chapter 6 financial statement analysis
DESCRIPTION
Chapter 6 Financial Statement AnalysisTRANSCRIPT
Chapter 6
FINANCIAL STATEMENT ANALYSIS
The Information Maze
Outline
• Financial statements
• Generally accepted accounting principles
• Financial ratios
• Standardised financial statements
• Applications of financial statement analysis
• Using financial statement analysis
• Going beyond the numbers
Important QuestionsManagers, shareholders, creditors and other interested groups seek answers to the following important questions about a firm:
• What is the financial position of the firm at a given point of time?
• How has the firm performed financially over a given period of time?
• What have been the sources and uses of cash over a period of time?
The accountant prepares the balance sheet, the profit and loss account, and the statement of cash flows to answer the above questions.
EQUITY AND LIABILITIES 20X1 20X0
Shareholders’ Funds • Share capital (Par value Rs.10)• Reserves and surplus
500100400
450100350
Non-current Liabilities Long-term borrowings Deferred tax liabilities (net) Long-term provisions
3002005050
2701804545
Current Liabilities Short-term borrowings @
Trade payables Other current liabilities Short-term provisions
20040
1203010
18030
1103010
1,000 900ASSETS Non-current Assets Fixed assets Non-current investments Long-term loans and advances
6005005050
5504504060
Current Assets Current investments Inventories Trade receivables Cash and cash equivalents Short-term loans and advances
40020
1601406020
35020
1401205020
1000 900
Balance Sheet of Horizon Limited as at March 31, 20X1 RS. in million
Equity and Liabilities
• Shareholder’s Funds
• Share capital
• Reserves and surplus
•Non-current Liabilities
• Long-term Borrowings
• Deferred tax liabilities (net)
• Long-term provisions
• Current Liabilities
• Short-term borrowings
• Trade payables
• Other current liabilities
• Short-term provisions
Assets
• Non-current Assets
• Fixed assets
• Non-current investments
• Long-term loans and advances
• Current Assets
• Current investments
• Inventories
• Trade receivables
• Cash and cash equivalents
• Short-term loans and advances
Divergence Between Accounting Values and Economic Values
• Use of the Historical Cost Principle
• Exclusion of Intangible Assets
• Understatement or Omission of Certain Liabilities
Statement of Profit and LossRs. in million
Current Period Previous Period
• Revenues from Operations 1290 1172• Other Income 10 8• Total Revenues 1300 1180• Expenses
• Material expenses 600 560 • Employee benefit expenses 200 180• Finance costs 30 25• Depreciation and amortisation expenses 50 45• Other expenses 240 210•Total expenses 1120 1020•Profit before Exceptional and Extraordinary Items and Tax 180 160•Exceptional items - -•Profit before Extraordinary Items and Tax 180 160•Extraordinary items - -•Profit Before Tax 180 160•Tax Expense 50 40•Profit (Loss) for the Period 130 120•Earnings Per Equity Share• Basic 13• Diluted 13
Basic and diluted earnings per share
To calculate the basic earnings per share, the net profit or loss for
the period attributable to equity shareholders is divided by the weighted
average number of equity shares during the period.
To calculate the diluted earnings per share, the net profit or loss
for the period attributable to equity shareholders and the weighted
average number of shares outstanding during the period should be
adjusted for the potential dilution arising from conversion of debt into
equity, exercise of warrants and stock options, and so on.
Convertible Debentures
To illustrate how diluted EPS is calculated, when a company has outstanding convertible debentures let us consider an example. Magnum Company has 10 million equity shares of Rs. 10 each and 200,000 convertible debentures of Rs. 100 each carrying a coupon rate of 8 percent. Each convertible debenture is convertible into 4 equity shares. Magnum’s profit after tax for the year ended March 31, 20X5, was Rs. 25 million and its tax rate is 30 percent.
The basic earnings per share is:
Basic earnings per share =
Rs. 25,000,000
= Rs. 2.50Rs.
10,000,000
The diluted earnings per share is calculated as follows:
Number of existing equity shares 10,000,000
Equivalent number of equity shares corresponding to convertible debentures
800,000
Number of equity shares for calculating the diluted earnings per share 10,800,000
Profit after tax Rs. 25,000,000
Add: After-tax debenture interest
200,000 x 100 x .08 x 0.701,120,000
Adjusted profit after tax 26,120,000
Diluted earnings per share
26,120,000 / 10,800,000Rs. 2.42
Stock Options To illustrate how the diluted earnings per share is calculated when a company has issued stock options, assume that the Magnum Company does not have convertible debentures but has issued stock options for 1 million shares which are exercisable at a price of Rs. 24. The fair value of an equity share is Rs. 30.
The excess of fair value (Rs. 30) over the exercise price (Rs. 24) is translated into an equivalent number of equity shares for calculating the diluted earnings per share. The calculation of the diluted earnings per share is shown below:
Number of existing equity shares 10,000,000
Number of equity shares under stock option
1,000,000
Number of equity shares that would have been issued at fair value: 1,000,000 x 24/30
800,000
Dilution impact in terms of equivalent number of shares
200,000
Number of equity shares for calculating the diluted earnings per share
10,200,000
Diluted earnings per share : Rs. 25,000,000 / 10,200,000
Rs. 2.45
Accounting Income versus Economic Income
Accounting income may diverge from economic income due to the
following reasons.
• Use of the accrual principle
• Omission of changes in value
• Depreciation
• Treatment of R&D and advertising expenditures
• Inflation
• Creative accounting
Statement of Cash Flow
Sources of Cash
• Increase in liabilities and owners’ equity
• Decrease in assets (other than cash)
Uses of Cash
• Decrease in liabilities and owners’ equity
• Increase in assets (other than cash)
Changes in Balance Sheet Items
Rs. in million
Equity and Liabilities March 31 March 31 20 x 1 20 x 0 Increase Decrease Shareholders’ Funds Share capital Reserves and surplus
500100400
450100350
-50
---
Non-current Liabilities Long-term borrowings Deferred tax liabilities (net) Long-term provisions
3002005050
2701804545
2055
-
Current Liabilities Short-term borrowings Trade payables Other current liabilities Short-term provisions
20040
1203010
18030
1103010
1010--
1,000 900
Assets Non-current Assets Fixed assets Non-current investments Long-term loans and
advances
6005005050
5504504060
5010
Current Assets Current investments Inventories Trade receivables Cash and cash equivalents Short-term loans and
advances
40020
1601406020
35020
1401205020
-202010-
1000 900
10
Using the above framework we can summarize the sources and uses of cash from the balance sheet data as follows:
Sources Uses
Increase in reserves and surplus 50 Increase in fixed assets (net) 50
Increase in long-term borrowings 20 Increase in non-current investments
10
Increase in deferred tax liabilities 5 Increase in inventories 20
Increase in long-term provisions 5 Increase in trade receivables 20
Increase in short-term borrowings 10Increase in trade payables 10Decrease in long-term loans and advances 10Total sources 110 Total uses 100
Net addition to cash 10
Sources Uses
Net profit 130 Dividend payment 80
Depreciation and amortisation 50 Purchase of fixed assets 100
Increase in long-term borrowings 20 Increase in non-current investments
10
Increase in deferred-tax liabilities 5 Increase in inventories 20
Increase in long-term provisions 5 Increase in trade receivables 20
Increase in short-term borrowings 10
Increase in trade payables 10
Decrease in long-term loans and
advances
10
Total sources 240 Total uses 230
Net addition to cash 10
Cash inflows from operations
Cash inflows from investing
activities
Cash inflows from financing
activities
Cash outflows from investing
activities
Cash flow from investing
activities
Cash outflows from financing
activities
Cash flow from financing
activities
Operating
Investing
Financing
–
–
=
=
=
+ –
+ –
=
–
Cash outflows from operations
Cash flow from operations
Net cash flow for the period
Statement Of Cash Flow
