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 ReportsFunctions performed by a public company’s annual report:1. Regulatoryprovision of financial statementsdeclarations of accounting policiesprovision of directors’ and auditor’s reports2. 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 receivedexpensesoperating profitabnormal itemsincome taxextraordinary items
5 Balance SheetProvides a summary of the assets, liabilities and shareholders’ equity of the company on a nominated balance date. Includes:assets - current and non-currentliabilities - current and non-currentshareholders’ equity - share capital, reserves, retained profits
6 Statement of Cash Flows Represents a sources and uses of funds statement. Includes:cash flows from operating activitiescash flows from investing activitiescash flows from financing activities
7 Need for Financial Statement Analysis Comparison ????
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.21,718Cost of sales , , ,049Gross profit Rs.12,293 Rs. 9,506 Rs. 8,6692010 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 bydividing each item by the base year.
12 Common Sizecompares 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 RatiosFinancial 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 ratiosTime-series comparisons - comparisons of a company’s financial ratios with its own historical ratiosCross-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 averageIndustry averages are published by companies such asMoody’sStandard & Poor’sFitchsDeshawCopal PartnersAnd 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 standardsCompare a firm to its own ratios from other yearsHelps highlight trends/changes that have occurred
23 Category of Financial Ratios Leverage ratiosMeasure extent to which firm has been financed by creditorsliquidity ratioMeasure firm’s ability to meet short-term obligationsProfitability ratiosMeasures productivity of money invested in firmTurnover ratiosMeasure rate of activityPer share dataExamines items that affect common stock’s market price per shareGrowth ratiosMeasures contribution of various items to firm’s developmentRisk analysis ratiosMeasures 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 RatiosShow how heavily the company is in debt.
31 Profitability RatiosUsed 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 SurplusThe others in this category may be ROA and ROCE
33 Market Value RatiosShow 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.
36 DuPont IdentityThe 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 AssetsSales Assets EquityBy 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) ROEReturn on Assets (Profitability)Financial leverageLiquidityNet profit MarginAsset turnoverSolvencySalesTotal assetsNet income/Sales/Current assetsNoncurrent assetsSales—Total cost+Cost of goods soldCashLandSG&AAcc. ReceivablesBuildingR&DInventoryEquipmentInterest expenseOtherIntangiblesIncome taxesOthers
38 Growth measuresKey accounting items for which growth is computed: sales, net income, earnings per share.Average growth = (growth per year for n years)/nCompound 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 GrowthCommon stock price appreciation depends on various factorsGrowth financed internally depends on the amount of retained earningsA corporation’s growth rate depends on the return on equityGrowth rate = RR x ROESubstituting the three-part DuPont ROE equation, we obtainShows that multiplefactors influencegrowth—one factorcan rise and anotherfall and growth canremain unchanged.
41 Credit Risk AnalysisProcedure 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 AnalysisA 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.
44 Credit Risk AnalysisExample - 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 AnalysisExample - 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 AnalysisCredit 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 AddedThe 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 EVAEVA 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 capitalWACC = Weighted Average Cost of CapitalIC = Invested Capital (at the beginning of the year)
50 MVAThe 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 ExampleCompany 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 millionwhereEBIAT = Earnings before interest, after adjusted taxIf 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 distortionsCan be a serious problem with the balance sheetSome fixed assets are reported at their historical costsAfter several years of high inflation historical costs can be irrelevantVague definition of accounting incomeA firm can modify its accounting income depending upon certain actionsSuch as which depreciation method or inventory valuation technique is used
55 Potential Problems with Financial Analysis Consolidated financial statementsWhen a firm owns a subsidiary corporation accounting issues arise when considering minority interestsGoodwillWhen a company merges, oftentimes ‘goodwill’ is then reflected on the consolidated balance sheetThis intangible asset cannot be measured with precision
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 includeLoans made in interbank call money marketInvestment in approved securities (SLR)Government securities64
65 Advances Classification based on Type/nature of assets Secured/unsecuredSectorial disbursement
66 Analysis of Banks Performance CAMELSCapital AdequacyAssets QualityManagement EffectivenessEarningsLiquidity (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/RWAWhere RWA is risk weighted assets
69 Cont… 2. Core CRAR Tier I capital/ RWA 3. Adjusted CRAR Total Capital- Net NPAs/ RWAHigher 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 capitalTier II capitalRisk 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 reservesLess: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:
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 capital3. 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 capital5. 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) / RWAAccording 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- ProvisionsNet advances= Net bank credit- ProvisionsGross NPA/ Total AssetsNet NPA/ Total AssetsNet NPA/ Total EquityProvision for loan losses/ Gross AdvancesProvisions for loan losses/ NPAsProvisions for loans and investment/Total Asset
81 Profitability Interest Expense= Interest exp/ Total income Non interest exp= Non-Interest Exp./Total incomeROAROEEPSP/ENP 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-ProvisionsNet NPA=gross NPA- ProvisionsNet advances= Net bank credit- Provisions
84 Cont… Non priority sector credit/ total credit (loans) Unsecured credit/ total creditInvestments/ total assetInvestment in money market instruments/ total assetsSLR securities/ total investmentsCash and bank including call money/ Demand depositsCash and bank including call money/ Total depositsCash and bank including call money/ Total Asset