Chapter 5 Financial Statement

Analysis
Objectives
After completing this chapter, the student should be able
to:
1. List and described the five basic management
questions that ratio analysis addresses.
2. Evaluate the financial performance of a pharmacy
using ratio analysis, common size statements, and the
Du Point Model of Profitability. Based on this analysis,
suggest ways to improve the pharmacy’s financial
performance.
3. Explain the differences between solvency and liquidity
between profitability and return on equity, and
4. Define, calculate and interpret the performance ratios
used by managed care organizations
Financial Analysis
• Two techniques:
1. Ratio analysis
2. Common size statements
Ratio Analysis
• a method of using income statement and balance sheet data
to detect trends and problems in the business
• It can be used to inventory and credit management problems,
for pricing policies, in checking declining sales and improving
profitability
5 Insights from Ratio
Analysis
1. Does the business earn adequate profits?That is, does it earn
as much as other firms in the same type of business and
having the same financial resources?These are tests of
profitability.
5 Insights from Ratio
Analysis
2. Are funds available to the business and its management
being used wisely? In this context, funds include debt and
equity. Debt consists of funds borrowed by the business.
Equity consists of funds that the owners have invested in
the business. Ratios used to answer this question are
referred to as tests of overall performance.
5 Insights from Ratio
Analysis
3. Can the firm pay its short term debts as they come due? This
is referred to as liquidity. A firm that can pay short-term
debts on time is said to have adequate liquidity.
5 Insights from Ratio
Analysis
4. Can the firm pay its long term debts as they come due?This is
referred to as solvency.
5 Insights from Ratio
Analysis
5. How efficiently are the firm’s assets being managed? An
efficiently run pharmacy will minimize the assets, such as
inventory and accounts receivable, which it needs to
generate a given level of sales and income
Test of Profitability
• Test of profitability indicate the pharmacy’s ability to cover its
expenses plus some excess to reward its owners (profit).
• Two ratios measure profitability: gross margin percent and
net income percent.
Gross Margin Percent
• Is a measure of the profitability of the pharmacy before
operating expenses are considered. It tells the percent of
every dollar of sales that is available to cover operating
expenses and profit.
• It is calculated as:
GM%=(Sales-COGS)/Sales x 100%
where COGS=cost of goods sold
Gross Margins
• Pharmacies earn higher gross margins when
they charge higher prices or buy merchandise
less expensively. Lower gross margins might
result from any of the following:
1. Low prices
2. Improper purchasing – the cost of goods sold
could be too high due to not taking cash
discounts or not purchasing from the least
expensive suppliers.
3. Shoplifting or other theft.
4. Owner or employees not ringing up sales.
Gross Margins
Gross margins of typical independently owned pharmacies:
23 to 24%
HMO pharmacies, mail-order pharmacies, and hospital
pharmacies typically have higher gross margins because they
are able to negotiate larger discounts and rebates from drug
manufacturers.
Net Income Percent
• The NI% is referred to as the net profit margin. It is a measure
of profitability after expenses are considered.
• The NI% is calculated as :
NI%= Net income/Sales x100
Net Income Percent
The net income percent may be increased by increasing the
gross margin percent which would require raising prices or
purchasing goods at lower cost, or by decreasing expenses.
Compare net income% calculation to the same type as there are
NI before and after taxes and NI before taxes and before
interest payments
Tests of Overall Performance
• Indicate how effectively funds available to the manager
have been used .
• Two types:
1. Return on equity
2. Return on assets
Return on Equity
• ROE
• Also known as return on investment (ROI)
and Return on net worth (RONW)
• ROE measures how effectively funds invested in
the firm by its owners or stockholders have been
used . For investors, this is an indicator how
much they would earn if they invest on the
business.
• ROE= Net income/Owner’s equity x 100
As with income percent, ROE can be calculated
with net income before and after taxes.
ROE
• ROE can be improved in two ways:
1. By increasing the pharmacy’s net income. If the unit
volume of sales can be maintained, then net income
can be increased by raising prices or by lowering
expenses.
2. ROE can be improved by decreasing owner’s equity.
This may be accomplished by operating the business
with more debts and less owner investment. That is
the owner can borrow more of the funds needed to
run the business and use less capital.This is known as
leverage.
ROE
Pharmacies that have high financial leverage operate with
much debt and little owner investment. This will
produce higher levels of ROE for a given net income, but
it is also risky.

