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Ratio Analysis
Lecture 12 & 13Required: Carry Annual Reports
Objectives of Ratio Analysis
• Standardize financial information for comparisons
• Evaluate current operations• Compare performance with past performance• Compare performance against other firms or
industry standards• Study the efficiency of operations• Study the risk of operations
Rationale Behind Ratio Analysis• A firm has resources• It converts resources into profits through– production of goods and services– sales of goods and services
• Ratios– Measure relationships between resources and financial
flows– Show ways in which firm’s situation deviates from
• Its own past• Other firms• The industry
Some Limitations…
Ratios are valuable analytical tools and serve as screening devices, but they
• do not provide answers in and of themselves• are not predictive• should be used with other elements of financial
analysis
Key Financial Ratios
Five categories of ratios• Liquidity ratios• Activity ratios• Leverage ratios• Profitability ratios• Market ratios
Key Financial RatiosLiquidity Ratios
Liquidity ratios measure a firm’s ability to meet cash needs as they arise. Liquidity ratios include
• current ratio• quick or acid-test ratio• cash flow liquidity ratio• average collection period• days inventory held• days payable outstanding
Liquidity RatiosShort-Term Solvency
Measures the ability of a firm to meet debt requirements as they come due
Current Ratio
Current assets
Current liabilities
What is the Current Ratio? But is the company healthy?
Traditional Analysis # 1
Traditional Analysis # 2
Liquidity RatiosShort-Term Solvency
Measures ability to meet short-term cash needs more rigorously by eliminating inventory
Quick or Acid-Test Ratio
Current assets - InventoryCurrent liabilities
What if Quick Ratio is low…
• Mc Donalds v/s Audi
Liquidity RatiosShort-Term Solvency
Focuses on ability of the firm to generate operating cash flows as a source of liquidity
Cash Flow Liquidity Ratio
*Cash flow from operating activities
Cash + Marketable securities + CFO *Current liabilities
Liquidity RatiosShort-Term Solvency
In absence of actual information on each transaction… With the help of public data ACP Helps gauge liquidity of accounts receivable (ability to collect cash from customers) and may help provide information about a company’s credit policies
Average Collection Period
Net accounts receivableAverage daily sales
Or 2 Steps…
• Receivables Turnover ratio = Sales/AR How many times your company earns money
currently owed by your debtors
• No. of days in a year / Receivable Turnover Ratio
Consider this as the no. of days your debtors take to pay
ACP indicator of credit granting policies of a company.
If your ACP is higher than industry average?Your policies may be lenient or your customers
may be running into financial troubles. Note different formulae could be used. But you
need to be consistent to get valid results.
Liquidity RatiosShort-Term Solvency
Measures the efficiency of the firm in managing its inventory; How fast can you convert it into sales (AR or Cash)
Days Inventory Held / Inventory Conversion Period
InventoryAverage daily cost of goods sold
2 Step Method
• Inventory Turnover Ratio = COGS / Average Inventory
• COGS = 1.2million and Avg. Inventory = 0.1 million
• ITR = 12 • It means you turnover inventory 12 times in a
year or once every month;• Or 365/12 = 30 days = No. of days it takes a
company to convert inventory to AR or Cash
Liquidity RatiosShort-Term Solvency
Offers insight into a firm’s pattern of payments to suppliers
Days Payable Outstanding
Accounts payableAverage daily cost of goods sold
Operating Cycle
• The operating cycle: time interval between arrival of inventory stock and date when cash is collected from receivables
• Equal to inventory period plus accounts receivable period
Cash Conversion Cycle
• Time it takes an entity to collect cash that has already been disbursed.
• CCC = Inventory Conversion Period + Receivables Conversion Period – Payables Conversion Period
CCC
• For a service-based company ICP = 0; hence CCC = RCP - PCP
• Is negative CCC possible? Yes, if the company receives down payment and collects advance before producing. ICP = RCP = 0; CCC = -PCP
Account Receivables Turnover
• The ratio is sometimes seasonally affected, rising during busy seasons and falling during the off-season. To account for this seasonality, the average accounts receivable ((beginning + ending accounts receivable)/2) could be used instead.
• Similarly Inventory Turnover Ratio and Accounts Payable Turnover
Example
ABC Inc. had COGS of $200 million and credit sales of $240million in 1998. The following data are from its balance
sheets. 12/31/97 12/31/98Inventory 40 60Accounts receivable 30 50Accounts payable 10 30How many days is ABC’s operating and cash cycle?
How many days is ABC’s operating cycle?
