FOUNDATIONS OF RATIO AND FINANCIAL ANALYSIS

Free Cash flow Valuation• It is a measure of financial

performance calculated as operating cash flow minus capital expenditures.

• Free cash flow (FCF) is actually the cash that a company is able to generate after laying

out the money required to maintain or expand its asset base. It allows a company to

work on opportunities that enhance shareholder value.

Free Cash flow Valuation• Cash is the sole resources to develop new

products, make acquisitions, retire debt, announce dividends etc

• FCF is calculated as: • EBIT(1-Tax Rate) + Depreciation & Amortization -

Change in Net Working Capital - Capital Expenditure

• It can also be calculated by taking operating cash flow and subtracting capital expenditures.

Ratio analysis

• Ratio analysis: Comparative measurement of risk and return, facilitating intelligent investment and credit decisions. It is simply the quantitative analysis of the financial statements information.

• Focus of users: minimize risk, ensure that resources are available to assure payment of interest and principal obligations.

RATIOS: CAUTIONARY NOTES• Economic assumptions: eliminate size

differences across firms and over time• Benchmarks: just useful for intra-industry

analysis but not for inter-industry analysis• Timing and window dressing• Negative numbers• Accounting methods: accounting methods

can affect income and balance sheet accounts

ACTIVITY ANALYSIS

• Describe the relationship between the firm’s level of operations and the assets needed to sustain the activity.

• Higher ratio more efficient the firm’s operations

• Used to forecast a firm’s capital requirements and to assess the firm’s ability to acquire the assets needed to sustain the forecasted growth.

COMPONENTS

• Short term activity ratios• Long term activity ratios

SHORT TERM ACTIVITY RATIOS

inventory Average

sold goods ofCost urnoverInventoryt

• The inventory turnover ratio

• The average number of days inventory

turnoverInventory

360 tockventoryinsberofdayinAveragenum

sreceivable Average

Sales Re urnoverceivablest

turnoversreceivable

360 tan dingareoutseceivablesberofdaysraveragenum

• The receivable turnover ratio

• The average numbers of days that receivables are outstanding

• The working capital turnover ratio

capital workingaverage

sales eritalturnovworkingcap

payables tradeAverage

Purchases rnoverPayablestu

ratio turnover Payables

360 esysofpayablNumberofda

LONG TERM INVESTMENT ACTIVITY RATIOS

assets totalAverage

Sales turnoverTotalasset

Fixed asset turnover = SALES / AVERAGE NET FIXED ASSETS

• SaleSale

• Fixed asset turnover = -------------------------------------Fixed asset turnover = -------------------------------------

• Average net fixed assetsAverage net fixed assets

• SaleSale

• Fixed asset turnover = -------------------------------------Fixed asset turnover = -------------------------------------

• Average net fixed assetsAverage net fixed assets

LIQUIDITY ANALYSIS

• Is used by short term lenders such as suppliers and creditors to assess the risk level and ability of a firm to meet its current obligations.

5 CATEGORIES OF CURRENT ASSETS

4

5

•Inventories

•Prepaid expenses

3 CATEGORIES OF CURRENT LIABILITIES

• Current assets

• Current ratio = -------------------------

• Current liabilities

• Current assets

• Current ratio = -------------------------

• Current liabilities

WORKING CAPITAL RATIOS

Current assets - InventoriesQuick ratio = ------------------------------------- Current liabilities

Current assets - InventoriesQuick ratio = ------------------------------------- Current liabilities

• Cash + Marketable securities

• Cash ratio = -------------------------------------

• Current liabilities

• Cash + Marketable securities

• Cash ratio = -------------------------------------

• Current liabilities

• Cash flow from Cash flow from operations

• operation ratio = -------------------------------------

• Current liabilities

• Cash flow from Cash flow from operations

• operation ratio = -------------------------------------

• Current liabilities

LONG TERM DEBT AND SOLVENCY ANALYSIS

• Examines the firm’s capital structure in terms of the mix of its financing sources

• Examines the ability of the firm to satisfy its longer term debt and investment obligations.

COMPONENTS

1. Debt ratios2. Interest Coverage Ratios

CAPITALIZATION TABLE AND DEBT RATIOS

Total debt

• Debt to total capital = -------------------------------------

Total capital

or equivalent

Total debt

• Debt to equity = -------------------------------------

Total equity

Total debt

• Debt to total capital = -------------------------------------

Total capital

or equivalent

Total debt

• Debt to equity = -------------------------------------

Total equity

INTEREST COVERAGE RATIOS

EBIT

• Times interest earned = --------------------------

• Interest expense

EBIT

• Times interest earned = --------------------------

• Interest expense

Earnings before fixed charges

and taxes

• Fixed charge coverage = -----------------------------

• Fixed charges

Earnings before fixed charges

and taxes

• Fixed charge coverage = -----------------------------

• Fixed charges

Average total assets

• Financial leverage = ----------------------------------

• Average total equity

Average total assets

• Financial leverage = ----------------------------------

• Average total equity

PROFITABLITY ANALYSIS

• Measures the net income of the firm relative to its revenue and capital

• Gross profit = Net sales – COGS• Operating profits = earnings before interest

and taxes or EBIT• Net income = earnings after taxes but before

dividends• Total capital = long term debt + short term

debt + common and preferred equity• Total capital = total assets

Net income

• Net profit margin = ----------------------------

Revenue

Net income

• Net profit margin = ----------------------------

Revenue

Gross profit

• Gross profit margin = ----------------------------

Revenue

Gross profit

• Gross profit margin = ----------------------------

Revenue

EBT

• ROS = -------------------------------------

Sales

EBT

• ROS = -------------------------------------

Sales

EBT

• ROA= -------------------------------------

Average total assets

EBT

• ROA= -------------------------------------

Average total assets

EBT

• ROE = -------------------------------------

Average total equity

• ( Return on Equity)

EBT

• ROE = -------------------------------------

Average total equity

• ( Return on Equity)

DUPONT SYSTEM OF ANALYSIS

• Be used to analyze return on equity (ROE)• Uses basic algebra to break down ROE into a

function of different ratios analyst can see the impact of leverage, profit margins, turnover on shareholder returns.

ROE

ROE = (net profit margin) x (asset turnover )x (leverage ratio)

= (net income / sale) x ( sale/ assets) x (assets / equity)

ROE = (net profit margin) x (asset turnover )x (leverage ratio)

= (net income / sale) x ( sale/ assets) x (assets / equity)