Financial statement analysis P.W.Sims Business Program LW Finance

Financial statement analysis Involves looking at Revenues Expenses Liabilities Uses this raw information from the operation of a business in new ways to compare period over period results compare your business to others compare your business to your industry

Financial statement analysis – Common size statement First step in financial statement analysis is usually common size statement  Common size income statement Presents each line as percent of revenue  Common size balance sheet Presents each line as percent of total assets

Quantitative factors - Common Size Statements Example

Financial statement analysis - Ratios When examined separately, ratios don’t convey much information. Ratios are compared with:  History—examine trends (how ratio has changed over time)  Competition—compare with other firms in same industry Link to comparison charts  Budget—compare actual ratios with expected or desired ratios

Categories of Financial Ratios Profitability Ratios Market Value Ratios Liquidity Ratios Asset Management Ratios Debt Management Ratios

Categories of Financial Ratios  Profitability—allow assessment of the firm’s ability to make money  Liquidity—indicate firm’s ability to pay its bills in short run  Asset Management—show firm’s ability to generate revenue using minimum amount of assets  Debt Management—determine if the firm is using so much debt that it is assuming excessive financial risk

Profitability Ratios Return on Assets  Adds effectiveness of asset management to Return on Sales  Measures ability of firm to utilize assets to earn profit  Often compared to firm’s cost of financing (after tax)

Profitability Ratios Return on Equity  Adds effect of borrowing to Return on Assets  Measures ability to earn a return on owners’ investment  If firm has substantial debt, ROE tends to be higher than ROA in good times and lower in bad times  Compared to returns available from alternate investments

Liquidity ratios Liquidity ratios measure the ability to convert assets to cash  The ability to pay short term bills

Liquidity Ratios Current Ratio  To ensure solvency, current ratio is expected to exceed 1.0  Standard ratio is 2:1  May be too high if too much money is tied up in receivables and inventory

Liquidity Ratios Quick Ratio (or Acid-Test Ratio)  Measures liquidity without considering inventory (least liquid current asset)  May be too high if too much money is tied up in receivables

Debt Management Ratios Debt management ratios measure financial risk from borrowing  High ratios viewed as risky by lenders and investors  Riskiness associated with debt and interest is called financial risk  High level of debt can burden income statement with excessive interest, a fixed financial charge  Firm may not be able to repay debt and interest if profits decline

Debt Management Ratios Debt Ratio  Need to determine if company is using so much debt that it is assuming excessive financial risk  High debt ratio is viewed as risky by investors and creditors and is negative  Range of 1:1 to 4:1

Debt Management Ratios Debt-to-equity ratio  Compares what is owned to what is financed  Measures mix of debt and equity within firm’s total capital  High ratio means cie relies to much on debt and should think of reducing debt

Debt Management Ratios Long Term Debt Ratio  Focuses the attention long term debt instead of all the debt

Debt Management Ratios Times Interest Earned  EBIT stands for Earning before interest and taxes  TIE is a coverage ratio Reflects how much EBIT covers interest expense High level of interest coverage implies safety for lenders  High TIE ratio often means a low debt/equity ratio  Lowest acceptable ratio 1.5; best result 2 to 3

Debt Management Ratios Cash coverage Ratio  Same as previous but looks only at cash expenses (depreciation is an accounting expense)  Lowest acceptable ration 1.5; best result 2 to 3

Debt Management Ratios Debt coverage ratio  EBIT stands for Earning before interest and taxes  TIE is a coverage ratio Reflects how much cash covers interest and principal payments  Lowest results acceptable 2 to 2.5

Debt Management Ratios Fixed Charge Coverage  Interest payments are not the only fixed charges  Lease payments are fixed financial charges similar to interest Must be paid regardless of business conditions

Question Debt ratio  Your debt ratio has increased from 50% to 55% in the last quarter, this means: Your asset value has increased Your asset value has decreased and so has your liability Your liabilities have increased faster than your assets

Question What does EBIT stand for? Debt coverage ratio, why do we add to before comparing it to