ratios and formulas financial analysis

8/2/2019 Ratios and Formulas Financial Analysis

1/17

Ratios and Formulas Financial Analysis

Financial statement analysis is a judgmental process. One of the primary objectives is

identification of major changes in trends, and relationships and the investigation of the

reasons underlying those changes. The judgment process can be improved by experience

and the use of analytical tools. Probably the most widely used financial analysis technique

is ratio analysis, the analysis of relationships between two or more line items on the

financial statement. Financial ratios are usually expressed in percentage or times.Generally, financial ratios are calculated for the purpose of evaluating aspects of a

company's operations and fall into the following categories:

liquidity ratios measure a firm's ability to meet its current obligations.

profitability ratios measure management's ability to control expenses and to earn a return

on the resources committed to the business.

leverage ratios measure the degree of protection of suppliers of long-term funds and can

also aid in judging a firm's ability to raise additional debt and its capacity to pay its

liabilities on time.

efficiency, activity or turnover ratios provide information about management's ability to

control expenses and to earn a return on the resources committed to the business.

A ratio can be computed from any pair of numbers. Given the large quantity of variables

included in financial statements, a very long list of meaningful ratios can be derived. Astandard list of ratios or standard computation of them does not exist. The following ratio

presentation includes ratios that are most often used when evaluating the credit worthiness

of a customer. Ratio analysis becomes a very personal or company driven procedure.

Analysts are drawn to and use the ones they are comfortable with and understand.

A. Analyzing Liquidity

Liquid assets are those that can be converted into cash quickly. The short-term liquidity

ratios show the firms ability to meet its short-term obligations. Thus a higher ratio (#1 and

#2) would indicate a greater liquidity and lower risk for short-term lenders. The Rules of

Thumb for acceptable values are: Current Ratio (2:1), Quick Ratio (1:1).

While high liquidity means that the company will not default on its short-term obligations,

one should keep in mind that by retaining assets as cash, valuable investment opportunities

may be lost. Obviously, cash by itself does not generate any return. Only if it is invested willwe get future return.

1. Current Ratio = Total Current Assets / Total Current Liabilities

2. Acid Test or Quick Ratio = (Total Current Assets - Inventories) / Total Current Liabilities

In the quick ratio, we subtract inventories from total current assets, since they are the least

liquid among the current assets.

Working Capital= Current Assets - Current Liabilities

Working capital compares current assets to current liabilities, and serves as the liquid

reserve available to satisfy contingencies and uncertainties. A high working capital balance

is mandated if the entity is unable to borrow on short notice. The ratio indicates the short-

term solvency of a business and in determining if a firm can pay its current liabilities when

due.

Cash Ratio= (Cash Equivalents + Marketable Securities) / Current LiabilitiesIndicates a conservative view of liquidity such as when a company has pledged its

receivables and its inventory, or the analyst suspects severe liquidity problems with

inventory and receivables.

Analyzing Sales and Profitability

Profitability is a relative term. It is hard to say what percentage of profits represents a

profitable firm, as profits depend on such factors as the position of the company and its

products on the competitive life cycle (for example profits will be lower in the initial years

when investment is high), on competitive conditions in the industry, and on borrowing


2/17

costs, expense management etc. Profits can also be analyzed using the framework of CVP

(cost-volume-prices). Analysts will be interested in the (historical and forecasted) trend

of sales/expenses/profits are the profits generally on the rise, are the sales stable or

rising, how do the profits compare to the industry average, is the market share of the

company rising/stable/falling? Are the expenses rising, stable or falling? The set of ratios

here include some of the traditional earnings based performance measures such as ROS,

ROA, ROI, and ROE. For a better understanding of growth rates, it will be useful to know thereal growth rate as opposed to nominal growth rate. For example, it is quite possible

that the sales growth rate figures are impressive due to inflation (rather than an increase in

the number of items sold). This is particularly useful if we are dealing with high inflation

period or conducting an extending time series analysis.

For decision-making, we are concerned only with the present value of expected future

profits. Past or current profits are important only as they help us to identify likely future

profits, by identifying historical and forecasted trends of profits and sales.

We want to know whether profits are generally on the rise; whether sales stable or rising;

how the profits compare to the industry average; whether the market share of the company

is rising, stable or falling; and other things that indicate the likely future profitability of the

firm.

1. Sales Growth Rate = {(Current year sales last year sales)/last year sales}*1002. Expense analysis = Various Expenses/Sales

3. Gross Margin/Sales = Gross Profit/Total Sales

4. Operating Profit/Sales= Operating Profit/Net Sales

5. Return on Sales (ROS) or Net Profit Margin = Profit after taxes/Sales

6. Return on Assets (ROA) = Profit after taxes/Total Assets

7. Return on Equity (ROE) = Profit after taxes/Shareholders Equity

8. Return on Investment (ROI) = Net Income/(Long-term Liabilities + Equity)

9. Earnings per Share (EPS) = (Profits after taxes - Preferred Dividend)/(No. of Equity

shares)

10. Payout Ratio = Cash Dividends/Net Income

11. EBIT/Sales = EBIT/Net Sales

12. Retention ratio = Retained Earnings/Net Income13. Sustainable growth rate (SGR) = ROE * Retention Ratio

It is useful to disaggregate the ROE figure into three elements as follows to get a better

insight

ROE (Du Pont Return on Assets) = {Net Income/Sales} * {Sales/Assets} * (Assets/Equity)

The above formulation clearly shows that if management wishes to improve their ROE, they

need to improve profitability, efficiently use the assets, and optimize the use of debt in their

capital structure. Thus two companies with similar profitability may have different ROEs

depending on their degree of financial leverage. If we combine this with ratio #10, we can

see that a firms growth rate will depend on all of these factors plus their divided policy.

Thus it covers the three main financial decisions in any corporation: investment decision,

operating decision and financing decision.

SGR shows how much the company will grow in the future if some of the key ratios remainthe same as in previous years. It is useful to disaggregate the sustainable growth rate as

follows.

