Financial Statement Analysis

Prof. Sobhesh Kumar Agarwalla

Indian Institute of Management Ahmedabad

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 Purpose

Purpose of FSA
Evaluate Financial Performance
I Income Statement

Evaluate Financial Position

I Balance Sheet

Evaluate Efficiency
I Linking Income Statement and Balance sheet

Assess Cash Flow Statement

I Bird’s-eye view

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 Industry Parameters

Indigo

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 Industry Parameters

Drreddys

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 Industry Parameters

Infosys

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 Industry Parameters

TCS

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 Industry Parameters

Reliance

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 Industry Parameters

D-Mart

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 Industry Parameters

Reliance-Retail

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 Industry Parameters

Ujjivan - MF/Bank

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 Purpose

Purpose of FSA
Evaluate Financial Performance
I Income Statement

Evaluate Financial Position

I Balance Sheet

Evaluate Efficiency
I Linking Income Statement and Balance sheet

Assess Cash Flow Statement

I Bird’s-eye view

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 Benchmarking

Benchmarking
Trend Analysis
Company X Company X Company X
Year(t) Year (t-1) Year (t-2)

Cross Sectional
Company X Company Y Company Z
Year(t) Year (t) Year (t)

Combination of both
Company X Company Y Company Z
Y(t) Y(t-1) Y(t-2) Y(t) Y(t-1) Y(t-2) Y(t) Y(t-1) Y(t-2)

Company X Industry Average

Y(t) Y(t-1) Y(t-2) Y(t) Y(t-1) Y(t-2)

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 Revenue

Income Statement
Trend in sales: Increasing/ Decreasing/ Stagnant

Reasons:
I Volume Effect

Market Size

Market Share [reflects level of competition in the industry]

Mix

I Price Effect

Capacity
I Utilization (Yield)

I Expansion (Capacity addition / Acquisition)

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 Profitability

Profitability Ratios
Profit Margins: Sales Vs. Profit
I Gross Margin = Gross Profit
Sales

I Operating profit PBIT

Operating Margin = Sales
= Sales

I EBITDA
Cash Operating (EBITDA) Margin = Sales

I Net Profit
Net Profit Margin = Sales

Cost Analysis: Expense Ratios

I Personnel expenses ratio = Personnel Cost
Sales

I Administration Cost
Administration expense ratio = Sales

I Selling Cost
Selling expense ratio = Sales

Shortcut: Common-size income statement

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 DOL/DFL

Relationship between sales and profits

Cost structure (Fixed vs. Variable Costs): Leverage effects of fixed cost

Two types of fixed costs

I Operating fixed costs: Operating Leverage

I Interest costs: Financial leverage

Example

Particulars Year 1 Year 2 Change

Sales 100 200 +100%
Variable Operating Exp. 40 80 +100%
Contribution 60 120 +100%
Fixed Operating Exp. 30 30 -
PBIT 30 90 +200%
Interest 10 10 -
PBT 20 80 300%

DOL= Contribution/PBIT 2
DFL= PBIT/PBT 1.5

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 Return

Return Ratios: Return vs. Investment

Return on Equity (ROE) or Return on Net Worth(RONW) =
PAT
Avg(Shareholders 0 equity )

Return on Invested Capital (ROIC/ROI) or Return on Capital Employed (ROCE) =

This assumes that long-term liabilities are permanent capital.

PBIT(1-Tax Rate† ) Profit after tax + after-tax interest

Avg(Capital Employed)
or Avg(Capital + Long term debts)

†
Tax rate = Effective Tax Rate and not Corporate Tax Rate

Return on assets = Return on all resources including current assets.

PBIT(1-Tax Rate† ) Profit after tax + after-tax interest
Avg(Total assets)
or Avg(Total assets)

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 Efficiency

Efficiency Ratios: Asset (and liability) Utilization

Sales
Fixed Asset Turnover = Average Fixed Assets

Sales
Current Assets Turnover = Average Current Assets

I COGS
Inventory Turnover: Average Inventory

I Sales
Debtors Turnover: Average debtors

Current Liabilities Turnover =

I Purchases
Creditors Turnover: Average Creditors

Current Assets - Current Liabilities = Working Capital (function of sales)

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 Short-term debt

Borrowings: Short term

Concern of suppliers of Short term loans and Creditors: Repayment on due date/ in short
notice
†
I Current Ratio = Current Assets
Current Liabilities

I Current Assets† - Inventories

Quick Ratio = Current Liabilities

†
Should I consider A/R or inventory more than x months old? Some banks don’t.

