TOOLS OF FINANCIAL STATEMENT ANALYSIS BY H ONDIGO SCHOOL OF BUSINESS UNIVERSITY OF NAIROBI 2012

Presentation Objectives 1. Explain business analysis and its relation to financial statement analysis 2. Identify and discuss different types of business analysis 3. Describe the component analysis 4. Learn the sources of financial information 5. Identify and describe the common tools of Financial analysis 6. Define EMH and State implications for Analysis 2

Prospective Analysis Accounting Analysis Business Environment & Strategy Analysis Industry Analysis Strategy Analysis Financial Analysis of Sources &Uses of Funds Profitability Analysis Risk Analysis Cost of Capital Estimate Intrinsic Value

Business Analysis  Business analysis is the evaluation of a company’s prospects & risks for the purpose of making business decision 4 Business Decision Makers include: Equity Investors Creditors Managers Merger and Acquisition Analysis External Auditors Directors Regulators Employees and Unions

Accounting Analysis Comparability problems — across firms and across time Manager estimation error Distortion problems Earnings management Distortion of business Accounting Risk Process to evaluate and adjust financial statements to better reflect economic reality

Strategy Analysis  The purpose of Business Strategy Analysis Identify key profit drives and business risks Assess company’s profit potential at a qualitative level Strategy Analysis involves Industry analysis Competitive strategy Corporate strategy analysis 6

Industry Analysis Analyzing a firm’s profit potential must first assess industry profitability. It includes: Degree of actual and potential competition (1) Rivalry among existing firms (2) Threat of new entrants (3) Threat of substitute products Bargaining power in input and output markets (1) Bargaining power of buyers (2) Bargaining power of suppliers 7

Competitive strategy analysis Competitive strategy analysis is the evaluation of a company’s decisions and success at establishing a competitive advantages Cost leadership: supply same product and service at the lower cost Differentiation: supply a unique product or service at a cost lower than the price premium customers will pay 8

Corporate strategy analysis Involves examining whether a company is able to create value in multiple businesses A well-crafted corporate strategy reduces costs or increase revenues from running several businesses in one firm. Cost saving or revenue increases come from specialized resources that the firm has to exploit synergies across these businesses 9

Financial (Statement) Analysis  Financial statement analysis is the process of analyzing financial information to predict the future financial performance and condition  An important part of business analysis  Provide a systematic and effective statement analysis  Reliable inferences are drawn about a company prospects and risks 10

Financial (Statement) Analysis Profitability analysis — Evaluate return on investments Risk analysis ——— Evaluate riskiness & creditworthiness Sources and uses — Evaluate source & of funds analysis deployment of funds Common tools Ratio analysis Cash flow analysis Process to evaluate financial position and performance using financial statements

Prospective Analysis Intrinsic Value Business Environment & Strategy Analysis Accounting Analysis Financial Analysis Process to forecast future payoffs

Sources of Financial Information  Principle financial statements include: –The Statement of financial Position (balance sheet) –The statement of income –The statement of cash flow –The statement of stockholders’ equity  Notes to the financial statements  Auditor’s report  Management discussion and analysis  Other data sources: Chairperson’s letter, Finance press, Web sites, Industry statistics, Economic indicators. 13

Business Survival There are two key factors for business survival: Profitability Solvency Profitability is important if the business is to generate revenue (income) in excess of the expenses incurred in operating that business. The solvency of a business is important because it looks at the ability of the business in meeting its financial obligations.

Financial Statement Analysis  Financial Statement Analysis will help business owners and other interested people to analyse the data in financial statements to provide them with better information about such key factors for decision making and ultimate business survival.

Financial Statement Analysis Purpose:  To use financial statements to evaluate an organisation’s –Financial performance –Financial position.  To have a means of comparative analysis across time in terms of: –Intra-company basis (within the company itself) –Intercompany basis (between companies) –Industry Averages (against that particular industry’s averages)  To apply analytical tools and techniques to financial statements to obtain useful information to aid decision making.

