Академический Документы
Профессиональный Документы
Культура Документы
Financial Analysis
Financial analysis is the process of identifying the financial strengths and weaknesses of the firm by establishing relationships between the item of the balance sheet and the profit and loss account.
Financial Analysis
Ratio-analysis is a concept or technique which is as old as accounting concept. Financial analysis is a scientific tool. It has been assumed to be an important tool for appraising the real worth of an enterprise, its performance during a period of time and its pit falls. Financial analysis is a vital apparatus for the interpretation of financial statements. It also helps to find out any cross-sectional and time series linkages between various ratios.
Financial Analysis
Unlike in the past when security was considered to be sufficient consideration for banks and financial institutions to grant loans and advances, nowadays the entire lending is need-based and the emphasis is on the financial viability of a proposal and not only on security alone. Further all business decision contains an element of risk. The risk is more in the case of decisions relating to credits. Ratio analysis and other quantitative techniques facilitate assessment of this risk.
Precaution while using Ratio Analysisfinancial statements a. The dates and duration of the
being compared should be the same. If not, the effects of seasonality may cause erroneous conclusions to be drawn. b. The accounts to be compared should have been prepared on the same bases. Different treatment of stocks or depreciations or asset valuations will distort the results. c. In order to judge the overall performance of the firm a group of ratios, as opposed to just one or two should be used. In order to identify trends at least three years of ratios are normally required.
Leverage Ratios
Liquidity Ratios
The liquidity ratios measure the liquidity of the firm and its ability to meet its maturing short term obligations. Liquidity is defined as the ability to realize value in money, the most liquid of assets. It refers to the ability to pay in cash, the obligations that are due. The corporate liquidity has two dimensions
Quantitative Concept Qualitative Concept
Current Ratio
Current ratio is defined as the ratio of current assets to current liabilities. Current assets would include debtors, inventories and cash while current liabilities would include payment due to suppliers of materials and services, provisions, and installments of loans falling in next 12 months. Depending upon the need, some analysts especially bankers are inclined to include bank borrowings, normally forming part of secured loans, for working capital in the current liabilities.
Cash Ratio
Cash Ratio is the most stringent measure of firms liquidity. It denotes the extend to which cash and near cash marketable securities are sufficient to meet the current liabilities. It is calculated as: Cash Ratio= Cash + Marketable Securities/Current Liabilities
The lower the value the better is the debt equity ratio The increasing amount of debt, as reflected in higher debt ratios, the firm is considered more vulnerable to external stocks and its operations are deemed risky. The low values of debt ratios imply foregoing the advantage of debt. Since debt is the cheapest source of funds than equity, its use enhances shareholders earnings
Higher value of debt ratio is disliked by one and all because: Increased debt makes the firm more vulnerable to economic or business cycles. Debt always carries with it a fixed interest burden that remains insensitive to the declining revenues under unfavorable economic conditions. The high debt firm is considered to be more risky in its operations
PBIT as stated in the Profit & Loss Account includes many items such as depreciation, amortization, write offs etc, which do not reflect cash flows, interest cover can be calculated on the basis of cash available for payment of interest. Formulae: Interest Cover (on cash basis)= PBIT + Depreciation + Non cash expense non cash income/ Interest Obligation
A higher turnover ratio or shorter current assets holding period denotes better utilization of funds deployed in current assets With smaller holding period- lower level of funds in current assets- it is implied that the firm can achieve larger sales with smaller capital, and exhibits better profitability to the extent of savings made in the cost of funds.
Net current assets ratio close to zero would give inordinately high returns for the net working capital but it also implies rather lower net working capital than desired. Ideally, net current asset ratio should be 4 times of gross current asset ratio. Ideally both gross and net ratio is not an aggregate measure of efficiency of working capital. It does not tell us which part of working capital the efficiency or inefficiency comes from.
Inventory-Holding Period
It denotes the shelf life of inventory. It shares the inverse relationship with inventory turnover ratio. Formula Average Inventory/Cost of Goods Sold (COGS)*365 days.
Ageing of Debtors
Ageing of Debtors
Debtors ageing schedule categorizes the debtors as per the period for which they have been outstanding. It is the device for monitoring of receivables and helps in identifying the potential defaulters and the corresponding risk.
Profitability Ratios
Profitability ratios refer to those financial metrics that are used to assess a businesss ability to generate earnings. A higher profitability ratio relative to a competitor's ratio or the same ratio from a previous period is indicative of better performance.
