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Transcript of ANALYSIS OF FINANCIAL STATEMENT FINANCIAL STATEMENTS ARE : MUCH MORE THAN JUST ACCOUTING. THEY...
ANALYSIS OF FINANCIAL STATEMENT
FINANCIAL STATEMENTS ARE :
MUCH MORE THAN JUST ACCOUTING.THEY PROVIDE WEALTH OF INFORMATION FOR MANAGERS, INVESTORS, LENDERS, CUSTOMERS, SUPPLIERS AND REGULATORS.ANALYSIS HELPS IN HIGHLIGHTING COMPANY’S STRENGTHS AND WEAKNESSES ALSO HELPS IN PREDICTING HOW STRATEGIC DECISIONS EG SALE OF A DIVISION, A MAJOR MARKETING PGM ETC ARE LIKELY TO AFFECT FUTURE PERFORMANCE.
CORPORATE VALUATION AND ANALYSIS OF FINANCIAL STATEMENTS
SALES REVENUE
Oprtg Cost &Taxes
Rqrd InvstmntIn Operations
FINCNG DECISIONS
Int Rates
FIRMRISK
Mkt Risk
Free Cash Flows Weighted Average Cost of Capital
Value of Co = FCF1 + FCF2 FCF3 …… FCF
(1 + WACC)1 (1+WACC) 2 (1+WACC)3 (1+WACC) 4
THE MANAGEMENT SHOULD TRY TO MAXIMIZE A COMPANY’S VALUEIT MUST TAKE ADVANTAGE OF THE COMPANY’S STRENGTH AND CORRECT ITS WEAKNESS.
FINANCIAL STATEMENT ANALYSIS INVOLVES :
COMPARING THE COMPANY’S PERFORMANCE WITH THAT OF OTHERCOMPANIES IN THE SAME INDUSTRY. &EVALUATING THE TRENDS IN THE COMPANY’S FINANCIAL POSITIONOVER TIME
THE REAL VALUE OF FINANCIAL STATEMENT LIES IN THE FACT THAT THEY CAN BE USED TO HELP PREDICT FUTURE EARNINGS,
DIVIDENDS, AND FREE CASH FLOW.
M/s Micro DriveBalance Sheet ($ in Mil)31 December 2003 / 2004
Assets 2004 2003Cash &Eqvlts 10 15Shrt Term Invst 0 65Accounts Rcvbl 375 315Inventories 615 415
Ttl C/Assets 1000 810Net Plant&Eqpt 1000 870
Total Assets 2000 1680
Liab&Equty 2004 2003A/c Pybl 60 30Note / Payable 110 60Accruals 140 130Ttl C/Liablities 310 220L.Term Bonds 754 580Total Debt 1064 800P.Stock(400000) 40 40C.Stock(50000000) 130 130Retained Earnings 766 710Total Com Eqty 896 840Ttl Liab & Eqty 2000 1680
Micro Drive IncIncome Statement
for the Year ending 31 Dec 00/01 (In Millions)
2004 2003Net Sales 3000 2850
Operating Cost Excldg Dep/Amtzn 2616.2 2497Erng b4 Int,Tax,Dpcn&Amtzn(EBITDA) 383.8 353Depreciation 100 90Amortization 0 0Depreciation &Amortization 100 90Earning before Int&Tax (EBIT or Op Incm) 283.8 263less interest 88 60Earning before Tax (EBT) 195.8 203Taxes @ 40 % 78.3 81.2Net Income before Preferred dividend 4 4Net Income 113.5 117.8Common Dividend 57.5 53Additions to retained earnings 56 64.8
PER SHARE DATA
2004 2003
COMMON STOCK PRICE $ 23 $ 26EARNING PER SHARE 2.27 2.36DIVIDEND PER SHARE 1.15 1.06BOOK VALUE PER SHARE 17.92 16.80CASH FLOW PER SHARE 4.27 4.16
ADDITIONAL INFORMATIONTHE BONDS HAVE A SINKING FUND REQUIREMENT OF $ 20 MILLION A YEARTHE COST INCLUDE LEASE PAYMENTS OF $ 28 MIL A YEAR
THERE ARE 50 MILL SHARES OF COMMON STOCK.
