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Ratio Analysis and Basic ValuationWorkshop1Standard P&LGross Sales-Excise/VATNet Sales-COGSGross Profit-Operating expenses (SG&A) excluding DepreciationEBITDA -DepreciationOperating Profit (EBIT) (EBITDA-D = EBIT)-Interest-Extra-ordinary incomes / lossProfit before tax (EBIT-I = EBT)-TaxProfit After Tax 2Types of RatiosProfitability : to check the margins for the firm and also for investorsLiquidity : to check how well the company is able to pay its short term liabilitiesEfficiency : to check how efficiently the company manages its operationsSolvency : to check whether the company is financially sound enough to meet its long term liabilities

Profitability Ratios4Gross Profit MarginUsed to analyze how efficiently a company is using its raw materials, labor and manufacturing-related fixed assets to generate profits.Industry characteristics of raw material costs have a major effect on a company's gross margin.

5EBITDA MarginEBITDA Sales EBITDA=Revenue-Expenses(Excl Interest Tax Depreciation and Amortization)Excludes non cash expenses like depreciation and amortizationIt nullifies the Financing and the differences in depreciation related provisions It is an appropriate metric to compare companies from different countriesNote: EBITDA can be used as proxy for CFO6Operating(EBIT) MarginOperating Profit / EBIT Sales EBIT=Revenue-Expenses(Excl Interest Tax)By excluding both taxes and interest expenses, it removes the effects of the different capital structures and tax rates and thus makes for easier cross-company comparisons.Operating income figure is often the preferred by investment analysts, versus net profit figure, for making inter-company comparisons.7PAT Margin PAT Sales

The bottom line is the most often mentioned when discussing a company's profitability. There are several income and expense operating elements that determine a net profit margin. Investors should take a comprehensive look at a company's profit margins on a systematic basis. 8Return on Equity Net Income _Shareholders equity

Indicates how profitable a company is by comparing its net income to its average shareholders' equity. Disproportionate amount of debt would translate into a smaller equity base. Thus, a small amount of net income (the numerator) could still produce a high ROE off a modest equity base (the denominator). 9Return on Investments/Return on Capital EmployedEBIT Total Assets-Current Liabilities

Should be higher than the rateat whichthe company borrows, otherwise any increase in borrowing will reduce shareholders' earnings.Total Assets Current Liabilities is your Capital EmployedCapital Employed is also equal to Total Equity + Long Term Debt

10Earnings Per Share PAT - Preference Dividend Number of Equity Shares

Portion of a company's profit allocated to each outstanding share of common stockShould not be compared with other companies.

11Dividends Per Share Dividend paid to Equity Shareholders Number of Equity Shares

Having a growing dividend per sharecan bea sign that the company's management believes that the growth can be sustained.Dividend distribution depends on the growth prospects of the company

12Liquidity Ratios13Current RatioAscertain whether a company's short-term assets are readily available to pay off its short-term liabilities.In theory, the higher the better.Try to understand the types of current assets the company has and how quickly these can be converted into cash to meet current liabilities

14Quick RatioMore conservative as it excludes inventory and other current assets, which are more difficult to turn into cash.

15Efficiency RatiosRatios that are typically used to analyze how well a company utilises and manages its assets and liabilities internally. Improvement in the efficiency ratios usually translate to improved profitability and cash flow Debtors Turnover Ratio Sales Net Average Debtors Also called Accounts Receivables RatioReceivables turnover looks at how fast we collect on our sales or, on average, how many times each year we clean up or totally collect our accounts receivablesHigher the debtors turnover ratio better it is. Higher turnover signifies speedy and effective collectionLower turnover indicates sluggish and inefficient collection leading to the doubts that receivables might contain significant doubtful debts

17Credit to the customers is a necessary evil

Average Collection Period = Days in an Year/ Month in an Year Debtors Turnover RatioAverage collection period is also called Days' Sales Outstanding (DSO)

Receivables collection period is expressed in number of days. It should be compared with the period of credit allowed by the management to the customers as a matter of policy. Such comparison will help to decide whether receivables collection management is efficient or inefficient.18Why is it important?The sooner the firm receives the payment, the sooner the firm can start putting that money to use e.g. to reduce an overdraftThe longer the debt is owed, the more likely it will become a bad debtHow should it be evaluated? - Against a standard for the market in which the firm operates - The trend over time - Compare with the equivalent ratio for payment to creditors

