Analysis of Financial Statements Chapter 3 Analysis of Financial Statements

Copyright © 2014 by Nelson Education Ltd.

Ratio Analysis Individual numbers in a firm’s financial statements do not mean much if looked at independently. Ratios are calculated to reveal relationships between different numbers and to extract important information. Ratios also remove the size factor between different firms and make comparison of them meaningful ($5 million of net income for $50 million vs. $100 million of sales). Copyright © 2014 by Nelson Education Ltd.

Financial Statements and Reports The Income Statement The income statement provides a financial summary of a company’s operating results during a specified period. Although they are prepared annually for reporting purposes, they are generally computed monthly by management and quarterly for tax purposes.

Penny Ltd. Income Statement Sales €80,000 Variable operating costs (60,000) Fixed costs, excluding depreciation (12,000) Depreciation ( 2,000) EBIT = NOI 6,000 Interest ( 1,000) Earnings before taxes (EBT) 5,000 Taxes (40%) ( 2,000) Net income € 3,000 Dividends 2,000 Addition to retained earnings 1,000

Financial Statements and Reports The Balance Sheet The balance sheet presents a summary of a firm’s financial position at a given point in time. Assets indicate what the firm owns, equity represents the owners’ investment, and liabilities indicate what the firm has borrowed.

Penny Ltd. Balance Sheet Current Current Year Year Cash & securities € 2,000 Accounts payable € 4,000 Accounts receivable 6,000 Accruals 5,000 Inventory 7,000 Notes payable 1,000 Current assets 15,000 Current liabilities 10,000 Net fixed assets 10,000 Long-term debt 6,000 Total assets €25,000 Total liabilities 16,000 Common stock 6,000 Retained earnings 3,000 Owners’ equity 9,000 Total liabilities & equity €25,000

Penny Ltd. Balance Sheet—Changes in Assets Current Previous Year Year Change Cash & securities € 2,000 €1,000 Accounts receivable 6,000 5,000 Inventory 7,000 8,000 Current assets 15,000 14,000 Net fixed assets 10,000 9,000 Total assets €25,000 €23,000 Source Use 1,000 (1,000) X Fixed assets if no purchases or sales = €9,000 - €2,000 = €7,000 Depreciation = €2,000 Change in fixed assets = €10,000 - €7,000 = €3,000 Sources of Cash Uses of Cash  Asset Account  Asset Account

Penny Ltd. Balance Sheet—Changes in Liabilities and Equity Current Previous Year Year Accounts payable € 4,000 € 2,000 Accruals 5,000 4,000 Notes payable 1,000 2,000 Current liabilities 10,000 8,000 Long-term debt 6,000 7,000 Total liabilities 16,000 15,000 Common stock 6,000 6,000 Retained earnings 3,000 2,000 Owners’ equity 9,000 8,000 Total liabilities & equity €25,000 €23,000 Change 2,000 (1,000) 1,000 Source Use X Sources of Cash Uses of Cash  Liability/Equity Account  Liability/Equity Account

Financial Statements and Reports Statement of Cash Flows The statement of cash flows provides a summary of the cash flows over the period of concern, typically the year just ended. This statement not only provides insight into a company’s investment, financing and operating activities, but also ties together the income statement and previous and current balance sheets.

Penny Ltd. Statement of Cash Flows Cash Flows from Operations: Net income (NI) €3,000 Adjustments to NI Depreciation 2,000  Inventory 1,000  Accounts payable 2,000  Accruals 1,000  Accounts receivable (1,000) Net CF from operations €8,000 Cash Flows from Long-Term Investing: Acquisition of assets (3,000) Cash Flows from Financing Activities:  Notes payable (1,000)  Long-term bonds (1,000) Dividend payment (2,000) Net CF from financing €(4,000) Net Change in cash 1,000 Cash at beginning of year 1,000 Cash at end of year €2,000

Notes to the Financial Statements Notes to the financial statements provide detailed information on the accounting policies, procedures, calculations, and transactions underlying various entries in the financial statements. Common issues include revenue recognition, income taxes, breakdowns of fixed asset accounts, debt and lease terms, and contingencies.

Financial Statements: Time Dimension Balance sheet—a “snapshot” of where the firm is at a specific point in time (stock statement). Income statement and statement of cash flows—shows the results of the firm’s activities over a period of time (flow statement).

Ratio (Financial Statement) Analysis General categories of analysis: Liquidity Asset management Debt management Profitability Market value

Liquidity Ratios Provide an indication of how well the firm can meet its current obligations Help measure the liquidity position of the firm Too little, or too much liquidity could be considered a “bad sign” too little liquidity—suggests the firm will have problems paying its current obligations in the future too much liquidity—might suggest the firm is not investing its funds wisely

Liquidity Ratios Current ratio = total current assets total current liabilities Quick ratio = Total Current Assets - Inventory total current liabilities

Asset Management Ratios Provide an indication of how well the firm manages its assets (efficiency) Show how often the firm is “turning over” its assets to generate funds Generally, when assets are not turned over quickly enough, it is because sales have slowed or current assets, such as inventory and receivables, are too high If assets are turned over too quickly, it could mean that the firm is not producing enough

Asset Management Ratios Inventory Turnover = Cost of Goods Sold Inventory DSO =Days Sales Outstanding = Receivables Average sales per day Fixed assets turnover ratio = Sales Net fixed assets Total Asset Turnover = Sales Total Assets

Debt Management Ratios Indicate how the firm’s financial position is affected by the amount of debt it has financial leverage refers to the use of debt leverage helps to magnify returns, on both the positive and the negative sides, because debt represents a fixed obligation

Debt Management Ratios Debt Ratio = Total Liabilities/Total Assets Times Interest Earned = EBIT/Interest charges Fixed charge coverage ratio = EBIT + Lease Pymts Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}

EBITDA Coverage (EC) Ratio = = 3.0x EBITDA + Lease payments Interest Lease expense pmt. + + Loan pmt. ($283.8 + $100) + $28 $88 + $28 + $20 Copyright © 2014 by Nelson Education Ltd.