Owner’s equity can also be decreased by

decreasing assets. If the manager is able to operate the
pharmacy using less cash , accounts receivable,
inventory of fixed assets, then less owner’s investment
is needed. For most pharmacies, the most reasonable
way is to increase ROE is to carry less inventory or
accounts receivable,
Return Assets
• This ratio measures how effectively all funds available to the
manager, both debt and equity have been used.
• ROA is a better indicator of a manager’s performance than
ROE because it considers all funds at the manager’s disposal,
not just invested funds.
• ROA is calculated as:
ROA= Net income/total assets x 100
ROA
• ROA may be improved by increasing net income
or by decreasing total assets. Increasing
borrowing will have no effect.
• As with ROE, the most likely method by which
pharmacies can improve ROA is to decrease
investment by proper management of accounts
receivable and inventory.
• ROE and ROA are regarded as the best measures
of overall performance of a firm. They consider
not only the firm’s profit but the amount of
investment needed to generate those profits.
Test of Liquidity
• Measures the firm’s ability to pay its current debt as it comes
due.
• Current Ratio
• Quick Ratio
• Accounts payable period
Current Ratio
• Compares a pharmacy’s current assets which supply the cash
to pay current debts. Creditors such as bankers or
wholesalers (who supply the pharmacy with merchandise on
credit) are interested in this ratio because it measures the
pharmacy’s ability to repay them on time.
CR= current assets/current liabilities
Current Ratio
• Creditors prefer high current ratios. The current ratio should
be between 2 to 3.8. A lower ratio indicates that the
pharmacy may have problems paying current debts on time. A
ratio greater than 3.8 suggests that the pharmacy has too
much invested in current assets.
Quick Ratio
• or acid ratio is similar to current ratio but is a more
stringent test of the firm’s liquidity,
QR= (current asset-inventory)/current liability
The ratio measures the excess of very liquid current assets-
cash and accounts receivable to current liabilities. The
ratio takes the perspective of whether the firm could pay
its current debts if it were not able to sell its inventories.
The quick ratio should be between 1.1 and 2.
Pharmacies can operate with lower quick ratios than
other businesses because their inventories are composed
of merchandise that sells quickly as compared with say
cars and appliances.
Accounts payable period
• APP indicates how long it takes the pharmacy to pay for
its credit purchases.
• It is the average number of days between when a
pharmacy makes a purchase and when it pays for the
purchase
APP= accounts payable/purchases per
day
The amount of annual purchases is frequently not shown
on the income statement or balance sheet . However, it
can be calculated from the available information using
the following formula:
COGS= BI+P-EI
Working Capital
• Is a measurement used to expressthe relationship between
current assets and current liabilities.
• Working capital is the excess of current assets over current
liabilities
Solvency Tests
• Solvency ratios measure the business ability to meet the long
term debt payments. They are also called debt-to-equity
ratios because they compare the amount the pharmacy has
borrowed to the amount its owners have invested.
Debt
• Debt refers to funds that have been lent to the
business which must be paid accordingly
according to a set schedule regardless of
whether or not the firm is profitable.
• Debt is a risky method of raising funds to finance
a business but on the other hand , it confers no
ownership of business to the lender. The owner
is required to repay only the debt and interest.
Equity
• Refers to funds that have been invested in the business. It
does not have to be repaid. It gives the investor ownership of
part of the business.
Solvency Ratios
Current liabilities to owner’s equity:
CL/OE x100
Long term debt to owner’s equity:
LT debt/OE x 100
Total debt to owner’s equity:
Total debt/OE x 100
Financial leverage= (total liabilities+OE)/OE
Solvency tests
• Lenders, such as bankers prefer that pharmacies have
low debt to equity ratios. This indicates that the
owner’s have more invested capital in the business than
does the lender, so the owners should have a strong
incentive to do well
• A rule of thumb suggests that total debt to owner’s
equity should be 80% or less. This rule must be
interpreted loosely because of the relationship between
a pharmacy’s age and debt level.
• New pharmacies typically have higher solvency ratios
than older ones because of the debt associated with
starting a business. Over time, a successful pharmacy
will make profits that it can use to repay debt or increase
owner’s equity . This reduces the solvency ratios.
Tests of Efficiency
• These ratios measure how efficiently the pharmacy’s assets
are used . Efficient use involves generating a given level of
activity-such as sales, medication orders dispensed, or
consultations with the smallest possible investment in assets
• Efficient use also means making maximum use of available
assets.
Accounts receivable collection
period
• ARCP is an estimate of the average number of days it
takes the pharmacy to collect an account receivable. It
estimates the average number of days between when a
charge sale is made and when payment for the sale is
collected.
ARCP= AR/Net credit sales per day
Net credit sales is the same as net sales if the firm bills
customers who do not pay in cash.
• This rule of thumb states that the ARCP should be no
greater than 1.5 x the firm’s credit terms
• Longer period indicate poor credit management. They
also suggest that many of the pharmacy’s customers are
not paying on time.
Inventory Turnover
• Measure the movement of inventory. It indicates how
quickly inventory is purchased, sold and replaced.
ITO=COGS/ave. inventory at cost

