Financial Management

Prof. Sapna U. Malya

Analysis of Financial Statements using RATIOS

Topics covered: Meaning of Ratio Why Ratio? Different types of ratios: Liquidity Ratios Asset Management Ratios Debt Management Ratios Profitability Ratios Market Value Ratios Du pont Equation Limitation of Ratio Analysis

Different Types of Ratios:

Current Assets / Current Liabilities Sales / Inventories

Sales / Net Fixed Assets

EBIT / Interest

EBIT / Total Assets

Price per share / Earnings per share

Liquidity Ratios

Current Ratio = Current Assets / Current Liabilities

Quick/ Acid Test Ratio = (Current Assets less inventories) / Current Liabilities

Asset Management Ratio

Inventory turnover ratio = Sales / Inventory

Debtors turnover ratio = Sales / Debtors

Days Sales Outstanding (DSO) = Receivables / Average sales per day

Creditors turnover = Purchases / Creditors

Fixed Assets turnover = Sales / Net fixed assets

Total Assets turnover = Sales / Total assets

Debt Management Ratios

Debt Ratio = Total Debt / Total Assets

Debt Equity = Debt / Equity or Debt / (Debt + Equity)

Interest Coverage Ratio = EBIT / Interest charges

Debt Service Coverage Ratio (DSCR) =

EBIDTA + Lease payments / Interest + Principal payments + Lease payments

Profitability Ratios

Profit margin = NPAT / Sales

Basic Earning Power ( BEP) = EBIT / Total Assets

Return on Total Assets = Net income available to Equity / Total Assets Return on Equity = Net income available to Equity / Equity

Market Value Ratios

Price earnings ratio = Market price per share / Earnings per share Price / Cash flow ratio = Price per share / Cash profit per share

Market / Book ratio = Market price per share / Book value per share

Du Pont equation

ROA = Net profit / Total Assets

ROA = Net profit * Sales Sales Total Assets ROA = Profit margin * Total Assets Turnover

OR

ROA = Net profit / Capital Employed

Du Pont equation.. Other side to it

ROE = Net profit / Equity( or Total Assets) ROE = Net profit * Sales Sales Total Assets * Total assets Equity

ROE = Net profit * Sales Sales Total Assets Equity multiplier = Total assets / Equity Therefore ROE = ROA * Equity multiplier

Certain questions to ponder over

Is a high inventory turnover always better? Why would the inventory turnover ratio be more important when analysing a grocery chain than an insurance company?

There is an increase in current ratio and a drop in its total assets turnover ratio. However, the companys sales, cash and marketable securities, DSO and fixed assets turnover ratio have remained constant. What explains these changes?
If a firm takes steps to improve its ROE, does this mean that shareholder wealth will also increase?

Limitations of Ratio Analysis

Benchmarking required for analysis

Inflation may distort comparative analysis

Window dressing techniques can be adopted to make ratios look stronger

Different accounting practices can distort comparison Difficult to generalise whether a ratio is good or bad

Time Value of Money

Topics covered:

Concept of Time Value of Money

Present Value
Future Value

Annuity Present Value

Annuity Future Value

Concept of Time Value

A Rupee today is more valuable than a rupee a year hence. Why ?
Current consumption is preferred to future consumption. Purchasing power of money is greater today than a year hence due to inflation. Capital can be employed productively to generate positive returns.

Thus rupee discounts from time to time

Concept of Time Value

Time value thus brings to light two important values:
Present Value

Future Value

Present Value & Future Value

Value of money at present that is at this point of time is said to be the present value..
Future Value therefore is the value of money in future..

Present Value & Future Value

What is the value of Re.1 received a year later if the rupee discounts at 10%?
Future Value of Re.1 = Present Value + Interest FV of Re.1 = PV of Re.1 + 10% on Re.1 FV = 1 + 1(10/100) FV = PV + 1(10/100) FV = PV + PV(10/100) FV = PV (1+ 10/100) FV = PV (1 + r )

Present Value & Future Value

Similarly PV = FV / (1+r)
And if this is to be calculated for the nth year it will be

PV = FV / (1+r)n PV = FV * 1 /(1+r)n

Annuity Future value

0 1 2 3 4 5 6

-100 Interest 5 5.25 5.51 Total 105.00 110.25 115.76 F.V2 = F.V.1( 1 + r ) = P.V(1+r) (1+r) = P.V. (1+r)^2 Therefore F.V.(n) = P.V. (1+r)^n

5.79 6.08 6.38 121.55 127.63 134.01

Applications of Present Value in Business

How much can you borrow for an asset?