Profitability ratios Indicate how the firm’s management of its liquidity position, assets, and debt has affected normal operating activities.

Profitability Ratios Profit Margin on Sales = Net Income/ Sales Return on Total Assets = Net Income/ Total Assets Return on Common Equity = Net Income available to common stockholders / Common equity Basic Earning Power = EBIT / Total assets

Market Value Ratios Measures that consider the value of the firm’s stock in the financial markets—that is, how well investors perceive that the firm is creating value.

Market Value Ratios P/E = Market Price Per Share of Common Stock Earnings Per Share CF per share =NI + Depr. / Shares out. P/CF = Price per share / Cash flow per share M/B = Market Price Per Share of Common Stock Book Value Per Share of Common Stock

Common Size Balance Sheets: Divide All Items By Total Assets 2017 2016 Ind. Cash 0.5% 0.9% 1.0% ST inv. 0.0% 3.9% 2.2% AR 18.8% 17.8% Invent. 30.8% 24.7% 19.8% Total CA 50.0% 48.2% 40.8% Net FA 51.8% 59.2% TA 100.0%

Divide All Items By Total Liabilities and Equity Assets 2017 2016 Ind. AP 3.0% 1.8% Notes pay. 5.5% 3.6% 4.4% Accruals 7.0% 7.7% Total CL 15.5% 13.1% 9.8% LT bonds 37.7% 34.5% 30.2% Total liabilities 53.2% 47.6% 40.0% Pref. stock 2.0% 2.4% 0.0% Total com. eq. 44.8% 50.0% 60.0% Total L&E 100.0%

Analysis of Common Size Balance Sheets The company has a higher proportion of inventory and current assets than industry. The company has less equity (which means more debt) than industry. The company now has zero short-term debt but more long-term debt than industry.

Common Size Income Statement: Divide All Items By Sales 2017 2016 Ind. Net sales 100.0% Op. costs 87.2% 87.6% EBITDA 12.8% 12.4% Depr. 3.3% 3.2% 2.8% EBIT 9.5% 9.2% 9.6% Int. exp. 2.9% 2.1% 1.3% EBT 6.5% 7.1% 8.3% Taxes 2.6% NI before pref. div. 3.9% 4.3% 5.0% Pref. dividends 0.1% 0.0% NI (profit margin) 3.8% 4.1%

Analysis of Common Size Income Statements The company has similar operating cost (87.2) as industry (87.6), but slightly higher depreciation and amortization. The result is that the company has similar EBIT. However, the high interest expense lowers the EBT (6.5) compared to industry (8.3).

Income Statement Percentage Change Analysis: % Change from Base Year Net sales 5.3% Operating costs 4.8% EBITDA 8.7% Depr. & amortization 11.1% EBIT 7.9% Int. exp. 46.7% EBT (3.5%) Taxes @40% NI before pref. dividends Preferred dividends 0.0% NI (3.7%)

Analysis of Percent Change Income Statement We see that 2017 sales grew 5.3% from 2016, and that NI fell 3.7% from 2016. So the company has become less profitable. The analysis reveals whether the firm’s condition has been improving or deteriorating over time. Similar analysis can be performed on the balance sheet. The extreme growth in inventories (48.2%) should be of great concern.

Tying the Ratios Together: The DuPont Equation The DuPont equation focuses on: expense control (PM) asset utilization (TATO) debt utilization (EM) It shows how these factors combine to determine the ROE. It also provides a “quick and dirty” estimate of the impact of operating changes on returns.

( )( )( ) = ROE The DuPont Equation x CE Profit margin TA turnover Equity multiplier NI Sales CE x = ROE

The DuPont Equation (cont’d) NI Sales TA CE x = ROE 2013: 3.8% x 1.5 x 2.23 = 12.7% Alternatively, ROE = ROA × equity multiplier = 5.7% x ($2,000/$896) = 12.7%

Comparative Ratios and Benchmarking Ratio analysis involves comparing a firm’s ratios with industry average figures. Managers can also use a technique called “benchmarking” – comparing the firm’s ratios with those of a smaller set of leading companies in its industry. Comparative ratios are available from various sources including FP informart.

Uses and Limitations of Ratio Analysis Comparison with industry averages is difficult if the firm operates many different divisions. “Average” performance is not necessarily good. Seasonal factors can distort ratios. “Window dressing” techniques can make statements and ratios look better.

Uses and Limitations (cont’d) Different accounting and operating practices can distort comparisons. Sometimes it is difficult to tell if a ratio value is “good” or “bad.” Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition.