For Students - FS Analysis

28/07/2018
FINANCIAL STATEMENT
ANALYSIS
CORNERSTONES
BFM 113: Financial Management
Prof. Jherome G. Ng, CPA, CEA, MBA
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Learning Objectives Learning Objectives (cont.)

1. Analyze financial statements using two forms of 4. Calculate and use leverage ratios to assess the
common-size analysis: horizontal analysis and ability of a company to meet its long- and short-
vertical analysis. term obligations.
2. Explain why historical standards and industrial 5. Calculate and use profitability ratios to assess
averages are important for ratio analysis. the extent to which a company’s resources are
3. Calculate and use liquidity ratios to assess the being used efficiently.
ability of a company to meet its current
obligations.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use. license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Common-Size Analysis Common-Size Analysis

▪ To make the analysis more meaningful,
percentages can be used.
▪ Common-size analysis expresses line items or
accounts in the financial statements as
percentages.
▪ The two major forms of common-size analysis are
horizontal analysis and vertical analysis.
LO-1 LO-1
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Cornerstone 16.1
Preparing Common-Size Income
Horizontal Analysis Statements: Horizontal Analysis
▪ Also called trend analysis, horizontal analysis
expresses a line item as a percentage of some
prior-period amount.
▪ Allows the trend over time to be assessed.
▪ In horizontal analysis, line items are expressed as
a percentage of a base period amount.
▪ The base period can be the immediately
preceding period, or it can be a period further in
the past.
LO-1 LO-1
Cornerstone 16.1
Preparing Common-Size Income
Vertical Analysis
Statements: Horizontal Analysis (cont.)
▪ While horizontal analysis involves relationships
among items over time, vertical analysis is
concerned with relationships among items within
a particular time period.
▪ Vertical analysis expresses the line item as a
percentage of some other line item for the same
period.
LO-1 LO-1
Cornerstone 16.2
Preparing Income Statements by Using
Vertical Analysis (cont.) Net Sales as the Base: Vertical Analysis
▪ With this approach, within-period relationships
can be assessed.
▪ Line items on income statements often are
expressed as percentages of net sales. Items on
the balance sheet often are expressed as a
percentage of total assets.
LO-1 LO-1
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Cornerstone 16.2
Preparing Income Statements by Using
Net Sales as the Base: Vertical Analysis (cont.) Percentage and Size Effects
▪ The use of common-size analysis makes
comparisons more meaningful because
percentages eliminate the effects of size.
▪ For example, Heisman Company earns $100,000
and Casciani Company earns $1 million, which
company is more profitable?
▪ The answer depends to a large extent on the
assets employed to earn the profits.
LO-1 LO-1
Percentage and Size Effects

Ratio Analysis
(cont.)
▪ If Heisman used an investment of $1 million to ▪ Ratio analysis is the second major technique for
earn the $100,000, then the return expressed as financial statement analysis.
a percentage of dollars is 10% ($100,000 ÷ ▪ Ratios are fractions or percentages computed by
$1,000,000). dividing one account or line-item amount by
▪ If Casciani used an investment of $20 million to another.
earn its $1 million, the percentage return is only ▪ For example, operating income divided by sales
5% ($1,000,000 ÷ $20,000,000). produces a ratio that measures the profit margin
▪ By using percentages, it is easy to see that the on sales.
first firm is relatively more profitable than the
second.
LO-1 LO-2
Standards for Comparison Standards for Comparison (cont.)

▪ Ratios by themselves tell little about the financial
well-being of a company.
▪ For meaningful analysis, the ratios should be
compared with a standard.
▪ Only through comparison can someone using a
financial statement assess the financial health of
a company.
▪ Two standards commonly used are the past
history of the company and industrial averages.
LO-2 LO-2
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Classification of Ratios Liquidity Ratios