Sources Uses
• Financing Capital Capital
• Operating Res. & Surplus Res. & Surplus
• Financing Loans Loans
• Operating Current Liabilities Current Liabilities & Provisions & Provisions
• Investment Fixed Assets Fixed Assets
• Investment Investments Investments
• Operating Inventories Inventories
• Operating Debtors a Debtors
A. CASH FLOW FROM OPERATING ACTIVITES
PROFIT BEFORE TAX 180
Adjustments for : Depreciation and amortisationFinance costsInterest income
5030
(10)
OPERATING PROFIT BEFORE WORKING CAPITAL CHANGES 250
Adjustments for changes in working capital :Trade receivables and short-term loan and advancesInventoriesTrade payables, short-term provisions, and other current liabilities
(20)(20)10
CASH GENERATED FROM OPERATIONS 220 Direct taxes paid (50)
NET CASH FROM OPERATING ACTIVITIES 170
B. CASH FLOW FFROM INVESTING ACTIVITIES Purchase of fixed assets Increase of non-current investments Reduction in long-term loans and advances Interest income
(100)(10)1010
NET CASH USED IN INVESTING ACTIVITIES (90)
C. CASH FLOW FROM FINANCING ACTIVITIES Increase in long term borrowings Increase in short-term borrowings Increase in deferred tax liabilities Increase in long-term provisions Dividend paid Finance costs
201055
(80)(30)
NET CASH FROM FINANCING ACTIVITIES NET CASH GENERATED (A+B+C)
(70) 10
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 70
CASH AND CASH EQUIVALENTS AT THE END OF PERIOD 80
Cash Flow Statement
Stand – Alone and Consolidated Financial Statements
Clause 32 of the listing agreement with the stock exchange(s) requires a company to provide consolidated financial statements in addition to the stand-alone financial statements. The consolidated financial statements are prepared by consolidating the accounts of the parent company with those of its subsidiaries in accordance with generally accepted accounting principles and in consonance with Accounting Standard 21 entitled “Consolidated Financial Statements”, issued by the Institute of Chartered Accountants of India.
The consolidation of the financial statements has to be done on a line by line basis by adding together like items of assets, liabilities, income, and expenses after eliminating intra-group balances/transactions and resulting unrealised profits/losses in full. The amount shown in respect of reserves comprise the amount of the relevant reserves as per the balance sheet of the parent company and its share in the post-acquisition increase in the relevant reserves of the consolidated entities.
The consolidated financial statements are prepared using uniform accounting policies for like transactions and other events in similar circumstances. The consolidated financial statements are presented, to the extent possible, in the same format as that adopted by the parent company for its stand-alone financial statements.
Alternative Measures of Cash Flow
As an analyst, you can use the following measures of cash flow to
determine the financial health of a company.
• Cash flow from operations
• Free cash flow
Cash Flow from Operations
When we looked at the profit and loss account, the emphasis was on profit after tax (also called the bottom line). In finance, however, the focus is on cash flow.
A firm’s cash flow generally differs from its profit after tax because some of the revenues/expenses shown on its profit and loss account may not have been received/ paid in cash during the year. The relationship between net cash flow and profit after tax is as follows:
Net cash flow = Profit after tax – Non cash revenues + Non cash expenses
An example of non cash revenue is accrued interest income that has not yet been received. It increases the bottom line but is not matched by a cash inflow during the accounting period – the cash inflow would occur in a subsequent period. An example of a noncash expense is depreciation.In practice, analysts define the net cash flow as:
Net cash flow = Profit after tax + Depreciation + Amortisation
Free Cash Flow
The cash flow from operations does not recognise that the firm has to make
investments in fixed capital and net working capital for sustaining
operations. So, a measure called free cash flow is considered.
