Financial Analysis
(Pravindra Awasthi) The most important quality for financial analysis is the passion to go for, go into and go beyond numbers. Let us begin by unlearning some common misconceptions. Many people relate financial analysis to number crunching. There are some others who have set benchmarks for financial ratios and numbers, like a current ratio of 2 or debt to equity ratio of 1, etc. Many have a tendency to calculate expected share price by multiplying EPS with a normative P/E. Were financial analysis such simple arithmetic, we would have given you a spreadsheet with pre-written formulae rather than this verbose piece. A financial analyst's job is akin to a surgeon. Just as each human body is different, every case for financial analysis is different. You have some acquired knowledge and techniques and then it is all up to your judgment and experience. Yes, numbers are important. Financial analysis starts with numbers. But it does not end there. What Is A Ratio? A ratio is nothing more than a simple division of two numbers. Often numbers by themselves do not convey anything until they are related. It needs a contextual reference. In our day-to-day life, we use ratios to analyze a variety of situations. For instance, in a one day cricket match if somebody tells you that India has to make 70 runs to win the match, it means nothing. Even if a kid is watching the game, he on his own would work out the asking rate, which is a run required per balls remaining. 70 runs in 10 overs is a more useful piece of information. You know that the asking rate is 7 runs per over. But is that enough? The same neighborhood kid watching the game will have some more interesting questions to ask. Such as how many wickets are remaining? Is our star batsman Sachin Tendulkar still batting? How many of the 10 overs remaining will be bowled by Shoib? Is the pitch playing true? And so on. Similarly, in financial analysis, we need qualitative information and try to read between the numbers. We have to ask all the right questions. Over the years, there are some ratios, which have become more popular and handy for rule of thumb analysis of financial statements. Our purpose in this note is not deride them but to advice the reader to use them properly to derive the correct results. How Not To Use Ratios? Now, let us take an example and understand how a ratio by itself can be misleading. Take an instance of a fast growing software company for which receivables as percentage of sales increased from 25% last year to 50% this year. Is it bad? Many pundits would immediately decree that the company's working capital management is poor, accounts receivables are high, company will have cash problems, interests on working capital will go up, etc. Nobody dislikes businesses, which are growing very fast, legitimately. It is quite likely that the sales towards the end of the year would be far greater than the average for the full year and receivables as a percentage of sales calculated on the basis of total year would be misleading. The company's receivables appear higher for this reason. In other words, suppose sales for the full year was Rs100, of which last quarter sales was Rs50. Three months credit period would
result in receivables of Rs50 i.e. 50 % of annual sales or equivalent to 6 months sales. In reality, they are only for 3 months sales. Also some businesses are seasonal. Nestle has to stock up in winter for its milk as well as coffee beans. These are critical raw materials and available in abundance only in winter, but used throughout the year. So if the year end is in December, the actual working capital figure will be significantly higher than the average for the year. Key Limitation of the Balance Sheet While balance sheet is made at a certain point in time, profit and loss account is for a period of time. Balance sheet, which is made to represent time period can easily be window dressed. And therefore, while doing analysis of any type, keep this fact in the back of your mind. Key Objectives of a Business Before you look at different ratios, let us look at a firm's objectives in a capitalist market. The one and only intention of any firm is to maximize shareholders value, which is effectively done by getting a bigger bang out of the capital employed. Exceptional cases like charity, passion, hobbies, etc also try to maximize return on capital employed, but there the definition of capital is different. For the time being, let us stick to financial capital. While businesses claim to have multiple objectives such as market share, brand building and even social objectives, at the end of the day, what really matters is how much money one makes. All are strategies to maximize return on capital employed, which is the one and only long term goal of all management. Obviously one will look at money made in relation to one's investment. If you use 10 times as much capital and make 5 times more money, it is of no good. If business A earns Rs10 on Rs 100 investment (10%), it is better than another business B that earns Rs50 on Rs1000 (5%). To analyze the performance of any business, the key ratio is therefore Return on Capital Employed (ROCE). We can further analyze this ratio using a model popularly knows as The Du Pont model. The model starts with analysis of ROCE in its two constituents Profit margin on sales Sales per unit of capital invested
To give an example, say business A is one in which Rs100 capital invested in a year generates sales of Rs100 with net profit margin of 10%. Whereas, in business B Rs100 investment generates a turnover of Rs500 but with a net profit margin of only 4%. As you can see, in business B, net profit margin can be lower but is more than compensated by the fact that turnover generated per unit of capital invested is significantly higher or capital turnover ratio is higher. Return on capital invested is the product of sales margin and capital turnover ratio. The same can be presented in the formula as follows. (Net profit/ sales) * (sales/ capital employed) = Return on capital employed The above two are the mother of all ratios. Let us look at their children.
Profit Margin We all know that profit is revenue minus cost. Each element of cost can be presented as a % of revenue and at different levels of costs; we have different versions of profit, i.e. EBIDTA, EBIT, EBT, etc. EBITDA margin is a good indicator of operational efficiency of any company. Even revenue can be broken up for the purpose of analysis, which is of use in a multi product, multi division entity. Typically, analysts look at the relative share of other income, because this item is where most Indian companies show extra ordinary profits to boost their bottom line. Asset Turnover Ratio The total asset turnover ratio can be divided into fixed assets to turnover and working capital to turnover ratios. Working capital to turnover ratio can further be divided into various components of working capital namely inventories, receivables, sundry creditors, etc. When we calculate inventories and receivables turnover ratio, we can also present them in a different manner i.e. in terms of number of days of various components of working capital. The basic understanding is that sales happen over 365 days, and so each item of working capital can be interpreted in number of days. If your receivables are 25% of annual sales, this is equivalent to saying that your receivables are three months' sales. The ratio gives us an idea about the credit extended by the business. Inventories Valued At Cost For inventory turnover ratio, it would be better to consider cost of goods sold rather than sales value. Let us take an example. Suppose the cost of manufacturing is Rs50 per unit and selling price is Rs100 and you have sales of 100 units in a year, your sales revenue will be Rs10, 000. At the end of the year if you have a stock of 25 units which is equivalent to 3 months sales in terms of volume, but in terms of costing, it will be equivalent to only one and half months. A sum of Rs1, 250 which is 1/8th of the sales or one and half month’s inventory is calculated by dividing inventories with cost of goods sold. To remove this anomaly inventory turnover ratio is calculated on as inventory divided by cost of sales. If you multiply this fraction by 12 you get the number of months. If you multiply this fraction by 365 you will get number of days. Return Ratios There are two types of providers of capital, owners and lenders. As returns to lenders are fixed, we don't have to calculate any return ratio on debt as the same is predetermined. From owners' perspective, the key ratio is return on net worth. Net worth represents owners' funds, paid up capital and retained profits called as reserves. As an owner, you would also be interested in knowing how much return is being generated by the total capital employed. Capital employed consists of net worth plus debt, i.e. owned and owed money. So when we calculate this ratio we have to add back the cost of debt, i.e. adjust for interest expenses. This ratio is calculated primarily on pre-tax basis and it is equivalent to EBIT (Earnings before Interest and Tax) divided by total capital employed. If we want to calculate it on post-tax basis, we will have to add interest adjusted for tax i.e. EBT + interest*(1-T)/ capital employed, where T is the tax rate.
Why Should Interest Be Adjusted For Tax? Under tax laws, interest is tax deductible. Say your tax rate is 35%. You have two alternatives, in both cases; say your profits are Rs200. In one, you have to pay an interest of Rs100 and in the other zero. Post tax profits of the two businesses will be
A Pre interest/ tax Interest Taxable profits Tax (@35%) Post-tax Rs200 (Rs100) Rs100 (Rs35) Rs65 B Rs200 Difference
(Rs100) (Rs100) (Rs35) (Rs65)
Rs200 (Rs70) Rs130
The difference of Rs100 is narrowed to Rs65, due to the benefit of tax deduction on interest expense. In other words the business which pays a tax of Rs100 has a post-tax profit lower by only Rs65 because of a lower tax; therefore this is called a tax shield. The effective cost of interest is only Rs65 and not Rs100. So when we have to add back interest we also have to add back interest adjusted for tax. Must We Add Back Interest for ROCE? Yes, while calculating ROCE, we have to add back interest. This ratio calculates the returns to all the providers of capital. As mentioned earlier, capital can be debt or equity. On debt, we pay interest while entire PAT belongs to equity holders. Therefore, when we calculate return on capital employed, we have to do so before any payment is made to the providers of capital. So if we do not add back interest we will be taking profits after making some payment to the provider of capital thereby distorting the real picture. Pay Out Ratios Out of PAT, a part is distributed as dividend to equity shareholders. The ratio of dividends paid to total PAT is called dividend pay out ratio, which indicates how much of funds is being paid out and how much is being retained within the company to further its prospects. Liquidity Ratios In the normal course of business, a firm will have short-term as well as long-term liabilities. If you fund long-term commitments by short-term funds you may run into asset liability mismatch. You may have access to long term funds yet in the short-term you may fail to meet your outflow obligations, resulting in problems. Working capital is current assets net of current liabilities. Current assets refer to assets which are likely to be realized into cash in less than a year's time. Current liabilities will have to be paid back in cash in a less than year's time. Traditional accountants have also taken a view that current assets should be more than twice the current liabilities so that whenever current liabilities arise for payment there is no liquidity crunch. This ratio is called current ratio defined as current assets divided by current liabilities. In current assets, we have financial assets like receivables/ bills, realization of which is already quantified and timing broadly predetermined. The same cannot be said about inventory. In order to have a more stringent test, one can remove inventory from current assets and then look at a
relationship with current liabilities. This is quantified in quick ratio which is defined as quick assets divided by quick liabilities. Quick liabilities are similar to current liabilities but quick assets are current assets minus inventory, a reflection of the company's "cash" position. This is also known as the acid test ratio. Although many people recommend current ratio of 2 xs and a quick ratio of 1x, there is no sanctity to these numbers. In many cases you will find that a high current ratio, in terms of textbook might indicate strong short-term liquidity, is in fact reflecting the reverse. It might be due to significant amount of funds blocked in inventories, slow moving items, etc. Also it may reflect poor working capital management and therefore lowering of return on capital employed and return on net worth. Debt equity ratio (a very commonly used ratio) is defined as long-term debt divided by net worth or equity holders funds. This reflects the extent of financial leverage of the firm. A high debt equity ratio indicates higher risk, as your profits can fluctuate but your commitment to pay interest to lenders is fixed. The interest cover ratio is an indicator of the company's ability to meet its interest outflow, which is fixed. This is defined as EBIT divided by interest payable. A high interest cover ratio gives comfort to the lender that his money will be repaid. All lenders focus at this ratio. In other words, if you have an interest liability of Rs100 and if you have profit before interest and tax of Rs400, then your interest cover ratio is 4, which is obviously better than an interest cover ratio of 2. The higher the ratio, the greater the comfort for the lender. Some people add back depreciation to the numerator to arrive at a modified interest coverage ratio. Operating and Financial Leverage Archimedes once said "Give me a lever long enough and I will move the whole earth around me". Similarly any businessman if given leverage large enough can move the whole world around him. Neither Archimedes nor any businessman could ever get access to a lever long enough. Leveraging refers to the risk which will have a multiplying effect on your earnings, on the upside as well as downside. Let us take an example from our daily life. Say, for travelling from your house to office requires a return railway ticket of Rs10 per day whereas a monthly season ticket costs Rs100. If you do not travel even for a single day, the decision to buy a monthly pass would mean a loss of Rs100 but on the other hand if you travel everyday in a month you would save Rs200. By buying a railway season pass you are increasing your fixed costs or in terms of financial analyst, you are increasing your leverage. What Is Break Even Volume? In theory, all costs can be divided into two categories - fixed and variable. For incremental volumes, you incur only variable cost. Difference in selling price and variable cost is contribution. Contribution minus fixed costs is net profit. With volumes, your sales revenues and variable costs both rise. Fixed costs are static and therefore net profits will rise disproportionately with increase in volumes. Similarly with a fall in volumes, revenues, variable costs and contribution margins will fall in proportion but fixed costs will remain static. Net profit will fall disproportionately. Break even volume is the volume at which your net profit is equal to zero i.e. is your contribution is equal to fixed costs. You can calculate break even volumes by dividing fixed costs by contribution per unit. This formula will give you volumes required to break even i.e. make contribution equal to fixed costs or net profit equal to zero. As you are converting a part of your variable operating cost to fixed costs for up to a particular capacity (30 days in our example, after the break even point (in
our example 10 days travel) the risk pays off and you gain significantly. On the other hand if you operate at less than breakeven point you are the loser. Operating Leverage Operating leverage refers to change in earnings before interest and tax (EBIT) in relation to change in volume, i.e. if volume grows by 10% and your EBIT grows by 20%, your operating leverage is 2. Financial Leverage If you have Rs1000 of own money and can take up a risky project whose returns can vary between 0% and 30%. You can double the scale by borrowing Rs1000. If the return is less than 15%, (which is what you have committed to pay the lender), the loss on your own money will be high. In other case if your actual return is higher than 15%, you would be able to benefit from the leveraging and return on your own capital will increase significantly. Financial leverage therefore refers to the extent a firm has fixed financing costs due to use of debt. While interest costs remain fixed, a change in EBIT results in disproportionate change in EBT. For instance if your EBIT is 1000 and interest cost is 500, 10% change in EBIT will lead to 20% change in EBT. But if interest cost is 100, same change leads to only 17.5% change in EBT. Total leverage is multiplication of operating leverage and financial leverage. These concepts enable us to understand how net profits would react to changes in volumes and EBIT, and hence an indicator of risk. Per Share Ratios An equity share is a legal document representing ownership of any entity. Shares of listed companies trade in stock markets. It therefore makes sense to look at most profitability indicators on a per share basis. The key ratio is earnings per share which is net profit (if the company has issued preference capital, then one must remove preference dividend to reflect what belongs to the common equity holders only) divided by number of outstanding shares (outstanding shares refers to total shares issued by the company). One variant of this ratio of cash earnings per share which is cash profit divided by number of outstanding shares. Cash profit is equivalent to profit after tax plus depreciation and other non cash charges. Should Depreciation Also Be Adjusted For Tax While Calculating Cash Profits? No. What we are looking for in cash profits is the total cash accrual to the business. You might turn around and argue whether capital expenditure and other outflows should be adjusted for. The answer is a big no, as capital items and revenue items are treated separately. A good way to look at the overall cash position of the company is to draw a cash flow table, where all sources and uses of cash get highlighted. Dividend per share The owner can allow profits to remain within business or can withdraw it for other or his personal use. When he withdraws, it is analogous to dividend payout. In a company, the management decides on behalf of the owner, whether or not to retain a part of profits within the company (that is called retained earnings) and gives back a part of profits to the owners called dividends.