EPS = NET INCOME / COMMON SHARE OUTSTANDING
EPS = $ 113,500,000 / 50,000,000 = $ 2.27DPS = DIVIDEND PAID TO COMMON / CMN SHR
O/SDPS = $ 57,500,000 / 50,000,000 = $ 1.15BVPS= TOTAL EQUITY / COMN SHARE O/SBVPS= 896,000,000 / 50,000,000 = $ 17.92CFPS = NET INCOME + DEP + AMT / CMN SHR O/SCFPS = $ 213,500,000/ 50,000,000 = $ 4.27
LIQUIDITY RATOSLiquidity ratios deals with liquid assets and current liabilities. Liquid assets are those assets which can be quickly converted to cash at the going market price.A full liquidity analysis requires use of cash budgets.
Current Ratio: Current Assets / Current liabilitiesIt measures short term solvency of the companyCreditors would always like to see a high current ratio of the companyIn case of financial difficulty the company will begin paying its bills (accounts payables) more slowly --- stretching of accounts payables.Borrowing from banks will increase
Micro Drive Current ratio = $ 1000 / 310 = 3.2 timesIndustry Average = 4.2 times If current liabilities are rising faster than current assets, the current ratio will fall and this could spell trouble.
Quick RatioThe quick ratio is computed by deducting
inventories and prepayments from current assets and then
dividing the remainder by Current Liabilities.
Acid Test = Current Assets – Inventories & prepayments.
Quick Ratio Current Liabilities
Quick Ratio = $ 385 / 310 = 1.2 timesIndustry Average 2.1 times
DEBT MANAGEMENT RATIOS
THE EXTENT TO WHICH A COMPANY USES DEBT FINANCING OR FINANCIAL LEVERAGE HAS 3IMPORTANT IMPLICATIONS :
1. BY RAISING DEBT THE STOCK HOLDERS CAN MAINTAIN CONTROL OF THE COMPANY WITHOUT INCREASING THEIR OWN INVESTMENTS.
2. IF THE COMPANY EARNS MORE ON INVESTMENTS FINANCED BY BORROWED FUNDS THAN IT PAYS IN INTEREST, THAN ITS SHARE HOLDERS RETURNS ARE MAGNIFIED / LEVERAGED.
3. CREDITORS LOOK TO EQUITY OR EQUITY SUPPLIED CAPITAL AS MARGIN OF SAFETY
HOW THE COMPANY IS FINANCED :TOTAL LIABILITIES TO TOTAL ASSETS
DEBT RATIO = TOTAL LIABILITES / TOTAL ASSETS DEBT RATIO = 310 + 754 / 2000 = 53.2 % INDUSTRY AVERAGE = 40 %- CREDITORS PREFER LOW DEBT RATIO I.E. GREATER
CUSHION- STOCK HOLDERS WANT MORE LEVERAGE BECAUSE IT
MAGNIFIES EXPECTED EARNINGS- OUR COMPANY’S DEBT RATIO IS 53.2% IE CREDITORS HAVE
SUPPLIED MORE THAN 50% OF THE TOTAL FINANCING.- IT MAKES COSTLY FOR OUR CO TO BORROW ADDITIONAL
FUNDS WITHOUT FIRST RAISING MORE EQUITY CAPITAL.- THE COMPANY WILL BE SUBJECT TO BANKRUPTCY IF IT
INCREASE ITS DEBT RATIO FURHTER.
ABILITY TO PAY INTEREST: TIMES INTEREST EARNED
T I E = EBIT / INTEREST CHARGEST I E = $ 283.8 / 88 = 3.2 TIMES INDUSTRY AVERAGE = 6 TIMESTIE MEASURES THE EXTENT TO WHICH INCOME CAN DECLINE BEFORE THE COMPANY IS UNABLE TO MEET ITS ANNUAL INTEREST COSTS. ( FAILURE LEADS TO BANKRUPTCY)EBIT IS USED BECAUSE INTEREST IS PAID WITHPRE TAX DOLLARS / RUPEES.OUR COMPANY’S TIE IS LOW . IT SHOWS THAT THE MARGIN OF SAFETY IS LOWER FROM CREDITORS POINT OF VIEW.
