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Appraisal of Business Performance

ITM Executive Education Centre

April 18th, 2010

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„ Financial Statement Analysis

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„ Why Measure / Analyse ?


„ What gets measured gets done

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Basic Questions
„ What is the financial position of a company at a given point of time ?
„ How has the company performed over a given period of time ?
„ What have been sources and uses of cash over a given period ?
„ Is the investment in the company safe ?
„ Does the company earn adequate profits ?
„ Is the company solvent enough to meet its obligations whenever they
mature ?
„ Does the company earn enough to build reserves for future growth ?
„ Is the company properly capitalized ?

Appraisal is Scientific Evaluation of Profitability and financial strength of the company


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Need for Financial Analysis
„ Appraisal is a useful measure of past performance
„ Performance evaluation is the Heart of Management Information System
• Ensure that the company is on road to profitable growth as per
plan
• Gives an early warning signal should something go wrong
• Provides basis for allocation of resources
• Evaluation of Managers and their compensation
„ Appraisal of the past answers two basis questions :
• How well is the business done if compared with what should have
been done ?
• What can be done to improve future performance ?
Appraisal is a process of evaluation of summarized financials, business data to obtain better
understanding of company’s position and performance 5

Measurement Areas
„ Profitability :
• How profitable is the venture ? Î return on sales, capital employed, equity ?
„ Investment Utilization :
• Measures balance between sales / profits and assets particularly fixed assets
and inventory. Also known as efficiency ratios.

„ Liquidity :
• Measures ability of the company to meet short term debts. Also concerned with
efficiency of working capital investment – receivables, inventory and payables.

„ Stability :
• Measures balance between debt and equity. Too much debt increases risk of
insolvency

„ Growth :
• Measures improvement or decline in performance from year to years
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„ Financial Statements

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„ Directors Report
„ Auditors Report
„ Balance Sheet
„ Profit and Loss Account
„ Cash Flow Statements
„ Notes / Schedules to Accounts

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Annual Report
„ Primary and most important source of information about a company is its
Annual Report
„ Annual Reports are well presented with relevant data about performance
of the company given over a period of time
„ Intelligent investor must read Annual Report in depth, between and
beyond lines to find truth and only then should decide whether the
company is worth investing in.
„ Important constituents of an Annual Report :
• Director’s Report
• Auditor’s Report
• Financial Statements
• Schedules and Notes to Accounts
„ Graphs, bar, pie charts, pictures and information on CSR add value to
contents of a good Annual Report
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Director’s Report
„ Director’s Report is addressed to shareholders advising them about
performance of the company for the year – evaluation of their performance
„ Opinion of Directors state of economy and impact on industry & company
„ Evaluation of financial performance of company and divisions
„ Company’s plans for expansion, modernization, diversification, plan for
acquisition and investment.
„ Availability of Profits and recommendation of dividend
„ Directors views on company’s performance in coming years
„ Valuable if read intelligently as it give good understanding of working of
the company , problems faced, directions it intends to take and future
prospects

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Audit Report
„ Auditors are required to present to Shareholders whether the financial
statements present a true and fair view of the state of affairs of the
company
„ Auditors Report draws attention of the reader to changes in Accounting
policies, inconsistencies and its impact on the financial statements.
„ Investor must carefully read Auditors Report to understand departures
made from normally accepted accounting principles and policies. Results
could change if adjustments are made based on notes and comments in
Auditors report.
„ Auditors also comment on any action or method of accounting they do not
agree with.

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Balance Sheet
„ Balance Sheet shows Financial strength of business at given point of time
„ Groups logically under specific heads company’s Assets – what company
owns and liabilities – What companies owes others
„ BS details financial position on a particular day and that the position could
be materially different on the following day.
„ Company has to source funds to purchase fixed assets , procure working
capital and fund its business.
„ Balance Sheet can be presented as a Source and Utilization Statement

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Shareholders Funds
„ Share Capital – Equity ( Risk Capital ) & Preference Capital. Dividend paid
out of profits.
• Authorized ( Potential ) Capital, Issued ( Offered ) , Subscribed ( Paid Up)
„ Reserves & Surplus – Retained earnings + Revenue & Capital reserves
• Capital Reserves – Share Premium, Revaluation, Capital Redemption Reserve
• Revenue Reserves – Accumulated earnings, Investment Allowance Reserve,
Dividend Equalization Reserve, General Reserves, Profit & Loss a/c credit
balance

„ Shareholders Funds = Net Worth = Equity + Reserves – Misc exp w/off


„ Share Capital can be issued in many ways : Private Placements, Public
Issues, Rights Shares, Bonus Issue
„ Pragmatic management follow a balanced dividend policy and retain /
plough back a part of profits for future expansion
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Secured / Unsecured Loans
„ Borrowing is preferred source as it is quicker , cheaper and enhances
return to shareholders if cost of funds is less than rate of earning.
„ Secured on charge of assets – either a floating charge or a fixed charge
„ Pledge / Hypothecation Î movable assets – Stocks, Receivables ( In
Equitable Mortgage title is deposited with lender )
„ Mortgage Î Immovable – Plant / Machinery , Buildings
„ Secured Loans : Debentures, Term Loans, Working Capital Loans
„ Unsecured Loans : Not secured by charge on assets – Public Deposits,
Promoter Loans, Inter Corporate Deposits, Clean loans from banks /
Financial Institutions

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Current Liabilities & Provisions
„ Current Liabilities & Provisions are obligations maturing within one year
„ Bills payable, trade creditors for supplies made, advances received. Credit
period depends on demand for the material, standing of the company and
market practices
„ Expenses accrued but not due : Interest on loans, selling, distribution and
admin expenses which are paid on specific dates so need to be estimated
based on past trends and provided for at the year end.
„ Provisions are amounts set aside from profits for expenses or losses -
taxes, dividend, employee funds, loans payable, within one year or
depreciation, bad and doubtful debts.
„ Other current liabilities include unclaimed dividends, dues payable to third
parties etc

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Assets
„ Owned & used in business to provide future economic benefits convertible in cash inflow
„ Resources are recognized a assets when
• Company acquires rights over them
• Can quantify future economic benefits with fair degree of accuracy
„ Asset Types – Fixed ,Investments ,Current Assets, Loan & Advances, Misc expenditure &
Losses
„ Fixed Assets – Tangible and Intangible
• Depreciation – Allocation of cost of Tangible fixed assets to various accounting
periods that benefit from its uses – Charge on profits
„ Tangible – Land, Buildings, Plant & Machinery,
„ Intangibles – Patents, Copyrights, Trademarks, Goodwill
„ Tangible Fixed Assets – Represented by net book value Î gross acquisition value –
accumulated depreciation

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Investments
„ Trade Investments – Shares and debentures of companies to earn income
by way of interest / dividend or to get access to information of other
companies.
„ Subsidiary & Associate Companies – Controlling interest directly or
through cross holdings – usually as diversification measure through JVs
„ Investments are classified as Quoted / Unquoted based on their listing on
Stock Exchanges. Quoted investments are liquid.
„ Investments are valued at either cost or market value whichever is lower.
„ Diminution in value of investments / losses are adequately accounted for.

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Current Assets , Loans and Advances
„ Current assets are owned and used in the normal course of business
„ Cash & other assets convertible in cash during operating cycle of company
„ Inventories – Raw Materials, Work in Process, Finished Goods, Packing
Materials, Stores – valued at cost ( Purchase value + Conversion+
Logistics ) or net realizable value whichever is lower
„ Receivables – Amount owed by customers adjusted to doubtful amounts
„ Cash , Banks and Cash equivalents
„ Other Current Assets – Interest Accrued, Fixed Assets for sale etc
„ Loans & Advances – Support to subsidiaries, deposits with Government
Authorities
„ Miscellaneous Expenses / Losses – Preliminary Expenses, Discount on
securities, Interest during construction, development expenses not w/off
„ Losses – Debit balance in Profit and Loss Account
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Profit & Loss Account
„ Profit & Loss Account summarizes activities and results achieved by the
company during accounting period
„ It is performance appraisal not only of the company but its management –
its competence, foresight and ability to take risk and lead.

