BAT 4M1 CPT Chapter 17 Notes Basics of Financial Statement Analysis Financial statement analysis involves evaluating a company s liquidity, solvency, and profitability Objective: to give capital providers information useful for decision making Short term creditors are mostly interested in liquidity Long term creditor are mostly interested in solvency (company s ability to survive over a long period of time Comparative Analysis Users of financial information make comparisons in order to evaluate a company s performance, and to use this information to help determine future expectations Every item in a financial statement has significance however, has very little value on its own amounts are used to see if there was an increase or decrease from previous years Comparisons can be made on different bases; 1. Intra company Basis: compares an item or financial relationship inside or within a company useful for identifying changes in financial relationships and discovering trends 2. Inter company Basis: compares an item or financial relationship of one company with other companies useful for understanding a company s competitive position Tools of Analysis Various tools are used to evaluate the significance of financial data for decision making; 1. Horizontal Analysis: compares data such as line items in a company s financial statements by expressing them as percentage increases and decreases over 2 or more years (periods) Helps identify changes and trends over time Used mainly in intracompany comparisons (within a company) 2. Vertical Analysis: compares data by expressing line items in a company s financial statement as a percentage of a total amount within the same financial statement and year (period) Focuses on the relationships between items on the same financial statement Used in both intracompany and intercompany comparisons It is useful to compare data both within a company (intracompany) and between 2 or more companies (intercompany) Vertical percentages can also be compared across time
3. Ratio Analysis: expresses the relationship between selected items of financial statement data within the same year (period) Helps us understand the relationship among selected items presented in one or more financial statements Used in both intracompany and intercompany comparisons Horizontal Analysis also known as a trend analysis Horizontal Analysis : a technique used to compare a series of data Ex. items in a company s financial statements over a period of time Views financial statement from left to right or vice versa Purpose is to determine whether the percentage over time has increased or decreased Horizontal Percentage of Base Period Amount : expresses revenue as a percentage of the base year amount Horizontal Percentage of Base Period Amount= Analysis Period Amount/Base Period Amoun t Horizontal Percentage Change For Period : measures the percentage change between two periods of time Horizontal Percentage Change For Period=(Analysis Period Amount Prior Period Amount)/Prior Period Amount Balance Sheet In a horizontal analysis, the amount column of the increase/decrease is additive, unlike the percentage column which is not. Any losses on fair value adjustments are on the income statement and not the statement of comprehensive income. Changes in current assets and current liabilities usually move in the same direction, meaning both will either increase or decrease, which is better than one increasing/decreasing more than the other. Income Statement In a horizontal analysis, it shows the dollar amounts and percentage changes during the period. If an item has a small value in a base or prior year and and a large value in the next year, the percentage change could be disproportionately large and may not be meaningful. If a negative amount shows in the base or prior year and there is a positive amount the following year (vice versa), no percentage change can be calculate. If an item as no value in a base or prior year and a value in the next year, no percentage change can be calculated. Vertical Analysis also known as a common size analysis Vertical Analysis: a technique for comparing an amount in a company's financial statements with a total (base) amount within the same financial statement.
Vertical analysis simply means that we view data from up and down in the same time period Horizontal looks at data longer than a year whereas vertical data is only for within one year Vertical percentage of base amount: calculated by dividing the financial statement amount under analysis by the relevant total or base amount for that particular statement Vertical percentage of Base Amount = Analysis Amount/ Base Amount The base amount commonly used for the balance sheet is total assets, the base amount for the income statement is revenues for a service company and net sales for a merchandising company. All base amounts in vertical analysis are equal to 100%. Balance Sheet Intracompany Comparison For the balance sheet the base amount being used is total assets. Due to the accounting equation total assets can be used for both assets and liabilities. Vertical analysis shows the size of each item for the year prior and the current year. Vertical analysis can be used to compare individual assets, liabilities and shareholders equity items between years. Intercompany Comparison The vertical analysis can also be used to compare companies. This becomes useful when comparing companies of different sizes. Income Statement When doing a vertical analysis on an income statement, the base amount is net sales. This can also be performed on the statement of comprehensive income, statement of changes in shareholders equity and cash flow statement. Vertical analysis can also be applied to intercompany comparisons of the income statement. Liquidity Ratios Liquidity Ratios : measure the company s short term ability to pay its maturing obligations and to meet unexpected needs for cash Short Term Creditors Include: Suppliers and bankers Interested in assessing liquidity Liquidity Ratios Include: Current Ratio Acid Test Ratio Receivables Turnover Collection Period Inventory Turnover
Days sales in inventory Operating cycle Current Ratio : measure of a company s liquidity and short term debt paying ability Desired Result: Higher Current Ratio = Current Assets/Current Liabilities Acid Test Ratio : excludes that assets are less than liquid (ex. inventory) which takes more time to be converted to cash Desired Result : Higher Acid Test Ratio = (Cash+Short term Investments+Receivables)/Current Liabilities Receivables Turnover : measures the number of times that receivables are collected during the period Assess the liquidity of the receivables Desired Result: Higher Receivables Turnover = (Net Credit Sales Cash Sales)/Average Gross Accounts Receivables Collection Period : variation of receivables turnover is to convert it into a collection period (in days) Desired Results: Lower Collection Period = Days in Year/Receivables Turnover Inventory Turnover : measures average number of times inventory is sold during the period Measures liquidity of inventory Desired Results : Higher Inventory Turnover = Cost of Goods Sold/Average Inventory Days Sales In Inventory : variant of inventory turnover is the days sales in inventory Desired Results: Lower Days Sales In Inventory = Days in Year/Inventory Turnover Operating Cycle : measures average time it takes to purchase inventory, sell on account and collect the cash from customers Desired Results: Lower Operating Cycle = Days Sales in Inventory + Collection Period
