Chapter 18: Financial Statement Analysis

1. Chapter 18: Financial Statement Analysis

2. Basics of Financial Statement Analysis Analyzing financial statements involves: Characteristics Comparison Bases Tools of Analysis • Liquidity • Profitability • Solvency • Intracompany • Industry averages • Intercompany • Horizontal • Vertical • Ratio

3. Tools of Analysis Horizontal Analysis • Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time. • Purpose is to determine the increase or decrease that has taken place. • Commonly applied to the balance sheet, income statement, and statement of retained earnings.

4. Tools of Analysis Horizontal Analysis **7.9%= [{curr.yr(2009)-base yr(2008)}/ base yr(2008)]*100 Changes suggest that the company expanded its asset base during 2009 and financed this expansion primarily by retaining income(bcoz more 38.6%) rather than assuming additional long-term debt.

5. Tools of Analysis Horizontal Analysis Overall, gross profit and net income were up substantially. Gross profit increased 17.1%, and net income, 26.5%. Quality’s profit trend appears favorable.

6. Tools of Analysis Vertical Analysis • Vertical analysis, also called common-size analysis, is a technique that expresses each financial statement item as a percent of a base amount. • On an income statement, we might say that selling expenses are 16% of net sales. • Vertical analysis is commonly applied to the balance sheet and the income statement.

7. Tools of Analysis **55.6%= 1020000/1835000)*100 **(take 100%=total asset 100%=total liab & equity) These results reinforce the earlier observations that Quality is choosing to finance its growth through retention of earnings rather than through issuing additional debt. Vertical Analysis

8. Tools of Analysis Vertical Analysis Quality appears to be a profitable enterprise that is becoming even more successful.

9. Ratio Analysis Ratio analysisexpresses the relationship among selected items of financial statement data. Financial Ratio Classifications Liquidity Profitability Solvency Measures short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Measures the income or operating success of a company for a given period of time. Measures the ability of the company to survive over a long period of time.

10. Ratio Analysis A single ratio by itself is not very meaningful. The discussion of ratios will include the following types of comparisons.

11. Ratio Analysis Liquidity Ratios • Measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. • Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity. • Ratios include the current ratio, the acid-test ratio, receivables turnover, and inventory turnover.

12. Ratio Analysis Liquidity Ratios Ratio of 2.96:1 means that for every dollar of current liabilities, Quality has $2.96 of current assets. (A ratio of 2:1 is preferred, the ratio essentially implies that current liabilities can be liquidated by current asset, to pay for current liabilities.)

13. Ratio Analysis Acid-Test Ratio Liquidity Ratios Acid-test ratio measures immediate liquidity.

14. Ratio Analysis Liquidity Ratios The quick ratio formula matches the most easily liquidated portions of current assets with current liabilities. The intent of this ratio is to see if a business has sufficient assets that are immediately convertible to cash to pay its bills. The key elements of current assets that are included in the quick ratio are cash, marketable securities, and accounts receivable. Inventory is not included in the quick ratio, since it can be quite difficult to sell off in the short term. Because of the exclusion of inventory from the formula, the quick ratio is a better indicator than the current ratio of the ability of a company to pay its obligations. Thus, a quick ratio of 1.02:1 means that a company has $1.02 of liquid assets available to cover each $1 of current liabilities. The higher the quick ratio, the better the company's liquidity position.

15. Ratio Analysis Liquidity Ratios • Measures the number of times, on average, the company collects receivables during the period. • Accounts receivable turnover measures the ability of a company to efficiently issue credit to its customers and collect it back in a timely manner. • A high ratio implies either that a company operates on a cash basis or that its extension of credit and collection of accounts receivable is efficient. • Low receivable turnover may be caused by a loose or nonexistent credit policy, or an inadequate collections function.A low ratio implies the company should re-assess its credit policies in order to ensure the timely collection of imparted credit • Quality's accounts receivable turned over 10.2 times during the past year, which means that the average account receivable was collected in (365/10.2)=35.78days.