Inventory period = [ { (40 + 60) / 2} / 200 ] * 365 = 91.25 days
Receivables period = [ { (30 + 50) / 2 } / 240 ] * 365 = 60.83 days
Operating cycle = 152.08 days
How many days is ABC’s cash cycle?
Accounts payable period = [ { (10 +30) / 2} / 200 ] * 365 = 36.5
Cash cycle = 115.58 days
Key Financial RatiosActivity Ratios
Activity ratios measure the liquidity of specific assets and the efficiency of managing assets. Activity ratios include
• accounts receivable turnover• inventory turnover• accounts payable turnover• fixed asset turnover• total asset turnover
Activity Ratios: Asset Liquidity, Asset Management Efficiency
Measures efficiency of firm’s collection and credit policies
Accounts Receivable Turnover
Net salesNet accounts receivable
Activity Ratios: Asset Liquidity, Asset Management Efficiency
Measures firm’s efficiency in managing its inventory.
Inventory Turnover
Cost of goods soldInventory
• A low turnover is usually a bad sign because products tend to deteriorate as they sit in a warehouse.
• Companies selling perishable items have very high turnover.
• Tradeoff – Companies with high inventory turnover generally have low profit margins and vice versa
• Average inventory accounts for any seasonality effects on the ratio.
Activity Ratios: Asset Liquidity, Asset Management Efficiency
Helps to gain insight into a firm’s pattern of payment to suppliers
Accounts Payables Turnover
Cost of goods soldAccounts payable
Activity Ratios: Asset Liquidity, Asset Management Efficiency
Assesses effectiveness in generating sales from investments in fixed assets
Fixed Asset Turnover
Net salesNet property, plant, equipment
• A higher fixed-asset turnover ratio shows that the company has been more effective in using the investment in fixed assets to generate revenues.
• Often used as a measure in manufacturing industries
• When companies make these large purchases, prudent investors watch this ratio in following years to see how effective the investment in the fixed assets was.
Activity Ratios: Asset Liquidity, Asset Management Efficiency
Assesses effectiveness in generating sales from investments in all assets
Total Asset Turnover
Net salesTotal assets
Pricing Strategy
• Ratio determines the amount of sales that are generated from each dollar of assets
• Companies with low profit margins tend to have high asset turnover, those with high profit margins have low asset turnover
• In the retail industry you would expect a very high turnover ratio - mainly because of cutthroat and competitive pricing
• This ratio is more useful for growth companies to check if in fact they are growing revenue in proportion to assets.
Model 3 – Financial Indicators
• From the data provided calculate ratios in Excel as we proceed
• It facilitates automatic calculation specially while analysing vast number of companies.
• Example
Debt Related Issues
• When is a firm said to default?• Why is a bankruptcy code required?• What is Chapter 7-liquidation? • What is Chapter 11-reorganization?• Corporate Insolvency in India - Winding up of the
company under the Companies Act, 1956• BIFR, SICA, Sick Industrial Companies (Special
Provisions) Repeal Act, 2003. • What are the Ex-Ante and Ex-Post Costs of Financial
Distress?
Key Financial RatiosLeverage Ratios
Leverage ratios measure the extent of a firm’s financing with debt relative to equity and its ability to cover interest and other fixed charges.
Keep reasons for change in capital structure ready for analysis.
Key Financial RatiosLeverage Ratios
Leverage ratios include• Debt ratio• Long-term debt to total capitalization• Debt to equity• Times interest earned• Fixed charge coverage• Cash flow adequacy
Leverage RatiosDebt Financing and Coverage
Considers the proportion of all assets that are financed with debt
Debt Ratio or Debt-Asset Ratio
Total liabilitiesTotal assets
Leverage RatiosDebt Financing and Coverage
Reveals the extent to which long-term debt is used for the firm’s permanent financing (both long-term debt and equity)
Long-term Debt to Total Capitalization
Long–term debtLong-term debt + Stockholders’ equity
Leverage Ratios: Debt Financing and Coverage (cont.)
Measures the riskiness of the firm’s capital structure in terms of the relationship between the funds supplied by creditors (debt) and investors (equity)
Debt to Equity
Total liabilitiesStockholders’ equity
• A ratio under 1 means a majority of assets are financed through equity, above 1 means they are financed more by debt. Furthermore you can interpret a high ratio as a "highly debt leveraged firm".
• If the ratio is high (financed more with debt) then the company is in a risky position - especially if interest rates are on the rise.
Leverage RatiosDebt Financing and Coverage
Indicates how well operating earnings cover fixed interest expenses
Times Interest Earned
Operating profit Interest expense
• A ratio under 1 means that the company is having problems generating enough cash flow to pay its interest expenses.
