ANALYSIS OF FINANCIAL STATEMENT

FINANCIAL STATEMENTS ARE :

MUCH MORE THAN JUST ACCOUTING.THEY PROVIDE WEALTH OF INFORMATION FOR MANAGERS, INVESTORS, LENDERS, CUSTOMERS, SUPPLIERS AND REGULATORS.ANALYSIS HELPS IN HIGHLIGHTING COMPANY’S STRENGTHS AND WEAKNESSES ALSO HELPS IN PREDICTING HOW STRATEGIC DECISIONS EG SALE OF A DIVISION, A MAJOR MARKETING PGM ETC ARE LIKELY TO AFFECT FUTURE PERFORMANCE.

CORPORATE VALUATION AND ANALYSIS OF FINANCIAL STATEMENTS

SALES REVENUE

Oprtg Cost &Taxes

Rqrd InvstmntIn Operations

FINCNG DECISIONS

Int Rates

FIRMRISK

Mkt Risk

Free Cash Flows Weighted Average Cost of Capital

Value of Co = FCF1 + FCF2 FCF3 …… FCF

(1 + WACC)1 (1+WACC) 2 (1+WACC)3 (1+WACC) 4

THE MANAGEMENT SHOULD TRY TO MAXIMIZE A COMPANY’S VALUEIT MUST TAKE ADVANTAGE OF THE COMPANY’S STRENGTH AND CORRECT ITS WEAKNESS.

FINANCIAL STATEMENT ANALYSIS INVOLVES :

COMPARING THE COMPANY’S PERFORMANCE WITH THAT OF OTHERCOMPANIES IN THE SAME INDUSTRY. &EVALUATING THE TRENDS IN THE COMPANY’S FINANCIAL POSITIONOVER TIME

THE REAL VALUE OF FINANCIAL STATEMENT LIES IN THE FACT THAT THEY CAN BE USED TO HELP PREDICT FUTURE EARNINGS,

DIVIDENDS, AND FREE CASH FLOW.

M/s Micro DriveBalance Sheet ($ in Mil)31 December 2003 / 2004

Assets 2004 2003Cash &Eqvlts 10 15Shrt Term Invst 0 65Accounts Rcvbl 375 315Inventories 615 415

Ttl C/Assets 1000 810Net Plant&Eqpt 1000 870

Total Assets 2000 1680

Liab&Equty 2004 2003A/c Pybl 60 30Note / Payable 110 60Accruals 140 130Ttl C/Liablities 310 220L.Term Bonds 754 580Total Debt 1064 800P.Stock(400000) 40 40C.Stock(50000000) 130 130Retained Earnings 766 710Total Com Eqty 896 840Ttl Liab & Eqty 2000 1680

Micro Drive IncIncome Statement

for the Year ending 31 Dec 00/01 (In Millions)

2004 2003Net Sales 3000 2850

Operating Cost Excldg Dep/Amtzn 2616.2 2497Erng b4 Int,Tax,Dpcn&Amtzn(EBITDA) 383.8 353Depreciation 100 90Amortization 0 0Depreciation &Amortization 100 90Earning before Int&Tax (EBIT or Op Incm) 283.8 263less interest 88 60Earning before Tax (EBT) 195.8 203Taxes @ 40 % 78.3 81.2Net Income before Preferred dividend 4 4Net Income 113.5 117.8Common Dividend 57.5 53Additions to retained earnings 56 64.8

PER SHARE DATA

2004 2003

COMMON STOCK PRICE $ 23 $ 26EARNING PER SHARE 2.27 2.36DIVIDEND PER SHARE 1.15 1.06BOOK VALUE PER SHARE 17.92 16.80CASH FLOW PER SHARE 4.27 4.16

ADDITIONAL INFORMATIONTHE BONDS HAVE A SINKING FUND REQUIREMENT OF $ 20 MILLION A YEARTHE COST INCLUDE LEASE PAYMENTS OF $ 28 MIL A YEAR

THERE ARE 50 MILL SHARES OF COMMON STOCK.

