Finance FINANCIAL ANALYSIS IN ENTERPRISES

Finance Lecture outline  Financial statements- structure and interpretation  Techniques of financial analysis

Finance Financial statement- definition  A financial statement is a formal record of the financial activities of a company, person, or other entity

Finance Financial statements as an element of financial reporting  The obligation of financial reporting creates the necessity of financial statements  International rules concerning the structure of financial statements  International Accounting Standards Board for the EU, Canada and Australia, Generally Accepted Accounting Principles in the USA

Finance Why do companies publish financial statements?  The information about the financial position and performance of the company is essential to many users  Owners and managers  Investors/prospective investors  Public finance entities  Financial markets participants  Employees

The structure of financial statements  Balance sheet (statements of financial position)  Income statement (statement of comprehensive income)  Statement of changes in equity  Cash flow statement Finance

Balance sheet Assets  Fixed assets  Current assets Liabilities  Equity  Borrowed capital (interest payments)  Other liabilities (no interest payments)

Income statement  All items of income and expense in a given period  Sometimes called the statement of profit and loss Finance

Income statement  The statement should include information about  revenue,  finance cost  share of the profit or loss of associates  tax expense  profit or loss,

Finance Statement of changes in equity  The statement should include  Total comprehensive income with distiction of the amounts attributable to owners and non-controlling interest  For each component of equity, the effects of restrospective application  For each component of equity, the changes between the amount at the beginning and the end of the period

Finance Cash flow statement  Cash flow- the movement of money into a company and out of the company  The statements shows how changes in balance sheet accounts and income affect cash  The statements involves operating, investing, and financing activities

Finance Cash flow statement-interpretation  Useful in determining the short-term ablity to meet the financial commitments of a company  Reflects a firm's liquidity

Finance The purpose of financial analysis  To evaluate the performance and the financial position of the company given the strategy of the firm, the economic and legal environment, the accounting flexibility and prospects

How is the financial analysis performed?  To evaluate the company’s performance we need a benchmark  Performance compared to past results  Performance compared to other companies  Artificial benchmarks build on economic experience Finance

Non-comparability of financial statements  Changes of the time span of the financial year  Different balance sheet dates  Changes in company structure  Accounting method changes and accounting estimate changes  Differences in presentation

Finance Types of financial analysis  Horizontal analysis  Common size analysis  Segmental analysis  Ratio analysis

Horizontal analysis  Also called trend analysis  Aimed at comparing the respective positions of the financial statement with previous statements  It usually covers a five year period Finance

Horizontal analysis

Finance Common size analysis  Aimed at comparing the performance of firms usually from the same industry  Size adjustment is needed- the positions in the balance sheet are expressed relatively to total assets, in the income statement relatively to the amount of sales

Finance Segmental analysis  Aimed at reporting accounts on a breakdown of the total revenue over the different business segments  Segmental reporting data may be subject to manipulation as the company may shift the data between segments in order to show to desirable result

Finance Ratio analysis  The ratio analysis is aimed at answering the following questions:  Can the company meet its financial commitments?  How successful, profitable and efficient is the company?  Is the business a good investment for shareholders?

Finance Profitability of the firm  The ratio combines the result of a firm with the investments made for the generation of this result  Return on equity ROE=Profit/Equity  Return on assets ROA= (Profit before tax+ Interest)/ Total assets

Finance Profitability of the firm (1)  Return on capital employed ROCE=(Profit before tax + Long term interest)/(Equity + Long term debt)

Finance Profitability of the firm (2)  Which investment base should be taken into account?  From the beginning of the year?  An average equity base?  In practice the most common benchmark the equity base at the end of the year

Finance Profitability of the firm- benchmarks  Time series or competitor comparisons  The proceeds from an investment in risk free loans as benchmark  This measure allows to see if the owners would be better off selling the company and placing the money in a bank?

Profitability of the firm-breakdown analysis  To see the which components of the firms activity played a role in shaping the profitability one can break down the ROA measure  The components relate to sales results and investment results ROA=Profit/Total sales * Total sales/Assets  Profit/Total sales- called profit margin reflects operating decisions  Total sales/Assets- called efficiency ratio reflects investment decisions Finance

Liquidity and solvency  Useful especially for external stakeholders  Information about the financial status can be obtained by analyzing the assets available to the company to meet its liabilities  Short, medium and long term analysis

Liquidity (1)  The subject of analysis are assets able to meet short term liabilities  The structure of working capital matters  Current ratio CR=Current assets/Current liabilities  Acid test ratio ATR=(Current assets-Inventory)/Current liabilities Finance

Liquidity (2)  Current assets are supposed to be converted into cash in the current operating cycle  The acid test ratio excludes inventory as this is the least convertible part of current assets  The benchmark for liquidity ratios depends on the industry Finance

Solvency (1)  To see if the company is able to meet its long term liabilities one has to analyze the capital structure  Of crucial importance is most of all the ratio of own and borrowed capital  Debt/equity ratio- most popular  A high debt/equity ratio implies higher financial risk due to higher interest payments, pay-off deadlines etc. Finance

Solvency (2)  Depending on the focus of the analysis the debt/equity ratio can be transformed Debt/Equity+Debt Long term debt/Equity  Or expressed relatively to assets Debt/assets Short term debt/ assets Finance

Solvency- benchmarks  The debt equity ratio could be influenced by national or institutional differences  In bank based economies e.g. Germany, France the debt/equity ratio will be higher than in countries with shareholder orientation e.g. UK  Firms from similar countries should be used as a benchmark Finance

Investment perspective (1)  Is the company worth investing?  Investment decisions require specific ratios besides liquidity, efficiency and profitability  Dividends performance, earnings per share, price/ earnings ratio Finance

Investment perspective (2)  Ratios for shareholders reported in financial statements  Companies can try to influence share prices by communicating to the market outside financial statements  Companies can create their own ratios eg.”like for like sales”, „profit before one-time” expenditures Finance

Univariate and multivariate ratio analysis  Univariate analysis- one ratio is considered at a time, judgment is based on the respective ratios calculated  Multivariate analysis- the respective ratios are weighted and combined  A popular multivariate measure- the Z- score (Altman 1968) Finance

The z-score  Aimed at predicting company failure  A risk measure  Based on research in the US manufacturing sector  Z-scores are sector specific-e.g.other weightings should be applied for banks and manufacturing companies Z=0,012x1+0,014x2+0,033x3+0,006x4+0,999x5  X1-working capital/total assets  X2-retained earnings/total assets  X3-earnings before interest and tax/total assets  X4- market capitalization/book value of debt  X5-sales/total assets Finance

Source: Wikipedia

Financial analysis-remarks  The ratio analysis should be accompanied by common size and trend analysis  These methods are complementary Finance

Example  Compute and compare the liquidity and solvency ratios for company A and B  Company A finances it’s activity via bank loans. The value of inventory is 200 the value of financial assets 100, the value of fixed assets is The value of the bank loan is 1200 from which 500 is due in the current operating cycle.

Finance Example  Company B leases the production infrastructure. The value of inventory is 200, the value of financial assets 100, the value of fixed assets is 800, the value of leased assets is The value of current liabilities is 100.

Finance Literature D. Alexander, A. Britton, A. Jorissen, International Finacial Reporting and Analysis, Cengage Learning, 2011