Overview

y Financial Statement Analysis y Importance of Ratio Analysis y Different types of ratios and their significance y Comparative analysis y Du Pont analysis y Problems & limitation in Financial Statement Analysis

Financial Statements
y Financial statements are summaries of the operating,

financing, and investment activities of a firm. y According to the Financial Accounting Standards Board (FASB), the financial statements of a firm should provide sufficient information that is useful to
y investors and y creditors y in making their investment and credit decisions in an

informed way.

Financial Statement Analysis

Purpose: y To use financial statements to evaluate an organisation s
Financial performance y Financial position.
y

y To have a means of comparative analysis across time in terms of:

Intra-company basis (within the company itself) y Intercompany basis (between companies) y Industry Averages (against that particular industry s averages)
y

y To apply analytical tools and techniques to financial statements to obtain useful information to aid decision making.

Financial Statement Analysis

Financial statement analysis involves analysing the information provided in the financial statements to:
y Provide information about the organisation s:

Past performance y Present condition y Future performance y Assess the organisation s: y Earnings in terms of power, persistence, quality and growth y Solvency
y

Effective Financial Statement Analysis

y To perform an effective financial statement

analysis, you organisation s:

y business strategy y objectives

need

to

be

aware

of

the

y annual report and other documents like articles about

the organisation in newspapers and business reviews. These are called individual organisational factors.

Effective Financial Statement Analysis

Requires that you: y Understand the nature of the industry in which the organisation works. This is an industry factor. y Understand that the overall state of the economy may also have an impact on the performance of the organisation. Financial statement analysis is more than just crunching numbers ; it involves obtaining a broader picture of the organisation in order to evaluate appropriately how that organisation is performing

Types of Financial Statements and Reports

   

The Income Statement The Balance Sheet The Statement of Retained Earnings The Statement of Cash Flows

The Income Statement

of a business over a period of time, usually either one month, three months, or one year.  Summarizes the results of the firm s operating and financing decisions during that time.  Operating decisions of the company apply to production and marketing such as sales/revenues, cost of goods sold, administrative and general expenses (advertising, office salaries)  Provides operating income/earnings before interest and taxes (EBIT)  Results of financing decisions are reflected in the remainder of the income statement.  When interest expenses and taxes are subtracted from EBIT, the result is net income available to shareholders.

 An income statement is a summary of the revenues and expenses

The Balance Sheet

y A summary of the assets, liabilities, and equity of a business at a particular point in time,

usually at the end of the firm s fiscal year.

Assets = (Resources of the business enterprise)

Liabilities + (Obligations of the business)

Equity (ownership left over Residual)

Fixed Assets Long-term Common stock outstanding (Plant, Machinery, Equipment (Notes, bonds, & Additional paid-in capital Buildings) Capital Lease Retained Earnings Current Assets Obligation) (Cash, Marketable Securities, Current Liabilities Account Receivable, Inventories) (Accounts Payable, Wages and salaries, Short-term loans Any portion of long-term Indebtedness due in one-year)

THE STATEMENT OF CASH FLOWS

y The statement is designed to show how the firm s operations have affected its cash position and to help answer questions such as these:
y Is the firm generating the cash needed to purchase

additional fixed assets for growth? y Is the growth so rapid that external financing is required both to maintain operations and for investment in new fixed assets?
y Does the firm have excess cash flows that can be used to

repay debt or to invest in new products?

Tools of Financial Statement Analysis:

The commonly used tools for financial statement analysis are: y Ratio Analysis:
y Comparative Analysis y Du-Pont Analysis

y Fund Flow Analysis

Financial Ratio Analysis

y Financial ratio analysis involves calculating and analysing ratios that use data from one, two or more financial statements. y Ratio analysis also expresses relationships between different financial statements. y Financial Ratios can be classified into 3 main categories: y Liquidity or Short-Term Solvency ratios y Profitability or Efficiency Ratios y Ownership Ratios
1) Earnings ratio 2) Dividend ratio 3) Leverage ratio - Capital structure ratio - Coverage ratio

Liquidity Ratio
y A liquid asset is one that can be easily converted into

cash at a fair market value y Liquidity question deals with this question
y Two measures of liquidity y Current Ratio y Quick/Acid Test Ratio

y Will the firm be able to meet its current obligations?

