FINANCIAL STATEMENTS ANALYSIS

Meaning
Financial statement analysis is the process of identifying the financial strengths and weaknesses of the firm by properly establishing relationships between the items of the balance sheet and the profit and loss account.

Balance sheet-related terms

Contents of P & L account

Profit concepts
GP=Sales COGS EBITDA=GP-all expenses other than I,T,D and A EBIT or OP=EBITDA-D&A PBT=EBIT-I PAT or NP=PBT-T Equity share holders earnings = PAT-pref. dividend EPS=Equity shareholders earnings/no. of equity shares

Profit concepts
Sales 450, COGS 300, other exp other than I,T,D and A-70 D-12, A-8 I-30 T-50% Preference dividend =5 No. of equity shares 20, calculate GP,EBITDA,EBIT,PBT, PAT, Earnings of equity share holders and EPS

FINANCIAL STATEMENT ANALYSISWHO

Trade creditors Suppliers of long-term debt Investors/financial institutions/banks Management Regulatory bodies, tax authorities

TYPES OF RATIOS
Liquidity ratios Leverage/capital structure/solvency ratios Activity/turnover ratios Profitability ratios Valuation ratios

1.Liquidity ratios Liquidity ratios measure a firms ability to meet its current payment (less than one year) obligations.

Liquidity ratios
Current assets Current ratio = Current liabilities Current assets Inventories Quick ratio = Current liabilities Cash + Marketable securities Cash ratio = Current liabilities

2. Leverage ratios
Leverage refers to the use of Debt finance To judge the long-term financial position of the firm, financial leverage, or capital structure ratios are calculated. These ratios indicate mix of funds provided by owners and lenders.

Leverage ratios-Debt/Equity ratio

Debt-Equity ratio = Debt/equity Debt = short term and long term debt to outsiders or external debt but does not include current liabilities Equity/net worth/owners funds/shareholders funds = equity capital+ preference capital + reserves+ surplus+ accumulated profits + deferred tax liability-accumulated losses/Misc. exp if any on the assets side of Balance sheet

Leverage ratio-interest coverage ratio

Indicates the number of times interest is covered by the profits available to pay interest charges Interest coverage ratio = EBIT/Interest Interest coverage ratio = EBITDA/Interest

Turnover ratios
Indicates efficiency of assets use. Inventory turn over ratio Receivables turn over ratio Fixed assets turnover ratio

Turnover ratios
Inv. TO=COGS/Avg inventory Inventory conversion period = 365/ITO ratio Receivables TO = Credit sales/Average receivables Average collection period = 365/receivablesTO Fixed assets TO=sales/average fixed assets

Profitability ratios
Profitability in relation to sales(usually mentioned as margin) Profitability in relation to investment

Profitability ratios
GP ratio=GP/Sales EBITDA or OP ratio=EBITDA/sales NP ratio=NP/sales Return on assets = PAT/Avg total assets Avg total assets =(FA+net CA) Return on capital employed =EBIT(1-Tax rate)/Avg total assets Return on equity = (PAT-Pref. dividend)/equity shareholders funds

Profitability ratios
Operating expenses ratio = op.exp/sales Return on investment = ROI = Return on capital employed = ROCE =EBIT/NA Net assets = capital employed=FA+CA-CL Return on equity = PAT/Net worth

Valuation ratios
EPS=PAT/No. of shares DPS=earnings distributed to shareholders/no. of shares Payout ratio = DPS/EPS

Valuation ratios
Earnings yield = EPS/Market price per share Dividend yield = DPS/Market price per share Price earnings ratio = Market price per share/EPS

Valuation ratios
Market value to book value ratio =market value per share/book value per share Tobins q=Market value of assets/replacement cost of assets

EVALUATION OF A FIRMS EARNING POWER: DUPONT ANALYSIS

RONA (or ROCE) is the measure of the firms operating performance. It indicates the firms earning power. RONA can be computed as follows:

DU PONT Analysis
A firm can convert its RONA into an impressive ROE through financial efficiency.

Standardized financial statements

Common size financial statements (sales=100, balance sheet total =1000 Common base year financial statements (base year figures 100)

Applications of financial analysis

Assessing performance Judging creditworthiness Forecasting bankruptcy Valuing equity shares Predicting bond ratings Profitability analysis Assets utilization Liquidity analysis Strategic Analysis

CAUTIONS IN USING RATIO ANALYSIS

Standards for comparison Company differences Price level changes Different definitions of variables Changing situations Historical data