ratio analysis_financial statement analysis

Ratio Analysis

Financial Statement Analysis

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Introduction• Purpose:

• To identify aspects of a business’s performance to aid decision making

• Quantitative process – may need to be supplemented by qualitative factors to get a complete picture

• Broadly it focuses on 6 major areas:

Liquidity Aspect – the ability of the firm to pay its way

Financing Aspect – information on the relationship between the exposure of the business to loans as opposed to share capital

Efficiency Aspect/Asset Utilisation Aspect – the rate at which the company sells its stock and the efficiency with which it uses its assets

Profitability Aspect– how effective the firm is at generating profits given sales and or its capital assets

Investment/shareholders Information Aspect – information to enable decisions to be made on the extent of the risk and the earning potential of a business investment

Stock Market Performance Aspect- information regarding the stock market performance

www. morningstar.com2

Liquidity Aspect

www. morningstar.com 3

Current Ratio

= Current Assets

Current Liabilities

Current Ratio: As compared to industry average, Too

high – Might suggest that too much of company assets are

tied up in unproductive activities i.e., too much inventory,

(for example). Too low indicates a risk of not being able to

meet its liability.

Quick Ratio or Acid Test Ratio is used to examine

whether firm has adequate cash or cash equivalents to

meet current obligations without resorting to liquidating

non cash assets such as inventories or prepaid expenses.

1:1 seen as ideal. should not be less than 1.

Liquidity Ratios Measure of company’s ability to meet short term requirements. Indicates whether current

liabilities are adequately covered by current assets. Measures safety margin available for short term creditors.

Quick Ratio

= Quick Assets

Current Liabilities

Note: Quick assets = Current assets – (inventories

+ prepaid expenses)

Gross Working Capital = Total Current Assets

Net Working Capital = Total Current Assets – Total Current Liabilities

Liquidity Aspect Working Capital Turnover Ratio

Net sales

Average Net Working Capital

Note-1: Average Net Working Capital =

Beginning net working capital + Ending net working capital) / 2

Note-2: If data for two years is not available, then it can be calculated

using one year net working capital data.

www. morningstar.com

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• A high working capital turnover ratio

can potentially give you a competitive

edge in your industry. It indicates you

use up your working capital more times

per year, which suggests that money is

flowing in and out of your small

business smoothly. This gives you more

spending flexibility and can help avoid

financial trouble.

Working Capital Productivity

Net Sales

Total Working Capital

Days Working Capital

= Average Net Working Capital * (365/

Annual Sales Revenue)

Note: If data for two years is not available, then it can be calculated

using one year net working capital data.

• Days working Capital: It indicates

how many days it will take for a

company to convert its working capital

into revenue. The faster a company

does this, the better.

Financing Aspect

Debt to Equity Ratio

Long-term debt + Short-term debt

Share Holder’s Equity

Equity multiplier

= Total assets

Share Holder’s equity

Debt to equity ratio is otherwise called as leverage ratio. High

leverage effect magnifies profits when the returns from the asset

more than offset the costs of borrowing, losses are magnified when

the opposite is true. High leverage effect is considered as high risk

for the firm. It is important to compare with the industry for a

meaningful conclusion. The addition of long term debt with short

term debt also mentioned as total liability.

There is both advantage and disadvantage of debt financing. Advantages might be Tax benefit, discipline the manager. The

dis advantage of debt financing is related to bankruptcy cost, agency cost and loos of future flexibility. The use of financial

leverage can positively - or negatively - impact a company's return on equity as a consequence of the increased level of risk.

Note: Share Holder’s Equity or Equity capital or Total

equity, meaning is same. It includes equity share capital

and retained earnings. Preference share capital is not

considered. Total asset includes all kind of assets.

Note: Share Holder’s Equity or Equity capital or Total

equity, meaning is same. It includes equity share capital

and retained earnings. Preference share capital is not

considered.