EPS = NET INCOME / COMMON SHARE OUTSTANDING

EPS = $ 113,500,000 / 50,000,000 = $ 2.27DPS = DIVIDEND PAID TO COMMON / CMN SHR

O/SDPS = $ 57,500,000 / 50,000,000 = $ 1.15BVPS= TOTAL EQUITY / COMN SHARE O/SBVPS= 896,000,000 / 50,000,000 = $ 17.92CFPS = NET INCOME + DEP + AMT / CMN SHR O/SCFPS = $ 213,500,000/ 50,000,000 = $ 4.27

LIQUIDITY RATOSLiquidity ratios deals with liquid assets and current liabilities. Liquid assets are those assets which can be quickly converted to cash at the going market price.A full liquidity analysis requires use of cash budgets.

Current Ratio: Current Assets / Current liabilitiesIt measures short term solvency of the companyCreditors would always like to see a high current ratio of the companyIn case of financial difficulty the company will begin paying its bills (accounts payables) more slowly --- stretching of accounts payables.Borrowing from banks will increase

Micro Drive Current ratio = $ 1000 / 310 = 3.2 timesIndustry Average = 4.2 times If current liabilities are rising faster than current assets, the current ratio will fall and this could spell trouble.

Quick RatioThe quick ratio is computed by deducting

inventories and prepayments from current assets and then

dividing the remainder by Current Liabilities.

Acid Test = Current Assets – Inventories & prepayments.

Quick Ratio Current Liabilities

Quick Ratio = $ 385 / 310 = 1.2 timesIndustry Average 2.1 times

DEBT MANAGEMENT RATIOS

THE EXTENT TO WHICH A COMPANY USES DEBT FINANCING OR FINANCIAL LEVERAGE HAS 3IMPORTANT IMPLICATIONS :

1. BY RAISING DEBT THE STOCK HOLDERS CAN MAINTAIN CONTROL OF THE COMPANY WITHOUT INCREASING THEIR OWN INVESTMENTS.

2. IF THE COMPANY EARNS MORE ON INVESTMENTS FINANCED BY BORROWED FUNDS THAN IT PAYS IN INTEREST, THAN ITS SHARE HOLDERS RETURNS ARE MAGNIFIED / LEVERAGED.

3. CREDITORS LOOK TO EQUITY OR EQUITY SUPPLIED CAPITAL AS MARGIN OF SAFETY

HOW THE COMPANY IS FINANCED :TOTAL LIABILITIES TO TOTAL ASSETS

DEBT RATIO = TOTAL LIABILITES / TOTAL ASSETS DEBT RATIO = 310 + 754 / 2000 = 53.2 % INDUSTRY AVERAGE = 40 %- CREDITORS PREFER LOW DEBT RATIO I.E. GREATER

CUSHION- STOCK HOLDERS WANT MORE LEVERAGE BECAUSE IT

MAGNIFIES EXPECTED EARNINGS- OUR COMPANY’S DEBT RATIO IS 53.2% IE CREDITORS HAVE

SUPPLIED MORE THAN 50% OF THE TOTAL FINANCING.- IT MAKES COSTLY FOR OUR CO TO BORROW ADDITIONAL

FUNDS WITHOUT FIRST RAISING MORE EQUITY CAPITAL.- THE COMPANY WILL BE SUBJECT TO BANKRUPTCY IF IT

INCREASE ITS DEBT RATIO FURHTER.

ABILITY TO PAY INTEREST: TIMES INTEREST EARNED

T I E = EBIT / INTEREST CHARGEST I E = $ 283.8 / 88 = 3.2 TIMES INDUSTRY AVERAGE = 6 TIMESTIE MEASURES THE EXTENT TO WHICH INCOME CAN DECLINE BEFORE THE COMPANY IS UNABLE TO MEET ITS ANNUAL INTEREST COSTS. ( FAILURE LEADS TO BANKRUPTCY)EBIT IS USED BECAUSE INTEREST IS PAID WITHPRE TAX DOLLARS / RUPEES.OUR COMPANY’S TIE IS LOW . IT SHOWS THAT THE MARGIN OF SAFETY IS LOWER FROM CREDITORS POINT OF VIEW.

