Ratio Analysis of Financial Statements – This is the most comprehensive guide to Ratio Analysis / Financial Statement Analysis
Here I have taken Colgate case study and calculated Ratios in excel from scratch.
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Ratio Analysis / Financial Statement Analysis – Read me First
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Ratio Analysis of financial statement
I have made an easy navigation for you to learn Ratio Analysis Types.
- What is Financial Statement Analysis / Ratio Analysis
- Vertical Analysis or Common Size Statements
- Horizontal Analysis
- Trend Analysis
- Ratio Analysis
- Liquidity Ratio Analysis
- Solvency Ratio Analysis
- Turnover Ratios
- Ratio Analysis – Operating Performance
- Operating Efficiency Ratio Analysis
- Operating Profitability Ratio Analysis
- Ratio Analysis – Risk
- Business Risk
- Financial Risk
- Ratio Analysis – External Liquidity Risk
What is Financial Statement Analysis / Ratio Analysis?
The purpose of Financial Statement Analysis (Ratio Analysis) is to evaluate management performance in Profitability, Efficiency and Risk
Although financial statement information is historical, it is used to project future performance
Financial Statement Analysis (Ratio analysis) can be done using Three Methods –
- Vertical Analysis (also called as Common Size Statements Analysis) – It compares the each item of to the base case of the financial statements. All income statement items are expressed as percentage of Sales. Balance Sheet Items are expressed as a percentage of Total Assets or Total Liabilities (please note Total Assets = Total Liabilities)
- Horizontal Analysis – It compares the two financial statements (income statement, balance sheet) o determine the absolute change as well as percentage changes.
Ratio Analysis – Puts important business variables into perspective by comparing it with other numbers. It provides meaningful relationship between individual values in the financial statements.
So, which one is the best when it comes to Financial Statement Analysis?
Ofcourse, you can’t pick and choose a single method as the best and ONLY method to do the financial statement analysis.
You need to do all THREE analysis in-order to get a complete picture of the Company.
Let us look at each one of them one by one.
Vertical Analysis or Common Size Statements
Vertical analysis is a technique used to identify where a company has applied its resources and in what proportions those resources are distributed among the various balance sheet and income statement accounts. The analysis determines the relative weight of each account and its share in asset resources or revenue generation
Vertical Analysis – Income Statement
- On the income statement, vertical analysis is a universal tool for measuring the firm’s relative performance from year to year in terms of cost and profitability.
- It should always be included as part of any financial analysis. Here, percentages are computed in relation to Sales which are considered to be 100%.
- This vertical analysis effort in the income statement is often referred to as margin analysis, since it yields the different margins in relation to sales.
- It also helps us do the time series analysis ( how the margins has increased/decreased over the years) and also helps in cross sectional analysis with other comparable companies in the industry.
Vertical Analysis of Income Statement: Colgate Case Study
- For each year, Income Statement line items is divided by its respective year’s Top Line (Net Sales) number.
- For example, for Gross Profit, it is Gross Profit / Net Sales. Likewise for other numbers
What can we interpret with Vertical Analysis of Colgate Palmolive
- Vertical Ratio Analysis helps us with analyzing the historical trends.
- Please note that from vertical analysis we only get to the point of asking the right questions (identification of problems). However, we do not get answers to our questions here.
- In Colgate, we note that gross profit margin (Gross Profit / Net Sales) has been in the range of 56%-59%. Why Fluctuating?
- We also note that the Selling General and administrative expenses (SG&A) has decreased from 36.1% in 2007 to 34.1% in the year ending 2015. Why?
- Also, note that the operating income has dropped significantly in 2015. Why?
- Net income decreased substantially to less than 10%. Why?
- Also, effective tax rates jumped to 44% in 2015 (from 2008 until 2014, it was in the range of 32-33%). Why?
Vertical Analysis – Balance Sheet (Common Size Ratio?)
- Vertical Analysis on the Balance Sheet normalizes the Balance Sheet and expresses each item in percentage of total assets/liabilities.
- It helps us to understand how each item of the balance sheet has moved over the years. For eg. Debt has increased or decreased?
- It also helps in cross sectional analysis (comparing the balance sheet strength with other comparable companies)
Vertical Analysis of Balance Sheet: Colgate Case Study
- For each year, Balance Sheet line items is divided by its respective year’s Top Assets (or Total Liabilities) number.
- For example, for Accounts Receivables, we calculate as Receivables / Total Assets. Likewise for other balance sheet items
Interpretation of Colgate’s Vertical Analysis
- Cash and Cash equivalents has increased from 4.2% in 2007 and is currently standing at 8.1% of the total assets. Why a built-up of cash?
- Receivables has decreased from 16.6% in 2007 to 11.9% in 2015. Does this mean a stricter credit policy terms?
- Inventories has decreased too from 11.6% to 9.9% overall. Why?
- What is included in “other current assets”? It shows a stead increase from 3.3% to 6.7% of the total assets over the last 9 years.
- What is included in other assets? Why shows a fluctuating trend?
- On the liabilities side, there can be many observations we can highlight. Accounts payable decreased continuously over the past 9 years and currently stands at 9.3% of the total assets.
- Why there has been a significant jump in the Long Term Debt to 52,4% in 2015. For this we need to investigate this in the 10K?
- Non controlling interests has also increased over the period of 9 years and is now at 2.1%
As with the vertical analysis methodology, issues will surface that need to be investigated and complemented with other financial analysis techniques. The focus is to look for symptoms of problems that can be diagnosed using additional techniques. Let’s look at an example.
Horizontal Analysis of Colgate’s Income Statement
For example, to find growth rate of Net Sales of 2015, the formula is (Net Sales 2015 – Net Sales 2014) / Net Sales 2014
What can we interpret with Horizontal Analysis of Colgate Palmolive
- The last two years Colgate has seen a dip in Net Sales figures. In 2015, Colgate saw a de-growth of -7.2% in 2015. Why?
- Cost of Sales, however, has decreased (positive from company’s point of view). Why is this so?
- Net Income decreased in the last three years, with as much as 36.5% delcine in 2015.
Trend Analysis compare the overall growth of key financial statement line item over the years from the base case.
