- ROHIT SHARMA

QUALITATIVE FINANCIAL ANALYSIS

Evaluating intangible factors that seem likely to influence

future performance of the company, such as

the integrity and experience of a company's management the positioning of its products and services labour relations industry cycles strength of R&D appeal of its marketing campaign

More subjective than quantitative analysis, which looks at

statistical data Advocates of this approach believe that success or failure in the corporate world is often driven as much by qualitative factors as by financial data

QUANTITATIVE FINANCIAL ANALYSIS

A mathematical analysis of the financial data of a company

to project potential future performance This type of analysis does not include a subjective assessment of the quality of management This methodology involves looking at
profit-and-loss statements sales and earnings histories and the statistical state of the economy rather than at more

subjective factors

While some people feel that quantitative analysis by itself

gives an incomplete picture of a company's prospects, advocates tend to believe that numbers tell the whole story

 A business or financial analysis technique that is used to

understand market behavior by employing complex mathematical and statistical modeling, measurement, and research. By assigning a numerical value to variables, quantitative analysts try to replicate reality in mathematical terms. Quantitative analysis helps measure performance evaluation or valuation of a financial instrument. It also can be used to predict real-world events such as changes in a share's price. things. Examples of quantitative analysis include everything from simple financial ratio calculations such as earnings per share to more complicated analyses such as discounted cash flow or option pricing. Although quantitative analysis is a powerful tool for evaluating investments, it only tells half the story; the other half is qualitative analysis. In financial circles, quantitative analysts are referred to as quants, quant jockeys, and rocket scientists.

In broad terms, quantitative analysis is a way of measuring

ACCOUNTING RATIOS
Accounting ratios describe a significant relationship between figures from a Balance Sheet, Profit & Loss Account or any other part of the Financial Statements of a Company Quantitative relationship between accounting data, which can be used for analysis & decision making Relevant / Effective only when compared with Industry Ratios (Interfirm Comparison) or Base Period Ratios (Trend Analysis) Useless on a standalone basis

ADVANTAGES
Simplifies comprehension of financial statements Facilitates inter-firm comparison: Ratios highlight the factors

associated with successful and unsuccessful firm. They also reveal strong firms and weak firms, overvalued and undervalued firms. Helps in planning & forecasting: Ratios can assist management, in its basic functions of forecasting. Planning, coordination, control and communications. Makes intra-firm comparison possible: Ratios analysis also makes possible comparison of the performance of different divisions of the firm. Helps in investment decisions in the case of investors and lending decisions in the case of bankers etc. The ratios are helpful in deciding about their efficiency or otherwise in the past and likely performance in the future. Ratios tell the whole story of changes in the financial condition of the business

LIMITATIONS
Limitations of Financial Statements: Ratios are based only on the

information which has been recorded in the financial statements.

Financial statements are affected to a very great extent by accounting

conventions and concepts. Personal judgment plays a great part in determining the figures for financial statements. Financial statements themselves are subject to several limitations.

Thus ratios derived, there from, are also subject to those limitations. Comparative study required: Ratios are useful in judging the efficiency of the business only when they are compared with past results of the business. However, such a comparison only provide glimpse of the past performance and forecasts for future may not prove correct since several other factors like market conditions, management policies, etc. may affect the future operations. Ratios alone are not adequate: Ratios are only indicators, they cannot be taken as final regarding good or bad financial position of the business. Other things have also to be seen.

 Lack of adequate standard: No fixed standard can be laid

down for ideal ratios. There are no well accepted standards or rule of thumb for all ratios which can be accepted as norm. It renders interpretation of the ratios difficult. Limited use of single ratios: A single ratio, usually, does not convey much of a sense. To make a better interpretation, a number of ratios have to be calculated which is likely to confuse the analyst than help him in making any good decision. Personal bias: Ratios are only means of financial analysis and not an end in itself. Ratios have to interpreted and different people may interpret the same ratio in different way. Incomparable: Not only industries differ in their nature, but even firms in the same industry widely differ in their size and accounting procedures etc. It makes comparison of ratios difficult and misleading.

