FINANCIAL MANAGEMENT - II

Session 1

Financial Statement Analysis – Ratio Analysis

 Suggested Readings

• PRESCRIBED TEXTBOOK
Brigham and Ehrhardt, Financial Management Theory and Practice, (14/ed) Cengage Learning.

• OTHER READINGS AND REFERENCES:

I M Pandey, (latest) financial management, Vikas publishing house 11/ed.

M.Y. Khan and P.K. Jain (2018) Financial Management: Text, Problems and Cases (8/ed), McGraw
Hill
 FMT I Recap
• PART 1 Overview of Corporate Finance - INTRODUCTION TO CORPORATE FINANCE  and
FINANCIAL STATEMENTS, TAXES, AND CASH FLOW , Financial Statements and Long-Term
Financial Planning

• PART 2 Valuation of Future Cash Flows - : THE TIME VALUE OF MONEY , DISCOUNTED
CASH FLOW VALUATION , INTEREST RATES AND BOND VALUATION  and STOCK
VALUATION 

• PART 3 Capital Budgeting- NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA ,
MAKING CAPITAL INVESTMENT DECISIONS  and PROJECT ANALYSIS AND EVALUATION 

• PART 4 Risk and Return- LESSONS FROM CAPITAL MARKET HISTORY and RETURN, RISK
AND THE SECURITY MARKET LINE 

• PART 5 Cost of Capital and Long-Term Financial Policy- COST OF CAPITAL , RAISING
CAPITAL , FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY and DIVIDENDS AND
PAYOUT POLICY 

• PART 6 Financial Analysis and Forecasting

• Part 7 Working Capital Management; Short-Term Financial Planning and Management-

SHORT-TERM FINANCE AND PLANNING , CASH AND LIQUIDITY MANAGEMENT and CREDIT
AND INVENTORY MANAGEMENT
 COURSE OBJECTIVES (CO)

The learning goals associated with this course are:

1. Explain and apply the fundamental concepts of financial statement

analysis across different industry segments

2. Estimate and analyse financial forecasting of companies

3. Understand different tools and processes through which corporate raise

their finance

4. Understand and apply working capital choices and its management

 FMT II Course Content

4 Modules:

1) Financial statement analysis – Ratio Analysis

2) Financial Forecasting
3) Financing Choices
4) Working Capital Management
ASSESSMENT SCHEME AND WEIGHTAGE

Duration (in CLO

Evaluation Weightage (%) Open/close Book
minutes) Tested

End-Term 40 150 Closed book CLO 4

Unit of
Evaluation Item Weight Time CLO
Evaluation

Quizzes Individual 30% After Session 5, 14 and 19 -

Submission for Deliverable 1 within

3 days after completion of session 10
Project Group 30% -
and Deliverable 2 within 3 days after
completion of Session 20
 PROJECT Guidelines

• FAS teams will work on the project.

• All team members must contribute equally. All Groups must select the
industry and five listed companies within the same industry. Out of
the five companies, identify one as base company and rest four will be
the peers.

• Their annual reports (for each of the three most recent fiscal years
2017, 2018, 2019 and 2020; you need to work on their consolidated
financial statements (Resources can be downloaded from the
Bloomberg Terminal or Annual Reports).
 PROJECT Guidelines
• Deliverable 1 (5-page Word document with excel file): Ratio analysis for all the
five companies for the last three years should be done and a detailed report with
interpretations and implication needs to be prepared.

• In Excel (Sheet 1 to Sheet 5), enter the data from Income Statement, Balance
Sheet and Cash Flow Statement for three latest financial years 2017, 2018, 2019
and 2020 from 2017-2018, 2018-2019 and 2019-2020 annual reports. An annual
report has two set of financial statements, viz. Standalone and Consolidated; but
you have to use only the consolidated financial statements data. You must do
this for all the five companies in separate excel files.
• In Excel (Sheet 6 to Sheet 10), Prepare a) Ratio analysis b) Common Size
financial statements – I/S, B/S, CF/S for the three years and c) Trend Analysis
d) DuPont and MVA analysis. You have to do this for all five companies in
separate excel files.
• In Excel (Sheet 11), for five future years (2021 till 2025) a) forecast financial
ratios only for the base company and b) prepare forecasted financial statements
only for the base company.
 PROJECT Guidelines

• Deliverable 2 (2-page Word document with excel file): Impact of working

capital ratios on the profitability of the base company.

• In Excel Spreadsheets

• In Excel (Sheet 12 to Sheet 16), For each of the five companies calculate the
Operating Cycle and Cash Conversion Cycle for the last three FY (2017, 2018,
2019 and 2020).

