Financial Soundness Analysis :

Illustrates a comprehensive analysis

Integrates material from previous learnings
Adds new resources
Offers a toolbox of analytical techniques

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From the Tools & Techniques

Presented. . .
Stakeholders can choose what to use to
meet specific objectives

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The 1st Step in Evaluating a

Firms Financial Reports is to. . .
Specify the objectives of the analysis

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An Investor
Decides whether to buy, hold, or sell a
firms security
Uses a companys historical financial
information to estimate future potential &
value

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A Creditor
Determines debt capacity of the firm
Assesses firms ability to service debt
Evaluates source of debt repayment

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Managers & Directors

Address questions relevant to investors &
creditors
Satisfy other user groups:
employees
competitors
suppliers

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Managers & Directors Continued:

Consider responses to financial reports by:
general public
regulators
financial press

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Financial Reporting Environment

Is often adversarial:
management wants to present most positive
picture possible
users want picture that represents financial
reality

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Sources of Information
Primary Sources
Four financial statements
Financial statement notes

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Sources of Information Continued:

10-K Annual report:
annual report filed with SEC/SEBI

10-Q uarterly reports:

quarterly (unaudited) reports filed with
SEC/SEBI

Proxy statement:
required by SEC/SEBI prior to shareholders
meetings
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Sources of Information Continued:

Auditors Reports
Independent reports expressing opinion
about fairness of financial statement
presentation

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Sources of Information Continued:

Management Discussion & Analysis
Section in annual report monitored by
SEC/SEBI which covers firms:
liquidity
capital resources
operations

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Sources of Information Continued:

Supplementary Schedules
Selected financial data on:
segments (unrelated lines of business)
operations outside Country.

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More Resources
Common size balance sheet:
expresses all items as a percentage of total
assets

Common size income statement:

expresses all items as percentage of total sales

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More Resources Continued:

Summary Analysis of Cash Flows**:
Separates cash inflows & outflows in dollar &
percentage terms
** Most Important

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Tools & Techniques

Financial Ratios
Standardize financial statement data
Mathematical relationships expressed in
percent or times

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Tools & Techniques Continued:

Trend analysis
evaluates financial data over several accounting
periods

Structural analysis
considers the internal composition of a firm

Industry comparisons
relate one firm with averages compiled for
industry in which it operates
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Financial Ratios

Use as screening devices

Use with caution: they dont supply answers
Use with other analytical tools
5Categories:Liquidity,Profitability,Leverage
&Coverage,Activity and Market related
Du Pont Analysis , Net Trade Cycle ,FLI ,
CFO LR ,CFO CR and CFO PS
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Financial Ratios Continued:

Look behind ratio that is out of line to
determine cause
There is no standardized set of ratios or
definitions

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Liquidity Ratios
Measure short-run solvency:
the ability of firm to meet debt payments as
they come due

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Liquidity Ratios Continued:

Current ratio:
Current assets
Current liabilities
Quick ratio:
Current assets - inventory
Current liabilities

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Liquidity Ratios Continued:

Cash flow liquidity ratio**(most
important):
Cash + Market Securities + Cash flow from operations
Current liabilities

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Liquidity Ratios Continued:

Average collection period*:
Accounts receivable
Average daily sales
*First Input for Net Trading Cycle
More Important Ageing of Receivables

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Liquidity Ratios Continued:

Days inventory held*:
Inventory
Average daily cost of sales
*Second Input for Net Trading Cycle

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Liquidity Ratios Continued:

Days payable outstanding*:
Accounts payable
Average daily cost of sales
*Third Input for Net Trading Cycle

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Net Trade Cycle**

Average collection period
+ days inventory held
- days payable outstanding
**Most Important Measures normal cash
conversion cycle of firm

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Activity Ratios
Measures turnover of assets & asset
management efficiency

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Activity Ratios Continued:

Accounts receivable turnover:
Net sales
Accounts receivable
Inventory turnover:
Cost of goods sold
Inventory

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Activity Ratios Continued:

Payables turnover:
Cost of goods sold
Accounts payable

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Activity Ratios Continued:

Fixed asset turnover:
Net sales
Net property, plant, equipment
Total asset turnover:
Net sales
Total assets
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Leverage** & Coverage* Ratios

Measures debt financing & debt coverage
*Coverage is more important
** In Leverage FLI (result) is more
important

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Leverage & Coverage Ratios

Continued:
Debt ratio:
Total liabilities
Total assets

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Leverage & Coverage Ratios

Continued:
Long-term debt to total capitalization:
Long-term debt
Long-term debt + stockholders equity

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Leverage & Coverage Ratios

Continued:
Debt to equity:
Total liabilities
Stockholders equity
Times interest earned:
Operating profit
Interest expense
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Leverage & Coverage Ratios

Continued:
Cash interest coverage**:
Cash flow from operations + interest paid + taxes paid
Interest paid

** Most Important

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Leverage & Coverage Ratios

Continued:
Fixed charge coverage:
Operating profit + rent expense
Interest expense + rent expense

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Leverage & Coverage Ratios

Continued:
Cash flow adequacy**:
Cash flow from operations
Capital expenditures + debt repayments +
dividends paid
**Most Important

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Profitability Ratios-1.On Sales

and 2. On Investment
Measures overall efficiency & performance

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Profitability Ratios Continued:

Gross profit margin:
Gross profit
Net sales
Operating profit margin:
Operating profit
Net sales
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Profitability Ratios Continued:

Net profit margin:
Net profit
Net sales
Cash flow margin**:
Cash flow from operations
Net sales
**Most Important
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Profitability Ratios Continued:

Return on assets (investment):
Net profit
Total assets
Return on equity:
Net profit
Stockholders equity
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Financial Leverage Index:

Use of Debt
FLI Magnifies returns to shareholders when
company earns more than after-tax cost of
debt
FLI= ROE/Adjusted ROA
Adjusted ROA=
PAT+ Interest(1-Tax rate)/Total Assets
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Financial Leverage:
Double-edged Sword
Produces negative effects on returns when
company earns less than after-tax cost of
debt

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Profitability Ratios Continued:

Cash return on assets**:
Cash flow from operations
Total assets
**Most Important

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Market Ratios
Basic earnings per share:
Net income
Weighted average number of common
shares outstanding
**Cash Flow earnings per Share:
CFO/WA of no of Common shares O/S
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Market Ratios Continued:

Dividend yield:
Cash dividends per share
Year-end market price of common stock

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Market Ratios Continued:

Price to earnings ratio:
Market price of common stock
Basic earnings per share

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Additional Information that is

Useful
Financial data provided for operating
segment (unrelated lines of business)
Financial data provided for operations
outside the country.

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Comprehensive AnalysisDuPont Analysis

Includes many steps & interrelated pieces
No one step or piece should be interpreted
in isolation from the other parts
ROE= NP/Net Sales * Net Sales/Assets
* Assets/Equity or NW
ROE= NPM * ATO * EM

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Final Steps of Analysis

Integrate the separate steps & pieces
Reach overall conclusions about the firms
financial condition
performance
future prospects

Make sound financial decisions

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Caution Flags
Changes in top company management
Key financial ratios indicating deteriorating
trends and/or weakness relative to industry
competitors

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More Caution Flags

Cash flow from operating activities are:
declining
negative
volatile **
not tracking with net income**

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Even More Caution Flags

Lack of profitability in key operating areas
Low price to earnings ratio relative to
competitors
Firms earnings less than after-tax cost of
debt*** FLI

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Final Caution Flags

Operating profits declining when debt is
rising
Deteriorating trends in operating segments

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