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Private and Confidential Not for Circulation
Advanced Accounting E-Book
Part 7 of 12
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Discussion topics
How to analyze a company?
Analytical techniques for Financial Statement Analysis
Horizontal Analysis
Trend Analysis
Vertical Analysis
Ratio Analysis
Solvency
Current Ratio /Quick Ratio / Cash ratio
Receivables turnover / Inventory turnover / Payables turnover / Cash Conversion Cycle
Operating
Operating Efficiency ratios
Operating Profitability
DuPont Formula
Extended DuPont Formula
Risk
Business Risk
Financial risk
External liquidity risk
Growth
Limitations of Financial Ratios
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Private and Confidential Not for Circulation
How to analyze a company?
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Analytical techniques for FSA
Purpose of Financial Statement Analysis is to evaluate management performance in
Profitability
Efficiency
Risk
Although financial statement information is historical, it is used to project future performance












An Analyst is expected to do a complete synthesis using all three methods
Which method is the
Best?
Horizontal
and Trend
Analysis
Compares two financial statements to determine dollar and
percentage changes
Compute dollar changes and percentage changes
Vertical
Analysis
Shows relationship of each item to a base amount on financial
statements
Income statement (each item expressed as percentage of net
sales)
Balance sheet (each item expressed as percentage of total
assets)
Ratio
Analysis
Puts numbers in perspective with other numbers
Helps control for different sizes of firms
Ratios provide meaningful relationships between individual
values in the financial statements
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Horizontal / Trend / Vertical Analysis
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Horizontal Analysis
Horizontal analysis shows the changes between years in the financial data in both dollar
and percentage form
Horizontal analysis on the income statement













Horizontal analysis can also be done on the liabilities or shareholders equity
[Current year Base year] /
[Base year]
Why provision for tax has
increased by 12.6%, while the
revenues increased by only 5.5%?

Why there is an increase of 9.1%
in Selling and administrative cost?
GKSR Income Statement 2006 2007 Increase ($) % YoY change
Rental Operations 801,240 847,401 46,161 5.8%
Direct Sales 79,603 82,141 2,538 3.2%
Net Revenues $880,843 $929,542 $48,699 5.5%
Cost of rental operations (518,543) (541,392) (22,849) 4.4%
Cost of direct sales (57,522) (59,579) (2,057) 3.6%
Selling and administrative costs (186,652) (203,614) (16,962) 9.1%
Operating Expenses ($762,717) ($804,585) ($41,868) 5.5%
-
Ebitda $118,126 $124,957 $6,831 5.8%
Depreciation (32,479) (34,789) (2,310) 7.1%
Amortization of intangibles (10,784) (10,806) (22) 0.2%
Ebit $74,863 $79,362 $4,499 6.0%
Interest Expense (13,226) (13,901) (675) 5.1%
Income before income taxes $61,637 $65,461 $3,824 6.2%
Provision for taxes (19,786) (22,271) (2,485) 12.6%
PAT $41,851 $43,190 $1,339 3.2%
Basic EPS $1.98 $2.03 $0.05 2.5%
Diluted EPS $1.97 $2.02 $0.05 2.4%
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Trend Analysis
Trend percentages state several years financial data in terms of a base year, which equals
100%
In the example below, we have taken base year as 2002






We can use the trend percentages to construct a graph so we can see the trend over time







[Current year ] / [Base year] * 100
While Operating cost has increased
by 42% since 2002, Net income
grew marginally by 13% during the
corresponding period
Income Statement 2002 2003 2004 2005 2006 2007
Net Revenues 677,591 705,588 733,447 788,775 880,843 929,542
Operating Expenses 565,077 598,974 625,064 674,566 762,717 804,585
PAT 38,267 33,689 35,384 38,179 41,851 43,190
Trend Analysis 2002 2003 2004 2005 2006 2007
Net Revenues 100.0% 104.1% 108.2% 116.4% 130.0% 137.2%
Operating Expenses 100.0% 106.0% 110.6% 119.4% 135.0% 142.4%
PAT 100.0% 88.0% 92.5% 99.8% 109.4% 112.9%
60%
80%
100%
120%
140%
160%
2002 2003 2004 2005 2006 2007
Trend Analysis
Net Revenues Operating Expense Net Income
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Vertical Analysis
Common-size statements use percentages to express the relationship of individual
components to a total within a single period is known as Vertical Analysis
Income Statement (as a percentage of Total Revenues)
Balance Sheet (As a percentage of Total Asset / Total Liabilities)














