Ratios and Formulas Financial Analysis

Financial statement analysis is a judgmental process. One of the primary objectives is

identification of major changes in trends, and relationships and the investigation of the
reasons underlying those changes. The judgment process can be improved by experience
and the use of analytical tools. Probably the most widely used financial analysis
technique is ratio analysis, the analysis of relationships between two or more line items
on the financial statement. Financial ratios are usually expressed in percentage or times.
Generally, financial ratios are calculated for the purpose of evaluating aspects of a
company's operations and fall into the following categories:
• liquidity ratios measure a firm's ability to meet its current obligations.
• profitability ratios measure management's ability to control expenses and to earn a
return on the resources committed to the business.
• leverage ratios measure the degree of protection of suppliers of long-term funds and can
also aid in judging a firm's ability to raise additional debt and its capacity to pay its
liabilities on time.
• efficiency, activity or turnover ratios provide information about management's ability to
control expenses and to earn a return on the resources committed to the business.
A ratio can be computed from any pair of numbers. Given the large quantity of variables
included in financial statements, a very long list of meaningful ratios can be derived. A
standard list of ratios or standard computation of them does not exist. The following ratio
presentation includes ratios that are most often used when evaluating the credit
worthiness of a customer. Ratio analysis becomes a very personal or company driven
procedure. Analysts are drawn to and use the ones they are comfortable with and
understand.
A. Analyzing Liquidity
Liquid assets are those that can be converted into cash quickly. The short-term liquidity
ratios show the firm’s ability to meet its short-term obligations. Thus a higher ratio (#1
and #2) would indicate a greater liquidity and lower risk for short-term lenders. The
Rules of Thumb for acceptable values are: Current Ratio (2:1), Quick Ratio (1:1).
While high liquidity means that the company will not default on its short-term
obligations, one should keep in mind that by retaining assets as cash, valuable investment
opportunities may be lost. Obviously, cash by itself does not generate any return. Only if
it is invested will we get future return.
1. Current Ratio = Total Current Assets / Total Current Liabilities
2. Acid Test or Quick Ratio = (Total Current Assets - Inventories) / Total Current
Liabilities
In the quick ratio, we subtract inventories from total current assets, since they are the
least liquid among the current assets.
Working Capital= Current Assets - Current Liabilities
Working capital compares current assets to current liabilities, and serves as the liquid
reserve available to satisfy contingencies and uncertainties. A high working capital
balance is mandated if the entity is unable to borrow on short notice. The ratio indicates
the short-term solvency of a business and in determining if a firm can pay its current
liabilities when due.
Cash Ratio= (Cash Equivalents + Marketable Securities) / Current Liabilities
Indicates a conservative view of liquidity such as when a company has pledged its
receivables and its inventory, or the analyst suspects severe liquidity problems with
inventory and receivables.
Analyzing Sales and Profitability
Profitability is a relative term. It is hard to say what percentage of profits represents a
profitable firm, as profits depend on such factors as the position of the company and its
products on the competitive life cycle (for example profits will be lower in the initial
years when investment is high), on competitive conditions in the industry, and on
borrowing costs, expense management etc. Profits can also be analyzed using the
framework of CVP (cost-volume-prices). Analysts will be interested in the (historical and
forecasted) “trend” of sales/expenses/profits … are the profits generally on the rise, are
the sales stable or rising, how do the profits compare to the industry average, is the
market share of the company rising/stable/falling? Are the expenses rising, stable or
falling? The set of ratios here include some of the traditional earnings based performance
measures such as ROS, ROA, ROI, and ROE. For a better understanding of growth rates,
it will be useful to know the “real growth rate” as opposed to “nominal growth rate”. For
example, it is quite possible that the sales growth rate figures are impressive due to
inflation (rather than an increase in the number of items sold). This is particularly useful
if we are dealing with high inflation period or conducting an extending time series
analysis.
For decision-making, we are concerned only with the present value of expected future
profits. Past or current profits are important only as they help us to identify likely future
profits, by identifying historical and forecasted trends of profits and sales.
We want to know whether profits are generally on the rise; whether sales stable or rising;
how the profits compare to the industry average; whether the market share of the
company is rising, stable or falling; and other things that indicate the likely future
profitability of the firm.
1. Sales Growth Rate = {(Current year sales – last year sales)/last year sales}*100
2. Expense analysis = Various Expenses/Sales
3. Gross Margin/Sales = Gross Profit/Total Sales
4. Operating Profit/Sales= Operating Profit/Net Sales
5. Return on Sales (ROS) or Net Profit Margin = Profit after taxes/Sales
6. Return on Assets (ROA) = Profit after taxes/Total Assets
7. Return on Equity (ROE) = Profit after taxes/Shareholders’ Equity
8. Return on Investment (ROI) = Net Income/(Long-term Liabilities + Equity)
9. Earnings per Share (EPS) = (Profits after taxes - Preferred Dividend)/(No. of Equity
shares)
10. Payout Ratio = Cash Dividends/Net Income
11. EBIT/Sales = EBIT/Net Sales
12. Retention ratio = Retained Earnings/Net Income
13. Sustainable growth rate (SGR) = ROE * Retention Ratio
It is useful to disaggregate the ROE figure into three elements as follows to get a better
insight
ROE (Du Pont Return on Assets) = {Net Income/Sales} * {Sales/Assets} *
(Assets/Equity)
The above formulation clearly shows that if management wishes to improve their ROE,
they need to improve profitability, efficiently use the assets, and optimize the use of debt
in their capital structure. Thus two companies with similar profitability may have
different ROEs depending on their degree of financial leverage. If we combine this with
ratio #10, we can see that a firm’s growth rate will depend on all of these factors plus
their divided policy. Thus it covers the three main financial decisions in any corporation:
investment decision, operating decision and financing decision.
SGR shows how much the company will grow in the future if some of the key ratios
remain the same as in previous years. It is useful to disaggregate the sustainable growth
rate as follows.
SGR = (Profitability, Asset Efficiency, Leverage, Dividend policy)
= Return on Sales * Asset turnover ratio * Leverage * Retention ratio
= (Net income/sales) * (sales/assets) * (assets/equity) * (RE/net income)
Note: The terms profits, earnings and net income are often used interchangeably in
financial statements. Be sure to review the statements to understand their components.
Financial Leverage Ratio
Debt ratios show the extent to which a firm is relying on debt to finance its investments
and operations, and how well it can manage the debt obligation, i.e. repayment of
principal and periodic interest. If the company is unable to pay its debt, it will be forced
into bankruptcy. On the positive side, use of debt is beneficial as it provides tax benefits
to the firm, and allows it to exploit business opportunities and grow.
Note that total debt includes short-term debt (bank advances + the current portion of
long-term debt) and long-term debt (bonds, leases, notes payable).
1. Asset-Equity Ratio or Leverage Ratio= Assets/Shareholder’s Equity
This shows firm’s reliance on external debt for financing (or the degree of leverage). Any
number above 100% shows that the company relies on external debt for financing some
of its assets. If the number equals 100%, it implies that the assets are fully financed by
the shareholders.
Some analysts tend to use the Debt ratio (given by total Debt/total assets) or Debt/Equity
ratio (given by total long-term debt/equity). These ratios also show company’s reliance
on external sources for financing its assets. Ratio 1d shows what proportion of the total
long-term capital comes from debt.
2. Debt to Equity Ratio = Total Debt/Total Equity
This shows the firm’s degree of leverage, or its reliance on external debt for financing.
3. Debt to Assets Ratio = Total Debt/Total assets
4. Long-term Debt to capital (Capitalization Ratio) = Debt/(Debt + Equity)
For a lender, more important than the degree of leverage is the firm’s ability to service
the debt and this is captured in the following two ratios.
Some analysts prefer to use this ratio, which also shows the company’s reliance on
external sources for financing its assets.
In general, with either of the above ratios, the lower the ratio, the more conservative (and
probably safer) the company is. However, if a company is not using debt, it may be
foregoing investment and growth opportunities. This is a question that can be answered
only by further company and industry research.
A frequently cited rule of thumb for manufacturing and other non-financial industries is
that companies not finance more than 50% of their capital through external debt.
2. Interest Coverage (or Times Interest Earned) Ratio = Earnings Before Interest and
Taxes/Annual Interest Expense
This shows the firm’s ability to cover fixed interest charges (on both short-term and long-
term debt) with current earnings. The margin of safety that is acceptable varies within
and across industries, and also depends on the earnings history of a firm (especially the
consistency of earnings from period to period and year to year).
3. Long-term Debt to Net Working Capital = Long-term Debt/(Current Assets - Current
Liabilities)
Provides insight into the ability to pay long term debt from current assets after paying
current liabilities.
4. Cash Flow Coverage = Net Cash Flow/Annual Interest Expense
Net cash flow = Net Income +/- non-cash items (e.g. -equity income + minority interest
in earnings of subsidiary + deferred income taxes + depreciation + depletion +
amortization expenses)
Since depreciation is usually the largest non-cash item in most companies, analysts often
approximate Net cash flow as being equivalent to Net Income + Depreciation.
Cash flow is a “critical variable” in assessing a company. If a company is showing strong
profits but has poor cash flow, you should investigate further before passing a favorable
opinion on the company. Analysts prefer ratio #3 to ratio #2, although ratio #2 is more
widely reported.
Efficiency Ratios
Cash Turnover= Net Sales/Cash
Measures how effective a company is utilizing its cash.
Sales to Working Capital (Net Working Capital Turnover) = Net Sales/Average Working
Capital
Indicates the turnover in working capital per year. A low ratio indicates inefficiency,
while a high level implies that the company's working capital is working too hard.
Total Asset Turnover= Net Sales/Average Total Assets
Measures the activity of the assets and the ability of the business to generate sales
through the use of the assets.
Fixed Asset Turnover= Net Sales/Net Fixed Assets
Measures the capacity utilization and the quality of fixed assets.
Days' Sales in Receivables= Gross Receivables/(Annual Net Sales / 365)
Indicates the average time in days, that receivables are outstanding (DSO). It helps
determine if a change in receivables is due to a change in sales, or to another factor such
as a change in selling terms. An analyst might compare the days' sales in receivables with
the company's credit terms as an indication of how efficiently the company manages its
receivables.
Accounts Receivable Turnover= Net Sales/Average Gross Receivables
Indicates the liquidity of the company's receivables.
Accounts Receivable Turnover in Days= Average Gross Receivable/(Annual Net
Sales/365)
Indicates the liquidity of the company's receivables in days.
Days' Sales in Inventory= Ending Inventory/(Cost of Goods Sold/365)
Indicates the length of time that it will take to use up the inventory through sales.
Inventory Turnover =Cost of Goods Sold/Average Inventory
Indicates the liquidity of the inventory
Inventory Turnover in Days= Average Inventory/(Cost of Goods Sold/365)
Indicates the liquidity of the inventory in days.
Operating Cycle= Accounts Receivable Turnover in Days + Inventory Turnover in Days
Indicates the time between the acquisition of inventory and the realization of cash from
sales of inventory. For most companies the operating cycle is less than one year, but in
some industries it is longer.
Days' Payables Outstanding= Ending Accounts Payable/ (Purchases/365)
Indicates how the firm handles obligations of its suppliers.
Payables Turnover= Purchases/Average Accounts Payable
Indicates the liquidity of the firm's payables.
Payables Turnover in Days= Average Accounts Payable/(Purchases/365)
Indicates the liquidity of the firm's payables in days.
Additional Ratios
Altman Z-Score
The Z-score model is a quantitative model developed in 1968 by Edward Altman to
predict bankruptcy (financial distress) of a business, using a blend of the traditional
financial ratios and a statistical method known as multiple discriminant analysis.
The Z-score is known to be about 90% accurate in forecasting business failure one year
into the future and about 80% accurate in forecasting it two years into the future.
Formula:
Z= [1.2*(Working Capital/Total Assets)] + [1.4*(Retained Earnings/Total Assets)] +
[0.6*(Market Value of Equity/Book Value of Debt)] + [0.999*(Sales/Total Assets)] +
[3.3* (EBIT/Total Assets)]

Z-score Probability of Failure

less than 1.8
greater than 1.81 but less than 2.99
greater than 3.0 Very High
Not Sure
Unlikely

Bad-Debt to Accounts Receivable Ratio= Bad Debts/Accounts Receivable

Bad-debt to Accounts Receivable ratio measures expected uncollectibility on credit sales.
An increase in bad debts is a negative sign, since it indicates greater realization risk in
accounts receivable and possible future write-offs.
Bad-Debt to Sales Ratio= Bad Debts/Sales
Bad-debt ratios measure expected uncollectibility on credit sales. An increase in bad
debts is a negative sign, since it indicates greater realization risk in accounts receivable
and possible future write-offs.
Book Value per Equity Share= (Total Stockholders' Equity - Liquidation Value of
Preference Shares-Preference Share Dividend in Arrears)/Equity Shares
Book value per common share is the net assets available to common stockholders divided
by the shares outstanding, where net assets represent stockholders' equity less preferred
stock. Book value per share tells what each share is worth per the books based on
historical cost.
Common Size Analysis
In vertical analysis of financial statements, an item is used as a base value and all other
accounts in the financial statement are compared to this base value.
On the balance sheet, total assets equal 100% and each asset is stated as a percentage of
total assets. Similarly, total liabilities and stockholder's equity are assigned 100%, with a
given liability or equity account stated as a percentage of total liabilities and stockholder's
equity.
On the income statement, 100% is assigned to net sales, with all revenue and expense
accounts then related to it.
Cost of Credit= [% of Discount/100-% of Discount]*[360/(Credit Period-Discount
Period)]
The cost of credit is the cost of not taking credit terms extended for a business
transaction. Credit terms usually express the amount of the cash discount, the date of its
expiration, and the due date. A typical credit term is 2 / 10, net / 30. If payment is made
within 10 days, a 2 percent cash discount is allowed: otherwise, the entire amount is due
in 30 days. The cost of not taking the cash discount can be substantial.
Example
On a Rs.1,000 invoice with terms of 2 /10 net 30, the customer can either pay at the end
of the 10 day discount period or wait for the full 30 days and pay the full amount. By
waiting the full 30 days, the customer effectively borrows the discounted amount for 20
days.
Rs.1,000 x (1 - .02) = Rs.980
This gives the amount paid in interest as:
Rs.1,000 - 980 = Rs.20
This information can be used to compute the credit cost of borrowing this money.
% Discount
100 - % Discount x 360
Credit Period - Discount Period
=2
98 x 360
20 = .3673
As this example illustrates, the annual percentage cost of offering a 2/10, net/30 trade
discount is almost 37%.
Current-Liability Ratios
Current to Non-current= Current Liabilities/Non-current Liabilities
Current to Total= Current Liabilities/Total Liabilities
Current-liability ratios indicate the degree to which current debt payments will be
required within the year. Understanding a company's liability is critical, since if it is
unable to meet current debt, a liquidity crisis looms. The following ratios are compared to
industry norms.
Rule of 72= 72/Rate of Return
A rule of thumb method used to calculate the number of years it takes to double an
investment.
Example
Paul bought securities yielding an annual return of 9.25%. This investment will double in
less than eight years because, 72/9.25=7.78 years
Ratio Analysis
Ratio Analysis is the most commonly used analysis to judge the financial strength of a
company. A lot of entities like research houses, investment bankers, financial institutions
and investors make use of this analysis to judge the financial strength of any company.
This analysis makes use of certain ratios to achieve the above-mentioned purpose. There
are certain benchmarks fixed for each ratio and the actual ones are compared with these
benchmarks to judge as to how sound the company is. The ratios are divided into various
categories, which are mentioned below:
Profitability ratios
Profitability ratios speak about the profitability of the company. The various profitability
ratios used in the analysis are, operating margin (operating profit divided by net sales),
gross margin (gross profit divided by net sales), net profit margin (net profit divided by
net sales), return on equity (net profit divided by net worth of the company) and return on
investment (operating profit divided by total assets). As obvious from the name, the
higher these ratios the better for the company.
Solvency ratios
These ratios are used to judge the long-term solvency of a firm. The most commonly used
ratios are – Debt Equity ratio (total debt divided by total equity), Long term debt to
equity ratio (long term debt divided by equity). While the accepted norm for debt equity
ratio differs from industry to industry, the usual accepted norm for D/E is 2:1. It should
not be more than this. For certain industries, a higher D/E is accepted, e.g., in banking
industry, a debt equity ratio of 12:1 is acceptable.
Turnover ratios
These ratios give an indication as to how efficiently a company is utilizing its assets. The
most commonly ratios are sales turnover ratio, inventory turnover ratio (average
inventory divided by net sales) and asset turnover ratio (net sales divided by total assets).
The higher these ratios, the better for the company.
Valuation Ratios
Valuation ratios give an indication as to whether the stock is under priced or overpriced
at any point of time. The most commonly used ratios are Price to Earnings (P/E) ratio and
price to book value (PBV) ratio. But care has to be taken while interpreting these ratios.
While P/E ratio of a company should be compared with the industry P/E and the P/E of
the competitors, it is the PBV that can distort.
While a lower PBV usually means a lower valuation, there can be a case where a low
PBV can be because of a very huge capital base of the company. In such a case, the stock
might be overvalued but the PBV will indicate that the stock is undervalued. On the other
extreme, a higher PBV usually means overvalued stock but that can also be because the
company has a very small capital base. So care has to taken while interpreting these
ratios.
Coverage ratios
These ratios give an indication about the repayment capabilities of a company. The most
commonly used coverage ratios are Interest coverage ratio (Interest outstanding divided
by earnings before interest and taxes) and debt service coverage ratio (earnings before
interest and taxes plus all non cash charges divided by interest outstanding plus the term
loan repayment installment). The acceptable norm for DSCR is 2:1.
Value Analysis
What is Fundamental Analysis?
Fundamental analysis is the analysis, wherein the investment decisions are taken on the
basis of the financial strength of the company. There are two approaches to fundamental
analysis, viz., E-I-C analysis or the Top Down approach to Fundamental analysis and C-
I-E analysis or the Bottom up approach. In the following section, we explain both these
approaches.
Economy-Industry-Company Analysis
In the Top down approach, first of all the overall Economy is analyzed to judge the
general direction, in which the economy is heading. The direction in which the economy
is heading has a bearing on the performance of various industries. That’s why Economy
analysis is important. The output of the Economy analysis is a list of industries, which
should perform well, given the general trend of the economy and also an idea, whether to
invest or not in the given economic conditions.
Measuring a Company's Financial Health
Gaining a true picture of a company's finances means not only scrutinizing the financial
statements but also analyzing relationships among various assets and liabilities, thus
highlighting trends in a company's performance and changes in its financial strength
relative to its competitors.
This section explains how to read a company's financial statements. Measures of value:
Book value is based on historical costs, not current values, but can provide an important
measure of the relative value of a company over time. Book value can be figured as
assets minus liabilities, or assets minus liabilities and intangible items such as goodwill;
either way, the figure that results is the company's net book value. This is contrasted with
its market capitalization, or total share price value, which is calculated by multiplying the
outstanding shares by their current market price.
You can also compare a company's market value to its book value on a per-share basis.
Divide book value by the number of shares outstanding to get book value per share and
compare the result to the current stock price to help determine if the company's stock is
fairly valued. Most stocks trade above book value because investors believe that the
company will grow and the value of its shares will, too. When book value per share is
higher than the current share price, a company's stock may be undervalued and a bargain
to investors. In fact, the company itself may be a bargain, and hence a takeover target.
Price/earnings ratio (P/E) is the more common yardstick of a company's value. It is the
current stock price divided by the earnings per share for the past year. For example, a
stock selling for Rs. 20 with earnings of Rs. 2 per share has a P/E of 10. While there's no
set rule as to what's a good P/E, a low P/E is generally considered good because it may
mean that the stock price has not risen to reflect its earning power. A high P/E, on the
other hand, may reflect an overpriced stock or decreasing earnings. As with all of these
ratios, however, it's important to compare a company's ratio to the ratios of other
companies in the same industry.
A measure of solvency
Debt-to-equity ratio provides a measure of a company's debt level. It is calculated by
dividing total liabilities by shareholders' equity. A ratio of 1-to-2 or lower indicates that a
company has relatively little debt. Ratios vary, however, depending on a company's size
and its industry, so compare a company's financial ratios with those of its industry peers
before drawing conclusions.
1. Introduction
Financial statement analysis involves analyzing the firm’s financial statements to extract
information that can facilitate decision-making. For example, an analysis of the financial
statement can reveal whether the firm will be able to meet its long-term debt
commitment, whether the firm is financially distressed, whether the company is using its
physical assets efficiently, whether the firm has an optimal financing mix, whether the
firm is generating adequate return for its shareholders, whether the firm can sustain its
competitive advantage etc; While the information used is historical, the intent is clearly to
arrive at recommendations and forecasts for the future rather than provide a “picture of
the past”.
The performance of a firm can be assessed by computing key ratios and analyzing: (a)
How is the firm performing relative to the industry? (b) How is the firm performing
relative to the leading firms in their industry? (c) How does the current year performance
compare to the previous year(s)? (d) What are the variables driving the key ratios? (e)
What are the linkages among the ratios? (f) What do the ratios reveal about the future
prospects of the firm for various stakeholders such as shareholders, bondholders,
employees, customers etc.? Merely presenting a series of graphs and figures will be a
futile exercise. We need to put the information in a proper context by clearly identifying
the purpose of our analysis and identifying the key data driving our analysis.
Financial analysis is performed by both internal management and external groups. Firms
would perform such an analysis in order to evaluate their overall current performance,
identify problem/opportunity areas, develop budgets and implement strategies for the
future. External groups (such as investors, regulators, lenders, suppliers, customers) also
perform financial analysis in deciding whether to invest in a particular firm, whether to
extend credit etc. There are several rating agencies (such as Moody’s, Standard & Poors)
that routinely perform financial analysis of firms in order to arrive at a composite rating.
2. Annual Reports and Financial Statements
The annual reports of companies typically contain: (a) CEO/President’s letter to
shareholders (b) Financial statements (c) Other information
(a) CEO/President’s letter summarizing the operations of last year, explanations for
good/bad performance, and a discussion on the goals for the immediate and long-term
future. It will be a good idea to review the letter to shareholders of some prominent
companies. Warren Buffet of Berkshire Hathaway is famous for writing the most
insightful letters.
(b) Four Financial Statements
The financial statements (typically published every quarter and annually) are prepared
according to GAAP and audited by “independent auditors”. However, as the recent
corporate scandals have revealed, there are definitely too many gaps/loopholes in how the
GAAP is implemented!!. Nonetheless, financial statements are an invaluable source of
information.
B1. Balance Sheet (also known as the Statement of Financial Position): This provides the
value of firm’s assets (what the firm owns), liabilities (what the firm owes to outsiders)
and equity (what the inside shareholders or owners own) on a particular date. The value
of assets will equal the value of liabilities plus owner’s equity (or A=L+E). Items in the
balance sheet are listed based on conservative principle i.e. if estimating or in doubt of
the actual value, the value of assets is not be overstated and the value of liabilities is not
be understated.
What do we see in the balance sheet? Assets: Current assets (e.g. cash, marketable
securities, accounts receivable, inventory, prepaid expenses) that are more liquid than the
long-term/fixed assets (e.g. equipment, land), assets that are intangible and yet valuable
(e.g. goodwill, patents, deferred charges). Liabilities could include current liabilities (e.g.
bank advances, income tax payable, accounts payable, accrued expenses), deferred
income taxes (difference between the tax reported on the income statement and tax
reported on the tax return), Minority interest in subsidiary companies (representing
outside ownership in subsidiary companies), long-term debt (e.g. Bonds, capital leases).
