FINANCIAL STATEMENT ANALYSIS (RATIO ANALYSIS)

Financial Structure Analysis FINANCIAL STATEMENTS SOLVENCY RATIOS Financial Structure Analysis (Solvency Ratios): This category of ratios are used to determine the ability of a company to meet long-term obligations. Financial structure analysis enables to determine capital structure of a company. Capital structure refers to the sources of financing for a company and it is a significant issue in analyzing the company’s financial stability and risk of insolvency depend on its financing activity and decisions. ABC CO. 31.12.20X1 BALANCE SHEET CURRENT ASSETS CURRENT LIABILITIES Cash and cash equivalents Bank Loans Financial Assets Trade Payables Trade Receivables Tax Payable Inventories Provisions NON-CURRENT ASSETS NON-CURRENT LIABILITIES Property, Plant and Equipment EQUITY

The Importance of Financial Structure Analysis FINANCIAL STATEMENTS SOLVENCY RATIOS The Importance of Financial Structure Analysis Capital structure consists of debt and equity (financial leverage ratio). A company’s financial stability and risk of insolvency depend on its financing sources and the types of assets. Assets refer to investing activity, debt and equity refer to financing activity of an entity. ABC CO. 31.12.20X1 BALANCE SHEET CURRENT ASSETS CURRENT LIABILITIES Cash and cash equivalents Bank Loans Financial Assets Trade Payables DEBT STRUCTURE Trade Receivables Tax Payable Inventories Provisions NON-CURRENT ASSETS NON-CURRENT LIABILITIES Property, Plant and Equipment EQUITY

Financial Structure Analysis FINANCIAL STATEMENTS SOLVENCY RATIOS Financial Structure Analysis (Solvency Ratios): Solvency ratios consists of; Common-sized ratios. Debt to Equity Ratio and Financial Leverage Ratio, ABC CO. 31.12.20X1 BALANCE SHEET CURRENT ASSETS CURRENT LIABILITIES Cash and cash equivalents Bank Loans Financial Assets Trade Payables DEBT STRUCTURE Trade Receivables Tax Payable Inventories Provisions NON-CURRENT ASSETS NON-CURRENT LIABILITIES Property, Plant and Equipment EQUITY

FINANCIAL STATEMENTS SOLVENCY RATIOS Common-Sized Ratios (Vertical Analysis) ABC CO. 31.12.20X1 BALANCE SHEET CURRENT ASSETS CURRENT LIABILITIES Cash and cash equivalents Bank Loans Financial Assets Trade Payables Trade Receivables Tax Payable Inventories Provisions NON-CURRENT ASSETS NON-CURRENT LIABILITIES Property, Plant and Equipment EQUITY

Debt to Equity Ratio (Capitalization Ratio) FINANCIAL STATEMENTS SOLVENCY RATIOS Debt to Equity Ratio (Capitalization Ratio) Debt to Equity ratio refers to the ability of equity in covering total debt. In traditionally financed companies, this ratio equals to 1. The increase in this ratio means the proportion of debts is increasing and the equity is not enough to cover the total debt. The use of debt is not necessarily a negative signal about a firm. In interpreting these measures, the financial leverage index and coverage ratios must be taken into account. ABC CO. 31.12.20X1 BALANCE SHEET CURRENT ASSETS CURRENT LIABILITIES NON-CURRENT ASSETS NON-CURRENT LIABILITIES EQUITY

FINANCIAL STATEMENTS SOLVENCY RATIOS Financial Leverage Ratio: Financial Leverage Ratio indicates the proportion of debt, in other words the proportion of asset financed with debt. This ratio measures the claims of creditors on the firm’s assets. ABC CO. 31.12.20X1 BALANCE SHEET CURRENT ASSETS CURRENT LIABILITIES NON-CURRENT ASSETS NON-CURRENT LIABILITIES DEBT STRUCTURE Property, Plant and Equipment EQUITY

LEVERAGE AND PROFITABILITY FINANCIAL STATEMENTS LEVERAGE AND PROFITABILITY ABC CO. 31.12.20X1 BALANCE SHEET CURRENT ASSETS CURRENT LIABILITIES Financial Leverage (Debt Structure) NON-CURRENT ASSETS NON-CURRENT LIABILITIES EQUITY Leverage means use of debt in the capital structure of the firm. How much leverage should be there in a firm?