19Firms can reduce debtor days by.Insisting on cash paymentOffering shorter credit periodsIntroducing penalties for late paymentGiving an incentive for prompt paymentBut there are dangers:- Chasing debtors leads to loss of goodwill- Customers may choose firms which allow a long payment period20 Creditors Turnover Ratio Purchases Average CreditorsAlso called Accounts Payable RatioIt indicates the speed with which the payments are made to the trade creditors How does it compare with debtor days?- Ideally this figure should be lower than the debtor days figure- If higher, it could result in cash flow problems

Average payment Period = Days in an Year/ Month in an Year Creditors Turnover RatioIt measure the average number of days it takes a business to pay any money owed to its suppliersShorter average payment period may have contradictory meaning:- Business has a better liquidity position and hence repays the outstanding amount quickly- Or, Credit rating among the suppliers is not good and therefore they do not allow reasonable period of credit

22Inventory Turnover RatioCost of Goods Sold Average InventoryInventory turnoveris a measure of the number of times inventory is sold or used in a given time period

A low turnover implies poor sales and, therefore, excess inventoryA high ratio implies either strong sales or ineffective buyingHigh inventory levels are unhealthy because they represent an investment with a rate of return of zero. It also opens the company up to trouble should prices begin to fall

23Days' Sales in Inventory = 365 Inventory Turnover Ratio

The Days' Sales in Inventory ratio tells the business owner how many days, on average, it takes to sell inventory

Lower the DSI is, the better, since it is better to have inventory sell quickly than to have it sit on your shelvesInventory turnover varies from industry to industry. Generally, a lower number of days' sales in inventory is better than a higher number of daysBusinesses which trade in perishable goods have very higher turnover with comparison to those dealing in durables e.g. Bakers shop

24Why High Inventory Turnover ?The purpose of increasing inventory turns is to reduce inventory for three reasons. - Increasing inventory turns reducesholding cost like rent, utilities, insurance, theft etc. - Reducingholding costincreasesnet incomeandprofitability - Items that turn over more quickly increase responsiveness to changes in customer requirements while allowing the replacement of obsolete itemsA low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effortHowever, high turns may indicate that the inventory is too low

25Working Capital Turnover RatioSales Working Capitalworking capital = current assets - current liabilitiesA company uses working capital to fund operations and purchase inventory. These operations and inventory are then converted into sales revenue for the company

Theworkingcapitalturnover ratio measure the efficiency with which theworkingcapitalis being used by a firm A high ratio indicates efficient utilization ofworkingcapitaland a low ratio indicates otherwiseBut a very highworkingcapitalturnover ratio may also mean lack of sufficientworkingcapitalwhich is not a good situation

26 Sales Total Fixed AssetsThe fixed-asset turnover ratio measures a company's ability to generate net sales from fixed-asset investments -specifically property, plant and equipment (PP&E) - netof depreciationA higher fixed-asset turnover ratio shows that the company has been more effective in using the investment in fixed assets to generate revenues.The fixed asset turnover ratio is most useful in "heavy industry," such as automobile manufacturing, where a large capital investment is required in order to do business.

Fixed Assets Turnover Ratio27Sales Total AssetsAsset turnoveris afinancial ratiothat measures the efficiency of a company's use of itsassetsin generating sales revenue to the company. The total asset turnover ratio considers all assets includingfixed assets, like plant and equipment, as well asinventoryandaccounts receivables.This ratio will vary by industry, as some industries are more capital intensive than others.The asset turnover ratio formula only looks at revenues and not profits. This is the distinct difference between return on assets (ROA) and the asset turnover ratio, as return on assets looks at net income, or profit, relative to assets.Total Assets Turnover Ratio28What could lower the total asset turnover ratio?

The firm could be holding obsolete inventory and not selling inventory fast enough.

With regard to accounts receivable, the firm's collection period could be too long and credit accounts may be on the books too long.

Fixed assets, such as plant and equipment, could be sitting idle instead of being used to their full capacitySales are not commensurate with the investment i.e. the company is not utilizing its capacity.

29Solvency Ratios

To find out whether the Company is financially sound and can meet its long-term obligations on the due time?