LIQUIDITY RATIOS
Attempt to measure a company's ability to pay off its short-

term debt obligations comparing a company's short-term assets with its shortterm liabilities. greater the coverage of liquid assets to short-term liabilities the better as it is a clear signal that a company can
pay its debts that are coming due in the near future still fund its ongoing operations

company with low coverage should raise a red flag for

investors as it may be a sign that the company will have difficulty

running its operations meeting its obligations

CURRENT RATIO (CR)

LEVEL I Tests a company's Liquidity by determining the

proportion of CA available to cover CL The concept behind this ratio is to ascertain whether a company's short-term assets are readily available to pay off its short-term liabilities Highlights a firms Working Capital position Theoretically, the higher the current ratio, the better Threshold limit for CR is 1

CR = CA / CL

 LEVEL II
CR>1 -> Good sign for creditors Payments

Not necessarily for owners Inefficiency CR<1 -> Bad sign for creditors Payments For owners efficiency
Check Creditors, Debtors, Inventory & Line of Credit High CR -> Debtors 6m, Inventory 4m, Creditors 2m, Low CR -> Debtors 2m, Inventory 4m, Creditors 6m

 LEVEL III Trend Analysis Compare Ratios with Past Years

Higher CR Why? Less STD More Inefficient Both

Lower CR Why?
More STD More Efficient Both

Interfirm Comparison With others in the same industry

Higher CR Why? Less STD More Inefficient Both

Lower CR Why?
More STD More Efficient Both

QUICK RATIO (QR)

Quick Assets (QA) Ratio Liquid Ratio Acid-Test Ratio
LEVEL I

QR is more conservative than CR because it includes

only the most liquid CAs QA excludes Inventory, Prepaid Expenses and other CA, which are more difficult to turn into cash Therefore it measures the proportion by which, the most liquid CA cover CL

 Liquidity Indicator, derived from CR A higher ratio means a more liquid current position QR = QA / CL QA = CA Stock Prepaid Expenses

 LEVEL II
QR>1 -> Good sign for creditors Payments

Not necessarily for owners Inefficiency QR<1 -> Bad sign for creditors Payments For owners efficiency
Check Creditors, Debtor & Line of Credit High QR -> Debtors 6m, Creditors 2m Low QR -> Debtors 2m, Creditors 6m

 LEVEL III Trend Ratios

Compare Ratios with Past Years

Higher QR Why? Less STD More Inefficient Both

Lower QR Why?
More STD More Efficient Both

Interfirm Comparison With others in the same industry

Higher QR Why? Less STD More Inefficient Both

Lower QR Why?
More STD More Efficient Both

CURRENT & QUICK RATIO COMPARITIVE

CR significantly higher than QR

means High Inventory

E.g. Car Showroom

CR barely higher than QR

means Low Inventory

E.g. McDonalds

CASH RATIO
LEVEL I

Measures the amount of cash, cash equivalents or

invested funds there are in CA to cover CL This Ratio is relevant as this amount is certainly realizable today itself

Cash Ratio (CR) = Cash & Cash Equivalents / Current Liabilities (CL)
Cash & Cash Equivalents = Cash + Bank +

Marketable Securities / Short-Term Investments

 LEVEL II High CaR -> Good sign for creditors Payments Not necessarily for owners Inefficiency
Low CaR -> Bad sign for creditors Payments

For owners efficiency

Check Loans & Line of Credit High CaR -> Loans & Interest, may not have enough money to pay LTD Salaries Payable may be high, not part of STD Low CaR -> Could mean funds being invested well Line of Credit

 LEVEL III Trend Ratios

Compare Ratios with Past Years

Higher CaR Why?

Lower CaR Why?

More STD More Efficient Both

Less STD More Inefficient Both

Interfirm Comparison

With others in the same industry

Higher CaR Why?

Lower CaR Why?

