Financial Statement Analysis Dr Gourav Vallabh XLRI Jamshedpur Dr Gourav Vallabh

FINANCIAL STATEMENT ANALYSIS The way to compare companies of different sizes is to use standard measures Financial ratios are standard measures that enable analysts to compare companies of different sizes Dr Gourav Vallabh

FINANCIAL STATEMENT ANALYSIS The objectives of financial statement analysis are to help investors Predict their expected returns (see the previous graph) Assess the risks associated with those returns Dr Gourav Vallabh

USING RATIOS TO MAKE BUSINESS DECISIONS A ratio expresses the relationship of one number to another The ratios used to make business decisions may be classified as follows: Ratios that measure the company’s ability to pay current liabilities Ratios that measure the company’s ability to sell inventory and collect receivables Dr Gourav Vallabh

USING RATIOS TO MAKE BUSINESS DECISIONS Ratios that measure the company’s ability to pay long-term debt Ratios that measure the company’s profitability Ratios used to analyze the company’s stock as an investment Dr Gourav Vallabh

MEASURING A COMPANY’S ABILITY TO PAY CURRENT LIABILITIES Working capital is defined as follows: Working capital = Current assets - Current liabilities Dr Gourav Vallabh

MEASURING A COMPANY’S ABILITY TO PAY CURRENT LIABILITIES Working capital is widely used to measure a business’s ability to meet its short-term obligations with its current assets The larger the working capital, the better able is the business to pay its debts Dr Gourav Vallabh

CURRENT RATIO The current ratio Is current assets divided by current liabilities Measures the ability of the company to pay current liabilities with current assets The following slides give the comparative income statement and balance sheet of Palisades Furniture, Inc. Dr Gourav Vallabh

Dr Gourav Vallabh

Dr Gourav Vallabh

The current ratio of Palisades Furniture, Inc The current ratio of Palisades Furniture, Inc., at December 31, 20X3 and 20X2, follow, along with the average for the retail furniture industry: Palisades’ Current Ratio Formula 20X3 20X2 Current assets $262,000 $236,000 Current ratio = = 1.85 = 1.87 Current liabilities $142,000 $126,000 In most industries a current ratio of 2.0 is considered good Industry Average = 1.70 In general, a higher current ratio indicates a stronger financial position Dr Gourav Vallabh

ACID TEST RATIO The acid-test (or quick) ratio Indicates whether the entity could pay all its current liabilities if they came due immediately Is computed by dividing cash, short-term investments, and net current receivables (accounts and notes receivable, net of allowances) by current liabilities Dr Gourav Vallabh

Palisades Furniture’s acid-test ratios for 20X3 and 20X2 are: Palisades’ Acid-Test Ratio Formula 20X3 20X2 Cash + short-term investments + net current receivables Acid-Test ratio = $29,000 + $0 + $114,000 $32,000 + $0 + $85,000 = 1.01 = 0.93 Current liabilities $142,000 $126,000 An acid-test ratio of 0.90 to 1.00 is acceptable in most industries Industry Average = 0.40 Dr Gourav Vallabh

MEASURING ABILITY TO SELL INVENTORY AND COLLECT RECEIVABLES Three ratios are presented that measure the company’s ability to sell inventory and collect receivables Inventory turnover Accounts receivable turnover Days’ sales in receivables Dr Gourav Vallabh

INVENTORY TURNOVER Inventory turnover is A measure of the number of times a company sells its average level of inventory during a year Computed by dividing the cost of goods sold by the average inventory for the period Dr Gourav Vallabh

INVENTORY TURNOVER A high rate of turnover indicates relative ease in selling inventory; a low turnover indicates difficulty in selling In general, companies prefer a high inventory turnover Inventory turnover varies widely with the nature of the business Dr Gourav Vallabh

Palisades’ Inventory Turnover Palisades Furniture’s inventory turnover for 20X3 is: Palisades’ Inventory Turnover Formula Cost of goods sold $513,000 Inventory turnover = = 4.58 Average inventory $112,000 Industry Average = 3.00 Palisades Furniture’s turnover of 4.58 times a year is high for its industry, which has an average turnover of 3.00 Dr Gourav Vallabh

ACCOUNTS RECEIVABLE TURNOVER Measures a company’s ability to collect cash from credit customers Is computed by dividing net sales by average net accounts receivable The resulting ratio indicates how many times during the year the average level of receivables was turned into cash Dr Gourav Vallabh

ACCOUNTS RECEIVABLE TURNOVER In general, the higher the ratio, the more successfully the business collects cash and the better off its operations A receivable turnover that is too high may indicate that credit is too tight, causing the loss of sales to good customers Dr Gourav Vallabh

