FINANCIAL STATEMENT ANALYSIS The major objectives of financial statement analysis are as follows: 1. Assessment of Past Performance Past performance is a good indicator of future performance. Investors or creditors are interested in the trend of past sales, cost of goods sold, operating expenses, net income, cash flows and return on investment. These trends offer a means for judging management's past performance and are possible indicators of future performance. 2. Assessment of current position Financial statement analysis shows the current position of the firm in terms of the types of assets owned by a business firm and the different liabilities liabilities due against the enterprise. 3. Prediction of profitability and growth prospects Financial statement analysis helps in assessing and predicting the earning prospects and growth rates in earning which are used by investors while comparing investment alternatives alternatives and other users in judging earning potential of business enterprise. 4. Prediction of bankruptcy and failure Financial statement analysis is an important tool in assessing and p redicting bankruptcy and probability of business failure. 5.
Assessment of the operational efficiency Financial statement analysis helps to assess the operational efficiency of the management of a company. The actual performance of the firm which is revealed in the financial statements can be compared with some standards set earlier and the deviation of any between standards and actual performance can be used as the indicator of efficiency of the management.
General Approach to FS Analysis 1. Traditional approach - use of ratio analysis, horizontal and vertical 2. Modern approach – both internal and external business environment are taken into consideration. The approach is futuristic as opposed to traditional approach.
Common Size/Vertical Analysis
Trend Analysis/Horizontal Analysis
VS
Financial Ratio Analysis
1. 2. 3. 4. 5.
Question How liquid is the firm? Will it be able to pay its bill as they become due? How has the firm financed the purchase of its assets? How efficient has the firm’s management been in utilizing its assets to generate sales? Has the firm earned adequate returns on investment? Are the firm’s managers creating value for shareholders?
Category of Ratios Used LIQUIDITY RATIOS CAPITAL STRUCTURE RATIOS ASSET MANAGEMENT EFFICIENCY RATIOS PROFITABILITY RATIOS MARKET VALUE RATIOS
A. LIQUIDITY RATIOS – short term solvency RATIO 1. Working Capital
FORMULA Current assets – Current Liabilities
2. Current Ratio
Current Assets ÷ Current Liabilities
3. Quick Ratio or Acid test ratio
(Current Assets - Inventory & Prepaid Assets) ÷ Current Liabilities
4. Absolute Cash Ratio
(Cash + Marketable Securities) ÷ Current Liabilities
FUNCTION It measures how much in liquid assets a company has available to build its business. Ability to repay short-term commitments promptly. (Short-term Solvency) Ideal Ratio is 2:1.High Ratio indicates existence of idle current assets. Ability to meet Ratio is 1.33:1
immediate liabilities. Ideal
Availability of cash to meet short-term commitments.
Can a Firm Have Too Much Liquidity? A high investment in liquid assets will enable the firm to repay its current liabilities in a timely manner. However, an excessive investment in liquid assets can prove to be costly as liquid assets generate minimal return. B. CAPITAL STRUCTURE RATIOS RATIO 1. Times Interest Earned 2. Debt Ratio
FORMULA EBIT ÷ Interest Expense Total Liabilities ÷ Total Assets
3. Equity Ratio
Total SHE ÷ Total Assets
4. Debt Equity Ratio
Total Liabilities ÷ Total SHE
5. Fixed Asset to Long-term Liabilities 6. Fixed Asset to Total Equity 7. Fixed Assets to Total Assets 8. BPS on CS 9. Times Preferred Dividend requirements 10. Times Fixed Charges Earned
Fixed Asset ÷ Long-term Liabilities Fixed Asset ÷ Total Equity Net Fixed Asset ÷ Total Assets CS equity ÷ # of CS Outstanding Net Income after Tax ÷ Preferred Dividend Requirement Net Income before Taxes and Fixed Charges ÷ Fixed Charges FC=rent+ interest+ sinking fund payment before taxes
FUNCTION Indicates the extent to which operations cover interest expense Measures the proportion of the firm’s assets that are financed by borrowing or debt financing. Measures the proportion of the firm ’s assets that are financed by owners. Measures the proportion of assets provided by creditors compared to that provided by owners. ; Ideal ratio is 2:1. Reflect the extent of the utilization of resources from long-term debt. Indicates sources of additional funds. Indicates the over or under investment by owners. Indicates possible over expansion of PPE Measures recoverable amount in the event of liquidation if assets are realized at their BV. Indicates ability to provide dividends to preferred shareholders
Indicates ability to cover fixed charges.
