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ANALYSIS OF FINANCIAL STATEMENT

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

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ANALYSIS OF FINANCIAL STATEMENT

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  1. 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.

  2. CORPORATE VALUATION AND ANALYSIS OF FINANCIAL STATEMENTS FINCNG DECISIONS SALES REVENUE Int Rates FIRM RISK Oprtg Cost & Taxes Rqrd Invstmnt In Operations Mkt Risk Weighted Average Cost of Capital Free Cash Flows Value of Co = FCF1 + FCF2FCF3 ……FCF (1 + WACC)1 (1+WACC) 2 (1+WACC)3 (1+WACC)4

  3. THE MANAGEMENT SHOULD TRY TO MAXIMIZE A COMPANY’S VALUE IT MUST TAKE ADVANTAGE OF THE COMPANY’S STRENGTH AND CORRECT ITS WEAKNESS. FINANCIAL STATEMENT ANALYSIS INVOLVES : • COMPARING THE COMPANY’S PERFORMANCE WITH THAT OF OTHER COMPANIES IN THE SAME INDUSTRY. & • EVALUATING THE TRENDS IN THE COMPANY’S FINANCIAL POSITION OVER 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.

  4. PER SHARE DATA 2004 2003 COMMON STOCK PRICE $ 23 $ 26 EARNING PER SHARE 2.27 2.36 DIVIDEND PER SHARE 1.15 1.06 BOOK VALUE PER SHARE 17.92 16.80 CASH FLOW PER SHARE 4.27 4.16

  5. ADDITIONAL INFORMATION • THE BONDS HAVE A SINKING FUND REQUIREMENT OF $ 20 MILLION A YEAR • THE 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 = $ 2.27 DPS = DIVIDEND PAID TO COMMON / CMN SHR O/S DPS = $ 57,500,000 / 50,000,000 = $ 1.15 BVPS= TOTAL EQUITY / COMN SHARE O/S BVPS= 896,000,000 / 50,000,000 = $ 17.92 CFPS = NET INCOME + DEP + AMT / CMN SHR O/S CFPS = $ 213,500,000/ 50,000,000 = $ 4.27

  6. LIQUIDITY RATOS Liquidity 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 liabilities • It measures short term solvency of the company • Creditors would always like to see a high current ratio of the company • In case of financial difficulty the company will begin paying its bills (accounts payables) more slowly --- stretching of accountspayables. • Borrowing from banks will increase Micro Drive Current ratio = $ 1000 / 310 = 3.2 times Industry Average = 4.2 times If current liabilities are rising faster than current assets, the current ratio will fall and this could spell trouble.

  7. Quick Ratio The 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 times Industry Average 2.1 times

  8. DEBT MANAGEMENT RATIOS THE EXTENT TO WHICH A COMPANY USES DEBT FINANCING OR FINANCIAL LEVERAGE HAS 3 IMPORTANT IMPLICATIONS : • BY RAISING DEBT THE STOCK HOLDERS CAN MAINTAIN CONTROL OF THE COMPANY WITHOUT INCREASING THEIR OWN INVESTMENTS. • IF THE COMPANY EARNS MORE ON INVESTMENTS FINANCED BY BORROWED FUNDS THAN IT PAYS IN INTEREST, THAN ITS SHARE HOLDERS RETURNS ARE MAGNIFIED / LEVERAGED. • CREDITORS LOOK TO EQUITY OR EQUITY SUPPLIED CAPITAL AS MARGIN OF SAFETY

  9. 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.

  10. ABILITY TO PAY INTEREST: TIMES INTEREST EARNED T I E = EBIT / INTEREST CHARGES T I E = $ 283.8 / 88 = 3.2 TIMES INDUSTRY AVERAGE = 6 TIMES TIE 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 WITH PRE TAX DOLLARS / RUPEES. OUR COMPANY’S TIE IS LOW . IT SHOWS THAT THE MARGIN OF SAFETY IS LOWER FROM CREDITORS POINT OF VIEW.

  11. ABILITY TO SERVICE DEBTEBITDA COVERAGE RATIO TIE HAS 2 SHORT COMMINGS • INTEREST IS NOT THE ONLY FIXED FINANCIAL CHARGE (CO SHOULD ALSO REDUCE DEBT AND MAKE LEASE PYMNTS) • 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 AND OTHER CREDITORS HAVE DEVELOPED EBITDA RATIO EBITDA COVERAGE RATIO= EBITDA+LEASE PAYMENTS INT + PRCPL PYMNTS+ LEASE PYMNTS

  12. 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 to reduce 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

  13. 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.

