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Page 1: FINANCIAL REPORTING AND ANALYSIS Financial Analysis Techniques 28... ·  1 Financial Analysis Techniques Reading - 28 FINANCIAL REPORTING AND ANALYSIS

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Financial Analysis Techniques

Reading - 28

FINANCIAL REPORTING AND ANALYSIS

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Activity Ratios

Activity ratios are also known as asset utilization ratios and they measure how efficiently a company performs day to day tasks such as collection of receivables and management of inventory. Various activity ratios are :-

a. Inventory turnover ratio : It is a measure of a firms effective inventory management . Higher the ratio, shorter the period that inventory is held.

b. Days of inventory on hand (DOH) : It is the average inventory processing period or the number of days of inventory on hand.

Cost of goods sold

Average InventoryInventory turnover ratio =

Number of days in period

Inventory TurnoverDays of inventory on hand =

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Activity Ratios…

c. Payable turnover ratio : It is the measure of company making use of available credit facilities.

d. Number of days of payables : It is the average number of days the company takes to pay its suppliers .

e. Total Asset turnover ratio : It measures the company’s overall ability to generate revenue with a given level of assets.

purchases

average rade payablesPayables turn over =

365

payable turnover ratioNumber of days of payables =

revenue

average total assetsTotal asset turnover =

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Activity Ratios…

f. Fixed asset turnover : It indicates the company’s use of fixed assets in generating revenue.

g. Working capital turnover ratio : It indicates the company’s efficient use of working capital in generating revenue .

revenue

average net fixed assetsFixed asset turnover =

revenue

average working capitalWorking capital turnover =

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Liquidity Ratios

Liquidity ratios measure the company’s ability to meet its short term cash requirements. Various liquidity ratios are :

a. Current ratio : It is the ratio of current assets to current liabilities.

Working capital equals current assets minus current liabilities.

b. Quick ratio (Acid test ratio) is the ratio of quick assets to current liabilities where quick assets are those assets which can be readily converted to cash.

Current Asset

Current LiabilitiesCurrent Ratio =

cash + short term marketable securities + receivables

current liabilitesQuick Ratio =

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Liquidity Ratios…

c. The Cash conversion cycle or net operating cycle is a measure of the time it takes to turn the firm’s cash investment from paying suppliers for materials to collecting cash from sales of inventory.

A conversion cycle that is too high shows that the company has its excess amount invested as working capital.

d. Defensive interval ratio : It indicates the number of days the company can pay its expenditures with its existing liquid assets .

Number of Number of Number of

days of inventory days of receivables days of payablesNet operating cycle = + -

cash + short term marketable investments + receivables

daily cash expenditures=Defensive interval ratio

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Solvency Ratios

a. Debt-to-assets ratio: This ratio measures the percentage of total assets financed with debt, thus a higher ratio means a weaker solvency.

b. Debt-to-capital ratio : This ratio measures the percentage of a company’s capital (debt plus equity) represented by debt.

c. Debt-to-equity ratio : This ratio measures the amount of debt capital relative to equity capital.

total debt

total assetsDebt to Assets =

total debt

total debt + total shareholders equityDebt-to-capital =

total debt

total shareholders equityDebt-to-equity ratio =

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Solvency Ratios…

d. Financial leverage ratio: This ratio is defined in terms of average of total assets and average total equity. It is also known as leverage ratio.

e. Interest coverage ratio : This ratio determines the firms ability to repay its debt obligations.

f. Fixed charge coverage ratio : This ratio measures the number of times a company’s earnings can cover the company’s interest and lease payments.

average total assets

average total equityFinancial leverage =

EBIT

interst paymentsInterest coverage =

EBIT + lease payments

interest payments + lease paymentsFixed charge coverage =

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Profitability Ratios

Profitability ratios measure the company’s ability to generate profitable sales from its assets. Various ratios are :

a. Gross profit margin : It indicates the available revenue to cover up

the operating expenditures.

b. Operating profit margin : It is the ratio of operating profit to

revenue or sales.

c. Pretax margin : Pretax income is calculated as operating profit minus interest.

gross profit

revenueGross profit margin =

operating income

revenueOperating profit margin =

EBT

revenuePretax margin =

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Profitability Ratios…

d. Net profit margin: It is a ratio of net income to revenue. It is revenue minus all expenses.

e. Return on assets : It measures the return earned by a company on its assets.

f. Operating return on assets : It measures the return on all assets invested in the company financed with liabilities debt or equity.

net income

revenueNet profit margin =

net income

average total assetsReturn on assets(ROA) =

EBIT

average total assetsOperating return on assets =

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Profitability Ratios…

g. Return on total capital : It measures the profits a company earns on all the capital that it employs be it short term or long term debt.

h. Return on equity (ROE) : It is the ratio of net income to average total equity (including preferred stock).

EBIT

average total capitalReturn on total capital =

net income

average total equityReturn on Equity =

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Valuation Ratios

a. Price to Earnings (P / E) ratio : This ratio expresses the relationship between price per share and the earnings per share. It is expressed as

b. Price to cash flow ratio :

c. Price to sales ratio : It is used as a comparative price metric when a company does not have positive net income.

price per share

earnings per shareP/E =

price per share

cash flow per shareP / CF =

price per share

sales pershareP / S =

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Valuation Ratios…

d. Price to book value ratio : It is a ratio of price per share to book value per share and it indicates the relationship between a company’s required rate of return and its actual rate of return.

price per share

book value per shareP / BV =

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DuPont Expression

• DuPont analysis is a tool used by analysts to make inferences about a company’s performance and target the areas of concern.

• The break down of return on assets into a two component model is simplest form of the DuPont approach.

Return on assets

Net profit margin

Total asset turnover

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DuPont Expression . .

• Return on assets ratio is net income divided by the average of total assets of the company and it is extended into two components as shown :

Net income Net income Revenue

Average total assets Revenue Average total assetsReturn on Assets = = *

*=Return on Assets Net Profit margin Total asset turnover

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DuPont Expression . .

• The return on shareholders equity can be represented as a three-component DuPont model as shown :

Net income Net income Revenues Average total assets

Average shareholders equity Revenues Average total assets Average shareholders equity

* financial leverage

Return on Equity = = * *

ROE = Net Profit Mragin * Total asset turnover

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DuPont Expression . .

• The extended DuPont expression which is a 5- part decomposition of ROE has the effect of non operating income items as one of the components as shown :

operating income income before taxes taxes revenues average total assets

revenues operating income income before taxes average total assets average shareholders equity* *( )ROE = * * 1 -

Tax effect * Total asset turnover * Financial leverageROE = Operating profit margin * Effect of nonoperating items *

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Dividend related Quantities

• It measures the percentage of earnings that the company pays out as dividends to shareholders.

Dividend payout

ratio

• It is the percentage of earnings that a company retains.

• It is complement of the payout ratio (1- payout ratio).

Retention ratio

• The company’s growth rate is a function of its profitability and its ability to finance itself without external equity issues .

• Here growth rate g = RR* ROE

Sustainable growth rate