Ratio Analysis

The steps involved in Business Analysis

Step 5 – Application Step 4 – Prospective
analysis: Valuation
for example:
•Outside Investor •RIM
Compare Value with Price to BUY, •Alternatives
SELL, or HOLD
•Inside Investor •Sensitivity
Compare Value with Cost to ACCEPT
or REJECT Strategy
Step 3 – Prospective
analysis: Forecasting
•Profit and Loss
•Balance Sheet
Step 1 – Understanding the •Cash Flow
Business
e.g.: Step 2 - Analyzing Information
•The Product market – Accounting Analysis and
•The Competition Strategy Financial Analysis
•The Regulatory Constraints •Quality of Accounting
•Business strategies information?
•Re-formatting to uncover
business activities
•Ratio and cash flow analysis

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Learning Objectives
At the conclusion of this lecture you
should understand:
1. How to evaluate firm performance
through returns (ROE and its
components)
2. How the operating activities of the
firm reflect in ROE
3. How the financing activities of the
firm reflect in ROE
4. How to evaluate firm risk (cash flow
analysis)

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Key Concepts

 There are two primary tools in financial analysis:

 Ratio analysis – to assess how various line items in financial
statements relate to each other and to measure relative
performance.
 Cash flow analysis – to evaluate liquidity and the
management of operating, investing and financing activities
as they relate to cash flow.

22319 Financial Statement Analysis 4

Assignment

 Reformat at least the last 5 years of your company's financial

statements.
 Use ratio analysis and cash flow analysis to evaluate the current
and past performance of the business and assess its
sustainability.

22319 Financial Statement Analysis 5

Determinants of Firm Value
and Ratio Analysis
 Profitability and growth drive firm value.
 Managers can employ four levers to achieve growth and profit
targets:
1. Operating management
2. Investment management
3. Financing strategy
4. Dividend policy
 Ratio analysis seeks to evaluate the firm’s effectiveness in these
areas.

22319 Financial Statement Analysis 6

22319 Financial Statement Analysis 7
Ratio Analysis
 Evaluating ratios requires comparison against some
benchmarks, such as:
 Ratios over time from prior periods (time series)
 Ratios of other firms in the industry (cross-sectional)
 Some absolute benchmark
 Common size analysis.
 Effective ratio analysis must attempt to relate underlying
business factors to the financial numbers .
 Ratio analysis should aid your understanding of
 The business model of the firm
 The returns that the firm generates
 Firm risk

22319 Financial Statement Analysis 8

Decomposing Profitability: Traditional Approach

 ROE is a comprehensive measure of overall profitability and is a

good starting point to systematically analyse firm performance.

 ROE = Net Income / Average Shareholders’ Equity

= ROA * Financial leverage
= Net income * Average Assets
Average Assets Average Shareholders’ equity

 The traditional approach has some limitations imposed by the

composition of the denominator and numerator.

22319 Financial Statement Analysis 9

Decomposing Profitability: Alternative Approach
ROE = Net income/average equity
= Return on net operating assets RNOA + [Financial leverage (FLEV) × SPREAD]

avg NFO
FLEV = SPREAD = RNOA - NBC
avg Equity

Step 1 RNOA = NOPAT/avg NOA

NFEat
RNOA NBC =
avg NFO

Step 2 PM = NOPAT/Sales ATO = Sales / avg NOA

Step 3 Sales PM Other Items PM

Gross Margin Ratio Expense Ratios Other OI/Sales Individual Asset and Borrowing Cost
Ratios Liability Turnovers Drivers

22319 Financial Statement Analysis 10

Formal Proof

22319 Financial Statement Analysis 11

Returns
 Returns can be measured from the perspectives of shareholders,
firms and debtholders.

