Measuring financial performance 4


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Measuring financial performance 4

  1. 1. Financial Statement Analysis © 2001 Prentice Hall Business 1 UPES Publishing Financial Accounting,
  2. 2. How to read Q o Q / Y o Y results © 2001 Prentice Hall Business 2 Publishing Financial Accounting,
  3. 3. FINANCIAL STATEMENT ANALYSIS Financial statements are the means of communicating accounting information which is generated in the various accounting processes to the external user of accounts. In India, a complete set of financial statements includes B/S, P/L A/C (Income statements) and schedule & notes forming the part of B/S and P/L A/C. © 2001 Prentice Hall Business 3 UPES Publishing Financial Accounting,
  4. 4. FINANCIAL STATEMENT ANALYSIS In addition to the financial statements, annual reports contain the following:  Notes to the financial statements, including a summary of the accounting methods used  Management’s discussion and analysis (MD&A) of the financial results  The auditor’s report  Comparative financial data for a series of years © 2001 Prentice Hall Business 4 UPES Publishing Financial Accounting,
  5. 5. FINANCIAL STATEMENT ANALYSIS The objectives of financial statement analysis are to help investors  Predict their expected returns  Assess the risks associated with those returns © 2001 Prentice Hall Business 5 UPES Publishing Financial Accounting,
  6. 6. FINANCIAL STATEMENT ANALYSISFor example, the graphs in the next exhibitshow NTPC’S three-year trend of netsales, market value of the company’s stock,and cumulative return to the company’sstockholders © 2001 Prentice Hall Business 6 UPES Publishing Financial Accounting,
  7. 7. Representative Financial Data of NTPC’S Representative Financial Data of NTPC’S Net Sales Market Value Cumulative Return Rs. Millions Rs. Millions to Shareholders20,000 140,000 250% 200 15,000 105,000 150 10,000 70,000 100 5,000 35,000 50 0 0 0 03 04 05 03 04 05 03 04 05 © 2001 Prentice Hall Business 7 UPES Publishing Financial Accounting,
  8. 8. FINANCIAL STATEMENT ANALYSISMethods are: Horizontal Analysis Trend Analysis Vertical Analysis Fund Flow Statement Cash Flow Statement Ratio Analysis © 2001 Prentice Hall Business 8 UPES Publishing Financial Accounting,
  9. 9. HORIZONTAL ANALYSIS The study of percentage changes in comparative statements is called horizontal analysis Computing a percentage change in comparative statements requires two steps:  Computing the amount of the change from the base period to the later period  Dividing the amount of change by the base- period amount © 2001 Prentice Hall Business 9 UPES Publishing Financial Accounting,
  10. 10. Horizontal analysis is illustrated for OIL’S as follows (Rs. in millions): Increase (Decrease) 2005 2004 Amount PercentSales 38137.44 30642.98 7494.46 24.4%Net income 16303.67 14817.25 1486.42 10.03% © 2001 Prentice Hall Business 10 UPES Publishing Financial Accounting,
  11. 11. The percentage change in OIL’s sales during 2005 is ,computed as follows:Step 1. Compute the amount of change in sales from2004 to 2005: 2005 2004 Increase - = 38137.44 30642.98 7494.46Step 2. Divide the amount of change by the base-periodamount to compute the percentage change during the laterperiod: Amount of change Percentage Change = Base-year amount 7494.46 = 24.4% = 30642.98 © 2001 Prentice Hall Business 11 UPES Publishing Financial Accounting,
  12. 12. HORIZONTAL ANALYSIS Trend percentages  Are a form of horizontal analysis that examine more than a two- or three-year period  Use a selected base year whose amounts are set equal to 100 percent © 2001 Prentice Hall Business 12 UPES Publishing Financial Accounting,
  13. 13. HORIZONTAL ANALYSIS To compute trend percentages, each item for following years is divided by the corresponding amount during the base year Amount of Any year Trend % = Amount of Base year © 2001 Prentice Hall Business 13 UPES Publishing Financial Accounting,
  14. 14.  YEAR SALES TREND RATIO1998 100000 1001999 120000 1202000 150000 1502001 175000 1752002 200000 200 CURRENT YEAR *100 BASE YEAR 14
  15. 15. VERTICAL ANALYSIS Vertical analysis of a financial statement reveals the relationship of each statement item to a specified base, which is the 100% figure Every other item on the financial statement is then reported as a percentage of that base When an income statement is analyzed vertically, net sales is usually the base © 2001 Prentice Hall Business 15 UPES Publishing Financial Accounting,
  16. 16. VERTICAL ANALYSIS Vertical analysis of balance sheet amounts are shown as a percentage of total assets The next exhibit shows the vertical analysis of OIL’S income statement as a percentage of net sales Each income statement itemVertical analysis % = Net Sales © 2001 Prentice Hall Business 16 UPES Publishing Financial Accounting,
  17. 17. COMMON-SIZE STATEMENTS  A common-size statement simplifies the comparison of different companies because their amounts are stated in percentages  On a common-size income statement, each item is expressed as a percentage of the net sales amount  In the balance sheet, the common size is total assets or the sum of total liabilities and stockholders’ equity © 2001 Prentice Hall Business 17 UPES Publishing Financial Accounting,
  18. 18. ONGC’S Analysis of Current Assets December 31,2004 and 2005 Percent of Total Assets 2005 2004Current Assets: Cash and cash equivalents 13.8% 9.7% Time deposits and marketable securities 1.8 2.3 Receivables, net 19.6 19.9 Inventories 11.5 12.0 Prepaid expenses 7.3 7.8 Total current assets 54.0 51.7Long-Term Assets 46.0 48.3Total Assets 100.0% 100.0% © 2001 Prentice Hall Business 18 UPES Publishing Financial Accounting,
  19. 19. USING RATIOS TO MAKE BUSINESS DECISIONSA ratio expresses the relationship of one number to another. The ratios used to make business decisions may be classified as follows: Liquidity ratios Profitability ratios Activity ratios Leverage ratios Ratio’s for Prospective Investors © 2001 Prentice Hall Business 19 UPES Publishing Financial Accounting,
  22. 22. USING RATIOS TO MAKE BUSINESS DECISIONSLiquidity ratios: Measuring a company’s ability to pay current liabilities. The main liquidity ratios are: Current ratio Quick ratio Working capital © 2001 Prentice Hall Business 22 UPES Publishing Financial Accounting,
  23. 23. CURRENT RATIO The current ratio  Is current assets divided by current liabilities  Measures the ability of the company to pay current liabilities with current assets © 2001 Prentice Hall Business 23 UPES Publishing Financial Accounting,
  24. 24. The current ratio of Oil India Limited, for 2005,: OIL’s Current Ratio Formula 2005 Current assets 352173.18Current ratio = = 4.03 Current liabilities 87196.26 In most industries a current ratio of 2.0 is considered good In general, a higher current ratio indicates a stronger financial position In general, a higher current ratio indicates a stronger financial position © 2001 Prentice Hall Business 24 UPES Publishing Financial Accounting,
  25. 25. ACID TEST RATIO The acid-test (or quick/ liquid) ratio  Indicates whether the entity could pay all its current liabilities if they came due immediately  Is computed by dividing cash, short-term investments, and net current receivables (accounts and notes receivable, net of allowances) by current liabilities © 2001 Prentice Hall Business 25 UPES Publishing Financial Accounting,
  26. 26. The acid-test ratio of Oil India Limited, for 2005,: OIL’s Acid-Test Ratio Formula 2005 Cash + short-termAcid-Test ratio = investments + net 326094.96 current receivables = 3.73 Current liabilities 87196.26 An acid-test ratio of 0.90 to 1.00 is acceptable in most industries © 2001 Prentice Hall Business 26 UPES Publishing Financial Accounting,
  27. 27. Working CapitalWorking capital is defined as follows:Working capital = Current assets - Current liabilities © 2001 Prentice Hall Business 27 UPES Publishing Financial Accounting,
  28. 28. Working Capital Working capital is widely used to measure a business’s ability to meet its short-term obligations with its current assets The larger the working capital, the better able is the business to pay its debts © 2001 Prentice Hall Business 28 UPES Publishing Financial Accounting,
  29. 29. MEASURING A COMPANY’S PROFITABILITYMeasure the degree of operating success of acompany in the accounting period. The mainprofitability ratios are: Rate of return on net sales Rate of return on total assets Rate of return on common stockholders’ equity Earnings per share of common stock © 2001 Prentice Hall Business 29 UPES Publishing Financial Accounting,
  30. 30. RATE OF RETURN ON NET SALES The rate of return on net sales shows the percentage of each sales earned as net income The higher the rate of return, the more net sales are providing income to the business and the fewer net sales are absorbed by expenses © 2001 Prentice Hall Business 30 UPES Publishing Financial Accounting,
