1. Financial Statement Analysis
CHAPTER 10
Financial Statement Analysis

2. Overview Liquidity measures Activity measures
Accounts receivable and inventory turnover
Profitability measures
Price earnings ratio and evaluation of share market price
Dividend yield and dividend payout ratio
Financial leverage
Common size financial statements
Other operating statistics
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3. Financial Statement Ratios
Ratios are used to interpret the financial position and results of operations of an entity and may be grouped in the following four categories:
Liquidity
Activity
Profitability
Debt, or financial leverage
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4. Specific identification
Liquidity Measures
The liquidity measures of working capital, current ratios and quick ratios were discussed in Chapter 3.
Remember:
The effect of the inventory cost-flow assumption on:
FIFO
Specific identification
Weighted average
current ratios
and
working capital
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5. Liquidity Measures Suppliers and creditors
Is the firm paying its bills promptly?
What is the firms current and recent payment experience?
May be indicated by extent that cash discounts are being taken.
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6. Turnover = Sales ÷ Average Assets
Activity Measures
Focus primarily on relationships between asset levels and net sales. The general model for calculating turnover is:
Turnover = Sales ÷ Average Assets
Average assets use balance sheet amounts reported at the beginning and end of a period.
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7. Activity Measures
Turnover is often used in the calculation for assessing activity of:
accounts receivable
inventories
plant and equipment
total operating assets
total assets.
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8. Activity Measures
Turnover ratios will be affected by inventory cost-flow assumptions and depreciation methods:
$ inventory $ depreciable assets
FIFO and accelerated depreciation
Weighted-average and straight line depreciation
$ inventory $ depreciable assets
Higher asset turnover
Lower asset turnover
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9. Activity Measures
These amounts will be used to demonstrate how the ratios can be calculated.
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10. Accounts Receivable Turnover
Sales
Average Accounts Receivable
Accounts Receivable
Turnover =
$500,000
($17,000 + $20,000) ÷ 2 =
= times
A measure of how many times a company converts its receivables into cash each year.
Or average collection period of 13.5 days.
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11. Inventory Turnover Cost of Goods Sold Average Inventory Inventory=
$140,000
($10,000 + $12,000) ÷ 2 =
= times
A measure of the number of times merchandise inventory is sold and replaced during the year.
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12. Inventory Turnover
Lower inventory compared to sales means less needs to be financed by debt or equity.
BUT…
risk of not having enough inventory to meet demand
risk of out of stock situation with delay in receiving raw materials or finished product and lost sales.
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13. Inventory management system
Inventory Turnover
Inventory management system
JIT - Just in time:
Keep the investment in inventories at a minimum by forecasting needs.
Suppliers deliver inventories only when needed.
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14. Activity Measures
In evaluating the firm’s operating efficiency, it is the trend of these calculations over time that is important.
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15. Profitability Measures
Discussed in Chapter 3:
Return on assets (ROA)
Return on equity (ROE).
Points to remember:
ROA is based on EBIT (earnings before interest and tax)
better measure of management activities as
interest is a function of capital structure
tax is a function of the tax laws.
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16. Profitability Measures
Need to maintain healthy scepticism about:
relationship?
True rate of return
ROA and ROE
Based on:
real economic profit related to
fair market values
No agreement on how to determine these
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17. Profitability Measures
Evaluations more valid when based on the trend of one company’s ROA and ROE relative to:
Trends in industry
Trends of competitors
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18. Market price per ordinary share Earnings per share
Price/Earnings Ratio
Price earnings
ratio
Market price per ordinary share Earnings per share =
A measure often used by investors to evaluate the market price of a company’s ordinary shares.
Price earnings
ratio
$4.10 $0.13 =
= 32.7 times
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19. Investors’ expectations about the firm’s future earnings
Price/Earnings Ratio
Market price of a share
Investors’ expectations about the firm’s future earnings
Relating market price and earnings per share in a ratio (price earnings ratio) is a way to express investors’ expectations
The greater the probability of increased earnings, the more investors are willing to pay.
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20. Price/Earnings Ratio
At first glance, company B shares look more expensive,
but company A shares are more expensive as investors are willing to pay 25 times earnings for the shares, compared with 18 times for company B.
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21. Dividend Yield Dividend yield Dividends per share
Market price per share =
Identifies the return, in terms of cash dividends, on the current market price of the shares.
$1.45
$60.00 =
= 2.4%
Dividend
Yield
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22. Annual dividend per share
Dividend Payout Ratio
Dividend
payout ratio
Annual dividend per share
Earnings per share =
Reflects the dividend policy of the company. Investors are able to project future dividends based on a company’s earnings prospects.
Dividend
Payout Ratio =
= 25.7%
$1.45
$5.64
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23. Financial Leverage
Financial leverage refers to the use of debt to finance the assets of the entity.
Leverage adds risk - if there is not enough cash to pay principal and interest, entity may be forced into bankruptcy.
BUT, as the cost of debt is fixed, leverage also magnifies the return to owners (ROE) relative to the return on assets (ROA).
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24. Financial Leverage
Borrowing at an interest rate that is less than the rate of return that can be earned on that money, multiplies the return on owners’ equity.
Debt and preference shares provide leverage opportunities as the interest cost or dividend rate is fixed.
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25. Financial Leverage - Debt Ratio
Total liabilities
Total liabilities + Owners’ equity
Debt ratio =
Measures the proportion of assets being provided by creditors.
Debt ratio =
= 40%
$40000
$100000
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26. Financial Leverage - Debt/Equity Ratio=
Total liabilities
Total owners’ equity
Debt/Equity ratio =
= 67.0%
$40000
$60000
Measures the relative proportion of contribution from owner’s and creditor’s.
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27. Financial Leverage - Times Interest Earned
Earnings before interest and taxes
interest expense =
A common measure of the ability of a firm to cover interest and provide protection to the long-term creditors.
Times interest earned =
= 1.95 times
$6587
3378
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28. Common Size Financial Statements
Each asset expressed as a % of total assets
Each liability and equity account expressed as a % of total
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29. Common Size Financial Statements
Each item on the Income Statement expressed as a % of total sales
This type of analysis makes spotting trends easier.
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30. Other operating statistics
Statistics other than financial ratios may be used to evaluate a firm.
Sales in units
Total number of employees
Sales dollar per employee
Operating income per employee
Plant operating expenses per square metre of plant
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