vy «inane statement Anayss of oe = 427 " jicies: Companies ofter ” ing en follow differe 4 Ae method's, Useful life estimates foraete cat oe ve policies, Inventory alua™ ross companies, rts, and revenue "y on recoppition practices 1 year: Most companies follow the March 34 year 5 eae ‘Ambuja Cement follows the calendar ma while hoe ot dots For ise. The Companies Act 213 requires companies i i sales they qualify forthe exemption wet ye eae of Financial Statement Analysis bers in financial statements are significant in themselves, But we can draw je mer inferences from their relationship to othe Learning Objective their 15 or their change from one petio in ber ete. THe tools of financial statement analysis help in establishing Be ae cen b gaships and changes, The most commonly used analytical tchiques are horizontal analysis, vertcat says rend analysis, vertical analysis, and ratio analysis. analysis, and ratio I this section, we illustrate the application of these techniques using the 2016 smal tidated financial statements of Dr. Reddy's Laboratories Limited (DRL). DRLis@ leading A an come fom Tver of five times. Level 3 describes the calculation Of margiy jrumover selects a combination that reflects how it int ao A jon, Does it want to sell upmarket, difterentiats es tT achieve a certain ROA, businesses can choose to aman goign and tumover. Companies qa lrg the mass marae dy have low profit margins, but keep high wget strategy. Companies that Supermarkets, asset tumover ~ “low sell premium p; te ina niche market enjoy high profit marging oo margin, low volume” strategy, a ‘Using the DuPont chart, we can analyze DRL’s ROA as follows: perenne Yea : 1.14% ms Ba% 0.81 times. 15.55% 13.49% 0.87 times FINANCIAL ANALYSISQUICK QUESTION Margin or Volume? ~~ This analysis shows that the company eared a lower ROA in 2016, because of j, lower margin and lower turnover. As a result, the ROA was down 2.35 per cent, Ae the following products as “low margin, high volume" or “high margin, low volume"? (2) Aston Manin (b) Chios, (c) Ginger Hotel, (d)Lifebuoy, (e) Lux, (9 Taj Vivanta, (g) Ulysse Nardin, (h) Xiaom ” Return on Equity Return on equity (ROE) is a measure of profitability from the shareholders’ standpoin, 1 measures the efficiency in the use of shareholders’ funds. In order to moderate the influence of share issue and buyback and change in retained earnings, analysts generally uso th, average of beginning and ending amounts for the year. From Exhibit 12.2 and Appendix DRL's equity is as follows: 117,009 in 2016; 98,531 in 2015; and 78,652 in 2014. Average equity is 107,770 in 2016 and 88,592 in 2015. Using the profit amount in Exhibit 12.1 ang the average equity, we can now compute DRL’s ROE: 23,364 21,514 19.96% 38,952 107,770 6.37% We are not’ surprised that the ROE follows the downward movement noticed in the other profitability measures. Competitors try and replicate a firm’s special advantages in product offerings, cost efficiencies, innovation, technology, distribution network, and brands. This adversely affects a firm’s ability to maintain a supernormal ROE. As a result, the ROE tends to revert towards the industry mean over time. The decrease in the ROE in 2016 was caused by the lower ROA. Shareholders expect the ROE to be higher than the cost of equity, their expected rate of return. Extended DuPont Analysis You would have noticed that in both 2015 and 2016 the ROE was higher than the ROA, implying that the company earned more per rupee of shareholders’ funds than per rupee of assets. One reason for the better return to DRL's shareholders is the use of debt financing, When the ROA is more than the interest rate on debt, shareholders benefit. Leveraging, or trading on the equity, is the use of debt finance to acquire assets in order to cama higher ROE. The flip side of debt financing is that, when the ROA falls below the interest rate, shareholders lose. We will consider the risk of debt financing later in this chapter. From Exhibit 12.5, borrowings are 16 per cent of DRL financing. However, the company also gets significant interest-free credit from its suppliers of goods and services and by deferring payment of its obligations. Shareholders benefit from interest-free financing. Figure 12.1 helps us to understand the effect of leverage on return on assets. From Levels 1 and 2, we note that ROE is the product of leverage and ROA, which in turn is the product of profit margin and asset turnover. For a given ROA, it is possible to produce a higher ROE by financing a part of the assets with debt. This is how the use of debt can “lever up” the ROA for the shareholders. The