Financial Statement Analysis

Using Ratios

Use of ratios

• The purpose of using financial ratios is to make sense of the complex information usually presented in a set of published accounts

• As time has passed the complexity of accounts has increased greatly

• Not only is there a balance sheet and profit and loss account but now a cash flow statement is included and increasingly a Statement of Recognised Gains and Losses

Purpose of Ratios

• There are four main reason for the use of ratios

1. To act as a set of summary statistics

2. To identify industry benchmarks

3. As an input for making formal decisions

4. Standardise for size

Uses of Financial Ratios

• The two most common uses of ratios are

1. Analysis of the performance of a company over time

2. Comparing performance of a company against those of similar companies

• This has obvious implications for the analysis of individual securities

Common Size Financial Accounts

• One way of trying to compare performance over time and amongst peers is to use a common size financial accounts

• In this everything would be expressed as a percentage of a fixed amount such as turnover for P&L

• In the balance sheet it would be for total funds as an example

Liquidity Ratios

• These assess the ability of a business to meet its obligations in the short run

• They generally relate current assets to current liabilities

Current Ratio

Current AssetsCurrent Liabilities

• Current assets and liabilities?• Measures ability of business to meet its

current liabilities• Generally the higher the ratio the better• Depends on the nature of the assets

Acid Test Ratio

• Quick assets are current assets less stock

Quick Assets

Current Liabilities

• Stringent measure of liquidity

• Stock is excluded because these are seen as the least liquid of the current assets

Cash Ratio

Cash and bank balances plus current investments

Current Liabilities

• These assets are the most liquid of the current assets• Stringent measure of liquidity • May be too stringent as there are other options available

such as delaying payments• Another option would be to borrow short notice money

such as extending the overdraft or to extend suppliers terms

Leverage Ratios

• Debt capital is a cheaper source of finance than equity

• It is also riskier than equity or other capital finance instruments

• Leverage ratios indicate the level of risk associated with debt finance

• There are two types of ratio– Structural– Coverage

Debt to Equity Ratio

Debt

Equity

• Shows relative contribution of owners and creditors• Debt is long and short term debt• Equity is net worth plus preference capital less deferred

taxes• Problems are fixed asset at book rather than MV• Some debt are protected by charges against assets • A lower D/E ratio is preferable

Debt to Asset Ratio

Debt

Assets

• Debt here is all debt

• Assets are all assets

• Measures the extent that borrowed funds support the businesses assets

Interest Coverage Ratio

Profit before interest and taxesInterest

• Taxes are excluded from profit as interest is a tax deductible expense

• In this case the higher the ratio the more easily the business can pay its interest

• A high ratio means that interest can be met even if there is a sharp decline in turnover

Fixed Charge Coverage Ratio

Profit before interest, taxes and depreciation

Interest+Loan Repayment

1-Tax Rate• This shows the amount of cash flow to cover all interest

and taxes• This shows the comprehensive debt servicing ability as it

covers both interest repayment and the capital repayment

• The measure can be expanded to include other fixed payments such as lease payments and preference dividends

Debt Service Coverage Ratio

Profit after tax+Depreciation+Other non cash charges+Interest on term loans+Lease Rentals

Interest on term loans+lease rentals + Repayment of term loans

Debt Service Coverage Ratio

• I personally have never seen this ratio and Chandra suggests that it is used by Indian financial institutions

• It calculates the ratio for the period for which the loan is applicable

• A ratio of 1.5 to 2 is regarded as being satisfactory

Turnover Ratios

• These can also be called as activity ratios or asset management ratios

• These ratios relate the level of activity, as given by sales or COGS, to the level of various assets.

• They are measures of how efficiently the assets are employed by the firm

Inventory Turnover Ratio

COGSAverage inventory

• Shows how quickly stock is moving through the firm thus generating sales

• It is a measure of inventory management• Issues are

• Too low inventory leading to stock outs• Too high stock giving inefficient use of working

capital

Debtor Turnover Ratio

Net Credit Sales

Average Sundry Debtors

• The higher the debtors turnover the greater the efficiency of the credit management system

• If NCS not available then sales could be used

Average Collection Period Ratio

Average Sundry Debtors

Average Daily Credit Sales

• Represents the number of days of credit sales included in sundry debtors

• The measure will depend on the nature of the trade but a figure approaching 30 would be sought

Fixed Asset Turnover Ratio

Net Sales

Average Net Fixed Assets

• Measures the sales in terms of the investment in fixed assets.

