Ratio Analysis

Objective of a Business

• Create value for its shareholders while maintaining a sound financial position.

• Return on investment.• Sound financial position.• Other important objectives include:– Employee satisfaction.– Social responsibility.– Ethical considerations.

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Annual Reports

Functions performed by a public company’s annual report:

1. Regulatory– provision of financial statements– declarations of accounting policies– provision of directors’ and auditor’s reports

2. Public relations based - enables public to view and understand the primary operations of the company.

3. Decision making - information contained in annual reports helps make performance, investment and credit-related decisions.

Profit and Loss Statement

Shows how profitable a firm has been over the past year. Includes:

– revenues - sales, interest and dividends received– expenses– operating profit– abnormal items– income tax– extraordinary items

Balance Sheet

Provides a summary of the assets, liabilities and shareholders’ equity of the company on a nominated balance date. Includes:

– assets - current and non-current– liabilities - current and non-current– shareholders’ equity - share capital, reserves,

retained profits

Statement of Cash Flows

Represents a sources and uses of funds statement. Includes:

– cash flows from operating activities– cash flows from investing activities– cash flows from financing activities

Need for Financial Statement Analysis

Comparison????

Financial Statement Analysis Tools

• Trend %• Common Size • Ratio Analysis

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Trend Percentages...

– are computed by selecting a base year whose amounts are set equal to 100%.

• The amounts of each following year are expressed as a percentage of the base amount.

Trend % = Any year Rs. ÷ Base year Rs.

Trend Percentages

Year 2012 2011 2010Revenues Rs.27,611 Rs.24,215 Rs.21,718Cost of sales 15,318 14,709 13,049Gross profit Rs.12,293 Rs. 9,506 Rs. 8,6692010 is the base year.

What are the trend percentages?

Trend Percentages

Year 2012 2011 2010Revenues 127% 111% 100%Cost of sales 117% 113% 100%Gross profit 142% 110% 100%

These percentages were calculated bydividing each item by the base year.

Common Size

– compares each item in a financial statement to a base number set to 100%.

• Every item on the financial statement is then reported as a percentage of that base.

Common Size

2012 %Revenues Rs.38,303 100.0Cost of sales 19,688 51.4Gross profit Rs.18,615 48.6Total operating expenses 13,209 34.5Operating income Rs. 5,406 14.1Other income 2,187 5.7Income before taxes Rs. 7,593 19.8Income taxes 2,827 7.4Net income Rs. 4,766 12.4

Common Size

Assets 2012 %Current assets:Cash Rs. 1,816 4.7Receivables net 10,438 26.9Inventories 6,151 15.9Prepaid expenses 3,526 9.1Total current assets Rs.21,931 56.6Plant and equipment, net 6,847 17.7Other assets 9,997 25.7Total assets Rs.38,775 100.0

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RatiosFinancial analysis using ratios is useful to investors because the ratios capture critical dimensions of the economic performance of the company.

Managers use ratios to guide, measure, and reward workers.

Often companies base employee bonuses on a specific financial ratio or a combination of some other performance measure and a financial ratio..

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Ratios- a double edged weaponRatios mean different things to different groups.

A creditor might think that a high current ratio is good because it means that the company has the cash to pay the debt.However, a manager might think that a high current ratio is undesirable because it could mean that the company is carrying too much inventory or is allowing its receivables to get too high.

Cont… GAAP does not define ratios. Multiple equally valid approaches to ratios and

analysis. Managers (e.g., division manager, sales manager)

should be measured to items that they control. Investors and top management are most interested

in overall performance or broadest measures of performance. Understanding less broad measures of performance may

give additional insight into overall performance.

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Structure of analysis

• From broadest to more specific levels. Principal value of financial analysis:

Suggests questions not answers. Ratio comparisons start with the supposition that all

other things are equal. (They rarely are.)

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Evaluating Financial RatiosFinancial ratios are evaluated using three types of comparisons.

Benchmarks - general rules of thumb specifying appropriate levels for financial ratios Time-series comparisons - comparisons of a company’s financial ratios with its own historical ratios

Cross-sectional comparisons - comparisons of a company’s financial ratios with the ratios of other companies or with industry averages

Evaluating Financial Ratios- Benchmarks

Experience. A feel for what is right or reasonable. Budget. A target developed within the company.

Factors to be considered: How carefully was budget constructed? What circumstances are different now?

Historical standards. Prior period’s results adjusted for changes in accounting methods.