Shareholders Firms Debtholders

Realised returns ROE RNOA NBC

Required returns
(cost of capital) cost of equity cost of operations NBC/interest rate

22319 Financial Statement Analysis 12

Qantas – what happened and why?
2005 2006 2007 2008 2009 2010 2011 2012

Return on Equity
Net Income / Equity 11.5% 8.3% 11.7% 16.2% 2.0% 1.9% 4.1% -4.1%

Return on Operating assets

NOPAT / NOA 6.7% 4.7% 6.5% 8.8% 1.3% 1.4% 2.7% -1.0%

Profit Marin
NOPAT/Sales 6.0% 3.8% 4.8% 5.8% 0.9% 1.2% 2.2% -0.8%

Asset Turnover
Sales/NOA 1.115 1.236 1.355 1.529 1.374 1.192 1.215 1.228

Spread
RNOA -Interest/NFO 5.4% 4.0% 6.3% 9.5% 0.9% 0.5% 1.4% -2.8%

Leverage
NFO / Equity 88.4% 90.4% 82.3% 77.6% 84.2% 96.7% 102.1% 112.7%

ROE 11.5% 8.3% 11.7% 16.2% 2.0% 1.9% 4.1% -4.1%

22319 Financial Statement Analysis 13

Disaggregating ROE – Profit Margin
 Disaggregation of PM should reflect the business model
 Assess the profitability of operating management

ROEt = RNOAt + FLEVt [RNOAt − NBCt ]

NOPATt NOPATt Salest

RNOAt = = ⋅
NOAave Salest NOAave

(1) NOPAT or Operating

profit margin:
The profitability of
each dollar of sales

22319 Financial Statement Analysis 14

Disaggregating ROE – Profit Margin
 PM can be further broken into various expense/sales ratios to
facilitate comparisons of key line items across time and
different firms.
 Identify the material expenses
 Identify the controllable expenses.

NOPATt
PM t =
Salest
Grosst − Selling t − Ad min t ...............
PM t =
Salest
Grosst Selling t Ad min t
PM t = − − − .................
Salest Salest Salest
22319 Financial Statement Analysis 15
Qantas

2005 2006 2007 2008 2009 2010 2011 2012

Expenses / Total Revenues
Manpower Expenses / Total Revenues 25.2% 24.3% 22.0% 21.8% 25.3% 24.7% 25.1% 24.0%
Selling & Marketing Expenses / Total Revenues 4.0% 3.4% 3.3% 4.7% 4.3% 4.2% 4.2% 4.0%
Aircraft - Variable Expenses / Total Revenues 18.9% 18.5% 17.3% 16.0% 19.5% 19.4% 18.5% 19.0%
Fuel & Oil Expenses / Total Revenues 15.4% 20.5% 22.0% 22.2% 24.8% 23.8% 24.4% 26.8%
Property Expenses / Total Revenues 2.4% 2.3% 2.3% 2.1% 2.8% 2.9% 2.7% 2.7%
Computer & Communication Expenses / Total Re 4.0% 3.6% 3.5% 2.4% 2.8% 2.9% 2.7% 2.8%
Depreciation & Amortisation Expenses / Total Re 9.9% 9.1% 9.0% 9.1% 9.6% 8.7% 8.4% 8.8%
Non Cancellable Operating Leases Expenses / T 2.1% 2.6% 2.7% 2.5% 3.1% 3.8% 3.8% 3.5%
Tour & Travel Expenses / Total Revenues 4.5% 4.3% 4.2% 3.8% 0.0% 0.0% 0.0% 0.0%
Capacity Hire, Insurance & Other Expenses / Tot 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
Insurance & Other Expenses / Total Revenues 3.0% 3.2% 4.3% 5.2% 5.3% 4.6% 5.0% 6.7%
Capacity Hire Expenses / Total Revenues 2.7% 2.7% 2.0% 1.7% 1.9% 1.8% 1.7% 1.7%

Expenses / Total Revenues 92.1% 94.6% 92.6% 91.4% 99.2% 96.9% 96.4% 100.1%

22319 Financial Statement Analysis 16

Disaggregating ROE – ATO
 ATO assesses the efficiency of investment (assets) management.
 Asset turnover may be broken into two primary components:
1. Working capital management
2. Long-term asset management

ROEt = RNOAt + FLEVt [RNOAt − NBCt ]

NOPATt NOPATt Salest

RNOAt = = ⋅
NOAave Salest NOAave

(2) Operating Asset Turnover:

The ability to generate sales for
a given asset base.
22319 Financial Statement Analysis 17
Working Capital Management
 Working capital is the difference between current assets and
current liabilities.
 Key ratios useful to analysing the management of working
capital include:
 Operating working capital to sales
 Operating working capital turnover
 Accounts receivable turnover (day’s receivables)
 Inventory turnover (day’s inventory)
 Accounts payable turnover (day’s payables)

22319 Financial Statement Analysis 18

Disaggregating ROE - ATO

Salest
ATOt =
NOAt
Salest
ATOt =
Inventoryt + A / Re ct + PPEt − A / Payt ...........

