Financial Statement Analysis

Techniques of Financial Statement

Analysis
• Horizontal analysis (%)
• Trend analysis (index)
• Vertical analysis (Common Size statement)
• Ratio analysis
 Ratio Analysis
Ratio analysis of financial statement is another tool that helps identify changes in a
company’s financial situation.

A single ratio is not sufficient to adequately judge the financial situation of the
company. Several ratios must be analyzed together and compared with prior-year ratios,
or even with other companies in the same industry. This comparative aspect of ratio
analysis is extremely important in financial analysis.

It is important to note that ratios are parameters and not precise or absolute
measurements. Thus, ratios must be interpreted cautiously to avoid erroneous
conclusions.
 Financial Ratios

Liquidity Ratios Profitability Ratios Turnover/Activity

Solvency Ratios
Ratios
 Liquidity Ratios

Liquidity ratio analysis measure how liquid the company’s assets are (how
easily can the assets be converted into cash) as compared to its current
liabilities. The common liquidity ratio are:

1.Current ratio analysis
2.Acid test (or quick asset) ratio analysis
 Current Ratio Analysis

Current ratio is the most frequently used ratio to measure company’s liquidity as it
is quick, intuitive and easy measure to understand the relationship between the
current assets and current liabilities.

It basically answers this question “How many dollars in current assets does the
company have to cover each $ of current liabilities”

Current Ratio = Current Assets / Current Liabilities

 INTERPRETATION OF CURRENT RATIO

Manufacturing companies - High CR

Retail Sector (Walmart, BigBazar) – Lower CR

CURRENT RATIO ANALYSIS – COLGATE
PALMOLIVE
Colgate has maintained a healthy current ratio of greater than 1 in the past 10 years.

Current ratio of Colgate for 2015 was at 1.24x. This implies that current assets of
Colgate are more than current liabilities of Colgate.

However, we still need to investigate on the quality and liquidity of Current Assets.
We note that around 45% of current assets in 2015 consists of Inventories and Other
Current Assets. This may affect the liquidity position of Colgate.

When investigating Colgate’s inventory, we note that majority of the Inventory

consists of Finished Goods (which is better in liquidity than raw materials supplies
and work-in-progress).
Comparison of Current Ratio of Colgate’s vs P&G
vs Unilever
 Competitive Comparison Data
Ticker Company Market Cap (M) Current Ratio
UL Unilever PLC $ 155,510.39 0.81
XAMS:UNA Unilever NV $ 150,542.24 0.81
XPAR:OR L'Oreal SA $ 147,791.56 1.24

EL The Estee Lauder Companies $ 66,356.58 1.69

Inc

CL Colgate-Palmolive Co $ 61,450.42 1.13

BOM:500696 Hindustan Unilever Ltd $ 56,179.60 1.37

LSE:RB. Reckitt Benckiser Group PLC $ 52,845.19 0.59

KMB Kimberly-Clark Corp $ 48,168.75 0.81

XTER:HEN3 Henkel AG & Co KGaA $ 42,512.42 1.02
TSE:4452 Kao Corp $ 35,398.23 1.86
WHAT IS QUICK RATIO?
• Sometimes current assets may contain huge amounts of inventory, prepaid expenses
etc. This may skew the current ratio interpretations as these are not very liquid.

• To address this issue, if we consider the only most liquid assets like Cash and Cash
equivalents and Receivables, then it should provide us with a better picture on the
coverage of short term obligations.

•This ratio is know as Quick Ratio or the Acid Test.

•The rule of thumb for a healthy acid test index is 1.0.

Quick Ratio = Current Assets – Stock - Prepaid Expenses/

Current Liabilities – B.O
 Interpretation of Q.R.
Low quick ratios in businesses that sell on cash basis (for example, restaurants,
supermarkets etc). In these businesses there are no receivables, however, there maybe a
huge pile of inventory.

Construction Companies – A/R takes much time to convert into cash

QUICK RATIO ANALYSIS – COLGATE PALMOLIVE
Comparison of Quick Ratio of Colgate’s vs P&G
vs Unilever
 Profitability Ratios
• Net Sales
• Return on Funds invested

1. GROSS PROFIT MARGIN?

Gross Margin Formula = (Sales – Costs of Goods Sold)/Net Sales

= Gross Profit / Net Sales
• Gross Margin can vary drastically between industries. For example, digital
products sold online will have extremely high Gross Margin as compared to a
company that sells Laptop.

• Gross margin is extremely useful when we look at the historical trends in the
margins.

•If the Gross Margins has increased historically, then it could be either because
of price increase or control of direct costs.

