FINANCIAL STATEMENT ANALYSIS

FINANCIAL STATEMENT ANALYSIS Objectives Prediction of future returns Assessment of risks associated with those returns Creditors Short term liquidity Long-term solvency Investors Profitability Dividends Stock price appreciation

HORIZONTAL ANALYSIS Percentage changes in comparative statements (Year to Year comparisons) Establishment of “Base Period” Trend percentages Form of horizontal analysis Series of years Current year data / Base year data

Relationship of statement items to a specified “Base Item” VERTICAL ANALYSIS Relationship of statement items to a specified “Base Item” Income statement = Net sales Balance sheet = Total assets

COMMON-SIZE STATEMENTS Reports only percentages for statement items “Base Items” normally same as vertical analysis Allows comparison of firms of different size %

BENCHMARKING Comparison of a company to standards found in the environment Against Industry Average Against a Major Competitor Against yourself (over time)

FINANCIAL STATEMENT RATIOS Objectives Ability to pay current liabilities (Liquidity) Ability to sell inventory and collect receivables (Liquidity / Turnover) Ability to pay long-term debt (Solvency) Profitability of the company Analysis of company’s stock as an investment

FINANCIAL STATEMENT ANALYSIS Limitations Statements are largely historical and involve many estimates Comparability between firms may be difficult Financial ratios are only indicators Specific reasons for problems must still be identified External factors will often impact the financial results of a company Users must look at the entire picture when using financial statement analysis

A profitability measure Also known as profit margin ratio Return on Sales (ROS) A profitability measure Also known as profit margin ratio Considers relative firm size Net Income Sales Revenue ROS = $39,700 $305,000 = 13.0% = Cup-A-Jo expects to generate 13 cents of bottom line profit for every dollar of sales revenue. @Cambridge Business Publishers, 2009 9

[Net income + Interest expense × (1 – Tax rate)] Return on Assets (ROA) A profitability measure Considers relative firm size [Net income + Interest expense × (1 – Tax rate)] Total assets ROA = = $39,700 + [$6,300 × (62.3%)] $472,450 = 9.2% *Effective Tax rate = $24,000/$63,700 = 37.7% Cup-A-Jo has earnings of 9.2% available for its business capital providers. @Cambridge Business Publishers, 2009 10

A profitability measure Also known as return on shareholders’ equity Return on Equity (ROE) A profitability measure Also known as return on shareholders’ equity Considers relative firm size Net income Shareholders’ equity $39,700 $371,700 ROE = = = 10.7% Cup-A-Jo is expected to generate about 10.7 cents of profit for every dollar of shareholders’ investment in the company. @Cambridge Business Publishers, 2009 11

Return on Equity Paradigm Reveals four ways to improve ROE Improve return on sales Improve asset turnover Improve use of financial leverage Some combination of 1, 2, and 3 Return on Shareholders’ Equity Return on Sales Asset Turnover Financial Leverage @Cambridge Business Publishers, 2009 12

Key performance indictor Asset Turnover How effective a business’s assets are being used by management to generate sales revenue Key performance indictor Asset Turnover Sales revenue Total assets $305,000 $472,450 = = = 0.646 For every dollar invested in the company’s assets. Cup-A-Jo generated 64.6 cents of sales. @Cambridge Business Publishers, 2009 13

Relative mix of debt versus equity financing used by a business Financial Leverage Relative mix of debt versus equity financing used by a business Financial Leverage Total assets Shareholders’ equity $472,450 $371,700 = = = 1.27 Cup-A-Jo’s assets are about 1.27 times the amount of shareholders’ equity invested @Cambridge Business Publishers, 2009 14

Return on Equity for Cup-A-Jo ROE = Return on Sales × Assets Turnover × Financial Leverage Net income Sales revenue Sales revenue Total assets Total assets Shareholders’ equity = × × $39,700 $305,000 $305,000 $472,450 $472,450 $371,700 = × × × = 13.0% 0.646 × 1.27 = 10.7% @Cambridge Business Publishers, 2009 15

Long-term Debt-to-Equity Reveals the relative investment of long-term lenders versus that of shareholders Indicates whether the financing strategy of the company is heavier on debt or equity Debt-to-Equity Long-term debt Shareholders’ equity $67,500 $371,700 = = = 0.182 Cup-A-Jo’s long-term debt is about 18% of the amount of shareholders’ equity. @Cambridge Business Publishers, 2009 16

Times-Interest-Earned Ratio Reveals the extent to which operating earnings is able to ‘cover’ current debt service charges (interest) Interest Coverage Operating income Interest expense $70,000 $6,300 = = = 11.1 Cup-A-Jo’s operating income is able to cover interest about 11 times per year. @Cambridge Business Publishers, 2009 17