The free cash flow is the post-tax cash flow generated from the
operations of the firm after providing for investments in fixed capital and
net working capital required for the operations of the firm. It is the cash
flow available for distribution to shareholders (by way of dividend and
share buyback) and lenders (by way of interest and debt repayment.)
Accounting Standards
• Globally, the US GAAP and IFRS dominate.
• Accounting Standards (AS) in India are notified by the central government
Initiatives taken by International Organisation of Securities
Commission(IOSCO) towards promoting International Accounting
Standards (IAS) and International Financial Reporting Standards
(IFRS) issued by the International Accounting Standards Board
(IASB) have created a momentum for harmonising Indian
Accounting Standards with IFRS.
Indian GAAP
In India, Accounting Standards (AS) are notified by the central government in exercise of powers under Section 211 (3C) of the Companies Act, 1956. The central government notifies AS on the recommendations of the National Advisory Committee of Accounting Standards (NACAS) constituted under Section 210 A of the Companies Act, 1956. Before the establishment of NACAS, the Accounting Standards Board (ASB) of the Institute of Chartered Accountants of India used to issue AS for its members to follow.
In a bid to align Indian GAAP with IFRS, in February 2011, the MCA notified Indian Accounting Standards (Ind AS) converged with IFRS. The effective date of Ind AS, which was previously announced to be April 1, 2011, has been deferred. The MCA is yet to announce notify the revised effective date.
Though very similar to the IFRS, the Ind AS have some carve outs meant to tailor these standards to the needs of the Indian environment
Global Situation
The Financial Accounting Standards Board (FASB), a non-governmental body, issues accounting standards that form the US GAAP. The FASB standards are supported by the Securities Exchange Commission in the US.
The International Accounting Standards Board (IASB) is an independent, privately funded body having members from nine countries with varied functional backgrounds. It is based in London. Committed to developing a single set of high-quality, global accounting standards, the IASB publishes its standards in the form of pronouncements called “International Financial Reporting Standards” (IFRS). IASB has also adopted the standards issued by the Board of the International Accounting Committee, which continue to be called “International Accounting standards.”
IFRS and the US GAAP
The key differences between IFRS (formulated by the International Accounting Standards Board or IASB) and the US GAAP (formulated by the Financial Accounting Standards Board or FASB) are as follows:
• IFRS is a more principle-based accounting system whereas the US GAAP is a more rule-based accounting system
• IFRS permits a company to revalue its fixed assets like land and buildings whereas the US GAAP does not.
• IFRS allows a company to amortise certain expenses like R & D expenses over several years, whereas the US GAAP does not
• IFRS has a less elaborate format for the accounting of derivatives whereas the US GAAP requires a detailed mention of various kinds of exposures and liabilities arising from derivative contracts.
• IFRS permits separate accounting in unusual circumstances such as a hyperinflationary situation whereas the US GAAP does not.
Key Trends in Accounting Standards
While presently there are substantial differences between accounting standards in different countries, accounting bodies have been working to evolve common standards. Here are some pointers:
• On January 1, 2005, Europe’s 7000 listed companies adopted International Financial Reporting Standards (IFRS), replacing 25 different local accounting regimes with one set of rules.
• IFRS formulated by the International Accounting Standards Board (IASB) has been growing in popularity. It has been adopted or will be adopted by nearly 100 countries. India too is moving in the direction of IFRS.
In June2007,SEC decided to allow foreign companies listed in the US to issue their financial reports using the English version of IFRS.
Financial Ratios
A ratio is an arithmetical relationship between two figures.
