Professional Documents
Culture Documents
DauderisAnnand IntroFinAcct Chapter12
DauderisAnnand IntroFinAcct Chapter12
Chapter 12
Financial Statement Analysis
Created by:
1
Chapter 12 Learning Objectives
Created by:
2
Financial Statement Analysis
LO1 – Ratio Analysis – Liquidity, Profitability, leverage, and Market
3
Ratio Analysis
•Gross profit ratio – the relationship between gross profit (the
numerator) and sales (denominator):
A B C
Created by:
6
Ratio Analysis
• Qualitative factors such as possessing an adequate
capacity or the necessary equipment for ongoing
production also provides valuable insights. Notes to
the financial statement are a good source.
• One of the main purposes of ratio analysis is to
highlight areas that require further analysis and
investigation.
Created by:
7
Ratio Analysis
• There are four major types of financial ratios:
– Liquidity ratios – measure the ability to pay
current liabilities as they are due.
– Profitability ratios – measures the ability to
generate an adequate return on assets employed,
and shareholder investment.
– Leverage ratios – measures the business’s relative
debt and its long-term financial viability.
– Market ratios – measures financial returns to
shareholders and market perceptions of its value.
Created by:
8
Ratio Analysis
• Liquidity Ratios: Analyzing Short-term Cash Needs
– Net profit does not mean cash in the bank. Profitable
companies without sufficient cash are at risk of not
meeting their short-term obligations.
– First, let’s look at working capital:
Current
Assets Working
Capital Current Liabilities
(Debt)
Created by:
9
Ratio Analysis
• Working capital is the $-value difference between a
company’s current assets and current liabilities at a
point in time.
Created by:
10
Ratio Analysis
• Liquidity Ratios: Current ratio – expresses working
capital as a ratio: __Current Assets__
Current Liabilities
Created by:
11
Ratio Analysis
• Current ratio:
Created by:
12
Ratio Analysis
• Current ratio: Is a 2:1 benchmark enough?
• Composition of the current assets is important:
Created by:
14
Ratio Analysis
• Acid-Test Ratio: Also called the quick ratio, it
excludes the accounts that cannot be converted into
cash quickly:
OR
Current Assets – Inventory – Prepaid Expenses
Current Liabilities
Created by:
15
Ratio Analysis
Created by:
17
Ratio Analysis
Accounts Receivable Collection Period:
The company’s collection period is increasing and exceeds the n/30 credit period.
Created by:
18
Ratio Analysis
• Liquidity Ratios: Number of days of sales in
inventory – measures the number of days that can
be serviced by existing inventory levels.
• Measures the average number of days needed to
collect an amount due, compared to the collection
period (i.e. net 30 means due within 30 days).
Created by:
19
Ratio Analysis
Number of Days of Sales in Inventory:
2021 2020
Average number of days sales in inventory 98 days 73 days
Average number of days to collect receivables 55 days 44 days
Number of days to complete revenue cycle 153 days 117 days
Created by:
21
Ratio Analysis
• The number of days to complete the revenue
operating cycle has significantly increased from 117
days to 153 days. This is a 30% increase in the
number of days, from the previous year!
• If accounts payable terms are n/60 days, the
company will not be able to pay their suppliers,
because the number of days in the cycle exceeds the
60-day terms.
• Summary: It appears that Big Dog Carworks Corp. is
growing less liquid. Current assets, especially quick
assets, are declining relative to current liabilities and
the revenue operating cycle is increasing.
Created by:
22
Ratio Analysis
• Profitability Ratios: Gross profit ratio – percentage of
sales revenue left after cost of goods sold:
Gross Profit
Net Sales
Created by:
23
Ratio Analysis
• Gross profit ratios:
Created by:
24
Ratio Analysis
• Profitability Ratios: Operating profit ratio –
percentage of sales revenue left after cost of goods
sold and operating expenses: Income from operations
Net Sales
Created by:
25
Ratio Analysis
• Operating profit ratios:
+9% +34%
• Sales is not keeping pace with increases in cost of goods sold and
operating expenses, resulting in a significant deceleration of
increases from 34% to 9%.
Created by:
26
Ratio Analysis
• Profitability Ratios: Net profit ratio – percentage of
sales revenue retained after all expenses:
Net Income
Net Sales
Created by:
27
Ratio Analysis
• Net profit ratios:
Created by:
28
Ratio Analysis
• Profitability Ratios: Sales to total assets ratio – sales
earned relative to assets invested:
_____Net Sales_____
Average Total Assets
Assets
Created by:
29
Ratio Analysis
• Sales to total assets ratios:
• Both sales and average total assets have increased, but sales
has weakened relative to the amount of assets invested each
year.
• Assets are not producing revenue as effectively as in the past,
so further investigation is required.
• Industry averages would be useful.