Vertical Analysis 2002 2003 2004 2005 2006 2007
Rental Operations 96.8% 96.6% 96.6% 93.9% 91.0% 91.2%
Alcohol 3.2% 3.4% 3.4% 6.1% 9.0% 8.8%
Net Revenues 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of rental operations -59.5% -60.5% -61.1% -59.6% -58.9% -58.2%
Cost of direct sales -2.3% -2.5% -2.6% -4.5% -6.5% -6.4%
Selling and administrative costs -21.6% -21.9% -21.5% -21.4% -21.2% -21.9%
Operating Expenses -83.4% -84.9% -85.2% -85.5% -86.6% -86.6%
Ebitda 16.6% 15.1% 14.8% 14.5% 13.4% 13.4%
Depreciation -4.4% -4.3% -4.3% -4.1% -3.7% -3.7%
Amortization of intangibles -0.9% -1.0% -1.1% -1.2% -1.2% -1.2%
Ebit 11.3% 9.8% 9.4% 9.2% 8.5% 8.5%
Interest Expense -2.0% -1.9% -1.6% -1.4% -1.5% -1.5%
Income before income taxes 9.3% 7.8% 7.8% 7.8% 7.0% 7.0%
Provision for taxes -3.7% -3.1% -3.0% -2.9% -2.2% -2.4%
PAT 5.6% 4.8% 4.8% 4.8% 4.8% 4.6%
Since 2004, cost of rentals have
decreased
EBITDA/EBIT/PAT margins a
concern - continuously
decreasing trend
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Ratio Analysis
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Ratio Analysis
Ratios can often be more informative that raw numbers
Puts numbers in perspective with other numbers
Helps control for different sizes of firms
Ratios provide meaningful relationships between individual values in the financial statements
Ratios can be used to evaluate four different areas of companys performance and conditions
Ratio
Analysis
Solvency
Ratios
Current/Cash
/Quick Ratio
Turnover
Ratios
Operating
Performance
Operating
Efficiency
Operating
Profitability
Risk Analysis
Business
Risk
Financial
Risk
External
liquidity risk
Growth
Sustainable
growth rate
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Private and Confidential Not for Circulation
Ratio Analysis - Solvency
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Ratio Analysis - Solvency
Analyst employ these ratios to determine the firms ability to pay its short-term liabilities
Current Ratio examines current assets and current liabilities
Higher the current ratio, more likely is that the company will be able to pay its short-term bills


A ratio of less than 1, means that the company has negative working capital and is probably facing
liquidity crisis

Quick Ratio adjusts current assets by removing less liquid assets
More stringent measure of liquidity


Higher the quick ratio, more likely is that the company will be able to pay its short-term bills

Cash ratio relates cash (ultimate liquid asset) to current liabilities
Higher the cash ratio, more likely is that the company will be able to pay its short-term bills



s Liabilitie Current
Assets Current
Ratio Current =
s Liabilitie Current
s Receivable Securities Marketable Cash
Ratio Quick
+ +
=
s Liabilitie Current
Securities Marketable Cash
Ratio Cash
+
=



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Ratio Analysis - Solvency
Receivables turnover examines the management of accounts receivable
Balance sheet items are taken as average of the account


Average collection period is the average number of days it takes for the companys
customer to pay their bills
It is desirable to have a collections period closer to the industry norm


Collection period too high mean that customers are too slow in paying their bills, which implies too much
capital is tied up in assets
Inventory turnover measures firms efficiency with respect to its processing and inventory
management
Balance sheet items are taken as average of the account


Given the turnover values, you can compute the average inventory processing time
It is desirable to have a collections period closer to the industry norm




s Receivable Average
Sales Annual Net
Turnover s Receivable =
Turnover s Receivable
365
Period Collection s Receivable Average =
Inventory Average
Sold Goods of Cost
Turnover Inventory =
Turnover Inventory
365
Period Processing Inventory Average =




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Evaluating Solvency Ratios
Payables turnover measures the use of trade credit by the firm
Balance sheet items are taken as average of the account


Given the turnover values, we can compute the average payment period processing time
It is desirable to have a collections payment closer to the industry norm


Cash Conversion Cycle
Combines information from the receivables turnover, inventory turnover, and accounts payable turnover



High conversion cycle is undesirable
Too high conversion cycle implies that company has excessive amount of capital investment in the sales
process




Payables Average
sold goods of Cost
Turnover Payables =
Turnover Payable
365
Period Payment Average =