For example, in case of Colgate, we assume that 2007 is the base case and analyze the performance in Sales and Net profit over the years.
- We note that Sales has increased by only 16.3% over a period of 8 years (2008-2015).
- We also note that the overall net profit has decreased by 20.3% over the 8 year period.
Ratio Analysis of Financial Statements
Ratio analysis of financial statement is another tool that helps identify changes in a company’s financial situation. A single ratio is not sufficient to adequately judge the financial situation of the company. Several ratios must be analyzed together and compared with prior-year ratios, or even with other companies in the same industry. This comparative aspect of ratio analysis is extremely important in financial analysis. It is important to note that ratios are parameters and not precise or absolute measurements. Thus, ratios must be interpreted cautiously to avoid erroneous conclusions. An analyst should attempt to get behind the numbers, place them in their proper perspective and, if necessary, ask the right questions for further types of ratio analysis.
Solvency Ratio Analysis
Solvency Ratio Analysis type is primarily sub-categorized into two parts – Liquidity Ratio Analysis and Turnover Ratio Analysis of financial statement. They are further sub-divided into 10 ratios as seen in the diagram below.
We will discuss each sub category one by one.
Liquidity ratio analysis measure how liquid the company’s assets are (how easily can the assets be converted into cash) as compared to its current liabilities. There are three common liquidity ratio
- Current ratio analysis
- Acid test (or quick asset) ratio analysis
- Cash Ratio analysis
#1 – Current Ratio Analysis
What is Current Ratio Analysis?
Current ratio is the most frequently used ratio to measure company’s liquidity as it is quick, intuitive and easy measure to understand the relationship between the current assets and current liabilities. It basically answers this question “How many dollars in current assets does the company have to cover each $ of current liabilities”
Let us take a simple Current Ratio Calculation example,
Current Ratio = $200 / $100 = 2.0x
This implies that the company has two dollar of current assets for every one dollar of current liabilities.
Analyst Interpretation of Current Ratio
- Current ratio analysis provides us with a rough estimate that whether the company would be able to “survive” for one year or not. If Current Assets is greater than Current Liabilities, we interpret that the company can liquidate its current assets and pay off its current liabilities and survive atleast for one operating cycle.
- Current Ratio analysis in itself does not provide us with full details of the quality of current assets and whether they are fully realizable.
- If the current assets consists primarily of receivables, we should investigate the collectability of such receivables.
- If current assets consists of large Inventories, then we should be mindful of the fact that inventories will take longer to convert into cash as they cannot be readily sold. Inventories are much less liquid assets than receivables.
- Average maturities of current assets and current liabilities should also be looked into. If current liabilities mature in the next one month, then current assets providing liquidity in 180 days may not be of much use.
Current Ratio analysis – Colgate Case Study Example
Let us now calculate the Current Ratios for Colgate.
- Colgate has maintained a healthy current ratio of greater than 1 in the past 10 years.
- Current ratio of Colgate for 2015 was at 1.24x. This implies that current assets of Colgate are more than current liabilities of Colgate.
- However, we still need to investigate on the quality and liquidity of Current Assets. We note that around 45% of current assets in 2015 consists of Inventories and Other Current Assets. This may affect the liquidity position of Colgate.
- When investigating Colgate’s inventory, we note that majority of the Inventory consists of Finished Goods (which is better in liquidity than raw materials supplies and work-in-progress).
source: Colgate 2015 10K Report, Pg – 100
Below is a quick comparison of Current Ratio of Colgate’s vs P&G vs Unilever
- Colgate’s current Ratio as compared to its peer group (P&G and Unilever) appears to be much better.
- Unilever current ratio seems to be declining over the past 5 years. However, P&G Current ratio has remained less than 1 in the past 10 years or so.
#2 – Quick Ratio Analysis
What is Quick Ratio?
- Sometimes current assets may contain huge amounts of inventory, prepaid expenses etc. This may skew the current ratio interpretations as these are not very liquid.
- To address this issue, if we consider the only most liquid assets like Cash and Cash equivalents and Receivables, then it should provide us with a better picture on the coverage of short term obligations.
- This ratio is know as Quick Ratio or the Acid Test.
- The rule of thumb for a healthy acid test index is 1.0.
Let us take a simple Quick Ratio Calculation example,
Accounts Receivables = $500
Current Liabilities = $1000
Then Quick Ratio = ($100 + $500) / $1000 = 0.6x
- Accounts Receivables are more liquid than the inventories.
- This is because Receivables directly convert into cash after the credit period, however, Inventories are first converted to Receivables which in turn take further time to convert into cash.
- In addition, there can be uncertainty related to the true value of the inventory realized as some of it may become obsolete, prices may change or it may become damaged.
- It should be noted that a low quick ratio may not always mean liquidity issues for the company. You may find low quick ratios in businesses that sell on cash basis (for example, restaurants, supermarkets etc). In these businesses there are no receivables, however, there maybe a huge pile of inventory.
Quick Ratio analysis – Colgate Case Study Example
Let us now look at the Quick Ratio calculations in Colgate.
Quick Ratio of Colgate is relatively healthy (between 0.56x – 0.73x). This acid test shows us the company’s ability to pay off short term liabilities using Receivables and Cash & Cash Equivalents.
Below is a quick comparison of Quick Ratio analysis of Colgate’s vs P&G vs Unilever
As compared to its Peers, Colgate has a very healthy quick ratio.
While, Unilever’s Quick Ratio has been declining for the past 5-6 years, we also note that P&G Quick ratio is much lower than that of Colgate.
#3 – Cash Ratio analysis
What is Cash Ratio analysis?
Cash ratio considers only the Cash and Cash Equivalents (there are the most liquid assets within the Current Assets). If the company has a higher cash ratio, it is more likely to be able to pay its short term liabilities.
Let us take a simple Cash Ratio Calculation example,
Current Liabilities = $1000
Then Quick Ratio = $500 / $1000 = 0.5x
- All three ratios – Current Ratios, Quick Ratios, and Cash Ratios should be looked at for understanding the complete picture on Company’s liquidity position.
- Cash Ratio analysis is the ultimate liquidity test. If this number is large, we can obviously assume that the company has enough cash in its bank to pay off its short term liabilities.
