Financil Statement Analysis

Financial Statement Analysis

Financial Statements Ratio Analysis Trend Analysis Common-Size and Index Analysis

Primary Types of Financial Statements

Balance Sheet
A summary of a firms financial position on a given date that shows total assets = total liabilities + owners equity.

Income Statement
A summary of a firms revenues and expenses over a specified period, ending with net income or loss for the period.

Financial Ratios
A Financial Ratio is an index that relates two accounting numbers and is obtained by dividing one number by the other. It is a tool frequently used to evaluate a firms financial condition and performance . Financial ratios are the analysts microscope; they allow us to get a better view of the firms financial health than just looking at the raw financial statements Calculating ratios is pointless unless you know how to use them. The most basic rule is: a single ratio provides very little information and may be misleading

Purpose
Comparison Forecasting / Budgeting Benchmarking KPIs

Types of Comparisons
Internal Comparisons: This involves analyzing and comparing a present
ratio with the past and future ratios for the same company.

External Comparisons: This involves comparing the ratios of one firm with those of similar firms or with industry averages. ( e.g PSO & Shell)

Types of Ratios
Balance Sheet Ratios Income Statement Ratios Income Statement / Balance Sheet Ratios

The Analysis of Financial Statements The Use Of Financial Ratios Analyzing Liquidity Analyzing Activity Analyzing Debt Analyzing Profitability A Complete Ratio Analysis

The Analysis of Financial Statements

THE USE OF FINANCIAL RATIOS
Financial Ratio are used as a relative measure that facilitates the evaluation of efficiency or condition of a particular aspect of a firm's operations and status Ratio Analysis involves methods of calculating and interpreting financial ratios in order to assess a firm's performance and status

Example
(1) (2) (1)/(2) 1.10 .92

Year End Current Assets/Current Liab. Current Ratio

1994 1995

$550,000 /$500,000 $550,000 /$600,000

Copyright

1994, HarperCollins Publishers

Interested Parties
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Three sets of parties are interested in ratio analysis:

Shareholders Creditors Management

Copyright 1994, HarperCollins Publishers

Types of Ratio Comparisons

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There are two types of ratio comparisons that can be made:

Cross-Sectional Analysis Time-Series Analysis

Combined Analysis uses both types of analysis to assess a firm's trends versus its competitors or the industry
Copyright 1994, HarperCollins Publishers

Words of Caution Regarding Ratio Analysis

A single ratio rarely tells enough to make a sound judgment. Financial statements used in ratio analysis must be from similar points in time. Audited financial statements are more reliable than unaudited statements. The financial data used to compute ratios must be developed in the same manner. Inflation can distort comparisons.
Copyright 1994, HarperCollins Publishers

Ratio Categories
Liquidity Ratios:- provides information about firm ability
to meet its short term obligations.

Leverage Ratios:- provide an indication of the long-term

solvency of the firm and measure the extent to which the firm is using long term debt.

Efficiency Ratios:- indicates how efficiently the firm utilizes

its assets.

Profitability Ratios:- indicates and measures the success of

the firm at generating profits.

Equity Ratios:- provides information and are of primary

concern to stockholders

Analyzing Liquidity
Liquidity refers to the solvency of the firm's overall financial position, i.e. a "liquid firm" is one that can easily meet its short-term obligations as they come due. A second meaning includes the concept of converting an asset into cash with little or no loss in value.
Copyright 1994, HarperCollins Publishers

Three Important Liquidity Measures

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Net Working Capital (NWC) NWC = Current Assets - Current Liabilities Current Ratio (CR) Current Assets CR = Current Liabilities Quick (Acid-Test) Ratio (QR) Current Assets - Inventory QR = Current Liabilities

Copyright

1994, HarperCollins Publishers

Analyzing Activity
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Activity is a more sophisticated analysis of a firm's liquidity, evaluating the speed with which certain accounts are converted into sales or cash; also measures a firm's efficiency
Copyright 1994, HarperCollins Publishers

