3. ratio analysis basics
DESCRIPTION
Fundamental analysisTRANSCRIPT
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Private and Confidential – Not for Circulation
Fundamental Analysis
Dheeraj Vaidya
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Discussion topics
How to analyze a company?
Analytical techniques for Financial Statement Analysis
Horizontal Analysis
Trend Analysis
Vertical Analysis
Ratio Analysis
Solvency
• Current Ratio /Quick Ratio / Cash ratio
• Receivables turnover / Inventory turnover / Payables turnover / Cash Conversion Cycle
Operating
• Operating Efficiency ratios
• Operating Profitability
• DuPont Formula
• Extended DuPont Formula
Risk
• Business Risk
• Financial risk
• External liquidity risk
Growth
Limitations of Financial Ratios
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How to analyze a company?
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Analytical techniques for FSA
Purpose of Financial Statement Analysis is to evaluate management performance in
Profitability
Efficiency
Risk
Although financial statement information is historical, it is used to project future performance
An Analyst is expected to do a complete synthesis using all three methods
Which method is the Best?
Horizontal and Trend Analysis
• Compares two financial statements to determine dollar and percentage changes
• Compute dollar changes and percentage changes
Vertical Analysis
• Shows relationship of each item to a base amount on financial statements
• Income statement (each item expressed as percentage of net sales)
• Balance sheet (each item expressed as percentage of total assets)
Ratio Analysis
• Puts numbers in perspective with other numbers
• Helps control for different sizes of firms
• Ratios provide meaningful relationships between individual values in the financial statements
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Horizontal / Trend / Vertical Analysis
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Horizontal Analysis
Horizontal analysis shows the changes between years in the financial data in both dollar and percentage form
Horizontal analysis on the income statement
Horizontal analysis can also be done on the liabilities or shareholder’s equity
[Current year – Base year] /
[Base year]
Why provision for tax has increased by 12.6%, while the revenues increased by only 5.5%?
Why there is an increase of 9.1% in Selling and administrative cost?
GKSR Income Statement 2006 2007 Increase ($) % YoY change
Rental Operations 801,240 847,401 46,161 5.8%
Direct Sales 79,603 82,141 2,538 3.2%
Net Revenues $880,843 $929,542 $48,699 5.5%
Cost of rental operations (518,543) (541,392) (22,849) 4.4%
Cost of direct sales (57,522) (59,579) (2,057) 3.6%
Selling and administrative costs (186,652) (203,614) (16,962) 9.1%
Operating Expenses ($762,717) ($804,585) ($41,868) 5.5%
-
Ebitda $118,126 $124,957 $6,831 5.8%
Depreciation (32,479) (34,789) (2,310) 7.1%
Amortization of intangibles (10,784) (10,806) (22) 0.2%
Ebit $74,863 $79,362 $4,499 6.0%
Interest Expense (13,226) (13,901) (675) 5.1%
Income before income taxes $61,637 $65,461 $3,824 6.2%
Provision for taxes (19,786) (22,271) (2,485) 12.6%
PAT $41,851 $43,190 $1,339 3.2%
Basic EPS $1.98 $2.03 $0.05 2.5%
Diluted EPS $1.97 $2.02 $0.05 2.4%
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Trend Analysis
Trend percentages state several years’ financial data in terms of a base year, which equals 100%
In the example below, we have taken base year as 2002
We can use the trend percentages to construct a graph so we can see the trend over time
[Current year ] / [Base year] * 100
While Operating cost has increased by 42% since 2002, Net income
grew marginally by 13% during the corresponding period
Income Statement 2002 2003 2004 2005 2006 2007
Net Revenues 677,591 705,588 733,447 788,775 880,843 929,542
Operating Expenses 565,077 598,974 625,064 674,566 762,717 804,585
PAT 38,267 33,689 35,384 38,179 41,851 43,190
Trend Analysis 2002 2003 2004 2005 2006 2007
Net Revenues 100.0% 104.1% 108.2% 116.4% 130.0% 137.2%
Operating Expenses 100.0% 106.0% 110.6% 119.4% 135.0% 142.4%
PAT 100.0% 88.0% 92.5% 99.8% 109.4% 112.9%
60%
80%
100%
120%
140%
160%
2002 2003 2004 2005 2006 2007
Trend Analysis
Net Revenues Operating Expense Net Income
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Vertical Analysis
Common-size statements use percentages to express the relationship of individual components to a total within a single period is known as Vertical Analysis
Income Statement (as a percentage of Total Revenues)
Balance Sheet (As a percentage of Total Asset / Total Liabilities)
Vertical Analysis 2002 2003 2004 2005 2006 2007
Rental Operations 96.8% 96.6% 96.6% 93.9% 91.0% 91.2%
Alcohol 3.2% 3.4% 3.4% 6.1% 9.0% 8.8%
Net Revenues 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of rental operations -59.5% -60.5% -61.1% -59.6% -58.9% -58.2%
Cost of direct sales -2.3% -2.5% -2.6% -4.5% -6.5% -6.4%
Selling and administrative costs -21.6% -21.9% -21.5% -21.4% -21.2% -21.9%
Operating Expenses -83.4% -84.9% -85.2% -85.5% -86.6% -86.6%
Ebitda 16.6% 15.1% 14.8% 14.5% 13.4% 13.4%
Depreciation -4.4% -4.3% -4.3% -4.1% -3.7% -3.7%
Amortization of intangibles -0.9% -1.0% -1.1% -1.2% -1.2% -1.2%
Ebit 11.3% 9.8% 9.4% 9.2% 8.5% 8.5%