ABILITY TO SERVICE DEBTEBITDA COVERAGE RATIO
TIE HAS 2 SHORT COMMINGS1. INTEREST IS NOT THE ONLY FIXED FINANCIAL CHARGE
(CO SHOULD ALSO REDUCE DEBT AND MAKE LEASE PYMNTS)
2. EBIT DOES NOT REPRESENT ALL THE CASH FLOW AVAILABLE TO SERVICE DEBT, ESPECIALLY IF THE CO HAS HIGH DEPRECIATION AND AMORTIZATION CHARGES.
TO OVER COME THE ABOVE PROBLEMS THE BANKERS ANDOTHER CREDITORS HAVE DEVELOPED EBITDA RATIOEBITDA COVERAGE RATIO= EBITDA+LEASE PAYMENTS
INT + PRCPL PYMNTS+ LEASE PYMNTS
EBITDA COVERAGE RATIO = 283.8+100+28 = 411.8 88+20+28 136 EBITDA COV RATIO = 3.0 TIMES INDUSTRY STANDARD = 4.3 TIMES
IT SEEMS THAT OUR COMPANY HAVE A HIGH LEVEL OF DEBT.
Note: Different analysts define EBITDA coverage ratio in a different ways. Some omit lease payments and some would gross up principal payments ie by dividing them by (1-T) .A Sinking fund is a required annual payment designed toreduce the balance of bond / preferred stock / debenture issue.
EBITDA RATIO USEFUL FOR SHORT TERM LENDERS WHEREAS LONG TERM CREDITORS FOCUS ON T I E RATIO
PROFITABILITY RATIOS
PROFITABLITY IS THE NET RESULT OF A NUMBER OF POLICIES AND DECISIONS. COMBINED FFECTS OF LIQUIDITY, ASSET MANAGEMENT AND DEBT OPERATING RESULTS.
PROFIT MARGIN ON SALES = NI AVL FOR COMN SHARE HOLDERS
SALES
PROFIT MARGIN = 113.5 / 3000 = 3.8 %INDUSTRY AVG 5.0 %Apparently our company’s COSTS are too high which shows inefficient operations.
Remember NI is after interest. Profit margin can also be affected as result of high financial leverage.
Basic Earning power
BEP = EBIT / Total Assets.
BEP = $ 283.8 / 2000 = 14.2 %Industry Average = 17.2 %
This ratio shows the raw earning power of the company’s assets before the influence of taxes and leverage .
It is useful for comparing Companies with different tax situations and different degrees of financial leverage.For computing this ratio we should use Average
assets figure.
RETURN ON TOTAL ASSETS
ROA = Net Income available to common stock holders
TOTAL ASSETSROA = $ 113.5 / 2000 = 5.7 % Industry Average = 9 %
The low return on assets is because1 The company’s low basic earning power2 High interest costs resulting from its above
average use of debt, both of which cause its net income to be relatively low
Return on equityThe BOTTOM LINE of accounting ratios is the ratio of Net Income to common equity, which measures the return on Common equity ( ROE)
ROE = Net income available to common stock holders Common equity
ROE = $ 113.5 / 896 = 12.7 %Industry Average = 15.0 %
Stock holders invest to get return on their money, and ROE tells how well they are doing in accounting sense.
Market Value ratios
Final group of ratios, the Market Value Ratios relates the Company’s stock price to itsEarnings, cash flow, and book value per share
ETC .These ratios give management an indication of what investors think of company’s past performance and future prospects. If the
liquidity, asset management , debt management, and profitability ratios all look good, then the market value ratios will be HIGH, and the STOCK PRICE will be probably as high as can be expected.
Price / Earning Ratio
P / E ratio shows how much investors are willing to pay per dollar / rupee of reported profits.
P/E ratio = Price per share / Earning per share
P/E = $ 23 / 2.27 = 10.1 times
Industry Average = 12.5 timesThis ratio is higher for companies having strong growth prospects but lower for riskier companies.
