Financial Statmenet Analysis.pdf

Financial Statement Analysis Section A Part 2 CMA USA RABEEH OVUNGAL Welcome to our Certified Management Accountant (CMA) Lecture YouTube Channel! Our channel is dedicated to providing you with high-quality and comprehensive lectures that cover all the key concepts and topics related to...

Financial Statement Analysis Section A Part 2 CMA USA RABEEH OVUNGAL Welcome to our Certified Management Accountant (CMA) Lecture YouTube Channel! Our channel is dedicated to providing you with high-quality and comprehensive lectures that cover all the key concepts and topics related to the CMA USA certification. Our lectures cover a wide range of topics, including financial accounting, management accounting, corporate finance, strategic management, and more. We use real-world examples and case studies to help you better understand the concepts. Whether you're just starting your journey toward becoming a CMA or are looking to enhance your knowledge and skills, our lectures are the perfect resource for you. Our videos are easily accessible and can be viewed at your own pace, making learning convenient and flexible. So, subscribe to our channel today and start your journey toward becoming a Certified Management Accountant! eduCafia YouTube Channel https://www.youtube.com/@educafia Contents: 1) Liquidity Ratio Page – 04 2) Solvency Ratio Page – 21 3) Activity Ratio Page – 39 4) Profitability Ratio Page – 57 5) Market Ratio Page – 69 Liquidity Ratios Part 02 – Financial Statement Analysis  Liquidity ratio the ability of a firm to meet its short term obligations. A company needs short term assets to finance its short term obligations for daily operations. But they doesn't need to have too much short term assets. Types of Liquidity Ratios 1) Current Ratio Cash in Hand 2) Quick Ratio Cash in Bank Marketable Securities 3) Cash Ratio Accounts Receivables Inventory 4) Working Capital Ratio Prepaid Expenses 5) Cashflow Ratio  𝟏) 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐑𝐚𝐭𝐢𝐨 Most commonly used to measure of liquidity. It relates the ratio between current asset to current liability. Current Asset Cash in Hand Cash in Bank Marketable Securities Accounts Receivables Inventory Prepaid Expenses  𝟏) 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐑𝐚𝐭𝐢𝐨 Most commonly used to measure of liquidity. It relates the ratio between current asset to current liability. 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐑𝐚𝐭𝐢𝐨 = 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐲 (𝑐𝑎𝑠ℎ + 𝑐𝑎𝑠ℎ 𝑖𝑛 𝑏𝑎𝑛𝑘 + 𝑚𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 + 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 + 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 + 𝑝𝑟𝑒𝑝𝑎𝑖𝑑 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠) 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 Standard Current Ratio is 2:1  Asset Amount Liability Amount Cash in hand 50,000 Accounts Payable 50,000 Cash in bank 1,00,000 Accrued Wages 50,000 Marketable Securities 50,000 Short Term Loans 1,00,000 Accounts Receivable 1,00,000 Long Term loans 3,00,000 Inventory 50,000 Share capital 4,00,000 Prepaid Expenses 50,000 Fixed Assets 5,00,000 Total Liabilities 9,00,000 Total Assets 9,00,000 and Equity 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 50,000 + 1,00,000 + 50,000 + 1,00,000 + 50,000 + 50,000 = 50,000 + 50,000 + 1,00,000 4,00,000 = =2 2,00,000  𝟐) 𝐐𝐮𝐢𝐜𝐤 𝐑𝐚𝐭𝐢𝐨 Also called Acid Test Ratio. Doesn't include inventory and prepaid expenses. More conservative than Current Ratio. It measures the firm ability to pay its short term debt using its most liquid asset. 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭 𝐟𝐨𝐫 𝐪𝐮𝐢𝐜𝐤 𝐫𝐚𝐭𝐢𝐨 𝐐𝐮𝐢𝐜𝐤 𝐑𝐚𝐭𝐢𝐨 = 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐲 (𝑐𝑎𝑠ℎ + 𝑐𝑎𝑠ℎ 𝑖𝑛 𝑏𝑎𝑛𝑘 + 𝑚𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 + 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 ) 𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 = 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 Standard Current Ratio is 1:1  Asset Amount Liability Amount Cash in hand 50,000 Accounts Payable 50,000 Cash in bank 1,00,000 Accrued Wages 50,000 Marketable Securities 50,000 Short Term Loans 1,00,000 Accounts Receivable 1,00,000 Long Term loans 3,00,000 Inventory 50,000 Share capital 4,00,000 Prepaid Expenses 50,000 Fixed Assets 5,00,000 Total Liabilities 9,00,000 Total Assets 9,00,000 and Equity 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡 𝑓𝑜𝑟 𝑞𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 50,000 + 1,00,000 + 50,000 + 1,00,000 = 50,000 + 50,000 + 1,00,000 3,00,000 = = 1.5 2,00,000  𝟑) 𝐂𝐚𝐬𝐡 𝐑𝐚𝐭𝐢𝐨 More conservative than Quick Ratio. It includes only Cash, cash equivalence and marketable securities. 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭 𝐟𝐨𝐫 𝐂𝐚𝐬𝐡 𝐑𝐚𝐭𝐢𝐨 𝐂𝐚𝐬𝐡 𝐑𝐚𝐭𝐢𝐨 = 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐲 𝑐𝑎𝑠ℎ + 𝑐𝑎𝑠ℎ 𝑖𝑛 𝑏𝑎𝑛𝑘 + 𝑚𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 = 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦  Asset Amount Liability Amount Cash in hand 50,000 Accounts Payable 50,000 Cash in bank 1,00,000 Accrued Wages 50,000 Marketable Securities 50,000 Short Term Loans 1,00,000 Accounts Receivable 1,00,000 Long Term loans 3,00,000 Inventory 50,000 Share capital 4,00,000 Prepaid Expenses 50,000 Fixed Assets 5,00,000 Total Liabilities 9,00,000 Total Assets 9,00,000 and Equity 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡 𝑓𝑜𝑟 𝑞𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 50,000 + 1,00,000 + 50,000 = 50,000 + 50,000 + 1,00,000 2,00,000 = =1 2,00,000  𝟒) 𝐖𝐨𝐫𝐤𝐢𝐧𝐠 𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐑𝐚𝐭𝐢𝐨 It measures the percentage of working capital from total assets. Working Capital 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦  𝟒) 𝐖𝐨𝐫𝐤𝐢𝐧𝐠 𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐑𝐚𝐭𝐢𝐨 It measures the percentage of working capital from total assets. 