• External benchmarks. Competitor, industry average

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Ratio Standards of Comparison-Cross-Sectional standards

Cross-Sectional standardsCompare a firm’s financial ratios to other firms or industry average

Industry averages are published by companies such as

Moody’sStandard & Poor’sFitchsDeshawCopal PartnersAnd Lot of Indian Firms Like Motilal Oswal, India Bulls

etc.Can reveal a firm’s strengths/weaknesses compared to other firms

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Ratio Standards of Comparison- Time-series comparisons

Time-Series standardsCompare a firm to its own ratios from other years

Helps highlight trends/changes that have occurred

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Category of Financial RatiosLeverage ratios

Measure extent to which firm has been financed by creditors

liquidity ratioMeasure firm’s ability to meet short-term obligations

Profitability ratiosMeasures productivity of money invested in firm

Turnover ratiosMeasure rate of activity

Per share dataExamines items that affect common stock’s market price per share

Growth ratiosMeasures contribution of various items to firm’s development

Risk analysis ratiosMeasures variability

Making comparisons

Finding the appropriate standard is difficult. A high ratio (e.g., current ratio, ROI) may be

good or bad. It can’t be viewed in isolation. Is a high CR good or bad? Is a high ROI always good?

Values of ratios compared across time trend analysis.

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Leverage Ratios

equity+debt term-long

debt term-long=ratioDebt

equity

debt term-long=ratioequity -Debt

Show how heavily the company is in debt.

Leverage Ratios

tioncapitalisa total

debt term-long=ratiotion capitalisa totalDebt to

assets total

equity rs'shareholde total=ratioEquity

expenseinterest

EBIT=coverInterest

Liquidity Ratios

Current ratio =current assets

current liabilities

Measure how easily the firm can obtain cash to pay its debts as they fall due.

Liquidity Ratios

sliabilitiecurrent

sreceivable+securities term-short+cash=ratioQuick

Activity Ratios

assets totalaverage

Sales=overasset turn Total

capital gnet workin average

Sales=Turnover Capital ngNet Worki

Measure how different asset groups contribute to overall profitability.

Activity Ratios

ITR

365=inventoryin sales Days

Inventory Average

Salesor Sold Goods ofCost =TurnoverInventory

Receivable Average

Salesor SalesCredit =Turnover Receivable

DTR

365 turnover Receivable Days

Profitability Ratios

sales

PAT=marginprofit Net

sales totalaverage

PBIT=sales on totalReturn

Used to judge how efficiently the firm is using its assets.

Profitability Ratios

equity rs'shareholde total

PAT=Equityon Return

Debt Reserves Capital P.Sh. Capital E.Sh.

PBIT=Investmenton Return

Sh. Equity= E S Capital + reserves

Net worth is E.S. Capital + P.S. Capital + Reserves and Surplus

The others in this category may be ROA and ROCE

Market Value Ratios

EPS

shareper uemarket val=Ratio PE

Show how the firm is valued by investors.

issueon sharesordinary #

after taxProfit EPS

earnings

dividends=ratioPayout

Price/Earnings (PE) ratio

Measure of overall performance. Market price is not controlled by company;

reflects all information available to the market. Reflects how investors judge the future

performance or prospects of the company. Commonly compared to other companies in the

same industry.

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Market Value Ratios

shareper uemarket val

shareper dividend=yield Dividend

shareper uemarket val

EPS=yield Earnings

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DuPont Identity• The DuPont Identity is essentially just an

expanded version of ROE. It is used to compare two companies’ profitability, efficiency, and leverage.

Net Income X Sales X Assets Sales Assets Equity– By breaking down ROE into these three things, it

allows you to determine exactly why one company has a better ROE than another.

– While this isn’t “Security Valuation” it can prove to be a very important metric.

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Net profit Margin

ROE

Return on Assets (Profitability) Financial

leverage

Asset turnover

Liquidity

Solvency

Net income Sales/

Sales Total cost—

Cost of goods soldSG&AR&D

Interest expense

Income taxes

Sales Total assets/

Current assets

Noncurrentassets+

Land

Building

Equipment

Intangibles

Others

Cash

Acc. Receivables

Inventory

Other

Growth measures• Key accounting items for which growth is

computed: sales, net income, earnings per share.

Average growth = (growth per year for n years)/n

Compound growth rate = based on present value concepts. May be misleading due to abnormally high or

low beginning or ending year.

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Implied growth rate

=Return on shareholders’ equity X Profit retention rate

= ROE X (1 – Dividend payout)• Estimates potential to grow profits without an

injection of new capital.

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Analysis of Growth

Common stock price appreciation depends on various factors

Growth financed internally depends on the amount of retained earnings

A corporation’s growth rate depends on the return on equity

• Growth rate = RR x ROE Substituting the three-part DuPont ROE

equation, we obtain

Sales

incomeNet

Equity

assets Total

assets Total

Sales RR rateGrowth

Shows that multiple factors influence

growth—one factor can rise and another fall and growth can remain unchanged.