assets-to-equity ratio is a measure of leverage. We can now see how Figure 12.1, Level 1 works, In 2016, DRL’s ROA was 11.14 percent. calculated as follows: Average assets, 193,041/ Average equity, 107,770. Its leverage was 1.71, ie the product of ROA of 11.14 per cent and leverage of The ROE of 19.96 per cent is Earnings Per Share J i i important measure Financial analysts regard the earnings per share (EPS) as an impor profitability. DLs basic EPS for 2016 was 7126.15, down 8 per cent from a eT tseful in comparing performance over time. The decrease in DRUs EPS in te that the company did worse on the whole. But the EPS is not of much helpanalsis a 435 firms because the . n ; . ‘ 1 igen which we shall see later in this chapter #8 an input into the price- Company's profit margin and return on xs, Mohan assets were 10 per cent and 18 per 1 Hepat Sete and 18 per test your cat npute the COMPANY'S asset turnover for 20x, 4 UNDERSTANDING 12.1 + for 2 and 3 belOW assume that the company's Working with ws Cees T1A00K YS PrOAE after tax for 20x1 was £2,700 Profitability Ratios Compute the company’s total assets at the end of 2ox1, 5; suppose in 20X2 the company plans to increase exis 3 Compute its asset turnover for 20x2 assuming no incr Lauds he sein cf Esto Laude, a cosmetis fim cone the tem pst inde’ when, uring the FINANCIAL VIEW ot ecession, lipstick sales went up ‘1 per cent. In the past, lipstick sales Fecorded an increase during the The Beauty of Recession Get Depeson (he lle 1920s to early 18808) andthe Second Word War (1859-1985). arreon ner as c increages when consumer confidence is lov. However, inthe afemath ofthe 2008 inonéal ee vor te war’ gest beauty company, found that inthe UK foundation edged out ips ae te men jacy fr wren, wth mare than one-third of 18 and 19-year cing it as thet most essntel desu petay agape ont oping fr lipstick. The sees of antidepressants ar also ily to be eountersycica Then tor, aS meses el cute, oc op tse hs WAL ard bad tines. The point is thatthe soles of some products and senies may be counteajeicl ot eyde-poot LLL teause people would flock to them in times of trouble. The analyst should look for inks betwoen o tras Coles tnd te wide social and economic conditions. 's by 15 per cent over 20x1. fase in assets over 20x1. reo company s oss margin decreased trom 21 per cent in 20K! fo 15 per cent in 20X2, Which ONE-MINUTE QUIZ 12.1 ne rer evens Wn 20K2 explains the change? There may be more than one conect Grswer. Gross Margin (0) Credit period increased. (b) Interest expense increased. (c) Cost of raw materials decreased but seling prices did not change. (6 Soles growth rate decreased. (Gquidity Analysis Liquidity is the ability of a business to meet its short-term obligations when they fall due. Learning Objective ‘An enterprise should have enough current assets, which can be converted into cash so that e ‘Analyze liquidity. it can pay its suppliers and lenders on time. For evaluating DRUS liquidity, we examine the following four ratios: 1. Current ratio; 2. Quick ratio; 3. Receivable turnover; and 4. Inventory turnover. Current Ratio ‘The current ratio is the ratio of current assets to current liabilities. It is a widely used indicator of a company’s ability to pay its obligations in the short-term. It shows the amount {current assets a company has per rupee of current liabilities. Current assets and current ‘abilities are those that are receivable or payable in the normal operating cycle or within '2 months after the reporting period. From Exhibit 122, DRLs current assets are as follows: 118,201 in 2016 and 118,767 in 2018. Current liabilities are as follows: 68,368 in 2016 and 68,213 in 2015. We calculate the current ratio as follows: a Current assets Current assets ‘Current liabilitiesON Chapter 12 Balance Sheet and Statement of ro 24 A current ratio of more than one means that a business has more current rupee of current liabilities, implying that it can pay its current liabilities usin 2° poy assets. In other words its operations will not be disrupted. Ths assumes thee f® Se, assets will fetch at least the stated amounts. DRL’s current ratio hardly changes On the face of it, a ratio of less than one may look unfavourable for the compan, ye as, term creditors. From another perspective, current assets have carrying costs in p80 of profit foregone on the investment and actual costs, such as interest, insurance and bad debts. Next, we examine the quality of current assets. Storage, Quick Ratio Current assets range from cash to sticky inventories. Cash is readily available tg ma payments to suppliers. Receivables can be converted into cash with some effort. Inventor: are two steps away from cash: sale and collection. Therefore, a large current ratio by ity is not a satisfactory measure of liquidi ity when inventories constitute a major Patt of the current assets. The WCK ratio, o acid test ratio, is computed as a supplement iy fe current ratio. This ratio considers relatively more liquid current assets, usually curren assets less inventories, to current liabilities. From Exhibit 12.2, DRU’s quick assets are as follows: 92,402 in 2016 and 93,068 in 2015, We calculate the current ratio as follows: ck ratio 016 Quick assets 92.402 _ 1 35 93,068 _ Current liabilities 68,368 68,213 ‘The decrease in the quick ratio is in line with the slight drop in the current ratio, As a rule of thumb, the current ratio is expected to be at least 2:1 and the quick ratio at leat 1:1. The latter means that a firm must have at least as much liquid assets as its current obligations so that it will have no difficulty in paying those obligations. As you can appreciate, across-the-board measures are not much realistic, but they provide a broad basis for comparison. In practice, analysts further refine these liquidity measures by excluding prepaid expenses, non-trade receivables, and employee loans since these can’t be converted into cash or realized at short notice. Receivable Turnover We should measure the liquidity of specific current assets in order to understand the qual of current assets. A company’s ability to collect promptl m it tomers enhances its liquidity Receivable tamnover GTO) cay the eBicnsy of a firm’ exedit poi} and collection mechanism and shows the number of times each year the receivables ere tumed into cash.* It provides some indication of the quality of a firm’s receivables and the effectiveness of its collection efforts. A high RTO indicates that receivables are being converted rapidly into cash and the quality of the company’s receivables is good. Receivable tumover is the ratio of net sales to average receivables. Ideally, the numerat0 should include only net credit sales, but this information is not available in published teports. Therefore, the analyst has no option but to use net sales, though it would indude cash sales. Average receivables are computed as the simple average of beginning ending receivables. From Exhibit 12.2 and Appendix B, DRL’s trade receivables are follows: 41,667 in 2016; 41,012 in 2015; and 33,253 in 2014, Average trade receivables a 41,340 in 2016 and 37,133 in 2015. Using the sales data in Exhibit 12.1 and the averas? trade receivables, we can now compute DRLUs RTO: . TT Receivables consist of trade receivables and bills receivable.437 159,671 “a3qp 7380 times 152,974 “Hr aay 7405 times ‘tre significantly lower RTO in 2016 indi, quicates relatively weaker man 1 es common pions RTO in average collection period, Faye als eng (050). We do Ya two-step procedure: —o Oh 1, Caleulate average daily sales: Net sales/360, ase, " daily sales are 436 for 2016 and 417 aois for 2015, "amed 360 days in a year, Average 2 Caleulate the average collection period: Tt is average receivables divi, sy a Be receivables divided by average ser) Era Tp Receivables 41,340 ——) 81390 . 37133 Daily sales ecpeane Me can also compute the average collection period by dividing the number of days in a year by receivable turnover: Sees 360 37,133 [= 30 54.80 da 3738, Receivable tumover 320480 days 4.05 DRUs receivables remained outstanding, on average, ‘» ® days in 2015, indicating slower collection. To asse ‘eed information on the company's credit terms. For ‘company is doing well in collection, but not if the te ‘Shree Company's average collect come, Company's averag lon are travel agents, Can What additional xt for 95 days in 2016 as compared ss whether this is satisfactory, we instance, if the terms are 1/120, the ms are 1/90. ri days and Lakshmi Company's is 45 days, Both Test YouR ee say that See Company maropee recevables bese? TEST TUR a a3 9 Information about receivables do we need? Evaluating Receivable Management ‘ventory Turnover WYEMory tumover (TO) is the number of times @ company’s inventories are turned into ‘sles. Investment in inventory represents idle cash, The lower the inventory level the Breater the cash available for ‘meeting day-to-day operating needs and for ieee Productive assets. Besides, lean fast-moving inventory runs a lower risk of Tem invents interest, insurance, and storage charges. A high ITO is a sign o Ca tory management. In recent years, many companies have started following just a aeetory Practices whereby they make purchases at the time they are requi pe