𝐖𝐨𝐫𝐤𝐢𝐧𝐠 𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐖𝐨𝐫𝐤𝐢𝐧𝐠 𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐑𝐚𝐭𝐢𝐨 = 𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡  Asset Amount Liability Amount Cash in hand 50,000 Accounts Payable 50,000 Cash in bank 1,00,000 Accrued Wages 50,000 Marketable Securities 50,000 Short Term Loans 1,00,000 Accounts Receivable 1,00,000 Long Term loans 3,00,000 Inventory 50,000 Share capital 4,00,000 Prepaid Expenses 50,000 Fixed Assets 5,00,000 Total Liabilities 9,00,000 Total Assets 9,00,000 and Equity 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 4,00,000 − 2,00,000 = 9,00,000 2,00,000 = = 0.2222 22.22% 9,00,000  𝟓) 𝐂𝐚𝐬𝐡𝐟𝐥𝐨𝐰 𝐑𝐚𝐭𝐢𝐨 It measures the ability of a meet its short term obligations based on the cash generated in the normal course of business or operating cashflow. 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐂𝐚𝐬𝐡𝐟𝐥𝐨𝐰 𝐂𝐚𝐬𝐡𝐟𝐥𝐨𝐰 𝐑𝐚𝐭𝐢𝐨 = 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐲 𝐐𝐮𝐞𝐬𝐭𝐢𝐨𝐧 Most of the current assets are prepaid expenses. What is the effect on current ratio? 𝐀𝐧𝐬𝐰𝐞𝐫 Current Ratio will overstate 𝐐𝐮𝐞𝐬𝐭𝐢𝐨𝐧 The company have accounts receivables and most of it was from a customer which is going to become bankrupt. What is the effect on companies current ratio? 𝐀𝐧𝐬𝐰𝐞𝐫 Current ratio seems to be good, but no enough liquidity. 𝐐𝐮𝐞𝐬𝐭𝐢𝐨𝐧 A company is paying its short term obligations just before preparing balance sheet. What is the effect current ratio? 𝐀𝐧𝐬𝐰𝐞𝐫 50,000 Paying for short term obligation Current Asset = 2,00,000 Current Asset = 1,50,000 Current Liability = 1,00,000 Current Liability = 50,000 2,00,000 1,50,000 Current Ratio = = 2: 1 Current Ratio = = 3: 1 1,00,000 50,000 2: 1 3: 1 𝐖𝐢𝐧𝐝𝐨𝐰 𝐃𝐫𝐞𝐬𝐬𝐢𝐧𝐠 𝐖𝐢𝐧𝐝𝐨𝐰 𝐃𝐫𝐞𝐬𝐬𝐢𝐧𝐠 It is the act of doing certain activities to just show the financial performance has been improved. In general the analyst and investors has the responsibility to look beyond the numbers. Because the firms actual condition may be different from what is shown in a ratio. Solvency Ratios Part 02 – Financial Statement Analysis Leverage In general leverage refers to the potential to earn a high level of return relative to the amount of cost spend. Leverage can be advantages but it can also be risky. Company with more equity than debt is more stable. Financial Leverage It is the use of debt to increase earnings. Interest is the fixed charge for which company is liable when taking debts. A company may be successful if they generate high return more than interest expense. And may not be successful if they didn’t generate high return using the debt. Solvency Ratios Degree of Financial Leverage (DFL) It measures by how much net income can be expected to change in the future due to the change in earnings before interest and tax. Sales Revenue ( Variable Cost ) 𝐄𝐁𝐈𝐓 𝐃𝐞𝐠𝐫𝐞𝐞 𝐨𝐟 𝐅𝐢𝐧𝐚𝐧𝐜𝐢𝐚𝐥 𝐋𝐞𝐯𝐞𝐫𝐚𝐠𝐞 = Contribution Margin 𝐄𝐁𝐓 ( Fixed Cost ) Earnings before Interest and Tax ( EBIT ) ( Interest ) Earnings before Tax ( EBT ) ( Tax ) Net Profit Solvency Ratios Degree of Financial Leverage (DFL) It measures by how much net income can be expected to change in the future due to the change in earnings before interest and tax. 𝐄𝐁𝐈𝐓 𝐃𝐞𝐠𝐫𝐞𝐞 𝐨𝐟 𝐅𝐢𝐧𝐚𝐧𝐜𝐢𝐚𝐥 𝐋𝐞𝐯𝐞𝐫𝐚𝐠𝐞 = 𝐄𝐁𝐓 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇 Solvency Ratios Degree of Operating Leverage (DOL) It is the ability to use fixed cost for increasing earnings before Interest and tax. Sales Revenue ( Variable Cost ) 𝐂𝐌 𝐃𝐞𝐠𝐫𝐞𝐞 𝐨𝐟 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐋𝐞𝐯𝐞𝐫𝐚𝐠𝐞 = Contribution Margin 𝐄𝐁𝐈𝐓 ( Fixed Cost ) Earnings before Interest and Tax ( EBIT ) ( Interest ) Earnings before Tax ( EBT ) ( Tax ) Net Profit Solvency Ratios Degree of Operating Leverage (DOL) It is the ability to use fixed cost for increasing earnings before Interest and tax. 𝐂𝐌 𝐃𝐞𝐠𝐫𝐞𝐞 𝐨𝐟 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐋𝐞𝐯𝐞𝐫𝐚𝐠𝐞 = 𝐄𝐁𝐈𝐓 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇 𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠 Solvency Ratios Degree of Combined Leverage (DCL) It is the ratio by which changes in sales will change net income. Sales Revenue ( Variable Cost ) 𝐂𝐌 𝐃𝐞𝐠𝐫𝐞𝐞 𝐨𝐟 𝐂𝐨𝐦𝐛𝐢𝐧𝐞𝐝 𝐋𝐞𝐯𝐞𝐫𝐚𝐠𝐞 = Contribution Margin 𝐄𝐁𝐓 ( Fixed Cost ) Earnings before Interest and Tax ( EBIT ) ( Interest ) Earnings before Tax ( EBT ) ( Tax ) Net Profit Solvency Ratios Degree of Combined Leverage (DCL) It is the ratio by which changes in sales will change net income. 