395 33 Powerpoint Slides 2 Comparative Historical Analysis CHAPTER 2

CHAPTER 2

CONTENTS

Introduction

Balance Sheet

Profit & Loss Account

Cash Flow Statement

Stakeholders

Ratios and their types:

• Liquidity ratios, Capital Structure ratios, Working Capital ratios, Profitability ratios, Valuation ratios, DU PONT analysis

COMPARATIVE AND HISTORICAL ANALYSIS

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CONTENTS

Common size statements

Uses of ratio analysis

Limitations of ratio analysis.


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INTRODUCTION

The historical financial performance is of significant importance for the various stakeholders.

Past performance forms the basis for future expectations.

Past financial performance is reflected in financial statements.

Financial statements consist of: Balance Sheet

Profit and Loss Account

Cash Flow Statement.


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BALANCE SHEET

Reflects the financial condition of the firm as on a particular date.

Consists of:

• Assets

• Liabilities

• Owners Equity


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BALANCE SHEET

Assets denote uses of funds Assets are classified broadly into:

• Fixed assets

• Investments

• Current assets, loans and advances

• Miscellaneous assets and losses.


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BALANCE SHEET

Liabilities are the sources of external funds.

They are also referred to as obligations (or what the business owes) to outsiders.

Liabilities are broadly classified as:

• Secured and unsecured loans

• Current liabilities and provisions

• Contingent liabilities.


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BALANCE SHEET

Owners’ equity refers to the capital contributed by the shareholders (owners).

It consists of:

• Paid up capital

• Reserves and Surplus

Share capital is of two types:

• Equity share capital

• Preference share capital


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PROFIT AND LOSS ACCOUNT

Shows the income earned and the expenses incurred during a period.

Reflects earning capacity and profitability for a period.

Also referred to as Income Statement.


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CASH FLOW STATEMENT

Summarizes sources and uses of cash.

Provides vital information for decision making and analysis.

Shows inflows and outflows of cash under the following three activities:

• Cash flow from operating activities

• Cash flow from investing activities

• Cash flow from financing activities.

Reflects the quality of liquidity (cash) of the business.


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STAKEHOLDERS

All those who have stake in the business.

Are varied and so are their interests.

Examples include:• Shareholders• Suppliers• Customers• Competitors• Lenders• Employees• Government & Society.


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STAKEHOLDERS

Depending on their stake, they look for some specific set of information in the financial statements.

Though profitability remains their common focus, specific areas of financial performance are of greater interest to them.

Financial statements at regular intervals provide answers to most questions that the they may have regarding the firms’ performance.


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RATIO AND TYPES

Tool for review and analysis of financial performance.

A ratio expresses the relationship between two related financial variables.

It facilitates analysis by eliminating:

• the problem of size and

• the bias that creeps in because of size.


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RATIO AND TYPES

By converting absolute figures into relative values, ratio analysis makes possible comparisons across time and firms.

There are 5 prominent categories of ratios: Liquidity Ratios

Capital Structure or Leverage Ratios

Working Capital Ratios

Profitability Ratios

Valuation Ratios.


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LIQUIDITY RATIOS

Denotes the firm’s capacity to pay its short-term obligations on time.

Depends on the level of current assets owned by the firm.

Three prominent measures of liquidity: • Current ratio,

• Acid test ratio and

• Cash ratio.


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LIQUIDITY RATIOS-CURRENT RATIO

The ratio of current assets to current liabilities.

A current ratio of more than 1 indicates that the current assets are in excess of current liabilities.

Higher the current ratio better is the firm from the lenders’ perspective.


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sLiabilitie CurrentAssets Current

=Ratio Current

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LIQUIDITY RATIOS – ACID TEST RATIO

Ratio of current assets, excluding inventory, to the current liabilities.

Inventories are excluded as they are least liquid of the current assets.

It is also referred to as quick ratio.

It is more stringent measure of liquidity than current ratio.


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sLiabilitie CurrentInventory-Assets Current

=Ratio Test Acid

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LIQUIDITY RATIO–CASH RATIO

Denotes the extent to which cash and near cash marketable securities are sufficient to meet the current liabilities.

Most stringent measure of firm’s liquidity.


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sLiabilitie Current es Securitile Marketab Cash

=Ratio Cash

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CAPITAL STRUCTURE RATIOS

Measure the relationship between owners’ funds and borrowed funds.

