Analyzing Financial Statements

Financial Statement and its Analysis Collective name for the tools and techniques that are intended to provide relevant information to decision makers. Objective is to assess a company’s financial health and performance. Assessment can be made by looking at past facts and figures with the latest up-to-date facts and figures for the same company. Comparisons can be made between different companies operating in the same industry and different industries

End Users of Financial Statements Existing and potential investors. Employees. Government. Managers. Creditors and other lenders. Banks. Trade and Worker’s Unions. Society.

Some purposes for financial analysis Information from past performances is useful in judging future performance. An assessment of current status will show where the company stands at present – borrowings, inventories, cash balances etc. Investment evaluations helps assess prospects for future investments patterns and also current investor’s predictions. Credit assessment is useful for creditors who are concerned with management’s compliance with loan indentures. Government’s taxation policies can be developed and formulated by assessing the industry’s financial performances.

Techniques used Horizontal Analysis – financial statements provide comparative information for the current year and the previous year. Idea: is to calculate amount changes and percentage change. Trend Analysis – involves calculations of percentage changes in the financial statement items for a number of successive years. Vertical Analysis – is the proportional expression of each item on a financial statement to the statement total. Example: any item as a percentage of sales. Ratio Analysis – involves establishing a relevant financial relationship between components of financial statement. It helps in identifying significant relationships between financial statement items.

Financial Ratios Profitability Ratios Liquidity Ratios Solvency Ratios Capital Market Ratios

Profitability Ratios Profitability ratios measure the degree of operating success of a company in an accounting period. Stakeholder interests in the profitability - 1)Potential and existing investors. 2)Government. 3)Employees. 4)Managers and Executive members. Some common profitability ratios: 1)Net Profit Margins, Gross Profit Margin, Operating Margin. 2)Asset Turnover Ratios. 3)Returns on Equity. 4)Inventory Turnover Ratios. 5)Creditors Payable Days

Profitability Ratios: Profits Margins Profits after Tax Net Sales Revenue EBITDA Net Sales Revenue Gross Profits Sales Profit Margin = Operating Margins = Gross Profit Margins =

Profitability Ratios: Asset Turnover Asset Turnover measures the efficiency with which the assets are utilized. It indicates the amount of sales is generated for every rupee worth of assets. Higher ratio indicates efficient utilization and lower ratio means the opposite. Lower ratio indicates that company has more assets than what is required and that it is not used optimally. It is generally observed that firm with lower profit margins tends to have higher asset turnover and vice versa Rs. Lakhs 2001 Rs. Lakhs Total Assets Sales Total Sales Average Total Assets ( )/2 AT = 1.40 times AT =

Profitability Ratios: Inventory Turnover Inventory turnover measures the rate at which inventories are turned over as a percentage of cost of sales. The ratio shows us the pace at which inventories are sold and replaced over a period. Inventory Cost of Sales Greater the number of days imply: 1.lack of demand. 2.It may reflect poor inventory control. 3.It may lead to inventory obsolescence and related write off. All is not bad: It may also indicate that the company is buying large inventory to benefit from possible trade discounts, or may be to avoid a possible cut or disruption in inventory supply to customer. * 365 days Inventory Turnover =

Profitability Ratios: Creditors Payable Days Creditors amount falling due within a year Credit Purchases Significance: Ratio is always compared with last year’s figures. A long credit period may be good as it represents a source of free finance. A long credit period may also indicate that the company is unable to pay more quickly because of liquidity problem. A company may develop a poor credit ratings/reputation. Having long credit period may discourage supplier firms from extending cash discounts as incentives and also may discontinue operations. * 365 CPD =

Profitability: ROE vs ROCE Profits after Interest and Tax (Net Profits) Ordinary Shareholders + Reserves and Surplus Operating Profits (EBIT) Share Capital + Reserves and Surplus + Borrowings ROE = ROCE =

Profitability: ROE & Du Pont Identity Du Pont Identity breaks the ROE into three important segments – Profit Margin. Total Asset Turnover. Financial Leverage. Significance of these 3 segments – Profit Margin – signifies operating efficiency. Total Asset Turnover - signifies asset use efficiency. Financial Leverage – signifies equity multiplier (assets/equity).

Profitability: Deriving Du Pont Net IncomeSales Total Assets Sales Avg Total Assets Ordinary Equity Significance, application and usefulness of Du Pont – In profit margin increases, it implies every one rupee in sales generates greater net income i.e. net income as a proportion of sales. Increase in asset turnover suggests for every one rupee invested in asset the company generates greater sales proportionally. Financial leverage indicates how a firm meets its financial obligations - is it through debt financing or equity financing ?? ** Du Pont =

Du Pont: Financial Leverage Increase in financial leverage indicates that the firm resorts to debt financing relative to equity financing. Financial leverage benefits diminish as the risk of defaulting on interest payments increases. So if the firm takes on too much debt, the cost of debt rises as creditors demand a higher risk premium, and ROE decreases. Increased debt will make a positive contribution to a firm's ROE only if the firm's return on assets (ROA) exceeds the interest rate on the debt significantly.