𝐂𝐌 𝐃𝐞𝐠𝐫𝐞𝐞 𝐨𝐟 𝐂𝐨𝐦𝐛𝐢𝐧𝐞𝐝 𝐋𝐞𝐯𝐞𝐫𝐚𝐠𝐞 = 𝐄𝐁𝐓 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝐶𝑜𝑚𝑏𝑖𝑛𝑒𝑑 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠 Solvency Ratios  𝐐𝐮𝐞𝐬𝐭𝐢𝐨𝐧 EBIT 40,000 Sales Revenue 2,00,000 DFL = = = 1.14 EBT 35,000 ( Variable Cost ) 60,000 Contribution Margin 1,40,000 CM 1,40,000 ( Fixed Cost ) 1,00,000 DOL = = = 3.5 EBIT 40,000 EBIT 40,000 ( Interest ) 5,000 CM 1,40,000 EBT 35,000 DCL = = =4 EBT 35,000 ( Tax ) 30% (12,250) Net Profit 22,750 Solvency Ratios Financial Leverage Ratio It measures the amount of debt company uses to finance its assets. Total Assets Finance Leverage Ratio = Total Equity Balance Sheet Example, 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐲 𝐅𝐢𝐧𝐚𝐧𝐜𝐢𝐚𝐥 𝐋𝐞𝐯𝐞𝐫𝐚𝐠𝐞 𝐑𝐚𝐭𝐢𝐨 = 𝟑: 𝟏 𝐀𝐬𝐬𝐞𝐭 𝟐 Preferred Share holder Capital 𝟑 𝐄𝐪𝐮𝐢𝐭𝐲 Common Share holder Capital 𝟏 Retained Earnings Solvency Ratios  Financial Leverage Ratio It measures the amount of debt company uses to finance its assets. Total Assets Finance Leverage Ratio = Total Equity A high financial leverage ratio implies, company is financing it assets mostly by using debts. If ratio is one, its means total asset is equal to total equity. Zero debt. Solvency Ratios 𝐒𝐨𝐥𝐯𝐞𝐧𝐜𝐲 𝐑𝐚𝐭𝐢𝐨𝐬 Solvency ratio the ability of a firm to meet its long term obligations. A company needs long term assets to finance its long term assets for long term obligations. Types of Solvency Ratios 1) Debt to Equity Ratio 2) Long-term Debt to Equity Ratio 3) Total Debt to Total Asset Ratio 4) Interest Coverage Ratio Solvency Ratios 1) Debt to Equity Ratio It compares the total liability is to total equity Total Liability Debt to Equity Ratio = Total Equity Solvency Ratios 2) Long-term Debt to Equity Ratio It compares the long term liability is to total equity Total Liability − Current Liability Long Term Debt to Equity Ratio = Total Equity Solvency Ratios 3) Total Debt to Total Asset It compares the total liability is to total asset Total Liability Total Debt to Total Asset = Total Asset Solvency Ratios 4) Interest Coverage Ratio Also called Times interest earned ratio. It measures the ability of the company to pay interest expense using earnings before interest and tax. EBIT Interest Coverage Ratio = Interest The Standard Ratio is at least 3 times. 3:1 Solvency Ratios  Asset Amount Liability Amount Cash in hand 40,000 Bills Payable 1,50,000 Cash in bank 1,00,000 Debentures 2,20,000 Accounts Receivable 1,50,000 Preference Share Capital 2,00,000 Inventory 1,50,000 Equity Share Capital 2,00,000 Plants and Machine 3,00,000 Retained Earnings 1,20,000 Land and Building 1,50,000 8,90,000 $ 8,90,000 $ EBIT = 3,20,000 $ Interest Expense = 80,000 $ 𝑇𝐴 8,90,000 Financial Leverage Ratio = = = 1.71 𝑇𝐸 5.20,000 𝑇𝐿 3,70,000 Debt to Equity Ratio = = = 0.71 𝑇𝐸 5.20,000 𝑇 𝐿𝑜𝑛𝑔𝑡𝑒𝑟𝑚 𝐿 2,20,000 Long Term Debt to Equity Ratio = = = 0.42 𝑇𝐸 5.20,000 Solvency Ratios  Asset Amount Liability Amount Cash in hand 40,000 Bills Payable 1,50,000 Cash in bank 1,00,000 Debentures 2,20,000 Accounts Receivable 1,50,000 Preference Share Capital 2,00,000 Inventory 1,50,000 Equity Share Capital 2,00,000 Plants and Machine 3,00,000 Retained Earnings 1,20,000 Land and Building 1,50,000 8,90,000 $ 8,90,000 $ EBIT = 3,20,000 $ Interest Expense = 80,000 $ 𝑇𝐿 3,70,000 Total Debt to Total Asset = = = 0.42 𝑇𝐴 8,90,000 𝐸𝐵𝐼𝑇 3,20,000 Interest Coverage Ratio = = =4 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 80,000 Solvency Ratios Activity Ratios Part 02 – Financial Statement Analysis Activity ratios provide information about a firm ability to efficiently manage the, Current Asset Current Liability Accounts Receivables Accounts Payable 𝐓𝐲𝐩𝐞𝐬 𝐨𝐟 𝐀𝐜𝐭𝐢𝐯𝐢𝐭𝐲 𝐑𝐚𝐭𝐢𝐨𝐬 1) Accounts receivable turnover ratio 2) Inventory turnover ratio 3) Accounts payable turnover ratio 4) Total assets turnover ratio 5) Fixed assets turnover ratio Activity Ratios 1) Accounts Receivables Turnover Ratio It measures how efficiently a company collects its accounts receivables. An increase in ARTR indicates that receivables are collected more rapidly. A decrease shows slow collection. Annual net credit sales ARTR = Average accounts receivable. 365 Average Collection Period = ARTR Activity Ratios  365 365 Average Collection Period = = ARTR 𝐴𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 = 𝐴𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠 365 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 = 𝑃𝑒𝑟 𝑑𝑎𝑦 𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴\R 𝐴𝐶𝑃 = 𝑃𝑒𝑟 𝑑𝑎𝑦 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒 Activity Ratios 𝐐𝐮𝐞𝐬𝐭𝐢𝐨𝐧 Annual Net credit sale = $ 1,00,000 Average accounts receivables = $ 25,000 Calculate ARTR and Avg Collection period if number of days in a year is 360. 𝐀𝐧𝐬𝐰𝐞𝐫 Annual net credit sales 1,00,000 ARTR = = =4 Average accounts receivable. 25,000 360 360 Average Collection Period = = = 90 𝑑𝑎𝑦𝑠 ARTR 4 Activity Ratios 2) Inventory Turnover Ratio It measures how efficiently a company converts their inventory into sales. Cost of goods sold ITR = Average inventory 365 𝐷𝑎𝑦 𝑠𝑎𝑙𝑒𝑠 𝑖𝑛 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = 𝐼𝑇𝑅 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐷𝑎𝑦 𝑠𝑎𝑙𝑒𝑠 𝑖𝑛 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = 𝑝𝑒𝑟 𝑑𝑎𝑦 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 Activity Ratios 𝐐𝐮𝐞𝐬𝐭𝐢𝐨𝐧 COGS = 2,00,000 $ Opening Inventory = 1,50,000 $ Closing Inventory = 2,00,000 $ Calculate inventory turnover ratio and days sales in inventory. 𝐀𝐧𝐬𝐰𝐞𝐫 Cost of goods sold 2,00,000 2,00,000 ITR = = = = 1.14 Average inventory 1,50,000 + 2,00,000 1,75,000 2 365 365 𝐷𝑎𝑦 𝑠𝑎𝑙𝑒𝑠 𝑖𝑛 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = = = 319 𝑑𝑎𝑦𝑠 𝐼𝑇𝑅 1.14 Activity Ratios 𝐂𝐨𝐬𝐭 𝐨𝐟 𝐆𝐨𝐨𝐝𝐬 𝐒𝐨𝐥𝐝 𝐂𝐎𝐆𝐒 = 𝐨𝐩𝐞𝐧𝐢𝐧𝐠 𝐬𝐭𝐨𝐜𝐤 + 𝐩𝐮𝐫𝐜𝐡𝐚𝐬𝐞 − 𝐂𝐥𝐨𝐬𝐢𝐧𝐠 𝐬𝐭𝐨𝐜𝐤 Activity Ratios 3) Accounts Payable Turnover Ratio It measures how efficiently a company pays there accounts payable. Annual credit purchase APTR = Average accounts payable 365 Day purchase in payable = APTR 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝐷𝑎𝑦 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑖𝑛 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 = 𝑝𝑒𝑟 𝑑𝑎𝑦 𝑐𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 Activity Ratios 𝐐𝐮𝐞𝐬𝐭𝐢𝐨𝐧 Accounts payable in 2020 = 60,000 $ Accounts payable in 2021 = 40,000 $ Credit purchase = 10,00,000 $ Calculate accounts payable turnover ratio and average payable period by assuming 360 days in a year. 