SGR = (Profitability, Asset Efficiency, Leverage, Dividend policy)

= Return on Sales * Asset turnover ratio * Leverage * Retention ratio

= (Net income/sales) * (sales/assets) * (assets/equity) * (RE/net income)

Note: The terms profits, earnings and net income are often used interchangeably in

financial statements. Be sure to review the statements to understand their components.

Financial Leverage Ratio


3/17

Debt ratios show the extent to which a firm is relying on debt to finance its investments and

operations, and how well it can manage the debt obligation, i.e. repayment of principal and

periodic interest. If the company is unable to pay its debt, it will be forced into bankruptcy.

On the positive side, use of debt is beneficial as it provides tax benefits to the firm, and

allows it to exploit business opportunities and grow.

Note that total debt includes short-term debt (bank advances + the current portion of long-

term debt) and long-term debt (bonds, leases, notes payable).1. Asset-Equity Ratio or Leverage Ratio= Assets/Shareholders Equity

This shows firms reliance on external debt for financing (or the degree of leverage). Any

number above 100% shows that the company relies on external debt for financing some of

its assets. If the number equals 100%, it implies that the assets are fully financed by the

shareholders.

Some analysts tend to use the Debt ratio (given by total Debt/total assets) or Debt/Equity

ratio (given by total long-term debt/equity). These ratios also show companys reliance on

external sources for financing its assets. Ratio 1d shows what proportion of the total long-

term capital comes from debt.

2. Debt to Equity Ratio = Total Debt/Total Equity

This shows the firms degree of leverage, or its reliance on external debt for financing.

3. Debt to Assets Ratio = Total Debt/Total assets4. Long-term Debt to capital (Capitalization Ratio) = Debt/(Debt + Equity)

For a lender, more important than the degree of leverage is the firms ability to service the

debt and this is captured in the following two ratios.

Some analysts prefer to use this ratio, which also shows the companys reliance on external

sources for financing its assets.

In general, with either of the above ratios, the lower the ratio, the more conservative (and

probably safer) the company is. However, if a company is not using debt, it may be

foregoing investment and growth opportunities. This is a question that can be answered

only by further company and industry research.

A frequently cited rule of thumb for manufacturing and other non-financial industries is that

companies not finance more than 50% of their capital through external debt.

2. Interest Coverage (or Times Interest Earned) Ratio = Earnings Before Interest andTaxes/Annual Interest Expense

This shows the firms ability to cover fixed interest charges (on both short-term and long-

term debt) with current earnings. The margin of safety that is acceptable varies within and

across industries, and also depends on the earnings history of a firm (especially the

consistency of earnings from period to period and year to year).

3. Long-term Debt to Net Working Capital = Long-term Debt/(Current Assets - Current

Liabilities)

Provides insight into the ability to pay long term debt from current assets after paying

current liabilities.

4. Cash Flow Coverage = Net Cash Flow/Annual Interest Expense

Net cash flow = Net Income +/- non-cash items (e.g. -equity income + minority interest in

earnings of subsidiary + deferred income taxes + depreciation + depletion + amortizationexpenses)

Since depreciation is usually the largest non-cash item in most companies, analysts often

approximate Net cash flow as being equivalent to Net Income + Depreciation.

Cash flow is a critical variable in assessing a company. If a company is showing strong

profits but has poor cash flow, you should investigate further before passing a favorable

opinion on the company. Analysts prefer ratio #3 to ratio #2, although ratio #2 is more

widely reported.

Efficiency Ratios


4/17

Cash Turnover= Net Sales/Cash

Measures how effective a company is utilizing its cash.

Sales to Working Capital (Net Working Capital Turnover) = Net Sales/Average Working

Capital

Indicates the turnover in working capital per year. A low ratio indicates inefficiency, while a

high level implies that the company's working capital is working too hard.

Total Asset Turnover= Net Sales/Average Total AssetsMeasures the activity of the assets and the ability of the business to generate sales through

the use of the assets.

Fixed Asset Turnover= Net Sales/Net Fixed Assets

Measures the capacity utilization and the quality of fixed assets.

Days' Sales in Receivables= Gross Receivables/(Annual Net Sales / 365)

Indicates the average time in days, that receivables are outstanding (DSO). It helps

determine if a change in receivables is due to a change in sales, or to another factor such as

a change in selling terms. An analyst might compare the days' sales in receivables with the

company's credit terms as an indication of how efficiently the company manages its

receivables.

Accounts Receivable Turnover= Net Sales/Average Gross Receivables

Indicates the liquidity of the company's receivables.Accounts Receivable Turnover in Days= Average Gross Receivable/(Annual Net Sales/365)

Indicates the liquidity of the company's receivables in days.

Days' Sales in Inventory= Ending Inventory/(Cost of Goods Sold/365)

Indicates the length of time that it will take to use up the inventory through sales.

Inventory Turnover =Cost of Goods Sold/Average Inventory

Indicates the liquidity of the inventory

Inventory Turnover in Days= Average Inventory/(Cost of Goods Sold/365)

Indicates the liquidity of the inventory in days.

Operating Cycle= Accounts Receivable Turnover in Days + Inventory Turnover in Days

Indicates the time between the acquisition of inventory and the realization of cash from

sales of inventory. For most companies the operating cycle is less than one year, but in

some industries it is longer.Days' Payables Outstanding= Ending Accounts Payable/ (Purchases/365)

Indicates how the firm handles obligations of its suppliers.

Payables Turnover= Purchases/Average Accounts Payable

Indicates the liquidity of the firm's payables.

Payables Turnover in Days= Average Accounts Payable/(Purchases/365)

Indicates the liquidity of the firm's payables in days.

Additional Ratios

Altman Z-Score

The Z-score model is a quantitative model developed in 1968 by Edward Altman to predict

bankruptcy (financial distress) of a business, using a blend of the traditional financial ratios

and a statistical method known as multiple discriminant analysis.

The Z-score is known to be about 90% accurate in forecasting business failure one yearinto the future and about 80% accurate in forecasting it two years into the future.

Formula:

Z= [1.2*(Working Capital/Total Assets)] + [1.4*(Retained Earnings/Total Assets)] +

[0.6*(Market Value of Equity/Book Value of Debt)] + [0.999*(Sales/Total Assets)] + [3.3*

(EBIT/Total Assets)]

Z-score Probability of Failure

less than 1.8


5/17

greater than 1.81 but less than 2.99

greater than 3.0 Very High

Not Sure

Unlikely

Bad-Debt to Accounts Receivable Ratio= Bad Debts/Accounts Receivable

Bad-debt to Accounts Receivable ratio measures expected uncollectibility on credit sales.An increase in bad debts is a negative sign, since it indicates greater realization risk in

accounts receivable and possible future write-offs.

Bad-Debt to Sales Ratio= Bad Debts/Sales

Bad-debt ratios measure expected uncollectibility on credit sales. An increase in bad debts

is a negative sign, since it indicates greater realization risk in accounts receivable and

possible future write-offs.

Book Value per Equity Share= (Total Stockholders' Equity - Liquidation Value of Preference

Shares-Preference Share Dividend in Arrears)/Equity Shares

Book value per common share is the net assets available to common stockholders divided

by the shares outstanding, where net assets represent stockholders' equity less preferred

stock. Book value per share tells what each share is worth per the books based on historical

cost.Common Size Analysis

In vertical analysis of financial statements, an item is used as a base value and all other

accounts in the financial statement are compared to this base value.

On the balance sheet, total assets equal 100% and each asset is stated as a percentage of

total assets. Similarly, total liabilities and stockholder's equity are assigned 100%, with a

given liability or equity account stated as a percentage of total liabilities and stockholder's

equity.

On the income statement, 100% is assigned to net sales, with all revenue and expense

accounts then related to it.

Cost of Credit= [% of Discount/100-% of Discount]*[360/(Credit Period-Discount Period)]

The cost of credit is the cost of not taking credit terms extended for a business transaction.

Credit terms usually express the amount of the cash discount, the date of its expiration, andthe due date. A typical credit term is 2 / 10, net / 30. If payment is made within 10 days, a

2 percent cash discount is allowed: otherwise, the entire amount is due in 30 days. The cost

of not taking the cash discount can be substantial.

Example

On a Rs.1,000 invoice with terms of 2 /10 net 30, the customer can either pay at the end of

the 10 day discount period or wait for the full 30 days and pay the full amount. By waiting

the full 30 days, the customer effectively borrows the discounted amount for 20 days.

Rs.1,000 x (1 - .02) = Rs.980

This gives the amount paid in interest as:

Rs.1,000 - 980 = Rs.20

This information can be used to compute the credit cost of borrowing this money.

% Discount100 - % Discount x 360

Credit Period - Discount Period

= 2

98 x 360

20 = .3673

As this example illustrates, the annual percentage cost of offering a 2/10, net/30 trade

discount is almost 37%.

Current-Liability Ratios


6/17

Current to Non-current= Current Liabilities/Non-current Liabilities

Current to Total= Current Liabilities/Total Liabilities

Current-liability ratios indicate the degree to which current debt payments will be required

within the year. Understanding a company's liability is critical, since if it is unable to meet

current debt, a liquidity crisis looms. The following ratios are compared to industry norms.

Rule of 72= 72/Rate of Return

A rule of thumb method used to calculate the number of years it takes to double aninvestment.

Example

Paul bought securities yielding an annual return of 9.25%. This investment will double in

less than eight years because, 72/9.25=7.78 years

Ratio Analysis

Ratio Analysis is the most commonly used analysis to judge the financial strength of a

company. A lot of entities like research houses, investment bankers, financial institutions

and investors make use of this analysis to judge the financial strength of any company.

This analysis makes use of certain ratios to achieve the above-mentioned purpose. There

are certain benchmarks fixed for each ratio and the actual ones are compared with these

benchmarks to judge as to how sound the company is. The ratios are divided into various

categories, which are mentioned below:Profitability ratios

Profitability ratios speak about the profitability of the company. The various profitability

ratios used in the analysis are, operating margin (operating profit divided by net sales),

gross margin (gross profit divided by net sales), net profit margin (net profit divided by net

sales), return on equity (net profit divided by net worth of the company) and return on

investment (operating profit divided by total assets). As obvious from the name, the higher

these ratios the better for the company.

Solvency ratios

These ratios are used to judge the long-term solvency of a firm. The most commonly used

ratios are Debt Equity ratio (total debt divided by total equity), Long term debt to equity

ratio (long term debt divided by equity). While the accepted norm for debt equity ratio

differs from industry to industry, the usual accepted norm for D/E is 2:1. It should not bemore than this. For certain industries, a higher D/E is accepted, e.g., in banking industry, a

debt equity ratio of 12:1 is acceptable.

Turnover ratios

These ratios give an indication as to how efficiently a company is utilizing its assets. The

most commonly ratios are sales turnover ratio, inventory turnover ratio (average inventory

divided by net sales) and asset turnover ratio (net sales divided by total assets). The higher

these ratios, the better for the company.

Valuation Ratios

Valuation ratios give an indication as to whether the stock is under priced or overpriced at

any point of time. The most commonly used ratios are Price to Earnings (P/E) ratio and

price to book value (PBV) ratio. But care has to be taken while interpreting these ratios.

While P/E ratio of a company should be compared with the industry P/E and the P/E of thecompetitors, it is the PBV that can distort.

While a lower PBV usually means a lower valuation, there can be a case where a low PBV

can be because of a very huge capital base of the company. In such a case, the stock might

be overvalued but the PBV will indicate that the stock is undervalued. On the other

extreme, a higher PBV usually means overvalued stock but that can also be because the

company has a very small capital base. So care has to taken while interpreting these ratios.

Coverage ratios

These ratios give an indication about the repayment capabilities of a company. The most


7/17

commonly used coverage ratios are Interest coverage ratio (Interest outstanding divided

by earnings before interest and taxes) and debt service coverage ratio (earnings before

interest and taxes plus all non cash charges divided by interest outstanding plus the term

loan repayment installment). The acceptable norm for DSCR is 2:1.