• However, if the Gross margins show a declining trend, then it may be because
of increased competitiveness and therefore resulting in decreased sales price.
Shipping and handling costs may be reported either in Cost of Sales or Selling
General and Admin Expenses. Colgate has however, reported these costs as a part
of Selling General and Admin Expenses. If such expenses are included in Cost of
Sales, then the Gross margin of colgate would have decreased by 770 bps from
58.6% to 50.9% and decreased by 770bps and 750 bps in 2014 and 2013
respectively.
 Operating Profit Margin
(Operating ability)

Operating profit or Earnings Before Interest and Taxes (EBIT) margin

measures the rate of profit on sales after operating expenses. Operating
income can be thought of as the “bottom line” from operations.

Operating Profit Margin = EBIT / Net Sales

or = EBITDA/Net Sales (Assume, Dep as Non-operating)
Historically, Colgate’s Operating Profit has remained in the range of 20%-23%
However, in 2015, Colgate’s EBIT Margin decreased significantly to 17.4%. This
was primarily due to change in accounting terms for CP Venezuela entity
 Venezuela’s Discontinuation: What Impact on
Colgate’s Earnings?
•Colgate derives more than 75% income from outside of United States. The
company is exposed to changes in economic conditions, exchange rates
volatilities and political uncertainty in some countries.

•Once such country has been Venezuela, where operating environment has
been very challenging for Colgate and economic uncertainty due to
wide exchange rate devaluations. Additionally, due to price controls, Colgate
has restricted ability to implement price increases without governmental
approval.

•Colgate’s ability to generate income continue to be negatively affected by

these difficult geo-political conditions.
•As a result, effective from December 31st, 2015, Colgate is no longer
including the results of CP Venezuela in its consolidated income statement and
began accounting of its CP Venezuela entity using Cost method of accounting.
As a result, the company has taken pre-tax charge of $1.084 billion in 2015.

•This has resulting in decrease of Operating Margin of Colgate in 2015.

 Net Profit Margin
(Operating & Financial ability)

Net Profit Margin Formula = Net Income / Net Sales

Net Profit Margin Ratio indicates the proportion of sales revenue that translates into
net profit.
For example, a net profit margin of 35% means that every $1 sale contributes 35
cents towards the net profits of the business.

Measuring the trend of NP margin over several periods in comparison to industry

benchmarks is crucial for identifying performance gaps that could be overcome to
improve the profitability of business in the future.
 PROFITABILITY MARGIN ANALYSIS
Below is the Top 20 companies in the Technology sector with Market Capitalization of more than $25
billion.
•Facebook and Adobe has the highest gross Margin in this peer group.  This is primarily due
the fact that they don’t sell tangible products (no raw material as they are into
software/internet where direct costs are less.

•Though Apple has a Gross Margin which is way low in comparison to Facebook. This is
because they have a higher direct cost (including the manufacturing, raw material and direct
labor costs).

•However, Apple does really well at the Operating level (~27.8%) and Profit Margin Levels
(21.2%)
 RETURN ON CAPITAL EMPLOYED

Company’s ability to utilize its capital employed (Debt & Equity) in the
business

ROCE Ratio = Net Operating Income (EBIT) /

(Total Assets – Current Liabilities)

ROCE = Higher the Better

 RETURN ON CAPITAL EMPLOYED- EXAMPLE # 1

In US $ Company A Company B

Revenue 500,000 400,000

COGS 420,000 330,000

Operating Expenses 10,000 8,000

Total Assets 300,000 400,000

Current Liabilities 15,000 20,000

ROCE ? ?
 RETURN ON CAPITAL EMPLOYED  – BEVERAGES – SOFT
DRINKS
Below is the list of top companies in Beverages in Soft Drinks Sector along with its Market Capitalization and ROCE

S. No Name  Market Cap ($ mn) ROCE

1 Coca-Cola  193,590 14.33%

2 PepsiCo  167,435 18.83%

3 Monster Beverage  29,129 24.54%

4 Dr Pepper Snapple Group 17,143 17.85%

5 National Beverage   4,156 45.17%

6 Embotelladora Andina   3,840 16.38%

7 Cott   1,972 2.48%

 RETURN ON CAPITAL EMPLOYED – GLOBAL BANKS
Below is the list of top Global banks with their Market Cap and ROCE

S. No Name  Market Cap ($ mn) ROCE

1 JPMorgan Chase   306,181 2.30%
2 Wells Fargo    269,355 2.23%
3 Bank of America  233,173 1.76%
4 Citigroup   175,906 2.02%
5 HSBC Holdings  176,434 0.85%
6 Banco Santander  96,098 2.71%
7 The Toronto-Dominion Bank  90,327 1.56%
8 Mitsubishi UFJ Financial  87,563 0.68%
9 Westpac Banking  77,362 3.41%
10 ING Groep 65,857 4.16%
11 UBS Group 59,426 1.29%
12 Sumitomo Mitsui Financial  53,934 1.19%
 ROCE – Energy Sector
Below list contains the Market Cap and ROCE of the top Energy Companies.