𝐀𝐧𝐬𝐰𝐞𝐫 Annual credit purchase 10,00,000 10,00,000 APTR = = = = 20 Average accounts payable 40,000 + 60,000 50,000 2 360 360 Day purchase in payable = = = 18 𝑑𝑎𝑦𝑠 APTR 20 Activity Ratios Operating Cycle It is the length of time it takes to convert investment of cash in inventory back into cash through the collection of receivables from the sales. Activity Ratios Operating Cycle Activity Ratios Operating Cycle It is the length of time it takes to convert investment of cash in inventory back into cash through the collection of receivables from the sales. Operating Cycle = Day sales in Inventory + Day sales in receivables Activity Ratios Net Operating Cycle It is the length of time it takes to convert investment of cash in inventory back into cash and recognizing payable days. Net Operating = Day sales in + Day period of − Day period Cycle Inventory receivables of payable Activity Ratios 4) Total Assets Turnover Ratio It measures the amount of sales revenue the company is generating from the use of its average total assets. It provides data regarding the overall efficiency of a firm in using their current assets and non current assets. Sales TATR = Average total assets Activity Ratios 5) Fixed Assets Turnover Ratio It measures the amount of sales revenue the company is generating from the use of its average fixed assets. Sales FATR = Average fixed assets Activity Ratios 𝐐𝐮𝐞𝐬𝐭𝐢𝐨𝐧 On financial statement a corporation sowed a sales of 3 million and net fixed asset of 13,00,000 $ and total assets of 2 million. Calculate total asset turnover ratio and fixed assets turnover ratio. 𝐀𝐧𝐬𝐰𝐞𝐫 Sales 30,00,000 TATR = = = 1.5 Avg Total Asset 20,00,000 Sales 30,00,000 FATR = = = 2.3 Avg fixed Asset 13,00,000 FIFO and LIFO effect 𝐅𝐈𝐅𝐎 − First in First out Inventory – Decrease 𝐂𝐎𝐆𝐒 − 𝐈𝐧𝐜𝐫𝐞𝐚𝐬𝐞 𝐋𝐈𝐅𝐎 − Last in First Out Inventory – Increase 𝐂𝐎𝐆𝐒 − 𝐃𝐞𝐜𝐫𝐞𝐚𝐬𝐞 Profitability Ratios Part 02 – Financial Statement Analysis It is used to compare company profitability. 𝐓𝐲𝐩𝐞𝐬 𝐨𝐟 𝐏𝐫𝐨𝐟𝐢𝐭𝐚𝐛𝐢𝐥𝐢𝐭𝐲 𝐑𝐚𝐭𝐢𝐨𝐬 1) Gross profit Margin 2) Operating Profit Margin 3) Net Profit Margin 4) EBITDA 5) Return on Assets 6) Return on Equity 7) Return on Common Equity Profitability Ratios  1) Gross Profit Margin Gross profit margin percentage measures the percentage of gross profit out of sales needed to cover selling and administrative expenses. It is the measure of companies overall profitability. Sales Revenue Gross Profit COGS Gross Profit Margin = Sales Gross Profit Other Expenses Operating Profit Interest Tax Net Profit Profitability Ratios  2) Operating Profit Margin It measures the percentage of operating profit out of sales. Operating profit includes revenues and expenses of the companies principle operations. It doesn't include revenues and expenses that result from secondary activities (indirect activities) such as gain or loss from investment, sale of fixed asset discontinued operations. Sales Revenue COGS Operating Profit Operating Profit Margin = Gross Profit Sales Other Expenses Operating Profit Interest Tax Net Profit Profitability Ratios  3) Net Profit Margin Net profit includes revenues and expenses of a company from all sources. It measures the percentage of sales of revenues that actually become net profit. Sales Revenue COGS Gross Profit Net Profit or Net Income Net Profit Margin = Other Expenses Sales Operating Profit Interest Tax Net Profit Profitability Ratios 𝐐𝐮𝐞𝐬𝐭𝐢𝐨𝐧 Sales Revenue – 120,00,000 Gross Profit COGS – 80,00,000 1) Gross Profit Margin = Sales Gross Profit – 40,00,000 Operating Expenses – 25,00,000 40,00,000 = = 0.3333 = 33.33% Operating Income – 15,00,000 120,00,000 Interest Expenses – 40,000 Interest Income – 13,000 Operating Profit 2) Operating Profit Margin = Dividend Income – 12,000 Sales Non operating gains – 57,857 15,00,000 Income before tax – 15,42,857 = = 0.125 = 12.5% 120,00,000 Tax (30%) – 4,62,857 Net Income – 10,80,000 Net Profit 3) Net Profit Margin = Sales Calculate 10,80,000 1) Gross Profit Margin, = = 0.09 = 9% 2) Operating Gross Margin 120,00,000 3) Net operating Margin Profitability Ratios  4) EBITDA Usually EBIT is calculated by deducting non cash expenses such as depreciation and amortization. EBITDA is calculated by adding back depreciation and amortization to EBIT. EBITDA EBITDA Margin = Sales Profitability Ratios  5) Return on Asset (ROA) It is the most commonly used to measure companies performance. It measures how much return the company earns on the capital it has invested in assets. A higher ROA indicates better performance. Also used to evaluating the effectiveness of managers. Net Income Return on Asset = Average Total Asset Profitability Ratios 6) Return on Equity (ROE) It measures the return a business receives on the shareholders equity invested in the business. Equity – Preferred Shares Common Shares Retained Earnings Net Income Return on Equity = Average Equity Profitability Ratios A companies financial data is as follows, Particulars Year 2 Year 1 Current Assets 2,50,000 1,75,000 Total Assets 6,00,000 5,00,000 Total Liability 3,00,000 2,25,000 Net Sales 2,00,000 1,50,000 Net Income 75,000 60,000 Calculates return on asset and return on equity in Year 2 𝐀𝐧𝐬𝐰𝐞𝐫 Net Income 75,000 75,000 ROA = = = = 13.63% Avg Total Asset 6,00,000 + 5,00,000 5,50,000 2 Net Income 75,000 75,000 ROE = = = = 26.08% Avg Total Equity 