▪ Ratios generally are classified into one of three ▪ Liquidity ratios are used to assess the short-term
categories: liquidity, borrowing capacity or leverage, debt-paying ability of a company.
and profitability.
▪ If a company does not have the short-term financial
▪ Liquidity ratios measure the ability of a company to meet its
current obligations. strength to meet its current obligations, it is likely to
▪ Leverage ratios measure the ability of a company to meet have difficulty meeting its long-term obligations.
its long- and short-term obligations. These ratios provide a ▪ Although there are numerous liquidity ratios, the most
measure of the degree of protection provided to a company’s
creditors. common ones include:
▪ Profitability ratios measure the earning ability of a ▪ current ratio
company. These ratios allow investors, creditors, and ▪ quick or acid-test ratio
managers to evaluate the extent to which invested funds are
▪ accounts receivable turnover ratio
being used efficiently.
LO-2 ▪ inventory turnover ratio LO-3
Current Ratio Current Ratio (cont.)

▪ The current ratio is a measure of the ability of a ▪ Current liabilities must be paid within an
company to pay its short-term liabilities out of operating cycle (usually within a year) and current
short-term assets. assets can be converted to cash within an
▪ The current ratio is computed as follows: operating cycle.
▪ The current ratio provides a direct measure of the
ability of a company to meet its short-term
obligations.
LO-3 LO-3
Current Ratio (cont.) Current Ratio (cont.)

▪ Many creditors use the rule of thumb that a 2.0 ▪ A declining current ratio may signal a move
ratio is needed to provide good debt-paying toward more efficient utilization of resources.
ability, but the rule has many exceptions. ▪ A declining current ratio coupled with a current
▪ A declining current ratio is not necessarily bad, ratio lower than that of other firms in the industry
particularly if it is falling from a high value. supports the judgment that a company is having
▪ A high current ratio may signal excessive liquidity problems.
investment in current resources.
LO-3 LO-3
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Cornerstone 16.3
Calculating the Current Ratio and
Quick or Acid-Test Ratio the Quick (or Acid-Test) Ratio
▪ The quick or acid-test ratio is a measure of
liquidity that compares only the most liquid assets
with current liabilities.
▪ Excluded from the quick ratio are non-liquid
current assets such as inventories.
▪ The numerator of the quick ratio includes only the
most liquid assets.
LO-3 LO-3
Accounts Receivable Accounts Receivable

Turnover Ratio Turnover Ratio
▪ A company’s liquidity problem can be investigated ▪ The liquidity of receivables is measured by the
by examining the liquidity of its receivables, or accounts receivable turnover ratio:
how long it takes the company to turn its
receivables into cash.
▪ A low liquidity of receivables signals more
difficulty since the quick ratio would be
▪ Average accounts receivable is defined as
overstated.
follows:
LO-3 LO-3
Accounts Receivable Accounts Receivable

Turnover in Days Turnover in Days (cont.)
▪ The accounts receivable turnover ratio can be ▪ Whether the result is good or bad depends to
taken further to determine the number of days the some extent on what other companies in the
average balance of accounts receivable is industry are experiencing.
outstanding before being converted into cash, ▪ A low turnover ratio may suggest a need to
which is calculated as follows: modify credit and collection policies to speed up
the conversion of receivables to cash.
LO-3 LO-3
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Cornerstone 16.4 Cornerstone 16.4

Calculating the Average Accounts Receivable, the Calculating the Average Accounts Receivable, the
Accounts Receivable Turnover Ratio, and the Accounts Accounts Receivable Turnover Ratio, and the Accounts
Receivable Turnover in Days Receivable Turnover in Days (cont.)
LO-3 LO-3
Using Ratio Analysis to Improve Cash

Management Decisions
Inventory Turnover Ratio
▪ Inventory turnover is also an important liquidity
measure.
▪ The inventory turnover ratio and average
inventory is computed as follows:
▪ This ratio tells an analyst how many times the

average inventory turns over, or is sold, during
the year.
LO-3 LO-3
Cornerstone 16.5
Calculating the Average Inventory, Inventory
Inventory Turnover Ratio Turnover Ratio, and the Inventory Turnover in Days
▪ A low turnover ratio may signal the presence of

too much inventory or sluggish sales.
▪ The number of days inventory is held before
being sold can be computed as:
LO-3 LO-3
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Cornerstone 16.5
Calculating the Average Inventory, Inventory
Turnover Ratio, and the Inventory Turnover in Days (cont.) Leverage Ratios
▪ When a company incurs debt, it has the
obligation to repay the principal and the interest.
▪ Holding debt increases the riskiness of a
company.
▪ Leverage ratios can help an individual to
evaluate a company’s debt-carrying ability.
▪ The most common leverage ratios are:
▪ Times interest earned ratio
▪ Debt ratio
LO-3 ▪ Debt-to-equity ratio LO-4

