Chapter 19. Financial Statement Analysis. Learning Objectives. The Annual Report Usually Contains...

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1 PowerPoint to accompany Chapter 19 Financial Statement Analysis Learning Objectives 1. Perform a horizontal analysis of comparative financial statements 2. Perform a vertical analysis of financial statements 3. Prepare common-size financial statements 4. Calculate the standard financial ratios used for decision making 5. Measure economic value added by a company s operations The Annual Report Usually Contains... financial statements. footnotes to the financial statements. a summary of accounting methods used. management s discussion and analysis of the financial results. an auditor s report. comparative financial data for a series of years.

2 Objective 1 Perform a horizontal analysis of comparative financial statements. Horizontal Analysis Increase/(Decrease) Amount Percent Sales $41,500 $37,850 $3,650 96% 9.6% Expenses 40,000 36,900 3, % Net profit 1, % Horizontal Analysis Difference Sales $41,500 $37,850 $3,650 $3,650 $37,850 =.0964, or 9.6%

3 Trend Percentages... are calculated by selecting a base year whose amounts are set equal to 100%. The amounts of each following year are expressed as a percentage of the base amount. Trend % = Any year $ Base year $ Trend Percentages Year Revenues $27,611 $24,215 $21,718 Cost of sales 15,318 14,709 13,049 Gross profit $12, $ 9,506 $ 8, is the base year. What are the trend percentages? Trend Percentages Year Revenues 127% 111% 100% Cost of sales 117% 113% 100% Gross profit 142% 110% 100% These percentages were calculated by dividing each item by the base year.

4 Objective 2 Perform a vertical analysis of financial statements. Vertical Analysis... compares each item in a financial statement to a base number set to 100%. Every item on the financial statement is then reported as a percentage of that base. Vertical Analysis 2007 % Revenues $38, Cost of sales 19, Gross profit $18, Total operating expenses 13, Operating profit $ 5, Other income 2, Income before taxes $ 7, Income taxes 2, Net profit $ 4,

5 Vertical Analysis Assets 2007 % Current assets Cash $ 1, Receivables net 10, Inventories 6, Prepaid expenses 3, Total current assets $21, Plant and equipment, net 6, Other assets 9, Total assets $38, Objective 3 Prepare common-size financial statements. Common-size Statements On the income statement, each item is expressed as a percentage of net sales. On the balance sheet, the common size is the total on each side of the accounting equation. Common-size statements are used to compare one company to other companies, and to the industry average.

6 Benchmarking Objective 4 Calculate the standard financial ratios used for decision making. Ratio Classification 1. Measuring ability to pay current liabilities. 2. Measuring ability to sell inventory and collect receivables. 3. Measuring ability to pay long-term debt. 4. Measuring profitability. 5. Analysing shares as an investment.

7 The Data (Exhibit 19-1 Lucent Technology 20X2 page 720) Net sales (Year 20X2) $858,000 Cost of goods sold 513,000 Gross profit $345,000 Total operating expenses 244,000 Plus Interest revenue 4,000 Interest expense (24,000) Profits before taxes $ 81,000 Income tax 33,000 Net profits $ 48,000 The Data (Exhibit 19-2 Lucent Technology) Assets 20X2 20X1 Current assets: Cash $ 29,000 $ 32,000 Receivables net 114,000 85,000 Inventories 113, ,000 Prepaid expenses 6,000 8,000 Total current assets $262,000 $236,000 Long-term investments 18,000 9,000 Plant and equipment, net 507, ,000 Total assets $787,000 $644,000 The Data (Exhibit 19-2 Lucent Technology) Liabilities 20X2 20X1 Current liabilities: Bills payable $ 42,000 $ 27,000 Accounts payable 73,000 68,000 Accrued liabilities 27,000 31,000 Total current liabilities $142,000 $126,000 Long-term debt 289, ,000 Total liabilities $431,000 $324,000

8 The Data (Exhibit 19-1 Lucent Technology) Shareholders Equity 20X2 20X1 Ordinary shares (93,000) $186,000 $186,000 Retained earnings 170, ,000 Total shareholders h equity $356,000 $320, Total liabilities and shareholders equity $787,000 $644,000 Measuring Ability to Pay Current Liabilities The current ratio measures the company s ability to pay current liabilities with current assets. Current ratio = Total current assets Total current liabilities Measuring Ability to Pay Current Liabilities Lucent s current ratio: 20X1: $236,000 $126,000 = X2: $262,000 $142,000 = 1.85 If the industry average is 1.80, what does this tell us? The current ratio decreased slightly during 2007 but it is still slightly higher than the industry average.

9 Measuring Ability to Pay Current Liabilities The acid-test ratio shows the company s ability to pay all current liabilities if they come due immediately. Acid-test ratio = (Cash + Short-term investments + Net current receivables) Total current liabilities Measuring Ability to Pay Current Liabilities Lucent s acid-test ratio: 20X1: ($32,000 + $85,000) $126,000 =.93 20X2: ($29,000 + $114,000) $142,000 = 1.01 If the industry average is.60. The company s acid-test ratio improved considerably during 2007 and is well above the industry average. Measuring Ability to Sell Inventory Inventory turnover is a measure of the number of times the average level of inventory is sold during a year. Inventory turnover = Cost of goods sold Average inventory

10 Measuring Ability to Sell Inventory Inventory turnover: 20X2: $513,000 $112,000* = 4.58 If the industry average is A high number indicates an ability to quickly sell inventory, but it might indicate stock-outs! * Average inventory ($113,000 + $111,000) 2 Measuring Ability to Collect Receivables Accounts receivable turnover measures a company s ability to collect cash from credit customers. Accounts receivable turnover = Net credit sales Average accounts receivable Measuring Ability to Collect Receivables Lucent s accounts receivable turnover: 20X2: $858,000 $99,500 = 8.62 times If the industry average is times. Lucent s receivable turnover is much lower than the industry average. If the company is a rural store that sells to local people who tend to pay their bills over a lengthy period of time then?