Liquidity or Short-Term Solvency ratios

y Working Capital = Current assets y Current Ratio =

Current Liabilities

Current Assets Current Liabilities

y Quick Ratio = Current Assets Inventory Prepayments Current Liabilities Bank Overdraft

Turnover Ratio
y Receivables turnover and inventory turnover ratios

measure the liquidity of a firm in an indirect way. The measure of liquidity is concerned with the speed with which inventory is converted into sales and accounts receivables converted into cash. Two ratios are used to measure the liquidity of a firms account receivables: y Accounts receivable turnover ratio =

Net credit sales

Average accounts receivable Higher the ratio greater the liquidity of the firm

Contd.
y Average collection period

= 360 / Average accounts receivable turnover

It represents the number of days the company takes to collect account receivable y Inventory Turnover ratio: it measures how fast the

inventory is moving through the firm and generating sales. = Cost of goods sold Average inventory

Profitability or Efficiency Ratios

y These measure the efficiency of the firm s activities

and its ability to generate profits. There are two types: y 1) Profit in relation to sales : it is important from the profit standpoint that the firm be able to generate adequate profit in each unit of sales. Two popular ratios a) gross profit margin ratio, b) net profit margin ratio. y 2) Profit in relation to Assets : it is important that profit be compared to the capital invested by owners and creditors. a) asset turnover ratio, b) earning power, and c) return on equity.

Contd.
y Gross profit Margin ratio

= Gross Profit * 100 Net Sales where Net Sales = Sales Excise duty This ratio shows the profit relative to sales after the direct production costs are reduced.
y Net profit Margin ratio

= Net Profit * 100 Net Sales This ratio shows the earnings left for shareholders as a percentage of net sales.

Contd.
y Asset Turnover ratio

= Sales / Average Assets It highlights the amount of assets that the firm used to produce its total sales. Average asset is calculated by adding the opening stock of assets and closing stocks of the assets of the present year. y Earning Power = Earnings before interest and taxes Average total assets it is a measure of the operating business performance which is not affected by interest charges and tax payments.

Contd.
y Return on Equity

= Net Income / Average equity Net income denotes profits after tax (PAT) and average equity is obtained by taking the average equities of year II and year I. The return on equity measures the profitability of equity funds invested in the firm. It reflects the productivity of capital employed in the firm.

Ownership Ratio
y Ownership ratios will help the stockholders in

analyzing his present and future investment in a firm. Ownership ratios compare the investment value with factors such as debt, earnings, dividends and the stock s market price. Analyzing Ownership ratio an analyst is able to assess the likely future value of the market. It is divided into three parts: 1) Earnings Ratio 2) Leverage Ratio a) Capital structure ratio b) Coverage ratio 3) Dividend Ratio

Contd.
y Earnings Ratios : from earnings ratio we get

information on earnings of the firm and their effect on price of common stock. The earnings ratios are, a) Earnings per Share (EPS), b) Price Earnings Ratio (P/E Ratio), and c) Capitalization ratio.
y a) Earnings Per Share (EPS) : Shareholders are

concerned about the earnings of the firm in two ways, one is availability of funds with the firm to pay their dividends and the other to expand their interest in the firm with retained earnings. These are expressed on a per share basis which in short is called EPS. = Net Income (PAT) / Number of outstanding shares

Contd.
y Price Earnings Ratio: it gives the relationship between

the market price of the stock and its earnings by revealing how earnings affect the market price of the firm s stock. If a stock has a low P/E multiple, ex. 3/1, it may be considered as an undervalued stock. If the ratio is 80/1, it may be viewed as overvalued. = market price of the share / EPS y The capitalization rate: the reciprocal of the P/E ratio, is called the capitalization rate = EPS / Market price of the share Example: if a stock has Rs. 12 EPS and sells for Rs. 100, the marketplace expects a return of 12/100, i.e. 12 percent. This is called the stock s capitalization rate.

