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FINANCIAL STATEMENTANALYSIS

Analyzing the FinancialStatements

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Basic Caveats

Focus of analysis depends upon the purpose in hand

Analysis depends upon data availability

Analysis of an entity for a period may not be adequate

Inter-period comparison

Inter-firm comparison

Flexible

No fixed formats / formula

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Internal UsersExternal Users

Financial statement analysis helps usersmake better decisions.

ManagersOfficers

Internal Auditors

ShareholdersLenders

Customers

Purpose of Analysis

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Liquidity

Efficiency

Leverage

Profitability

Shareholders value

Performance Analysis:Four window approach

The four factors are interdependent. The overall performance of a

Firm is a function of these four factors. They have a multiplier impact

on the overall performance.

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Growthin sales

Return tostockholders

Profitmargins

Return onequity

Determined byanalyzing thefinancial

statements.

Financial measures are often usedto rank corporate performance.

Example measures include:

Purpose of Analysis

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Horizontal analysis

Vertical analysis

Trend analysis

Ratio analysis

Tools of Analysis

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Horizontal Analysis

Financial Statements present comparative

information for at least 2 years

Horizontal Analysis calculates the amount &

percentage changes from the previous year to

the current year.

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Vertical Analysis/Common Size

Statements

Expressing various components of the financial statements asa percentage of a common denominator.

Balance sheet Percentage of total of the balance sheet

Profit and loss a/c Percentage of sales

Helps is understanding the relative importance of different

components.

Change in weight over a period of time.

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Trend analysis is used to reveal patterns in data

covering successive periods.

TrendPercent

Analysis Period AmountBase Period Amount

100%=

Trend Analysis

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2001 is the base period so its

amounts will equal 100%.

Berry ProductsIncome Information

For the Years Ended December 31,

Item 2005 2004 2003 2002 2001

Revenues 400,000$ 355,000$ 320,000$ 290,000$ 275,000$Cost of sales 285,000 250,000 225,000 198,000 190,000

Gross profit 115,000 105,000 95,000 92,000 85,000

Item 2005 2004 2003 2002 2001

Revenues 145% 129% 116% 105% 100%

Cost of sales 150% 132% 118% 104% 100%Gross profit 135% 124% 112% 108% 100%

(290,000 275,000) 100% = 105%

(198,000 190,000) 100% = 104%

(92,000 85,000) 100% = 108%

Trend Analysis

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Trend Analysis/Indexed Financial

Statements

Expressing various components of the

balance sheet, and profit and loss a/c as a

percentage of the base year.

Helps is understanding the growth/ trend of

different items in the financial statements

over a period of time.

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Ratio Analysis

Expressing one item of financial statement in

relation to another

Profit and loss a/c ratios: Relating different numbers

of profit and loss a/c

Balance sheet a/c ratios: Relating different numbers

of balance sheet

Cross ratios: Relating a number of profit and lossa/c with a number of balance sheets.

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Types of Ratios

Depending upon focus of analysis

Profitability ratio

Growth

Dividend policy

Asset utilization / Efficiency

Liquidity

Capital structure

Return

Market related

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Profitability Ratios

Ratios Expressed as Comments

Gross margin ratio

Gross profit / Sales

% Higher the margin, better it is.

Compare with the industry average and trend over a

period of time.

Cash operating margin

EBITDA / Total incomeOperating margin

EBIT/ Total income


Compare with the industry average and trend over aperiod of time.

Net margin

PAT/ Total income


Compare with the industry average and trend over a

period of time.

Earnings per share

PAT / Number of shares

` Higher the EPS, better it is.

Compare the trend over a period of time.

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Growth Ratio

Compound Annual Growth Rate (CAGR)

Find the value of g using the following expression

A = P (1+g)^n

Where,

A is current years number

P is base years number

n is number of years.

CAGR can be calculated for various parameters

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Growth Ratio

Year-on-year growth

(Current year Previous year) / Previous year

Can be calculated for sales, income, different

measures of profit

Expressed as percentage.

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Dividend Policy

Ratio Expressed as Comments

Dividend payout ratio

(Dividend + Dividend tax) / PAT

% As dividend attracts dividend distribution tax,

the same is also considered a part of the

payout.

What % of profits after tax is being

distributed? Growing companies have a

lower payout.

Rtention ratio

1 D/P ratio

% What % of profits after tax is being retained.

Growing companies have a higher retention.

Dividend yield

Dividend per share/ Current

market price

% Return to the shareholder by way of dividend

on the current market price.