Revenue Expenditure
Sales Cost of Goods Sold
Other Income Employee Cost
Operating & Other Expenses – Selling,
Admin, General
Interest & Finance Charges
Depreciation
Taxation
Dividends

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Contingent Liabilities
„ Contingent liabilities are liabilities that may arise on the happening of an
event.It is uncertain whether that event will happen or not
„ Contingent liabilities are not recorded in accounts but are shown by way of
notes / information to readers of potential liability should the event happen
„ Examples :
• Bills Discounted with banks – May crystallize in liabilities if dishonored
• Outstanding guarantees / Letters of Credit
• Cheques discounted
• Uncalled liability for partly paid shares and debentures
• Gratuity of employees not provided for
• Legal suits against company not provided for
• Claims against company not acknowledged as debt or accepted
• Claims against company for taxes and duties
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Schedules and Notes to Accounts
„ Schedules/ Notes to accounts are integral part of financial statements and
have to be read along with financial statements
„ Schedules detail pertinent information about items of Balance Sheet and
Profit & Loss Account
„ Notes to accounts cover – Accounting policies, Contingent Liabilities and
relate to Î how sales are accounted ?, What are R&D costs?, How is
gratuity liability expensed? , How fixed assets are valued ? How
depreciation is calculated? How stocks – finished goods, WIP, raw
materials and consumables are valued ? How are investments stated?
How has foreign exchange translated ?

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Accounting v / s Economic Values
„ Use of Historical Cost Principle :
• Accounting uses historical cost as basis of valuation
• Asset Value = Cost – Accumulated Depreciation
• Historical Values differ significantly from Economic Values
„ Exclusion of Intangible Assets :
• Intangible stated at cost of acquisition less amortization
• Economic Values attached to technical knowledge , Brand equity, Managerial
capability, Goodwill is ignored as difficult to objectively to value them

„ Understatement / Omission of certain liabilities


• Contingent liabilities not recorded but shown by way of notes to accounts

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Net Cash Flow
„ Cash flow generally differs from PAT due to accrual concept of accounting
„ Relationship between cash flow and PAT :
• Net Cash Flow = PAT – Non Cash Revenue + Non cash Expenses
„ In practice, Analysts define net cash flows :
• Net Cash Flow = PAT + Depreciation + Amortization
• Accuracy of reconciliation depends on correct estimates of accrued incomes
and expenses

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Free Cash Flow
„ Operating FCF = Cash Inflow from operations – Cash outflow from
operations
• Cash inflow from sale of goods – payments to suppliers of goods
„ Investing FCF = Cash Inflow Investing Activities – Cash Outflows from
Investing Activities
• Receipt from sale of assets , recovery of loans, Interest, dividend – Payment for
purchase of assets, disbursement of loans

„ Financing FCF = Cash Inflow from financing activities – Cash outflow from
financing activities
• Receipts from issue of securities, Loans, Deposits – Outflow from interest on
loans, dividend payment, retirement of borrowings and redemption of capital

„ Net FCF = Operating FCF + Investing FCF + Financing FCF

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Accounting v / s Analysis
„ Accounting – Classification , recording, summarizing and presentation of
financial data
„ Analysis – Unveiling the meaning and significance of items in financial
statements to assist management in formation of sound operating financial
policies
„ Analysis reveals significant facts relating to financial strength , profitability ,
corporate efficiency, weakness, management performance , solvency and
other factors related to company

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„ Analysis of Financial Statements

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Measurement Areas
„ Every stakeholder is interested in reviewing economic performance of
business in which he has stake
„ Board and Management reviews and evaluates periodically to establish
whether actual position is in line with projections
„ Financial performance appraisal is basic exercise for monitoring past
performance to have fruitful planning of the future
„ Focus is on various tools of analysis for appraisal of business performance
„ Productivity and Profitability are two yardsticks against which business
performance is judged
„ Financial appraisal is an objective evaluation of profitability and financial
strength of the business unit through application of technique financial by
using .

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Ratio Analysis Summary

Financial Goals

For a given Risk


Return

ROI Financial Position

Investment Stability Liquidity


Profitability
Growth
Utilization Long Term Short Term
Subject to Accounting policies
Qualitative factors External Factors Time frame of analysis
Industry Trends Ratio Definitions Suitability of historic data as prediction tool

Measurement Areas
„ Financial Statements – Important source of information for evaluating performance and
prospects
„ All stakeholders are interested in getting an insight :
• Management – Performance Review
• Lenders – Short term liquidity
• Investors – Portfolio Analysis
• Researchers –
„ Purpose of analysis may be varied :
• Simple analysis for short term liquidity
• Comprehensive assessment of strengths and weaknesses
• Corporate excellence
• Creditworthiness
• Intrinsic value of equity shares
• Assessment of market risks

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Methods of Analysis
„ Horizontal Analysis : Comparison , Analysis and interpretation of similar
items of financial statements relating to two accounting periods
„ Vertical Analysis : Comparison , Analysis and interpretation of two items
or variables of financial statements relating to same accounting period
„ Static & Dynamic Analysis : Static Analysis measures relationship
among items in single statement. Dynamic Analysis measures changes in
such items in successive statements
„ Internal & External Analysis : Internal represents Analysis of financial
data by management for internal decision making. External represents
analysis done by outsiders like investors , bankers, Government,
Creditors, Customers and others for decision making

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Financial Ratios
„ In analysis of financial statements, ratios are most useful because they
help in comparing strengths, weaknesses and performance of companies
„ Ratios express mathematically relationship between performance figures
and / or assets / liabilities in a form that can be easily understood and
interpreted.
„ No single ratio tells complete story – when various different ratios are
calculated and arranged, complete set of comparison emerges.
„ Five Broad types of Ratios :
• Profitability Ratios
• Leverage Ratios
• Turnover Ratio
• Liquidity Ratios
• Valuation Ratios
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Financial Ratios
„ Profit & Loss Ratios – Show relationship between two items or groups of
items in Profit and Loss Account or Income Statement
• Sales to Cost of Goods Sold
• Selling Expenses to Sales
• Net Profit to Sales
• Gross Profit to Sales
„ Balance Sheet Ratios – These deal with relationship in Balance Sheet
• Shareholder Equity to Borrowed Funds
• Current Assets to Current Liabilities
• Liabilities to Net Worth
• Debt to Assets
• Liabilities to Assets

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Financial Ratios
„ Balance Sheet and Profit & Loss Ratios – These relate an item on Balance
Sheet and Profit & Loss Account
• Earnings to Shareholders Funds
• Net Income to Assets employed
• Sales to Stock
• Sales to Receivables
• COGS to Creditors
„ Financial Statements and Market Ratios – relate to Financial numbers to
market prices
• Market Value to Earnings
• Book Value to market Value
„ Ratios being measured should be consistent and valid and length of
periods should be similar
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„ Liquidity Ratios

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Financial Ratios – Liquidity
Ratio Formula Meaning Desired Trend
ƒ Number of times short term • Rule of Thumb 2:1
assets can cover short term
Current Total Current Assets Total
debts
• Too Low – Business
Ratio Current Liabilities discontinuity
ƒ Indicates ability to meet short
term obligations as they come • Too high – suboptimal use of
due. capital
• Rule of Thumb 1;1
Cash Equivalent + Avg • Indicates ability to meet • Too low – Risk of Insolvency
Acid Test Receivables short term payments using • Too High – inefficient use of
Total current Liabilities most liquid assets capital

Current Assets minus • Higher is safer


Current Liabilities • Net funds tied up in • Too low – business at risk Too
Working
Capital
working capital high – low return. Adverse
impact on profitability
• Should be close to industry
average
• How high is average
Accounts Receivable • Too low – credit policies tight
Age of outstanding balance on
Average Daily Sales and scaring business
Receivables credit sales ?
• Too high – customers
enjoying at company’s cost
Financial Ratios – Turnover
Ratio Formula Meaning Desired Trend
• Rule of Thumb 2:1
Age of ƒ How many days on average
Average Inventory
does an item of inventory
• Too Low – Business
Inventory Average Daily COGS discontinuity
remain in stock ?
• Too high – insufficient use of
capital

Accounts Payable • Close to industry average


Age of Average Daily Purchases • Indicates number of days • Too low – extend credit period
Payables it takes for business to pay and source cash
Or
Accounts Payable its suppliers • Too high – suppliers may cut
Average Daily COGS off supplies
• Close to industry trend
Fixed Asset • Indicates rupee sales • Too high – existence of old
Rotation Net Sales / Average net
fixed Assets generated by investment assets
in Fixed Assets • Too low – under utilized or
asset block not productive
• Incremental investment and
Total Asset • Indicates rupee sales return to be established
turnover Net Sales / Average total
assets generated by investment • Too High – lean asset block
in total assets • Too low – underutilized, slow
moving

Liquidity Ratios
„ Cornerstone of any investment. Liquidity or conversion to cash is crucial
for the company to meet obligations both for operations and on maturity of
loans.
„ If liquidity is constrained, company may be forced to sell its assets or may
lead to liquidation
„ Indicates ability of a company to meet its obligations in short run – usually
a year
„ Liquidity Ratio – Based on relationship between current assets ( sources
of meeting short term obligations ) and current liabilities
„ Companies have become conscious of cost of capital, opportunity cost of
tying up of capital unproductively as a result Just In Time inventory
„ Current assets are deliberately kept low – efficient management of funds

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Current Ratio
„ Current Ratio = Current Assets / Current Liabilities
„ Current Assets – Cash + Current Investments + Receivables + Inventories
+ Loans & Advances + Prepaid Expenses
„ Current Liabilities – Loans ( Secured & Unsecured ) due in one year ,
current liabilities and provisions
„ CR measures ability of the company to meet CL
„ Higher the CR the greater is short term solvency
„ Quality of CA is crucial
„ Higher portion on cash / Receivables – more liquid than higher portion of
inventories
„ CR norm in India is 1.33:1. Internationally, 2:1.

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Current Ratio
„ As On March 31st 2009 ITM limited’s current assets were Rs 400 Lakhs
and current liabilities Rs 125 lakhs.
„ Current Ratio = 400 / 125 = 3.2. ITM can meet its current liabilities by
selling mere 31.2% of its current assets

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Liquid Ratio
„ Also known as Acid Test / Quick Ratio
„ Liquid Ratio = ( Current Assets – Inventories ) / Current Liabilities
„ Fairly stringent measure of liquidity
„ Used to measure company has enough cash or cash equivalents to pay
debts. Inventories are excluded in computing liquid assets.
„ India norm 1:1
„ Cash Ratio – Most liquid
„ Cash Ratio = ( Cash & Bank Balances + Current Investments ) / CL
„ Cash Ratio is overly stringent measure of liquidity. In real life situations,
lack of immediate cash can be overlooked if company can release dues ,
stretch payments or borrow money at short notice.

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Liquid Ratio

• Company cannot pay off its current


Rs Lakhs
• Liabilities with cash or cash
Cash at Bank 150 equivalents
Receivable 1850 • Stocks have been excluded from
Inventories 3100 calculations as it is difficult to dispose
Investments 500 off stocks except at distressed value
Current Assets 5600
Current Liabilities 4000

Quick Ratio = 150 + 1850 + 500 = 0.625


4000

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Net Current Assets
„ Net Current Assets = Gross Current Assets – Current Liabilities
„ Not a ratio but helps to ascertain whether company has adequate current
assets to meet current liabilities
„ Net Current Assets is also known as Net working Capital
„ NCA used as a base to determine quantum of W/C required to support
certain level of sales. A ratio of 20% would indicate if sales increase by
20% , current assets would need to increase proportionately.
„ As a defensive strategy, management may want to know no of days
company may remain in business without additional financing / sales eg
worker strike situation. Example follows.
„ Current liabilities coverage ratio establishes relationship between cash
inflow from operations and current liabilities to determine whether
company can meet maturing obligations from internally generated funds.
Important ratio in times of cash crunches. Example follows.
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Example of Defensive Ratio : Example
„ Cash and cash equivalent of ITM limited whose annual operating
expenses are Rs 730 Lakhs is as follows :
Rs Lakhs
Cash 35
Marketable Securities 145
180
Daily Operating Expenses 730 / 365 = 2 2

Defense interval would be 180 /2 = 90 90 days

This means that ITM Limited can remain in existence for 90 days without any sales
Or financing

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Current Liabilities Coverage : Example
„ For the year ended March 31st 2009, ITM Limited earned a net income
before tax but after depreciation of Rs 750 L. Depreciation was Rs 25 L.
Current liabilities at 31st March 2009 and 2008 were Rs 2350 L and Rs
1450 L.
„ Current Liabilities Coverage Ratio = Cash Profit / Current Liabilities
„ (750+25) / 0.5 (2350+ 1450) = 0.41 or 41%
„ In other words, cash flow from operations was only 41% of current
liabilities. If current liabilities were to be paid from internal generations, it
would take 2.44 years. As such funding would be required – either equity
or borrowings.

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Net Current Assets Example
„ In 2009 ITM Limited had sales turnover of Rs 2000 lakhs and net current
assets were Rs 450 Lakhs after meeting its current obligations

2009 2008 Net current Assets are Rs 450 L and sales


Current Assets Rs 2000 L.
Receivables 310 280 So net current assets to sales ratio
Inventories 390 320 Is 0.5 ( 400+450) / 2000 x 100 = 21.25%
Total Current Assets 700 600 This means that working capital will have to
Creditors 220 190 go up by 21.25% to support every rupee increase
Accrued Expenses 5 3 In sales.
Tax Payable 25 7 If sales were to go up by Rs 100 L,
Other Current Liabilities 250 200 Net current assets would go up by Rs 21.25 L
Net Current Assets 450 400 This linear equation may not always hold true but

Gives a thumb rule.


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Net Trade Cycle
„ It is important to determine time company takes to realize its sales
proceeds after paying for purchase of raw materials
„ A very useful tool for determining company’s liquidity and is computed by
as Debtors turnover (no of days) + stock turnover ( no of days) – creditors
turnover ( no of days )
„ Improvement ( reduction in no of days ) in this ratio signifies improvement
in management of net current assets
„ Alternatively, ratio could improve if Creditors no of days go up indicating
un-ability of the company to suppliers in time.
„ Need to go beyond numbers to determine reasons for change in net trade
cycle. Longer the trade cycle, greater need of financing and so cost.
„ Also individual components of cycle need to be studied to arrive at right
conclusions
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Net Trade Cycle – Example
Extract from ITM Limited’s Financial Statement
2009 2008
Receivable Turnover =
Sales 280 200
Average Receivables/Sales x 365
Cost of Goods Sold 224 160
Inventory Turnover =
Receivables 44 24
Average Inventory / sales x 365
Inventories 48 36
Net Trade Cycle Creditors Turnover =

Receivables Turnover - days 44 days Average Creditors / sales x 365


Inventories Turnover – days 68 days
Less Net Trade Cycle =
Creditors Turnover – days 39 days Receivable Turnover + Inventories
Net Trade Cycle – days 73 days turnover – Creditors turnover

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Cash is King
„ Liquidity is becoming increasingly important for companies and lack of it
could make a company sick
„ If cash crunch happens, companies begin to postpone / delay paying bills.
Supplier dues build up, supplies dry out. Impacts production then sales
and has snowballing effect.
„ Negative liquidity ratio need not necessarily be bad. Strong companies
keep low current assets – are able to get long credits / advances from
suppliers. JIT inventory, low receivable and extended supply credit could
turn net working capital negative.
„ Checking quality of company’s assets and ascertaining its current
realizable value is crucial. Current Assets should not include deferred
revenue expenditures as it may not have realizable value.bobny ys aAua

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Financial Ratios - Recap
„ Ratios do not provide answers. They suggest possibilities.
„ Interpreters must examine these possibilities along with general factors
that would affect the company such as its Board, management style,
government policies, state of economy and industry to arrive at a logical
conclusion.
„ Ratios are tool for interpreting financial statements but their usefulness
depends entirely on their logical and intelligent interpretation.
„ Ultimately, the market value of shares is what matters to an investor as
would purchase share if , in his perception, its price is low or reasonable
and has growth potential.
„ If share is priced high, an investor would sell as the cardinal principle is “
buy cheap and sell dear”
„ Ratios help investor to decide on holding period to recover investment.
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„ Leverage

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Financial Ratios – Stability
Ratio Formula Meaning Desired Trend
Net Worth • Higher is Safer
Total Equity
to Total Assets
ƒ What percentage of business • Too low – Too much debt
owned by Shareholders • Too High – Underleveraged
Total Assets reducing ROE.

• Lower the safer


Total Debt to • What percentage of
Total Liabilities • Opposite of Net worth to
business is financed
Total Assets Total Assets Assets
through debt ?

Debt • Lower is safer


Total Liability • Too low – inefficient use of
to • Number of times debt for
Total Equity equity
Equity every rupee of equity
• Too high – over leveraged
and risky

Long Term
Debt
EBIT • Number of times • Assurance to lenders that
Interest Interest on Long Term availability of profit to meet sufficient cover exits for
Coverage Debt interest payment liability interest payment

Leverage
„ Leverage indicates the extent to which a company dependent on borrowed
funds to finance its business
„ In highly leveraged firms, owner’s funds are minimal and they are able to
control business with fairly low stakes. Main risks are borne by lenders.
„ In good times, companies make large profits if they are in high margin
business. Reverse occurs in times of recession. Interest charges eat into
profits and often turns in to large losses.
„ Companies with no or moderate borrowings is safer and can be depended
upon both in good and adverse years.
„ Highly geared companies are risky and earnings can be negative in bad
years. In good years financial results of leveraged companies can be very
good.
„ Important to investors in evaluation of companies.

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Leverage – Example
Company A Company B Company C
Rs Lakhs Rs Lakhs Rs Lakhs

Share Capital 40 160 200


Borrowed Funds 160 40
Total 200 200 200
Good Year
Earning Before Interest & Tax 100 100 100
Interest @ 20% 32 8 0
Profit Before Tax 68 92 100
Tax @ 33% 22 30 33
Profit After Tax 46 62 67
Returns to Ordinary Shareholders
Before Tax % 170 57.5 50
After Tax % 114 39 34
Reasonable Year
Earning Before Interest & Tax 60 60 60
Interest @ 20% 32 8 0
Profit Before Tax 28 52 60
Tax @ 33% 9 17 20
Profit After Tax 19 35 40
Returns to Ordinary Shareholders
Before Tax % 70 33 30
After Tax % 47 22 20
Bad Year
Earning Before Interest & Tax 24 24 24
Interest @ 20% 32 8 0
Profit Before Tax -8 16 24
Tax @ 33% 5.28 7.92
Profit After Tax -8 10.72 16.08

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Leverage – Learning from Example
„ Company A is highly leveraged. Company B borrowed funds up to 20 % of
its funding needs. Company C is debt free.
„ In good year Company A makes stupendous 170% before tax where as
Company C makes modest 50%
„ So long as earning rate exceeds cost of borrowing, highly leveraged
company makes impressive profits.
„ In reasonable years, profits of leveraged companies is higher than
companies that do not borrow. Earnings before tax of Company A is twice
that of Company C.
„ During recession, interest costs are comparatively high and profits gets
wiped out both on account of lower margin and interest burden. Company
C makes highest profits as it has no borrowings.

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Leverage Ratios

„ Based on proportion of Debt & equity in capital structure


• Debt : Equity
• Debt : Asset
„ Relationship between debt service commitment and sources of meeting
these burdens
• Interest Coverage
• Fixed Charges Coverage
• Debt Service Coverage

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Debt : Equity

„ Shows extent of funds are obtained from external sources and how
dependent the company is on borrowings to finance its business.
„ Debt : Equity = Debt ( Long Term + Short Term )
Net Worth + Preference Capital
„ Lower the DE ratio Î higher is the degree of protection enjoyed by
creditors
„ BV of equity may be lower than market capitalization as tangible assets
recorded at historical value net of depreciation and Intangible assets like
Brand, Goodwill, Intellectual Property Rights, Knowhow are not recorded
in Balance Sheet.
„ Secured debentures , Borrowings, Loans are protected on charge of
assets and enjoy superior protection

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Debt : Equity Example

„ Balance Sheet of ITM Limited as Rs Lakhs


on March 31st 2009 is as follows :
Shareholder’s Equity 158
„ Debt : Equity Ratio :
Debentures 150
„ (150+ 40+ 40 ) / ( 158-10 ) = 1.55
Terms Loans 40
„ Company’s liabilities are 1.55
times net worth. Alternatively, Current Liabilities 40
liabilities finance 60.85%
388
„ Extremely useful ratio when one
is determining how well Tangible Assets 378
shareholders would be
Intangibles 10
compensated should company go
bankrupt. 388

57

Liabilities to Assets Ratio

„ Indicates total borrowings used to finance company and the extent to


which external liabilities finances assets of companies
„ Liabilities include both current / long term liabilities
„ Assets include all assets excluding intangibles such as deferred revenue
expenditures – preliminary expenses, goodwill, deferred advertising
expenditure etc. )
„ Debt : Assets = Debt ( Long Term + Short Term )
Total Assets OR ( Debt + Equity)
„ Alongside, it would be useful to examine company’s contingent liabilities
such as guarantees, legal suits. If these are significant and likely to
crystallized, the result would change drastically.