1 Inventoryt A / Re ct PPEt A / Payt

= + + − .................
ATOt Salest Salest Salest Salest

22319 Financial Statement Analysis 19

Qantas
2005 2006 2007 2008 2009 2010 2011 2012
Asset Turnover
Sales / Net Operating Assets 1.115 1.236 1.355 1.529 1.374 1.192 1.215 1.228
Net Operating Assets / Sales 0.897 0.809 0.738 0.654 0.728 0.839 0.823 0.814

Net Current Operating Assets / Sales -0.068 -0.049 -0.017 -0.054 -0.054 0.006 0.009 -0.006

Current Operating Assets / Sales 0.280 0.296 0.317 0.295 0.342 0.400 0.367 0.340
Current Operating Liabilities / Sales 0.348 0.345 0.333 0.349 0.396 0.394 0.357 0.346

Property Plant and Equip / Sales 1.007 0.917 0.814 0.761 0.842 0.896 0.878 0.884
Other Non Current Net Operating Assets / Sales -0.042 -0.060 -0.059 -0.053 -0.060 -0.062 -0.065 -0.063

Other Non Current Operating Assets / Sales 0.084 0.078 0.070 0.078 0.102 0.111 0.099 0.097
Other Non Current Operating Liabilities / Sales 0.126 0.138 0.129 0.131 0.162 0.173 0.164 0.160

22319 Financial Statement Analysis 20

 Disaggregating ROE – Financing Effects
 Financial leverage affects ROE (e.g., increases ROE, as long as the
cost of debt is lower than the return of investing the funds in
operations)
 However, from the equity holders’ point of view, although ROE has
increased, risk (and therefore the cost of capital for equity) also
increases (more on the actual maths for this in the valuation
section!)
(3) Financial Leverage:
• Amount of leverage
• Spread

ROEt = RNOAt + FLEVt [RNOAt − NBCt ]

22319 Financial Statement Analysis 21
Disaggregating ROE – Financing Effects

Positive correlation

ROEt = RNOAt + FLEVt ⋅ [RNOAt − NBCt ]

Need to consider about 3 things with financial leverage:

1. Affect on ROE
2. Cost of debt (NBC)
3. Financial risk associated with level of debt

22319 Financial Statement Analysis 22

Evaluating Financial Leverage
 What are the benefits of debt financing?
1. Typically cheaper than equity because of predefined payments (risk
reduction)
2. Interest can be tax deductible
3. Extra discipline on management
4. Easier to communicate privately to debtholders than to equityholders

 Some debt can be beneficial, but how much debt should a firm take? –
determined primarily by the firms’ business (operating) risk

 Analysis of leverage can be performed on both short- and long-term debts:

 Liquidity analysis relates to evaluating current liabilities
 Solvency analysis relates to longer term liabilities.

22319 Financial Statement Analysis 23

Liquidity Analysis

 There are several ratios useful to evaluate a firm’s liquidity,

including:
 Current ratio
 Quick ratio
 Cash ratio
 Operating cash flow ratio.
 Each of these ratios attempts to measure the ability of a firm to
pay its current obligations.

22319 Financial Statement Analysis 24

Liquidity Analysis
 Knowing how the liquidity ratios are calculated allows the user
to understand how to interpret them:
Current ratio = Current assets
Current liabilities

Quick ratio = Cash + Short-term investments + Accounts receivable

Current liabilities

Cash ratio = Cash + Marketable securities

Current liabilities

Operating cash flow ratio = Cash flows from operations

Current liabilities

22319 Financial Statement Analysis 25

Debt and Coverage Ratios
 Beyond short-term survival, solvency measures the ability of a firm
to meet long-term obligations.

