Financial and Managerial Accounting

Chapter 2
Company Performance Analysis
and Evaluation

Master of Business Administration[MBA]

International Leadership Institute

1
Aim of Financial Statement
Analysis

Analysis of financial statements can

examine:
– financial strengths and weaknesses,
– its credit worthiness,
– safety of funds invested in the firm,
– adequacy or otherwise of its earnings,
– ability to meet its obligations of firms.
Financial Analysis tools

Financial analysis tools are:

– Analyzing ratios or numerical
calculations
– Comparative Analysis
– trend analysis
– Common size analysis
Financial Analysis

What is financial analysis?

– Evaluating a firm’s financial performance
– Analyzing ratios or numerical calculations
– Comparing a company to its industry and to its
past performance
– A long-run trend analysis over a 5-10 year
period is usually performed by an analyst.
– Ratio analysis may not answer questions, but
leads to further inquiry
 Comparative Analysis

 Every item reported in a financial statement

has significance: Its inclusion indicates that
the item exists at a given time and in a
certain quantity.
 For example, if Iomega Corporation reports
$243.8 million on its balance sheet as cash, it
is known that Iomega did have cash and its
quantity was $243.8 million.

5 02/03/21
 Comparative Analysis

Three types of comparisons increase the

decision usefulness of financial information:
 Intra-company basis: Comparisons within a
company are often useful to detect changes in
financial relationships and significant trends.
 Industry averages: Comparisons with industry
averages provide information about a
company’s relative position with the industry.

7 02/03/21
 Comparative Analysis

 Intercompany basis: Comparisons with

other companies provide insight into a
company’s competitive position.

8 02/03/21
 Comparative Analysis

Three basic tools are used in financial

statement analysis to highlight the
significance of financial statement data:
 Horizontal analysis
 Vertical analysis
 Ratio analysis

9 02/03/21
 Horizontal and vertical
analysis

10 02/03/21
 Horizontal Analysis

 Horizontal analysis (also known as trend analysis)

is a technique for evaluating a series of financial
statement data over a period of time.
 The purpose of horizontal analysis is to
determine whether an increase or decrease has
taken place.
 The increase or decrease can be expressed as
either an amount, or a percentage of a base-year
amount.

11 02/03/21
 Horizontal Analysis

12 02/03/21
 Horizontal Analysis

13 02/03/21
 Horizontal Analysis

14 02/03/21
 Horizontal Analysis

15 02/03/21
 Horizontal Analysis: Balance Sheet

The comparative balance sheets show that a

number of changes occurred in Kellogg’s
financial position from 1996 to 1997.
 In the assets section, current assets
decreased $60.9 million, or 4.0%
($60.9 /$1,528.6), plant assets (net)
decreased $159.6, or 5.4%, and other assets
increased 8.2%.

16 02/03/21
 Horizontal Analysis: Income
Statement

Horizontal analysis of the income statements

shows these changes:
 Net sales increased $153.5, or 2.3%
($153.5  $6.676.6).
 Cost of goods sold increased $147.2, or
4.7%.
 Selling and administrative expenses
decreased $91.9, or 3.7%.

17 02/03/21
 Horizontal Analysis: Income
Statement

 Overall, gross profit increased $6.2 million,

or less than 1%, and net income increased
2.8%. The increase in net income can be
primarily attributed to the decrease in
selling and administrative expenses.

18 02/03/21
 Horizontal Analysis: Complications

The measurement of changes from period to

period in percentages is relatively
straightforward and quite useful. However,
complications can arise in performing the
computations.
 If an item has no value in a base year or
preceding year, no percentage change can be
computed.

19 02/03/21
 Vertical Analysis

 Vertical analysis is a technique for

evaluating financial statement data that
expresses each item in a financial
statement as a percent of a base amount.
 Total assets is always the base amount in
vertical analysis of a balance sheet.
 Net sales is always the base amount in
vertical analysis of an income statement.

21 02/03/21
 Vertical Analysis

 Vertical analysis shows the relative size of

each category on the financial statements.
 To further illustrate vertical analysis,
Kellogg’s 2-year condensed balance sheets
and income statements for 1996 and 1997
with vertical analysis percentages are shown
on the following two slides.

22 02/03/21
23 02/03/21
24 02/03/21
 Vertical Analysis: Balance Sheet

Note the following changes in Kellogg’s financial

position.
 Current assets decreased slightly from 30.3%
to 30.1% of total assets from 1996 to 1997.
Plant assets (net) decreased from 58.0% to
56.9% of total assets.
 Current liabilities went down from 43.5% to
34.0%, while long-term liabilities went up from
31.1% to 45.6% of total liabilities and
stockholders’ equity.
25 02/03/21
 Vertical Analysis: Balance Sheet

 Significantly, during the same year,

stockholders’ equity decreased from 25.4%
to 20.4%.
 Thus, the company shifted toward a heavier
reliance on debt financing, both by using
more long-term debt and by reducing the
amount of outstanding equity.

