CB Ratio Analysis

8/13/2019 CB Ratio Analysis

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A n a l y Ratio Analysis

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Corporate Bridge Academy

[email protected]

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1Private and Confidential – Not for Circulation



Discussion topics

How to analyze a company?

Analytical techniques for Financial Statement Analysis

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Hor zonta Ana ys s

Trend Analysis

Vertical Analysis

Ratio Analysis

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A n a l y Solvency

• Current Ratio /Quick Ratio / Cash ratio

• Receivables turnover / Inventory turnover / Payables turnover / Cash Conversion Cycle

Operating

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• Operating Profitability

• DuPont Formula

• Extended DuPont Formula

Risk

• Business Risk

• Financial risk

• External liquidity risk

Growth

PRIVATE AND CONFIDENTIAL [email protected] 2

Limitations of Financial Ratios



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How to analyze a company?

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3Private and Confidential – Not for Circulation

PRIVATE AND CONFIDENTIAL [email protected]



Analytical techniques for FSA

Purpose of Financial Statement Analysis is to evaluate management performance in

Profitability

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c ency

Risk

Although financial statement information is historical, it is used to project future performance

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Horizontaland TrendAnalysis

• Compares two financial statements to determine dollar andpercentage changes

• Compute dollar changes and percentage changes

• Compares two financial statements to determine dollar andpercentage changes

• Compute dollar changes and percentage changes

• Shows relationship of each item to a base amount on financial• Shows relationship of each item to a base amount on financial

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Which method is theBest?

Which method is theBest?Vertical

Analysis

statements

• Income statement (each item expressed as percentage of netsales)

• Balance sheet (each item expressed as percentage of totalassets)

statements

• Income statement (each item expressed as percentage of netsales)

• Balance sheet (each item expressed as percentage of totalassets)

RatioAnalysis

• Puts numbers in perspective with other numbers• Helps control for different sizes of firms

• Ratios provide meaningful relationships between individualvalues in the financial statements

• Puts numbers in perspective with other numbers• Helps control for different sizes of firms

• Ratios provide meaningful relationships between individualvalues in the financial statements

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An Analyst is expected to do a complete synthesis using all three methods




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Horizontal / Trend / Vertical Analysis

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5PRIVATE AND CONFIDENTIAL [email protected]



Horizontal Analysis

Horizontal analysis shows the changes between years in the financial data in both dollarand percentage form

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[Current year – Base year] /[Base year]

GKSR Income Statement 2006 2007 Increase ($) % YoY change

Rental Operations 801,240 847,401 46,161 5.8%

Direct Sales 79,603 82,141 2,538 3.2%

Net Revenues $880,843 $929,542 $48,699 5.5%

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Why provision for tax hasincreased by 12.6%, while therevenues increased by only 5.5%?

ost o renta operat ons (518,543) (541,392) (22,849) 4.4%

Cost of direct sales (57,522) (59,579) (2,057) 3.6%

Selling and administrative costs (186,652) (203,614) (16,962) 9.1%

Operating Expenses ($762,717) ($804,585) ($41,868) 5.5%

- Ebitda $118,126 $124,957 $6,831 5.8%

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Why there is an increase of 9.1%in Selling and administrative cost?

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Amortization of intangibles (10,784) (10,806) (22) 0.2%

Ebit $74,863 $79,362 $4,499 6.0%

Interest Expense (13,226) (13,901) (675) 5.1%

Income before income taxes $61,637 $65,461 $3,824 6.2%

Provision for taxes (19,786) (22,271) (2,485) 12.6%

PAT $41,851 $43,190 $1,339 3.2%

Horizontal anal sis can also be done on the liabilities or shareholder’s e uit

Basic EPS $1.98 $2.03 $0.05 2.5%

Diluted EPS $1.97 $2.02 $0.05 2.4%

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Trend Analysis

Trend percentages state several years’ financial data in terms of a base year, which equals100%

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[Current year ] / [Base year] * 100

Income Statement 2002 2003 2004 2005 2006 2007Net Revenues 677,591 705,588 733,447 788,775 880,843 929,542

Operating Expenses 565,077 598,974 625,064 674,566 762,717 804,585

PAT 38,267 33,689 35,384 38,179 41,851 43,190

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Trend Analysis 2002 2003 2004 2005 2006 2007

Net Revenues 100.0% 104.1% 108.2% 116.4% 130.0% 137.2%

Operating Expenses 100.0% 106.0% 110.6% 119.4% 135.0% 142.4%

PAT 100.0% 88.0% 92.5% 99.8% 109.4% 112.9%

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140%

160%

Trend Analysis

by 42% since 2002, Net incomegrew marginally by 13% during the

corresponding period

60%

80%

100%

2002 2003 2004 2005 2006 2007

Ne t Reve nues Ope ratin g Expense Net In co me




Vertical Analysis

Common-size statements use percentages to express the relationship of individualcomponents to a total within a single period is known as Vertical Analysis

