Financial management

FINANCIAL STATEMENT ANALYSIS

LECTURE 2
TALHA A SIDDIQUI
 Financial Statement
Analysis

Financial Statement Analysis is done in order

to diagnose the financial health of firm . It
helps users of financial statement/
stakeholders to take appropriate decisions.
User of Financial Analysis

• Trade creditors : Interested in firm’s ability to

meet their obligation
• Supplier of long term debt : Concerned with
firm long term solvency and survival
• Investors : Are mostly concerned with firm’s
earning
• Management : Interested in every aspect of
financial analysis.
Financial Statement Analysis

Purpose:
• To use financial statements to evaluate an organisation’s
• Financial performance
• Financial position.
• To have a means of comparative analysis across time in
terms of:
• Intracompany basis (within the company itself)
• Intercompany basis (between companies)
• Industry Averages (against that particular industry’s averages)
• 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:
• Provide information about the organisation’s:
• Past performance
• Present condition
• Future performance
• Assess the organisation’s:
• Earnings in terms of power, persistence, quality
and growth
• Solvency
Effective Financial Statement
Analysis

• To perform an effective financial statement

analysis, you need to be aware of the
organisation’s:
• business strategy
• objectives
• 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:

• Understand the nature of the industry in which
the organisation works. This is an industry factor.
• 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
Tools of Financial Statement
Analysis:

The commonly used tools for financial statement analysis are:

• Financial Ratio Analysis

• Comparative financial statements analysis:
• Horizontal analysis/Trend analysis.
• Vertical analysis/Common size analysis.
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 Ratio Analysis
Financial Ratios can be classified into 5 main categories:
Financial Ratio Analysis

• Liquidity ratios : Measure firm ability to meet

current obligations
• Leverage ratios : Shows the proportion of debt and
equity in firms financing assets
• Asset Management/Activity ratios : It reflects firms
efficiency in utilizing its assets
• Profitability ratios : Measures the over all
performance.
Liquidity ratios

• Liquidity ratios measures the ability of forms to meets its

current or short term obligations
• A firm should ensure that it does not suffer from lack of
liquidity and also that it does not have excess liquidity
• The two most common ratios which indicate extent of
liquidity are
1. Current ratio
2. Quick or Acid test ratio
Liquidity ratios

• Current Ratio = Current Assets

Current Liabilities

• Quick Ratio = Current Assets – Inventory

Current Liabilities
Financial Structure or Leverage Ratios

• The short term creditors are concerned with firms current

debt paying ability. While long term creditors are more
concerned with firms long term financial strength.

• To judge firms long term financial position leverage ratios or

financial structure ratios are calculated.

• These ratios indicate the mix of fund provided by owner’s

/equity holders and debt in financing firms assets.

• As a general rule there should be an appropriate mix of fund

from both kind.
Financial Structure or Leverage Ratios

• Debt/Equity ratio = Debt / Equity

• Debt/Total Assets ratio = Debt *100

Total Assets

• Equity ratio = Equity * 100

Total Assets
Asset Management or Activity
Ratios

• This ratio measures how well assets are used by firm

to generate revenues (income) and its impact on
the overall profitability of the business.
Asset Management or Activity
Ratios

• Asset Turnover = Sales

Total Assets

• Inventory Turnover = Cost of Goods Sold

Inventory
Profitability Ratios

• A company should earn profit to survive and grow

over a long period of time.

• Profit is the difference between revenue and

expenses over a period of time usually one year.

• The profitability ratios are calculated to measure

the operating efficiency of firm .

• Creditors and shareholders are interested in

profitability of firm .
Profitability Ratios
• Gross Profit % = Gross Profit * 100
Net Sales

• Net Profit % = Net Profit after tax * 100

Net Sales
Or in some cases, firms use the net profit before tax figure. Firms have no control over tax expense as they would
have over other expenses.
 Net Profit % = Net Profit before tax *100
Net Sales

• Return on Assets = Net Profit * 100

Average Total Assets

• Return on Equity = Net Profit * 100

Average Total Equity
Market value or Market test
Ratios

• These ratios are based on information not necessarily

contained in financial statements

• They are based on the share market's perception of the

company

• These measure can only be calculated for publically traded

comapanies
Market Test Ratios

• Earnings per share = Net Profit after tax

Number of issued ordinary shares

• Dividends per share = Dividends

Number of issued ordinary
shares

• Dividend payout ratio = Dividends per share *100

Earnings per share

• Price Earnings ratio = Market price per share

Earnings per share
Horizontal analysis/Trend
analysis

• Trend percentage
• Line-by-line item analysis
• Items are expressed as a percentage of a
base year
• This is a time series analysis
• For example, a line item could look at
increase in sales turnover over a period
of 5 years to identify what the growth in
sales is over this period.
Vertical analysis/Common size analysis/
Component Percentages

• All items are expressed as a percentage of a common

base item within a financial statement
• e.g. Financial Performance – sales is the base
• e.g. Financial Position – total assets is the base
• Important analysis for comparative purposes
• Over time and
• For different sized enterprises
Limitations of Financial Statement Analysis

• We must be careful with financial statement

analysis.
• Strong financial statement analysis does not
necessarily mean that the organisation has a strong
financial future.
• Financial statement analysis might look good but
there may be other factors that can cause an
organisation to collapse.
 Illustration: Financial statement analysis

• The following financial statements of Walker Ltd. Its is a

diversified enterprise with its main interests in the manufacture
and retail of plastic products.
• 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 2006 Horizontal

Analysis
$000 $000 $000 $000
Current Assets
Bank 33.5 41.0
Accounts receivable 240.8 210.2
Inventory 300.0 370.8
574.3 622.0 108
Non-current assets
Fixtures & fittings (net) 64.6 63.2
Land & buildings (net) 381.2 376.2
445.8 439.4 99
Total assets 1,020.1 1,061.4 104

Current Liabilities
Accounts payable 261.6 288.8
Income tax 60.2 76.0
321.8 364.8 113
Non-current liabilities
Loan 200.0 60.0 30

Shareholders Funds
Paid-up ordinary capital 300.0 334.1
Retained profit 198.3 302.5
498.3 636.6 128
Total liabilities & equity 1,020.1 1,061.4 104
Walker Ltd
Statement of Financial Performance for year ended 31
March

2005 2006 Horizontal

Analysis
$000 $000 $000 $000
Sales 2,240.8 2,681.2 120
Less Cost of goods sold 1,745.4 2,072.0 119
Gross profit 495.4 609.2 123
Wages & salaries 185.8 275.6
Rates 12.2 12.4
Heat & light 8.4 13.6
Insurance 4.6 7.0
Interest expense 24.0 6.2
Postage & telephone 9.0 16.4
Depreciation -
Buildings 5.0 5.0
Fixtures & fittings 27.0 276.0 32.8 369.0 134

Net profit before tax 219.4 240.2 109

Less Income tax 60.2 76.0 126
Net profit after tax 159.2 164.2 103
Walker Ltd
Statement of Cash Flows for the year ended 31 March

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

• Credit purchases for the year 2006 were $2,142,800.

• 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:
• 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.
• Gross profit margin 25%
• Net profit margin 7%
• Inventory turnover 6 times
• Debt/equity ratio 0.6 : 1
• Return on Assets 12%
• Return on Equity 20%
Relevant ratios

Profitability Benchmarks 2005 2006

ratios:
Gross Profit Industry 22% 22.7%
Margin 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%

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.
Relevant ratios

Asset Benchmarks 2005 2006

Management
ratios:

Inventory Turnover Industry 5.8 times 5.58 times

6%

Asset Turnover Not given 2.2 2.53

Relevant ratios

Liquidity ratios: Benchmarks 2005 2006

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

Days Payable Standard Credit purchases 49.19 days

30 days not available
Relevant ratios

Financial Benchmarks 2005 2006

Structure ratios:

Debt/Equity Industry 1.05: 1 0.67:1

0.6:1
Standard
benchmark
1:1
TIE Standard 10.14 times 39.74 times
benchmark:
Between 3 and 5.
Below 3 risky.
Above 5 very
favourable
Report

• 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%. 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.
• ROE has decreased by 4% but the company’s ROE at 26% is still
better than the industry average of 20%
• Riskiness of business is being reduced by the significant
repayment of loan in 2006.
Report

• Profitability
• 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%.
• The horizontal analysis information show that Sales have
increased by 20%. However operating costs have
increased by 34%.
• 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 more sales being generated
from asset usage
Report

• 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).
• Days Payable is a concern as there may be poor
debt payment management.
Report

• Financial Structure
• 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.
• TIE is extremely good for the business at 39.74 times
(well above 5 the standard benchmark).
• Cash flow situation
• Strong cash flow from operating activities (increased
from 160,600 to 185,000).
• Spending under investing activities suggest more
growth.
• 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.