tangtion ©F sales. DRUs IFRS consolidated income statement reports cost of g0o% son Eo, feeenue) of 62,427 in 2016 and 62.786 in 2015. in 2015; and 24,188 a, From Exhibit 723, ee are as follows: 25,799 in 2016; 25,699 Cee, ma aaa {Average inventories are 25,749 in 2016 and 24,944 in 2015. Using "erage inventories, we calculate inventory tumove =02 36172 Equity 117,009" ° ost 7 Nate: These are year-end amounts. ge. A high debt-to-equity ratio tly leveraged company is more risky for In2016, DRU's debt-to-equity ratio declined due a combination of lower debt because of repayment of borrowings and higher equity resulting from retained earnings. Most Indian ‘companies have debt and some have significant amounts of debt. Financial leverage differs from industry to industry. Firms that have n elatively stable demand for their products (e.g. lectricity) tend to have high leverage. In contrast, firms that are subject to wide fluctuations in demand (e.g. consumer goods) prefer low leverage. The unpredictability of the outcome of R&D activities and of the drug approval process implies a high business risk for DRL. So low financial leverage is preferable. Unbilities-to-equity Ratio A variant of the debt-to-equity rato is the liabilitiesto-equity ratio. Here, the numerator has all liabilities, not only borrowings. The ratio is computed as follows: 87,447 AlLiiabiliti Seon Toe Equity ‘ 089) The fallin the liabilties-to-equity ratio indicates DRS decreasing dependence on liabilities, much of which is interest-free, This measure is especially useful in the case of firms that keep rolling over short-term obligations. In effect, some of he cure Habtes take a Tong-term character and are not essentially eterent fom interest-free db, Since these are available for the firm's use for a Jong Pear ea a ve may have noted invested in long-term assets such as property, plant and ea ty ‘ratio that you saw in the that the liabilities-to-equity ratio is related to the assets-to-equi discussion on return on equity.440 Operating Leverage Operating leverage indicates the extent of fixed costs in the o Pay them. Combining high financial leverage with FINANCIAL ViE\ 4 'r Ww ‘When you're highly leveraged, getting ugly doesn't take a lot’, says Professor Carmen incurred regardless of the amount of sales oe curr ales or proc hea building maintenance are examples of fixed cost, Having es rents insu is Fisky, because even when the business is not doing well tee pePOtn of n h igh operati overall isk of a business. Since we don’t have information sbot Reg statements, we are unable to calculate the degree of operating leverage Debt, M Reinhart, usic, and _'ocser Kenneth Rogoff This Tne i fre, an aaj of debt ses. “One att yy ne Skyscraper a placement ofa bond, what would seem ike a shoctrun shortal n roloverproslene that stampede scenario" What Professor Reinhart sad about soverign de apps coe {0 corporate debt. Debt can be a dangerous atracon. The advice that Polis para Pet FNeer 2 Serower or ender be For ano ses bo sel and end Ad oro ae hhusbandry” (Hamlet Lil. 75-77). ‘announced a “debt standstil” (a briliant euphemism for defauit in November 2008. The ‘some of the worlds most extravagant real estate projects, such as Bur You discover who's been swimming naked.” Interest Cover Interest cover js a measure of the protection available to the creditors for The ratio shows whether the company has sufficent interest charges by the company. ~ sry re 205 ere Combining high nancial leverage with high operating leverage isa recipe for disaster, Wor Satelite ratio servic, had to fold up, because offs debt of $21 tlio and lrg upon pogo and production costs and heavy satlite rentals. This was case of deb! stopping musi foe” company’s customers. As, when @ company uses debt to fund projects tet have log ges Chance feta. Thi was the cate win Dba Wot he fash company of te Gvenme a fk mn Khalifa the words beg skyscrper-andsvila-remmed Palm Jumeirah island, and the arfcial Arabian Canal. n decng ce 4ebt, itis useful to remember Warren Bufet’s famous quote about risky behaviour “Only when ae Hest tow, Ne ey, ing fy 8 ep, 2st ae ther onde 's ert Cs elena Bde goes Payment of income to cover its interest requirements by a wide margin, Interest cover is computed by dividing profit before interest and tax by interest expense. A high ratio implies adeque safety for payment of interest even if there were to be a drop in the company’s earings DRL interest cover is calculated as follows: Profit before interest and tax 32.196 «59.97 Interest expense a 2780 The extent of interest cover depends on profit, debt level, and interest