Income Statement as a ercenta e of Total Revenues

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Balance Sheet (As a percentage of Total Asset / Total Liabilities)

Vertical Analysis 2002 2003 2004 2005 2006 2007

Rental Operations 96.8% 96.6% 96.6% 93.9% 91.0% 91.2%Since 2004, cost of rentals have

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Net Revenues 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Cost of rental operations -59.5% -60.5% -61.1% -59.6% -58.9% -58.2%

Cost of direct sales -2.3% -2.5% -2.6% -4.5% -6.5% -6.4%Selling and administrative costs -21.6% -21.9% -21.5% -21.4% -21.2% -21.9%

decreased

R a Operating Expenses -83.4% -84.9% -85.2% -85.5% -86.6% -86.6%

Ebitda 16.6% 15.1% 14.8% 14.5% 13.4% 13.4%

Depreciation -4.4% -4.3% -4.3% -4.1% -3.7% -3.7%

Amortization of intangibles -0.9% -1.0% -1.1% -1.2% -1.2% -1.2%

Ebit 11.3% 9.8% 9.4% 9.2% 8.5% 8.5%

Interest Expense -2.0% -1.9% -1.6% -1.4% -1.5% -1.5%

Income before income taxes 9.3% 7.8% 7.8% 7.8% 7.0% 7.0%

EBITDA/EBIT/PAT margins aconcern - continuously

decreasing trend

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- . - . - . - . - . - .

PAT 5.6% 4.8% 4.8% 4.8% 4.8% 4.6%




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Ratio Analysis

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9Private and Confidential – Not for CirculationPRIVATE AND CONFIDENTIAL [email protected]



Ratio Analysis

Ratios can often be more informative that raw numbers

Puts numbers in perspective with other numbers

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e ps contro or erent s zes o rms

Ratios provide meaningful relationships between individual values in the financial statements

Ratios can be used to evaluate four different areas of company’s performance and conditions

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Analysis

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SolvencyRatios

OperatingPerformance

Risk Analysis Growth

Current/Cash/Quick Ratio

TurnoverRatios

OperatingEfficiency

OperatingProfitability

BusinessRisk

FinancialRisk

Externalliquidity risk

Sustainablegrowth rate




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Ratio Analysis - Solvency

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Analyst employ these ratios to determine the firm’s ability to pay its short-term liabilities

Current Ratio examines current assets and current liabilities

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Higher the current ratio, more likely is that the company will be able to pay its short-term bills

A ratio of less than 1, means that the company has negative working capital and is probably facing

sLiabilitieCurrentAssetsCurrentRatioCurrent =

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qu y cr s s

Quick Ratio adjusts current assets by removing less liquid assets

More stringent measure of liquidity

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Higher the quick ratio, more likely is that the company will be able to pay its short-term bills

sLiabilitieCurrent

sReceivableSecuritiesMarketableCashRatioQuick

++=

Cash ratio relates cash (ultimate liquid asset) to current liabilities

Higher the cash ratio, more likely is that the company will be able to pay its short-term bills

SecuritiesMarketableCashRatioCash

+=

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sL a t eCurrent





Receivables turnover examines the management of accounts receivable

Balance sheet items are taken as average of the account

i s Average collection period is the average number of days it takes for the company’s

customer to pay their bills

sReceivableAverage

SalesAnnual NetTurnover sReceivable =

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A n a l y It is desirable to have a collections period closer to the industry norm

Turnover sReceivable

365Period CollectionsReceivableAverage =

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,capital is tied up in assets

Inventory turnover measures firm’s efficiency with respect to its processing and inventorymanagement


Given the turnover values, you can compute the average inventory processing time

It is desirable to have a collections period closer to the industry norm

InventoryAverageSold Goodsof CostTurnover Inventory =

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Turnover Inventory

365Period ProcessingInventoryAverage =




Evaluating Solvency Ratios

Payables turnover measures the use of trade credit by the firm


i s Given the turnover values, we can compute the average payment period processing time

It is desirable to have a collections payment closer to the industry norm

PayablesAverage

sogoo soosTurnover Payables =

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Cash Conversion Cycle

Turnover Payable

365Period PaymentAverage =

R a Combines information from the receivables turnover, inventory turnover, and accounts payable turnover

Cash Con Cycle Receivable period Inventory period= + Payable period-

High conversion cycle is undesirable

Too high conversion cycle implies that company has excessive amount of capital investment in the salesprocess




Calculating Cash Conversion Cycle

Example : Cash conversion cycle

Balance Sheet Income Statement

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Cash $156,000 $46,800 Net Sales $2,808,000

Accounts Receivables 312,000 468,000 COGS (1,560,000)

Inventory 936,000 624,000 Salaries expenses (514,800)

