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Unit - 1

Analysis of Financial Statements

Sitaram Dhakal

Contents

Analysis of Financial Statements


Financial Planning and Control
Risk and Rates of Return
Short Term Financing Decisions
Long-term financing decisions
Dividend policies
Bond and stock valuation

Rules and Regulations


Participants are not allowed to enter the class after the
entrance of Faculty.
Participants should read and make at least 10 key notes
of the prior readings before each class. Faculty can take
any 10 sample participants to verify.
Participants without text book and calculator are not
allowed in the class.
Participants should bring Text book with latest edition i.e.
9th edition.
Participants should have to collect assignment questions
given in the session plan from the text book of library.

Evaluation Scheme
Class Participation

20%

Presentations

20%

Quizzes

10%

Assignments

20%

Behaviour and
discipline in the class
Class test

20%
10%

35% of
total mark
is carried
out as
faculty
marks.

Balance sheet
Everest Limited
Balance Sheet
As on 31st December, 2013
Assets

Cash and marketable


securities
Account receivables
Inventories
Total current assets

Amount

(Rs. in thousands)

Liabilities and Equity

Accounts Payables
Rs. 500 Notes payables
700 Accruals
1,000
2,200 Total Current Liabilities
Long term debts
Preference Share Capital

Net Fixed Assets

Rs. 3,800 Shareholders equity

Total Assets

Rs. 6,000 Total liabilities and


equity

Amount

Rs. 400
300
1,000
1,700
1,300
500
2,500
Rs. 6,000

Balance Sheet
The statement of firms financial position at
a specific point in the time.
Balances the firms assets against its
financing sources - debt and equity.

Statement of assets, liabilities and a


capital fund in a given period of time.

Liabilities
Represents the amount to be paid to
outsiders.
Classified into two parts current liabilities
and long term debts.
Current liabilities are due for payments
within one year.
Long term liabilities or debts have
maturities over one year.

Owners equity
Represents the capital fund of the corporate.
Includes paid up capital, paid in capital and
retained earnings.
Also called shareholders equity, stockholders
equity, net worth, common equity or simply
total equity.
Equity holders are owners and they have
voting right.

Preference share

A hybrid security.
Priority claim rather than shareholders
equity in case of liquidation.
Carries fixed dividend to the shareholders.

Relation of Assets, Liabilities and Equity

Market Value Vs Book value


Book values shown on the balance sheet for the firms
assets.
Book Values are not the values what the assets are
actually worth.
Fixed assets are depreciated to calculate the book
values.
The values what the assets are actually worth are
called market values.
Assets dont matter how long ago they were purchased
or how much they are worth today.
Market value represents the price of the stock traded in
the capital market.

Income Statement
ABC CORPORATION
2010 Income Statement
Particular
Net sales
Cost of goods sold
Depreciation
Earnings before interest and taxes
Interest paid

Taxable income
Taxes

(Rs. in millions)
Amount
Rs.1,509
(750)
(65)
694
(70)

Rs.624
212

Net income

Dividends
Addition to retained earnings

Rs.412
Rs.103
309

Income Statement

A statement of revenue and expenses


from the firms principal operations.
Shows the relationship between the
sales, cost and profit to make a major
financial decision to a manager.

Some Basic Equations

Revenues Expenses = Income


Where,
Q = Sales or production quantity
S = Selling Price per unit
V = Variable cost per unit
FC = Fixed Costs
I = Interest amount on debt
T = Tax rate

Net Cash Flow, NCF


Financial Managers focus on net cash flow.
The value of a firm is determined by the cash flow it
generates.
A businesss net cash flow generally differs from its
accounting profit because some of the revenues and
expenses listed on the income statement were not paid in
cash during the year.
NCF = Net income + Depreciation + amortization

Free Cash Flow, FCF


The cash flow actually available for distribution to all
investors (stockholders and debt holders) after the
company has made all the investments in fixed
assets, new products, and working capital
necessary to sustain ongoing operations.

FCF = NOPAT Net investment in


operating capital

Net Cash Flow, NCF and Free Cash Flow, FCF

Operating Cash Flow, OCF - Equal to


NOPAT plus any noncash adjustments,
calculated on an after-tax basis.
OCF = EBIT(1-t) + Depreciation
Net Operating Profit after tax, NOPATEqual to EBIT tax paid to the government.
NOPAT = EBIT(1-t)

GAAP
Generally Accepted Accounting principles.
Shows the assets at historical cost.
Shows the net income of the firm no matter
whether cash comes in or does nor come
in.
Based on realization principles.
Income is recognized at the time of sale,
but does not matter the time of collection.

Case - 1
Butwal Hydro power company had sales of
Rs.50000, cost of goods sold of 60% of sales,
administrative and selling expenses of Rs.5000,
depreciation of Rs.10000, and interest
expenses of Rs.1000. The firm has net
investment in operating capital is Rs. 1300. If the
corporate tax rate is 40%:

What is the net income for the firm?


What is Net Operating Profit after tax?
What is the operating cash flow of the firm?
What is its net cash flow?
What is free cash flow?

Case - 2
ABC company recently paid dividend of Rs. 960
from the net income of 2013. Dividend payout
ratio is 40% and the cost of goods sold of 60%
of sales, administrative and selling expenses of
Rs.5000, depreciation of Rs.10000, and interest
expenses of Rs.1000. If the corporate tax rate is
40%, you are required to determined the annual
sales of 2013.

Thank You

Ratio Analysis :
A tool to quantify the relationship between
two or more sets of financial data taken from
income statement and balance sheet.
Provides information relating to strengths
and weaknesses of the firm.

An important tool to extract additional


meaning from the figures of financial
statements of a firm.

Following ratios are evaluated and analyzed:


1.Liquidity Ratios
2.Assets Management of Efficiency Ratios
3.Debt Management or Leverage Ratios
4.Profitability Ratios
5.Market Value Ratios

Liquidity Ratios
Measure the firms ability to satisfy its
short-term commitments out of current
or liquid assets.
Focus on current assets and liabilities
and are used to ascertain the short-term
solvency position of a firm.
The two primary tests of liquidity are
current ratio and quick ratio.

a. Current Ratio
The quantitative relationship between
current assets (CA) and current liabilities
(CL).
Measures the ability of the firm to meet
obligations due within one year.

The ratio 2:1 is employed as a standard


for comparison.

b. Quick Ratio
Termed as acid-test ratio or liquid ratio, measure
of short-term solvency of a firm.
The quantitative relationship between quick
assets and current liabilities.

Exclude inventory from current assets to find the


quick assets.
The ratio 1:1 is employed as standard for
comparison.

C. Other Liquidity Ratio

Cash Ratio and Net working capital Ratio


are also analysed.

Case - 3
The Petry Company has $1,312,500 in current assets
and $525,000 in current liabilities. Its initial inventory
level is $375,000, and it will raise funds as additional
notes payable and use them to increase inventory. How
much can Petrys short-term debt (notes payable)
increase without pushing its current ratio below 2.0?
What will be the firms quick ratio after Petry has
raised the maximum amount of short-term funds? What
is quick ratio after financing?

Case - 4
1. Barnaby Cartage Company has current assets of
$800,000 and current liabilities of $500,000. What effect
would the following transactions have on the firms current
ratio (and state the resulting figures)?
a. Two new trucks are purchased for a total of $100,000 in
cash.
b. The company borrows $100,000 short term to carry an
increase in receivables of the same amount.
c. Additional common stock of $200,000 is sold and the
proceeds invested in the expansion of several terminals.
d. The company increases its accounts payable to pay a
cash dividend of $40,000 out of cash.

2. Assets Management Ratio


Known as turnover ratios or activity ratios or
efficiency ratios.
They provide the measure for how effectively the
firms assets are being managed.
Measures the utilization of assets to generate
revenue or profit.
Better off if low level of assets generates high
volume of sales revenue.
Following ratios are evaluated:

a. Inventory Turn over Ratio [ITOR]


Measures how a firms average investment in
inventory is capable of generating sales.
It is the test of the liquidity of firms investment in
inventories.
A low inventory turnover ratio indicates that the firm
is holding excessive stock of inventory or is unable
to turn it over in terms of sales.
A high inventory turnover ratio indicates that the
firm is turning over its inventory at higher rate.
Calculated using following ratio:

Equations of ITOR

Cost of Goods Sold = Sales Gross Profit

b. Receivable turnover ratio

Measures how many times the account


receivables or debtors turnover occur during
the year.
Measure of the productivity of receivable
investment and the test of the liquidity of
debtors of firm.
A low receivable turnover ratio indicates that
the firm is making excessive investment in
receivables.