Cash Ratio – Colgate Case Study Example
Let us calculate Cash Ratios in Colgate.
Colgate has been maintaining a healthy cash ratio of 0.1x to 0.28x in the past 10 years. With this higher cash ratio, the company is in a better position to payoff its current liabilities.
Below is a quick comparison of Cash Ratio of Colgate’s vs P&G vs Unilever
Colgate’s Cash ratio as compared to its peers seems to be much superior.
Unilever’s Cash Ratio has been declining in the past 5-6 years.
P&G cash ratio has steadily improved over the past 3-4 years period.
Turnover Ratio Analysis of financial statement
We saw from the above three liquidity ratios (Current, Quick and Cash Ratios) that it answer the question “Whether the company has enough liquid assets to square off its current liabilities”. So this ratio is all about the $ amounts.
However, when we look at Turnover ratio analysis, we try to analyze the liquidity from “how long it will take for the firm to convert inventory and receivables into cash or time taken to pay its suppliers”.
The commonly used turnover ratios include:
- 4) Receivables turnover
- 5) Accounts receivables days
- 6) Inventory turnover
- 7) Inventory days
- 8) Payables turnover
- 9) Payable days
- 10) Cash Conversion Cycle
#4 – Receivables Turnover Ratio analysis
What is Receivables Turnover Ratio analysis?
- Accounts Receivables Turnover Ratio can be calculated by dividing Credit Sales by Accounts Receivables.
- Intuitively. it provides us the number of times Accounts Receivables (Credit Sales) is converted into Cash Sales
- Accounts Receivables can be calculated for the full year or for a specific quarter.
- For calculating accounts receivables for a quarter, one should take annualized sales in the numerator.
Let us take a simple Receivables Turnover Calculation example,
Credit given is 80%
Accounts Receivables = $200
Credit Sales = 80% of $1000 = $800
Accounts Receivables Turnover = $800 / $200 = 4.0x
- Please note that the Total Sales include Cash Sales + Credit Sales. Only Credit Sales convert to Accounts Receivables, hence, we should only take Credit Sales.
- If a company sells most of its items on Cash Basis, then there will be No Credit Sales.
- Credit Sales figures may not be directly available in the annual report. You may have to dig into the Management discussions to understand this number.
- If it is still hard to find the percentage of credit sales, then do have a look at conference calls where analysts question the management on relevant business variables. Sometimes it is not available at all.
Accounts Receivables – Colgate Example
- To calculate the receivables turnover, we have considered average receivables. We consider the “average” figures as these are balance sheet items.
- For eg. as shown in the image below, we took the average receivables of 2014 and 2015.
- Also, please note that I have taken the assumption that 100% of Colgate’s Sales were “Credit Sales”.
- We note that the Receivables Turnover was less than 10x in 2008-2010. However, it improved significantly in the past 8 years and is was closer to 11x in 2015.
- Higher Receivables Turnover implies higher frequency of converting receivables into cash (this is good!)
Below is a quick comparison of Receivables turnover of Colgate vs P&G vs Unilever
- We note that P&G Receivable turnover ratio is slightly higher than Colgate.
- Unilever’s Receivables turnover is closer to that of Colgate.
#5 – Days Receivables
What is Days Receivables?
You may calculate Account Receivable days based on the year end balance sheet numbers.
Many analysts, however, prefer to use the average balance sheet receivables number to calculate the average collection period. (right way is to use the average balance sheet)
Let us take the previous example and find out the Days Receivables
Let us take a simple Days Receivables Calculation example,
Number of days in a year = 365
Days Receivables = 365 / 4.0x = 91.25 days ~ 91 days
This implies that it takes 91 days for the company to convert Receivables into Cash.
- Number of days taken by most analysts is 365, however, some analyst also use 360 as the number of days in the year. This is normally done to simplify the calculations.
- Accounts receivable days should be compared with the average credit period offered by the company. For example in the above case, if the Credit Period offered by the company is 120 days and they are receiving cash in just 91 days, this implies that the company is doing well to collect its receivables.
- However, if the credit period offered is say 60 days, then you may find significant amount of previous accounts receivables on the balance sheet, which obviously is not good from company’s point of view.
Days Receivables – Colgate Case Study Example
- Let’s calculate Days Receivables for Colgate. To calculate Days Receivables, we have taken 365 days assumption.
- Since, we had already calculated receivables turnover above, we can easily calculate the days receivables now.Days receivables or Average Receivables collection days has decreased from around 40 days in 2008 to 34 days in 2015.
- This means that Colgate is doing a better job in collecting its receivables. They may have started implementing a stricter credit policy.
#6 – Inventory Turnover Ratio analysis
What is Inventory Turnover Ratio analysis?
Inventory Ratio means how many times the inventories are restored during the year. It can be calculated by taking Cost of Goods Sold and dividing by Inventory.Inventory Turnover Formula = Cost of Goods Sold / Inventory
Let us take a simple Inventory Turnover Ratio Calculation example.
Inventory = $100
Inventory Turnover Ratio = $500 / $100 = 5.0x
This implies that during the year, inventory is used up 5 times and is restored to its original levels.
You may note that when we calculate receivables turnover, we took Sales (Credit Sales), however, in inventory turnover ratio, we took Cost of Goods Sold. Why?
The reason is that when we think about receivables, it directly comes from Sales made on the credit basis. However, Cost of Goods sold is directly related to inventory and is carried on the balance sheet at cost.
To get an intuitive understanding of this, you may see the BASE equation.
B = Beginning Inventory
A = Addition to Inventory (purchases during the year)
S = Cost of Goods sold
E = Ending Inventory
S = B + A – E
As we note from the above equation, Inventory is directly related to Cost of Goods Sold.
Inventory Turnover Ratio – Colgate Case Study Example
- Let us calculate Inventory Turnover Ratio of Colgate. Like in receivables turnover, we take the average inventory for calculating Inventory Turnovers.
- Colgate’s inventory consists of Raw material and supplies, work in progress and finished goods.
- Colgate’s inventory turnover has been in the range of 5x-6x.
