COMPANY ANALYSIS – FORECASTING OF

EARNINGS:

USING FINANCIAL STATEMENTS, EARNINGS

POTENTIAL CAN BE SOMEWHAT GAUGED.

THE VARIOUS INGREDIENTS IN THE FINANCIAL

STATEMENTS CAN BE RELATED IN SUCH A WAY
THAT THE ANALYST IS ABLE TO VISUALIZE
THE CRITICAL ASPECTS OF THE FIRM’S
OPERATION THAT DICTATES THE LEVEL,
TREND AND STABILITY OF THE EARNINGS.

THERE ARE SOME METHODS EMPLOYED BY

THE ANALYST IN ASSESSING THE OUTLOOK
FOR REVENUES, EXPENSES AND EARNINGS IN
THE FIRM OVER A FORWARD HOLDING PERIOD
GIVEN THE ECONOMIC AND INDUSTRY
OUTLOOK.
Earnings:

The efficiency with which a firm uses its assets is a key

influence on earnings level and growth.
Better managed companies have high priorities per
rupee of assets than do poorly managed companies.

Other thing is that how fast it increases productive asset

base and sources from the most beneficial places for
financial expansion. (i.e) this shows the ability of the
company to have effective debt and equity mix.

Asset productivity and earnings is clearly revealed

through ratio analysis:

Return on Assets = EBIT ÷ Asset

Obviously higher the ratio better it is.

Poser: Why we should hold asset as the base for

our evaluation?
ROA = (Sales / Assets ) * ( EBIT / Sales )
= Turnover X Margin

Industry ROA T.O Margin

Jeweler 0.15 .5 ?
Super ? 1.50 0.1
Market

Poser: Analyze the above. What are the most essential

criteria in your opinion for choosing the industry to
invest? Why?

Poser: Whether such a situation is possible within the

industry

Textile ROA T.O Margin

Premium 0.15 .5 .3
textiles
Cheap textiles 0.15 15.0 0.1

IN SUM THE PRODUCTIVITY OF TOTAL FUNDS

PROVIDED BY THE FIRM IS PRODUCT OF
MANAGEMENT’S ABILITY TO:
a. GENERATE SALES AND REVENUES IN
RELATION TO THE INTENSITY OF
UTILIZATION OF ASSETS.
b. INCREASE THE PROFITABILITY THAT
RESULTS FROM SALE.
EARNINGS AND THE ROLE OF FINANCING:

THE PRODUCTIVITY OF FUNDS REFLECTS IN

RETURN ON ASSETS.

THE COST OF BORROWED FUNDS IS CALLED

EFFECTIVE INTEREST RATES.

EFFECTIVE INTEREST RATE IS

= INTEREST EXPENSE/TOTAL LIABILITIES.

Sales 10 Equity =25 Asset =50

0 Liability =25
-Operating costs 88
EBIT 12 Effective interest rate
-Interest 2 (I)= 2/25 = 8%
expenses
EBT 10 ROA( R) = 12/50 = 24%
- Taxes 4
EAT 6 Benefits from borrowed
÷ No. of Shares 5 money = R – I
EPS 1.2 = 24% - 8% = 16%
BORROWING MONEY AND USING THOSE
FUNDS TO EARN A RETURN ON THE
ASSETS IS KNOWN AS EMPLOYING
LEVERAGE.

AS LONG AS (R –I) IS POSITIVE, LEVERAGE

IS BEING USED TO FIRM’S ADVANTAGE.

(R –I) MUST BE MAXIMUM TO HAVE THE

HIGHEST ADVANTAGE AND R< I SHOULD
BE AVOIDED.

POSER: LINK THIS SITUATION TO THE

PRESENT ECONOMIC SCENARIO AND HOW
A COMPANY CAN PROJECT A BETTER
RESULT UNDER THE GIVEN
CIRCUMSTANCES FOR THE IMMEDIATE
QUARTER (2ND) AND FOR THE YEAR END.

WHEN (R –I) IS AT A COMFORTABLE

POSITION CREDITORS WILL FIND THE
POSITION LESS RISKY. WHY?

WHEN (R –I) SHRINK RATE OF INTEREST IS

ALSO LIKELY TO GO UP. WHY?
POSER: IF THE RATE OF INTEREST TO
BORROWING INCREASES, IT WILL ALSO PUSH
UP THE COST OF EQUITY –EXPLAIN.

POSER: WHAT IS THE EFFECT OF STOCK

PRICES IN THE MARKET IF THE COST OF
EQUITY RISES?

POSER: IF THE EQUITY PRICE INCREASES,

WHAT HAPPENS TO INTEREST RATE ON
FURTHER BORROWING?

We know that Benefits of borrowed money

= Return on assets- effective rate of interest.= R –I

Converting the above in money terms:

EBT=EBIT – I =(R*A) – (I*L) ; But A= L+E

EBT = ( L + E ) * R − I * L

EBT = RL + RE − IL

EBT = RE + L ( R − I )

EBT = ( RE / E + L( R − I ) / E ) * E

EBT = ( R + ( R − I ) L / E ) * E
Now we see that (R-I) is magnified by the
term L/E.
In the previous example we had
EBT = (.24 + (.24 − .08)25 / 25) * 25 = 10
If L=40 & E =10 what will happen to EBT?
EBT = (.24 + (.24 − .08 ) 40 / 10 ) *10 = 8.8

In the first case EBT = 10

EBT/equity = 10/25=40%

In the Second case EBT = 8.8

EBT/equity = 8.8/10=88%

So when we are able to have (R-I) positive,

larger value of L/E magnify the difference.

POSER: DISCUSS THE VERACITY AND

OTHER DIMENSIONS OF THIS
STATEMENT

POSER: IF L/E MULTIPLIER IS LARGE

ALWAYS THE POSSIBILITY OF
BANKRUPTCY IS HIGH -EXAMPLES
THE ABOVE STATEMENT NEED NOT
NECESSARILY BE TRUE-EXAMPLES