Lecture 7 (Financial Analysis Section 2)Revised

8/3/2019 Lecture 7 (Financial Analysis Section 2)Revised

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Financial Analysis

11

Hari Sharma Neupane


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Financial Analysis -recall

It involves examining the activities andresource flows of individual entities orgroups of entities

(e.g., an industrial or commercial firm,public institution, artisans, farmers, retailersetc.)

the standpoint of the entity or entitiesis adopted.

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Financial Analysis

Financial analysis involves comparison of:

costs: the operating and investment expenses(outlays and, possibly, non-monetary flows);

benefits: the revenues (receipts and, possibly, non-monetary flows) resulting from the activity

That means, the exact value of the flows paid out orreceived is taken into account

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Financial Analysis

Financial analysis involves:identifying and estimating all the flows of money, goods and

services resulting from the activities of the entity in the with-and without-project situations, including investment costs,operating costs, and benefits which the entity earns from theseactivities;

estimating the borrowing requirements for the with-projectsituation;

assessing the impact of the project on the entity's overallfinancial situation, and thus the entity's solvency and viability;

calculating the return on invested capital;

estimating the financial assistance necessary.

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Financial Analysis-the principle

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Financial Analysis- Recall

Types:

(1) Income Analysis,

(2) Fund Flow Analysis and(3) Investment Analysis or Benefit CostAnalysis

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Comparison of Income Analysis, Fund Flow Analysisand Investment /Benefit-Cost Analysis

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Item Income Analysis Fund flow analysis Investment or benefit-cost analysis

General objective To check currentperformance of theproject

To check the liquidityof the project (Current,Acid test, Debtstructure ratio)

To check theattractiveness of theinvestment

Period usuallyanalyzed

Individual years Loan repayment period Useful life of theinvestment

Prices used Current prices Current Prices Constant prices, butinflation is considered

Treatment of capital Annual depreciationcharge included in theexpenditure

Cash purchase andsales included

Initial investment andresidual value includedbut not depreciation

Off-farm income excluded cash portion included Both cash and non-cash included

Home-consumption ofthe production

included excluded included

Time value Undiscounted Undiscounted Discounted

PerformanceIndicators

Profit and income Cash surplus or deficit Net present value,Benefit Cost RatioInternal rate of return,


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III. Pricing of Project Costs and Benefits:Prerequisites? Recall

(1) Finding Market Prices

(2) Farm-gate price

(3) Project boundary price

(4) Financial Export and Import Parity Prices (cif and fob)

(5) Pricing intermediate goods

(6) Predicting Future Prices

(7) Inflation

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Measures of Financial Viability and

Investment

(1) Rate of Return

(2) Liquidity(3) Solvency

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Measures of Financial Viability and Investment

(1) Rate of Return (ROR)- Measures the profitability ofthe investment (%).

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Item Equation Interpretation % or Ratio

1. Financial rate of return- Measures the profitability of the investment.

(i) Rate of return on total

investment (Income

statement)

Profit plus interest paid

divided by average total

investment.

Profit= equity earning of capital (30)

Interest= Debt earning of capital (20)

Assuming total inv=total asset Rs360.0

(30+20)/360

=14%

(ii) Rate of return on

equity (%) (Income

statement and Balance

Sheet)

Profit divided by average net-

worth

or Net income divided by

equity*100

More significant measure. 30/20

=1.5%

(iii) Turnover ratio

(Income statement and

Balance sheet)

Gross operating receipts

divided by total asset.

Effectiveness of asset use. Higher the

ratio, the greater the turnover of asset

and greater opportunity to produce

profits.

400/360

=1.1


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(2) Liquidity- Measures the ability of business/asset to generate

sufficient cash to meet its financial commitments as they becomedue.

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Item Equation Interpretation Ratio

(i) Current ratio

(Liquidity Measure)

(Balance sheet)

Total current asset

divided by Total current

liabilities

Higher ratio is preferred. For

every rupee liability, firm has

Rs2.0 current asset. Ideally acurrent ratio of 2 is preferred.

180/90

=2.0

(ii) Acid test ratio

(Balance sheet)

Sum of cash and govt

securities and other cash

divided by current

liabilities

Higher ratio is preferred. For

every rupee current liability, firm

has cash Rs1.1.