Leverage Ratios
y When we extend the analysis to the long term solvency of a firm we

have two types of leverage ratios. They are a) structural ratios, and b) coverage ratios. Structural ratios are based on the proportion of debt and equity in the capital structure of the firm, whereas coverage ratios are derived from the relationships between debt servicing commitments and sources of funds for meeting these obligations. y 1) Capital Structure Ratio: various capital structure ratios are: a) Debt-equity ratio, b) Debt-assets ratio. a) Debt-equity ratio: it indicates the relative contributions of creditors and owners. = Debt / Equity In the manufacturing industry a debt-equity ratio is 1.5:1 is considered to be healthy. In general, the lower the debt-equity ratio, the higher the degree of protection felt by the lenders.

Contd.
y b) Debt-Asset Ratio: this ratio measures the extent to

which borrowed funds support the firm s assets. It is defined as: = Debt / Assets A debt asset ratio of 0.57 implies that 57% of the total assets are financed from debt sources.
y 2) Coverage Ratios: it gives the relationship between

the financial charges of a firm and its ability to service them. Important coverage ratios are, a) Interest coverage ratio, b) fixed charges ratio, and c) debt service coverage ratio.

Contd.
y a) Interest coverage ratio: this ratio tells us how

many times the firm can cover or meet the interest payments associated with debt. = EBIT / Interest expense The greater the interest coverage ratio, the higher the ability of the firm to pay its interest expense. y b) Fixed charges coverage ratio : this ratio shows how many times the pre tax operating income covers all fixed financing charges. = earnings before depreciation, debt interest and lease rentals and taxes / debt interest + lease rentals + (loan repayment installment / 1 tax rate ) + (preference dividend / 1 tax rate)

Contd.
y c) Debt Service Coverage ratio: it is used by term

lending financial institutions in India. It depicts the post tax earnings against the total obligations of a firm in a particular financial year. = (PAT + Depreciation + Other non cash charges + interest on term loan) / (Interest on term loan + repayment of the term loan).

Dividend Ratio
y The common stockholder is very much concerned

about the firm s policy regarding the payment of cash dividends. The firm must be liquid and profitable to pay consistent and adequate dividends. Without profits, the firm will not have sufficient resources to give dividends, without liquidity the firm cannot get cash to pay the dividends. Two dividend ratios are important; a) dividend pay-out ratio, b) dividend yield ratio

Contd.
y a) Dividend pay-out ratio: this is the ratio of

dividend per share DPS to earning per share EPS. It indicates what percentage of total earnings are paid to shareholders. The percentage of the earnings that is not paid out (1 dividend pay out) is retained for the firm s future needs.

y b) Dividend Yield: this the ratio of dividends per

share DPS to market price of the share. This ratio gives current return on his investment. This is mainly of interest to the investors who are desirous of getting income from dividends. = DPS / market price of the share

Comparative Analysis
y The comparison between two financial statements is

called comparative analysis. It is done to review the changes that have occurred from year to year and over the years. The most important factor revealed by comparative financial statement is trend. It would also reveal the direction, velocity, and the amplitude of trend. y 1) Cross sectional analysis y 2) Time series analysis : a) year to year change b) index analysis y 3) Common size analysis

Contd.
y Cross Sectional Analysis: It is calculated in order to

assess whether the financial ratios are within the limits, they are compared with industry averages or with a good player in normal business conditions if an organized industry is not there. y Time Series Analysis a) Year to year change: a comparison of financial statements over two to three years can be undertaken by computing the year to year change in absolute amounts and in terms of percentage changes.

Contd.
y Time series analysis b) Index analysis: when a

comparison of financial statements covering more than three years is undertaken, the year to year method of comparison may become too cumbersome. Therefore to simplify it index analysis is done. The computation of a series of index numbers requires the choice of a base year that will, for all items, have an index amount of 100. y Common Size analysis: common size statements are very well suited to inter company comparison because the financial statements of a variety of companies can be recast into the uniform common size format.

DuPont System What is It?

y

Analyzing return ratios in terms of profit margin and turnover ratio is referred to as the DU Pont system. The system identifies profitability as being impacted by three different levers:
1. 2. 3.

