Financial Statement Analysis
Ratio Analysis
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Introduction • Purpose: • To identify aspects of a business’s performance to aid decision making • Quantitative process – may need to be supplemented by qualitative factors to get a complete picture • Broadly it focuses on 6 major areas: Liquidity Aspect – the ability of the firm to pay its way Financing Aspect – information on the relationship between the exposure of the business to loans as opposed to share capital Efficiency Aspect/Asset Utilisation Aspect – the rate at which the company sells its stock and the efficiency with which it uses its assets Profitability Aspect– how effective the firm is at generating profits given sales and or its capital assets Investment/shareholders Information Aspect – information to enable decisions to be made on the extent of the risk and the earning potential of a business investment
Stock Market Performance Aspect- information regarding the stock market performance 2 www. morningstar.com
Liquidity Aspect Liquidity Ratios Measure of company’s ability to meet short term requirements. Indicates whether current liabilities are adequately covered by current assets. Measures safety margin available for short term creditors.
Current Ratio = Current Assets Current Liabilities
Quick Ratio = Quick Assets Current Liabilities Note: Quick assets = Current assets – (inventories + prepaid expenses)
Current Ratio: As compared to industry average, Too high – Might suggest that too much of company assets are tied up in unproductive activities i.e., too much inventory, (for example). Too low indicates a risk of not being able to meet its liability. Quick Ratio or Acid Test Ratio is used to examine whether firm has adequate cash or cash equivalents to meet current obligations without resorting to liquidating non cash assets such as inventories or prepaid expenses. 1:1 seen as ideal. should not be less than 1.
Gross Working Capital = Total Current Assets Net Working Capital = Total Current Assets – Total Current Liabilities www. morningstar.com
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Liquidity Aspect Working Capital Turnover Ratio Net sales Average Net Working Capital Note-1: Average Net Working Capital = Beginning net working capital + Ending net working capital) / 2 Note-2: If data for two years is not available, then it can be calculated using one year net working capital data.
• A high working capital turnover ratio can potentially give you a competitive edge in your industry. It indicates you use up your working capital more times per year, which suggests that money is flowing in and out of your small business smoothly. This gives you more spending flexibility and can help avoid financial trouble.
Working Capital Productivity Net Sales Total Working Capital
Days Working Capital = Average Net Working Capital * (365/ Annual Sales Revenue) Note: If data for two years is not available, then it can be calculated using one year net working capital data. www. morningstar.com
• Days working Capital: It indicates how many days it will take for a company to convert its working capital into revenue. The faster a company does this, the better. 4
Financing Aspect
There is both advantage and disadvantage of debt financing. Advantages might be Tax benefit, discipline the manager. The dis advantage of debt financing is related to bankruptcy cost, agency cost and loos of future flexibility. The use of financial leverage can positively - or negatively - impact a company's return on equity as a consequence of the increased level of risk.
Debt to Equity Ratio Long-term debt + Short-term debt Share Holder’s Equity Note: Share Holder’s Equity or Equity capital or Total equity, meaning is same. It includes equity share capital and retained earnings. Preference share capital is not considered.
Equity multiplier = Total assets Share Holder’s equity Note: Share Holder’s Equity or Equity capital or Total equity, meaning is same. It includes equity share capital and retained earnings. Preference share capital is not considered. Total asset includes all kind of assets.
Debt to equity ratio is otherwise called as leverage ratio. High leverage effect magnifies profits when the returns from the asset more than offset the costs of borrowing, losses are magnified when the opposite is true. High leverage effect is considered as high risk for the firm. It is important to compare with the industry for a meaningful conclusion. The addition of long term debt with short term debt also mentioned as total liability. The equity multiplier is a way of examining how a company uses debt to finance its assets. Also known as the financial leverage or financial leverage multiplier. It is used in Due Pont Analysis. Also called the assets-to-equity ratio. Analysts use the ratio to measure how efficiently a company uses debt to finance its assets. A higher equity multiplier indicates higher financial leverage, which means the company is relying more on debt to finance its assets. A high multiplier, in comparison to the results for the same industry, implies that a it may have incurred more debt than is the norm.
Financing Aspect Interest Coverage ratio or Times interest earned Earnings before interest and taxes ( i.e., EBIT) Interest Expenses
The interest coverage ratio is used to determine how easily a company can pay interest expenses on outstanding debt. The interest coverage ratio (ICR) is a measure of a company's ability to meet its interest payments. Also known as times interest earned, is a measure of how well a company can meet its interest-payment obligations. Higher is beteer.
• Some Other Ratios Related to Financing Aspects are: • Debt to assets ratio = Total liabilities (i.e., Long Term Debt + Short term Debt)/ Total assets • Cash coverage ratio = (EBIT + Depreciation)/Interest • Gearing Ratio = (Loan Capital + Preference capital) / Total Capital • Equity ratio = (Share Holder Equity Capital / Total Assets) www. morningstar.com
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Asset Utilisation Aspect Asset turnover is a catch-all efficiency ratio that highlights how effective management is at using its assets. All else equal, the higher the total asset turnover, the better.
