Financial Statement Analysis

FINANCIAL ACCOUNTING
FINANCIAL STATEMENT ANALYSIS
Applying analytical tools to financial data in order to assess how successfully has the
company performed relative to its own past performance, its competitors and forecasts future
performance.
Example:
1
Reasons for Financial Statement Analysis

1. Valuing Equity Securities
2. Assessing Credit Risk
3. Conducting Due Diligence Related to an Acquisition
4. Assessing performance of a subsidiary
Emphasis on Growth
Equity Analysis Owner’s Perspective

Credit Analysis Creditor’s Perspective
Emphasis on Risk
2
Preliminary Tasks for Financial Statement Analysis Process

1. Purpose of Analysis
2. Level of detail required
3. Available Data
4. Influencing Factors
5. Desired Outcome
6. Analytical limitations and if they impair the analysis
 Distinguishing between Computation and Analysis?
3
Ways of Analysis
1. Cross Sectional Analysis – Comparison with other companies
2. Trend/ Time Series Analysis – Comparison across time periods
Analysis Tools and Techniques

1. Ratios
2. Common Size Statements – expressing financial data in entire financial statement in
relation to a single financial item
For example, expressing each item of income statement as a percentage of sales or
expressing each item of balance sheet as a percentage of total assets
1. Use of Graphs
2. Regression Analysis
4
Ratios
 Express one quantity in relation to other
 Reduce effect of size that improves comparison
 Differences in accounting policies can distort ratios and adjustments may be required
 All ratios are not relevant. Selecting the relevant ratio requires skill.
 Ratio Analysis doesn’t stop with computation, it requires interpretation
Purpose of Ratios
 Microeconomic Relationships
 Company’s Financial Flexibility
 Management’s Ability
5
Categories of Financial Ratios

1. Activity Ratios How efficiently company performs day to day tasks, such as
collection of receivables and management of inventory
2. Liquidity Ratio Company’s ability to meet short-term obligations
3. Solvency Ratios Company’s ability to meet long-term obligations
4. Profitability Ratios Company’s ability to generate profitable sales from available

resources (assets)
5. Valuation Ratios Measure the quantity of an asset or flow (e.g., earnings)

associated with ownership of a specified claim (e.g., a share or
ownership of the enterprise) 6

1. Activity Ratios – how efficiently company performs day to day tasks
 Asset Utilization Ratios or
 Operating efficiency Ratios
 Indicator of ongoing operational performance
i. Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

ii. Days of Inventory on Hand (DOH) = No. of days in period / Inventory Turnover
 Used to indicate the level of effectiveness of inventory management

 High Inventory Turnover Low DOH Highly Effective Inventory Management
 Low Inventory Turnover High DOH Slow moving inventory Due to
Technological Change in Fashion

Obsolescence 7

1. Activity Ratios
iii. Receivable Turnover Ratio = Revenue / Average Receivables
iv. Days of Sales Outstanding (DSO) = No. of days in period / Receivable Turnover
Time elapsed between a sale and cash collection
 Used to indicate the level of effectiveness/efficiency of receivables management

 High Receivable Turnover Low DSO Highly Efficient Cash Collection
 High Receivable Turnover May also be due to strict credit policies that may result in lost sales
 Low Receivable Turnover High DSO Slow cash collection that may result in bad debts
 Ageing of Receivables along with DSO may help analyze trend of Receivables
8

1. Activity Ratios
v. Payables Turnover Ratio = Purchases / Average Trade Payables
how many times the company pays to its suppliers
vi. No. of Days Payment Outstanding (DPO) = No. of days in period / Payable Turnover
Average number of days company takes to pay its suppliers
 Used to indicate the level of effectiveness/efficiency of cash management

 High Payable Turnover Low DPO Company is not making full use of available credits
 High Payable Turnover May also be due to taking early payment discounts
 Low Payable Turnover High DPO Trouble in making payments

 Low Payable Turnover May also be due to availing lenient supplier terms
• Hence, only high/low payables turnover may not indicate effective management
• Better to analyze terms of credit along with the payable turnover and DPO
9

1. Activity Ratios
vii. Working Capital Turnover Ratio = Revenue / Average Working Capital
 How efficiently the company generates revenue from its working capital
 High Turnover indicates greater efficiency
viii. Fixed Assets Turnover Ratio = Revenue / Average Total Fixed Assets
 How efficiently the company generates revenue from its investment in fixed assets
 Turnover ratio may also be affected by factors other than efficiency.
For example, assets are new or old
10

1. Activity Ratios – Focus of Efficiency
ix. Total Assets Turnover Ratio = Revenue / Average Total Assets
 Company’s overall ability to generates revenue from its overall level of assets
2. Liquidity Ratios – Focus on Cash Flows

i. Current Ratio = Current Assets / Current Liabilities
 Higher Ratio ----------- Higher Liquidity
 Lower Ratio implies Lower Liquidity
o Greater reliance on operating cash flows and outside financing to meet short term obligations
ii. Quick Ratio = (Cash + Short Term Marketable Investments + Receivables) / Current Liabilities
 More conservative than current ratio
 Higher ratio indicates greater liquidity
 This ratio reflects that prepaids are costs paid in advance and will not convert into cash
 It reflects that inventory may not be easily convertible into cash
11

