lec4 analy. of financial statement_ new

8/13/2019 Lec4 Analy. of Financial Statement_ New

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Financial Analysis


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Financial Statements


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Balance Sheet

A balance sheet mirrors the financial

position of a firm on a particular date in

terms of the structure of assets, liabilitiesand ownersequity, and so on.


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The profit and loss account or the income

statement shows the results of operations

during a certain period of time in terms ofthe revenues obtained and the cost incurred

during the year.


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REVENUE

- Cost of Goods Sold

GROSS PROFIT- Operating Expenses

NET OPERATING INCOME (NOI ) or

EARNINGS BEFORE INTEREST &TAXES (EBIT)

- Interest Expense

- Income TaxesNET INCOME

- Dividends on Preferred Stock

- Dividends on Common Stock

RETAINED EARNINGS

Income Statement


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We will want to answer

questions about the firms

Are the profits adequate?

Are the assets being usedefficiently?

Is the firm solvent?

Can the firm meet its current

obligations?


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Financial Statement Analysis

The analysis of financial statements

is a process of evaluating the

relationships between componentparts of financial statements to

obtain a better understanding of the

firms position and performance.


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Financial Ratios

Tools that help us determine the

financial health of a company.

We can compare a companys

financial ratios with its ratios in

previous years (trend analysis).

We can compare a companysfinancial ratios with those of its

industry.


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Liquidity Ratios : Liquidity ratio measures

the ability of the firm to meet its current

obligations (liabilities).

Turnover or Activity Ratios : shows the

efficiency with which the firms managesand utilises its assets.

Funds of creditors and owners are invested in various

assets to generate sales and profits. The better the

management of assets, the larger the amount of sales.These ratios are also called turnover ratios because

they indicate the speed with which assets are being

converted or turned over into sales.


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Leverage Ratios : debt-paying ability.

Profitability Ratios : Profit is difference

between revenues and expenses over a

period of time.


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Liquidity Ratio

Liquidity ratio measures the ability of the

firm to meet its current obligations

(liabilities).

Current ratio

Quick ratio

Cash ratio Interval measures


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Current ratio Current ratio= current assets/current

liabilities Current assets include cash and those assets

that can be converted into cash within a

year, such as marketable securities, debtorsand inventories.

All obligations maturing within a year are

included in current liabilities. Likecreditors, bills payable, short term bank

loan, income tax liability and long term debt

maturing in the current year.


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Quick ratio

Quick ratio, also called acid test ratio,

establishes a relationship between quick, or

liquid assets and current liabilities. An

assets is liquid if it can be converted into

into cash immediately or reasonably soonwithout a loss of value. Cash is the most

liquid assets.

Quick ratio= current assets-inventories/current liabilities


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Cash ratio Since cash is the most liquid assets, a

financial analyst may examine cash ratioand its equivalent to current liabilities.

Cash ratio= cash+ marketable securities/current liabilities

Marketable securities are also equivalent tocash ; therefore, they may be included in thecomputation of cash ratio.


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Interval Measure Interval measure assesses a firms ability to

meet its regular cash expenses. Intervalmeasure relates liquid assets to average

daily operating cash outflows.

The daily operating expenses will be equalto cost of goods sold plus selling,

administrative and general expenses less

depreciation divided by no. of days in a

year.

Interval measure= current assests-inventory/

average daily operatingexpenses


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Leverage Ratios

The short-term creditors, like bankers and

suppliers of raw material, are more concerned withthe firms current debt-paying ability. On the otherhand, long-term creditors, like debenture holders,financial institutions etc. are more concerned with

the firms long term financial strength. In fact, a firm should have a strong short as well as

long-term financial position. To judge the long-term financial position of the firm, financial

leverage, or capital structure ratios are calculated.These ratios indicate mix of funds provided byowners and lenders. As a general rule, thereshould be an appropriate mix of debt and owners

equity in financing the firms assets.


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Debt ratio

Several debt ratios may be used to analyse the

long-term solvency of a firm. The firm may beinterested in knowing the proportion of theinterest-bearing debt in the capital structure.Therefore, it may compute debt ratio

Debt ratio=total debt/ capital employed or net assets.Total debt will include short and long term

borrowings from financial institutions,debentures/bonds, deffered payment arrangements

for buying capital equipments, bank borrowings,public deposits and any other interest-bearingloan. Capital employed will include total debt and

Net worth.


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Debt- Equity Ratio

Debt equity ratio is directly computed by

dividing total debt by net worth.

D/E ratio = TD/NW


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Coverage Ratios

Debt ratios described are static in nature,

and fail to indicate the firms ability to meet

interest (and other fixed charges)

obligations. The interest coverage ratio or

the times-interest-earned is used to test thefirms debt-servicing capacity. The interest

coverage ratio is computed by dividing

earnings before interest and taxes (EBIT) byinterst charges.