• Ideally you want the ratio to be over 1.5.
• When is the ratio infinity?
Leverage RatiosDebt Financing and Coverage
Measures how many times interest payments can be covered by cash flow from operations before interest and taxes
Cash Interest Coverage
CFO + interest paid + taxes paidInterest paid
Leverage RatiosDebt Financing and Coverage
Broader measure of how well operating earnings cover fixed charges
Fixed Charge Coverage
*Rent expense = operating lease payments
Operating profit + Rent expenseInterest expense + Rent expense
Leverage RatiosDebt Financing and Coverage
Measures firm’s ability to cover capital expenditures, long-term debt payments and dividends each year
Cash Flow Adequacy
Cash flow from operating activitiesCapital expenditures + debt repayments +
dividends paid
Setting Target Capital Structure:A Checklist
• Taxes- Does the company benefit from debt tax shields?• Expected Distress Costs- Cash flow volatility and potential for increase- Need for external funds for investment- Competitive threat if pinched for cash- Customers care about distress- Hard to redeploy assets
Does the checklist explain observed ratios?
INDUSTRY DEBT RATIO %
ELECTRIC AND GAS 43.2
FOOD PRODUCTION 22.9
PAPER AND PLASTIC 30.4
EQUIPMENT 19.1
RETAILERS 21.7
CHEMICALS 17.3
COMPUTER SOFTWARE 3.5
What does the checklist explain?
• Explains capital structure difference at broad level e.g. between Electric and Gas (43.2%) and Computer Software (3.5%). In general, industries with more volatile cash flows tend to have lower leverage.
• Probably not so good at explaining small difference in debt ratios e.g. between Food Production (22.9%) and Manufacturing Equipment (19.1%)
• Other factors such as sustainable growth are also important.
Key Points
• Recall the tension in Cullum between product market goals (fast goals) and financial goals (modest leverage)
• Fast growing companies reluctant to issue equity end up with debt ratios greater than the target implied by the checklist
• Slow growing companies reluctant to buy back equity or increase dividends end up with debt ratios below the target implied by the checklist.
Key Points
• O.K. to stray somewhat from target capital structure
• But keep in mind: Fast growth companies that stray too far from the target with excessive leverage, risk financial distress.
• Ultimately, must have a consistent product market strategy and financial strategy.
Profitability ratios measure the overall performance of a firm and its efficiency in managing assets, liabilities, and equity.
Key Financial RatiosProfitability Ratios
Profitability ratios include• gross profit margin• operating profit margin• net profit margin• cash flow margin• return on total assets (ROA) or return on investment
(ROI)• return on equity (ROE)• cash return on assets
Key Financial RatiosProfitability Ratios
Profitability RatiosOverall Efficiency and Performance
Measures ability of a company to control costs of inventories or manufacturing of products and to pass along price increases through sales to customers
Gross Profit Margin
Gross profitNet sales
Profitability RatiosOverall Efficiency and Performance
Measures overall operating efficiency and incorporates all of the expenses associated with ordinary business activities
Operating Profit Margin
Operating profitNet sales
Profitability RatiosOverall Efficiency and Performance
Measures profitability after consideration of all revenue and expense, including interest, taxes, and nonoperating items
Net Profit Margin
Net earningsNet sales
Profitability RatiosOverall Efficiency and Performance
Measures ability to translate sales into cash
Cash Flow Margin
Cash flow from operating activitiesNet sales
Profitability RatiosOverall Efficiency and Performance
Measures overall efficiency of firm in managing investment in assets and generating profits
Return on Total Assets (ROA) or Return on Investment (ROI)
Net earningsTotal assets
Profitability RatiosOverall Efficiency and Performance
Measures rate of return on stockholders’ investment
Return on Equity (ROE)
Net earnings(Average) Stockholders’ equity
Profitability RatiosOverall Efficiency and Performance
Measures firm’s ability to generate cash from the utilization of its assets
Cash Return on Assets
Cash flow from operating activitiesTotal assets
Key Financial RatiosMarket Ratios
Market ratios measure returns to stockholders and the value the marketplace puts on a company’s stock. Market ratios include
• earnings per common share• price-to-earnings• dividend payout• dividend yield• EV/EBITDA & PEG
Market RatiosEarnings per Common Share
Provides the investor with a common denominator to gauge investment returns
Earnings per Common Share
Net earnings – Preference Dividend
Average equity shares outstanding
Market RatiosPrice-to-Earnings
Relates earnings per common share to the market price at which the stock trades.“Multiple” expresses the value that the stock market places on a firm’s earnings.