rate. AS we have seen, DRL doesn’t have much interest-bearing debt; so a high-interest cover should come as no surprise. Selected information from the 20X6 financial statements of Company A and Company 8 is iT YOUR te 720,000 Profit before interest and tax.. 3,000 7,000 20,000 70,000 35,000 Which company is more successful in using leverage? Why? 14,400 2,500 60,000 90,000 20,000La sinelniiihnniieniennt mann oe le to borrow wisely? Suzlon Energy manufactures wind turbines. Suzlon literally means REAL WORLD wi deb 542 from the Gujarat suz-buz (inteligence or smartness) and lon, the Gujarati way of Is Smart Debt an “nga. (9c early 204 Pen ‘company was cited in the international media as an example Oxymoron? acestl emerging market giant The company’s chairman and managing director, Tulsi ‘tie pushed aggressively for growth. Suzlon set up manufacturing facilities around the world Wi eqted Hansen Transmissions International, Belgium and REpower Systems, Germany. The in was financed by debt of about £130 billion in foreign currency convertible bonds | (F608). In its enthusiasm fo acquire Repower, Suzlon seemed to have overpaid for it and ged up with 94 per cent of the stake. The economic crisis folowing the collapse of Lehman frothers in September 2008 adversely affected the company's wind power markets in the US ind Europe. Nearly 60 per cent of the company’s order book came from REpower. All of these ‘ontriuted to Suzlon defaulting on the redemption of an instalment of FCCBs. Possibly, wind frergy was (and still is) a good business, but it was brought down by debt. Too much debt ‘would appear to be not such a smart idea. Saece: Company annual reports. garower Company's long-term debt increased by 20 per cent in 20X1 over 20%2, but interes! expense aeesed by 25 per cent over the some period. The debi-to-equly ratio was 2.2:1 in both yeors. ONE-MINUTE QUIZ 123 Uitich of the following events in 20X2 explains the change? There may be more than one corect nswer. {o) Sales growth decreased. {b] Some current debt was rolled over on a long-term basis at lower interest rates. {c} Some current debt was rolled over on a long-term basis at the same interest rates. {0} Some current debt wos rolied over on a long-term basis at higher interest rates. {Debt and Interest Rate (capital Market Standing ) Copital market ratios relate the market price of a company’s share to the company’s earnings Learning Objective and dividends. Price-earnings (PE) ratio, dividend yield, and price-to-book ratio are the Waldate capital | most commonly used ratios that aid investors and analysts in understanding the strength market standing. ofa company in the capital market. Price-earnings Ratio Price-earnings ratio, of PE ratio, is a popular measure extensively used in investment analysis, The PE ratio is often the only measure in discussions. It is the ratio of the market price of a share to the annual EPS. Many view the PE multiple as an indicator of a firm’s growth prospects. Analysts use it as a screen to detect mispriced stocks. A high PE ratio indicates the stock market's confidence in the company’s future earnings growth. DRU's stock prices in the National Stock Exchange were as follows: Ce eae ae GaSe) 00 Low 2,887.15 3,300.15 Average 3,085.08 3,497.58 Closing 3,035.20 3,488.75, We take the average of the high and low prices.’ Using the basic EPS of %126.15 for 2016 and 2137.18 for 2015, the computation of the price-earnings ratio is as follows ‘Market price per share 3,085.08 Earnings per share 126.15 =24.46 times 3 We could also use the yearend closing price of the stock MME,402 wl 0 2016 the market ha The company’s stock price The a faith in DRI by movement in the whole 10 2015. fowth prospects relative arket ‘The PE ratio tells us how much welling to pay per rup * example, a PE of 15 implies that ay ready to pay 815 for 81 of earnings. Is a 1 h, low or reasonable? 4 0 ly simple and easy to calculate, and is therefore widely misu: PE ato you dont nee knowledge of accounting nance oF the a stor is tempted to use the PE ratio, Many investors feo P™nys olumns when the prices go up. in fact ome ee that to buy single-digit PE stocks. At the other end, some yet ht to be valuable because they are expensive. Mv estors Unfortunately, being a simple measure, the PE ratio is misunderstood. 