3,00,000 + 2,75,000 2,87,500 2 𝐸𝑞𝑢𝑖𝑡𝑦 𝑌𝑒𝑎𝑟 2 = 6,00,000 − 3,00,000 = 3,00,000 𝐸𝑞𝑢𝑖𝑡𝑦 𝑌𝑒𝑎𝑟 1 = 5,00,000 − 2,25,000 = 2,75,000 Profitability Ratios 7) Return on Common Equity (ROCE) It measures how much return company generates using common shareholders equity. Net Income − prefered dividents ROCE = Avg common share holders equity 𝐂𝐨𝐦𝐦𝐨𝐧 𝐒𝐡𝐚𝐫𝐞 𝐡𝐨𝐥𝐝𝐞𝐫 𝐄𝐪𝐮𝐢𝐭𝐲 = 𝐄𝐪𝐮𝐢𝐭𝐲 − 𝐏𝐫𝐞𝐟𝐞𝐫𝐫𝐞𝐝 𝐬𝐡𝐚𝐫𝐞 𝐡𝐨𝐥𝐝𝐞𝐫𝐬 𝐞𝐪𝐮𝐢𝐭𝐲 Profitability Ratios A companies financial data is as follows, Particulars Year 2 Year 1 Preferred Stock ($ 100 par value) 1,00,000 1,00,000 5% 1000 share Common Stock ($ 10 par value) 1,50,000 1,50,000 2000 shares 1500 shares outstanding and issued. Additional paid in Capital Common Share 75,000 75,000 Retained Earnings 65,000 50,000 Calculates return on asset and return on equity in Year 2 Calculate return on common equity if the net income was 55,000 in year 2 𝐀𝐧𝐬𝐰𝐞𝐫 Net income − preferred divident ROCE = Avg common share holders equity 55,000 − 5000 ROCE = = 17.69% 150,000 + 75,000 + 57500 Profitability Ratios Market Ratios Part 02 – Financial Statement Analysis 𝐓𝐲𝐩𝐞𝐬 𝐨𝐟 𝐌𝐚𝐫𝐤𝐞𝐭 𝐑𝐚𝐭𝐢𝐨𝐬 1) Earnings per share 2) Diluted Earnings per share 3) Dividend payout ratio 4) Profit to earnings ratio (PE Ratio) 5) Price to EBIDTA Ratio 6) Dividend Yield Ratio 7) Earnings Yield Ratio 8) Market to book ratio 9) Book value per share 10) Shareholders Return Market Ratios  1) Earnings per Share Earnings Per Share (EPS) is the amount of income the holders of one share of common stock would have received if the 100% company earning had been paid (distributed the dividend). Income Available to common shareholders EPS = Weighted average no. of common shares outstanding It is the average number of common shares that where outstanding during the year. Market Ratios Weighted average number of common shares outstanding (WANCSO) 1) Take Beginning no of shares 2) New shares issued – add no of shares based on outstanding months. 3) Repurchased share (treasury stock) – Deduct the no of shares based on the outstanding months. 4) Stock Split or Stock dividend – These are adjusted as if they have occurred in the beginning of the year. Adjustment for stock split and stock dividend are made only to share transactions that where implies before stock dividend and stock split acquire, Adjustment are not made for share transaction after split or stock dividend. Market Ratios Stock Dividend It is the dividend paid to shareholders as stock or shares rather than cash. When stock dividend occurs the number of shares increases but the percentage of ownership of each shareholders will remain same Stock Split This is the way to increase the number of shares and decrease the share price. It is usually done when the market price of the shares becomes very high. The stock split brings the price down and makes the stocks more affordable. Market Ratios Stock Split A 2 for 1 stock split make the share double and the share price becomes half. No. of shares = 5000 Share Price = 5 $ Total shareholders equity 25,000 $ (5000 shares × 5 $) 2:1 stock split occurs. No of Shares = 5000 × 2 = 10,000 5 Share Price = = 2.5 2 Total shareholders equity = 10,000 × 2.5 = 25,000 Market Ratios Mathews corporation has 1,00,000 common shares, par value of $ 10 outstanding on January 1st. During the year following share transaction take place. + On April 1st 10,000 shares issued for $ 50 each + On August 1st Mathews repurchased 24,000 shares to be held as treasury stock. + On October 1st Mathews carries out for stock splits. + On November 1st 15,000 shares issued for $ 55 each. + On December 1st Mathews declares a 10% stock dividend. Calculate WANCSO 𝐀𝐧𝐬𝐰𝐞𝐫𝐬 2 + New shares issued = 15,000 × 12 = 2500 Beginning no. of shares = 1,00,000 Total Shares now = 9 1,95,000 + 2500 = 1,97,500 + New shares issued = 10,000 × 12 = 7500 5 - Repurchase = 24,000 × 12 = 10,000 + Stock dividend of 10 % = 19,750 WANCSO = 1,97,500 + 19,750 = 2,17,250 Total Shares = 97,500 Stock Split Occurs = 97500 × 2 = 1,95,000 Market Ratios 1,00,000 shares of common stock issued and outstanding share 20,000 of preferred shared issued and outstanding on July 1st company issued a 10% stock dividend and paid a cash dividend of 2 $ per share on its preferred stock. Net income for the years was 7,80,000. Calculate EPS. 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑜𝑟 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒 ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝐸𝑃𝑆 = 𝑊𝐴𝑁𝐶𝑆𝑂 IACS = Net income − Preferred Dividend = 7,80,000 − 2 × 20,000 = 7,40,000 𝑊𝐴𝑁𝐶𝑆𝑂 = 1,00,000 + 10% 𝑜𝑓 1,00,000 = 1,10,000 7,40,000 𝐸𝑃𝑆 = = 6.72 1,10,000 Market Ratios 2) Diluted Earnings per Share It is calculated by assuming that all potentially common shares that were outstanding at the years and had actually being converted or exercised Potential issuable shares are in form of convertible bonds convertible preference shares, options and warrants. They are classified as potential issuable shares, because they are not currently outstanding. But someone other than company has the ability to convert them into common shares. The calculation of DEPS is done so that potential investors and investors are able to understand what EPS would have been if this potential shares had actually been outstanding shares 𝐸𝑥𝑎𝑚𝑝𝑙𝑒 If a company many potential issuable shares in the form of stock options issued to Executives, the exercise of that option in future would greatly reduce the EPS of existing shareholders Market Ratios 𝐒𝐭𝐨𝐜𝐤 𝐖𝐚𝐫𝐫𝐞𝐧𝐭𝐬 It gives the holders the right to purchase a companies stock at specific price and specific date it is directly issued by the company. 