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BBC406 Fundamentals of Finance Week 5 Analysis of Financial Statements

BBC406 Fundamentals of Finance

Week 5 Analysis of Financial Statements

Learning Objectives

At the end of this chapter, you should be able to:

Explain the purpose and importance of financial analysis

Calculate and use a comprehensive set of measurements to evaluate a firm’s performance

Describe the limitations of financial ratio analysis

Introduction

Knowledge of financial statements and the techniques in analysing financial statements is desirable towards enabling one to make optimal financial decisions that can have future impact on the actions and direction of a firm.

However, some form of restatement, computations and analysis may be required before information may be obtained from the financial statements.

Financial Statements

A complete set of financial statements includes:

Income Statement Balance Sheet Statement of changes in equity Cash Flow Statement Notes to Financial Statement

Financial Statements are prepared for a certain period of time (Accounting Period) which normally equals to 12 months.

Financial Statements

Just like a doctor takes a look at a patient’s x- rays or cat-scan when diagnosing health problems, a manager or analyst can take a look at a firm’s primary financial statements i. e. the income statement and the balance sheet, when trying to gauge the status or performance of a firm.

Income statement: periodic recording of the sources of revenue and expenses of a firm,

Balance sheet: provides a point in time snap shot of the firm’s assets, liabilities and owner’s equity.

Benchmarking

The financial statements constitute fairly complex documents involving a whole bunch of numbers.

Absolute values

tell us something about the amount of assets, liabilities, equity, revenues, expenses, and taxes of a firm,

difficult to really gauge what’s going on, primarily because of size and maturity differences among firms.

requires “benchmarking” against some standard.

One common method of benchmarking a is to compare a firm’s current performance against that of its own performance over a 3-5 year period (trend analysis), by looking at the growth rate in various key items such as sales, costs, and profits.

Benchmarking (continued)

Table 5.1 Cogswell Cola’s Abbreviated Income Statements ($ in thousands)

Benchmarking (continued) Table 5.1 Cogswell Cola’s Abbreviated Income Statements ($ in thousands)

Benchmarking (continued)

Another useful way to make some sense out of this mess of numbers, is to re-cast the income statement and the balance sheet into common size statements, by expressing each income statement item as a percent of sales and each balance sheet item as a percent of total assets.

Benchmarking (continued)

Table 5.2

Benchmarking (continued) Table 5.2

Benchmarking (continued)

Table 5.3

Benchmarking (continued) Table 5.3

Benchmarking (continued)

Benchmarking is a good starting point to detect trends (if any) in a firm’s performance and to make quick comparisons of key financial statement values with competitors on a relative basis.

More in-depth diagnosis requires individual item analyses and comparisons which are best done by conducting ratio analysis.

Income Statement

Measuring the financial performance of the company.

Prepared to find out the Net Profit (Income > Expenditure) or Net Loss (Expenditure > Income) of the business after taking intro account all expense for that accounting year.

Income Statement

Sales = CoGS + Gross Margin

COGS

Gross

Margin

Sales

Revenue

Balance Sheet

Measuring the Financial position of the company

Statement of capital/owner equity, liabilities and assets of a business at a particular point of time.

Balance Sheet

Assets = Equity + Liability

Equity

Liability

Assets

Cash Flow Statement

Assessing the liquidity, solvency, and financial flexibility

Free cash Flow to the firm: Amount of cash available to both debt and equity holders

Operating Cash Flow

PLUS: Interest Paid Times (1-tax rate) LESS: Investment in Fixed Capital ____

Free

Cash Flow to the Firm

______

____

Cash Flow Statement

Free Cash Flow to Equity: amount of cash available to equity holders only

Operating cash flow

LESS: Investments in Fixed Capital

PLUS: New Debt Borrowing

LESS: Debt Repayment __________

Free

Cash Flow to Equity

______

___

Financial Analysis and Financial Ratios

Financial analysis is the use of financial statements to analyse a firm’s financial position and its performance. Questions:

Does a firm have the resources to succeed and grow? Does it have adequate resources to invest in new projects? What are its sources of profitability? Did the earnings of the firm meet its forecast earnings? What are the sources of a firm’s future earnings power?

Benefits of Ratios

Helpful in Decision Making Helpful in Financial Forecasting and Planning Helpful in Communication Helpful in Co-ordination Helps in Control Helpful for Shareholder’s decisions Helpful for Creditors’ decisions

Financial Ratios

Financial ratio analysis employs relative rather than absolute concepts.

Financial ratios help readers to identify the financial strengths and weaknesses of a firm.

Financial ratios are classified into:

Profitability ratios Liquidity ratios Leverage ratios Efficiency ratios Market ratios

Recommended Steps

a) Establishing the objective(s) of the analysis

b) Accumulating the necessary data from the financial statements

c) Performing computations d) Summarising and interpreting data e) Reaching the conclusions

Financial Ratios (continued)

5 key areas of a firm’s performance can be analyzed using financial ratios:

  • 1. Profitability ratios: How well has the company performed overall?

  • 2. Liquidity ratios: Can the company meet its obligations over the short term?

  • 3. Leverage ratios: Can the company meet its obligations over the long term?

  • 4. Efficiency ratios: How efficiently is the company managing its assets to generate sales?

  • 5. Market value ratios: How does the market (investors) view the company’s financial prospects?

Can also conduct a Du Pont analysis which involves a breakdown of the return on equity into its three components, i.e. profit margin, turnover, and leverage.

Minion Bhd

Minion Bhd

Minion Bhd (cont.)

Minion Bhd (cont.)

Profitability Ratios

Analyses the ability of management to generate adequate profits from use of firm’s capital and assets.

Gross profit margin Operating profit margin Net profit margin (before or after tax)

Profitability Ratios (cont.)

Gross profit

Gross profit margin =

100%

Revenue

Gross profit margin measures how much a firm earns from its revenue less the cost of goods sold

Gross profit margin =

911,000

100% = 26.85%

3,393,000

For every RM1 of revenue earned by the firm, its cost of sales amounts to RM0.7315. Minion Bhd has earned sufficient revenue to more than cover the cost of sales, hence the positive gross profit margin, i.e. RM0.2685 of gross profits for every RM1 of revenue made by firm.

Profitability Ratios (cont.)

Operating profit margin =

Operating income

Revenue

100%

Operating income = Revenue – Cost of goods sold – Selling, general and administrative expenses – Depreciation

272,000

Operating profit margin =

3,393,000

100% = 8.02%

For every RM1 of revenue earned by the firm, the revenue is enough to cover up to RM0.9198 of the firm’s total operating expenses. Management has been able to manage the forces that influence the amount of operating income that a firm earns.

Profitability Ratios (cont.)

Profit before tax

Net profit margin =

Revenue

100%

245,000

Net profit margin =

3,393,000

or

100% = 7.22%

Net profit margin Profit = after tax

Revenue

100%

171,000

Net profit margin =

3,393,000

100% = 5.04%

Liquidity Ratios

Measures the extent to which a firm has adequate cash flows or liquid assets to meet the short-term liabilities of the firm:

  • - Current ratio

  • - Acid Test Ratio (Quick Ratio)

  • - Stock Turnover Ratio

  • - Debtors Turnover Ratio

  • - Creditors Turnover Ratio

Current Ratio and Acid Test Ratio (Quick Ratio)

Current assets

Current ratio =

Current liabilities

This ratio indicates the extent of a firm’s liquidity, as measured by the firm’s liquid assets (current assets) relative to its liquid liabilities (current liabilities).

Acid test ratio =

Current assets-stock

Current liabilities

A more stringent version of liquidity ratio

Acid test ratio measures the ratio of current assets (less stock) to current liabilities.

Current Ratio and Acid Test Ratio (Quick Ratio) (cont.)

Current ratio =

1,182,000

736,000

= 1.61 times

1,182,000 - 435,000

Acid test ratio =

1.01 times

736,000

=

Stock Turnover Ratio

Stock turnover ratio =

Cost of goods sold

stocks

Stock turnover ratio =

2,483,000

435,000

=

5.7 times

Stock turnover days =

Stocks

= 365 days

Cost of goods sold

435,000

Stock turnover days =

2,482,000

X 365

= 63.97 days

Indicates the relative liquidity of stocks in a firm

Debtors Turnover Ratio

Indicates how long it takes for a firm to collect its

receivables

Debtors turnover ratio = Credit sales

Trade debtors

3,393,000

Debtors turnover ratio =

441,000

= 7.7 times

Debtors turnover days = Trade debtors X

Credit sales

365 days

Debtors turnover days =

441,000

days

3,393,000

X 365

= 47.44

Creditors Turnover Ratio

Indication of the extent of how quick the cash

outflows are in a firm

Credit purchases

Creditors turnover ratio =

Trade creditors

2,482,000

Creditors turnover ratio =

321,000

= 7.7 times

Trade creditors

Creditors turnover days =

Credit purchases

X 365 days

Creditors turnover days =

321,000

47.20 days

2,482,000

X 365

=

Leverage Ratios

Investigate how a firm is being financed and provide indicators as to the extent a firm is able to meet the interest payments

Questions:

What is the relative ratio between the use of debt versus equity to finance a firm’s assets?

Has the firm used too much debt?

Is the firm earning sufficiently to meet the interest liabilities?

Debt ratio Interest cover ratio

Debt Ratio

Debt ratio =

Trade liabilities

Total assets 883,000 + 736,000

Debt ratio =

1,700,000 + 1,182,000

= 0.5617 or 56.17%

Indicates that slightly more than 50% of the firm’s total assets is financed using debt (long and short term debt)

Debt ratio =

Total long term borrowings

Total equity

Debt ratio =

707,000

1,263,000

= 0.5598 or 55.98%

Interest Cover Ratio

Earnings before interest and tax

Interest cover ratio =

Interest expense

320,000

Interest cover ratio =

75,000

= 4.3 times

Firm has earnings before interest and tax that currently covers up to 4.3 times its existing interest expense.

Firm may still be able to take on further borrowings

Efficiency Ratios

Efficiency ratios measure the extent to which a firm is able to earn sufficient earnings and returns to its investors.

Earnings per share (EPS) Return on capital employed (ROCE) Return on assets (RoA) Return on equity (RoE)

Earnings Per Share

Earnings per share =

Earnings attributable to ordinary shareholders

X 100 cents

Number of ordinary shares in issue

151,000

Earnings per share =

100,000

X 100

= 151 cents

For every one ordinary share held by shareholders, Minion Bhd has earned 151 cents of income, which may be either distributed to ordinary shareholders as dividends or be kept in the firm as retained earnings, but still belong to the ordinary shareholders.

Return on Capital Employed (ROCE)

Return on capital employed =

Earnings before interest and tax (EBIT) X 100%

Capital employed

Where capital employed = Long term debt + Equity

Return on capital employed =

320,000

1,970,000

X 100

= 16.24%

Assessment of the level of efficiency of the management of Minion Bhd:

For every RM1 of funding provided to the management of Minion Bhd, the firm is able to earn a return of RM0.1624 annually on average.

Return on Assets (RoA)

Profit after tax

Return on assets =

Total assets

X 100%

Total assets = Non current assets + Current assets

Return on assets =

171,000

2,882,000

X 100

= 5.93%

Assessment of the level of efficiency of the management of Minion Bhd:

For every RM1 of assets that is made available to the firm or that the firm invests in, the management of Minion Bhd is able to generate a return after tax of RM0.0593.

Return on Equity (RoE)

Return on equity =

Profit after tax

X 100%

Total shareholders' equity

Return on ordinary equity =

Earnings attributable to ordinary shareholders X 100%

Total shareholders' equity-Preference shares

171,000

Return on equity =

1,263,000

X 100%

= 13.54%

Return on ordinary equity =

151,000

X 100% =

1,263,000-48,000

12.43%

Market Ratios

Market ratios are ratios that are based on the market price of a firm’s share

Price earnings ratio (P/E) Market-to-book ratio

Price Earnings Ratio (P/E)

Profit share

P/E ratio =

Earnings per share

P/E ratio =

  • 1350 = 8.94

151

Minion Bhd’s shares currently sell for 8.94 times

its earnings.

Generally, firms with high P/E ratios are generally

taken as firms with bright future prospects.

Market-to-Book Ratio

Market-to-book ratio =

Profit per share

Book value per share

1,263,000 -

Book value per share =

48,000 100,000

= 12.15

Market-to-book ratio =

13.50

= 1.11

12.15

Market-to-book ratio compares the market price of a firm’s shares relative to the historical cost of the shares.

DuPont Analysis

Using the ‘Decomposed Formula’

Basic formula is Return on assets =

Profit after tax

Sales

  • X Sales

Total assets

Total assets

Return on equity =(Return on assets) X

Equity

=

Profit tax

Sales

Sales

  • X Total assets X

Total assets

Equity

Du Pont Analysis

Du Pont Analysis

Time Series Analysis

Comparison between the firm’s current year ratios with the same ratios of the corresponding previous years

Ascertain whether the firm’s situation has:

  • 1. Improved

  • 2. Worsened

  • 3. Stayed the same

between one year and the subsequent year(s).

Time Series Analysis (cont.)

Suppose Minion Bhd’s current ratio for the last five years were as follows:

Year

Current ratio

  • 2005 5.32

  • 2006 3.20

  • 2007 2.56

  • 2008 1.98

  • 2009 1.61

Cross-sectional Analysis

Comparisons between the firm’s results and the results of:

  • a) Other firms in the same industry

  • b) Other firms in other industries

Limitations of Ratios

Difficulties in identifying suitable industry category to classify a firm—firm may be involved in many different activities (how to identify similar firms?)

Effects of inflation ignore—can distort figures Accounting practices may differ between firms, complicating comparisons of results between firms

Results may be distorted if there exist changes in accounting standards, resulting in changes in the presentation of financial results

Limitations of Ratios (cont.)

Firms may experience seasonality in their performance.

An industry average may not be the desired target or the norm, since industry averages represent averages that includes the results of both good and bad performing firms. Hence, one should seek to compare against the ‘best in the class’.

Progress of firm needs to be set in the context of what other firms have done, and whether there exist exceptional or special circumstances or environmental or economic influences that impact firms’ performances.

Limitations of Ratio

Limited Use of Single Ratio Lack of Adequate Standards Inherent Limitation of Financial Accounting Changes of Accounting Procedures Window Dressing Personal Bias Matchless Price Level Changes Ratios are not Substitute of Financial Statements Wrong Interpretation