Financial Analysis

ACCOUNTING


Accounting is a system of collecting, summarizing, analyzing, and reporting in monetary terms, information about an organization.

Financial Statements

A balance sheet mirrors the financial position of a firm on a particular date in terms of the structure of assets, liabilities and owners equity, and so on. on.

Balance Sheet
Liabilities & Owners Equity LongLong-Term Liabilities
Long term Debt (Term Loans) Debentures

Assets Fixed Assets

Land Plant & Equipment less: depreciation

Owners Equity
Equity Capital Reserves & Surplus

Current Assets
Cash Marketable Securities Accounts Receivable/ Debtors Inventories

Current Liabilities
Accounts Payable/ Creditors Accrued Salaries Outstanding expenses

The profit and loss account or the income statement shows the results of operations during a certain period of time in terms of the revenues obtained and the cost incurred during the year. year.

REVENUE Income Statement - Cost of Goods Sold GROSS PROFIT - Operating Expenses NET OPERATING INCOME (NOI ) or EARNINGS BEFORE INTEREST & TAXES (EBIT) - Interest Expense - Income Taxes NET INCOME - Dividends on Preferred Stock - Dividends on Common Stock RETAINED EARNINGS

Financial Statement Analysis

 The

analysis of financial statements is a process of evaluating the relationships between component parts of financial statements to obtain a better understanding of the firms position and performance.

We will want to answer questions about the firms

 Liquidity  Efficient

use of Assets  Leverage (financing)  Profitability

Financial Ratios
 Tools

that help us determine the financial health of a company.  We can compare a companys financial ratios with its ratios in previous years (trend analysis).  We can compare a companys financial ratios with those of its industry.

Liquidity: Liquidity: ratios designed to measure the ability of the firm to meet its short-term liabilities as they come due. shortdue. Operating efficiency: measures of the efficiency with efficiency: which corporate resources are employed to earn a profit. profit. Capital structure (leverage): measures of the extent to (leverage): which debt financing is employed by the company. company. Profitability: "bottomProfitability: "bottom-line" ratios designed to measure the earning power and profitability record of the company. company.

Example: CyberCyber-Dragon Corporation

CyberCyber-Dragons Balance Sheet (000)

Liabilities & Owners' Equity:
Accounts Payable Bills Payable Accrued taxes payable Other current liabilities Total Current Liabilities LongLong-term debt (bonds) Total Liabilities Common Stock Retained earnings Total stockholders' equity Total liabilities & equity 9,721 Cash 8,500 Marketable securities 3,200 Accounts Receivable 4,102 Inventories 25,523 Total Current Assets 22,000 Plant and Equipment 47,523 less accum deprec. 23,000 Net Plant & Equip. 11,367 Total Assets 34,367 81,890

Assets:
2,540 1,800 18,320 27,530 50,190 43,100 11,400 31,700 81,890

CyberCyber-Dragons Income Statement

Sales (all credit) Cost of Goods Sold Gross Profit Operating Expenses: Selling General & Administrative Total Operating Expenses Earnings before interest and taxes (EBIT) Interest charges: Interest on loan: Interest on bonds: Total Interest charges Earnings before taxes (EBT) Taxes 112,760 85,300 27,460 6,540 9,400 15,940 11,520 850 2,310 3,160 8,360 3,344

Net Income

5,016

CyberCyber-Dragon
Other Information

Dividends paid on common stock Earnings retained in the firm Shares outstanding (000) Market price per share Book value per share Earnings per share Dividends per share

2,800 2,216 1,300 20 26.44 3.86 2.15

1. Liquidity Ratios
 Do

we have enough liquid assets to meet approaching obligations?

Liquidity
 Measure the firms ability to meet recurring financial obligations  Net Working capital:  Current assets - Current liabilities company A Rs. 1,80,000 1,20,000 60,000 company B 30,000 10,000 20,000

Current assets Current Liabilities NWC

Current ratio:A higher current ratio indicates greater liquidity (2 : 1 considered satisfactory) Current assets / Current liabilities
Company A Rs. 1,80,000 1,20,000 1.5 : 1 Company B 30,000 10,000 3:1

Current assets Current Liabilities CR

What is Cyber-Dragons Current CyberRatio? Ratio?

What is Cyber-Dragons Current CyberRatio? Ratio? 50,190 = 1.97 25,523

What is CyberDragons Current Ratio? Ratio? 50,190 = 1.97 25,523 If the average current ratio for the industry is 2.4, is this good or not? 2.4,

AcidAcid-Test (Quick) ratio: Quick Assets / Current Liabilities Quick assets = Current assets inventories Quick ratio determines firms ability to pay off current liabilities without relying on the sale of inventories.

What is the firms Acid Test Ratio? Ratio?

What is the firms Acid Test Ratio? Ratio? 50,190 - 27,530 = .89 25,523

What is the firms Acid Test Ratio? Ratio? 50,190 - 27,530 = .89 25,523 Suppose the industry average is .92. .92. What does this tell us?

Activity ratios/ Turnover ratios

Measure how effectively the firms assets are being managed The efficiency with which the assets are used would be reflected in the speed and rapidity with which the assets are converted into cash.

Inventory Turnover ratio :

Inventory turnover !
Cost of Goods Sold Average Inventory

Inventory holding period !

Days in period (i.e.365) Inventory turnover

Average Inventory= Opening inventory + Closing inventory 2

These ratios provide information on how well the firm manages its inventory. It indicates the number of times inventory is replaced during a year/ how quickly the inventory is sold

Debtor/Receivables Turnover Ratio:

Receivable s/ Debtors ! / turnover
Credit Sales Average receivable s

Debt collection period !

Days in period (i.e.365) Receivables turnover

These ratios measures how rapidly debts are collected from debtors.

Creditors Turnover ratio:

Payables turnover !
Credit Purchases Average Creditors

Creditors Payment period !

Days in period (i.e.365) Payables turnover

These ratios provide information on the extent to which trade creditors are willing to wait for payment.

Total Assets Turnover = Net Sales/Average total assets

Fixed Assets Turnover = Net Sales/ Average Fixed Assets



Measures the efficiency of a firm in managing and utilizing its assets. Higher is the ratio more efficient is the utilization, whereas a low ratio indicates underutilization of available resources and presence of idle capacity.

What is the firms Accounts Receivable Turnover? Turnover?

What is the firms Accounts Receivable Turnover? Turnover? 112,760 18,320 = 6.16 times

What is the firms Accounts Receivable Turnover? Turnover? 112,760 18,320 = 6.16 times

CyberDragon turns their A/R over 6.16 times per year. The industry average is 8.2 times. Is this efficient?

What is the firms Average Collection Period? Period?

What is the firms Average Collection Period? Period? 18,320 112,760 / 365 = 59.3 days

What is the firms Average Collection Period? Period? 18,320 112,760 / 365 = 59.3 days

If the industry average is 47 days, what days, does this tell us?

What is the firms Inventory Turnover? Turnover?

What is the firms Inventory Turnover? Turnover? 85,300 27,530 = 3.10 times

What is the firms Inventory Turnover? Turnover? 85,300 27,530 = 3.10 times

CyberDragon turns their inventory over 3.1 times per year. The industry average is 3.9 times. Is this efficient?

Low inventory turnover:

The firm may have too much inventory, which is expensive because:
 Inventory

takes up costly warehouse

space.
 Some

items may become spoiled or obsolete.

What is the firms Fixed Asset Turnover? Turnover?

What is the firms Fixed Asset Turnover? Turnover? 85,300 31,700 = 2.69 times

What is the firms Fixed Asset Turnover? Turnover? 85,300 31,700 = 2.69 times

If the industry average is 3.7 times, what does this tell us about CyberDragon?

What is their Total Asset Turnover? Turnover?

What is their Total Asset Turnover? Turnover? 85,300 81,890

= 1.04 times

What is their Total Asset Turnover? Turnover? 85,300 81,890

= 1.04 times

The industry average is 2.1 times. times. The firm needs to figure out how to squeeze more sales dollars out of its assets.

Financial Leverage
 

Measure the extent to which a firm relies on debt financing . Debt ratio:
Total liabilities / total liabilities and owners equity

Debt / equity ratio:

Total liabilities / total owners equity

Debt Coverage ratio:

earnings before interest and taxes / interest expense Interest coverage ratio is directly connected to the firms ability to pay interest.

Leverage Ratios (financing decisions)

the impact of using debt capital to finance assets.  Firms use debt to lever (increase) returns on common equity.
 Measure

How does Leverage work?

 Suppose

we have an all equityequityfinanced firm worth $100,000. Its earnings this year total $15,000.

ROE =

(ignore taxes for this example)

How does Leverage work?

 Suppose

we have an all equityequityfinanced firm worth $100,000. Its earnings this year total $15,000. 15,000 ROE = 100,000

= 15%

How does Leverage work?

 Suppose

the same $100,000 firm is financed with half equity and half 8% debt (bonds). Earnings are still $15,000.

ROE =

How does Leverage work?

 Suppose

the same $100,000 firm is financed with half equity and half 8% debt (bonds). Earnings are still $15,000. 15,000 - 4,000 =

ROE =

50,000

How does Leverage work?

 Suppose

the same $100,000 firm is financed with half equity and half 8% debt (bonds). Earnings are still $15,000. 15,000 - 4,000 = 22%

ROE =

50,000

Debt / equity ratio:

Total Liabilities / Total Owners Equity LongLong-term Debt/ Total Owners Equity

Indicates the margin of safety to the creditors Depends on type of industry.

Financial Leverage
 

Measure the extent to which a firm relies on debt financing . Debt ratio:
Debt / Total Assets OR Total liabilities / Total liabilities and owners equity

Interest/ Debt Coverage ratio:

Earnings before interest and taxes / Interest expense

Interest coverage ratio is directly connected to the firms ability to pay interest.

What is Cyber-Dragons Debt CyberRatio? Ratio?

What is Cyber-Dragons Debt CyberRatio? Ratio? 47,523 81,890 = 58%

What is Cyber-Dragons Debt CyberRatio? Ratio? 47,523 81,890 = 58%

If the industry average is 47%, what 47%, does this tell us?

What is the firms Times Interest Earned Ratio?

What is the firms Times Interest Earned Ratio?

11,520 3,160 = 3.65 times

What is the firms Times Interest Earned Ratio?

11,520 3,160 = 3.65 times

The industry average is 6.7 times. This is further evidence that the firm uses more debt financing than average.

Profitability


Earnings per share:

Net income available to equity shareholders / number of equity shares

Dividend payout ratio:

Annual dividend per share / earnings per share Shows percentage of profits paid out as dividend to equity shareholders

Profitability


Return on assets:
Net income / average investment (total assets)

Return on equity:
Net income / average owners equity
(PAT Pref. Dividend)/ Net Worth

Gross Profit ratio: Gross Profit/ Sales

High ratio means cost of production is less. It indicates good management as it indicates higher sales price without a increase in cost of goods sold.

Net Profit Ratio or Net Profit margin:Net Profit/ Sales

It measures the overall efficiency of production, administration, selling, financing, pricing and tax management.

Price/earning ratio: Market price of equity shares / earning per

share

P/E ratio shows how much investors are willing to pay for $1 of Earnings Per Share. It also reflects investors views of the growth potential of different sectors.

What is Cyber-Dragons CyberReturn on Equity (ROE)?

What is Cyber-Dragons CyberReturn on Equity (ROE)? 5,016 34,367 = 14.6%

What is CyberDragons Return on Equity (ROE)? 5,016 34,367 = 14.6%

The industry average is 17.54%. 17.54%.

What is CyberDragons Return on Equity (ROE)? 5,016 34,367 = 14.6%

The industry average is 17.54%. 17.54%. Is this what we would expect, given the firms leverage?

Conclusion:

 Even

though Cyber-Dragon has Cyberhigher leverage than the industry average, they are much less efficient, and therefore, less profitable.

Example
From the following details, prepare the balance sheet of ABC Ltd: Capital turnover ratio 2 Fixed assets turnover ratio 4 Gross profit 20% Debt collection period 2 months Creditors payment period 73 days Stock Turnover 6 The gross profit was Rs 60,000. closing stock was Rs.5,000 in excess of the opening stock.

Gross Profit Ratio = Gross Profit/ Sales *100 20 = 60000/Sales *100 Sales = 3,00,000 Cost of goods Sold = Sales Gross profit = 2,40,000 Stock Turnover = Cost of goods Sold/ Average Stock 6 = 2,40,000/Average Stock Average Stock = 40,000 (Closing Stock + Opening Stock)/2 = 40,000 Given, Closing Stock Opening Stock = 5,000 Solving, Opening Stock = 37,500 Closing Stock = 42,500

Capital Turnover ratio = Cost of goods sold/ Capital 2 = 2,40,000/ Capital Capital = 1,20,000 Fixed Assets Turnover = Cost of goods Sold/ Fixed Assets 4 = 2,40,000/Fixed Assets Fixed Assets = 60,000 Debtors Turnover = 12/Debt collection Period = 6 Debtors Turnover = Credit Sales/ Average Debtors Debtors = 3,00,000/ 6 = 50,000 Creditors Turnover = 365/ Creditors Payment Period = 5

Cost of Goods Sold = Opening Stock + Purchases Closing Stock Purchases = 2,45,000 Creditors Turnover = Credit Purchase/ Creditors 5 = 2,45,000/Creditors Creditors = 49,000
Liabilities Assets Closing Stock Debtors Fixed Assets Cash (balancing Figure) 1,69,000 42,500 50,000 60,000 16,500 1,69,000

Capital Creditors

1,20,000 49,000