Price-to-Earnings
Market price of common stock
Earnings per share
Calculate p/e
• A current price of the stock ABC is Rs.35 per share and the companies earnings for the prior 12 months or fiscal year is Rs.3.5 a share.
• P/E = 10• This no. can be thought of as the number of
years it will take the company ABC to earn back the amount of your initial investment, assuming of course the company’s earnings stay constant.
To explain that…
• Take the same example… • Lets say you buy 100 shares of the ABC stock
for Rs.3500. Current earnings are Rs.3.5 so your 100 shares will earn Rs.350 in one year.
• The original investment of Rs.3500 will be earned back in 10 years.
• However you don’t have to go through this exercise because the p/e ratio of 10 tells you its 10 years.
• If you buy shares in a company selling at 2 times earnings, you will earn your initial investment in 2 years, but in a company selling at 40 times earnings, it would take 40 years to accomplish the same thing.
• With all the low p/e opportunities around why would anybody buy a stock with a higher p/e?
- Because corporate earnings do not stay constant
Bargain Hunters Strategy: Buy all stocks with low p/e’s say (ard 8)
• Does this strategy make sense?• No!• What’s bargain p/e for a FMCG is’nt
necessarily the same as a bargain p/e for a IT company.
Ranges
• Lowest p/e levels tend to be lowest for the slow growers and highest for high growers with cyclical stocks oscillating in between
• Let us try to categorize sectors by finding average p/e of industry.
Peter Lynch says…
• “It is silly to get bogged down in p/e’s but you don’t want to ignore them”
• “this company is selling at a discount to the industry” – meaning its p/e is at a bargain level
• Before you buy a stock, you might want to track its p/e ratio back through several years to get a sense of its normal levels.
• E.g. If you buy Infosys, its useful to know whether what you’re paying for the earnings is in line with what others have paid for the earnings in the past. The p/e ratio can tell you that.
Few cases
• Premise: A company with a high p/e must have incredible earnings growth to justify the high price that’s been put on the stock.
• 1972, Mc Donald’s was the same great company it had always been, but the stock was bid up to $75 a share, which gave it a p/e of 50. There was no way that Mc. Donald’s could live up to those expectations, the stock fell from $75 to $25, sending back the P/E to a more realistic 13. There was nothing wrong with McD. The stock was simply overpriced.
Electronic Data Systems
• Hot stock in the late 1960s. This company had a P/E of 500!
• It would take 5 centuries to make back your investment in EDS, if earnings stayed constant.
• A brokerage report on the company said: P/E was conservative because EDS ought to have a P/E of 1000.
What is the flaw?
• Years that followed, EDS performed very well. The earnings and sales grew dramatically, everything it did was a whopping success.
• EDS, the stock, was another story. The price declined from $40 to $3 in 1974, not because there was anything amiss at head-quarters, but because stock was very overpriced.
• High PE Shares are those shares on which investors/traders have high confidence
• During bull markets they are normally stocks of day E.g. Educomp, GMR Infra during 2007
The P/E of the Market
• The stock market as a whole has its own collective p/e, which is a good indicator whether the market at large is overvalued or undervalued.
• In the bull market of 1982 to 1987 in US, market’s overall p/e crept gradually from 8 to 16. Meaning?
• Investors in 1987 were willing to pay twice what they paid in 1982 for the same corporate earnings. Red flag?
• How do you think interest rates effect on prevailing p/e ratios? – Investors pay more for stocks when interest rates
are low, leading to higher p/e levels.
• Consider a period when the fast growers command ridiculously high p/e levels and slow growers command p/e ratios normally reserved for fast growers; also if the market hits a p/e of 22 (unheard levels in the past). Can students of p/e issue a recommendation?
Forward Price Earnings Ratio
A measure of the price-to-earnings ratio (P/E) using forecasted earnings for the P/E calculation. While the earnings used are just an estimate, there is still benefit in estimated P/E analysis.
Why use Forward P/E?
• If earnings are expected to grow in the future what is the relation between the estimated P/E and the current P/E?
• Former is lower.• This measure is used to compare one
company to another with a forward-looking focus.
Future Earnings – How do you predict those?
• Lots of analysts and statisticians are launched against the question of future growth and future earnings. They often fail as…
• The word most frequently with “earnings” is “surprise”
• If you cant predict future earnings, at least you can find out how the company plans to increase its earnings using 5 basic ways and periodic checks
How can companies increase its earnings?
• Reduce costs• Raise prices• Expand into new markets• Sell more of its product in old market• Revitalize/close/dispose off a losing operation
Earnings yield
• The reverse (or reciprocal) of the P/E is the E/P.