Value Analysis

What is Fundamental Analysis?

Fundamental analysis is the analysis, wherein the investment decisions are taken on thebasis of the financial strength of the company. There are two approaches to fundamental

analysis, viz., E-I-C analysis or the Top Down approach to Fundamental analysis and C-I-E

analysis or the Bottom up approach. In the following section, we explain both these

approaches.

Economy-Industry-Company Analysis

In the Top down approach, first of all the overall Economy is analyzed to judge the general

direction, in which the economy is heading. The direction in which the economy is heading

has a bearing on the performance of various industries. Thats why Economy analys is is

important. The output of the Economy analysis is a list of industries, which should perform

well, given the general trend of the economy and also an idea, whether to invest or not in

the given economic conditions.

Measuring a Company's Financial HealthGaining a true picture of a company's finances means not only scrutinizing the financial

statements but also analyzing relationships among various assets and liabilities, thus

highlighting trends in a company's performance and changes in its financial strength

relative to its competitors.

This section explains how to read a company's financial statements. Measures of value:

Book value is based on historical costs, not current values, but can provide an important

measure of the relative value of a company over time. Book value can be figured as assets

minus liabilities, or assets minus liabilities and intangible items such as goodwill; either

way, the figure that results is the company's net book value. This is contrasted with its

market capitalization, or total share price value, which is calculated by multiplying the

outstanding shares by their current market price.

You can also compare a company's market value to its book value on a per-share basis.Divide book value by the number of shares outstanding to get book value per share and

compare the result to the current stock price to help determine if the company's stock is

fairly valued. Most stocks trade above book value because investors believe that the

company will grow and the value of its shares will, too. When book value per share is

higher than the current share price, a company's stock may be undervalued and a bargain

to investors. In fact, the company itself may be a bargain, and hence a takeover target.

Price/earnings ratio (P/E) is the more common yardstick of a company's value. It is the

current stock price divided by the earnings per share for the past year. For example, a stock

selling for Rs. 20 with earnings of Rs. 2 per share has a P/E of 10. While there's no set rule

as to what's a good P/E, a low P/E is generally considered good because it may mean that

the stock price has not risen to reflect its earning power. A high P/E, on the other hand,

may reflect an overpriced stock or decreasing earnings. As with all of these ratios, however,it's important to compare a company's ratio to the ratios of other companies in the same

industry.

A measure of solvency

Debt-to-equity ratio provides a measure of a company's debt level. It is calculated by

dividing total liabilities by shareholders' equity. A ratio of 1-to-2 or lower indicates that a

company has relatively little debt. Ratios vary, however, depending on a company's size

and its industry, so compare a company's financial ratios with those of its industry peers

before drawing conclusions.


8/17

1. Introduction

Financial statement analysis involves analyzing the firms financial statements to extract

information that can facilitate decision-making. For example, an analysis of the financial

statement can reveal whether the firm will be able to meet its long-term debt commitment,

whether the firm is financially distressed, whether the company is using its physical assets

efficiently, whether the firm has an optimal financing mix, whether the firm is generating

adequate return for its shareholders, whether the firm can sustain its competitiveadvantage etc; While the information used is historical, the intent is clearly to arrive at

recommendations and forecasts for the future rather than provide a picture of the past.

The performance of a firm can be assessed by computing key ratios and analyzing: (a) How

is the firm performing relative to the industry? (b) How is the firm performing relative to

the leading firms in their industry? (c) How does the current year performance compare to

the previous year(s)? (d) What are the variables driving the key ratios? (e) What are the

linkages among the ratios? (f) What do the ratios reveal about the future prospects of the

firm for various stakeholders such as shareholders, bondholders, employees, customers

etc.? Merely presenting a series of graphs and figures will be a futile exercise. We need to

put the information in a proper context by clearly identifying the purpose of our analysis

and identifying the key data driving our analysis.

Financial analysis is performed by both internal management and external groups. Firmswould perform such an analysis in order to evaluate their overall current performance,

identify problem/opportunity areas, develop budgets and implement strategies for the

future. External groups (such as investors, regulators, lenders, suppliers, customers) also

perform financial analysis in deciding whether to invest in a particular firm, whether to

extend credit etc. There are several rating agencies (such as Moodys, Standard & Poors)

that routinely perform financial analysis of firms in order to arrive at a composite rating.

2. Annual Reports and Financial Statements

The annual reports of companies typically contain: (a) CEO/Presidents letter to

shareholders (b) Financial statements (c) Other information

(a) CEO/Presidents letter summarizing the operations of last year, explanations for

good/bad performance, and a discussion on the goals for the immediate and long-term

future. It will be a good idea to review the letter to shareholders of some prominentcompanies. Warren Buffet of Berkshire Hathaway is famous for writing the most insightful

letters.

(b) Four Financial Statements

The financial statements (typically published every quarter and annually) are prepared

according to GAAP and audited by independent auditors. However, as the recent

corporate scandals have revealed, there are definitely too many gaps/loopholes in how the

GAAP is implemented!!. Nonetheless, financial statements are an invaluable source of

information.

B1. Balance Sheet (also known as the Statement of Financial Position): This provides the

value of firms assets (what the firm owns), liabilities (what the firm owes to outsiders)

and equity (what the inside shareholders or owners own) on a particular date. The value of

assets will equal the value of liabilities plus owners equity (or A=L+E). Items in thebalance sheet are listed based on conservative principle i.e. if estimating or in doubt of the

actual value, the value of assets is not be overstated and the value of liabilities is not be

understated.