Interest Expense -2.0% -1.9% -1.6% -1.4% -1.5% -1.5%
Income before income taxes 9.3% 7.8% 7.8% 7.8% 7.0% 7.0%
Provision for taxes -3.7% -3.1% -3.0% -2.9% -2.2% -2.4%
PAT 5.6% 4.8% 4.8% 4.8% 4.8% 4.6%
Since 2004, cost of rentals have decreased
EBITDA/EBIT/PAT margins a concern - continuously
decreasing trend
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Ratio Analysis
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Ratio Analysis
Ratios can often be more informative that raw numbers
Puts numbers in perspective with other numbers
Helps control for different sizes of firms
Ratios provide meaningful relationships between individual values in the financial statements
Ratios can be used to evaluate four different areas of company’s performance and conditions
Ratio Analysis
Solvency Ratios
Current/Cash/Quick Ratio
Turnover Ratios
Operating Performance
Operating Efficiency
Operating Profitability
Risk Analysis
Business Risk
Financial Risk
External liquidity risk
Growth
Sustainable growth rate
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Ratio Analysis - Solvency
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Ratio Analysis - Solvency
Analyst employ these ratios to determine the firm’s ability to pay its short-term liabilities
Current Ratio examines current assets and current liabilities
Higher the current ratio, more likely is that the company will be able to pay its short-term bills
A ratio of less than 1, means that the company has negative working capital and is probably facing liquidity crisis
Quick Ratio adjusts current assets by removing less liquid assets
More stringent measure of liquidity
Higher the quick ratio, more likely is that the company will be able to pay its short-term bills
Cash ratio relates cash (ultimate liquid asset) to current liabilities
Higher the cash ratio, more likely is that the company will be able to pay its short-term bills
sLiabilitieCurrent
AssetsCurrent RatioCurrent
sLiabilitieCurrent
sReceivableSecurities MarketableCashRatioQuick
sLiabilitieCurrent
Securities MarketableCashRatioCash
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Receivables turnover examines the management of accounts receivable
Balance sheet items are taken as average of the account
Average collection period is the average number of days it takes for the company’s customer to pay their bills
It is desirable to have a collections period closer to the industry norm
Collection period too high mean that customers are too slow in paying their bills, which implies too much capital is tied up in assets
Inventory turnover measures firm’s efficiency with respect to its processing and inventory management
Balance sheet items are taken as average of the account
Given the turnover values, you can compute the average inventory processing time
It is desirable to have a collections period closer to the industry norm
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Ratio Analysis - Solvency
sReceivable Average
Sales AnnualNet Turnover sReceivable
Turnover sReceivable
365Period Collection sReceivable Average
Inventory Average
Sold Goods ofCost TurnoverInventory
TurnoverInventory
365Period ProcessingInventory Average
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Evaluating Solvency Ratios
Payables turnover measures the use of trade credit by the firm
Balance sheet items are taken as average of the account
Given the turnover values, we can compute the average payment period processing time
It is desirable to have a collections payment closer to the industry norm
Cash Conversion Cycle
Combines information from the receivables turnover, inventory turnover, and accounts payable turnover
High conversion cycle is undesirable
Too high conversion cycle implies that company has excessive amount of capital investment in the sales process
Payables Average
sold goods ofCost Turnover Payables
Turnover Payable
365PeriodPayment Average
Cash Con Cycle Receivable period Inventory period= + Payable period-
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Ratio Analysis – Operating
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Ratio Analysis – Operating Efficiency
Operating Efficiency Ratios
Examines how management uses its assets to generate sales and it considers the relationship between various asset categories and sales
Total Asset Turnover ratio indicates effectiveness of a firm’s use of its total asset base to produce sales
Different types of industries have different asset turnovers. Infrastructure business are capital intensive and may have Asset Turnover closer to 1, however, retail business might have turnover ratios in double digits
Low asset turnover may mean that the company has much capital tied up in its asset base
Equity Turnover measures the employment of owner’s capital
Equity capital includes all preferred and common stock, paid-in capital and retained earnings
AssetsNet Total Average
SalesNet TurnoverAsset Total
Equity Average
SalesNet TurnoverEquity
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Ratio Analysis – Operating Profitability
Operating profitability ratios
Examines how management is doing at controlling costs so that a large proportion of the sales dollar is converted into profit
What proportion of the sales dollar is left after cost of goods sold?
