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Appraisal of Business Performance

ITM Executive Education Centre

April 18th, 2010


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Financial Statement Analysis


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Why Measure / Analyse ?

What gets measured gets done


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Basic Questions

What is the financial position of a company at a given point of time ?

How has the company performed over a given period of time ?

What have been sources and uses of cash over a given period ?

Is the investment in the company safe ?Does the company earn adequate profits ?

Is the company solvent enough to meet its obligations whenever theymature ?

Does the company earn enough to build reserves for future growth ?

Is the company properly capitalized ?

Appraisal is Scientific Evaluation of Profitability and financial strength of the company


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Need for Financial Analysis

Appraisal is a useful measure of past performance

Performance evaluation is the Heart of Management Information System

Ensure that the company is on road toprofitable growthas per plan

Gives an early warning signalshould something go wrong

Provides basis for allocation of resources

Evaluation of Managersand their compensationAppraisal of the past answers two basis questions :

How well is the business done if compared with whatshould havebeen done ?

What can be done to improve future performance ?

Appraisal is a process of evaluation of summarized financials, business data to obtain better


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Measurement Areas

Profitability :

How profitable is the venture ? return on sales, capital employed, equity ?Investment Utilization :

Measures balance between sales / profits and assets particularly fixed assetsand inventory. Also known as efficiency ratios.

Liquidity :

Measures ability of the company to meet short term debts. Also concerned withefficiency of working capital investment receivables, inventory and payables.

Stability :

Measures balance between debt and equity. Too much debt increases risk of insolvency

Growth :

Measures improvement or decline in performance from year to years


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Financial Statements


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Directors Report Auditors Report

Balance Sheet

Profit and Loss Account

Cash Flow Statements

Notes / Schedules to Accounts


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Annual Report

Primary and most important source of information about a company is its

Annual ReportAnnual Reports are well presented with relevant data about performanceof the company given over a period of time

Intelligent investor must read Annual Report in depth, between andbeyond lines to find truth and only then should decide whether thecompany is worth investing in.

Important constituents of an Annual Report : Directors Report Auditors Report Financial Statements Schedules and Notes to Accounts

Graphs, bar, pie charts, pictures and information on CSR add value tocontents of a good Annual Report


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Directors Report

Directors Report is addressed to shareholders advising them about

performance of the company for the year evaluation of their performanceOpinion of Directors state of economy and impact on industry & company

Evaluation of financial performance of company and divisions

Companys plans for expansion, modernization, diversification, plan for acquisition and investment.

Availability of Profits and recommendation of dividend

Directors views on companys performance in coming years

Valuable if read intelligently as it give good understanding of working of the company , problems faced, directions it intends to take and futureprospects


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Audit Report

Auditors are required to present to Shareholders whether the financial

statements present a true and fair view of the state of affairs of thecompany

Auditors Report draws attention of the reader to changes in Accounting

policies, inconsistencies and its impact on the financial statements.

Investor must carefully read Auditors Report to understand departuresmade from normally accepted accounting principles and policies. Resultscould change if adjustments are made based on notes and comments inAuditors report.

Auditors also comment on any action or method of accounting they do notagree with.


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Balance Sheet

Balance Sheet shows Financial strength of business at given point of time

Groups logically under specific heads companys Assets what companyowns and liabilities What companies owes others

BS details financial position on a particular day and that the position couldbe materially different on the following day.

Company has to source funds to purchase fixed assets , procure working

capital and fund its business.Balance Sheet can be presented as a Source and Utilization Statement


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Shareholders Funds

Share Capital Equity ( Risk Capital ) & Preference Capital. Dividend paid

out of profits. Authorized ( Potential ) Capital, Issued ( Offered ) , Subscribed ( Paid Up)

Reserves & Surplus Retained earnings + Revenue & Capital reserves

Capital Reserves Share Premium, Revaluation, Capital Redemption Reserve Revenue Reserves Accumulated earnings, Investment Allowance Reserve,

Dividend Equalization Reserve, General Reserves, Profit & Loss a/c creditbalance

Shareholders Funds = Net Worth = Equity + Reserves Misc exp w/off

Share Capital can be issued in many ways : Private Placements, PublicIssues, Rights Shares, Bonus Issue

Pragmatic management follow a balanced dividend policy and retain /plough back a part of profits for future expansion


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Secured / Unsecured Loans

Borrowing is preferred source as it is quicker , cheaper and enhances

return to shareholders if cost of funds is less than rate of earning.Secured on charge of assets either a floating charge or a fixed charge

Pledge / Hypothecation movable assets Stocks, Receivables ( InEquitable Mortgage title is deposited with lender )

Mortgage Immovable Plant / Machinery , Buildings

Secured Loans : Debentures, Term Loans, Working Capital Loans

Unsecured Loans : Not secured by charge on assets Public Deposits,Promoter Loans, Inter Corporate Deposits, Clean loans from banks /Financial Institutions


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Current Liabilities & Provisions

Current Liabilities & Provisions are obligations maturing within one year

Bills payable, trade creditors for supplies made, advances received. Creditperiod depends on demand for the material, standing of the company andmarket practices

Expenses accrued but not due : Interest on loans, selling, distribution andadmin expenses which are paid on specific dates so need to be estimatedbased on past trends and provided for at the year end.

Provisions are amounts set aside from profits for expenses or losses -taxes, dividend, employee funds, loans payable, within one year or

depreciation, bad and doubtful debts.Other current liabilities include unclaimed dividends, dues payable to thirdparties etc


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Assets

Owned & used in business to provide future economic benefits convertible in cash inflow

Resources are recognized a assets when Company acquires rights over them Can quantify future economic benefits with fair degree of accuracy

Asset Types Fixed ,Investments ,Current Assets, Loan & Advances, Misc expenditure &Losses

Fixed Assets Tangible and Intangible

Depreciation Allocation of cost of Tangible fixed assets to various accountingperiods that benefit from its uses Charge on profits

Tangible Land, Buildings, Plant & Machinery,

Intangibles Patents, Copyrights, Trademarks, Goodwill

Tangible Fixed Assets Represented by net book value gross acquisition value accumulated depreciation


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Investments

Trade Investments Shares and debentures of companies to earn income

by way of interest / dividend or to get access to information of other companies.

Subsidiary & Associate Companies Controlling interest directly or

through cross holdings usually as diversification measure through JVsInvestments are classified as Quoted / Unquoted based on their listing onStock Exchanges. Quoted investments are liquid.

Investments are valued at either cost or market value whichever is lower.

Diminution in value of investments / losses are adequately accounted for.


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Current Assets , Loans and Advances

Current assets are owned and used in the normal course of business

Cash & other assets convertible in cash during operating cycle of companyInventories Raw Materials, Work in Process, Finished Goods, PackingMaterials, Stores valued at cost ( Purchase value + Conversion+

Logistics ) or net realizable value whichever is lower Receivables Amount owed by customers adjusted to doubtful amounts

Cash , Banks and Cash equivalentsOther Current Assets Interest Accrued, Fixed Assets for sale etc

Loans & Advances Support to subsidiaries, deposits with GovernmentAuthoritiesMiscellaneous Expenses / Losses Preliminary Expenses, Discount onsecurities, Interest during construction, development expenses not w/off

Losses Debit balance in Profit and Loss Account


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Profit & Loss Account

Profit & Loss Account summarizes activities and results achieved by the

company during accounting periodIt is performance appraisal not only of the company but its management its competence, foresight and ability to take risk and lead.