1 interpreted with great care, Plocisely because itis simple. The PE rat tlle wb the earning power of a business based on its future growth. A low PE ratio might grat weak growth prospects, or the stock might be genuinely underpriced. Similarly, a high ny stock might have strong, growth prospects, or it might be overpriced. We need to aalyre the financial statements to decide which of these explanations to accept. Further, the Eps affected by accounting method differences, one-time items and other eamingg quality i hhorefore, investing in a stock should be based on a detailed analysis ofthe company’s business, earnings quality, competition, and industry and economic trends. The E can, at best, be a good place to start. It would be naive to think that a single number n capture the complexities of investment deci Alternative price-earnings measures. ‘The PE ratio that we calculated is the historical PE or trailing PE and it is based on past earnings. The rolling PE uses the earnings per share from the latest four quarters. The forward PE or leading PE uses earnings forecast by analysts. Often, the consensus foreensi, which is the average of individual analyst forecasts, is used for calculating the forward PE. One measure that has become widely popular is the cyclically adjusted PE ratio (CAPE) that uses 10 years of earnings. It was developed by Professor Robert Shiller, a professor of economics at Yale University, who was awarded the Nobel Prize in 2013, The intuition that underlies this measure is that the business cycle Interpreting the pric is decepti to use tl business, So the lay im low PE stocks will advisers tell th feel that high PE stock measure it lasts ten years. Earnings yield is the reciprocal of the PE ratio, i.e. EPS divided by market price per share. Using DRL’s EPS and stock price, we calculate the earnings yield as follows: 2016 ro 126.18 _ 4 990, 137.18 3 3,437.58 Earnings yield Earnings yield is the investor’s return on the stock based on earnings. Since earnings is an accrual measure, earnings yield indicates the return to the investor over the long term. Dividend Yield Dividend yieldrepresents the current cash return to shareholders. It is the ratio of dividend per share to market price per share. The dividend yield for DRL is shown below: Dividend per share_ 5 5 ‘Market price per share ose "018% ae 15% We note that in 2016 dividend yi i ividend is i @ ; yield was a tad higher. The dividend is important meg Such as retired persons and pension funds, who depend on it to meet theit¥ per sending j we! aaa, jm eto jets of dividend and change in st i sob cnt Windham sero Serre) os ‘Change in stock price over the period + Dividend. ® ‘Beginning stock price gestation of stock return for 2016 i as follows: tte (6,085.08 3,437.58) 45 ee tS = 011% DRL shareholders eared a negative retum of over 10 per co ir 1 a par ee 2 8 cn igs rate with the risk assumed by them. Another way te lane eee jet0 Orth the market trend. From April 2015 to March See : 2016, the NSE Ni or ied a decline of 8.07 per cent. DRL’s stock performed a little woree funtee prceto-book Ratio for the period ‘Thus, rice-to-book ratio (PB ratio) compares a company’s stock price with the book value Praccounting value). Book value per share is the amount of sharehold 7 ers’ equity divided §F the number of shares. We calculate DRL’ price-to-book ratio as follows: " Market price per share 3,085.08 ‘Book value per share 686.08 3,437.58 ‘57852 A low PB ratio is often seen as an indication of underpricing of the stock. A PB ratio of more than one means that the market expects the company to earn higher than the required rate of return on equity. The PB ratio too is affected by the choice of accounting methods, since the denominator is an accounting variable. 94 times As you would know, the face value of a share does not matter for most purposes. However, LADDER investors are sometimes obsessed with par. Face value is irrelevant in calculating PE and PB ratios. Face Value and Stock ‘Aso, face value and stock price need not be related. For example, suppose two companies, Price Slice and Whole, that are identical have a market capitalization (the sum of the prices of their respective equity shares) of 81,000,000. Slice has 20,000 shares of face value of &1 and Whole has 10,000 shares of face value of €2. Both have the same paid-up capital, %20,000, but that amount Is split into twice the number of shares in Slice as that in Whole. The price of a share of Sice is €50, i.e. £1,000,000 + 20,000, while that of Whole is £100, ie. Z1,000,000 + 10,000. ‘The investor pays the market price, not the face value. To understand this better, suppose Slice Performs well and its stock price rises to 275. There is no change in the face value of Slice’s shares. Whole continues to perform as before, so its stock price does not change. Stock prices reflect expected performance. Beta Besides financial statement information, investors assess