Financial Statement Analysis Financial statement analysis involves analysing the information provided in the financial statements to: –Provide information about the organisation’s: Past performance Present condition Future performance –Assess the organisation’s: Earnings in terms of power, persistence, quality and growth Solvency

Effective Financial Statement Analysis  To perform an effective financial statement analysis, you need to be aware of the organisation’s: –business strategy –objectives –annual report and other documents like articles about the organisation in newspapers and business reviews. These are called individual organisational factors.

Effective Financial Statement Analysis Requires that you:  Understand the nature of the industry in which the organisation works. This is an industry factor.  Understand that the overall state of the economy may also have an impact on the performance of the organisation. → Financial statement analysis is more than just “crunching numbers”; it involves obtaining a broader picture of the organisation in order to evaluate appropriately how that organisation is performing

Tools of Financial Statement Analysis: The commonly used tools for financial statement analysis are:  Financial Ratio Analysis  Comparative financial statements analysis: –Horizontal analysis/Trend analysis –Vertical analysis/Common size analysis/ Component Percentages  Cash Flow Analysis  Valuation

Financial Ratio Analysis  Financial ratio analysis involves calculating and analysing ratios that use data from one, two or more financial statements.  Ratio analysis also expresses relationships between different financial statements.  Financial Ratios can be classified into 5 main categories: –Profitability Ratios –Liquidity or Short-Term Solvency ratios –Asset Management or Activity Ratios –Financial Structure or Capitalisation Ratios –Market Test Ratios

Profitability Ratios 3 elements of the profitability analysis:  Analysing on sales and trading margin –focus on gross profit  Analysing on the control of expenses –focus on net profit  Assessing the return on assets and return on equity

Profitability Ratios  Gross Profit % = Gross Profit * 100 Net Sales  Net Profit % = Net Profit after tax * 100 Net Sales Or in some cases, firms use the net profit before tax figure. Firms have no control over tax expense as they would have over other expenses.  Net Profit % = Net Profit before tax *100 Net Sales  Return on Assets = Net Profit * 100 Average Total Assets  Return on Equity = Net Profit *100 Average Total Equity

Liquidity or Short-Term Solvency ratios Short-term funds management  Working capital management is important as it signals the firm’s ability to meet short term debt obligations. For example: Current ratio  The ideal benchmark for the current ratio is $2:$1 where there are two dollars of current assets (CA) to cover $1 of current liabilities (CL). The acceptable benchmark is $1: $1 but a ratio below $1CA:$1CL represents liquidity riskiness as there is insufficient current assets to cover $1 of current liabilities.

Liquidity or Short-Term Solvency ratios  Working Capital = Current assets – Current Liabilities  Current Ratio = Current Assets Current Liabilities  Quick Ratio = Current Assets – Inventory – Prepayments Current Liabilities – Bank Overdraft

Asset Management or Activity Ratios  Efficiency of asset usage –How well assets are used to generate revenues (income) will impact on the overall profitability of the business. For example: Asset Turnover  This ratio represents the efficiency of asset usage to generate sales revenue

Asset Management or Activity Ratios  Asset Turnover = Net Sales Average Total Assets  Inventory Turnover = Cost of Goods Sold Average Ending Inventory  Average Collection Period = Average accounts Receivable Average daily net credit sales* * Average daily net credit sales = net credit sales / 365

Financial Structure or Capitalisation Ratios Long term funds management  Measures the riskiness of business in terms of debt gearing. For example: Debt/Equity  This ratio measures the relationship between debt and equity. A ratio of 1 indicates that debt and equity funding are equal (i.e. there is $1 of debt to $1 of equity) whereas a ratio of 1.5 indicates that there is higher debt gearing in the business (i.e. there is $1.5 of debt to $1 of equity).  This higher debt gearing is usually interpreted as bringing in more financial risk for the business particularly if the business has profitability or cash flow problems.

Financial Structure or Capitalisation Ratios Debt/Equity ratio = Debt / Equity Debt/Total Assets ratio = Debt *100 Total Assets Equity ratio = Equity *100 Total Assets Times Interest Earned = Earnings before Interest and Tax Interest

Market Test Ratios  Based on the share market's perception of the company. For example: Price/Earnings ratio  The higher the ratio, the higher the perceived quality of the earnings by the share market.