Revenue Expenditure

Sales Cost of Goods Sold

Other Income Employee CostOperating & Other Expenses Selling,Admin, General

Interest & Finance ChargesDepreciation

Taxation

Dividends


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Contingent Liabilities

Contingent liabilities are liabilities that may arise on the happening of an

event.It is uncertain whether that event will happen or notContingent liabilities are not recorded in accounts but are shown by way of notes / information to readers of potential liability should the event happen

Examples :

Bills Discounted with banks May crystallize in liabilities if dishonored

Outstanding guarantees / Letters of Credit Cheques discounted Uncalled liability for partly paid shares and debentures

Gratuity of employees not provided for Legal suits against company not provided for Claims against company not acknowledged as debt or accepted Claims against company for taxes and duties


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Schedules and Notes to Accounts

Schedules/ Notes to accounts are integral part of financial statements and

have to be read along with financial statementsSchedules detail pertinent information about items of Balance Sheet andProfit & Loss Account

Notes to accounts cover Accounting policies, Contingent Liabilities andrelate to how sales are accounted ?, What are R&D costs?, How isgratuity liability expensed? , How fixed assets are valued ? Howdepreciation is calculated? How stocks finished goods, WIP, rawmaterials and consumables are valued ? How are investments stated?How has foreign exchange translated ?


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Accounting v / s Economic Values

Use of Historical Cost Principle :

Accounting uses historical cost as basis of valuation Asset Value = Cost Accumulated Depreciation Historical Values differ significantly from Economic Values

Exclusion of Intangible Assets :

Intangible stated at cost of acquisition less amortization

Economic Values attached to technical knowledge , Brand equity, Managerialcapability, Goodwill is ignored as difficult to objectively to value them

Understatement / Omission of certain liabilities

Contingent liabilities not recorded but shown by way of notes to accounts


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Net Cash Flow

Cash flow generally differs from PAT due to accrual concept of accounting

Relationship between cash flow and PAT : Net Cash Flow = PAT Non Cash Revenue + Non cash Expenses

In practice, Analysts define net cash flows :

Net Cash Flow = PAT + Depreciation + Amortization Accuracy of reconciliation depends on correct estimates of accrued incomes

and expenses


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Free Cash Flow

Operating FCF = Cash Inflow from operations Cash outflow from

operations Cash inflow from sale of goods payments to suppliers of goods

Investing FCF = Cash Inflow Investing Activities Cash Outflows fromInvesting Activities Receipt from sale of assets , recovery of loans, Interest, dividend Payment for

purchase of assets, disbursement of loans

Financing FCF = Cash Inflow from financing activities Cash outflow fromfinancing activities

Receipts from issue of securities, Loans, Deposits Outflow from interest onloans, dividend payment, retirement of borrowings and redemption of capital

Net FCF = Operating FCF + Investing FCF + Financing FCF


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Accounting v / s Analysis

Accounting Classification , recording, summarizing and presentation of

financial dataAnalysis Unveiling the meaning and significance of items in financialstatements to assist management in formation of sound operating financial

policiesAnalysis reveals significant facts relating to financial strength , profitability ,corporate efficiency, weakness, management performance , solvency andother factors related to company


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Analysis of Financial Statements


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Measurement Areas

Every stakeholder is interested in reviewing economic performance of

business in which he has stakeBoard and Management reviews and evaluates periodically to establishwhether actual position is in line with projections

Financial performance appraisal is basic exercise for monitoring pastperformance to have fruitful planning of the future

Focus is on various tools of analysis for appraisal of business performanceProductivity and Profitability are two yardsticks against which businessperformance is judged

Financial appraisal is an objective evaluation of profitability and financialstrength of the business unit through application of technique financial byusing .


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Ratio Analysis Summary

Financial Goals

ReturnFor a given Risk

ROI Financial Position

GrowthProfitability Investment

Utilization

Stability

Long Term

Liquidity

Short Term

Subject to

Qualitative factors External Factors

Industry Trends Ratio Definitions

Accounting policies

Time frame of analysis

Suitability of historic data as prediction tool

M A


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Measurement Areas

Financial Statements Important source of information for evaluating performance andprospects

All stakeholders are interested in getting an insight :

Management Performance Review Lenders Short term liquidity Investors Portfolio Analysis Researchers

Purpose of analysis may be varied : Simple analysis for short term liquidity Comprehensive assessment of strengths and weaknesses

Corporate excellence Creditworthiness Intrinsic value of equity shares

Assessment of market risks

M h d f A l i


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Methods of Analysis

Horizontal Analysis :Comparison , Analysis and interpretation of similar

items of financial statements relating to two accounting periodsVertical Analysis :Comparison , Analysis and interpretation of two itemsor variables of financial statements relating to same accounting period

Static & Dynamic Analysis :Static Analysis measures relationshipamong items in single statement . Dynamic Analysis measures changes insuch items in successive statements

Internal & External Analysis :Internal represents Analysis of financialdata by management for internal decision making . External represents

analysis done by outsiders like investors , bankers, Government,Creditors, Customers and others for decision making

Fi i l R ti


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Financial Ratios

In analysis of financial statements, ratios are most useful because they

help in comparing strengths, weaknesses and performance of companiesRatios express mathematically relationship between performance figuresand / or assets / liabilities in a form that can be easily understood and

interpreted.No single ratio tells complete story when various different ratios arecalculated and arranged, complete set of comparison emerges.

Five Broad types of Ratios :

Profitability Ratios

Leverage Ratios Turnover Ratio Liquidity Ratios Valuation Ratios

Fi i l R ti


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Financial Ratios

Profit & Loss Ratios Show relationship between two items or groups of

items in Profit and Loss Account or Income Statement Sales to Cost of Goods Sold Selling Expenses to Sales

Net Profit to Sales Gross Profit to Sales

Balance Sheet Ratios These deal with relationship in Balance Sheet

Shareholder Equity to Borrowed Funds Current Assets to Current Liabilities

Liabilities to Net Worth Debt to Assets Liabilities to Assets

Fi i l R ti


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Financial Ratios

Balance Sheet and Profit & Loss Ratios These relate an item on Balance

Sheet and Profit & Loss Account Earnings to Shareholders Funds Net Income to Assets employed

Sales to Stock Sales to Receivables COGS to Creditors

Financial Statements and Market Ratios relate to Financial numbers tomarket prices

Market Value to Earnings Book Value to market Value

Ratios being measured should be consistent and valid and length of periods should be similar


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Liquidity Ratios


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Financial Ratios Liquidity

Age of Receivables

WorkingCapital

Acid Test

CurrentRatio

Formula Meaning Desired Trend

Total Current Assets TotalCurrent Liabilities

Number of times short termassets can cover short termdebtsIndicates ability to meet shortterm obligations as they comedue.

