3. Ratio Analysis Basics

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Fundamental Analysis

Dheeraj Vaidya

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Discussion topics

How to analyze a company?

Analytical techniques for Financial Statement Analysis

Horizontal Analysis

Trend Analysis

Vertical Analysis

Ratio Analysis

Solvency

• Current Ratio /Quick Ratio / Cash ratio

• Receivables turnover / Inventory turnover / Payables turnover / Cash Conversion Cycle

Operating

• Operating Efficiency ratios

• Operating Profitability

• DuPont Formula

• Extended DuPont Formula

Risk

• Business Risk

• Financial risk

• External liquidity risk

Growth

Limitations of Financial Ratios

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How to analyze a company?

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Analytical techniques for FSA

Purpose of Financial Statement Analysis is to evaluate management performance in

Profitability

Efficiency

Risk

Although financial statement information is historical, it is used to project future performance

An Analyst is expected to do a complete synthesis using all three methods

Which method is the Best?

Horizontal and Trend Analysis

• Compares two financial statements to determine dollar and percentage changes

• Compute dollar changes and percentage changes

Vertical Analysis

• Shows relationship of each item to a base amount on financial statements

• Income statement (each item expressed as percentage of net sales)

• Balance sheet (each item expressed as percentage of total assets)

Ratio Analysis

• Puts numbers in perspective with other numbers

• Helps control for different sizes of firms

• Ratios provide meaningful relationships between individual values in the financial statements

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Horizontal / Trend / Vertical Analysis

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Horizontal Analysis

Horizontal analysis shows the changes between years in the financial data in both dollar and percentage form

Horizontal analysis on the income statement

Horizontal analysis can also be done on the liabilities or shareholder’s equity

[Current year – Base year] /

[Base year]

Why provision for tax has increased by 12.6%, while the revenues increased by only 5.5%?

Why there is an increase of 9.1% in Selling and administrative cost?

GKSR Income Statement 2006 2007 Increase ($) % YoY change

Rental Operations 801,240 847,401 46,161 5.8%

Direct Sales 79,603 82,141 2,538 3.2%

Net Revenues $880,843 $929,542 $48,699 5.5%

Cost of rental operations (518,543) (541,392) (22,849) 4.4%

Cost of direct sales (57,522) (59,579) (2,057) 3.6%

Selling and administrative costs (186,652) (203,614) (16,962) 9.1%

Operating Expenses ($762,717) ($804,585) ($41,868) 5.5%

-

Ebitda $118,126 $124,957 $6,831 5.8%

Depreciation (32,479) (34,789) (2,310) 7.1%

Amortization of intangibles (10,784) (10,806) (22) 0.2%

Ebit $74,863 $79,362 $4,499 6.0%

Interest Expense (13,226) (13,901) (675) 5.1%

Income before income taxes $61,637 $65,461 $3,824 6.2%

Provision for taxes (19,786) (22,271) (2,485) 12.6%

PAT $41,851 $43,190 $1,339 3.2%

Basic EPS $1.98 $2.03 $0.05 2.5%

Diluted EPS $1.97 $2.02 $0.05 2.4%

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Trend Analysis

Trend percentages state several years’ financial data in terms of a base year, which equals 100%

In the example below, we have taken base year as 2002

We can use the trend percentages to construct a graph so we can see the trend over time

[Current year ] / [Base year] * 100

While Operating cost has increased by 42% since 2002, Net income

grew marginally by 13% during the corresponding period

Income Statement 2002 2003 2004 2005 2006 2007

Net Revenues 677,591 705,588 733,447 788,775 880,843 929,542

Operating Expenses 565,077 598,974 625,064 674,566 762,717 804,585

PAT 38,267 33,689 35,384 38,179 41,851 43,190

Trend Analysis 2002 2003 2004 2005 2006 2007

Net Revenues 100.0% 104.1% 108.2% 116.4% 130.0% 137.2%

Operating Expenses 100.0% 106.0% 110.6% 119.4% 135.0% 142.4%

PAT 100.0% 88.0% 92.5% 99.8% 109.4% 112.9%

60%

80%

100%

120%

140%

160%

2002 2003 2004 2005 2006 2007

Trend Analysis

Net Revenues Operating Expense Net Income

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Vertical Analysis

Common-size statements use percentages to express the relationship of individual components to a total within a single period is known as Vertical Analysis

Income Statement (as a percentage of Total Revenues)

Balance Sheet (As a percentage of Total Asset / Total Liabilities)

Vertical Analysis 2002 2003 2004 2005 2006 2007

Rental Operations 96.8% 96.6% 96.6% 93.9% 91.0% 91.2%

Alcohol 3.2% 3.4% 3.4% 6.1% 9.0% 8.8%

Net Revenues 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Cost of rental operations -59.5% -60.5% -61.1% -59.6% -58.9% -58.2%

