CHAPTER 3 FINANCIAL STATEMENT ANALYSIS TOOLS

OBJECTIVES Discuss and interpret the analysis tools of financial statement. Apply several basic financial statement major ratios and techniques. Identify the relevant analysis information beyond financial statements. Explain the types of equity or valuation analysis methods. Analyze the ways to use the ratio and caution using the financial tools.

FINANCIAL ANALYSIS TOOLS The basic tools are: –Comparative financial statement Horizontal Analysis Trend Index Analysis –Common size financial statement –Ratio analysis Profitability analysis Credit Analysis Equity Analysis and Evaluation

Comparative Financial Statement Analysis Comparative financial statement analysis involves a review of changes in individual account balances on year-to-year or multiyear basis. The most important information often revealed from a comparative financial statement analysis is trend. referred to as horizontal analysis. HORIZONTAL ANALYSIS: –Shows the changes between years in the financial data in both amount and percentage form. AMOUNT CHANGE = CURRENT YEAR – BASE YEAR TREND INDEX ANALYSIS: –Trend percentages state several years’ financial data in terms of a base year, which equals 100 percent Trend index = Current Year Amount X 100 Base Year Amount

ABC Corp BASE YEAR CURRENT YEAR Income statements Fiscal year ended December 31 (RM in millions) Change analysis % Net sales Cost of goods sold 1, , , ,034.5 Gross operating profit Selling, administrative, and other operating expenses Depreciation & authorization Other income, net Earnings before interest & taxes Interest expense Earning before taxes Income taxes Net profit after tax Dividends paid per share Earnings per share (EPS) Number of common shares outstanding ( in millions) Base year Current year

Common Size Analysis Done by proportioning a group or subgroup of the items in the account. Also called vertical analysis. Common size financial statement analysis is useful to understand the internal make up of a company including the: –Distribution of financing across liabilities and utilization of assets (for common size balance sheet) and –Distribution of expenses and profit over sales (for common size income statement) There are two types of common size analysis: –common size income statement –common size balance sheet. Specifically in analyzing balance sheet, it is common to express total asset (or liabilities plus equity) as 100%. Then, accounts within these groupings are expressed as a percentage of their respective totals.

ABC Corp Comparative Balance Sheet December 31 (RM in millions) 2007 Common size analysis Assets Current assets Cash Receivables Inventories Other current assets Total current Assets500.3 Noncurrent Assets Gross Property, plant, & equipment Accumulated depreciation & depletion Net Property, plant, & equipment Other noncurrent assets (372.5) Total Noncurrent assets440.9 Total Assets Liabilities and Stockholders’ Equity Current liabilities Account payable Short-term debt Other current liabilities % Total Current liabilities374.0 Noncurrent liabilities Long-term debt Other noncurrent liabilities Total noncurrent liabilities272.7 Total liabilities Stockholders equity Common shares Retained earnings Total equity294.5 Total Liabilities and Stockholders’ equity %

ABC Corp Income statements Fiscal year ended December 31 (RM in millions) 2007 Common size analysis Net sales Cost of goods sold 1, , % Gross operating profit809.5 Selling, administrative, and other operating expenses Depreciation & authorization Other income, net Earnings before interest & taxes234.2 Interest expense13.4 Earning before taxes221.8 Income taxes82.1 Net profit after tax Dividends paid per share Earnings per share (EPS) Number of common shares outstanding ( in millions)

Ratio Analysis Analyzed to identify the company's strengths and weaknesses and useful insights can be gained through the process. Classifications of ratio that the most commonly used are: –Liquidity –Debt (or Leverage) –Activity (or Turnover) –Profitability –Market ratio

Liquidity Ratio Determine a company's ability to pay off its short-terms debts obligations. Generally, the higher the value of the ratio, the larger margin of safety that the company possesses to cover its short-term debts It can give a sense of the efficiency of a company's operating cycle or its ability to turn its product into cash.

i) Current Ratio Measures a company's ability to pay short-term obligations. Current Ratio = Current Assets Current Liabilities Example: Current ratio for ABC corp in 2007 = = This figures indicate that ABC had RM 1.34 in short-term resources to service every dollar of current debt. Suggest that the company has more than enough current asset to cover it’s current liability.

ii) Acid-Test Ratio The most stringent liquidity test as it indicates whether a firm has enough short-term assets to cover its immediate liabilities without selling inventory. = ( Cash + Accounts Receivable + Short-term Investments) Current Liabilities or = Total Current Asset - Inventory Current Liabilities

iii) Working Capital Measure of both a company's efficiency and its short-term financial health. It frequently used to derive the working capital ratio, which is working capital as a ratio of sales. Working Capital = Current Assets – Current Liabilities –Positive working capital means that the company is able to pay off its short-term liabilities. –Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (i.e. cash, accounts receivable and inventory).

iV) Working Capital Turnover Measure, which compares the depletion of working capital to the generation of sales over a given period. This provides some useful information as to how effectively a company is using its working capital to generate sales. Working Capital Turnover =_____Sales____ Working Capital the higher the working capital turnover, the better because it means that the company is generating a lot of sales compared to the money it uses to fund the sales.

Leverage Ratio i)Debt Ratio Indicates the proportion of debt a company has relative to its assets. The measure gives an idea to the leverage of the company along with the potential risks the company faces in terms of its debt-load. Total Debt = Total Debt Total Assets A debt ratio of greater than 1 indicates that a company has more debt than assets; meanwhile, a debt ratio of less than 1 indicates that a company has more assets than debt.

ii) Debt/Equity Ratio Measure of a company's financial leverage calculated by dividing its Long Term liabilities by stockholders' equity. Debts to Equity ratio also were used to measure “Capital Structure” of a company. Debt/Equity Ratio = Long Term Debt Shareholders’ Equity A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense.

Activity Ratio i)Inventory turnover Inventory include the raw materials, work-in-process goods and completely finished goods Inventory Turnover = Cost of a Good Sold Average Account Receivables Example: IT =RM 1,938.0=18.69 RM The more sales the company can get out of its inventory, the better the return on this vital resource. A turnover of almost 19 times a year means that the firm is holding inventory for less than a month – actually for about 20 days (365/18.9 = The higher the turnover figure, the less time an item spends in inventory and the better the return the company is able to earn from funds tied up in inventory.

ii) Receivables Turnover Ratio Number of times that accounts receivable amount is collected throughout the year. Accounts Receivable Turnover = Sales___________ Average Accounts Receivable Some companies' reports will only show sales - this can affect the ratio depending on the size of cash sales.

Profitability Ratio Profitability analysis is a financial metrics that are used to assess a business's ability to generate earnings as compared to its expenses and other relevant costs incurred during a specific period of time.

Profit Margin It measures how much out of every dollar of sales a company actually keeps in earnings. Profit Margin = Net Income/Net Profit Revenue/Sales A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors.

ii) Return on Asset (ROA) An indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Return on Asset (ROA) = Net Income Total Assets ROA tells you what earnings were generated from invested capital (assets).

iii) Return on Equity (ROE) A measure of a corporation's profitability that reveals how much profit a company generates with the money shareholders have invested. Return on Equity (ROE) = Net Income________ Shareholder’s Equity The ROE is useful for comparing the profitability of a company to that of other firms in the same industry.

DuPont Method DuPont Method is a method of analysis that breaks down return on equity into the sources of that profitability. The method is named for the company that originally conducted the analysis.

(1)(2)(3) Net Profit Margin X Total Asset Turnover = Return On Investment Net income Net sales X Total assets = Net income Total assets (3)(4)(5) Return On Investment X Financial Leverage = Return On Equity Net income Total assets X Stockholders’ equity =Net income Stockholders’ equity The first three ratios reveal that the (3) return on investment (profit generated from the overall investments in assets) is a product of the (1) net profit margin (profit generated from the sales) and the (2) total asset turnover (the firm’s ability to produce sales from its assets). Extending the analysis, the remaining three ratios show how the (5) return on equity (overall return to shareholders, the firm’s owners) is derived from the product of (3) return on investment and (4) financial leverage (proportion of debt in the capital structure).

Sources of Company’s Profit It is possible to break down the return on equity (ROE) ratio into several smaller parts. This is useful because there are five ways for a company to increase its profits. Four of these ways are captured in the following equation: Margin x Turnover x Leverage x Tax effect = ROE E.B.T x Sales x Total Assets x 1 – tax rate = ROE Sales Total Assets Equity

COMPANY STRATEGY…. –Improve its profit margin by doing a better job of controlling costs and pricing its products appropriately –Increase its turnover through leverage on the use of effective advertising, branding, sales promotions, and training of its sales force. –Increases leverage by utilizing bit more to finance the company. –Reduce the amount of taxes paid as a result of effective tax planning (although this is generally the least important of the four factors).

Investors would rather invest in a company that is: –Performing very well in the operations area (purchasing, production, working etc.) and which is conservatively financed (i.e., has a low level of debt), rather than – Performing very poorly in the operations area and is very aggressively financed (i.e., has a high level of debt)?

HOW TO USE RATIO…. There are two primary ways to use financial ratios: –Compare a ratio's value over several periods of time (trend analysis or time-series analysis). If we see a deteriorating trend in any ratio's values over several quarters or years, we can investigate to find the cause. –Compare the company's ratios to the industry average (cross-sectional analysis). A single ratio value by itself usually means nothing - we need a standard, or benchmark, to compare it to. This benchmark is usually the industry average (i.e., the ratio's average value for all firms in the industry).

Cautions in Using Ratios Ratios don't prove that a problem exists or provide definite answers to any of our questions Realize that there may be significant differences between the characteristics of the company and the "average" firm in the industry Always make sure that you are calculating a ratio exactly as the industry average ratio is calculated. Companies frequently don't have the same fiscal year Companies' accounting practices may differ considerably. Be careful about depending too much on any one ratio. Audited financial statements should be used whenever possible.

END OF CHAPTER 3 TIME TO TEST YOUR UNDERSTANDING….…. Get into your group and lets do this exercise !!!!