26 02/03/21
 Vertical Analysis: Income
Statement

Vertical analysis of the income statements

reveals:
 Cost of goods sold as a percentage of net
sales increased 1.1% (from 46.8% to 47.9%)
while selling and administrative expenses
decreased 2.2% (from 36.8% to 34.6%).
 Even with these changes, net income as a
percent of net sales remained the same, yet
net income actually increased $15 million.
27 02/03/21
 2.2. Ratios analysis

32 02/03/21
Objectives of Financial Analysis

Analysis of financial statements can

examine:
– financial strengths and weaknesses,
– its credit worthiness,
– safety of funds invested in the firm,
– adequacy or otherwise of its earnings,
– ability to meet its obligations of firms.
 Importance of Ratios
Which ratios are most important?
 It depends on your perspective.

– Suppliers and banks (lenders) are most

interested in liquidity ratios.
– Shareholders are most interested in profitability
ratios.
– Bondholders concentrate on debt utilization ratios
– The effective utilization of assets is
management’s responsibility.

34 02/03/21
Financial Analysis
Example

 Let’s see For MA Inc.: Balance Sheets and

Income statements for Years ending
December 31, 2010 and 2009 respectively
(Millions of Dollars. Except for per share
Data).
 Table 2-1a: MA Inc.: Balance Sheets for Years ending
December 31(Millions of Dollars. Except for per share Data).

ASSETS 2010 2009 LIABILITIES AND EQUITY 2010 2009

Cash and cash equivalents $10 $15 Accounts payable $60 30
Short-term investments 0 65 Notes payable 110 60
Account Receivable 375 315 Accruals 140 130
Inventories 615 415 Total current liabilities 310 220
Total current Assets 1000 810 Long-term bonds 754 580
Net Plant and equipment 1000 870 Total debt $106 800
4
Preferred stock (400,000 shares) 40 40
Common stock (50,000,000 shares) 130 130
Retained earnings 766 710
Total common equity 896 840
Total Assets $2000 $1680 Total liabilities and equity $2000 1680
Table 2-1b: MA Inc.: Income statements for Years ending
December 31(Millions of Dollars. Except for per share Data).

2010 2009
Net sales $3,000 $2850.0
Operating costs excluding depreciation and amortization 2,616.2 2497.0
Earnings before interest, taxes, depreciation, and amortization $383.8 $353.0
(EBITDA)
Depreciation 100 90.0
Amortization 0.0 0.0
Depreciation and amortization $100 90.0
Earnings before interest and taxes (EBIT, or operating income) 283.8 263.0
Less interest 88.0 60
Earnings before taxes (EBT) 195.8 203.0
Taxes (40%) 78.3 81.2
Net income before preferred dividends b 117.5 121.80
Preferred dividends 4.0 4.0
Net income $113.5 117.80
Common dividends $57.5 53.0
Addition to retained earnings $56.0 64.80
Per-share data:
Common stock price 23.00 26.00
Earnings per share (EPS) a 2.27 2.36
Dividends per share (DPS) a 1.15 1.06
Book value per share (BVPS) a 17.92 16.80
Cash flow per share (CFPS) a 4.27 4.16
The bonds have a sinking fund requirement of $20 million a year. The costs include lease
payments of $28 million a year. a There are 50,000,000 shares of common stock
outstanding. Note that EPS is based on earnings after preferred dividends — that is, on
net income available to common stockholders. Calculations of EPS, DPS, BVPS, and CFPS
for 2001 are as follows:
1. Profitability ratios:
 Measures management's overall effectiveness as
shown by returns of the period. They are:
i. Net Profit Margin
ii. Basic Earning Power (BEP) Ratio
iii. Return on Total Assets
iv. Return on Common Equity
 i. Net Profit Margin

 The net profit margin, which is also called the

profit margin on sales,

 Comments: As we compare with the industry

average the net profit margin is below…..
 ii. Basic Earning power(BEP) ratio
 Basic Earning power(BEP) is:

 Industry average=17%
 Comment:

41 02/03/21
iii. Return on Total Assets(Investment)

 The ratio of net income to total assets

measures the return on total assets (ROA)
after interest and taxes.

 Comments:
iv. Return on Common Equity

 The ratio of net income to common equity

measures the return on common equity
(ROE):

 Comments:
 2. Asset Utilization ratios

Measures the effective use of resources. They are

five:
i. Receivable turnover(RTO)
ii. Daily sales Outstanding (DSO)/ACP
iii. Inventory turnover(ITO)
iv. Fixed Asset turn over(FATO)
v.Total Asset turn over(TATO)
 i. Receivable Turnover

 Receivable turnover is calculated as sales on

credit divided by account receivable.