Times-Interest-Earned
Times-Interest-Earned Ratio
Ratio (cont.)
▪ The first leverage ratio uses the income ▪ Income before taxes must be recurring income;
statement to assess a company’s ability to thus, unusual or infrequent items appearing on
service its debt. the income statement should be excluded in
▪ This ratio, called the times-interest-earned order to compute the ratio.
ratio, is computed as follows: ▪ Recurring income is used because it is the
income that is available each year to cover
interest payments.
LO-4 LO-4
Cornerstone 16.6 Cornerstone 16.6

Calculating the Times-Interest- Calculating the Times-Interest-
Earned Ratio Earned Ratio (cont.)
LO-4 LO-4
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Debt Ratio Debt Ratio (cont.)

▪ Investors and creditors are the two major ▪ Since total liabilities are compared with total
sources of capital. assets, the ratio measures the degree of
▪ As percentage of assets financed by creditors protection afforded to creditors in case of
increases, the riskiness of the company insolvency.
increases. ▪ Creditors often impose restrictions on the
▪ The debt ratio measures this percentage and is percentage of liabilities allowed.
computed as follows: ▪ If this percentage is exceeded, the company is in
default, and foreclosure can take place.
LO-4 LO-4
Debt-to-Equity Ratio Debt-to-Equity Ratio (cont.)

▪ Another ratio useful in assessing the leverage ▪ Creditors would like this ratio to be relatively low,
used by a company is the debt-to-equity ratio. indicating that stockholders have financed most
▪ This ratio compares the amount of debt that is of the assets of the firm.
financed by stockholders and is calculated as ▪ Stockholders, on the other hand, may wish this
follows: ratio to be higher because that indicates that the
company is more highly leveraged and
stockholders can reap the return of the creditors’
financing.
LO-4 LO-4
Cornerstone 16.7
Calculating the Debt Ratio and the
Debt-to Equity Ratio
Profitability Ratios
▪ Investors earn a return through the receipt of
dividends and appreciation of the market value of
their stock.
▪ Both dividends and market price of shares are
related to the profits generated by companies.
▪ Since they are the source of debt-servicing
payments, profits also are of concern to creditors.
▪ Managers also have a vested interest in profits
LO-4 LO-5
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Profitability Ratios (cont.) Return on Sales

▪ Bonuses, promotions, and salary increases often ▪ Return on sales is the profit margin on sales.
are tied to reported profits. ▪ It represents the percentage of each sales dollar
▪ Profitability ratios, therefore, are given that is left over as net income after all expenses
particular attention by both internal and external have been subtracted.
users of financial statements. ▪ Return on sales is one measure of the efficiency
of a firm and is computed as follows:
LO-5 LO-5
Information for Information for

Cornerstone Calculations Cornerstone Calculations (cont.)
LO-5 LO-5
Cornerstone 16.8
Calculating the Return on Sales Return on Total Assets
▪ Return on assets measures how efficiently assets
are used by calculating the return on total assets
used to generate profits.
▪ Return on total assets and average total
assets is computed as follows:
LO-5 LO-5
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Cornerstone 16.9
Calculating the Average Total Assets
Return on Total Assets (cont.) and the Return on Assets
▪ By adding back the after-tax cost of interest, this
measure reflects only how the assets were
employed.
▪ It does not consider the manner in which they
were financed (interest expense is a cost of
obtaining the assets, not a cost of using them).
LO-5 LO-5
Return on Common Return on Common