• Measures the efficiency of use of fixed assets

• Beware the use of NBV of assets

Total Asset Turnover Ratio

Net Sales

Average Total Sales

• Ratio measures how efficiently the assets are employed

Profitability Ratios

• These reflect the final results of the business

• There are two types of ratio

• Profit margin ratios showing the relationship of sales and profits

• Rate of return ratios showing the relationship between profit and investment

Gross Profit Margin Ratio

Gross Profit

Net Sales

• This is the difference between sales and COGS

• This shows the difference between sales and costs

• This may be broken down into the various elements of direct costs such as labour

Net Profit Margin Ratio

Net Profit

Net Sales

• This shows the amount of earnings left for ordinary and preference shareholders

• It measures the overall performance of control of the indirect costs in the P&L

Gross and Net Profit Rate

• These two measures taken together give an overall view of the cost and profit structures of the companies

• Their joint use can identify where any problems lie in either direct or indirect costs

• Again, this information is of use to many parties

Return on Assets Ratio

Profit after tax

Average total assets

• The numerator measures the available return to shareholders

• The denominator measures the contribution of all contributors including lenders

• Remember ARR in Project Appraisal

Earning Power Ratio

Profit before interest and taxes

Average total assets

• Focuses on only earnings before other external claims, i.e. interest and tax.

• Measures efficiency without consideration of capital structure or current tax rate.

• Good peer group comparison measure

Return on Capital Employed Ratio

Profit before interest and tax(1-tax rate)

Average total assets

• This is Earning Power after tax

• Does not reflect the capital structure of the business

• Can be compared directly with post tax WACC

Return on Equity Ratio

Equity EarningsAverage Equity

• Numerator is profit after tax less preference dividends therefore is the amount available to ordinary shareholders

• The denominator is ALL contributions by equity shareholders including paid up capital, reserves and surpluses

• The measure is of great interest to the stock markets as it gives the return on the investment

Valuation Ratios

• These ratios measure how the equity of a company is viewed in the markets

• Equity MV measures how markets perceive the risk and return on a stock

• These can be seen as the most comprehensive of the ratios

Price to Earnings Ratio (PER)

Market price per share

Earnings per share

• The most popular measure of financial efficiency

• Reflects• Risk characteristics• Growth prospects• Shareholder orientation of management

EV to EBITDA Ratio

Enterprise value (EV)

Earnings before interest, taxes, depreciation and amortisation

• EV is the sum of market value of debt and of equity• MV equity is outstanding shares times MV of shares• Debt was discussed in detail in Project Appraisal• Chandra suggests this reflects profitability, growth, risk,

liquidity and corporate image

Market Value to Book Value Ratio

Market Value per share

Book Value per share

• This shows how much wealth has been generated for the society at large

• If ratio >1 then a net contribution to the wealth of the country has been achieved

Q Ratio

Market value of equity and liabilities

Estimated replacement cost of assets

• Resembles MV to BV ratio

• Different in that– Numerator includes equity– Denominator includes all assets– These assets are at their replacement costs

Disaggregating of Ratios

• DuPont analysis is an example of disaggregating of ratios where the Return on Assets (ROA) is broken down into its component parts

• Many more ratios than the Return on Assets (ROA) can be broken down to give further information

DuPont in short

• A shortened version of DPA is

Net Profit = Net Profit * Net Sales

Av Total Assets Net Sales Av Total Assets

ROA NPM TATR

• When supplemented by comparing common size statements then this shows where cost control measures can be directed

Du Pont Analysis

A variation on DuPont

This disaggregates ROE or Net Income / Total Equity

Net Income = Net Income * Assets

Total Equity Assets Total Equity

(ROA) * (Equity Multiplier)

(1+D/E Ratio)

Aggregation of Ratios

• Similarly some of the ratios can be aggregated to give further reaching measures

• As mentioned my particular favourite was comparing debtors and creditors ratios to indicate potential liquidity measures

Audience for Ratios - Internal

• Performance evaluation of managers

• Comparison of performance for different divisions

• Planning for the future

Audience for Ratios - External

• Assessment of creditworthiness by suppliers

• Assessment of future prospects by customers

• Credit rating agencies

• Evaluating competitors

• Acquiring other firms

Problems with ratios

• Selection of ratios• Based on accounting data inc. estimation• Data unavailable – time lag & division• Unsynchronised data• Different accounting standards• Negative numbers and small divisors

• CHANDRA pp 194 gives a different list of problems

The need to compare

• As stressed throughout this presentation these ratios are in themselves pretty meaningless

• They need to be compared – Across time with previous results of the

company to measure changes in performance– With other businesses in the same risk class – With other businesses in the structuring of a

portfolio

That’s all folks

• Read Chandra pp 152 ff

• If further reading is required I have both RW&J and BM&M in both Indian and Western publications

• In addition I have Bill Rees “Financial Analysis” which is one of the seminal works on the subject.