• In Excel (Sheet 17), Using Simple linear regression with the dependent variable
taken as Profit ratio (ROA, ROIC, GOI, NOI etc) and the independent variable as
Working Capital ratio (CCC, OC), analyse the impact of working capital on the
profitability of the base company.
Industry list – CMIE database source
 Requests

1. Read the material [both the prescribed textbook and

cases if any assigned] before entering the classroom
2. Submit Session assignments & Case Work on Time
3. Let the learning sequence be… Self-reading-listening to
the lecture – active participation in case and classroom
discussions- re-reading the classroom discussion –
working out the chapter end problems and cases
 Estimating the Discount Rate (Equity and Firm)
1) Historical Risk Premium
Equity Discount Rate (historical data)
2) Modified Historical Risk
Premium (correct for
country risk)
Cost of Equity (COE) = Risk free rate + Beta * (Risk Premium) 3) Implied Equity Premium

2 conditions for an Asset 3 approaches to estimate Beta :

as Risk free: 1) Historical Market Beta (Regression
Estimates i.e. regress stock returns with
market returns or Service Beta )
1) No Default Risk 2) Fundamental or Bottom-Up Beta
2) No Reinvestment Risk 3) Accounting Beta

1) Effective Tax Rate = Taxes due / taxable Income

2) Marginal or Statutory tax rate - since interest
expense save taxes at the margin –right tax rate
Firm Discount Rate to use

Cost of Capital = COE * (Equity/(Equity + Debt)) + Cost of Borrowing (1-t) * (Debt / Debt+ Equity))

Cost of borrowing should be based on

Cost of Equity Based 1) Synthetic Rating
Copyright © 2018,
2) 2016, 2015
Default Pearson Education, Inc. All Rights Reserved.
Spread
on Bottom-Up Beta
Cost of borrowing = Risk free rate + Default Spread
 Measuring Cash Flows

This Summarizes the Cash flows to Firm and Cash Flows to Equity

Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved.
 Measuring Cash Flow to the Firm

Cash flow to the firm = Pre-debt Cash Flows

= EBIT ( 1 - tax rate)

- (Capital Expenditures - Depreciation)
- Change in non-cash Working Capital

Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved.
 Measuring Cash Flow to the Equity

Cash flow to the Equity = After – debt Cash Flows

= Net Income
- (Capital Expenditures - Depreciation)
- Change in non-cash Working Capital
- (Principal Repaid – New Debt Issues)
[If preferred stock exist, preferred dividends will also need to be netted out]

Or

Cash flow to the Equity = Dividends +Stock Buybacks

Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved.
 What are operating current assets?
• Operating current assets are the CA needed to support operations.
– Op CA include: cash, inventory, receivables.
– Op CA exclude: short-term investments, because these are not a part of
operations.

What are operating current liabilities?

• Operating current liabilities are the CL resulting as a normal part of operations.
– Op CL include: accounts payable and accruals.
– Op CL exclude: notes payable, because this is a source of financing, not a
part of operations.

Net Operating Working Capital (NOWC)

Operating Operating
NOWC = -
CA CL
Total net operating capital or operating capital

Operating Capital = NOWC + Net fixed assets.

FCF = NOPAT - Net investment in operating capital

 Financial Statement Analysis

CHAPTER 3 of the Prescribed Textbook

 Financial Statement Analysis Overview

FS: Provide a summarized view of the financial position and operations

of a firm and analysis of FS is an important aid to financial analysis

BS: Mirrors the financial position on a particular date in terms of the

structure of assets, liabilities and equity.

I/S: Shows the results of operations during a certain period of time in

terms of revenue obtained and cost incurred during the year.

Limitation of FS: Traditional financial statements do not give all the

information related to the operations of a firm.
Focus of Financial Analysis is on key figures in the financial
statements and is a process of evaluating the relationship between
different components of FS to obtain a better understanding of the
firm’s financial position and performance.
Financial Statement Analysis Overview

I. Ratio Analysis
II. DuPont system
III. Effects of improving ratios
IV. Limitations of ratio analysis
V. Qualitative factors
 I. Ratio Analysis
• Ratio Analysis widely used tool of financial analysis.
• Ratio Analysis focuses on how financial statements are
analyzed by management, investors and creditors.
• Ratios reveal the relationships in a more meaningful way so as to
enable management, investors and creditors make better
investment and credit decisions.
• Ratios are used by:
– Lenders to determine creditworthiness
– Stockholders to estimate future cash flows and risk
– Managers to identify areas of weakness and strength

• Ratios facilitate comparison of:

– One company over time
– One company versus other companies
 I. Ratio Analysis

• Objective of business is to create value for its shareholders, ROI

and sound financial position.

• Top Management and Investors are interested in the overall

performance or broad measures of performance.

• Financial statement analysis should be done on consolidated

basis rather than on standalone basis.