Dividend per share is the total dividend paid per equity share. In case there was a fresh issue of equity capital in the year, most companies make pro rata payment, i.e. supposing in a financial year (April to March) there was an issue of equity shares on October 1. The new shares which were issued on Oct 1 will be entitled for only 50% dividend as compared to other shareholders who were there for the full year. Quantitative Ratios Till now we have looked only at financial numbers. Quantitative numbers are as important i.e. number of units sold or number of units consumed as raw material. One can look at unit realization i.e. unit selling price. However in most cases quantitative numbers for a particular category are given in lots and unit realization numbers to that extent are not reflective. Trends in Some Key Ratios By trends we mean progress year after year. So one can look at trends in sales, fixed assets, working capital and trends in various ratios. Trends in some key performance ratios such as operating margin, return on net worth also convey meaningful results. For instance, operating margin which was 8% last year and 9% this year is a welcome trend, assuming ceteris paribus (other things remaining the same). Annualizing Numbers Many a time, companies change their accounting years and during transition, the accounting year is not for 12 months. One has to but apply common sense to understand where annualizing is needed. Annualizing is required only when accounting period is not 12 months. If any ratio has one component that is for full period, it would require annualization. But if both the components (numerator as well as denominator) are for the same time period, no adjustment is required. Also, if both the constituents of ratio represent values at a given point in time and not for the entire year or accounting period, you do not have to annualize. Let us take an instance of a company that has changed it accounting year from March to December. The accounting period is now for 9 months only. Return on net worth would require annualization as profit after tax is for 9 months and net worth, the denominator is as on December 31, a point in time. Book value does not require annualization because both the figures numerator as well as denominator are as on December 31, a point in time. Beneath The Numbers One obviously has to look at qualitative factors underlying the numbers. For instance working capital turnover ratio might appear high if there was a transporters strike in the last week of the year. A business which has just started may record abnormally high growth in the first few years. On the enlarged base, growth may slow down but that is not negative reflection on the management. A small company can achieve a growth; of say 200-300% but a company which is already a market leader cannot achieve that kind of growth because of base effect. That does not mean that the management of the company that has achieved 200% growth is superior to that of the large company. Also, there may be inevitable circumstances like fire or disruption which can adversely affect the performance in any single year.
Comparison One can make comparisons across years in terms of trends in margins, growth or comparison across companies within a sector or across a sector, by comparing large companies in either the sectors or sector aggregates. As mentioned earlier, these numbers are just a starting point. Another type of comparison is inter firm comparison i.e. firms of the same industry are compared on various parameters. For instance you can compare operating margins of Gujarat Cement, Madras Cement and analyze the reason for differences. One can look at aggregate numbers of one industry and compare them with aggregate numbers of another industry to understand the differences in performance of various industries. For instance, if you look at the consumer durable industry which might be generating a return on net worth of 8-10%, whereas software industry may be generating a return on net worth of 40-50%. So one can easily conclude that software industry is doing significantly better than the consumer durables industry. Per Share Ratios In stock market, fractions of ownership known as shares are traded. Therefore in order to arrive or get a proper picture of the worth of a share (one unit of the company), we should look at numbers calculated on a per share basis. An earnings per share is profit after tax (adjusted for preference dividend if any) divided by number of outstanding shares. Similarly, you can calculate cash profit per share, sales per share, etc. This will facilitate valuation and comparison with other companies. The most famous of the valuation ratios is the Price earnings ratio (P/E ratio), which the current market is priced of the share divided by the earnings per share.