1. Analyzing Financial Data and Ratios
Mr. Michael Wong
Lecturer, PolyU HKCC

2. Value of Financial Statement Analysis
Financial statements, by their nature, are backward-looking
So why analyze the statements?
Analysis provides knowledge of a firm’s operating and financial structure
This aids in estimating future returns

3. Major Financial Statements
Corporate annual reports must include:
Statement of Financial Position
Income statement
Statement of cash flows
Enough for analysis?

4. Purpose of Financial Statement Analysis
Evaluate management performance in
Profitability
Efficiency
Risk
Although financial statement information is historical, it is used to project future performance

5. Five Categories of Financial Ratios
Common size statements
Internal liquidity (solvency)
Operating performance
Operating profitability
Operating efficiency
Risk analysis
Business risk
Financial risk
Growth analysis

6. Common Size Statements
Normalize balance sheets and income statement items to allow easier comparison of different size firms
A common size balance sheet expresses accounts as a percentage of total assets
A common size income statement expresses all items as a percentage of sales

7. Consolidated Statement of Income

8. Consolidated Statement of Financial Position

9. Evaluating Internal Liquidity
Internal liquidity (solvency) ratios indicate the ability to meet future short-term financial obligations
Current Ratio
Quick Ratio
Cash Ratio

10. Evaluating Operating Performance
Ratios that measure how well management is operating a business
Operating profitability ratios
Examine how management is doing at controlling costs so that a large proportion of the sales dollar is converted into profit
Operating efficiency ratios
Examine how management uses its assets to generate sales; considers the relationship between various asset categories and sales

11. Operating Profitability Ratios
Operating profitability ratios measure
Gross profit margin
Operating profit margin
Net profit margin
Return on owner’s equity (ROE)

12. Operating Efficiency Ratios
How effectiveness of a firm’s use of its total asset base to produce sales
Total asset turnover
Non-current asset turnover
Operating cycle
Cash conversion cycle

13. Operating Cycle & Cash Conversion Cycle
Order Placed
Stock Arrives
Raw material purchased
Cash received
Finished goods sold
Inventory period
Accounts receivable period
Time
Accounts payable period
Firm receives invoice
Cash paid for materials
Operating cycle
Cash conversion cycle

14. Operating Profitability Ratios
Return on owner’s equity (ROE) indicates the rate of return earned on the capital provided by the stockholders after paying for all other capital used

15. Operating Profitability Ratios
The DuPont System divides ROE into several ratios that collectively equal ROE while individually providing insight
An extended DuPont System provides additional insights into the effect of financial leverage on the firm and pinpoints the effect of income taxes on ROE

16. Operating Profitability Ratios
Profit Total Asset Financial
Margin Turnover Leverage = x

17. Risk Analysis
Risk analysis examines the uncertainty of income for the firm and for an investor
Total firm risks can be decomposed into two basic sources:
Business risk: The uncertainty in a firm’s operating income, highly influenced by industry factors
Financial risk: The added uncertainty in a firm’s net income resulting from a firm’s financing decisions

18. Business Risk Variability of the firm’s operating income over time
Two primary determinants of business risk
Sales variability
The main determinant of earnings variability
Cost Variability and Operating leverage
Production has fixed and variable costs
Greater fixed production costs cause greater profit volatility with changes in sales
Fixed costs represent operating leverage
Greater operating leverage is good when sales are high and increasing, but bad when sales fall

19. Effect of operating leverage
More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline.
What happens if variable costs change?
Sales $
Rev. TC FC
QBE }
Profit

20. Financial Risk
Interest payments are deducted before we get to net income
These are fixed obligations
Similar to fixed production costs, these lead to larger earnings during good times, and lower earnings during a business decline
Fixed financing costs are called financial leverage
The use of debt financing increases financial risk and possibility of default

21. Financial Risk
Two sets of financial ratios help measure financial risk
Balance sheet ratios
Earnings or cash flow available to pay fixed financial charges
Acceptable levels of financial risk depend on business risk
A firm with considerable business risk should likely avoid lots of debt financing

22. Financial Risk Balance Sheet Ratios
Total debt ratio
Debt-equity ratio
Equity multiplier
Earnings or cash flow available to pay fixed financial charges
Times interest earned ratio
Cash coverage ratio

23. Potential Growth Analysis
Important to both creditors and owners
ability to pay future obligations
Ability to pay dividends
g = ROE x Retention rate
The retention rate is one minus the firm’s dividend payout ratio
Anything that impacts ROE would also be a determinant of future growth

24. Importance of Relative Financial Ratios
In order to make sense of a ratio, we must compare it with some appropriate benchmark or benchmarks
Examine a firm’s performance relative to:
The aggregate economy
Its industry or industries
Its major competitors within the industry
Its own past performance (time-series analysis)

25. Comparing to the Aggregate Economy
Most firms are influenced by economic expansions and contractions in the business cycle
Analysis helps you estimate the future performance of the firm during subsequent business cycles

26. Comparing to the Industry Norms
Most popular comparison
Industries affect the firms within them differently, but the relationship is always significant
The industry effect is strongest for industries with homogenous products
Can also examine the industry’s performance relative to aggregate economic activity

27. Comparing to the Firm’s Major Competitors
Industry averages may not be representative
A firm may operate in several distinct industries
Several approaches:
Select a subset of competitors for the comparison group
Construct a composite industry average from the different industries in which the firm operates

28. Comparing to the Firm’s Own Past Performance
Determine whether it is progressing or declining
Helpful for estimating future performance
Consider trends as well as averages over time

29. Other than financial statements
Corporate Profile
Chairman’s Statement
Management Discussion and Analysis
Notes to Financial Statements
Segment information
Noncurrent assets component
Any commitments, etc.
Government & Industry Statistics
Your Observation

30. Is financial performance everything?
Financial performance may lead management’s emphasis on short-run financial performance
Need to have some measures that translate an organisation’s mission and strategy into a comprehensive set of performance measures.

31. Other perspectives Four key perspectives: Financial Customer
Internal business processes
Learning and growth

32. Other perspectives
Because the non-financial and operational indicators measure fundamental changes that a company is making.
The financial benefits of these fundamental changes may not be captured in short-run earnings.
Strong improvements in non-financial measures signal the prospect of creating economic value in the future.

33. Q&A

34. Summary of Ratio analysis34