Receivable turnover ratio contd...

The equation of receivable turn over Ratio is:

Comparatively higher RTOR shows better


liquidity of debtors and quick collection of
receivables.

C. Days sales Outstanding

Known as average collection period (ACP).


Measures how quickly the accounts receivable
are being converted into cash.
Shows the average length of time in terms of
number of days that a firm must wait after
making sales before receiving cash.
High average collection period indicates that
customers are not paying their bills on time.

Days sales Outstanding contd...

It is calculated as:

Average sales per day:


Average collection period also can be restated as

d. Fixed Assets Turnover Ratio

Indicates the firms ability to generate


sales from investment in its various fixed
assets.
Measures the effectiveness firms ability to
make efficient utilization of fixed assets.
A low fixed assets turnover ratio indicates
that the firm is using its fixed assets not as
efficiently as other firm in the industry.

Fixed Assets Turnover Ratio contd

FATR can be calculated as:

e. Total Assets Turnover Ratio

Measures the efficiency of assets


management in relation to all of the
firms assets. It is calculated as sales
divided by total assets.
It is calculated as:

Case - 5

The Kretovich Company had a quick


ratio of 1.4, a current ratio of 3.0, an
inventory turnover of 6 times, total
current assets of $810,000, and cash
and marketable securities of $120,000
in 2001. What were Kretovichs annual
sales and its DSO for that year?
Assume there are 365 days in a year.

Thank You

3. Debt Management Ratios

Known as leverage ratios, indicate the


extent to which debt financing is being
used by a firm.
Measure of long-term solvency of a firm.
Based on realization principles.
The following ratios are calculated:

a. Debt-Assets Ratio

Show the proportion of total debts used in


financing total assets of a firm.
The firm with low debt ratio will not be able
to take leverage advantages of debt.
It is calculated as:

b. Debt-Equity Ratio

Used leverage ratio to evaluate the longterm solvency of a firm.


Expresses the relationship between debt
capital and equity capital, and reflects the
relative claim of them on the assets of the
firm.
Following equations are used:

Alternative equations of debt to equity

D/E can be calculated as:

c. Long-term Debt to Total Assets Ratio

represents the relationship between


long-term debts to total assets of a firm.
It is calculated as:

d. Equity multiplier

Referred to as the leverage factor, simply


states the relationship of total assets to
equity of a firm.
Equity multiplier is 2, it denotes that total
assets of the firm is 2 times of the equity of
50 percent of the total assets are financed
with equity(because debt ratio is equal to).
The following ratios are calculated:

Equity Multiplier contd...

Equations of EM

EM = 1+DE

e. Interest Coverage Ratio

Referred to as times-interest-earned (TIE)


ratio.
Measures the extent to which interest on
debt capital is covered by EBIT. Following
equations are used:

f. Cash coverage ratio

provides the extent to which a firm is able


to cover its interest expense out of cash
flow. It is measured as:

g. EBITDA Coverage Ratio

Most useful for short term lenders which


rarely make loans for longer than about
five year.
For short period depreciation and other
non cash expenses can be used to service
debt.

Case - 6

Graser Trucking has $12 billion in assets,


and its tax rate is 40 percent. The
companys basic earning power (BEP)
ratio is 15 percent, and its return on assets
(ROA) is 5 percent. What is Grasers
times-interest-earned (TIE) ratio?

4. Profitability Ratio
Measures how efficiently the firm is
being operated and managed.
Owners, managers, creditors are eager
to know their returns whereas managers
are interested in their operating
efficiency.
Evaluated in terms of profit earned by
the firm.

a. Net Profit Margin


The ratio between net income and sales.
Shows a firms ability to generate net
income per rupee of sales.
Higher net profit margin is preferred by
the owners, the management as well as
the creditors because it is a good sign of
the efficiency of a firm.

b. Gross Profit Margin


The ratio between gross profit and
sales.
Higher gross profit margin is
preferred as it allows greater cushion
to absorb other expenses.

