financial ratios and comparables analysis
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8/4/2019 Financial Ratios and Comparables Analysis
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Financial Ratios/ComparablesAnalysis
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Evaluating Financial Ratios (or Comparables) is acrucial method for evaluating the financial andcompetitive health of a company relative to itscompetitive peers. This document provides anoverview to Financial Analysis, as well as deep diveinto 20 widely used Financial Ratios.
Profitability/
EfficiencyRatios
LiquidityRatios
Solvency
Ratios
InvestmentRatios
1
2
3
4
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Financial analysis Introduction
INPUTS TO FINANCIAL ANALYSIS
The Balance Sheet
The Profit and Loss (P&L)Account
The Cash Flow statement
DIMENSIONS OF FINANCIAL ANALYSIS
Breaks down cost structure into constituents
(see cost structure analytic)
Cost Structure Analysis
Assess evolution of:
Revenues, profits, and costs
Capital base (debt, equity)
Asset base (tangible, intangible)
Cashflow
Assesses/measures specific financial features of
a firm
Ratio/Trends Analysis
Financial analysis consists of analyzing the financial performance of a company, over time and relative to its peers: In particular to understand whether and how companies create value
Used to assess where a companys problems might lie
Can be done internally for own company, or externally for competitors
Ratios are especially useful in comparisons with competitors
Building on three different kind of financial statements, financial analysis allows either trends, ratios or cost structureanalyses
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Financial analysis introduction (cont.)
All of the statements are linked together and relate back to the ongoing activities of the firm.
Transactions in yearCash received and paid
credit given and received
Trading
Revenues Recorded in Year
Expenditure Recorded in Year
Other
Capital Paid In
BorrowingAssets Purchased
ONGOING STREAM OF EVENTS
PROFIT AND LOSS ACCOUNT
Revenues relevant to year =
Expenditure relevant to year = --
OpeningBALANCE SHEET
AssetsFixed Assets
Working capitalFinancing
Owners interestsOutside liabilities
ClosingBALANCE SHEET
AssetsFixed Assets
Working capitalFinancing
Owners interestsOutside liabilities
CASHFLOW STATEMENTOperating activities
Investing activitiesServicing of financing
TaxationFinancing
PROFIT AND LOSS
P&LMatches costs to
associated revenues in a
given year to give arepresentative picture of
profitability. Hence, assets
are Depreciated over time
and charged to P&Lgradually as the asset is
used up over its useful
life to enable the revenues
to be created.
CASHFLOW
Shows the real cash flows associated withincome and expenses in a given year, to show
the actual change in cash position. Costs andrevenues are not matched.
BALANCE SHEET
Summarizes the value ofwhat a company owns less
what it owes, and balancesthem with the sources of
financing (debt andshareholders funds).
Stated at a specified point
in time (not for a period)
Income
Expenses
Profit (loss)
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Financial analysis introduction (cont.)
Definition of Common Financial Terms
Accounts Payable Money owed to suppliers
Accounts Receivable(or Trade Credit)
Money owed by customers
Assets Things owned
Book Value The value at which an item is reported in financial statements (cf. market value)
Capital The amount invested in a venture
Capitalization Sum of all long-term sources of financing to the firm (equals total assets less current
liabilities)
Cash flow The amount of cash generated or consumed by an activity over a certain period of time
Common Shares(or Common Stock)
Securities representing an ownership in a firm
Cost of Goods Sold Cost of sales
Total of all costs required to acquire and prepare goods for sale
Cost ofDebt Yield to maturity on debt (i.e. internal rate of return to maturity)frequently after tax, in
which event it is 1 minus the tax rate times the yield to maturity
Debt (Liability) An obligation to pay cash or to provide other goods or services to another party
Depreciation Reduction in the value of a long-lived asset from use or obsolescence. The decline is
recognized in accounting by a periodic allocation of the original cost of the asset tocurrent operations
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Financial ratio analysis Introduction
Ratios are measures of a firms specific financial features
Financial ratios typically fall into four categories:
What It Is
Financial ratios help us diagnose the financial health of afirm:
Profitability/efficiency ratios measure how well a firm usesits assets to generate profits
Liquidity ratios measure a firms ability to meet short-termliabilities
Solvency ratios are an indicator of a firms financial strength(assess the mix of funds in the balance sheet and measurefirms ability to withstand operating setbacks)
Investment ratios are indicative of the markets perceptionsof a company. They are used mainly by investors to valuea company.
