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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