16. Ratio Analysis Liquidity Ratios • Measures the number of times, on average, the inventory is sold during the period. • COGS (cost of goods sold) may be substituted because sales are recorded at market value, while inventories are usually recorded at cost. Also, average inventory may be used instead of the ending inventory level to minimize seasonal factors. • This ratio should be compared against industry averages. A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies either strong sales or ineffective buying. • High inventory levels are unhealthy because they represent an investment with a rate of return of zero. It also opens the company up to trouble should prices begin to fall. • Things to Remember: • A low turnover is usually a bad sign because products tend to deteriorate as they sit in a warehouse. • Companies selling perishable items have very high turnover. • For more accurate inventory turnover figures, the average inventory figure, ((beginning inventory + ending inventory)/2), is used when computing inventory turnover. Average inventory accounts for any seasonality effects on the ratio.

17. Ratio Analysis A variant of the receivables turnover ratio is to convert it to an average collection periodin terms of days. 365 days / 10.2 times = every 35.78 days Receivables are collected on average every 36 days. A variant of inventory turnover is the days in inventory. 365 days / 2.3 times = every 159 days Inventory turnover ratios vary considerably among industries.

18. Ratio Analysis Profitability Ratios • Measure the income or operating success of a company for a given period of time. It is used to assess a business's ability to generate earnings as compared to its expenses and other relevant costs incurred during a specific period of time. For most of these ratios, having a higher value relative to a competitor's ratio or the same ratio from a previous period is indicative that the company is doing well. • Income, or the lack of it, affects the company’s ability to obtain debt and equity financing, liquidity position, and the ability to grow. • Ratios include the profit margin, asset turnover, return on assets, return on common stockholders’ equity, earnings per share, price-earnings, and payout ratio.

19. Ratio Analysis Profitability Ratios Measures the percentage of each dollar of sales that results in net income. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. Profit margin is displayed as a percentage; a 12.6% profit margin, for example, means the company has a net income of $0.126 for each dollar of sales.

20. Ratio Analysis Profitability Ratios • Measures how efficiently a company uses its assets to generate sales. • Asset turnover measures a firm's efficiency at using its assets in generating sales or revenue - the higher the number the better. • a high turnover ratio should mean that management is making excellent use of assets to create a large amount of sales. • Ideally, a company with a high total asset turnover ratio can operate with fewer assets than a less efficient competitor, and so requires less debt and equity to operate. The result should be a comparatively greater return to its shareholders. • It Represents The amount of sales generated for every dollar's worth of assets. • This ratio is more useful for growth companies to check if in fact they are growing revenue in proportion to assets.

21. Profitability Ratios Ratio Analysis • A measure of profitability generated through the assets. • The return on net assets measure compares net profits to net assets to see how well a company is able to utilize its asset base to create profits. A high ratio of assets to profits is an indicator of excellent management performance. • ROA tells you what earnings were generated from invested capital (assets). • The assets of the company are comprised of both debt and equity. Both of these types of financing are used to fund the operations of the company. The ROA figure gives investors an idea of how effectively the company is converting the money it has to invest into net income. • The higher the ROA number, the better, because the company is earning more money on less investment. For example, if one company has a net income of $1 million and total assets of $5 million, its ROA is 20%; however, if another company earns the same amount but has total assets of $10 million, it has an ROA of 10%. Based on this example, the first company is better at converting its investment into profit. When you really think about it, management's most important job is to make wise choices in allocating its resources. Anybody can make a profit by throwing a ton of money at a problem, but very few managers excel at making large profits with little investment.

22. Ratio Analysis Profitability Ratios • Shows how many dollars of net income the company earned for each dollar invested by the owners. • The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. • The higher the better.