Rule of Thumb 2:1 Too Low Business

discontinuity Too high suboptimal use of

capital

Cash Equivalent + AvgReceivablesTotal current Liabilities

Indicates ability to meetshort term payments usingmost liquid assets

Rule of Thumb 1;1 Too low Risk of Insolvency Too High inefficient use of

capital

Current Assets minusCurrent Liabilities Net funds tied up in

working capital

Higher is safer Too low business at risk Too

high low return. Adverseimpact on profitability

Accounts Receivable

Average Daily Sales

How high is averageoutstanding balance oncredit sales ?

Should be close to industryaverage

Too low credit policies tightand scaring business

Too high customersenjoying at company s cost

Ratio


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Financial Ratios Turnover

Total Assetturnover

Fixed AssetRotation

Age of Payables

Age of Inventory


Average InventoryAverage Daily COGS

How many days on averagedoes an item of inventoryremain in stock ?

Rule of Thumb 2:1 Too Low Business

discontinuity Too high insufficient use of

capitalAccounts PayableAverage Daily Purchases

Or

Accounts PayableAverage Daily COGS

Indicates number of daysit takes for business to pay

its suppliers

Close to industry average Too low extend credit period

and source cash

Too high suppliers may cutoff supplies

Net Sales / Average netfixed Assets

Indicates rupee sales

generated by investmentin Fixed Assets

Close to industry trend Too high existence of old

assets Too low under utilized or

asset block not productive

Net Sales / Average totalassets

Indicates rupee salesgenerated by investmentin total assets

Incremental investment andreturn to be established

Too High lean asset block Too low underutilized, slow

moving

Ratio

Liquidity Ratios


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Liquidity Ratios

Cornerstone of any investment. Liquidity or conversion to cash is crucial

for the company to meet obligations both for operations and on maturity of loans.

If liquidity is constrained, company may be forced to sell its assets or may

lead to liquidationIndicates ability of a company to meet its obligations in short run usuallya year

Liquidity Ratio Based on relationship between current assets ( sourcesof meeting short term obligations ) and current liabilities

Companies have become conscious of cost of capital, opportunity cost of tying up of capital unproductively as a result Just In Time inventory

Current assets are deliberately kept low efficient management of funds

Current Ratio


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Current Ratio

Current Ratio = Current Assets / Current Liabilities

Current Assets Cash + Current Investments + Receivables + Inventories+ Loans & Advances + Prepaid Expenses

Current Liabilities Loans ( Secured & Unsecured ) due in one year ,current liabilities and provisions

CR measures ability of the company to meet CL

Higher the CR the greater is short term solvency

Quality of CA is crucial

Higher portion on cash / Receivables more liquid than higher portion of inventories

CR norm in India is 1.33:1. Internationally, 2:1.

Current Ratio


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Current Ratio

As On March 31 st 2009 ITM limiteds current assets were Rs 400 Lakhs

and current liabilities Rs 125 lakhs.Current Ratio = 400 / 125 = 3.2. ITM can meet its current liabilities byselling mere 31.2% of its current assets

Liquid Ratio


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Liquid Ratio

Also known as Acid Test / Quick Ratio

Liquid Ratio = ( Current Assets Inventories ) / Current LiabilitiesFairly stringent measure of liquidity

Used to measure company has enough cash or cash equivalents to paydebts. Inventories are excluded in computing liquid assets.

India norm 1:1

Cash Ratio Most liquid

Cash Ratio = ( Cash & Bank Balances + Current Investments ) / CL

Cash Ratio is overly stringent measure of liquidity. In real life situations,lack of immediate cash can be overlooked if company can release dues ,stretch payments or borrow money at short notice.

Liquid Ratio


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Liquid Ratio

Rs LakhsCash at Bank 150

Receivable 1850

Inventories 3100

Investments 500

Current Assets 5600

Current Liabilities 4000

Quick Ratio = 150 + 1850 + 500 = 0.625

4000

Company cannot pay off its current Liabilities with cash or cash

equivalents

Stocks have been excluded fromcalculations as it is difficult to dispose

off stocks except at distressed value

Net Current Assets


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Net Current Assets

Net Current Assets = Gross Current Assets Current Liabilities

Not a ratio but helps to ascertain whether company has adequate currentassets to meet current liabilities

Net Current Assets is also known as Net working Capital

NCA used as a base to determine quantum of W/C required to supportcertain level of sales. A ratio of 20% would indicate if sales increase by20% , current assets would need to increase proportionately.

As a defensive strategy, management may want to know no of dayscompany may remain in business without additional financing / sales egworker strike situation. Example follows.

Current liabilities coverage ratio establishes relationship between cashinflow from operations and current liabilities to determine whether company can meet maturing obligations from internally generated funds.Important ratio in times of cash crunches. Example follows.

Example of Defensive Ratio : Example


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Example of Defensive Ratio : Example

Cash and cash equivalent of ITM limited whose annual operating

expenses are Rs 730 Lakhs is as follows :Rs Lakhs

Cash 35

Marketable Securities 145180

Daily Operating Expenses 730 / 365 = 2 2

Defense interval would be 180 /2 = 90 90 days

This means that ITM Limited can remain in existence for 90 days without any sales

Or financing


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Net Current Assets Example


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Net Current Assets Example

In 2009 ITM Limited had sales turnover of Rs 2000 lakhs and net current

assets were Rs 450 Lakhs after meeting its current obligations2009 2008

Current Assets

Receivables 310 280

Inventories 390 320

Total Current Assets 700 600

Creditors 220 190

Accrued Expenses 5 3

Tax Payable 25 7Other Current Liabilities 250 200

Net Current Assets 450 400

Net current Assets are Rs 450 L and sales

Rs 2000 L.

So net current assets to sales ratio

Is 0.5 ( 400+450) / 2000 x 100 = 21.25%

This means that working capital will have to

go up by 21.25% to support every rupee increase

In sales.

If sales were to go up by Rs 100 L,Net current assets would go up by Rs 21.25 L

This linear equation may not always hold true but

Gives a thumb rule.

Net Trade Cycle


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Net Trade Cycle

It is important to determine time company takes to realize its sales

proceeds after paying for purchase of raw materialsA very useful tool for determining companys liquidity and is computed byas Debtors turnover (no of days) + stock turnover ( no of days) creditors

turnover ( no of days )Improvement ( reduction in no of days ) in this ratio signifies improvementin management of net current assets

Alternatively, ratio could improve if Creditors no of days go up indicatingun-ability of the company to suppliers in time.

Need to go beyond numbers to determine reasons for change in net tradecycle. Longer the trade cycle, greater need of financing and so cost.

Also individual components of cycle need to be studied to arrive at rightconclusions

Net Trade Cycle Example


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y p

Extract from ITM Limiteds Financial Statement

2009 2008Sales 280 200

Cost of Goods Sold 224 160

Receivables 44 24

Inventories 48 36

Net Trade Cycle

Receivables Turnover - days 44 days

Inventories Turnover days 68 days

Less

Creditors Turnover days 39 days

Net Trade Cycle days 73 days

Receivable Turnover =

Average Receivables/Sales x 365

Inventory Turnover =Average Inventory / sales x 365

Creditors Turnover =

Average Creditors / sales x 365

Net Trade Cycle =

Receivable Turnover + Inventoriesturnover Creditors turnover

Cash is King


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g

Liquidity is becoming increasingly important for companies and lack of itcould make a company sick

If cash crunch happens, companies begin to postpone / delay paying bills.Supplier dues build up, supplies dry out. Impacts production then sales

and has snowballing effect.Negative liquidity ratio need not necessarily be bad. Strong companieskeep low current assets are able to get long credits / advances fromsuppliers. JIT inventory, low receivable and extended supply credit couldturn net working capital negative.

