by
firms are different
• PBDIT to Sales
– Used to measure comparable returns when asset base is very
high and depreciation policy is different
• Gross Margin to Sales
– Used to measure efficiency of current operations
33
EVA based Ratios JS
• EVA = Economic Value Add

– Share capital is not free, it has a cost

– Shareholders expect return on their investment

– EVA measures return to shareholders after the cost of

capital is considered

Like Investment in Our House for Individual 34

Asset Based Ratios JS
• Book value based
– Return on Capital Employed

– Return on Equity
– Book value per share
• Market Capitalization

– Physical Capital = Net Worth

– Market Capital – Net Worth = Intellectual Capital

35
Growth based Ratios JS
• PE Ratio: Price Earnings Ratio
– Price / Earnings or EPS

– Price / EBIT
– Price / EBIDTA
• PEG: Price Earnings Growth Ratio

– PE / Earnings Growth

36
The Next Class:
Presentation JS
1. What is Management Accounting? Explain this with

reference to Segment Accounting given in your Annual

Report?

2. What are the main differences between Financial

accounting and Cost Accounting?

3. Explain what is the difference between Standard Costing

and Budgetary Controls?

37