• Robert Shiller’s plot of the S&P Composite Real Price-Earnings Ratio and Interest Rates (1871–2008), from Irrational Exuberance
• Shiller warns that "the stock market has not come down to historical levels: the price-earnings ratio as I define it in this book is still, at this writing [2005], in the mid-20s, far higher than the historical average. ... People still place too much confidence in the markets and have too strong a belief that paying attention to the gyrations in their investments will someday make them rich, and so they do not make conservative preparations for possible bad outcomes.“
• PE ratio India Inc. now and 2006?
• Price-Earnings ratios as a predictor of twenty-year returns based upon the plot by Robert Shiller.
• The vertical axis shows the geometric average real annual return on investing in the S&P Composite Stock Price Index, reinvesting dividends, and selling twenty years later.
• Shiller states that this plot "confirms that long-term investors do well when prices were low relative to earnings at the beginning of the twenty years. Long-term investors would be well advised, individually, to lower their exposure to the stock market when it is high, as it has been recently, and get into the market when it is low."
PEG
"The P/E ratio of any company that's fairly priced will equal its growth rate“
- Peter Lynch
The PEG ratio's validity at extremes in particular (when used, for example, with low-growth companies) is highly questionable. It is generally only applied to so-called growth companies (those growing earnings significantly faster than the market).
Market RatiosDividend Payout
Determined by the formula cash dividends per share divided by earnings per share
Dividend Payout
Dividends per share
Earnings per share
Market RatiosDividend Yield
Shows the relationship between cash dividends and market price
Dividend Yield
Dividends per share
Market price of common stock
Enterprise Value
• A measure of a company's value, often used as an alternative to straightforward market capitalization. Enterprise value is calculated as market cap plus debt, minority interest and preferred shares, minus total cash and cash equivalents.
• theoretical takeover price
EV/EBITDA alternative to P/E
• An advantage of this multiple is that it is capital structure-neutral. Therefore, this multiple can be used for direct cross-companies application
• how many years it would take to pay back the investment used by private equity professionals
• EBITDA/EV is the metric most used to measure the cash rate of return on the investment
Analyzing the Data
There are five broad areas that would typically constitute a fundamental analysis of financial statements:
• Background on the firm, industry, economy, and outlook
• Short-term liquidity• Operating efficiency• Capital structure and long-term solvency• Profitability
Background: Economy, Industry, and Firm
Economic developments and the actions of competitors affect the ability of any business enterprise to perform successfully.
It is necessary to evaluate the environment in which the firm conducts business.
This process involves blending hard facts with guess and estimates.
Short-Term Liquidity
Especially important to creditors, suppliers, management, and others who are concerned with the ability of a firm to meet near-term demands for cash
Should include analysis of selected financial ratios and a comparison with industry averages
Predicts the future ability of the firm to meet prospective needs for cash
Operating Efficiency
Turnover ratios measure the operating efficiency of a firm.
The efficiency in managing a company’s accounts receivable, inventory, and accounts payable is discussed in the short-term liquidity analysis.
Capital Structure and Long-Term Solvency
Analytical process includes an evaluation of the amount and proportion of debt in a firm’s capital structure as well as the ability to service debt.
Debt financing implies risk and leverage.
Profitability
Analysis of how well the firm has performed in terms of profitability, beginning with the evaluation of several key ratios
Final Presentation
• Aim of this presentation, which is the final leg of your analysis for your company as CFO, is to identify 2 strengths and 2 weaknesses of your company. Your opinion about investment potential (for investors) and creditworthiness of the firm (for bankers) is called for.
Make a 5-slide 5-minute presentation under the following heads –
• Strengths & Weaknesses (Obtained AFTER analysis, not stating the obvious)
• Guide to investors (Focus on the future growth, you can use the 5 factors that lead to growth using the basic checklist)
• Guide to creditors (Leverage Ratios, Target Capital Structure checklist)
• Read up a recent move undertaken by the company (it could be with relation to capital structure, sales, acquisition etc.) and see if it fits your analysis. E.g. a launch of 630Crore buy-back program by HUL. Can you explain the same by your ‘AFS’ including g and g* analysis.
• Survival of your company in the upcoming recession. How well prepared is your company?
• These presentation hold 2.5-5% of your final grade and will be graded in class in the last week on August.
• Q&A Session
• Be prepared to answer questions on quality of financial reporting about the company. E.g do you feel that your company follows a liberal, conservative or industry-based methods of accounting. Target Capital Structure checklist should also be kept in mind wrt your company.
• Please strictly adhere to the above guidelines.