Checking quality of companys assets and ascertaining its currentrealizable value is crucial. Current Assets should not include deferredrevenue expenditures as it may not have realizable value.bobny ys aAua

Financial Ratios - Recap


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p

Ratios do not provide answers. They suggest possibilities.

Interpreters must examine these possibilities along with general factorsthat would affect the company such as its Board, management style,government policies, state of economy and industry to arrive at a logical

conclusion.Ratios are tool for interpreting financial statements but their usefulnessdepends entirely on their logical and intelligent interpretation.

Ultimately, the market value of shares is what matters to an investor aswould purchase share if , in his perception, its price is low or reasonable

and has growth potential.If share is priced high, an investor would sell as the cardinal principle is buy cheap and sell dear

Ratios help investor to decide on holding period to recover investment.


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Leverage

Financial Ratios Stability


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Financial Ratios Stability

Long TermDebt

InterestCoverage

Debt

to

Equity

Total Debt to

Total Assets

Net Worth

to

Total Assets


Total EquityTotal Assets What percentage of businessowned by Shareholders

Higher is Safer Too low Too much debt Too High Underleveraged

reducing ROE.

Total LiabilitiesTotal Assets

What percentage of business is financedthrough debt ?

Lower the safer Opposite of Net worth to

Assets

Total LiabilityTotal Equity Number of times debt for

every rupee of equity

Lower is safer Too low inefficient use of

equity Too high over leveraged

and risky

EBIT

Interest on Long TermDebt

Number of timesavailability of profit to meetinterest payment liability

Assurance to lenders thatsufficient cover exits for interest payment

Ratio

Leverage


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g

Leverage indicates the extent to which a company dependent on borrowedfunds to finance its business

In highly leveraged firms, owners funds are minimal and they are able tocontrol business with fairly low stakes. Main risks are borne by lenders.

In good times, companies make large profits if they are in high marginbusiness. Reverse occurs in times of recession. Interest charges eat intoprofits and often turns in to large losses.

Companies with no or moderate borrowings is safer and can be dependedupon both in good and adverse years.

Highly geared companies are risky and earnings can be negative in badyears. In good years financial results of leveraged companies can be verygood.

Important to investors in evaluation of companies.

Leverage Example


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Company A Company B Company CRs Lakhs Rs Lakhs Rs Lakhs

Share Capital 40 160 200Borrowed Funds 160 40Total 200 200 200Good YearEarning Before Interest & Tax 100 100 100Interest @ 20% 32 8 0

Profit Before Tax 68 92 100Tax @ 33% 22 30 33Profit After Tax 46 62 67Returns to Ordinary ShareholdersBefore Tax % 170 57.5 50After Tax % 114 39 34Reasonable YearEarning Before Interest & Tax 60 60 60Interest @ 20% 32 8 0Profit Before Tax 28 52 60Tax @ 33% 9 17 20Profit After Tax 19 35 40Returns to Ordinary Shareholders

Before Tax % 70 33 30After Tax % 47 22 20Bad YearEarning Before Interest & Tax 24 24 24Interest @ 20% 32 8 0Profit Before Tax -8 16 24

Tax @ 33% 5.28 7.92Profit After Tax -8 10.72 16.08

Leverage Learning from Example


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Company A is highly leveraged. Company B borrowed funds up to 20 % of its funding needs. Company C is debt free.

In good year Company A makes stupendous 170% before tax where asCompany C makes modest 50%

So long as earning rate exceeds cost of borrowing, highly leveragedcompany makes impressive profits.

In reasonable years, profits of leveraged companies is higher thancompanies that do not borrow. Earnings before tax of Company A is twicethat of Company C.

During recession, interest costs are comparatively high and profits getswiped out both on account of lower margin and interest burden. CompanyC makes highest profits as it has no borrowings.

Leverage Ratios


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Leverage Ratios

Based on proportion of Debt & equity in capital structure

Debt : Equity Debt : Asset

Relationship between debt service commitment and sources of meetingthese burdens

Interest Coverage

Fixed Charges Coverage Debt Service Coverage

Debt : Equity


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Shows extent of funds are obtained from external sources and how

dependent the company is on borrowings to finance its business.Debt : Equity = Debt ( Long Term + Short Term )

Net Worth + Preference Capital

Lower the DE ratio higher is the degree of protection enjoyed bycreditors

BV of equity may be lower than market capitalization as tangible assetsrecorded at historical value net of depreciation and Intangible assets likeBrand, Goodwill, Intellectual Property Rights, Knowhow are not recordedin Balance Sheet.

Secured debentures , Borrowings, Loans are protected on charge of

assets and enjoy superior protection

Debt : Equity Example


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Balance Sheet of ITM Limited as

on March 31 st 2009 is as follows :Debt : Equity Ratio :

(150+ 40+ 40 ) / ( 158-10 ) = 1.55Companys liabilities are 1.55times net worth. Alternatively,

liabilities finance 60.85%Extremely useful ratio when oneis determining how wellshareholders would becompensated should company gobankrupt.

Rs Lakhs

Shareholders Equity 158

Debentures 150

Terms Loans 40


388

Tangible Assets 378

Intangibles 10

388


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Liabilities to Assets Ratio Example


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Balance Sheet of ITM Limited as on

March 31 st 2009 is as follows :

Liabilities to Assets Ratio :

( 50+200) / (350 -10 ) = 0.7474% of assets of the company arefinanced by liabilities

Conversely, it can also beconcluded that assets are sold at74% of book value, would meetcompanys liability commitment.

Rs Lakhs

Sources of Funds

Shareholders Funds 100

Debentures 50


350

Application of Funds

Fixed Assets 80

Investments 40

Preliminary Expenses 10

Current Assets 220

350

Incremental Gearing with Example


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2009 2008

Net Income Before Tax 400 300

Taxation 75 50

Profit After Tax 325 250

Borrowings 480 400

Incremental Gearing ratio attempts to determine additional borrowingsrequired to finance growth. Ratio is calculated by dividing net increase in

debt by increase in net income after tax but before dividend.

Incremental gearing is : for every rupee used to finance growth, net incomeWould increase by Rs 75. ( 0.5 x (480 400) / ( 325 250) ) = 75

This is a very high dependence.

Interest Coverage


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Determines whether companys profits are adequate to meet its interest

dues. If not, interest will have to be paid out of reserves, borrowings,fresh issue of capital

Times Interest earnings Earning Before Interest & Tax / Interest

EBIT is considered as numerator as the ability of a company to payinterest is not affected by tax payment as interest is tax deductible

Must exceed 1 and higher ratio better - can meet its commitmentLower ratio means financial embarrassment should profits decline

Ratio used by lenders to assess debt capacity major determinant inBond / Debt rating

Variant of this ratio could be cash flow before Interest and Taxes

Modified as ( EBIT + Depreciation ) / Interest

Interest Coverage Example


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ITM Limited earned Rs 450 L before interest and tax during the year

ended March 31st

2009. Interest expense was Rs 200 LInterest Cover Ratio = 450 / 200 = 2.25 times

Companys earnings before interest are more than double its interestexpense. A comfortable situation.

