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# Analysis of Financial Statements

## Instructor: Muhammad Jibran Sheikh E-mail: jibransheikh@comsats.edu.pk

An Analysis Framework
A framework for business analysis can break business analysis and valuation into the five stages outlined below.

Business Strategy Analysis Accounting Analysis Financial Analysis Prospective Analysis Valuation
(Palepu, Bernard and Healy, Business Analysis & Valuation Using Financial Statements,1995)

- Business Strategy Analysis Examines the environment in which a company operates. - Accounting Analysis Analyses the companys accounting policies and estimates and indicates the reliability of the outcomes. - Financial Analysis Evaluates the financial data which will include a detailed ratio analysis.

- Prospective Analysis Forecasting future profits and cash flows. - Valuation Company valuation (dividend discount model, discounted earnings approach, accounting models etc.)

## Using Financial Statements

The many versions of profit Mostly used is Profit After Tax (PAT)/Net Profit/Net Income Other versions may also be used a) Contribution margin: is defined as Revenue minus Variable costs. This measures the contribution which an additional unit makes towards covering fixed costs. Used to estimate the breakeven level of sales volume; b) Gross profit: Revenue less Cost of Goods Sold. Objective is to measure performance of manufacturing activity;

## Using Financial Statements

c) EBITDA: Earnings before Interest, taxes depreciation and amortization. This adds back depreciation and amortization, to get closer to cash flow and to minimize the impact of different depreciation policies. d) EBIT: Earnings before Interest and taxes, which measures a business's income before it is divided among creditors, owners and tax payments. e) Net Profit: It represents profit available to shareholders after deducting all other claims on income, including taxes and interest expense.

## Using Financial Statements

f) Net Operating Profit after Tax (N O P A T): A favorite for financial analysts. This is a measure of ungeared profits but on an after tax basis. It is most easily calculated by simply adding back after tax interest expense (and other financing costs included in the Net Profit) to Net profit. This is a good measure of the operating performance of a company's asset base.

## Using Financial Statements

Other adjustments to profit

Leases: when calculating operating measures such as EBITDA, EBIT and NOPAT adjust for the financing charges in leases;
Normalize results: reported profits are often impacted by one off impacts. To get a measure of underlying performance we should normally try to adjust for one off impacts, both favorable and unfavorable.

## Using Financial Statements

Adjusting the Balance Sheet As with profit it is sometimes useful to adjust the balance sheet to a more useful format. One common adjustment is to calculate Funds Employed or Net Operating Capital.

To implement this approach need to distinguish between interest bearing debt and non interest bearing liabilities.
Interest bearing debt represents debts that are provided by external financiers. Non interest bearing liabilities include liability accounts such as accounts payable and provisions. These types of liabilities do not have an explicit interest charge and arise out of the operations of the business rather than being raised from external financiers.

To calculate we simply deduct non interest bearing liabilities from the total assets, to give either: Funds Employed: which shows how much funds have been provided by external financiers. This is represented by the sum of interest bearing liabilities and equity; Net operating capital: This shows how these funds have been invested. financing which the business generates.

## Financial Analysis - Ratios

Ratios provide a quick and simple means of examining financial health of a business. By calculating a small number of ratios it is often possible to build up a picture of the position and performance of a business. Thus they are widely used by investors and others interested in business performance. A ratio is often easy to calculate but difficult to interpret and even more difficult to evaluate along with all the other ratios. Ratios are only the starting point, they cannot by themselves explain why strengths or weaknesses exist or why certain changes have taken place. Only a detailed investigation will reveal underlying causes.

Advantages of Ratios
Figures in accounts are often only meaningful when considered in relation to other figures. Enable us to compare businesses of different size. Enable us to gain a vision of the companys trading pattern. Enable comparison with published industrial averages. Substitute a small set of ratios to replace the complexity of the detailed financial statements.

Categories of Ratios
Profitability Ratios

Gearing Ratios
Liquidity Ratios Efficiency/Working Capital Activity Ratios Investment ratios

Profitability Ratios
Businesses aim to create wealth for owners. Profitability ratios provide an insight to the degree of success. They express the profits made in relation to other key figures in the financial statements. There are 4 main profitability ratios: - Return on capital employed (ROCE) - Return on equity (ROE or ROSF) - Gross profit [margin] - Net profit [margin]
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## Return on Capital Employed (ROCE)

ROCE is a fundamental measure of business performance which expresses the relationship between the profit generated by the business and the long term capital invested in the business

## Profit x100 =X% Capital

There are a number of ways of calculating ROCE ratios, each one with a different definition of profit and capital. BEWARE

Profit before interest and tax x100 =X% Shareholders Equity +Long Term Loans
The ratio attempts to measure the returns to suppliers of long-term finance before any deductions for interest payable to lenders or payments to dividends to shareholders are made.
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## Return on Equity (ROE)

ROE is based on the funds contributed by shareholders or retained by the company rather than those paid out as dividends (i.e. equity)

## Gross profit [margin] ratio

- The gross profit margin relates the gross profit of the business to the sales generated for the same period.

- Gross profit represents the difference between sales and the cost of sales. The ratio is thus a measure of profitability in buying/producing and selling goods before any other expenses are taken into account.

## Gross Profit x100 =X% Sales

Net profit ratio The net profit relates the net profit for the period to the sales.
Profit before Tax and Interest x100 =X% Sales
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Secondary Ratios
Any return on capital employed can be analysed into the secondary ratios, being the net profit percentage and the asset turnover ratio:

Return Turnover

Turnover x Capital

Return Capital

The net profit percentage relates the performance achieved by the company to the level of activity, while the asset turnover ratio expresses the relationship between the level of activity and the resources employed by the business
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Gearing Ratios
Ratios which examine the relationship between the amount financed by the owners of the business and the amount contributed by outsiders. The main ratios used are: Capital-based gearing Income-based gearing

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## Calculating Gearing Ratios

There are a number of ways of calculating the capital based gearing ratio. In a certain sense it does not matter which method you use as long as you are consistent.
Long Term Liabilities x100 =X% Shareholders Equity +Long Term Liabilities

The income based gearing ratio is usually called the interest cover ratio or times interest earned
Profit before Tax and Interest Charges x100 =X% Interest Charges
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## Gearing Ratio Comments

The level of gearing adopted by a company will be influenced by various factors:

- The attitude of the owners to risk - The attitude of management to risk - The attitude of lenders towards the company
- The availability of equity funds
If the stock market is depressed it may be difficult to raise equity funds and so a company may be forced to go out and borrow.

## - The type of industry in which the business operates.

In general, levels of gearing will be higher in industries where profits are stable and less affected by changes in consumer taste, economic recession etc. 14

Liquidity Ratios
Ratios which examine the relationship between liquid resources held and creditors due for payment in the near future.

## The two main ratios are:

- Current [assets] ratio - Acid test ratio

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## Current [assets] ratio

The current ratio compares the business liquid assets (i.e. cash and those assets held which will soon be turned into cash) with its short-term liabilities (creditors due within one year). Current Assets Current Liabilities Some people have suggested that there is an ideal current ratio of around 2 times, but this fails to recognise that different types of business require different current ratios.
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Acid test
This ratio is the same calculation but excludes inventory/stock on the grounds that inventory is often not immediately convertible into cash. Beware of other items than may be even less liquid than inventory as they should be excluded too.

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## Efficiency/Working Capital Activity Ratios

Ratios may be used to measure the efficiency with which certain resources have been utilised within the business. The most common ratios used are: Inventory/Stock turnover (Fixed) Asset turnover Trade debtor (receivables) collection period Trade creditor (payables) payment period

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Inventory/stock Turnover
Inventory represent a major part of the assets of many businesses. The inventory turnover period measures the average period for which stocks are being held.
Inventory X 365days Cost of sales = Xdays

Normally a business prefer a low number of days so that funds are not tied up in stocks when they (i.e. the funds) could be used more profitably

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## Asset turnover ratio

The fixed assets turnover ratio measures how effective the assets of a business are in generating sales revenue.

