Professional Documents
Culture Documents
1
’
2
’
3
’
Basic Questions
What is the financial position of a company at a given point of time ?
How has the company performed over a given period of time ?
What have been sources and uses of cash over a given period ?
Is the investment in the company safe ?
Does the company earn adequate profits ?
Is the company solvent enough to meet its obligations whenever they
mature ?
Does the company earn enough to build reserves for future growth ?
Is the company properly capitalized ?
Liquidity :
• Measures ability of the company to meet short term debts. Also concerned with
efficiency of working capital investment – receivables, inventory and payables.
Stability :
• Measures balance between debt and equity. Too much debt increases risk of
insolvency
Growth :
• Measures improvement or decline in performance from year to years
6
’
Financial Statements
7
’
Directors Report
Auditors Report
Balance Sheet
Profit and Loss Account
Cash Flow Statements
Notes / Schedules to Accounts
8
’
Annual Report
Primary and most important source of information about a company is its
Annual Report
Annual Reports are well presented with relevant data about performance
of the company given over a period of time
Intelligent investor must read Annual Report in depth, between and
beyond lines to find truth and only then should decide whether the
company is worth investing in.
Important constituents of an Annual Report :
• Director’s Report
• Auditor’s Report
• Financial Statements
• Schedules and Notes to Accounts
Graphs, bar, pie charts, pictures and information on CSR add value to
contents of a good Annual Report
9
’
Director’s Report
Director’s Report is addressed to shareholders advising them about
performance of the company for the year – evaluation of their performance
Opinion of Directors state of economy and impact on industry & company
Evaluation of financial performance of company and divisions
Company’s plans for expansion, modernization, diversification, plan for
acquisition and investment.
Availability of Profits and recommendation of dividend
Directors views on company’s performance in coming years
Valuable if read intelligently as it give good understanding of working of
the company , problems faced, directions it intends to take and future
prospects
10
’
Audit Report
Auditors are required to present to Shareholders whether the financial
statements present a true and fair view of the state of affairs of the
company
Auditors Report draws attention of the reader to changes in Accounting
policies, inconsistencies and its impact on the financial statements.
Investor must carefully read Auditors Report to understand departures
made from normally accepted accounting principles and policies. Results
could change if adjustments are made based on notes and comments in
Auditors report.
Auditors also comment on any action or method of accounting they do not
agree with.
11
’
Balance Sheet
Balance Sheet shows Financial strength of business at given point of time
Groups logically under specific heads company’s Assets – what company
owns and liabilities – What companies owes others
BS details financial position on a particular day and that the position could
be materially different on the following day.
Company has to source funds to purchase fixed assets , procure working
capital and fund its business.
Balance Sheet can be presented as a Source and Utilization Statement
12
’
Shareholders Funds
Share Capital – Equity ( Risk Capital ) & Preference Capital. Dividend paid
out of profits.
• Authorized ( Potential ) Capital, Issued ( Offered ) , Subscribed ( Paid Up)
Reserves & Surplus – Retained earnings + Revenue & Capital reserves
• Capital Reserves – Share Premium, Revaluation, Capital Redemption Reserve
• Revenue Reserves – Accumulated earnings, Investment Allowance Reserve,
Dividend Equalization Reserve, General Reserves, Profit & Loss a/c credit
balance
14
’
Current Liabilities & Provisions
Current Liabilities & Provisions are obligations maturing within one year
Bills payable, trade creditors for supplies made, advances received. Credit
period depends on demand for the material, standing of the company and
market practices
Expenses accrued but not due : Interest on loans, selling, distribution and
admin expenses which are paid on specific dates so need to be estimated
based on past trends and provided for at the year end.
Provisions are amounts set aside from profits for expenses or losses -
taxes, dividend, employee funds, loans payable, within one year or
depreciation, bad and doubtful debts.
Other current liabilities include unclaimed dividends, dues payable to third
parties etc
15
’
Assets
Owned & used in business to provide future economic benefits convertible in cash inflow
Resources are recognized a assets when
• Company acquires rights over them
• Can quantify future economic benefits with fair degree of accuracy
Asset Types – Fixed ,Investments ,Current Assets, Loan & Advances, Misc expenditure &
Losses
Fixed Assets – Tangible and Intangible
• Depreciation – Allocation of cost of Tangible fixed assets to various accounting
periods that benefit from its uses – Charge on profits
Tangible – Land, Buildings, Plant & Machinery,
Intangibles – Patents, Copyrights, Trademarks, Goodwill
Tangible Fixed Assets – Represented by net book value Î gross acquisition value –
accumulated depreciation
16
’
Investments
Trade Investments – Shares and debentures of companies to earn income
by way of interest / dividend or to get access to information of other
companies.
Subsidiary & Associate Companies – Controlling interest directly or
through cross holdings – usually as diversification measure through JVs
Investments are classified as Quoted / Unquoted based on their listing on
Stock Exchanges. Quoted investments are liquid.
Investments are valued at either cost or market value whichever is lower.
Diminution in value of investments / losses are adequately accounted for.
17
’
Current Assets , Loans and Advances
Current assets are owned and used in the normal course of business
Cash & other assets convertible in cash during operating cycle of company
Inventories – Raw Materials, Work in Process, Finished Goods, Packing
Materials, Stores – valued at cost ( Purchase value + Conversion+
Logistics ) or net realizable value whichever is lower
Receivables – Amount owed by customers adjusted to doubtful amounts
Cash , Banks and Cash equivalents
Other Current Assets – Interest Accrued, Fixed Assets for sale etc
Loans & Advances – Support to subsidiaries, deposits with Government
Authorities
Miscellaneous Expenses / Losses – Preliminary Expenses, Discount on
securities, Interest during construction, development expenses not w/off
Losses – Debit balance in Profit and Loss Account
18
’
Profit & Loss Account
Profit & Loss Account summarizes activities and results achieved by the
company during accounting period
It is performance appraisal not only of the company but its management –
its competence, foresight and ability to take risk and lead.
Revenue Expenditure
Sales Cost of Goods Sold
Other Income Employee Cost
Operating & Other Expenses – Selling,
Admin, General
Interest & Finance Charges
Depreciation
Taxation
Dividends
19
’
Contingent Liabilities
Contingent liabilities are liabilities that may arise on the happening of an
event.It is uncertain whether that event will happen or not
Contingent liabilities are not recorded in accounts but are shown by way of
notes / information to readers of potential liability should the event happen
Examples :
• Bills Discounted with banks – May crystallize in liabilities if dishonored
• Outstanding guarantees / Letters of Credit
• Cheques discounted
• Uncalled liability for partly paid shares and debentures
• Gratuity of employees not provided for
• Legal suits against company not provided for
• Claims against company not acknowledged as debt or accepted
• Claims against company for taxes and duties
20
’
Schedules and Notes to Accounts
Schedules/ Notes to accounts are integral part of financial statements and
have to be read along with financial statements
Schedules detail pertinent information about items of Balance Sheet and
Profit & Loss Account
Notes to accounts cover – Accounting policies, Contingent Liabilities and
relate to Î how sales are accounted ?, What are R&D costs?, How is
gratuity liability expensed? , How fixed assets are valued ? How
depreciation is calculated? How stocks – finished goods, WIP, raw
materials and consumables are valued ? How are investments stated?
How has foreign exchange translated ?
21
’
Accounting v / s Economic Values
Use of Historical Cost Principle :
• Accounting uses historical cost as basis of valuation
• Asset Value = Cost – Accumulated Depreciation
• Historical Values differ significantly from Economic Values
Exclusion of Intangible Assets :
• Intangible stated at cost of acquisition less amortization
• Economic Values attached to technical knowledge , Brand equity, Managerial
capability, Goodwill is ignored as difficult to objectively to value them
22
’
Net Cash Flow
Cash flow generally differs from PAT due to accrual concept of accounting
Relationship between cash flow and PAT :
• Net Cash Flow = PAT – Non Cash Revenue + Non cash Expenses
In practice, Analysts define net cash flows :
• Net Cash Flow = PAT + Depreciation + Amortization
• Accuracy of reconciliation depends on correct estimates of accrued incomes
and expenses
23
’
Free Cash Flow
Operating FCF = Cash Inflow from operations – Cash outflow from
operations
• Cash inflow from sale of goods – payments to suppliers of goods
Investing FCF = Cash Inflow Investing Activities – Cash Outflows from
Investing Activities
• Receipt from sale of assets , recovery of loans, Interest, dividend – Payment for
purchase of assets, disbursement of loans
Financing FCF = Cash Inflow from financing activities – Cash outflow from
financing activities
• Receipts from issue of securities, Loans, Deposits – Outflow from interest on
loans, dividend payment, retirement of borrowings and redemption of capital
24
’
Accounting v / s Analysis
Accounting – Classification , recording, summarizing and presentation of
financial data
Analysis – Unveiling the meaning and significance of items in financial
statements to assist management in formation of sound operating financial
policies
Analysis reveals significant facts relating to financial strength , profitability ,
corporate efficiency, weakness, management performance , solvency and
other factors related to company
25
’
26
’
Measurement Areas
Every stakeholder is interested in reviewing economic performance of
business in which he has stake
Board and Management reviews and evaluates periodically to establish
whether actual position is in line with projections
Financial performance appraisal is basic exercise for monitoring past
performance to have fruitful planning of the future
Focus is on various tools of analysis for appraisal of business performance
Productivity and Profitability are two yardsticks against which business
performance is judged
Financial appraisal is an objective evaluation of profitability and financial
strength of the business unit through application of technique financial by
using .
27
Ratio Analysis Summary
Financial Goals
29
’
Methods of Analysis
Horizontal Analysis : Comparison , Analysis and interpretation of similar
items of financial statements relating to two accounting periods
Vertical Analysis : Comparison , Analysis and interpretation of two items
or variables of financial statements relating to same accounting period
Static & Dynamic Analysis : Static Analysis measures relationship
among items in single statement. Dynamic Analysis measures changes in
such items in successive statements
Internal & External Analysis : Internal represents Analysis of financial
data by management for internal decision making. External represents
analysis done by outsiders like investors , bankers, Government,
Creditors, Customers and others for decision making
30
’
Financial Ratios
In analysis of financial statements, ratios are most useful because they
help in comparing strengths, weaknesses and performance of companies
Ratios express mathematically relationship between performance figures
and / or assets / liabilities in a form that can be easily understood and
interpreted.
No single ratio tells complete story – when various different ratios are
calculated and arranged, complete set of comparison emerges.
Five Broad types of Ratios :
• Profitability Ratios
• Leverage Ratios
• Turnover Ratio
• Liquidity Ratios
• Valuation Ratios
31
’
Financial Ratios
Profit & Loss Ratios – Show relationship between two items or groups of
items in Profit and Loss Account or Income Statement
• Sales to Cost of Goods Sold
• Selling Expenses to Sales
• Net Profit to Sales
• Gross Profit to Sales
Balance Sheet Ratios – These deal with relationship in Balance Sheet
• Shareholder Equity to Borrowed Funds
• Current Assets to Current Liabilities
• Liabilities to Net Worth
• Debt to Assets
• Liabilities to Assets
32
’
Financial Ratios
Balance Sheet and Profit & Loss Ratios – These relate an item on Balance
Sheet and Profit & Loss Account
• Earnings to Shareholders Funds
• Net Income to Assets employed
• Sales to Stock
• Sales to Receivables
• COGS to Creditors
Financial Statements and Market Ratios – relate to Financial numbers to
market prices
• Market Value to Earnings
• Book Value to market Value
Ratios being measured should be consistent and valid and length of
periods should be similar
33
’
Liquidity Ratios
34
Financial Ratios – Liquidity
Ratio Formula Meaning Desired Trend
Number of times short term • Rule of Thumb 2:1
assets can cover short term
Current Total Current Assets Total
debts
• Too Low – Business
Ratio Current Liabilities discontinuity
Indicates ability to meet short
term obligations as they come • Too high – suboptimal use of
due. capital
• Rule of Thumb 1;1
Cash Equivalent + Avg • Indicates ability to meet • Too low – Risk of Insolvency
Acid Test Receivables short term payments using • Too High – inefficient use of
Total current Liabilities most liquid assets capital
37
’
Current Ratio
Current Ratio = Current Assets / Current Liabilities
Current Assets – Cash + Current Investments + Receivables + Inventories
+ Loans & Advances + Prepaid Expenses
Current Liabilities – Loans ( Secured & Unsecured ) due in one year ,
current liabilities and provisions
CR measures ability of the company to meet CL
Higher the CR the greater is short term solvency
Quality of CA is crucial
Higher portion on cash / Receivables – more liquid than higher portion of
inventories
CR norm in India is 1.33:1. Internationally, 2:1.