The equity multiplier is a way of examining how a company uses

debt to finance its assets. Also known as the financial leverage or

financial leverage multiplier. It is used in Due Pont Analysis. Also

called the assets-to-equity ratio. Analysts use the ratio to measure

how efficiently a company uses debt to finance its assets. A higher

equity multiplier indicates higher financial leverage, which means

the company is relying more on debt to finance its assets. A high

multiplier, in comparison to the results for the same industry,

implies that a it may have incurred more debt than is the norm.

• Some Other Ratios Related to Financing Aspects are:

• Debt to assets ratio = Total liabilities (i.e., Long Term Debt + Short term Debt)/ Total assets

• Cash coverage ratio = (EBIT + Depreciation)/Interest

• Gearing Ratio = (Loan Capital + Preference capital) / Total Capital

• Equity ratio = (Share Holder Equity Capital / Total Assets)www. morningstar.com

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Financing Aspect

Interest Coverage ratio or Times interest earned

Earnings before interest and taxes ( i.e., EBIT)

Interest Expenses

The interest coverage ratio is used to determine

how easily a company can pay interest expenses on

outstanding debt. The interest coverage ratio (ICR)

is a measure of a company's ability to meet its

interest payments. Also known as times interest

earned, is a measure of how well a company can

meet its interest-payment obligations. Higher is

beteer.

Asset Utilisation Aspect

Total Asset Turnover =

Net Sales

Total Assets

Fixed Asset Turnover =

Net Sales

Fixed Assets

Current Asset Turnover =

Net Sales

Current Assets

Three Asset

Turnover

Ratios

Asset turnover is a catch-all efficiency ratio

that highlights how effective management is

at using its assets. All else equal, the higher

the total asset turnover, the better.

Total Asset turnover ratio considers short-

term (Current asset) , long-term assets

(Fixed Assets) and Intangible assets as well.

Fixed Assets turnover ratio considers only

the long term Fixed Assets minus the

accumulated depreciation.

Current Assets turnover ratio considers

only the short term Current Assets of the

company.

If the data is available, then average value

of these total asset, fixed asset and current

assets can be considered for calculation. If

data is not available one year data can be

taken for calculation.www. morningstar.com

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Efficiency Aspect

www. morningstar.com8Efficiency ratios measure how effectively the company utilizes these

assets, as well as how well it manages its liabilities.

The Inventory turnover illustrates how well a company manages its

inventory levels. If inventory turnover is too low, it suggests that a

company may be overstocking or overbuilding its inventory or that it

may be having issues selling products to customers. All else equal,

higher inventory turnover is better. How many times inventory is

created and sold during the period.

The accounts receivable turnover ratio measures how effective the

company's credit policies are. If accounts receivable turnover is too

low, it may indicate the company is being too generous granting

credit or is having difficulty collecting from its customers. All else

equal, higher receivable turnover is better. How many times accounts

receivable are created and collected during the period.

The Accounts payable turnover is important because it measures

how a company manages paying its own bills. Measures the number

of times a company pays its suppliers during a specific accounting

period. A falling ratio is a sign that the company is taking longer to

pay off its suppliers. A rising turnover ratio means that the company is

paying off suppliers at a faster rate.

Account Receivable turnover =

Net Sales

Average Account Receivables

Inventory turnover =

Cost of Goods Sold

Average Inventory

Note: If sufficient data is available you can take the

average value of two years in the denominator. If data is

not available, please take the values for the one year.




Account Payable turnover =

Total purchases

Average accounts payable




Efficiency Aspect


Cash Conversion Cycle (CCC) =

Days Inventory Outstanding (DIO)

+ Days Sales Outstanding (DSO)

- Days Payable Outstanding (DPO)

The cash conversion cycle (CCC, or Operating Cycle) is the length of

time between a firm's purchase of inventory and the receipt of cash

from accounts receivable. Measured in terms of number of “ Days” or

the length of time a company takes to turn purchases into cash

receipts from customers. In other words it is the time required for a

business convert resource inputs into cash flows.

CASH CONVERSION CYCLE

Inventory

Average Days Cost of

Goods Sold (COGS)

Note: Average days of COGS

= Total COGS/365

𝐴account Receivables

Average days of revenue

Note: Average days revenue

= Net Sales/ 365DIO DSO

DPO

Accounts payable

Average 𝑑𝑎𝑦𝑠Purchase

Note: Average days purchase

= Total Purchase/365


Efficiency Aspect

Net operating cycleor

Cash conversion cycle=Number of days

of inventory+Number of days

of receivables−Number of days

of payables

= Inventory + 𝐴ccount Receivables - Accounts payable

Average Days Average days of revenue Average 𝑑𝑎𝑦𝑠 Purchase

Cost of Goods Sold

How many days does it take a company to pay for and generate cash from the sales of its inventory?

“This is what the Cash Conversion Cycle or Net Operating Cycle tells us. The entire CCC is often referred to as the Net

Operating Cycle. It is “net” because it subtracts the number of days of Payables the company has outstanding from the

Operating Cycle. It gives us an indication as to how long it takes a company to collect cash from sales of inventory. Often a

company will finance its inventory instead of paying for it with cash up front. This means they owe someone money which

generates “Accounts Payable”. Many times they will turn around and sell that inventory on credit without getting all the cash

at the time of the sale. This means people owe them money and generates “Accounts Receivable”. The first two components

of the CCC, DSO namely DIO are what is called the Operating Cycle. This is how many days it takes for a company to

process raw material and/or inventory and collect cash from the sale.” Source: Timothy P. Connolly, A Look at the Cash Conversion Cycle, CFA Institute.

Days of Payables Outstanding tells

you how many days the company

takes to pay its suppliers.

Days of Receivable tells you how

many days after the sale it takes

people to pay you on average.

It tells you how many

days inventory sits on

the shelf on average.

Continue….. An Example


Assume that, Company A and B operates in the

same industry. The cash conversion cycle (CCC)

calculation indicates that, Company A is a market

leader as compared to Company B. This is because

Company A with a negative CCC suggest that

company receives from its customers well in

advance as compared to the Company B.

If we see the Operating Cycle figure (DIO + DSO)

it suggest that, Company A is efficient enough to

convert its inventory in to sales and to collect

account receivables from its customers. Company

B is close to the efficiency level of Company A for

receivable collection, but fails to match in terms of

inventory to sale conversion.

Product demand for Company A is also good in

the market. This is because on an average product

stays in the inventory only for 5 days, while it

takes 114 days for a sale of inventory in case of

Company B.

Year 2014 Company A Company B

Revenue or Sales 164687 1,26,405

Purchases (all credit) 64,000 72,000

Cost of Goods Sold (COGS) 95,668 15,738

2014 Account receivable 12786 11673

2014 Accounts Payable 87632 8342

2014 Inventory 1346 4937

Average Dyas COST OF Goods Sold

(COGS/365) 262.10 43.12

Average Days Revenue (Revenue/365) 451.20 346.32

Average days Purchases (Purchases/365) 175.34 197.26

Number of Days of Inventory (DIO) 5.14 114.50

Nummber of Days of Receivables (DSO) 28.34 33.71

Number of Days of Pyable (DPO) 499.78 42.29

Operaing cycle (DIO + DSO) 33.47 148.21

Cash Conversion Cycle (DIO+DSO-DPO) -466.30 105.92


Continue….. HUL Analysis

Data from HUL Annual Report 2015 2014Revenue or Sales 30805.62 28019.13

Purchases (Assuming all credit): Cost of

materials consumed + Purchases of stock-in-trade15565.27 14,510.00

Cost of Goods Sold (COGS): Cost of materials consumed + Purchases of stock-in-

trade + Changes in inventories of finished goods +

Total Other expenses

24018.49 22107.92

Account receivable 782.94 816.43

Accounts Payable 5,288.90 5,623.84

Inventory 2602.68 2747.53

Average Dyas Cost of Goods Sold (COGS/365) 65.80 60.57

Average Days Revenue (Revenue/365) 84.40 76.76

Average days Purchases (Purchases/365) 42.64 39.75

Number of Days of Inventory (DIO) 39.55 45.36

Nummber of Days of Receivables (DSO) 9.28 10.64

Number of Days of Pyable (DPO) 124.02 141.47

Operaing cycle (DIO + DSO) 48.83 56.00

Cash Conversion Cycle (DIO+DSO-DPO) -75.19 -85.47

• Analysis of HUL’s Cash Conversion Cycle

suggest that, it collects from customers way

ahead of its payment to supplier. The negative

figure is due to the higher payment period (124

days & 141 days) to its suppliers.