Palisades’ Accounts Receivable Turnover Palisades’ Furniture’s accounts receivable turnover ratio for 20X3 is computed as follows: Palisades’ Accounts Receivable Turnover Formula Accounts receivable = turnover Net credit sales $858,000 = 8.62 Average net accounts receivable $99,000 Industry Average = 31.3 Palisades’ receivable turnover of 8.62 is much lower than the industry average, possibly because larger stores sell their receivables Dr Gourav Vallabh

DAYS’ SALES IN RECEIVABLES The days’-sales-in-receivables ratio tells How many days’ sales remain in Accounts Receivable Is computed by a two-step process First, divide net sales by 365 days to figure the average sales amount for one day Second, divide this average day’s sales amount into the average net accounts receivable Dr Gourav Vallabh

Palisades’ Days’ Sales in Accounts Receivable Formula Net sales $858,000 1. One day’s sales = = $2,351 365 days 365 days Average net accounts receivable Days’ sales in average accounts = receivable 2. $99,500 = 42 days One days’ sales $2,351 Industry Average = 2 days The day’s sales in receivables for Palisades is higher (worse) than the industry average because the company collects its own receivables Dr Gourav Vallabh

MEASURING A COMPANY’S ABILITY TO PAY LONG-TERM DEBT Two indicators of a business’s ability to pay long-term liabilities are the Debt ratio Times-interest-earned ratio Dr Gourav Vallabh

DEBT RATIO The debt ratio tells the proportion of the company’s assets that it has financed with debt The higher the debt ratio, the higher the strain of paying interest each year and the principal amount at maturity The lower the ratio, the lower the business’s future obligations Dr Gourav Vallabh

Calculation of the debt ratios for Palisades Furniture at the end of 20X3 and 20X2 is as follows: Palisades’ Debt Ratio Formula 20X3 20X2 Total liabilities $431,000 $324,000 Debt ratio = = 0.55 = 0.50 Total assets $787,000 $644,000 The average debt ratio for most companies ranges from 0.57- 0.67 Industry Average = 0.64 The company’s debt ratio indicates a fairly low-risk debt compared to the retail furniture industry average Dr Gourav Vallabh

MEASURING A COMPANY’S PROFITABILITY There are four rate-of-return measurements that help evaluate a company’s profitability: Rate of return on net sales Rate of return on total assets Rate of return on common stockholders’ equity Earnings per share of common stock Dr Gourav Vallabh

RATE OF RETURN ON NET SALES The rate of return on net sales shows the percentage of each sales dollar earned as net income The higher the rate of return, the more net sales dollars are providing income to the business and the fewer net sales dollars are absorbed by expenses Dr Gourav Vallabh

Palisades’ Rate of Return on Sales The rate-of-return-on-sales ratios for Palisades Furniture are calculated as follows: Palisades’ Rate of Return on Sales Formula 20X3 20X2 Rate of return on sales Net income $48,000 $26,000 = = 0.056 = 0.032 Net Sales $858,000 $803,000 Industry Average = 0.008 The increase in Palisades Furniture’s return on sales identifies the company as more successful than the average furniture store Dr Gourav Vallabh

RATE OF RETURN ON COMMON STOCKHOLDERS’ EQUITY Rate of return on stockholders’ equity (return on equity) Shows the relationship between net income and common stockholders’ investment in the company Is calculated by dividing net income available to common stockholders by the average stockholders’ equity during the year Dr Gourav Vallabh

Palisades’ 20X3 Rate of Return on Common Stockholders’ Equity The rate of return on common stockholders’ equity for Palisades Furniture is calculated as follows: Palisades’ 20X3 Rate of Return on Common Stockholders’ Equity Formula Rate of return on common stockholders’ equity Net income Preferred Dividends - $48,000 - $0 0.142 = = Average common stockholders’ equity $338,000 Industry Average = 0.121 Dr Gourav Vallabh

RATE OF RETURN ON COMMON STOCKHOLDERS’ EQUITY Palisades’ return on equity (0.142) is higher than its return on assets (0.101). This difference results from borrowing at one rate (8%) and investing the funds to earn a higher rate (14.2%) This practice is called trading on the equity or using financial leverage Dr Gourav Vallabh

LIMITATIONS OF FINANCIAL ANALYSIS Ratios have their limitations Financial analysis may indicate that something is wrong, but it may not identify the specific problem or show how to correct it Managers must evaluate data on all ratios in the light of other information about the company Dr Gourav Vallabh

LIMITATIONS OF FINANCIAL ANALYSIS Ratios should be analyzed over a period of years Any one year, or even any two years, may not be representative of the company’s performance over the long term Dr Gourav Vallabh