WEEK 10 Analysis of Financial Statements

Transcription

1 WEEK 10 Analysis of Financial Statements

2 Learning Objectives 1. Organize a systematic financial statements analysis using common-size financial statements and ratio analysis. 2. Recognize the potential impact that differing accounting methods can have on the financial ratios of otherwise essentially identical companies. 3. Introduce Types of Financial Ratios using illustrations

3 Framework for Financial Statement Analysis Financial statement analysis- the examination of the relationships among: Financial statement numbers The trends of the statement numbers over time. To analyze financial statements, analyst use: Common sized financial statements Ratio analysis

4 Framework for Financial Statement Analysis Common-Size Financial Statements- analysis of a company s single-year financial statements. Financial statements are standardized by a measure of size, either sales or total assets. All amounts are stated in terms of a percentage of the size measure. Ratio Analysis- Analysis of a company s financial statements by computing ratios and comparing them against both trends and industry averages.

5 Common-Size Income Statement For common-size income statements, the denominator, is equal to net sales. 100% = Net Sales 100% = Net Sales 100% = Net Sales

6 Common-Size Financial Statements Comparative Income Statements (in thousands) 2008 % 2007 % Net sales 5, , Cost of goods sold 4, , Gross profit on sales 1, , Selling expense 1, , General expense Total operating expenses 1, , Operating income (loss) Other revenue (expense) Income before taxes Income tax Net income

7 Common-Size Balance sheet For common-size balance sheets, again the denominator, is equal to the net sales for the year. 100% - Net sales A common-size balance sheet can also be prepared using total assets to standardize each amount.

8 Common-Sized Balance Sheet Comparative Balance Sheets (in thousands ) Assets 2008 % 2007 % Current assets Land, building, and equipment (net) 1, , Intangible assets Other assets Total assets 2, ,

9 Types of Financial Ratios Liquidity ratios Solvency ratios Turnover ratios Profitability ratios Equity-related ratios

10 Profitability ratios Net profit margin = Net profit before interest and tax x 100% Sales revenue Gross profit margin = Gross profit x 100% Sales revenue Return on capital employed = Net profit before interest and taxation x 00% Equity + long-term loans Return on ordinary shareholders funds = Net profit after interest and tax x 100% Equity

11 Leverage Ratios Higher leverage increases ROE through the following chain of events: 1. More borrowing means that more assets can be purchased without any additional equity investment by owners. 2. More assets means that more sales can be generated. 3. More sales means that net income should increase

12 Solvency Ratios Solvency ratios measure the dependence of a firm on borrowed funds. Debt-equity ratio Debt Interest ratio Debt Equity (Net Worth) Debt Debt Debt Equity Capital employed coverage Earnings before interest and tax Interest

13 Liquidity Ratios Liquidity ratios measure a firm s ability to meet its current obligations. Current assets Current ratio = Current liabilities Current assets Inventories Quick ratio = Current liabilities Cash + Marketable securities Cash ratio = Current liabilities

14 Turnover (Efficiency) Ratios Net asset turnover = Sales revenue Total assets less Current liabilities Stockholding period = Stock held X365 days Cost of goods sold

15 Turnover (Efficiency) Ratios Debtor Collection Period = Trade debtors X 365 days Credit Sales Creditor payment period = Trade creditors X 365 days Credit Purchases

16 Earnings/Share of Common Stock This ratio is the profit that goes to each share of common stock. It would be simply the net income less preferred dividends divided by the number of common shares. However, the number of common shares is complicated by certain securities that may become (converted to) a common share. How to account for these is a complex issue.

17 Profit after tax- preference dividend Number of shares Earnings Per Share (EPS)

18 Dividend payout ratio Dividend Payout Ratio. Dividends Net income.

19 Cautions in Using Ratio Analysis Standards of comparisons Company differences Price level Different definition Changing situations Past data

20 Impact of Alternative Accounting Methods If companies are using differing accounting practices, it will impact the ratios. Careful financial statement users should make adjustments for accounting differences among the companies being analyzed.

21 Utility of Ratio Analysis Assessment of the firm s financial conditions and capabilities. Diagnosis of the firm s problems, weaknesses and strengths. Credit analysis Security analysis Comparative analysis Time series analysis

22 Summary Common-size financial statements and ratio analysis are the methods of financial statements analysis Types of Ratios are Liquidity ratios, Solvency ratios, Turnover ratios, Profitability ratios and Equity-related ratios Financial analysis helps in assessment of the firm s financial conditions and capabilities and diagnosis of the firm s problems, weaknesses and strengths.