The finance perspective dupont

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  • Knowing the absolute level of a single entry on the income statement or balance sheet doesn’t provide sufficient information to evaluate performance. Ratios help by focusing on relationships among entries on the financial statements. The ratios in the DuPont system show the connection between the firm’s operations, its capital structure and the returns for investors. Because a firm’s size affects financial statement values, it’s hard to evaluate performance using absolute levels. By controlling for differences in size to make comparisons ratios facilitate the evaluation of a firm’s performance.
  • Limitations 1.      Large firms operate different divisions in different industries  a.  Difficult to develop meaningful industry averages  b.  More useful for small, narrowly focused firms 2.      Firms want to be better than average  a.  Attaining average performance not necessarily good  b.  Best to focus on industry leaders’ ratios 3.      Inflation may have distorted balance sheets  a.  Must consider effects when comparing over time 4.      Seasonal factors distort ratio analysis  a.  Use monthly averages for season items such as inventory 5.      Window dressing can make financial statements look better 6.      Different accounting practices can distort comparisons  a.  Inventory valuation, depreciation methods 7.      Difficult to generalize whether a ratio is “good” or “bad”  a.  High current ratio – strong liquidity or too much cash (nonearning) 8.      Ratios can give “mixed” view of company  a.  Analyze net effects of a set of ratios