S. No Name  Market Cap ($ mn) ROCE

1 ConocoPhillips  56,152 -5.01%
2 EOG Resources  50,245 -4.85%
3 CNOOC 48,880 -0.22%
4 Occidental Petroleum  45,416 -1.99%
5 Canadian Natural 33,711 -1.21%
6 Pioneer Natural Resources 26,878 -5.26%
7 Anadarko Petroleum  25,837 -6.97%
8 Apache  18,185 -5.71%
9 Concho Resources  17,303 -18.24%
10 Devon Energy  16,554 -13.17%
11 Hess  13,826 -12.15%
12 Noble Energy  12,822 -6.89%
LIMITATIONS OF RETURN ON CAPITAL
EMPLOYED (ROCE)

There are a couple of disadvantages of ROCE.

First, you can’t depend on ROCE alone because you need to calculate other
profitability ratios to get the whole picture. Moreover, ROCE is calculated on EBIT
and not on Net Income which can turn out to be a great disadvantage.

Second, ROCE seems to favor older companies. Because older companies are able to
depreciate their assets more than newer companies, and as a result, for older
companies, ROCE becomes better.
 Return on Equity
Return on equity (ROE) is the amount of net income returned as a
percentage of shareholders' equity. Return on equity (also known as
"return on net worth" [RONW]) measures a corporation's profitability
by revealing how much profit a company generates with the money
shareholders have invested.

Return on Equity = Net Income/Shareholder's Equity

ROE OF SOFT DRINK SECTOR
Let us have a look at the ROE’s of Top Soft Drink companies. Details provided here is the Market Capitalization, ROE, Profit
Margin, Asset Turnover and Equity Multiplier.

Market Cap ($ Return on Equity Profit Margin Asset Equity

Name million) (Annual) (Annual) Turnover Multiplier
Coca-Cola 180454 26.9% 15.6% 0.48x 3.78x
PepsiCo 158977 54.3% 10.1% 0.85x 6.59x
Monster Beverage 26331 17.5% 23.4% 0.73x 1.25x

Dr Pepper Snapple 17502 39.2% 13.2% 0.66x 4.59x

Group

Embotelladora 3835 16.9% 5.1% 1.19x 2.68x

Andina

National Beverage 3603 34.6% 8.7% 2.31x 1.48x

Cott 1686 -10.3% -2.4% 0.82x 4.54x

 RETURN ON EQUITY OF AUTOMOBILE SECTOR
Below is the list of Top automobile companies with Market
Capitalization, ROEs
Market Cap ($ Return on Equity Profit Margin Asset Equity
Name
million) (Annual) (Annual) Turnover Multiplier

Toyota Motor 167658 13.3% 8.1% 0.56x 2.83x

Honda Motor Co 55943 4.8% 2.4% 0.75x 2.70x

General Motors 54421 22.5% 5.7% 0.75x 5.06x

Ford Motor 49599 15.9% 3.0% 0.64x 8.16x

Tesla 42277 -23.1% -9.6% 0.31x 4.77x

Tata Motors 24721 14.6% 3.6% 1.05x 3.43x

Fiat Chrysler 21839 10.3% 1.6% 1.11x 5.44x

Automobiles

Ferrari 16794 279.2% 12.8% 0.84x 11.85x

 Return on Assets
Return on assets (ROA) is a financial ratio that shows the percentage of profit a company
earns in relation to its overall resources.

Return on Total Assets = EBIT / Average Total Assets

• Return on Total Assets of a company is more than 20% for the last 5 years. Do
you think it’s a good measure to invest into the company for future benefits?

• In simple terms, we can say that increase in the Return on Total Assets means
better use of assets to generate returns for the firm and decrease in the Return on
Total Assets means that the firm has a room for improvement – maybe the firm
needs to reduce few expenses or to replace few old assets that are eating out the
profits of the company.
 ROA
Particulars Company A (in US $) Company B (in US $)

Operating Profit – EBIT 10000 8000

Taxes 2000 1500

Assets at the beginning of the year 13000 14000

Assets at the end of the year 15000 16000

For industries which are asset intensive won’t generate that much income
compared to the industries which are not asset intensive. For example, if
we take into account an auto industry, to produce auto and as a result of
that, profits; the industry first needs to invest a lot in the assets. Thus, in
case of auto industry, the ROA won’t be that higher.

However, in case of services companies where investments in Assets is

minimal, then the ROA will be pretty high.
 Earnings Per Share (EPS)

Every investor invests into a company’s stock mainly for two reasons –

Firstly, the investors invest in a company’s stock because they expect a handsome
dividend from the company.