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 Long-term debt

Borrowings: Long term

Suppliers of Long Term Loans: Concerned with repayment of interest and instalments
I PBIT PBIT (year)
Interest Coverage Ratio = Interest
or Interest + Instalments due in next 12 months

Are you repaying the interest/ instalments from profits or new loans?

Their interest is also affected by the share of capital contributed by them vs. equity
holders (Riskiness)
I Debt Ratio or Debt Capitalization = Debt
Debt + Equity

I Debt
Debt-Equity Ratio = Equity

Shortcut: Common-size balance sheet

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 Summary

Financial Performance - Key Ratios

Financial Performance Company A Company B
Year t t-1 t-2 t t-1 t-2
Liquidity:
Current ratio = CA/CL
Quick ratio = (Cash + AR)/CL

Asset Utilization:
Total assets turnover=Sales/avg(FA+WC)
Days’ inventory=365/(COGS/Avg(inv))
Days’ receivable= 365/(Sales/Avg(Receivable))
Day’s payable = 365/(Purchases/Avg(Payable))

Leverage:
Debt-equity
Debt Ratio
Interest coverage (1) =(EBIT+Depn)/Interest
Interest coverage (2)=EBIT/Interest

Profitability/Margins:
Gross profit margin = GP/Sales
Net profit margin = PAT/Sales
ROE=PAT/Avg.(Equity)
ROA=(PAT+Int.)/Avg.(Equity + Debt)

Others:
Sales growth

Industry Specific

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 Dupont/ Linking

Linking Various Ratios

PAT
ROE = Equity

PAT Sales
= Sales
× Equity

PAT Sales Assets

= Sales
× Assets × Equity

Sales - COGS - G & A exp - S & D exp - . . . 1 Assets

= Sales
× Assets × Equity
Sales

COGS G&Aexp S&Dexp 1 Assets

= (1 − Sales
− Sales
− Sales
− . . .) × Fixed Asset + Current Asset - Current Liabilities × Equity
Sales

COGS G&Aexp S&Dexp

= (1 − Sales
− Sales
− Sales
− . . .) (Profitability ratios)

1 Assets
× P&M Building Inventory (Efficiency ratios) × Equity (Leverage)
Sales
+ Sales + Sales + Debtors
Sales
− Creditors
Sales

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 Cash Flow Statement

Cash Flow Statement

Cash Flow statement is prepared using Income Statement and Balance sheet and it
summarizes important portion of I/S and B/S

Bird’s-eye view:

Major sources: Major uses of cash

I Operations or financing? I CAPEX

I Asset disposal/ sale of operations? I Dividend and buy backs

I Financing - Equity or Debt I Repayments of Debt

Trends: Net Income, CFO, Dividends, Debts, Working Capital

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 Cash Flow Statement CFO

Cash Flow from Operation

CFO: Positive or Negative (Important source of liquidity)

CFO vs. NI

Changes in Working Capital

Sale of Assets - Profit or Loss (view about accounting policies)

CFO vs. CAPEX

CFO vs. CAPEX + Dividend

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 Cash Flow Statement CFI

Cash Flow from Investing

Investment of Excess Cash:Fixed Assets or Purchase of Businesses

Investment in Fixed Assets: Expansion or Replacement

Sale of assets/ sale of operations

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 Cash Flow Statement CFF

Cash Flow from Financing

Borrowings:
I Net Repayments or new borrowings

I Long term or short term

Financing Pattern:
I Equity or Debt

I Public Offers

I Net Borrowings or Repayments

I Dividends / Buy backs

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 Earnings Quality

Meaning of quality of earnings

Investors use information content of financial statements to price stock

The level of earnings and changes in earnings convey relevant information about
company’s current and future ability to generate economic value

Empirical findings suggest that for two identical/ comparable company in the same
industry with the same projected earnings and growth rate the Company with higher EQ
would have higher PE multiple

Investors use EQ:

I To assess management bias towards prudence

I To assess volatility of income

I To assess what portion of earnings is available in distributable cash

I To assess riskiness of the stocks

I To identify Red flags: extra care should be taken while analyzing the numbers

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 Earnings Quality

Properties of High Quality Earnings

No clear definition, concept not used in similar fashion, or no single way of analyzing
earnings quality.

