Financial Statement Analysis CHAPTER 10 Financial Statement Analysis

Overview Liquidity measures Activity measures Accounts receivable and inventory turnover Profitability measures Price earnings ratio and evaluation of share market price Dividend yield and dividend payout ratio Financial leverage Common size financial statements Other operating statistics PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Financial Statement Ratios Ratios are used to interpret the financial position and results of operations of an entity and may be grouped in the following four categories: Liquidity Activity Profitability Debt, or financial leverage PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Specific identification Liquidity Measures The liquidity measures of working capital, current ratios and quick ratios were discussed in Chapter 3. Remember: The effect of the inventory cost-flow assumption on: FIFO Specific identification Weighted average current ratios and working capital PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Liquidity Measures Suppliers and creditors Is the firm paying its bills promptly? What is the firms current and recent payment experience? May be indicated by extent that cash discounts are being taken. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Turnover = Sales ÷ Average Assets Activity Measures Focus primarily on relationships between asset levels and net sales. The general model for calculating turnover is: Turnover = Sales ÷ Average Assets Average assets use balance sheet amounts reported at the beginning and end of a period. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Activity Measures Turnover is often used in the calculation for assessing activity of: accounts receivable inventories plant and equipment total operating assets total assets. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Activity Measures Turnover ratios will be affected by inventory cost-flow assumptions and depreciation methods: $ inventory $ depreciable assets FIFO and accelerated depreciation Weighted-average and straight line depreciation $ inventory $ depreciable assets Higher asset turnover Lower asset turnover PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Activity Measures These amounts will be used to demonstrate how the ratios can be calculated. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Accounts Receivable Turnover Sales Average Accounts Receivable Accounts Receivable Turnover = $500,000 ($17,000 + $20,000) ÷ 2 = = 27.03 times A measure of how many times a company converts its receivables into cash each year. Or average collection period of 13.5 days. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Inventory Turnover Cost of Goods Sold Average Inventory Inventory = $140,000 ($10,000 + $12,000) ÷ 2 = = 12.73 times A measure of the number of times merchandise inventory is sold and replaced during the year. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Inventory Turnover Lower inventory compared to sales means less needs to be financed by debt or equity. BUT… risk of not having enough inventory to meet demand risk of out of stock situation with delay in receiving raw materials or finished product and lost sales. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Inventory management system Inventory Turnover Inventory management system JIT - Just in time: Keep the investment in inventories at a minimum by forecasting needs. Suppliers deliver inventories only when needed. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Activity Measures In evaluating the firm’s operating efficiency, it is the trend of these calculations over time that is important. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Profitability Measures Discussed in Chapter 3: Return on assets (ROA) Return on equity (ROE). Points to remember: ROA is based on EBIT (earnings before interest and tax) better measure of management activities as interest is a function of capital structure tax is a function of the tax laws. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Profitability Measures Need to maintain healthy scepticism about: relationship? True rate of return ROA and ROE Based on: real economic profit related to fair market values No agreement on how to determine these PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Profitability Measures Evaluations more valid when based on the trend of one company’s ROA and ROE relative to: Trends in industry Trends of competitors PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Market price per ordinary share Earnings per share Price/Earnings Ratio Price earnings ratio Market price per ordinary share Earnings per share = A measure often used by investors to evaluate the market price of a company’s ordinary shares. Price earnings ratio $4.10 $0.13 = = 32.7 times PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Investors’ expectations about the firm’s future earnings Price/Earnings Ratio Market price of a share Investors’ expectations about the firm’s future earnings Relating market price and earnings per share in a ratio (price earnings ratio) is a way to express investors’ expectations The greater the probability of increased earnings, the more investors are willing to pay. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Price/Earnings Ratio At first glance, company B shares look more expensive, but company A shares are more expensive as investors are willing to pay 25 times earnings for the shares, compared with 18 times for company B. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Dividend Yield Dividend yield Dividends per share Market price per share = Identifies the return, in terms of cash dividends, on the current market price of the shares. $1.45 $60.00 = = 2.4% Dividend Yield PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Annual dividend per share Dividend Payout Ratio Dividend payout ratio Annual dividend per share Earnings per share = Reflects the dividend policy of the company. Investors are able to project future dividends based on a company’s earnings prospects. Dividend Payout Ratio = = 25.7% $1.45 $5.64 PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Financial Leverage Financial leverage refers to the use of debt to finance the assets of the entity. Leverage adds risk - if there is not enough cash to pay principal and interest, entity may be forced into bankruptcy. BUT, as the cost of debt is fixed, leverage also magnifies the return to owners (ROE) relative to the return on assets (ROA). PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Financial Leverage Borrowing at an interest rate that is less than the rate of return that can be earned on that money, multiplies the return on owners’ equity. Debt and preference shares provide leverage opportunities as the interest cost or dividend rate is fixed. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Financial Leverage - Debt Ratio Total liabilities Total liabilities + Owners’ equity Debt ratio = Measures the proportion of assets being provided by creditors. Debt ratio = = 40% $40000 $100000 PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Financial Leverage - Debt/Equity Ratio = Total liabilities Total owners’ equity Debt/Equity ratio = = 67.0% $40000 $60000 Measures the relative proportion of contribution from owner’s and creditor’s. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Financial Leverage - Times Interest Earned Earnings before interest and taxes interest expense = A common measure of the ability of a firm to cover interest and provide protection to the long-term creditors. Times interest earned = = 1.95 times $6587 3378 PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Common Size Financial Statements Each asset expressed as a % of total assets Each liability and equity account expressed as a % of total PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Common Size Financial Statements Each item on the Income Statement expressed as a % of total sales This type of analysis makes spotting trends easier. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Other operating statistics Statistics other than financial ratios may be used to evaluate a firm. Sales in units Total number of employees Sales dollar per employee Operating income per employee Plant operating expenses per square metre of plant PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd