FINANCIAL STATEMENTS ANALYSIS

1. SOURCES OF INFORMATION

The accounts of a business are designed to provide users with information about the performance
and financial position of the entity. The bare figure, however are not particularly useful and it is
only through comparisons (usually ratios) that their significance can be established. Comparisons
may be made with previous financial periods, with other similar businesses or with averages for
the particular industry. The choice will depend on the purpose for which the comparison is being
made and the information that is available.

Financial Analysis

The lack of detailed information available to the outsider is a considerable disadvantage to

undertaking ratio analysis. The first difficulty is that there may be simply insufficient data to
calculate all of the required ratios. A second concern is the availability of a suitable yard stick with
which the calculated ratios can be compared.

2. RATIO ANALYSIS

Ratio analysis involves comparing one figure to another to produce a ratio and assessing whether a
ratio indicates a strength or weakness of the company’s affairs.

Ratio analysis can be used to determine the following;

Whether the business

➢ is profitable
➢ has enough money to pay its employees higher wages
➢ has enough money to pay its bills
➢ is paying its tax
➢ is using its assets efficiency
➢ has a gearing problem or not
➢ is a candidate for being bought by another company or investor

Categories of ratios

1.) Profitability ratios

Has the business made good profits when compared to it turnover

2.) Return ratios

Compared to it assets and capital employed has the business made good profits

3.) Liquidity and efficiency ratios

Does the business has enough money to pay its bills and how the business had made use of
its current and fixed assets

4.) Gearing ratios

 Does the company have a lot of debts or is it mainly financed by shares

5.) Investors ratios

1.) PROFITABILITY

Basic profitability

1.) Gross profit margin = Gross Profit *100

(Gross profit ratio) Sales

2.) Operating profit = Operating profit *100

margin Sales

= Net Profit *100

3.) Net profit margin Sales

In profitability ratios, we try to measure the profitability of the business by comparing profits to
sales/turnover/revenue.

There are several measurements of profits such as Gross profit, Operating profits, profit before
interest tax and profit for the year (profit after tax).

Each of the ratios mentioned above measures the profit made by the company for each rupee of
sale.

Gross Profit Margin

This ratio measures the gross profit made by the company on each rupee of sale made by the
company and shows the relationship between the company’s sales and cost of sales.

Net Profit Margin

This measures the net profit made by the company on each rupee of sale.

There are alternative methods of performing this calculation.

1.) Net profit margin = Profit before tax *100

Sales

2.) Net profit margin = Profit after tax *100

Sales
2.) RETURN RATIOS

I. Return on capital employed

1.) Return on capital employed = Profit before interest and tax (operating profit) *100
Total capital employed (Equity + Debt)

Alternative formula,

Return on capital employed = Profit before interest and tax (operating profit) *100
Total assets – current liabilities

This measures the total return the business has made when compared to the capital invested in it.
This ratio shows by the available fund to the business (whether equity or debt) the total profits
generated from operations which are available to its lenders and equity holders.

2.) Return on equity = Profit for the year (Profit after tax) *100
Total equity

This measures the profit available to share holders as a % of the equity. This tries to determine the
amount of return made by the company which is available for the share holders as a percentage of
the equity invested in the company.

II.) Return on Total Assets Ratio

The Return on Total Assets Ratio (ROTA) has a similar meaning to ROCE and the method of
calculating it is the same, too.

PBIT
Return on Total Assets (ROTA) = * 100
Total Assets

Notice that a different profit figure is used for this ratio - we use profit before interest and tax this
time.

Accountants would say that interest payments and tax payments are separate from the ways in
which the total assets are used. That is, if we are trying to measure the efficiency of our total
assets, then take the profit that they have generated before interest and taxation.

Interest and tax problems are the senior managers' concern, since they decide how much to borrow
and therefore how much interest they ought to pay; senior managers decide on capital investment,
too, and they have a big say in how much tax they pay for a year. Therefore, since operating
managers can't control the amounts of interest and taxation paid, they should not be assessed
against it.
3. Advanced Rate of Return

First some advanced Rate of Return equations:

Return on Fixed Assets PBIT

= * 100
(ROFA) Fixed Assets

Return on Working Capital PBIT

= * 100
(ROWC) Working Capital

In addition to the ROCE and ROTA ratios, there are other ratios that will help us to appreciate the
efficiency with which the management is using its resources. Here are two ratios that help us with
this further analysis.

Remember that with the ROTA we used PBIT for our numerator (that's the number on the top of
the formula).

We use the same measure of profit for the Return on Fixed Assets (ROFA) and the Return on
Working Capital (ROWC).

3. ASSET USAGE, EFFICIENCY AND LIQUIDITY

Stock turnover, Debtors' turnover and Creditors' turnover help us to assess the liquidity
position as well as giving us detailed information about stock control and credit control.

Total asset turnover - The overall efficiency of the business. We will look at total asset turnover
and net asset turnover; then we will investigate the fixed and current asset turnover ratios

WORKING CAPITAL MANAGEMENT (I) : LIQUIDITY

Working capital management is concerned with making sure we have exactly the right amount of
money and lines of credit available to the business at all times.