C. ASSET MANAGEMENT EFFICIENCY RATIOS RATIO 1. Accounts Receivable Turnover
FORMULA
FUNCTION
Annual Credit Sales ÷ Ave. Accounts Receivable
Measures how many times accounts receivable are “rolled over” during a year
2. Average Collection Period
Accounts Receivable ÷ Daily Credit Sales or 365 ÷ Receivable Turnover
Measures how fast the firm collects its accounts receivables
3. Inventory Turnover
Cost of Goods Sold ÷ Ave. Inventory
4. Average Age of Inventory
Inventory ÷ Daily COGS or 365 ÷ Inventory Turnover
5. Operating Cycle
Average Collection Period + Average Age of Inventory
6. Trade Payables Turnover
Net Credit Purchases ÷ Ave. Trade Payables
7. Average Age of Trade Payables 8. Cash Flow Cycle 9. Current Asset Turnover 10. Working Capital to Total Asset 11. Working Capital Turnover 11. Sales to Fixed Assets (Plant Turnover) 12. Asset Turnover 13. Fixed Asset Turnover
365 ÷ Payables Turnover Operating Cycle - Average Age of Trade Payables [COGS + OPEX(excluding depreciation & amortization)] ÷ Ave. Current Assets Working Capital ÷ Total Asset
Net Sales ÷ Ave. Working Capital
Net Sales ÷ Net Fixed Assets Sales ÷ Total Asset Sales ÷ Net Fixed Asset
Measures how many times the company turns over its inventory during the year. Indicates the number of days before an inventory is sold. Shorter inventory cycles lead to greater liquidity since the items in inventory are converted to cash more quickly. Indicates the number of days it takes for inventories to be converted into cash. The shorter the better. This measurement of liquidity measures the number of times account payables turnover in one year. Low turnover is indicative of cash flow problems. Indicates the number of days it takes for payables to be paid. The longer the better Indicates how fast the company purchases inventories, sell it to customers, collect payment and pay its suppliers. Measures the movement and utilization of current assets to meet operating requirements Indicates relative liquidity of total assets and distribution of resources employed. Indicates adequacy and activity of working capital Test roughly the efficiency of management in keeping plant properties employed Indicates the revenue generated by total assets. The higher the better. Measures firm’s efficiency in utilizing its fixed assets.
D. PROFITABILITY RATIOS RATIO 1. Gross Profit Ratio 2. Return on Sales
FORMULA Gross Profit ÷ Net Sales Income ÷ Net Sales
FUNCTION It shows how well the firm’s management controls its expenses to generate profits. Indicates the amount of income earned for every peso sale. It indicates how well the firm is managing its income statement. Indicate the efficiency of managers in using total assets in operating the business.
3. Operating Profit EBIT ÷ Net Sales Ratio 4. Return on Total Income ÷ Ave Total Assets Asset (ROA) 5. Return on Net Income ÷ Ave. Equity Indicates the amount earned on investment. Owners’ Equity (ROE) 6. Earnings Per (Net Income – Preferred dividends Indicate the amount of income earned by each Share Requirement) ÷ Weighted Ave # of CS common share. 7. Rate of Return Indicates the profitability of current assets on Current Net Income / Ave Current Assets invested. Assets ***** Du Pont Method: ROE = ROS(Profitability) x Asset Turnover(Efficiency) x Equity Multiplier
E. MARKET VALUE RATIOS RATIO 1. Price/Earnings Ratio
FORMULA Price per share ÷ Earnings per share
2. Dividend Yield
Dividend per share ÷ Price per share
3. Dividend Payout
Common Dividend per share ÷ EPS
FUNCTION Indicates the number of pesos required to pay 1 peso of earnings Indicates the rate of return in the investor’s CS investment Indicates the portion of earnings distributed as dividends
The Limitations of Ratio Analysis 1. 2. 3. 4. 5. 6.
Picking an industry benchmark can sometimes be difficult. Published peer-group or industry averages are not always representative of the firm being analyzed. An industry average is not necessarily a desirable target or norm. Accounting practices differ widely among firms. Many firms experience seasonal changes in their operations. Financial ratios offer only clues. We need to analyze the numbers in order to fully understand the ratios. 7. The results of financial analysis are dependent on the quality of the financial statements.