Shareholder’s Equity includes Share capital (par or stated value of shares received at the
time of original issue), Paid-in-capital (when shares are sold for more than the par or
stated value), retained earnings/deficit (undistributed earnings), foreign currency
translation adjustment (fluctuation in the value of assets of foreign subsidiaries due to
changes in exchange rates). Equity is also expressed as “residual interest” (E=A-L). If E
is negative, the firm is technically bankrupt.
Net worth or Book Value refers to what is available to equity shareholders and is given
by:
Total Assets – Total Liabilities – Preference Share Capital = Net Worth
Net worth divided by number of equity shares outstanding will give us the book value per
share. The market value is equal to the price per share times the number of shares
outstanding (also referred to as the market capitalization of a company). We can estimate
the intrinsic value of stock by using discounted cash flow models.
All assets (except Land) lose their value over time and this is accounted for through
depreciation (for fixed assets), depletion (for natural resources) and amortization (for
intangible assets/deferred charges).
Limitations of Balance Sheet: The balance sheet records the values of assets and
liabilities in terms of their original cost. This is especially misleading for fixed assets
(that could have significantly changed in value). Also, it is difficult to value intangible
assets. Current assets are less troublesome; partly because of their short-term nature
(inventories and marketable securities are listed at lower of their cost or market values).
Liabilities are also not biased (since they are generally contractual, and market values
will be equal to their book values; For example, if the company has taken a loan, the
dollar amount of loan obligation does not change with time). Also, an analyst should pay
close attention to “off-balance sheet items”.
B2. Income Statement (also known as the statement of earnings or profit & loss statement
or the statement of operations): The income statement provides information on the
various revenue and expense items during a certain period. Thus this statement shows the
total income generated in a certain period. Items in the income statement are based on
accrual principle i.e. transactions (such as sales) are recognized when they occur and not
when actual cash is received. Furthermore, the expenses are matched to when the revenue
is recognized and not when the actual payment is made. The above principle makes it
obvious that there could be wide discrepancy between a firm’s revenue and actual cash
flow.
There are several forms of income statement. An example of a generic form is as follows:
Sales Revenue - Cost of Good Sold = Gross Profit - Selling and Administrative expenses
- Depreciation = Earnings before Interest and Taxes (EBIT) - interest expenses (on bank
loans and bonds) + interest income = Earnings before Taxes (EBT) - taxes (current and
deferred) = Earnings after Taxes (EAT) + income from subsidiaries (equity income) +/-
Gains/Losses from discontinued operations +/- Gain/loss on extraordinary items = Net
Earnings – Preference Share Dividend = Earnings available for equity shareholders
Limitations of Income Statement: In Finance, the focus is on “valuation” that requires
knowledge of expected cash flows rather than historical earnings. Note net income does
not equal the actual cash flow. This is because the income statement reports
revenue/expenses when they are earned / accrued and not when actual cash is received.
Further, several items are subjectively determined (e.g. depreciation). Also, depreciation
is based on historical cost of the asset. Thus, during periods of inflation, depreciation
expense will be understated as it is based on historical cost while the revenues reflect the
current market price.... such non-synchronization leads to inflated earnings. Furthermore,
a traditional income statement only records transactions and not “opportunities”. “The
economist defines income as the change in real worth that occurs between the beginning
and the end of a specified time period. To the economist, an increase in the value of a
firm’s land as a result of a new airport being built on an adjacent property is an increase
in the real worth of the firm. It, therefore, represents income. The accountant does not
ordinarily employ such a broad definition of income”.
B3. Statement of Retained Earnings (also known as the Statement of changes in
shareholders’ equity or statement of shareholders’ investment): It shows the balance in
retained earnings after making adjustments for current profits and current dividend. It
also shows information on treasury stock, any new shares issued, the impact of exercised
options, preference shares details and additional paid-up-capital.
B4. Cash Flow Statement: It shows how the company obtained cash and for what purpose
they were used. Thus cash balance at the end = Cash in the beginning + Net Cash flow
from operating (income statement cash items) + Net Cash flow from financing (e.g.
proceeds from sale of bonds, repayment of loan, payment of dividend) + Net Cash flow
from investing activities (e.g. Sale/purchase of asset).
(c) Other information in the annual report
1. Notes to financial statements
2. The Auditor’s report
3. What You Need to Know About Financial Statements
Frequent Restructuring Charges and Write-Downs - As businesses adjust their internal
structure, they incur costs for shutting down one activity and starting another. In a small
company, charges for these activities would occur infrequently, but in a large company,
they will be routine. If charges and write downs for restructurings occur regularly, the
company may be classifying normal business expenses as extraordinary to create the
illusion that the core business is more profitable than it really is.
Reserve reversals - Companies generally establish reserves to cover the costs of
restructuring. Reserves allow management to "store profits" for later use if the reserves
are unusually large. At a later time, they can reverse the reserve for the amount that was
not spent and it flows directly to the bottom line.
Pension Funds - are great sources of earnings manipulation. Boost earnings by under
funding them or by overestimating the investment return of the fund so that current
payments will be lower and profits higher. If the fund does particularly well, pull the
excess back into the income statement to boost profits.
Footnotes to Financial Statements - Statements can mislead and evade but they must
come clean in the footnotes or face criminal charges. That’s why the pros look here first.
You will learn about risk exposure, debt that changes character under certain conditions,
the use of aggressive accounting practices and all sorts of other details that management
would like to avoid telling you.
Sales/Non-Sales - Look at the revenue and receivable numbers over several years. Is the
ratio of receivables to sales increasing? If yes, then the company is shipping goods faster
than customers are paying for them. Are deferred revenues dropping? If so, the company
is living off last year’s sales. In the current slowdown, customers look to change sales
terms to use the supplier’s money as much as possible by acknowledging the sale as late
as possible.
Cash Flow - The pros know that it is too easy to manipulate earnings numbers. So they
focus on cash flow as being a more reliable indicator of performance because the cash is
either there or it isn’t.
Acquire the company’s financial statements for several years. As a minimum, get the
following statements, for at least 3 to 5 years.
• Balance sheets
• Income statements
• Shareholders equity statements
• Cash flow statements
Quickly scan all of the statements to look for large movements in specific items from one
year to the next. For example, did revenues have a big jump, or a big fall, from one
particular year to the next? Did total or fixed assets grow or fall? If you find anything that
looks very suspicious, research the information you have about the company to find out
why. For example, did the company purchase a new division, or sell off part of its
operations, that year?
