1. Ratio Analysis

2. Objective of a Business
Create value for its shareholders while maintaining a sound financial position.
Return on investment.
Sound financial position.
Other important objectives include:
Employee satisfaction.
Social responsibility.
Ethical considerations.

3. Annual Reports
Functions performed by a public company’s annual report:
1. Regulatory
provision of financial statements
declarations of accounting policies
provision of directors’ and auditor’s reports
2. Public relations based - enables public to view and understand the primary operations of the company.
3. Decision making - information contained in annual reports helps make performance, investment and credit-related decisions.

4. Profit and Loss Statement
Shows how profitable a firm has been over the past year. Includes:
revenues - sales, interest and dividends received
expenses
operating profit
abnormal items
income tax
extraordinary items

5. Balance Sheet
Provides a summary of the assets, liabilities and shareholders’ equity of the company on a nominated balance date. Includes:
assets - current and non-current
liabilities - current and non-current
shareholders’ equity - share capital, reserves, retained profits

6. Statement of Cash Flows
Represents a sources and uses of funds statement. Includes:
cash flows from operating activities
cash flows from investing activities
cash flows from financing activities

7. Need for Financial Statement Analysis
Comparison ????

8. Financial Statement Analysis Tools
Trend %
Common Size
Ratio Analysis

9. 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.

10. Trend Percentages Year 2012 2011 2010
Revenues Rs.27,611 Rs.24,215 Rs.21,718
Cost of sales , , ,049
Gross profit Rs.12,293 Rs. 9,506 Rs. 8,669
2010 is the base year.
What are the trend percentages?

11. Trend Percentages Year 2012 2011 2010 Revenues 127% 111% 100%
Cost of sales 117% 113% 100%
Gross profit 142% 110% 100%
These percentages were calculated by
dividing each item by the base year.

12. Common Size
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.

13. Common Size 2012 % Revenues Rs.38,303 100.0 Cost of sales 19,688 51.4%
Revenues Rs.38,
Cost of sales ,
Gross profit Rs.18,
Total operating expenses ,
Operating income Rs. 5,
Other income ,
Income before taxes Rs. 7,
Income taxes ,
Net income Rs. 4,

14. Common Size Assets 2012 % Current assets: Cash Rs. 1,816 4.7
Receivables net ,
Inventories ,
Prepaid expenses ,
Total current assets Rs.21,
Plant and equipment, net ,
Other assets ,
Total assets Rs.38,

15. Ratios
Financial analysis using ratios is useful to investors because the ratios capture critical dimensions of the economic performance of the company.
Managers use ratios to guide, measure, and reward workers.
Often companies base employee bonuses on a specific financial ratio or a combination of some other performance measure and a financial ratio.

16. Ratios- a double edged weapon
Ratios mean different things to different groups.
A creditor might think that a high current ratio is good because it means that the company has the cash to pay the debt.
However, a manager might think that a high current ratio is undesirable because it could mean that the company is carrying too much inventory or is allowing its receivables to get too high.

17. Cont… GAAP does not define ratios.
Multiple equally valid approaches to ratios and analysis.
Managers (e.g., division manager, sales manager) should be measured to items that they control.
Investors and top management are most interested in overall performance or broadest measures of performance.
Understanding less broad measures of performance may give additional insight into overall performance.

18. Structure of analysis From broadest to more specific levels.
Principal value of financial analysis:
Suggests questions not answers.
Ratio comparisons start with the supposition that all other things are equal. (They rarely are.)

19. Evaluating Financial Ratios
Financial ratios are evaluated using three types of comparisons.
Benchmarks - general rules of thumb specifying appropriate levels for financial ratios
Time-series comparisons - comparisons of a company’s financial ratios with its own historical ratios
Cross-sectional comparisons - comparisons of a company’s financial ratios with the ratios of other companies or with industry averages

20. Evaluating Financial Ratios- Benchmarks
Experience. A feel for what is right or reasonable.
Budget. A target developed within the company. Factors to be considered:
How carefully was budget constructed?
What circumstances are different now?
Historical standards. Prior period’s results adjusted for changes in accounting methods.
External benchmarks. Competitor, industry average