Debt Service Coverage Ratio DSCR


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Helps determine time taken by company to repay its short / long term

debt from its income or internally generated funds.Relevant if debt is not to be extinguished through sale of assets or byissue of fresh capital or debt.

Internally generated funds means income after tax + non cash expensessuch as depreciation and non operating income and expenses.

Debt would comprise of bank OD, term loans and debentures.PAT + Depreciation + Non cash items + Interest on TL + Lease RentalsInterest on term loans + Lease Rentals + Repayment of term loans

Financial Institutions consider DSCR of 1.5 - 2 as satisfactory

Ratio critical during high inflation and recession when company may find

it in difficult situation to meet this financial covenant to service debt

Debt Service Coverage Ratio DSCR Example


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2009 2008

Net Income before tax and depreciation 500Depreciation 100

Net Profit Before Tax 400

Tax 160Net Profit After Tax 240

Bank Overdraft 150 100

Debentures 380 400

Term Loans 90 100

520 600

Debt Service Coverage Ratio = ( 240 + 100 ) / 0.5 ( 600+ 520) = 0.60

This would mean that it would take the company ( 12 x 0.60) = 1.7 years to repay from

its profits

Liability Coverage Ratio with example


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Liability Coverage ratio is an extension of debt coverage.

Used to check whether a company can repay all liabilities through internalgenerations.

Calculated by dividing internally generated funds by its average totalliabilities. Alternatively, ratio is calculated on balance sheet date instead of average as it is more relevant figure which will have to be repaid.

In year ended March 31st

2009, ITM Limited generated Rs 500 Linternally. Its total liabilities at the end of 2009 and 2008 were Rs 4500 Land Rs 3500 L respectively.

Liabilities coverage Ratio = 500 / ( 0.5 ( 3500+ 4500) = 0.25

This means that internally generated funds are only 25% of companysaverage liabilities. Entire debt can be repaid in 4 years.

Fixed Charge Coverage Ratio I


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Companies use leased funds as alternative means of financing

advantage is company is not required to borrow to acquire asset and alsolease rentals are deductible expense for tax purposes

This is known as Off Balance Sheet Financing as neither the real cost

of asset nor its liability is reflected in balance sheetFixed charge cover considers off balance sheet obligations such asrental expenses and assesses whether a company earns enough incometo meet its interest and rental commitments.

At times, it is argued that dividend payable on preference shares is to be

considered as it is fixed charge to be paid off.More comprehensive ratio as ikt considers all fixed expenses andexamines whether its earnings are sufficient to meet them

Fixed Charge Coverage Ratio II


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Times cash flow before Interest and taxes to cover all financial charges

( EBIT + Depreciation ) / Interest + ( Repayment of loans (1 tax rate) )In denominator, repayment of loans is adjusted upwards for tax factor because loan repayment amount unlike interest is not deductible

Measures debt servicing ability comprehensively because it considersboth interest and principal repayment obligations.

Ratio may be amplified to include other fixed charges like lease paymentand preference dividend

EBIDTA

Debt Interest + Lease payment + ( Loan repayment Installment /( 1- tax rate)+ Preference Dividend / ( 1- tax rate)

ST loans like WCTL/ CP - self renewing in nature and not repaid annuallyso FCCR less than 1 need not be viewed with concern


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Fixed Charge Coverage Ratio - Example

Rs Lakhs

Rental Expenses 400Earnings before Interest and Tax 750

Interest 200

Earning before Tax 550

Tax at 40% 220

Profit After Tax 330

ITM Limiteds Income Statement included following figures :

Fixed Charge Cover = ( 750 + 400 ) / ( 200 + 400 ) = 1.91

Cash Flow Surplus


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Cash flow surplus ratio is based on going concern concept. Assumes

company will incur capital expenditure and that there would be increase innet working capital

Companys ability to pay debt determined after providing for increase in

capital expenditure and net working capitalCash flow is net capital expenditure & increase in net working investment

Ratio calculated by dividing cash surplus by total debtMay be negative as the company grows rapidly it incurs capitalexpenditure and net working capital increases. This exceeds net fundsgenerated funded by loans and short term bank facilities.

Cash Flow Surplus Example


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In 2009 , average debt of ITM Limited was Rs 400 L. Its internally generated

funds were Rs 40 L. Its net working investments had increased by Rs 10 Land it had incurred capital expenditure of Rs 20 L.

Cash Flow Surplus = ( 40 10 20 ) / 400

It would take company 40 years to repay its debts by utilizing cash flowsurplus

It also indicates need to borrow and extent of such borrowings


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Asset Management Efficiency Ratios

Financial Ratios Asset Turnover


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Total AssetTurnover

Fixed Assets

Turnover

InventoryTurnover


COGSAverage Inventory

Rotation of Inventory duringthe financial year.Speed at which inventorymoves

Higher is better Too low Obsolescence Too High Stock outs

Net SalesAverage Net Fixed Assets

Rupee earned for everyrupee of fixed assets

Measures utility of fixedassets to business

Higher the better Too low mismatch in assets

/ unutilized assets Too high assets flogged or

old assets needingreplacement

Net Sales

Average Total Assets

Rupees earned for everyrupee of total assets

Measures usefulness of assets

Higher the better Too low presence of

redundant assets Too high risk of business

disruption, loss of opportunities.

Ratio

Financial Ratios Return on Investment


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Return on

CapitalEmployed

Earningpower

Return onEquity

Return on Assets


Net IncomeAverage Total AssetsMay also use EBITinstead of Net Income

Quantum and quality of returns generated by Assets

High return signify better utilization of assets

Net IncomeAverage ShareholdersEquity

Whether the business isgenerating return meetingshareholder expectations

How higher than hurdlerate ?

Return higher than hurdle rateleads to shareholder satisfaction

PBIT / Average totalassets

Indicates quality andability of asset block toproduce earnings beforefinancial charge

High return indicates better utilization.

Impact of leverage / borrowingcosts removed

PBIT ( 1- Tax rate ) / (NetFixed Assets + Net

Current Assets )

Indicates quantum of return on capital employedin comparison withborrowing costs

Return higher than cost of capital means every rupeeinvested increasesshareholder wealth

Ratio

Financial Ratios Growth


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AssetGrowth

SalesGrowth

ProfitGrowth


Profit yr 2 Profit yr 1Profit yr1

Growth or decline in profitover past two operatingperiods

Growth is good Quantum to be benchmarked

with expectations / hurdle rate

Sales yr 2 Sales yr 1Sales yr1

Growth or decline of salesover past two operatingperiods

Sales growth is good Quality of incremental sale to

bring profit is crucial

Harmful if incremental salesachieved at loss of margin

Assets yr 2 Assets yr 1

Assets yr 1

How much have assetsgrown over past twooperating periods

Incremental Assets shouldresult in profitable growth or cash position will be strained.

Ratio

Asset Management Efficiency Ratios


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Also known as Turnover Ratios, Activity ratio, Asset Management Ratio

Companies make profit by efficient management of assetsCritical to decide whether assets are adequate either from capital or borrowings

Excess holding of assets funds locked in / interest burden / loss of opportunities

Asset Management Ratios indicates adequacy of assets & efficiency of use of assets.