Five Important Activity Measures

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Inventory Turnover (IT)

IT =

Cost of Goods Sold Inventory Accounts Receivable

Average Collection Period (ACP)

ACP =

Annual Sales/360 Accounts Payable

Average Payment Period (APP)

APP= Annual Purchases/360 Sales

Fixed Asset Turnover (FAT)

FAT =

Net Fixed Assets Sales Total Assets

Total Asset Turnover (TAT)

TAT =

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Analyzing Debt
Debt is a true "double-edged" sword as it allows for the generation of profits with the use of other people's (creditors) money, but creates claims on earnings with a higher priority than those of the firm's owners. Financial Leverage is a term used to describe the magnification of risk and return resulting from the use of fixed-cost financing such as debt and preferred stock.
Prof. Kuhle

Measures of Debt
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There are Two General Types of Debt Measures Degree of Indebtedness Ability to Service Debts

Four Important Debt Measures

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Debt Ratio (DR) Debt-Equity Ratio (DER) Times Interest Earned Ratio (TIE) Fixed Payment Coverage Ratio (FPC)

DR=

Total Liabilities Total Assets Long-Term Debt

DER=

Stockholders Equity

Earnings Before Interest & Taxes (EBIT) TIE= Interest Earnings Before Interest & Taxes + Lease Payments FPC= Interest + Lease Payments +{(Principal Payments + Preferred Stock Dividends) X [1 / (1 -T)]}

Analyzing Profitability
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Profitability Measures assess the firm's ability to operate efficiently and are of concern to owners, creditors, and management A Common-Size Income Statement, which expresses each income statement item as a percentage of sales, allows for easy evaluation of the firms profitability relative to sales.

Seven Basic Profitability Measures

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Gross Profit Margin (GPM) Operating Profit Margin (OPM) Net Profit Margin (NPM) Return on Total Assets (ROA) Return On Equity (ROE) Earnings Per Share (EPS) Price/Earnings (P/E) Ratio

GPM=

Gross Profits Sales Operating Profits (EBIT)

OPM =

Sales Net Profit After Taxes

NPM= ROA= ROE=

Sales Net Profit After Taxes Total Assets Net Profit After Taxes Stockholders Equity Earnings Available for Common Stockholders Number of Shares of Common Stock Outstanding Market Price Per Share of Common Stock Earnings Per Share

EPS =

P/E =

Computation
Share Capital Retained Earnings Creditors Accounts Payable Other Current Liabilities Plant and Equipments Land and Building Cash Account Receivable Inventory Prepaid Insurance Sales COGS GP Op Exp EBIT Tax EAT 1,000,000 Calculate: 368,000 Current Ratio 104,000 Quick ratio 200,000 Stock Turn Over (COGS) 20,000 640,000 Debtor Turn Over 80,000 GP Ratio 160,000 NP (EAT) Ratio 320,000 Operating Ratio ? 12,000 ? 3,080,000 920,000 ? 240,000 ? 120,000

Analysis
For each of the following transaction indicate weather the transaction will improve, decline or will have no effect on current ratio of ABC Sell Improve Co: additional equity shares
Sell 10% Long term debentures Improve Pay Bills payable No Change Received collection from debtors No Change Purchased additional plant Weaken Issuing bills payable to creditors No Change Purchase T Bills No Change Writing off bad debts Weaken

Analysis
Indicate weather the transaction will improve, decline or will have no effect on current ratio of ABC Co which is currently 2:1
Payment of current liability Purchase of Fixed Assets Cash Collection from Debtors Bill receivable dishonored Issuance of new share Signed MOU with XYZ Co No Change Weaken No Change No Change Improve No Change

Identify the effect of each of the following transactions on below mentioned ratios i.e. Ratio will Improve, Decline or will have no effect
Description Debt Gross Current Equity Profit Ratio Ratio Ratio Debtors Turn Stock Over T/O