More STD More Efficient Both

Less STD More Inefficient Both

Excess Cash lying idle is a bad sign Less Cash is also a bad sign, if there is no Line of Credit

CASH CONVERSION CYCLE (CCC)

This liquidity metric expresses the length of time (in

days) that a company uses to sell inventory, collect receivables and pay its accounts payable CCC measures the number of days a company's cash is tied up in the production and sales process of its operations & the benefit it gets from payment terms from its creditors The shorter this cycle, the more liquid the company's working capital position is The CCC is also known as the "cash" or "operating" cycle

 CCC =

+ -

ACP IHP PPP

TURNOVER RATIOS
Activity Ratios Asset Management Ratios Operational Efficiency Ratios

Measure how efficiently the assets are employed by a

firm Measures how quickly certain assets are converted to cash Relationship between Level of Activity & Levels of certain Assets

FIXED ASSETS TURNOVER

Measures the productivity of a company's FA wrt Sales

Generation For most companies, their investment in fixed assets represents the single largest component of their total assets This annual turnover ratio is designed to reflect a company's efficiency in managing these significant assets Simply put, the higher the yearly turnover rate, the better

Fixed Assets Turnover = Net Sales

/ Avg. Net Fixed Assets

INVENTORY TURNOVER
Stock Turnover

Measures how fast the inventory is moving through the

firm Reflects the efficiency of inventory management Higher the ratio the more efficient the inventory management & vice-versa (Not always true) High Inventory Turnover may be because of low level of inventory which would result in Stockouts & Loss of Sales & Customer GW {Avg. Inventory, as we are comparing a flow figure(COGS) to a stock figure(Inventory)}

Inventory Turnover = COGS / Avg. Inventory

RECEIVABLES TURNOVER
Debtors Turnover Shows how many times Debtors turn over during the

year Measures how quickly receivables are collected A higher ratio indicates a short time lag between credit sales & cash collection The higher the ratio, the higher the efficiency of credit management

Receivables Turnover = Net Sales / Avg. Receivables

PAYABLES TURNOVER
Creditors Turnover Shows how many times Creditors turn over during the

year Measures how quickly payables are paid A higher ratio indicates a short time lag between credit purchases & cash payment

Payables Turnover = Net Purchases

/ Avg. Payables

INVENTORY HOLDING PERIOD

Represents number of days of sales locked in

Receivables

IHP = Avg. Inventory / Daily Cost of Goods Sold (COGS)

Daily Cost of Goods Sold = COGS / 365 Avg. Inventory = (Opening + Closing Inventory) / 2

IHP = 365 / Inventory Turnover

AVERAGE COLLECTION PERIOD (ACP)

Debtors Collection Period - Represents number of

days of sales locked in Receivables

ACP = Avg. Receivables / Daily Net Sales

Daily Net Sales = Net Sales / 365

Avg. Receivables = (Opening + Closing Receivables) / 2

ACP = 365 / Receivables Turnover

PAYABLES PAYMENT PERIOD

Represents number of days of available to pay Payables

PPP = Avg. Payables / Daily Net Purchases

Daily Net Purchases = Net Purchases / 365
Avg. Payables = (Opening + Closing Payables) / 2

PPP = 365 / Payables Turnover

LEVERAGE RATIOS
Leverage = the action of a lever Lever = a rigid bar that pivots about one point

and that is used to move an object at a second point by a force applied at a third
Give users a general idea of the company's overall debt

load as well as its mix of equity and debt Debt ratios can be used to determine the overall level of FINANCIAL RISK of a company Generally, the greater the amount of debt held by a company the greater the financial risk of bankruptcy*

 Why? Owners Perspective 1) Lenders may interfere in the running of the business 2) Strict Debt Covenants for further borrowing 3) Further borrowing automatically becomes tougher 4) High Debt payments

Lenders Perspective 1) If the company goes bankrupt, Lenders may suffer 2) Owners have a lesser share they would care less about the

company 3) Bearing the risk to let owners earn magnified returns

 Why Not? Owners Perspective

1) With a limited stake, retain control

2) Return would be magnified, as benefits go to smaller

number of shareholders (leverage or trading on equity)

