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Financial Statement Analysis © Mary Low
Financial Statement Analysis © Mary Low

Financial Statement Analysis

Financial Statement Analysis © Mary Low

© Mary Low

Ratio Analysis

Shows the relative size of one financial statement component to another.

Effective only when used in combination with other ratios, analysis, and information

Ratio Analysis involves methods of calculating and interpreting financial ratios in order to assess a firm's

performance and status

© Mary Low

Ratio Analysis
Ratio Analysis

A single ratio by itself is not very meaningful.

The discussion of ratios will include the following types of comparisons.

Ratio Analysis A single ratio by itself is not very meaningful . The discussion of ratios
Ratio Analysis A single ratio by itself is not very meaningful . The discussion of ratios
Ratio Analysis A single ratio by itself is not very meaningful . The discussion of ratios

.

© Mary Low

Financial Ratio Analysis

Financial ratio analysis involves calculating and analysing ratios that use data from one, two or more financial statements. Ratio analysis also expresses relationships between different financial statements. Financial Ratios can be classified into 4 main categories:

Liquidity ratios Asset Management or Activity Ratios Debt Ratios Profitability Ratios

Financial Ratio Analysis • Financial ratio analysis involves calculating and analysing ratios that use data from

© Mary Low

Ratio Analysis Liquidity Ratios
Ratio Analysis
Liquidity Ratios

Measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.

  • Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity.

  • Ratios include the current ratio, the Quick ratio.

© Mary Low

Liquidity ratios

For example: Current ratio

Current Ratio =

Current Assets

Liquidity ratios For example: Current ratio • Current Ratio = Current Assets Current Liabilities This ratio

Current Liabilities This ratio is calculated in times.

The ideal benchmark for the current ratio is $2:$1 where there are two dollars

of current assets (CA) to cover $1 of current liabilities (CL). The acceptable benchmark is $1: $1 but a ratio below $1CA:$1CL represents liquidity riskiness as there is insufficient current assets to cover $1 of current liabilities.

A ratio of 5 : 1 would imply the firm has $5 of assets to cover every $1 in liabilities

A ratio of 0.75 : 1 would suggest the firm has only 75c in assets available to

cover every $1 it owes

Too high Might suggest that too much of its assets are tied up in unproductive activities too much stock, for example?

© Mary Low

Liquidity ratios

Quick Ratio = Current Assets Inventory Current Liabilities

This ratio is calculated in times.

Liquidity ratios • Quick Ratio = Current Assets – Inventory Current Liabilities This ratio is calculated

1:1 seen as ideal

The omission of stock gives an indication of the cash the firm has in relation to its liabilities.

A ratio of 3:1 therefore would suggest the firm has 3 times as much cash as it owes very healthy!

A ratio of 0.5:1 would suggest the firm has twice as many liabilities as it has cash to pay for those liabilities. This might put the firm under pressure but is not in itself the end of the world!

© Mary Low

Asset Management or Activity Ratios

Efficiency of asset usage

How

well

assets

are

used to generate

revenues

(income) will impact on the overall profitability of the

business.

For example: Asset Turnover

Asset Management or Activity Ratios • Efficiency of asset usage – How well assets are used

This

ratio

represents

the efficiency

of asset

usage to generate sales revenue

All turnover ratios are calculated in times while all period ratios are calculated in days.

© Mary Low

Asset Management or Activity Ratios

Asset Turnover =

Net Sales

 
 

Total Assets

Inventory Turnover =

Cost of Goods Sold Inventory

Inventory Period

=

Inventory Cost of goods sold/365

Average Payment Period (APP)

 

Accounts Payable

 

Annual Purchases/365

Average Collection Period =

Accounts Receivable Average daily net sales*

 

* Average daily net sales = net sales / 365

© Mary Low

Inventory turnover

This ratio is calculated in times.

The rate at which a company’s stock is turned over

A high stock turnover might mean increased efficiency?

But: dependent on the type of business supermarkets might have high stock turnover ratios whereas a shop selling high value musical instruments might have low stock turnover ratio

Low stock turnover could mean poor customer satisfaction if people are not buying the goods.

© Mary Low

Average Collection Period = Accounts Receivable Average daily net sales* This ratio is calculated in days. Shorter the better

Gives a measure of how long it takes the business to recover debts

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Debt Ratios

Long term funds management Measures the riskiness of business in terms of debt

For example: Debt/Equity

Debt Ratios Long term funds management Measures the riskiness of business in terms of debt •

This ratio measures the relationship between debt and equity. A ratio of 1 indicates that debt and equity funding are equal (i.e. there is $1 of debt to $1 of equity) whereas a ratio of 1.5 indicates that there is higher debt in the business (i.e. there is $1.5 of debt to $1 of equity). This higher debt is usually interpreted as bringing in more financial risk for the business particularly if the business has profitability or cash flow problems.

© Mary Low

• Debt Ratios Debt/Equity ratio = Long term debt / Total Equity  This ratio is

Debt Ratios

Debt/Equity ratio = Long term debt / Total Equity

  • This ratio is calculated in times.

Debt/Total Assets ratio =

Total Liabilities

*100

Total Assets

  • This ratio is calculated in percentage.

Times Interest Earned = Earnings before Interest and Tax

Interest

  • This ratio is calculated in times.

© Mary Low

Profitability Ratios

Measures the income or operating success of a company for a given period of time.

Profitability measures look at how much profit the firm generates from sales or from its capital assets.

All Profitability ratios are calculated in terms of percentage.

Gross Profit % = Gross Profit * 100

 
 

Net Sales

Net Profit % = Net Profit after tax * 100

 

Net Sales

Return on Assets =

Net Profit

* 100

 

Total Assets

Return on Equity =

Net Profit

*100

Total Equity

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Gross Profit Margin Ratio

Gross Profit % = Gross Profit * 100

Net Sales

The higher the better

Enables the firm to assess the impact of its sales and how much it cost to generate (produce) those sales

A gross profit margin of 45% means that for every $1 of sales, the firm makes 45c in gross profit

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Return on Equity

Return on Equity =

Net Profit

*100

Total Equity

The higher the better Shows how effective the firm is in using its capital to generate profit A ROE of 25% means that it uses every $1 of capital to generate 25c in profit

© Mary Low

Relevant ratios Profitability Benchmarks 2005 2006 ratios: Gross Profit Margin Industry 22% 22.7% 25% Net Profit
Relevant ratios
Profitability
Benchmarks
2005
2006
ratios:
Gross Profit
Margin
Industry
22%
22.7%
25%
Net Profit
Margin
Industry
7.1%
6.1%
7%
Return on
12%
15.6%
15.5%
Assets
Return on
Equity
Industry
32%
26%
20%
© Mary Low
Asset Benchmarks 2005 2006 Management ratios: Inventory Industry 5.8 times 5.58 times Turnover 6 % Asset

Asset

Benchmarks

2005

2006

Management

ratios:

Inventory

Industry

  • 5.8 times

  • 5.58 times

Turnover

6 %

Asset Turnover

2.0

  • 2.2 times

  • 2.53 times

© Mary Low

Liquidity Benchmarks 2005 2006 ratios: Current Ratio Ideal standard 1.78:1 1.70:1 2:1 Acceptable standard 1:1 Quick

Liquidity

Benchmarks

2005

2006

ratios:

Current Ratio

Ideal standard

1.78:1

1.70:1

2:1

Acceptable

standard

1:1

Quick Ratio

Ideal standard

0.85:1

0.69:1

2:1

Acceptable

standard

1:1

© Mary Low

Financial Benchmarks 2005 2006 Structure ratios: Debt/Equity Industry 1.05: 1 0.67:1 0.6:1 Standard benchmark 1:1 Debt
Financial
Benchmarks
2005
2006
Structure
ratios:
Debt/Equity
Industry
1.05: 1
0.67:1
0.6:1
Standard
benchmark
1:1
Debt Ratio
Standard
benchmark: 50%
55%
45%
© Mary Low

Report

Report • For the investor considering the purchase of shares in the company, the return they

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.

ROE in 2006 is 26%. this return is certainly more attractive.

ROE has

decreased

by

6%

in

2006

but the

company’s ROE at 26% is still better than the industry average of 20%

© Mary Low

Profitability

• Profitability – The NP% and ROA ratios show a small downward trend in % over

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.

Gross Profit Margin is slightly unfavourable at about 2.3% below the industry benchmark of 25%.

Asset Management

IT has gone down slightly from 5.8 to 5.58 times. IT is still close to the industry benchmark of 6 times.

AT

has

increased

showing

generated from asset usage

more

sales

being

© Mary Low

Liquidity

Current ratios of 1.78:1 (2005) and 1.70: 1 are at above acceptable levels but below ideal level.

Quick ratios appear more of a concern being below acceptable levels in both years and

even more so in 2006 (0.69:1).

Raises some concerns over the liquidity of the business and inventory management (although IT ratio only shows a slight decline

in 2006).

• Liquidity – Current ratios of 1.78:1 (2005) and 1.70: 1 are at above acceptable levels

© Mary Low