Financial ratio analysis is a study of ratios between various items or groups
of items in financial statements. Financial ratios have been classified in
several ways. For our purposes, we divide them into five broad categories
as follows:
• Liquidity ratios
• Leverage ratios
• Turnover ratios
• Profitability ratios
• Valuation ratios
Liquidity Ratios
Liquidity refers to the ability of a firm to meet its obligations in the
short run, usually one year. Liquidity ratios are generally based on
the relationship between current assets (the sources for meeting
short-term obligations) and current liabilities. The important
liquidity ratios are: current ratio, acid-test ratio, and cash ratio.
Current Ratio
A very popular ratio, the current ratio is defined as:
Current assets
Current liabilities
Current assets include cash, current investments, debtors,
inventories (stocks), loans and advances, and pre-paid expenses.
Current liabilities represent liabilities that are expected to mature in
the next twelve months. These comprise (i) loans, secured or
unsecured, that are due in the next twelve months and (ii) current
liabilities and provisions.
Horizon Limited’s current ratio for 20X1 is 400/200 = 2.00
Acid-test Ratio
Also called the quick ratio, the acid-test ratio is defined as:
Quick assets
Current liabilities
Quick assets are defined as current assets excluding inventories.
Horizon's acid-test ratio for 20X1 is: (400- 160)/200 = 1.20
Cash Ratio
Because cash and bank balances and short term marketable
securities are the most liquid assets of a firm, financial analysts look
at cash ratio, which is defined as:
Cash and bank balances + Current investments
Cash ratio =
Current liabilities
Horizon Limited’s cash ratio for 20X1 is: (60 + 20)/200 = 0.40
Leverage Ratios
• Financial leverage refers to the use of debt finance.
•There are two types of ratios commonly employed to analyse
financial leverage: structural ratios and coverage ratios.
•Structural ratios
• Debt-equity ratio
• Debt-assets ratio
• Coverage ratios
• Interest coverage ratio
• Fixed charges coverage ratio
• Debt service coverage ratio
Debt-equity Ratio
The debt-equity ratio shows the relative contributions of creditors
and owners. It is defined as:
Total liabilities (Debt)
Shareholder’s funds (equity)
The numerator of this ratio consists of all liabilities, non-
current and the denominator consists of share capital and reserves
and surplus.
Horizon’s debt-equity ratio for the 20X1 year-end is:
(300+200)/500=1.0
Debt-asset Ratio The debt-asset ratio measures the extent to which liabilities support the firm's assets. It is defined as:
Total liabilities (Debt)
Total assets
The numerator of this ratio includes all liabilities (non-current and current) and the denominator of this ratio is the total of all assets (the balance sheet total).
Horizon's debt-asset ratio for 20X1 is: 500 / 1000 = 0.5
This ratio is related to the debt-equity ratio as follows:
Debt Debt/Equity=
Assets 1 + Debt/Equity
Interest Coverage Ratio
Also called the times interest earned, the interest coverage ratio is
defined as:
Profit before interest and taxes
Interest
Horizon's interest coverage ratio for 20X1 is: 210 / 30 = 7.0
Fixed Charges Coverage Ratio
This ratio shows how many times the cash flow before interest and taxes covers all fixed financing charges. It is defined as:
Profit before interest and taxes + Depreciation and amortisation Repayment of loan
Interest + 1 - Tax rate
In the denominator of this ratio the repayment of loan alone is adjusted upwards for the tax factor because the loan repayment amount, unlike interest, is not tax deductible. Horizon’s tax rate has been assumed to be 30 percent.Horizon's fixed charges coverage ratio for 20X1 is: 210 + 50
= 2.5630+ 50
(1-0.3)
Debt Service Coverage Ratio
Used by financial institutions in India, the debt service coverage
ratio is defined as:
Profit after tax + Depreciation + Other non-cash charges + Interest on term loan + Lease rentals
Interest on term loan + Lease rentals + Repayment of term loan
Financial institutions calculate the average debt service coverage
ratio for the period during which the term loan for the project is
repayable. Normally, financial institutions regard a debt service
coverage ratio of 1.5 to 2.0 as satisfactory.
Turnover Ratios
Turnover ratios, also referred to as activity ratios or asset
management ratios, measure how efficiently the assets are employed
by a firm. These ratios are based on the relationship between the
level of activity, represented by revenues or cost of goods sold, and
levels of various assets. The important turnover ratios are: inventory
turnover, average collection period, receivables turnover, fixed
assets turnover, and total assets turnover.
Inventory Turnover
The inventory turnover, or stock turnover, measures how fast the
inventory is moving through the firm and generating sales. It is
defined as:
Revenues from operations
Average inventory
Horizon’s inventory turnover for 20X1 is:
1290
= 8.6
(160 + 140) / 2
Debtors' Turnover
This ratio shows how many times sundry debtors trade receivables
turn over during the year. It is defined as:
Net credit sales
Average trade receivables
If the figure for net credit sales is not available, one may have to
make do with the revenues from operations.
Horizon's debtors’ turnover for 20X1 is:
1290 ÷ [(140+120)/2] = 9.92
Obviously, the higher the debtors’ turnover the greater the
efficiency of credit management.
Average Collection Period
The average collection period represents the number of days' worth of credit sales that is locked in trade receivables. It is defined as:
Average trade receivablesAverage daily credit sales
If the figure for credit sales is not available, one may have to make do with the revenue from operations.Horizon's average collection period for 20X1 is:
[(140 + 120) / 2] (1290 / 365) = 36.8 days Note that the average collection period and the debtors’ turnover are related as follows:
365 Average collection period =
Debtors’ turnover
Fixed Assets Turnover
This ratio measures sales per rupee of investment in fixed assets. It is
defined as:
Revenues from operations
Average net fixed assets
Horizon's fixed assets turnover ratio for 20X1 is:
1290 ÷ [(500+450)/2] = 2.72
Total Assets Turnover
Akin to the output-capital ratio in economic analysis, the total assets
turnover is defined as:
Total revenues
Average total assets
Horizon's total assets turnover ratio for 20X1 is:
1300 ÷ [(1000+900)/2] = 1.37
This ratio measures how efficiently assets are employed, overall.
Profitability Ratios
Profitability ratios reflect the final result of business operations.
• There are two types of profitability ratios• Profit margin ratio• Rate of return ratios
•Profit margin ratios• Gross profit margin ratio• Net profit margin ratio
• Rate of return ratios• Return on assets• Earning power• Return on capital employed• Return on equity
Gross Profit Margin Ratio
The gross profit margin ratio is defined as:
Gross profit
Revenues from operations
Gross profit is defined as the difference between revenues from
operations and cost of goods sold. Cost of goods sold is the sum of
manufacturing costs relating to the operating revenues of the period.
Manufacturing costs include material costs, employee benefit costs
for manufacturing personnel, and manufacturing expenses.
Net Profit Margin Ratio
The net profit margin ratio is defined as: Net profit
Total revenues
Horizon's net profit margin ratio for 20X1 is:130 / 1300 = 0.10 or 10 percent
This ratio shows the earnings left for shareholders (both equity and preference) as a percentage of total revenues. It measures the overall efficiency of production, administration, selling, financing, pricing, treasury, and tax management. Jointly considered, the gross and net profit margin ratios provide a valuable understanding of the cost and profit structure of the firm and enable the analyst to identify the sources of business efficiency/inefficiency.
Return on Assets
The return on assets (ROA) is defined as:
Profit after tax
ROA =
Average total assets
Horizon’s ROA for the year 20X1 is:
130 [(1000 + 900) / 2] = 13.7 percent
Earning Power
The earning power is defined as:
Profit before interest and tax
Earning power =
Average total assets
Horizon’s earning power for the year 20X1 is:
210 [(1000 + 900) / 2] = 22.1 percent
Return on Capital Employed
The return on capital employed is defined as:
Profit before interest and tax (1 – Tax rate)
ROCE =
Average total assets
The numerator of this ratio viz., profit before interest and tax (1-tax
rate) is also called net operating profit after tax (NOPAT).
