Financial Statement Analysis

L E C T U R E 4 – F I N A N C I A L A N A LY S I S - C O N T E N T S O F F I N A N C I A L S TAT E M E N T S &
F O U N D AT I O N O F R AT I O A N A LY S I S ( PA RT 2 )
RECAP FROM
PREVIOUS
LECTURE
Financial Ratios - Categories
A. PROFITABILITY ratios

B. LIQUIDITY ratios

C. ACTIVITY ratios

D. SOLVENCY ratios
C. ACTIVITY RATIOS

(USE OF ASSETS
RATIOS)
1. Inventory turnover
INVENTORY TURNOVER = (Cost of Sales/Average Inventory*) = … times

* Average inventory = (Opening Inventory + Closing Inventory)/2

Points to note:
1. It is used as an indication of how quickly profits are incurred.
2. Low inventory turnover is a sign of:
1. High volume of unsold inventory, restricting in this way current assets that can be
realized and create profits.
2. Risk that unsold inventory may be damaged or expired.
3. Acceptable or preferable ratios depend on the industry of the organization.
4. If multiplied by 365, 52 or 12 it can be expressed in days, weeks or months respectively.
 2. Average collection period
Average collection period = (Trade receivable / Credit Sales) * 365 = … days

Points to note:
1. The shorter the period, the better for the business meaning that collections occur in a
short period of time.
2. This decreases the possibility of bad debts and the risk of customers not paying.
3. This should be evaluated as to whether it is in line with the management’s policy,
otherwise it will be an indication of management’s inefficient collection processes.
 3. Average payment period
Average payment period = (Trade payables / Credit Purchases) * 365 = … days

Points to note:
1. The business should try to keep this period as long as possible, as this will have a
positive impact on the net cash flows from operations.
2. However, delays may lead to bad relations with the suppliers and may consequently
impact credit terms, therefore any such delay should be aligned with the supplier.
3. When this period is longer than the average collection period, this creates a cash flow
benefit for the organization.
D. SOLVENCY
RATIOS
1. Gearing ratio (%)
GEARING RATIO = (Fixed Return Funding* / Total Capital Employed **) * 100 = …%
* Fixed Return Funding = Preference shares + Debentures + other Non-current liabilities
** Total capital employed = Share capital + Reserves + Non-current liabilities

Points to note:
1. Shows how each organization finances its Assets – i.e. how much comes from fixed
return funding.
2. Generally, a gearing ratio of more than 50% means that the company is Highly Geared,
whereas a ratio of less than 50% means that the company is Low Geared.
2. Further solvency ratios
1. Liabilities-to-equity ratio = Total liabilities / Shareholder’s equity

> Indicates how much the total liabilities financing the firm correspond to the total
shareholders’ contributions.
> Restates Assets-to-equity ratio after subtracting 1 (see ROE below)

2. Debt-to-equity ratio = (Current debt + Non-current debt) / Shareholders’ equity

> How many euros of debt financing the firm is using for each euro invested by
shareholders.
More on
Profitability –
RETURN ON EQUITY
(ROE)
 RETURN ON EQUITY (ROE) -
Definition
ROE = (Profit or Loss / Shareholders’ equity) * 100

Definition:
- It provides an analysis tool to evaluate how well the organization manages the funds invested by shareholders, because of
the ability of the company to generate returns.

Further considerations:
- ROE for large publicly traded varies depending on the industry sector.
- ROE vs Cost of Capital – how are these different?
- When ROE exceeds Cost of Capital, then Market Value exceeds the Book Value of the company
- Long-run competitive equilibrium:
The state at which the cost of capital can be considered as a benchmark for the ROE.

How is this achieved? Supernormal profitability in an industry will bring new competition (assuming no barriers to entry). As
a result, there is a force to drive ROE downwards towards normal levels and closer to the Cost of Capital (Cost of Equity).
RETURN ON EQUITY (ROE) -
Calculation
How to calculate Equity:
Option 1 – Beginning Equity
Option 2 – Ending Equity
Option 3 – Average Equity within a period/year
Most analysts use ending Equity for simplicity purposes – however any method can be used
given that it is used consistently. This is true for all ratios where one item is a flow variable
and the other one is a stock variable.
Definitions:
Flow variable: Income statement or cash flow statement items
Stock variable: Balance sheet items
RETURN ON EQUITY (ROE) -
Decomposing
RATIO 1  ROE = Return on Assets (ROA) X Equity multiplier
RATIO 2  Return on Assets (ROA) = (Profit or loss / Total Assets) X 100
RATIO 3  Equity multiplier = (Total Assets/Equity) X 100