ABILITY TO SERVICE DEBTEBITDA COVERAGE RATIO

TIE HAS 2 SHORT COMMINGS1. INTEREST IS NOT THE ONLY FIXED FINANCIAL CHARGE

(CO SHOULD ALSO REDUCE DEBT AND MAKE LEASE PYMNTS)

2. EBIT DOES NOT REPRESENT ALL THE CASH FLOW AVAILABLE TO SERVICE DEBT, ESPECIALLY IF THE CO HAS HIGH DEPRECIATION AND AMORTIZATION CHARGES.

TO OVER COME THE ABOVE PROBLEMS THE BANKERS ANDOTHER CREDITORS HAVE DEVELOPED EBITDA RATIOEBITDA COVERAGE RATIO= EBITDA+LEASE PAYMENTS

INT + PRCPL PYMNTS+ LEASE PYMNTS

EBITDA COVERAGE RATIO = 283.8+100+28 = 411.8 88+20+28 136 EBITDA COV RATIO = 3.0 TIMES INDUSTRY STANDARD = 4.3 TIMES

IT SEEMS THAT OUR COMPANY HAVE A HIGH LEVEL OF DEBT.

Note: Different analysts define EBITDA coverage ratio in a different ways. Some omit lease payments and some would gross up principal payments ie by dividing them by (1-T) .A Sinking fund is a required annual payment designed toreduce the balance of bond / preferred stock / debenture issue.

EBITDA RATIO USEFUL FOR SHORT TERM LENDERS WHEREAS LONG TERM CREDITORS FOCUS ON T I E RATIO

PROFITABILITY RATIOS

PROFITABLITY IS THE NET RESULT OF A NUMBER OF POLICIES AND DECISIONS. COMBINED FFECTS OF LIQUIDITY, ASSET MANAGEMENT AND DEBT OPERATING RESULTS.

PROFIT MARGIN ON SALES = NI AVL FOR COMN SHARE HOLDERS

SALES

PROFIT MARGIN = 113.5 / 3000 = 3.8 %INDUSTRY AVG 5.0 %Apparently our company’s COSTS are too high which shows inefficient operations.

Remember NI is after interest. Profit margin can also be affected as result of high financial leverage.

Basic Earning power

BEP = EBIT / Total Assets.

BEP = $ 283.8 / 2000 = 14.2 %Industry Average = 17.2 %

This ratio shows the raw earning power of the company’s assets before the influence of taxes and leverage .

It is useful for comparing Companies with different tax situations and different degrees of financial leverage.For computing this ratio we should use Average

assets figure.

RETURN ON TOTAL ASSETS

ROA = Net Income available to common stock holders

TOTAL ASSETSROA = $ 113.5 / 2000 = 5.7 % Industry Average = 9 %

The low return on assets is because1 The company’s low basic earning power2 High interest costs resulting from its above

average use of debt, both of which cause its net income to be relatively low

Return on equityThe BOTTOM LINE of accounting ratios is the ratio of Net Income to common equity, which measures the return on Common equity ( ROE)

ROE = Net income available to common stock holders Common equity

ROE = $ 113.5 / 896 = 12.7 %Industry Average = 15.0 %

Stock holders invest to get return on their money, and ROE tells how well they are doing in accounting sense.

Market Value ratios

Final group of ratios, the Market Value Ratios relates the Company’s stock price to itsEarnings, cash flow, and book value per share

ETC .These ratios give management an indication of what investors think of company’s past performance and future prospects. If the

liquidity, asset management , debt management, and profitability ratios all look good, then the market value ratios will be HIGH, and the STOCK PRICE will be probably as high as can be expected.

Price / Earning Ratio

P / E ratio shows how much investors are willing to pay per dollar / rupee of reported profits.

P/E ratio = Price per share / Earning per share

P/E = $ 23 / 2.27 = 10.1 times

Industry Average = 12.5 timesThis ratio is higher for companies having strong growth prospects but lower for riskier companies.

OUR company is regarded as riskier and having poor growth

prospects.