OUR company is regarded as riskier and having poor growth
prospects.
PRICE / CASH FLOW RATIO
In some industries, stock price is tied more closely to Cash Flow rather than net income.
PRICE / CASH FLOW RATIO = PRICE PER SHARE CASH FLOW PER SHARE
P/Cflw RATIO = $ 23 / 4.27 = 5.4 Times
Industry Average = 6.8 Times
It tells that growth prospects are below average and risk is above average or both.
Market / Book Value ratioMarket Book Value Ratio. This ratio gives an other indication how investors regard the company. Companies with relatively higher rates of return on equity generally sells at higher multiples of book value than those with low returns.
Mkt / Book Value ratio = Mkt price per share / Book Value per Share
For computing this ratio we also require Book Value per share.
Book Value per share = Common Equity / Shares Outstanding
BV / Share = $ 896 / 50 = $ 17.92 Now using the above Book value we can compute theMkt / |Book value ratio = $23 / 17.92 = 1.3 timesIndustry Average = 1.7 times
Book Value is the record of the past, showing the Cumulative amount that stock holders have invested , either directly by purchasing newly issued shares or Indirectly through retained earnings.
Market Price is forward looking, incorporating investor’s expectations of future cash flows.
Other important ratios: Dividend yield = Dividend per share / Market price per
shareEarning Yield = EPS / MPS
Price EBITDA per share, Price / Customers, Price / SalesEtc etc
DUPONT ANALYSIS
Dupont Analysis : The relationship between various ratios. How the return of equity is affected by Asset Turn over, the profit margin and leverage. ROE= ROA x Equity multiplier (5.7 x 2.23= 12.7)ROA= NI / Total Assets or Profit Margin x Asset turnover = 113.5 / 2000 or (113.5/ 3000) x (3000/2000)=5.7 ROE=Profit Margin x Total Asset turn over x Equity multiplierProfit Margin = NI / Sales 113.5/ 3000 = 3.78 Asset Turn over= Sales / Total Assets 3000/2000= 1.5Equity multiplier= Total Assets / Common equity
= 2000 / 896 = 2.23
Modified Du pont Chart
Return on Equity 12.7%
Return on Assets 5.7% X Assets / Equity = 2000/696 = 2.23
Profit Margin ie Earning as a % of Sales X Total Asset turn over 1.5 3.8 % Sales Divided into Net Income Sales Divided by Total
Assets3000 113.5 3000 2000
Total Cost Subtracted from Sales Fixed Assets Added to Cur Assets
2886.5 3000 1000 1000Other Optng Interest +Cost 2616.2 Prfd Dividend Cash & Mktble (Labor + Overhead) 92 Securities 10
Depreciation Taxes A/ Rcbl Inventories
100 78.3 375 615
IF the company were financed only with common equity
Then ROA and ROE would be same because Total Assets = Total equity
ROA = NI / TA and ROE = NI/Common equity
In our company’s case DEBT is also being used
Therefore ROE must be greater than ROA 12.7 % 5.7 %
IMP : TO FIND ROE MULTIPLY THE RATE OF RETURN
ON ASSETS BY EQUITY MULTIPLIER.
EQUITY MULTIPLIER = TA / COMN EQUITY
Company that use high amount of debt financing ( a lot
of leverage ) will necessarily have HIGH EQUITY
MULTIPLIER.