𝐒𝐭𝐨𝐜𝐤 𝐎𝐩𝐭𝐢𝐨𝐧𝐬 It is a contract between two people that gives the holders to buy or sell a stock at specific price before contract expiry date 𝐄𝐦𝐩𝐥𝐨𝐲𝐞𝐞 𝐒𝐭𝐨𝐜𝐤 𝐎𝐩𝐭𝐢𝐨𝐧 It is a type of compensation granted by company to their employees and Executives. Rather than issuing directly the company gives option to employees 𝐂𝐨𝐧𝐯𝐞𝐫𝐭𝐢𝐛𝐥𝐞 𝐒𝐞𝐜𝐮𝐫𝐢𝐭𝐢𝐞𝐬 Convertible Securities that can be converted into common shares Market Ratios Steps in calculation of DEPS 1) Calculate basic earnings per share 2) Calculate the EPS effect of warrants and options 3) Add EPS effect of options and warrants to WANCSO and calculate intermediate debts. 4) Calculate EPS effective convertible bonds and convertible preference shares 5) Rank EPS effects from lowest EPS effect to highest EPS effect 6) Add EPS effects starting with lowest to intermediate DCSP until an antidilutive security is reached 7) Calculate final diluted EPS Market Ratios 𝐀𝐝𝐣𝐮𝐬𝐭𝐢𝐧𝐠 𝐎𝐩𝐭𝐢𝐨𝐧𝐬 𝐚𝐧𝐝 𝐖𝐚𝐫𝐫𝐚𝐧𝐭𝐬 These are evaluated based on treasury stock method. this method assumes that, + Option and warrants were converted into common stock at the beginning of the period. - The proceeds were used purchase the company common stock (treasury stock) at average market price during the period. Market Ratios 𝐀𝐝𝐣𝐮𝐬𝐭𝐢𝐧𝐠 𝐂𝐨𝐧𝐯𝐞𝐫𝐭𝐢𝐛𝐥𝐞 𝐒𝐞𝐜𝐮𝐫𝐢𝐭𝐢𝐞𝐬 The effect on income available to common shareholders due to decrease in interest expense (net of tax or decrease in preferred dividends if the convertible securities are converted is an increase to income available to common shareholders in the numerator of EPS calculation) Income Available to common shareholders EPS = Weighted average no. of common shares outstanding Market Ratios A corporation had a net income by 1 million for the year and the company had 5,00,000 common shares outstanding. Company also had 7500 shares of $ 100 par value preferred stock paying 4% dividend. During the year for which DEPS is calculated, the company also granted options to its president to purchase 30,000 common shares at a price of $ 10 per share. During the year the companies common stock solved at the following prices. Jan 1st - $ 22 Dec 31st - $ 30 Average Market price = $ 27 In addition to the options company had a convertible bond with a total face value of $ 10,00,000 that incurred interest of 5% per year. Each $ 1000 bond was convertible into 10 common shares Each preference shares can be converted into 10 common shares. Calculate Diluted Earnings per Share. Step 1 :- Calculate basic earnings per share Income Available to common shareholders 9,70,000 EPS = = = 1.94 Weighted average no. of common shares outstanding 5,00,000 IACS = Net income – Preferred dividend = 10,00,000 − 7500 × 100$ × 4% = 9,70,000 Market Ratios During the year for which DEPS is calculated, the company also granted options to its president to purchase 30,000 common shares at a price of $ 10 per share. During the year the companies common stock buyback at the following prices. Jan 1st - $ 22 Dec 31st - $ 30 Average Market price = $ 27 Step 2 :- Calculate the EPS effect on Options Cash received if the options are exercised, = 30,000 × 10 = 3,00,000 No. of shares that can be repurchased at average market price using cash received. 3,00,000 = = 11,111 shares. 27 Net shares outstanding = 30,000 − 11,111 = 18,889 Step 3 :- Adding the EPS effect of option into WANCSO IACS = 9,70,000 9,70,000 𝐼𝑛𝑡𝑒𝑟𝑚𝑒𝑑𝑖𝑎𝑡𝑒 𝐷𝐸𝑃𝑆 = = 1.86 5,18,889 WANCSO = 5,00,000 + 18,889 Market Ratios = 5,18,889 In addition to the options company had a convertible bond with a total face value of $ 10,00,000 that incurred interest of 5% per year. Each $ 1000 bond was convertible into 10 common shares Step 4 :- Calculate EPS effect of convertible bond and convertible preference shares. EPS effect of convertible bond, Interest expense = 10,00,000 × 5% = 50,000 $ If convertible bonds are converted into common shares, company will not incurs interest expense of 50,000 and this is an addition to income available to common share holders net of tax. Gross Benefit = 50,000 $ − 𝑡𝑎𝑥 30% ⇒ 35,000 $ Total Value 10,00,000 No. of bonds = = = 1000 bonds Face Value of one bond 1000 Each bond can be converted into 10 common shares. No. of common shares if converted = 1000 × 10 = 10,000 shares. 𝟑𝟓, 𝟎𝟎𝟎 𝐄𝐏𝐒 𝐄𝐟𝐟𝐞𝐜𝐭 𝐨𝐧 𝐛𝐨𝐧𝐝 = = 𝟑. 𝟓 Market Ratios 𝟏𝟎, 𝟎𝟎𝟎 A corporation had a net income by 1 million for the year and the company had 5,00,000 common shares outstanding. Company also had 7500 shares of $ 100 par value preferred stock paying 4% dividend. EPS Effect of preference shares, Preference dividend = 7500 × 100 × 4% = 30,000 If preference shares the company need to pay dividend to preference share holders this is an addition to IACS (30,000). Each preference shares can be converted into 10 common shares. No. of shares outstanding= 7500 × 10 = 75,000 𝟑𝟎, 𝟎𝟎𝟎 𝐄𝐏𝐒 𝐄𝐟𝐟𝐞𝐜𝐭 𝐨𝐧 𝐩𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞 𝐬𝐡𝐚𝐫𝐞 = = 𝟎. 𝟒 𝟕𝟓, 𝟎𝟎𝟎 Step 5 :- Rank EPS effect from lowest to highest 𝐄𝐏𝐒 𝐄𝐟𝐟𝐞𝐜𝐭 𝐨𝐧 𝐩𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞 𝐬𝐡𝐚𝐫𝐞 = 𝟎. 𝟒 𝑅𝑎𝑛𝑘 1 𝐄𝐏𝐒 𝐄𝐟𝐟𝐞𝐜𝐭 𝐨𝐧 𝐛𝐨𝐧𝐝 = 𝟑. 𝟓 𝑅𝑎𝑛𝑘 2 Market Ratios  𝐄𝐏𝐒 𝐄𝐟𝐟𝐞𝐜𝐭 𝐨𝐧 𝐩𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞 𝐬𝐡𝐚𝐫𝐞 = 𝟎. 𝟒 𝑅𝑎𝑛𝑘 1 𝐄𝐏𝐒 𝐄𝐟𝐟𝐞𝐜𝐭 𝐨𝐧 𝐛𝐨𝐧𝐝 = 𝟑. 