In part 1 of our look at working capital management we will look at the liquidity ratios. Cash is the
life-blood of any business, no matter how large or small. If a business has no cash and no way of
getting any cash, it will have to close down. It's that simple!

Following on from this we can see that if a business has no idea of its liquidity and working capital
position, it could be in serious trouble.

Current ratio = Current Assets: Current Liabilities

Quick assets ratio/ acid test ratio = (Current Assets-Stocks): Current Liabilities
The two liquidity ratios, the current ratio and the acid test ratio, are the most important ratios in
almost the whole of ratio analysis are also the simplest to use and to learn.

The Current Ratio

The current ratio is also known as the working capital ratio and is normally presented as a real
ratio. That is, the working capital ratio looks like this:

Current Assets: Current Liabilities = x: y eg 1.75: 1

The Acid Test Ratio

The acid test ratio is also known as the liquid or the quick ratio. The idea behind this ratio is that
stocks are sometimes a problem because they can be difficult to sell or use. That is, even though a
supermarket has thousands of people walking through its doors every day, there are still items on
its shelves that don't sell as quickly as the supermarket would like. Similarly, there are some items
that will sell very well.

Nevertheless, there are some businesses whose stocks will sell or be used slowly and if those
businesses needed to sell some of their stocks to try to cover an emergency, they would be
disappointed. Engineering companies can have their materials in stock for as much as 9 months to
a year; a greengrocer should have his stocks for no longer than 4 or 5 days - a good greengrocer
anyway.

Acid Test Ratio = (Current Assets - Stocks) : Current Liabilities

WORKING CAPITAL MANAGEMENT (II) STOCKS/ DEBTORS/ CREDITORS

What we are about to study - stock, debtors and creditors control - are all part of working capital
management in the same way that a discussion of liquidity was part of working capital
management.

We know that working capital is concerned with the ability of a business to be able to pay its way.
The three ratios we are concerned with now are concerned with spending and saving money in the
right places.

Too much stock and we waste money on buying it and keeping it. Too much money loaned to our
debtors and it's money we can't use for something else, such as buying machinery, paying our
creditors or even investing it. Too much money in the form of creditors and we might have a
problem that no one else will give us credit for anything else because they think we can't afford it,
and, if we suddenly have a cash problem, we might not be able to pay our creditors.

Working capital management is concerned with the control aspects of the issues we have just
mentioned.

I.) Stock Turnover: stock control

In principle, the lower the investment in stocks the better. Apart from buffer stocks that businesses
sometimes need in case of shortages of supply and strategic stocks in case of war, sudden changes
in demand and so on, modern stock control theory tells us to minimize our investment in stocks.

Cost of sales
Stock Turnover times =
Average Stocks

Stock Turnover days (stock Average Stocks * 365 = 1 * 365

=
resident period) Cost of sales Stock turnover times
Alte
rnatives,
➢ In the absence of average stock closing stocks can be used.

In such a case the same formula should be used for all periods calculated.

II.) Debtors' Turnover

In the same way that stock control is a vital aspect of working capital management, so too is
debtors' control. Many businesses need to sell their goods on credit, otherwise they might find it
difficult to survive if their competitors provide such credit facilities; this could mean losing
customers to the opposition.

Nevertheless, since we do provide credit, we must do so as optimally as possible. We've used the
word 'optimal' before and it doesn't necessarily mean the best possible, but the best possible under
the circumstances.

Credit Sales
Debtors' Turnover times =
Average Debtors

Debtors' Turnover Days Average Debtors * 365 = 1 * 365

(Debtors resident = Debtors turnover times
Credit Sales
period/settlement period)

Alternatives,
➢ In the absence of average debtors closing debtors can be used.
➢ In the absence of credit sales total sales can be used

In such a case the same formula should be used for all periods calculated.

III.) Creditors' Turnover Ratio

Creditors are the businesses or people who provide goods and services in credit terms. That is, they
allow us time to pay rather than paying in cash.

There are good reasons why we allow people to pay on credit even though literally it doesn't make
sense! If we allow people time to pay their bills, they are more likely to buy from your business
than from another business that doesn't give credit. The length of credit period allowed is also a
factor that can help a potential customer decide whether to buy from your business or not: the
longer the better, of course.

Credit purchase
Creditors' Turnover times =
Average creditors

= 1 * 365
Creditors' Turnover days Average Creditors *365
= Creditors turnover times
(creditors settlement period) Credit purchase

Alternatives,
➢ In the absence of average creditors closing creditors can be used.
➢ In the absence of credit purchase total purchase can be used
➢ In the absence of total purchase cost of sales can be used

In such a case the same formula should be used for all periods calculated.

Total Asset Turnover

The asset turnover ratio simply compares the turnover with the assets that the business has used to
generate that turnover. In its simplest terms, we are just saying that for every Rs.1 of assets, the
turnover is Rs. X. Formula for total asset turnover is:

Turnover
Total Asset Turnover =
Total Assets

IV.) Cash flow analysis

The cash flow ratio is the ratio of a company's net cash inflow to its total debts.

(a) Net cash inflow is the amount of cash which the company has coming into the
business from its operations.

(b) Total debts are short-term and long-term creditors, together with provisions for
liabilities and charges. A distinction can be made between debts payable within
one year and other debts and provisions.