  31. 31. The rate-of-return-on-sales ratios for OIL’s is calculated as follows: OIL’s Rate of Return on Sales Formula 2005Rate of return PBT 155522 on sales = = 40.77% Net Sales 381374.43 © 2001 Prentice Hall Business 31 UPES Publishing Financial Accounting,
  32. 32. RATE OF RETURN ON TOTAL ASSETS The rate of return on total assets (return on assets) measures a company’s success in using its assets to earn a profit The sum of interest expense and net income in the numerator is the return to creditors and shareholders who have financed the company’s operations © 2001 Prentice Hall Business 32 UPES Publishing Financial Accounting,
  33. 33. Computation of the return-on-assets ratio : FormulaRate of return EBIT on assets = total assets © 2001 Prentice Hall Business 33 UPES Publishing Financial Accounting,
  34. 34. RATE OF RETURN ON COMMON STOCKHOLDERS’ EQUITY Rate of return on stockholders’ equity (return on equity)  Shows the relationship between net income and common stockholders’ investment in the company  Is calculated by dividing net income available to common stockholders by the average stockholders’ equity during the year © 2001 Prentice Hall Business 34 UPES Publishing Financial Accounting,
  35. 35. The rate of return on common stockholders’ equity is calculated as follows: FormulaRate of return Net Preferred on common income - Dividendsstockholders’ = common equity stockholders’ equity © 2001 Prentice Hall Business 35 UPES Publishing Financial Accounting,
  36. 36. EARNINGS PER SHARE OF COMMON STOCK Earnings per share (EPS) is  The amount of net income per share of the company’s outstanding common stock  Computed by dividing net income available to common stockholders by the number of common shares outstanding during the year © 2001 Prentice Hall Business 36 UPES Publishing Financial Accounting,
  37. 37. Computation of the firm’s EPS is as follows: FormulaEarnings Net Preferredper share income - Dividends =of common Number of shares ofstock common stock outstanding © 2001 Prentice Hall Business 37 UPES Publishing Financial Accounting,
  38. 38.  Overall Profitability analysis1).Return on Propritors fund =PAT / Propritors fund2). Return on equity capital = PAPD / Equity capital3). Return on total investment = EBIT / Total investment4). Return on Total assets = EBIT / Total assetsAll above are in percentage(%) 38
  39. 39. Activity Ratios These ratios are presented company’s ability to sell inventory and collect receivables. The main activity ratios are  Inventory turnover  Accounts receivable turnover  Days’ sales in receivables © 2001 Prentice Hall Business 39 UPES Publishing Financial Accounting,
  40. 40. INVENTORY TURNOVER Inventory turnover is  A measure of the number of times a company sells its average level of inventory during a year  Computed by dividing the cost of goods sold by the average inventory for the period © 2001 Prentice Hall Business 40 UPES Publishing Financial Accounting,
  41. 41. INVENTORY TURNOVER A high rate of turnover indicates relative ease in selling inventory; a low turnover indicates difficulty in selling In general, companies prefer a high inventory turnover Inventory turnover varies widely with the nature of the business © 2001 Prentice Hall Business 41 UPES Publishing Financial Accounting,
  42. 42. The Inventory turnover ratio of Oil India Limited, for 2005,: OIL’s’ Inventory Formula Turnover Cost of goods sold 218337.71 Inventory turnover = Average inventory 24113.67 = 9.05OIL’s turnover of 9.05 times a year is high for its industry, which has anOIL’s turnover of 9.05 times a year is high for its industry, which has an average turnover of 5.00 average turnover of 5.00 © 2001 Prentice Hall Business 42 UPES Publishing Financial Accounting,
  43. 43. ACCOUNTS RECEIVABLE TURNOVER Accounts receivable turnover  Measures a company’s ability to collect cash from credit customers  Is computed by dividing net sales by average net accounts receivable  The resulting ratio indicates how many times during the year the average level of receivables was turned into cash © 2001 Prentice Hall Business 43 UPES Publishing Financial Accounting,
  44. 44. ACCOUNTS RECEIVABLE TURNOVER In general, the higher the ratio, the more successfully the business collects cash and the better off its operations © 2001 Prentice Hall Business 44 UPES Publishing Financial Accounting,