Cost of direct sales -2.3% -2.5% -2.6% -4.5% -6.5% -6.4%

Selling and administrative costs -21.6% -21.9% -21.5% -21.4% -21.2% -21.9%

Operating Expenses -83.4% -84.9% -85.2% -85.5% -86.6% -86.6%

Ebitda 16.6% 15.1% 14.8% 14.5% 13.4% 13.4%

Depreciation -4.4% -4.3% -4.3% -4.1% -3.7% -3.7%

Amortization of intangibles -0.9% -1.0% -1.1% -1.2% -1.2% -1.2%

Ebit 11.3% 9.8% 9.4% 9.2% 8.5% 8.5%

Interest Expense -2.0% -1.9% -1.6% -1.4% -1.5% -1.5%

Income before income taxes 9.3% 7.8% 7.8% 7.8% 7.0% 7.0%

Provision for taxes -3.7% -3.1% -3.0% -2.9% -2.2% -2.4%

PAT 5.6% 4.8% 4.8% 4.8% 4.8% 4.6%

Since 2004, cost of rentals have decreased

EBITDA/EBIT/PAT margins a concern - continuously

decreasing trend

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Ratio Analysis

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Ratio Analysis

Ratios can often be more informative that raw numbers

Puts numbers in perspective with other numbers

Helps control for different sizes of firms

Ratios provide meaningful relationships between individual values in the financial statements

Ratios can be used to evaluate four different areas of company’s performance and conditions

Ratio Analysis

Solvency Ratios

Current/Cash/Quick Ratio

Turnover Ratios

Operating Performance

Operating Efficiency

Operating Profitability

Risk Analysis

Business Risk

Financial Risk

External liquidity risk

Growth

Sustainable growth rate

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Ratio Analysis - Solvency

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Ratio Analysis - Solvency

Analyst employ these ratios to determine the firm’s ability to pay its short-term liabilities

Current Ratio examines current assets and current liabilities

Higher the current ratio, more likely is that the company will be able to pay its short-term bills

A ratio of less than 1, means that the company has negative working capital and is probably facing liquidity crisis

Quick Ratio adjusts current assets by removing less liquid assets

More stringent measure of liquidity

Higher the quick ratio, more likely is that the company will be able to pay its short-term bills

Cash ratio relates cash (ultimate liquid asset) to current liabilities

Higher the cash ratio, more likely is that the company will be able to pay its short-term bills

sLiabilitieCurrent

AssetsCurrent RatioCurrent

sLiabilitieCurrent

sReceivableSecurities MarketableCashRatioQuick

sLiabilitieCurrent

Securities MarketableCashRatioCash

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Receivables turnover examines the management of accounts receivable

Balance sheet items are taken as average of the account

Average collection period is the average number of days it takes for the company’s customer to pay their bills

It is desirable to have a collections period closer to the industry norm

Collection period too high mean that customers are too slow in paying their bills, which implies too much capital is tied up in assets

Inventory turnover measures firm’s efficiency with respect to its processing and inventory management

Balance sheet items are taken as average of the account

Given the turnover values, you can compute the average inventory processing time

It is desirable to have a collections period closer to the industry norm

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Ratio Analysis - Solvency

sReceivable Average

Sales AnnualNet Turnover sReceivable

Turnover sReceivable

365Period Collection sReceivable Average

Inventory Average

Sold Goods ofCost TurnoverInventory

TurnoverInventory

365Period ProcessingInventory Average

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Evaluating Solvency Ratios

Payables turnover measures the use of trade credit by the firm

Balance sheet items are taken as average of the account

Given the turnover values, we can compute the average payment period processing time

It is desirable to have a collections payment closer to the industry norm

Cash Conversion Cycle

Combines information from the receivables turnover, inventory turnover, and accounts payable turnover

High conversion cycle is undesirable

Too high conversion cycle implies that company has excessive amount of capital investment in the sales process

Payables Average

sold goods ofCost Turnover Payables

Turnover Payable

365PeriodPayment Average

Cash Con Cycle Receivable period Inventory period= + Payable period-

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Ratio Analysis – Operating

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Ratio Analysis – Operating Efficiency

Operating Efficiency Ratios

Examines how management uses its assets to generate sales and it considers the relationship between various asset categories and sales

Total Asset Turnover ratio indicates effectiveness of a firm’s use of its total asset base to produce sales

Different types of industries have different asset turnovers. Infrastructure business are capital intensive and may have Asset Turnover closer to 1, however, retail business might have turnover ratios in double digits

Low asset turnover may mean that the company has much capital tied up in its asset base

Equity Turnover measures the employment of owner’s capital

Equity capital includes all preferred and common stock, paid-in capital and retained earnings

AssetsNet Total Average

SalesNet TurnoverAsset Total

Equity Average

SalesNet TurnoverEquity

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Ratio Analysis – Operating Profitability

Operating profitability ratios

Examines how management is doing at controlling costs so that a large proportion of the sales dollar is converted into profit

What proportion of the sales dollar is left after cost of goods sold?

