# Financial Statement Analysis

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```					    Financial Statement
Analysis

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
economy.

   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
comparison
   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
Liquidity
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
1
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
Sales

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

Net Margin                        =                      Net profit
Sales
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
Sales
•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
Equity
• 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
firm.

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.

ROE                  =        Net Income
equity

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
components

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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 views: 21 posted: 5/7/2012 language: pages: 19