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Ratio Analysis

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**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.

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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.

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**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

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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

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**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

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**Need for Financial Statement Analysis**

Comparison ????

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**Financial Statement Analysis Tools**

Trend % Common Size Ratio Analysis

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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.

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**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?

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**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.

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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.

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**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,

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**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,

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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.

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**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.

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**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.

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**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.)

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**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

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**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

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**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

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**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

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**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

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**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.

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Leverage Ratios Show how heavily the company is in debt.

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Leverage Ratios

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

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Liquidity Ratios

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

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Activity Ratios

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

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**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

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

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**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.

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Market Value Ratios

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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.

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**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

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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.

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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.

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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.

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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.

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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.

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Credit Risk Analysis

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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?

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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.

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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.

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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.

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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)

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**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)

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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

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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

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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

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**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

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**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

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**Financial Statement Analysis-Sector Specific**

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Banks & FIs

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**Banking Regulation act, 1949**

Schedule Liability 01 Capital 02 Reserves and surplus 03 Deposits 04 Borrowings 05 Other liabilities and provisions 12 Contingent liabilities

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**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

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**Banking Regulation act, 1949**

Schedule Income and expense 13 Interest earned 14 Other incomes 15 Interest expensed 16 Operating expense

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**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

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Deposits Demand Deposits Savings Deposits Term Deposits

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**Cont… Borrowings-Include RBI And other banks borrowings**

Other liabilities- B/P, Inter office adjustment, interest accrued etc. 63

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**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

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**Advances Classification based on Type/nature of assets**

Secured/unsecured Sectorial disbursement

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**Analysis of Banks Performance**

CAMELS Capital Adequacy Assets Quality Management Effectiveness Earnings Liquidity (ALM) Systems control

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**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).

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**Ratios Capital Adequacy Minimum capital requirement = (CRAR)**

Total Capital/RWA Where RWA is risk weighted assets

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**Cont… 2. Core CRAR Tier I capital/ RWA 3. Adjusted CRAR**

Total Capital- Net NPAs/ RWA Higher the ratio better it is

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**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)

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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

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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:

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Cont… Domestic Operations

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Cont… Domestic Operations

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Cont… Domestic Operations

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Cont… Domestic Operations

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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.

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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.

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**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%.

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**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

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**Profitability Interest Expense= Interest exp/ Total income**

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

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**Cont… Interest earned on Investment Interest earned on deposits**

Assets utilization= Total income/Total asset

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**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

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**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

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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Analyzing Financial Statements Chapter 14.

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Analyzing Financial Statements Chapter 14.

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