(20+

80)/90

=1.1

(iii) Debt structure

ratio. (Balance sheet)

Current liabilities divided

by total liabilities *100

Lower ratio is preferred. Higher

ratio indicates liquidity problem

or more obligation of current

asset.

90/340

=26.5%

II. Measures of Financial Viability and Investment


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(3) Solvency- Measures the long run financial security. (measuresthe liability of the business relative to the amount of owner's

equity invested in the business).

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Item Equation Interpretation Ratio

(i) Networth ratio (%)

(Balance sheet)

Networth divided by Total

Asset x 100

A NW of 50% or more is

suggested for a financially sound

business. About 5.5% NW is

shared by business after payingall obligations.

20/360

*100

=5.6%

(ii) Leverage ratio or

Debt to equity ratio

(Balance sheet)

Total liabilities divided by

Networth

(Debt to Equity ratio)

The smaller the ratio, larger the

NW or equity is relative to total

liability. Hence, smaller ratio is

preferred. Higher ratio is an

indicative of more claims toequity.

340/20

=17.0

(iii) Net capital ratio

(Balance sheet)

Total asset divided by

total liabilities

It shows overall strength of an

investment. A net capital ratio of 2

is often considered a safe ratio.

Higher ratio is preferred.

360/340

=1.0

II. Measures of Financial Viability and Investment


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Financial Statements

Finances of the enterprise are closelyreviewed through projections andfinancial statements:

1. Balance Sheet,2. Income Statements, and

3. Source-and-Use-of-Funds or Cash

flow statements4. Shareholders equity statements

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I. Financial Statement: (1) Balance Sheet

Shows financial condition of an enterprise at a specific

moment in time (say 1 January 2005).

Systematic listing of all assets and liabilities of thebusiness.

Objective: To reveal liquidity (firm's capacity to generate

cash to meet financial obligations), solvency (firm's ability tomeet long run claims) and wealth of business at a particularmoment of time.

General Equation:

Total Asset= Liability + Owners' equity or Net-worth.

Total Asset = Claim against the business by otherindividual without ownership (Debt) + claim against thebusiness by the owner himself (Equity).

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Financial Statement: (2) Income Statement

Summarizes the revenue and expenses of anenterprise during an accounting period (say 1January to 31 December 2010).

A statement that shows the result of operationof the enterprise during the period.

Net income or profit = Revenue - Expenses

Profit after tax = Profit - Depreciation - interest -

taxes. Retained earning = Profit after tax- dividend.

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Financial Statement:(3) Sources-and-Uses-of-Funds Statement

Synonymously sources and application offunds statement" and sometimes Cash Flow".

Measures the total flow of financial resourcesinto and out of an enterprise during an

accounting period (say 1 January to 31December 2010).

Totals of sources and uses of funds are always

equal.

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(1) Hypothetical Balance Sheet of Firm X for 1 January2000 (NRs'000)

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Assets Sub-

total

Amount Liabilities and NW Sub-

total

Amount

(a) Current Asset 180 (e) Current Liabilities 90Cash 20 Amount payable 80

Inventories 80 Tax due this year 10Receivables 80

(b) Intermediate Asset (f) Intermediate Liabilities

(c) Fixed Asset 180 (g) Long term liabilities

Farmland 100 Assured loan 80 250Warehouse 80 Conditional loan 50

Reserve 20Share capital 100

(d) Total Asset (a+b+c) 360 (h) Total Liabilities (e+f+g) 340(i) Owner's equity or NW (d-h) 20

(j) Liability+ NW (h+i) 360


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(2) Hypothetical Income Statement of Firm X for 1 Jan1999 to1 Jan 2000 NRs'000

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Items Variables Amount

Operating receipts a 400

Operating expenses b 300

Net cash income from operation c=(a-b) 100

Depreciation d 20

Earning before interest and tax e=(c-d) 80

Interest payment f 20

Profit before tax g=(e-f) 60Tax h 30

Profit after tax i=(g-h) 30

Dividends j 10

Retained earnings k=(i-j) 20


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(3) Hypothetical Projected Balance Sheet for 1 Jan 2000 and 1 Jan2001 (NRs'000)

2020

Account type Sub-total

1 Jan '00 Change Items Change 1 Jan '01

Asset Amount Amount(a) Current Asset 180 215

(i) Cash 20 Balancing cash 10 20+10=30

(i) Inventories 80 Exptd. increase in inventories 10 80+10=90(i) Receivables 80 Exptd. increase in receivables 15 80+15=95