Value Addition
Contribution Margin
Profitability Ratios
Return on Equity
Value Addition
Value addition is the enhancement made to the value of a product or service before offering the same to customers. Higher the value added as a percentage of sales, better is the bottom-line for the firm. Value Addition= Sales-Purchases Value Addition in %=( SalesPurchases)Sales*100
Contribution Margin
The margin available once the variable costs have been covered before is known as contribution margin. The margin goes to meet the fixed costs. A larger contribution margin is desirable. Contribution =Sales-Variable Cost Contribution in % = (Sales-Variable Cost)*Sales
a measure of efficiency of capital. It is also known as return on investment. How efficient the firm has been in using the capital at its disposal is reflected by its ROCE. Profit after tax (PAT) is a commonly used measure of return, which is erroneous because PAT is the residual available to shareholders while the capital in the firm comes from two sources equity and debt. Therefore, appropriately ROCE is defined as: Return on Capital Employed (ROCE) = EBIT(I T)/Net Assets x 100%
ROE is not only important for owners of the firm but also to the managers as they have the responsibility towards the shareholders on whose behalf they manage the firm. ROE is affected by several factors such as capital structure, tax rates, efficiency of assets, cost of debt, etc. Increasing ROE denotes improving efficiency of the firm in handling its shareholders funds.
Valuation Ratios
Valuation ratios judge the value the stock market places on any given company. If the liquidity, profitability, capital structure, and working capital ratios look good, then the market value ratios will be high. The prominent valuation ratios are: earnings. and dividends yield, price earnings and price to book ratios
PriceEarnings Ratio
Earnings Yield & Dividend Yield Market Value to Book Value Ratio
Valuation Ratios
It is taken as a summary measure of performance of the firm as market determines the price of the share factoring in the complex relationship of all the variables of performance measure. The markets are supposed to be operating on expected future performance rather than current performance, the P/E multiple is often calculated using expected earnings instead of current earnings It is taken as a benchmark of corporate image and projects the future market price for the firm.
The ratio of market price to its book value also reflects the perception of investors towards the stock. Firms with relatively higher returns on equity generally sell at higher multiples of book value as compared to the ones with low returns. The formula for calculating book value of the share (Rs/share) is: Net Worth/ Number of shares Price to Book Value Ratio: Market Price/ Book Value
Book value of shares would indicate the extend to which the profit shave been retained in the business on a per share basis. Comparing book value to market value gives an indication of the firms growth potential as perceived by the market. If the market value is in excess of book value, if market to book value >1 it indicates a positive outlook of the market in the retention of the funds by the firm.
Introduced and used by DuPont Co. of USA, the DuPont analysis establishes relationship of few ratios. Return on assets (ROA) is the product of net profit margin and assets turnover can be seen from the following formula: ROA=PAT/Total Assets (Net profit After Tax/Sales)* (Sales/ Total Assets) Net profit margin*Asset Turnover
INTERLINKING THE RATIOS: DuPont a function of margin on sales The return on capital isANALYSIS
and the speed of the utilization of the assets. It is a product of profitability and operating efficiency of the firm. Firm A having net profit margin of 10% and sales to asset turnover of 3 would have a return on capital employed of 30%. Firm B too can have same return on capital employed of 30% by having a net profit margin of 7.5% and asset turnover of 4. Two firms can achieve identical return on total assets by different strategies. One may have greater profit margin and lower turnover of assets, while the other may decide to compensate lower profit margin by increased turnover of assets.
For a firm that is 100% equity financed, return on equity (ROE) would be same as return on assets (ROA). If a part of equity is replaced by debt, and making assumption that the (ROA) exceeds cost of debt, the return on equity would increase.
ROE is said to be product of operating margin, operating efficiency, and the financial leverage. Improved margin, higher efficiency, and increased debt would lead to higher return on equity. Dividing ROE into its components helps diagnose the problem in case the ratio is found to be inadequate or does not meet expectations of the shareholders. It provides a convenient and systematic way for the management to address the weak areas and formulate strategies to enhance the return to shareholders.
Net Profit/ Sales* Assets/ Sales * Assets /Equity Operating Margin x Operating Efficiency x Financial Leverage In case ROE of 36.25% does not meet the benchmark of the industry or expectations of the investors, a further inquiry would be required as to what causes it to be low.
Many options are available to improve upon the ROE while operating margin, operating efficiency, and financial leverage are subjects corresponding to marketing, production, and finance function respectively. Depending upon the feasibility and scope available, the management may adopt a suitable strategy to reward the shareholders.