Horizon’s ROCE for the year 20X1 is:
210 (1 – 0.3) [(1000 + 900 ) / 2 ] = 15.5 percent
Return on Equity
A measure of great interest to equity shareholders, the return on equity is defined as:
Equity earnings Average equity
The numerator of this ratio is equal to profit after tax less
preference dividends. The denominator includes all contributions made by shareholders (paid-up capital + reserves and surplus). This ratio is also called the return on net worth or return on shareholders’ funds. For our purpose equity, net worth, and shareholders’ funds are synonymous.
Horizon's return on equity for 20X1 is:
130 ÷ [(500 + 450) / 2] = 27.4 per cent
Valuation Ratios
Valuation ratios indicate how the equity stock of the company is
assessed in the capital market. Since the market value of equity
reflects the combined influence of risk and return, valuation ratios
are the most comprehensive measures of a firm's performance. The
important valuation ratios are: price-earnings ratio, yield, and
market value to book value ratio.
Price-earnings Ratio
Perhaps the most popular financial statistic in stock market discussion, the price-earnings ratio is defined as:
Market price per share Earnings per share
The market price per share may be the price prevailing on a certain day or the average price over a period of time. The market price per share of Horizon as on 31st March 20 x 1 is Rs. 200. The earnings per share is simply: profit after tax less preference dividend divided by the number of outstanding equity shares.
Horizon' price-earnings ratio at the end of 20X1 is: 200 / 13 = 15.4
EV-EBITDA Ratio
A widely used multiple in company valuation, the EV-EBITDA ratio is defined as:
Enterprise value (EV)Earnings before interest, taxes, depreciation, and amortisation (EBITDA)
EV is the sum of the market value of equity and the market value of debt. The market value of equity is simply the number of outstanding equity shares times the price per share. As far as debt is concerned, its market value has to be imputed. Generally, a rupee of loan is deemed to have a rupee of market value.
Horizon's EV-EBITDA ratio for 20X1 is:10 x 200 + 500 2500 = = 9.62 260 260
Market Value to Book Value Ratio
Another popular stock market statistic, the market value to book
value is defined as:
Market value per share
Book value per share
Horizon's market value to book value ratio at the end of 20X1 was:
200 / 50 = 4.00
Q Ratio
Proposed by James Tobin, the q ratio is defined as:
Market value of equity and liabilities
Estimated replacement cost of assets
The q ratio resembles the market value to book value ratio.
However, there are two key differences: (i) The numerator of the q
ratio represents the market value of equity as well as debt, not just
equity. (ii) The denominator of the q ratio represents all assets.
Further these assets are reckoned at their replacement cost, not
book value.