  45. 45. OILs’ accounts receivable turnover ratio for 2005 iscomputed as follows: OIL’s Accounts Formula Receivable Turnover Accounts Net credit sales 381374.43 receivable = = 6.65 turnover Average net accounts receivable 57272.03 © 2001 Prentice Hall Business 45 UPES Publishing Financial Accounting,
  46. 46. DAYS’ SALES IN RECEIVABLES The days’-sales-in-receivables ratio tells  How many days’ sales remain in Accounts Receivable  Is computed by a two-step process  First, divide net sales by 365 days to figure the average sales amount for one day  Second, divide this average day’s sales amount into the average net accounts receivable © 2001 Prentice Hall Business 46 UPES Publishing Financial Accounting,
  47. 47. OIL’s Sales in Accounts Formula Receivable Days’ sales in 360 360average accounts = = 54 days receivable Accounts receivable 6.65 turnover © 2001 Prentice Hall Business 47 UPES Publishing Financial Accounting,
  48. 48. Leverage Ratios-measuring a company’s ability to pay long-term debt Two indicators of a business’s ability to pay long-term liabilities are the  Debt- Equity ratio  Proprietary Ratio © 2001 Prentice Hall Business 48 UPES Publishing Financial Accounting,
  49. 49. DEBT EQUITY RATIO Debt Equity Ratio= External Equity ------------------- Internal EquityExternal= Long term debt + current liabilityInternal= Share Capital + Res.& Surplus The lower the ratio it means that the Co. has borrowed more from internal resources and there is a large extent up to which the Co. can borrow from external resources. © 2001 Prentice Hall Business 49 UPES Publishing Financial Accounting,
  50. 50. Proprietary Ratio Proprietary or Equity Ratio= Proprietor fund ------------------- Total AssetsProprietor fund is also knows as NetWorthThis ratio depicts that how much is the net worth of the company in term of total asset of the company. © 2001 Prentice Hall Business 50 UPES Publishing Financial Accounting,
  51. 51. ANALYZING A COMPANY’S STOCK AS AN INVESTMENT Investors purchase stock to earn a return on their investment, which consists of two parts:  Gains (or losses) from selling the stock at a price that differs from the investors’ purchase price  Dividends, the periodic distributions to stockholders  Return= ending price-beg. Price +dividend ______________________________________ Beg. price © 2001 Prentice Hall Business 51 UPES Publishing Financial Accounting,
  52. 52. PRICE EARNINGS RATIO The price earnings ratio is the ratio of the market price of a share of common stock to the company’s earnings PE= MP/ EPS Simply tells how much the investor iswilling to pay the on 1 Rs. Earningfor the share. © 2001 Prentice Hall Business 52 UPES Publishing Financial Accounting,
  53. 53. DIVIDEND YIELD Dividend yield is the ratio of dividends per share of stock to the stock’s market price per share This ratio measures the percentage of a stock’s market value that is returned annually as dividends © 2001 Prentice Hall Business 53 UPES Publishing Financial Accounting,
  54. 54. LIMITATIONS OF FINANCIAL ANALYSIS Ratios have their limitations Financial analysis may indicate that something is wrong, but it may not identify the specific problem or show how to correct it Managers must evaluate data on all ratios in the light of other information about the company © 2001 Prentice Hall Business 54 UPES Publishing Financial Accounting,
  55. 55. LIMITATIONS OF FINANCIAL ANALYSIS Ratios should be analyzed over a period of years Any one year, or even any two years, may not be representative of the company’s performance over the long term © 2001 Prentice Hall Business 55 UPES Publishing Financial Accounting,
  56. 56. EFFICIENT MARKETS, MANAGEMENT ACTION, AND INVESTOR DECISIONS An efficient capital market is one in which market prices fully reflect all information available to the public Because stocks are priced in full recognition of all publicly accessible data, it can be argued that the stock market is efficient © 2001 Prentice Hall Business 56 UPES Publishing Financial Accounting,
  57. 57. EFFICIENT MARKETS, MANAGEMENT ACTION, AND INVESTOR DECISIONS This means that managers cannot fool the market with accounting gimmicks For investors, an appropriate strategy seeks to manage risk and diversity. The role of financial statement analysis consists mainly of identifying the risks of various stocks to manage the risk of the overall investment portfolio © 2001 Prentice Hall Business 57 UPES Publishing Financial Accounting,
  58. 58. Thanks © 2001 Prentice Hall Business 58 UPESPublishing Financial Accounting,