Financial Statement Analysis

2 Internal UsersExternal Users Financial statement analysis helps users make better decisions. Managers Officers Internal Auditors Shareholders Lenders Customers Purpose of Analysis

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4 Outcomes Describe meaning and usage of financial statement analysis 3 Types of Analysis 5 Types of Financial Ratios

5 Ratio Analysis numbers versus ratios Why? AABBCOMPANY $ 1,000,000$ 10,000NET INCOME $ 5,000,000$ 20,000TOTAL ASSETS 0.20 = 20%0.50 = 50%NI / TA EX :

6 Ratio Analysis Types of ratio analysis 1.Industry Comparative You 28 %22 %NI / TA To compare with the average of the companies in the same industry (your performance is higher or lower than the mean?) Industry average

7 Ratio Analysis Types of ratio analysis 2.Trend or time series 2001YEAR 22 %25 %NI / TA To compare with yourself along the period of time (your performance is improving or getting worse?) %

8 Ratio Analysis Types of ratio analysis 3.Cross-sectional YouCOMPANY 28 %22 %NI / TA To compare with your main competitors (your performance is better or worse than them?) C1C2 19 % C3 36 %

9 Types of Financial Ratios Liquidity Asset Management (Efficiency) Debt Management (Financial Leverage) Profitability Market Value

10 1. Liquidity Ratios = Ability to pay current obligations (S-T debts; A/P, N/P) By using current sources of cash (Current Assets) Quick or acid-test ratio = (CA - Inventories) ÷ CL Inventories are the least liquid current assets so exclude it out You Current ratio Co1Example 0.70 Co2 GoodNormalAnalysisBad Current ratio= CA ÷ CL

11 2. Asset Management Ratios = Measure how efficient the assets can turn into sales $ 1,000,000 $ 3,000,000 (Investment) Meaning: investing $1 can generate sales $3 (Sales)

12 Average collection period (ACP)= A/R x 365 ÷ S Inventory Turnover= COGS ÷ Inventory Receivables Turnover= S ÷ A/R 2. Asset Management Ratios Example: A/R = $100, Sales = $3,650 ACP = A/R x 365 ÷ S ACP = $100 x 365 days ÷ $3,650 ACP = 10 days Meaning: Make sales today Collect cash from customer 010 days

13 Inventory Turnover Rate This ratio measures the number of times merchandise inventory is sold and replaced during the year. This ratio measures the number of times merchandise inventory is sold and replaced during the year. Cost of Goods Sold Average Inventory Inventory Turnover = times = times $140,000 ($10,000 + $12,000) ÷ 2 Inventory Turnover =

14 Accounts Receivable Turnover Rate This ratio measures how many times a company converts its receivables into cash each year. Net Sales Average Accounts Receivable Accounts Receivable Turnover = times = times $500,000 ($17,000 + $20,000) ÷ 2 Accounts Receivable Turnover =

15 Number of Days to Collect Receivables This ratio measures, on average, how many days it takes to collect an account receivable. Average Collection Period = 365 Days Accounts Receivable Turnover days = days Average Collection Period = 365 Days Times

16 2. Asset Management Ratios Total Asset Turnover= Sales ÷ Total Assets You $ 3 m$ 1 mSales Co1Example $ 1.4 m Co2 $ 1 m Total Assets$ 2 m Fixed Asset Turnover= Sales ÷ Fixed Assets TATO0.70 GoodNormalAnalysisBad

17 3. Debt Management Ratios Debt ratio = TL ÷ TA Total Debt to Equity ratio = TL ÷ TE = How much the firm has borrowed to make an investment = Ability of a firm to meet total debt obligations (S-T & L-T) Brown Co. TA $100,000 TL $ 80,000 TE $ 20,000 Green Co. TA $100,000 TL $ 20,000 TE $ 80,000 TL TA = TL TE = 80 % 4x TL TA = TL TE = 20 % 0.25x

18 4. Profitability Ratios = Ability to earn profit generated from sales = Ability to control costs, expenses Gross Profit Margin =Gross Profit / Sales How many %profit left after paying cost of goods sold Higher  good control of cost of goods sold Lower  cost of goods sold are too high

19 4. Profitability Ratios (cont.) Operating Profit Margin =EBIT / Sales How many %profit left after paying cost of goods sold and operating expense Higher  good control of both CGS and operating exp Lower  CGS and operating expense are too high

20 4. Profitability Ratios (cont.) Net Profit Margin (NPM)= NI to CS ÷ S Sales - expenses NI to CS 100, ,000 60, , ,000 40, %NPM40 % Ex :Co. 1Co. 2

21 4. Profitability Ratios (cont.) = How much is the profit from $ 1 total investment Return on Assets (ROA)= NI to CS ÷ TA Return on Equity (ROE)= NI to CS ÷ CE = How much is the profit from $ 1 owners’ investment Brown Co: TA = $100,000 NICS = $10,000ROA =10% Example : Green Co : TA = $100,000 NICS = $20,000ROA =20% CE = Investment from Common Shareholders = CS par + Paid in + RE

22 = How much the investors value the firm in the market = Tell you what investors think about the firm’s future 5. Market Value Ratios Price to earnings ratio (P/E) = Market price per share Earnings per share = How much the investors are willing to pay for each $ 1 of earnings per share (EPS) **Earnings per share = NI to CS ÷ # of Common Shares

23 5. Market Value Ratios (cont.) Dividend Yield (DY)= DPS Market price per share Dividend per share (DPS)= Dividends to CS # of Common Shares

24 Dividend Yield This ratio identifies the return, in terms of cash dividends, on the current market price of the stock. Dividend Yield Ratio Dividends Per Share Market Price Per Share = Dividend Yield Ratio $1.50 $15.25 = 9.84% = 9.84% Babson Builders pays an annual dividend of $1.50 per share of capital stock. The market price of the company’s capital stock was $15.25 at the end of 2007.