Need for Balance Use MV of Debt & Equity PSC

DEBT-ASSET RATIO
DEBT RATIO Used to gain a general idea as to the amount of leverage

being used by a company A low percentage means that the company is less dependent on leverage, i.e., money borrowed from and/or owed to others The lower the percentage, the less leverage a company is using and the stronger its equity position Generally, the higher the ratio, the more risky the company
Debt Ratio = Total Debt / Total Assets

PROPRIETARY RATIO
Indicates the ratio of total assets financed by owners Used to gain a general idea as to the amount of

leverage being used by a company A high percentage means that the company is less dependent on leverage The higher the percentage, the less leverage a company is using and the stronger its equity position Generally, the higher the ratio, the less risky the company
Proprietary Ratio = Equity / Total Assets

DEBT-EQUITY RATIO
This is a measurement of how much suppliers, lenders,

creditors and obligors have committed to the company versus what the shareholders have committed. To a large degree, the debt-equity ratio provides another vantage point on a company's leverage position A lower percentage means that a company is using less leverage and has a stronger equity position.

Debt-Equity Ratio = Long-Term Debt / Equity

or = Total Debt / Equity

Equity = Paid-Up Capital + Reserves & Surplus

CAPITALIZATION RATIO
DEBT to TOTAL CAPITAL RATIO There is no right amount of debt Leverage varies according to industries, a company's

line of business and its stage of development Common sense tells us that low debt and high equity levels in the capitalization ratio indicate investment quality

Capitalization Ratio = Long-Term Debt

/ (Equity + Long-Term Debt)

CAPITAL-GEARING RATIO
Provides the relationship between equity funds

and fixed-income bearing funds Used to show the effect of the use of Fixed Interest/Dividend vs the use of Dividend based on Profits on the earnings available to equity shareholders
Capital-Gearing Ratio = Equity (Shareholders Funds) / Fixed-Income Bearing Capital

COVERAGE RATIOS
Second category of Leverage Ratios
Computed from information available in the P/L a/c These ratios analyze the ability of the firm to meet its

fixed payments Measures the extent to which profit covers the fixed payment

INTEREST COVERAGE RATIO (ICR)

ICR is used to determine how easily a company can pay

interest expenses on outstanding debt Tells us how many times the EBIT covers Interest The lower the ratio, the more the company is burdened by debt expense Hence the higher the better When a company's interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable

ICR = EBIT / Interest

DIVIDEND COVERAGE RATIO (DCR)

Measure the ability of the firm to pay Preference

Dividend Tells us how many times the EAT covers Preference Dividend Preference Dividend is an Appropriation of Profits The higher the better for Preference Shareholders
DCR = EAT / Preference Dividend

DEBT SERVICE COVERAGE RATIO (DSCR)

Comprehensive measure to compute Debt Service Capacity Debt Service Capacity is the ability of a firm to make

contractual payments required on a scheduled basis over the life of the debt Used by Financial Institutions in India Number of times the total debt service obligations are covered by total operating funds 2:1 satisfactory for lenders
DSCR = EAT + Dep + Other Non-Cash Charges +

Int on Loan + LR / Int on Loan + Repayment of Loan + LR

FIXED CHARGES COVERAGE RATIO (FCCR)

FCCR shows us how many times the Profit before Interest,

Tax & Lease Payments covers all the Fixed Financing Charges takes into account all Fixed obligations
Debt Interest

Lease Payments
Loan Repayment Installment Preference Dividend

FCCR = EBIT + LR

/ [Debt Int + LR + {(Loan Repayment Inst + Pref Div)/ 1-T}]

