CHAPTER 9 Financial statement analysis I

Contents The purpose of analysis Traditional analysis Tools of analysis Analysing financial statements

The purpose of analysis Different groups of financial statement users with different information needs Focus will be on needs of equity investors and suppliers of credit Differing levels of technical expertise Focus on tools used by a sophisticated user

The purpose of analysis (cont.) Primary questions relate to company performance and financial strength, but user emphasis may differ Investment analysts are primarily interested in financial statements as a predictor of future performance Lenders will primarily focus on the financial strength (default risk) Each question is the sum of different issues

Traditional analysis Basis of traditional analysis is relevant comparison Comparison over time or in space Time series analysis: comparing company performance over time Cross-sectional analysis: comparing company performance with other companies in the same industry (or industry average)

Time series analysis Horizontal analysis Using a multi-year information base Trend percentages Select a base year Set item amounts of that year = 100% Corresponding amount of each following year = % of base mount Impact of inflation

Time series analysis- Illustration Trend percentages of total sales (2000 = 100%) 2005 2004 2003 2002 2001 2000 Sales (€million) 617 583 492 413 627 445 Sales – trend % 139% 131% 111% 93% 141% 100%

Cross-sectional analysis Comparison with other companies in the same industry for the same year Differences in company characteristics should always be accounted for in interpretation Comparison with industry averages Multi-product companies Definition and size of industry groupings

Tools of analysis Common-size financial statements Use of financial ratios Management performance ratios Financial strength ratios

Common-size financial statements Standardizing financial statements by introducing a common denominator In a common-size balance sheet each component of the balance sheet is expressed as a percentage of total assets In a common-size income statement each item is expressed as a percentage of sales

Common-size financial statements (cont.) Allow comparison of companies of different size (in terms of total assets and sales) Allow (internal) structural analysis of the financial statements of a company Relative magnitude of asset, liability, equity and income statement components Combination of horizontal and vertical analysis

Common-size balance sheet - Illustration

Common-size income statement - Illustration

Use of financial ratios A financial ratio expresses the mathematical relationship between two or more financial statement items that are logically linked Comparison over time and in space Like must always be compared with like Combined use of financial ratios is more informative Financial ratios as indicators of management performance and financial strength

Management performance ratios Profitability and asset utilization ratios Margin ratios (return on sales) show how successful management is in creating profit from a given quantity of sales Return on investment ratios take into account the investment needed to generate the profit Asset utilization ratios measure how efficient management uses the company’s assets

Table 9.1 Profitability ratios

Margin ratios Main ratios: Measure operating efficiency Gross operating margin Net operating margin Net profit margin Measure operating efficiency Tend to be highly industry-specific

Return on investment ratios Main ratios: Return on equity (ROE) Return on assets (ROA) Return on capital employed (ROCE) Each reflects the profit generated by a specific pool of funds, excluding the costs of the specific funds considered Different denominators (investment base) and numerators (profit figure retained)

ROI - perspectives ROE measures how much a company has earned on the funds invested by its shareholders (shareholder perspective) ROA shows how well a company’s funds were used, irrespective of the relative magnitudes of the sources of these funds (current liabilities, debt and equity) ROCE shows how much a company has earned on invested long-term funds (permanently employed capital = equity + LT debt)

Figure 9.1 Capital employed Assets Financing Fixed assets Equity Net working capital LT Debt Current assets Current liabilities Capital employed Capital employed

Earnings per share (EPS) Shows how much of a period’s net profit has been earned by each ordinary share outstanding (basic EPS) or by shares outstanding plus all potential shares (diluted EPS) Potential shares are equity instruments issued that can be converted into ordinary shares at the option of the holder of the instrument IAS 33 Earnings per Share requires that listed companies disclose both basic and diluted EPS on the face of the income statement

Price/earnings ratio EPS is used as input to a market ratio, the price/earnings or P/E ratio: Price/Earnings = Market price per share EPS Reflects how the market (market price) judges the company’s performance (growth expectations) It is an inverted rate of return ratio Also called the Earnings Multiple

Dividend yield ratio The dividend yield ratio reflects the relationship between the dividends per share paid to shareholders and the current market price of a share: Dividend Yield = Dividend per share Market price per share Both P/E and dividend yield ratios of listed companies are published daily by major financial newspapers

Asset utilization ratios Main ratios: Total asset turnover Fixed asset turnover Inventory turnover Receivable turnover Turnover ratios measure efficiency of use of (categories of) assets Tend to be industry-specific

Table 9.1 Asset utilization ratios

Financial strength ratios Indicate the strength of a company’s financial position from the point of view of long-term solvency risk and short-term liquidity risk Solvency refers to the long-term ability to generate cash internally or from external sources in order to meet long-term financial obligations Liquidity refers to the ability to generate cash to meet short-term obligations

Long-term solvency risk ratios Main ratios: Debt/equity ratio Gearing ratio Interest and dividend cover Gearing as indicator of default risk Debt financing introduces financial risk because it implies fixed commitments in the form of interest payments and principal repayment and exposure to interest rate movements

Table 9.2 Long-term solvency risk ratios

Short-term liquidity risk ratios Main ratios: Current ratio and acid-test ratio Credit given and credit obtained Days inventory outstanding Liquidity tests focus on the make-up of working capital and the activity level of its components Low liquidity implies financial risk as inability to service short-term debt payments may lead to higher interest expense and, eventually, bankruptcy

Table 9.2 Short-term liquidity risk ratios

Analysing financial statements Decode messages built into financial statements and use them to ‘tell the story’ Time series analysis of ratios Combine patterns of financial ratios Compare cross-sectionally Ratio analysis is only part of an investment appraisal process - also consider: Non-financial performance indicators Broader economic variables Information about future business plans, etc.

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