Ratio Analysis

Lecture 12 & 13 Required: Carry Annual Reports

Objectives of Ratio Analysis

Standardize financial information for comparisons Evaluate current operations Compare performance with past performance Compare performance against other firms or industry standards Study the efficiency of operations Study the risk of operations

Rationale Behind Ratio Analysis

A firm has resources It converts resources into profits through
production of goods and services sales of goods and services

Ratios
Measure relationships between resources and financial flows Show ways in which firm s situation deviates from
Its own past Other firms The industry

Some Limitations
Ratios are valuable analytical tools and serve as screening devices, but they
do not provide answers in and of themselves are not predictive should be used with other elements of financial analysis

Key Financial Ratios

Five categories of ratios Liquidity ratios Activity ratios Leverage ratios Profitability ratios Market ratios

Key Financial Ratios Liquidity Ratios

Liquidity ratios measure a firm s ability to meet cash needs as they arise. Liquidity ratios include
current ratio quick or acid-test ratio cash flow liquidity ratio average collection period days inventory held days payable outstanding

Liquidity Ratios Short-Term Solvency

Current Ratio Measures the ability of a firm to meet debt requirements as they come due Current assets Current liabilities

What is the Current Ratio? But is the company healthy?

Traditional Analysis # 1

Traditional Analysis # 2

Liquidity Ratios Short-Term Solvency

Quick or Acid-Test Ratio Measures ability to meet short-term cash needs more rigorously by eliminating inventory Current assets - Inventory Current liabilities

What if Quick Ratio is low

Mc Donalds v/s Audi

Liquidity Ratios Short-Term Solvency

Cash Flow Liquidity Ratio Focuses on ability of the firm to generate operating cash flows as a source of liquidity Cash + Marketable securities + CFO * Current liabilities
*Cash flow from operating activities

Liquidity Ratios Short-Term Solvency

Average Collection Period
In absence of actual information on each transaction With the help of public data ACP Helps gauge liquidity of accounts receivable (ability to collect cash from customers) and may help provide information about a company s credit policies

Net accounts receivable Average daily sales

Or 2 Steps
Receivables Turnover ratio = Sales/AR How many times your company earns money currently owed by your debtors No. of days in a year / Receivable Turnover Ratio Consider this as the no. of days your debtors take to pay

ACP indicator of credit granting policies of a company. If your ACP is higher than industry average? Your policies may be lenient or your customers may be running into financial troubles. Note different formulae could be used. But you need to be consistent to get valid results.

Liquidity Ratios Short-Term Solvency

Days Inventory Held / Inventory Conversion Period
Measures the efficiency of the firm in managing its inventory; How fast can you convert it into sales (AR or Cash)

Inventory Average daily cost of goods sold

2 Step Method
Inventory Turnover Ratio = COGS / Average Inventory COGS = 1.2million and Avg. Inventory = 0.1 million ITR = 12 It means you turnover inventory 12 times in a year or once every month; Or 365/12 = 30 days = No. of days it takes a company to convert inventory to AR or Cash

Liquidity Ratios Short-Term Solvency

Days Payable Outstanding Offers insight into a firm s pattern of payments to suppliers Accounts payable Average daily cost of goods sold

Operating Cycle
The operating cycle: time interval between arrival of inventory stock and date when cash is collected from receivables Equal to inventory period plus accounts receivable period

Cash Conversion Cycle

Time it takes an entity to collect cash that has already been disbursed. CCC = Inventory Conversion Period + Receivables Conversion Period Payables Conversion Period

CCC
For a service-based company ICP = 0; hence CCC = RCP - PCP Is negative CCC possible? Yes, if the company receives down payment and collects advance before producing. ICP = RCP = 0; CCC = -PCP

Account Receivables Turnover

The ratio is sometimes seasonally affected, rising during busy seasons and falling during the off-season. To account for this seasonality, the average accounts receivable ((beginning + ending accounts receivable)/2) could be used instead. Similarly Inventory Turnover Ratio and Accounts Payable Turnover

Example
ABC Inc. had COGS of $200 million and credit sales of $240 million in 1998. The following data are from its balance sheets. 12/31/97 12/31/98 Inventory 40 60 Accounts receivable 30 50 Accounts payable 10 30 How many days is ABC s operating and cash cycle?

How many days is ABC s operating cycle?

