FM II FINANCIAL ANALYSIS

Ratio Analysis References CFA Notes Financial Management I M Pandey

BASICS OF ANALYSIS
Financial statement analysis applies analytical tools to financial statements & related data for making business decisions
Horizontal analysis Vertical analysis Ratio analysis

HORIZONTAL ANALYSIS

Comparison of a companys financial position & performance across time Comparative statements - shows financial amounts in side by side columns on a single statement (comparative format) Comparing financial statements over a relatively short period of time (2-3 years) is often done by analyzing change in line items A change analysis usually includes analyzing absolute dollar amount changes & percent changes. Both analyses are relevant because dollar changes can yield large percent changes inconsistent with their importance It is common when using horizontal analysis to compare amounts to either average or median values from prior periods (smooth out erratic or unusual fluctuations)

HORIZONTAL ANALYSIS

Trend analysis

A form of horizontal analysis that can reveal patterns in data across successive periods It involves computing trend percents for a series of financial numbers & is a variation on the use of percent changes The difference is that trend analysis does not subtract the base period amount in the numerator Graphical depictions often aid analysis of trend percents

VERTICAL ANALYSIS

A tool to evaluate individual financial statement items or a group of items in terms of a specific base amount You define a key aggregate figure as the base: Total revenue for the income statement amounts Total assets for balance sheet amounts Common size statements Reveals changes in the relative importance of each financial statement item All individual amounts in common size statements are redefined in terms of common size percents A common size percent is measured by dividing each individual financial statement amount under analysis by its base amount

VERTICAL ANALYSIS
Common size statements Example

VERTICAL ANALYSIS

RATIO ANALYSIS
Ratios allow analysts to compare a various aspect of a company's financial statements against others in its industry, to determine a company's ability to pay dividends, and more The selected ratios are organized into the four building blocks of financial statement analysis: Liquidity ratios Activity ratios Leverage ratios Profitability ratios

LIQUIDITY RATIOS

Liquidity ratios measure a firms ability to meet its current obligations Current Ratio - indicates the ability of a company to meet its current liabilities. A minimum ratio of 1:33 is recommended by the Tandon Committee and the same is followed by commercial banks. Quick Ratio (QR) / Acid-Test Ratio - shows the actual liquidity position of the company since its deducts inventory which is not so easily convertible into cash and hence, not that liquid Cash Ratio considers only cash and marketable securities.

LIQUIDITY RATIOS
Current assets Current liabilities Current assets Inventories Quick ratio = Current liabilities Cash + Marketable securities Cash ratio = Current liabilities Current ratio =

ACTIVITY RATIOS

Activity ratios are employed to evaluate the efficiency with which the firm manages and utilizes its assets. 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 measure the quality of a business' receivables and how efficiently it uses and controls its assets Inventory Turnover Ratio - shows how many times inventory has turned over to achieve the sales. A higher ratio shows the efficiency in inventory management. However, it could also indicate over trading. Debtors Turnover Ratio - indicates the number of times the debtors are converted into cash in a year. It measures the efficiency of debtors or credit management. Creditors Turnover Ratio - indicates the number of times the creditors are turned over in a year. It measures the extent of credit allowed by the suppliers. A low ratio indicates that a generous credit period is allowed by the suppliers.

ACTIVITY RATIOS

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ACTIVITY RATIOS

Fixed asset turnover ratio - quantifies how efficiently a firm employs its fixed assets. Predictably, this financial ratio is most useful when a firm has a lot of fixed assets: real estate, equipment, and so forth Total assets turnover ratio - measures how efficiently you're employing your assets. It indicates the sales generated per rupee of investment in total assets. Working Capital Turnover Ratio - indicates the number of times the working capital is converted to sales. It measures the efficiency of working capital management

ACTIVITY RATIOS
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LEVERAGE RATIOS

Leverage ratios measure a companys ability to meet its obligations and how much of the companys assets are financed with debt. They reveal the equity cushion that is available to absorb any losses that may occur. Debt to Equity (D/E) Ratio - measure the long term solvency of the firm. A high ratio indicates a high financial leverage and low margin of safety. Debt Service Coverage Ratio (DSCR) - shows the firms capacity to repay its debt along with interest. Financial institutions look for 1.3 - 2.0 Interest Coverage Ratio - shows the firms capacity to pay interest on its debt obligations. Graham suggest this to be around 4 for equity investors.

LEVERAGE RATIOS

PROFITABILITY RATIOS

Profitability ratios measure the operating efficiency of the company Generally two major types of profitability ratios are calculated
Profitability in relation to sales Profitability in relation to investments

PROFITABILITY RATIOS

Profitability in relation to sales

PROFITABILITY RATIOS

Profitability in relation to investments

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Capital Employed = Total Debt + Networth

Capital Employed = Total Assets Interest free liabilities Capital Employed = Net Fixed Assets + Investments + Net current Assets

PROFITABILITY RATIOS
Adjustment to CE

CWIP Deduct CWIP to get true capital employed in the business Intangible assets except goodwill Should be part of CE Goodwill depends upon the components of goodwill

Adjustment for ROE

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GROWTH RATIOS
Historical growth ratios are required for projections and determining future growth of the company

Sales CAGR analysts typically go for 5-yrs CAGR for sales PAT CAGR

Cal. CAGR for Nestle with sales being 7,200 crs, 6,300 crs and 5,200 crs for CY11, CY10 and CY09

GROWTH POTENTIAL

Sustainable Growth Rate G = RR * ROE RR = retention rate = 1 - (dividend declared / net income) ROE = return on equity = net income / total equity

SEGMENT ANALYSIS
Segment analysis requires conducting ratio analysis on any operating segment that accounts for more than 10% of a companys revenues or total assets, or that is easily distinguishable from the other company business in terms of products provided or the risk/return profile of the segment. Lines of business are often broken down into geographical segments, when the size or type of business differentiates them from other business lines. Since many segments have different risk profiles, they should be analyzed and valued separately from other parts of the business. Conducting ratio analysis, specifically profit margins, return on assets and other profitability measures can give analysts insight into how the segment affects overall financial performance.

DUPONT ANALYSIS
A system of analysis has been developed that focuses the attention on all three critical elements of the financial condition of a company: the operating management, management of assets and the capital structure. This analysis technique is called the "DuPont Formula". The DuPont Formula shows the interrelationship between key financial ratios Return on equity (ROE) = net income / total equity ROE = (net income / sales) * (sales / assets) * (assets / equity) ROE = net profit margin * asset turnover * equity multiplier

USES & LIMITATIONS OF FINANCIAL RATIOS

Benchmarking Financial Ratios Financial ratios are not very useful on a stand-alone basis; they must be benchmarked against something. Analysts compare ratios against the following

The Industry norm Aggregate economy - It is sometimes important to analyze a company's ratio over a full economic cycle. This will help the analyst understand and estimate a company's performance in changing economic conditions, such as a recession The company's past performance

Limitations of Financial Ratios

Many large firms operate different divisions in different industries. For these companies it is difficult to find a meaningful set of industry-average ratios. Inflation may have badly distorted a company's balance sheet. In this case, profits will also be affected. Thus a ratio analysis of one company over time or a comparative analysis of companies of different ages must be interpreted with judgment. Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect a business can reduce the chance of misinterpretation Different accounting practices can distort comparisons even within the same company (leasing versus buying equipment, LIFO versus FIFO, etc.). It is difficult to generalize about whether a ratio is good or not. A high cash ratio in a historically classified growth company may be interpreted as a good sign, but could also be seen as a sign that the company is no longer a growth company and should command lower valuations.