23. Ratio Analysis Profitability Ratios • A measure of the net income earned on each share of common stock. • The portion of a company's profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company's profitability. • An important aspect of EPS that's often ignored is the capital that is required to generate the earnings (net income) in the calculation. Two companies could generate the same EPS number, but one could do so with less equity (investment) - that company would be more efficient at using its capital to generate income and, all other things being equal, would be a "better" company.

24. Ratio Analysis Profitability Ratios • Measures the net income earned on each share of common stock. • A valuation ratio of a company's current share price compared to its per-share earnings. • If a company were currently trading at a (P/E) of 20, interpretation is that an investor is willing to pay $20 for $1 of current earnings per share. • Generally a high P/E ratio means that investors are anticipating higher growth in the future. • The average market P/E ratio is 20-25 times earnings.

25. Profitability Ratios Ratio Analysis • Measures the percentage of earnings distributed in the form of cash dividends. • The amount of earnings paid out in dividends to shareholders. Investors can use the payout ratio to determine what companies are doing with their earnings. • A very low payout ratio indicates that a company is primarily focused on retaining its earnings rather than paying out dividends. • The payout ratio also indicates how well earnings support the dividend payments: the lower the ratio, the more secure the dividend because smaller dividends are easier to pay out than larger dividends. • The ratio can be used to derive the following information: • A high ratio indicates that the company's board of directors is essentially handing over all profits to investors, which indicates that there does not appear to be a better internal use for the funds. • A low ratio indicates that the board is more concerned with the reinvestment of funds in the business, with the assumption being that investors will instead generate a return through the appreciation of their shares on the market. • A downward trend in the ratio can indicate that the cash flows of the business are declining, so that less cash is available for dividends. • An upward trend indicates that the cash flows of the business are increasing, which makes it easier for the company to support more payouts. • A payout ratio of greater than 1:1 is not sustainable, and will eventually lead to a dangerous decline in the cash reserves of the business. • Here,ratio is 0.23:1.. So good

26. Ratio Analysis Solvency Ratios • Solvency ratios measure the ability of a company to survive over a long period of time. to measure an enterprise’s ability to meet its debt and other obligations. • Debt to Total Assets and • Times Interest Earned are two ratios that provide information about debt-paying ability.

27. Solvency Ratios Ratio Analysis • Measures the percentage of the total assets that creditors provide. • The debt to assets ratio (or debt to asset ratio) is an indicator of the proportion of a company's assets that are being financed with debt, rather than equity. • ratio greater than 1 indicates that a considerable proportion of assets are being funded with debt, while a low ratio indicates that the bulk of asset funding is coming from equity. • A ratio greater than 1 also indicates that a company may be putting itself at risk of not being able to pay back its debts, • Here, 0.45:1 indicates that 45.3% is debt financed. (not bad)

28. Solvency Ratios Ratio Analysis • Provides an indication of the company’s ability to meet interest payments as they come due. • times interest earned ratio is a comparison of the earnings of a business that are available for use in paying down the interest expense on debt, divided by the amount of interest expense. The ratio is commonly used by lenders to ascertain whether a prospective borrower can afford to take on any additional debt. • A ratio of less than 1, indicates that a business may not be in a position to pay its interest obligations, and so is more likely to default on its debt. A much higher ratio is a strong indicator that the ability to service debt is not a problem for a borrower. • Here, 13 (good) • It is usually quoted as a ratio and indicates how many times a company can cover its interest charges on a pretax basis. Failing to meet these obligations could force a company into bankruptcy. • Ensuring interest payments to debt holders and preventing bankruptcy depends mainly on a company's ability to sustain earnings. However, a high ratio can indicate that a company has an undesirable lack of debt or is paying down too much debt with earnings that could be used for other projects. The rationale is that a company would yield greater returns by investing its earnings into other projects and borrowing at a lower cost of capital than what it is currently paying to meet its debt obligations.

29. Ratio Analysis Summary of Ratios

30. Ratio Analysis