a number of factors such as management and governance quality, industry conditions, and general economic environment. The final results are expressed in the form of a rate of return required for a Specified level of risk, The risk associated with the return on an equity share consists of two components: ™ Systematic risk ™ Unsystematic risk,TEST YOUR UNDERSTANDING 12.5 Selecting Stocks ‘ONE-MINUTE QUIZ 12.4 Price-eamnings Ratio FORENSIC CORNER Financial Statement Analysis Chapter 12 Balance Sheet and Statement of Prof ang tos, Systematic risk is the change in the price of a share for a change in the the mat as a whole, Beta is 4 measure of systematic risk. For example, if a oe on a beta of 15, a 10 per cent increase (decrease) in the market would likely resui i an J cent increase (decrease) in the price of the share. An equity share with a bejg oro fea less risky investment because it is less swayed by market price movements. q (75 tf one means thatthe stock is just a5 risky as the market. The market is usually jp be represented by an index of share prices such as the CNX S&P 500 Index. Aceon Reuters, DRL beta was 0.15 in early April 2017. e ‘Unsystematic risk jg specific to a share and is not correlated with any other fact, g, the unsystematic risks of several shares will cancel out, this risk can be diversified » completely by investing in a portfolio of shares. The computation of beta fora pone! enables investors to determine the risk level desired and the return required, lio nce Information about two companies, both in the electrical appliances industry, is as follons, ey Earnings per share . 76.75 Dividend per share ... 33.00 Market price per share. 5.00 50 Beta seven ‘Comment on the capital market standing of the two companies. Which share would yoy recommend? ing profit, 2100 milion: interest ex Value Company forecasts the following for 20X2: operating profit, £100 pense tio rrilion: preference dividends, % milion: effective tax rate, 30 per cent: equity dividend payout rag, 20 per cent: the number of equity shares, 3 milion. The company's equity shares are expected 1g trade at a price-eamings ratio of 10. What would be the market price per equity share? (o) 239.2. (b) 2190. (c) e180. (a) T1196. Analysts and investigators look for tell-tale signs of financial statement fraud. Bur fraudsters ae clever and cover their tracks well. Even so, some indicators of fraud may be available. For example, Benford’ law says that in the real world in the first digit the number 1 is mote likely to appest than the number 2, the number 2 is more likely to appear than the number 3, and so on. Benford’ law predicts that the number 1 will appear about 30 per cent of the time in the first digit. If in an actual case it appears only 10 per cent of the time, it might suggest the possibility of fraud Unfortunately, Benford’s law is not a silver bullet. In fact, there is no silver bullet. Increasingly, daa analytics are used to identify patterns and deviations. It is a rapidly evolving field with grea potential for use in detection and investigation of accounting fraud. Red flog signaling accounting fraud: * ‘Significantly higher or lower margin than competitors. Sales growth out of tune with changes in inventories and receivables, Always meeting or narrowly beating earings estimates. © A lower price-carnings ratio than the peers, # Delay in announcement of financial results, ™ Changing the fiscal year frequently. "The most commen sources of informati formation about lis a a statements, stock exchanges, and government ae asus " Analysts make comparisons wit ts standards, and sat y Ey rule-of-thumb indicators, past performance, inter!| wt! problem tal analysis 100Ks at the year povicotel yeat-on. sere as a Poy careening TE SH ean total . Ratio. analyst cial years, Vr satonship between corms of ancial sates stable to the statement bility ratios tell us al al statements, a rel + on cas nee SSOP Sopa ” q assets, 8S. The ma . iat y Measures are current rato, ick rate Tt is shortteme cay ote and operating cycle, ‘atio, receivable tumnopers °PbBAtions, The ¥ Slency ratios indicate the extent of depend Prenton turnover, rato, and interest cover are the main ) Issued equity shares for cs Receivable tmover Repaid a loan. ivable ts (9) rsd mace fr cash Debetoesiy Issued debentures for ¢é sun on 6 ie ay tee (g) Collected from customers for past sales. Bot ae (h) Accrued festival bonus to employees. ae 8 per share {@)_ Sold goods for cash es (Accrued interest expense. © if tum on equity (k) Issued bonus shares. ao (Q) Wrote off a bad debt. Receivable tumover (mm) Issued debentures in exchange