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Liquidity Ratios


Current ratio

Current assets / Current

liabilities and provisions

Times Short term investments should also be

included in the current assets

2:1 considered adequate; higher ratio

indicates blockage of funds in unproductiveassets, whereas low ratio indicated inability of

companys current assets to cover its current

liabilities.

Quick ratio

(Current ratio Inventories) /

Current liabilities and

provisions

Times Inventories are less liquid;

Also called liquid ratio or acid test ratio

1 : 1 considered adequate; higher ratio

indicates blockage of funds in unproductive

assets.

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Capital Structure Ratios


Debt equity ratio

Borrowed funds / Shareholders

funds

Times Only long tern debts to be considered

2: 1 considered adequate; Higher ratio implies higher

financial leverage; inability of the firm to meet its

long term commitments attached with debt. Lower

ratio means that the company is not taking

advantage of financial leverage.

Financial leverage ratio

Total assets / Shareholders funds

Times Higher ratio implies higher financial leverage.

Interest coverage ratio

EBIT / Interest and finance charges

Times Ability of the firms operating profits to cover its

interest obligation.

Higher the ratio better it is. Compare with the

industry average and trend over a period of time.

Cash flow coverage ratio(EBIT + Depreciation) / [Interest +

Loan repayment/ (1-Tax Rate)]

Times Often used by the banks and financial institution toascertain the adequacy of the firms cash flows to

cover its debt obligationinterest as well as

principal.

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Assets Utilization Ratio


Total assets turnover ratio

Total income / Total assets

Times May use average assets in the denominators i.e.

(Opening + Closing)/2

Indicator of efficiency in utilization of assets, higher

turnover means higher ability to generate revenue forthe same set of assets.

Fixed assets turnover ratio

Total income / Fixed assets

Times May use average assets in the denominators i.e.,

(Opening + Closing)/2.

Working capital turnover

ratio

Total income / Working capital

Times Working capital means current assets less current

liabilities

Indicator of efficiency in utilization of working capital ,

higher turnover means higher ability to generate

revenue for the same set of working capital.

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Assets Utilization Ratio


Debtors turnover ratio

Credit sales / Debtors

Times If credit sales figure is not separately available, use

the total sales figure.

Indicator of efficiency in debt collection, higher

turnover means better debt collection.

Inventory turnover ratio

Cost of goods sold / Inventories

Times If cost of goods sold is not available, use the total

sales figure.

Indicator of efficiency in managing inventories, higher

turnover means better inventory management.

Average collection period

365 / Debtors turnover ratio

Number of days Also called days sales outstanding. Can be

calculated as Debtors / Average daily sales.

Average daily sales = Total sales / Number of days in

the accounting period.

Average holding period

365 / Inventory turnover ratio

Number of days Can also be calculated as: Inventories / Average daily

consumption or Average daily sales.

Average payment period

365 x Creditors / Purchases

Number of days

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Return Ratios


Return on assetsEBIT (1-Tax rate) / Total assets

% EBIT (1-Tax rate) is also called the Net OperatingProfit After Tax (NOPAT). Can also be calculated as

PAT/ Total assets

ability of the firm, to generate return on the total

assets. Higher the better. Compare with industry

average and past trends.

Return on Capital Employed (ROCE)

EBIT (1-Tax rate) / (Borrowed funds

+ Shareholders funds)

% Can also be calculated as PAT/ Capital employed

ability of the firm, to generate return on the capital

employed. Higher the better. Compare with

industry average and past trends.

Return on equity

PAT / Shareholders funds

% Shareholders funds include reserve and surplus.

Any accumulated losses and fictitious assets should

be deducted

Ability of the firm to generate return on theshareholders funds. Higher the better. Compare

with industry average and past trends.

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Dupont Analysis


Return on equityDuPont

analysis

(PAT/Sales) x (Sales/Assets )

x (Assets/Shareholders

funds)

= Net margin x Assets

turnover x Financial

leverage

% Helps in breaking down the ROE into

profitability, assets utilization and

financial leverage.

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Market Ratios


Price earning multiple

(times)

Current market price / EPS

Times Inverse of earning yields (EPS/CMP) High growth firms/

industries normally have a higher P/E multiple

Price earnings to growth ratio

Price earnings ratio / Growth rate

Time PEG ratio of 1 is considered as fair price

Book value per share

Shareholders funds / Number of

shares

` Shareholders funds include reserve and surplus. Any

accumulated losses and fictitious assets should be

deducted.Not much meaningful as based upon historical cost of

the assets and does not consider the earning capacity of

the assets.

Price to book value ratio

Current Market Price / Book Value per

Share

Times

Market capitalization

No. of shares x Current market price

` Total market value of all the shares issued by the firm

higher market capitalization acts as a safeguard against

hostile takeover

Documents

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