Period of Loan amortisation. Finding the interest rate.

Applications of Future Value in Business

Knowing what lies in store for you

How much should you save annually

Finding the interest rate

Annual deposit in the sinking fund

Conclusion
Present Value and Annuity Value is calculated assuming that the discounting is done at the end of each year and not any time during the year. Higher the Discounting rate.. Lower the Present Value factor..

Stock Valuation
Concepts to be known: Common Stock / Equity Preferred Stock Pre-emptive right Closely held company Publicly owned company Primary market (IPO) Secondary market

Valuation of Common stock / Equity

Models used for valuation: Zero Growth or Constant Dividend Model Constant Growth Model / Gordon Model Valuation of stocks with non constant growth Capital Asset Pricing Model Other Approaches to valuing Equity: P/E Multiple EVA Approach

Zero Growth or Constant Dividend Model

Dividends received annually Dividends received in perpetuity No growth in dividends There is an expectation of the investor from the company

P0 = D1/ ke
P0 = Price of the stock today D1 = Dividend received in future ke = expected return by the investor

Constant Growth Model / Gordon Model

Dividends received annually Dividends received in perpetuity There is a growth in dividends which is constant There is an expectation of the investor from the company

P0 = D1/ (ke g)
P0 = Price of the stock today D1 = Dividend received in future ke = expected return by the investor

Valuation of stocks with non constant growth

Dividends received annually Dividends received for n periods There is a change in dividends which is not constant There is an expectation of the investor from the company

P0 = D1 + D2 + Dn (1+ke)^1 (1+ke)^2 (1+ke)^n

P0 = Price of the stock today D1 = Dividend received in future ke = expected return by the investor

MVA & EVA as a valuation technique

MVA( Market Value Added)

Market value of stock Equity share capital

EVA (Economic Value Added)

NOPAT (Capital Employed * Cost of capital)
= EBIT(1 T) (Capital Employed * Cost of capital)

Cost of Capital
Types of Capital Debt Preference Capital Retained Earnings Equity Capital

Cost of Capital Debt (kd)

Debt is long term in nature Interest is paid on debt at a fixed rate Interest is tax deductible

kd = I (1 T) But if the debt is traded and has a different market price with maturity period, then the value of debt is the YTM of that debt which is: rd = I + ( Face value F Current market price P0 ) / n

0.6 P0 + 0.4 F

kd = rd (1-t)

Cost of Capital Preference kp

Preference capital forms a part of owners funds Dividends at a fixed rate are paid to these financers Dividends are always paid after tax

kp = D / P But if the preference is traded and has a different market price with maturity period, then the value of preference is the YTM of that preference which is: rp = I + ( Face value F Current market price P0 ) / n

0.6 P0 + 0.4 F

Cost of Capital Retained Earnings (Ks)

Profits accumulated every year Profits accumulated are after payment of interest, tax and preference dividend Profits belonging to the owner

ks = ke (except ke at times increases due to floatation cost)

Cost of Capital Retained Earnings (Ks)

Various approaches used for valuation are:
CAPM

Bond Yield Plus Risk Premium Approach

Dividend Yield Plus Growth Rate Approach

Cost of Capital Equity (ke)

P0 = D1/ (ke g)
ke = (D1 / P0) + g ke = (D1 / P0 f) + g

Capital Asset Pricing Model ( CAPM)

ke = kf + (km-kf)
ke = Expected rate of return from equity kf = Risk free rate of return ( Treasury bills, PPF account) km - kf = Market risk premium = Stocks Beta

Weighted Average Cost of Capital WACC

WACC = wdkd+ wpkp + weke

Weights can be according to book values or market values. However market values are more relevant for new issues of capital/ new sources of finance