Created by:
30
Ratio Analysis
• Profitability Ratios: Return on total assets ratio
(ROA) – efficiency of assets used to produce income
from operations: Income from Operations
Average Total Assets
Assets
Created by:
31
Ratio Analysis
• Return on total assets ratios:
Created by:
32
Ratio Analysis
• Profitability Ratios: Return on equity ratio (ROE) –
measures the return to shareholders in the form of
net income earned for the owners:
__Net Income__
Average Equity
Equity
Created by:
33
Ratio Analysis
• Return on equity ratios:
Created by:
34
Ratio Analysis
• Leverage Ratios: Analyzing Financial Structure
• Both shareholders and creditors have claims to a
portion of the company’s assets:
Assets = Liabilities + Equity
= Creditors + Shareholders
$2,486 = $1,255 + $1,231
Liabilities
Created by:
36
Ratio Analysis
Created by:
37
Ratio Analysis
• The equity ratio can also be calculated directly:
Total Equity
Total Assets
Created by:
40
Ratio Analysis
• Debt – Pros:
– Management’s reliance on creditor financing can be good because
issuing more shares to investors may weaken the percentage of
ownership and control of the existing shareholders.
– Existing shareholders may see creditor financing as a good decision if the
company can earn more with borrowed funds than the interest paid on
the debt.
• Debt – Cons:
– Management’s increasing reliance on creditor financing increases risk
because interest and principal must be paid.
– Interest rates can rise causing net income to decrease.
• Overall:
– There is no single most appropriate debt to equity ratio. There are
techniques to determine this, but this is beyond the scope of this course.
Created by:
41
Ratio Analysis
• Leverage Ratios: Times interest earned ratio – indicates the
company’s ability to pay interest to long-term creditors:
Income from Operations
Interest Expense
Created by:
43
Ratio Analysis
• Market Ratios: Earnings-per-Share (EPS) – measures
shareholders’ returns on a per-share basis:
_Net Income – preferred share dividends_
Number of Common Shares Outstanding
Created by:
46
Ratio Analysis
• Market Ratios: Dividend Yield – short-term cash
return expected from an investment in the
company’s shares:
__Dividend per share__
Market Price per Share
Created by:
48
Ratio Analysis
• Note that dividends declared increased over the past
three years, even though net income has remained
relatively flat and despite the company’s poor
liquidity position. Investors might ask why such high
levels of dividends are being paid in this situation.
Created by:
49
Ratio Analysis
• Overall Analysis:
• Ratio analysis is more useful if accompanied by overall
industry performance ratios, general economy indicators,
financial ratios from prior years, analysts’ opinions and
management’s plans.
• Although sales are increasing, net income has not kept
up.
• Gross profits are stable, but operating expenses appear to
be an issue.
• Income from operations has not kept up with the
increases in the asset base, including increases in current
assets.
Created by:
50
Ratio Analysis
• Shortage of working capital and poor liquidity is an
immediate concern. The company should review its
credit policies and monitor its inventory levels to
ensure that these stay in line with sales.
• The plant expansion caused an increase in current
liabilities due to increased borrowings. As a result,
its ability to meet its debt obligations is weakening.
• The ability of income to cover interest expense has
also weakened.
Created by:
51
Ratio Analysis
• The company should investigate alternatives to short-
term borrowings, such as converting some to long-
term debt, and/or issuing additional share capital to
retire some of its short-term debt obligations.
• Despite the shortcomings above, the stock market
price indicates that it expects the company to
continue to increase its profits in the future. Perhaps
the negative ratios are only temporary or easily
rectifiable by management.
Created by:
52
Chapter 12 Learning Objectives
LO2 – Horizontal and Vertical Trend Analysis
Created by:
53
Financial Statement Analysis
Created by:
54
Horizontal Analysis
• Alternatively, horizontal analysis is to calculate the
percentage change between two years:
Created by:
55
Vertical Analysis
• Vertical analysis requires the financial statement to
be restated as percentages of a base dollar amount.
• For income statement analysis, sales is the base
dollar amount as 100%. For balance sheet analysis,
total assets, total liabilities and equity are used as
the base amounts.
• When financial statements are converted to
percentages, they are called common-size financial
statements.
Created by:
56
Vertical Analysis
Created by:
57
References
All clip-art was retrieved from http://openclipart.org on
Sept 6, 2016.
Slide 6: https://openclipart.org/detail/78121/apple
Slide 6: https://openclipart.org/detail/202259/green-apple
Slide 6: https://openclipart.org/detail/88669/orange
Slide 7: https://openclipart.org/detail/202768/puzzle-pieces-with-magnifying-glass
Slide 9: https://openclipart.org/detail/70183/mortgage
Slide 14: https://openclipart.org/detail/169757/check-and-cross-marks
Created by:
58