Financial Statement Analysis

Concept

 Financial Statements: convey a company’s financial

position
 Analysis: application of analytical tools/ techniques
to financial data to aid decision making
 Sources of financial information:
 Company’s annual reports
 Newspapers, business magazines, websites for stock
market related data
 Analysts’/ brokers’/ investment bankers’ equity research
reports/ data bases
 Regulatory sites of stock exchanges, SEBI etc.
 Reports of credit rating agencies
Types of Comparative Analysis

 Ratio Analysis
 Time Series/ Trend Analysis
 Cross-Sectional Analysis
 Common size Statements
Ratio Analysis

 Ratio : defines relationships between two variables

 Quantifies firm values
 Expressed as in : percentages, proportions, times
 Interested parties:
 ST creditors: short term liquidity/ solvency
 LT creditors: long term liquidity/ solvency and profitability
 Owners/ shareholders: liquidity, profitability, stock price
 Management: overall operating efficiency
 Other stakeholders like employees, customers, suppliers,
analysts….
Types of Comparisons

 Trend analysis/ ratios: comparison of ratios of

a firm over time
 Interfirm comparison: comparison of firm’s
ratios with its competitors or industry
averages
 Comparison with standards/ plans/ budgeted
figures
Types of Ratios

 Liquidity ratios: measures ST liquidity/ solvency

 Capital Structure ratios: measures LT solvency, thus
are mainly for LT investors, both lenders and owners
 Turnover/ Activity Ratios: measures efficiency in
asset management
 Profitability/ Efficiency ratios: measures efficiency in
operations; are mainly for management
Liquidity Ratios
Liquidity: firm’s ability to pay its ST obligations as they become
due

Direct measures of liquidity:

 Net Working Capital: Total Current assets – Total Current
liabilities
 Current ratio: current assets/ current liabilities
 Quick/ acid test ratio: quick assets/ current liabilities
 quick assets = current assets less inventories and prepaid expenses
 Cash Ratio: (cash and bank bal. + current investments)/ current
liabilities
Turnover Ratios
Indirect measures of liquidity:
(Indicate speed of conversion of a current asset into cash or
sales)
 Debtors turnover ratio = net credit sales/ average debtors
(including accounts receivables)
 Average collection period = average debtors/ avg. daily sales, or
= 365/ debtors turnover ratio
 Inventory turnover ratio = COGS/ avg. inventory
 Inventory holding period = 365/ Inventory turnover ratio
 Creditors Turnover ratio = Credit purchases/ average creditors
(including bills payables)
 Average Payment Period = 365/ creditors turnover ratio
Leverage or Capital Structure Ratios

 To assess long term solvency of the firm

 Its ability to pay:
 Periodic Interest as and when due
 Principal repayments of debt
 Indicates degree of financial risk or leverage
 Identifies sources of funds
 Helps plan future fund raising
Types

Capital
Structure
Ratios

Coverage
Ownership
Ratios
Ratios
(from
(from B/S)
P & L A/c)

Total Fixed
Interest Dividend Cash Flow
Debt-Equity Debt Asset Equity Asset Charges
Coverage Coverage Coverage DSCR
Ratio Ratio Ratio Coverage
Ratio Ratio Ratio
Ratio
Ownership Ratios

 Debt equity ratio = debt/ equity: relative

contributions of creditors and owners
 Debt assets ratio = debt/ assets: extent to which
assets are financed by debt; also called
leverage or trading on equity
 Equity Assets Ratio = Equity/ Assets: extent to
which assets are financed by equity capital; also
called proprietary ratio
 Capital gearing ratio = equity funds/ fixed
income bearing funds like preference shares,
debentures, other borrowed funds
Coverage Ratios
Indicate firm’s ability to service its financial obligations and are
equal to funds available to meet an obligation/ amount of that
obligation
 Interest coverage (TIE) ratio = EBIT/ interest expense
 Dividend Coverage ratio = PAT/ Preference dividend
 Fixed charges coverage ratio = (EBIT + Lease Payments)/
fixed financial charges (post tax ones converted to pre tax)
 Cash Flow Coverage Ratio = (EBIDTA + Lease Payments)/
fixed financial charges (post tax ones converted to pre tax)
 Debt service coverage ratio (DSCR) = (PAT+ Interest+ dep.
and non cash charges) / (interest + principal repayment
installment)
Profitability/ Efficiency Ratios

Profitability Ratios

In relation to
In relation to Sales Investments
(ROI)

Return on Capital
Return on Assets Return on Equity
Profit Margin Expenses Ratio Employed
(ROA) (ROE)
(ROCE)

