Interpretation and Analysis of Financial Statement: CA N Maheswara Rao

Interpretation and Analysis of Financial Statement
CA N Maheswara Rao
Apr 22, 2012
CA N Maheswara Rao
Financial Analysis
Assessment of the firms past, present and
future financial conditions Done to find firms financial strengths and weaknesses Primary Tools:
Financial Statements Comparison of financial ratios to past performance , industry, sector and all firms
Apr 22, 2012 CA N Maheswara Rao 2
Financial Statements
Balance Sheet Income Statement Cashflow Statement

Review: Major Balance Sheet Items

Assets Current assets:
Cash & securities Receivables Inventories
Liabilities and Equity Current liabilities:

Payables Short-term debt
Long-term liabilities Shareholders' equity
Fixed assets: Tangible assets Intangible assets
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CA N Maheswara Rao
Financial Perspective of the Firm
Debt Operating Assets

I n t e r e s t
Equity
Retained Profit
Revenues Operating Expenses

Apr 22, 2012
Net Operating Profit
Net Income
CA N Maheswara Rao
Dividends
Review: Major Income Statement Items

Gross Profit = Sales - Costs of Goods Sold EBITDA
= Gross Profit - Cash Operating Expenses EBIT = EBDIT - Depreciation - Amortization EBT = EBIT - Interest NI or EAT = EBT- Taxes Net Income is a primary determinant of the firms cashflows and, thus, the value of the firms shares
An Example: Abbreviated Income Statement

Sales Rs.25,265.00 Costs of Goods Sold Rs.19,891.00 Gross Profit Rs.5,374.00 Cash operating expense Rs.2,761.00 EBITDA Depreciation & Amortization Rs.156.00 Other Income (Net) EBIT Apr 22, 2012 CA N Maheswara Rao Rs.2,451.00 -
2,613.00 -Rs.6.00
7
Apr 22, 2012
CA N Maheswara Rao
Financial Statement Analysis

1. Horizontal Analysis 2. Vertical Analysis 3. Common Size Statement 4. Ratio Analysis 5. Proforma Financial Statement 6. Measure Economic Value Added
& Market Value Added
1. Horizontal Analysis
Increase/(Decrease) 2005 2004 Amount Percent Rs.41,500 Rs.37,850 Rs.3,650 9.6% 40,000 36,900 3,100 8.4% 1,500 950 550 57.9%
Sales Expenses Net income
Apr 22, 2012
CA N Maheswara Rao
Trend Percentages...
are computed by selecting a base year
whose amounts are set equal to 100%. The amounts of each following year are expressed as a percentage of the base amount. Trend % = Any year Rs. Base year Rs.
2. Vertical Analysis...
compares each item in a financial statement
to a base number set to 100%. Every item on the financial statement is then reported as a percentage of that base.
Apr 22, 2012
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2. Vertical Analysis
Revenues Cost of sales Gross profit Total operating expenses Operating income Other income Income before taxes Income taxes Net income
Apr 22, 2012
2005 Rs.38,303 19,688 Rs.18,615 13,209 Rs. 5,406 2,187 Rs. 7,593 2,827 Rs. 4,766
% 100.0 51.4 48.6 34.5 14.1 5.7 19.8 7.4 12.4

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CA N Maheswara Rao
2. Vertical Analysis ..
Assets Current assets: Cash Receivables net Inventories Prepaid expenses Total current assets Plant and equipment, net Other assets Total assets
Apr 22, 2012
2005 Rs. 1,816 10,438 6,151 3,526 Rs.21,931 6,847 9,997 Rs.38,775
% 4.7 26.9 15.9 9.1 56.6 17.7 25.7 100.0

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CA N Maheswara Rao
3. Common-size Statements
On the income statement, each item is
expressed as a percentage of net sales. On the balance sheet, the common size is the total on each side of the accounting equation. Common-size statements are used to compare one company to other companies, and to the industry average.
3. Common-size Statements.. Benchmarking

Percent of Net Sales Lucent Technologies
12.4% 7.4% 51.4% 28.8% 38.2% 8.0% 43.0% 10.8%
MCI
s Cost of goods sold s Income tax

Apr 22, 2012
s Operating expenses s Net income

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CA N Maheswara Rao
4. Financial Ratios
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Rationale Behind Ratio Analysis