Liabilities-to-equity ratio = Total liabilities

Shareholders’ equity

Debt-to-equity ratio = Short-term debt + Long-term debt

Shareholders’ equity

Debt-to-capital ratio = Short-term debt + Long-term debt

Short-term debt + Long-term debt + Shareholders’ equity

Interest coverage ratio = Net income + Interest expense + Tax expense

(earnings basis) Interest expense

Interest coverage ratio = Cash flow from operations + Interest expense + Taxes paid
(cash flow basis) Interest expense

22319 Financial Statement Analysis 26

Net Borrowing Cost

NFE
NBC =
NFO
 FL After - tax Interest on Financial Liabilies 
= x 
 NFO FL 
 FA After - tax Interest on Financial Assets 
− x 
 NFO FA
 FA Unrealized Gains on FA 
− x 
 NFO FA
 Preferred Stock Pref. Divs. 
+ x  + ---
 NFO Preferred Stock 

22319 Financial Statement Analysis 27

Cash Flow Analysis

 The ratio analysis previously discussed used accrual accounting.

 Cash flow analysis can provide further insights into operating,
investing and financing activities.
 All Australian and New Zealand companies are required to
include a statement of cash flows in their financial statements.
 Companies can choose two cash flow statement formats: direct
and indirect formats.

22319 Financial Statement Analysis 28

Analysing Cash Flow Information

 A number of questions can be answered through analysis of the

statement of cash flows. For example:
 Operating activities
 How strong is the firm’s internal cash flow generation?
 How well is working capital being managed?
 Investing activities
 How much cash did the company invest in growth assets?
 Financing activities
 What type of external financing does the company rely on?
 Did the company use internally generated funds for investments?
 Did the company use internally generated funds to pay
dividends?

22319 Financial Statement Analysis 29

Qantas
Y2017

22319 Financial Statement Analysis 30

Cash Flow Analysis

 Differences in reporting cash flow information allow for

variation across firms that complicate comparisons.
 Analysts can make adjustments to net income to arrive at free
cash flows, a commonly used metric for financial analysis.
 Compare cash flow from operations to net income
 Significant differences assessed
 One-off events?
 Accounting policies?
 Relation changing over time?

22319 Financial Statement Analysis 31

Putting It Together – An Example
Reformatted P&L 2013 Reformatted Balance Sheet 2012 2013
Sales 8,900 Net Operating Assets
Operating expenses (6,668)
Operating assets 8,000 10,100
2,232
Operating liabilities (400) (1,200)
Tax expense (424+132) (556)
Net operating assets 7,600 8,900
NOPAT 1,676

Interest expense (548) Net Financing Obligations

Interest Revenue 108 Marketable securities 1,600 800
(440)
Bonds payable (5,600) (5,200)
Tax Shelter (30%) 132
Net financing liabilities (4,000) (4,400)
Net Financing Expense (308)
Net Income 1,368
Other comprehensive income 10 Book value (net) 3,600 4,500
Comprehensive income 1,378

22319 Financial Statement Analysis 32

Putting It Together

 Calculate the following items:

1. Return on equity - ROE

2. Return on net operating assets - RNOA
3. Supply the numbers for the following formula:

ROEt = PM t × ATOt + FLEVt ⋅ [RNOAt − NBCt ]

22319 Financial Statement Analysis 33

Putting It Together

1. Return on equity – ROE

ROE = NI / OE
ROE = 1368 / [(4,500+3,600)/2]
ROE = 33.78%

2. Return on net operating assets – RNOA

RNOA = NOPAT / NOA
RNOA = 1676 / [(8,900+7,600)/2]
RNOA = 20.32%

22319 Financial Statement Analysis 34

Putting It Together
3. Supply the numbers for the following formula:
ROE = 33.78%
PM = 18.83%
ATO = 1.079
RNOA = 20.32%
FLEV = 1.037
NBC = 7.33%

33.78 = 18.83 x 1.079 + 1.037 x (20.32-7.33)

ROEt = PM t × ATOt + FLEVt [RNOAt − NBCt ]

22319 Financial Statement Analysis 35

Common mistake!

“Why my ROE formula left-hand side doesn’t balance

right-hand side?”

 Given your reformatting is correct, most likely you

calculate ROE using comprehensive income (CI).
 You should use net income (NI) instead.

 In assignment, you need to show ROE formula left-

hand side equals to the right-hand side.

22319 Financial Statement Analysis 36

Conclusion

This week Next Week

 Understanding past  The future - forecasting
performance
 Understanding the drivers
of past performance

22319 Financial Statement Analysis 37