Why is the leverage important? FINANCIAL STATEMENTS LEVERAGE AND PROFITABILITY ABC CO. 31.12.20X1 BALANCE SHEET CURRENT ASSETS CURRENT LIABILITIES Financial Leverage (Debt Structure) NON-CURRENT ASSETS NON-CURRENT LIABILITIES EQUITY Why is the leverage important? Because of two reasons: a higher debt ratio can increase the rate of return on equity capital during good economic times (depend on interest rate) a higher debt ratio also increases the risk of the firm’s earnings stream

LEVERAGE AND PROFITABILITY FINANCIAL STATEMENTS LEVERAGE AND PROFITABILITY For Example The expected Earnings Before Interest and Taxes (EBIT) of ABC Co. is $ 50 and plans to invest a fixed asset which costs $100 (or total assets=$100). The average rate of interest is %30 and the tax rate is %20. I. Case: ABC Co. intends to use 100% of equity in financing the investment II. Case: ABC Co. intends to use 50% of equity and 50% of debt to finance the investment III. Case: ABC Co. intends to use 50% of equity and 50% of debt to finance the investment and the interest rate is %60.

I. CASE: %100 Equity, Investment= 100 TL FINANCIAL STATEMENTS LEVERAGE AND PROFITABILITY I. Case: ABC Co. intends to use 100% of equity in financing the investment costs 100 TL. EBIT= 50 TL, Interest Rate=30%, Tax Rate = 20% I. CASE: %100 Equity, Investment= 100 TL Earnings Before Interest and Tax (EBIT) 50 Interest Expense - Earnings Before Tax Tax (50 *0,2) (10) Net Income 40 Return on Equity (Net Income/Equity) 40/100=40%

LEVERAGE AND PROFITABILITY FINANCIAL STATEMENTS LEVERAGE AND PROFITABILITY II. Case: ABC Co. intends to use 50% of equity and 50% of debt to finance the investment costs 100 TL. EBIT= 50 TL, Interest Rate=30%, Tax Rate = 20% I. CASE: %100 Equity, Investment=100 TL II. CASE: %50 Equity, %50 Debt, Investment =100 TL Earnings Before Interest and Tax (EBIT) 50 EBIT Interest Expense - Interest Expense (50*0,30) 15 Earnings Before Tax 35 Tax (50 *0,2) (10) Tax (35 * 0,2) (7) Net Income 40 28 Return on Equity (Net Income/Equity) 40/100=40% Return on Equity 28/50= 56%

LEVERAGE AND PROFITABILITY FINANCIAL STATEMENTS LEVERAGE AND PROFITABILITY III. Case: ABC Co. intends to use 50% of equity and 50% of debt to finance the investment costs 100 TL and the interest rate is %50: EBIT= $50, Interest Rate=60%, Tax Rate = 20%. I. CASE: %100 Equity, Investment 100 TL II. CASE: %50 Equity, %50 Debt, Investment = 100 TL Interest rate = %30 III. CASE: %50 Equity, %50 Debt, Investment = 100 Interest rate=60% EBIT 50 Interest Expense - Interest Expense (50*0,30) 15 Interest Expense (50*0,60) 30 Earnings Before Tax 35 20 Tax (50 *0,2) (10) Tax (35 * 0,2) (7) Tax (20 * 0,2) (4) Net Income 40 28 14 Return on Equity (Net Income/Equity) 40/100=40% Return on Equity 28/50=56% 14/50= 28%