Summary of Liquid Ratios It is better to take fewer days to collect receivables and have fewer days of inventory on hand. A current ratio can be high at times because of higher balances of receivables and inventory included in current assets due to slow moving inventory/uncollectible receivables. Never conclude as assessment of liquidity with just one ratio, the current ratio should always be interpreted with the acid test, receivables turnover and inventory turnover ratio, and the acid test ratio should always be interpreted with the receivables as well as the receivables turnover ratio. Solvency Ratios Solvency Ratios : measures the company s ability to last over a long period of time Long Term Creditors Interested in company s long term solvency Ability to pay interest as it comes due and to repa the face value of debt at maturity Solvency Ratios Include: Debt to total assets Interest coverage Free cash flow Debt to Total Assets : measures percentage of total assets provided by creditors The higher the percentage of total debt to total assets, the greater the risk that the company may be unable to meet its maturing obligations The lower the debt to total assets, the more net assets there are to repay creditors if the company becomes insolvent Desired Results : Lower Less debt reduces dependence on debt financing, flexibility for future financing alternatives Debt to Total Assets = Total Liabilities/Total Assets Interest Coverage : an indication of whether the company is able to make its interest payments when due Desired Results : Higher Interest Coverage = (Profit + Interest Expense +Income)/Interest Expense Free Cash Flow : an indication of how solvent a company is as well as its ability to expand its operations, repay debt or pay dividends Desired Results : Higher Free Cash Flow = Cash Used by Operating Expenses Cash Provided by Investing Activities
Summary of Solvency Ratios You should interpret the debt to total assets and interest coverage ratio together. If a company has a high debt to total assets ratio as well as a high interest coverage ratio it means it is able to handle a high level of debt. If a company has a low debt to total assets ratio as well as a low interest coverage ratio, it means it has difficulty paying interest for even a small amount of debt. Profitability Ratios Profitability Ratio: measures a company s operating success for a specific period of time Profit, or lack of, affects a company s ability to obtain debt and equity financing, its liquidity position and growth Interested: Creditors and Investors Gross Profit Margin: indicates the relationship between net sales and cost of goods sold Too high lose sales if pricing is not competitive Too low may not have enough to cover expenses Gross Profit Margin = Gross Profit/Net Sales Profit Margin: measures the percentage of each dollar of sales that results in profit Profit Margin = Profit/Net Sales Asset Turnover: measures how efficiently a company uses its assets to generate sales Asset Turnover = Net Sales/Average Total Assets Return on Assets: measure of profitability on assets Return on Assets = Profit/Average Total Assets Return on Equity: measures profitability of shareholders investments Return on Equity = Profit/Average Shareholders Equity
Earnings per Share (EPS): measure of profit earned on each common share Reducing profit to a per share basis gives a useful measure of profitability EPS = (Profit Preferred Dividends)/Weighted Average Number of Common Shares Price Earnings (PE) Ratio: measures the relationship between market price per share and earnings per share PE= Market Price per Share/Earnings per Share Payout Ratio: measures percentage of profit distributed as cash dividends Payout Ratio = Cash Dividends/Profit Summary of Profitability Ratios The higher the price earnings ratio, the more investors favor that company and have high expectations of future profitability. Investors who are interested in purchasing a company s shares for income purposes are interested in companies with a high payout ratio. Investors who are interested in purchasing a company s share for growth purposes are interested in a low payout ratio. A company s solvency doesn t just require satisfactory liquidity but it also affected by its profitability Alternative Accounting Policies Companies may use different inventory cost determination methods or different depreciation methods depending on the pattern of the revenues their assets produce, and using these different methods can result in differing financial positions and performance and that will reduce comparability. Although depreciation expense and the carrying amount of property, plant and equipment may be different in one or more periods because of the choice of depreciation methods, in total, over the life of the assets, there is no difference. Intercompany comparability may also be hindered by differing accounting policy options available for private companies. Intracompany comparability can be affected by the use of different accounting policies over different periods of time. Comprehensive Income Comprehensive income is the sum of net income and other items that must bypass the income statement because they have not been realized, including items like an unrealized holding gain or loss from available for sale securities and foreign currency translation gains or losses. In some cases where other comprehensive income is significant and depending on the source of the income, some analysts will adjust profitability ratios in order to incorporate the effect of total
comprehensive income. ASPE does not report comprehensive income, so this limitation would apply only to the public and private companies. Quality of Information A company that has high quality index includes full and transparent information that will not confuse or mislead users of the financial statements. A strong corporate governance process, including an active board of directors and audit committee, is essential to ensuring the quality of information. Economic Factors Economic measures such as the rate of interest, unemployment and changes in demand and supply can have a significant impact on a company s performance. When losses result in negative numbers, it is difficult to calculate percentages and ratios, much less interpret them and that is when vertical analysis becomes useful. If a company has losses, they must be assessed based on the factors driving the loss in the current period. Less attention should be paid to comparing the losses with results from prior periods.