SESSION 1 Financial Statement Analysis

7/31/2019 SESSION 1 Financial Statement Analysis

http://slidepdf.com/reader/full/session-1-financial-statement-analysis 1/70

Financial Statement Analysis(Ratio Analysis)

Prof. Mishu Tripathi

Faculty-Finance



Financial Analysis

• Financial analysis is the process of identifying

the financial strengths and weaknesses of the

firm by establishing relationships between the

item of the balance sheet and the profit and

loss account.





Financial Analysis

• Unlike in the past when security was consideredto be sufficient consideration for banks andfinancial institutions to grant loans and advances,nowadays the entire lending is need-based and the

emphasis is on the financial viability of a proposaland not only on security alone.

• Further all business decision contains an elementof risk. The risk is more in the case of decisions

relating to credits.

• Ratio analysis and other quantitative techniquesfacilitate assessment of this risk.



Ratio Analysis (RA)

• Ratio-Analysis is the process of computing,determining and presenting the relationship of

related items/ groups of items of the financial

statements.• RA provide summarized idea about the

financial position of a unit. They are important

tools for financial analysis.• RA is used as a decision making tool.



Definition and Uses of Ratio

• A ratio can be defined as one number dividedby another. Two numbers when viewed as ratio

provide a relationship of one with respect to

another.• Financial ratios is used in 3 ways namely:

– As an absolute number

– As a historic sequence or time series – As a comparison with the industry or a

benchmark.





Importance of Ratio Analysis

It is a tool which enables the banker or lender toarrive at the following factors :

• Liquidity position

• Profitability

• Solvency

• Financial Stability

• Quality of the Management

• Safety & Security of the loans & advances to

be or already been provided



Precaution while using RatioAnalysis

a. The dates and duration of the financial statementsbeing compared should be the same. If not, the effects

of seasonality may cause erroneous conclusions to be

drawn.

b. The accounts to be compared should have been

prepared on the same bases. Different treatment of

stocks or depreciations or asset valuations will distort

the results.c. In order to judge the overall performance of the firm

a group of ratios, as opposed to just one or two should

be used. In order to identify trends at least three years

of ratios are normally required.



How a Ratio is Expressed?

1. As Percentage-such as 25% or 50% . Forexample if net profit is Rs.25,000/- and the sales isRs.1,00,000/- then the net profit can be said to be25% of the sales.

2. As Proportion-The above figures may beexpressed in terms of the relationship between netprofit to sales as 1 : 4.

3. As Pure Number /Times-The same can also beexpressed in an alternatively way such as the saleis 4 times of the net profit or profit is 1/4th of thesales.



Types of Financial Ratios

RatioAnalysis

LiquidityRatios

Leverage

Ratios

AssetManagement

Ratios

ProfitabilityRatios

Operating

Ratios

MarketBased

Ratios



Liquidity Ratios

• The liquidity ratios measure the liquidity of the

firm and its ability to meet its maturing short

term obligations. Liquidity is defined as the

ability to realize value in money, the mostliquid of assets. It refers to the ability to pay in

cash, the obligations that are due.

• The corporate liquidity has two dimensions – Quantitative Concept

– Qualitative Concept





How liquid the firm should be?

• Excess liquidity though the guarantor of solvency would reflect lower profitability,

deterioration in managerial efficiency,

increased speculation ,unjustified expansion

and extension of too liberal credit and dividend

policies.

• Too little liquidity may lead to frustration,

business objections, reduced rate of return,

missing of profitable business opportunities

and weakening of morale.



Types of Liquidity Ratios

Current Ratio

Quick Ratio/AcidTest Ratio

Cash Ratio





Importance of Current Ratio

• A current ratio of more than 1 indicates the

excess of current assets over current liabilities

and the firm is said to be liquid.

• Higher the current ratio the better is the firm

from the lenders perspective. But the firm has

to be cautions of a very high current ratio as it

affects the profitability adversely.















Capital Structure Ratios • Capital Structure Ratios measure the

relationship between owners funds and

borrowed funds.

• A high usage of borrowed funds bring down

the cost of financing but makes the firm more

risky.



Capital Structure Ratios • Debt equity ratio, debt to asset ratio, total

outside liabilities to net worth, total outside

liabilities to assets, debt coverage ratio, interest

coverage ratio and the debt service coverageratio are the most prominent measure of capital

structure.



Debt Equity Ratio

• The debt equity ratio is defined as amount of long term debt divided by the amount of

shareholder’s funds.

• The current ratio is more meaningful for short-term creditors of the firm, who are concerned

about cash generation in immediate future, the

long term creditors prepared to look fartherinto the future are more concerned about debt

equity ratio.