Interest coverage= EBIT or EBITDA / interest


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Activity Ratio

Activity ratios are employed to evaluate the

efficiency with which the firms manages andutilises its assets.

Funds of creditors and owners are invested in

various assets to generate sales and profits. The

better the management of assets, the larger theamount of sales.

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 show a relationship between sales

and assets.


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Inventory ratio Inventory ratio indicates the efficiency of the firm

in producing and selling its product.

Inventory ratio=cost of good sold/ averageinventory

The manufacturing firms inventory consists of two

more components:Raw material and work in process. We examine the

efficiency with which the firm converts rawmaterials into work in process into finished goods.

So it is necessary to know the levels of rawmaterials inventory and work in process inventory.

The raw material should be related to materialsconsumed, and work in process to the cost of

production.


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Account Receivable Turnover or

Debtor turnover

Debtors turnover=credit sales/ average

debtors

Total assets turnover= sales/ total assets

Working capital turnover:

Net current assets turnover= sales/net current

assets.


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Profitability Ratios

Profit is difference between revenues and expenses

over a period of time.

Gross margin profit=salescost of goods sold /sales.

Net profit margin= profit after tax / sales.

Operating expense ratio = operating expenses / sales.

Earning per share= profit after tax / no. of shareoutstanding


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Example:

Cyber-DragonCorporation


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Sales (all credit) 112,760

Cost of Goods Sold 85,300Gross Profit 27,460

Operating Expenses:

Selling 6,540

General & Administrative 9,400Total Operating Expenses 15,940

Earnings before interest and taxes (EBIT) 11,520

Interest charges:

Interest on loan: 850

Interest on bonds: 2,310Total Interest charges 3,160

Earnings before taxes (EBT) 8,360

Taxes 3,344

Net Income 5,016

Cyber-Dragons

Income Statement


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Cyber-DragonOther Information

Dividends paid on common stock 2,800

Earnings retained in the firm 2,216Shares outstanding (000) 1,300

Market price per share 20

Book value per share

Earnings per share

Dividends per share


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Cyber-DragonOther Information

Dividends paid on common stock 2,800

Earnings retained in the firm 2,216Shares outstanding (000) 1,300

Market price per share 20

Book value per share 26.44

Earnings per share 3.86

Dividends per share 2.15


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1. Liquidity Ratios

Do we have enough liquid assetsto meet approaching obligations?


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Liquidity

Measures the ability of the firm to meet its short-termliabilities as they come due

Net Working capital:

Current assets - Current liabilities

company A company B

Current assets Rs. 1,80,000 30,000

Current Liabilities 1,20,000 10,000

NWC 60,000 20,000


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Current ratio:A higher current ratio indicates greaterliquidity (2 : 1 considered satisfactory)

Current assets / Current liabilities

Company A Company B

Current assets Rs. 1,80,000 30,000

Current Liabilities 1,20,000 10,000

CR 1.5 : 1 3 : 1


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What is Cyber-Dragons Current

Ratio?

50,190

25,523= 1.97


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What is CyberDragons Current

Ratio?

50,190

25,523= 1.97

If the average current ratio for the

industry is 2.4, is this good or not?

Higher the current ratio, thegreater the ability of the firm to

pay its bills.


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Acid-Test (Quick) ratio:

Quick Assets / Current Liabilities

Quick assets = Current assetsinventories

Quick ratio determines firms ability to payoff current liabilities without relying on thesale of inventories.


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What is the firms Acid Test Ratio?


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50,190 - 27,530

25,523= .89


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50,190 - 27,530

25,523= .89

Suppose the industry average is .92.

What does this tell us?

It shows a firms ability to meet

current liabilities with its most

Liquid assets.


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Activity ratios/ Turnover ratios

Measure how effectively the firms assets are

being managed

The efficiency with which the assets are used

would be reflected in the speed and rapidity

with which the assets are converted into cash.


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These ratios measures how rapidly debts arecollected.

sreceivableAverage/ Debtorsturnover

s/Receivable = Credit Sales

turnoversReceivable

(i.e.365)periodinDaysperiodcollectionDebt =


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These ratios provide information on the extent to

which trade creditors are willing to wait for

payment.

CreditorsAverageturnoverPayables = Credit Purchases

turnoverPayables

(i.e.365)periodinDaysperiodPaymentCreditors =


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What is the firms Accounts

Receivable Turnover?

112,760

18,320= 6.16 times

CyberDragon turns their A/R over 6.16

times per year. The industry average

is 8.2times. Is this efficient?


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What is the firms Average Collection

Period?