Total Asset Turnover = Net Sales Total Assets Fixed Asset Turnover =
Net Sales Fixed Assets
Three Asset Turnover Ratios
Current Asset Turnover = Net Sales Current Assets www. morningstar.com
Total Asset turnover ratio considers shortterm (Current asset) , long-term assets (Fixed Assets) and Intangible assets as well. Fixed Assets turnover ratio considers only the long term Fixed Assets minus the accumulated depreciation. Current Assets turnover ratio considers only the short term Current Assets of the company. If the data is available, then average value of these total asset, fixed asset and current assets can be considered for calculation. If data is not available one year data can be 7 taken for calculation.
Efficiency Aspect Inventory turnover = Cost of Goods Sold Average Inventory Note: If sufficient data is available you can take the average value of two years in the denominator. If data is not available, please take the values for the one year.
Account Receivable turnover = Net Sales Average Account Receivables Note: If sufficient data is available you can take the average value of two years in the denominator. If data is not available, please take the values for the one year.
Account Payable turnover = Total purchases Average accounts payable Note: If sufficient data is available you can take the average value of two years in the denominator. If data is not available, please take the values for the one year.
The Inventory turnover illustrates how well a company manages its inventory levels. If inventory turnover is too low, it suggests that a company may be overstocking or overbuilding its inventory or that it may be having issues selling products to customers. All else equal, higher inventory turnover is better. How many times inventory is created and sold during the period. The accounts receivable turnover ratio measures how effective the company's credit policies are. If accounts receivable turnover is too low, it may indicate the company is being too generous granting credit or is having difficulty collecting from its customers. All else equal, higher receivable turnover is better. How many times accounts receivable are created and collected during the period.
The Accounts payable turnover is important because it measures how a company manages paying its own bills. Measures the number of times a company pays its suppliers during a specific accounting period. A falling ratio is a sign that the company is taking longer to pay off its suppliers. A rising turnover ratio means that the company is paying off suppliers at a faster rate. Efficiency ratios measure how effectively the company utilizes these8 www. morningstar.com assets, as well as how well it manages its liabilities.
Efficiency Aspect Cash Conversion Cycle (CCC) = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) - Days Payable Outstanding (DPO)
The cash conversion cycle (CCC, or Operating Cycle) is the length of time between a firm's purchase of inventory and the receipt of cash from accounts receivable. Measured in terms of number of “ Days” or the length of time a company takes to turn purchases into cash receipts from customers. In other words it is the time required for a business convert resource inputs into cash flows. CASH CONVERSION CYCLE
DIO
Accounts payable Average 𝑑𝑎𝑦𝑠 Purchase
DSO
𝐴account Receivables Average days of revenue Note: Average days revenue = Net Sales/ 365
Inventory Average Days Cost of Goods Sold (COGS)
DPO
Note: Average days purchase = Total Purchase/365
Note: Average days of COGS = Total COGS/365 www. morningstar.com
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Efficiency Aspect It tells you how many days inventory sits on the shelf on average.
Net operating cycle Number of days or = of inventory Cash conversion cycle = Inventory Average Days Cost of Goods Sold
Days of Receivable tells you how many days after the sale it takes people to pay you on average.
Number of days + of receivables + 𝐴ccount Receivables Average days of revenue
Days of Payables Outstanding tells you how many days the company takes to pay its suppliers.
Number of days − of payables - Accounts payable Average 𝑑𝑎𝑦𝑠 Purchase
How many days does it take a company to pay for and generate cash from the sales of its inventory? “This is what the Cash Conversion Cycle or Net Operating Cycle tells us. The entire CCC is often referred to as the Net Operating Cycle. It is “net” because it subtracts the number of days of Payables the company has outstanding from the Operating Cycle. It gives us an indication as to how long it takes a company to collect cash from sales of inventory. Often a company will finance its inventory instead of paying for it with cash up front. This means they owe someone money which generates “Accounts Payable”. Many times they will turn around and sell that inventory on credit without getting all the cash at the time of the sale. This means people owe them money and generates “Accounts Receivable”. The first two components of the CCC, DSO namely DIO are what is called the Operating Cycle. This is how many days it takes for a company to process raw material and/or inventory and collect cash from the sale.” Source: Timothy P. Connolly, A Look at the Cash Conversion Cycle, CFA Institute. 10 www. morningstar.com
Continue….. An Example Year 2014
Company A
Company B
Revenue or Sales Purchases (all credit) Cost of Goods Sold (COGS) 2014 Account receivable 2014 Accounts Payable 2014 Inventory Average Dyas COST OF Goods Sold (COGS/365)
164687 1,26,405 64,000 72,000 95,668 15,738 12786 11673 87632 8342 1346 4937 262.10
43.12
Average Days Revenue (Revenue/365)
451.20
346.32
Average days Purchases (Purchases/365) Number of Days of Inventory (DIO) Nummber of Days of Receivables (DSO) Number of Days of Pyable (DPO) Operaing cycle (DIO + DSO) Cash Conversion Cycle (DIO+DSO-DPO)
175.34 5.14 28.34 499.78 33.47 -466.30
197.26 114.50 33.71 42.29 148.21 105.92 www. morningstar.com
Assume that, Company A and B operates in the same industry. The cash conversion cycle (CCC) calculation indicates that, Company A is a market leader as compared to Company B. This is because Company A with a negative CCC suggest that company receives from its customers well in advance as compared to the Company B.