Comparisons can be made over years and with other units in Industry

High may not necessarily mean greater efficiency / high returns. Maybe due to inadequate level of assets may affect performance in future

Inventory Turnover or Stock Turnover


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Measures how efficiently companys assets are used optimal holding iscrucial arising from high cost of borrowing

Under Just In Time policy inventory levels are always under scanner

How fast inventory is moving to generate sales = COGS / Avg Inventory

Reflects efficiency of inventory management

Higher Ratio more efficient management of inventories

High ratio may be caused by low level of inventory stock-outs / loss of sales and customer goodwill

Average inventory is used as we compare flow figure cost of good sold

to stock figureTwo Expressions : Inventory Turnover COGS / Average Stock

Inventory Holding Average Inventory / Ave COGS

Inventory Turnover / Inventory Holding Example


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Average inventory of ITM Limited as on March 31 st 2009 and 2008 was

Rs 160 L and Rs 150 L respectively. During this period average COGSwas Rs Rs 1200 L and Rs 1050 L. Calculate Ratios

Inventory Turnover Ratio

2009 1200 / 160 7 Times

2008 1050 / 150 7.5 Times

Stock Holding Ratio

2009 160 / 1200 x 365 49 days

2008 150 / 1050 x 365 52 days

Company has successfully reduced inventory levels by 3 days of production and has

turned over stock 0.5 times more.

Receivable Turnover


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Selling with trade credit is normal practice. Cost of finance is built intosales price. Cash discounts are offered for prompt payments

Receivable turnover = Times / rotation of turnover during the year

Turnover = Net Credit Sales / Average Receivables

Holding - Average Collection period = 365 / Receivable turnover

Compare average collection period with credit terms own / industry to judge efficiency of credit management

Higher collection is slow , loss of interest , warning of bad debts

Lower either efficiency is low or excessive conservatism requiring

resetting of credit termsRegulating receivables would enhance efficiency and reduce borrowings

saving interest cost.

Receivable Turnover / Average Collection Example


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In 2009 , sales of ITM Limited grew by 15% from Rs 348 L to 400 L. Its

average trade receivables during 2008 and 2009 were Rs 49 L and Rs59 L respectively. Average collection period is calculated as follows :

2008 Average Sales = 348 / 365 = 0.95 L

Collection Period = 49 / 0.95 = 51 days

2009 Average Sales = 400 / 365 = 1.09 L

Collection period = 59 / 1.09 = 54 days

Period of collection increased by 3 days. Assuming normal credit periodof 30 days, it is clear that company is not in a position to collect in time.

Company is being forced to extend credit period and management isunable to exercise control on collections.

Average Payment Period / Supplier Outstanding


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Average payment period ratio or Creditors ratio indicates time taken for

company to pay creditors.Supplier Payment period = Average Trade Creditors / Daily COGS

Helps answer following questions :

Whether the company is availing all credit it can ?

Whether company is having difficulty in procuring on credit terms ?

Is the company having difficulty in paying creditors on time ?

If the company is in strong and commanding position , it can obtain

longer credit terms.Longer credit period company can finance its working capitalefficiently and to that extent cost of funds fall.

Average Payment Period / Supplier Outstanding - Example


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Average creditors of ITM Limited for 2009 and 2008 were Rs 34 L and Rs

29 L respectively. Its cost of goods sold was Rs 425 L and Rs 410 L.respectively.

Average payment period is calculated as follows :

2008 Average COGS = 410 / 365 = Rs 1.12 L.

Average payment period = 29 / 1.12 = 26 days

2009 Average COGS = 425 / 365 = Rs 1.16 L

Average payment period = 34 / 1.16 = 29 days

Average payment period in number of days has improved from 26 daysto 29 days. This indicates reduction in working capital investment andimprovement in efficiency of assets.

Fixed Assets Turnover


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Measures how well a company is utilizing its fixed assets.

Should be compared over a period of time and also with industry unitsMeasures sales per rupee of investment in fixed assets

Net Sales / Average Net Fixed AssetsMeasures efficiency with which fixed assets are employed

High Degree of efficiency in asset utilization high may be due to old /depreciated assets

Low Inefficiency of utilization. Either sales may have fallen or asset

block new in comparison with other units with older blocks.Not truly reflective of fixed asset utilization as costs in industry unitsdiffer.

Fixed Assets Turnover Example

Relevant financials of ITM Limited are as follows :


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2009 2008 2007Sales 620 580 540

Fixed Assets Gross 150 130 105

Depreciation 70 65 60

Fixed Assets Net 80 65 45

Relevant financials of ITM Limited are as follows :

Net Fixed Asset Utilization :2009 620 / (65+80 ) / 2 = 8.55

2008 580 / (65 + 45) / 2 = 10.55

Although sales increased only by 6 % , fixed assets went up by 31% . This suggests

that company is expanding but favorable result of this expansion is yet to be

reflected in net fixed asset utilization.


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Margins

Financial Ratios Profitability


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Net Incometo Sales

OperatingExpenses to

Sales

Gross Profitto Sales

COGS toSales


COGS x 100Net Sales

% of COGS relative to salesMeasures relative cost of inputs

Lower the ratio,lower the cost

Gross ProfitsNet Sales x 100

% of Gross Profit on sales( Inverse of COGS % of sales )

Referred to as margin

Higher the ratio better it is Each rupee of sales brings in

positive margin

Opex Expenses x 100Sales

% of any or all operatingexpenses relative to sales

Measures relative impactof operating expenses

Lower the ratio, lower theexpenses relative to sales

Net Income x 100Net Sales

% of net income earnedfor every rupee sales

Measures ultimateProfitability

Higher the ratio, moreprofitable is each sale

Ratio

Profitability Ratios I

E f A lR lh h l h i db 24%i


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Extract from Annual Report although sales have increased by 24% inthe year under review, profits have fallen due to increase in cost of production causing margins to erode

Margins indicate earnings company makes on sales its markup on

cost of manufacture. Higher the margin higher is profit on unit sold.Level of margin determine success or failure of a business markup or margin is usually based on what market can bear principle.

Low volume businesses have high margins and vive versa.Margins help to determine cost structure of business high / low cost ,high / low volume. Company operating on low margins a small declinewould result in losses

Margin analysis is an important constituent of inter firm comparison andmanagement efficiency trends.

Profitability Ratios I I

M i l i h l i d i bili f


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Margins analysis helps an investor to determine ability of a company to

pass on to consumer impact of higher cost due to inflation, input costincrease, tax and levies depends on strength of the company anddemand for its products.

Company operating in an intense competition may have to absorb impactof such higher costs.

Product mix has an effect on margins. Proportion of high margin productswould result in overall improvement in margin and consequently on profits.

If margin cannot be increased for some reason, it will be necessary to

significantly increase volume and also ensuring that working capitalremains within norms.

Profitability Ratios I I I

P fit bilit ti i t i t i i h ll


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Profitability ratios assist investors in comparing how well a company

within industry and with reference to its performance in earlier yearsManagements effectiveness basis returns generated on sales andinvestment can be judged

Ratios to be calculated on avg assets / liabilities and not on period end.