PROFITABILITY RATIOS
Help us understand how well the company utilized its
the survival of the company benefit received by shareholders

resources in generating profit and shareholder value The long-term profitability of a company is vital for both
5 Profit Margin Ratios display the amount of profit a

company generates on its sales

Profits are calculated at the different stages of an income

statement these are equated upon sales at each level

The Rate of Return Ratios reflect the relationship

between profit & investment

They detail how effective a company is at generating income from its resources

ALL PROFITABILITY RATIOS are expressed as a %

PROFIT MARGINS
In the P/L A/C, there are 5 levels of profit or profit margins Gross Profit Margin EBITDA Margin Operating Profit Margin Pretax Profit Margin Net Profit Margin Margin can apply to the absolute number for a given profit level and/or

the number as a percentage of net sales/revenues Profit Margin Analysis uses amount of profit (at different levels) generated by the company as a percent of the sales generated Provides a comprehensive measure of a company's profitability on a historical basis (3-5 years) and in comparison to peer companies and industry benchmarks The objective of margin analysis is to detect consistency or +ve / -ve trends in a company's earnings +ve profit margin analysis translates into +ve investment quality To a large degree, it is the quality, and growth, of a company's earnings that drive its stock price

FORMULAS
Gross Profit Margin = Gross Profit / Net Sales EBITDA Margin = EBITDA / Net Sales

Operating Profit Margin = EBIT / Net Sales

Pretax Profit Margin = EBT / Net Sales Net Profit Margin = EAT / Net Sales

RATE OF RETURN RATIOS

RETURN ON ASSETS (ROA)
This ratio indicates how profitable a company is

relative to its total assets. The ROA ratio illustrates how well management is employing the company's total assets to make a profit. The higher the return, the more efficient management is in utilizing its asset base. The ROA ratio is calculated by comparing net income to average total assets, and is expressed as a percentage

ROA = EAT / Avg. Total Assets

Avg. Total Assets = Opening + Closing Total Assets / 2

RETURN ON EQUITY (ROE)

This ratio indicates how profitable a company is by

comparing its PAT to its average shareholders equity ROE measures how much the shareholders earned for their investment in the company The higher the percentage, the more efficient management is in utilizing its equity base and the better return is to investors

ROE = (EAT Preference Dividend)

/ Avg. Equity
Equity = Paid-Up Capital + Reserves & Surplus Avg. Equity = Opening + Closing Equity / 2

RETURN ON CAPITAL EMPLOYED(ROCE)

ROCE complements the ROE by adding a company's

Debt to Equity to reflect a company's total "capital employed" This measure narrows the focus to gain a better understanding of a company's ability to generate returns from its available capital base By comparing net income to the sum of a company's debt and equity capital, investors can get a clear picture of how the use of leverage impacts a company's profitability ROCE is considered to be a more comprehensive profitability indicator because it gauges management's ability to generate earnings from a company's total pool of capital

 ROCE = NOPAT / Avg. Capital Employed

NOPAT / NOEAT = EBIT ( 1 T ) Capital Employed / Net Assets

= Total Assets Short-Term Liabilities or = Equity + Long-Term Debt

Avg. Capital Employed

= Opening + Closing Capital Employed / 2

EARNING POWER (EP)

Investors can get a clear picture of how the use of

leverage impacts a company's profitability, ignoring taxation

EP = EBIT / Avg. Capital Employed

EFFECTIVE TAX RATE

This amount will often differ from the company's

stated Tax Rate due to many accounting factors, including foreign exchange provisions Tax Profit = Accounting Profit? This effective tax rate gives a good understanding of the tax rate the company actually faces The purpose of this is to see the efficiency in Tax Planning of the organization

Effective Tax Rate = Tax / EBT

DU-PONT ANALYSIS
It is also known as "DuPont identity" A method of performance measurement that was started by the

DuPont Corporation in the 1920s If ROE is unsatisfactory, the DuPont analysis helps locate the part of the business that is underperforming 3-Stage DuPont analysis tells us that ROE is affected by 3 things:
Operating efficiency, indicated by PROFIT MARGIN
Asset use efficiency, indicated by TOTAL ASSET TURNOVER Financial leverage, indicated by the EQUITY MULTIPLIER or

