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Financial Statement Analysis Using Ratios

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Use of ratios The purpose of using financial ratios is to make sense of the complex information usually presented in a set of published accounts As time has passed the complexity of accounts has increased greatly Not only is there a balance sheet and profit and loss account but now a cash flow statement is included and increasingly a Statement of Recognised Gains and Losses

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Purpose of Ratios There are four main reason for the use of ratios 1.To act as a set of summary statistics 2.To identify industry benchmarks 3.As an input for making formal decisions 4.Standardise for size

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Uses of Financial Ratios The two most common uses of ratios are 1.Analysis of the performance of a company over time 2.Comparing performance of a company against those of similar companies This has obvious implications for the analysis of individual securities

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Common Size Financial Accounts One way of trying to compare performance over time and amongst peers is to use a common size financial accounts In this everything would be expressed as a percentage of a fixed amount such as turnover for P&L In the balance sheet it would be for total funds as an example

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Liquidity Ratios These assess the ability of a business to meet its obligations in the short run They generally relate current assets to current liabilities

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Current Ratio Current Assets Current Liabilities Current assets and liabilities? Measures ability of business to meet its current liabilities Generally the higher the ratio the better Depends on the nature of the assets

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Acid Test Ratio Quick assets are current assets less stock Quick Assets Current Liabilities Stringent measure of liquidity Stock is excluded because these are seen as the least liquid of the current assets

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Cash Ratio Cash and bank balances plus current investments Current Liabilities These assets are the most liquid of the current assets Stringent measure of liquidity May be too stringent as there are other options available such as delaying payments Another option would be to borrow short notice money such as extending the overdraft or to extend suppliers terms

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Leverage Ratios Debt capital is a cheaper source of finance than equity It is also riskier than equity or other capital finance instruments Leverage ratios indicate the level of risk associated with debt finance There are two types of ratio –Structural –Coverage

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Debt to Equity Ratio Debt Equity Shows relative contribution of owners and creditors Debt is long and short term debt Equity is net worth plus preference capital less deferred taxes Problems are fixed asset at book rather than MV Some debt are protected by charges against assets A lower D/E ratio is preferable

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Debt to Asset Ratio Debt Assets Debt here is all debt Assets are all assets Measures the extent that borrowed funds support the businesses assets

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Interest Coverage Ratio Profit before interest and taxes Interest Taxes are excluded from profit as interest is a tax deductible expense In this case the higher the ratio the more easily the business can pay its interest A high ratio means that interest can be met even if there is a sharp decline in turnover

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Fixed Charge Coverage Ratio Profit before interest, taxes and depreciation Interest+Loan Repayment 1-Tax Rate This shows the amount of cash flow to cover all interest and taxes This shows the comprehensive debt servicing ability as it covers both interest repayment and the capital repayment The measure can be expanded to include other fixed payments such as lease payments and preference dividends

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Debt Service Coverage Ratio Profit after tax+Depreciation+Other non cash charges+Interest on term loans+Lease Rentals Interest on term loans+lease rentals + Repayment of term loans

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Debt Service Coverage Ratio I personally have never seen this ratio and Chandra suggests that it is used by Indian financial institutions It calculates the ratio for the period for which the loan is applicable A ratio of 1.5 to 2 is regarded as being satisfactory

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Turnover Ratios These can also be called as activity ratios or asset management ratios These ratios relate the level of activity, as given by sales or COGS, to the level of various assets. They are measures of how efficiently the assets are employed by the firm

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Inventory Turnover Ratio COGS Average inventory Shows how quickly stock is moving through the firm thus generating sales It is a measure of inventory management Issues are Too low inventory leading to stock outs Too high stock giving inefficient use of working capital

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Debtor Turnover Ratio Net Credit Sales Average Sundry Debtors The higher the debtors turnover the greater the efficiency of the credit management system If NCS not available then sales could be used

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Average Collection Period Ratio Average Sundry Debtors Average Daily Credit Sales Represents the number of days of credit sales included in sundry debtors The measure will depend on the nature of the trade but a figure approaching 30 would be sought

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Fixed Asset Turnover Ratio Net Sales Average Net Fixed Assets Measures the sales in terms of the investment in fixed assets. Measures the efficiency of use of fixed assets Beware the use of NBV of assets

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Total Asset Turnover Ratio Net Sales Average Total Sales Ratio measures how efficiently the assets are employed

