financials ratios

8/13/2019 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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=

=


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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

financials ratios

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