Why We Use It
Strengths:
Can be used to identify potential areas of improvement
Limitations:
Accounting principles can differ making comparisonsdifficult
Need to be wary of management managing year-endfigures
Book values for fixed assets may be out of date
Strengths & Limitations
Key strategic ratios Other ratiosa
Inventory turnover Days inventory
Total asset turnover Days receivable Fixed asset
utilisation
Return on sales: Profit margin
Gross margin Return on net assets Return on equity
Quick ratio
Working capital
Current ratio
Interest cover Debt equity ratio
Dividend yield Earning yield
Dividend cover Dividend per share
Price-earning ratio Earning per share
Profitability/
EfficiencyRatios
LiquidityRatios
SolvencyRatios
InvestmentRatios
1
2
3
4
1 To be used selectively, according to the industry and/or the level of detail required.
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Profitability/Efficiency Ratios
Financial ratio analysis how to do it
Key Strategic Ratios (1/5)
Ratio
Profit Margin
(also known asoperating margin)
Formula
= PBIT
Sales
Where:
PBIT: profit before interestand tax
= Sales cost of goodssold operatingexpenses
= Trading profit
What It Does
Measures bottom line company
profitability Indicates the effectiveness ofsales and production inproducing profit
Constitutes a good ratio forcomparing the performances ofcompetitors in the same industry
Drivers
Sales:
Price Volume
Operating expenses
Gross Margin = Gross profitSales
Where:
Gross profit
= Sales cost of goodssold
Measures percentage ofrevenue remaining after the costof goods sold is covered
Constitutes a weak ratiolooksat variable1 costs only
Price Cost of producing
goods
Return on sales (ROS): Are goods sold at an appropriate price and produced efficiently?
Two ratios reflect ROS:
1 Costs that are altered by a change in output.
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Profitability/Efficiency Ratios (cont.)
Financial ratio analysis how to do it
Key Strategic Ratios (2/5)
Ratio
RONA is also knownas:
Return on Asset(ROA)
Return on CapitalEmployed (ROCE)
Formula
= (Profit Before Interest + Tax)a
Fixed Assets + (CurrentAssets Current Liabilities)b
(Profit Margin x Asset Turnover)
a. Can be defined as profit after tax, but beforededuction of interest.
b. Current assets current liabilities = workingcapital.It represents the amount of day-to-dayoperating liquidity available to business.
What It Does
Measures profitability
Measures how wellassets have beenemployed, irrespectiveof how the company is
financed
Drivers
Profit margin:
Price
Cost
Asset turnover:
SalesCapital employed
Return on Equity (ROE): What is shareholders profit?
Ratio
ROE
Formula
= Profit After TaxOrdinary Fundsa
a. Issued capital + capital reserves + revenuesreserves
Profit after tax used because it is the returnfrom which dividend is subtracted.
What It Does
Measures the return onordinary shareholdersfunds:
Assesses theefficiency with whichthe firm employsowners capita
Measures return forshareholder
Drivers
Profit margin: Price
Cost
Asset turnover:
Sales
Capital employed
Financing:
Debt to equity ratio
Cost of debt
Tax-effectiveness
Return on Net Assets (RONA): How profitable is this company?
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Profitability/Efficiency Ratios (cont.)
Financial ratio analysis how to do it
Key Strategic Ratios (3/5)
Ratio
Current Ratio
Formula
Current AssetsCurrent Liabilities
i.e.: (cash and near-cash assets available tobusiness) over(upcoming cashrequirements)
What It Tells
Indicates a companys short-term financial position:
Compares the assets that willturn into cash within the yearto the liabilities that must bepaid within the year
A company with a low currentratio lacks liquidity in thesense that it cannot reduce itscurrent asset investment tosupply cash to meet maturingobligations:
It must rely instead onoperating income andoutside financing
The most informative feature ofa current ratio is its normal leveland any trend from year to year
Drivers
Nature of the industry:
Some have to carrylarge stocks and,have long productioncycles
Others carry almostno stock and receivemore credit than theygive
Type of current asset:
Some are more liquid
(i.e. easier to sellreadily)
Volatility of workingcapital requirements
Debtor and creditormanagement:
Bargaining power ofcompany
Current Ratio: Will the company have sufficient cash in the immediate future to meet its short-term liabilities?
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Financial analysis illustrative output
Cashflow, $MM, 1983-1994
-100
-
0
- 0
-
0
-2 0
0
20
0
0
0
1
1
1
1
1
1
1
1
0 1
1 1
2 1
1
Tax
Dividends
Interest
Capex (Net)
Changes in working capital
Other / Ex traordinary i tems
Depreciation
PBIT
Net Cashflow
Cumulative Cashflow
Trends inratios can
similarly beplotted
Source: Dawson International
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Financial ratio analysis illustrative output
A Dupont Tree (also known as RONA model) is a useful way to structure and present output.
Margin
Costs
AssetBase
$
Levers ShareholderValue
RONA/Dupont Model
Raw Materials &
Consumables
Maintenance
External Costs
Other Operating
Costs
Carriage
Intra-Group
Materials
Loose Plant, Spares& Tools
Raw Materials
Work in Progress
Finished Goods
Trade Debtors
Trade Creditors
UK External Sales
EU and EFTA Sales
Rest of World
Sales
Intras-Group Sales
Sales
Gross Sales
Cost of Sales
Total Employment
Stock Revaluation
Depreciation and
Grant Costs
Exceptional Items
Other Intra-Group
Costs
Stocks
Short Term
Investments
Debtors
Creditors (
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