A high usage of borrowed funds:

• brings down the cost of financing

• increases returns to shareholders

• makes the firm more risky.

Can be sub-divided into:

• structural ratios

• coverage ratio.


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STRUCTURAL RATIOS Structural ratios denote the

composition of capital (i.e. proportion of debt vis-à-vis equity used in financing).

Most commonly used structural ratios are:

• Debt to equity ratio

• Debt to asset ratio

• Total outside liabilities to net worth.


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• Debt-equity ratio

• Debt to asset ratio

• Total outside liabilities to net worth


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Worth Net Debt Term Long

=

Assets Net Debt Term Long

Worth Net sLiabilitie Outside Total

=

CHAPTER 2


STRUCTURAL RATIOS

Denote the relationship between the borrowed funds and owners’ funds.

Generally a large value of structural ratio is disliked. It makes the firm vulnerable to business cycles.


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STRUCTURAL RATIOS

CAPITAL STRUCTURE RATIOS-COVERAGE RATIOS

While structural ratios depict proportion of debt compared to equity or assets, coverage ratios express ability of the firm to service its debt.

Commonly used coverage ratios are:

• Interest coverage ratio

• Debt service coverage ratio


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CAPITAL STRUCTURE-COVERAGE RATIOS

CHAPTER 2COMPARATIVE AND HISTORICAL ANALYSIS

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Rate Tax-1Instalment Loan

Obligation Interest

comeExpense/In Cash NononDepreciatiPBIT= Ratio Coverage

ServiceDebt

obligation Interest(PBIT) Taxes and Interest Before Profit

= Cover Interest

CAPITAL STRUCTURE-COVERAGE RATIOS

Higher the value of coverage ratios safer is the firm from the lenders perspective.

Interest cover indicates the extent to which profit is able to pay interest. Higher ratio means more cushion available to lenders.

Debt service coverage ratio measures the ability of the firm to meet out its total debt obligations (both interest and principal).


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WORKING CAPITAL RATIOS

Denote the efficiency of firms in handling their operations.

More quickly a firm turns over the current assets into cash, more efficient it is.

Also referred to as Turnover ratios or Activity Ratios.

At an aggregate level, efficiency of internal operations is measured by current assets required to generate sales (i.e. current assets turnover ratio).


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WORKING CAPITAL RATIOS

Further insight to operational efficiency is provided by analysing components of working capital.

Commonly used ratios are:

• Inventory turnover

• Debtors’ turnover

• Creditors’ turnover.


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CURRENT ASSET TURNOVER

Defined as sales to current assets.

Indicates how many times the current assets have been turned over into sales in a given period (usually a year).

An increasing ratio is a sign of improving efficiency.


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Assets Current AverageSales

=

Ratio Turnover Assets Current

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CURRENT ASSET TURNOVER

Alternatively, it can also be expressed in terms of no. of days (i.e. current assets holding period)

Lesser the holding period, more efficient the operations.


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days X 365 Sales

Assets Current Average=

Period Holding

Assets Current

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INVENTORY TURNOVER RATIO

Expresses the relationship between cost of goods sold and inventory.

Alternatively it can also be expressed as no. of days of inventory (referred to as Inventory holding period)


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Inventory Average SoldGoodsof Cost

= Ratio Turnover Inventory

Days 365x SoldGoodsof Cost

Inventory Average=

Period Holding Inventory

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INVENTORY TURNOVER RATIO

Denotes efficiency in inventory management.

An increasing ratio (or a decreasing holding period) signifies better inventory management.


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DEBTOR TURNOVER RATIO

Expresses the relationship between sales and debtors.

Alternatively, it can be expressed in no. of days (referred to as Average Collection Period)


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Debtors AverageSales

= Ratio Turnover Debtors

Days 365x Sales

Debtors Average=

Period Collection Average

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DEBTOR TURNOVER RATIO

It reflects the efficiency with which the firm realises its sales i.e. how fast the debtors are turned over into cash.

Improvement in the ratio (or reduction in the average collection period) indicates better receivables management.


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CREDITORS TURNOVER RATIO

Reflects the number of times the dues to the suppliers are settled.

Alternatively, it can be expressed in terms of no. of days (referred to as average credit availed)


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CreditorsPurchases

= Ratio Turnover Creditors

Days 365x PurchasesCreditors

=

Availed Credit Average

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PROFITABILITY RATIOS

Reflect business's ability to generate earnings.