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Credit Risk Analysis

• Procedure to determine the likelihood a customer will pay its bills. Consider the customer’s previous credit history, bank or trade references, financial statements, and any other information supplied by the customer or collected.

• Credit agencies provide reports on the credit worthiness of a potential customer.

• Financial ratio analysis can be used to help determine a customer’s ability to pay its bills.

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Credit Risk Analysis

A technique used to develop a measurement of solvency, sometimes called a Z Score. Edward Altman developed a Z Score formula that was able to identify bankrupt firms approximately 95% of the time.

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Credit Risk Analysis

assets total

capital working1.2+

assets total

earnings retained1.4+

debtbook total

equity of uemarket val0.6+

assets total

sales1.0+

assets total

EBIT3.3=Z

formula Score Altman Z

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Credit Risk Analysis

Example - If the Altman Z Score cut off for a credit worthy business is 2.7 or higher, would we accept the following client?

9.0debtbook

equitymarket

4.1assets total

sales

2.1assets total

EBIT

12.0assets total

capital working

4.0assets total

earnings retained

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Credit Risk Analysis

Example - If the Altman Z Score cut off for a credit worthy business is 2.7 or higher, would we accept the following client?

A score above 2.7 indicates good credit.

04.3)12.0 x 2.1()4.0 x 4.1(

)9.0 x 6.0()4.1 x 0.1()12.0 x 3.3(

Score ZsFirm'

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Credit Risk Analysis

• Credit analysis is only worth while if the expected savings exceed the cost.– Don’t undertake a full credit analysis unless the

order is big enough to justify it.– Undertake a full credit analysis for the doubtful

orders only.

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Economic Value Added The idea behind economic value added (EVA) is

that a company must earn more than it must pay for capital if it is to increase in value. Capital is considered both debt and equity. The cost of capital in EVA is a weighted average of

interest cost and the returns required by equity investors.

If a company has positive EVA, the company is adding value; if a company has negative EVA, the company is losing value and might be better off liquidating.

EVA

• EVA can also be defined as the difference between the net operating profit before interest, but after tax (NOPAT) and a capital charge based on the WACC multiplied by the IC:

• EVA = NOPAT – (WACC x IC)

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EVA

• EVA is calculated as follows:• EVA = (ROIC – WACC) x IC• where• ROIC = Return on invested capital• WACC = Weighted Average Cost of Capital• IC = Invested Capital (at the beginning of the

year)

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MVA

• The link between MVA, the cumulative measure, and EVA, which is an incremental measure, is that MVA is equal to the present value of all future EVA to be generated by the company.

• MVA = present value of all future EVA

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Example• Company Z has invested capital amounting to R100

million at the beginning of the year. This is financed by 60% equity and 40% debt. The debt has an interest rate of 12% before tax. The tax rate is 30% and the WACC 15%. The net income for the year before interest and tax is R30 million.

• ROIC is R30 million / R100 million x (1 – tax rate of 30%) = 21%.

• EVA = (ROIC – WACC) x IC• = (21% - 15%) x R100 million• = 6% x R100 million• = R6 million

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Cont…• Applying the second formula given for EVA, the result is

the same:• EVA = EBIAT – (WACC x IC)• = R21 million – (15% x R100 million)• = R6 million• where• EBIAT = Earnings before interest, after adjusted tax• If the future EVAs are expected to remain indefinitely at

R6 million per year, the MVA can be calculated as follows:

• MVA = EVA / WACC• = R6 million / 15%• = R40 million

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Potential Problems with Financial AnalysisInflation distortions

Can be a serious problem with the balance sheetSome fixed assets are reported at their historical costs

After several years of high inflation historical costs can be irrelevant

Vague definition of accounting incomeA firm can modify its accounting income depending upon certain actions

Such as which depreciation method or inventory valuation technique is used

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Potential Problems with Financial Analysis

Consolidated financial statementsWhen a firm owns a subsidiary corporation accounting issues arise when considering minority interests

GoodwillWhen a company merges, oftentimes ‘goodwill’ is then reflected on the consolidated balance sheet

This intangible asset cannot be measured with precision

Financial Statement Analysis-Sector Specific

Banks & FIs

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Banking Regulation act, 1949

Schedule Liability01 Capital02 Reserves and surplus03 Deposits04 Borrowings05 Other liabilities and

provisions12 Contingent liabilities

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Banking Regulation act, 1949

Schedule Assets06 Cash and balances with

RBI07 Balances with banks

and money at call and short notice

08 Investments09 Advances10 Fixed Assets11 Other assets

Banking Regulation act, 1949

Schedule Income and expense13 Interest earned14 Other incomes15 Interest expensed16 Operating expense

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Balance sheet

Minimum capital 100 Cr. (old banks are exempted)Statutory Reserves- not less then 20% of profits before dividendCapital reserve- Surplus due to revaluationShare premiumOthers

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Deposits Demand Deposits Savings Deposits Term Deposits

6363

Cont… Borrowings-Include RBI And other banks borrowings Other liabilities- B/P, Inter office adjustment,

interest accrued etc.