Inventory period = [ { (40 + 60) / 2} / 200 ] * 365 = 91.25 days Receivables period = [ { (30 + 50) / 2 } / 240 ] * 365 = 60.83 days Operating cycle = 152.08 days

How many days is ABC s cash cycle?

Accounts payable period = [ { (10 +30) / 2} / 200 ] * 365 = 36.5 Cash cycle = 115.58 days

Key Financial Ratios Activity Ratios

Activity ratios measure the liquidity of specific assets and the efficiency of managing assets. Activity ratios include
accounts receivable turnover inventory turnover accounts payable turnover fixed asset turnover total asset turnover

Activity Ratios: Asset Liquidity, Asset Management Efficiency

Accounts Receivable Turnover Measures efficiency of firm s collection and credit policies Net sales Net accounts receivable

Activity Ratios: Asset Liquidity, Asset Management Efficiency

Inventory Turnover Measures firm s efficiency in managing its inventory. Cost of goods sold Inventory

 A low turnover is usually a bad sign because products tend to deteriorate as they sit in a warehouse. Companies selling perishable items have very high turnover. Tradeoff Companies with high inventory turnover generally have low profit margins and vice versa Average inventory accounts for any seasonality effects on the ratio.

Activity Ratios: Asset Liquidity, Asset Management Efficiency

Accounts Payables Turnover Helps to gain insight into a firm s pattern of payment to suppliers Cost of goods sold Accounts payable

Activity Ratios: Asset Liquidity, Asset Management Efficiency

Fixed Asset Turnover Assesses effectiveness in generating sales from investments in fixed assets Net sales Net property, plant, equipment

 A higher fixed-asset turnover ratio shows that the company has been more effective in using the investment in fixed assets to generate revenues. Often used as a measure in manufacturing industries When companies make these large purchases, prudent investors watch this ratio in following years to see how effective the investment in the fixed assets was.

Activity Ratios: Asset Liquidity, Asset Management Efficiency

Total Asset Turnover Assesses effectiveness in generating sales from investments in all assets Net sales Total assets

Pricing Strategy
Ratio determines the amount of sales that are generated from each dollar of assets Companies with low profit margins tend to have high asset turnover, those with high profit margins have low asset turnover In the retail industry you would expect a very high turnover ratio - mainly because of cutthroat and competitive pricing This ratio is more useful for growth companies to check if in fact they are growing revenue in proportion to assets.

Model 3 Financial Indicators

From the data provided calculate ratios in Excel as we proceed It facilitates automatic calculation specially while analysing vast number of companies. Example

Debt Related Issues

When is a firm said to default? Why is a bankruptcy code required? What is Chapter 7-liquidation? What is Chapter 11-reorganization? Corporate Insolvency in India - Winding up of the company under the Companies Act, 1956 BIFR, SICA, Sick Industrial Companies (Special Provisions) Repeal Act, 2003. What are the Ex-Ante and Ex-Post Costs of Financial Distress?

Key Financial Ratios Leverage Ratios

Leverage ratios measure the extent of a firm s financing with debt relative to equity and its ability to cover interest and other fixed charges. Keep reasons for change in capital structure ready for analysis.

Key Financial Ratios Leverage Ratios

Leverage ratios include
Debt ratio Long-term debt to total capitalization Debt to equity Times interest earned Fixed charge coverage Cash flow adequacy

Leverage Ratios Debt Financing and Coverage

Debt Ratio or Debt-Asset Ratio Considers the proportion of all assets that are financed with debt Total liabilities Total assets

Leverage Ratios Debt Financing and Coverage

Long-term Debt to Total Capitalization Reveals the extent to which long-term debt is used for the firm s permanent financing (both long-term debt and equity) Long term debt LongLong-term debt + Stockholders equity

Leverage Ratios: Debt Financing and Coverage (cont.)

Debt to Equity Measures the riskiness of the firm s capital structure in terms of the relationship between the funds supplied by creditors (debt) and investors (equity) Total liabilities Stockholders equity

 A ratio under 1 means a majority of assets are financed through equity, above 1 means they are financed more by debt. Furthermore you can interpret a high ratio as a "highly debt leveraged firm". If the ratio is high (financed more with debt) then the company is in a risky position especially if interest rates are on the rise.

Leverage Ratios Debt Financing and Coverage

Times Interest Earned Indicates how well operating earnings cover fixed interest expenses Operating profit Interest expense

 A ratio under 1 means that the company is having problems generating enough cash flow to pay its interest expenses. Ideally you want the ratio to be over 1.5. When is the ratio infinity?

Leverage Ratios Debt Financing and Coverage

Cash Interest Coverage Measures how many times interest payments can be covered by cash flow from operations before interest and taxes

CFO + interest paid + taxes paid Interest paid

Leverage Ratios Debt Financing and Coverage

Fixed Charge Coverage Broader measure of how well operating earnings cover fixed charges Operating profit + Rent expense Interest expense + Rent expense
*Rent expense = operating lease payments

Leverage Ratios Debt Financing and Coverage

Cash Flow Adequacy Measures firm s ability to cover capital expenditures, long-term debt payments and dividends each year Cash flow from operating activities Capital expenditures + debt repayments + dividends paid

Setting Target Capital Structure: A Checklist

Taxes Does the company benefit from debt tax shields? Expected Distress Costs Cash flow volatility and potential for increase Need for external funds for investment Competitive threat if pinched for cash Customers care about distress Hard to redeploy assets

Does the checklist explain observed ratios?

INDUSTRY ELECTRIC AND GAS FOOD PRODUCTION PAPER AND PLASTIC EQUIPMENT RETAILERS CHEMICALS COMPUTER SOFTWARE DEBT RATIO % 43.2 22.9 30.4 19.1 21.7 17.3 3.5

What does the checklist explain?

Explains capital structure difference at broad level e.g. between Electric and Gas (43.2%) and Computer Software (3.5%). In general, industries with more volatile cash flows tend to have lower leverage. Probably not so good at explaining small difference in debt ratios e.g. between Food Production (22.9%) and Manufacturing Equipment (19.1%) Other factors such as sustainable growth are also important.

Key Points
Recall the tension in Cullum between product market goals (fast goals) and financial goals (modest leverage) Fast growing companies reluctant to issue equity end up with debt ratios greater than the target implied by the checklist Slow growing companies reluctant to buy back equity or increase dividends end up with debt ratios below the target implied by the checklist.

Key Points
O.K. to stray somewhat from target capital structure But keep in mind: Fast growth companies that stray too far from the target with excessive leverage, risk financial distress. Ultimately, must have a consistent product market strategy and financial strategy.

Key Financial Ratios Profitability Ratios

Profitability ratios measure the overall performance of a firm and its efficiency in managing assets, liabilities, and equity.

Key Financial Ratios Profitability Ratios

Profitability ratios include
gross profit margin operating profit margin net profit margin cash flow margin return on total assets (ROA) or return on investment (ROI) return on equity (ROE) cash return on assets

Profitability Ratios Overall Efficiency and Performance

Gross Profit Margin Measures ability of a company to control costs of inventories or manufacturing of products and to pass along price increases through sales to customers Gross profit Net sales

Profitability Ratios
Overall Efficiency and Performance
Operating Profit Margin Measures overall operating efficiency and incorporates all of the expenses associated with ordinary business activities Operating profit Net sales

Profitability Ratios
Overall Efficiency and Performance
Net Profit Margin Measures profitability after consideration of all revenue and expense, including interest, taxes, and nonoperating items Net earnings Net sales

Profitability Ratios
Overall Efficiency and Performance
Cash Flow Margin Measures ability to translate sales into cash

Cash flow from operating activities Net sales

Profitability Ratios
Overall Efficiency and Performance
Return on Total Assets (ROA) or Return on Investment (ROI) Measures overall efficiency of firm in managing investment in assets and generating profits Net earnings Total assets

Profitability Ratios
Overall Efficiency and Performance
Return on Equity (ROE) Measures rate of return on stockholders investment Net earnings (Average) Stockholders equity

Profitability Ratios
Overall Efficiency and Performance
Cash Return on Assets Measures firm s ability to generate cash from the utilization of its assets

Cash flow from operating activities Total assets

Key Financial Ratios Market Ratios

Market ratios measure returns to stockholders and the value the marketplace puts on a company s stock. Market ratios include earnings per common share price-toprice-to-earnings dividend payout dividend yield EV/EBITDA & PEG

Market Ratios Earnings per Common Share

Earnings per Common Share Provides the investor with a common denominator to gauge investment returns Net earnings Preference Dividend Average equity shares outstanding

Market Ratios Price-to-Earnings

Price-to-Earnings Relates earnings per common share to the market price at which the stock trades. Multiple expresses the value that the stock market places on a firm s earnings. Market price of common stock Earnings per share

Calculate p/e
A current price of the stock ABC is Rs.35 per share and the companies earnings for the prior 12 months or fiscal year is Rs.3.5 a share. P/E = 10 This no. can be thought of as the number of years it will take the company ABC to earn back the amount of your initial investment, assuming of course the company s earnings stay constant.

To explain that
Take the same example Lets say you buy 100 shares of the ABC stock for Rs.3500. Current earnings are Rs.3.5 so your 100 shares will earn Rs.350 in one year. The original investment of Rs.3500 will be earned back in 10 years. However you don t have to go through this exercise because the p/e ratio of 10 tells you its 10 years.

 If you buy shares in a company selling at 2 times earnings, you will earn your initial investment in 2 years, but in a company selling at 40 times earnings, it would take 40 years to accomplish the same thing. With all the low p/e opportunities around why would anybody buy a stock with a higher p/e? - Because corporate earnings do not stay constant

Bargain Hunters Strategy: Buy all stocks with low p/e s say (ard 8)
Does this strategy make sense? No! What s bargain p/e for a FMCG is nt necessarily the same as a bargain p/e for a IT company.

Ranges
Lowest p/e levels tend to be lowest for the slow growers and highest for high growers with cyclical stocks oscillating in between Let us try to categorize sectors by finding average p/e of industry.

Peter Lynch says

It is silly to get bogged down in p/e s but you don t want to ignore them this company is selling at a discount to the industry meaning its p/e is at a bargain level Before you buy a stock, you might want to track its p/e ratio back through several years to get a sense of its normal levels. E.g. If you buy Infosys, its useful to know whether what you re paying for the earnings is in line with what others have paid for the earnings in the past. The p/e ratio can tell you that.

Few cases
Premise: A company with a high p/e must have incredible earnings growth to justify the high price that s been put on the stock. 1972, Mc Donald s was the same great company it had always been, but the stock was bid up to $75 a share, which gave it a p/e of 50. There was no way that Mc. Donald s could live up to those expectations, the stock fell from $75 to $25, sending back the P/E to a more realistic 13. There was nothing wrong with McD. The stock was simply overpriced.

Electronic Data Systems

Hot stock in the late 1960s. This company had a P/E of 500! It would take 5 centuries to make back your investment in EDS, if earnings stayed constant. A brokerage report on the company said: P/E was conservative because EDS ought to have a P/E of 1000.

What is the flaw?

Years that followed, EDS performed very well. The earnings and sales grew dramatically, everything it did was a whopping success. EDS, the stock, was another story. The price declined from $40 to $3 in 1974, not because there was anything amiss at head-quarters, but because stock was very overpriced.

 High PE Shares are those shares on which investors/traders have high confidence During bull markets they are normally stocks of day E.g. Educomp, GMR Infra during 2007

The P/E of the Market

The stock market as a whole has its own collective p/e, which is a good indicator whether the market at large is overvalued or undervalued. In the bull market of 1982 to 1987 in US, market s overall p/e crept gradually from 8 to 16. Meaning? Investors in 1987 were willing to pay twice what they paid in 1982 for the same corporate earnings. Red flag?

 How do you think interest rates effect on prevailing p/e ratios?

Investors pay more for stocks when interest rates are low, leading to higher p/e levels.
Consider a period when the fast growers command ridiculously high p/e levels and slow growers command p/e ratios normally reserved for fast growers; also if the market hits a p/e of 22 (unheard levels in the past). Can students of p/e issue a recommendation?

Forward Price Earnings Ratio

A measure of the price-to-earnings ratio (P/E) using forecasted earnings for the P/E calculation. While the earnings used are just an estimate, there is still benefit in estimated P/E analysis.

Why use Forward P/E?

If earnings are expected to grow in the future what is the relation between the estimated P/E and the current P/E? Former is lower. This measure is used to compare one company to another with a forward-looking focus.

Future Earnings How do you predict those?

Lots of analysts and statisticians are launched against the question of future growth and future earnings. They often fail as The word most frequently with earnings is surprise If you cant predict future earnings, at least you can find out how the company plans to increase its earnings using 5 basic ways and periodic checks

How can companies increase its earnings?

Reduce costs Raise prices Expand into new markets Sell more of its product in old market Revitalize/close/dispose off a losing operation

Earnings yield
The reverse (or reciprocal) of the P/E is the E/P.