Cash Con Cycle
Receivable period Inventory period
= + Payable period -
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Private and Confidential Not for Circulation
Ratio Analysis Operating
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Ratio Analysis Operating Efficiency
Operating Efficiency Ratios
Examines how management uses its assets to generate sales and it considers the relationship between
various asset categories and sales
Total Asset Turnover ratio indicates effectiveness of a firms use of its total asset base to
produce sales
Different types of industries have different asset turnovers. Infrastructure business are capital intensive
and may have Asset Turnover closer to 1, however, retail business might have turnover ratios in double
digits


Low asset turnover may mean that the company has to much capital tied up in its asset base
Net Fixed Asset turnover reflects utilization of fixed assets
This number can look temporarily bad if the firm has recently added greatly to its capacity in anticipation
of future sales


Equity Turnover measures the employment of owners capital
Equity capital includes all preferred and common stock, paid-in capital and retained earnings
Assets Net Total Average
Sales Net
Turnover Asset Total =
Assets Fixed Net Average
Sales Net
Turnover Asset Fixed =
Equity Average
Sales Net
Turnover Equity =



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Ratio Analysis Operating Profitability
Operating profitability ratios
Examines how management is doing at controlling costs so that a large proportion of the sales dollar is
converted into profit
What proportion of the sales dollar is left after cost of goods sold?
Is the firm buying inputs (inventory and direct labor) at good prices?
Gross Profit Margin
Gross profit margin measures the rate of return after cost of goods sold


Operating Profit Margin
Operating profit margin measures the rate of profit on sales after operating expenses


Operating income can be thought of as the bottom line from operations
Net Margin
Shows the combined effect of operating profitability and the firms financing decisions (since net income is
after interest and tax payments)


Sales Net
Profit Gross
Margin Profit Gross =
Sales Net
Profit Operating
Margin Profit Operating =
Sales Net
Income Net
Margin Profit Net =



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Ratio Analysis Operating Profitability



Example: Operating Ratios
Income Statement 2007
Sales $18,000
COGS $13,200
Selling and Admin expenses $3,400
Interest income $800
Interest expense $500
Gain on sale of long term investments $1,200
Provision for income taxes $1,015
Selected Balance Sheet items 2007
Book value of total assets $44,000
Accumulated depreciation ($12,000)
Net total assets $32,000
Shareholder's Equity 22000
Calculate the following
a) Operating Profit Margin
b) Net profit Margin
c) Asset Turnover
d) Equity Turnover
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Ratio Analysis Operating Profitability
Return on total capital relates the firms earnings to all capital invested in the business
This number should not be too low as compared to the industry average


We should consider Gross interest expense in our calculation
Return on total equity indicates the rate of return earned on the capital provided by the
stockholders after paying for all other capital used
Total Equity includes preferred stock


Return on owners equity is based only on the common shareholders equity
Preferred dividends are deducted from Net Income as they are a priority claim



Capital Total Average
Expense Interest Income Net
Capital Total on Return
+
=
Equity Total Average
Income Net
Equity Total on Return =
Equity Common Average
Dividend Preferred - Income Net
Equity s Owner' on Return =



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Ratio Analysis Operating Profitability
DuPont System divides ROE into several ratios that collectively equal ROE while individually
providing insight
Most important term in ratio analysis


Basic algebra for ROE breakdown





Extended DuPont System
Provides additional insights into the effect of financial leverage on the firm and pinpoints the effect of
income taxes on ROE
We begin with the operating profit margin (EBIT divided by sales) and introduce additional
ratios to derive an ROE value

Equity Common
Income Net
ROE =
Equity Common
Assets Total
Assets Total
Sales
Sales
Income Net
Equity Common
Income Net
=
Profit margin Asset Turnover Financial Leverage


Equity Common
Assets Total
Assets Total
Sales
Sales
Income Net
Equity Common
Income Net
=

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Ratio Analysis Operating Profitability
Extended DuPont Analysis








Financial leverage involves acquiring assets with funds at a fixed rate of interest
If Return on Investment in Asset > Fixed rate of borrowing = Positive financial leverage
If Return on Investment in Asset < Fixed rate of borrowing = Negative financial leverage
t) - 1 (
Equity Common
Assets Total
Assets Total
Sales
Sales
EBT
Equity Common
Income Net
=
t) - 1 (
Equity Common
Assets Total
Assets Total
Expense Interest
Assets Total
Sales
Sales
EBIT
Equity Common
Income Net
|
.
|

\
|
=
Op. Profit Margin Asset Turnover Interest exp. rate Financial leverage Tax retention rate