Market Test Ratios  Earnings per share = Net Profit after tax Number of issued ordinary shares  Dividends per share = Dividends Number of issued ordinary shares  Dividend payout ratio = Dividends per share *100 Earnings per share  Price Earnings ratio = Market price per share Earnings per share

Illustration: Financial statement analysis  The following financial statements of Hifadhi Ltd were prepared in accordance with IFRSs. Hifadhi Ltd is a diversified enterprise with its main interests in the manufacture and retail of plastic products.  The financial statements of Hifadhi Ltd need to be analysed. An investor is considering purchasing shares in the company. Relevant ratios need to be selected and calculated and a report needs to be written for the investor. The report should evaluate the company’s performance and position

Hifadhi Ltd Statement of Financial Position as at 31 March

Hifadhi Ltd Statement of Financial Performance for year ended 31 March

Hifadhi Ltd Statement of Cash Flows for the year ended 31 March

Additional information: Credit purchases for the year 2012 were $2,142,800. General prospects for the major industries in which Hifadhi is involved look good with a forecast glut of oil set to reduce the cost of production and world demand for plastic remaining strong. Benchmarks: There are no exact benchmarks for Hifadhi Ltd because it is a diversified company. The following are average indicators that relate to the plastic retailing and manufacturing industries for the year  Gross profit margin25%  Net profit margin 7%  Inventory turnover 6 times  Debt/equity ratio0.6 : 1  Return on Assets12%  Return on Equity20%

Relevant ratios Profitability ratios: Benchmarks Gross Profit Margin Industry 25% 22%22.7% Net Profit Margin Industry 7% 7.1%6.1% Return on Assets 12%15.6%15.5% Return on Equity Industry 20% 32%26% Important note: The calculations of the ratios in this illustration did not use “averages” for total assets, equity and inventory. The 2011 and 2012 year end figures were used and this is a slight variation to the formulas provided.

Relevant ratios cont… Asset Management ratios: Benchmarks Inventory Turnover Industry 6 % 5.8 times5.58 times Asset Turnover Not given

Relevant ratios cont… Liquidity ratios: Benchmarks Current Ratio Ideal standard 2:1 Acceptable standard 1:1 1.78:11.70:1 Quick Ratio Ideal standard 2:1 Acceptable standard 1:1 0.85:10.69:1 Days Payable Standard 30 days Credit purchases not available days

Relevant ratios cont… Financial Structure ratios: Benchmarks Debt/Equity Industry 0.6:1 Standard benchmark 1:1 1.05: 10.67:1 TIE Standard benchmark: Between 3 and 5. Below 3 risky. Above 5 very favourable times39.74 times

The Report  For the investor considering the purchase of shares in the company, the return they will earn is the key financial factor but an overall evaluation of the company’s performance and position is also important to get a better picture of how well the company is actually doing.  ROE in 2012 is 26%. Whether or not this is attractive depends on the perceived riskiness of this investment and other alternatives available but this return is certainly more attractive than current bank interest rates.  ROE has decreased by 4% but the company’s ROE at 26% is still better than the industry average of 20%  Riskiness of business is being reduced by the significant repayment of loan in 2012.

The Report cont… Profitability  The NP% and ROA ratios show a small downward trend in % over the 2 year period. ROE% ratio show a more significant decrease but is still better than the industry average.  Gross Profit Margin is slightly unfavorable at about 2.3% below the industry benchmark of 25%.  The horizontal analysis information show that Sales have increased by 20%. However operating costs have increased by 34%. Asset Management  IT has gone down slightly from 5.8 to 5.58 times.  IT is still close to the industry benchmark of 6 times.  AT has increased showing more sales being generated from asset usage

The Report cont…  Liquidity –Current ratios of 1.78:1 (2011) and 1.70: 1 are at above acceptable levels but below ideal level. –Quick ratios appear more of a concern being below acceptable levels in both years and even more so in 2012 (0.69:1). –Raises some concerns over the liquidity of the business and inventory management (although IT ratio only shows a slight decline in 2012). –Days Payable is a concern as there may be poor debt payment management.