LEVERAGE AND PROFITABILITY FINANCIAL STATEMENTS LEVERAGE AND PROFITABILITY I. CASE: %100 Equity, Investment 100 TL II. CASE: %50 Equity, %50 Debt, Investment = 100 TL Interest rate = %30 III. CASE: %50 Equity, %50 Debt, Investment = 100 Interest rate=60% EBIT 50 Interest Expense - Interest Expense (50*0,30) 15 Interest Expense (50*0,60) 30 Earnings Before Tax 35 20 Tax (50 *0,2) (10) Tax (35 * 0,2) (7) Tax (20 * 0,2) (4) Net Income 40 28 14 Return on Equity (Net Income/Equity) 40/100=40% Return on Equity 28/50=56% 14/50= 28% As you see in this example since interest is a fixed cost (which can be written off against revenue) a debt can cause an increase in return o equity without a corresponding increase in the equity. But in making capital budgeting decisions the interest rate must be taken into account. As you see in case III, the return on equity decreases to 28%, in order to increase in interest expense. The financial leverage ratio must be interpreted by regarding profitability ratios.

LEVERAGE AND PROFITABILITY FINANCIAL STATEMENTS LEVERAGE AND PROFITABILITY I. CASE: %100 Equity, Investment=100 TL II. CASE: %50 Equity, %50 Debt, Investment = 100 TL III. CASE: %50 Equity, %50 Debt Interest rate=60% Earnings Before Interest and Tax (EBIT) 50 EBIT Interest Expense - Interest Expense (50*0,30) 15 Interest Expense (50*0,60) 30 Earnings Before Tax 35 20 Tax (50 *0,2) (10) Tax (35 * 0,2) (7) Tax (20 * 0,2) (4) Net Income 40 28 14 Return on Equity (Net Income/Equity) 40/100=40% Return on Equity 28/50=56% 14/50= 28% Return on Total Capital 28+7+15/100=50% 14+4+30/100=48% Financial Leverage Ratio Financial Leverage %50 For III. Case we cannot mention about the advantage of financial leverage.

Assets ABC CO. Balance Sheet 1.1.20X1 Liabilities FINANCIAL STATEMENTS PROFITABILITY ANALYSIS Assets ABC CO. Balance Sheet 1.1.20X1 Liabilities I. Current Assets III. Current Liabilities II. Non-Current Assets IV. Non-Current Liabilities V. Equity Profit/Loss Total Assets Total Liabilities Profitability ratios identify the success of the management in managing operating, financing and investment activities. Income Statement 1.1.20X1-31.12.20X1 I. Sales II. Cost of Goods Sold (-) Gross Profit/Loss III. Operating Expenses (-) Operating Profit/Loss IV. Other Revenue and Income IV. Other Expense and Loss V. Interest Expense Profit/Loss of the Period (Profit/Loss Before Tax ) Tax Expense (-) Net Profit/Loss of the Period (Profit/Loss After Tax)

Assets ABC CO. Balance Sheet 1.1.20X1 Liabilities FINANCIAL STATEMENTS PROFITABILITY ANALYSIS Assets ABC CO. Balance Sheet 1.1.20X1 Liabilities I. Current Assets III. Current Liabilities II. Non-Current Assets IV. Non-Current Liabilities V. Equity Profit/Loss Total Assets Total Liabilities Profitability analysis is important for all users but especially for equity investors and creditors. For equity investors, net income means dividends and change in security values. For creditors, income and operating cash flows are the main sources of interest and principle payments. Income Statement 1.1.20X1-31.12.20X1 I. Sales II. Cost of Goods Sold (-) Gross Profit/Loss III. Operating Expenses (-) Operating Profit/Loss IV. Other Revenue and Income IV. Other Expense and Loss V. Interest Expense Profit/Loss of the Period (Profit/Loss Before Tax ) Tax Expense (-) Net Profit/Loss of the Period (Profit/Loss After Tax)

Income is defined as revenue less expenses over a reporting period. FINANCIAL STATEMENTS PROFITABILITY ANALYSIS Income Statement 1.1.20X1-31.12.20X1 I. Sales II. Cost of Goods Sold (-) Gross Profit/Loss III. Operating Expenses (-) Operating Profit/Loss IV. Other Revenue and Income IV. Other Expense and Loss V. Interest Expense Profit/Loss of the Period (Profit/Loss Before Tax ) Tax Expense (-) Net Profit/Loss of the Period (Profit/Loss After Tax) Income is defined as revenue less expenses over a reporting period. In analyzing income, the accounting methods and the estimation issues must be taken into account.