• HUL takes around 48 days in 2015 and 56 days

in 2014 to convert its inventory to sales and to

collect from the account receivable.

• HUL takes around 9 to 10 days to collect from

its account receivable.

• It takes around 40 to 45 days to convert its

inventory to sales.

• Comparable figures as compared to industry can

suggest hoe HUL is doing as compared to the

industry.

Profitability Aspect

Net Profit Margin

Net Profit after Taxes

Net Sales

• Net Sales is the sales revenue minus the

excise tax and sales return if any.

• Net income equals total revenues minus

total expenses and is the Net income (or

PAT) from income statement.

• For calculating the Net profit after tax

the income from other sources like

interest income, dividend income

considered, because this ratio deals with

final profit figure if the company.

• If the company is a loss making

company the numerator will take the

Loss or the negative value.

The Net Profit margin ratio directly

measures what percentage of sales is made up

of net income. In other words, it measures

how much profits are produced at a certain

level of sales. This ratio also measures how

well a company manages its expenses relative

to its net sales. That is why companies strive

to achieve higher ratios. They can do this by

either generating more revenues why keeping

expenses constant or keep revenues constant

and lower expenses.


Profitability Aspect

Gross Profit Margin

Gross Profit

Net Sales

• Gross Profit = Net Sales – Cost of Goods Sold (COGS)

• The cost of goods sold, also known as COGS, includes the expense required to

manufacture a product or provide a service.

• Net Sales is the sales revenue minus the excise tax and sales return if any.

• Any income under the category of other income (for e.g., interest income,

dividend income) will not be considered.

Gross Profit margin ratio is a profitability ratio

that measures how profitable a company can sell

its inventory. It only makes sense that higher

ratios are more favourable. Higher ratios mean

the company is selling their inventory at a higher

profit percentage.


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Return on assets (ROA)

= Net Profit/Total assets

Return on equity (ROE)

= Net Profit/Total equity

Investment/shareholders Information Aspect

Since income is derived from assets in use through the year, including new

plant or machinery, the value used in the calculation is an average. Return

on assets, or ROA, tests management's ability to earn a fair return on assets.

It is also can be calculated by multiplying net profit margin and asset

turnover ratio. The assets required to produce revenues will vary by industry.

Therefore, benchmarks and comparisons should only be made between

companies that produce similar products or provide essentially the same

services. How efficiently a company uses its assets to produce profits.

Return on equity (ROE) or return on capital is the ratio of net income of a

business during a year to its stockholders' equity during that year. It is a

measure of profitability of stockholders' investments. It shows net income

as percentage of shareholder equity. A measure of how well a company uses

shareholders' funds to generate a profit.

Cash Return on Capital Invested

= EBITDA / Capital Invested

Cash return on capital invested (CROCI) is calculated by dividing the

earnings before interest, taxes, depreciation and amortization by the total

capital invested. The capital invested is defined as the equity capital and

preferred shares. Long term loans are also included in the capital employed.