Earnings & efficiency in earnings Ability of your assets to be turned into profits Financial leverage

The DuPont System

y Method to breakdown ROE into: y ROA and Equity Multiplier y ROA is further broken down as: y Profit Margin and Asset Turnover y Helps to identify sources of strength and weakness in

current performance y Helps to focus attention on value drivers

35

The DuPont System

ROE

ROA
Profit Margin

Equity Multiplier

Total Asset Turnover

The DuPont System

ROE ROA Profit Margin Equity Multiplier

Total Asset Turnover

ROE

! ROA v Equity Multiplier Net Income Total Assets ! v Total Assets Common Equity

The DuPont System

ROE ROA Profit Margin Equity Multiplier

Total Asset Turnover

ROA ! Profit Margin v Total Asset Turnover Net Income Sales ! v Sales Total Assets

The DuPont System

ROE ROA Profit Margin Equity Multiplier

Total Asset Turnover

! Profit t !

rgin v ot l Asset urnover v Equity l tl t v v tl t C Equity

ultipli

The DuPont System: XYZ

Net Income Sales Total Assets ROE ! v v Sales Total Assets Common Equity ! Profit Margin v Total Asset Turnover v Equity Multiplier ! ROA v Equity Multiplier $1,666.00 $25,265.00 $11,471.00 v v ROE ! $25,265.00 $11,471.00 $5,308.00 ! 0.0659 v 2.2025 v 2.1611 ! 0.1452 v 2.1611 ! 31.39%

Summary of Financial Ratios

y Ratios help to: y Evaluate performance y Structure analysis y Show the connection between activities and performance y Benchmark with y Past for the company y Industry y Ratios adjust for size differences

Limitations of Ratio Analysis

y y y y y y

A firm s industry category is often difficult to identify Published industry averages are only guidelines Accounting practices differ across firms Sometimes difficult to interpret deviations in ratios Industry ratios may not be desirable targets Seasonality affects ratios

Ratios and Forecasting

y Common stock valuation based on
y Expected cashflows to stockholders y ROE and V are major determinants of cashflows to

stockholders

y Ratios influence expectations by:

y Showing where firm is now y Providing context for current performance

y Current information influences expectations by:

y Showing developments that will alter future

performance

Illustration: Financial statement analysis

y The following financial statements of Walker Ltd

were prepared in accordance with New Zealand GAAPs. Walker Ltd is a diversified enterprise with its main interests in the manufacture and retail of plastic products. y The financial statements of Walker Ltd need to be analysed. An investor is considering purchasing shares in the company. Relevant ratios need to be selected and calculated and a report needs to be written for the investor. The report should evaluate the company s performance and position

Walker Ltd Statement of Financial Position as at 31 March

2005 $000 Current Assets Bank Accounts receivable Inventory Non-current assets Fixtures & fittings (net) Land & buildings (net) Total assets Current Liabilities Accounts payable Income tax Non-current liabilities Loan Shareholders Funds Paid-up ordinary capital Retained profit Total liabilities & equity 33.5 240.8 300.0 574.3 64.6 381.2 445.8 1,020.1 63.2 376.2 439.4 1,061.4 99 104 $000 $000 41.0 210.2 370.8 622.0 108 2006 $000 Horizontal Analysis

261.6 60.2 321.8 200.0

288.8 76.0 364.8 60.0 113 30

300.0 198.3 498.3 1,020.1

334.1 302.5 636.6 1,061.4 128 104

Walker Ltd Statement of Financial Performance for year ended 31 March

2005 $000 Sales Less Cost of goods sold Gross profit Wages & salaries Rates Heat & light Insurance Interest expense Postage & telephone Depreciation Buildings Fixtures & fittings Net profit before tax Less Income tax Net profit after tax $000 2,240.8 1,745.4 495.4 $000 2006 $000 2,681.2 2,072.0 609.2 Horizontal Analysis 120 119 123

185.8 12.2 8.4 4.6 24.0 9.0 5.0 27.0

275.6 12.4 13.6 7.0 6.2 16.4 5.0 32.8

276.0 219.4 60.2 159.2

369.0 240.2 76.0 164.2

134 109 126 103

Walker Ltd Statement of Cash Flows for the year ended 31 March
2005 $000 Cash flow from operations Receipts from customers Payments to suppliers & employees Interest paid Tax paid Net cash flow from operating activities Investing activities Purchase of non-current assets Net cash used in investing activities Financing activities Dividends paid Issue of ordinary shares Repayment of loan capital Net cash outflow from financing activities Increase in cash & cash equivalents 2,281 (2,050) (24) (46.4) 160.6 (121.2) (121.2) (32.0) 20.0 -__ (12) 27.4 (40.2) 34.1 (140.0) (146.1) 7.5 (31.4) (31.4) $000 $000 2,711.8 (2,460.4) (6.2) (60.2) 185 2006 $000