A firm has resources It converts resources into profits through production of goods and services sales of goods and services Ratios Measure relationships between resources and financial flows Show ways in which firms situation deviates from
Its own past Other firms The industry All firms-
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Objectives of Ratio Analysis

Standardize financial information for
comparisons Evaluate current operations Compare performance with past performance Compare performance against other firms or industry standards Study the efficiency of operations Study the risk of operations
Types of Ratios
Financial Ratios: Liquidity Ratios
Assess ability to cover current obligations
Leverage Ratios
Assess ability to cover long term debt obligations
Operational Ratios: Activity (Turnover) Ratios

Assess amount of activity relative to amount of resources used
Profitability Ratios
Apr 22, 2012
Valuation Ratios:
Assess profits relative to amount of resources used

CA Assess market price N Maheswara Rao relative to assets or earnings 19
Ratio Classification
1. Measuring Assets Utilization. 2. Measuring ability to pay current liabilities 1. Measuring ability to sell inventory and
collect receivables 1. Measuring ability to pay short-term and long-term debt 1. Measuring profitability 1. Analyzing stockNas an investment Apr 22, 2012 CA Maheswara Rao
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Total Assets Turnover
Total assets turnover measures a firm's ability to
generate sales from a given level of assets. A large asset turnover is preferred to a low one. Total assets turnover is related to three similar ratios
a. Accounts receivable turnover b. Inventory turnover c. Fixed asset turnover
Fixed Asset Turnover

Measures the relation between investment in long-term
or fixed assets (such as property, plant, equipment) and sales. Efficient use of fixed assets would be associated with high sales. If fixed assets turn over every four years, then each Rupees invested in fixed assets is generating a quarter of a Rupees in sales per year. A high turnover is preferred to a low one.
Measuring Ability to Pay Current Liabilities

The current ratio measures The current ratio measures the companys ability to pay the companys ability to pay current liabilities with current assets. current liabilities with current assets. Current ratio = Current ratio = Total current assets Total current liabilities Total current assets Total current liabilities
Measuring Ability to Pay Current Liabilities

The acid-test ratio shows the companys The acid-test ratio shows the companys ability to pay all current liabilities ability to pay all current liabilities if they come due immediately. if they come due immediately. Acid-test ratio = Acid-test ratio = (Cash + Short-term investments (Cash + Short-term investments + Net current receivables) + Net current receivables) Total current liabilities Total current liabilities
Measuring Ability to Sell Inventory

Inventory turnover is aameasure Inventory turnover is measure of the number of times the average of the number of times the average level of inventory is sold during aayear. level of inventory is sold during year.
Inventory turnover = Cost of goods sold Inventory turnover = Cost of goods sold Average inventory Average inventory
q
Holding inventory is costly because the funds invested in inventory can be used elsewhere.
q
A high turnover is preferred to a low one.

CA N Maheswara Rao 25
Apr 22, 2012
Measuring Ability to Collect Receivables

Accounts receivable turnover measures a companys Accounts receivable turnover measures a companys ability to collect cash from credit customers. ability to collect cash from credit customers. Accounts receivable turnover = Accounts receivable turnover = Net credit sales Average accounts receivable Net credit sales Average accounts receivable
q
A high turnover is preferred to a low one.

Apr 22, 2012
Measuring Ability to Collect Receivables

Days sales in receivable ratio measures how Days sales in receivable ratio measures how many days sales remain in Accounts Receivable. many days sales remain in Accounts Receivable. One days sales = Net sales 365 days One days sales = Net sales 365 days Days sales in Accounts Receivable = Days sales in Accounts Receivable = Average net Accounts Receivable One days sales Average net Accounts Receivable One days sales
Measuring Ability to Pay Debt

The debt ratio indicates the proportion The debt ratio indicates the proportion of assets financed with debt. of assets financed with debt. Total liabilities Total assets Total liabilities Total assets
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Measuring Ability to Pay Debt

Times-interest-earned ratio Times-interest-earned ratio measures the number of times measures the number of times operating income can cover interest expense. operating income can cover interest expense. Times-interest-earned Times-interest-earned = Income from operations = Income from operations Interest expense Interest expense
Measures of Long-Term Risk

Debt-to-equity ratio (total liabilities)/(total equities) total equities = total liab. + shareholders equity Percentage of total financing provided by debtors or creditors. A firm is said to be highly leveraged when this ratio is large. Cash from operations to total liabilities ratio Measures the ability of the firm to pay all liabilities from cash without new debt or additional investment.
Measures of Long-Term Risk (Cont.)

Interest coverage ratio =
(interest before interest and income tax) (interest expense) Number of times interest is covered by income Indicates the relative protection that operating profitability provides to debtors Some analysts use cash flows instead of income
Profit Margin Ratio
Profit margin ratio measures a firm's ability to
control its expenses relative to its sales.

We expect expenses to grow as sales grow, but not
as fast. A high profit margin ratio is preferred to a low one.

Return on Equity
The numerator measures return as net income reduced by
any payments to preferred shareholders as these dividends are not available to the common shareholder and have not been deducted from net income. The denominator is the average amount contributed by common shareholders which includes
Common stock at par, Additional paid in capital, and Retained earnings.
Apr 22, 2012
ROCE
The first two have been previously defined. Leverage ratio indicates the relative proportion of
capital provided by common shareholders as distinct from that provided by creditors (debtors) or preferred shareholders.
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Earnings Per Share

EPS does not consider the amount of assets or capital required
to generate earnings.
EPS is of limited use in comparing two firms. For investment purposes, the price to earnings ratio is
sometimes used (P/E ratio). This is the return to the purchaser of a share.
P/E = (market price of a share of stock)/(EPS) A low P/E is preferred to a high P/E, same earnings at a lower price.
Apr 22, 2012
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Analyzing Stock as an Investment
Dividend yield shows the percentage Dividend yield shows the percentage of a stocks market value returned as of a stocks market value returned as dividends to stockholders each period. dividends to stockholders each period. Dividend per share of common Dividend per share of common (or preferred) stock Market price per share (or preferred) stock Market price per share of common (or preferred) stock of common (or preferred) stock
Analyzing Stock as an Investment
Book value per share of common stock Book value per share of common stock = (Total stockholders equity Preferred equity) = (Total stockholders equity Preferred equity) Number of shares of common stock outstanding Number of shares of common stock outstanding
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Summary of Financial Ratios

Ratios help to: Evaluate performance Structure analysis Show the connection between activities and performance Benchmark with Past for the company Industry Ratios adjust for size differences
Limitations of Ratio Analysis

A firms industry category is often difficult to
identify Published industry averages are only guidelines Accounting practices differ across firms Sometimes difficult to interpret deviations in ratios Industry ratios may not be desirable targets Seasonality affects ratios
Apr 22, 2012
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5. Financial Forecasting
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Ratios and Forecasting

Common stock valuation based on Expected cashflows to stockholders ROE and are major determinants of cashflows to stockholders Ratios influence expectations by: Showing where firm is now Providing context for current performance Current information influences expectations by: Showing developments that will alter future performance
Apr 22, 2012
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Pro Forma Financial Statements

Pro forma refers to a projection of what the financial
statements might look like if certain future conditions prevail. Of course, a pro forma statement is only as good as the forecast of the future conditions. In order to prepare a set of pro forma statements:
1. Project operating revenues 2. Project operating expenses given the level of revenues 3. Project assets required to support the revenues 4. Project financing for the additional assets 5. Project the cost of the financing 6. Project the cash flow statement based on assumptions about the timing of revenues and payments on debt and for expenses.
6. Measure Economic Value & Market Value Added

MVA & EVA

Market Value
Added
Economic Value
Each can be viewed from Total Assets or Total Equity The examples in this set of notes consider the case of Total Equity
Added
Apr 22, 2012
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MVA & EVA (to Equity Owners)

Market Value Added
Market Value of Equity minus Total Money Invested by Equity Owners (Book Value of Equity)
Total Value created by owning assets which have a greater return than cost of equity
Economic Value Added

Net Income for a Year minus Cost of Equity times Book Value of Equity
Value created this year by earning profits in excess of cost of equity capital
Apr 22, 2012
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Information Used in Calculating MVA and EVA (to equity owners)

Equity Information as of the End-of-Period Net Income for Past Year Rs. 200 (known) Total Equity Book Value Rs.1,080 (known) Number of Shares 100 (known) Book Value per Share Rs. 10.80 (calced) Current Stock Price Assumed Cost of Equity Constant Future Dividend Growth Rate
Apr 22, 2012
Rs. 25.92
(assumed)
13% 8%
(assumed) (assumed)
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CA N Maheswara Rao
MVA Calculation
Equity Capitalization
(Rs.25.92 times 100 shares) minus
Rs.2,592
Total Equity Book Value Rs.1,080 Market Value Added

Apr 22, 2012 CA N Maheswara Rao
Rs.1,512
47
(Conceptually, this is equal to the summation of all Net Present Values of projects in which the firm has invested.)
EVA Calculation
Net Income During the Period Rs.200
minus
Period Rs. Cost of Capital

Rs.1,000 capital invested (until period end) times 13% cost of equity
Rs.130
Economic Value Added

Rs. 70
48
(Conceptually, this is the true economic profit created during the year; income above capital cost.)
Reconciliation of MVA & EVA

MVA is the present value of expected future EVAs. If the past years EVA is expected to grow by 8% and the cost of equity is 13%, MVA = [Rs.70 (1.08)] / [0.13 - 0.08] = Rs.1,512
(This is an application of the constant growth valuation model that is discussed later in the course)
Apr 22, 2012
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Apr 22, 2012
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Accounting Statement of Cash Flows
Statement of Cash Flows

A relatively new financial statement Intended to highlight major areas from which cash was received
and used Until accountants began reporting the Statement of Cash Flows, financial analysts prepared a Sources & Uses of Funds statement based on published balance sheets and income statements
The Statement of Cash Flows categorizes
follows: --- Cash Flows from Operations --- Cash Flows from Investing Activities --- Cash Flows from Financing Activities These categories fit well with how finance people view the firm
cash flows as
Apr 22, 2012
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Accounting Statement of Cash Flows

Cash Flow from Operating Activities:
Net Income Depreciation Total Increase in Accruals Increase in Accounts Payable Increase in Accts. Rec. Increase in Inventory 44,220 20,000 64,220 4,000 29,600 - 50.800 -120,800
Net Cash Flow from Operations -73,780 Cash Flow from Investment:
Fixed Asset Increase
Operations Investment
-36,000
25,000 101,180 -22,000
Cash Flow from Financing:

Increase in Notes Payable Increase in Long-term Debt Common Dividends
Net Cash Flow from Financing Total Change in Cash
104,180 -5,600
Financing This balances to change in Cash
Apr 22, 2012
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Categories in the Statement of Cash Flows

Cash Flows from Operations include:
Net Operating Profit After Taxes Plus adjustments for non-cash expenses (amortization of depreciation, patents, goodwill, bad debt allowances, etc.) Changes in Current Assets & Current Liabilities * which move more or less spontaneously with Sales + Current Asset = decrease in cash - Current Asset = increase in cash + Current Liability = increase in cash - Current Liability = decrease in cash
* Exclude Interest Bearing Short Term Debt

Cont..
53
Cash Flows from Investment Activities include:
--- Purchase or sale of long-term operating assets such as plant & equipment --- Acquisitions of other firms or divestitures of divisions --- Ideally separate Operating Assets from Non-Operating Assets ---- Sale or retirement of debt ---- Interest expense (after taxes) ---- Sale or retirement of equity securities ---- Dividend payments
Cash Flows from Financing Activities include:
Cont..
Operating Assets versus Non- Operating Assets

We will not treat any Non- Operating Assets in this set of
notes
Non-operating assets include items such as excess marketable securities, Goodwill recorded in an acquisition, deferred taxes, land held for future use, investment in unconsolidated subsidiaries, and so forth
Apr 22, 2012
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Preparation of a Statement of Cash Flows

Published financials will include such a statement. But many times you will not be working with audited financials or will have to adjust published statements to organize them in a more meaningful way. Thus, you should know how to prepare the Statement.
1 Start by subtracting one balance sheet from another 2 Arrange balance sheet changes into two columns
Sources of Cash Uses of Cash 3 Be sure the two columns balance (total to the same value) 4 Rearrange the data into the three categories used in the Statement of Cash Flows
Cash Statement Accts. Receivable 50,800 Operating Cash Flow Inventory 120,800Operating Cash Flow Gross Fixed Assets 36,000Investment Cash Flow Accum. Depreciation 20,000 Adjust to Net Income Accounts Payable 29,600 Operating Cash Flow ST Notes Payable 25,000 Financing Cash Flow Accruals 4,000 Operating Cash Flow NOPAT Long Term Debt 101,180 Financing Cash Flow 89,820 Ret. Earn. Net Income 44,220 Interest AT Dividends 22,000 Financing Cash Flow 45,600 Total 229,600229,600
Change in Finl Resources Category Source Use 5,600 Balancing Item in
Source and Use of Funds Statement (Or Changes in Balance Sheets)
Financial Statement of Free Cash Flows