PRICE / CASH FLOW RATIO

In some industries, stock price is tied more closely to Cash Flow rather than net income.

PRICE / CASH FLOW RATIO = PRICE PER SHARE CASH FLOW PER SHARE

P/Cflw RATIO = $ 23 / 4.27 = 5.4 Times

Industry Average = 6.8 Times

It tells that growth prospects are below average and risk is above average or both.

Market / Book Value ratioMarket Book Value Ratio. This ratio gives an other indication how investors regard the company. Companies with relatively higher rates of return on equity generally sells at higher multiples of book value than those with low returns.

Mkt / Book Value ratio = Mkt price per share / Book Value per Share

For computing this ratio we also require Book Value per share.

Book Value per share = Common Equity / Shares Outstanding

BV / Share = $ 896 / 50 = $ 17.92 Now using the above Book value we can compute theMkt / |Book value ratio = $23 / 17.92 = 1.3 timesIndustry Average = 1.7 times

Book Value is the record of the past, showing the Cumulative amount that stock holders have invested , either directly by purchasing newly issued shares or Indirectly through retained earnings.

Market Price is forward looking, incorporating investor’s expectations of future cash flows.

Other important ratios: Dividend yield = Dividend per share / Market price per

shareEarning Yield = EPS / MPS

Price EBITDA per share, Price / Customers, Price / SalesEtc etc

DUPONT ANALYSIS

Dupont Analysis : The relationship between various ratios. How the return of equity is affected by Asset Turn over, the profit margin and leverage. ROE= ROA x Equity multiplier (5.7 x 2.23= 12.7)ROA= NI / Total Assets or Profit Margin x Asset turnover = 113.5 / 2000 or (113.5/ 3000) x (3000/2000)=5.7 ROE=Profit Margin x Total Asset turn over x Equity multiplierProfit Margin = NI / Sales 113.5/ 3000 = 3.78 Asset Turn over= Sales / Total Assets 3000/2000= 1.5Equity multiplier= Total Assets / Common equity

= 2000 / 896 = 2.23

Modified Du pont Chart

Return on Equity 12.7%

Return on Assets 5.7% X Assets / Equity = 2000/696 = 2.23

Profit Margin ie Earning as a % of Sales X Total Asset turn over 1.5 3.8 % Sales Divided into Net Income Sales Divided by Total

Assets3000 113.5 3000 2000

Total Cost Subtracted from Sales Fixed Assets Added to Cur Assets

2886.5 3000 1000 1000Other Optng Interest +Cost 2616.2 Prfd Dividend Cash & Mktble (Labor + Overhead) 92 Securities 10

Depreciation Taxes A/ Rcbl Inventories

100 78.3 375 615

IF the company were financed only with common equity

Then ROA and ROE would be same because Total Assets = Total equity

ROA = NI / TA and ROE = NI/Common equity

In our company’s case DEBT is also being used

Therefore ROE must be greater than ROA 12.7 % 5.7 %

IMP : TO FIND ROE MULTIPLY THE RATE OF RETURN

ON ASSETS BY EQUITY MULTIPLIER.

EQUITY MULTIPLIER = TA / COMN EQUITY

Company that use high amount of debt financing ( a lot

of leverage ) will necessarily have HIGH EQUITY

MULTIPLIER.

MORE DEBT LESS EQUITY HENCE HIGER EMExample

ASSETS = LIABILITIES O/E EM

Co A 1000 800 200 5

Co B 1000 200 800 1.25

OUR COMPANYS ROE

ROE = ROA X EM = NI/TA X TA/CE

=5.7 % X 2000/896=5.7% X 2.23

R O E = 12.7%

WE CAN ALSO SAY EXTENDED DUPONT EQUATION IS

ROE = PROFIT MARGIN X TTL ASST TURNOVER X E M = NI/SALES X SALES / ASSETS X ASSETS / EQTY

= 3.8% X 1.5 X 2.23 = 12.7 %

THE ROE IE 12 . 7 % COULD OF COURSE BE CALCULATED DIRECTLY. BOTH SALES AND TOTAL ASSETS CANCELS AND LEAVE

NI / COMMON EQUITY = 113 / 896 = 12.7 %

HOWEVER DU PONT MODEL SHOWS HOW PROFIT MARGIN , ASSET TURN OVER AND DEBT INTERACT TO DETERMINE THE RETURN ON EQUITYEG: HOLDING OTHER THINGS EQUAL IF OUR CO