Obviously, a company needs to be earning enough cash from operations to be able to meet its
foreseeable debts and future commitments, and the cash flow ratio, and changes in the cash flow
ratio from one year to the next, provides a useful indicator of a company's cash position.

THE CASH CYCLE

To help you to understand liquidity ratios, it is useful to begin with a brief explanation of the cash
cycle. The cash cycle describes the flow of cash out of a business and back into it again as a result
of normal trading operations.
Cash goes out to pay for supplies, wages and salaries and salaries and other expenses, although
payments can be delayed by taking some credit. A business might hold stock for a while and then
sell it. Cash will come back into the business from the sales, although customers might delay
payment by them selves taking some credit.

RAW
MATERIALS CREDITORS

WORK IN CASH CYCLE

PROGRESS CASH
OR

OPERATING
CYCLE
FINISHED
GOODS

PROFIT IN DEBTORS

However there is an apparent difference exist between the cash cycle and the operating cycle.

The operating cycle

Operating cycle is the time period between the acquisition of inventory and the collection of cash
from receivables.

Operating cycle = Inventory period + Debtors period

The Cash cycle

It is the time period between cash disbursement and cash collection

Cash cycle = operating cycle – creditors period

The points about the cash cycle are as follows.

 (a) The timing of cash flows in and out of a business does not coincide with the time
when sales and costs of sales occur. Cash flows out can be postponed by taking
credit. Cash flows in can be delayed by having debtors.

(b) The time between making a purchase and making a sale also affects cash flows. If
stocks are held for a long time, the delay between the cash payment for stocks and
cash receipts from selling them will also be a long one.

(c) Holding stocks and having debtors can therefore be seen as two reasons why cash
receipts are delayed. Another way of saying this is that if a company invests in
working capital. Its cash position will show a corresponding decrease.

(d) Similarly, taking credit from creditors can be seen as a reason why cash payments
are delayed. The company's liquidity position will worsen when it has to pay the
creditors, unless it can get more cash in from sales and debtors in the meantime.

The liquidity ratios and working capital turnover ratios are used to test a company's
liquidity, length of cash cycle, and investment in working capital.

4.) FINANCIAL GEARING

I.) Gearing I

Long Term Liabilities

Gearing =
Equity Shareholders' Funds

Gearing is concerned with the relationship between the long terms liabilities that a
business has and its capital employed. The idea is that this relationship ought to be in
balance, with the shareholders' funds being significantly larger than the long term
liabilities.

Shareholders ought to have the upper hand because if they don't that could cause them
problems as follows:

o Shares earn dividends but in poor years dividends may be zero: that is, businesses
don't always need to pay any!
o Long term liabilities are usually in the form of loans and they have to be paid
interest; even in bad years the interest has to be paid
o Equity shareholders have the voting rights at general meetings and can made
significant decisions
o Long term liability holders don't have any voting rights at general meetings but
they have the power to override the wishes of the shareholders if there are severe
problems over their interest or capital repayments
 So, shareholders like to see the gearing ratio, the relationship between long term liabilities
and capital employed.

II.) Gearing II

There is an alternative gearing ratio, we can call it the Gearing Ratio II.

The formula for this ratio is:

Long Term Liabilities

Gearing II =
Long Term Liabilities + Equity Shareholders' Funds

5.) INVESTOR RATIOS

Basic equations you'll need to know:

I.) Earnings per share: EPS

This is, perhaps, the fundamental investor ratio: in this case, we work out the average
amount of profits earned per ordinary share issued.

Earnings per share Profit available to equity shareholders

=
(EPS) Weighted Average number of issued equity shares

II.) Dividends per Share: DPS

The DPS ratio is very similar to the EPS: EPS shows what shareholders earned by way of
profit for a period whereas DPS shows how much the shareholders were actually paid by
way of dividends. The DPS formula is:

Dividends per share Dividends paid to equity shareholders

=
(DPS) Number of issued equity shares

III.) Dividend Yield

The dividend yield ratio allows investors to compare the latest dividend they received with
the current market value of the share as an indictor of the return they are earning on their
shares.

Note, though, that the current market share price may bear little resemblance to the price
that an investor paid for their shares. Take a look at the history of a business's share price
over the last year or two and you will see that today's share price might be a lot higher or a
lot lower than it was a year ago, two years ago and so on.
 We clearly need the latest share price for this ratio and we can get that from newspapers.
We can also find the share prices on the Internet.

The formula for the dividend yield is:

Latest annual dividends (DPS)

Dividend yield =
Current market share price (MPS)

IV.) Price Earnings Ratio: P/E ratio

The P/E ratio is a vital ratio for investors. Basically, it gives us an indication of the
confidence that investors have in the future prosperity of the business. A P/E ratio of 1
shows very little confidence in that business whereas a P/E ratio of 20 expresses a great
deal of optimism about the future of a business.