Definitions:
ROA: How much profit a company can generate for each unit cost spent on the assets invested.
Equity multiplier: How many unit cost of assets a firm can employ for each unit cost invested by
its shareholders.
RETURN ON ASSETS (ROA) -
Decomposing
RATIO 1  ROA = Net Profit Margin X Asset Turnover
RATIO 2  Net Profit Margin = Profit or loss / Revenue
RATIO 3  Asset Turnover = Revenue / Total Assets

Definitions:
Net Profit Margin: Alternatively Return on Revenue – this ratio shows how much the company
can keep as profits each unit cost of revenue it makes.
Asset Turnover: How many unit costs of revenue the firm can make for each unit cost of its
asset.
RETURN ON EQUITY (ROE) -
Decomposing
Given that:
NET PROFIT MARGIN (%) X ASSET TURNOVER = RETURN ON ASSETS (%)
And that:
RETURN ON ASSETS (%) X EQUITY MULTIPLIER = RETURN ON EQUITY (%)

Then, the Drivers of ROE are:

1. NET PROFIT MARGIN
2. ASSET TURNOVER
3. EQUITY MULTIPLIER
LIMITATIONS OF THIS
APPROACH
1. Total Assets also include all the assets of the company, which are not only claimed by the
equity holders but also by the debt holders.
On the contrary, the earnings used in the numerator are available to equity holders (after
interest payments).
Therefore, the ratio is inconsistent in its calculation.

2. Assets include both operating and non-operating investments – Valuation methods differ
for these two categories.

3. Profit or loss includes profit from operating and investment activities, as well as interest
income and expense, which are consequences of financing decisions.
More on Profitability
– RETURN ON EQUITY
(ROE) - DRIVERS
1. NET PROFIT MARGINS
Further analysis of the net profitability of organizations, allow analysis to be made with
regards to the efficiency of the company’s operating management.

Approach 1: Vertical analysis or Common-sized income statements:

- Enables comparison of trends in income statement relationships over time for the firm
- Assess consistency of the company’s margins
- Identify changes in the company’s margins and understand the underlying causes
- Evaluate company’s management of administrative costs.
1. NET PROFIT MARGINS
Approach 2: Decomposing and evaluating Gross profit margin

Gross Profit margin = (Revenue – Cost of Sales) / Revenue

Hence, Gross margin is influenced by two factors:

1. Price of products – influenced by competition and differentiation of product.
2. Efficiency of the firm’s procurement and production process – influenced by the
cost strategy of a company.
1. NET PROFIT MARGINS –
alternative ratios
NOPAT margin = Net Operating Profit after tax / Revenue

EBITDA margin = Earnings before interest, tax, depreciation and amortization / Revenue

Some analysts prefer EBITDA margin since it focuses on “cash” operating items, but can be
misleading since:
1. Revenue, Cost of Sales and Administrative expenses can be non-cash
2. Depreciation and amortization reflect the consumption of resources
2. ASSET TURNOVER
Two primary areas of asset management:

A. Working capital management:

The difference between a firm’s current assets and current liabilities.
However, since these sections may also include non-operating components such as
financing and investment components; operating working capital is used in many cases.

Operating working capital = (Current assets – Excess cash and cash equivalents)
– (Current Liabilities – Current portion on debt)
B. Management of non-current operating assets:
Net non-current operating assets = Total non-current operating assets
– Non-interest bearing non-current liabilities
2A. Working capital
management ratios
Indicates how many unit costs a company can generate from each unit cost invested in its
operating working capital.
Examples: Trade receivables, inventories, trade payables, accruals.
Operating working capital-to-sales ratio = Operating working capital / Revenue
Operating working capital turnover = Revenue / Operating working capital
Trade receivables turnover = Revenue / Trade receivables
Inventories turnover = Cost of Sales / Inventories
Trade payables turnover = Purchases / Trade Payables
2B. Non-current assets
management ratios
Measures the efficiency with which a firm uses its net non-current operating assets.
Examples: Property, plant and equipment (PPE), Intangibles such as goodwill, patents.

Net non-current operating asset turnover = Revenue / Net non-current operating assets
PPE turnover = Revenue / Net property, plant and equipment
More on
Profitability –
DIVIDEND PAYOUT
RATIO
Sustainable growth rate
Sustainable growth rate = ROE X (1 – Dividend payout ratio)

Dividend payout ratio = Cash dividends paid / Profit or loss

Definitions:
Dividend payout ratio is a measure of its dividend policy.
CASE STUDY –
ROLLS ROYCE
BENTLEY
ASTON MARTIN