Basic Finance Analysis of Financial Statements 9 An introduction to financial institutions, investments & Management Eleventh Edition
General Accounting Principles Reliability Understandability Comparability
The Balance Sheet Enumerates Assets Liabilities Stockholders’ Equity
Assets Current: cash and cash equivalents, accounts receivable, and inventory Long-term: land, buildings, machinery, and equipment Hidden assets Goodwill and intangible assets
Liabilities Current Long-term debt Accounts Payable Accruals Notes payable Long-term debt
Equity Preferred stock Common stock Additional paid-in capital Retained earnings Book value Book value per share
Income Statement Enumerates To determine Revenues Expenses Income (earnings) Earnings per share
Statement of Cash Flows Enumerates sources of funds (cash inflows) uses of funds (cash outflows) Determines change in the cash position Emphasis on the firm’s ability to generate cash
Cash Inflows A decrease in an asset An increase in a liability An increase in equity
Cash Outflows An increase in an asset A decrease in a liability A decrease in equity
Limitations of Accounting Data Nonmeasureable items are excluded Aggregations Possible biased estimates of data Insufficient challenges by auditors
Depreciation Allocation of the cost of plant and equipment over time Non-cash expense Impact on taxes and cash flow
Depreciation Straight-line depreciation Accelerated depreciation Equal allocation each year Accelerated depreciation Larger proportion during the early years
Modified Accelerated Cost Recovery System (MACRS) Asset classified by years 3, 5, 7, 10, 15, 20 years The half-year convention
Ratio Analysis How do you evaluate a company?
Ratio Analysis What is Ratio Analysis http://www.investopedia.com/terms/r/ratioanalysis.asp?lgl=no-infinite
Ratio Analysis Analysis Accounting data are often used to analyze a firm’s financial condition. Creditors measure the safety of their loans Investors how well managers are doing Management identify weakness in the firm
Ratio Analysis 5 Groups Liquidity Activity or Asset Utilization Profitability Leverage Coverage
Ratio Analysis 5 Groups Liquidity Ratio Indicate the ability of the firm to meet its short-term obligation as they become due
Ratio Analysis 5 Groups Activity or Asset Utilization Ratio Are concerned with the amount of assets a firm uses to support it sales. More rapidly assets turn over, the fewer assets the firm needs to generate sales. High turnover of inventory and accounts receivable also indicates how quickly the firm is able to convert these to current assets into cash.
Ratio Analysis 5 Groups Profitability Ratio Are a measure of performance, they indicate what the firm earns on it sales, assets, and equity.
Ratio Analysis 5 Groups Leverage Ratio Are concerned with the firm’s capital structure, or the extent to which debt is used to finance the firm’s assets.
Ratio Analysis 5 Groups Coverage Ratio Indicate the extent to which the firm generates operating income to cover an expense.
Ratio Analysis Facilitates Comparisons Time-series analysis: Analysis of a firm over a period of time Cross-sectional analysis: Analysis of several firms in the same industry at a point in time
Liquidity Ratio What are liquidity Ratio’s http://www.investopedia.com/terms/l/liquidityratios.asp?lgl=no-infinite
Liquidity Ratio Liquidity is the ease with which assets may be converted into cash without loss. Current Ratio Quick Ratio (acid test) Cash Ratio
Current Ratio What is the Current Ratio http://www.investopedia.com/terms/c/currentratio.asp?lgl=no-infinite
Current Ratio Current ratio: Ratio of current assets to current liabilities: Measure of liquidity Ratio indicates how well the current liabilities, which must be paid in a year are covered. Current assets / current liabilities $2,945 ,021/ $2,062,846 = 1.43
Current Ratio Desirable to have more current assets than current liabilities Rule of thumb is 2:1 Determines if the firm has sufficient liquid assets to meet it bills. Low current ratio is undesirable: it indicates financial weakness High current ration may be undesirable: it may imply the firm is not using funds economically
Quick Ratio What is the Quick Ratio (acid test): http://www.investopedia.com/terms/q/quickratio.asp?lgl=no-infinite
Quick Ratio Quick Ratio (acid test): Current assets excluding inventory divided by current liability: Measures liquidity Considers that not all current assets are equally liquid Eliminates inventory, places a greater emphasis on cash, cash equivalents and accounts receivables
Quick Ratio (Current assets - inventory) / current liabilities
Cash Ratio What is the Cash Ratio http://www.investopedia.com/terms/c/cash-ratio.asp?lgl=no-infinite
Cash Ratio (Cash and Cash equivalents) / current liabilities ($373,145) / $ 2,062,846 = 0.18
Interpretations Current ratio: the firm’s current assets are 1.43 times its current liabilities Quick ratio: the firm’s more liquid current assets are 0.83 its current liabilities Cash ratio: the firm’s cash position are .18 its current liabilities
Activity Ratios What are Activity Ratios http://www.investopedia.com/terms/a/activityratio.asp?lgl=no-infinite
Activity Ratios Activity ratios indicate how rapidly the firm is turning its assets (inventory & accounts receivable) into cash. Inventory turnover Receivable turnover More rapidly the firm turns over its inventory & receivables more rapidly it acquires cash.
Activity Ratios High turnover indicates that the firm is rapidly receiving cash & is more able to pay it liabilities as they come due. Does not imply that the firm is maximizing profits Why?
Inventory Turnover What is Inventory Turnover Ratio http://www.investopedia.com/terms/i/i nventoryturnover.asp?lgl=no-infinite
Inventory Turnover Inventory turnover: speed with which inventory is sold Sales / average inventory Sales/(20x1+20x0/2) $10,148/($1,237,613+$1,378,216)/2 $10,148 / $1,308 = 7.8
Inventory Turnover 2nd Equation Cost of Goods Sold / avg inventory COGS/(20x1+20x0/2) $6,564 / $1,308 = 5.02
Inventory Turnover Difference Sales / average inventory $10,148 / $1,308 = 7.8 Cost of Goods Sold / avg inventory $6,564 / $1,308 = 5.02
Inventory Turnover What is Days Sales of Inventory Ratio http://www.investopedia.com/terms/d/dsi.asp?l gl=no-infinite
Inventory Turnover Days in a year/Inventory Turnover Equation 1 $10,148 / $1,308 = 7.8 365/7.8 = 47 Days Equation 2 $6,564 / $1,308 = 5.02 365/5.02 = 73 Days
Receivables Turnover What is the Receivable Turnover Ratio http://www.investopedia.com/terms/r/re ceivableturnoverratio.asp?lgl=no-infinite
Receivables Turnover Receivable turnover: Speed at which accounts receivable are collected Sales / accounts receivable $10,148 / $1,172 = 8.7 a year 365/8.7 = 42 Days
Days Sales Outstanding (Average Collection Period) What is the Days Sales Outstanding Ratio http://www.investopedia.com/terms/d/dso.asp?l gl=no-infinite
Days Sales Outstanding (Average Collection Period) Days sales outstanding (average collection period): Number of days required on the average to collect an account receivable Accounts receivable / sales per day Sales / 365 = Sales per day $1,172 / 27,803 = 42 Days
Interpretations Inventory turnover: inventory turns over (is sold) every 47 days. Receivables turnover and days sales outstanding: receivables are collected in 42 days (i.e., are outstanding for 42 days)
Fixed Asset Turnover What is the Fixed Asset Turnover Ratio http://www.investopedia.com/terms/f/fixe d-asset-turnover.asp?lgl=no-infinite
Fixed Asset Turnover Fixed asset turnover: Ratio of sales to fixed assets; measure of fixed assets necessary to generate sales. This ratio specifically measures how able a company is to generate net sales from fixed- asset investments. Sales / fixed assets (land, plant ect)- Dep $10,148 / $1,978 = 5.1
Total Asset Turnover What is the Total Asset Turnover Ratio http://www.investopedia.com/terms/a/asse tturnover.asp?lgl=no-infinite
Total Asset Turnover Total asset turnover: Ratio of sales to total assets; measure of total assets required to generate sales Sales / total assets $10,148 / $9,664 = 1.05
Interpretations Fixed asset turnover: every $1 in fixed assets generates $5.1 in sales Total asset turnover: every $1 in assets generates $1.05 in sales
Profitability Ratio What is a Profitability Ratio http://www.investopedia.com/terms/p/profitabilityratios.asp?lgl=no-infinite
Profitability Ratio Profitability Ratio: measure of performance that indicate what the firm is earning on its sales or assets or equity. Operating profit margin Net profit margin Gross profit margin Return on total assets Return on equity Basic earning power
Operating Profit Margin What is the Operating Profit Margin Ratio http://www.investopedia.com/terms/o/operatingmargin.asp?lgl=no-infinite
Operating Profit Margin Operating Profit Margin Ratio: Ratio of operating income to sales; percentage earned on sales before deducting interest expense and taxes. Earnings before interest & taxes (EBIT)/ Sales $1,572 / $10,148 = 15.5%
Operating Profit Margin What is the Net Profit Margin Ratio http://www.investopedia.com/terms/n/net_margin.asp?lgl=no-infinite
Net Profit Margin Net Profit Margin Ratio: Ratio of earnings after interest and taxes to sales; percentage earned on sales. Typically expressed as a percentage, net profit margins show how much of each dollar collected by a company as revenue translates into profit. Earnings after interest & taxes / sales $923 / $10,148 = 9.1%
Gross Profit Margin What is the Gross Profit Margin Ratio http://www.investopedia.com/terms/g/gross_profit_margin.asp?lgl=no-infinite
Gross Profit Margin Gross profit margin is a financial metric used to assess a company's financial health and business model by revealing the proportion of money left over from revenues after accounting for the cost of goods sold (COGS). Gross profit margin, is also known as gross margin.
Gross Profit Margin Gross Profit Margin Ratio: Ratio of revenues minus cost of goods sold to sales; percentage earnings on sales before considering operating expenses, interest and taxes. (revenues - cost of goods sold) / sales $3,584 / $10,148 = 35.3%
Interpretation Gross profit margin: the firm earns $0.353 on every $1 in sales after deducting the cost of the goods sold. Operating profit margin: the firm earns $0.1.55 on every $1 in sales after deducting operating expenses. Net profit margin: the firm earns $0.091 on every $1 in sales after deducting operating expenses, financing costs and taxes.
Return on Assets What is the Return on Total Asset Ratio http://www.investopedia.com/terms/r/return_on_total_assets.asp?lgl=no-infinite
Return on Total Assets Return on Total Asset: Ratio of earnings to total assets; percentage earned on assets. The ratio is considered to be an indicator of how effectively a company is using its assets to generate earnings before contractual obligations must be paid. Earnings after Interest & Taxes/ Total Assets $923 / $9,664 = 9.6%
Return on Equity What is the Return on Equity Ratio http://www.investopedia.com/terms/r/returnonequity.asp?lgl=no-infinite
Return on Equity Return on Equity: Ratio of earnings to owners’ equity; percentage earned on equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. Earnings after interest & taxes / equity $923 / $1,220 = 75.7%
Basic Earning Power Basic Earning Power: Ratio of operating income to total assets; measure of the firm’s ability to generate income before considering interest and taxes. EBIT / total assets $1,572 / $9,664 = 16.3%
Interpretations Return on assets: the firm earns $0.096 on every $1.00 of assets. Return on equity: the firm earns $0.757 on every $1.00 of equity (stock). Basic earning power: the firm earns $0.163 on every $1.00 of assets before considering sources of financing.
Leverage Ratio What is a Leverage Ratio http://www.investopedia.com/terms/l/leverageratio.asp?lgl=no-infinite
Leverage Ratio Leverage Ratio Companies rely on a mixture of owners' equity and debt to finance their operations. A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt (loans), or assesses the ability of a company to meet financial obligations. Debt/Net Worth Ratio Debt Ratio
Leverage Ratio Leverage Ratio give you an indication of financial Risk. High leverage ratios are considered riskier, to creditors why How about investors and why
Debt Ratio What is the Debt/Net Worth Ratio http://www.investopedia.com/terms/d/debtequityratio.asp?lgl=no-infinite
Debt to Equity Ratio Debt / Net Worth Equity: Ratio of debt to equity; debt divided by equity. Debt/Equity Ratio is a debt ratio used to measure a company's financial leverage. The D/E ratio indicates how much debt a company is using to finance its assets relative to the amount of value represented in shareholders’ equity. D/E Ratio = Debt/Equity $8,434 / $1,219 = 6.91
Debt Ratio What is the Debt Ratio http://www.investopedia.com/terms/d/debtratio.asp?lgl=no-infinite
Debt Ratio Debt Ratio: Total debt divided by total assets; proportion of assets financed by debt; a measure of financial leverage. It can be interpreted as the proportion of a company’s assets that are financed by debt. Debt ratio = Debt/Total Assets $8,434 / $9,664= 87.3%
Interpretations Debt ratio: debt finances 87.3 percent of the firm’s assets Debt to equity ratio: debt is 6.9 times the firm’s equity.
DuPont System of Analysis Combines Net profit margin Turnover Leverage Helps identify source of weakness
DuPont System of Analysis
Times-interest-earned Earnings before interest and taxes / interest $1,572 / $340 = 4.6 Interpretation: operating earnings is 4.6 times interest expense
Ratio Comparisons Ratios of firms within an industry tend to have similar numerical values differences in numerical values are reasons for further analysis
Possible Problems with Ratio Comparisons Readily available data from internet sources may differ Differences in time periods covered Differences in ratio definitions used for calculations