Financial Statement Analysis

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					    Financial Statement

Analyst review company financial statements to gain insight
to the firm’s financial decision making and operating
performance. Financial data is converted to ratios for ease of
analysis. Although there are several ratios that
can be computed a relatively small subset can provide most
of the relevant information….
Salient points in financial analysis
   A single value of a financial ratio is not meaningful
    by itself, but must be examined in context of the
    firm’s history, industry, competitors and the

   Ratios themselves don’t answer the analyst’s
    questions. Rather ratios are designed to provide
    analysts with pertinent questions to assist in
    conducting the analysis of the firm.

   Ratios enable the analysts to ask: Why? What? How?
    Objectives of Ratio Analysis

   Standardize financial information for
   Compare performance with past performance
   Compare performance against other firms or
    industry standards
   Study the efficiency of operations
   Study the risk of operations
   Identify potential financial shenanigans
Common Size Financial Statements

   Normalize balance sheets and income statements to allow
    comparison of firms of different sizes.

   Common size balance sheet - All balance sheet items as a % of
    total assets - depicts a snapshot of sources and usage of funds.

   Common size income statement - All income statement items
    as a % of total income - useful to identify trends in costs and
    profit margins
    Common size statements cont..

                Common size income statement
                 ratios = Incomes statement item / Sales

                Common size balance sheet
                 ratios = Balance sheet item / Total Assets

Sample financial statement
Types of Ratios

       Liquidity

       Operating efficiency and profitability

       Solvency
  Evaluate the firm’s ability to pay its short term liabilities

     Current ratio =    Current Assets
                        Current Liabilities

  Current ratio is the best known measure of liquidity

     Quick Ratio =              Cash and cash equivalents+ receivables
                                        Current Liabilities

  Quick ratio is a more stringent measure of liquidity as it includes only the most
  liquid current assets (i.e. cash and assets that can be quickly converted to cash)

  Higher the current/quick ratio more likely that the company will be able to pay
     it’s short
  term liabilities.                                           Sample financial statement
     Operating Efficiency measures

Receivable collection days                 =            Receivables outstanding
(debtor turnover days)                                  Average sales per day 1

Note 1 Average sales per day    =          annual sales / 365

•Also a measure of liquidity

•To be compared against industry norm/ history / firms credit terms

•Ceteris paribus shorter the collection period operating efficiency and financial health

• if too long could mean too much capital is tied up in receivables, collection difficulties
that can result in increase in future B&D provisions, profit & margins artificially boosted
by higher price in return for longer credit period or fictitious receivables

•If too short could mean policy is too rigorous hampering potential sales.

                                                                        Sample financial statement
          Operating Efficiency measures cont…

     Inventory holding period                                       =        Inventory balance
                                                                                              per day
                                                                        Average cost of sales 1

    *1 Average cost of sales per day = annual cost of sales / 365

• Also   a measure of liquidity

• To be compared against industry norm/ history.

• Ceteris paribus shorter the inventory holding period better the operating
  efficiency and financial health

• if too long could mean too much capital is tied up in inventory, obsolete
  inventory that can result in future impairment charges, profits & margins
  artificially boosted by overvalued inventory or fictitious inventory

• If too short could mean high risk of stock outs hampering sales

                                                                                      Sample financial statement
Operating Efficiency measures cont..

  Cash                 receivables        inventory   payables
  Conversion     =     collection +       holding   - payment
  cycle                period             period      period

  • To be compared against industry norm/history

  • Ceteris paribus shorter the cash conversion cycle better the working capital
  management of the company

  • Long cash conversion cycles can mean excessive amount of capital invested in
  working capital.
          Operating Efficiency measures cont..

            Asset Turnover                 =                   Sales
                                                            Total Assets

            Fixed asset turnover           =                    Sales
                                                         Total fixed assets

• Measures how effectively the firm uses its assets to generate revenue
• To be compared against industry and history

• Capital intensive industry will have low asset turnover and vice versa

• Too low could mean idling assets / build up of non core assets

• Too high could mean lack of new investments and outdated assets suggesting pending
capital expenditure
                                                                           Sample financial statement
Operating Profitability measures
Gross profit margin               =                       Gross profit

Operating profit margin           =      Operating profit (profit before interest & tax)

 Net Margin                        =                      Net profit
 Net profit should be based on net income from continuing operations in order to eliminate any impact
 due to one-off transactions or from discontinued operations.

 EBITDA margin                     =           PBIT + Depreciation+ Amortization
•All margins to be compared against industry and history
•Low or falling margins should be investigated.
•EBITDA margin useful to estimate cash generation rate and eliminate the impact of depreciation
policies which are subject to management discretion.

                                                                                 Sample financial statement
Profitability measures
 Return on total Capital (ROCE)                    =       Profit before interest & tax
                                                          Average total capital (total assets)

 • Calculates the return available for distribution among all capital providers (debt and equity) and
 the government.

 • Independent of the capital structure of the firm and tax regime. Thus allows comparison of firms
 with different capital structures and tax regimes.

  Return on Equity (ROE)                       =                         Net income
                                                                        average equity

  • Calculates the return available for equity capital providers

                                                                                     Sample financial statement
  Risk Measures
Debt to equity ratio                                 =                   Total Debt
                                                                         Total Equity

Financial Leverage multiplier                        =                   Total Assets
• Total debt is often defined as total interest bearing liabilities
• Interest cost in debt financing is a fixed obligation that should be paid irrespective of the performance
  of the firm during a particular year therefore higher the debt equity ratio higher the financial risk of a

Interest cover                                      =                  Earning before interest & tax
                                                                             Interest expenses

• Lower the interest cover ratio higher the risk of firm having difficulty of meeting interest payments
• Vulnerable when the interest rate of the economy is forecasted to increase.

Debt service         =       Interest cost+ debt installments falling due within the year
cover ratio              Earnings before interest, tax, depreciation & Amortization (EBITDA)

• Measures the ability of the firm to meet its debt obligations as and when they fall due.
•Lower the ratio higher the risk
                                                                                             Sample financial statement
DuPont analysis
    Arguably the most important ratio in financial analysis since it breaks
    down a very important ratio into three components.

 Start with

 ROE                  =        Net Income

 This can be broken down into :

 ROE =        Net income          Sales              Assets
               Sales       *      Assets      *      Equity

         Net profit                Asset                  Leverage
         Margin                   Turnover
                                                                 Sample financial statement
DuPont analysis cont..
   If the ROE is low it must mean that at least one of the below is true for
   the company :

   1. Poor profit margins
   2. Poor asset turnover
   3. Firm has low leverage

 A firm can increase the ROE by increasing any of the above three

 However analyst has to question if the method employed to increase the ROE
 is sustainable
Sample Financial Statements
Common Size Ratios
Key Ratios Based on Sample Financial Statements

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