21. Ratio Standards of Comparison-Cross-Sectional standards
Compare a firm’s financial ratios to other firms or industry average
Industry averages are published by companies such as
Moody’s
Standard & Poor’s
Fitchs
Deshaw
Copal Partners
And Lot of Indian Firms Like Motilal Oswal, India Bulls etc.
Can reveal a firm’s strengths/weaknesses compared to other firms

22. Ratio Standards of Comparison- Time-series comparisons
Time-Series standards
Compare a firm to its own ratios from other years
Helps highlight trends/changes that have occurred

23. Category of Financial Ratios
Leverage ratios
Measure extent to which firm has been financed by creditors
liquidity ratio
Measure firm’s ability to meet short-term obligations
Profitability ratios
Measures productivity of money invested in firm
Turnover ratios
Measure rate of activity
Per share data
Examines items that affect common stock’s market price per share
Growth ratios
Measures contribution of various items to firm’s development
Risk analysis ratios
Measures variability

24. Making comparisons Finding the appropriate standard is difficult.
A high ratio (e.g., current ratio, ROI) may be good or bad. It can’t be viewed in isolation.
Is a high CR good or bad?
Is a high ROI always good?
Values of ratios compared across time  trend analysis.

25. Leverage Ratios
Show how heavily the company is in debt.

26. Leverage Ratios

27. Liquidity Ratios
Measure how easily the firm can obtain cash to pay its debts as they fall due.

28. Liquidity Ratios

29. Activity Ratios
Measure how different asset groups contribute to overall profitability.

30. Activity Ratios

31. Profitability Ratios
Used to judge how efficiently the firm is using its assets.

32. Profitability Ratios Sh. Equity= E S Capital + reserves
Net worth is E.S. Capital + P.S. Capital + Reserves and Surplus
The others in this category may be ROA and ROCE

33. Market Value Ratios
Show how the firm is valued by investors.

34. Price/Earnings (PE) ratio
Measure of overall performance.
Market price is not controlled by company; reflects all information available to the market.
Reflects how investors judge the future performance or prospects of the company.
Commonly compared to other companies in the same industry.

35. Market Value Ratios

36. DuPont Identity
The DuPont Identity is essentially just an expanded version of ROE. It is used to compare two companies’ profitability, efficiency, and leverage.
Net Income X Sales X Assets
Sales Assets Equity
By breaking down ROE into these three things, it allows you to determine exactly why one company has a better ROE than another.
While this isn’t “Security Valuation” it can prove to be a very important metric.

37. Return on Assets (Profitability)
ROE
Return on Assets (Profitability)
Financial leverage 
Liquidity
Net profit Margin
Asset turnover 
Solvency
Sales
Total assets
Net income /
Sales /
Current assets
Noncurrent assets
Sales —
Total cost +
Cost of goods sold
Cash
Land
SG&A
Acc. Receivables
Building
R&D
Inventory
Equipment
Interest expense
Other
Intangibles
Income taxes
Others

38. Growth measures
Key accounting items for which growth is computed: sales, net income, earnings per share.
Average growth = (growth per year for n years)/n
Compound growth rate = based on present value concepts.
May be misleading due to abnormally high or low beginning or ending year.

39. Implied growth rate
=Return on shareholders’ equity X Profit retention rate
= ROE X (1 – Dividend payout)
Estimates potential to grow profits without an injection of new capital.

40. Analysis of Growth
Common stock price appreciation depends on various factors
Growth financed internally depends on the amount of retained earnings
A corporation’s growth rate depends on the return on equity
Growth rate = RR x ROE
Substituting the three-part DuPont ROE equation, we obtain
Shows that multiple
factors influence
growth—one factor
can rise and another
fall and growth can
remain unchanged.

41. Credit Risk Analysis
Procedure to determine the likelihood a customer will pay its bills. Consider the customer’s previous credit history, bank or trade references, financial statements, and any other information supplied by the customer or collected.
Credit agencies provide reports on the credit worthiness of a potential customer.
Financial ratio analysis can be used to help determine a customer’s ability to pay its bills.

42. Credit Risk Analysis
A technique used to develop a measurement of solvency, sometimes called a Z Score.
Edward Altman developed a Z Score formula that was able to identify bankrupt firms approximately 95% of the time.

43. Credit Risk Analysis

44. Credit Risk Analysis
Example - If the Altman Z Score cut off for a credit worthy business is 2.7 or higher, would we accept the following client?

45. Credit Risk Analysis
Example - If the Altman Z Score cut off for a credit worthy business is 2.7 or higher, would we accept the following client?
A score above 2.7 indicates good credit.

46. Credit Risk Analysis
Credit analysis is only worth while if the expected savings exceed the cost.
Don’t undertake a full credit analysis unless the order is big enough to justify it.
Undertake a full credit analysis for the doubtful orders only.

47. Economic Value Added
The idea behind economic value added (EVA) is that a company must earn more than it must pay for capital if it is to increase in value.
Capital is considered both debt and equity.
The cost of capital in EVA is a weighted average of interest cost and the returns required by equity investors.
If a company has positive EVA, the company is adding value; if a company has negative EVA, the company is losing value and might be better off liquidating.

48. EVA
EVA can also be defined as the difference between the net operating profit before interest, but after tax (NOPAT) and a capital charge based on the WACC multiplied by the IC:
EVA = NOPAT – (WACC x IC)

49. EVA EVA is calculated as follows: EVA = (ROIC – WACC) x IC where
ROIC = Return on invested capital
WACC = Weighted Average Cost of Capital
IC = Invested Capital (at the beginning of the year)

50. MVA
The link between MVA, the cumulative measure, and EVA, which is an incremental measure, is that MVA is equal to the present value of all future EVA to be generated by the company.
MVA = present value of all future EVA

51. Example
Company Z has invested capital amounting to R100 million at the beginning of the year. This is financed by 60% equity and 40% debt. The debt has an interest rate of 12% before tax. The tax rate is 30% and the WACC 15%. The net income for the year before interest and tax is R30 million.
ROIC is R30 million / R100 million x (1 – tax rate of 30%) = 21%.
EVA = (ROIC – WACC) x IC
= (21% - 15%) x R100 million
= 6% x R100 million
= R6 million

52. Cont…
Applying the second formula given for EVA, the result is the same:
EVA = EBIAT – (WACC x IC)
= R21 million – (15% x R100 million)
= R6 million
where
EBIAT = Earnings before interest, after adjusted tax
If the future EVAs are expected to remain indefinitely at R6 million per year, the MVA can be calculated as follows:
MVA = EVA / WACC
= R6 million / 15%
= R40 million

54. Potential Problems with Financial Analysis
Inflation distortions
Can be a serious problem with the balance sheet
Some fixed assets are reported at their historical costs
After several years of high inflation historical costs can be irrelevant
Vague definition of accounting income
A firm can modify its accounting income depending upon certain actions
Such as which depreciation method or inventory valuation technique is used

55. Potential Problems with Financial Analysis
Consolidated financial statements
When a firm owns a subsidiary corporation accounting issues arise when considering minority interests
Goodwill
When a company merges, oftentimes ‘goodwill’ is then reflected on the consolidated balance sheet
This intangible asset cannot be measured with precision

56. Financial Statement Analysis-Sector Specific

57. Banks & FIs

58. Banking Regulation act, 1949
Schedule Liability
01 Capital
02 Reserves and surplus
03 Deposits
04 Borrowings
05 Other liabilities and provisions
12 Contingent liabilities

59. Banking Regulation act, 1949
Schedule Assets
06 Cash and balances with RBI
07 Balances with banks and money at call and short notice
08 Investments
09 Advances
10 Fixed Assets
11 Other assets

60. Banking Regulation act, 1949
Schedule Income and expense
13 Interest earned
14 Other incomes
15 Interest expensed
16 Operating expense

61. Balance sheet Minimum capital 100 Cr. (old banks are exempted)
Statutory Reserves- not less then 20% of profits before dividend
Capital reserve- Surplus due to revaluation
Share premium
Others

62. Deposits
Demand Deposits
Savings Deposits
Term Deposits

63. Cont… Borrowings-Include RBI And other banks borrowings
Other liabilities- B/P, Inter office adjustment, interest accrued etc. 63

64. Assets Cash and balances with RBI (CRR) Balances kept with other banks
Investment include
Loans made in interbank call money market
Investment in approved securities (SLR)
Government securities 64

65. Advances Classification based on Type/nature of assets
Secured/unsecured
Sectorial disbursement

66. Analysis of Banks Performance
CAMELS
Capital Adequacy
Assets Quality
Management Effectiveness
Earnings
Liquidity (ALM)
Systems control

67. Capital Adequacy of Banks
Need for Capital:
Financial Intermediaries need capital for two reasons:
To run operations of their business.
To safeguard against the losses, that may arise.
Adequate capital helps banks to survive even during substantial losses. It gives time to re-establish the business and avoid any break in operations.
To ensure the good performance of banks the regulatory authority (RBI) has specified the minimum capital for the Financial Intermediaries.
This requirement is called Capital Adequacy, and it is specified for Banks and Non Banking Financial Corporations (NBFCs).