2. Liquidity Ratios
iii. Cash Ratio = Cash + Short Term Marketable Investments / Current Liabilities
 Most reliable measure of liquidity into liquidity crises
 However, in general market crises when marketable securities significantly decline in value , even this measure
is unable to provide reliable information
iv. Defensive Interval Ratio (DIR) = (Cash + Short Term Marketable Inv. + Rec) / Daily Cash Expenditure
 How long the company can pay its expenses from existing liquid assets without receiving any additional cash
inflows
 DIR of 50 means company can continue to pay its operating expenses for 50 days before running out of quick
assets
 Higher DIR indicates greater liquidity
v. Cash Conversion Cycle / Net Operating Cycle = DOH + DSO - DPO

 The time between outlay of cash and collection of cash
 Shorter cash conversion cycle indicates greater liquidity
12

3. Solvency Ratios – Company’s ability to meet its long-term obligations
 Analysis of company’s use of debt is important because Company’s capital structure is important for
assessing the company’s risk and return characteristics
a) Debt Ratios Focus on Balance Sheet

b) Coverage Ratios Focus on Income Statement
a) Debt Ratios – Focus on Balance Sheet
i. Debt to Assets Ratio/Total Debt Ratio = Total Debt* / Total Assets

Total Debt* = Short-term + Long-term interest bearing debt/liabilities
 Percentage of total assets financed with debt
 Higher ratio means higher financial risk and weaker solvency
13

3. Solvency Ratios
a) Debt Ratios
ii. Debt to Capital Ratio = Total Debt / (Total Debt + Total Shareholder’s Equity)
 Percentage of company’s capital (Debt + Equity) represented by debt
 Higher ratio means higher financial risk and weaker solvency
iii. Debt to Equity Ratio = Total Debt / Total Equity

 Amount of debt capital relative to its equity capital
 Ratio of “1”means equal contribution of debt and equity in total capital
 Higher ratio means greater financial risk and weaker solvency
14

3. Solvency Ratios
a) Debt Ratios
iv. Financial Leverage Ratio =Average Total Assets / Average Total Equity
 Amount of Total assets for each money unit of equity
 For example, value of $3 means that every $1 of equity support $3of assets. That means that company will be
needing debt to finance the assets in excess of equity. Hence, higher ratio means higher leverage.
b) Coverage Ratios – Focus on Income Statement
i. Interest Coverage Ratio = Earning Before Interest and Taxes (EBIT) / Interest Payments
 No. of times a company’s EBIT could cover interest payments
 Higher ratio indicates stronger solvency
15

3. Solvency Ratios
b) Coverage Ratios – Focus on Income Statement
ii. Fixed Charge Coverage Ratio = (EBIT + Lease Payments) / Interest Payments + Lease Payments
 No. of times a company’s earnings (before interest, taxes & lease payments) can cover the company’s interest
and lease payments
 Sometimes, used as an indication of preferred dividend, i.e. higher ratio indicating more secure preferred
dividends
4. Profitability Ratios – measure return earned by the company during a period
a) Return on Sales
b) Return on Investments
16

4. Profitability Ratios
a) Return on Sales
i. Gross Profit Margin = Gross Profit / Revenue

 Percentage of Revenue available to cover operating and other expenditures
 Higher Gross Profit Increase in Price Decrease in Cost
o i.e. competitive advantage over cost
ii. Operating Profit Margin = Operating Income / Revenue

 Increase in operating margin greater than gross margin indicates improvement in controlling operating
costs
iii. Pretax Margin = Earning Before Taxes (EBT) / Revenue

 Reflects effects of leverage and other non-operating incomes and expenses on profitability
iv. Net Profit Margin = Net Income / Revenue

 Offers a better view of company’s future profitability
17

4. Profitability Ratios
a) Return on Investments
i. Return on Assets (ROA) = Net Income / Average Total Assets
ii. Return on Total Capital = EBIT / STD + LTD + Equity
iii. Return on Equity = Net Income / Average Total Equity
iv. Return on Common Equity = Net Income – Preferred Dividends / Average Common Equity
18

5. Integrated Financial Ratios
 DuPont Analysis – The Decomposition of ROE = NI / Average Total Equity into components
 ROE is the product of these components because each component is an indicator of performance that
effects ROE
 It is useful in determining reasons for changes in ROE over time and among companies
19

5. Integrated Financial Ratios
 DuPont Analysis
ROE = ROA x Leverage
= NI/Average Total Assets x Average Total Assets/Average Share Holders Equity
Further Decomposing ROA = Net Profit Margin x Assets Turnover

Profitability Efficiency Solvency
ROE = Net Profit Margin x Assets Turnover x Leverage
= NI/Revenue x Revenue/Avg. Total Assets x Avg. Total Assets/Avg. SHE
Further Decomposing NPM = Tax Burden x Interest Burden x EBIT Margin