CANDRIVE UP ITS RATIO OF SALES / TOTAL ASSETS=

1.8THEN ROE WILL IMPROVE 3.8 % X 1.8 X 2.23 =15.2 % ------- WHAT IF ANALYSIS ------

Predicting business failure

The analysis of financial ratios is largely concerned with the efficiency and effectiveness of use of resources by a company’s management, and also with the financial stability of the company. Investors will like to know:

Whether additional funds could be lent to the company with reasonable safety.Whether the company would fail without additional funds.

One method of predicting business failure is the use of liquidity ratios ( The current and quick ratios eg if Current ratio < 2:1).Research indicates that Current ratio and trends in other ratios are some time poor indicators of business failure.

Altman Z score Model – predictor of business failure

E I Altman researched into the simultaneous analysis ofseveral financial ratios as a combined predictor of business failure. He analyzed 22 accounting and non accounting variables for a selection of failed and non failed US Companies. He arrived at 5 key indicators. The companies with a Z score above certain level would be predicted financially sound, and Companies with Z score below certain level would be categorized as probable failure. Altman also identified a range of Z scores in between the non failure and failure categories in which eventual failure or non failure was uncertain.

Altman Z score derived in 1968

Z = 1.2 X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

Where X1 = Working Capital / total AssetsX2 = retained earnings / total AssetsX3 = earning before interest and tax / total

AssestsX4 = market value of equity / book value of debtX5 = Sales / Total Assets.

In Altman’s model a Z score of 2.7 or more indicated

Non failure and a Z score of 1.8 or less indicated failure.

USES AND LIMITATION OF RATIOS

RATIOS USED BY 3 MAIN GROUPS:1 MANAGEMENT FOR ANALYSING &

CONTROLING COMPANY’S OPERATIONS.2 CREDIT ANALYSTS FOR TO ASSES SOLVENCY 3 STOCK ANALYSTS WHO ARE INTERESTED IN

CO’S EFFICIENCY, RISK AND GROWTH PROSPECTS.

LIMITATIONS

DIFFICULTIES IN DEVELOPING MEANINGFUL SET OF INDUSTRY AVERAGE ESPECIALLY FOR LARGE COMPANIES HAVING DIFFERENT DIVISIONS OPERATING IN DIFFERENT INDUSTRIES.COMPANY’S PERFORMANCE SHOULD BE BETTER THAN INDUSTRY AVERAGE MERE ATTAINING THE AVERAGE IS NOT NECESSARILY GOODINFLATION BADLY DISTORT BALANCE SHEET FIGSSEASONAL FACTORS ALSO DISTORT RATIOSCOMPANIES USE WINDOW DRESSING TECHNIQUES WHICH DISTORT FIGURESDIFFERENT ACCOUNTING PRACTICES CAN DISTORT COMPARISONDIFFICULT TO GENERALISE WHETHER A RATIO IS GOOD OR BAD ( LIQUIDITY RATIOS ) RATIOS DEPENDS UPON FINANCIAL STATEMENT ACCURACY

LOOKING BEYOND NUMBERS

SOUND FINANCIAL ANALYSIS INVOLVES MORE THAN NUMBERS. ---- QUALITATIVE FACTORS

ARE THE COMPANY’S REVENUE TIED UP TO ON KEYCUSTOMER ?TO WHAT EXTENT ARE THE COMPANY’S REVENUE TIED UP TO ONE KEY PRODUCT.TO WHAT EXTENT DOES THE CO RELY ON A SINGLE SUPPLIERWHAT PERCENTAGE OF BUSINESS IS GENERATED OVERSEASCOMPETITION LEVELFUTURE PROSPECTSLEGAL AND REGULATORY ENVIRONMENT ETC