Secondly, the investors may see a great growth potential of the company in near
future. If the company grows, the share price will also rise and that will only help
investors in ensuring a great return on their investments.
Hit Technology Inc. has the following information –

The net income for the year end 2017 – $450,000

The preferred dividends paid in 2017 – $30,000

At the beginning of the year 2017, the common shares outstanding were
50,000 shares. In the middle of the year, Hit Technology Inc. issued another
40,000 common shares.
 Activity/Turnover Ratios
1. Inventory Turnover Ratio (ITR): It dictates how fast a company
replaces a current batch of inventories and transforms the inventories
into sales.
Colgate’s Inventory Turnover
 Accounts Receivables Turnover Ratio

• This ratio is a measure that computes that how easily a company can
convert its receivables into cash
•A higher Accounts receivables turnover is healthy for a company. It denotes that
the time interval between the credit sales and the receipt of money is lower. And that
means the firm is quite efficient in collecting the accounts receivables.

•On the other hand, a lower Accounts receivables turnover is not good enough for a
company. It indicates that the time interval between the credit sales and the receipt
of money is higher. And as a result, there’s always a risk of not receiving the due
amount.

•When an investor looks at the Accounts receivables turnover, he/she needs to know

how efficient the firm is in collecting the due amount. If there’s any risk in delaying
or not receiving the payment, it may directly affect the cash flow of the company.
 AVERAGE COLLECTION PERIOD

• The collection period is the time between the credit sales are made and
the cash is paid.
BIG Company decides to increase its credit term. The top management of the company
requests the accountant to find out the collection period of the company in current scenario.

Here is the information available to the accountant –

Net Credit Sales for the year – $150,000

Accounts Receivables at the beginning of the year – $20,000

Accounts Receivables at the end of the year – $30,000

As an accountant, find out the collection period of BIG Company.

For example, if a company has a collection period of 40 days, it should provide the
term as 30-35 days.

Knowing the collection period is very useful for any company.

There are two reasons for this –

• First, a huge percentage of company’s cash flow depends on the collection period.

• Second, knowing the collection period beforehand helps a company decide means to
collect the money that is due on the market.
 Solvency Ratios
Solvency ratios are calculated to determine the ability of the business to
service its debt in the long run.

Long term investors are interested in safety of their principal amount

and interest.

1. Debt-Equity ratio
2. Interest Coverage ratio
 Debt-Equity Ratio
• Measures the relationship between long-term debt and equity.

• From security point of view, capital structure with less debt and more
equity is considered favourable as it reduces the chances of bankruptcy.

Debt-Equity Ratio = Long − term Debts/Shareholders' Funds

Shareholders’ Funds (Equity) = Share capital + Reserves and Surplus +

Retained Earnings
 Interest Coverage ratio
• It is a measure of security of interest payable on long-term debts. It
expresses the relationship between profits available for payment of
interest and the amount of interest payable.

Interest Coverage Ratio = EBIT/ Interest on long-term debts

• A higher ratio ensures safety of interest on debts.

 P/E Ratio
• Used to determine how much investors are willing to pay for a stock relative to the
company’s earnings.

P/E Ratio = Market Value per Share / Earnings per Share

P/E is sometimes referred to as the price multiple because it shows how much investors
are willing to pay per dollar of earnings.

Let’s say, P/E ratio = 20

An investor is willing to pay $20 for $1 of current earnings.

Particulars Company A (in US $) Company B (in US $)

Market value per share 18 18

EPS 2 6

P/E ratio 9 3

Investor can invest in Company B, because he/she is paying less for the same
amount of earning.
 P/BV Ratio
• To compare a company’s market value with its book value.

• This ratio also indicates whether you're paying too much for what
would remain if the company went bankrupt immediately.

P/B ratio = market price per share / book value per share

A lower P/B ratio could mean the stock is undervalued. However, it

could also mean something is fundamentally wrong with the company.
As with most ratios, this varies by industry.
 Dividend Yield Ratio

• A financial ratio that indicates how much a company pays out

in dividends each year relative to its share price.

• For Investors’ dividend yield is a way to measure how much cash flows
they are getting for each dollar invested in a dividend-paying shares.

Dividend Yield ratio = Annual dividend per share/

Market Price per share
Valuation
Ratio
(PEG
ratio)

• a company's P/E and expected growth should be equal, which denotes a

fairly valued company and supports a PEG ratio of 1.0. When a company's
PEG exceeds 1.0, it's considered overvalued while a stock with a PEG of less
than 1.0 is considered undervalued.
 Summary

Ratio analysis is to provide a deeper analysis of the profitability,

liquidity, solvency and activity levels in the business. It is also to
identify the problem areas as well as the strong areas of the business.

Users can not rely on single ratios for decision-making