58
Liabilities to Assets Ratio Example ’

„ Balance Sheet of ITM Limited as on Rs Lakhs


March 31st 2009 is as follows : Sources of Funds

„ Liabilities to Assets Ratio : Shareholders Funds 100

„ ( 50+200) / (350 -10 ) = 0.74 Debentures 50


Current Liabilities 200
„ 74% of assets of the company are
financed by liabilities 350
Application of Funds
„ Conversely, it can also be
concluded that assets are sold at Fixed Assets 80

74% of book value, would meet Investments 40


company’s liability commitment. Preliminary Expenses 10
Current Assets 220
350

59
Incremental Gearing with Example ’

2009 2008

Net Income Before Tax 400 300


Taxation 75 50
Profit After Tax 325 250
Borrowings 480 400

• Incremental Gearing ratio attempts to determine additional borrowings


required to finance growth. Ratio is calculated by dividing net increase in
debt by increase in net income after tax but before dividend.
• Incremental gearing is : for every rupee used to finance growth, net income
Would increase by Rs 75. Î ( 0.5 x (480 – 400) / ( 325 – 250) ) = 75
This is a very high dependence.
60

Interest Coverage

„ Determines whether company’s profits are adequate to meet its interest


dues. If not, interest will have to be paid out of reserves, borrowings,
fresh issue of capital
„ Times Interest earnings Î Earning Before Interest & Tax / Interest
„ EBIT is considered as numerator as the ability of a company to pay
interest is not affected by tax payment as interest is tax deductible
„ Must exceed 1 and higher ratio better - can meet its commitment
„ Lower ratio means financial embarrassment should profits decline
„ Ratio used by lenders to assess debt capacity – major determinant in
Bond / Debt rating
„ Variant of this ratio could be cash flow before Interest and Taxes
• Modified as ( EBIT + Depreciation ) / Interest
61

Interest Coverage Example

„ ITM Limited earned Rs 450 L before interest and tax during the year
ended March 31st 2009. Interest expense was Rs 200 L
„ Interest Cover Ratio = 450 / 200 = 2.25 times
„ Company’s earnings before interest are more than double its interest
expense. A comfortable situation.

62

Debt Service Coverage Ratio – DSCR

„ Helps determine time taken by company to repay its short / long term
debt from its income or internally generated funds.
„ Relevant if debt is not to be extinguished through sale of assets or by
issue of fresh capital or debt.
„ Internally generated funds means income after tax + non cash expenses
such as depreciation and non operating income and expenses.
„ Debt would comprise of bank OD, term loans and debentures.
„ PAT + Depreciation + Non cash items + Interest on TL + Lease Rentals
Interest on term loans + Lease Rentals + Repayment of term loans
„ Financial Institutions consider DSCR of 1.5 - 2 as satisfactory
„ Ratio critical during high inflation and recession when company may find
it in difficult situation to meet this financial covenant to service debt
63

Debt Service Coverage Ratio – DSCR – Example
2009 2008
Net Income before tax and depreciation 500
Depreciation 100
Net Profit Before Tax 400
Tax 160
Net Profit After Tax 240
Bank Overdraft 150 100
Debentures 380 400
Term Loans 90 100
520 600

Debt Service Coverage Ratio = ( 240 + 100 ) / 0.5 ( 600+ 520) = 0.60
This would mean that it would take the company ( 12 x 0.60) = 1.7 years to repay from
its profits

64

Liability Coverage Ratio with example

„ Liability Coverage ratio is an extension of debt coverage.


„ Used to check whether a company can repay all liabilities through internal
generations.
„ Calculated by dividing internally generated funds by its average total
liabilities. Alternatively, ratio is calculated on balance sheet date instead of
average as it is more relevant figure which will have to be repaid.
„ In year ended March 31st 2009, ITM Limited generated Rs 500 L
internally. Its total liabilities at the end of 2009 and 2008 were Rs 4500 L
and Rs 3500 L respectively.
„ Liabilities coverage Ratio = 500 / ( 0.5 ( 3500+ 4500) = 0.25
„ This means that internally generated funds are only 25% of company’s
average liabilities. Entire debt can be repaid in 4 years.

65

Fixed Charge Coverage Ratio I

„ Companies use leased funds as alternative means of financing –


advantage is company is not required to borrow to acquire asset and also
lease rentals are deductible expense for tax purposes
„ This is known as “ Off Balance Sheet “ Financing as neither the real cost
of asset nor its liability is reflected in balance sheet
„ Fixed charge cover considers off balance sheet obligations such as
rental expenses and assesses whether a company earns enough income
to meet its interest and rental commitments.
„ At times, it is argued that dividend payable on preference shares is to be
considered as it is fixed charge to be paid off.
„ More comprehensive ratio as ikt considers all fixed expenses and
examines whether its earnings are sufficient to meet them

66

Fixed Charge Coverage Ratio II

„ Times cash flow before Interest and taxes to cover all financial charges
„ ( EBIT + Depreciation ) / Interest + ( Repayment of loans – (1 – tax rate) )
„ In denominator, repayment of loans is adjusted upwards for tax factor
because loan repayment amount unlike interest is not deductible
„ Measures debt servicing ability comprehensively because it considers
both interest and principal repayment obligations.
„ Ratio may be amplified to include other fixed charges like lease payment
and preference dividend
„ EBIDTA
Debt Interest + Lease payment + ( Loan repayment Installment /( 1- tax rate)
+ Preference Dividend / ( 1- tax rate)
„ ST loans like WCTL/ CP - self renewing in nature and not repaid annually
so FCCR less than 1 need not be viewed with concern
67

Fixed Charge Coverage Ratio - Example

ITM Limited’s Income Statement included following figures :

Rs Lakhs
Rental Expenses 400
Earnings before Interest and Tax 750
Interest 200
Earning before Tax 550
Tax at 40% 220
Profit After Tax 330

Fixed Charge Cover = ( 750 + 400 ) / ( 200 + 400 ) = 1.91

68

Cash Flow Surplus

„ Cash flow surplus ratio is based on going concern concept. Assumes


company will incur capital expenditure and that there would be increase in
net working capital
„ Company’s ability to pay debt determined after providing for increase in
capital expenditure and net working capital
„ Cash flow is net capital expenditure & increase in net working investment
„ Ratio calculated by dividing cash surplus by total debt
„ May be negative Î as the company grows rapidly it incurs capital
expenditure and net working capital increases. This exceeds net funds
generated Î funded by loans and short term bank facilities.

69

Cash Flow Surplus – Example

„ In 2009 , average debt of ITM Limited was Rs 400 L. Its internally generated
funds were Rs 40 L. Its net working investments had increased by Rs 10 L
and it had incurred capital expenditure of Rs 20 L.
„ Cash Flow Surplus = ( 40 – 10 – 20 ) / 400
„ It would take company 40 years to repay its debts by utilizing cash flow
surplus
„ It also indicates need to borrow and extent of such borrowings

70

„ Asset Management Efficiency Ratios

71
Financial Ratios – Asset Turnover
Ratio Formula Meaning Desired Trend

COGS ƒ Rotation of Inventory during • Higher is better


the financial year.
Inventory Average Inventory • Too low – Obsolescence
ƒ Speed at which inventory
Turnover moves • Too High – Stock outs

• Higher the better


• Rupee earned for every • Too low – mismatch in assets
Net Sales rupee of fixed assets / unutilized assets
Fixed
Assets
Average Net Fixed Assets • Measures utility of fixed • Too high – assets flogged or
Turnover assets to business old assets needing
replacement
• Higher the better
• Rupees earned for every • Too low – presence of
Net Sales
Total Asset rupee of total assets redundant assets
Turnover Average Total Assets
• Measures usefulness of • Too high – risk of business
assets disruption, loss of
opportunities.
Financial Ratios – Return on Investment
Ratio
Formula Meaning Desired Trend

Net Income
Return on Average Total Assets ƒ Quantum and quality of • High return signify better
Assets May also use EBIT returns generated by Assets utilization of assets
instead of Net Income

• Whether the business is


Net Income generating return meeting • Return higher than hurdle rate
Return on shareholder expectations leads to shareholder
Average Shareholders
Equity Equity • How higher than hurdle satisfaction
rate ?

