Week 4 and Week 5 Handout Financial Statement Analysis

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1 Week 4 and Week 5 Handout Financial Statement Analysis Introduction After understanding the basic financial statements, one may be interested in analysing the financial statements to understand the performance of the business. Financial statement analysis helps answer basic questions such as How has the business performed during the year What is the financial condition of the company How investment activities have performed during the year Does the company have enough liquidity to meet its day - today operations and many more Let us examine the sequence of accounting and analysis as depicted below Preparation of Finanacial Statements Analyzing the Financial Statements Evaluating the performance and position of the business using certain tools Forecasting about the future period and diagnosing the present situation Taking steps to address the problems areas if any 1.What does analysis involve? Financial statement analysis is a set of tools and techniques used to assess the financial performance of the business. Here one must understand that business does not operate in vacuum and therefore understanding the business context, the industry, the company s own strategy are important before we start the analysis. Apart from financial statements there are several additional inputs in the annual report that aid in analyzing the financial statements. These are Directors report/chairman s statement, Segment Reporting, Companies Risks and mitigation measures, Notes and explanations in the annual report. Using the additional parts of the annual report the numbers can be interpreted in a better manner.

2 2. Tools to analysis Once you develop the basic understanding. We can go to number crunching ie analysis We start with the following basic tools Horizontal Analysis Vertical or Common sizing statements and Ratio analysis Let s elaborate each one: 2.1 Horizontal Analysis & Trend Analysis The trend analysis is a technique of studying several financial statements over a series of years. In this analysis the trend percentages are calculated for each item by taking the figure of that item for the base year taken as 100. Generally, the first year is taken as a base year. This analysis helps in understanding the trend of figures, whether moving upward or downward. Trend analysis shows the level of growth that the company has achieved over the years on each component of financial statements. Suppose the growth rate of sales is 20% but its cost has increased by 26%, then its profitability is affected. One can perform such analysis by observing the trends on each element in the balance sheet as well as the income statement. 2.2 Common Sizing The common size statements (Balance Sheet and Income Statement) are shown in analytical percentages. The figures of these statements are shown as percentages of total assets, total liabilities and total income respectively. Take the example of Balance Sheet. The total assets are taken as 100 and different assets are expressed as a percentage of the total. Similarly, various liabilities are taken as a percentage of total liabilities. In the income statement, the total income is taken as 100 and all other elements (such as different type of expenses) of the income statement are worked out as a percentage to the revenue. Common size statement analysis if performed across several years helps understand the structure of the company and track the changes in the allocation of assets or liabilities. In the income statement one can also observe the movement in the various expenses and identify which of the expense contributed to the change in the net profit compared to the previous year.

3 2.3 Ratio analysis A ratio is a mathematical relationship between two numbers. Financial ratio analysis is a study of ratios between various items or groups of items in financial statements. This can be related to only the income statement or the balance sheet or a combination of both the financial statements. Ratio analysis is among the most popular and widely used tools of financial analysis. Ratios may be expressed as percentages or fractions or as a stated comparison between simple numbers. A ratio simply presents information regarding a single financial relationship but it is not an end in itself. Ratios help in the judging the efficiency of the business. There are various ratios that are used for evaluating the performance and the financial condition of the company. Broadly, ratios help determine the Operational efficiency, Investment efficiency, Financing Efficiency Remember ratios cannot tell the complete story. Ratios properly interpreted help in identifying areas which require further examination. Financial ratios can be mainly classified into the broad categories as follows: Profitability ratios Asset management or Turnover ratios Liquidity ratios and Leverage ratios Other Ratios Profitability ratios Profit represents the excess of revenue over expenses for a period. Profit is a number but is that number a good number or an ideal number for the business considering the scale and size of business? Here arises the concept of profitability. Profitability is the ability of the firm to generate earnings. Profitability denotes the efficiency of the business in generating profits. Analysis of profit is of vital importance to all the stakeholders. hey can be divided as margin ratios and return ratios. Margin ratios indicates the relationship between profit and revenue. Since profit can be measured at different stages, there are several measures of profit margin. Some of them are as follows:

4 Gross Profit Margin Ratio The gross profit margin ratio is defined as: Gross profit Revenues from operations Gross profit is defined as the difference between revenues from operations and cost of goods sold. Cost of goods sold is the sum of manufacturing costs relating to the revenues of the period. This ratio shows the margin left after meeting manufacturing costs. It measures the efficiency of production as well as pricing. More importantly, this can act as a bargaining tool. A higher or an adequate gross margin is always advantageous. Higher GP represents better ability to absorb the fixed costs. A company should have a stable gross profit margin unless there have been changes to the company's business model. To analyze the factors underlying the variation in gross profit margin the proportion of various elements of cost (labor, materials, and manufacturing overheads) to sales may be studied in detail. Net Profit Margin Ratio The net profit margin ratio is defined as: Net profit Total revenues This ratio shows the net earnings or net profit after all expense as a percentage of total revenues. It measures the overall efficiency of production, administration, selling, financing and tax management. The ratio provides a valuable understanding of the cost and profit structure of the firm and enable the analyst to identify the sources of business efficiency/inefficiency. Return on Assets The return on assets (ROA) is defined as: ROA = Profit after tax Average total assets The ratio helps understand the return generated from the use of assets. It captures both the cost management and efficient utilization of assets. Note: The generic term used is return on investment. Many organizations use variants of the above equation. For example: Return on capital employed or Return on net assets etc. Investors always look for companies which generate good returns on investments in assets. Higher ROA represents a firm s return generating ability.

5 Return on Equity A measure of great interest to equity shareholders, the return on equity is defined as: Net profit Average equity The numerator of this ratio is equal to profit after tax. The denominator includes all contributions made by shareholders (capital + retained earnings). This ratio is also referred as return on net worth or return on shareholders funds. This ratio is very important measure because as it reflects the efficiency of the using the shareholder funds employed in the firm. It is influenced by several factors: profit, debt-equity ratio, average cost of debt funds, and tax rate. In judging all the profitability measures it should be borne in mind that the historical valuation of assets imparts an upward bias to profitability measures during an inflationary period. This happens because the numerator of these measures represents current values, whereas the denominator represents historical values Turnover Ratios/Asset Management Ratio Turnover ratios, also referred to as activity ratios or asset management ratios, measure how efficiently the assets are employed by a firm. These ratios are based on the relationship between the level of activity, represented by revenues or cost of goods sold, and levels of various assets. The important turnover ratios are: inventory turnover, average collection period, receivables turnover, fixed assets turnover, and total assets turnover. Total Assets Turnover Akin to the output-capital ratio in economic analysis, the total assets turnover is defined as: Total revenues Average total assets This ratio measures how efficiently assets are employed, overall

6 Property Plant and Equipment (Fixed Assets) Turnover This ratio measures revenue per dollar of investment in property plant and equipment. It is defined as: Revenues Average net fixed assets This ratio measures the efficiency with which property plant and equipment are employed - a high ratio indicates a high degree of efficiency in asset utilization and a low ratio reflects inefficient use of assets. However, in interpreting this ratio, one caution should be borne in mind. When the fixed assets of the firm are old and substantially depreciated, the fixed assets turnover ratio tends to be high because the denominator of the ratio is very low. Inventory Turnover The inventory turnover, measures how fast the inventory is moving through the firm and generating sales. It is defined as: Revenues from operations Average inventory The inventory turnover reflects the efficiency of inventory management. The higher the ratio, the more efficient the management of inventories and vice versa. However, this may not always be true. A high inventory turnover may be caused by a low level of inventory which may result in frequent stock outs and loss of sales. Receivables' Turnover This ratio shows how many times trade receivables turn over during the year. It is defined as: Revenue Average trade receivables The ratio indicates the efficiency of credit management ie. collection from its customers.

