Corporate Finance

Term 3

Assistant Professor, Divya Aggarwal

FPM - XLRI
Students negotiating with faculty for assignment deadline submission date

CR
TOPPER

OTHERS
 Broad categories of ratios

Profitability Solvency

Asset Turnover Liquidity

 How to make sense of income statement

How to make use of numbers from income statement? What can Profitability
be interpreted from the profit breakup and expense format? Margins Ratio

Gross Margin
Formula: Gross Profit/Sales We can answer how
Ability of a company to control direct costs well the company is
able to manage
costs?
Operating Margin
Formula: Operating Profit/Sales
Overall operating efficiency; accounts for all operating expenses

Net Profit Margin

Formula: Net Profit/Sales
Proportion of sales available for distribution to shareholders
 Profitability - Financial Statement Ratios

Operating Performance
Gross Profit Margin (Sales – COGS)/Sales
EBITDA Margin EBITDA/Sales
Operating Profit Margin Income from operations i.e. EBIT/Sales
PBT Margin PBT/Sales
Net profit margin Net income or PAT /Sales
Earnings per share Net income/ No. of shares outstanding
Cash realization Cash generated by operations/Net income
 Profitability Return Metrics

How to make use of numbers from both balance sheet and Profitability
income statement Return Ratio

Return on Equity (ROE) How much return

Formula: Net income/Average shareholder’s Equity the company is able
Return on owner’s capital to generate for its
stakeholders?

Return on Assets (ROA)

Formula: Net income/Average Total Assets
Efficiency with which assets are utilized to generate returns for
stakeholders
 Profitability - Financial Statement Ratios
Return on Investment = Net income/Investment
Investment??????
Return on Investment Net income/Investment
Return on Assets (ROA) (Net income + interest expense(1-tax rate))/Avg Total assets
Return on net assets (RONA) (Net income + interest expense(1-tax rate))/Avg Net assets

Net assets = Total assets – non interest bearing liabilities

Return on capital employed (ROCE) EBIT(1-t) / Average capital employed
Return on Invested capital (ROIC) (Net income + interest expense(1-tax rate))/ Invested capital
Invested capital = (working capital + NCA) or (NCL + OE)
(Focuses on permanent capital, excludes CL)
Return on equity (ROE) Net income/ Avg shareholder’s equity

Capital employed = Total debt (both long & short) + Shareholder’s equity (Net worth)
Shareholder’s equity = Total assets – Intangible assets – Total debt – current liabilities
 Why average ?

• In ratios, averaging of balance sheet items is used as:

• P&L reflects full year of firm’s operation whereas balance sheet states the position of
the firm as on a specific date

• Only when both numerator and denominator are sourced only from P&L or from BS,
then averaging is not required
 Efficiency Ratios

• Asset Turnover
• How efficiently are the assets being utilized?
• How efficiently is the company managing its working capital?

• Which ratios?
• Total asset turnover, fixed asset turnover, working capital turnover,
inventory turnover
 Efficiency Financial Statement Ratios
Efficiency Ratios
Total asset turnover (in times) Sales / Average Total assets
Fixed asset turnover (in times) Sales / Average Total fixed assets
PPE turnover (in times) / Capital asset intensity Sales / Average PPE
Working capital turnover (in times) Sales / Avg working capital
Equity turnover Sales/ Avg shareholder’s equity
Cash turnover (in times) Sales/Avg cash & CE
Receivable turnover (in times) Sales / Average debtors
Average collection period (in days) (Debtors velocity or Debtor days) 365 / Receivable turnover ratio
Payable turnover (in times) COGS / Average creditors
Average payables period (in days) (Creditors velocity or Creditor days) 365 / Payable turnover ratio
Inventory turnover (in times) COGS / Average inventories
Average inventories period (in days) (Stock velocity) 365 / Inventories turnover ratio
 Efficiency Financial Statement Ratios
Efficiency Ratios
Day’s cash Cash / (Cash expenses / 365)
Day’s receivables (or collection period) Accounts Receivable / (Sales/365)
Day’s inventory Inventory / (Cost of sales/365)
Cash conversion cycle days inventory outstanding + days sales
outstanding - days payables outstanding.
Stock velocity in months 12/Inventory turnover ratio
Creditors velocity in months 12/Creditor turnover ratio
Debtors velocity in months 12/Debtor Turnover ratio
 Risk Analysis ratios - Solvency

• Solvency
• What is the level of financial risk borne by the shareholders from
long term perspective?
• How well is the company placed to meet its interest obligations?