Cash Flow from Operating Activities:
Net Operating Profit Depreciation Total Increase in Accruals Increase in Accounts Payable Decrease in Cash Increase in Accts. Rec. Increase in Inventory 89,820 20,000 109,820 4,000 29,600 5,600 - 50.800 -120,800
Net Cash Flow from Operations -22,580 Cash Flow from Investment: Fixed Asset Increase -36,000 Free Cash Flow from Assets-58,580 Cash Flow from Financing:
Increase in Notes Payable Increase in Long-term Debt Interest after tax Common Dividends 25,000 101,180 -45,600 -22,000
Operations Investment
Net Cash Flow from Financing
58,580
Cash from Capital Suppliers

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Apr 22, 2012
CA N Maheswara Rao
Sources of Cash From Capital Suppliers:

Increase in Notes Payable 25,000 Increase in Long-term Debt 101,180 Interest after tax -45,600 Common Dividends - 22,000 Net Cash Flow from Financing 58,580
Apr 22, 2012
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Analysis of the Statement of Cash Flows

Operations drained cash
--- NOPAT + Depreciation provided Rs.109,820 --- but Inventory & A / R absorbed Rs.171,600 of potential cash inflow
New investment took another Rs.36,000 of cash This was financed by new debt (mainly Long-Term) And they continued to pay dividends (Rs.22,000)
This state of affairs can not continue

Implications of the Statement of Cash Flows

There might be a problem with excess Inventory &
Accounts Receivable
Unless sales increase substantially to warrant higher
Inventory & Receivables, they need to be reduced

Notice also that Inventory & Receivables were financed
with long-term debt, is there a problem with this?

Apr 22, 2012
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Interpretation and Analysis of Financial Statement

Apr 22, 2012

Balance Sheet Income Statement Cashflow Statement

Review: Major Balance Sheet Items

Liabilities and Equity Current liabilities:

Long-term liabilities Shareholders' equity

Fixed assets: Tangible assets Intangible assets

Apr 22, 2012

Financial Perspective of the Firm

Debt Operating Assets

Revenues Operating Expenses

Net Operating Profit

Review: Major Income Statement Items

An Example: Abbreviated Income Statement

Apr 22, 2012

Financial Statement Analysis

& Market Value Added

Sales Expenses Net income

Apr 22, 2012

Apr 22, 2012

% 100.0 51.4 48.6 34.5 14.1 5.7 19.8 7.4 12.4

% 4.7 26.9 15.9 9.1 56.6 17.7 25.7 100.0

3. Common-size Statements.. Benchmarking

s Cost of goods sold s Income tax

s Operating expenses s Net income

Apr 22, 2012

Rationale Behind Ratio Analysis

Apr 22, 2012

Objectives of Ratio Analysis

Operational Ratios: Activity (Turnover) Ratios

Assess profits relative to amount of resources used

Total Assets Turnover

Total assets turnover measures a firm's ability to

Fixed Asset Turnover

Measuring Ability to Pay Current Liabilities

Measuring Ability to Pay Current Liabilities

Measuring Ability to Sell Inventory

A high turnover is preferred to a low one.

Apr 22, 2012

Measuring Ability to Collect Receivables

A high turnover is preferred to a low one.

Apr 22, 2012

Measuring Ability to Collect Receivables

Measuring Ability to Pay Debt

Apr 22, 2012

Measuring Ability to Pay Debt

Measures of Long-Term Risk

Measures of Long-Term Risk (Cont.)

Profit Margin Ratio

Profit margin ratio measures a firm's ability to

control its expenses relative to its sales.

as fast. A high profit margin ratio is preferred to a low one.

The numerator measures return as net income reduced by

Apr 22, 2012

Apr 22, 2012

Earnings Per Share

Apr 22, 2012

Analyzing Stock as an Investment

Analyzing Stock as an Investment

Apr 22, 2012

Summary of Financial Ratios

Limitations of Ratio Analysis