for equipment. Debt-to-equity (n) Entered into a finance lease for a new plant. Interest cover (0) Purchased goods on credit. ; Asset turnover (p) Accrued interest on investment in Treasury bill. Return on equity (@ Sold a plant at book value in exchange for shares. Return on assets (0) Transferred cash to a six-month deposit account. Quick ratio (6) Paid principal amount for instalment purchase of the Profit margin plant. Required State whether each transaction resulted in increase or decrease in the specified ratio or had no effect on it. Consider each transaction independently. peed Balan Company entered into the following transac (Current ratio Receivable turnover Interest cover Asset turnover Return on assets Return on equity Receivable turnover Interest cover Receivable turnover Inventory turnover Profit margin Debt-to-equity Profit margin Current ratio Asset turnover Debt-to-equity Quick ratio Receivable tum Interest cover449 4 resi ch transaction resulted in i her €0 sulted in increase or soe veer each transaction independently. Se OF decrease in the specified ratio of had no ef ai no effect, ip tana statements of Grace Corporation are as follows GRACE CORPORATION ‘cher Horizontal “and Vertical Analysis 444 Non-current investments... : 226500 Current assets 5 4,300 es. - : ‘rade receivables ~ 1000 4,900 Cash and cash equivalents 15,600 Other current assets.. 7,000 Total assets.. 200 1400 Equity and Liabilities 100 59,700 Equity Equity share capital Other equity. 5900 Liabilities en) Non-current liabilities Long-term borrowings... Current liabilities Trade payables Total equity and liabi 5 53,700 GRACE CORPORATION of Profit and Lo: 288400 57,600 30,800 4,500 36,300 1,400 34,900 12,000 12.900 ats oft statement of prot and on a bane hs showin PrePae and percentage changes from 20X10 20X2 ee 2 Prepare on the results obtained from Requirements 1 and 2 ace Corporation is available: problem 1 refer to Problem 128. The following adiinal information for Cs Problem 129 000 © €40.00 Market price per share. 320 2.80 Dividend per share 448 516 Barnings Per sharepblem 12.14 2paration of Statements 'm Incomplete ormation 44+ ee —__ of Profig, ang Required and why? What additional in, id account balances ate represen Mion ave ot Which customer's Ioan request should be accepted required in making a decision? Assume that the year-en whole year. ‘The following information is available for Arogya Company: We i cranny PA eeu Assets Property, plant and equipment ... Non-current investments. Inventories. Trade receivables... Cash and cash equivalents.... Other current assets Total assets. Equity and Liabili Equity Equity share capital. Other equity... Liabilities Non-current liabilities Long-term borrowings. Other long-term liabilities. Current Liabilities ‘Trade payables Total equity and liabilities. ~ 17,000 AROGYA COMPANY Statement of Profit and Los ee CTC Reet Cost of goods sold Gross profit. Selling and administrative expenses Profit before interest and tax. Interest expense Profit before tax.. Income tax. Profit after tax. we ig lL, ol. I 350 Additional information: Profit margit gin, 7 per cent; (b) C 0, 13; ity, 15; (@) ae aan oh iogPet Cents (b) Current ratio, 1.3; (c) Debt-to-equity, 15; ( ventory ene none 2 ( ) Average collection period, 72 days; (6 Interest cover, 8 times; and (g) Retum Required Complete the financial statement ts of Arogya Co, : ‘et ren cunt a eae 28, Show pring iis srsso 453 mation is available for Surat Company: Problem 12.15 Preparation of Statements from Incomplete Information #444 Altermative to Problem 12.14 owing info pe fo Tie meon ong Poteet ae ae! val : ‘and cash equivalents. ‘tal assets. squity and Liabilities Equity guity share capital ‘other equity- Liabilities Non-current liabilities Long-term borrowings. Current liabilities short-term borrowings ~ Trade payables nan ‘Total equity and liabilitie SURAT COMPANY Per rac u ee Peer eee clean 22 2 Gross profit.. 7 Selling and administrative expense 1300 Profit before interest and i Interest expense — Profit before ta 1350 Income tax. — Profit after tax ) Tota Habits to equity, 15, ©) Current ratio, 18 Gd average collection period. $6 Toa fo 15 pr cont (OIneest expense OE -term loans at num and oF (© Aer es 4aye en pet a2 Short-term loans at 15 per cent Per Samum: (g) Income t2%, 50 Per ‘cent of Pro! ‘Additional information: (2) Ase wired ‘ eae nal statements er oat rz stom spporingciens SNS ee ie year-end account ‘balances are representative of year. m sy or Sandra Corporation fOr he IS peviod are as follows: apc 12.4 srement of profit and loss of Sande Corp ‘sandra Corporation ‘The st MMe