- In the last 3 years, Colgate has seen a lower inventory turnover ratio. This means that Colgate is taking longer to process its inventory to finished goods.
#7 – Days Inventory
What is Days Inventory?
We calculated Inventory Turnover Ratio earlier. However, most analyst prefer calculating inventory days. This is obviously the same information but more intuitive. Think of Inventory Days as the approximate number of days it takes for inventory to convert into finished product.
Let us take a simple Days Inventory Calculation example. We will use the previous example of Inventory Turnover Ratio and calculate Inventory Days.
Inventory = $100
Inventory Turnover Ratio = $500 / $100 = 5.0x
Inventory Days = 365/5 = 73 days.
This implies that Inventory is used up every 73 days on an average and is restored to its original levels.
- You may also think of inventory days as the number of days a company can continue with production without replenishing its inventory.
- One should also look at the seasonality patter in how inventory is consumed depending on the demand. It is rare that inventory is consumed constantly throughout the year.
Inventory Days – Colgate Case Study Example
Let us calculate the Inventory turnover days for Colgate. Inventory Days for Colgate = 365 / Inventory Turnover.
- We see that inventory processing period has increased from 64.5 days in 2008 to around 70.5 days in 2015.
- This implies that Colgate is processing its inventory a bit slowly as compared to 2008.
#8 – Accounts Payable Turnover
What is Accounts Payable Turnover?
Payables turnover indicates the number of times that payables are rotated during the period. It is best measured against purchases, since purchases generate accounts payable.
Let us take a simple Accounts Payable Turnover calculation example. From the Balance Sheet, you are provided with the following –
Beginning Inventory = $200
Cost of Goods Sold = $500
Accounts Payable = $200
In this example, we need to first find out Purchases during the year. If you remember the BASE equation that we used earlier, we can easily find purchases.
B + A = S + E
B = Beginning Inventory
A = Additions or Purchases during the year
S = COGS
E = Ending Inventory
we get, A = S + E – B
Purchases or A = $500 + $500 – $200 = $800
Payables Turnover = $800 / $200 = 4.0x
- Some analysts make a mistake of taking Cost of Goods Sold in the numerator of this accounts payable turnover formula.
- It is important to note here that Purchase is the one that leads to Payables.
- We earlier saw Sales can be Cash Sales and Credit sales. Likewise, Purchases can be Cash Purchases as well Credit Purchases. Cash Purchases does not results in payables, it is only the Credit Purchases that leads to Accounts payables.
- Ideally, we should seek for Credit Purchases information from the annual report.
Accounts Payable Turnover – Colgate Case Study Example
Once we have the purchases, we can now find the payables turnover. Please note that we use the average accounts payable to calculate the ratio.
We note that Payable turnover has decreased to 5.50x in 2015. This implies that Colgate is taking a bit longer to make payment to its suppliers.
#9 – Days Payable Ratio Analysis
What is Days Payable Ratio analysis?
Like with all the other turnover ratios, most analyst prefer to calculate much intuitive Days payable. Payable days represent the average number of days a company takes to make the payment to its suppliers.
Let’s take a simple Payable Days calculation example. We will use the previous example of Accounts Payable Turnover to find the Payable days
Payable Days = 365 / 4 = 91.25 ~ 91 days
This implies that the company pays its clients every 91 days.
- Higher the accounts payable days, better it is for the company from liquidity point of view.
- Payable days can be affected by seasonality in the business. Sometimes business may stock inventories due to upcoming business cycle. This may distort the interpretations that we make on payable days if we are not aware of seasonality.
Accounts Payable Ratio Analysis – Colgate Case Study Example
Payable days have been constant at around 66 days for the past 3 years. This means that Colgate takes around 66 days for paying its suppliers.
#10 – Cash Conversion Cycle
What is Cash Conversion Cycle?
Cash Conversion cycle depends primarily on three variables – Receivable Days, Inventory Days and Payable Days.
Let us take a simple Cash Conversion Cycle calculation example,
Inventory Days = 60 days
Payable Days = 30 days
Cash conversion cycle = 100 + 60 – 30 = 130 days.
Analyst Interpretation of Cash Conversion
- It signifies the number of days firm’s cash is stuck in the operations of the business.
- Higher cash conversion cycle means that it takes longer time for the firm to generate cash returns.
- However, a lower cash conversion cycle may be viewed as a healthy company.
- Also, one should compare the cash conversion cycle with the industry averages so that we are in a better position to comment on higher/lower side of cash conversion cycle.
Cash Conversion Cycle – Colgate Case Study Example
- Cash Conversion Cycle of colgate = Receivable Days + Inventory Days – Payable Days
- Overall, we note that the cash collection cycle has decreased from around 46 days in 2008 to 38 days in 2015.
- This implies that overall Colgate is improving its cash conversion cycle with each year.
- We note that the receivables collection period has decreased overall that has contributed to the decrease in cash conversion cycle.
- Additionally, we also note that the average payable days has increased, which again positively contributed to the cash conversion cycle.
- However, the increase in inventory processing days in the recent years has negatively affected its cash conversion cycle.
Ratio Analysis of financial statement – Operating Performance
Operating performance ratios try and measure how the business is performing at the ground level and is sufficiency generating returns relative to the assets deployed.
Operating Performance Ratios are two sub-divided as per the diagram below
Operating Efficiency Ratios
#11 – Asset Turnover Ratio analysis
What is Asset Turnover Ratio analysis?
The asset turnover ratio is a comparison of sales to total assets. This ratio provides with an indication on how efficiently the assets are being utilized to generate sales.
Let us take a simple Cash Conversion Cycle calculation example.
Total Assets = $1.8 billion
Asset Turnover = $900/$1800 = 0.5x
This implies that for every $1 of assets, the company is generating $0.5
- Asset turnovers can be extremely low or very high depending on the Industry they operate in.
- Asset turnover of Manufacturing firm will be on the lower side due to large asset base as compared to a companies that operates in the services sector (lower assets).
- If the firm has seen considerable growth in assets during the year or the growth has been seasonal, then the analyst should find additional information to interpret such numbers.
