Chapter 3 Financial Statement Analysis

Financial Statement Analysis, Some Background Financial statements reflect the results of actions taken by the management of a company. Analysis of historical data can give perspective on past performance, and may help to predict future performance. Financial statement analysis helps to set goals for the company to attain in future periods. Financial statement analysis allows us to compare the performance of a company to its competitors, wherever possible.

Ratio Analysis, an Important Tool in Financial Statement Analysis Expresses relationship among selected items of financial statement data Relationship can be expressed in term of: Percentages – for example, gross profit as a % of net sales, gross profit percentage Rates – 365 days, Days in (Cost of Goods Sold ÷ Average Inventory) Inventory Proportions – Current Assets ÷ Current Liabilities, Current Ratio

Ratio Analysis Comparisons Intracompany comparisons - covering two years of the same company Industry average comparisons - based on average ratios for a particular industry Intercompany comparisons - based on comparisons with a competitor in the same industry

Ratio Analysis Classifications: Liquidity Ratios - measures of short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Solvency Ratios - Measures of the ability of the company to survive over a long period of time. Profitability Ratios - Measures of the income or operating success of a company for a given period of time.

Common Size Financial Statement Ratios Relates the components of the financial statements to some reference amount to scale dollar amounts for size. Balance sheet – the reference is usually total assets. Income Statement – the reference is usually net sales. See Table 3.3 and 3.4 for examples of common sized balance sheets and income statements. Common size financial statement exercise

For Tomorrow Read Chapter 3 Work through the T/F and Multiple Choice questions, exercises 42 (a) (b), and 44.

Exam 1 Results Of 29 students who took the exam, scores were distributed as follows: 90 – 100 (17) (4) 70 – 79 (3) < 69 (5)

Wednesday June 29 Chapter 3 – Financial Statement Analysis How to use ratios in analyzing financial statements to assess a firm’s: Profitability Liquidity Solvency

Ratios Great diagnostic tools – they point to areas of operations, financing, or investing that should be researched further before reaching conclusions. Relatively easy to calculate, however, flexibility in GAAP may mean that there can be some variation in how numbers used in ratios are calculated.

Horizontal and Vertical Analysis 1.Horizontal Analysis: a.Analysis of dollar value and percentage changes. b.Over time c.Sometimes called trend analysis. 2.Vertical Analysis: a.Analysis of dollar value amounts relative to a common base. b.Top to bottom. c.Sometimes called Common Size Statement Analysis.

From the text, p. 89 Why compare:To see if the: Current liabilities to current assets company is able to meet its payroll and pay its suppliers on time. Accounts receivable to salescompany can collect its receivables Inventory to cost of goods soldcompany's inventory is turning over quickly enough Fixed charges to incomebusiness can service its debt.

From the text, p. 89 Continued Why compare:To see if the: Total debt to total assetsbusiness can service its debt. Total assets to salescompany's assets are productive. Net income to salescompany as a whole is efficient.

Analyzing The Balance Sheet 1.Horizontal Analysis: how have assets, liabilities and equities changed over time? 2.Vertical Analysis: express all other accounts relative to total assets.

Analyzing the Income Statement 1.Horizontal Analysis: how have sales, expenses, COGS changed over time? 2.Vertical Analysis: express all other accounts relative to sales.

Factors That Affect Profitability Sales volume Sales price Expenses – Cost of goods sold, operating expenses. Operating expenses are directly related to the efficiency of a firm’s assets Cost of capital (funds) – interest charges

Factors That Affect Liquidity Liquidity refers to the ability to meet day-to-day cash needs for business expenses. The speed with which cash payments are received on accounts receivable. The delaying of cash payments on accounts payable and other payables. Working capital requirements – that is the amount of cash needed for day-to-day operations.

Factors That Affect Solvency Recall that solvency is a longer-term aspect than liquidity. Financial structure – aka capital structure (debt/equity) Debt paying ability.

Market-Value Ratios (Table 3.1) Measures of the income or operating success of a company for a given period of time 15.Earnings per share ($) Net Income Number of shares of stock outstanding 16.Price/earnings ratio (times) Price per common share Earnings per common share

Profitability Ratios (Table 3.1) Measures of the income or operating success of a company for a given period of time 11.Profit margin on sales (%) Operating Income Sales 12.Return on sales. (%) Income after taxes Sales

Profitability Ratios (Table 3.1) 13.Return on total assets. (%) Income after taxes Total assets 14.Return on equity (ROE). (%) Income after taxes Owners’ equity

Liquidity Ratios (Table 3.1) Measure of short - term ability to pay obligations 1.Current ratio (times) Current Assets Current liabilities 2.Quick ratio (times) Quick Assets Current liabilities

Leverage Ratios (Table 3.1) Measures of the ability to pay debts in the current year and beyond 3.Debt-to-total-assets (%) Total debts Total assets 4.Debt-to-equity (times) Total debts Total shareholder’s equity

Leverage Ratios (Table 3.1) Measures of the ability to pay debts in the current year and beyond 5.Times-interest-earned (times) Income before tax + Interest charges Interest charges 6.Fixed-charge-coverage (times) – SKIP

Asset-Management Ratios (Table 3.1) 7.Average Collection period (days) Accounts Receivable Daily Sales 8.Inventory turnover (times) Cost of goods sold (average )Inventory

Asset-Management Ratios (Table 3.1) 9.Capital asset turnover (times) SKIP 10.Total asset turnover (times) Sales Total assets

Horizontal and Vertical Analysis 1.Horizontal Analysis: a.Analysis of dollar value and percentage changes. b.Over time c.Sometimes called trend analysis. 2.Vertical Analysis: a.Analysis of dollar value amounts relative to a common base. b.Top to bottom. c.Sometimes called Common Size Statement Analysis.

Analysis of The Balance Sheet 1.Horizontal Analysis: how have assets, liabilities and equities changed over time? 2.Vertical Analysis: express all other accounts relative to total assets.

Analyzing the Income Statement 1.Horizontal Analysis: how have sales, expenses, COGS changed over time? 2.Vertical Analysis: express all other accounts relative to sales.

Dupont Method - skip