• Indicates quality and • High return indicates better


PBIT / Average total ability of asset block to utilization.
Earning
power
assets produce earnings before • Impact of leverage / borrowing
financial charge costs removed

• Indicates quantum of • Return higher than cost of


PBIT ( 1- Tax rate ) / (Net return on capital employed capital means every rupee
Return on Fixed Assets + Net
Capital Current Assets ) in comparison with invested increases
Employed borrowing costs shareholder wealth
Financial Ratios – Growth
Ratio Formula Meaning Desired Trend

Profit Profit yr 2 – Profit yr 1 ƒ Growth or decline in profit • Growth is good


Growth over past two operating
Profit yr1 periods • Quantum to be benchmarked
with expectations / hurdle rate

• Sales growth is good


Sales Sales yr 2 – Sales yr 1 • Growth or decline of sales • Quality of incremental sale to
Growth Sales yr1 over past two operating bring profit is crucial
periods • Harmful if incremental sales
achieved at loss of margin

Asset
Growth Assets yr 2 – Assets yr 1
• How much have assets • Incremental Assets should
grown over past two result in profitable growth or
Assets yr 1
operating periods cash position will be strained.

Asset Management Efficiency Ratios

„ Also known as Turnover Ratios, Activity ratio, Asset Management Ratio


„ Companies make profit by efficient management of assets
„ Critical to decide whether assets are adequate either from capital or
borrowings
„ Excess holding of assets Î funds locked in / interest burden / loss of
opportunities
„ Asset Management Ratios indicates adequacy of assets & efficiency of
use of assets.
„ Comparisons can be made over years and with other units in Industry
„ High Î may not necessarily mean greater efficiency / high returns. May
be due to inadequate level of assets – may affect performance in future

75

Inventory Turnover or Stock Turnover

„ Measures how efficiently company’s assets are used – optimal holding is


crucial arising from high cost of borrowing
„ Under Just In Time policy inventory levels are always under scanner
„ How fast inventory is moving to generate sales = COGS / Avg Inventory
„ Reflects efficiency of inventory management
„ Higher Ratio – more efficient management of inventories
„ High ratio may be caused by low level of inventory – stock-outs / loss of
sales and customer goodwill
„ Average inventory is used as we compare flow figure – cost of good sold
to stock figure
„ Two Expressions : Inventory Turnover – COGS / Average Stock
Inventory Holding – Average Inventory / Ave COGS

76

Inventory Turnover / Inventory Holding – Example

„ Average inventory of ITM Limited as on March 31st 2009 and 2008 was
Rs 160 L and Rs 150 L respectively. During this period average COGS
was Rs Rs 1200 L and Rs 1050 L. Calculate Ratios
„Inventory Turnover Ratio

2009 1200 / 160 7 Times


2008 1050 / 150 7.5 Times
Stock Holding Ratio
2009 160 / 1200 x 365 49 days
2008 150 / 1050 x 365 52 days

Company has successfully reduced inventory levels by 3 days of production and has
turned over stock 0.5 times more.

77

Receivable Turnover

„ Selling with trade credit is normal practice. Cost of finance is built into
sales price. Cash discounts are offered for prompt payments
„ Receivable turnover = Times / rotation of turnover during the year
„ Turnover = Net Credit Sales / Average Receivables
„ Holding - Average Collection period = 365 / Receivable turnover
„ Compare average collection period with credit terms own / industry to
judge efficiency of credit management
„ Higher – collection is slow , loss of interest , warning of bad debts
„ Lower – either efficiency is low or excessive conservatism requiring
resetting of credit terms
„ Regulating receivables would enhance efficiency and reduce borrowings
– saving interest cost.

78

Receivable Turnover / Average Collection – Example

„ In 2009 , sales of ITM Limited grew by 15% from Rs 348 L to 400 L. Its
average trade receivables during 2008 and 2009 were Rs 49 L and Rs
59 L respectively. Average collection period is calculated as follows :
„ 2008 Average Sales = 348 / 365 = 0.95 L
Collection Period = 49 / 0.95 = 51 days
2009 Average Sales = 400 / 365 = 1.09 L
Collection period = 59 / 1.09 = 54 days
„ Period of collection increased by 3 days. Assuming normal credit period
of 30 days, it is clear that company is not in a position to collect in time.
„ Company is being forced to extend credit period and management is
unable to exercise control on collections.

79

Average Payment Period / Supplier Outstanding

„ Average payment period ratio or Creditors ratio indicates time taken for
company to pay creditors.
„ Supplier Payment period = Average Trade Creditors / Daily COGS
„ Helps answer following questions :
„ Whether the company is availing all credit it can ?
„ Whether company is having difficulty in procuring on credit terms ?
„ Is the company having difficulty in paying creditors on time ?
„ If the company is in strong and commanding position , it can obtain
longer credit terms.
„ Longer credit period Î company can finance its working capital
efficiently and to that extent cost of funds fall.

80

Average Payment Period / Supplier Outstanding - Example

„ Average creditors of ITM Limited for 2009 and 2008 were Rs 34 L and Rs
29 L respectively. Its cost of goods sold was Rs 425 L and Rs 410 L.
respectively.
„ Average payment period is calculated as follows :
„ 2008 Average COGS = 410 / 365 = Rs 1.12 L.
Average payment period = 29 / 1.12 = 26 days
2009 Average COGS = 425 / 365 = Rs 1.16 L
Average payment period = 34 / 1.16 = 29 days
„ Average payment period in number of days has improved from 26 days
to 29 days. This indicates reduction in working capital investment and
improvement in efficiency of assets.

81

Fixed Assets Turnover

„ Measures how well a company is utilizing its fixed assets.


„ Should be compared over a period of time and also with industry units
„ Measures sales per rupee of investment in fixed assets
„ Net Sales / Average Net Fixed Assets
„ Measures efficiency with which fixed assets are employed
„ High – Degree of efficiency in asset utilization high may be due to old /
depreciated assets
„ Low – Inefficiency of utilization. Either sales may have fallen or asset
block new in comparison with other units with older blocks.
„ Not truly reflective of fixed asset utilization as costs in industry units
differ.

82
Fixed Assets Turnover – Example ’

• Relevant financials of ITM Limited are as follows :

2009 2008 2007


Sales 620 580 540
Fixed Assets – Gross 150 130 105
Depreciation 70 65 60
Fixed Assets – Net 80 65 45

Net Fixed Asset Utilization :


2009 620 / (65+80 ) / 2 = 8.55
2008 580 / (65 + 45) / 2 = 10.55
Although sales increased only by 6 % , fixed assets went up by 31% . This suggests
that company is expanding but favorable result of this expansion is yet to be
reflected in net fixed asset utilization.

83

Margins

84
Financial Ratios – Profitability
Ratio
Formula Meaning Desired Trend

COGS to ƒ % of COGS relative to sales


COGS x 100
Sales ƒ Measures relative cost of • Lower the ratio,lower the cost
Net Sales
inputs

• % of Gross Profit on sales


• Higher the ratio better it is
Gross Profit Gross Profits ( Inverse of COGS % of
to Sales Net Sales x 100 sales ) • Each rupee of sales brings in
positive margin
• Referred to as margin

• % of any or all operating


Operating Opex Expenses x 100 expenses relative to sales • Lower the ratio, lower the
Expenses to Sales • Measures relative impact expenses relative to sales
Sales of operating expenses

• % of net income earned


Net Income x 100 for every rupee sales • Higher the ratio, more
Net Income Net Sales • Measures ultimate profitable is each sale
to Sales Profitability

Profitability Ratios I

„ Extract from Annual Report “ although sales have increased by 24% in


the year under review, profits have fallen due to increase in cost of
production causing margins to erode “
„ Margins indicate earnings company makes on sales Î its markup on
cost of manufacture. Higher the margin – higher is profit on unit sold.
„ Level of margin determine success or failure of a business – markup or
margin is usually based on what market can bear principle.
„ Low volume businesses have high margins and vive versa.
„ Margins help to determine cost structure of business Î high / low cost ,
high / low volume. Company operating on low margins – a small decline
would result in losses
„ Margin analysis is an important constituent of inter firm comparison and
management efficiency trends.