Current market share price (MPS)

Price/earnings or PE ratio =
Earnings per share (EPS)

Some other ratios are,

Latest annual earnings (EPS)

Earnings yield =
Current market share price (MPS)

Dividend pay out Latest annual dividends (DPS)

=
(DPO) Latest annual earnings (EPS)

Retention Ratio = 1 - DPO

Net profit available to equity shareholders

Dividend cover =
Dividends paid to equity shareholders

Net Assets per share Share capital + Reserves

=
(NAPS) Average number of issued equity shares

Current market share price (MPS)

Price to Book value =
Net assets per share (NAPS)

V.) Interest cover

The interest cover ratio is the twin brother of the dividend payout ratio and it both means
the same and is calculated in the same way. Here's the interest cover ratio formula:

Net profit before interest

Interest Cover =
Interest paid
 The interest cover ratio tells us the safety margin that the business has in terms of being
able to meet its interest obligations. That is, a high interest cover ratio means that the
business is easily able to meet its interest obligations from profits. Similarly, a low value
for the interest cover ratio means that the business is potentially in danger of not being
able to meet its interest obligations.

LIMITATIONS OF RATIO ANALYSIS

1. Non availability of comparable information

2. Use of historical information
3. Ratios are not definitive; they are only a guide
4. It is a subjective exercise
5. It can be subject to manipulation
6. Ratios are not defined in standard form
7. Negative effect
8. Problems of interpretation
9. Depending on balance sheet is figures could be in appropriate; Balance
sheet is only a snap shot
10. Adopting inappropriate accounting policies

Ratios for specific industries

Financial Services (Banks and other financial institutions)

(I) Profitability Measurement

1. Net Interest Margin - (Net Interest income / Interest Earning assets)

a. Net Interest income = Total Interest income – Total Interest expense

2. Composition of income
a. Interest income / Total operating income
b. Other income / Total operating income
c. Total operating income = Interest income + Other income

3. Cost to income ratio

a. Total Non‐Interest Expense (excluding provision) / (Net Interest Revenue+ Other
Operating Income)

(II) Capital Adequacy

1. Core Capital Ratio = Core Capital / Risk Weighted Assets

2. Total Capital Ratio = Total Capital / Risk Weighted Assets
(III) Liquidity

1. Liquid Assets to Customer Deposits = Liquid Assets / Customer Deposits

a. Liquid assets = Cash + Bank Balances + Government securities (maturity <1 yr)

(IV) Asset Quality

1. Gross Non performing loan ratio (Gross NPL ratio) = Non performing Loan value – before
provisioning / Total Loans
2. Net NPL ratio = Net NPLs / Total Loans
3. NPL Coverage Ratio = Loan Loss Reserve / NPL
 CFA Level 1
Financial Ratios Sheet

Activity Ratios
Solvency ratios Ratio calculation

Activity ratios measure how efficiently a company performs Debt-to-assets

Total debt

day-to-day tasks, such as the collection of receivables and Total assets

management of inventory. The table below clarifies how to Total debt

Dept-to-capital
calculate most of the activity ratios. Total debt + Total shareholders’ equity

Total debt
Dept-to-equity
Total shareholders’ equity
Activity Ratios Ratio calculation
Average total assets
Financial leverage
Cost of goods sold Total shareholders’ equity
Inventory turnover
Average inventory

Number of days in period Coverage Ratios Ratio calculation

Days of inventory on hands (DOH)
Inventory turnover
EBIT
Revenue or Revenue from credit sales Interest coverage
Receivables turnover Interest payements
Average receivables
EBIT + Lease payements
Number of days Fixed charge coverage
Days of sales outstanding (DSO) Interest payements + Lease payements
Receivable turnover

Purchases
Payable Turnover
Average payables
Profitability Ratios
Number of days in a period
Number of days of payables
Payable turnover Profitability ratios measure the company’s ability to
Revenue generate profits from its resources (assets). The table below
Working capital turnover
Average working capital shows the calculations of these ratios.
Revenue
Fixed assets turnover
Average fixed assets
Return on sales ratios Ratio calculation
Revenue
Total assets turnover
Average total assets Gross profit
Gross profit margin
Revenue

Operating profit
Operating margin
Liquidity Ratios Revenue

EBT (Earnings Before Taxes)

Pretax margin
Liquidity ratios measure the company’s ability to meet its Revenue
short-term obligations and how quickly assets are converted Net income
into cash. The following table explains how to calculate the Net profit margin
Revenue
major liquidity ratios.
Return on investment ratios Ratio calculation

Liquidity ratios Ratio calculation Operating income

Opearting ROA
Average total assets
Current assets
Current Net income
Current liabilities
ROA
Average total assets
Cash + Short term marketable securities + Receivables
Quick EBIT
Current liabilities
Return on total capital
Debt + Equity
Cash + Short term marketable securities
Cash Net income
Current liabilities
ROE
Average total equity
Cash + Short term marketable securities + Receivables
Defensive interval Net income - Preferred dividends
Daily expenditures Return on common equity
Average common equity
Cash conversion cycle DOH + DSO - Number of days of payables

Valuation Ratios
Solvency Ratios Valuation ratios measure the quantity of an asset or flow
Solvency ratios measure a company’s ability to meet long-term (i.e., earnings) associated with ownership of a specified claim
obligations. Subsets of these ratios are also known as “leverage” (i.e., a share or ownership of the enterprise). The following
and “long-term debt” ratios. tables show the most of the common valuation ratios.