68. Ratios Capital Adequacy Minimum capital requirement = (CRAR)
Total Capital/RWA
Where RWA is risk weighted assets

69. Cont… 2. Core CRAR Tier I capital/ RWA 3. Adjusted CRAR
Total Capital- Net NPAs/ RWA
Higher the ratio better it is

70. Cont… Computation of capital adequacy ratio (CAR) of banks:
For computation of CAR, we need to calculate:
Tier I capital
Tier II capital
Risk Weighted Assets (RWA)

71. Cont…
Step 1: Compute Tier I capital: Tier I capital is the most permanent and readily available support against unexpected losses. It consists of-
1. Paid up equity capital 2. Statutory reserves 3. Capital reserves 4. Other disclosed free reserves
Less:
1. Equity investments in subsidiaries 2. Intangible assets 3. Current and Accumulated Losses, if any

72. Cont…
Step 2: Compute Risk Weighted Assets Step 2: Calculation of Risk Weighted Assets (RWA)
RWA are calculated by multiplying the relevant weights to the value of assets and off-balance sheet items.
The weights assigned to each of the items are as follows:

73. Cont…
Domestic Operations

74. Cont…
Domestic Operations

75. Cont…
Domestic Operations

76. Cont…
Domestic Operations

77. Cont…
Step 3: Compute tier II capital These are not permanent in nature or, are not readily available.
Tier II capital consists of-
1. Undisclosed reserves and cumulative perpetual preference shares- Cumulative preference shares should be fully paid and should not contain clauses which permit redemption from shareholders.
2. Revaluation Reserves (RR)- 45% of RR is only taken in calculation of tier II capital
3. General Provisions and Loss Reserves (GPLR)- Actual GPLR or 1.25% of Risk Weighted Assets, whichever is lower, is taken.

78. Cont…
4. Hybrid Debt Capital Instruments- These combine characteristics of both equity and debt. As they are more or less similar to equity, they are included in the Tier II capital
5. Subordinated Debts- These must be fully paid up, unsecured, subordinated to the claims of other creditors, also there should be no such clause which permits redemption. The amount of subordinate debts to be taken as Tier II capital depends upon the maturity of debt. Subordianate Debt Instruments will be limited to 50% of Tier I capital.

79. Cont… Note: Tier II capital cannot be more than Tier I capital.
Capital Adequacy Ratio:
Capital Adequacy Ratio = (Tier I capital + Tier II capital) / RWA
According to the present norm, the Capital Adequacy Ratio of bank as defined earlier should be at least 10%.

80. Asset Quality Gross NPA/Gross advances Net NPA/ Net advances
Where Net NPA=gross NPA- Provisions
Net advances= Net bank credit- Provisions
Gross NPA/ Total Assets
Net NPA/ Total Assets
Net NPA/ Total Equity
Provision for loan losses/ Gross Advances
Provisions for loan losses/ NPAs
Provisions for loans and investment/Total Asset

81. Profitability Interest Expense= Interest exp/ Total income
Non interest exp= Non-Interest Exp./Total income
ROA
ROE
EPS
P/E
NP Margin

82. Cont… Interest earned on Investment Interest earned on deposits
Assets utilization= Total income/Total asset

83. Liquidity Total loans/ Total assets Net loans/ Total asset
Net loans= Total loan-Provisions
Net NPA=gross NPA- Provisions
Net advances= Net bank credit- Provisions

84. Cont… Non priority sector credit/ total credit (loans)
Unsecured credit/ total credit
Investments/ total asset
Investment in money market instruments/ total assets
SLR securities/ total investments
Cash and bank including call money/ Demand deposits
Cash and bank including call money/ Total deposits
Cash and bank including call money/ Total Asset