The Report cont…  Financial Structure –Although slightly higher than D/E industry benchmark (0.67:1), business has become less risky due to the significant repayment of loan in –TIE is extremely good for the business at times (well above 5 the standard benchmark).  Cash flow situation –Strong cash flow from operating activities (increased from 160,600 to 185,000). –Spending under investing activities suggest more growth. –Repayment of debt under financing activities imply restructuring of business to have more equity funding rather than debt funding.

Recommendation Given: 1) The strong forecast for the industry (ie general prospects looking good and world demand for plastic products remaining strong), 2) The sales growth in this business, 3) Acceptable ratios as they are quite close to the industry averages, 4) Good cash flows from operating activities and 5) Favourable ROE, although it has decreased, it is still better than the industry average ROE. =>it is recommended that the investor purchase shares in the Hifadhi Ltd company.

Comparative/Horizontal Financial Statement Analysis This involves reviewing consecutive financial statements from period to period. It usually involves a review of changes in individual account balances on a year to year or a multi year basis. The most important information revealed by the analysis is the trend. For example a 10% increase in sales accompanied by a 20 % in cost of sales or selling expenses may require investigation and explanation. Similarly a 30% increase in receivables accompanied by a sales increase of 10% calls for investigation. Two comparative analysis techniques include:  Year to year change analysis  Index number/ Trend analysis

Trend (percentage) analysis  Line-by-line item analysis  Items are expressed as a percentage of a base year  This is a time series analysis  For example, a line item could look at increase in sales turnover over a period of 5 years to identify what the growth in sales is over this period.

Comparative Analysis Purpose:Evaluation of consecutive financial statements Output: Direction, speed, & extent of any trend(s) Types:  Year-to-year Change Analysis  Index-Number Trend Analysis Yr2 Yr1 Yr3

Analysis Preview 1-49

Extract of Trend Analysis of Kodak

Vertical analysis/Common size analysis/ Component Percentages  All items are expressed as a percentage of a common base item within a financial statement  e.g. Financial Performance – sales is the base  e.g. Financial Position – total assets is the base  Important analysis for comparative purposes –Over time and –For different sized enterprises

Common-Size Analysis Purpose :  Evaluation of internal makeup of financial statements  Evaluation of financial statement accounts across companies Output: Proportionate size of assets, liabilities, equity, revenues, & expenses

2-53 Common-Size Analysis

2-54 Common-Size Analysis

Cash Flow Analysis  This is primarily a tool used to evaluate the sources and uses of funds. It provides insights into how a company is obtaining its financing and deploying its resources, It is used in cash flow forecasting as part of liquidity analysis  While a simple analysis of the statement of cash flows conveys much information about sources and uses of funds, it is important to analyze statement of cash flows in more detail to understand the composition and implications of statement of cash flows along with the knowledge of the company’s business environment and strategies

Valuation  Is an important outcome of many types of business and financial statement analysis  It refers to the estimation of the true/intrinsic/ theoretical value of a company or a security (Debt or Bond).  The basis of valuation is the present value theory, which states that the value of equity or debt security (or any asset for that matter) is the sum of all future payoffs from that security that are discounted to the present at an appropriate discount rate.  It uses the time value of money concept.

Bond Valuation  As stated earlier, the value of a security is the present value of its future payoffs discounted at an appropriate discount rate.  The future payoffs from a debt security are its interest and principal payments.  A bond contract specifies its future payoffs along with the investment horizon. The value of a bond (B) at time t, B t is given by the following formula/model:

Debt (Bond) Valuation B t = I t +1 + I t +2 + I t I t +n + F (1+r) 1 (1+r) 2 (1+r) 3 (1+r) n (1+r) n Where, B t is the value of the bond at time t I t +n is the interest payment in period t+n F is the principal payment (usually the debt’s face value) r is the interest rate (yield to maturity)

Equity Valuation  The basis of equity valuation, like debt valuation, is the present value of future payoffs discounted at an appropriate discount rate  Equity valuation is however more complex than debt valuation,this is because the future payoffs are predetermined, with equity the investor has no predetermined payoffs  Investors in equity looks for two main (uncertain) payoffs: –Dividends payments –Capital appreciations (gains)

