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# Chapter 5 Financial Statement Analysis

Nature Year-to-year comparisons and trend analyses are useful in understanding an organizations performance. But as the size of an organization changes, year-toyear comparisons of peso amounts can be misleading. Comparisons with competing organizations of different sizes are also difficult to interpret with only peso amounts. Thus, to adjust to size differences, analysts and accountants have developed common-size financial statements.

## Common-size financial statements

Translate peso amounts to percentages, which indicate the relative size of an item in proportion to the whole.
Common-size balance sheets show assets,

## liabilities and owners equity as a percentage of total assets.

Common-size income statements - express revenue

## and expenses as a percentage of sales revenues.

Purposes
Common-size statements which are also known as component percentage or 100 percent statements enable analyst to:

Comprehend or visualize the changes in individual items that have taken place from year to year in relation to the total assets, total liabilities and owners equity or total net sales. Compare statements of two or more companies or statement of one company with the statements for an entire industry and evaluate their current financial position and operating results. Point out efficiencies and inefficiencies that might otherwise go unnoticed.

Conversion Procedures

For the balance sheet, each item therein is converted to percent by dividing it by total assets.

In the income statement, each item is restated as a percentage of net sales or net operating revenue by dividing the former by the latter.

## Guidelines in the Interpretation of Common-size Statements

Balance Sheet

A common-size balance sheet shows the percent of total assets that has been invested in each type or kind of asset. These percentages may be compared with those of a competitor or the industry to determine whether or not the firm has over or underinvested in one or more of its assets. The common-size statement will also show the distribution of liabilities and equity, i.e..the sources of the capital invested in the assets.

The percentage of current assets may also be related to the percentage of current liabilities to determine debt-paying capacity of the company.

Income Statement
The common-size income statement shows the amount or percentage of the sales that has been absorbed by each individual cost or expense item and the percentage that remains as net income. A comparison of year-to-year income statement common-size ratios will show whether a larger or smaller relative amount of net sales was used to meet particular costs or expenses. These percentages may also be compared with a competitors statements to determine in order effect a higher profit margin. Comparison of the gross profit percentages from year to year may also reveal success or failure in the company efforts to increase efficiency in the procurement and merchandizing policies ,etc.

## Illustrative Problem 5.1

Financial Statement Analysis Using Common-size Statement

## Gilbert Company Comparative Balance Sheet-Common-Size Percentages As of December 31 Percent (%)

Items ASSETS
Current Assets
Cash Marketable securities Trade & receivable, net Inventory Other Current Assets 2.6 9.7 24.1 18.2 5.6 4.3 2.9 14.9 16.1 3.7 4.0 2.7 15.6 16.4 3.5 4.7 2.5 17.1 17 3.3 5.2 2.8 18.2 15.8 2.2 2002 2003

December 31
2004 2005 2006

## Total Current Assets

Land,building & equipment, net Other assets

60.2
39.4 0.4

41.9
50 8.1

42.2
46.8 11

44.6 45.3
10.1

44.2
44.9 10.9

Total Assets

100.0

100.0

100.0

100.0

100.0

## LIABILITIES AND EQUITY

Current Liabilities
Accounts payable Notes Payable Other current liabilities 17.3 5.2 6.8 29.3 15 13.3 7.7 1.4 22.4 19.5 11.7 6.0 1.7 19.4 16.3 9.6 3.9 2.2 15.7 14.5 10.0 2.7 1.8 14.5 12.5

## Total current liabilities

Long-term Liabilities(4%)

Total Liabilities

44.3
39.2 6.5 10.0

41.9
38.5 8.8 10.8

35.7
42.0 10.8 11.5

30.2
39.3 10.1 20.4

27.0
38.7 10.0 24.3

Equity
Share Capital (P100 par) common Capital paid in excess of par value Retained Earnings Total Equity

## Total Liabilities & Equity

55.7 100.0

58.1 100.0

94.3
100.0

69.8
100.0

73.0
100.0

Gilbert Company Comparative Income Statement-Common-Size Percentages For the Years Ended December 31, 2002 to 2006
Percent 2004 100.0 71.7 28.3

2002

2003
100.0 73.0 27.0

2005
100.0 71.9 288.1

2006
100.0 70.9 29.3

Net Sales Cost of goods sold Gross Margin on Sales Operating expenses Selling expenses General and administrative expense

13.5 5.8

13.5 6.3

15.2 6.6

15.7 6.1

17.0 6.2

## Total Operating expenses Operating income

Other income and expenses, net (deduct) Income before taxes Less: Income taxes

19.3 7.6
(1.2)

19.8 7.2
(1.00

281. 6.5
(1.1)

21.8 6.3
(0.80

23.2 6.1
(0.5)

Net Income

## Evaluation of the Financial Position

The Gilbert Companys balance sheets showed that there had been substantial changes in the proportions of current and fixed assets and current and long-term liabilities during the period from Dec. 31, 2002 to Dec. 31, 2006. the percentages showed a declining liquidity in the companys assets accompanied by a consistent reduction in liabilities over the five-year period. It can be observed that Cash Balance and accounts receivable as a percentage of total assets had been increasing while investment in inventory in relation to total assets had been decreasing. Considering that the volume of sales was increasing, these changes can be viewed as beneficial to the company.

The increase in investment in fixed assets had been financed largely from owners investment as indicated in the increasing percentage of equity to total assets. The decreasing percentage of total liabilities to total assets further indicates lesser reliance of the company from creditors in raising additional capital. This, of course, is favorable as far as the long-term financial position among the creditors.

Evaluation of Profitability

Favorable changes could be observed in the gross margin percentage in relation to net sales. The increase in percentage over the years could be due to improvement in the companys mark-up policy or better procurement policy.

Selling expenses in relation to sales however, show increasing percentages from 2002 to 2006 while administrative expenses had more or less remained constant. Better control over the selling expenses should be instituted to further improve the profitability of the company. Decrease in the percentage of other expenses to net sales is traceable to the decreasing amount of notes payable and long-term debts.

## Financial Ratio Analysis

Is a comparison in fraction, proportion, decimal or percentage form of two significant figures taken financial statements. It expresses the direct relationship b/w two or more quantities in the balance sheet and income statement of business firm.

Purpose

Through ratio analysis, the financial statements user comes into possession measures w/c provide insight into the profitability of operations, the soundness of the firms short-term and long-term financial condition and the efficiency with w/c management has utilized the resources entrusted to it.

## Limitations of Financial Ratios

Ratios must be used only as financial tools, that is, as indicators of weakness or strength and not to be regarded as good or bad per se. Financial ratios are generally computed directly from the companys financial statements, without adjustment. Conventional financial statements prepared in accordance w/ GAAP have a number of weakness that managers must consider if the ratios are to be meaningful. Ratios are composite of many different figures some covering a time period, others are instant time and still others representing averages.

Ratios to be meaningful should be evaluated with the use of certain yardsticks. The most common of these are: Company's own experience (prior years) Other companies in the same industry (industry averages) A standard set by management ( a budget)
Rules of thumb

## Financial Ratio Analysis

Liquidity ratios are ratios that measure the firms ability to meet cash needs as they arise( payment of accounts payable, bank loans and operating costs) Activity ratios - are ratios that measure the liquidity of specific assets and efficiency in managing assets such as accounts receivable, inventory and fixed assets.

Leverage ratios are ratios that measure the extent of the firms financing, with debt relative to equity and its ability to cover interest and other fixed charges such as rent and sinking fund payments Profitability ratios are ratios that measure the overall performance of the firm and its efficiency managing assets, liabilities and equity.

## Financial Ratio Analysis

EBC Enterprises, Inc. Balance Sheet at December 31, 2006 and 2005 (In thousands)
2006 Assets Current Assets Cash Marketable securities Accounts Receivable Allowance for doubtful accounts Inventories Prepaid expenses Total current assets Property, Plant, Equipment Land Buildings and leasehold improvements Equipment Less Accum. Depreciation & amortization Net property, plant,equipment Other Assets Total Assets 2030.5 2636.0 4704.0 -224.0 25520.5 256.0 32923.0 11981.0 4002.0 48383.5 -208.5 18384.5 379.5 28132.0 2005

## 405.5 5964.0 6884.0 13523.5 -3765.0 9488.5 334.0 37488.5

Liabilities and Equity Current Liabilities Accounts payable notes payable current maturities of long-term debt Accrued liabilities Total Current liabilities Deferred Income Taxes Long -term debt Total Liabilities Equity ordinary shares par value P 1, authorized 10,000,000 shares; issued 2,297,000 shares in 2006 and 2,401,500 shares in 2005 Additional paid- in capital Retained earnings Total Equity Total Liabilities and Equity 7147.0 2807.0 9842.0 2834.5 13730.5 421.5 10529.5 24681.5 3795.5 3006.0 758.0 2656.5 10216.0 317.5 8487.5 19021.0

## 2297.0 455.0 16181.5 18933.5 37954.5

EBC Enterprises, Inc. Income Statement and Retained Earnings Fro the Years Ended December 31, 2006, 2005, and 2004
2006
Net Sales Cost of Goods sold 107,800.0 64,682.0

2005
76,500.0 45,939.5

2004
70,350.0 40,803.0

Gross Profit

43,118.0

30,560.5

29,547.0

Selling and Administrative expenses Advertising Lease Payments Depreciation and amortization Repairs and maintenance Total Operating Profit

## Other income (expenses) Interest income interest expense

Earnings before income taxes

211.0 (1,292.5)

419.0 (1,138.5 )

369.0 (637.0 )

8,540.0

5,183.5

5,360.0

3,843.0 4,697.0

2,228.5 2,955.0

2,412.0 2,948.0

## Earnings per common share Statements of retained Earnings

Retained earnings at beginning of year

2.0

1.29

1.33

16,181.5 4,697.0

14,157.5 2,955.0

13,130.0 2,948.0

Net Income Cash dividends (2006-0.33 per share; 2005-0.41 per share) Retained earnings at the end of year

(791.0) 20,087.5

(931.0) 16,181.5

(920.5 ) 14,157.5

Summary of most Commonly Used Ratios : Their Formulas and Basic Significance

Ratios Used To Evaluated Short-Term Financial Position ( Short-Term Solvency And Liquidity )
NAME Current Ratio FORMULA total current assets total current liabilities SIGNIFICANCE primary test of solvency to meet current obligations from current assets as a going concern; measure of adequacy of working capital a more severe test of immediate solvency test of ability to meet demands from current assets

Working capital

## working Capital total assets

current assets less current liabilities

## Cash flow liquidity ratio

Cash + marketable securities+ cash flow from operating activities current liabilities

measures short-term liquidity by considering as cash resources (numerator)cash plus cash flow from operating activities

## quick assets projected daily operational expenses

measures length of time in days the firm can operate on its present liquid resources

## Ratios Used To Evaluate the Asset Liquidity and Management Efficiency

NAME trade receivable turnover FORMULA net credit sales average trade receivable(net) SIGNIFICANCE velocity of collection of trade accounts and

## inventory turnover a) merchandize turnover

cost of goods sold ave.merchandize inventory cost of goods sold ave. finished goods inventory

## cost of goods manufactured ave.goods-in process inventory

measures efficiency of the firm in managing and selling inventories number of times raw materials inventory was used and replenished during the period measures average number of days to sell or consume in the average inventory indicates adequacy and activity of working capitals

## net sales ave. working capital

percent of each current assets to total current assets current assets turnover

## indicates relative investment in each current asset

cost of sales + operating expenses + income taxes + other expenses (net) (excluding depreciation and amortization) ave. current assets net purchases average accounts payable average conversion period of inventories + average collection period of receivable + days cash

## measures movement and utilization of current resources to meet operating requirements

payable turnover

measure efficiency of the company in meeting trade payable measures the length of time required to convert cash to finished goods; then to receivable and then back to cash

operating cycle

## Free cash flow

net cash from operating activities less cash used for investing activities and dividends

## investment or assets turnover

net sales ave. total investment or total assets net sales ave. fixed assets (net)