Average inv. Is calculated using inventory levels at the beg.

and end of the year.
• A high inventory turnover is desirable. It indicates that the
pharmacy is being run with a minimum investment in
inventory
• If inventory turnover is too high, the pharmacy may
frequently find itself out of stock.
• Inventory turnover may be increased by either increasing
sales without increasing inventory or by decreasing
inventory and maintaining the same volume of sales.
Asset turnover
• Measures how efficiently the pharmacy’s total assets
are used. ATO is calculated by dividing the
pharmacy’s sales for the year by its total assets.
ATO= Sales/total assets

• A high ATO is desirable . It indicates that the

pharmacy is being operated with a minimum
investment in assets.
• ATO can be improved by increasing sales while
holding asset investment constant or by decreasing
asset investment while increasing or maintaining
sales.
Test of Efficiency for Institutional
Pharmacy
• Measures of overall performance, liquidity and solvency
are not applicable to most institutional pharmacies. Tests
of efficiency are used to assess the performance of these
pharmacies.
• Includes inventory turnover ratio
• Other measures of efficiency:
1. Drug expense per patient day
2. Personnel expense per patient per day
Personnel Expense Per patient
Day
• The efficiency with which personnel are utilized
is measured by the personnel expense per
patient day ratio. The ratio is calculated by:
Personnel expense per patient day=
Total annual pharmacy payroll/annual patient
days
Annual patient days is a measure of workload
based on the number of patient’s treated and
their average length of stay in the hospital. A
patient in the hospital for 1 day would equal 1
patient day. Ten patients in the hospital for 5
days each would equal 50 patient days.
Drug Expense per patient Day
• The efficiency with which pharmaceutical expenditures are
managed is measured by the drug expense per patient day
ratio. The ratio is calculated as:
Drug expense per patient day=
Total annual drug expense/annual patient days
Managed Care Pharmacy Ratios
1. Per member per month (PMPM) drug expense. This
ratio is used to measure and track the amount that
managed care organization spends on prescriptions. It is
calculated as follows:
PMPM drug expense=
Total drug expense for the month/total no. of MCO
members for the month
• This ratio indicates the average drug expenditure per
MCO member for a month.
• An increasing ratio over time indicates that the MCO
may be doing a poor job of controlling drug costs.
GFR
2. Generic fill ratio measures the extent to which
generic drugs, rather brand name products are
dispensed. This ratio is calculated as:

GFR= no. of prescriptions dispensed with

the generic product/total no. of Rx
dispensed
Encourage pharmacies to use generic drugs
because it lowers drug expenses.
Interpreting Ratios
• Ratios are meaningful only when compared to
some standard. There are two commonly used
standards.
1. The pharmacy’s ratio for the past years.
Comparison of the present year’s ratio to past
years identifies trend indicating whether the
pharmacy’s performance is improving or
deteriorating (internal benchmarking).
2. The second standard is the ratios of other
pharmacies of the same type (External
benchmarking)
Cautions
• Ratio analysis is a diagnostic technique. A
thorough ratio analysis will identify a pharmacy’s
problems and their probable causes but give
little information about how to solve the
problems.
• Limitations of balance sheets and income
statements data from which ratios are based.
Example fixed assets are valued at historical
costs rather than at their replacement costs.
Du Pont Model of Profitability
• Provides another way of assessing a pharmacy’s
financial performance. It has the advantage of
showing how the various ratios and their
components interact to determine the
pharmacy’s overall performance. The Du Pont
Model assumes that the best measure of
performance for a business is ROE. In the Du
Pont Model, ROE is
ROE= NI% x ATO x Financial leverage
The 3 components of profitability are Net
profitability, asset turnover, and financial
leverage.
Du Pont Model
• https://corporatefina
nceinstitute.com/res
ources/knowledge/fi
nance/dupont-analys
is/
• DuPont analysis is
one of many metrics
used to evaluate
companies.
The Accounting Cycle
1. Analysis of transactions
2. Journalizing
3. Posting
4. Preparation of the unadjusted trial balance
5. Adjusting entries
6. Preparation of the adjusted trial balance
7. Preparation of the 3 financial statements
8. Closing entries
9. Computation of financial ratios
10. Analysis and interpretation of business performance
Common Size Statements
• The performance of the pharmacy can be compared with
other pharmacies or with past years’ performance to
obtain more useful information.
• The comparison are simplified by restating each item on
the income statement and balance sheet as a percent of
sales.
• After making these changes, statements for pharmacies
with different sales volumes, assets and liabilities can be
more easily and directly compared. Such financial
statements are called common size statements
• Common size income statements are used to compare
expenses and profits.
• Common size balance sheets are used to compare levels
of current and fixed assets and source of financing.
Common Size Statements
Vertical Analysis
• Convert the balance sheets and income statement into
common size statements
• By restating each item on the income statement and
balance sheet as a percent of sales.
• After making these changes, statements for pharmacies
with different sales volumes, assets and liabilities can be
more easily and directly compared.
• Common size income statements are used to compare
expenses and profits.
• Common size balance sheets are used to compare levels
of current and fixed assets and source of financing.
• Compute for the year and compare with industry figures,
competitors or other divisions of the same company
Common Size Statements
Horizontal Analysis
• Compute ratios and convert to common size
statements financial statements covering two or
more periods:
e.g. 2004 2005 2006 2007
• Sales trends over a 5 year period, calculating
percentage change from one year to the next.
• Do the same for COGS and Net Income
• These figures can be compared with industry
trends, those of competitors or other divisions of
the same company.
Trend Percentages
• Changes in financial statement items from a base year to
following years show extent and direction of change.
• Two steps are necessary:
1.Select a base year
2.Express each item in the financial statement for the following
years as percentage of its base year amount
Trend Percentages
Dollar 2005 2004 2003 2002 2001 2000
Amounts
Sales $450,000 $360,000 $330,000 $321,000 $312,000 $300,000
Net 22,950 14,550 21,450 19,200 15,600 15,000
Income
Trend % 2005 2004 2003 2002 2001 2000
Sales 150% 120% 110% 107% 104% 100%
Net 153 97 143 128 104 100
Income
Trend Percentages
• The trend percentages indicate a modest growth
in sales in the early years and accelerated
growth in 2004 and 2005
• Net income shows an increasing growth trends
with the exception of the year 2004, when net
income decline despite solid increase in sales.
The problem was overcome in 2005 with a sharp
rise in income.
• Overall the trend percentages give a picture of
profitable growing enterprise.
Component Percentages
• Indicate the relative size of each item included in a total.
• Each item in the balance sheet could be expressed as a
percentage of total assets. This shows quickly the
relative importance of each type of assets as well as the
relative amount of financing obtained from current
creditors, long term creditors and stockholders.
• Computing component percentages fo several successive
balance sheets shows which are increasing in importance
and which are becoming less significant
Condensed Income Statement
and Common Size Form