 Robert Shiller s plot of the S&P Composite Real PriceEarnings Ratio and Interest Rates (1871 2008), from Irrational Exuberance Shiller warns that "the stock market has not come down to historical levels: the price-earnings ratio as I define it in this book is still, at this writing [2005], in the mid-20s, far higher than the historical average. ... People still place too much confidence in the markets and have too strong a belief that paying attention to the gyrations in their investments will someday make them rich, and so they do not make conservative preparations for possible bad outcomes. PE ratio India Inc. now and 2006?

 Price-Earnings ratios as a predictor of twenty-year returns based upon the plot by Robert Shiller. The vertical axis shows the geometric average real annual return on investing in the S&P Composite Stock Price Index, reinvesting dividends, and selling twenty years later. Shiller states that this plot "confirms that long-term investors do well when prices were low relative to earnings at the beginning of the twenty years. Long-term investors would be well advised, individually, to lower their exposure to the stock market when it is high, as it has been recently, and get into the market when it is low."

PEG
"The P/E ratio of any company that's fairly priced will equal its growth rate - Peter Lynch

The PEG ratio's validity at extremes in particular (when used, for example, with low-growth companies) is highly questionable. It is generally only applied to socalled growth companies (those growing earnings significantly faster than the market).

Market Ratios Dividend Payout

Dividend Payout Determined by the formula cash dividends per share divided by earnings per share Dividends per share Earnings per share

Market Ratios Dividend Yield

Dividend Yield Shows the relationship between cash dividends and market price Dividends per share Market price of common stock

Enterprise Value
A measure of a company's value, often used as an alternative to straightforward market capitalization. Enterprise value is calculated as market cap plus debt, minority interest and preferred shares, minus total cash and cash equivalents. theoretical takeover price

EV/EBITDA alternative to P/E

An advantage of this multiple is that it is capital structure-neutral. Therefore, this multiple can be used for direct crosscompanies application how many years it would take to pay back the investment used by private equity professionals EBITDA/EV is the metric most used to measure the cash rate of return on the investment

Analyzing the Data

There are five broad areas that would typically constitute a fundamental analysis of financial statements:
Background on the firm, industry, economy, and outlook Short-term liquidity Operating efficiency Capital structure and long-term solvency Profitability

Background: Economy, Industry, and Firm

Economic developments and the actions of competitors affect the ability of any business enterprise to perform successfully. It is necessary to evaluate the environment in which the firm conducts business. This process involves blending hard facts with guess and estimates.

Short-Term Liquidity
Especially important to creditors, suppliers, management, and others who are concerned with the ability of a firm to meet near-term demands for cash Should include analysis of selected financial ratios and a comparison with industry averages Predicts the future ability of the firm to meet prospective needs for cash

Operating Efficiency
Turnover ratios measure the operating efficiency of a firm. The efficiency in managing a company s accounts receivable, inventory, and accounts payable is discussed in the shortterm liquidity analysis.

Capital Structure and Long-Term Solvency

Analytical process includes an evaluation of the amount and proportion of debt in a firm s capital structure as well as the ability to service debt. Debt financing implies risk and leverage.

Profitability
Analysis of how well the firm has performed in terms of profitability, beginning with the evaluation of several key ratios

Final Presentation
Aim of this presentation, which is the final leg of your analysis for your company as CFO, is to identify 2 strengths and 2 weaknesses of your company. Your opinion about investment potential (for investors) and creditworthiness of the firm (for bankers) is called for.

Make a 5-slide 5-minute presentation under the following heads

Strengths & Weaknesses (Obtained AFTER analysis, not stating the obvious) Guide to investors (Focus on the future growth, you can use the 5 factors that lead to growth using the basic checklist) Guide to creditors (Leverage Ratios, Target Capital Structure checklist) Read up a recent move undertaken by the company (it could be with relation to capital structure, sales, acquisition etc.) and see if it fits your analysis. E.g. a launch of 630Crore buy-back program by HUL. Can you explain the same by your AFS including g and g* analysis. Survival of your company in the upcoming recession. How well prepared is your company?

 These presentation hold 2.5-5% of your final grade and will be graded in class in the last week on August. Q&A Session Be prepared to answer questions on quality of financial reporting about the company. E.g do you feel that your company follows a liberal, conservative or industry-based methods of accounting. Target Capital Structure checklist should also be kept in mind wrt your company. Please strictly adhere to the above guidelines.