• Net Operating Profit after Taxes (NOPAT) = Operating Profit x (1 - Tax Rate)

• NOPAT = Net Income + Interest Expense (1-Tax Rate) - Non-Operating Income (1-Tax Rate)

• Invested Capital (IC) = Fixed Assets + Non-Cash Working Capital

• Non-Cash Working Capital = Current Assets - Current Liabilities - Cash

Investment/shareholders Information Aspect The return on invested capital (ROIC) is the percentage

return that a company makes over its invested capital. It is

similar to ROA, but takes into account sources of financing, so

the denominator is different. Invested capital is in the

denominator of the ROIC equation. This is calculated as the

company's fixed assets plus current assets minus current

liabilities and cash. The objective is to find out how much

capital the company has in assets that are producing net

operating profits after taxes. The important fact to remember

about ROIC is the measure filters out a lot of the noise that

limits some of the other return calculations. The focus of this

measure is the profits produced by the income-generating

assets of the company.

Return on Invested Capital

= Net Operating Profit After Tax

Invested Capital

Du Pont Analysis

• Shows which variables account for profitability

• ROE = Net income/Total Equity

• ROE= (Net income/Sales) (Sales/Total Assets) (Total Assets/Total Equity)

• ROE = (Profit margin) (Total asset turnover) (Equity multiplier)

Total

Equity

Du Pont Analysis name comes from the DuPont

Corporation of US that started using this formula in the

1920s. The DuPont analysis is a way of decomposing and

examining the financial ratio return on equity (ROE).

Was it because management was efficient? Because they

had high financial leverage? What drove a high ROE

number?

Stock Market Performance Aspect


Earnings Per Share

= Net Profit

No. of outstanding shares

Price Earning Ratio (PE Ratio)

= Market Price Per Share

Earnings per share

Price Earnings Growth Ratio (PEG ratio)

= PE Ratio

Annual EPS Growth Rate

Market to Book Ratio (M/B Ratio)

= Market price per share

Book Value Per share

Dividend Yield

= Dividend Per share

Market Price Per shareDividend Rate = Dividend Paid/ Net Profit

Retention Rate = 1-Dividend Rate

Book Value of Assets = Total Asset – Intangible assets

– Long term Loan – Short term Loan

The M/B ratio denotes how much equity investors are paying

for each dollar in net assets.

Few Insights

Ratios High Low

PE Ratio • Commanding a higher price today for the

higher future earnings

• Determine if the expected growth warrants

the premium.

• Compare it to its industry peers to see its

relative valuation to determine whether the

premium is the worth the cost of the

investment. High P/E ratio is expensive

Can be an indication that market is yet to

factor the growth potential and hence can

be picked up for investment.

(Under Valued)

PEG Ratio A lower PEG means the stock is more

undervalued.

Price to

Sales Ratio

How much market values every dollar of the company's sales.

Turnover is valuable only if, at some point, it can be translated into earnings

Sales dollars cannot always be treated the same way for every company.

Market to

Book Ratio

If the ratio is above 1 then the stock is

undervalued

If it is less than 1, the stock is overvalued.

Enterprise Value (EV)/EBITDA

• Also known as the EBITDA Multiple OR the firm multiple.

Enterprise Value = Market Capitalization +Debt +Preferred

Share Capital + Minority Interest - Cash and cash equivalents

The EV/EBITDA ratio is better as it values the worth

of the entire company.

It estimates the number of years in which the business will repay

its acquisition cost to the buyer through its earnings.

The ratio proves a great tool for valuing companies that are making

losses at the net earning level, but are profitable at the EBITDA level.

Economic value added (EVA) is an internal management performance measure

that compares net operating profit to weighted average cost of capital (WACC).

EVA = Net Operating Profit After Tax - (Capital Invested x WACC)

Economic value added asserts that businesses should create returns at a rate above their cost of capital

What is the WACC?•WACC = (D/D+E) rd (1-Tc) + (E/D+E) reL

• D/D+E and E/D+E are capital structure weights evaluated at market value, based on the firm’s target capital structure

• Tc is the firm’s marginal tax bracket, but the effective tax rate is often used as estimate

• rd is the cost of debt based on the risk of the debt (which depends on the debt ratio)

• reL is the required rate of return on equity (I.e. the cost of equity)

• the cost of equity depends on the business risk of the assets

• and on the debt ratioCost of Equity Capital = Risk-Free Rate + (Beta times Market Risk Premium).

Thank you


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