Review the notes accompanying the financial statements for additional information that
may be significant to your analysis.
Examine the balance sheet. Look for large changes in the overall components of the
company's assets, liabilities or equity. For example, have fixed assets grown rapidly in
one or two years, due to acquisitions or new facilities? Has the proportion of debt grown
rapidly, to reflect a new financing strategy? If you find anything that looks very
suspicious, research the information you have about the company to find out why.
Examine the income statement. Look for trends over time. Calculate and graph the
growth of the following entries over the past several years.
• Revenues (sales)
• Net income (profit, earnings)
Are the revenues and profits growing over time? Are they moving in a smooth and
consistent fashion, or erratically up and down? Investors value predictability, and prefer
more consistent movements to large swings.
For each of the key expense components on the income statement, calculate it as a
percentage of sales for each year. For example, calculate the percent of cost of goods sold
over sales, general and administrative expenses over sales, and research and development
over sales. Look for favorable or unfavorable trends. For example, rising G&A expenses
as a percent of sales could mean lavish spending. Also, determine whether the spending
trends support the company’s strategies. For example, increased emphasis on new
products and innovation will probably be reflected by an increased proportion of
spending on research and development.
Look for non-recurring or non-operating items. These are "unusual" expenses not directly
related to ongoing operations. However, some companies have such items on almost an
annual basis. How do these reflect on the earnings quality?
If you find anything that looks very suspicious, research the information you have about
the company to find out why.
Examine the shareholder's equity statement. Has the company issued new shares, or
bought some back? Has the retained earnings account been growing or shrinking? Why?
Are there signals about the company's long-term strategy here?
If you find anything that looks very suspicious, research the information you have about
the company to find out why.
Examine the cash flow statement, which gives information about the cash inflows and
outflows from operations, financing, and investing.
While the income statement provides information about both cash and non-cash items,
the cash flow statement attempts to reconstruct that information to make it clear how cash
is obtained and used by the business, since that is what investors and creditors really care
about.
If you find anything that looks very suspicious, research the information you have about
the company to find out why.
Financial Ratio Analysis
A popular way to analyze the financial statements is by computing ratios. A ratio is a
relationship between two numbers, e.g. ratio of A: B = 30:10==> A is 3 times B. A ratio
by itself may have no meaning. Hence, a given ratio is compared to (a) ratios from
previous years - internal trends, or (b) ratios of other firms in the same industry - external
trends. Ratios are more of a diagnostic tool that helps us to identify problem areas and
opportunities within a company. In this section, we will discuss how to measure and
interpret some key ratios. Obviously, since ratio is simply a comparison of two variables,
the possibilities for number of ratios are endless! There is no “one” way of classifying
various ratios so you may find different groupings depending on what text or article you
read. Also, there are no specific rules on what is an “ideal or acceptable” number for a
ratio, although there are some rules of thumb. Calculate financial ratios in each of the
following categories, for each year.
• Leverage (or debt) ratios
• Profitability ratios
• Efficiency ratios
• Value ratios
Graph the ratios over time, to find the trends in the ratios from year to year. Are they
going up or down? Is that favorable or unfavorable? This should trigger further questions
in your mind, and help you to look for the underlying reasons.
Obtain data for the company’s key competitors, and data about the industry.
For competitor companies, you can get the data and calculate the ratios in the same way
you did for the company being studied.
Compare the ratios for the competitors and the industry to the company being studied. Is
the company favorable in comparison? Do you have enough information to determine
why or why not? If you don’t, you may need to do further research.
Review the market data you have about the company’s stock price, and the price to
earnings (P/E) ratio. Try to research and understand the movements in the stock price and
P/E over time. Determine in your own mind whether the stock market is reacting
favorably to the company’s results and its strategies for doing business in the future.
Review the evaluations of stock market analysts.
Review the dividend payout. Graph the payout over several years. Determine whether the
company’s dividend policies are supporting their strategies. For example, if the company
is attempting to grow, are they retaining and reinvesting their earnings rather than
distributing them to investors through dividends? Based on your research into the
industry, are you convinced that the company has sufficient opportunities for profitable
reinvestment and growth, or should they be distributing more to the owners in the form of
dividends? Viewed another way, can you learn anything about their long-term strategies
from the way they pay dividends?
Review all of the data that you have generated. You will probably find that there is a mix
of positive and negative results. Answer the following question:
“Based on everything I know about this company and its strategies, the industry and the
competitors, and the external factors that will influence the company in the future, do I
think this company is worth investing in for the long term?”
A popular way to analyze the financial statements is by computing ratios. A ratio is a
relationship between two numbers, e.g. ratio of A: B = 1.5:1 ==> A is 1.5 times B. A
ratio by itself may have no meaning. Hence, a given ratio is compared to:
• Ratios from previous years for internal trends
• Ratios of other firms in the same industry for external trends
Ratio analysis is a diagnostic tool that helps to identify problem areas and opportunities
within a company. The most frequently used ratios by Financial Analysts provide insights
into a firm's-
• Liquidity
• Degree of financial leverage or debt
• Profitability
• Efficiency
• Value
D. Analyzing Efficiency
These ratios reflect how well the firm’s assets are being managed. The inventory ratios
show how fast the inventory is being produced and sold. Ratio #1 shows how quickly the
inventory is being turned over (or sold) to generate sales ... higher ratio implies the firm
is more efficient in managing inventories by minimizing the investment in inventories.
Thus a ratio of 12 would mean that the inventory turns over 12 times or the average
inventory is sold in a month. Obviously, this ratio should be higher for WAWA (selling
perishable goods) relative to a VW car dealer. Some texts prefer to use “ending
inventory” rather than “average inventory”. High ratio by itself does not mean high level
of efficiency as high ratio could also mean shortages. Ensure that there has been no
change in inventory reporting policy (LIFO, FIFO) during the analysis period. Ratio #2 is
referred to as the “shelf-life” i.e. how many days the inventory was held in the shelf.