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 CFA Level 1
Financial Ratios Sheet

Valuation ratios Ratio calculation Price per share Ratio calculation

Price per share

P/E FFO + Interest paid - Operatinf lease adjustments
Earnings per share
FFO (funds from operations)
interest coverage Gross interest (prior to deductions for capitalized
Price per share interest or interest income)
PC/F
Cash flow per share

Price per share

P/S
Sales per share EBIT
Price per share Return on capital Average capital
P/BV
Book value per share
where Capital = Equity + Non-current deffered taxes + Debt

FFO
Price per share Ratio calculation FFO (Funds from operations) to debt
Total debt

Net income - Preferred dividends CFO (adjusted) - Capital expenditures

Basic EPS Free operating cash flow-to-debt
Weighted average number of ordinary shares outstanding Total debt

CFO - Capital expenditures - Dividend paid

Net income - Preferred dividends Discretionary cash flow-to-debt
+ Aftertax interest on ordinary shares outstanding Total debt
Diluted EPS Weighted average number of ordinary shares outstanding FFO - Dividends
+ Number of common shares that would Net cash flow-to-capital expenditures
have been issued at conversion Capital expenditures

CFO - Preferred dividends

Cash flow per share
Weighted average number of ordinary shares outstanding
Leverage Ratios
EBITDA
EBITDA per share Leverage ratios measure the extent to which a company uses
Average number of common stock
liabilities rather than equity to finance its assets
Dividends paid
Dividends per share
Number of shares outstanding
Leverage Ratios

Total debt A
Dividend - related ratios Ratio calculation Debt-to-assets ratio
Total assets

Common share dividends Total debt A

Dividend payout ratio Debt-to-capital ratio
Net income attributable to common shares Total debt + Total equity

Total debt A
Net income attributable to common shares Debt-to-equity ratio
- Common share dividends Total equity
Retention rate (b)
Net income attributable to common shares Average total assets
Financial leverage ratio
Average equity
Sustainable growth rate b x ROE A
| Debt is defined as the sum of interest-bearing short-term and long-term debt.

Segment Ratios
Solvency Ratios
Segment ratios are important for segment reporting.
Solvency ratios measure a company’s ability to meet long-term Remember that a company doesn’t have to disclose
obligations. Subsets of these ratios are also known as “leverage” information about all of its segments; they only need to be
and “long-term debt” ratios. disclosed if that segment constitutes 10 percent or more of
the combined operating segments' revenue, assets, or profit.
Price per share Ratio calculation
If the revenue of the reported segments is less than 75% of
the revenue of the entire company, more segments must be
reported until the 75% level is reached.
EBIT
EBIT interest coverage Gross interest (prior to deductions for capitalized
interest or interest income)
Segment ratio Numerator Denominator Indication
Measures a segment’s
Segment profit profitability relartive to its
Segment margin Segment revenue
(loss) revenues
EBITDA
EBITDA interest coverage Gross interest (prior to deductions for capitalized Measures a segment’s
interest or interest income) Segment turnover Segment revenue Segment assets ability to generate revenue
using assets

Measures a segment’s
Segment profit operating profitability
Segment ROA Segment assets
(loss) relative its assets

Measures a segment
Segmentt debt ratio Segment liabilities Segment assets solvency

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 CFA Level 1
Financial Ratios Sheet

Performance Ratios

Performance ratios are based on CFO. CFO is operating cash

flow under US GAAP or under IFRS, conditional to the fact that
the company includes interest paid in operating activities.

Leverage Ratios Calculation Indication

CFO Operating cash generated per

Cash flow to revenue
Net revenue dollar of revenue

CFO Operating cash generated per

Cash return on assets
Average total assets dollar of asset investment

CFO Operating cash generated per

Cash return on equity
Average shareholders’ equity dollar of owner investment

CFO
Cash to income Cash generated from operations
Operating income

CFO - Pref.dividends
Operating cash flow on a per
Cash flow per share Number of common share basis
shares outstanding

CFO
Ability to pay debts with
Debt payment Cash paid for long operating cash flows
term debt repayment

CFO Ability to pay dividends with

Dividend payment
Dividends paid operating cash flows

CFO Ability to acquire assets, pay

Investing and Financing Cash outflows for investing debts, and make distributions
and financing activities to owners

CFO Financial risk and financial

Debt Coverage
Total debt leverage

CFO + Interest paid + Taxes paid Ability to meet interest

Interest Coverage
Interest paid obligations

CFO Ability to acquire assets with

Reinvestment
Cash paid for long term assets operating cash flows

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 How to do fundamental analysis
from
Penman, Financial Statement Analysis and Security Valuation, 2001.

Step 1: Economic and Market Analysis

Structure of the Industry: competition and market dynamics

Products being produced: what the products do, technology, substitute products
Firm cost structure and revenue composition
Firm Strategy: what are the firm’s stated objectives for future growth
Regulatory Environment

Step 2: Analysis of Financial Statements

Balance sheet: Price to book value of equity; net market value of assets
Income statement: earnings, free cash flow, revenues, EVA
Cash flow statement: Operating, financing and investing
Other factors not included in the financial statements: industry and government publications

Step 3: Forecasting relevant payoffs

What are the important ‘value drivers’?

What are ‘best guess’ forecasts of the value drivers?
What factors could act to undermine the forecasts?