18,320

112,760 / 365= 59.3 days


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What is the firms Average Collection

Period?

18,320

112,760 / 365= 59.3 days

If the industry average is 47 days, what

does this tell us?


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What is the firms Inventory

Turnover?

85,300

27,530= 3.10 times


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What is the firms Inventory

Turnover?

85,300

27,530= 3.10 times

CyberDragon turns their inventory over 3.1

times per year. The industry average

is 3.9times. Is this efficient?


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Low inventory turnover:

The firm may have too much inventory,

which is expensive because:

Inventory takes up costly warehouse

space.

Some items may become spoiled or

obsolete.


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Capital Turnover = Sales/ Capital Employed

Capital includes (Owners equity + R&S + Long-term

liabilities)

Fixed Assets Turnover = Sales/ Fixed Assets

Measures the efficiency of a firm in managing and utilizing

its assets. Higher is the ratio more efficient is the utilization,whereas a low ratio indicates underutilization of available

resources and presence of idle capacity.

assetstotalAverage

salesoverasset turnTotal =

Wh i h fi Fi d A


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What is the firms Fixed Asset

Turnover?

112,760

31,700= 3.56 times

Wh t i th fi Fi d A t


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What is the firms Fixed Asset

Turnover?

85,300

31,700= 2.69 times

If the industry average is 3.7times, what

does this tell us about CyberDragon?


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What is their Total Asset Turnover?

112,760

81,890= 1.38 times


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Leverage Ratios


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Leverage Ratios

(financing decisions)

Measure the impact of using debt

capital to finance assets.

Firms use debt to lever (increase)

returns on common equity.


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Debt / equity ratio:Total Liabilities / Total Owners Equity

Long-term Debt/ Total Owners Equity

Indicates the margin of safety to the

creditors

Depends on type of industry.


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Financial Leverage

Measure the extent to which a firm relies on debtfinancing .

Debt ratio:

Debt / Total Assets OR

Total liabilities / Total liabilities and owners equity

Interest/ Debt Coverage ratio:

Earnings before interest and taxes / Interest expense

Interest coverage ratio is directly connected to the

firms ability to pay interest.

What is Cyber-Dragons Debt


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y g

Ratio?



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y g

Ratio?

47,523

81,890= 58%


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If the industry average is 47%, what

does this tell us?

47,523

81,890= 58%


Ratio?


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What is the firms Times Interest


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What is the firm s Times Interest

Earned Ratio?

11,520

3,160= 3.65 times

What is the firms Times Interest


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What is the firm s Times Interest

Earned Ratio?

11,520

3,160= 3.65 times

The industry average is 6.7times. This

is further evidence that the firm uses moredebt financing than average.


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Profitability

Return on assets:Net income / average investment (total assets)

Return on equity:Net income / average owners equity

(PATPref. Dividend)/ Net Worth


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Gross Profit ratio: Gross Profit/ Sales *100

High ratio means cost of production is less. It indicates

good management as it indicates higher sales pricewithout a increase in cost of goods sold.

Price/earning ratio:Market price of common stock / earning per share

P/E ratio shows how much investors are willing to pay

for Rs. 1 of Earnings PerShare.

It also reflects investors views of the growth potentialof different sectors.


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Conclusion:

Even though Cyber-Dragon has

higher leverage than the industryaverage, they are much less

efficient, and therefore, less

profitable.


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Example

From the following details, prepare the balance sheet of ABC

Ltd:

Capital turnover ratio 2

Fixed assets turnover ratio 4Gross profit 20%

Debt collection period 2 months

Creditors payment period 73 days

Stock Turnover 6The gross profit was Rs 60,000. closing stock was Rs.5,000 in

excess of the opening stock.


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Gross Profit Ratio = Gross Profit/ Sales *100

20 = 60000/Sales *100

Sales = 3,00,000

Cost of goods Sold = SalesGross profit = 2,40,000

Stock Turnover = Cost of goods Sold/ Average Stock

6 = 2,40,000/Average Stock

Average Stock = 40,000

(Closing Stock + Opening Stock)/2 = 40,000

Given, Closing StockOpening Stock = 5,000

Solving, Opening Stock = 37,500

Closing Stock = 42,500


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Capital Turnover ratio = Cost of goods sold/ Capital

2 = 2,40,000/ Capital

Capital = 1,20,000

Fixed Assets Turnover = Cost of goods Sold/ Fixed Assets4 = 2,40,000/Fixed Assets

Fixed Assets = 60,000

Debtors Turnover = 12/Debt collection Period = 6Debtors Turnover = Credit Sales/ Average Debtors

Debtors = 3,00,000/ 6 = 50,000

Creditors Turnover = 365/ Creditors Payment Period = 5


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