Asset Turnover Ratio analysis – Colgate Case Study Example
We note that the Asset Turnover for Colgate is showing a declining trend. Asset turnover was at 1.53x in 2008, however, each year this ratio has sequentially decreased (1.26x in 2015).
#12 – Net Fixed Asset Turnover
What is Net Fixed Asset Turnover?
Net Fixed Asset turnover reflects utilization of fixed assets (Property Plant and Equipment).
Let us take a simple Net Fixed Asset Turnover calculation example.
Net Fixed Assets = $600
Net Fixed Asset Turnover = $600 / $600 = 1.0x
This implies that for every $ spent on the fixed assets, the company is able to generate $1.0 in revenues.
- This ratio should be applied to high capital intensive sectors like Automobile, Manufacturing, Metals etc.
- You should not apply this ratio to asset light companies like Services or Internet based as the Net Fixed assets will be really low and not meaningful from analysis point of view.
- This number can look temporarily bad if the firm has recently added greatly to its capacity in anticipation of future sales
Net Fixed Asset Turnover – Colgate Case Study Example
Like the Asset Turnover, Net Fixed asset turnover is also showing a declining trend.
Net Fixed Asset turnover was at 5.0x in 2008, however, this ratio has reduced to 4.07x in 2015.
#13 – Equity Turnover
What is Equity Turnover?
Equity turnover is the ratio of Total Revenue to the Shareholder’s Equity Capital. This ratio measures how efficiency the company is deploying equity to generate sales.
Let us take a simple Equity Turnover calculation example,
Shareholder’s Equity = $300
Equity Turnover Ratio = $600 / $300 = 2.0x.
This implies that company is generating $2.0 of sales for every $1.0 of shareholder’s equity.
Equity Turnover – Colgate Case Study Example
We note that historically, Colgate’s Equity Turnover has been in the range of 6x-7x. However, it jumped to 37.91x in 2015.
This was primarily due to two reasons – a) Share buy back program of Colgate resulting in lowering of Equity base each year. b) Accumulated losses net of taxes (these are those losses that don’t flow into the income statement).
Operating Profitability Ratios
Operating Performance Ratios measure how much are the costs relative to the sales and how much profit is generated in the overall business. We try to answer questions like “how much the profit percentage” or “Is the firm controlling its expenses by buying inventory etc at a reasonable price?”
#14 – Gross Profit Margin
What is Gross Profit Margin?
Gross Profit is the difference between Sales and the direct cost of making a product or providing service. Please note that costs like overheads, taxes, interests are not deducted here.
Let us take a simple Gross Margin calculation example,
Gross Profit = $1000 – $600 = $400
Gross Profit Margin = $400/$1000 = 40%
- Gross Margin can vary drastically between industries. For example, digital products sold online will have extremely high Gross Margin as compared to a company that sells Laptop.
- Gross margin is extremely useful when we look at the historical trends in the margins. If the Gross Margins has increased historically, then it could be either because of price increase or control of direct costs. However, if the Gross margins show a declining trend, then it may be because of increased competitiveness and therefore resulting in decreased sales price.
- In some companies, Depreciation expenses are also included in Direct Costs. This is incorrect and should be shown below the Gross Profit in the Income Statement.
Gross Margins – Colgate Case Study Example
Please note that depreciation related to manufacturing operations are included here in Cost of Operations (Colgate 10K 2015, pg 63)
Shipping and handling costs may be reported either in Cost of Sales or Selling General and Admin Expenses. Colgate has however, reported these costs as a part of Selling General and Admin Expenses. If such expenses are included in Cost of Sales, then the Gross margin of colgate would have decreased by 770 bps from 58.6% to 50.9% and decreased by 770bps and 750 bps in 2014 and 2013 respectively.
source: – Colgate 10K 2015, pg 46
#15 – Operating Profit Margin
What is Operating Profit Margin?
Operating profit or Earnings Before Interest and Taxes (EBIT) margin measures the rate of profit on sales after operating expenses. Operating income can be thought of as the “bottom line” from operations.Operating Profit Margin = EBIT / Sales
Let us take a simple Operating Profit Margin calculation example,
Assume from the Sales of a firm is $1,000 ands its COGS is $600
SG&A expense = $100
Depreciation and Amortization = $50
EBIT = Gross Profit – SG&A – D&A = $400 – $100 – $50 = $250
EBIT Margin = $250/$1000 = 25%
- Please note that some analyst take EBITDA (Earning before interest taxes depreciation and amortization) instead of EBIT as Operating Profit. If this is so, they assume that depreciation and amortization are non-operating expenses.
- Most analyst prefer taking EBIT as Operating Profit. Operating Profit Margin is most commonly tracked by analysts
- You need to be mindful of the fact that many companies include non recurring items (gains/losses) in SG&A or other expenses above EBIT. This may increase or decrease the EBIT Margins and skew your historical analysis.
Operating Profit Margin – Colgate Case Study Example
Colgate’s Operating Profit = EBIT / Net Sales
Historically, Colgate’s Operating Profit has remained in the range of 20%-23%
However, in 2015, Colgate’s EBIT Margin decreased significantly to 17.4%. This was primarily due to change in accounting terms for CP Venezuela entity (as explained below)
- Colgate derives more than 75% income from outside of United States. The company is exposed to changes in economic conditions, exchange rates volatilities and political uncertainty in some countries.
- Once such country has been Venezuela, where operating environment has been very challenging for Colgate and economic uncertainty due to wide exchange rate devaluations. Additionally, due to price controls, Colgate has restricted ability to implement price increases without governmental approval.
- Colgate’s ability to generate income continue to be negatively affected by these difficult geo-political conditions.
- As a result, effective from December 31st, 2015, Colgate is no longer including the results of CP Venezuela in its consolidated income statement and began accounting of its CP Venezuela entity using Cost method of accounting. As a result, the company has taken pre-tax charge of $1.084 billion in 2015.
- This has resulting in decrease of Operating Margin of Colgate in 2015.
#16 – Net Margin
What is Net Margin?
Net Margin is basically the net effect of operating as well as financing decisions taken by the company. It is call as Net Margin because in the numerator we have Net Income (Net of all the operating expenses, interest expenses as well as taxes)
Let us take a simple Net Margin calculation example, Continuing with our previous example, EBIT = $250, Sales = $1000.
Interest = $100
EBT = $150
Taxes = $45
Net Profit = $105
Net Profit Margin = $105/$1000 = 10.5%
- Like Gross margins, Net Margins can also vary drastically across industries. For example Retail is a very low margin business (~5%) whereas a website selling digital products may have Net Profit Margin in excess of 40%.
- Net Margins is useful for comparison between companies within the same industry due to similar product and cost structure.
- Net Profit Margins can vary historically due to presence of non recurring items or non operating items.
Net Margin – Colgate Case Study Example
Let us have a look at the Net Margin of Colgate.
- Historically, Net Margin for Colgate has been in the range of 12.5% – 15%.
- However, it decreased substantially in 2015 to 8.6% primarily due to CP Venezuela Accounting changes (reasons described in EBIT margin discussion).
#17 – Return on Total Assets
What is Return on Total Assets?
Return on Assets or Return on Total Assets relates to the firm’s earnings to all capital invested in the business.
Two important things to note there –
- Please note that in the denominator, we have Total Assets which basically takes care of both the Debt and Equity Holders.
- Likewise in the numerator, the Earnings should reflect something that is before the payment of interest.
Let us take a simple Return on Total example,
Return on Total Assets = $500/$2000 = 25%
This implies that the company is generating a Return on Total Assets of 25%.
- Many analysts use the numerator as Net Income + Interest Expenses instead of EBIT. They basically are deducting the taxes.
- Return on Assets can be low or high depending on the type of industry. If the company operates in a capital intensive sector (Asset heavy), then the return on assets may be on the lower side. However, if the company is Asset Light (services or internet company), they tend to have have a higher Return on Assets.
Return on Total Assets – Colgate’s Case Study Example
Colgate’s Return on total assets have been declining since 2010. Most recently, it has declined to its lowest to 21.9%. Why?
Two reasons can contribute to decrease – either the denominator i.e. average assets have increased significantly or the Numerator Net Sales have dropped significantly.
In Colgate’s case, the total assets have infact decreased in 2015. This leaves us to look at the Net Sales figure.
We note that the overall Net sales has decreased by as much as 7% in 2015.
We note that the primary reason for sales decrease for the negative impact due to foreign exchange of 11.5%.
Organic sales of colgate has however increased by 5% in 2015.
#18 – Return on Total Equity
What is Return on total Equity?
Return on Total Equity means the rate of return earned on the Total Equity of the firm. Can be thought of dollar profits a company generates on each dollar investment of Total Equity.Please note Total Equity = Ordinary Capital + Reserves + Preference + MinorityInterests
Let us take a simple Return on Total Equity example.
Total Equity = $500
Return on Total Equity = $50/$500 = 10%
Return on total equity is 10%
- Please note that the Net income will be before the preference dividends and minority interest are paid.
- Higher Return on Total Equity implies higher return to the Stakeholders.
Return on Total Equity – Colgate Case Study Example
- Colgate’s Return on Total Equity = Net Income (before pref dividends & minority interest) / average total equity.
- Please do remember to take the Net income before minority interest payments in colgate. This is because we are using the total equity (including the non controlling assets).
- We note that the Return on Total Equity has jumped to 230.9%. This is despite the fact that the Net Income has decreased 34% in 2015.
- This result is somehow not making much sense here and cannot be interpreted as the Return On total Equity that will continue in the future.
- Return on Total Equity has jumped primarily due to decrease in denominator – Shareholder’s equity (increase in treasury stock because of buy back and also because of accumulated losses that flow through the Shareholder’s Equity)
#19 – Return on Equity or Return on Owner’s Equity
What is ROE?
Return on equity or Return on Owner’s Equity is based only on the common shareholder’s equity. Preferred dividends and minority interests are deducted from Net Income as they are a priority claim.Return on equity provides us with the Rate of return earned on the Common Shareholder’s Equity.
Let us take a simple ROE calculation example,
Total Equity = $500
Shareholder’s Equity = $400
ROE (owners) = $50 / $400 = 12.5%
ROE of the company is 12.5%
- Since common shareholder’s equity is a year end number, some analyst prefer taking the average shareholder’s equity (average of beginning and year end)
- ROE can be basically considered as profitability ratio from shareholder’s point of view. This provides how much returns on generated from shareholder’s investments, not from the overall company investments in assets. (Please note Total Investments = Shareholder’s Equity + Liability that includes Current Liabilities and Long term Liabilities)
- ROE should be analyzed over a period of time (5 to 10 year period) in order to get a better picture of the growth of the company. Higher ROE does not get passed directly to the shareholder’s. Higher ROE -> Higher Stock Prices.
ROE Calculation – Colgate Case Study Example
Like the Return on Total Equity, Return on Equity has jumped significantly to 327.2% in 2015.
This has happened despite 34% decrease in the Net Income in 2015.
Return on Equity also jumped because of the decrease in Shareholder’s Equity because of the much lower base in 2015. (reasons as discussed earlier in Return on Total Equity).
#20 – Dupont ROE
What is Dupont ROE?
Dupont ROE is nothing but an extended way of writing an ROE formula. It divides ROE into several ratios that collectively equal ROE while individually providing insight to most important term in ratio analysis of financial statement
= (Net Income / Sales) x (Sales / Total Assets) x (Total Assets / Shareholder’s Equity)
The above formula is nothing but the ROE formula = Net Income / Shareholder’s Equity
Let us take a simple Dupont ROE calculation example.
Sales = $500
Total Assets = $200
Shareholder’s Equity = $400
Gross Margin = Net Income / Sales = $50 / $500 = 10%
Asset Turnover = Sales / Total Assets = $500/$200 = 2.5x
Asset Leverage = Total Asset / Shareholder’s Equity = $200 / $400 = 0.5
Dupont ROE = 10% x 2.5 x 0.5 = 12.5%
- Dupont ROE formula provides with additional ways to analyze the ROE ratio and helps us find out reason to the final number.
- The first term (Net Income/Sales) is nothing but the Net Profit Margin. We know that Retail sector operates on low profit margin, however, software product based company may operating on high profit margin.
- The second term here is (Sales/Total Assets), we normally call this term as Asset turnovers. It provides us with a measure of how efficiently the assets are being utilized.
- The third term here is (Total Assets / Shareholder’s Equity), we call this ratio as Asset Leverage. Asset leverage gives insight into how the company may be able to finance the purchase of new assets. A higher Asset leverage does not mean that it is better than the low multiplier. We need to look at the financial health of the company by performing full ratio analysis of financial statement.
Dupont ROE – Colgate Case Study Example
Please note that the Net Income is after the minority shareholder’s payment.
Also, the shareholder’s equity consists of only the common shareholder’s of Colgate.
We note that the asset turnover has shown a declining trend over the past 7-8 years.
Profitability has also declined over the past 5-6 years
However, ROE has not shown a declining trend. It is increasing overall. This is because of the Financial Leverage (average total assets / average total equity). You will note that the Financial Leverage has shown a stead increase over the past 5 years and is currently standing at 30x.
Ratio Analysis of financial statement – Risk
Risk analysis examines the uncertainty of income for the firm and for an investor
Total firm risks can be decomposed into three basic sources – 1) Business risk 2) Financial
Risk 3) External Liquidity Risk
Wikipdedia defines as “the possibility a company will have lower than anticipated profits or experience a loss rather than taking a profit”. If you look at the income statement, there are many line items that contribute to the risk of making losses. In this context, we discus three kinds of business risks – Total Leverage, Operating leverage and Financial Leverage.
# 21. Operating Leverage
What is Operating Leverage?
Please note that greater use of fixed costs, greater the impact of a change in sales on the operating income of a company.
Let us take a simple Operating Leverage calculation example.
Sales 2014 = $400, EBIT 2014 = $150
% change in EBIT = ($200-$150)/$100 = 50%
% change in Sales = ($500-$400)/$400 = 25%
Operating Leverage = 50/25 = 2.0x
This means that for Operating profit changes by 2% for every 1% change in Sales.
- Greater the fixed costs, higher is the operating leverage.
- Between five to ten years of data should be used for calculating Operating Leverages
Operating Leverage – Colgate Case Study Example
- Colgate’s Operating Leverage = % change in EBIT / % change in Sales
- I have calculated the operating leverages for each year from 2008 – 2015.
- Colgate’s operating leverage is very volatile as it ranges from 1x to 5x (excluding the year of 2009 where sales growth was almost 0%).
- It is expected that Colgate’s Operating leverage to be higher as we note that Colgate has made significant investments in Property, plant and equipment as well as intangible assets. Both these long term assets account for more than 40% of the total assets.
# 22. Financial Leverage
What is Financial leverage?
Financial leverage is the percentage change in Net profit relative to Operating Profit. Financial leverage measures how sensitive the Net Income is to the change in Operating Income.Financial leverage primarily originates from company’s financing decisions (usage of debt). Like in the operating leverage, fixed assets leads to higher operating leverage. In Financial leverage, the usage of debt primarily increases the financial risk as they need to payoff interest
Let us take a simple Financial Leverage calculation example,
Net Income 2014 = $40, EBIT 2014 = $150
% change in EBIT = ($200-$150)/$100 = 50%
% change in Net Income = ($120-$40)/$40 = 200%
Financial Leverage = 200/50 = 4.0x
This means that for Net Income changes by 4% for every 1% change in Operating Profit.
- Greater the Debt, higher is the Financial leverage.
- Between five to ten years of data should be used for calculating Financial Leverages
Colgate Case Study
Colgate’s Financial Leverage has been relatively stable between 0.90x – 1.69x (excluding the 2014 financial leverage number)
# 23. Total Leverage
What is Total Leverage?
Total leverage is the percentage change in Net profit relative to its Sales. Total leverage measures how sensitive the Net Income is to the change in Sales.
= Operating Leverage x Financial Leverage
Let us take a simple Total Leverage calculation example,
Sales 2014 = $400, EBIT 2014 = $150, Net Income 2014 = $40
% change in Sales = ($500-$400)/$400 = 25%
% change in EBIT = ($200-$150)/$100 = 50%
% change in Net Income = ($120-$40)/$40 = 200%
Total Leverage = % change in Net Income / % change in Sales =200/25 = 8x.
Total Leverage = Operating Leverage x Financial Leverage = 2 x 4 = 8x (Operating and Financial Leverage calculated earlier)
This implies for every 1% change in Sales, the Net Profit moves by 8%.
Higher sensitivity could be because of higher operating leverage (higher fixed cost) and higher financial leverage (higher debt)5-10 years of data should be taken to calculate the total leverage.
Total Leverage – Colgate Case Study Example
- Colgate’s Operating leverage is higher as we note that Colgate has made significant investments in Property, plant and equipment as well as intangible assets.
- However, Colgate’s Financial Leverage is pretty stable.
Financial risk is the type of risk primarily associated with the risk of default on the company loan. We discuss 3 types of financial risk ratios – Leverage Ratio, Interest Coverage Ratio and DSCR ratio.
# – 24. Leverage Ratio or Debt to Equity Ratio
What is Leverage Ratio?
How much debt does the firm employ in relation to its use of equity? This is an important ratio for bankers as it provides company’s ability to pay off debt using its own capital. Generally lower the ratio better it is.Debt includes current debt + long term debt
Let us take a simple Leverage Ratio calculation example.
Long Term Debt = $900
Shareholder’s Equity = $500
Leverage Ratio = ($100 + $900) / $500 = 2.0x
- A lower ratio is generally considered better as it shows greater asset coverage of liabilities with own capital.
- Capital intensive sectors generally show a higher debt to equity ratio (leverage ratio) as compared to services sector.
- If the leverage ratio is increasing over time, then it may be concluded that the firm is unable to generate sufficient cash flows from its core operations and is relying on external debt to stay afloat.
Leverage Ratio – Colgate Case Study Example
We note that the leverage ratio has been increasing since 2009. The Debt to Equity has increased from 0.98x in 2009 to 4.44x in 2014. Also, please note that the Equity Capital for 2015 was negative and hence, the ratio was not calculated.
We note that the Debt Ratio in 2014 was at 0.80.