If we see the Operating Cycle figure (DIO + DSO) it suggest that, Company A is efficient enough to convert its inventory in to sales and to collect account receivables from its customers. Company B is close to the efficiency level of Company A for receivable collection, but fails to match in terms of inventory to sale conversion. Product demand for Company A is also good in the market. This is because on an average product stays in the inventory only for 5 days, while it takes 114 days for a sale of inventory in case of Company B. 11
Continue….. HUL Analysis Data from HUL Annual Report
2015
2014
Revenue or Sales Purchases (Assuming all credit):
30805.62
28019.13
15565.27
14,510.00
24018.49
22107.92
Cost of materials consumed + Purchases of stock-in-trade
Cost of Goods Sold (COGS): Cost of materials consumed + Purchases of stock-intrade + Changes in inventories of finished goods + Total Other expenses
Account receivable Accounts Payable Inventory
782.94 5,288.90 2602.68
816.43 5,623.84 2747.53
Average Dyas Cost of Goods Sold (COGS/365)
65.80
60.57
Average Days Revenue (Revenue/365) Average days Purchases (Purchases/365) Number of Days of Inventory (DIO) Nummber of Days of Receivables (DSO) Number of Days of Pyable (DPO) Operaing cycle (DIO + DSO) Cash Conversion Cycle (DIO+DSO-DPO)
84.40
76.76
42.64 39.55 9.28 124.02 48.83 -75.19
39.75 45.36 10.64 141.47 56.00 -85.47
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• Analysis of HUL’s Cash Conversion Cycle suggest that, it collects from customers way ahead of its payment to supplier. The negative figure is due to the higher payment period (124 days & 141 days) to its suppliers. • HUL takes around 48 days in 2015 and 56 days in 2014 to convert its inventory to sales and to collect from the account receivable.
• HUL takes around 9 to 10 days to collect from its account receivable. • It takes around 40 to 45 days to convert its inventory to sales. • Comparable figures as compared to industry can suggest hoe HUL is doing as compared to the industry. 12
Profitability Aspect Net Profit Margin Net Profit after Taxes Net Sales
• Net Sales is the sales revenue minus the excise tax and sales return if any. • Net income equals total revenues minus total expenses and is the Net income (or PAT) from income statement. • For calculating the Net profit after tax the income from other sources like interest income, dividend income considered, because this ratio deals with final profit figure if the company. • If the company is a loss making company the numerator will take the Loss or the negative value.
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The Net Profit margin ratio directly measures what percentage of sales is made up of net income. In other words, it measures how much profits are produced at a certain level of sales. This ratio also measures how well a company manages its expenses relative to its net sales. That is why companies strive to achieve higher ratios. They can do this by either generating more revenues why keeping expenses constant or keep revenues constant and lower expenses.
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Profitability Aspect Gross Profit Margin Gross Profit Net Sales
Gross Profit margin ratio is a profitability ratio that measures how profitable a company can sell its inventory. It only makes sense that higher ratios are more favourable. Higher ratios mean the company is selling their inventory at a higher profit percentage.
• Gross Profit = Net Sales – Cost of Goods Sold (COGS) • The cost of goods sold, also known as COGS, includes the expense required to manufacture a product or provide a service. • Net Sales is the sales revenue minus the excise tax and sales return if any. • Any income under the category of other income (for e.g., interest income, dividend income) will not be considered.
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Investment/shareholders Information Aspect Return on assets (ROA) = Net Profit/Total assets
Return on equity (ROE) = Net Profit/Total equity
Cash Return on Capital Invested = EBITDA / Capital Invested
Since income is derived from assets in use through the year, including new plant or machinery, the value used in the calculation is an average. Return on assets, or ROA, tests management's ability to earn a fair return on assets. It is also can be calculated by multiplying net profit margin and asset turnover ratio. The assets required to produce revenues will vary by industry. Therefore, benchmarks and comparisons should only be made between companies that produce similar products or provide essentially the same services. How efficiently a company uses its assets to produce profits. Return on equity (ROE) or return on capital is the ratio of net income of a business during a year to its stockholders' equity during that year. It is a measure of profitability of stockholders' investments. It shows net income as percentage of shareholder equity. A measure of how well a company uses shareholders' funds to generate a profit.