86

Profitability Ratios I I

„ Margins analysis helps an investor to determine ability of a company to


pass on to consumer impact of higher cost – due to inflation, input cost
increase, tax and levies – depends on strength of the company and
demand for its products.
„ Company operating in an intense competition may have to absorb impact
of such higher costs.
„ Product mix has an effect on margins. Proportion of high margin products
would result in overall improvement in margin and consequently on profits.
„ If margin cannot be increased for some reason, it will be necessary to
significantly increase volume and also ensuring that working capital
remains within norms.

87

Profitability Ratios I I I

„ Profitability ratios assist investors in comparing how well a company


within industry and with reference to its performance in earlier years
„ Management’s effectiveness basis returns generated on sales and
investment can be judged
„ Ratios to be calculated on avg assets / liabilities and not on period end.
„ Rate of inflation and cost of capital and borrowing is crucial for investor to
explore alternative avenues and ensuring it is inflation proof.
„ Ratio are only indicative and need to be explored further
„ Profit margin ratio shows relationship between profit and sales – Gross
Profit Margin ratio, Net Profit Margin Ratio,
„ Rate of return ratio reflects relationship between profit and investment –
ROCE / ROE
88

Gross Profit Margin / Net Profit Margin Ratios

„ GPM ratio = Gross Profit / Net Sales


„ GMP ratio = (Net Sales – COGS) / Net Sales
„ Margin left after manufacturing costs, efficiency of production and pricing
„ In variance analysis proportion of various elements of costs, material and
labor need to be studied
„ NPM Ratio = Net Profit / Net Sales
„ Earnings left for shareholders ( equity and preference )
„ Measures overall efficiency of production , administration, selling,
financing, pricing and tax management
„ GPMR / NPMR provide valuable understanding of cost & profit structure
to unable an analyst identify sources of business efficiency & inefficiency

89

Gross Profit Margin – Example

„ Following figures extracted from financial statements of ITM Ltd


2009 2008
Sales 500 400
Cost of Sales 350 275
150 125
Gross Margin % 30 31.25

ITM’S sales increased by 25% to Rs 500 L and its gross profit increased by Rs 25 L. Both are
positive in difficult times. Gross margin has fallen by 1.25%.This could be due to several
reasons – 1 ) Increased competition – reduction in margin to boost sales. 2) Company may have
taken conscious decision to reduce margin to improve sales. 3 ) Deterioration in product
Mix 4) Company was unable to pass on cost increase to customers so had to absorb it.

90

Operating Margin Ratio

„ Profitability of company before tax, miscellaneous income and interest


costs is indicated by operating margin
„ Operating margin is arrived by deducting selling , general and
administrative expenses from gross profit which is expressed as % of
sales.
„ Analyst must examine operating margin ratio as it indicates likely reasons
for improvement or deterioration in profitability and ascertain causes for
it.

91

Operating Profit Margin – Example

„ Following figures extracted from financial statements of ITM Ltd


2009 2008
Sales 4000 3000
Gross Profit ( sales – COGS ) 800 600
Selling, General & Administrative Expenses 500 400
Operating Margin 300 200
Operating Margin % 7.50% 6.33%

Improvement in operating margin by 1.17%. Sales increase is higher than increase in opex.
Sales and GP increased by 33% but expenses went up by 25% . On many occasions,
expenses increase disproportionately to increase in sales and gross profits and every
incremental rupee sale results in increase in loss.

92

Break Even Margin

„ Every organization has certain expenses like selling, administrative and


other miscellaneous expenses that it has to bear even if there is no sales
„ BE margin indicates number of units that a company must sell to meet
these expenses.
„ If a company has BE at 50 % , of its capacity, it means company would be
in a no profit no loss situation if it produced and sold half its capacity. Any
unit sold over this level would yield profit. Any drop below BE level would
result in loss.
„ BE margin ratio arrived at by dividing expenses including financing costs
by gross income per unit. Non recurring/unusual profits excluded.
„ BE important measure as it indicates number of units to reach profit
position. Important management ratio in alternative scenario planning.

93

Break Even Margin – Example

Number of units sold 1000 2009 „ At present cost 675 units will have to be
sold to bear expenses. At this level
Sales 8000 company make no profit / loss.
Less : Cost of Sales 6000
„ Gross income per unit is Rs 2 ( 2000/
Gross Income 2000 1000) So every unit over 675 units would
Less : Expenses 1200 earn Rs 2 or incur loss of Rs 2 if sold
under 675.
Operating Income 800
Add : Profit on sale of asset 50 „ As a stricter measure, alternative could be
deducting selling prices from gross
Earning before interest & tax 850
margin. Done as sales are connected with
Less : Interest charges 150 sales and no selling price if no sale.
Earnings before Tax 700 „ BE margin 1200 – 400 + 150 = 594 units
(2000 – 400) /1000
BE margin = (1200 +150) / 2000 x 1000 =
675 units

94

Return on Assets
„ Return on Assets = PAT / Average Total Assets
• Whether company has earned reasonable return on its sale ?
• Whether assets have been efficiently and effectively used ?
• Whether cost of borrowing is reasonable ?
„ Inconsistent as numerator measures returns to shareholders and denominator represents
contribution of all investors
„ Earning Power = EBIT / Average Total Assets
„ Measure of business performance not affected by interest and tax
„ Abstracts away effect of capital structure and tax factor and focuses on operating
performance
„ Eminently suited for inter firm comparison
„ Consistent – Numerator represents measure of pre tax earning belonging to all sources of
finance and denominator – total financing.

95

Return on Assets Example

Rs Lakhs 2009 2008 2007

Net Income after Tax 600 400 300

Total Assets 11000 7000 5000

Return on total assets is calculated as follows :


2008 Î 400 / ( 0.5 ( 5000+ 7000) = 6.67 %
2009 Î 600 / ( 0.5 ( 7000+ 11000) = 6.67 %
Although net income has improved by 50% , the company’s profitability
Has not improved since its average assets have also increased by 50%

96

Return on Capital Employed

„ Determines whether capital employed has been efficiently used


„ ROCE = PBIT / Average Total Assets
„ PBIDT ( 1- Tax rate ) is also called net operating PAT or NOPAT
„ ROCE is the post tax version of earning power
„ Considers effect of taxation but not capital structure
„ Internally consistent – compares directly with post tax weighted average
cost of capital

97

Return on Equity

„ Purpose is to determine whether return earned is comparable with


alternatives. Higher the return higher is risk
„ ROE = Equity Earnings Î PAT less preference dividend
Average Equity Î Paid up capital , reserves and surplus
„ Should not include extraordinary, unusual, non recurring items.
„ Also called Return on Net Worth
„ Measures profitability of equity funds invested.
„ Reflects productivity of ownership ( or risk) capital employed
„ Influenced by earning power, DE ratio, average cost of debt fund, tax rate
„ Historical valuation of asset imparts upward bias to profitability measures
during inflationary periods Î numerator represents current value and
denominator historical value

98

Return on Equity

2009 2008 2007


Income Before Tax 1700 1100
Extraordinary Items 300
Taxation 500 400
Profit After Tax 1200 1000
Shareholders Equity 12200 11000 10000

Return on total assets is calculated as follows :


2008Î ( 1000 – 300 (1 – tax rate ) / ( 0.5 x ( 10000 + 11000) ) =
2009 Î ( 1200 / (0.5 x ( 12200 + 11000 ) ) = 10.34%
ROE has improved in 2009 but investor will have to determine whether it is best return
that he could have got or he could have earned more had he invested elsewhere.