11 Measuring Ability to Collect Receivables Days sales in receivable ratio measures how many day s sales remain in Accounts Receivable. One days sales = Net sales 365 days Days sales in Accounts Receivable = Average net Accounts Receivable One day s sales Measuring Ability to Collect Receivables Days sales in Accounts Receivable for 20X2: One day s sales: $858, = $2,351 Days sales in Accounts Receivable: $99,500 $2,351 = 42 days What is the industry average? 365/22.2 Measuring Ability to Pay Debt The debt ratio indicates the proportion of assets financed with debt. Total liabilities Total assets

12 Measuring Ability to Pay Debt Lucent s debt ratio: 20X1: $324,000 $644,000 = X2: $431,000 $787,000 = 0.55 Industry average Lucent expanded operations during 20X2 by financing through borrowing but it is still lower than the industry. Measuring Ability to Pay Debt Times-interest-earned ratio measures the number of times profits before both interest and tax can cover interest expense. Times-interest-earned = Net Profits plus (interest expense and tax) Interest expense Measuring Ability to Pay Debt Times-interest-earned ratio: 20X2: ($81,000 + $24,000*) $24,000 = 4.37 The industry average is Is this a favourable sign? * Profits before tax are $81,000 (or $48,000 + $33,000) and if we paid no interest of $24,000 profits would be $105,000.

13 Measuring Profitability Rate of return on net sales shows the percentage of each sales dollar earned as net profits. Rate of return on net sales = Net profits Net sales Measuring Profitability Lucent s rate of return on sales: 20X1: $26,000 $803,000 = X2: $48,000 $858,000 = The industry average is The increase is significant in itself and also because it is much better than the industry average. Measuring Profitability Rate of return on total assets measures how profitably a company uses its assets. Rate of return on total assets = (Net profits + income tax + interest expense) Average total assets

14 Measuring Profitability Rate of return on total assets for 20X2: $105,000 $715,500* = What if the industry average is 0.049? How does Lucent compare to the industry? * ($644,000 + $787,000) 2 = $715,500 Measuring Profitability Shareholders equity includes any additional issued ordinary shares and retained profits. Rate of return on ordinary shareholders equity = (Net profits preferred dividends) Average ordinary shareholders equity Measuring Profitability Lucent s rate of return on ordinary shareholders equity for 20X2: ($48,000 $0) $338,000* = Why is this ratio larger than the return on total assets (.101)? Because Lucent uses leverage or gearing. * ($356,000 + $320,000) 2 = $338,000

15 Gearing Example I borrow $90 (at 5%) and I put in $10 Invest $100 and earn 10% on it Revenue $10.00 ($100 x 10%) Expenses $ 4.50 ($90 x 5%) Profit $ Not bad on the $10 I put in. But what if the assets only earned say 2% Loss of $2.50 Gearing is RISKY! Measuring Profitability Earnings per share (EPS) = (Net profits Preference dividends) Number of ordinary shares issued Measuring Profitability Lucent s earnings per share for 20X2: ($48,000 $0) 93,000 = $0.52 EPS is important because it is becoming common to express the profit in this form rather than large dollar amounts. Only important in comparison to previous EPS not other companies EPS. Why?

16 Analysing Shares as an Investment Price/earning ratio is the ratio of market price per share ($5) to earnings per share. 20X2: $5 $0.52 = 9.6 Given Lucent s 2007 P/E ratio of 9.6, we would say that the company s shares are selling at 9.6 times earnings. P/E ratios are commonly provided for listed companies. Analysing Shares as an Investment Dividend yield shows the percentage of a share s market value returned as dividends to shareholders each period. Dividend yield = Dividend per ordinary share market price per ordinary shares Analysing Shares as an Investment Dividend yield on Lucent s ordinary shares 20X2: $0.12 $5.00 =.024 (2.4%) An investor who buys Lucent s ordinary shares for $5 may expect to receive 2.4% of the investment annually in the form of cash dividends.

17 Analysing Shares as an Investment Book value per ordinary share = (Total ordinary shareholders equity) Number of ordinary shares issued Analysing Shares as an Investment Book value per share of Lucent s ordinary shares: 20X1: ($320,000) 93,000 = $ X2: ($356,000) 93,000 = $3.83 Book value bears no relation to market value (the price quoted on the evening news). Limitations of Financial Analysis Business decisions are made in a world of uncertainty. No single ratio or one-year figure should be relied upon to provide an assessment of a company s performance. Another way to analyse a company is to look for red flags such as too much debt. The annual report also contains other information such as the auditor s report.

18 Objective 6 Measure economic value added by a company s operations. Economic Value Added (EVA ) Economic value added (EVA ) combines accounting income and corporate finance to measure whether the company s operations have increased stockholder wealth. EVA = Net profits + Interest expense Capital charge Red Flags Earnings problems Decreased cash flow Too much debt. Inability to collect receivables Buildup of inventories. Movement of sales, inventory and receivables..

19 Analysing non-financial data Chairman's Report Managing Director s Report Auditor s Report PowerPoint to accompany End of Chapter 19