  14. 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.

  15. RETURN ON TOTAL ASSETS ROA = Net Income available to common stock holders TOTAL ASSETS ROA = $ 113.5 / 2000 = 5.7 % Industry Average = 9 % The low return on assets is because • The company’s low basic earning power • High interest costs resulting from its above average use of debt, both of which cause its net income to be relatively low

  16. Return on equity The 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.

  17. Market Value ratios Final group of ratios, the Market Value Ratios relates the Company’s stock price to its Earnings, 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.

  18. 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 times This 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.

  19. 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.

  20. Market / Book Value ratio Market 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 the Mkt / |Book value ratio = $23 / 17.92 = 1.3 times Industry Average = 1.7 times

  21. 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 share Earning Yield = EPS / MPS Price EBITDA per share, Price / Customers, Price / Sales Etc etc

  22. 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 multiplier Profit Margin = NI / Sales 113.5/ 3000 = 3.78 Asset Turn over= Sales / Total Assets 3000/2000= 1.5 Equity multiplier= Total Assets / Common equity = 2000 / 896 = 2.23

  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 Assets 3000 113.5 3000 2000 Total Cost Subtracted from Sales Fixed Assets Added to Cur Assets 2886.5 3000 1000 1000 Other Optng Interest + Cost 2616.2 Prfd Dividend Cash & Mktble (Labor + Overhead) 92 Securities 10 Depreciation Taxes A/ Rcbl Inventories 100 78.3 375 615

  24. 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.

  25. 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 EM Example ASSETS = LIABILITIES O/E EM Co A 1000 800 200 5 Co B 1000 200 800 1.25

  26. 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 %

  27. 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 EQUITY EG: HOLDING OTHER THINGS EQUAL IF OUR CO CAN DRIVE UP ITS RATIO OF SALES / TOTAL ASSETS= 1.8 THEN ROE WILL IMPROVE 3.8 % X 1.8 X 2.23 =15.2 % ------- WHAT IF ANALYSIS ------

  28. 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.

  29. Altman Z score Model – predictor of business failure E I Altman researched into the simultaneous analysis of several 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.

  30. Altman Z score derived in 1968 Z = 1.2 X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 Where X1 = Working Capital / total Assets X2 = retained earnings / total Assets X3 = earning before interest and tax / total Assests X4 = market value of equity / book value of debt X5 = 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.

  31. USES AND LIMITATION OF RATIOS RATIOS USED BY 3 MAIN GROUPS: • MANAGEMENT FOR ANALYSING & CONTROLING COMPANY’S OPERATIONS. • CREDIT ANALYSTS FOR TO ASSES SOLVENCY • STOCK ANALYSTS WHO ARE INTERESTED IN CO’S EFFICIENCY, RISK AND GROWTH PROSPECTS.

  32. 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 GOOD • INFLATION BADLY DISTORT BALANCE SHEET FIGS • SEASONAL FACTORS ALSO DISTORT RATIOS • COMPANIES USE WINDOW DRESSING TECHNIQUES WHICH DISTORT FIGURES • DIFFERENT ACCOUNTING PRACTICES CAN DISTORT COMPARISON • DIFFICULT TO GENERALISE WHETHER A RATIO IS GOOD OR BAD ( LIQUIDITY RATIOS ) • RATIOS DEPENDS UPON FINANCIAL STATEMENT ACCURACY

  33. LOOKING BEYOND NUMBERS SOUND FINANCIAL ANALYSIS INVOLVES MORE THAN NUMBERS. ---- QUALITATIVE FACTORS • ARE THE COMPANY’S REVENUE TIED UP TO ON KEY CUSTOMER ? • TO WHAT EXTENT ARE THE COMPANY’S REVENUE TIED UP TO ONE KEY PRODUCT. • TO WHAT EXTENT DOES THE CO RELY ON A SINGLE SUPPLIER • WHAT PERCENTAGE OF BUSINESS IS GENERATED OVERSEAS • COMPETITION LEVEL • FUTURE PROSPECTS • LEGAL AND REGULATORY ENVIRONMENT ETC

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