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LIST OF ARTICLES - By Ajit Oberoi

1. FINANCIAL STATEMENT ANALYSIS - ACCOUNTING FOR MANAGERS - By Ajit Oberoi

Financial Statement Analysis - 1

Assessment of the firm’s past, present and future financial conditions

Done to find firm’s financial strengths and weaknesses

Primary Tools:

Financial Statements
Comparison of financial ratios to past, industry, sector and all firms

Uses for Ratio Analysis - 2

Evaluate Bank Loan Applications

Evaluate Customers’ Creditworthiness

Assess Potential Merger Candidates

Analyze Internal Management Control

Analyze and Compare Investment Opportunities

FINANCIAL STATEMENT ANALYSIS - ACCOUNTING FOR MANAGERS

Types of Ratios - 4

Financial Ratios:

Liquidity Ratios
Assess ability to cover current obligations
Leverage Ratios
Assess ability to cover long term debt obligations

Operational Ratios:

Activity (Turnover) Ratios
Assess amount of activity relative to amount of resources used
Profitability Ratios
Assess profits relative to amount of resources used

Valuation Ratios:

Assess market price relative to assets or earnings

Horizontal, Vertical, & TrendAnalysis - 3

Horizontal Analysis = calculating the Rupee change and % change in financial statement amounts across time

Trend Analysis = Using the “first” year as a base year, calculate future year Rupee values as a ratio.

Vertical Analysis (Common Size Analysis) = changing all Rupee values for accounts to % values.

Liquidity Ratios - 5

Current Ratio

Current Assets / Current Liabilities

Current Assets include Cash, Marketable Securities, Accounts Receivable and Inventory

Current Liabilities include Accounts Payable, Debt Due within one year, and Other Current Liabilities

Liquidity Ratios - 6

Quick Ratio or Acid Test

Current Assets minus Inventory / Current Liabilities

A more precise measure of liquidity, especially if inventory is not easily converted into cash.

Liquidity Ratios - 7

Cash Ratio

Reserve borrowing capacity - the credit limit sanctioned by the bank

Liquidity Ratios - 8

Interval Measure

Calculated to asses a firms ability to meet its regular cash outgoings

Leverage Ratios - 9

Leverage ratios measure the extent to which a firm has been financed by debt.

Leverage ratios include:
Debt Ratio
Debt-Equity Ratio

Generally, the higher this ratio, the more risky a creditor will perceive its exposure in your business. Thus, high leverage ratios make it more difficult to obtain credit (loans).

Leverage ratios also include the Interest-coverage Ratio, Fixed coverage Ratio etc,.

In contrast to the leverage ratios discussed on previous slide, the higher the Interest Coverage Ratio (Times-Interest-Earned Ratio), the more credit worthy the firm is, and the easier it will be to obtain credit (loans).

Debt Ratio - 10

Proportion of interest bearing debt in the Capital structure.

In general, the lower the number, the better.

Debt-Equity Ratio - 11

The Debt-Equity Ratio indicates the percentage of total funds provided by creditors versus by owners.

This ratio indicates the extent to which the business relies on debt financing (creditor money versus owner’s equity).

Interest Coverage Ratio - 12

interest coverage ratio indicates the extent to which earnings can decline without the firm becoming unable to meet its annual interest costs.

Also called the Times-Interest-Earned Ratio, this calculation shows how many times the firm could pay back (or cover) its annual interest expenses out of earnings before interest and taxes (EBIT).

Interest Coverage Ratio - 13

DA = Depreciation and Amortization expenses

Fixed Coverage Ratio (OR) - 14
Debt Service Coverage Ratio (DSCR)

Principal repayments are added to interest payments

Activity Ratios - 15

Activity ratios measure how effectively a firm is using its resources, or how efficient a company is in its operations and use of assets.

In general, the higher the ratio, the better.

Activity ratios include:

Inventory turnover
Accounts receivable turnover
Average collection period.
Total assets turnover
Fixed assets turnover

Inventory Turnover Ratio - 16

The inventory turnover ratio indicates how fast a firm is selling its inventories

This ratio indicates how well inventory is being managed, which is important because the more times inventory can be turned (i.e., the higher the turnover rate) in a given operating cycle, the greater the profit.

In the absence of information. Instead of CGS we can
use Sales

In the case of CGS and Inventory both are valued at cost.

While the sales are valued at market prices
Therefore better to use CGS

Accounts Receivable Turnover - 17

The accounts receivable turnover ratio, indicates the average length of time it takes a firm to collect credit sales (in percentage terms), i.e., how well accounts receivable are being collected.

If receivables are excessively slow in being converted to cash, liquidity could be severely impaired.

Average Collection Period - 18

The average collection period is the average length of time (in days) it takes a firm to collect on credit sales.