7 Average Collection Period The average collection period represents the number of days' of credit sales. It is defined as: Average trade receivables Average daily credit sales The average collection period may be compared with the firm's credit terms to gauge the efficiency of credit management. Please note that this is an average figure and managers must monitor the receivables due based on each customer Liquidity Ratios Liquidity Ratios: Liquidity refers to the ability of a firm to meet its short-term obligations. Liquidity ratios are generally based on the relationship between current assets (the sources for meeting shortterm obligations) and current liabilities. The important liquidity ratios are: current ratio and acid-test ratio. Current Ratio A very popular ratio, the current ratio is defined as: Current assets Current liabilities Current assets include current investments, inventories, trade receivables, cash and cash equivalents, and other current assets. Current liabilities represent liabilities that are expected to mature in the next twelve months. These comprise of short-term borrowings, trade payables, other current liabilities, and short-term provisions. The current ratio measures the ability of the firm to meet its current liabilities - current assets get converted into cash during the operating cycle of the firm and provide the funds needed to pay current liabilities. Apparently, the higher the current ratio, the greater the short-term solvency. However, in interpreting the current ratio the composition of current assets must not be overlooked. A firm with a high proportion of current assets in the form of cash and receivables is more liquid than one with a high proportion of current assets in the form of inventories even though both the firms have the same current ratio.

8 Acid-test Ratio Also called the quick ratio, the acid-test ratio is defined as: Current Asset Inventory Current liabilities The acid-test ratio is a fairly stringent measure of liquidity. It is based on those current assets which are highly liquid - inventories are excluded from the numerator of this ratio because inventories are deemed to be the least liquid component of current assets. Solvency ratios Solvency of a business is important in the long run as well. A set of ratios to track the long term financial position is called solvency ratios. Lenders are usually interested in this ratio. While debt capital is a cheaper source of finance, it is also a riskier source of finance. Leverage ratios help in assessing the risk arising from the use of borrowings or debt. Two types of ratios are commonly used to analyze financial leverage: structural ratios and coverage ratios. The most important structural ratio is the debt-equity ratio. Debt-equity Ratio The debt-equity ratio shows the relative contributions of creditors and owners. It is defined as: Total liabilities Shareholders funds The numerator of this ratio consists of all liabilities 1, non-current and current, and the denominator consists of share capital and retained earnings 2. 1 Alternatively, the ratio of non-current liabilities to equity may be calculated. What is important is that the same ratio is used consistently when comparisons are made. 2 For the sake of simplicity, preference capital is subsumed under equity. Since preference capital is usually a very minor source of finance, its inclusion or exclusion hardly makes any difference.

9 Sometimes also calculated as Long Term Debt Shareholders funds In general, the lower the debt-equity ratio, the higher the degree of protection enjoyed by the creditors. The ratio also captures the leverage in the business. Coverage ratios show the relationship between debt servicing commitments and the sources for meeting these burdens. The important coverage ratios are: interest coverage ratio, and debt service coverage ratio. Interest Coverage Ratio Also called the times interest earned, the interest coverage ratio is defined as: Profit before interest and taxes Interest (Finance Cost) Note that profit before interest and taxes are used in the numerator of this ratio because the ability of a firm to pay interest is not affected by tax payment, as interest (or finance costs) on debt funds is a tax-deductible expense. A high interest coverage ratio means that the firm can easily meet its interest burden even if earnings before interest and taxes suffer a considerable decline. This ratio is widely used by lenders to assess a firm's debt capacity. There are several modifications of this ratio Other ratios There are several other ratios that can be computed by the firm. For example valuation ratios such as earnings per share etc. A Word of caution. Ratios are not an end in itself. It has to be used judiciously along with other information.

n Financial Statement Analysis n Dollar and Percentage Changes n Common Sized Statements n Ratio Analysis McGraw-Hill /Irwin McGraw-Hill /Irwin

14-1 Today s Agenda Management Accounting Lecture 3 (Chapter 14) Financial Statement Analysis Bangor University Transfer Abroad Programme n Financial Statement Analysis n Dollar and Percentage Changes