Rate of inflation and cost of capital and borrowing is crucial for investor to

explore alternative avenues and ensuring it is inflation proof.Ratio are only indicative and need to be explored further

Profit margin ratio shows relationship between profit and sales GrossProfit Margin ratio, Net Profit Margin Ratio,

Rate of return ratio reflects relationship between profit and investment

ROCE / ROE

Gross Profit Margin / Net Profit Margin Ratios

GPM ti G P fit /N tS l


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GPM ratio = Gross Profit / Net Sales

GMP ratio = (Net Sales COGS) / Net SalesMargin left after manufacturing costs, efficiency of production and pricing

In variance analysis proportion of various elements of costs, material andlabor need to be studied

NPM Ratio = Net Profit / Net Sales

Earnings left for shareholders ( equity and preference )

Measures overall efficiency of production , administration, selling,

financing, pricing and tax managementGPMR / NPMR provide valuable understanding of cost & profit structureto unable an analyst identify sources of business efficiency & inefficiency

Gross Profit Margin Example

F ll i g fig t t d f fi i l t t t f ITMLtd


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Following figures extracted from financial statements of ITM Ltd

2009 2008Sales 500 400

Cost of Sales 350 275

150 125

Gross Margin % 30 31.25

ITMS sales increased by 25% to Rs 500 L and its gross profit increased by Rs 25 L. Both are

positive in difficult times. Gross margin has fallen by 1.25%.This could be due to several

reasons 1 ) Increased competition reduction in margin to boost sales. 2) Company may hav

taken conscious decision to reduce margin to improve sales. 3 ) Deterioration in product

Mix 4) Company was unable to pass on cost increase to customers so had to absorb it.

Operating Margin Ratio

Profitabilit ofcompan beforeta miscellaneo sincomeandinterest


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Profitability of company before tax, miscellaneous income and interest

costs is indicated by operating marginOperating margin is arrived by deducting selling , general andadministrative expenses from gross profit which is expressed as % of

sales.Analyst must examine operating margin ratio as it indicates likely reasonsfor improvement or deterioration in profitability and ascertain causes for it.

Operating Profit Margin Example

Followingfiguresextractedfromfinancial statementsof ITMLtd


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Following figures extracted from financial statements of ITM Ltd

2009 2008Sales 4000 3000

Gross Profit ( sales COGS ) 800 600

Selling, General & Administrative Expenses 500 400

Operating Margin

Operating Margin %

300

7.50%

200

6.33%

Improvement in operating margin by 1.17%. Sales increase is higher than increase in opex.

Sales and GP increased by 33% but expenses went up by 25% . On many occasions,expenses increase disproportionately to increase in sales and gross profits and everyincremental rupee sale results in increase in loss.

Break Even Margin

Everyorganizationhascertainexpenses likeselling administrativeand


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Every organization has certain expenses like selling, administrative and

other miscellaneous expenses that it has to bear even if there is no salesBE margin indicates number of units that a company must sell to meetthese expenses.

If a company has BE at 50 % , of its capacity, it means company would bein a no profit no loss situation if it produced and sold half its capacity. Anyunit sold over this level would yield profit. Any drop below BE level wouldresult in loss.

BE margin ratio arrived at by dividing expenses including financing costs

by gross income per unit. Non recurring/unusual profits excluded.BE important measure as it indicates number of units to reach profitposition. Important management ratio in alternative scenario planning.

Break Even Margin Example

At t t675 it illh t b

N b f it ld1000 2009


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At present cost 675 units will have to besold to bear expenses. At this levelcompany make no profit / loss.

Gross income per unit is Rs 2 ( 2000/1000) So every unit over 675 units wouldearn Rs 2 or incur loss of Rs 2 if soldunder 675.

As a stricter measure, alternative could be

deducting selling prices from grossmargin. Done as sales are connected withsales and no selling price if no sale.

BE margin 1200 400 + 150 = 594 units(2000 400) /1000

Number of units sold 1000 2009

Sales 8000Less : Cost of Sales 6000

Gross Income 2000

Less : Expenses 1200

Operating Income 800

Add : Profit on sale of asset 50

Earning before interest & tax 850

Less : Interest charges 150

Earnings before Tax 700

BE margin = (1200 +150) / 2000 x 1000 =

675 units

Return on Assets

ReturnonAssets=PAT/AverageTotalAssets


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Return on Assets PAT / Average Total Assets

Whether company has earned reasonable return on its sale ? Whether assets have been efficiently and effectively used ? Whether cost of borrowing is reasonable ?

Inconsistent as numerator measures returns to shareholders and denominator representscontribution of all investors

Earning Power = EBIT / Average Total Assets

Measure of business performance not affected by interest and taxAbstracts away effect of capital structure and tax factor and focuses on operatingperformance

Eminently suited for inter firm comparisonConsistent Numerator represents measure of pre tax earning belonging to all sources of finance and denominator total financing.

Return on Assets Example


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Rs Lakhs 2009 2008 2007

Net Income after Tax 600 400 300

Total Assets 11000 7000 5000

Return on total assets is calculated as follows :

2008 400 / ( 0.5 ( 5000+ 7000) = 6.67 %2009 600 / ( 0.5 ( 7000+ 11000) = 6.67 %

Although net income has improved by 50% , the companys profitability

Has not improved since its average assets have also increased by 50%

Return on Capital Employed

Determineswhethercapital employedhasbeenefficientlyused


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Determines whether capital employed has been efficiently used

ROCE = PBIT / Average Total AssetsPBIDT ( 1- Tax rate ) is also called net operating PAT or NOPAT

ROCE is the post tax version of earning power Considers effect of taxation but not capital structure

Internally consistent compares directly with post tax weighted averagecost of capital

Return on Equity

Purposeis todeterminewhetherreturnearnediscomparablewith


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Purpose is to determine whether return earned is comparable withalternatives. Higher the return higher is risk

ROE = Equity Earnings PAT less preference dividend

Average Equity Paid up capital , reserves and surplus

Should not include extraordinary, unusual, non recurring items.

Also called Return on Net Worth

Measures profitability of equity funds invested.Reflects productivity of ownership ( or risk) capital employed

Influenced by earning power, DE ratio, average cost of debt fund, tax rate

Historical valuation of asset imparts upward bias to profitability measuresduring inflationary periods numerator represents current value anddenominator historical value

Return on Equity


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2009 2008 2007

Income Before Tax 1700 1100Extraordinary Items 300

Taxation 500 400

Profit After Tax 1200 1000

Shareholders Equity 12200 11000 10000

Return on total assets is calculated as follows :

2008 ( 1000 300 (1 tax rate ) / ( 0.5 x ( 10000 + 11000) ) =2009 ( 1200 / (0.5 x ( 12200 + 11000 ) ) = 10.34%ROE has improved in 2009 but investor will have to determine whether it is best return

that he could have got or he could have earned more had he invested elsewhere.

Du Pont Analysis

DuPontcompanyofUSpioneeredsystemoffinancialanalysiswhich


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Du Pont company of US pioneered system of financial analysis whichreceived widespread recognition and acceptance

Considers important relationship based on information found in financialstatements at Apex of Du Pont chart is Return of Assets ( ROA) definedas product of net profit margin ( NPM) and total assets turnover ratio (TATR )

Net Profit / Avg Total Assets = Net Profit / Net Sales x Net Sales / Ave T A

ROA NTM TATRDecomposition helps in understanding how return on total assets isinfluenced by net profit margin and total asset turnover ratio

Numerators points areas of profit improvement through various means

Denominator highlights importance asset rotation as a key for improved

performance.