Cash return on capital invested (CROCI) is calculated by dividing the earnings before interest, taxes, depreciation and amortization by the total capital invested. The capital invested is defined as the equity capital and preferred shares. Long term loans are also included in the capital employed.15
Investment/shareholders Information Aspect Return on Invested Capital = Net Operating Profit After Tax Invested Capital
• • • •
The return on invested capital (ROIC) is the percentage return that a company makes over its invested capital. It is similar to ROA, but takes into account sources of financing, so the denominator is different. Invested capital is in the denominator of the ROIC equation. This is calculated as the company's fixed assets plus current assets minus current liabilities and cash. The objective is to find out how much capital the company has in assets that are producing net operating profits after taxes. The important fact to remember about ROIC is the measure filters out a lot of the noise that limits some of the other return calculations. The focus of this measure is the profits produced by the income-generating assets of the company.
Net Operating Profit after Taxes (NOPAT) = Operating Profit x (1 - Tax Rate) NOPAT = Net Income + Interest Expense (1-Tax Rate) - Non-Operating Income (1-Tax Rate) Invested Capital (IC) = Fixed Assets + Non-Cash Working Capital Non-Cash Working Capital = Current Assets - Current Liabilities - Cash www. morningstar.com
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Du Pont Analysis Du Pont Analysis name comes from the DuPont Corporation of US that started using this formula in the 1920s. The DuPont analysis is a way of decomposing and examining the financial ratio return on equity (ROE). Was it because management was efficient? Because they had high financial leverage? What drove a high ROE number?
• Shows which variables account for profitability
Total Equity
• ROE = Net income/Total Equity • ROE= (Net income/Sales) (Sales/Total Assets) (Total Assets/Total Equity) • ROE = (Profit margin)
(Total asset turnover) (Equity multiplier)
Stock Market Performance Aspect Earnings Per Share = Net Profit No. of outstanding shares Price Earning Ratio (PE Ratio) = Market Price Per Share Earnings per share Price Earnings Growth Ratio (PEG ratio) = PE Ratio Annual EPS Growth Rate
Market to Book Ratio (M/B Ratio) = Market price per share Book Value Per share Dividend Yield = Dividend Per share Market Price Per share
The M/B ratio denotes how much equity investors are paying for each dollar in net assets.
Book Value of Assets = Total Asset – Intangible assets – Long term Loan – Short term Loan Dividend Rate = Dividend Paid/ Net Profit www. morningstar.com
Retention Rate = 1-Dividend Rate
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Few Insights Ratios PE Ratio
PEG Ratio
High • Commanding a higher price today for the higher future earnings • Determine if the expected growth warrants the premium. • Compare it to its industry peers to see its relative valuation to determine whether the premium is the worth the cost of the investment. High P/E ratio is expensive
Low Can be an indication that market is yet to factor the growth potential and hence can be picked up for investment. (Under Valued)
A lower PEG means the stock is more undervalued.
Price to Sales Ratio
How much market values every dollar of the company's sales. Turnover is valuable only if, at some point, it can be translated into earnings Sales dollars cannot always be treated the same way for every company.
Market to Book Ratio
If the ratio is above 1 then the stock is If it is less than 1, the stock is overvalued. undervalued
Enterprise Value (EV)/EBITDA • Also known as the EBITDA Multiple OR the firm multiple. Enterprise Value = Market Capitalization +Debt +Preferred Share Capital + Minority Interest - Cash and cash equivalents
The EV/EBITDA ratio is better as it values the worth of the entire company. It estimates the number of years in which the business will repay its acquisition cost to the buyer through its earnings. The ratio proves a great tool for valuing companies that are making losses at the net earning level, but are profitable at the EBITDA level.
Economic value added (EVA) is an internal management performance measure that compares net operating profit to weighted average cost of capital (WACC). EVA = Net Operating Profit After Tax - (Capital Invested x WACC) Economic value added asserts that businesses should create returns at a rate above their cost of capital
What is the WACC? • WACC = (D/D+E) rd (1-Tc) + (E/D+E) reL • D/D+E and E/D+E are capital structure weights evaluated at market value, based on the firm’s target capital structure • Tc is the firm’s marginal tax bracket, but the effective tax rate is often used as estimate • rd is the cost of debt based on the risk of the debt (which depends on the debt ratio) • reL is the required rate of return on equity (I.e. the cost of equity) • the cost of equity depends on the business risk of the assets • and on the debt ratio Cost of Equity Capital = Risk-Free Rate + (Beta times Market Risk Premium).
Thank you
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