Significance of Debt EquityRatio

• The lower the value the better is the debtequity ratio

• The increasing amount of debt, as reflected in

higher debt ratios, the firm is considered morevulnerable to external stocks and its operations

are deemed risky.

•The low values of debt ratios imply foregoingthe advantage of debt. Since debt is the

cheapest source of funds than equity, its use

enhances shareholders’ earnings





Examples of Debt Equity Ratio

• Capital Intensive Industries such as cement,steel, and infrastructure would have higher

debt ratio as compared to industries such as

software development, consumer goods etc.• Role of banks and Financial institutions in debt

equity ratio??

– More debt is provided to capital intensiveindustries because they have large base of fixed

assets





Interest Cover Ratio

• It indicates the extend to which profits (PBIT)

are sufficient to pay the existing interest

obligations.

• Higher the ratio more is the cushion available

to lenders.





Fixed Charge/Debt ServiceCoverage Ratio

• It measures the ability of the firm to meet its

total debt obligations (both interest and

principal)

• Formula for calculating DSCR: PBIT +

Depreciation + Non cash expense – non cash

income/ (Interest Obligation + Loan

Installment/ (1-Tax Rate))





Working Capital Ratios

CurrentAsset

Turnover

InventoryTurnover

Ratio

DebtorsTurnover

Ratio



Working Capital Ratios

• It denotes the efficiency of firms in handling

its operations. More quickly a firm turns over

the different current assets eventually into

cash, more efficient is the firm.





Current Assets Holding Period

• Formula

• Average Current Assets/Sales*365 days

•Expressing current assets as holding period innumber of days provides an estimate about the

length of the firm’s working cycle.

• There is an inverse relationship between

current assets turnover and the holding period.

Si ifi f C A



Significance of Current AssetsHolding Period

• A higher turnover ratio or shorter currentassets holding period denotes better utilization

of funds deployed in current assets

• With smaller holding period- lower level of funds in current assets- it is implied that the

firm can achieve larger sales with smaller

capital, and exhibits better profitability to theextent of savings made in the cost of funds.









Inventory Turnover Ratios•

Inventory component in the current assets isfarthest from cash and deserves attention.

• It expresses the relationship between cost of goods sold and inventory

• It denotes the efficiency in inventorymanagement. An increasing ratio signifiesbetter inventory management.

• Formula:• Cost of Goods Sold (COGS)/Average

Inventory



Inventory Turnover Ratios • There are three components of inventory

turnover ratio:

– Raw-Material Turnover Ratio (Raw Material

Consumption/Average Raw Material Inventory)

– W.I.P. Turnover Ratio (Cost of Production/

Average WIP Inventory)

– Finished Goods Turnover Ratio (Cost of Sales/ Average Finished Goods Inventory)



Inventory-Holding Period

• It denotes the shelf life of inventory.

• It shares the inverse relationship with

inventory turnover ratio.

• Formula

• Average Inventory/Cost of Goods Sold

(COGS)*365 days.

R f i l



Reason of using sales asnumerator??

1. Uniformity of Interpretation

2. Non-availability of relevant figures of raw

material consumption, cost of production and

cost of sales in publicly available financial

statements

3. As a matter of convenience

U f I T R i



Uses of Inventory Turnover Ratiosor Holding Periods

1. Measurement tools for determining theefficiency of inventory management, and thetrend over successive periods

2. Diagnostic tools to find weak areas such as

accumulation of non-moving or slow movingstocks

3. Norm-setting tools for developing guidelines forfinancing

4. Comparative tools for accessing relativeperformance of a firm with respect to itscompetitors, industry and against a benchmark.



Debtors Turnover Ratio

• It expresses the relationship between sales anddebtors.

• It reflects the efficiency with which the debtors

are turned over into cash• Improvement in the ratio indicates better

receivables management.



Debtors Turnover Ratio • Debtors Turnover Ratio=Sales/Average

Debtors

• Average Collection Period= Average

Debtors/Sales*365 days

• Increasing debtors turnover brings down

collection period and hence reduces the

blockage of fund sin receivables.



Uses of Debtors Turnover Ratio • It is a measurement tool to know the speed of

collection and efficiency of collection

department

•It is a comparative tool to assess the collectionpolicy with respect to competitors and industry

• A norm-setting tool to formulate guidelines for

financing by banks and financial institutionscollection and credit policy on sales, volume

and profit.



Ageing of Debtors



Uses of Debtors Turnover Ratio • A predictive tool for understanding the level of

competition and likely changes in the

profitability. Normally increasing credit implies

hotter competition and declining profitability

• A analytical tool for cost volume profit planning

by ascertaining the impact of changes in the

collection and credit policy on sales, volume and

profit.• It is a policy determinant for deciding the cash

discount incorporating the cost of capital of the

firm



Ageing of Debtors

• Debtors’ ageing schedule categorizes the

debtors as per the period for which they have

been outstanding.