Leverage ratio has been increasing due to two reasons –
Shareholder’s equity is decreasing steadily over the years due to buy back of shares as well as accumulated losses that flow to the Shareholder’s Equity.
Additionally, we note that Colgate has been systematically increasing debt to support its capital structure strategy objectives to funds its business and growth initiatives, as well as to minimize its risk adjust weighted average cost of capital.
Colgate 10K, 2015 (pg 41)
# 25. Interest Coverage Ratio
What is Interest Coverage Ratio?
This ratio signifies the ability of the firm to pay interest on the assumed debt.
Please note that EBITDA = EBIT + Depreciation & Amortization
Let us take a simple Interest Coverage Ratio calculation example,
Depreciation and Amortization = $100
Interest Expense = $50
EBITDA = $500 + $100 = $600
Interest Coverage Ratio = $600 / $50 = 12.0x
- Capital intensive firms have higher depreciation and amortization resulting in lower operating profit (EBIT)
- In such cases, EBITDA is one of the most important measure as it is the amount available to payoff interest (depreciation and amortization is non cash expense).
- Higher interest coverage ratios implies greater ability of the firm to payoff its interests.
- If Interest coverage is less than 1, then EBITDA is not sufficient to payoff interest, which implies finding other ways to arrange funds.
Interest Coverage Ratio – Colgate Case Study Example
Please note that depreciation and amortization expenses are not provided in the income statement. These were taken from the Cash Flow statements.
Also, Interest expense shown in the Income Statement is the net number (Interest Expense – Interest Income)
Colgate has a very healthy Interest coverage ratio. More than 100x in the past two years.
We also note that in 2013, the Net Interest Expense was negative. Hence the ratio was not calculated.
# 26. Debt Service Coverage Ratio (DSCR)
What is DSCR?
Debt Service Coverage Ratio tells us whether the Operating Income is sufficient to payoff all obligations that are related to debt in an year. It also includes committed lease payments.Debt servicing consists of not only the interest, but also some principal portion also is repaid annually.
Operating Income is nothing but EBIT
Debt Service is Principal Payments + Interest Payments + Lease Payments
Let us take a simple DSCR calculation example,
Pricipal Payment = $125
Interest Payment = $50
Lease Payments = $25
Debt Service = $125 + $50 + %25 = $200
DSCR = EBIT / Debt Service = $500/$200 = 2.5x
- A DSCR of less than 1.0 implies that the operating cash flows are not sufficient enough for Debt Servicing implying negative cash flows.
- This is pretty useful matrix from Bank’s point of view, especially when they give loans against property to individuals
DSCR – Colgate’s Case Study Example
Debt Service = Principal Repayment of Debt + Interest Payment + Lease Obligations
For Colgate, we get the Debt service obligations from its 10K reports.
Colgate 10K 2015, pg 43.
Please note that you get the forecast of the Debt Service in the 10K reports.
For finding out the historical Debt Service Payments, you need to refer to the 10Ks prior to 2015.
As noted from the graph below, we see that the Debt Service Coverage Ratio or DSCR for Colgate is health at around 2.78.
However, the DSCR has deteriorated a bit in the recent past.
You can click here for a detailed indepth article on DSCR Ratio
Ratio Analysis of financial statement – External Liquidity Risk
#27 – Bid Ask Spread
What is Bid Ask Spread?
Bid – Ask Spread is a very important parameter that helps us understand how the stock prices gets affected with purchase or sale of stocks. Bid is the highest price that the buyer is willing to pay
Ask is the lowest price at which the seller is willing to sell.
Let us take a simple Bid Ask Spread calculation example.
- External market liquidity is an important source of risk to investors.
- If the bid-ask spread is low, then the investors are able to buy or sell assets with little price changes.
- Also, another factor of external market liquidity is the dollar value of shares traded
External Liquidity Risk – Colgate Case Study Example
As we note from the below snapshot, Bid = 74.12 and Ask = $74.35
Bid Ask Spread = 74.35 – 74.12 = 0.23
source : Yahoo Finance
#28 – Trading Volume
What is Trading Volume?
Trading volume refers to the average number of shares traded in a day or over a period of time. When the average trading volume is high, this implies that the stock has high liquidity (can be easily traded). Numerous buyers and sellers provide liquidity.
Let us take a simple Trading Volume example.
Average daily traded volume of Company A is 1000 and that of Company B is 1 million.
Which company is more liquid? Obviously company B as there is more investors interest and traded more.
- If the trading volume is high, then investors will show more interest in the stock that may help in increase of the share price.
- If the trading volume is low, then less investors will have interest in the stocks. Such stock will be less expensive due to unwillingness of investors to buy such stocks.
Trading Volume – Colgate’s Case Study Example
Ratio Analysis of financial statement – Growth
Growth rate is one of the most important parameter when we look at analyzing a company. As a company becomes bigger and bigger, its growth tapers and reaches a long term sustainable growth rate. In this we discuss how sustainable growth rates are important.
#29 – Sustainable Growth
What is Sustainable Growth?
Company’s topline growth is one of the most important parameter for investors as well as creditors in ratio analysis. It helps the investor forecast the growth in earnings and valuations.
It is important to find the sustainable growth rate of the company. Sustainable growth rate is a function of two variables:
What is the rate of return on equity (which gives the maximum possible growth)?
How much of that growth is put to work through earnings retention (rather than being paid out in
Sustainable Growth Rate Formula = ROE x Retention rate
Let us take a simple Sustainable Growth calculation example.
Dividend Payout ratio = 30%
Sustainable Growth Rate = ROE x Retention Rate = 20% x (1-0.3) = 14%
- If the company is not growing then there can be greater chances of default on the debt. Company’s growth phase is generally dividend into three parts – Hyper growth period, Maturity Phase, Decline Phase
- Sustainable Growth rate formula is primarily applicable in the Mature Phase.
Sustainable Growth – Colgate’s Case Study Example
Now that we have calculated all 29 ratios, you should appreciate that financial statement analysis includes learning about the company from all dimensions. A single ratio does not provide us with a full understanding of the company. All the ratios needs to be looked at cohesively and are interconnected. We noted that Colgate has been an amazing company with solid fundamentals.
What do you think?