• Which ratios?
• Debt to equity, Debt to total capital, Interest coverage ratio, total
coverage ratio
 Financial Statement Ratios
Capital Structure & Solvency
Financial leverage Assets / Shareholder’s equity
Total debt to equity Total liabilities/shareholder’s equity
Debt capitalization LT debt/ (LT debt + shareholder’s equity)
Overall gearing ratio (Long term debt + short term debt)/shareholder’s equity
Net gearing ratio (LT debt + St debt – cash & ST invt)/shareholder’s equity
Long term debt to equity Long term liabilities/ shareholder’s equity
Times interest earned/Interest Income before income taxes and interest expense/Interest expense
coverage
Coverage EBITDA/Total fixed charges
Total debt to CFO (LT debt + ST debt)/ cash flow from operations
Total debt to EBITDA (LT debt + ST debt)/EBITDA
Capital Block to current Assets Capital Block / Current Assets
Capital Block = Equity funds + Debentures/Term loans etc
 Du Pont Analysis : Breaking of ROE
• Why ROE is relevant?
• DuPont analysis is an approach to analyze ROE in detail – a way to decompose ROE to evaluate
what changes are driving the changes in ROE

• ROE = Net income/ Avg shareholder’s equity

• ROE = Net income/Sales * Sales/ Avg shareholder’s equity

• ROE = Net income/Sales * Sales/ Total Assets * Total Assets/Avg shareholder’s equity

• ROE = Profitability * Operating efficiency (asset turnover) * Leverage

• Profitability = Net income/Sales = EBIT/Sales * EBT/EBIT * Net income/EBIT

• = Ebit margin*interest burden*tax burden
 Risk Analysis ratios - Liquidity

• Liquidity
• How are short term financing requirements being met?
• Are there sufficient liquid assets to meet its short term
obligations?

• Which ratios?
• Current ratio, Quick ratio, Cash ratio
However, a high current or quick ratio is not necessarily indicative of a problem- free company. It may also indicate that
the company is holding too much cash and not investing in other resources necessary to create more profit.
 Financial Statement Ratios

Liquidity Ratios
Current Ratio Current Assets/Current Liabilities
Acid test/Quick Ratio (Cash & CE + Mkt securities + Acc Receivables)/ Current liabilities
(Current Assets – Inventories)/Current liabilities
Cash Ratio (Cash & CE + Mkt securities)/Current liabilities
 Cash flow ratios

Cash realization ratio (i.e., quality of earnings).

• Cash generated by operations ÷ Net income.

Coverage ratios.
• Use cash flow as numerator both coverage ratios (i.e., times interest
earned, fixed charges coverage).

Source and use percentages.

• Reorganize data into sources and uses format; then show each item as
percent of total sources.
• Ratio of cash generated by operations to total debt.
 Altman z score
• Altman’s Z-Score model is a numerical measurement that is used to predict the chances of a
business going bankrupt in the next two years. The model was developed by American finance
professor Edward Altman in 1968 as a measure of the financial stability of companies

• Altman’s Z-Score interpretation:

• < 1.8 = company is in financial distress and with

a high probability of going bankrupt

• Btw 1.8 and 3 = company is in a grey area and

with a moderate chance of filing for
bankruptcy

• > 3 = company is in a safe zone and is unlikely

to file for bankruptcy
 Financial Statement Ratios

Market Measures
Price to Earnings Market price per share/ Earnings per share
Earnings Yield Earnings per share/ Market price per share
Dividend Yield Cash dividends per share/ Market price per share
Dividend payout rate Cash dividends per share/ Earnings per share
Price to book Market price per share/ Book value per share
Price to sales Market price per share/Sales per share
Price to cash flow Market price per share/cash flow per share
 With whom to compare the ratios with?

• There can be four types of standards with which the ratios can be compared with
• Experience

• Budget

• Historical amount

• An external benchmark – can be like industry average etc