• Question is How to Measure Performance

 Ratio Analysis – Five Categories

Ratio Analysis makes use of 5 Categories to measure performance :

1. Profitability Analysis
2. Overall Performance Analysis
3. Investment Utilization Analysis
4. Working Capital Analysis
5. Financial Condition Analysis
 Ratio Analysis – Steps
• Identify the Type of Firm in the Annual Reports ( I/S, B/S, CFS)
• Then compute the ratios accordingly (compute the value of
ratios across time). Compute these 5 categories of Ratios to
measure firm performance:

1. Profitability Analysis
2. Overall Performance Analysis
3. Investment Utilization Analysis
4. Working Capital Analysis
5. Financial Condition Analysis
• Longitudinal Analysis or Trend Analysis – comparison of the
ratios of a firm over time.
• Vertical Analysis – comparison of items within a single year’s
financial statement of a firm.
 1. Profitability Analysis

Profitability
Management wants to measure the operational efficiency and owners want to know the returns on the funds invested
Analysis
by them. Both these depend on the profits earned by the firm

Gross
EBITDA EBIT PBT PAT
Profit
Margin Margin Margin Margin
Margin

If the purpose is to know the Firm’s rate of return on Sales

 1. Profitability Analysis

What is the company’s rate of return on:

 Sales?

Profitability Analysis ideally requires one to do these

analyses:

a. Profit Margin Analysis

b. EPS Analysis
c. Common – Size I/S Analysis (Vertical analysis)
 a. Profit Margin Analysis
Format for Profit Margin Analysis
Format for Profit Margin Analysis
 b. EPS Analysis

EPS Analysis compute for all companies

 c. Common- Size I/S Analysis

Vertical Analysis

1. Common Size I/S: Divide all items by Sales or Express

each item on I/S as a percentage of Total Revenue

2. Percentage Change Analysis: % Change from First

Year (2017 till 2019)
 2. Overall Performance Analysis

Overall
Management wants to measure the operational efficiency and owners want to know the returns on the funds invested
Performance
by them. Both these depend on the profits earned by the firm
Analysis

If the purpose ROA

is to know the Firms rate ofROIC
return on Assets ROE
 2. Overall Performance Analysis
What is the company’s rate of return on:
 Assets?

Overall Performance Analysis requires to compute return

on investment:

a. ROA or ROTA
b. ROIC or ROCE or ROC
c. ROE

Compute tax rate (t):

Effective tax rate (t) = (tax expense / PBT) *100
Tax expense is Current and Deferred tax
(1-t) = tax retention rate
 2. Overall Performance Analysis
Overall Performance Analysis requires to compute return
on investment:
– Variants of Investments : Assets ; Owners’ Equity; Invested Capital or Capital
Employed
– Variants of Returns : EBIT (1-t) ; PAT

a. ROA or ROTA = (Returns / Total Assets)*100

= [EBIT (1-t) / Total Assets]*100

b. ROIC or ROCE or ROC = (Returns / IC or CE)*100

= [EBIT (1-t) / IC or CE]*100
IC = CE which is Permanent Capital or Long-Term Capital
TA – CL = OE + LTL

c. ROE = (Returns / Equity)*100 = (PAT / OE)*100

Example Firm X - Income Statement

2013 2014
Sales $5,834,400 $7,035,600
COGS except depr. 4,980,000 5,800,000
Other expenses 720,000 612,960
Deprec. 116,960 120,000
Tot. op. costs 5,816,960 6,532,960
EBIT 17,440 502,640
Int. expense 176,000 80,000
EBT (158,560) 422,640
Taxes (40%) (63,424) 169,056
Net income ($ 95,136) $ 253,584
37
Common Size Income Statement: Divide all items by Sales
Inference - Firm X has lower COGS (82.4) than industry (84.5), but higher other
expenses. Result is that Firm X has similar EBIT (7.1) as industry.

2013 2014 Ind.

Sales 100.0% 100.0% 100.0%
COGS 85.4% 82.4% 84.5%
Depr. 2.0% 1.7% 4.0%
Other exp. 12.3% 8.7% 4.4%
EBIT 0.3% 7.1% 7.1%
Int. Exp. 3.0% 1.1% 1.1%
Pre-tax earn. -2.7% 6.0% 5.9%
Taxes -1.1% 2.4% 2.4%
NI -1.6% 3.6% 3.6%

38
Percentage Change Analysis: % Change from First Year (base
year 2012)

Inference - In 2014 sales grew 105% from 2012, and that NI grew 188% from 2012.
So Firm X has become more profitable

Income St. 2013 2014

Sales 70.0% 105.0%
COGS 73.9% 102.5%
Depr. 518.8% 534.9%
Other exp. 111.8% 80.3%
EBIT -91.7% 140.4%
Int. Exp. 181.6% 28.0%
EBT -208.2% 188.3%
Taxes -208.2% 188.3%
NI -208.2% 188.3% 39