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Assets Cash and balances with RBI (CRR) Balances kept with other banks Investment include

• Loans made in interbank call money market• Investment in approved securities (SLR)• Government securities

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Advances Classification based on Type/nature of assets Secured/unsecured Sectorial disbursement

Analysis of Banks Performance

• CAMELSCapital AdequacyAssets QualityManagement EffectivenessEarningsLiquidity (ALM)Systems control

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Capital Adequacy of Banks

Need for Capital: Financial Intermediaries need capital for two reasons:

•To run operations of their business. •To safeguard against the losses, that may arise.

Adequate capital helps banks to survive even during substantial losses. It gives time to re-establish the business and avoid any break in operations. To ensure the good performance of banks the regulatory authority (RBI) has specified the minimum capital for the Financial Intermediaries. This requirement is called Capital Adequacy, and it is specified for Banks and Non Banking Financial Corporations (NBFCs).

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Ratios Capital Adequacy

Minimum capital requirement = (CRAR)

Total Capital/RWA

Where RWA is risk weighted assets

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Cont…

2. Core CRARTier I capital/ RWA

3. Adjusted CRARTotal Capital- Net NPAs/ RWA

Higher the ratio better it is

Cont…

• Computation of capital adequacy ratio (CAR) of banks:

• For computation of CAR, we need to calculate: • Tier I capital • Tier II capital • Risk Weighted Assets (RWA)

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Cont…

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Step 1: Compute Tier I capital: Tier I capital is the most permanent and readily available support against unexpected losses. It consists of- 1. Paid up equity capital 2. Statutory reserves 3. Capital reserves 4. Other disclosed free reservesLess: 1. Equity investments in subsidiaries 2. Intangible assets 3. Current and Accumulated Losses, if any

Cont…• Step 2: Compute Risk Weighted Assets

Step 2: Calculation of Risk Weighted Assets (RWA)

• RWA are calculated by multiplying the relevant weights to the value of assets and off-balance sheet items.

• The weights assigned to each of the items are as follows:

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Cont…

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Domestic Operations

Cont…

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Domestic Operations

Cont…

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Domestic Operations

Cont…

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Domestic Operations

Cont…• Step 3: Compute tier II capital

These are not permanent in nature or, are not readily available.

• Tier II capital consists of-1. Undisclosed reserves and cumulative perpetual preference shares- Cumulative preference shares should be fully paid and should not contain clauses which permit redemption from shareholders. 2. Revaluation Reserves (RR)- 45% of RR is only taken in calculation of tier II capital 3. General Provisions and Loss Reserves (GPLR)- Actual GPLR or 1.25% of Risk Weighted Assets, whichever is lower, is taken.

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Cont…

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4. Hybrid Debt Capital Instruments- These combine characteristics of both equity and debt. As they are more or less similar to equity, they are included in the Tier II capital 5. Subordinated Debts- These must be fully paid up, unsecured, subordinated to the claims of other creditors, also there should be no such clause which permits redemption. The amount of subordinate debts to be taken as Tier II capital depends upon the maturity of debt. Subordianate Debt Instruments will be limited to 50% of Tier I capital.

Cont…

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Note: Tier II capital cannot be more than Tier I capital. Capital Adequacy Ratio: Capital Adequacy Ratio = (Tier I capital + Tier II capital) / RWA According to the present norm, the Capital Adequacy Ratio of bank as defined earlier should be at least 10%.

Asset Quality Gross NPA/Gross advances Net NPA/ Net advances

• Where Net NPA=gross NPA- Provisions• Net advances= Net bank credit- Provisions

Gross NPA/ Total Assets Net NPA/ Total Assets Net NPA/ Total Equity Provision for loan losses/ Gross Advances Provisions for loan losses/ NPAs Provisions for loans and investment/Total Asset

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Profitability• Interest Expense= Interest exp/ Total income• Non interest exp= Non-Interest Exp./Total

income• ROA• ROE• EPS• P/E• NP Margin

Cont…

• Interest earned on Investment• Interest earned on deposits• Assets utilization= Total income/Total asset

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Liquidity

• Total loans/ Total assets• Net loans/ Total asset• Net loans= Total loan-Provisions• Net NPA=gross NPA- Provisions• Net advances= Net bank credit- Provisions

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Cont… Non priority sector credit/ total credit (loans) Unsecured credit/ total credit Investments/ total asset Investment in money market instruments/

total assets SLR securities/ total investments Cash and bank including call money/ Demand deposits Cash and bank including call money/ Total deposits Cash and bank including call money/ Total Asset

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