Transcript

  • 1. The Finance Perspective By Atul Sapre
  • 2. Financial Statements
    • The balance sheet
    • The profit and loss account
    • Fund flow statement
  • 3. Balance Sheet
    • A statement showing the sources and application of funds on a given date.
    • A snap shot still picture of the sources and application.
    • Assets and liabilities are the two components of the balance sheet.
  • 4. Balance Sheet
    • Assets represent the application of funds and liabilities represent the sources.
    • Assets are source of future cash inflows (except losses that need to be recovered).
    • Liabilities are future obligations for cash outflows.
  • 5. Assets
    • Assets consist of:
        • Fixed assets: gross and net
        • Misc. Non current assets
        • Investments
        • Current assets,loans and advances
        • Receivables
        • Inventories
    Capital Investment Decisions Working Capital Decisions
  • 6. Capital Investment Decisions
    • Change in the gross block indicates purchase or sale or discarding of fixed assets like machinery building.
      • Issues.
        • Magnitude and gestation period of investment (purchase).
          • Core or non core area investment.
        • Return on investment.
        • Payback and net present value.
  • 7. Working Capital
    • Working funds of the business.
      • Change not commensurate with change in sales.
      • High levels of inventories, receivables.
    • Working capital cycle and length.
      • Implication on return on investment.
  • 8. Liabilities Are Future Sources of Cash Outflow All Liabilities Have a Cost
  • 9. Liabilities
    • Shareholders funds
      • Equity and reserves
    • Long term loans
      • Term loans and debentures
    • Short term sources
      • Bank borrowings
      • Creditors
    • Dividends
    • Interest
    • Interest and costs associated with negative covenants
  • 10. Financing Pattern
    • Long term sources to finance long term uses and part of short term uses.
    • Short term sources to finance short term uses not financed by long term sources.
  • 11. Financing Pattern Long Term Sources Short Term Sources Long Term Uses Short Term Uses
  • 12. Profit and Loss Account
    • Shows the sum of all transactions during a period of time.
    • Shows the expenses incurred to get the income.
    • In other words, the reward and efforts.
      • Expenses, thus should have a relationship with the income generated.
  • 13. Profit and Loss Account
    • Net income.
    • Less cost of goods sold.
      • Material, labor, etc.
    • Gross profit.
    • Selling expenses.
    • Earnings before interest and depreciation.
    • Revenue source
      • Sales and other income
    • Gross profit margin
    • Sales cost
    • Net profitability
  • 14. Profit and Loss Account
    • Gross profit margin is the ratio of gross profit to sales. Indicates margin over material and other manufacturing costs.
    • Net profit margin is the ratio of net profit to sales. Indicates the net profit per rupee of sales.
  • 15. Business and Balance Sheet
    • Business receives funds (creating liabilities) from the financial markets and converts it to physical or other business assets.
    • The assets generate a revenue stream to pay for the liabilities as they mature for payment.
  • 16. Business and Balance Sheet
    • All assets are financed by liabilities and liabilities have costs.
      • Assets, which don’t generate revenue or generate inadequate revenue for paying the the current assets consumed and the cost of liabilities, cause loss.
      • Assets that generate revenue to pay for the current assets consumed and the cost of the liabilities, cause profits.
  • 17. Working Capital
    • Working capital is the ‘working funds’ of the business.
    • In accounting terms current assets less current liabilities.
  • 18. Working Capital
    • Sources
      • Operations
      • Issue of shares
      • Long term borrowings
      • Sale of divestment of assets
    • Uses
      • Dividend payment
      • Repayment of long term borrowing
      • Investment in assets (capital expenditure)
  • 19. Costs and Profits
    • Businesses incur costs in anticipation of a customer.
    • Costs that the customer does not pay are losses.
  • 20. Costs and Profits
    • Costs are, typically:
      • Fixed costs: also called period costs, they are invariant with levels of activity in the business.
      • Variable costs: these are costs that increase or decrease with the level of activity in the business.
  • 21. Costs and Profits
    • Every unit of service or product bears a variable cost a part of the fixed cost and profit.
      • Thus, the customer pays for variable cost, part of the fixed cost and the profit.
      • If the customers of a period pay for the variable cost and all fixed cost, the firm achieves break even.
        • Break even is no profit no loss.
  • 22. Profits
    • Many profits!!!!
      • Earning before interest depreciation and tax
      • Earnings before interest and tax
      • Profits before tax
      • Profits after tax
      • Cash profits
  • 23. Break Even Analysis
    • Increase in unit selling price shifts the break even point to the left.
    • Increase in fixed costs shifts the break even point to the right.
    • Increase in variable cost per unit would shift the break even point to right.
  • 24. Strategic Financial Objectives
    • Business can have many strategic financial objectives:
      • Revenue growth
      • Increase in profitability
      • Positive EVA
      • Cost reduction
      • Better working capital management
      • Generating cash through operations
  • 25. Analysis of Financial Statements Ratios
  • 26. Analysis of Financial Statements
    • Ratio analysis involves:
      • Comparison with industry average
      • Comparison with past trend
      • Comparison with a leading competitor or player
  • 27. Analysis of Financial Statements
    • Profitability ratio: profitability ratios are ratios that indicate a relationship between profits on one hand and assets, sales, money invested etc on the other hand.
    • Leverage ratios: indicate the relationship between amount of borrowed money and owned money.
    • Valuation ratios: indicate the relationship between the financial (accounting) parameters and the financial markets evaluation of these ratios as reflected in the value of the securities.
    • Turnover ratios : these are ratios that show utilization of assets of the business to achieve revenue. Typically this ratio is sales divided by fixed assets, current assets, etc.
  • 28. Analysis of Financial Statements
    • Return on capital employed: A profitability ratio.
      • Earnings before interest and tax divided by capital employed.
    • Shows the efficiency of use of long term funds for generating earnings.
  • 29. Analysis of Financial Statements
    • Earnings per share.
      • Profit divided by number of outstanding shares.
    • Indicates the earnings each share is entitled to.
  • 30. Financial Ratios
    • Ratios help to:
      • Evaluate performance
      • Structure analysis
      • Show the connection between activities and performance
    • Benchmark with
      • Past for the company
      • Industry
    • Ratios adjust for size differences
  • 31. Net Profit/Net Worth Net Profit/Sales Sales/Total Assets Total Assets/Net Worth Dupont Analysis
  • 32. Limitations of Ratio Analysis
    • A firm’s industry category is often difficult to identify
    • Published industry averages are only guidelines
    • Accounting practices differ across firms
    • Sometimes difficult to interpret deviations in ratios
    • Industry ratios may not be desirable targets
    • Seasonality affects ratios
  • 33. Business and Financial Markets
    • Market capitalization: the value that any investor would have to pay to become a 100 percent owner of a company, that is current market price multiplied by outstanding share.
    • Market capitalization increase implies that is costlier to be acquired and the shareholders are wealthier.
  • 34. Business and Financial Markets
    • The equity investors take the risk of the business and have variable dividend, depending on the profits.
    • The lenders are entitled to fixed income on the agreed terms and conditions.
  • 35. Business and Financial Markets
    • The equity is a cushion to the lenders in case of liquidation of the company. It provides the lenders an assurance that their money is safe.
    • The ratio of debt to equity in the long term liabilities of a company indicates the relative share of the owners (shareholders) and the lenders in the long term liabilities of the company.
  • 36. Business and Financial Markets
    • If you own a share you are a part owner of the company.
      • This means, you are a part owner of the earnings of the company.
          • If you want to be a part owner of the earnings then you need to purchase a share in the company. You need to pay its current market price.
          • The price-earning ratio is the inverse of the price that you pay per share to become a part owner of the earnings. Market price of a share divided by the earnings per share.
  • 37. Business and Financial Markets
    • All ratios have problems, so does P/E.
      • Earnings are accounting.
      • Future investment, what about them?
      • Changes daily, hourly, almost every minute.
  • 38. Business and Financial Markets
    • Economic value added (EVA): is the value added by the business over its cost of capital (that is liabilities).
    • Cost of capital consists of cost of shareholders money and borrowed money.
  • 39. Caution!!!!!!!!
    • All companies are affected by overall market direction.
    • It is important to outperform competitors and enhance relative position.
  • 40. What Do Shareholders Want?
    • Return from price appreciation and dividend
    • Information about the progress and prospects
    • Confidence about the top management team
  • 41. Corporate Strategy
    • Operational excellence
    • Product leadership
    • Customer intimacy
  • 42. Achieving Corporate Strategy
    • Through
      • Organic growth
      • Mergers and acquisition
      • Cost optimization
      • Asset divestment
      • Capital investment
      • Optimal cost of capital
  • 43. Impact on Financial Statements
    • All transactions impact the balance sheet.
    • Some transactions impact the profit and loss account and through it the balance sheet.
  • 44. Impact on Financial Statements
    • Increase in production without corresponding increase in sales (volume) would increase the inventory , which in turn would increase the borrowings for working capital, which would reduce the profits .
    • Note red items are from balance sheet and blue from profit and loss account
  • 45. Impact on Financial Statements
    • Increase in capital expenditure like R&D would increase the requirements of long term loans or equity. Long term loans would increase the interest and equity would increase dividends