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Profitability Ratios These reflect the final results of the business There are two types of ratio Profit margin ratios showing the relationship of sales and profits Rate of return ratios showing the relationship between profit and investment

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Gross Profit Margin Ratio Gross Profit Net Sales This is the difference between sales and COGS This shows the difference between sales and costs This may be broken down into the various elements of direct costs such as labour

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Net Profit Margin Ratio Net Profit Net Sales This shows the amount of earnings left for ordinary and preference shareholders It measures the overall performance of control of the indirect costs in the P&L

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Gross and Net Profit Rate These two measures taken together give an overall view of the cost and profit structures of the companies Their joint use can identify where any problems lie in either direct or indirect costs Again, this information is of use to many parties

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Return on Assets Ratio Profit after tax Average total assets The numerator measures the available return to shareholders The denominator measures the contribution of all contributors including lenders Remember ARR in Project Appraisal

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Earning Power Ratio Profit before interest and taxes Average total assets Focuses on only earnings before other external claims, i.e. interest and tax. Measures efficiency without consideration of capital structure or current tax rate. Good peer group comparison measure

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Return on Capital Employed Ratio Profit before interest and tax(1-tax rate) Average total assets This is Earning Power after tax Does not reflect the capital structure of the business Can be compared directly with post tax WACC

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Return on Equity Ratio Equity Earnings Average Equity Numerator is profit after tax less preference dividends therefore is the amount available to ordinary shareholders The denominator is ALL contributions by equity shareholders including paid up capital, reserves and surpluses The measure is of great interest to the stock markets as it gives the return on the investment

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Valuation Ratios These ratios measure how the equity of a company is viewed in the markets Equity MV measures how markets perceive the risk and return on a stock These can be seen as the most comprehensive of the ratios

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Price to Earnings Ratio (PER) Market price per share Earnings per share The most popular measure of financial efficiency Reflects Risk characteristics Growth prospects Shareholder orientation of management

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EV to EBITDA Ratio Enterprise value (EV) Earnings before interest, taxes, depreciation and amortisation EV is the sum of market value of debt and of equity MV equity is outstanding shares times MV of shares Debt was discussed in detail in Project Appraisal Chandra suggests this reflects profitability, growth, risk, liquidity and corporate image

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Market Value to Book Value Ratio Market Value per share Book Value per share This shows how much wealth has been generated for the society at large If ratio >1 then a net contribution to the wealth of the country has been achieved

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Q Ratio Market value of equity and liabilities Estimated replacement cost of assets Resembles MV to BV ratio Different in that –Numerator includes equity –Denominator includes all assets –These assets are at their replacement costs

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Disaggregating of Ratios DuPont analysis is an example of disaggregating of ratios where the Return on Assets (ROA) is broken down into its component parts Many more ratios than the Return on Assets (ROA) can be broken down to give further information

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DuPont in short A shortened version of DPA is Net Profit = Net Profit *Net Sales Av Total Assets Net SalesAv Total Assets ROANPMTATR When supplemented by comparing common size statements then this shows where cost control measures can be directed

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Du Pont Analysis

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A variation on DuPont This disaggregates ROE or Net Income / Total Equity Net Income = Net Income *Assets Total EquityAssetsTotal Equity (ROA)* (Equity Multiplier) (1+D/E Ratio)

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Aggregation of Ratios Similarly some of the ratios can be aggregated to give further reaching measures As mentioned my particular favourite was comparing debtors and creditors ratios to indicate potential liquidity measures

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Audience for Ratios - Internal Performance evaluation of managers Comparison of performance for different divisions Planning for the future

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Audience for Ratios - External Assessment of creditworthiness by suppliers Assessment of future prospects by customers Credit rating agencies Evaluating competitors Acquiring other firms

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Problems with ratios Selection of ratios Based on accounting data inc. estimation Data unavailable – time lag & division Unsynchronised data Different accounting standards Negative numbers and small divisors CHANDRA pp 194 gives a different list of problems

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The need to compare As stressed throughout this presentation these ratios are in themselves pretty meaningless They need to be compared –Across time with previous results of the company to measure changes in performance –With other businesses in the same risk class –With other businesses in the structuring of a portfolio

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That’s all folks Read Chandra pp 152 ff If further reading is required I have both RW&J and BM&M in both Indian and Western publications In addition I have Bill Rees “Financial Analysis” which is one of the seminal works on the subject.

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