2005 2004 2005 2004

Net Sales $1,000,000 $600,000 100.0% 100.0%
Cost of Goods 700,000 360,000 70.0 60.0
Sold
Expenses 250,000 180,000 25.0 30.0
(includes
income taxes)
Net Income $50,000 $60,000 5.0% 10.0%
Quality of Earnings
• Interest not only on total amount of earnings but also on the
rate of earnings on sales, on total assets, on owner’s equity
• Stability and source of earnings-not for erratic earnings vs
steady earnings. Increasing earnings vs flat earnings
• Report breakdown of sales and earnings by product lines and
geographical areas
Quality of Earnings
• Check method of accounting used by management whether
high quality (conservative measurement) or low quality (tends
to inflate reported earnings.
• Remember effect of inventory valuation method (LIFO and
FIFO) and depreciation policies.
Quality of Assets and Relative
Amount of Debt
• Composition of assets, their condition and liquidity, timing of
repayment of liabilities, total amount of debt outstanding.
• Window Dressing- manipulation of measures of financial
performance (ratios) to make the company look good than it
is.
Earnings per Share
• Ownership of a corporation is evidenced by shares of capital
stock.
• Earnings per share relate the corporation’s net income to their
ownership shares.
Net Income ………. $72,000
Shares of capital stock outstanding…15,000
Earning’s per share ……….. $4.80
Price Earnings Ratio
• The relationship between the market price of a
company’s stock and the underlying earnings per share
• This ratio is computed by dividing the current market
price per share of the company’s stock by annual
earnings per share. (a p/e ratio cannot be computed for
a period in which the company incurs a lost)

Current price per market share of stock ….$96

Earnings per share(for the last 12 mos.)…..$4.80
Price-earnings ratio ……………………. 20
Price Earning’s Ratio
• The p/e ratio reflects investors concerning the company’s
future performance
• The more optimistic these expectations, the higher the p/e
ratio is likely to be
• Financially sound companies p/e ratio 12 to 15 x
earnings.
• Expected rapid earnings growth or overvalued
stock 20, 30 or higher
• Expected declining earnings or undervalued
stock 10
Dividends Yield
• Some stockholders invest primarily to receive regular cash
income (dividends).
• While others with the expectation of rising stock market
prices(speculation)
• Dividends per share divided by market price per share
determine the yield rate of the company’s stock.
• Important for those who are after income from dividends.
Measures for Evaluating the Current
Market Price of Common Stock
Market Value of Quoted in financial press Reflects both investors
Financial instruments or disclosed in financial expectations and
statements current market
conditions
Price-earnings ratio Current stock price/EPS A measure of investor’s
expectations about the
company’s future
prospects
Dividend Yield Annual Dividends expressed as
Dividend/Current Stock a rate of return on the
Price market price of the
stock
Book Value per Share Common Stockholder’s The recorded value of
Equity/Shares of net assets underlying
Common Stock each share of common
Outstanding stock
Sample of Earnings and
Dividends Data
Date Market Earnings Price Dividends Dividend
Value per per share Earnings per Share Yield %
Share Ratio
Dec 31, $160 $20.25 8 $5.00 3.1
2004

Dec. 31, 132 13.20 10 4.80 3.6

2005
• Not all thing that counts can
be counted, not all things that
can be counted counts….

• Albert Einstein