Comparative Analysis
• Cross Section Analysis
• Time Series Analysis
Time Series of Certain Ratios
Time Series of Certain Financial Ratios
1 2 3 4 5Debt–equity ratio 1.3 1.2 1.0 0.9 1.0Total asset turn over ratio 1.34 1.41 1.35 1.39 1.37Net profit margin (%) 8.0 9.0 10.2 10.5 10.0Return on equity (%) 20.1 22.0 26.0 27.6 27.4Price-earning ratios 12.5 13.2 13.8 14.9 15.4
Return on Assets 13.7%
Net Profit margin 10%
Net Profit 130
Total Revenues 1300
Total Revenues
1300
Total Costs 1170
Total Assets Turnover 1.37
Total Revenues
1300
Average Total Assets
950
Average Non-current assets
575
Average Current Assets
375
Du Pont Chart Applied to Horizon Limited
+
x
÷
÷
-
Return on Equity
27.4 %
Return on Assets 13.7%
Average Total Assets to
Average Equity Ratio 2.0
Extension of Du Pont Chart
Common Size StatementsPart A: Profit and Loss Account
Regular(in million) Common Size(%)20x1 20X0 20X1 20X0
Total revenues Rs. 1300 Rs.1180 100 100
Total expenses other than finance cost 1090 995 84 84 PBIT 210 185 16
16Interest (Finance costs) 30 20 2 2PBT 180 160 14 14Tax 50 40 4 4 PAT 130 120 10 10
Part B: Balance Sheet
Regular(in million) Common Size(%)20x1 20X0 20X1 20X0
Shareholders’ funds 500 450 50 50Non-current liabilities 300 270 30 30Current liabilities 200 180 20 20Total 1000 900 100 100Non –current assets 600 550 60 61Current assets 400 350 40 39Total 1000 900 100 100
Common Base Year Financial StatementsPart A: Profit and Loss Account
Regular(in million) Common Size(%) 20x1 20X0 20X1 20X0
Total revenues Rs. 1300 Rs.1180 110 100
Total expenses other than finance cost 1090 995 110 100 PBIT 210 185 114
100Interest (Finance costs) 30 20 150 100PBT 180 160 113 100Tax 50 40 125 100 PAT 130 120 108 100
Part B: Balance Sheet
Regular(in million) Common Size(%)20x1 20X0 20X1 20X0
Shareholders’ funds 500 450 111 100Non-current liabilities 300 270 111 100Current liabilities 200 180 111 100Total 1000 900 111 100Non –current assets 600 550 109 100Current assets 400 350 114 100Total 1000 900 111 100
Applications Of Financial Analysis
Financial ratios may be employed to:
• Assess corporate excellence
• Judge creditworthiness
• Forecast bankruptcy
• Value equity shares
• Predict bond ratings
• Estimate market risk
Shortcomings of Financial Statements
• The Annual Reporting Requirements
• Inability of Management to Report Objectively on Itself
• Choice Between Flexibility and Consistency
Problems In Financial Statement Analysis
• Heuristic and Intuitive Character
• Development of Benchmarks
• Window Dressing
• Price Level Changes
• Variations in Accounting Policies
• Interpretation of Results
• Correlation among Ratios
Potential Red Flags
As an analyst, you should learn to identify potential red flags. Here is a list of common red flags.
• A qualified audit opinion.
• A change in accounting policy that is not satisfactorily
explained.
• An unusual increase in accruals.
•A widening gap between reported income and cash flow from
operations.
• Large adjustments in the fourth quarter.
• An abrupt change in external or internal auditor.
• An increase in transactions with related parties.
• An unusual increase in short-term financing or lending.
Guidelines
• Use ratio to get clues to ask the right questions
• Be selective in the choice of ratios
• Employ proper benchmarks
• Know the tricks used by accountants
• Read the foot notes
• Understand how the ratios are inter- Related
• Remember … fsa .. odd mixture of art & science
Looking Beyond the Numbers
1. Are the company’s revenues tied to one key customer ?
2. To what extent are the company’s revenues tied to one key product ?
3. To what extent does the company rely on a single supplier ?
4. What percentage of the company’s business is generated overseas ?
5. Competition
6. Future prospects
7. Legal and regulatory environment
Summing Up• Balance sheet, profit and loss account, and the statement of cash flows are the three financial statements
• The balance sheet shows the financial position at a given point of time, the profit and loss account reflects the
financial performance over a period of time, and the statement of cash flows displays the sources and uses of cash over a period of time.
• Financial statement analysis can provide valuable insights into a firm’s performance and position.
• The principal tool of financial statement analysis is financial ratio analysis.
• Financial ratios may be divided into five broad categories:• Liquidity ratios• Leverage ratios• Turnover ratios• Profitability ratios• Valuation ratios
• Generally, the financial ratios of a company are compared with some benchmark ratios.
• The Du Pont chart is a popular tool of financial analysis. It provides insights into the determinants of the return on equity
• There are certain problems and issues in financial statement analysis that call for care, circumspection, and judgment.