financials ratios
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FM II FINANCIALANALYSISRatio Analysis
References
CFA Notes
Financial Management I M Pandey
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Financial statement analysis applies analytical toolsto financial statements & related data for makingbusiness decisions
Horizontal analysis
BASICS OFANALYSIS
Vertical analysis
Ratio analysis
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Comparison of a companys financial position & performance across time
Comparative statements - shows financial amounts in side by side
columns on a single statement (comparative format)
HORIZONTAL ANALYSIS
ompar ng nanc a s a emen s over a re a ve y s or per o o me -
years) is often done by analyzing change in line items
A change analysis usually includes analyzing absolute dollar amount
changes & percent changes. Both analyses are relevant because dollar
changes can yield large percent changes inconsistent with their
importance
It is common when using horizontal analysis to compare amounts to either
average or median values from prior periods (smooth out erratic or
unusual fluctuations)
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HORIZONTAL ANALYSIS
Trend analysis
A form of horizontal analysis that can reveal patterns in data acrosssuccessive periods
It involves computing trend percents for a series of financial numbers &is a variation on the use of percent changes
The difference is that trend analysis does not subtract the base periodamount in the numerator
Graphical depictions often aid analysis of trend percents
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A tool to evaluate individual financial statement items or a group of
items in terms of a specific base amount
You define a key aggregate figure as the base:
Total revenue for the income statement amounts
Total assets for balance sheet amounts
VERTICAL ANALYSIS
Common size statements
Reveals changes in the relative importance of each financial
statement item
All individual amounts in common size statements are redefinedin terms of common size percents
A common size percent is measured by dividing each individual
financial statement amount under analysis by its base amount
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Common size statements ExampleVERTICAL ANALYSIS
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VERTICAL ANALYSIS
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Ratios allow analysts to compare a various aspect of a company's financial
statements against others in its industry, to determine a company's ability
to pay dividends, and more
The selected ratios are organized into the four building blocks of financialstatement analysis:
RATIO ANALYSIS
Liquidity ratios
Activity ratios
Leverage ratios
Profitability ratios
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LIQUIDITY RATIOS Liquidity ratios measure a firms ability to meet its current
obligations
Current Ratio - indicates the ability of a company to meet its
current liabilities. A minimum ratio of 1:33 is recommended by theTandon Committee and the same is followed by commercial banks.
Quick Ratio (QR) / Acid-Test Ratio - shows the actual liquidity
position of the company since its deducts inventory which is not so
easily convertible into cash and hence, not that liquid
Cash Ratio considers only cash and marketable securities.
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LIQUIDITY RATIOS
Current assetsCurrent ratio =
Current liabilities
Current assets Inventories =
Current liabilities
Cash + Marketable securitiesCash ratio =
Current liabilities
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ACTIVITY RATIOS Activity ratios are employed to evaluate the efficiency with which the firm
manages and utilizes its assets.
These ratios are also called turnover ratios because they indicate the speed
with which assets are being converted or turned over into sales. Activity
ratios measure the quality of a business' receivables and how efficiently ituses and controls its assets
Inventory Turnover Ratio - shows how many times inventory has turned
over to achieve the sales. A higher ratio shows the efficiency in inventory
management. However, it could also indicate over trading.
Debtors Turnover Ratio - indicates the number of times the debtors are
converted into cash in a year. It measures the efficiency of debtors or credit
management.
Creditors Turnover Ratio - indicates the number of times the creditors are
turned over in a year. It measures the extent of credit allowed by the
suppliers. A low ratio indicates that a generous credit period is allowed by
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ACTIVITY RATIOS
=( )
=
=
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ACTIVITY RATIOS Fixed asset turnover ratio - quantifies how efficiently a firm employs its
fixed assets. Predictably, this financial ratio is most useful when a firm has a
lot of fixed assets: real estate, equipment, and so forth
Total assets turnover ratio - measures how efficiently you're employing
your assets. It indicates the sales generated per rupee of investment in total
.
Working Capital Turnover Ratio - indicates the number of times the
working capital is converted to sales. It measures the efficiency of working
capital management
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ACTIVITY RATIOS
=
=
=
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LEVERAGE RATIOS Leverage ratios measure a companys ability to meet its obligations and how
much of the companys assets are financed with debt. They reveal the equity
cushion that is available to absorb any losses that may occur.