Is the firm buying inputs (inventory and direct labor) at good prices?

Gross Profit Margin

Gross profit margin measures the rate of return after cost of goods sold

Operating Profit Margin

Operating profit margin measures the rate of profit on sales after operating expenses

Operating income can be thought of as the “bottom line” from operations

Net Margin

Shows the combined effect of operating profitability and the firm’s financing decisions (since net income is after interest and tax payments)

SalesNet

Profit GrossMarginProfit Gross

SalesNet

Profit OperatingMarginProfit Operating

SalesNet

IncomeNet MarginProfit Net

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Ratio Analysis – Operating Profitability

DuPont System divides ROE into several ratios that collectively equal ROE while individually providing insight

Most important term in ratio analysis

Basic algebra for ROE breakdown

EquityCommon

IncomeNet ROE

EquityCommon

Assets Total

Assets Total

Sales

Sales

IncomeNet

EquityCommon

IncomeNet

Profit margin Asset Turnover Financial Leverage

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Ratio Analysis – Risk

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Ratio Analysis – Risk

Risk analysis examines the uncertainty of income for the firm and for an investor

Total firm risks can be decomposed into three basic sources – 1) Business risk 2) Financial Risk 3) External Liquidity Risk

Business Risk

Function of Business variability, Sales variability and Operating leverage

Between five to ten years of data should be used for calculating business and sales variability

Also critical is the measure of how much company’s production costs are fixed (as opposed to variable)

Greater the use of fixed costs, greater the impact of a change in sales on the operating income of a company and hence, higher is the risk

income operatingMean

income) (operatingDeviation Standardty variabiliBusiness

salesMean

(sales)Deviation Standardty variabiliSales

Salesin change %

Earnings Operatingin change %leverage Operating

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Ratio Analysis – Financial Risk

Financial risk

The added uncertainty in a firm’s net income resulting from a firm’s financing decisions (primarily through employing leverage)

Interest payments are deducted before we get to net income and these are fixed obligations. Similar to fixed production costs, these lead to larger earnings during good times, and lower earnings during a business decline

The use of debt financing increases financial risk and possibility of default while increasing profitability when sales are high

Two sets of financial ratios help measure financial risk

• Balance sheet ratios

• Earnings or cash flow available to pay fixed financial charges

Balance Sheet Ratios

How much debt does the firm employ in relation to its use of equity?

Assessment of overall debt load, including short-term

equity termLong

debt termLongratioequity Debt to

Equity Total Debt Total

debt termLong sliabilitieCurrent RatioDebt

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Ratio Analysis – Financial Risk

Earnings/Cash flow ratios

Relate operating income (EBIT) to fixed payments required from debt obligations

Higher ratio means lower risk

Interest coverage ratio determines the firm’s ability to repay its debt obligations

expenseInterest

EBITcoverageInterest

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Ratio Analysis – External Liquidity Risk

External liquidity risk

External market liquidity is a source of risk to investors

Market Liquidity is the ability to buy or sell an asset quickly with little price change from a prior transaction assuming no new information

The most important factor of external market liquidity is the dollar value of shares traded

This can be estimated from the total market value of outstanding securities

It will be affected by the number of security owners

Numerous buyers and sellers provide liquidity

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Ratio Analysis – Growth

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Ratio Analysis – Growth

Growth is important to both creditors and owners

Creditors interested in ability to pay future obligations

For owners, the value of a firm depends on its future growth in earnings, cash flow, and dividends

If the company doesn’t grow, it stands a much greater chance of defaulting on its loans

Sustainable growth rate is a function of two variables:

What is the rate of return on equity (which gives the maximum possible growth)?

How much of that growth is put to work through earnings retention (rather than being paid out in dividends)?

Growth = ROE x Retention rate

Also remember ROE is a function of

Net profit margin

Total asset turnover

Financial leverage (total assets/equity)

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Limitations of Financial Ratios

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Limitation of Financial Ratios

Accounting treatments may vary among firms, especially among non-U.S. firms

Always consider relative financial ratios. They do not make any sense when viewed in isolation

Firms may have divisions operating in different industries making it difficult to derive industry ratios

Conclusions cannot be made by just looking at only one set of ratios

Ratios outside an industry range may be cause for concern

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