ROE = Tax Burden x Interest Burden x EBIT Margin x Assets Turnover x Leverage
ROE = NI/EBT x EBT/EBIT x EBIT/Revenue x Revenue/Avg. TA x Avg. TA/Avg. SHE
 Lower Tax Burden Higher Tax Rate Lower Profits 20

6. Valuation Ratios and Related Quantities
 One application of Financial Statement Analysis is to select securities as part of portfolio management process
a) Valuation Ratios
i. Price Earning Ratio (P/E) = Price per share / Earning per share
 How much and investor in common stock pays per dollar of current earnings
 Calculated based on net income , hence, the ratio can be sensitive to non-recurring earnings or one-off events
ii. Price to Cash Flow Ratio (P/CF) = Price per share / Cash flow per share
 Alternative measure, particularly where earning quality is an issue as net income is generally considered to be
more susceptible to manipulation than cash flows
21

a) Valuation Ratios
iii. Price to Sales Ratio (P/S) = Price per share / Sales per share
 Sometimes used as a comparative price metric when a company does not have positive net income
iii. Price to Book Value Ratio = Price per share / Book value per share
 This ratio is often interpreted as an indicator of market judgement about the relationship of a company’s
required rate of return and its actual rate of return
22

b) Per Share Quantities
i. Basic EPS = Weighted average number of

Net income – preferred dividends
common shares outstanding
Adjusted income available for Weighted average number of

ii. Diluted EPS = ordinary shares, reflecting ordinary and potential ordinary
conversion of dilutive securities shares outstanding
iii. Dividends per share = Common dividends Weighted average number of

declared common shares outstanding
23
b) Dividend-Related Quantities
Net income
i. Dividend payout ratio = Common share dividends attributable to
common shares
Net income attributable to Net income

ii. Retention Rate (b) = common shares – attributable to
Common share dividends common shares
iii. Sustainable growth rate (g) = Retention Rate (b) ROE
 A Company’s sustainable growth rate is viewed as a function of its profitability (ROE) and its
ability to finance itself from internally generated funds (retention rate) 24

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FINANCIAL ACCOUNTING

Reasons for Financial Statement Analysis

Equity Analysis Owner’s Perspective

Preliminary Tasks for Financial Statement Analysis Process

 Distinguishing between Computation and Analysis?

Analysis Tools and Techniques

Categories of Financial Ratios

2. Liquidity Ratio Company’s ability to meet short-term obligations

3. Solvency Ratios Company’s ability to meet long-term obligations

4. Profitability Ratios Company’s ability to generate profitable sales from available

5. Valuation Ratios Measure the quantity of an asset or flow (e.g., earnings)

Categories of Financial Ratios

i. Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

 Used to indicate the level of effectiveness of inventory management

Technological Change in Fashion

Categories of Financial Ratios

Time elapsed between a sale and cash collection

 Used to indicate the level of effectiveness/efficiency of receivables management

Categories of Financial Ratios

 Used to indicate the level of effectiveness/efficiency of cash management

 Low Payable Turnover High DPO Trouble in making payments

Categories of Financial Ratios

Categories of Financial Ratios

2. Liquidity Ratios – Focus on Cash Flows

Categories of Financial Ratios

v. Cash Conversion Cycle / Net Operating Cycle = DOH + DSO - DPO

Categories of Financial Ratios

a) Debt Ratios Focus on Balance Sheet

a) Debt Ratios – Focus on Balance Sheet

i. Debt to Assets Ratio/Total Debt Ratio = Total Debt* / Total Assets

Categories of Financial Ratios

iii. Debt to Equity Ratio = Total Debt / Total Equity

Categories of Financial Ratios

b) Coverage Ratios – Focus on Income Statement

Categories of Financial Ratios

b) Coverage Ratios – Focus on Income Statement

4. Profitability Ratios – measure return earned by the company during a period

Categories of Financial Ratios

i. Gross Profit Margin = Gross Profit / Revenue

ii. Operating Profit Margin = Operating Income / Revenue

iii. Pretax Margin = Earning Before Taxes (EBT) / Revenue

iv. Net Profit Margin = Net Income / Revenue

Categories of Financial Ratios

i. Return on Assets (ROA) = Net Income / Average Total Assets

ii. Return on Total Capital = EBIT / STD + LTD + Equity

iii. Return on Equity = Net Income / Average Total Equity

Categories of Financial Ratios

Categories of Financial Ratios

Further Decomposing ROA = Net Profit Margin x Assets Turnover

Further Decomposing NPM = Tax Burden x Interest Burden x EBIT Margin

Categories of Financial Ratios

Categories of Financial Ratios

Categories of Financial Ratios

b) Per Share Quantities

i. Basic EPS = Weighted average number of

Adjusted income available for Weighted average number of

iii. Dividends per share = Common dividends Weighted average number of

Net income attributable to Net income

iii. Sustainable growth rate (g) = Retention Rate (b) ROE

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