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Financial Performance Analysis

Financial Analysis
• Tool of financial management
• Simplifies the financial statements
• Consists of the evaluation of the financial
conditions & operating performance of a firm
• Help in forecasting the firm’s future conditions
& performance
• A means for examining risk & expected return

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Why Financial Analysis?
• To assess a firm’s past, present, & future
financial health
• To base for intelligent decision making &
starting point for planning the future courses
of actions
• Objectives:
• To determine financial strength
• To identify weaknesses
• To identify significance r/ships existing
among the key figures 3
Financial Statements & Process of
Financial Analysis
• Financial Statements
• Income Statement
• Balance Sheet
• Statement of Retained Earnings
• Statement of Cash flows
• Process of Financial Analysis involves:
• Setting comparison bases
• Applying tools of analysis
• Characterizing profitability and solvency
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Users of Financial Analysis
• Investors: Existing & Potential
• Lenders: Current & Potential
• Managers
• Suppliers
• Employees
• Others:
─ Government Bodies
─ Competitors
─ Rating & Indexing Agencies
─ Investors’ Services
─ Financial Markets
Considerations in Financial
Analysis
1) The financial statements being compared
should be dated at the same point in time
during the year.
2) A single analysis does not provide sufficient
information from which to judge the overall
performance of a firm.
3) Use audited financial statements for analysis.
4) Consider different methods used especially for
inventories & depreciation.
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5) Consider the distortions due to inflation.
Types and Tools of Financial
Analysis
• Benchmarks / Basis for Comparison
• Various Analysis Approaches:
• Time-Series Analysis:
• Applied when evaluating performance
overtime
• Present/recent ratios compared with a
firm’s own past ratios
• Allows a firm to determining whether its
progressing as planned
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Types and Tools of …
• Cross-Sectional Analysis:
• Comparison of different firms’ financial
ratios at the same point in time
• How well a firm performed / positioned in
relation to its competitors
• To uncover major operating deficiencies

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Types and Tools of …
• Industry Analysis:
• Comparison of a particular ratio to the
standard made to isolate any deviation
from the norm
• Too high or too low values reflect
symptoms of a problem
• Provides a useful insight on how the firm
measures up to its competitors
• Pro Forma Analysis:
• Comparing a ratio to its corresponding
from the pro forma statements 9
Types of Financial Ratios &
Interpretations
• Liquidity Ratios:
Ability to meet current obligations
• Leverage Ratios:
shows the degree of a firm’s indebtedness
• Activity Ratios:
Proper & effective use of assets
• Profitability Ratios:
Measures management effectiveness
• Market Value Ratios:
Indicators of what investors think of firm’s past results &
future prospects 10
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Liquidity Ratios
• CURRENT RATIO
measures a firm’s ability to satisfy or cover claims of short-
term creditors by using only current assets
Current Current Assets
=
Ratio Current Liabilities

• QUICK (ACID-TEST) RATIO


measures short-term liquidity by removing the least
liquid assets

Quick Current Assets - Inventories


=
Ratio Current Liabilities
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Leverage Ratios
• DEBT RATIO
shows the extent of assets financed through debts
Debt Total Liabilities
=
Ratio Total Assets
• DEBT-TO-EQUITY RATIO
expresses the relationship between the amount of a firm’s total
assets financed by creditors (debt) & owners capital (equity)

Debt-Equity Total Liabilities


=
Ratio Stockholders’ Equity
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Leverage Ratios …
• TIMES INTEREST EARNED RATIO
measures a firm’s ability to pay interest on a timely basis
Times Interest EBIT
=
Earned Ratio Interest
• CASH COVERAGE RATIO
indicates the extent to which earnings may fall without
causing any problem to the firm regarding the payment
of interest charges

Cash Coverage EBIT + Depreciation


=
Ratio Interest 15
Activity Ratios
• INVENTORY TURNOVER
measures the efficiency with which a firm is managing its
investments in inventories
CGS
Inventory Turnover =
Average Inventory

• AVERAGE AGE OF INVENTORY


the number of days inventory is kept before it is sold

Average Age of No of Days in a Year (365 Days)


=
Inventory Inventory Turnover

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Activity Ratios …
• RECEIVABLES TURNOVER
measures the liquidity of a firm’s accounts receivable
Receivables Net Sales
=
Turnover Average Accounts Receivables
• AVERAGE COLLECTION PERIOD
shows how long it takes for accounts receivables to be
cleared (collected)

Average Collection 365 Days


=
Period Receivables Turnover

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Activity Ratios …
• FIXED ASSETS TURNOVER
measures the efficiency with which the firm has been using
its fixed assets to generate revenue
Net Sales
Fixed Assets Turnover =
Average Fixed Assets
• TOTAL ASSETS TURNOVER
measures a firm’s efficiency in managing its total assets
to generate sales

Fixed Assets Net Sales


=
Turnover Total Assets
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Profitability Ratios
• GROSS PROFIT MARGIN
indicates management’s effectiveness in pricing policy,
generating sales and controlling production costs
Gross Profit
Gross Profit Margin =
Net Sales
• NET PROFIT MARGIN
measures the profitableness of sales

Net Income
Net Profit Margin =
Net Sales

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Profitability Ratios …
• RETURN ON INVESTMENT (ROI)
measures the overall effectiveness of management in
generating profit with its available assets
Net Income
Return on Investment (ROI) =
Total Assets
• RETURN ON EQUITY (ROE)
measures the earning power on shareholders’ book value
investment
Net Income
Return on Equity (ROE) =
SHE

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Profitability Ratios …
• EARNING PER SHARE
measures profitability of the firm from the view point of
ordinary shareholders
indicates the profit available to each ordinary share

Earnings Avail. to Common


Earning Per Share Stockholders
=
(EPS) Number of Shares of Common
Stock Outstanding

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Market Value Ratios
• PRICE EARNINGS (P/E) RATIO
indicator of the firm’s growth prospects, risk characteristics,
shareholders orientation, corporate reputation, and the
firm’s level of liquidity
Market Price per Share
P/E Ratio =
Earning per Share

• MARKET-TO-BOOK RATIO
measures a firm’s contributions to wealth creation in the
society
MV per Share
Market-to-Book Ratio =
BV per Share
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Benefits of Ratio Analysis
• Simplifies the financial statements
• Provides useful information concerning a firm’s
operation and financial conditions
• Helps identify symptoms of problems
• Helps reach to the causes of problems
• Provides a common ground for comparisons
• Helps in comparing companies of different size
with each other
• Helps in trend analysis which involves comparing a
single company over a period
• Highlights important information in simple form
quickly
Limitations of Ratio Analysis
• Difficulty to develop a meaningful set of industry
averages
• Tendency of firms just to be better than the
average
• Inflation may distort a firm’s balance sheet
• Employing “window dressing” techniques
• Differences in accounting practices
• Difficulty of generalizing “good” or “bad” on a
ratio
• Difficulty of overall evaluation 24
Du Pont Analysis
• Developed by Donaldson Brown in 1914
• Du Pont Corp. started to use in the 1920s
• Expressing the ROE breaking into 3 parts
• Meant to provide an adequate measure of overall
effectiveness
Sales Assets
ROE =
Profitability
× Efficiency
× Equity Multiplier

Net Profit Total Assets


=
Margin
× Turnover
× Equity Multiplier

Net Income Net Sales Total Assets


= × ×
Net Sales Total Assets SHE
Net Income Net Sales Debt
= × × 1+
Net Sales Total Assets Equity
Chapter
Ends

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