Step 4: Formulating a security value

Specifying the approach to valuation

Applying the valuation model to the available data from steps 1-4

Step 5: Making a recommendation

For an outside investor, recommend buy, sell or hold.

Stating qualifications to the forecast
 FSA Note: Summary of Financial Ratio Calculations

This note contains a summary of the more common financial statement ratios. A few points should be noted:
• Calculations vary in practice; consistency and the intuition underlying the calculated ratio are important. This list is not exhaustive.
• A firm’s fiscal year end often corresponds to the point in time at which business activity is at its lowest. Hence, ratios calculated using
internal data at different points in the year may differ significantly from those based on published financial statements.

Pictorial Summary of Common Financial Ratios

Asset Return to
Liquidity Debt Management Management Profitability Investors

Short Run Liquidity of Amount of Coverage of Operating Margins Returns Earnings per
Solvency Current Debt Debt Efficiency Share
Assets

Current ratio Collection Debt to assets Times interest Receivable Gross profit ROIC ROE
period earned turnover margin

Quick ratio Days Debt to CFO to Inventory Operating Cash ROA ROCE
inventory equity interest turnover profit margin
held

Cash ratio Days Long term CFO to debt Fixed asset Net profit ROA Dividend
payables debt to total turnover margin yield
outstanding capital

CFO ratio Net trade Cash flow Asset ROE Dividend

cycle adequacy turnover payout

Defensive Return on P/E

interval assets

(Not all ratios are represented in this picture; some ratios pertain to more than one category.)

Page 1 of 5
FSA formulas
 Numerator
Liquidity Ratios Interpretation and benchmark
Denominator
Short-term debt paying ability. Current assets less current liabilities =
Current assets
“working capital,” the relatively liquid portion of an enterprise that serves
Current ratio = as a safeguard for meeting unexpected obligations arising within the
Current liabilities
ordinary operating cycle of the business.
Benchmark: PG, HA, ROT (>2)
Cash + marketable securities + net receivables
Immediate short-term liquidity
Quick (acid-test) ratio =
Benchmark: PG, HA, ROT (>1)
Current liabilities
Cash + marketable securities More conservative than quick ratio as it excludes net receivables (all of
Cash ratio = which may not be collected)
Current liabilities Benchmark: PG, HA, ROT (>40-50%)
CFO
Ability to repay current liabilities from operations
CFO ratio =
Benchmark: PG, HA, ROT (>40-50%)
Average current liabilities
365 X Quick ratio numerator
Conservative view of firm’s liquidity. Compares currently available quick
Defensive interval =
sources of cash with estimated outflows needed to operate.
(Cash burn rate) Projected expenditures (= COGS + Other
Benchmark: PG, HA
operating expenses except depreciation)
Note: you may have used a different definition from corporate finance.
Working capital = Current assets – Current liabilities Please use this definition for FSA.

Abbreviations for benchmarks:

ROT: rule of thumb.
EB: economic benchmark.
PG: peer group average.
HA: firm’s historical average.
Note: The rule of thumb numbers vary significantly depending on whose “thumbs” we are talking about. Provided here are the often-seen numbers.
Industry peer and firms’ historical average are always useful benchmarks.