MORE DEBT LESS EQUITY HENCE HIGER EMExample
ASSETS = LIABILITIES O/E EM
Co A 1000 800 200 5
Co B 1000 200 800 1.25
OUR COMPANYS ROE
ROE = ROA X EM = NI/TA X TA/CE
=5.7 % X 2000/896=5.7% X 2.23
R O E = 12.7%
WE CAN ALSO SAY EXTENDED DUPONT EQUATION IS
ROE = PROFIT MARGIN X TTL ASST TURNOVER X E M = NI/SALES X SALES / ASSETS X ASSETS / EQTY
= 3.8% X 1.5 X 2.23 = 12.7 %
THE ROE IE 12 . 7 % COULD OF COURSE BE CALCULATED DIRECTLY. BOTH SALES AND TOTAL ASSETS CANCELS AND LEAVE
NI / COMMON EQUITY = 113 / 896 = 12.7 %
HOWEVER DU PONT MODEL SHOWS HOW PROFIT MARGIN , ASSET TURN OVER AND DEBT INTERACT TO DETERMINE THE RETURN ON EQUITYEG: HOLDING OTHER THINGS EQUAL IF OUR CO
CANDRIVE UP ITS RATIO OF SALES / TOTAL ASSETS=
1.8THEN ROE WILL IMPROVE 3.8 % X 1.8 X 2.23 =15.2 % ------- WHAT IF ANALYSIS ------
Predicting business failure
The analysis of financial ratios is largely concerned with the efficiency and effectiveness of use of resources by a company’s management, and also with the financial stability of the company. Investors will like to know:
Whether additional funds could be lent to the company with reasonable safety.Whether the company would fail without additional funds.
One method of predicting business failure is the use of liquidity ratios ( The current and quick ratios eg if Current ratio < 2:1).Research indicates that Current ratio and trends in other ratios are some time poor indicators of business failure.
Altman Z score Model – predictor of business failure
E I Altman researched into the simultaneous analysis ofseveral financial ratios as a combined predictor of business failure. He analyzed 22 accounting and non accounting variables for a selection of failed and non failed US Companies. He arrived at 5 key indicators. The companies with a Z score above certain level would be predicted financially sound, and Companies with Z score below certain level would be categorized as probable failure. Altman also identified a range of Z scores in between the non failure and failure categories in which eventual failure or non failure was uncertain.
Altman Z score derived in 1968
Z = 1.2 X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
Where X1 = Working Capital / total AssetsX2 = retained earnings / total AssetsX3 = earning before interest and tax / total
AssestsX4 = market value of equity / book value of debtX5 = Sales / Total Assets.
In Altman’s model a Z score of 2.7 or more indicated
Non failure and a Z score of 1.8 or less indicated failure.
USES AND LIMITATION OF RATIOS
RATIOS USED BY 3 MAIN GROUPS:1 MANAGEMENT FOR ANALYSING &
CONTROLING COMPANY’S OPERATIONS.2 CREDIT ANALYSTS FOR TO ASSES SOLVENCY 3 STOCK ANALYSTS WHO ARE INTERESTED IN
CO’S EFFICIENCY, RISK AND GROWTH PROSPECTS.
LIMITATIONS
DIFFICULTIES IN DEVELOPING MEANINGFUL SET OF INDUSTRY AVERAGE ESPECIALLY FOR LARGE COMPANIES HAVING DIFFERENT DIVISIONS OPERATING IN DIFFERENT INDUSTRIES.COMPANY’S PERFORMANCE SHOULD BE BETTER THAN INDUSTRY AVERAGE MERE ATTAINING THE AVERAGE IS NOT NECESSARILY GOODINFLATION BADLY DISTORT BALANCE SHEET FIGSSEASONAL FACTORS ALSO DISTORT RATIOSCOMPANIES USE WINDOW DRESSING TECHNIQUES WHICH DISTORT FIGURESDIFFERENT ACCOUNTING PRACTICES CAN DISTORT COMPARISONDIFFICULT TO GENERALISE WHETHER A RATIO IS GOOD OR BAD ( LIQUIDITY RATIOS ) RATIOS DEPENDS UPON FINANCIAL STATEMENT ACCURACY
LOOKING BEYOND NUMBERS
SOUND FINANCIAL ANALYSIS INVOLVES MORE THAN NUMBERS. ---- QUALITATIVE FACTORS
ARE THE COMPANY’S REVENUE TIED UP TO ON KEYCUSTOMER ?TO WHAT EXTENT ARE THE COMPANY’S REVENUE TIED UP TO ONE KEY PRODUCT.TO WHAT EXTENT DOES THE CO RELY ON A SINGLE SUPPLIERWHAT PERCENTAGE OF BUSINESS IS GENERATED OVERSEASCOMPETITION LEVELFUTURE PROSPECTSLEGAL AND REGULATORY ENVIRONMENT ETC