38
’
Current Ratio
As On March 31st 2009 ITM limited’s current assets were Rs 400 Lakhs
and current liabilities Rs 125 lakhs.
Current Ratio = 400 / 125 = 3.2. ITM can meet its current liabilities by
selling mere 31.2% of its current assets
39
’
Liquid Ratio
Also known as Acid Test / Quick Ratio
Liquid Ratio = ( Current Assets – Inventories ) / Current Liabilities
Fairly stringent measure of liquidity
Used to measure company has enough cash or cash equivalents to pay
debts. Inventories are excluded in computing liquid assets.
India norm 1:1
Cash Ratio – Most liquid
Cash Ratio = ( Cash & Bank Balances + Current Investments ) / CL
Cash Ratio is overly stringent measure of liquidity. In real life situations,
lack of immediate cash can be overlooked if company can release dues ,
stretch payments or borrow money at short notice.
40
’
Liquid Ratio
41
’
Net Current Assets
Net Current Assets = Gross Current Assets – Current Liabilities
Not a ratio but helps to ascertain whether company has adequate current
assets to meet current liabilities
Net Current Assets is also known as Net working Capital
NCA used as a base to determine quantum of W/C required to support
certain level of sales. A ratio of 20% would indicate if sales increase by
20% , current assets would need to increase proportionately.
As a defensive strategy, management may want to know no of days
company may remain in business without additional financing / sales eg
worker strike situation. Example follows.
Current liabilities coverage ratio establishes relationship between cash
inflow from operations and current liabilities to determine whether
company can meet maturing obligations from internally generated funds.
Important ratio in times of cash crunches. Example follows.
42
’
Example of Defensive Ratio : Example
Cash and cash equivalent of ITM limited whose annual operating
expenses are Rs 730 Lakhs is as follows :
Rs Lakhs
Cash 35
Marketable Securities 145
180
Daily Operating Expenses 730 / 365 = 2 2
This means that ITM Limited can remain in existence for 90 days without any sales
Or financing
43
’
Current Liabilities Coverage : Example
For the year ended March 31st 2009, ITM Limited earned a net income
before tax but after depreciation of Rs 750 L. Depreciation was Rs 25 L.
Current liabilities at 31st March 2009 and 2008 were Rs 2350 L and Rs
1450 L.
Current Liabilities Coverage Ratio = Cash Profit / Current Liabilities
(750+25) / 0.5 (2350+ 1450) = 0.41 or 41%
In other words, cash flow from operations was only 41% of current
liabilities. If current liabilities were to be paid from internal generations, it
would take 2.44 years. As such funding would be required – either equity
or borrowings.
44
’
Net Current Assets Example
In 2009 ITM Limited had sales turnover of Rs 2000 lakhs and net current
assets were Rs 450 Lakhs after meeting its current obligations
47
’
Cash is King
Liquidity is becoming increasingly important for companies and lack of it
could make a company sick
If cash crunch happens, companies begin to postpone / delay paying bills.
Supplier dues build up, supplies dry out. Impacts production then sales
and has snowballing effect.
Negative liquidity ratio need not necessarily be bad. Strong companies
keep low current assets – are able to get long credits / advances from
suppliers. JIT inventory, low receivable and extended supply credit could
turn net working capital negative.
Checking quality of company’s assets and ascertaining its current
realizable value is crucial. Current Assets should not include deferred
revenue expenditures as it may not have realizable value.bobny ys aAua
48
’
Financial Ratios - Recap
Ratios do not provide answers. They suggest possibilities.
Interpreters must examine these possibilities along with general factors
that would affect the company such as its Board, management style,
government policies, state of economy and industry to arrive at a logical
conclusion.
Ratios are tool for interpreting financial statements but their usefulness
depends entirely on their logical and intelligent interpretation.
Ultimately, the market value of shares is what matters to an investor as
would purchase share if , in his perception, its price is low or reasonable
and has growth potential.
If share is priced high, an investor would sell as the cardinal principle is “
buy cheap and sell dear”
Ratios help investor to decide on holding period to recover investment.
49
’
Leverage
50
Financial Ratios – Stability
Ratio Formula Meaning Desired Trend
Net Worth • Higher is Safer
Total Equity
to Total Assets
What percentage of business • Too low – Too much debt
owned by Shareholders • Too High – Underleveraged
Total Assets reducing ROE.
Long Term
Debt
EBIT • Number of times • Assurance to lenders that
Interest Interest on Long Term availability of profit to meet sufficient cover exits for
Coverage Debt interest payment liability interest payment
’
Leverage
Leverage indicates the extent to which a company dependent on borrowed
funds to finance its business
In highly leveraged firms, owner’s funds are minimal and they are able to
control business with fairly low stakes. Main risks are borne by lenders.
In good times, companies make large profits if they are in high margin
business. Reverse occurs in times of recession. Interest charges eat into
profits and often turns in to large losses.
Companies with no or moderate borrowings is safer and can be depended
upon both in good and adverse years.
Highly geared companies are risky and earnings can be negative in bad
years. In good years financial results of leveraged companies can be very
good.
Important to investors in evaluation of companies.
52
’
Leverage – Example
Company A Company B Company C
Rs Lakhs Rs Lakhs Rs Lakhs
53
’
Leverage – Learning from Example
Company A is highly leveraged. Company B borrowed funds up to 20 % of
its funding needs. Company C is debt free.
In good year Company A makes stupendous 170% before tax where as
Company C makes modest 50%
So long as earning rate exceeds cost of borrowing, highly leveraged
company makes impressive profits.
In reasonable years, profits of leveraged companies is higher than
companies that do not borrow. Earnings before tax of Company A is twice
that of Company C.
During recession, interest costs are comparatively high and profits gets
wiped out both on account of lower margin and interest burden. Company
C makes highest profits as it has no borrowings.
54
’
Leverage Ratios
55
’
Debt : Equity
Shows extent of funds are obtained from external sources and how
dependent the company is on borrowings to finance its business.
Debt : Equity = Debt ( Long Term + Short Term )
Net Worth + Preference Capital
Lower the DE ratio Î higher is the degree of protection enjoyed by
creditors
BV of equity may be lower than market capitalization as tangible assets
recorded at historical value net of depreciation and Intangible assets like
Brand, Goodwill, Intellectual Property Rights, Knowhow are not recorded
in Balance Sheet.
Secured debentures , Borrowings, Loans are protected on charge of
assets and enjoy superior protection
56
’
Debt : Equity Example
57
’
Liabilities to Assets Ratio
58
Liabilities to Assets Ratio Example ’
59
Incremental Gearing with Example ’
2009 2008
ITM Limited earned Rs 450 L before interest and tax during the year
ended March 31st 2009. Interest expense was Rs 200 L
Interest Cover Ratio = 450 / 200 = 2.25 times
Company’s earnings before interest are more than double its interest
expense. A comfortable situation.
62
’
Debt Service Coverage Ratio – DSCR
Helps determine time taken by company to repay its short / long term
debt from its income or internally generated funds.
Relevant if debt is not to be extinguished through sale of assets or by
issue of fresh capital or debt.
Internally generated funds means income after tax + non cash expenses
such as depreciation and non operating income and expenses.
Debt would comprise of bank OD, term loans and debentures.
PAT + Depreciation + Non cash items + Interest on TL + Lease Rentals
Interest on term loans + Lease Rentals + Repayment of term loans
Financial Institutions consider DSCR of 1.5 - 2 as satisfactory
Ratio critical during high inflation and recession when company may find
it in difficult situation to meet this financial covenant to service debt
63
’
Debt Service Coverage Ratio – DSCR – Example
2009 2008
Net Income before tax and depreciation 500
Depreciation 100
Net Profit Before Tax 400
Tax 160
Net Profit After Tax 240
Bank Overdraft 150 100
Debentures 380 400
Term Loans 90 100
520 600
Debt Service Coverage Ratio = ( 240 + 100 ) / 0.5 ( 600+ 520) = 0.60
This would mean that it would take the company ( 12 x 0.60) = 1.7 years to repay from
its profits
64
’
Liability Coverage Ratio with example
65
’
Fixed Charge Coverage Ratio I
66
’
Fixed Charge Coverage Ratio II
Times cash flow before Interest and taxes to cover all financial charges
( EBIT + Depreciation ) / Interest + ( Repayment of loans – (1 – tax rate) )
In denominator, repayment of loans is adjusted upwards for tax factor
because loan repayment amount unlike interest is not deductible
Measures debt servicing ability comprehensively because it considers
both interest and principal repayment obligations.
Ratio may be amplified to include other fixed charges like lease payment
and preference dividend
EBIDTA
Debt Interest + Lease payment + ( Loan repayment Installment /( 1- tax rate)
+ Preference Dividend / ( 1- tax rate)
ST loans like WCTL/ CP - self renewing in nature and not repaid annually
so FCCR less than 1 need not be viewed with concern
67
’
Rs Lakhs
Rental Expenses 400
Earnings before Interest and Tax 750
Interest 200
Earning before Tax 550
Tax at 40% 220
Profit After Tax 330
68
’
Cash Flow Surplus
69
’
Cash Flow Surplus – Example
In 2009 , average debt of ITM Limited was Rs 400 L. Its internally generated
funds were Rs 40 L. Its net working investments had increased by Rs 10 L
and it had incurred capital expenditure of Rs 20 L.
Cash Flow Surplus = ( 40 – 10 – 20 ) / 400
It would take company 40 years to repay its debts by utilizing cash flow
surplus
It also indicates need to borrow and extent of such borrowings
70
’
71
Financial Ratios – Asset Turnover
Ratio Formula Meaning Desired Trend
Net Income
Return on Average Total Assets Quantum and quality of • High return signify better
Assets May also use EBIT returns generated by Assets utilization of assets
instead of Net Income
Asset
Growth Assets yr 2 – Assets yr 1
• How much have assets • Incremental Assets should
grown over past two result in profitable growth or
Assets yr 1
operating periods cash position will be strained.
’
Asset Management Efficiency Ratios
75
’
Inventory Turnover or Stock Turnover
76
’
Inventory Turnover / Inventory Holding – Example
Average inventory of ITM Limited as on March 31st 2009 and 2008 was
Rs 160 L and Rs 150 L respectively. During this period average COGS
was Rs Rs 1200 L and Rs 1050 L. Calculate Ratios
Inventory Turnover Ratio
Company has successfully reduced inventory levels by 3 days of production and has
turned over stock 0.5 times more.
77
’
Receivable Turnover
Selling with trade credit is normal practice. Cost of finance is built into
sales price. Cash discounts are offered for prompt payments
Receivable turnover = Times / rotation of turnover during the year
Turnover = Net Credit Sales / Average Receivables
Holding - Average Collection period = 365 / Receivable turnover
Compare average collection period with credit terms own / industry to
judge efficiency of credit management
Higher – collection is slow , loss of interest , warning of bad debts
Lower – either efficiency is low or excessive conservatism requiring
resetting of credit terms
Regulating receivables would enhance efficiency and reduce borrowings
– saving interest cost.
