Financial statement analysis

Financial Statements

Balance Sheet

Income Statement

Managers and Analysts Use Financial Statement to Conduct:- Cash Flow Analysis

- Performance (Ratio) Analysis

The Link Between the Balance Sheets and the Income Statement.

1999 2000 2000

• Why Accounting Profits and Cash Flows Differ– Revenue Recognition– The Matching Principle– Depreciation

Accounting Profits andCash Flows

•Are Accounting Profits and cash Flows same?

Translating Accounting Profits intoCash Flows

• The statement is based on three cash flow categories:Cash flow from operations is net income

adjusted for depreciation and changes in receivables, payables, and inventories.

Translating Accounting Profits intoCash Flows

Cash flow from investing activities arise from the purchase and sale of marketable securities and productive assets such as machinery.

Cash flow from financing activities include the repayment of debt, the payment of dividends, and the issuance of new securities.

Sources And Uses Of Cash

• Sources of cash– Operations—customers pay invoices– Investing—firm sells assets– Financing—firm borrows or issues new shares

• Uses of cash– Operations—pay its suppliers– Investing—capital expenditures– Financing—interest and dividend payments

Sources of Cash Inflow and Cash Outflow.

The Sources and Uses of Corporate Cash

• Decrease in any asset

• Increase in any liability

• Net profits after taxes

• Depreciation and other non-cash charges

• Sale of stock

• Increase in any asset

• Decrease in any liability

• Net loss

• Dividends paid

• Repurchase or retirement of stock

SourcesSources UsesUses

Key Measures of Cash Flow

12

Cash Flow from

Operations

Operating Cash Flow

Free Cash Flow

• Total Cash Generated

• Cash Flow Before Repaying Lenders

• Cash Flow Firm Could Distribute to Investors

FINANCIAL STATEMENT ANALYSIS

Objectives of Analysis

• The adequacy or otherwise of the profits earned

• The adequacy or otherwise of the financial strength

• Its ability to generate enough cash and cash equivalents, their timing and certainty

• The future growth outlook

Why Evaluate Financial Statements?

• Internal uses– Performance evaluation – compensation and

comparison between divisions– Planning for the future – guide in estimating future

cash flows

• External uses– Creditors– Suppliers– Customers– Stockholders, Analysts

The Tool Kit

• Multi – Step Income Statement

• Horizontal Analysis

• Common-Sized Analysis

• Trend Analysis

• Analytical Balance Sheet

• Ratio Analysis

• Cash flow Analysis

Multi-step Income Statement

• GP

• PBDIT

• OP / PBIT

• PBTEOT

• PBT

• PAT

Analytical Balance Sheet

Ratio Analysis

• RoI Ratios

• Solvency Ratios

• Liquidity ratios

• Turnover Ratios

• Profitability Ratios

• Market Ratios

• Dupont Analysis

RoI Ratios

• RoNW = PAT – Preferred dividend / Networth (%)

• EPS (Rs)

• CEPS = PAT – Preferred dividend + non-cash charges / no. of equity shares o/s (Rs)

Solvency Ratios

• NAV / NWPS / BVPS (Rs)

• DER

• Interest cover = PAT + Int (LTD) + non-cash charges / int (LTD) – Times

• DSCR = PAT + Int (LTD) + non-cash charges / int (LTD) + principal repayment – Times

Liquidity ratios

• CR = CAs, loans and advances + ST Inv / CLs + provisions + ST debt

• QR• CP allowed to customers = receivables x 365 /

credit sales• Supplier’s credit = payables x 365 / credit

purchases• Inventory holding period = inventory x 365 /

COGS

Turnover Ratios

• FATO = Net sales / fixed assets

• NWTO = Net sales / NW

• Debtor turnover

• Inventory turnover

Profitability Ratios

• Multi-step profit margins

• Ratios of individual costs and expenses to sales

• Ratios of other income, extraordinary items and prior year adjustments to PBT and/or net sales

The DuPont Model

Brings together:

• Profitability

• Efficiency

• Leverage

Deriving the Du Pont Identity

• ROE = NI / TE• Multiply by 1 and then rearrange

– ROE = (NI / TE) (TA / TA)– ROE = (NI / TA) (TA / TE) = ROA * EM

• Multiply by 1 again and then rearrange– ROE = (NI / TA) (TA / TE) (Sales / Sales)– ROE = (NI / Sales) (Sales / TA) (TA / TE)– ROE = PM * TAT * EM

Du Pont Analysis

Net Income Sales Assets Return on equity =

Sales Asset Shareholder’s Equity

EquityMultiplier

TotalAsset

Turnover

NetProfit

Margin

Using the Du Pont Identity

• ROE = PM * TAT * EM– Profit margin is a measure of the firm’s

operating efficiency – how well does it control costs

– Total asset turnover is a measure of the firm’s asset use efficiency – how well does it manage its assets

– Equity multiplier is a measure of the firm’s financial leverage

Potential Problems• There is no underlying theory, so there is no way

to know which ratios are most relevant• Benchmarking is difficult for diversified firms• Globalization and international competition makes

comparison more difficult because of differences in accounting regulations

• Varying accounting procedures, i.e. FIFO vs. LIFO

• Different fiscal years• Extraordinary events

• Comparison with industry averages is difficult if the firm operates many different divisions.

• “Average” performance is not necessarily good.• Seasonal factors can distort ratios.

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• Window dressing techniques can make statements and ratios look better.

• Sometimes it is difficult to tell if a ratio value is “good” or “bad.”

• Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition.

What are some qualitative factors analysts should consider when

evaluating a company’s likely future financial performance?

• Are the company’s revenues tied to a single customer?

• To what extent are the company’s revenues tied to a single product?

• To what extent does the company rely on a single supplier?

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• What percentage of the company’s business is generated overseas?

• What is the competitive situation?• What does the future have in store?• What is the company’s legal and

regulatory environment?

Non-Financial Measures of Operating Effectiveness

• Innovation

• Customer Service

• Product Quality

• Reputation

• Good Employee Relations

Balanced Scorecard• Organisational Learning and Growth

(Employee Training & Education, Innovation, Opportunities for Improvement, New Product Dev. Time)

• Business and Production Process Efficiency (Quality, Productivity, Cycle time)

• Customer Value (Customer Satisfaction and Loyalty)

• Financial Performance