What do we see in the balance sheet? Assets: Current assets (e.g. cash, marketable

securities, accounts receivable, inventory, prepaid expenses) that are more liquid than the

long-term/fixed assets (e.g. equipment, land), assets that are intangible and yet valuable

(e.g. goodwill, patents, deferred charges). Liabilities could include current liabilities (e.g.

bank advances, income tax payable, accounts payable, accrued expenses), deferred income


9/17

taxes (difference between the tax reported on the income statement and tax reported on

the tax return), Minority interest in subsidiary companies (representing outside ownership

in subsidiary companies), long-term debt (e.g. Bonds, capital leases). Shareholders Equity

includes Share capital (par or stated value of shares received at the time of original issue),

Paid-in-capital (when shares are sold for more than the par or stated value), retained

earnings/deficit (undistributed earnings), foreign currency translation adjustment

(fluctuation in the value of assets of foreign subsidiaries due to changes in exchange rates).Equity is also expressed as residual interest (E=A-L). If E is negative, the firm is

technically bankrupt.

Net worth or Book Value refers to what is available to equity shareholders and is given by:

Total Assets Total Liabilities Preference Share Capital = Net Worth

Net worth divided by number of equity shares outstanding will give us the book value per

share. The market value is equal to the price per share times the number of shares

outstanding (also referred to as the market capitalization of a company). We can estimate

the intrinsic value of stock by using discounted cash flow models.

All assets (except Land) lose their value over time and this is accounted for through

depreciation (for fixed assets), depletion (for natural resources) and amortization (for

intangible assets/deferred charges).

Limitations of Balance Sheet: The balance sheet records the values of assets and liabilitiesin terms of their original cost. This is especially misleading for fixed assets (that could have

significantly changed in value). Also, it is difficult to value intangible assets. Current assets

are less troublesome; partly because of their short-term nature (inventories and

marketable securities are listed at lower of their cost or market values). Liabilities are also

not biased (since they are generally contractual, and market values will be equal to their

book values; For example, if the company has taken a loan, the dollar amount of loan

obligation does not change with time). Also, an analyst should pay close attention to off-

balance sheet items.

B2. Income Statement (also known as the statement of earnings or profit & loss statement

or the statement of operations): The income statement provides information on the various

revenue and expense items during a certain period. Thus this statement shows the total

income generated in a certain period. Items in the income statement are based on accrualprinciple i.e. transactions (such as sales) are recognized when they occur and not when

actual cash is received. Furthermore, the expenses are matched to when the revenue is

recognized and not when the actual payment is made. The above principle makes it obvious

that there could be wide discrepancy between a firms revenue and actual cash flow.

There are several forms of income statement. An example of a generic form is as follows:

Sales Revenue - Cost of Good Sold = Gross Profit - Selling and Administrative expenses -

Depreciation = Earnings before Interest and Taxes (EBIT) - interest expenses (on bank

loans and bonds) + interest income = Earnings before Taxes (EBT) - taxes (current and

deferred) = Earnings after Taxes (EAT) + income from subsidiaries (equity income) +/-

Gains/Losses from discontinued operations +/- Gain/loss on extraordinary items = Net

Earnings Preference Share Dividend = Earnings available for equity shareholders

Limitations of Income Statement: In Finance, the focus is on valuation that requiresknowledge of expected cash flows rather than historical earnings. Note net income does not

equal the actual cash flow. This is because the income statement reports revenue/expenses

when they are earned / accrued and not when actual cash is received. Further, several

items are subjectively determined (e.g. depreciation). Also, depreciation is based on

historical cost of the asset. Thus, during periods of inflation, depreciation expense will be

understated as it is based on historical cost while the revenues reflect the current market

price.... such non-synchronization leads to inflated earnings. Furthermore, a traditional

income statement only records transactions and not opportunities. The economist


10/17

defines income as the change in real worth that occurs between the beginning and the end

of a specified time period. To the economist, an increase in the value of a firms land as a

result of a new airport being built on an adjacent property is an increase in the real worth

of the firm. It, therefore, represents income. The accountant does not ordinarily employ

such a broad definition of income.

B3. Statement of Retained Earnings (also known as the Statement of changes in

shareholders equity or statement of shareholders investment): It shows the balance inretained earnings after making adjustments for current profits and current dividend. It also

shows information on treasury stock, any new shares issued, the impact of exercised

options, preference shares details and additional paid-up-capital.

B4. Cash Flow Statement: It shows how the company obtained cash and for what purpose

they were used. Thus cash balance at the end = Cash in the beginning + Net Cash flow from

operating (income statement cash items) + Net Cash flow from financing (e.g. proceeds

from sale of bonds, repayment of loan, payment of dividend) + Net Cash flow from

investing activities (e.g. Sale/purchase of asset).

(c) Other information in the annual report

1. Notes to financial statements

2. The Auditors report

3. What You Need to Know About Financial StatementsFrequent Restructuring Charges and Write-Downs - As businesses adjust their internal

structure, they incur costs for shutting down one activity and starting another. In a small

company, charges for these activities would occur infrequently, but in a large company,

they will be routine. If charges and write downs for restructurings occur regularly, the

company may be classifying normal business expenses as extraordinary to create the

illusion that the core business is more profitable than it really is.

Reserve reversals - Companies generally establish reserves to cover the costs of

restructuring. Reserves allow management to "store profits" for later use if the reserves

are unusually large. At a later time, they can reverse the reserve for the amount that was

not spent and it flows directly to the bottom line.

Pension Funds - are great sources of earnings manipulation. Boost earnings by under

funding them or by overestimating the investment return of the fund so that currentpayments will be lower and profits higher. If the fund does particularly well, pull the excess

back into the income statement to boost profits.

Footnotes to Financial Statements - Statements can mislead and evade but they must come

clean in the footnotes or face criminal charges. Thats why the pros look here first. You will

learn about risk exposure, debt that changes character under certain conditions, the use of

aggressive accounting practices and all sorts of other details that management would like

to avoid telling you.

Sales/Non-Sales - Look at the revenue and receivable numbers over several years. Is the

ratio of receivables to sales increasing? If yes, then the company is shipping goods faster

than customers are paying for them. Are deferred revenues dropping? If so, the company is

living off last years sales. In the current slowdown, customers look to change sales terms

to use the suppliers money as much as possible by acknowledging the sale as late aspossible.