Gross Profit = Sales - CGS

c. Operating Profit Ratio


Shows the relationship between operating
profit and sales and indicates operating
efficiency of a firm.
Higher operating profit ratio is preferred
because it is a good sign of operating
efficiency of a firm.

Operating Profit = EBIT

d. Basic Earning Power Ratio [BEP]


The ratio of firms earnings before interest
and tax and total assets.
Calculated to evaluate the firms ability to
generate profit before the payment of
interest and taxes out of the assets used.
Higher earning power ratio indicates better
asset utilization.

e. Return on assets [ ROA]

Measure the overall effectiveness of


management in generating profit with
its available assets.
The higher the firms return on assets
the better it is doing in operation and
vice versa.

f. Return on equity [ROE]


Measures the return on the owners
investment in the firm.
Higher ratio of return on equity is better for
owner.

Case - 7
Midwest Packagings ROE last year was only 3
percent, but its management has developed a
new operating plan designed to improve things.
The new plan calls for a total debt ratio of 60
percent, which will result in interest charges of
$300,000 per year. Management projects an
EBIT of $1,000,000 on sales of $10,000,000, and
it expects to have a total assets turnover ratio of
2.0. Under these conditions, the tax rate will be
34 percent. If the changes are made, what return
on equity will the company earn?

5. Market Value or Growth Ratio

Used to assess firms stock price in


relation to its earning and book value of
shares.
Price Earning Ratio, Market to Book
Value Ratio, Payout Ratios are analysed.
Used by the investors in capital market to
come to final decision to make final
investment decision.

a. Price Earnings Ratio

The ratio between market price per share


and earnings per share.
Represents the amount which investors
are willing to pay for each rupee of the
firms earnings.
The higher PE ratio indicates the greater
confidence of investor in the firms future.

b. Market-to-Book Ratio

The ratio between market price per share


to book value per share.
Book value per share = Total
equity/Number of outstanding shares of
common stock.
measures how the financial market has
put the value to the firms overall
management and efficiency over the time.

c. Payout Ratio

Measures the proportion of earnings that


has been distributed as dividends to
common stockholders.

Closely related with plowback ratio or


retention ratio
Growth rate shows how rapidly the common
stockholders equity is growing because of
reinvestment of retained earnings.

Case - 8

Jaster Jets has $10 billion in total assets.


The left side of its balance sheet consists
of $1 billion in current liabilities, $3 billion in
long-term debt, and $6 billion in common
equity. The company has 800 million
shares of common stock outstanding, and
its stock price is $32 per share. What is
Jasters market/book ratio?

Du Pont Chart and Equation

A comprehensive model to represents an


integrated view on financial analysis, planning
and control process relating to firm.
First propounded and used by Du-Pont
Corporation U.S.A.
Used to make a classified assessment of firms
financial performance.
Provides a summary of firms profitability in
terms of return on assets (ROA) and return on
equity (ROE).

Du Pont chart
ROE

ROA

EM

ATR

NPM

NI

Sales

Sales

TA

d. Du Pont equation
The Du Pont Equation is:
Return on equity (ROE)

= Return on assets x Equity multiplier

=Profit margin x assets turnover x Equity multiplier


ROE

Return on assets (ROA) = Profit margin x Assets turnover

Case - 9

Doublewide Dealers has an ROA of 10


percent, a 2 percent profit margin, and a
return on equity equal to 15 percent. What
is the companys total assets turnover?
What is the firms equity multiplier?

Use of Financial ratio


To have information about the earnings of
the company.
To analyze financial statement.
To know about short-term solvency
position of the firm.
To know the current debt payment
capacity of a firm.
Helps the analysts to form a judgment
whether performance of the firm at a point
of time is good or bad.

Limitations of Ratio Analysis

Requires basis of comparison


Differences in interpretation
Difference in situation of two firms
Change in price level
Short term changes
No indication of the future

Thank You