PROFITABILITY ANALYSIS FINANCIAL STATEMENTS PROFITABILITY ANALYSIS For example: ABC Co.’s sales revenue is 200 TLand Cost of Goods Sold is 100 TL. The depreciation costs in cost of goods sold is 30 TL. If ABC Co. changes its depreciation method, the depreciation costs in cost of goods sold increases to 40 TL and the gross profit decreases to 90 TL. Income Statement Sales 200 Cost of Goods Sold (100) (110) Gross Profit 100 90

PROFITABILITY RATIOS Return Ratios and Common-Size Ratios FINANCIAL STATEMENTS PROFITABILITY ANALYSIS Assets ABC CO. Balance Sheet 1.1.20X1 Liabilities I. Current Assets III. Current Liabilities II. Non-Current Assets IV. Non-Current Liabilities V. Equity Profit/Loss Total Assets Total Liabilities PROFITABILITY RATIOS Profitability ratios comprise of: Return Ratios and Common-Size Ratios Income Statement 1.1.20X1-31.12.20X1 I. Sales II. Cost of Goods Sold (-) Gross Profit/Loss III. Operating Expenses (-) Operating Profit/Loss IV. Other Revenue and Income IV. Other Expense and Loss V. Interest Expense Profit/Loss of the Period (Profit/Loss Before Tax ) Tax Expense (-) Net Profit/Loss of the Period (Profit/Loss After Tax)

Return Ratios FINANCIAL STATEMENTS PROFITABILITY ANALYSIS Assets ABC CO. Balance Sheet 1.1.20X1 Liabilities I. Current Assets III. Current Liabilities II. Non-Current Assets IV. Non-Current Liabilities V. Equity Profit/Loss Total Assets Total Liabilities Return Ratios Return on Assets (ROA) Return on Equity (ROE) Return on Total Capital (ROC) (Ekonomik Rantabilite, Toplam Kaynakların Karlılığı) Income Statement 1.1.20X1-31.12.20X1 I. Sales II. Cost of Goods Sold (-) Gross Profit/Loss III. Operating Expenses (-) Operating Profit/Loss IV. Other Revenue and Income IV. Other Expense and Loss V. Interest Expense Profit/Loss of the Period (Profit/Loss Before Tax ) Tax Expense (-) Net Profit/Loss of the Period (Profit/Loss After Tax)

PROFITABILITY ANALYSIS FINANCIAL STATEMENTS PROFITABILITY ANALYSIS Balance Sheet I. Current Assets III. Current Liabilities II. Non-Current Assets IV. Non-Current Liabilities V. Equity Profit/Loss Total Assets Total Liabilities Return On Assets Ratio ROA is composed of two components: Net Profit Margin Assets Turnover Income Statement NET SALES Operating Profit/Loss Profit/Loss of the Period (Profit/Loss Before Tax ) Tax Expense (-) Net Profit/Loss of the Period (Profit/Loss After Tax)

PROFITABILITY ANALYSIS FINANCIAL STATEMENTS PROFITABILITY ANALYSIS Return On Assets Ratio In this equation we can see that ROA is a function of a firm’s profitability and efficiency. A firm can increase ROA by improving profitability and efficiency. For Example: ABC Co.’s Net profit margin is 9% and Assets Turnover Ratio is 2. Then, ROA ratio of ABC Co. is 18%.