Cash Flow - The pros know that it is too easy to manipulate earnings numbers. So they

focus on cash flow as being a more reliable indicator of performance because the cash is

either there or it isnt.

Acquire the companys financial statements for several years. As a minimum, get the

following statements, for at least 3 to 5 years.

Balance sheets

Income statements


11/17

Shareholders equity statements

Cash flow statements

Quickly scan all of the statements to look for large movements in specific items from one

year to the next. For example, did revenues have a big jump, or a big fall, from one

particular year to the next? Did total or fixed assets grow or fall? If you find anything that

looks very suspicious, research the information you have about the company to find out

why. For example, did the company purchase a new division, or sell off part of itsoperations, that year?

Review the notes accompanying the financial statements for additional information that

may be significant to your analysis.

Examine the balance sheet. Look for large changes in the overall components of the

company's assets, liabilities or equity. For example, have fixed assets grown rapidly in one

or two years, due to acquisitions or new facilities? Has the proportion of debt grown

rapidly, to reflect a new financing strategy? If you find anything that looks very suspicious,

research the information you have about the company to find out why.

Examine the income statement. Look for trends over time. Calculate and graph the growth

of the following entries over the past several years.

Revenues (sales)

Net income (profit, earnings)Are the revenues and profits growing over time? Are they moving in a smooth and

consistent fashion, or erratically up and down? Investors value predictability, and prefer

more consistent movements to large swings.

For each of the key expense components on the income statement, calculate it as a

percentage of sales for each year. For example, calculate the percent of cost of goods sold

over sales, general and administrative expenses over sales, and research and development

over sales. Look for favorable or unfavorable trends. For example, rising G&A expenses as a

percent of sales could mean lavish spending. Also, determine whether the spending trends

support the companys strategies. For example, increased emphasis on new products and

innovation will probably be reflected by an increased proportion of spending on research

and development.

Look for non-recurring or non-operating items. These are "unusual" expenses not directlyrelated to ongoing operations. However, some companies have such items on almost an

annual basis. How do these reflect on the earnings quality?

If you find anything that looks very suspicious, research the information you have about the

company to find out why.

Examine the shareholder's equity statement. Has the company issued new shares, or

bought some back? Has the retained earnings account been growing or shrinking? Why?

Are there signals about the company's long-term strategy here?



Examine the cash flow statement, which gives information about the cash inflows and

outflows from operations, financing, and investing.

While the income statement provides information about both cash and non-cash items, thecash flow statement attempts to reconstruct that information to make it clear how cash is

obtained and used by the business, since that is what investors and creditors really care

about.



Financial Ratio Analysis

A popular way to analyze the financial statements is by computing ratios. A ratio is a

relationship between two numbers, e.g. ratio of A: B = 30:10==> A is 3 times B. A ratio by


12/17

itself may have no meaning. Hence, a given ratio is compared to (a) ratios from previous

years - internal trends, or (b) ratios of other firms in the same industry - external trends.

Ratios are more of a diagnostic tool that helps us to identify problem areas and

opportunities within a company. In this section, we will discuss how to measure and

interpret some key ratios. Obviously, since ratio is simply a comparison of two variables,

the possibilities for number of ratios are endless! There is no one way of classifying

various ratios so you may find different groupings depending on what text or article youread. Also, there are no specific rules on what is an ideal or acceptable number for a ratio,

although there are some rules of thumb. Calculate financial ratios in each of the following

categories, for each year.

Leverage (or debt) ratios

Profitability ratios

Efficiency ratios

Value ratios

Graph the ratios over time, to find the trends in the ratios from year to year. Are they going

up or down? Is that favorable or unfavorable? This should trigger further questions in your

mind, and help you to look for the underlying reasons.

Obtain data for the companys key competitors, and data about the industry.

For competitor companies, you can get the data and calculate the ratios in the same wayyou did for the company being studied.

Compare the ratios for the competitors and the industry to the company being studied. Is

the company favorable in comparison? Do you have enough information to determine why

or why not? If you dont, you may need to do further research.

Review the market data you have about the companys stock price, and the price to

earnings (P/E) ratio. Try to research and understand the movements in the stock price and

P/E over time. Determine in your own mind whether the stock market is reacting favorably

to the companys results and its strategies for doing business in the future.

Review the evaluations of stock market analysts.

Review the dividend payout. Graph the payout over several years. Determine whether the

companys dividend policies are supporting their strategies. For example, if the company is

attempting to grow, are they retaining and reinvesting their earnings rather thandistributing them to investors through dividends? Based on your research into the industry,

are you convinced that the company has sufficient opportunities for profitable reinvestment

and growth, or should they be distributing more to the owners in the form of dividends?

Viewed another way, can you learn anything about their long-term strategies from the way

they pay dividends?

Review all of the data that you have generated. You will probably find that there is a mix of

positive and negative results. Answer the following question:

Based on everything I know about this company and its strategies, the industry and the

competitors, and the external factors that will influence the company in the future, do I

think this company is worth investing in for the long term?

A popular way to analyze the financial statements is by computing ratios. A ratio is a

relationship between two numbers, e.g. ratio of A: B = 1.5:1 ==> A is 1.5 times B. A ratioby itself may have no meaning. Hence, a given ratio is compared to:

Ratios from previous years for internal trends

Ratios of other firms in the same industry for external trends

Ratio analysis is a diagnostic tool that helps to identify problem areas and opportunities

within a company. The most frequently used ratios by Financial Analysts provide insights

into a firm's-

Liquidity

Degree of financial leverage or debt


13/17

Profitability

Efficiency

Value

D. Analyzing Efficiency

These ratios reflect how well the firms assets are being managed. The inventory ratios

show how fast the inventory is being produced and sold. Ratio #1 shows how quickly the

inventory is being turned over (or sold) to generate sales ... higher ratio implies the firm ismore efficient in managing inventories by minimizing the investment in inventories. Thus a

ratio of 12 would mean that the inventory turns over 12 times or the average inventory is

sold in a month. Obviously, this ratio should be higher for WAWA (selling perishable goods)

relative to a VW car dealer. Some texts prefer to use ending inventory rather than

average inventory. High ratio by itself does not mean high level of efficiency as high ratio

could also mean shortages. Ensure that there has been no change in inventory reporting

policy (LIFO, FIFO) during the analysis period. Ratio #2 is referred to as the shelf-life i.e.

how many days the inventory was held in the shelf. Ratio #3 shows how much sales the

firm is generating for every dollar of investment in assets naturally, higher the better.

However, note that this ratio is biased (as assets are listed at historical costs while sales

are based on current prices). Ratios #4 and #5 show the firms efficiency in collecting from

credit sales. While a low ratio is good it could also mean that the firm is being very strict inits credit policy, which may drive away some customers. Ratios #6 and 7 focus on efficiency

in making payments. Combining inventories, accounts receivable and accounts payable we

get ratio #8, which shows the financing period to fund working capital needs. Longer the

period, greater the short-term liquidity risk.

The inventory ratios show how fast the inventory is being produced and sold.

1. Inventory Turnover = Cost of Goods Sold / Average Inventory

Days in Inventory = (Average Inventory/Cost of Sales)*365

Days in Inventory = Days in a year / Inventory turnover

Ratio #5 is referred to as the shelf-life i.e. how quickly the manufactured product is sold

off the shelf. Thus #5 and #1 are related.

This ratio shows how quickly the inventory is being turned over (or sold) to generate sales.

A higher ratio implies the firm is more efficient in managing inventories by minimizing theinvestment in inventories. Thus a ratio of 12 would mean that the inventory turns over 12

times, or the average inventory is sold in a month.

2. Total Assets Turnover = Net Sales / Average Total Assets

This ratio shows how much sales the firm is generating for every dollar of investment in

assets. The higher the ratio, the better the firm is performing.

3. Accounts Receivable Turnover = Annual Credit Sales / Average Receivables

4. Average Collection period= (Average Accounts Receivable/Net Sales)*365

Ratios #3 and #4 show the firms efficiency in collecting cash from its credit sales. While a

low ratio is good, it could also mean that the firm is being very strict in its credit policy,

which may not attract customers.

5. Accounts Payable turnover = Purchases / Accounts Payable

6. Days AP outstanding = (Accounts Payable / Cost of Sales)*3657. Financing Period= Average Collection period + days in inventory days AP outstanding

E. Value Ratios

Earnings per share (EPS) are widely reported although it is now less closely followed (after

academic theory insights into the drawback of EPS and importance of cash flow based

measures). SEC requires that the company report both basic and diluted EPS. Basic EPS

uses the actual number of shares currently outstanding in the market while diluted EPS

uses currently outstanding shares + all potential shares (due to convertibility of debt or

preferred stock as well as exercise of stock options, rights and warrants). Dividend yield,


14/17

while widely reported, may not contain much useful information by itself (especially when

comparing across firms) since dividend policies vary across firms. Furthermore, price

appreciation (as opposed to dividends) is the more important source of yield for

shareholders.

Value ratios such as PE ratio show the embedded value in stocks and are used by the

investors as a screening device before making their investment. For example, a high P/E

ratio may be regarded by some as being a sign of over pricing. When the markets arebullish or if the investor sentiment is optimistic about a particular stock, the P/E ratio will

tend to be high indicating that investors are willing to pay a high price for companys

earnings. For example, in late 1990s internet stocks had extremely high P/E ratios (despite

their lack of earnings) reflecting investors optimism about the future prospects of these

companies. Of course, the burst of the bubble showed that such confidence was misplaced.

PS ratio can be combined with PE ratio to analyze a company. Ratio #7 is useful for valuing

companies such as internet services or cable services that rely primarily on members to

generate income. Thus an assessment of members (total members, current and future

expected growth rate, and average spending by member) can provide useful guideline in

valuing such companies (especially when planning acquisitions).

1. Earning per Share (EPS) = (Net Earning Preference Share Dividend) / No. of equity

shares2. Earning Yield = 1 / EPS

3. Cash flow per Share (CPS) = Net Cash Flows / No. of shares

4. Dividend Yield = Annual Dividend / Current Market price

5. Price-earning Ratio (PE) = Market Price per share / EPS

6. Price-Sales Ratio (PS) = Market price per share / Sales per share

7. Membership Value = No. of members * value per member

8. Free CF per share = (Net Cash flow from Operations Capital Expenditure) / No. of

shares

9. Total Shareholder Return (TSR) = (Ending Price + Dividend Beginning Price) /

Beginning Price

10. EVA = EAT Cost of Financing (that is, Net Capital Assets Employed * WACC)

These ratios reflect how well the firms assets are being managed.Value ratios show the embedded value in stocks, and are used by investors as a screening

device before making investments.

For example, a high P/E ratio may be regarded by some as being a sign of over pricing.

When the markets are bullish (optimistic) or if investor sentiment is optimistic about a

particular stock, the P/E ratio will tend to be high. For example, in the late 1990s Internet

stocks tended to have extremely high P/E ratios, despite their lack of profits, reflecting

investors' optimism about the future prospects of these companies. Of course, the burst of

the bubble showed that such confidence was misplaced.

On the other hand, a low P/E ratio may show that the company has a poor track record. On

the other hand, it may simply be priced too low based on its potential earnings. Further

investigation is required to determine whether the company would then provide a good

investment opportunity.F. Uses and Limitations of Ratio analysis

Uses

1. To evaluate performance, compared to previous years and to competitors and the

industry

2. To set benchmarks or standards for performance

3. To highlight areas that need to be improved, or areas that offer the most promising

future potential

4. To enable external parties, such as investors or lenders, to assess the creditworthiness


15/17

and profitability of the firm

Limitations

1. There is considerable subjectivity involved, as there is no correct number for the

various ratios. Further, it is hard to reach a definite conclusion when some of the ratios are

favorable and some are unfavorable.