Net Assets Turnover - 19

The total assets turnover ratio, indicates how efficiently a firm is using all its assets to generate revenues.

This ratio helps to signal whether a firm is generating a sufficient volume of business for the size of its asset investment

Profitability Ratios - 20

Profitability ratios measure management’s overall effectiveness as shown by returns generated on sales and investment.

Profitability ratios include

Gross profit margin
Operating profit margin
Net profit margin
Return on total assets (ROA)
Return on stockholders’ equity (ROE)

Gross Profit Margin - 21

The gross profit margin is the total margin available to cover operating expenses and yield a profit. This ratio indicates how efficiently a business is using its labor and materials in the production process, and shows the percentage of net sales remaining after subtracting cost of goods sold.

The higher the ratio, the better. A high gross profit margin indicates that a firm can make a reasonable profit on sales, as long as it keeps overhead costs under control.

Operating Profit Margin - 22

The Operating Profit Margin measures profitability without concern for taxes and interest.

The higher the ratio, the better. A high operating profit margin indicates that a firm can make a reasonable profit on sales, as long as it does good tax planning.

Operating Profit Margin - 23

The Operating Profit Margin measures profitability without concern for taxes and interest.

The higher the ratio, the better. A high operating profit margin indicates that a firm can make a reasonable profit on sales, as long as it does good tax planning.

Net Profit Margin - 24

The net profit margin shows the after-tax profits per rupee of sales.

The higher the ratio, the better.

Return on Investment (ROI) OR - 25
Return on Capital Employed (ROCE)

The return on total assets ratio shows the after-tax profits per dollar of assets; this is also called return on investment (ROI).

The ROI is perhaps the most important ratio of all. It is the percentage of return on money invested in the business. The ROI should always be higher than the rate of return on an alternative, risk-free investment.

The higher the ratio, the better

Return on Shareholders’ Equity - 26

The net profit margin shows the after-tax profits per rupee of sales.

The higher the ratio, the better.

Market Valuation Ratios - 27

Earnings per share (EPS)

Price-earnings ratio (P/E).

Dividend Yield

Market to Book Ratio

Tobin’s q

EVA or Economic Value Added

Earnings Per Share (EPS) - 28

The Profitability of the common shareholders’ Investment.

The higher the ratio, the better.

Adjust for the bonus issues

Dividends Per Share (DPS) - 29

Earnings distributed to the shareholders’ as cash dividends.

The higher the ratio, the better.

Dividend Payout Ratio - 30
&
Retention Ratio

Retention Ratio = 1- Payout Ratio

Growth in Equity = Retention Ratio * ROE

Market Valuation Measures - 31

Dividend Yield
Dividend / Market Value per Share
payout declared as a percentage of the stock price

Earnings Yield
EPS / Market Value per Share

Dividend and Earnings yield evaluate the shareholders’ return in relation to the market value of the share

Price-Earnings Ratio - 32

Measure of optimism or pessimism about firm’s future.

High PE Ratio indicates optimism

Low PE Ratio indicates pessimism

Market Value to Book Value Ratio - 33

Stock price / book value per share

The number of times the market values the stock over its paid-in capital and retained earnings.

The DuPont System - 34

Method to breakdown ROE into:
ROA and Equity Multiplier

ROA is further broken down as:
Profit Margin and Asset Turnover

Helps to identify sources of strength and weakness in current performance

Helps to focus attention on value drivers

EVA or Economic Value Added - 40

Captures in one number how much value has been added to the firm over and above the firm’s hurdle rate (the rate investors expect ).

Example: If an investor expects the firm to return Rs100 on an investment of Rs1,000 and it returns Rs150, it has added Rs 50 of EVA.

EVA equals the company’s profit less what it would have earned with an expected return on capital.

Ratio Analysis Limitations - 41

Financial ratios are based on accounting data, and firms differ in their treatment of such items as depreciation, inventory valuation, research and development expenditures, pension plan costs, mergers, and taxes.

Reflects Book Value

Does not take size differences of companies into account

Identifies problem areas, but not causes

Limitations - 42

Seasonal factors can influence comparative ratios.

A firm’s financial condition depends not only on the functions of finance, but also on many other factors
such as -

Management, marketing, production/operations, R&D, and MIS decisions

Actions by competitors, suppliers, distributors, creditors, customers, and shareholders

Economic, social, cultural, demographics, environmental, political, governmental, legal, and technological trends.

QUERIES AND OBSERVATIONS RELATED TO THIS ARTICLE - netjist.mc@gmail.com

AUTHOR - Ajit Oberoi
E MAIL - ajit_oberoi@hotmail.com
THIS ARTICLE CAN NOT BE USED IN ANY FORM WITHOUT WRITTEN PERMISSION OF AUTHOR