(b) Intermediate Asset 0 0

(c) Fixed Asset 180 Additional outlay in fixed asset 30(i) Farmland 100 Depreciation from fixed asset -20 180+10=190

(i) Warehouse 80

(d) Total Asset (a+b+c) 360 Sum change 45 360+45=405Total Asset + Sum change 405

Liabilities and Networth

(e) Current Liabilities 90 Current liabilities 0 90+0=90(i) Amount payable 80

(i) Tax due this year 10

(f) Intermediate Liabilities

(g) Long term liabilitiesAssured loan 80 250 Additional assured loan 20

Repayment of loan from assured loan -5 80+15=95Conditional loan 50 Expected increase in conditional loan 10 50+10=60

Reserve 20 Retained earnings addition to reserve 20 20+20=40Share capital 100 0 100+0=100

(h) Total Liabilities (e+f+g) 340 385(i) Owner's equity or NW (d-h) 20 0 20+0=20

(j) Liability+ NW (h+i) 360 Liability and NW Change 45 360+45=405


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(4) Hypothetical Projected Financial Statement for 1 Jan 2000 and1 Jan 2001 (NRs'000)

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*Application of fixed asset in USES is considered before depreciationi.e. 30. If we deduct depreciation from this amount net increase is 30-20=10**Indeed the increase in reserve 20 is due to addition of retainedearning, which is capitalized amount and not available as immediatesource, hence not accounted in source.

Asset 1 Jan '00 1 Jan

'01

Change Liability 1 Jan

'00

1 Jan '01 Change

Current asset 180 215 35 Current liability 90 90 0

Intermediate asset 0 0 0 Assured loan 80 95 15

Fixed asset* 180 190 10 Conditional loan 50 60 10

0 Reserve** 20 40 20

0 Share capital 100 100 0

0 NW 20 20 0

Total Asset 360 405 45 Total liability + NW 360 405 45


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(5) Hypothetical Projected Source-and-Use-of-Fundsfor 1 Jan 2001 (NRs'000)

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Source Amount Uses AmountProfit before tax (Tab-2) 60 Taxes (Tab-2) 30

Depreciation (Tab-2) 20 Dividends (Tab-2) 10Increase in assured loan

(Tab-4)

15 Gross increase in fixedasset (w/o depreciationi.e. additional outlay in

fixed asset (Tab-3)

30

Increase in conditional

loan (Tab-4)

10 Increase in current

asset (Tab-4)

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Total source 105 Total Uses 105


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(6) Hypothetical Projected Cash Flow Statement(NRs'000)

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Adapted from P. Chandra (2000)

Source of Funds Amount

Uses of funds Amount

Earning before tax (Profit before tax +

interest) (Tab-2) 60+20=80

Fixed asset (additional outlay- by

assumption) (Tab-3) 30Depreciation (T-ab2) 20 Current asset increase:

Increase in assured loan (Tab-4) 15 - inventories (Tab-3) 10Increase in conditional loan (Tab-4) 10 - Receivable (Tab-3) 15

Interest (Tab-2) 20Tax (Tab-2) 30

Dividends (Tab-2) 10Total source (A) 125 Total use (B) 115

(C) Opening cash balance

(Retained earning) (Tab-2) 20

(D) Net surplus or deficit in source

and use (125-115=10) 10


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Project Cost and Benefit contd:Project Budget

Assuming the production and inputsknown, the analyst may proceed to drawup the project budget (cash flow).

Objective: to estimate the incremental netbenefit arising from the project over theproject period.

Incremental Net Benefit is used tomeasure the project's worth (differencebetween with and without project)

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A sample Project Budget (Cash Flow, Incr NB)

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S.N. Items Project Year

1 2 3 4 5

Inflow (Income)

1 Gross value of production

Crop 180 230 240 250 260Livestock 50 60 70 80 100

Off-farm income - - - - -

Incremental residual value - - - - 400

Total inflow 230 290 310 330 760

Outflow (Investment)

2 Investment 500 100 - - -

Incremental working capital 40 48 56 80 -

Operating expenditures 20 50 60 70 100

Other expenses (tax) 5 3 4 4 5Total outflow 565 201 120 154 105

Net benefit before financing

3 Net benefit before financing (total inflowminus total outflow)

-335 89 190 176 655

Financing

4 Financing

a Loan receipts 500 100 - - -

b Debt services - 100 100 100 450

Net financing (a-b) 500 0 -100 -100 -450Net benefit after financing

5 Net benefit after financing (with project) i.e.(3+net financing)

165 89 90 76 205

Assume thatNet benefit after financing (without project)