2. Ratios may not be strictly comparable for different firms due to a variety of factors such

as different accounting practices or different fiscal year periods. Furthermore, if a firm isengaged in diverse product lines, it may be difficult to identify the industry category to

which the firm belongs. Also, just because a specific ratio is better than the average does

not necessarily mean that the company is doing well; it is quite possible rest of the industry

is doing very poorly.

3. Ratios are based on financial statements that reflect the past and not the future. Unless

the ratios are stable, it may be difficult to make reasonable projections about future trends.

Furthermore, financial statements such as the balance sheet indicate the picture at one

point in time, and thus may not be representative of longer periods.

4. Financial statements provide an assessment of the costs and not value. For example,

fixed assets are usually shown on the balance sheet as the cost of the assets less their

accumulated depreciation, which may not reflect the actual current market value of those

assets.5. Financial statements do not include all items. For example, it is hard to put a value on

human capital (such as management expertise). And recent accounting scandals have

brought light to the extent of financing that may occur off the balance sheet.

6. Accounting standards and practices vary among countries, and thus hamper meaningful

global comparisons.

7. Management decision making is a dynamic process in a constantly changing environment

while ratio analysis is a static analysis based on historical data.

8. The linkage among various ratios is not readily obvious.

Cash Flow Curries

Think of cash as the lifeblood of every business. Without cash flow, no business can

function and without an accurate picture of cash flow, no investor can have a complete

picture of a company.A company's statement of cash flows reflects how readily the business can pay its bills, and

it provides important information about a company's sources and uses of cash. But

measuring cash flow solely from a balance sheet or an income statement is difficult and

potentially misleading. That's because not all revenue is received when a company earns it,

and not all expenses are paid when incurred. (For an explanation of financial statements,

see "What's the Deal with Financial Statements?" plus "Understanding the Income

Statement" and "How to Read a Balance Sheet," presented earlier in this series.)

The difference between an income statement and a statement of cash flows is roughly

analogous to the difference between a credit card statement and a checkbook ledger. A

credit card statement includes charges that haven't been paid off yet, while an updated

checkbook ledger indicates where cash has been spent and whether there's enough to pay

off debts like a credit card bill. Similarly, a company's expenses and revenues are recordedon an income statement, regardless of whether cash has changed hands yet. A statement of

cash flows, on the other hand, traces where cash came from and where it was used.

The statement also separates cash generated by the normal operations of a company from

that gleaned through other investing and financing activities, as seen in the sample

statement of cash flows of the hypothetical XYZ Corp.

Cash flow from operations:

Cash flow from operations starts with net income (from the income statement) and adjusts

out all of the non-cash items. Income and expenses on the income statement are recorded


16/17

when a company earns revenue or incurs expenses, not necessarily when cash is received

or paid. To figure out how much cash the company received or spent; net income is

adjusted for any sales or expenditures made on credit and not yet paid with cash.

Examples of these adjustments are shown above. XYZ had Rs. 20 million in sales to

customers who had not paid the company as of the end of the year, so this increase in

receivables is subtracted. XYZ also reported Rs.15 million in depreciation expense (the

portion of long-lasting assets, such as buildings, that is written off each year); depreciationis not a cash item, so it is added back. Finally, XYZ purchased Rs.10 million of additional

inventory that was not sold as of year end. Because the inventory was not sold, it is not

considered an expense. But because cash was used in the purchase, the Rs.10 million is

subtracted from net income. Net cash received from XYZ's operations, after the above

adjustments, was Rs.15 million.

Cash flow from investing

Cash flow from investing includes cash received from or used for investing activities, such

as buying stocks in other companies or purchasing additional property or equipment. XYZ

Corp. had no cash receipts from investing in 1999 but spent Rs.150 million to purchase

equipment.

Cash flow from financing

Cash flow from financing activities includes cash received from borrowing money or issuingstock and cash spent to repay loans. XYZ Corp. received Rs.100 million in cash from issuing

bonds in 1999.

Sizing up operating performance

Of the three main sources of cash flow, analysts look to that from operations as the most

important measure of performance. If operations alone don't generate positive cash flow,

that may be cause for concern. In addition, a decrease in cash flow due to a sharp increase

in inventory or receivables can signal that a company is having trouble selling products or

collecting money from customers. However, analysts look at the relative amount of these

changes if accounts receivable have gone up by the same percentage as sales revenues, the

increase may not be unusual.

Company Valuation

Whenever people talk about equity investments, one must have come across the word"Valuation". In financial parlance, Valuation means how much a company is worth of.

Talking about equity investments, one should have an understanding of valuation.

Valuation means the intrinsic worth of the company. There are various methods through

which one can measure the intrinsic worth of a company. This section is aimed at providing

a basic understanding of these methods of valuation. They are mentioned below:

Net Asset Value (NAV)

NAV or Book value is one of the most commonly used methods of valuation. As the name

suggests, it is the net value of all the assets of the company. If you divide it by the number

of outstanding shares, you get the NAV per share.

One way to calculate NAV is to divide the net worth of the company by the total number of

outstanding shares. Say, a companys share capital is Rs. 100 crores (10 crores shares of

Rs. 10 each) and its reserves and surplus is another Rs. 100 crores. Net worth of thecompany would be Rs. 200 crores (equity and reserves) and NAV would be Rs. 20 per share

(Rs. 200 crores divided by 10 crores outstanding shares).

NAV can also be calculated by adding all the assets and subtracting all the outside liabilities

from them. This will again boil down to net worth only. One can use any of the two methods

to find out NAV.

One can compare the NAV with the going market price while taking investment decisions.

Discounted Cash Flows Method (DCF)

DCF is the most widely used technique to value a company. It takes into consideration the


17/17

cash flows arising to the company and also the time value of money. Thats why, it is so

popular. What actually happens in this is, the cash flows are calculated for a particular

period of time (the time period is fixed taking into consideration various factors). These

cash flows are discounted to the present at the cost of capital of the company. These

discounted cash flows are then divided by the total number of outstanding shares to get the

intrinsic worth per share.

ratios and formulas financial analysis

Documents