Financial analysts seem to believe that high-quality earnings-per-share companies have

these characteristics:
I Accounting policies in accordance with GAAP (and acceptable to industry)

I Consistent, conservative and prudent accounting policy

I Recurring income stream (related to basic business of the company) Vs. one-time
gains

I Recording sales that quickly convert to cash

I Appropriate capital structure

I Earnings that are not materially inflated by unrealized inflation or currency gains

I Earnings trends that are stable, predictable, and indicative of future earnings levels

I Discretionary expenses: Maintenance and up-to-date fixed assets

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 Red flags

Detection of red flags - 1

Audit Report

Change in auditors

Reduction in Managed costs

Accounting change

Unusual increase in intangible assets

Non-recurring income

Sources of income- not company’s core business

Gross profit margin

Substantial increase in accounts receivable

Extension of trade payables

Slowdown of inventory turnover rate

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 Red flags

Detection of red flags - 2

Reduction of specific reserves, e.g. under-reserving for future bad-debts

Acquisition at end of year/quarters

Borrowing level

Increase in unfunded pension liabilities

Low cash and cash equivalents at end of year (may be because of repayment of liabilities
at year-end to improve current ratio)

Related party transactions

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 Modified Dupont

Alternate (or Modified) Dupont Analysis

Modified Dupont analysis breaks a business down into operating assets and net debt
Step 1: Strip out interest bearing debt from current liabilities and LT liabilities. The
deduct cash to arrive at net debt

Step 2: Determine working capital as current assets (less cash) minus current
liabilities (less interest bearing debt)

Step 3: Determine LT net operating assets by taking LT assets minus other LT

liabilities

Step 4: Take net income and add back after-tax net interest (interest expenses less
interest income, all times one minus tax rate). This is effectively income for
all-equity firm
NI = (EBIT − Int) × (1 − T )
= EBIT (1 − T ) − Int(1 − T ) (1)
= NOPAT − Int(1 − T )

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 Modified Dupont

Linking Leverage and ROA to ROE

PAT
ROE = Equity

Net Operating Profit after tax (NOPAT )−Int exp after tax (IEAT )
= Equity

NOPAT IEAT
= Equity
− Equity

NOPAT Assets

IEAT Debt


= Assets
× Equity
− Debt
× Equity

NOPAT Equity +Debt

IEAT Debt


= Assets
× Equity
− Debt
× Equity
 Debt

 IEAT Debt


= Operating ROA × 1 + Equity
− Debt
× Equity
 Debt IEAT


= Operating ROA + Equity
× Operating ROA − Debt

= Operating ROA + [Financial leverage × Spread]

 NOPAT 
Note: Operating ROA = NOPAT
Assets
= Sales
Sales
× Assets i.e. operating margin x operating asset turnover

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 Modified Dupont

Linking Leverage and ROA to ROE

Operating ROA provides a measure of how profitably the company deployed its operating
assets to generate operating profits

Operating ROA can be decomposed into operating margin and operating asset turnover

Spread is the difference between the ROA and cost of borrowing. It determines the
incremental ROE gained from introducing debt into capital structure

Borrowing has a positive economic effect as long as “ROA > Cost of borrowing”

The debt-to-equity ratio is a measure of financial leverage. A firm’s spread times the
leverage ratio is the financial leverage gain to the equity shareholders

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 Modified Dupont

Definition of Items used in Ratios Analysis

Item Definition
Net Interest expense after tax (Interest expenses - interest income) x (1 - Tax Rate)

Net Operating profits after tax Net income + Net interest expense after tax

Operating working capital (Current assets - cash and marketable securities) - (cur-
rent liabilities - ST debt and current portions of LT debt)

Net long-term assets Total long-term assets - Non-interest-bearing LT liabili-

ties

Net debt Total interest bearing liabilities - cash and marketable

securities

Net assets Operating working capital + Net long-term assets

Net capital Net debt + Shareholders’ equity

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 Thank you.

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