Ratio #3 shows how much sales the firm is generating for every dollar of investment in
assets … naturally, higher the better. However, note that this ratio is biased (as assets are
listed at historical costs while sales are based on current prices). Ratios #4 and #5 show
the firm’s efficiency in collecting from credit sales. While a low ratio is good it could
also mean that the firm is being very strict in its credit policy, which may drive away
some customers. Ratios #6 and 7 focus on efficiency in making payments. Combining
inventories, accounts receivable and accounts payable we get ratio #8, which shows the
financing period to fund working capital needs. Longer the period, greater the short-term
liquidity risk.
The inventory ratios show how fast the inventory is being produced and sold.
1. Inventory Turnover = Cost of Goods Sold / Average Inventory
Days in Inventory = (Average Inventory/Cost of Sales)*365
Days in Inventory = Days in a year / Inventory turnover
Ratio #5 is referred to as the “shelf-life” i.e. how quickly the manufactured product is
sold off the shelf. Thus #5 and #1 are related.
This ratio shows how quickly the inventory is being turned over (or sold) to generate
sales. A higher ratio implies the firm is more efficient in managing inventories by
minimizing the investment in inventories. Thus a ratio of 12 would mean that the
inventory turns over 12 times, or the average inventory is sold in a month.
2. Total Assets Turnover = Net Sales / Average Total Assets
This ratio shows how much sales the firm is generating for every dollar of investment in
assets. The higher the ratio, the better the firm is performing.
3. Accounts Receivable Turnover = Annual Credit Sales / Average Receivables
4. Average Collection period= (Average Accounts Receivable/Net Sales)*365
Ratios #3 and #4 show the firm’s efficiency in collecting cash from its credit sales. While
a low ratio is good, it could also mean that the firm is being very strict in its credit policy,
which may not attract customers.
5. Accounts Payable turnover = Purchases / Accounts Payable
6. Days AP outstanding = (Accounts Payable / Cost of Sales)*365
7. Financing Period= Average Collection period + days in inventory – days AP
outstanding
E. Value Ratios
Earnings per share (EPS) are widely reported although it is now less closely followed
(after academic theory insights into the drawback of EPS and importance of cash flow
based measures). SEC requires that the company report both basic and diluted EPS. Basic
EPS uses the actual number of shares currently outstanding in the market while diluted
EPS uses currently outstanding shares + all potential shares (due to convertibility of debt
or preferred stock as well as exercise of stock options, rights and warrants). Dividend
yield, while widely reported, may not contain much useful information by itself
(especially when comparing across firms) since dividend policies vary across firms.
Furthermore, price appreciation (as opposed to dividends) is the more important source of
yield for shareholders.
Value ratios such as PE ratio show the “embedded value” in stocks and are used by the
investors as a screening device before making their investment. For example, a high P/E
ratio may be regarded by some as being a sign of “over pricing”. When the markets are
bullish or if the investor sentiment is optimistic about a particular stock, the P/E ratio will
tend to be high indicating that investors are willing to pay a high price for company’s
earnings. For example, in late 1990s internet stocks had extremely high P/E ratios
(despite their lack of earnings) reflecting investor’s optimism about the future prospects
of these companies. Of course, the burst of the bubble showed that such confidence was
misplaced. PS ratio can be combined with PE ratio to analyze a company. Ratio #7 is
useful for valuing companies such as internet services or cable services that rely
primarily on members to generate income. Thus an assessment of members (total
members, current and future expected growth rate, and average spending by member) can
provide useful guideline in valuing such companies (especially when planning
acquisitions).
1. Earning per Share (EPS) = (Net Earning – Preference Share Dividend) / No. of equity
shares
2. Earning Yield = 1 / EPS
3. Cash flow per Share (CPS) = Net Cash Flows / No. of shares
4. Dividend Yield = Annual Dividend / Current Market price
5. Price-earning Ratio (PE) = Market Price per share / EPS
6. Price-Sales Ratio (PS) = Market price per share / Sales per share
7. Membership Value = No. of members * value per member
8. Free CF per share = (Net Cash flow from Operations – Capital Expenditure) / No. of
shares
9. Total Shareholder Return (TSR) = (Ending Price + Dividend – Beginning Price) /
Beginning Price
10. EVA = EAT – Cost of Financing (that is, Net Capital Assets Employed * WACC)
These ratios reflect how well the firm’s assets are being managed.
Value ratios show the “embedded value” in stocks, and are used by investors as a
screening device before making investments.
For example, a high P/E ratio may be regarded by some as being a sign of “over pricing”.
When the markets are bullish (optimistic) or if investor sentiment is optimistic about a
particular stock, the P/E ratio will tend to be high. For example, in the late 1990s Internet
stocks tended to have extremely high P/E ratios, despite their lack of profits, reflecting
investors' optimism about the future prospects of these companies. Of course, the burst of
the bubble showed that such confidence was misplaced.
On the other hand, a low P/E ratio may show that the company has a poor track record.
On the other hand, it may simply be priced too low based on its potential earnings.
Further investigation is required to determine whether the company would then provide a
good investment opportunity.
F. Uses and Limitations of Ratio analysis
Uses
1. To evaluate performance, compared to previous years and to competitors and the
industry
2. To set benchmarks or standards for performance
3. To highlight areas that need to be improved, or areas that offer the most promising
future potential
4. To enable external parties, such as investors or lenders, to assess the creditworthiness
and profitability of the firm
Limitations
1. There is considerable subjectivity involved, as there is no “correct” number for the
various ratios. Further, it is hard to reach a definite conclusion when some of the ratios
are favorable and some are unfavorable.
2. Ratios may not be strictly comparable for different firms due to a variety of factors
such as different accounting practices or different fiscal year periods. Furthermore, if a
firm is engaged in diverse product lines, it may be difficult to identify the industry
category to which the firm belongs. Also, just because a specific ratio is better than the
average does not necessarily mean that the company is doing well; it is quite possible rest
of the industry is doing very poorly.
3. Ratios are based on financial statements that reflect the past and not the future. Unless
the ratios are stable, it may be difficult to make reasonable projections about future
trends. Furthermore, financial statements such as the balance sheet indicate the picture at
“one point” in time, and thus may not be representative of longer periods.
4. Financial statements provide an assessment of the costs and not value. For example,
fixed assets are usually shown on the balance sheet as the cost of the assets less their
accumulated depreciation, which may not reflect the actual current market value of those
assets.
5. Financial statements do not include all items. For example, it is hard to put a value on
human capital (such as management expertise). And recent accounting scandals have
brought light to the extent of financing that may occur off the balance sheet.
6. Accounting standards and practices vary among countries, and thus hamper
meaningful global comparisons.
7. Management decision making is a dynamic process in a constantly changing
environment while ratio analysis is a static analysis based on historical data.
8. The linkage among various ratios is not readily obvious.
Cash Flow Curries
Think of cash as the lifeblood of every business. Without cash flow, no business can
function and without an accurate picture of cash flow, no investor can have a complete
picture of a company.
A company's statement of cash flows reflects how readily the business can pay its bills,
and it provides important information about a company's sources and uses of cash. But
measuring cash flow solely from a balance sheet or an income statement is difficult and
potentially misleading. That's because not all revenue is received when a company earns
it, and not all expenses are paid when incurred. (For an explanation of financial
statements, see "What's the Deal with Financial Statements?" plus "Understanding the
Income Statement" and "How to Read a Balance Sheet," presented earlier in this series.)
The difference between an income statement and a statement of cash flows is roughly
analogous to the difference between a credit card statement and a checkbook ledger. A
credit card statement includes charges that haven't been paid off yet, while an updated
checkbook ledger indicates where cash has been spent and whether there's enough to pay
off debts like a credit card bill. Similarly, a company's expenses and revenues are
recorded on an income statement, regardless of whether cash has changed hands yet. A
statement of cash flows, on the other hand, traces where cash came from and where it was
used.
The statement also separates cash generated by the normal operations of a company from
that gleaned through other investing and financing activities, as seen in the sample
statement of cash flows of the hypothetical XYZ Corp.
Cash flow from operations:
Cash flow from operations starts with net income (from the income statement) and
adjusts out all of the non-cash items. Income and expenses on the income statement are
recorded when a company earns revenue or incurs expenses, not necessarily when cash is
received or paid. To figure out how much cash the company received or spent; net
income is adjusted for any sales or expenditures made on credit and not yet paid with
cash.
Examples of these adjustments are shown above. XYZ had Rs. 20 million in sales to
customers who had not paid the company as of the end of the year, so this increase in
receivables is subtracted. XYZ also reported Rs.15 million in depreciation expense (the
portion of long-lasting assets, such as buildings, that is written off each year);
depreciation is not a cash item, so it is added back. Finally, XYZ purchased Rs.10 million
of additional inventory that was not sold as of year end. Because the inventory was not
sold, it is not considered an expense. But because cash was used in the purchase, the
Rs.10 million is subtracted from net income. Net cash received from XYZ's operations,
after the above adjustments, was Rs.15 million.
Cash flow from investing
Cash flow from investing includes cash received from or used for investing activities,
such as buying stocks in other companies or purchasing additional property or equipment.
XYZ Corp. had no cash receipts from investing in 1999 but spent Rs.150 million to
purchase equipment.
Cash flow from financing
Cash flow from financing activities includes cash received from borrowing money or
issuing stock and cash spent to repay loans. XYZ Corp. received Rs.100 million in cash
from issuing bonds in 1999.
Sizing up operating performance
Of the three main sources of cash flow, analysts look to that from operations as the most
important measure of performance. If operations alone don't generate positive cash flow,
that may be cause for concern. In addition, a decrease in cash flow due to a sharp increase
in inventory or receivables can signal that a company is having trouble selling products or
collecting money from customers. However, analysts look at the relative amount of these
changes if accounts receivable have gone up by the same percentage as sales revenues,
the increase may not be unusual.
Company Valuation
Whenever people talk about equity investments, one must have come across the word
"Valuation". In financial parlance, Valuation means how much a company is worth of.
Talking about equity investments, one should have an understanding of valuation.
Valuation means the intrinsic worth of the company. There are various methods through
which one can measure the intrinsic worth of a company. This section is aimed at
providing a basic understanding of these methods of valuation. They are mentioned
below:
Net Asset Value (NAV)
NAV or Book value is one of the most commonly used methods of valuation. As the
name suggests, it is the net value of all the assets of the company. If you divide it by the
number of outstanding shares, you get the NAV per share.
One way to calculate NAV is to divide the net worth of the company by the total number
of outstanding shares. Say, a company’s share capital is Rs. 100 crores (10 crores shares
of Rs. 10 each) and its reserves and surplus is another Rs. 100 crores. Net worth of the
company would be Rs. 200 crores (equity and reserves) and NAV would be Rs. 20 per
share (Rs. 200 crores divided by 10 crores outstanding shares).
NAV can also be calculated by adding all the assets and subtracting all the outside
liabilities from them. This will again boil down to net worth only. One can use any of the
two methods to find out NAV.
One can compare the NAV with the going market price while taking investment
decisions.
Discounted Cash Flows Method (DCF)
DCF is the most widely used technique to value a company. It takes into consideration
the cash flows arising to the company and also the time value of money. That’s why, it is
so popular. What actually happens in this is, the cash flows are calculated for a particular
period of time (the time period is fixed taking into consideration various factors). These
cash flows are discounted to the present at the cost of capital of the company. These
discounted cash flows are then divided by the total number of outstanding shares to get
the intrinsic worth per share.

Financial Performance
What Does Financial Performance Mean?
A subjective measure of how well a firm can use assets from its primary mode of
business and generate revenues. This term is also used as a general measure of a firm's
overall financial health over a given period of time, and can be used to compare similar
firms across the same industry or to compare industries or sectors in aggregation.

Investopedia explains Financial Performance

There are many different ways to measure financial performance, but all measures should
be taken in aggregation. Line items such as revenue from operations, operating income or
cash flow from operations can be used, as well as total unit sales. Furthermore, the
analyst or investor may wish to look deeper into financial statements and seek out margin
growth rates or any declining debt.