• It is the device for monitoring of receivables

and helps in identifying the potential defaulters

and the corresponding risk.



Creditors’ Turnover Ratio

• It reflects the number of times average dues tothe suppliers is settled.

• Higher the turnover, lower the payment period

offered by the suppliers• Creditors Turnover Ratio= Purchases/Average

Creditors

• Average Credit Availed= AverageCreditors/Purchases*365 days





Use of Average Figures

• In case of working capital ratios, average of the opening and closing values of stock,debtors, creditors and stock is used because thecorresponding figure relates to the period

rather than one point of time.• It is to smoothen out the changes over the

period of time

• In case of high-growth firms use of averagefigures rather than end-of-the-period valueswould lead to more sound conclusions



Profitability Ratios

• Profitability ratios refer to those financial

metrics that are used to assess a business’s

ability to generate earnings.

• A higher profitability ratio relative to a

competitor's ratio or the same ratio from a

previous period is indicative of better

performance.



ProfitabilityRatios

ValueAddition

Contribu-tion

Margin

GrossProfit

Margin

Net ProfitMarginReturn on

CapitalEmployed(ROCE)

Return onEquity

EarningPer Share

(EPS)

DividendPer Share

(DPS)



Value Addition

• Value addition is the enhancement made to thevalue of a product or service before offering

the same to customers.

• Higher the value added as a percentage of sales, better is the bottom-line for the firm.

• Value Addition= Sales-Purchases

• Value Addition in %=( Sales-Purchases)Sales*100



Uses of Value Addition • Increasing value addition in absolute terms

without the increase in value addition ratio

implies increasing volumes and market share

but stagnation in the area of productdevelopment

• If value addition ratio is increasing without

the increase in value addition ratio in absolute

terms it would imply creativity, product

innovation etc on part of the firm.



Contribution Margin

• The margin available once the variable costshave been covered before is known as

contribution margin.

• The margin goes to meet the fixed costs.• A larger contribution margin is desirable.

• Contribution =Sales-Variable Cost

• Contribution in % = (Sales-VariableCost)*Sales



Gross Profit Margin

• Gross profit margin is defined as excess of sales over cost of goods sold.

• While computing Gross Profit Margin the

following must be kept in mind: – Depreciation is to be included in cost of production

– Selling, general and administrative overheads must

be excluded from the cost and

– Non-operational income must be excluded from

the revenue



Gross Profit Margin • Gross Profit Margin is the excess of total sales

revenue over its cost of goods sold.

• It reflects production efficiency.

• Higher the gross margin, more is the cushion

available to meet its overheads.

• Formula

• Gross Profit Margin= Sales-Cost of Goods

Sold (COGS)/ Sales and EBIT/Sales*100



Gross Profit Margin • Gross Margin in absolute terms represents the

amount of money the company generated over

the cost of producing its goods and services.

• In relation to sales, it reflects the proportion of

sales revenue that the company generates as

gross profit to be put towards paying off

general and administrative expenses andultimately banked as net income.

Precautions while calculating Gross



Precautions while calculating GrossProfit Margin

1. Depreciation to be included in the cost of

production

2. Selling, general and distribution overheads

must be excluded from the cost and

3. Non-operational income must be excluded

from the revenue.

Significance of Gross Profit



Significance of Gross ProfitMargin

• Good Gross Profit margin reflects the ability of

the firm to meet production expenses while EBIT

based profitability reflects the ability to recover

all expenses of procurement, production andsales. Financial expenses, which depend upon the

capital structure are excluded

• The comparison of EBIT based profit of various

firm excludes the leverage employed in financing

by the enterprise

Significance of Gross Profit



Significance of Gross ProfitMargin

• Poor profit indicates any one of the following:1. Inability of the firm to procure inputs at

competitive prices

2. Selling finished product at lower prices

3. Excessive overheads

4. High capital investment resulting in higher

utilization or;

5. Poor utilization of production capacity



Net Profit Margin

• Net profit often referred to as “the bottom line”

is arrived by taking revenues and adjusting

them for the cost of doing business,

depreciation, interest, taxes and other expenses

• Net Margin as a percentage of sale reflects the

overall profitability of the business.

• Formula:

• PAT/Sales*100



Significance of Net Profit Margin • It measures the efficiency of the firm in

managing production, procurement, sales,

financing and tax planning



Valuation Ratios

MarketValue to

Book ValueRatio

Price-Earnings

Ratio

EarningsYield &

DividendYield

Date post:	05-Apr-2018
Category:	Documents
Upload:	khushal-gorwadiya
View:	220 times
Download:	0 times

SESSION 1 Financial Statement Analysis

Documents