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Ratio Analysis Operating Profitability
Example : DuPont Analysis
Please evaluate the following ratios for Pratts company
2006 2007
Pre-interest profit margin (EBIT/S) 0.15 0.10
Asset turnover (S/A) 1.00 1.50
Leverage (A/E) 2.00 2.50
Tax retention (1-t) 0.70 0.70
Interest expense ratio (I/A) 0.05 0.05
Comment on the firm's ROE trends
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Ratio Analysis Risk
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Ratio Analysis Risk
Risk analysis examines the uncertainty of income for the firm and for an investor
Total firm risks can be decomposed into three basic sources 1) Business risk 2) Financial
Risk 3) External Liquidity Risk

Business Risk
Function of Business variability, Sales variability and Operating leverage
Between five to ten years of data should be used for calculating business and sales variability




Also critical is the measure of how much companys production costs are fixed (as opposed to variable)


Greater the use of fixed costs, greater the impact of a change in sales on the operating income of a
company and hence, higher is the risk




income operating Mean
income) (operating Deviation Standard
ty variabili Business =
sales Mean
(sales) Deviation Standard
ty variabili Sales =
Sales in change %
Earnings Operating in change %
leverage Operating =



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Ratio Analysis Financial Risk
Financial risk
The added uncertainty in a firms net income resulting from a firms financing decisions (primarily through
employing leverage)
Interest payments are deducted before we get to net income and these are fixed obligations. Similar to
fixed production costs, these lead to larger earnings during good times, and lower earnings during a
business decline
The use of debt financing increases financial risk and possibility of default while increasing profitability
when sales are high
Two sets of financial ratios help measure financial risk
Balance sheet ratios
Earnings or cash flow available to pay fixed financial charges
Balance Sheet Ratios
How much debt does the firm employ in relation to its use of equity?


How much debt does the firm employ in relation to all long-term sources of funds?


Assessment of overall debt load, including short-term
equity term Long
debt term Long
ratio equity Debt to =
capital term long Total
debt term Long
capital Total Debt to =
Equity Total Debt Total
debt term Long s liabilitie Current
Ratio Debt
+
+
=



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Ratio Analysis Financial Risk
Earnings/Cash flow ratios
Relate operating income (EBIT) to fixed payments required from debt obligations
Higher ratio means lower risk
Interest coverage ratio determines the firms ability to repay its debt obligations


Cash flow to long term debt ratio determines the ability of the firm to meet its long term debt through
its cash flows




expense Interest
EBIT
coverage Interest =
lease operating of PV debt term long of Book value
CFO
debt term long to flow Cash
+
=


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Ratio Analysis External Liquidity Risk
External liquidity risk
External market liquidity is a source of risk to investors
Market Liquidity is the ability to buy or sell an asset quickly with little price change from a prior
transaction assuming no new information
The most important factor of external market liquidity is the dollar value of shares traded
This can be estimated from the total market value of outstanding securities
It will be affected by the number of security owners
Numerous buyers and sellers provide liquidity


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Ratio Analysis Example


Example : Ratio Analysis
Please evaluate the following ratios
2006 2007
Cash Ratio 0.84 0.60
Operating Profit Margin 30% 36%
Current Ratio 1.80 1.44
Total Debt-to-Total Capital Ratio 78% 74%
Cash Flow-to-Total Debt Ratio 66 60
Cash Conversion Cycle (days) 54 60
Interest coverage 3.00 2.40
Net Profit Margin 10% 8%
Debt-to-Equity Ratio 132% 127%
Comment on the firm's trends on the following
a) Profitability
b) Liquidity
c) Financial Risk (Coverage)
d) Financial Risk (Leverage)
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Ratio Analysis Growth
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Ratio Analysis Growth
Growth is important to both creditors and owners
Creditors interested in ability to pay future obligations
For owners, the value of a firm depends on its future growth in earnings, cash flow, and dividends
If the company doesnt grow, it stands a much greater chance of defaulting on its loans
Sustainable growth rate is a function of two variables:
What is the rate of return on equity (which gives the maximum possible growth)?
How much of that growth is put to work through earnings retention (rather than being paid out in
dividends)?
Growth = ROE x Retention rate
Also remember ROE is a function of
Net profit margin
Total asset turnover
Financial leverage (total assets/equity)

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Limitations of Financial Ratios
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Limitation of Financial Ratios
Accounting treatments may vary among firms, especially among non-U.S. firms
Always consider relative financial ratios. They do not make any sense when viewed in
isolation
Firms may have divisions operating in different industries making it difficult to derive industry
ratios
Conclusions cannot be made by just looking at only one set of ratios
Ratios outside an industry range may be cause for concern




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