## total assets net sales

measures efficiency of the firm to generate sales through employment of its resources

## Ratios Used To Evaluate Long-Term Financial Position Or Stability/Leverage

NAME
Debt Ratio

FORMULA
total liabilities total assets

SIGNIFICANCE
shows proportion of all assets that are financed with debt indicates proportion of assets provided by owners. Reflects financial strength and caution to creditors measures debt relative to amounts of resources provided by owners

Equity ratio

total equity
total assets

## fixed assets (net) total equity

measures the proportion of owner's capital invested in fixed assets measures investment in longterm capital assets

fixed assets to total equity book value per share of ordinary shares

## ordinary shareholder's equity no. of outstanding ordinary shares

measures recoverable amount in the event of liquidation if assets are realized at their book values

## net income after taxes preferred dividends req.

indicates aboilty to provide dividends for preference shareholders measures coverage capability more

## and fixed charges

fixed charges

earned by including other fixed charges

(rent+interest+
sinking fund payment before taxes

## Ratios Used To Measure Profitability And Returns To Investors

NAME FORMULA SIGNIFICANCE
measures profit generated after considering of cost

of product sold

## Rate of return on assets (ROA)

Net Profit Ave. Total Assets alternative formula: asset turnover x net profit margin

measures overall efficiency of the firm in managing assets and generating profits

## net income ave. ordinary equity net income less preference

measures rate of return on resources provided by owners peso return on each ordinary share. indicative of ability to pay dividends

## dividends requirement ave. ordinary shares outstanding

Price/earnings ratio

## market value per share

measures relationship b/w price of ordinary shares in the open market and profit earned on per share basis

Dividend Payout

Dividend Yield

## If there is interest-bearing debt, rate of return on assets is computed as follows:

a measure of the productivity of assets regardless of how the assets are financed

## Shows portion income distributed to shareholders on a per share basis

Rate of return on average current assets Rate of return per turnover of current assets

## Financial Ratios Analysis

I. Analysis of Liquidity or Short-Term Solvency II. Analysis of Asset Liquidity and Asset Management Efficiency III. Analysis of Leverage : Debt Financing and Coverage

## I. Analysis of Liquidity or Short-Term Solvency

Current Ratio is widely regarded as a measure of short-term debt-paying ability. Quick or Acid test ratio is a much more rigorous test of a companys ability to meet in short term debts. Cash flow liquidity ratio considers cash flow from operating activities in addition to the truly liquid assets, cash and marketable securities.

## II. Analysis of Asset Liquidity and Asset Management Efficiency

Accounts Receivable Turnover roughly measures how many times a companys accounts receivable have been turned into cash during the year. Average Collection Period helps evaluate the liquidity of accounts receivable and the firms credit policies. Inventory Turnover measures the efficiency of the firm in managing and selling inventory.

Average sale period the number of days being taken to sell the entire inventory one time, is computed by dividing 365 days by the inventory turnover period. Fixed Asset Turnover is another approach to assuring managements effectiveness in generating sales from investments in fixed assets particularly for a capital-intensive firm.

## III. Analysis of Leverage : Debt Financing and Coverage

Debt Ratio measures the proportion of all assets that are financed with debt.

Debt Equity Ratio measures the riskiness of the firms capital structure in terms of relationship between the funds supplied by creditors (debt) and investors (equity).

Times interest earned ratio is the most common measure of the ability of a firms operations to provide protection to long-term creditors. Fixed Charge Coverage measures the firms coverage capability to cover not only interest payments but also the fixed payment associated with leasing which must be met annually.

## IV. Operating Efficiency and Profitability

Gross Profit Margin which shows the relationship between sales and the cost of products sold, measures the ability of a company both to control costs and inventories or manufacturing of products and to pass along price increases through sales to customers. Operating Profit Margin is a measure of overall operating efficiency and incorporates all of the expenses associated with ordinary or normal business activities

Net Profit Margin measures profitability after considering all revenue and expenses, including interest, taxes and non operating items such as extraordinary items, cumulative effect of accounting change, etc. Cash Flow Margin is another important measure or perspective on operating performance. ROA and ROE are two ratios that measure the overall efficiency of the firm in managing its total investment in assets and in generating return to shareholders.