Assignment: Answers to be given next meeting 1. Russell Securities has P100 million in total assets and its corporate tax rate is 40 percent. The company recently reported that its basic earning power (BEP) ratio was 15 percent and that its return on assets (ROA) was 9 percent. What was the comp any’s interest expense? 2. A firm has a profit margin of 15 percent on sales of P20,000,000. If the firm has debt of P7,500,000, total assets of P22,500,000, and an after-tax interest cost on total debt of 5 percent, what is the firm's ROA? 3. Tapley Dental Supply Company has the following data: Net income: Debt ratio: BEP ratio:
P240 75% 13.33%
Sales: TIE ratio:
P10,000 2.0
Total assets: Current ratio:
P6,000 1.2
If Tapley could streamline operations, cut operating costs, and raise net income to P300, without affecting sales or the balance sheet (the additional profits will be paid out as dividends), by how much would its ROE increase? 4. Your company had the following balance sheet and income statement information for 2003: Balance sheet: Cash P 20 A/R 1,000 Inventories 5,000 Total C.A. P 6,020 Debt P 4,000 Net F.A. 2,980 Equity 5,000 Total Assets P 9,000 Total claims P 9,000 Income statement: Sales Cost of goods sold EBIT Interest (10%) EBT Taxes (40%) Net Income
P10,000 9,200 P 800 400 P 400 160 P 240
The industry average inventory turnover is 5. You think you can change your inventory control system so as to cause your turnover to equal the industry average, and this change is expected to have no effect on either sales or cost of goods sold. The cash generated from reducing inventories will be used to buy tax-exempt securities which have a 7 percent rate of return. What will your profit margin be after the change in inventories is reflected in the income statement? 5. Ruth Company currently has P1,000,000 in accounts receivable. Its days sales outstanding (DSO) is 50 days (based on a 365-day year). Assume a 365-day year. The company wants to reduce its DSO to the industry average of 32 days by pressuring more of its customers to pay their bills on time. The company's CFO estimates that if this policy is adopted the company's average sales will fall by 10 percent. Assuming that the company adopts this change and succeeds in reducing its DSO to 32 days and does lose 10 percent of its sales, what will be the level of accounts receivable following the change? 6. The Meryl Corporation's common stock is currently selling at P100 per share, which represents a P/E ratio of 10. If the firm has 100 shares of common stock outstanding, a return on equity of 20 percent, and a debt ratio of 60 percent, what is its return on total assets (ROA)? 7. Oliver Incorporated has a current ratio = 1.6, and a quick ratio equal to 1.2. The company has P2 million in sales and its current liabilities are P 1 million. What is the company’s inventory turnover ratio? 8. Kansas Office Supply had P 24,000,000 in sales last year. The company’s net income was P400,000. Its total assets turnover was 6.0. The company’s ROE was 15 percent. The company is financed entirely with debt and common equity. What is the company’s debt ratio?
9. The Merriam Company has determined that its return on equity is 15 percent. Management is interested in the various components that went into this calculation. You are given the following information: total debt/total assets = 0.35 and total assets turnover = 2.8. What is the profit margin? 10. Harvey Supplies Inc. has a current ratio of 3.0, a quick ratio of 2.4, and an inventory turnover ratio of 6. Harvey's total assets are P1 million and its debt ratio is 0.20. The firm has no long-term debt. What is Harvey's sales figure? 11. Collins Company had the following partial balance sheet and complete annual income statement: Partial Balance Sheet: Cash P 20 Income Statement: A/R 1,000 Sales P10,000 Inventories 2,000 Cost of goods sold 9,200 Total current assets P 3,020 EBIT P 800 Net fixed assets 2,980 Interest (10%) 400 Total assets P 6,000 EBT P 400 Taxes (40%) 160 Net Income P 240 The industry average DSO is 30 (based on a 365-day year). Collins plans to change its credit policy so as to cause its DSO to equal the industry average, and this change is expected to have no effect on either sales or cost of goods sold. If the cash generated from reducing receivables is used to retire debt (which was outstanding all last year and which has a 10 percent interest rate), what will Collins' debt ratio (Total debt/Total assets) be after the change in DSO is reflected in the balance sheet? 12. Last year, Quayle Energy had sales of P200 million, and its inventory turnover ratio was 5.0. The company’s current assets totaled P100 million, and its current ratio was 1.2. What was the company’s quick ratio?