Gross Profit
Margin

Net Profit Margin

Profit Margin Ratios

 Gross Profit margin ratio = GP/ net sales; is an

indicator of efficiency of production operation
 EBIDTA Margin ratio: EBIDTA/ Net Sales;
EBIDTA being an indicator of cash operating
profits
 Operating profit ratio = EBIT/ Net Sales
 Net Profit margin ratio = NP/ net sales:
measures overall efficiency
Expenses Ratios

 COGS Ratio = COGS/ Net Sales

 Operating expenses ratio = general,
administrative and selling expenses/ Net
Sales
 Operating Ratio= (COGS + operating
expenses)/ Net Sales
 Financial Expenses ratio = Financial
Expenses / Net Sales
Return on Investments

 Return on Assets (ROA): PAT or (PAT+ Interest)/ Average

Total Assets
 Return on Capital Employed: EBIT/ Average Total Capital
Employed i.e. total LT funds supplied by lenders and
owners (D+E)
 Return on equity or on Net Worth (ROE) = net income or
PAT less preference dividends/ average Net Worth (NW)
 NW or Book Value =paid up equity +reserves – fictitious
assets
 Ratio measures profitability of equity funds invested

 Earning power of assets (similar to ROA) = EBIT/ average

total assets: is a measure of operating business
performance
Some Valuation Ratios

Help analyze market value of investment

 Earnings per share (EPS) = PAT/ no. of outstanding

equity shares
 Cash EPS = (PAT + depreciation and non cash
expenses)/ no. of outstanding shares
 Diluted EPS = PAT/ no. of outstanding shares after
potential conversion of all convertible instruments
 Price earning ratio (P/E multiple) = MPS/ EPS
 Capitalization rate or earnings yield= EPS/ MPS or
inverse of P/E multiple: indicates reqd. rate of return
by equity investor
 Book Value (BV) per share (BPS)= Net Worth/ no. of
outstanding equity shares
 Price to BV Ratio = MPS/ BPS
 Dividend per share (DPS) = Total dividends paid to
equity shareholders/ no. of outstanding equity
shares
 Dividend pay-out ratio (D/P ratio) = DPS/ EPS or
total dividends/ PAT
 Dividend yield = DPS/ MPS: indicates return on
investment
Activity or Turnover Ratios

 Also termed as efficiency ratios or asset utilization

ratios
 Measures the efficiency in asset management
 Efficiency of usage of assets is reflected in speed or
rapidity with which these are converted into sales
 Speed is the rate of turnover or conversion
 Higher the turnover, more efficient is the utilization
of assets
Types of Activity Ratios

 Inventory turnover ratio

 Debtors turnover ratio
 Total Assets Turnover Ratio = Net Sales/
Average Total Assets
 Fixed Assets Turnover: Net sales/ average
net fixed assets
Du Pont Analysis or Integrated Analysis
of Ratios
This approach integrates both P&L and B/S ratios to explain
overall efficiency of business

 Analyzes return ratios in terms of profit margin and turnover

ratios
 Breaks down each component into further parts
 Helps boil down to the real source of problem or inefficiency
 Thus assists in decision taking
 ROA = NP margin * asset turnover
 Thus ROA may be higher due to either better NP margin or better
asset utilization
 ROE = NP margin * asset turnover * equity multiplier
 where equity multiplier = Assets/ Equity indicating the extent of
leverage
 Higher leverage results in higher ROE
Comparative Analysis
 Cross Sectional Analysis: comparison with industry averages or
with standard player averages
 Time Series analysis or Trend Analysis:
 Year on year (YoY) change: present ratios over a period of time,
depict changes in absolute amounts or in percentages
 Index analysis: chose a base year ( typical/ normal business
conditions), given index of 100; helps standardize, common
frame of reference
 Common size analysis:
 presents items as %ge of group/ sub group total

 in B/S, total assets/ liabilities figure is taken as 100% and in P&L

A/c, sales figure is taken as 100%
 Facilitates inter company as well as intra company (over a period
of time) comparisons
Problems in FS Analysis

 Development of benchmarks: especially in

conglomerate firms
 “Window Dressing”
 Price Level Changes: impact of inflation is
normally not incorporated in financial
statements
 Differences in Accounting Policies
 Conceptual Diversity: differences in
interpretations of various concepts, terms and
ratios
Going beyond the numbers
 Shareholders profile
 Quality of management
 Customer profile break up
 Revenue break up product wise
 Supplier profile analysis
 Overseas vs. domestic business
 Competitors
 Innovations/ R&D efforts
 Legal and regulatory environment: impact of changes in tax structure
proposed, if any

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