## Short Term Liquidity and Activity

Short term liquidity analysis is of particular significance to trade and short-term creditors, management and other parties concerned with the ability of a firm to meet near- term demands for cash. EBCs current and quick ratios decreased indicating a deterioration of short-term liquidity. However, the cash flow liquidity ratio improved in 2006 after a negative cash generation in 2005.

The average collection period for accounts receivable and the inventory turnover improved in 2006 which could indicate improvement in the quality of accounts receivable and liquidity of inventory. The increase in inventory level has been accomplished by reducing holdings of cash and cash equivalents. This represents a trade-off of highly liquid assets for potentially less liquid assets. The efficient management of inventories is critical for the firms ongoing liquidity.

Presently, there appears to be no major problems with the firms short-term liquidity position.

Long-Term Solvency
The debt ratios for EBC show a steady increase I the use of borrowed funds. Total debt has increased relative to total assets, long term debt has increased as a proportion of the firms permanent financing and external or debt financing has risen relative to internal financing. Why has debt increased? The statement of cash flows shows that EBC has substantially increased its investment in capital or fixed assets and their investments have been financed largely by borrowing especially in 2005 when the firm had a rather sluggish operating performance and no internal cash generation.

Given the increased level of borrowing the times interest earned and fixed charge coverage improved slightly in 2006. these ratios should however be monitored closely in the future particularly if EBC continues to expand.

## Operating Efficiency and Profitability

As noted earlier, EBC has increased its investment in fixed asset as a result of store expansion. The asset turnover in 2006, the progress traceable to improved management of inventories and receivable. There has been substantial sale growth which suggests future performance potential.

The gross profit margin was stable, a positive sign in the light of new store openings featuring discounted and sale items to attract customers. The firm also managed to improved its operating profit margin in 2006 principally due to the firms ability to control operating costs. The net profit margin also improved despite increased interest and tax expenses and a reduction in interest income from marketable security investment. Return on assts and return on equity increased considerably in 2006. these ratios measure the overall success of the firm in generating profits from its investment and management strategies.

Conclusion
It appears that EBC Enterprises, Inc. is well positioned for future growth. Close monitoring the firms management of inventories is important considering the size of the companys capital tied up in it. The expansion in their operation may necessitate a sustained effort to advertised more, to attract customers to both new and old areas. EBC has financed much of its expansion with debt, and so far, its shareholders have benefited from the use of debt through financial leverage. The company should however be cautious of the increased risk associated with debt financing.

REVIEW QUESTIONS
1.

2.

3.

What is the basic purpose for examining trends in a companys financial ratios and other data? What other kinds of comparisons might an analyst make? In financial analysis , why does analyst compute financial ratios rather than simply studying raw financial data? What are the limitations in the use of ratios? Assume that two companies in the same industry have equal earnings. Why might these companies have different price-earnings ratios? If a company has a price-earnings ratio of 20 and reports earnings per share for the current year of P4, at what price would you expect to find the stock selling on the market.

True or False
1. The asset turnover rate multiplied by the rate of net income earned on sales equals the rate on total assets. 2. If the information were available, financial analysts would be interested in knowing the sales volume volume at the break-even point for a business enterprise. 3. If the amount of current assets exceeds the amount of current liabilities, a decrease in current assets with a corresponding decrease in current liabilities increases the current ratio.

4. The number of days sales in receivable at the end of an accounting period is a better measure of the quality of receivable than the receivable turnover rate. 5. Window dressing is a violation of generally accepted accounting principles. 6. The debt ratio is useful to creditors as well as to stockholders, but each of these groups places somewhat different emphasis on it. 7. Short- term creditors generally are more concerned with vertical analysis than with horizontal analysis. 8. Horizontal analysis is possible for both an income statement and a balance sheet. 9. Common-size financial statements show peso change in specific items from one year to the next. 10. A company with 2.0 current ratio will experience a decline in the current ratio when a short-term liability is paid.
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