30Long-term Debt EquityIt indicates what proportion of equity and debt the company is using to finance its assetsIdeally the cost of debt financing mustnot outweigh the return thatthe companygenerates on the debt through investment and business activitiesA high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expenseA ratio of 1:1 is usually considered to be satisfactory ratio although there is no thumb ruleThe interpretation of the ratio depends upon the financial and business policy of the companyFor example, capital-intensive industries such as automanufacturing tend to have a debt/equity ratio above 2, while software companies have a debt/equity of under 0.5Debt- Equity Ratio31 EBIT Interest on Long- term LoansInterest Coverage Ratio is also know as Debt service ratioInterest coverage ratio (ICR)is a measure of a company's ability to meet its interest payments.It determines the number of times a company could make the interest payments on its debt with itsEBITAn interest coverage ratio below 1.0 indicates the business is having difficulties generating the cash necessary to pay its interest obligations (i.e. interest payments exceed its earnings)The lower the interest coverage ratio, the higher the company's debt burden and the greater the possibility ofbankruptcyor default.A higher ratio indicates a better financial health as it means that the company is more capable to meeting its interest obligations from operating earnings. On the other hand, a high ICR may also suggest a company is "too safe" and is neglecting opportunities to magnify earnings through leverage. So in this case debt raised from external sources should also be taken into considerationInterest Coverage Ratio32 Cash flows from operating activities after tax Interest on Long- term Loans +Installments paid during the year on long-term loansIt is also known as debt coverage ratio It is the ratio of cash available for debt servicing to interest, principal and lease paymentsDebt service coverage ratio (DSCR) essentially calculates the repayment capacity of a borrower. DSCR less than 1 would meana negative cash flow and inability of firms profits to serve its debts Whereas a DSCR greater than 1 means not only serving the debt obligations but also the ability to pay the dividendsDSCR is calculated when a company / firm takes loan from bank / financial institution / any other loan provider. The higher this ratio is, the easier it is to obtain a loanAcceptable industry norm for a debt service coverage ratio is between 1.5 to 2Debt Service Coverage Ratio

33Valuation Methodologies34Price to Earning Ratio:

Market Price Per Share/ Normalized Earning Per Share

There are two types of P/E ratios:Historical: Based on the previous year/quarters earning per shareForward: Based on expected i.e. estimated earning per share

Application:The P/E ratio is most appropriate in the valuation of companies that have relatively stable earnings .Such companies can be found in sectors where prices and demand are relatively stable, such as FMCG, Consumer Durables, Pharmaceutical

Limitations: Not all companies, particularly in todays new economy, have earnings. For example, fast growing biotechnology companies may be investing all of their revenue into research and development,Valuation Multiples35Valuation MultiplesPrice to Earning Growth Ratio:

PE Ratio/Growth Rate

Use: This ratio is used to get a sense of how the market is valuing a particular companys ability to grow, or its future growth potential.

Type of Company: This metric can be used across sectors (providing they have earnings) but is most commonly used in high growth industries (such as technology and telecommunications).36Valuation MultiplesPrice to Sales Ratio(P/S):

Price per share/Sales per share

Use: Without earnings, revenue projections can be a useful tool in approximating the relative worth of a company

Type of Company: The metric is particularly useful in the valuation of under-earners or companies without any visible earnings, such as early stage technology companies, or companies with high fixed costs

Limitation: This ratio is less appropriate for service companies such as banks or insurers who do not technically have sales.

37Valuation MultiplesPrice to Book Value (P/S):

Price per share/Book Value Per Share

Use: This ratio works well in the valuation of companies that have a lot of hard assets, such as factories or oil reserves, or financial assets such as loans.

Generally speaking, a book value of less than 1.0x would be an indication of good value, as the market is assigning a value to the company that is less than what you would get if you were to sell the company and pay off all liabilities.

Limitation: In the new economy, this particular metric does not work well, as many companies have intangible assets, such as intellectual capital. 38Enterprise ValueEnterprise Value is equal to the total value of the company, as it is trading for on the stock market. To compute it, add the market cap (see above) and the total net debt of the company. The total net debt is equal to total long and short term debt minus cash. The Enterprise Value is the best approximation of what a company is worth at any point in time because it takes into account the actual stock price instead of balance sheet prices. Enterprise Value fluctuates rapidly based on stock price changes.Most important multiple in M&A transactions: EV/EBITDACommon equity atmarket value + (debt at market value-cash and cash equivalents) +preferred equity at market value39Most Important Multiple?

It's useful for transnational comparisons because it ignores the distorting effects of individual countries' taxation policies. It's used to find attractive takeover candidates. Enterprise value is a better metric than market cap for takeovers. It takes into account the debt which the acquirer will have to assume. Therefore, a company with a low enterprise multiple can be viewed as a good takeover candidate.Note: If EBITDA is negative one may consider EV/Sales40Industry MultiplesSectorMultiple UsedRationaleCyclical ManufacturingP/E, Relative P/EOften with normalized earningsHigh Tech, High GrowthPEGBig differences in growth acrossfirmsHigh Growth/No EarningsP/S , EV/EBITDAAssume future margins will be goodHeavy InfrastructureFirms in sector have losses in earlyyears and reported earnings can varydepending on depreciation methodFinancial ServicesP/BVBook value often marked to marketRetailP/SIf leverage is similar across firmsRetailEV/SalesIf leverage is different41THANK YOUHope you crack it !!!!!!