Is the firm buying inputs (inventory and direct labor) at good prices?
Gross Profit Margin
Gross profit margin measures the rate of return after cost of goods sold
Operating Profit Margin
Operating profit margin measures the rate of profit on sales after operating expenses
Operating income can be thought of as the “bottom line” from operations
Net Margin
Shows the combined effect of operating profitability and the firm’s financing decisions (since net income is after interest and tax payments)
SalesNet
Profit GrossMarginProfit Gross
SalesNet
Profit OperatingMarginProfit Operating
SalesNet
IncomeNet MarginProfit Net
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Ratio Analysis – Operating Profitability
DuPont System divides ROE into several ratios that collectively equal ROE while individually providing insight
Most important term in ratio analysis
Basic algebra for ROE breakdown
EquityCommon
IncomeNet ROE
EquityCommon
Assets Total
Assets Total
Sales
Sales
IncomeNet
EquityCommon
IncomeNet
Profit margin Asset Turnover Financial Leverage
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Ratio Analysis – Risk
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Ratio Analysis – Risk
Risk analysis examines the uncertainty of income for the firm and for an investor
Total firm risks can be decomposed into three basic sources – 1) Business risk 2) Financial Risk 3) External Liquidity Risk
Business Risk
Function of Business variability, Sales variability and Operating leverage
Between five to ten years of data should be used for calculating business and sales variability
Also critical is the measure of how much company’s production costs are fixed (as opposed to variable)
Greater the use of fixed costs, greater the impact of a change in sales on the operating income of a company and hence, higher is the risk
income operatingMean
income) (operatingDeviation Standardty variabiliBusiness
salesMean
(sales)Deviation Standardty variabiliSales
Salesin change %
Earnings Operatingin change %leverage Operating
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Ratio Analysis – Financial Risk
Financial risk
The added uncertainty in a firm’s net income resulting from a firm’s financing decisions (primarily through employing leverage)
Interest payments are deducted before we get to net income and these are fixed obligations. Similar to fixed production costs, these lead to larger earnings during good times, and lower earnings during a business decline
The use of debt financing increases financial risk and possibility of default while increasing profitability when sales are high
Two sets of financial ratios help measure financial risk
• Balance sheet ratios
• Earnings or cash flow available to pay fixed financial charges
Balance Sheet Ratios
How much debt does the firm employ in relation to its use of equity?
Assessment of overall debt load, including short-term
equity termLong
debt termLongratioequity Debt to
Equity Total Debt Total
debt termLong sliabilitieCurrent RatioDebt
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Ratio Analysis – Financial Risk
Earnings/Cash flow ratios
Relate operating income (EBIT) to fixed payments required from debt obligations
Higher ratio means lower risk
Interest coverage ratio determines the firm’s ability to repay its debt obligations
expenseInterest
EBITcoverageInterest
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Ratio Analysis – External Liquidity Risk
External liquidity risk
External market liquidity is a source of risk to investors
Market Liquidity is the ability to buy or sell an asset quickly with little price change from a prior transaction assuming no new information
The most important factor of external market liquidity is the dollar value of shares traded
This can be estimated from the total market value of outstanding securities
It will be affected by the number of security owners
Numerous buyers and sellers provide liquidity
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Ratio Analysis – Growth
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Ratio Analysis – Growth
Growth is important to both creditors and owners
Creditors interested in ability to pay future obligations
For owners, the value of a firm depends on its future growth in earnings, cash flow, and dividends
If the company doesn’t grow, it stands a much greater chance of defaulting on its loans
Sustainable growth rate is a function of two variables:
What is the rate of return on equity (which gives the maximum possible growth)?
How much of that growth is put to work through earnings retention (rather than being paid out in dividends)?
Growth = ROE x Retention rate
Also remember ROE is a function of
Net profit margin
Total asset turnover
Financial leverage (total assets/equity)
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Limitations of Financial Ratios
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Limitation of Financial Ratios
Accounting treatments may vary among firms, especially among non-U.S. firms
Always consider relative financial ratios. They do not make any sense when viewed in isolation
Firms may have divisions operating in different industries making it difficult to derive industry ratios
Conclusions cannot be made by just looking at only one set of ratios
Ratios outside an industry range may be cause for concern
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