Page 2 of 5
FSA formulas
 Numerator
Activity Ratios Interpretation and Benchmark
Denominator
Net sales
Liquidity of receivables
Receivable turnover =
Benchmark: PG, HA
Average net trade receivables
Effectiveness of firm’s credit policies and level of investment in
365
receivables needed to maintain firm’s sales level. Average
Average receivables collection day =
number of days until A/R collected.
Receivable turnover
Benchmark: PG, HA
Cost of goods sold (COGS)
Liquidity of inventory
Inventory turnover =
Benchmark: PG, HA
Average total inventory
365
Average number of days inventory held until sold.
Average days inventory in stock =
Benchmark: PG, HA
Inventory turnover
COGS + change in inventory = Purchases
Importance as source of financing for operating activities
Payables turnover =
Benchmark: PG, HA
Average accounts payable
365
Average number of days until payables are paid
Average days payables outstanding =
Benchmark: PG, HA
Payables turnover
Indicates the days in the normal operating cycle.
Operating cycle = Receivables collection days + Inventory holding days
Benchmark: PG, HA
Indicates the days in the normal cash conversion cycle of the firm.
Net trade cycle or cash cycle = Operating cycle - Average days payables outstanding
Benchmark: PG, HA
Net sales
Amount of operating capital needed to maintain a given sales level
Working capital turnover =
Benchmark: PG, HA
Average working capital
Net sales
Efficiency of fixed assets (productive capacity) in generating sales
Fixed asset turnover =
Benchmark: PG, HA
Average net fixed assets
Net sales
Efficiency of asset use in sales generation
Asset turnover =
Benchmark: PG, HA
Average total assets
Accumulated depreciation
Estimate of how long the average fixed asset has been held.
Average PPE age =
Benchmark: PG, HA
Depreciation expense
Estimate the average useful (depreciable) life of PPE assets. If
Ending balance of gross PPE
annual data are used this ratio estimates the number of years of
Average PPE useful life =
estimated useful life.
Depreciation expense
Benchmark: PG, HA
Page 3 of 5
FSA formulas
 Numerator
Profitability Ratios Interpretation and Benchmark
Denominator
Net income
Profitability of all equity investors’ investment
Return on equity (ROE) =
Benchmark: EB (Cost of equity capital), PG, HA
Average total shareholders’ equity
Net Income + Interest expense * (1-tax rate)
Overall profitability of assets. Sometimes called return on investment (ROI).
Return on assets (ROA) =
Benchmark: EB (WACC), PG, HA
Average total assets
NOPAT = EBIT * (1- tax rate) Overall profitability of invested capital. Sometimes called return on capital
Return on invested capital (ROIC) =
employed (ROCE) or return on net operating assets (RNOA).
(See Course Note for details)
Average invested capital Benchmark: EB (WACC), PG, HA
Net sales – COGS = Gross margin Captures the relation between sales generated and manufacturing (or merchandising)
Gross profit margin on sales = costs
Net sales Benchmark: PG, HA
EBIT
Measures profitability independently of an enterprise’s financing and tax positions
Operating Margin =
Benchmark: PG, HA
Net sales
Net income
Net income generated by each sales dollar
Net profit margin on sales =
Benchmark: PG, HA
Net Sales
CFO
Measures return on assets on “cash” basis.
Cash return on assets =
Benchmark: PG, HA
Average total assets
Net income less preferred dividends
Net income earned per common share
Earnings per share (EPS) =
Benchmark: PG, HA
Weighted common shares outstanding
Market price of stock
Ratio of market price to earnings per share
Price earnings ratio (P-E) =
Benchmark: PG, HA
Earnings per share
Market value of equity Ratio of the market’s valuation of the enterprise to the book value of the enterprise
Market to book ratio = on its financial statements.
Book value of equity Benchmark: PG, HA
Cash dividends paid on common equity Percentage of earnings distributed as cash dividends. Note: Some firms/analysts
Dividend Payout = calculate this using cash dividends declared in the numerator instead.
Net income Benchmark: PG, HA
Cash dividends paid per share of common equity
Percentage of share price distributed as cash dividends
Dividend Yield =
Benchmark: PG, HA
Price per share

Page 4 of 5
FSA formulas
 Numerator
Solvency Ratios Interpretation and Benchmark
Denominator
Percentage of total assets provided by creditors. Total debt is a subset of total
Total debt liabilities. Typically, you sum total long term debt and the current portion of long
Debt to total assets = term debt in the numerator. Other additions might be made: notes payable,
Total assets capital leases, and operating leases if capitalized.
Benchmark: EB (optimal capital structure), PG, HA
Total debt
Percentage of total assets provided by owners.
Debt to equity =
Benchmark: EB (optimal capital structure), PG, HA
Total shareholders’ equity
Degree to which enterprise uses owners’ capital to finance assets. We’ll calculate
Total (average) assets
this ratio using the averages of the balance sheet accounts to facilitate our ratio
Financial leverage =
decomposition.
Total (average) shareholders’ equity
Benchmark: EB (optimal capital structure), PG, HA
EBIT Ability to meet interest payments as they mature. EBIT is sometimes called
Times interest earned (TIE) = Operating Income.
Interest expense Benchmark: PG, HA, ROT (minimal 2-4)
Ability to meet interest payments from operating cash flow. Some analysts
CFO + interest and taxes paid in cash calculate the numerator using CFO + interest expense + tax expense. This
CFO to interest = calculation is less internally consistent as what we are striving for in the
Interest expense numerator is a cash flow number, not a mix of cash flow and accruals.
Benchmark: PG, HA, ROT (>=2-4)
CFO + interest and taxes paid in cash Ability to repay total liabilities in a given year from operations. See caveat above
CFO to debt = regarding numerator.
Average total liabilities Benchmark: PG, HA, ROT (?)
CFO Measures how many times capital expenditures, debt repayments, cash dividends
Cash flow adequacy = covered by CFO.
CAPEX + debt and dividends payments Benchmark: PG, HA, ROT (1)
Common shareholders’ equity Amount each share would receive if company were liquidated at the amounts
Book value per share = reported on the balance sheet
Outstanding shares Benchmark: none
Operating cash flow + accruals = operating earnings. This ratio gives an
CFO
indication of how much CFO differs from operating earnings due to accounting
CFO to Operating earnings =
accruals.
Operating earnings
Benchmark: PG, HA, ROT (>1).

Page 5 of 5
FSA formulas
 CALCULATION OF IMPORTANT RATIOS
SL.NO PARTICULARS FORMULA FOR CALCULATION IDEAL POSITION INTERPRETATION

Own fund to Working Own funds x 100 Higher the Own funds, lower will be the
1 Above 8 %
fund Working fund outside liabilities and cost of funds

Deposit to Working Monthly Average deposit X 100 Ability to reduce the dependence on
2 NA
funds Total Working funds Borrowings

To the extend of priority

Borrowings to Average borrowings X 100 sector lending where CRR and SLR not required, operating
3
working funds Working funds concessional refinance is cost is low
available

70-75 % of deposits for

Average Loans and advances outstanding X 100 banks not having
4 Loans to working fund Ability to generate interest income
Working funds borrowings for others, no
limit