78
’
Receivable Turnover / Average Collection – Example
In 2009 , sales of ITM Limited grew by 15% from Rs 348 L to 400 L. Its
average trade receivables during 2008 and 2009 were Rs 49 L and Rs
59 L respectively. Average collection period is calculated as follows :
2008 Average Sales = 348 / 365 = 0.95 L
Collection Period = 49 / 0.95 = 51 days
2009 Average Sales = 400 / 365 = 1.09 L
Collection period = 59 / 1.09 = 54 days
Period of collection increased by 3 days. Assuming normal credit period
of 30 days, it is clear that company is not in a position to collect in time.
Company is being forced to extend credit period and management is
unable to exercise control on collections.
79
’
Average Payment Period / Supplier Outstanding
Average payment period ratio or Creditors ratio indicates time taken for
company to pay creditors.
Supplier Payment period = Average Trade Creditors / Daily COGS
Helps answer following questions :
Whether the company is availing all credit it can ?
Whether company is having difficulty in procuring on credit terms ?
Is the company having difficulty in paying creditors on time ?
If the company is in strong and commanding position , it can obtain
longer credit terms.
Longer credit period Î company can finance its working capital
efficiently and to that extent cost of funds fall.
80
’
Average Payment Period / Supplier Outstanding - Example
Average creditors of ITM Limited for 2009 and 2008 were Rs 34 L and Rs
29 L respectively. Its cost of goods sold was Rs 425 L and Rs 410 L.
respectively.
Average payment period is calculated as follows :
2008 Average COGS = 410 / 365 = Rs 1.12 L.
Average payment period = 29 / 1.12 = 26 days
2009 Average COGS = 425 / 365 = Rs 1.16 L
Average payment period = 34 / 1.16 = 29 days
Average payment period in number of days has improved from 26 days
to 29 days. This indicates reduction in working capital investment and
improvement in efficiency of assets.
81
’
Fixed Assets Turnover
82
Fixed Assets Turnover – Example ’
83
’
Margins
84
Financial Ratios – Profitability
Ratio
Formula Meaning Desired Trend
86
’
Profitability Ratios I I
87
’
Profitability Ratios I I I
89
’
Gross Profit Margin – Example
ITM’S sales increased by 25% to Rs 500 L and its gross profit increased by Rs 25 L. Both are
positive in difficult times. Gross margin has fallen by 1.25%.This could be due to several
reasons – 1 ) Increased competition – reduction in margin to boost sales. 2) Company may have
taken conscious decision to reduce margin to improve sales. 3 ) Deterioration in product
Mix 4) Company was unable to pass on cost increase to customers so had to absorb it.
90
’
Operating Margin Ratio
91
’
Operating Profit Margin – Example
Improvement in operating margin by 1.17%. Sales increase is higher than increase in opex.
Sales and GP increased by 33% but expenses went up by 25% . On many occasions,
expenses increase disproportionately to increase in sales and gross profits and every
incremental rupee sale results in increase in loss.
92
’
Break Even Margin
93
’
Break Even Margin – Example
Number of units sold 1000 2009 At present cost 675 units will have to be
sold to bear expenses. At this level
Sales 8000 company make no profit / loss.
Less : Cost of Sales 6000
Gross income per unit is Rs 2 ( 2000/
Gross Income 2000 1000) So every unit over 675 units would
Less : Expenses 1200 earn Rs 2 or incur loss of Rs 2 if sold
under 675.
Operating Income 800
Add : Profit on sale of asset 50 As a stricter measure, alternative could be
deducting selling prices from gross
Earning before interest & tax 850
margin. Done as sales are connected with
Less : Interest charges 150 sales and no selling price if no sale.
Earnings before Tax 700 BE margin 1200 – 400 + 150 = 594 units
(2000 – 400) /1000
BE margin = (1200 +150) / 2000 x 1000 =
675 units
94
’
Return on Assets
Return on Assets = PAT / Average Total Assets
• Whether company has earned reasonable return on its sale ?
• Whether assets have been efficiently and effectively used ?
• Whether cost of borrowing is reasonable ?
Inconsistent as numerator measures returns to shareholders and denominator represents
contribution of all investors
Earning Power = EBIT / Average Total Assets
Measure of business performance not affected by interest and tax
Abstracts away effect of capital structure and tax factor and focuses on operating
performance
Eminently suited for inter firm comparison
Consistent – Numerator represents measure of pre tax earning belonging to all sources of
finance and denominator – total financing.
95
’
Return on Assets Example
96
’
Return on Capital Employed
97
’
Return on Equity
98
’
Return on Equity
99
’
Du Pont Analysis
100
’
Du Pont Analysis
Du Pont Chart Net sales +/- operating
Net Profit
Surplus / Deficit
NP Margin - -
/ Total Costs
Net Sales
Avg Investments
/ +
101
’
Valuation Ratios
102
Financial Ratios – Valuation
Ratio Meaning Desired Trend
Market value of equity & • Improved version of MV / • Higher than 1 signifies that
Q Ratio liabilities / Estimated BV as both MV and aset company has returned higher
replacement cost of replacement costs are overall yield even on
assets closer to realities replacement costs
’
Earning Per Share
104
’
Cash Earning Per Share
EPS may not be proper measure of Rs Lakhs Rs Lakhs
earning as depreciation, tax and
interest varies from company to Sales 5000
company.
Cash EPS = EBIDTA / Weighted Cost of Goods Sold 3000
number of shares issued
Gross Income 2000
Cash EPS is always higher than
normal EPS
Selling Cost 300
Summarized P n L of ITM Limited for
the year ended March 31st 2009 Admin Cost 200 500
Issued Share 500000 of Rs 10 each
Cash EPS = (1500 + 40+ 20 ) Net Income 1500
500000
= Rs 3.12 Admin expense include interest Rs 40 L
and depreciation of Rs 20 Lakhs
105
’
Dividend Per Share
106
’
Dividend Payout ratio
107
’
Price Earnings Ratio
108
’
Price Earnings Ratio – Example
ITM Limited for the year ended March 31st 2009 made profit after tax and
preference dividend of Rs 400 lakhs. Market value of share on Dec 31st
2009 was Rs 112. Equity Capital Rs 50 Lakhs 5,00,000 shares of Rs 10
each. Pref Capital Rs 10 Lakhs 100000 shares of Rs 10 each. Reserves
Rs 70 Lakhs.
EPS = 400 / 50 = Rs 8
PE ratio = 112 / 8 = Rs 14
Yield = 100 / 14 = 7.14 %
PE ratio of well established / sound companies is high and vice versa
PE ratio high as investors have faith in the company’s ability to grow &
earn a return and appreciation in share price. So prices rise during
inflationary period and fall during depression
109
’
Price Earnings Ratio
Price an investor pays is based on future prospects of the company and its
anticipated earnings.
Flaw in PE ratio working is current market price is divided by past earnings
/ share. Ideally, market price should be divided by anticipated earnings of
current year.
PE ratio reflects reputation of the company and its management and
confidence investors have in earning potential of the company
PE ratio that is considered reasonable by different investors will be the one
that fulfills their particular investment return requirements.
PE is usually higher in developing economies as companies are in growth
mode. As economy and companies mature, earnings stabilize and PE ratio
fall.
110
’
Yield
• Low growth prospects Î high dividend yield and low capital gains yield
• Superior growth prospects Î Low dividend yield and high capital gains yield
111
’
Market Value to Book Value
Market Value to book value = Market value per share / BV per share
MV > BV Î investor confidence If, BV > MV lack of investor confidence
Reflects contribution made to the wealth of the society
If ratio exceeds 1, company has contributed to society’s wealth
If ratio is 2 , Company has created wealth one rupee for every rupee
invested. If MV > 3 BV Î risky investment not backed by tangible assets
Ratio 1, company neither contributed nor detracted
Q ratio as proposed by James Tobin
Market Value of equity and Liabilities / Estimated replacement cost of
assets
• Numerator – Market value of equity and debt
• Denominator – All assets at replacement value not book value
112
Feedback
Thank You