Net property, plant and equip 2,184,000 2,293,200 Depreciation expense (109,200)

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Total Expense (2,246,400)

Liabilities 2006 2007 Pre-tax Income 561,600

Accounts Payable $589,680 $780,000 Income tax expense (168,480)

Mortgage Payable 1,248,000 1,294,800 Net Income $393,120

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Retained earnings 814,320 421,200

Total liabilities and Equity $3,588,000 $3,432,000

Calculate average cash conversion cycle for the company






Ratio Analysis – Operating Efficiency

Operating Efficiency Ratios

Examines how management uses its assets to generate sales and it considers the relationship betweenvarious asset categories and sales

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Total Asset Turnover ratio indicates effectiveness of a firm’s use of its total asset base to

produce sales Different types of industries have different asset turnovers. Infrastructure business are capital intensive

and may have Asset Turnover closer to 1, however, retail business might have turnover ratios in doubledigits

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Low asset turnover may mean that the company has much capital tied up in its asset base

Assets NetTotalAverage

Sales NetTurnover AssetTotal =

R a e xe sse urnover re ec s u za on o xe asse s

This number can look temporarily bad if the firm has recently added greatly to its capacity in anticipationof future sales

AssetsFixed NetAverage

Sales NetTurnover AssetFixed =

Equity Turnover measures the employment of owner’s capital

Equity capital includes all preferred and common stock, paid-in capital and retained earnings

Sales NetTurnover Equity =

17

qu tyverage




Ratio Analysis – Operating Profitability

Operating profitability ratios

Examines how management is doing at controlling costs so that a large proportion of the sales dollar isconverted into profit

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What proportion of the sales dollar is left after cost of goods sold?

Is the firm buying inputs (inventory and direct labor) at good prices?

Gross Profit Margin

Gross rofit mar in measures the rate of return after cost of oods sold

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Operating Profit Margin

Sales Net

ProfitGrossMarginProfitGross =

R a Operating profit margin measures the rate of profit on sales after operating expenses

Operating income can be thought of as the “bottom line” from operations

Sales Net

ProfitOperatingMarginProfitOperating =

Net Margin

Shows the combined effect of operating profitability and the firm’s financing decisions (since net income isafter interest and tax payments)

Income NetMarginProfit Net =

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Example: Operating Ratios

Income Statement 2007

Sales $18,000

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COGS $13,200

Selling and Admin expenses $3,400Interest income $800

Interest expense $500

Calculate the following

a) Operating Profit Margin

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Gain on sale of long term inves $1,200

Provision for income taxes $1,015

Selected Balance Sheet items 2007Book value of total assets 44 000

c) Asset Turnover

d) Equity Turnover

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Accumulated depreciation ($12,000)

Net total assets $32,000

Shareholder's Equity 22000





Return on total capital relates the firm’s earnings to all capital invested in the business

This number should not be too low as compared to the industry average

i s We should consider Gross interest expense in our calculation

Return on total equity indicates the rate of return earned on the capital provided by the

CapitalTotalAverage

ExpenseInterestIncome NetCapitalTotalonReturn

+=

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s oc o ers a er pay ng or a o er cap a use

Total Equity includes preferred stock

EquityTotalAverage

Income NetEquityTotalonReturn =

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Return on owner’s equity is based only on the common shareholder’s equity

Preferred dividends are deducted from Net Income as they are a priority claim

EquityCommonAverage

Dividend Preferred -Income NetEquitysOwner'onReturn =





DuPont System divides ROE into several ratios that collectively equal ROE while individuallyproviding insight

Most im ortant term in ratio anal sis

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Basic algebra for ROE breakdown

EquityCommon

Income Net

ROE =

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EquityCommon

AssetsTotal

AssetsTotal

Sales

Sales

Income Net

EquityCommon

Income Net××=

Profit margin Asset Turnover Financial Leverage

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Extended DuPont System

Provides additional insights into the effect of financial leverage on the firm and pinpoints the effect ofincome taxes on ROE

We be in with the o eratin rofit mar in EBIT divided b sales and introduce additional

ratios to derive an ROE value

EquityCommon

AssetsTotal

AssetsTotal

Sales

Sales

Income Net

EquityCommon

Income Net××=





Extended DuPont Analysis

t-1AssetsTotalSalesEBTIncome Net

×××=

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EquityCommonAssetsTotalSalesEquityCommon

t)-1(EquityCommon

AssetsTotal

AssetsTotal

ExpenseInterest

AssetsTotal

Sales

Sales

EBIT

EquityCommon

Income Net××⎟

⎠

⎞⎜⎝

⎛ −×=

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Op. Profit Margin Asset Turnover Interest exp. rate Financial leverage Tax retention rate

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If Return on Investment in Asset > Fixed rate of borrowing = Positive financial leverage