𝟓 𝑅𝑎𝑛𝑘 2 Step 6 :- Add EPS Effect from lowest to highest. Preference share Bonds IACS = 9,70,000 $ Income = 30,000 $ Income = 35,000 $ WANCSO = 5,18,889 Shares = 75,000 Shares = 10,000 9,70,000+30,000 Adjusting the effect of convertible preference shares = = 1.68 5,18,889+75,000 9,70,000+30,000+35,000 Adjusting the effect of convertible bonds = = 1.71 5,18,889+10,000+10,000 When the next item is added, EPS is higher than before, that means anti effect. Anti diluted and not included. Therefore, Final Diluted EPS = 1.68 Market Ratios 3) Dividend Payout Ratio (DPR) This ratio measures how much dividend with the company actually based to common shareholders from income available to common shareholders Common Dividend DPR = Income available to common shareholders Example, Net Income = 1,30,000 $ Prefeed Dividend = 50,000 $ Dividend distributed to common shareholders is 20,000 No. Of Shares = 10,000 Calculate DPR 20,000 20,000 DPR = = = 0.25 = 25% 1,30,000 − 50,000 80,000 Market Ratios 4) Price to Earnings Ratio (PE Ratio) It shows what the market is willing to pay for a stock based on its current earnings Market Price Per Share PE Ratio = Earnings per share Example, A company stock is currently trading for $ 40 and it has an earnings per share of $ 5. Find P/E. 40 PE Ratio = =8 5 The market price of the share is 8 times of its earnings Market Ratios 5) Price to EBITDA Ratio It compares market price of a share with earnings before interest tax and depreciation and amortization. Market Price Per Share Price to EBIDTA Ratio = EBITDA per share Market Ratios 6) Dividend Yield Ratio It compares the dividend per share with the price spend for buying that share. Dividend Per Share Dividend Yield Ratio = Market Price per share Market Ratios 7) Earnings Yield Ratio It measures the relationship between earnings per share and current market price of that share. Earnings Per Share Earnings Yield Ratio = Market Price per share Market Ratios 𝐐𝐮𝐞𝐬𝐭𝐢𝐨𝐧 Dividend Per share = $ 2 Current Market price of a share = $ 10 No. of Shares = 1000 Net Income = 7000 Preferred Dividend = 2000 Calculate, i. Dividend Yield Ratio ii. Earnings Yield Ratio 𝐀𝐧𝐬𝐰𝐞𝐫 DPS 2 IACS 7000 − 2000 DYR = = = 0.2 = 20% EPS = = =5 MPS 10 WANCSO 1000 EPS 5 EYR = = = 0.5 = 50% MPS 10 Market Ratios 8) Book Value per Share Ratio It represents the per share amount for common shareholders that would result if the company where to be liquidated at the amounts that are reported on the companies balance sheet. Book Value Per Total Share holders Equity − Preferred Equity = Share of common stock No. Of Common Shares outstanding Market Ratios Data regarding equity of a company on Dec 31st 2010 is as follows, Total Shareholders Equity = 2,00,000 Preference Shareholders Equity = 1,00,000 No. Of Common Shares outstanding = 50,000 Net Income in 2011 = 1,50,000 Dividend Pay in 2011 = 30,000 Preferred Dividend Pay = 20,000 Calculate Book Value Per Share in 2011. Book Value Per Total Share holders Equity − Preferred Equity Share of common stock = No. Of Common Shares outstanding 2,00,000 − 1,00,000 + 1,50,000 − 30,000 − 20,000 = 50,000 =4 Market Ratios 9) Market to Book Ratio It is the ratio between the company current market price per common share and its book value per share on the same date. Market price per share Market to Book Ratio = Book Value per share Market Ratios 10) Shareholders Return Ratio It measures the total return share holder on their investment in companies common stock it consists of annual dividend received per share and the amount of change in per share price during the year Shareholders Trading stock price − Beginning Stock Price + DPS = return ratio Beginning Stock Price Market Ratios Comparative Financial Statement Part 02 – Financial Statement Analysis One of the main difficulties in the comparison of financial statements between companies or a between periods of the same company is the difference in size. To deal with this, comparative financial statements are prepared. In this, each item in financial statements, are expressed in percentage instead of numerical amount. a) Vertical Analysis b) Horizontal Analysis Comparative Financial Statement 1) Vertical analysis In this one year’s operating results are expressed as a percentage of total amount. Line items of income statements are usually presented as a percentage of sales revenue. Line items of balance sheet are usually presented as a percentage of total assets. Vertical analysis helps to compare the financial results of different companies of different sizes during the same period.. Comparative Financial Statement  Income Statment Vertical Analysis Sales Revenue = 1500 = 100% 800 COGS = 800 = 53.33% = × 100 1500 700 Gross Profit = 700 = 46.66% = × 100 1500 300 Operating Expenses = 300 = 20% = 400 × 100 1500 Operating Income = 400 = 26.66% = 1500 × 100 Comparative Financial Statement 2) Horizontal analysis It is used to evaluate trends for a single business over a period of several years. In this financial results of 1st year is taken as base year. Financial results of future years are presented not as the dollar amounts, but as percentage of base year amount with the base year as 100%. New amount Horizontal Financial Statement Formula = × 100 Base Amount Comparative Financial Statement  Year 1 Year 2 Year 3 Sales Revenue = 1000 1200 1400 COGS = 500 700 800 Gross Profit = 500 500 600 Horizontal Analysis Year 1 Year 2 Year 3 Sales Revenue = 100% 120% 140% COGS = 100% 140% 160% Gross Profit = 100% 100% 120% 1200 = × 100 = 120% 1000 Comparative Financial Statement Comparative Financial Statement Comparative Financial Statement Special Issues Part 02 – Financial Statement Analysis  𝐅𝐮𝐧𝐜𝐭𝐢𝐨𝐧𝐚𝐥 𝐂𝐮𝐫𝐫𝐞𝐧𝐜𝐲 Translation Functioning Parent