ANALYSING FINACIAL STATEMENTS

Terminology Invested capital = Equity + Total debt Capital employed = Equity + Long-term debt; It represents the long-term funds employed in the firm Total Asset = Invested capital + Interest-free credits Profit Hierarchy Gross profit = Net sales Cost of sales (earlier it was called cost of goods sold) o In a merchandising business it includes total costs incurred to acquire the merchandise and to bring it to the location and condition of sale. o In a manufacturing business it includes total costs incurred to manufacture finished goods and to bring it to the location and condition of sale. Earnings before interest tax, depreciation and amortization (EBITDA) It is also called cash profit o EBITDA = Gross Profit + Depreciation on manufacturing facilities Operating expenses (other than depreciation and amortization) Earnings before interest and tax (EBIT) It measures operating profit if, other income is not material o EBITDA Depreciation and amortization Net profit = EBIT Interest Tax expense

Net Operating Profit less Adjusted Tax (NOPAT) NOPAT = EBIT (1 Tax rate) RATIOS

Return on Investment Alternative ratios Return on invested capital (ROIC) = EBIT/Av. In Cap or NOPAT/Av. In Cap Return on Capital Employed (ROCE) = EBIT/Av. C E or NOPAT/Av. CE Return on Total Assets (ROA) = EBIT/Av. Assets or NOPAT/ Av. Assets Return on Equity (ROE) = Net profit/Av. Equity Decomposition of ROIC ROIC = NOPAT/Av. Invested Capital = (Net sales/Av. IC) (EBIT/Net Sales) (NOPAT/EBIT) = Turnover ratio Margin Tax Adjustment Decomposition of Turnover Ratio Examine the turnover of each class of asset Fixed Asset Turnover = Net sales/Av. FA (Net block) Working capital Turnover = Net sales/Av. WC Current Asset Turnover = Net sales/Av. CA Inventory turnover = Net sales/Av. Inventory Receivable Turnover = Net sales/Av. Receivables Decomposition of Margin Gross Profit Ratio = Gross profit/Net sales

EBITDA Ratio = EBITDA/Net Sales [Also called cash profit ratio] Operating Ratio: Each expense is expressed as a percentage of net sales Liquidity Ratio Liquidity measures the ability of the company to meet short-term financial commitments. Current Ratio = Av. CA/Av. CL Acid Test Ratio or quick Ratio = Av. Quick Assets/Av. CL Quick Assets = CA Inventories Pre-paid Expenses Solvency Ratios Solvency measures the ability of the company to meet long-term financial commitments. Debt-Equity Ratio (Also called gearing ratio) = Total Debt/Equity Interest coverage = EBIT/Interest expense [A ratio of 3 is considered good] Exchange Difference Initially transactions are recorded at the then prevailing exchange rate. Financial assets and financial liabilities denoted in foreign currency are translated using the balance sheet date exchange rate. The exchange difference is charged to profit and loss account. When the amount due is settled the exchange difference is charged to the profit and loss account

Economic Value Added (EVA) EVA = Invested capital (ROIC WACC)

EVA= NOPAT Capital Charge = NOPAT-(C* X Capital) EVA/Capital = NOPAT/Capital C* EVA= (R-C*) x Capital

Capital Structure Decision

Relevance of Capital Structure Decision Capital structure refers to the combination of debt and equity capital used by a company to finance long-term fixed assets and net working capital. Capital structure decision has important implications for the value of the company and its cost of capital. The relevance of capital structure decision is that the value of a company can be maximized implying that the cost of its capital can be minimized by taking debt up to a particular level or with a specific debt-equity ratio. The job of a financial manager is to determine that specific debt-equity ratio for maximizing the value of shareholders equity. Financial Leverage and Its Impact The financial leverage or gearing of a company is the ratio of debt to equity capital in its capital structure. Business risk is the riskiness of a companys assets if it uses no debt. Financial risk is the additional risk placed on the equity shareholders as a result of the use of debt by the company. These risks are measured by the std deviation of return on equity (ROE). Total risk of equity shareholders = ROE Business risk = ROE(u) Financial risk = ROE - ROE(u) Theories of Capital Structure Modigliani and Miller (MM) Model MM model without corporate taxes (1958) - MM Proposition I : The Pie Model - MM Proposition II : The Cost of Equity and Financial Leverage MM model with corporate taxes (1963)

- MM Proposition I - MM Proposition II MM Model Without Corporate Taxes MM Proposition I : The Pie Model The market value of any firm is independent of its capital structure and is given by capitalizing its expected return at the rate appropriate to its risk class. V(lev) = V(unlev) = EBIT / Ko = EBIT / Keu Where, V(lev) = market value of a leveraged company V(unlev) = market value of an unleveraged company Ko = weighted average cost of capital (WACC) of a leveraged company Keu = cost of equity of an unleveraged company EBIT = earnings before interest and tax Assumptions of MM Model MM made the following assumptions. Some of which are plainly unrealistic. Capital markets are perfect. There are no transaction costs. Investors are rational and have symmetrical information. All investors have access to the same information and have identical estimates of each firms future EBIT. Individual investors and firms can borrow or lend at the risk-free rate. All cash flows are perpetuities. There is no growth in EBIT. MM Proposition II : The Cost of Equity and Financial Leverage The cost of equity capital of a company is a linear function of its capital structure. The expected yield on a equity share is equal to the sum of the appropriate overall capitalization rate, Ko corresponding to the risk class of business and a premium due to financial risk equal to the debt equity ratio times the difference or spread between overall capitalisation rate, Ko and the cost of debt, Kd. Ke = Ko + (Ko Kd) * D/E where Ko = overall capitalization rate (WACC) Ke = cost of equity capital Kd = cost of debt We = proposition of equity in total capital Wd = proposition of debt in total capital E = amount of equity capital D = amount of debt capital MM Model With Corporate Taxes Proposition I (Value of unlevered company) The value of an unlevered company is: Vu = EBIT*(1-t) / Keu where

Vu = value of unlevered company Keu = cost of equity of unlevered company t = corporate tax rate The value of a levered Company, when taxes are considered is the value of unlevered company In the same risk class plus the gain from leverage which is the present value of interest tax shield. The present value of interest tax shield is obtained by capitalizing the interest tax shield using the capitalization rate equal to the cost of debt. Proposition I (Value of levered company) V(lev) = Vu + Dt where V(lev) = market value of levered company Vu = market value of unlevered company D = market value of debt t = corporate tax rate Proposition II (Cost of Equity of a levered company) The cost of equity of a levered company, Ke is the sum of the cost of equity of an unlevered company in the same risk class, Keu and a financial risk premium. Ke = Keu + (Keu Kd) * D/E * (1-t) where Ke = cost of equity of levered company Keu = cost of equity of unlevered company Kd = cost of debt D/E = debt equity ratio t = corporate tax rate Making Capital Structure Decision : EBIT-EPS Analysis A company may have various financing choices to fund investment projects. One widely used method to identify the best alternative is to use EBIT-EPS analysis. Obviously, a company should use that mode of financing which maximizes the earnings per share (EPS) for equity holders.
Example A company has EBIT of Rs.40 million. The company pays out all of its income as dividends. The required rate of return, Keu is 15 % if no debt is used depending on the business risk faced by the company. It has debt capital of Rs.100 million with interest payable at the rate of 10 %. The corporate tax rate is 40 %. What is the WACC of the company? The value of unlevered company that has zero debt but pays taxes will be: Vu = EBIT*(1-t) / Keu = 40*(1-0.4) / 0.15 = Rs.160 million

The value of the company with debt capital of Rs.100 million will be : V(lev) = Vu + Dt = Rs.160 million + Rs.100 million * 0.4 = Rs.200 million The value of equity capital of the company will be: E = V(lev) D = Rs.200 million Rs.100 million = Rs.100 million The cost of equity capital of the company will be: Ke = Keu + (Keu Kd) * D/E * (1-t) = 0.15 + (0.15 0.10) *100/100*(1-0.4) = 18 % The weighted average cost of capital (WACC) of the company will be: WACC = We * Ke + Wd * Kd * (1 t) We = proportion of equity in total capital = 100/200 = 0.5 Wd = proportion of debt in total capital = 100/200 = 0.5 So, WACC = 0.5 * 0.18 + 0.5 * 0.10 * (1 0.4) = 12 %