Higher ratios indicate better performance.

Examples of profitability ratios are:

• Profit margin

• Return on capital employed

• Return on assets

• Return on equity.


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PROFITABILITY RATIOS -CONTRIBUTION MARGIN

Margin available, vis-à-vis sales, once the variable costs have been covered.

As this margin goes to meet the fixed costs larger margin is desirable.


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100 x Sales

cost Variable-Sales=

(%) MarginonContributi

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PROFITABILITY RATIOGROSS PROFIT MARGIN

Gross Profit expressed as a percentage of sales.

Reflects production efficiency.

Higher the gross profit margin more is the cushion to meet out the overheads.


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x100Sales

SoldGoodsof Cost -Sales

(%) MarginProfit Gross

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PROFITABILITY RATIONET PROFIT MARGIN

Net Profit Margin (or simple Net margin) is ratio of Profit After Tax (PAT) to sales.

Reflects the overall efficiency of the business.


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100xSalesPAT

Margin(%)Profit Net

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PROFITABILITY RATIORETURN ON CAPITAL EMPLOYED

(ROCE)

Is a measure of efficiency of capital.

Also known as Return on Investment (ROI).


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x100Assets Net

T)-EBIT(1=

% (ROCE) Employed Capital on Return

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PROFITABILITY RATIORETURN ON EQUITY

(ROE) Return that the firm has been able to earn

on the equity financed portion of its capital.

Increasing ROE denotes improving efficiency of the firm in handling its shareholders’ funds.


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x100Worth Net

(PAT) Tax After Profit= ROE%

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PROFITABILITY RATIOEPS AND DPS

Earnings per Share (EPS) is the return earned on a per share basis.

The part of EPS that the firm distributes to the shareholders is known as Dividend per share (DPS).


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sharesof NumberPAT

=)(Rs./Share EPS

sharesof Number Dividend

=)(Rs./Share DPS

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VALUATION RATIOS

Assess the value that stock market places on stocks.

Commonly used ratios are:

• Earnings and dividends yield

• Price earnings ratio

• Price to book ratio.


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VALUATION RATIOEARNINGS AND

DIVIDENDS YIELD

Earnings/dividends expressed as a percentage of market price gives earnings/dividends yields respectively.


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Share perPrice MarketEPS

(%) Yield Earnings

Share perPrice MarketDPS

(%) Yield Dividends

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VALUATION RATIOS-PRICE EARNINGS RATIO

Shows how much the investors are willing to pay per rupee of reported profits.

Also referred to as P/E multiple.

Reflects the confidence that the market reposes in a given firm/scrip.


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Shareper Earnings

Shareper PriceMarket (P/E) Ratio Earnings Price

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VALUATION RATIOPRICE BOOK RATIO

Ratio of market price of a stock to its book value.

Reflects the perception of investors towards a stock.

Firms with relatively higher returns on equity generally sell at higher P/B.


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Share perValue Book Share perPrice Market

(P/B) Ratio Book to Price

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DUPONT ANALYSIS

Introduced by DU Pont Co. of USA.

Establishes relationship of few important ratios.

Return on assets or the return on capital employed is a function of margin on sales (i.e. profitability) and the efficiency of the assets utilisation (i.e. operating efficiency).


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DUPONT ANALYSIS


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Worth NetAssets

Assets

Tax After ProfitWorth Net

Tax After Profit ROE

Worth NetWorth NetLoan

AssetsTax After Profit

)(EquityDebt

1 ROA

)EquityDebt

(1 Turnover Asset Profit Net

Leverage Financial

Efficiency Operating

MarginOperating

CHAPTER 2

COMMON SIZE STATEMENTS

A financial statement that displays all items as percentages of a common base figure.

Allow easy analysis across companies and across time.

Enables to remove bias due to size.

The values are expressed as a percentages of revenue or assets.


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USES OF RATIO ANALYSIS

Ratio analysis helps in:

• Diagnosis and objective analysis of financial performance.

• Financial planning and decision-making by creditors

• Setting a benchmark for performance.


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LIMITATIONS OF RATIO ANALYSIS

Arbitrariness in the selection

Lack of unanimous definitions

Locational, business, and accounting differences.


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395 33 Powerpoint Slides 2 Comparative Historical Analysis CHAPTER 2

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