Additional information:
y Credit purchases for the year 2006 were $2,142,800. y General prospects for the major industries in which Walker is involved look good with a forecast glut of oil set to reduce the cost of production and world demand for plastic remaining strong. Benchmarks: y There are no exact benchmarks for Walker Ltd because it is a diversified company. The following are average indicators that relate to the plastic retailing and manufacturing industries for the year 2006.
y y y y y y

Gross profit margin Net profit margin Inventory turnover 6 times Debt/equity ratio Return on Assets Return on Equity

25% 7% 0.6 : 1 12% 20%

Relevant ratios
Important note: The calculations of the ratios in this illustration did not use averages for total assets, equity and inventory. The 2005 and 2006 year end figures were used and this is a slight variation to the formulas provided.

Po

b o :

B nchm k

2005

2006

Gross Profit Margin Net Profit Margin Return on Assets Return on Equity

Industry 25% Industry 7% 12%

22%

22.7%

7.1%

6.1%

15.6%

15.5%

Industry 20%

32%

26%

Asset M n gement ratios: Inventory Turnover Asset Turnover

Benchmarks

2005

2006

Industry 6% Not given

5.8 times

5.58 times

2.2

2.53

Liquidity ratios: Current Ratio

Benchmarks
Ideal standard 2:1 Acceptable standard 1:1 Ideal standard 2:1 Acceptable standard 1:1

2005 1.78:1

2006 1.70:1

Quick Ratio

0.85:1

0.69:1

Days Payable

Standard 30 days

Credit purchases not available

49.19 days

Financial Structure ratios: Debt/Equity

Benchmarks

2005

2006

Industry 0.6:1 Standard benchmark 1:1 Standard benchmark: Between 3 and 5. Below 3 risky. Above 5 very favourable

1.05: 1

0.67:1

TIE

10.14 times

39.74 times

Report
y For the investor considering the purchase of shares in the company, the return they will earn is the key financial factor but an overall evaluation of the company s performance and position is also important to get a better picture of how well the company is actually doing. y ROE in 2006 is 26%. Whether or not this is attractive depends on the perceived riskiness of this investment and other alternatives available but this return is certainly more attractive than current bank interest rates. y ROE has decreased by 4% but the company s ROE at 26% is still better than the industry average of 20% y Riskiness of business is being reduced by the significant repayment of loan in 2006.

y Profitability
y The NP% and ROA ratios show a small downward trend

in % over the 2 year period. ROE% ratio show a more significant decrease but is still better than the industry average. y Gross Profit Margin is slightly unfavourable at about 2.3% below the industry benchmark of 25%. y The horizontal analysis information show that Sales have increased by 20%. However operating costs have increased by 34%.

y Asset Management
y IT has gone down slightly from 5.8 to 5.58 times. y IT is still close to the industry benchmark of 6 times. y AT has increased showing more sales being generated

from asset usage

y Liquidity
y Current ratios of 1.78:1 (2005) and 1.70: 1 are at above

acceptable levels but below ideal level. y Quick ratios appear more of a concern being below acceptable levels in both years and even more so in 2006 (0.69:1). y Raises some concerns over the liquidity of the business and inventory management (although IT ratio only shows a slight decline in 2006). y Days Payable is a concern as there may be poor debt payment management.

y Financial Structure
y Although slightly higher than D/E industry benchmark

(0.67:1), business has become less risky due to the significant repayment of loan in 2006. y TIE is extremely good for the business at 39.74 times (well above 5 the standard benchmark).

y Cash flow situation

y Strong cash flow from operating activities (increased

from 160,600 to 185,000). y Spending under investing activities suggest more growth. y Repayment of debt under financing activities imply restructuring of business to have more equity funding rather than debt funding.

Recommendation
Given: 1) the strong forecast for the industry (ie general prospects looking good and world demand for plastic products remaining strong), 2) the sales growth in this business, 3) acceptable ratios as they are quite close to the industry averages, 4) good cash flows from operating activities and 5) favourable ROE, although it has decreased, it is still better than the industry average ROE.
=> it is recommended that the investor purchase shares in the Walker Ltd company.