Stockholders’ Equity (cont.) Stockholders’ Equity (cont.)
▪ Return on total assets is measured without regard ▪ The return on stockholders’ equity provides a
to the source of invested funds. measure that can be used to compare against
▪ For common stockholders, however, the return other return measures (e.g., preferred dividend
that they receive on their investment is of rates and bond rates) and is computed as follows:
paramount importance.
▪ Of special interest to common stockholders is
how they are being treated relative to other
suppliers of capital funds.
LO-5 LO-5
Cornerstone 16.10
Calculating the Average Common Stockholders’
Equity and the Return on Stockholders’ Equity Earnings Per Share
▪ Investors also pay considerable attention to a
company’s profitability on a per-share basis.
▪ Earnings per share is computed as follows:
▪ Average common shares outstanding is

computed by taking a weighted average of the
common shares for the period under study.
LO-5 LO-5
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Cornerstone 16.11
Computing Earnings Per Share Price-Earnings Ratio
▪ The price-earnings ratio is calculated as follows:
▪ Price-earnings ratios are viewed by many

investors as important indicators of stock values.
▪ If investors believe that a company has good
growth prospects, then the price-earnings ratio
should be high.
LO-5 LO-5
Cornerstone 16.12
Price-Earnings Ratio (cont.) Computing the Price-Earnings Ratio
▪ The price-earnings ratio should be interpreted

with caution since it is comprised of stock price,
which is a number that can be manipulated to
meet certain targets involving analyst
expectations, managerial bonuses, and other
organizational goals.
LO-5 LO-5
Dividend Yield and Payout

Dividend Yield and Payout Ratios Ratios (cont.)
▪ The profitability measure called dividend yield is ▪ The dividend payout ratio is computed as
computed as follows: follows:
▪ The payout ratio tells an investor the proportion of

▪ By adding the dividend yield to the percentage
earnings that a company pays in dividends.
change in stock price, a reasonable ▪ Investors who prefer regular cash payments instead of
approximation of the total return accruing to an returns through price appreciation will want to invest in
investor can be obtained. companies with a high payout ratio.
▪ Investors who prefer gains through appreciation will
generally prefer a lower payout ratio.
LO-5 LO-5
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Cornerstone 16.13
Computing the Dividend Yield and Importance of Profitability Ratios to
the Dividend Payout Ratio External Users
▪ Of course, for ratio analysis to be useful, it is
critically important that the underlying financial
information be accurate.
▪ The purpose of financial statements prepared for
outside users is to fairly represent the underlying
economic position of the firm.
LO-5 LO-5
Importance of Profitability Ratios to

External Users (cont.)
▪ A look back at the past five to 10 years shows
many instances where corporate leaders,
knowing the importance of various ratios, took
unethical steps to make the information fit the
desired ratio results rather than letting the ratios
come from fairly generated information.
▪ Enron is a good example.
LO-5
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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28/07/2018

Learning Objectives Learning Objectives (cont.)

Common-Size Analysis Common-Size Analysis

Percentage and Size Effects

Standards for Comparison Standards for Comparison (cont.)

Classification of Ratios Liquidity Ratios

Current Ratio Current Ratio (cont.)

Current Ratio (cont.) Current Ratio (cont.)

Accounts Receivable Accounts Receivable

Accounts Receivable Accounts Receivable

Cornerstone 16.4 Cornerstone 16.4

Using Ratio Analysis to Improve Cash

▪ This ratio tells an analyst how many times the

▪ A low turnover ratio may signal the presence of

LO-3 ▪ Debt-to-equity ratio LO-4

Cornerstone 16.6 Cornerstone 16.6

Debt Ratio Debt Ratio (cont.)

Debt-to-Equity Ratio Debt-to-Equity Ratio (cont.)

Profitability Ratios (cont.) Return on Sales

Information for Information for

Return on Common Return on Common

▪ Average common shares outstanding is

▪ Price-earnings ratios are viewed by many

▪ The price-earnings ratio should be interpreted

Dividend Yield and Payout

▪ The payout ratio tells an investor the proportion of

Importance of Profitability Ratios to

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