FINANCIAL LEVERAGE

ROE = Profit Margin (Profit/Sales) * Total Asset Turnover (Sales/Avg. Total Assets) * Equity Multiplier (Avg. Total Assets/Avg. Equity)

 If a company's ROE goes up Due to an increase in the net profit margin or asset

turnover Good Sign

Due to equity multiplier company was already appropriately leveraged Bad Sign as the company is now riskier company was under-leveraged Good Sign as it indicates better management

 5-Stage DuPont analysis tells us that ROE is affected by 5

things:

Asset use efficiency, measured by TOTAL ASSET TURNOVER Financial leverage, measured by the EQUITY MULTIPLIER or

FINANCIAL LEVERAGE Profitability, indicated by EBIT Margin The Change in Profit due to Tax indicated by Tax Burden The Change in Profit due to Interest indicated by Interest Burden

ROE = Tax Burden (EAT/EBT)

* Interest Burden (EBT/EBIT) * EBIT Margin (EBIT/Sales) * Total Asset Turnover (Sales/ Total Assets) * Equity Multiplier (Total Assets/Equity)

VALUATION RATIOS
Used to estimate the attractiveness of a potential or

existing investment and get an idea of its valuation When looking at the financial statements of a company many users can suffer from information overload as there are so many different financial values Investment valuation ratios attempt to simplify this evaluation process by comparing relevant data that help users gain an estimate of valuation The most well-known investment valuation ratio is the P/E ratio, which compares the current price of company's shares to the amount of earnings it generates The purpose of this ratio is to give users a quick idea of how much they are paying for each Re. of earnings With one simplified ratio, you can easily compare the P/E ratio of one company to its competition and to the market

PRICE-TO-BOOK VALUE RATIO

A valuation ratio used by investors which compares a stock's per

share price (Market Value) to its book value (Shareholders Equity) It is expressed as a multiple (i.e. how many times a company's stock is trading per share compared to the company's book value per share), Indicates how much shareholders are paying for the net assets of a company The book value of a company is the value of a company's assets expressed on the balance sheet It is the difference between the B/S Assets & B/S Liabilities Provides investors a way to compare the market value, or what they are paying for each share, to a conservative measure of the value of the firm

P/BV = MVPS / BVPS

PRICE/EARNINGS (P/E) RATIO

P/E is the best known of the investment valuation

indicators P/E ratio has its imperfections, but it is nevertheless the most widely reported and used valuation by investment professionals and the investing public The financial reporting of both companies and investment research services use a basic EPS figure divided into the current stock price to calculate the P/E multiple (i.e. how many times a stock is trading (its price) per each Re. of EPS)

 It's not surprising that estimated EPS figures are often

very optimistic during bull markets, while reflecting pessimism during bear markets As a matter of historical record, it's no secret that the accuracy of stock analyst earnings estimates should be looked at skeptically by investors Nevertheless, analyst estimates and opinions based on forward-looking projections of a company's earnings do play a role in influencing the MP The ratio will vary widely among different companies and industries
P/E Ratio = Market Price / EPS

PRICE-TO-SALES RATIO
Sales Revenue is not easy to manipulate as Earnings &

BV which depend on accounting convention High Sales do not indicate High Earnings

P/S = MVPS / Sales per share = Market Value of Equity / Total Sales

EV/EBITDA RATIO
measures the value of a company

alternative to the P/E Ratio

advantage of this multiple is that it is capital structure-

neutral useful for transnational comparisons because it ignores the distorting effects of individual countries taxation policies

EV/EBITDA = EV / EBITDA

IMPORTANT TERMS
EPS = Earnings to ESH

/ No. of Equity Shares

Earnings to ESH = EAT Preference Dividend REPS = Retained Earnings

/ No. of Equity Shares

Retained Earnings = EAT Preference Dividend

Equity Dividend

 DPS = Dividend Distributed / No. of Equity Shares Earnings Yield = EPS / MVPS * 100 Dividend Yield = DPS / MVPS * 100 Dividend Payout Ratio = DPS / EPS Retention Ratio = REPS / EPS