Debt to Equity (D/E) Ratio - measure the long term solvency of the firm. A
high ratio indicates a high financial leverage and low margin of safety.
Debt Service Coverage Ratio (DSCR) - shows the firms capacity to repay
its debt along with interest. Financial institutions look for 1.3 - 2.0
Interest Coverage Ratio - shows the firms capacity to pay interest on its
debt obligations. Graham suggest this to be around 4 for equity investors.
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LEVERAGE RATIOS
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PROFITABILITY RATIOS Profitability ratios measure the operating efficiency of the company
Generally two major types of profitability ratios are calculated
Profitability in relation to sales
Profitability in relation to investments
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PROFITABILITY RATIOS Profitability in relation to sales
=
=
=
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PROFITABILITY RATIOS Profitability in relation to investments
( ) =
( )=
( ) =
Capital Employed = Total Debt + Networth
Capital Employed = Total Assets Interest free liabilities
Capital Employed = Net Fixed Assets + Investments + Net current
Assets
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PROFITABILITY RATIOSAdjustment to CE
CWIP Deduct CWIP to get true capital employed in the business
Intangible assets except goodwill Should be part of CE
Goodwill depends upon the components of goodwill
Adjustment for ROE
( ) = (1 )
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GROWTH RATIOS
Historical growth ratios are required for projections and determining
future growth of the company
Sales CAGR analysts typically go for 5-yrs CAGR for sales
Cal. CAGR for Nestle with sales being 7,200 crs, 6,300 crs and 5,200 crs
for CY11, CY10 and CY09
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Sustainable Growth Rate
G = RR * ROE
RR = retention rate = 1 - (dividend declared / net income)
ROE = return on equity = net income / total equity
GROWTH POTENTIAL
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Segment analysis requires conducting ratio analysis on any operating segment that
accounts for more than 10% of a companys revenues or total assets, or that is easily
distinguishable from the other company business in terms of products provided or
the risk/return profile of the segment. Lines of business are often broken down into
geographical segments, when the size or type of business differentiates them from
other business lines.
SEGMENT ANALYSIS
nce many segmen s ave eren r s pro es, ey s ou e ana yze an
valued separately from other parts of the business. Conducting ratio analysis,
specifically profit margins, return on assets and other profitability measures can give
analysts insight into how the segment affects overall financial performance.
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A system of analysis has been developed that focuses the attention on all three
critical elements of the financial condition of a company: the operating
management, management of assets and the capital structure. This analysis
technique is called the "DuPont Formula". The DuPont Formula shows the
interrelationship between key financial ratios
Return on equity (ROE) = net income / total equity
DUPONT ANALYSIS
ROE = (net income / sales) * (sales / assets) * (assets / equity)
ROE = net profit margin * asset turnover * equity multiplier
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USES & LIMITATIONS OF FINANCIAL RATIOS
Benchmarking Financial RatiosFinancial ratios are not very useful on a stand-alone basis; they must be
benchmarked against something. Analysts compare ratios against the
following
The Industry norm
Aggregate economy - It is sometimes important to analyze a company's ratio over
a full economic cycle. This will help the analyst understand and estimate a
company's performance in changing economic conditions, such as a recession The com an 's ast erformance
Limitations of Financial Ratios
Many large firms operate different divisions in different industries. For these companies
it is difficult to find a meaningful set of industry-average ratios.
Inflation may have badly distorted a company's balance sheet. In this case, profits will
also be affected. Thus a ratio analysis of one company over time or a comparativeanalysis of companies of different ages must be interpreted with judgment.
Seasonal factors can also distort ratio analysis. Understanding seasonal factors that
affect a business can reduce the chance of misinterpretation
Different accounting practices can distort comparisons even within the same company
(leasing versus buying equipment, LIFO versus FIFO, etc.).
It is difficult to generalize about whether a ratio is good or not. A high cash ratio in a
historically classified growth company may be interpreted as a good sign, but could also
be seen as a sign that the company is no longer a growth company and should command
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