Equity Valuation – Dividend model  Capital gains are determined by future dividends therefore the value of an equity security,V t, at time t equals to the sum of the present values of all future dividends expected as per the model below : V t = E(D t +1 ) + E(D t +2 ) + E(D t +3 ) E(D t +n ) +... (1+k) 1 (1+k) 2 (1+k) 3 (1+k) n Where: V t is the value of an equity security at time t D t +n is the dividend in period t+n k is the cost of capital E( ) refers to expected dividends

Equity Valuation - Free Cash Flow Model  An alternative to dividend valuation is the present value of future cash flows- free cash flows (FCF)  FCF are cash flows that at are free to be paid to investors which are appropriate measure of equity payoffs Where: FCF t+n - is the free cash flow in the period t + n [often defined as cash flow from operations less capital expenditures] k - is the cost of capital E() refers to an expectation V t = E(FCF t +1 ) + E(FCF t +2 ) + E(FCF t +3 ) E(FCF t +n ) +... (1+k) 1 (1+k) 2 (1+k) 3 (1+k) n

Equity Valuation - Residual Income Model The model uses accounting variables. It defines the value of equity at time t is the sum of current book value and the present value of all future expected residual income Where: Ri t+n is the residual income in period t + n [defined as net income, NI, minus a charge on beginning book value, BV, or RI t = NI t - (k x BV t-1 )] k is the cost of capital E() refers to an expectation V t = BV t + E(RI t +1 ) + E(RI t +2 ) + E(RI t +3 ) E(RI t +n ) +... (1+k) 1 (1+k) 2 (1+k) 3 (1+k) n

Limitations of Financial Statement Analysis  We must be careful with financial statement analysis. –Strong financial statement analysis does not necessarily mean that the organisation has a strong financial future. –Financial statement analysis might look good but there may be other factors that can cause an organisation to collapse.

Analysis in an Efficient Market  The efficient market hypothesis (EMH), deals with the reaction of market prices to financial or other information  The weak form asserts that prices reflect fully the information contained in historical price movements  The semi strong form asserts that prices reflect fully all publicly available information  The semi form asserts that prices reflect all information including inside information

Efficient Market Hypothesis  There are considerable research on EMH.  Early evidence strongly supported both the weak and semi strong form of EMH in developed and emerging markets.  More recent research (in behavioral finance) question the generality of the EMH  A number of stock anomalies have been uncovered suggesting investors can earn excess returns using simple trading strategies  However as an approximation, the current market price is a reasonable estimate of equity value

Market Efficiency and Analysis Market Efficiency Assumes competent and informed analysts using the tools of analysis described Assumes analyst are continuously evaluating and acting on the stream of information entering the market place Extreme proponents of EMH claim that if all the information is instantly reflected in prices then attemptds to reap abnormal returns through analysis is futile. However if analyts presume their efforts in analysis are futile, the efficiency of the market ceases. This presents the EMH paradox

The EMH paradox  EMH is based on the aggregate rather than individual investor behavior- focusing on the aggregate behavior averages performances  Market efficiency depends not only on the availability of information but also on its correct interpretation. Analysis is complex and demanding  A competent analysis of information entering into the market place requires sound analytical knowledge and information mosaic- knowing information to aid evaluation and interpretation.  Warren Buffet expresses amazement that EMH is still embraced by some scholars and analysts.  According to Buffet by observing correctly that the market is frequently efficient, some scholars conclude incorrectly that it is always efficient. 67

Course Presentation Organization Financial Reporting & Analysis Part I Introduction and Overview Part III Financial Analysis Part II Accounting Analysis 1: Overview of Financial Analysis 2: Financial Reporting and Analysis 3: Analyzing Financial Activities 4: Analyzing Investing Activities 5: Analyzing Investing Activities: Special topic 6: Analyzing Operating Activities 7: Cash Flow Analysis 8: Return on Invested Capital 9: Profitability Analysis 10: Prospective Analysis 11: Credit Analysis 12: Equity Analysis and Valuation

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