Du Pont Analysis

Du Pont Chart

Net sales +/- operating


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Average Net Current

Assets

Return on

Total assets

NP Margin

Total Assets

Turnover

Net Profit

x

/

/

-

Net Sales

Net Sales

Avg Total

Assets

Net sales +/- operating

Surplus / Deficit-

Total Costs

Avg Fixed Assets

Avg Investments

+

+


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Valuation Ratios

Financial Ratios Valuation

M i D i d T dRatio


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Q Ratio

Yield

PriceEarning

Ratio

Meaning Desired Trend

Market price per share /Earning per share

Contribution of company towealth of societyAbility of company to stayfocused and de-risk fromglobal / domestic fluctuation

Higher than 1 meanscompany contributed tocreation of wealth

( Dividend + price change) / Initial price

Measure of rate of returnearned by shareholders

Fusion of dividend yieldand capital gains / lossyield

Higher dividend yield and lowCG yield maturedcompanies

High CG yield Low dividendyield new generationcompany

Market value of equity &liabilities / Estimated

replacement cost of assets

Improved version of MV /BV as both MV and aset

replacement costs arecloser to realities

Higher than 1 signifies thatcompany has returned higher

overall yield even onreplacement costs

Ratio

Earning Per Share

Earningisayardstickbywhichcompaniesarefinallyjudged.


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Earning is a yardstick by which companies are finally judged.

EPS enables investor to quantify income earned by a share and todetermine whether it is reasonably priced.

EPS = PAT / Weighted average number of shares issued

Diluted earning per share represents EPS after considering effect of proposed issue and also outstanding ESOPs.

Investors value share as a multiple of earning say if EPS IS Rs 5 andyield of 10% considered reasonable share is priced at Rs 50.

ITM limited PAT is Rs 5 Lakhs. as on March 31 st 2009. Number of share200000. Fresh Shared issued 100000 in June 09.

EPS = 500000 / ( 200000 X 0.5) + ( 300000 X 0.5 ) = Rs 2.

Cash Earning Per Share

EPSmaynotbepropermeasureof

RsLakhs RsLakhs


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EPS may not be proper measure of earning as depreciation, tax andinterest varies from company tocompany.

Cash EPS = EBIDTA / Weightednumber of shares issued

Cash EPS is always higher thannormal EPS

Summarized P n L of ITM Limited for the year ended March 31 st 2009

Issued Share 500000 of Rs 10 each

Cash EPS = (1500 + 40+ 20 )500000

= Rs 3.12

Rs Lakhs Rs Lakhs

Sales 5000

Cost of Goods Sold 3000

Gross Income 2000

Selling Cost 300

Admin Cost 200 500

Net Income 1500

Admin expense include interest Rs 40 L

and depreciation of Rs 20 Lakhs

Dividend Per Share

It isarguedthatEPSisofvalueto thosewhodeterminepoliciesof the


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It is argued that EPS is of value to those who determine policies of the

company and so, for common investor it is not a right measureIncome of investor is dividend value of shares should be multiple of dividend paid on that share

Investor return = Capital Appreciation and Dividend receiptIf 35% is overall expectation and capital appreciation is 30% high dividendwould be expected

If a share has a market value of Rs 40, and in past 3 years appreciated by25%. For an investor aiming yield of 30% , a dividend of 5% would beadequate. If company pays dividend of 15% its market value on the basisof dividend / share would be = Rs 1.5 ( Dividend ) / 5 ( return required) x100 = Rs 30. So the share is overpriced by Rs 10. ( 15% dividend on facevalue or 5% on market value )

Dividend Payout ratio

Dividendpayoutratiomeasuresamountofdividendpaidoutofearnings


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Dividend payout ratio measures amount of dividend paid out of earnings

and the balance is ploughed back for long term growth.Dividend payout ratio = Dividend / PAT

Aggressive companies have low payout ratios due to retained earnings for growth. Matured companies have higher payouts.

Dividend is paid out of current earnings and not from capital

ITM Limiteds PAT for March 31 st 2009 is Rs 68 lakhs. Of this it paiddividend of Rs 28 lakhs.

Dividend payout ratio = 28/68 = 41.2%

ITM distributed 41.2 % of its PAT as dividend and retained 58.8% for itsgrowth and expansion

Price Earnings Ratio

Most popular, commonly used financial ratio by investor community


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p p , y y y

Reduces to arithmetical relationship market price and EPS highlightswhether share is overpriced or underpriced and period of recovery

Reflects opinion of investor community whether company is growing or declining. Share rising, declining or remaining stagnant

PE Ratio = Market Price per share / Earning per share

Market Price per share = On any specific day Average or closing priceEPS = ( PAT Preference Dividend) / No of Equity Shares

PE ratio reflects growth prospects , risk characteristics , shareholder orientation, Corporate image and degree of liquidity

Price Earnings Ratio Example

ITM Limited for the year ended March 31st 2009 made profit after tax and


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y ppreference dividend of Rs 400 lakhs. Market value of share on Dec 31 st

2009 was Rs 112. Equity Capital Rs 50 Lakhs 5,00,000 shares of Rs 10each. Pref Capital Rs 10 Lakhs 100000 shares of Rs 10 each. ReservesRs 70 Lakhs.

EPS = 400 / 50 = Rs 8

PE ratio = 112 / 8 = Rs 14

Yield = 100 / 14 = 7.14 %

PE ratio of well established / sound companies is high and vice versa

PE ratio high as investors have faith in the companys ability to grow &earn a return and appreciation in share price. So prices rise duringinflationary period and fall during depression

Price Earnings Ratio

Price an investor pays is based on future prospects of the company and its


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p y p p p yanticipated earnings.

Flaw in PE ratio working is current market price is divided by past earnings/ share. Ideally, market price should be divided by anticipated earnings of

current year.PE ratio reflects reputation of the company and its management andconfidence investors have in earning potential of the company

PE ratio that is considered reasonable by different investors will be the onethat fulfills their particular investment return requirements.

PE is usually higher in developing economies as companies are in growthmode. As economy and companies mature, earnings stabilize and PE ratiofall.

Yield

Measure of rate of return Yield = (Dividend + Price Change)/Initial Price


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( g )

Split into two parts :Yield = ( Dividend / Initial price ) + ( Price Change / Initial Price )

Dividend yield Capital Gains / Loss yield

Low growth prospects high dividend yield and low capital gains yield Superior growth prospects Low dividend yield and high capital gains yield

Market Value to Book Value

Market Value to book value = Market value per share / BV per share


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p p

MV > BV investor confidence If, BV > MV lack of investor confidenceReflects contribution made to the wealth of the society

If ratio exceeds 1, company has contributed to societys wealth

If ratio is 2 , Company has created wealth one rupee for every rupeeinvested. If MV > 3 BV risky investment not backed by tangible assets

Ratio 1, company neither contributed nor detractedQ ratio as proposed by James Tobin

Market Value of equity and Liabilities / Estimated replacement cost of assets Numerator Market value of equity and debt Denominator All assets at replacement value not book value


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