Industry average =6times

 Comment: MA collects its receivable faster than
does the industry.

45 02/03/21
 ii. The Days Sales Outstanding(DSO):
Evaluating of Receivables
 Days sales outstanding (DSO),also called the “average
collection period” (ACP), is used to appraise accounts
receivable, and it is calculated by dividing accounts receivable
by average daily sales to find the number of days’ sales that are
tied up in receivables.

 Comments:
iii. The Inventory Turnover Ratio:
Evaluating of Inventories
 The inventory turnover ratio is defined as
sales divided by inventories:

 Comments:
iv. The Fixed Assets Turnover
Ratio: Evaluating of Fixed Assets
 The fixed assets turnover ratio measures how
effectively the firm uses its plant and equipment. It
is the ratio of sales to net fixed assets:

 Comments:
v. The Total Assets Turnover
Ratio: Evaluating of Total Assets

 The total assets turnover ratio is calculated

by dividing sales by total assets:

 Comments:
 3. Liquidity Ratios

 Measures the firm's ability to meet short

term obligations. They are:
i. Current ratio
ii. Quick or Acid test ratio
 i. The Current Ratio

 The current ratio is calculated by dividing current

assets by current liabilities:

 Comments:
ii.The Quick, or Acid Test, Ratio
 The quick, or acid test, ratio is calculated by
deducting inventories from current assets and
then dividing the remainder by current liabilities:

 Comments:
4. Debt Utilization Ratios:

 Measures the extent of which the firm's

assets are financed by long term debt. They
are:
i. Total Liabilities to Total Assets
ii. Times -Interest-Earned Ratio
iii. EBITDA Coverage Ratio
i. Total Liabilities to Total
Assets: How the Firm is Financed
 The ratio of total liabilities to total assets is called
the debt ratio, or sometimes the total debt ratio.

 Comments:
Debt-to-equity ratio
 Creditors may be reluctant to lend the firm more
money because a high debt ratio is associated with a
greater risk of bankruptcy. Some sources report the
debt-to-equity ratio, defined as:

 Comments:
 Market debt ratio
 MA’s market value of equity is $23(50) = $1,150.
Often it is difficult to estimate the market value of
liabilities; so many analysts define the market debt
ratio as:

 Previous years MD ratio is 38.1%.

 Comments:
 ii. Times -Interest-Earned Ratio:
Ability to Pay Interest

 The times-interest-earned (TIE) ratio, also

called the interest coverage ratio.

 Comments:
 iii. EBITDA Coverage Ratio: Ability to
Service Debt

(1) Interest is not the only fixed financial charge —companies must also reduce
debt on schedule, and many firms lease assets and thus must make lease
payments. If they fail to repay debt or meet lease payments, they can be
forced into bankruptcy. (2) EBIT does not represent all the cash flow avail-
able to service debt, especially if a firm has high depreciation and/or
amortization charges. The EBITDA coverage ratio accounts for these
deficiencies:

Comments:
5. Market Value Ratios
 Market value ratios relate a firm’s stock price
to its earnings, cash flow, and book value per
share. Market value ratios are a way to
measure the value of a company’s stock
relative to that of another company. They are:
i. Price /Earnings Ratio
ii. Price/ Cash Flow Ratio
iii. Market/Book Ratio
i. Price /Earnings Ratio

 The price/earnings (P/E) ratio shows how much

investors are willing to pay per dollar of reported
profits.

 Comments:
ii. Price/ Cash Flow Ratio
 Stock prices depend on a company’s ability to
generate cash flows. Cash flow is defined as
net income plus depreciation and amortization.

 Comments:
 iii. Market/Book Ratio

 The ratio of a stock’s market price to its book value

gives another indication of how investors regard the
company.

 Comments:
Limitations of Financial Analysis

 Horizontal, vertical, and ratio analysis are

frequently used in making significant
business decisions.
 One should be aware of some of the
limitations of these tools and of the financial
statements on which they are based.
 Estimates

 Financial statements contain numerous estimates.

 Estimates are used, for example, in determining
the allowance for uncollectible receivables,
periodic depreciation, the costs of warranties,
and contingent losses.
 To the extent that these estimates are
inaccurate, the financial ratios and percentages
are also inaccurate.

64 02/03/21
 Cost
 Traditional financial statements are based on historical
cost and are not adjusted for price level changes.
 Comparisons of unadjusted financial data from
different periods may be rendered invalid by
significant inflation or deflation.
 Some assets such as property, plant, and equipment
might be many years old. The cost at which they are
shown on the balance sheet might be significantly lower
than current market value.

65 02/03/21
 End of the chapter
Thank You!

66 02/03/21