99

Du Pont Analysis

„ Du Pont company of US pioneered system of financial analysis which


received widespread recognition and acceptance
„ Considers important relationship based on information found in financial
statements – at Apex of Du Pont chart is Return of Assets ( ROA) defined
as product of net profit margin ( NPM) and total assets turnover ratio (
TATR )
„ Net Profit / Avg Total Assets = Net Profit / Net Sales x Net Sales / Ave T A
ROA NTM TATR
„ Decomposition helps in understanding how return on total assets is
influenced by net profit margin and total asset turnover ratio
„ Numerators points areas of profit improvement through various means
„ Denominator highlights importance asset rotation as a key for improved
performance.

100

Du Pont Analysis
„ Du Pont Chart Net sales +/- operating
Net Profit
Surplus / Deficit
NP Margin - -
/ Total Costs

Net Sales Avg Fixed Assets


Return on
x
Total assets +

Net Sales
Avg Investments

/ +

Total Assets Average Net Current


Avg Total
Turnover Assets Assets

101

„ Valuation Ratios

102
Financial Ratios – Valuation
Ratio Meaning Desired Trend

Price ƒ Contribution of company to


Earning wealth of society • Higher than 1 means
Market price per share /
Ratio Earning per share ƒ Ability of company to stay company contributed to
focused and de-risk from creation of wealth
global / domestic fluctuation

• Higher dividend yield and low


• Measure of rate of return
CG yield – matured
Yield earned by shareholders
companies
( Dividend + price change • Fusion of dividend yield
) / Initial price • High CG yield Low dividend
and capital gains / loss
yield new generation
yield
company

Market value of equity & • Improved version of MV / • Higher than 1 signifies that
Q Ratio liabilities / Estimated BV as both MV and aset company has returned higher
replacement cost of replacement costs are overall yield even on
assets closer to realities replacement costs

Earning Per Share

„ Earning is a yardstick by which companies are finally judged.


„ EPS enables investor to quantify income earned by a share and to
determine whether it is reasonably priced.
„ EPS = PAT / Weighted average number of shares issued
„ Diluted earning per share represents EPS after considering effect of
proposed issue and also outstanding ESOPs.
„ Investors value share as a multiple of earning say – if EPS IS Rs 5 and
yield of 10% considered reasonable share is priced at Rs 50.
„ ITM limited – PAT is Rs 5 Lakhs. as on March 31st 2009. Number of share
200000. Fresh Shared issued 100000 in June 09.
„ EPS = 500000 / ( 200000 X 0.5) + ( 300000 X 0.5 ) = Rs 2.

104

Cash Earning Per Share
„ EPS may not be proper measure of Rs Lakhs Rs Lakhs
earning as depreciation, tax and
interest varies from company to Sales 5000
company.
„ Cash EPS = EBIDTA / Weighted Cost of Goods Sold 3000
number of shares issued
Gross Income 2000
„ Cash EPS is always higher than
normal EPS
Selling Cost 300
„ Summarized P n L of ITM Limited for
the year ended March 31st 2009 Admin Cost 200 500
„ Issued Share 500000 of Rs 10 each
„ Cash EPS = (1500 + 40+ 20 ) Net Income 1500
500000
= Rs 3.12 Admin expense include interest Rs 40 L
and depreciation of Rs 20 Lakhs
105

Dividend Per Share

„ It is argued that EPS is of value to those who determine policies of the


company and so, for common investor it is not a right measure
„ Income of investor is dividend Î value of shares should be multiple of
dividend paid on that share
„ Investor return = Capital Appreciation and Dividend receipt
„ If 35% is overall expectation and capital appreciation is 30% high dividend
would be expected
„ If a share has a market value of Rs 40, and in past 3 years appreciated by
25%. For an investor aiming yield of 30% , a dividend of 5% would be
adequate. If company pays dividend of 15% its market value on the basis
of dividend / share would be = Rs 1.5 ( Dividend ) / 5 ( return required) x
100 = Rs 30. So the share is overpriced by Rs 10. ( 15% dividend on face
value or 5% on market value )

106

Dividend Payout ratio

„ Dividend payout ratio measures amount of dividend paid out of earnings


and the balance is ploughed back for long term growth.
„ Dividend payout ratio = Dividend / PAT
„ Aggressive companies have low payout ratios due to retained earnings for
growth. Matured companies have higher payouts.
„ Dividend is paid out of current earnings and not from capital
„ ITM Limited’s PAT for March 31st 2009 is Rs 68 lakhs. Of this it paid
dividend of Rs 28 lakhs.
„ Dividend payout ratio = 28/68 = 41.2%
„ ITM distributed 41.2 % of its PAT as dividend and retained 58.8% for its
growth and expansion

107

Price Earnings Ratio

„ Most popular, commonly used financial ratio by investor community


„ Reduces to arithmetical relationship market price and EPS Î highlights
whether share is overpriced or underpriced and period of recovery
„ Reflects opinion of investor community whether company is growing or
declining. Share rising, declining or remaining stagnant
„ PE Ratio = Market Price per share / Earning per share
„ Market Price per share = On any specific day – Average or closing price
„ EPS = ( PAT – Preference Dividend) / No of Equity Shares
„ PE ratio reflects growth prospects , risk characteristics , shareholder
orientation, Corporate image and degree of liquidity

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Price Earnings Ratio – Example

„ ITM Limited for the year ended March 31st 2009 made profit after tax and
preference dividend of Rs 400 lakhs. Market value of share on Dec 31st
2009 was Rs 112. Equity Capital Rs 50 Lakhs 5,00,000 shares of Rs 10
each. Pref Capital Rs 10 Lakhs 100000 shares of Rs 10 each. Reserves
Rs 70 Lakhs.
„ EPS = 400 / 50 = Rs 8
„ PE ratio = 112 / 8 = Rs 14
„ Yield = 100 / 14 = 7.14 %
„ PE ratio of well established / sound companies is high and vice versa
„ PE ratio high as investors have faith in the company’s ability to grow &
earn a return and appreciation in share price. So prices rise during
inflationary period and fall during depression

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Price Earnings Ratio

„ Price an investor pays is based on future prospects of the company and its
anticipated earnings.
„ Flaw in PE ratio working is current market price is divided by past earnings
/ share. Ideally, market price should be divided by anticipated earnings of
current year.
„ PE ratio reflects reputation of the company and its management and
confidence investors have in earning potential of the company
„ PE ratio that is considered reasonable by different investors will be the one
that fulfills their particular investment return requirements.
„ PE is usually higher in developing economies as companies are in growth
mode. As economy and companies mature, earnings stabilize and PE ratio
fall.

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Yield

„ Measure of rate of return Î Yield = (Dividend + Price Change)/Initial Price


„ Split into two parts :
„ Yield = ( Dividend / Initial price ) + ( Price Change / Initial Price )
Dividend yield Capital Gains / Loss yield

• Low growth prospects Î high dividend yield and low capital gains yield
• Superior growth prospects Î Low dividend yield and high capital gains yield

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Market Value to Book Value

„ Market Value to book value = Market value per share / BV per share
„ MV > BV Î investor confidence If, BV > MV lack of investor confidence
„ Reflects contribution made to the wealth of the society
„ If ratio exceeds 1, company has contributed to society’s wealth
„ If ratio is 2 , Company has created wealth one rupee for every rupee
invested. If MV > 3 BV Î risky investment not backed by tangible assets
„ Ratio 1, company neither contributed nor detracted
„ Q ratio as proposed by James Tobin
„ Market Value of equity and Liabilities / Estimated replacement cost of
assets
• Numerator – Market value of equity and debt
• Denominator – All assets at replacement value not book value

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