Company Remeasurement Subsdiary 𝐑𝐞𝐩𝐨𝐫𝐭𝐢𝐧𝐠 𝐂𝐮𝐫𝐫𝐞𝐧𝐜𝐲 𝐂𝐮𝐫𝐫𝐞𝐧𝐜𝐲 𝐨𝐟 𝐑𝐞𝐜𝐨𝐫𝐝 Special Issues  𝐑𝐞𝐦𝐞𝐚𝐬𝐮𝐫𝐦𝐞𝐧𝐭 𝐓𝐫𝐚𝐧𝐬𝐥𝐚𝐭𝐢𝐨𝐧 𝐂𝐮𝐫𝐫𝐞𝐧𝐜𝐲 𝐨𝐟 𝐑𝐞𝐜𝐨𝐫𝐝 𝐅𝐮𝐧𝐜𝐭𝐢𝐨𝐧𝐚𝐥 𝐂𝐮𝐫𝐫𝐞𝐧𝐜𝐲 𝐑𝐞𝐩𝐨𝐫𝐭𝐢𝐧𝐠 𝐂𝐮𝐫𝐫𝐞𝐧𝐜𝐲 Subsdiary Functioning Parent Company Special Issues 𝐀𝐜𝐜𝐨𝐮𝐧𝐭𝐢𝐧𝐠 𝐟𝐨𝐫 𝐅𝐨𝐫𝐞𝐢𝐠𝐧 𝐓𝐫𝐚𝐧𝐬𝐚𝐜𝐭𝐢𝐨𝐧 A company with various entities and operations must report consolidated financial results as though all of the entities where a single reporting entity. Some of the operations may be located in other countries and those countries entity may report financial results in various currencies and accounting principle other than US GAAP. It is not possible to consolidate financial results that expressed in different currencies and different principles. Therefore the financial results of the foreign operations must be restated according to US GAAP. And converted (remeasured and translated) into US dollars. 𝐓𝐰𝐨 𝐌𝐚𝐢𝐧 𝐏𝐫𝐨𝐜𝐞𝐬𝐬 The restatement of financial result prepared under other principles into US GAAP. The conversion of financial results prepared in a foreign currency to reporting currency. Special Issues 3 Currency 1) 𝐂𝐮𝐫𝐫𝐞𝐧𝐜𝐲 𝐨𝐟 𝐑𝐞𝐜𝐨𝐫𝐝 ⇒ For foreign subsidiary used to keep their books of record 𝟐) 𝐅𝐮𝐧𝐜𝐭𝐢𝐨𝐧𝐚𝐥 𝐂𝐮𝐫𝐫𝐞𝐧𝐜𝐲 ⇒ It is a currency of primary economic environment in which foreign subsidiary operates. It is the currency in which the entity generate and expense cash. 𝟑) 𝐑𝐞𝐩𝐨𝐫𝐭𝐢𝐧𝐠 𝐂𝐮𝐫𝐫𝐞𝐧𝐜𝐲 ⇒ It is the Currency of parent company Special Issues  𝐓𝐫𝐚𝐧𝐬𝐥𝐚𝐭𝐢𝐨𝐧 After the financial statements are expressed in terms of functional currency, if that functional currency is different from foreign entities, reporting currency (US Dollars), the financial statements must be converted into US dollar amounts. This conversion from functional currency to reporting currency is called Translation Special Issues The changes or adjustments from Remeasurement are considered as non operating gain or loss. And adjusted to income statement The gain or loss from translation are adjusted to “other comprehensive income” in income statement “accumulated other comprehensive income” in balance sheet under equity Special Issues Accounting for Changes/ Errors A major changes can be, 1) A change in accounting principle eg, From FIFO to LIFO principle 2) A change in accounting principle. eg, Changing estimation of bad debts 3) A change in reporting entity. 4) Errors or mistakes Special Issues 𝐌𝐞𝐭𝐡𝐨𝐝𝐬 For changes or correption of accounts 1) Retrospective Application change in account principle 2) Restatement change in error 3) Prospective Application change in estimation Special Issues 𝐌𝐞𝐭𝐡𝐨𝐝𝐬 For changes or correption of accounts 1) Retrospective Application The financial statement for all periods presented are adjusted for the effect of change in each specific period, unless it is impracticable to do so Change in accounting principle Change in reporting entity 2) Restatement It is used to correct and error in previously issued financial statement. The re-stated financial statement must be identified as restated, and the term “restated” is to be used only for error corrections. The cumulative adjustments are made to the opening balances of asset and liability for the first period presented and adjustment is also made to the retained earnings. Eg, change in errors Special Issues 3) Prospective Application No change this are made to previously reported results. No attempt is made it to catch up for the prior periods. The effect of all changes is accounted for the period of change. If the change effects that period only. Also accounted for the period change and future periods, if the change affect the both. Eg, A change in accounting estimate Special Issues Earnings Quality It refers to the validity and accuracy of reported earnings or information. It reflects the current period performance and help uses to asses future performance. The basic factors affecting earning quality, 1) Selection of accounting principle. 2) Character of Management. 3) Business Environment. Special Issues Earnings Quality 1) Selection of Accounting Principle. A company can be both liberal or conservative. Conservative accounting is less likely to overstate earnings so the quality of earnings is higher. 2) Character of Management The management can put off the discretionary expenses such as advertisement, repairs and maintenance to show higher earnings. But for long term the companies earnings will be low. Avoiding discretionary expenses will affect earnings quality. That is the quality of earnings will be low 3) Business Environment Skillful management should try to minimize the effects of bad business condition instead of showing higher earnings Special Issues Sustainable Growth Rate It measures the ability of a firm to grow or to increase sales without having external fund that is using only internal fund. Sustainable Divident growth rate = 1− × Return on payout ratio common equity Special Issues Accounting Profit and Economic Profit Accounting Profit = Revenue – Explicit Cost Economic Profit = Revenue – Explicit Cost − Implicit Cost Special Issues Benefits of Ratio Analysis Helps to compare financial performance of different companies. Helps to measure liquidity, solvency, efficiency, profitability and performance of a share of a company in the market etc. Limitations of Ratio Analysis The reliability of ratio analysis depends upon the accuracy of financial statements and the attitude of financial analyst. The comparison of ratios of different companies operating in different industries may not be meaningful. Special Issues THE END