If Return on Investment in Asset < Fixed rate of borrowing = Negative financial leverage





Example : DuPont Analysis

Please evaluate the following ratios for Pratts company

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2006 2007

Pre‐interest profit margin (EBIT/S) 0.15 0.10

Asset turnover (S/A) 1.00 1.50

Leverage (A/E) 2.00 2.50

Tax retention 1‐t 0.70 0.70

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A n a l y Interest expense ratio (I/A) 0.05 0.05

Comment on the firm's ROE trends

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Ratio Analysis – Risk

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Ratio Analysis – Risk

Risk analysis examines the uncertainty of income for the firm and for an investor

Total firm risks can be decomposed into three basic sources – 1) Business risk 2) Financial

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Business Risk

Function of Business variability, Sales variability and Operating leverage

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Between five to ten years of data should be used for calculating business and sales variability

incomeoperatingMean

income)(operatingDeviationStandard tyvariabiliBusiness =

(sales)DeviationStandard tvariabiliSales =

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Also critical is the measure of how much company’s production costs are fixed (as opposed to variable)

salesMean

Salesinchange%

EarningsOperatinginchange%leverageOperating =

Greater the use of fixed costs, greater the impact of a change in sales on the operating income of acompany and hence, higher is the risk




Ratio Analysis – Financial Risk

Financial risk

The added uncertainty in a firm’s net income resulting from a firm’s financing decisions (primarily throughemploying leverage)

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Interest payments are deducted before we get to net income and these are fixed obligations. Similar tofixed production costs, these lead to larger earnings during good times, and lower earnings during abusiness decline

The use of debt financing increases financial risk and possibility of default while increasing profitabilitywhen sales are high

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• Balance sheet ratios

• Earnings or cash flow available to pay fixed financial charges

Balance Sheet Ratios

R a How much debt does the firm employ in relation to its use of equity?

How much debt does the firm employ in relation to all long-term sources of funds?

equitytermLong

debttermLongratioequityDebt to =

Assessment of overall debt load, including short-term

capitaltermlongTotal

debttermLongcapitalTotalDebt to =

debttermLongsliabilitieCurrentRatioDebt

+=

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qu tyotae tota +




Ratio Analysis – Financial Risk

Earnings/Cash flow ratios

Relate operating income (EBIT) to fixed payments required from debt obligations

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g er rat o means ower r s

Interest coverage ratio determines the firm’s ability to repay its debt obligations

expenseInterest

EBITcoverageInterest =

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as ow to ong term e t rat o eterm nes t e a ty o t e rm to meet ts ong term e t t rougits cash flows

leaseoperatingof PVdebttermlongof Book value

CFOdebttermlongtoflowCash

+=

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Ratio Analysis – External Liquidity Risk

External liquidity risk

External market liquidity is a source of risk to investors

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ar et qu ty s t e a ty to uy or se an asset qu c y w t tt e pr ce c ange rom a pr ortransaction assuming no new information

The most important factor of external market liquidity is the dollar value of shares traded

This can be estimated from the total market value of outstanding securities

It will be affected by the number of security owners

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A n a l y Numerous buyers and sellers provide liquidity

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Ratio Analysis – Example

Example : Ratio Analysis

Please evaluate the following ratios

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Cash Ratio 0.84 0.60

Operating Profit

Margin 30% 36%

Current Ratio 1.80 1.44

Total Debt‐to‐Total Capital Ratio 78% 74%

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Cash Flow‐to‐Total Debt Ratio 66 60

Cash Conversion Cycle (days) 54 60

Interest coverage 3.00 2.40

Net Profit Margin 10% 8%

Debt‐to‐Equity Ratio 132% 127%

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Comment on the firm's trends on the followinga) Profitability b) Liquidity c) Financial Risk (Coverage)

Financia Ris Leverage




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Ratio Analysis – Growth

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Ratio Analysis – Growth

Growth is important to both creditors and owners

Creditors interested in ability to pay future obligations

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or owners, t e va ue o a rm epen s on ts uture growt n earn ngs, cas ow, an v en s

If the company doesn’t grow, it stands a much greater chance of defaulting on its loans

Sustainable growth rate is a function of two variables:

What is the rate of return on equity (which gives the maximum possible growth)?

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A n a l y How much of that growth is put to work through earnings retention (rather than being paid out in

dividends)?

Growth = ROE x Retention rate

Also remember ROE is a function of

R a e pro marg n

Total asset turnover

Financial leverage (total assets/equity)




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Limitations of Financial Ratios

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Limitation of Financial Ratios

Accounting treatments may vary among firms, especially among non-U.S. firms

Always consider relative financial ratios. They do not make any sense when viewed in

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Firms may have divisions operating in different industries making it difficult to derive industry

ratios

Conclusions cannot be made by just looking at only one set of ratios

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CB Ratio Analysis

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