## Total Sales Revenue "Fixed Assets" (NBV)

Generally speaking, a higher asset turnover ratio is preferred to a lower one as a higher ratio suggests that assets are being used more productively in the generation of revenue. The ratio is only useful when compared with previous periods or with other businesses in the same industry.
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Net book value is the value of an asset on the books of the company. For example, suppose a company buys a machine with a five-year useful life for \$5,000 cash. It debits Fixed Assets \$5,000 and credits Cash \$5,000. The machine's net book value is currently \$5,000. After one year, the company records depreciation by debiting Deprecation Expense \$1,000 (\$5,000/5) and crediting Accumulated Depreciation for \$1,000. The machine's net book value is now the original cost (\$5,000) less the accumulated depreciation (\$1,000), or \$4,000. The problem with net book value is whether it reflects economic reality or merely accounting convention. The net book value of \$4,000 probably isn't what the machine would fetch at public auction. Further, the net book value calculation itself is an estimate, because the machine's exact useful life is unknowable. Nevertheless, net book value does give financial statement readers a rough idea of asset values. Note that net book value is similarly used to value long-term liabilities which are amortized, such as bonds. Finally, net book value is often simply expressed as the book value.

## Trade receivables collection period.

A business is usually concerned with how long it takes customers to pay the amounts owing. The speed of paying can have a significant effect on cash flow. The trade receivable collection period calculates how long, on average, credit customers take to pay the amounts that they owe to the business: Trade Receivables x 365 days =X days Credit Sales

There is no such thing as an ideal debtor collection period. It depends on many factors. A business however would become concerned if the days were rising as this could indicate difficulties in collecting cash from customers.

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## Trade payables payment period

This ratio measures how long, on average, the business takes to pay its trade payables (creditors). Trade Payables x 365 days =X days Credit Purchases You would become concerned if the days were rising as this could indicate that the business was heading for cashflow problems. But like all ratios, it would be necessary to investigate the circumstances before arriving at a conclusion. If days were reducing, it could be the result of deliberate decisions e.g. paying creditors promptly to take advantage of discounts or maintain goodwill.

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Investment ratios

Ratios determining the returns the owners receive: Dividend yield Dividend cover Earnings per share P/E ratio

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Dividend yield
This ratio applies to ordinary shareholders and is calculated as follows:

## Dividend per share x 100 = X% Market price per share

This ratio measures the rate of return that a shareholder receives on his shares based on the market value not the face value .

## Ignores capital growth.

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Dividend Cover
This ratio focuses on the security of the current rates of dividends, and by doing so provides a measure of the likelihood of those dividends being maintained in the future.
Net profit after tax and preference dividend Paid and proposed dividends = X times

The higher the ratio, the more profits could decline without dividends being affected. This is important as the capital market prefers companies whose dividends do not fluctuate but grow steadily.
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## Earnings per share (EPS)

This ratio measures the potential benefit that shareholders derive from the profitability of a company in which they have invested, irrespective of actual dividend distributions.

Net profit after tax and preference dividend = Xp Number of ordinary shares in issue

It is a key indicator of corporate performance from a shareholder perspective and is widely quoted in the financial press, at least for quoted companies.
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## Price/Earnings ratio (P/E ratio)

This ratio compares the benefits derived (at least potentially) from owning a share with the cost of purchasing such a share.