Investments to Average Investments X 100 Above 25% but below

5 Compliance of SLR
Working fund Working funds 30% of deposit

Not less than interest How far cost free funds are deployed in
Earning Asset to Average loans and advances + Average Investments X 100
6 tagged funds to Working earning assets and ability to generate
Working fund Working fund
fund interest income

Average Deposits + Average Borrowings X 100

Interest tagged funds Not more than earning Proportion of cost free and interest
7 Working funds
to working fund assets to Working funds tagged funds

Interest Expenses on deposits(P&L a/c) X 100

Should be 4% less than Cost effectiveness in mobilizing
8 Cost of deposits Average Deposits
average yield on loans Deposits
 Interest Expenses on borrowings(P&L a/c) X 100 Within the average cost of
9 Cost of borrowings To ascertain the strength and weakness
Average Borrowings deposits

Interest income from loans(P&L a/c) X 100 4% more than average To know whether any change in the mix
10 Yield on Loans
cost of deposits of loans is necessary or not
Average Loan Outstanding
Interest income form Investment(p&L) X 100
Note less than average To know whether the yield is less than
11 Yield on Investments Average Investments cost of deposit average cost of Deposit

Total interest income(P&L a/c) X 100 Minimum 3.5% more than

Average yield on To know whether any change in the
12 Working funds average cost of working
working fund compositions of Asset is required or not
fund

Total interest expenses(P&L a/c) X 100 Minimum 3.5% less than To know whether any change in the
Average cost of
13 Working funds average yield on working compositions of liabilities is required or
Working fund
fund not

14 Gross financial margin Average yield on Working fund-Average cost of WF 3.5% and above Intensive health

Operating cost of Salary + Contingencies(P&L a/c) X 100

15 2% to 2.5% To measure Staff productivity
working fund Working funds
Miscellaneous income Non interest income other than provision revised X 100 To assess the quality and variety of
16 0.50%
to working fund Working funds services

Current Deposits+SB Deposits X 100 Higher proportions of CASA Deposits

Low cost deposits to
17 Above 30% will reduce the cost of deposit and vice
Total deposits
Total deposits versa
Average Cash and bank balance(CA) X 100
Cash and Current It will carry with CRR, higher
Average deposits
18 account balance to 3.5 % to 4.00 % proportion will reduce the yield on
deposits working fund
 Average Investment X 100 Since the yield on loans is more than
Investments to Average Deposits yield on investments higher proportion
19 30%
deposits of investments will reduce average yield
on working fund

Average loan outstanding X 100

On the basis of the increased proportion
20 Credit Deposit ration Average deposit Not less than 70 % of borrowings to working funds the CD
Ratio may be even more than 100 %

Growth rate of (Deposits of the year-Deposits of the just previous year) X 100 To increase in operating cost is about
21 20%
deposits 12% per annum
Deposit of the just previous year

ST(SAO)(incl.Agri.G ST(SAO)Outstanding X 100

22 18 to 20% Commitment to the priority sector
L)to total loans Total loan outstanding
Loan outstanding of the year X 100
Loan outstanding of the previous year To generate income sufficient to meet
23 Increase in loans Above 15%
increasing overhead cost

Total loans issued during the year X 100 If the operations in CC and OD are
Loans issued to loan Loans outstanding of the just previous year regular and ST loans below 1 Year
24 80 % of the above
outstanding period is significant it may be more than
100%

Gross NPA to loan Amount under NPA Laon accounts X 100

25 Below 10% Quality of loan portfolio
outstanding Total Loan outstanding

Amount Under NPA accounts-Provisions held for NPA X 100

Net NPA to Net Loan One of the requisites for operation
26 Below 5%
Outstanding freedom is low level of NPA
Total Loan outstanding-Provisions held for NPA
 Overdue Interest amount X 100
Overdue to Interest demand To meet interest and non interest
27 Below 20%
Demand(Interest) expenses out of Interest income

Interest expenses to Total Interest Expenses(P&L a/c) X 100

28 Below 62 % Efficiency in resource management
Interest income Total interest income

Salary + Contingencies X 100

Cost of Management Total interest income + Non interest income If more than 25%, it shows low
29 Not exceeding 20 %
to Total Income employee productivity

Non Interest income other than provision revised X 100

Miscellaneous Income Level quality and variety of customer
30 Above 5 %
to total income Total interest income +Non interest income service

Average Deposit X 100

To have earning assets to generate
No. of Staff
31 Per employee deposit Rs.200 lakhs above income sufficient to meet operating
expenses

Average Loan outstanding X 100 To meet operating expenses out of

32 Per employee loan Rs.150 Lakhs above
No. of Staff interest margin from loans

Total Int. income + Misc. Income-Interest expenses(P&L a/c)

Per Employee No. of staff More than per employee
33 To assess employee productivity
contribution operating cost

Salary+ Contingency expenses

Per employee Less than per employee
34 No. of staff To compare employee productivity
operating cost contribution

Net Profit X 100

35 Return on Asset 1.00% Quality of Earning Assets
Net Assets
Interest Income to Total Interest Income X 100 4 % above average cost of
36 Quality of Assets
Earning Assets Average Loans +Average Investments Working fund