Cost of Capital
Cost of Equity Retained Earnings Cost of Equity New Issues Cost of Preference Share Capital Cost of Debt Weighted Average Cost of Capital (WACC) Cost of Equity Retained Earnings Discounted Cash Flow (DCF) approach - Constant Dividend Growth Model - Two-stage Growth Model Capital Asset Pricing Model (CAPM) Constant Dividend Growth Model

Ke = (D1 /P0) + g where {D1=D0 (1+g)}

Po = Current value of the equity share Do = Dividend per share paid at time 0 g = Constant rate of growth of dividends Ke = Cost of the retained earnings Two-stage Growth Model gr = Rapid growth rate of dividend during the first n years gn =Normal growth rate of dividend continuously for ever Pn = Share price at the end of n years Do = Dividend per share paid at time 0 Ke = Cost of the retained earnings Using Constant dividend growth model after n years till infinity, we get Pn = Do(1+gr)^n *(1+gn) / (Ke - gn)

Now, using DCF approach, Po = Do (1+gr) / (1+Ke) + Do (1+gr)^2 / (1+Ke)^2 +.. + Do (1+gr)^n / (1+Ke)^n +Pn / (1+Ke)^n Solving the equation, we get the value of Ke. Two-stage Growth Model- Example Suppose a company has paid Rs.2 as dividend in the current year and expects that the dividend would grow for the next 3 years at the rate of 8 % due to rapid growth in business activities but would finally settle at 4 % afterwards. The current market price is Rs.15. What is the cost of equity? gr=8%,gn=4%, Po=Rs.15 Do = Rs.2 Dl = Rs.2 * 1.08 =2.16 D2 = Rs.2.16 * 1.08 = Rs.2.33 D3 = Rs.2.33 * 1.08 = Rs.2.52 D4 = Rs.2.52 * 1.04 = Rs.2.62 The price of the share after 3 years will be P3 = D4 / (Ke - gn) = 2.62/(Ke-.04) So, by equating the present values, we get Po= 15 = 2.16/(1+Ke)+ 2.33/(1+Ke)^2+ 2.52/(1+Ke)^3+ [2.62/(Ke-0.04)]/(1+Ke)^3 Solving this equation by trial and error method, we get Ke = cost of equity = 19.32 % Capital Asset Pricing Model (CAPM) Approach E(Rs) = Rf + s [E(Rm) -Rf] where E(Rs) = Expected rate of return of the security Rf = Risk-free rate of return E(Rm) = Expected rate of return of the market s = Beta co-efficient of the security Cost of Equity New Issues The net amount received is Net proceeds = Po (1 - f) where Po = Gross amount received per share, f = Percent floatation costs. Cost of new equity is calculated by using the net proceeds in the DCF equation. Cost of the new equity = Cost of the existing equity + Adjustment for the flotation costs Where, Adjustment for flotation costs = {D1 / [Po(1-f)] } + g

Cost of Preference Share Capital For perpetual preference shares,

Kp = D / [Po (1-f)]
Where Kp = Cost of Preference share capital D = Annual dividend f = Floatation cost Post-Tax Cost of Debt Interest expenses reduce taxes, and the net cost of debts is less by the amount of taxes saved by the interest payments. This is represented as Kd (1-t) where Kd is the pretax cost and t is the rate of corporate income tax. WACC The Weighted Average cost of Capital can be calculated as follows:

WACC=We*Ke +Wp*Kp+Wd * Kd (l-t)

Adjusting WACC When Debt Ratios Change The relationship between equity beta and leverage is as follows: a) Without Corporate tax: (equity) = (asset) (1+D/E) b) With Corporate tax: (equity) = (unlevered firm) [1+(1-t)*D/E] Time value of Money