## Market price per share = X Earnings per share

The P/E ratio compares the EPS with the market price per share. As such it compares directly the profit that is generated for equity shareholders with the price that currently has to be paid to participate in those profits. It tells us that the market price is X times the earnings i.e. that it would take us X years before we recovered the market price paid for the shares out of earnings. It reflects the markets assessment of the amount and the risk of earnings. As such it is commonly reported in the financial press. NOTE that it is a based on current market price and past earnings. There is no guarantee that this will continue. High p/e implies either Expectation of growth in earnings Low perceived risk

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Ratio Decomposition
A common approach to ratio analysis is ratio decomposition. A well known version is the Du Pont ROE (Return on equity) ROE = Profitability x Efficiency x Financial leverage x Interest burden x Tax retention rate = x x x x EBIT/Sales Sales/Average Total Assets Average Total Assets/ Equity EBT/EBIT Net Profit or /EBT

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The DuPont model was internally developed by Du Pont (E. I. DU PONT DE NEMOURS AND COMPANY) as a tool to measure its investment projects, but eventually became widely used as a financial tool. The DuPont analysis breaks down a companys return on equity or ROE into three components. DuPont was founded in 1802 and was incorporated in Delaware in 1915. DuPont is a world leader in science and innovation across a range of disciplines, including agriculture and industrial biotechnology, chemistry, biology, materials science and manufacturing. The company operates globally and offers a wide range of innovative products and services for markets including agriculture and food, building and construction, electronics and communications, general industrial, and transportation. Total worldwide employment at December 31, 2010, was approximately 60,000 people

Ratio Analysis
Any analyst using ratio analysis will follow a series of steps.

## Observation and calculation of Ratios

Analysis of Ratios

Interpretation of Ratios

Decision making
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## To act as a summary statistic

To identify industry benchmarks As an input to formal decision models To standardise for size

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## Problems with ratio analysis

Ratio selection Accounting estimation Unavailable data Unsynchronised data Non-standardised accounting Negative numbers and small divisors
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## Cross-sectional Financial Statement Studies

There is little to be gained by analysing the financial statements of a company for one year alone. A benchmark is needed by which to judge a company's performance. This "bench-mark" can be obtained by comparing companies within the same industry. This is known as a cross-sectional study. There are two cross-sectional study techniques - Common size statements, and - Ratio analysis
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## Common Size Statements

Total assets Land and Building Plant and equipment Stock Debtors Bank and cash

## 450.0 75% 25.8 4% 47.4 8% 40.8 7% 36.0 6% 600.0 100%

Total liabilities plus Shareholders' equity Creditors 91.6 23% 45.6 8% Bank overdraft 40.0 10% 54.6 9% Debentures 48.0 12% 55.0 9% Ordinary share capital 200.0 50% 400.0 67% Retained profits 20.4 5% 44.8 7% 400.0 100% 600.0 100%

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## Time Series Financial Statement Studies

A temporal or time-series study:

- to compare the accounts of one company with its own previous years' accounts - possible to see if a company is improving in certain areas or not.
Main time-series technique for analysing financial statements is ratio analysis

- Ratios of one company are compared across time - Ratios used in time-series studies are the same as those used in cross-sectional studies.
Another time-series technique often used is that of the trend statement.
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Trend statements

Trend statements start with a base year, then express all other years relative to their value in the base year.
Company wishes to analyse past 5 years sales figures as follows: Year 1 2 3 4 Sales m 744.2 804.5 704.5 916.5

If 2000 were base year, trend statement would appear as followsYear Sales 1 100 2 108 3 95 4 123

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Assignment
Given the following extracts from the 5-year summary of a Unfortunate Group, provide a short commentary. 2006 2005 2004 2003 2002 Rs m Rs m Rs m Rs m Rs m Turnover 1,083.6 Profit from retail operations 102.0 Exceptional items 1.2 Profit for the financial year 74.6 Earnings per share 17.8p Dividend per share 7.2p Total net assets 532.0 Number of stores 435.0 Net selling space (000 sq ft) 5,268.0 1,079.1 87.2 61.6 14.8p 6.3p 484.2 433.0 5,005.0 1,045.5 65.2 - 6.4 38.9 9.4p 5.5p 447.3 431.0 4,815.0 1,139.3 43.0 - 31.4 0.4 0.1p 5p 423.9 425.0 4,704.0 1,179.8 10.0 10.8 2.6p 5p 438.3 736.0 6,452.0

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