90 85 90 85 90

6 Home-consumed production 20 15 18 16 20

7 Cash surplus or deficit or net cash inflow

(5-6)

145 74 72 60 185


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Financial Analysis

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Step 1: Acquire the companys financial statements for several years

Step 2: Quickly scan all of the statements to look for large movements.Step 3: Review the notes accompanying the financial statements for additional informationthat may be significant to your analysis.

Step 4: Examine the balance sheet. Look for large changes in the overall components of thecompany's assets, liabilities or equity

Step 5: Examine the income statement. Look for trends over time.Step 6: Examine the shareholder's equity statement

Step 7: Examine the cash flow statement, to know the cash inflows and outflows fromoperations, financing, and investing.

Step 8: Calculate financial ratios

Step 9: Obtain data for the companys key competitors, and the industry

Step 10. Review the market data you have about the companys stock price, and the priceto earnings (P/E) ratio

Step 11. Review the dividend payout

Step 12. Review all of the data that you have generated


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Answer the following question-

Based on everything I know about thiscompany and its strategies, the industry and

the competitors, and the external factorsthat will influence the company in the future,do I think this company is worth investing in

for the long term?

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Financial Ratio Analysis

Computing Ratios are popular way to analyze the financial

statements.

A ratio is a relationship between two numbers, and a given ratio iscompared to:

Ratios from previous years for internal trends

Ratios of other firms in the same industry for external trends.

Ratio analysis is a diagnostic tool that helps to identify problemareas and opportunities within a company.

The most frequently used ratios by Financial Analysts provide

insights into a firm's

Liquidity Degree of financial leverage or Debt Profitability EfficiencyValue

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Financial Ratios

A. Analyzing Liquidity: Liquid assets are those that can be

converted into cash quickly. The short-term liquidity ratios showthe firms ability to meet its short-term obligations

1.

2.

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Financial Ratios

B. Analyzing Debt

Debt ratios show the extent to which a firm is relying on debt tofinance its investments and operations, and how well it canmanage the debt obligation, i.e. repayment of principal andperiodic interest

1. Leverage ratio

a. Debt to Equity Ratio = Total Debt / Total Equity

This shows the firms degree of leverage, or its reliance on external debtfor financing.

b. Debt to Assets Ratio = Total Debt / Total assets

2. Cash Flow Coverage = Net Cash Flow / Annual Interest Expense

Net cash flow = Net Income +/- non-cash items (e.g. -equity income +minority interest in earnings of subsidiary + deferred income taxes +

depreciation + depletion + amortization expenses) 3030


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C. Analyzing Profitability

1. Net Profit Margin = Profit after taxes / Sales

2. Return on Assets (ROA) = Profit after taxes / Total Assets

3. Return on Equity (ROE) = Profit after taxes / Shareholders Equity

(book value)

4. Earnings per Common share (EPS) = (Profits after taxes -

Preferred Dividend) / (# of common shares outstanding)

5. Payout Ratio = Cash Dividends / Net Income

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Financial Ratios


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D. Analyzing Efficiency

1. Inventory Turnover= Cost of Goods Sold / Average Inventory

A higher ratio implies the firm is more efficient in managinginventories by minimizing the investment in inventories. Thus a ratio of12 would mean that the inventory turns over 12 times, or the averageinventory is sold in a month.

2. Total Assets Turnover= Sales / Average Total Assets

This ratio shows how much sales the firm is generating for everydollar of investment in assets. The higher the ratio, the better the firm isperforming.

3. Accounts Receivable Turnover= Annual Credit Sales / AverageReceivables

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Financial Ratios


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Financial Ratios

E. Value Ratios

Value ratios show the embedded value in stocks, and areused by investors as a screening device before makinginvestments.

1. Price To Earnings Ratio (P/E) = Current Market PricePer Share / After-tax Earnings Per Share

2. Dividend Yield = Annual Dividends Per Share / CurrentMarket Price Per Share

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Financial Analysis-summary

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Fi i l A l i


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Financial Analysis-summary

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Lecture 7 (Financial Analysis Section 2)Revised

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