Return On Assets Equity FINANCIAL STATEMENTS PROFITABILITY ANALYSIS Balance Sheet I. Current Assets III. Current Liabilities II. Non-Current Assets IV. Non-Current Liabilities V. Equity Profit/Loss Total Assets Total Liabilities Return On Assets Equity This ratio measures return generated relative to capital provided from owners. Income Statement NET SALES Operating Profit/Loss Profit/Loss of the Period (Profit/Loss Before Tax ) Tax Expense (-) Net Profit/Loss of the Period (Profit/Loss After Tax)

Return On Assets Equity FINANCIAL STATEMENTS PROFITABILITY ANALYSIS Balance Sheet I. Current Assets III. Current Liabilities II. Non-Current Assets IV. Non-Current Liabilities V. Equity Profit/Loss Total Assets Total Liabilities Return On Assets Equity This ratio measures return generated relative to capital provided from owners. ROE is a function of; Profitability Equity Turnover Income Statement NET SALES Operating Profit/Loss Profit/Loss of the Period (Profit/Loss Before Tax ) Tax Expense (-) Net Profit/Loss of the Period (Profit/Loss After Tax)

Return On Capital Employed (or Total Investment or Total Capital) FINANCIAL STATEMENTS PROFITABILITY ANALYSIS Balance Sheet I. Current Assets III. Current Liabilities II. Non-Current Assets IV. Non-Current Liabilities V. Equity Profit/Loss Total Assets Total Liabilities Return On Capital Employed (or Total Investment or Total Capital) Return on Total Capital ratio measures the overall performance of the business. When interpreting this ratio , Return on Equity ratio must be taken into account. Income Statement Profit/Loss of the Period (Profit/Loss Before Tax ) Tax Expense (-) Net Profit/Loss of the Period (Profit/Loss After Tax)

Return On Capital Employed (or Total Investment or Total Capital) FINANCIAL STATEMENTS PROFITABILITY ANALYSIS Balance Sheet I. Current Assets III. Current Liabilities II. Non-Current Assets IV. Non-Current Liabilities V. Equity Profit/Loss Total Assets Total Liabilities Return On Capital Employed (or Total Investment or Total Capital) To mention about the profitability of equity, the ROE ratio must be higher than ROCE ratio. Otherwise, the interest costs are high and firm can not take advantage of financial leverage. Therefore the financial leverage effects the return on equity. Income Statement Profit/Loss of the Period (Profit/Loss Before Tax ) Tax Expense (-) Net Profit/Loss of the Period (Profit/Loss After Tax)

FINANCIAL STATEMENTS EXERCISES The financial leverage ratio of ABC Co. is %70. Calculate the Debt-Equity Ratio.

FINANCIAL STATEMENTS EXERCISES Beginning Work-In Process is 2.000 TL, ending work-in process is 3.000 TL. The cost of beginning finished goods is 5.000 TL and the cost of ending finished goods is 3.000 TL. The reported amount of cost of goods sold is 55.000 TL. Calculate the current year’s cost of product. TL Beginning Workin-In Process 2.000 The Current Period’s Cost of Product 59.000 Ending Workin-In Process (-) (3.000) The Current Period’s Finished Goods 58.000 Beginning Finished Goods 5.000 Ending Finished Goods (-) Cost of Goods Sold 55.000

FINANCIAL STATEMENTS EXERCISES The A/R collection period is 90 days, the trade payables payment period is 20 days and selling or holding days of finished goods is 80 days. Calculate the cash operating cycle period. Operating Cycle Finished goods holding period 80 days Receivables collection period 90 days Payables payment period (20 days) Cash Operating Cycle Period 150 days

FINANCIAL STATEMENTS EXERCISES Calculate the items stated below: Current Ratio 1,6 Total Assets 6.500 Equity 2.500 Non-current Liabilities 3.000 Working Capital ? Non-Current Assets Answers: Working Capital 600 TL Non-Current Assets 4.900 TL