Purchase of Equipment on Credit Sales on Credit, COGS will be recorded at the end of period Signed Contract with Bank for running finance facility Shipment of raw material from Wh to factory Paid Dividend to Share holders

Practice Question
From the following information prepare Balance Sheet of Margalla Co for June 30, 2011 Sales to Total Assets 3 times Sales to Fixed Assets 5 Sales to Current Assets 7.5 Sales to Inventory 20 Sales to Debtors 15 Current Ratio 2 Total Assets to Equity 2.5 Long Term Debt to Equity 1 Sales $3.6 Million

From the following information prepare Balance Sheet of Singh Co for Dec 30,10 GP (20% of Sales) Rs 60,000 Share Holders Equity 50,000 Credit Sales 80% Asset Turn Over 3 Times Inventory T/O (COGS) 8 Times Avg Coll period (360 days) 18 days Current Ratio 1.6 times LT Debt to Equity 40%

Practice Question

Practice Question
From the following information prepare Pnl & Balance Sheet of Zaki Co for Dec 30,10 Net Sales RS 100,000 Debtors T/O 2 times Inventory T/O (COGS) 1.25 Fixed Assets T/O (COGS) 0.8 Total Debt to Asset Ratio 0.6 NP Margin 5% GP margin 25% Return On Asset 2% TAX % 50% ST Creditors Rs 50,000

Practice Question
From the following information prepare Balance Sheet of AJK Co for Dec 30,10 Working Capital Rs 120,000 Reserves 20,000 Working Capital to Equity 0.3 times Current Ratio 2.5 Quick ratio 1.5

Practice Question
As a Credit Manager of ABC Commercial Bank, you have been approached by two companies for a loan 640,000 of Rs 10 Million for 1 year without any security. Since 1,000,000 the bank already reached its 1,200,000 quota for loan hence only 254,000 1,700,000 one of these request can be 40% entertained. Both Cos furnished following Specify the Co to whom you information's: will grant Loan and Why?
Description Co A Cash 170,000 A/R 274,000 Stock 900,000 Fixed Assets 1,344,000 Current Liabilities 500,000 Long Terms Debts 800,000 Share capital 800,000 R/E 44,000 Sales 2,400,000 GP rate 30% Co B 300,000 424,000 1,350,000 2,075,000

A Complete Ratio Analysis

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DuPont System of Analysis

DuPont System of Analysis is an integrative approach used to dissect a firm's financial statements and assess its financial condition It ties together the income statement and balance sheet to determine two summary measures of profitability, namely ROA and ROE

DuPont System of Analysis

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The firm's return is broken into three components: A profitability measure (net profit margin) An efficiency measure(total asset turnover) A leverage measure (financial leverage
multiplier)

Summarizing All Ratios

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An approach that views all aspects of the firm's activities to isolate key areas of concern Comparisons are made to industry standards (cross-sectional analysis) Comparisons to the firm itself over time are also made (time-series analysis)

KPIs
Inventory Turn Over Fill rates Receivable Turn Over Cash to cash Cycles

Practice Question

The following information taken from 2 companies of same industry

Description Cash A/R Stock Fixed Assets Total Assets Current Liabilities Debentures Share capital R/E Sales COGS Op Exp Interest Expenses Income Tax Dividends Co A 210,000 330,000 1,230,000 1,695,000 3,465,000 900,000 500,000 1,100,000 965,000 5,600,000 4,000,000 800,000 40,000 380,000 100,000 Co B 320,000 630,000 950,000 2,400,000 4,300,000 1,050,000 1,000,000 1,750,000 500,000 8,200,000 6,480,000 860,000 80,000 390,000 180,000

1.

2.

3.

4. 5.

Which Co is using Share Holders money more profitably? Which Co is better able to meet its current debts? If you want to purchase debenture of Co which Co you will prefer? Which Co collects it rec faster? How long both co took to convert Stock investment into cash?

End of Chapter