1. Principles of Financial Analysis Week 2: Lecture 2 1Lecturer: Chara Charalambous

2. Learning Goals Accounting focuses on how financial statements are made, Managerial Finance focuses on how financial statements are used by the management to improve the firm’s performance and by investors to examine the firm’s financial position when evaluating its attractiveness as an investment. 2Lecturer: Chara Charalambous

3. Analysis of financial statements: A Managerial view Financial statement analysis involves a comparison of a firm’s performance with that of other firms operating in the same industry. Generally the analysis is used to determine the firm’s financial / economic position in order to identify its current strengths and weaknesses and to suggest actions the firm might perform to take advantage of the strengths and correct the weaknesses in the future 3Lecturer: Chara Charalambous

4. Who analyzes financial statements? Financial statement analysis is not only important for the firm’s managers – Internal users (i.e., management) – External users Examples? Investors, creditors & … stock market analysts and auditors 4Lecturer: Chara Charalambous

5. What do internal users use it for? Planning, evaluating and controlling company operations. Also analysis help to make financing and investment decisions to maximize the firm’s value. What do external users use it for? Assessing past performance and current financial position and making predictions about the future profitability and the ability of the company to meet its current and expected future economic obligations. As well as evaluating the effectiveness of management. in this way they see how attractive is the firm as an investment 5Lecturer: Chara Charalambous

6. Information is available from – Published annual reports (1)Financial statements (2)Notes to financial statements (3)Letters to stockholders (4)Auditor’s report (Independent accountants) (5)Management’s discussion and analysis – Reports filed with the government – Other sources (1)Newspapers (2)Periodicals (3)Financial information organizations such as: Moody’s, Standard & Poor’s e.t.c (4)Other business publications Financial Statement Analysis 6Lecturer: Chara Charalambous

7. Annual Report A report used annually (yearly) by a corporation to its stockholders. It contains basic financial statements (the income statement, the balance sheet and the statement of cash flows) as well as management’s opinion of the past years operations and the firm’s future prediction. Together these statements give an accounting picture of the firm’s operations and financial position. Detailed data are provided for the two most recent years. Lecturer: Chara Charalambous7

8. The Income Statement Trading and Profit and Loss statement Contains information on the profitability of the firm during some period of time Indicates the firm’s revenues - sales, expenses, and earnings during an accounting period. THE NET INCOME AVAILABLE TO STOCKHOLDERS o Recall from what you learned in accounting that the income statement is created using the accrual method of accounting: revenues are recognized when they are earned not when the cash is received, and expenses are realized when they are incurred, not when the cash is paid. 8Lecturer: Chara Charalambous

9. Comparative Income Statement for years ending 31 st Dec (millions of Euros except the per share data) 2000 1999 Net Sales 1500 1435 Cost of Goods Sold (1230) (1176.7) Gross Profit 270 258.3 Fixed operating expenses (90) (85) Depreciation (50) (40) Earnings before interest and taxes (EBIT) 130 133.3 Interest (40) (35) Earnings before Taxes (EBT) 90 98.3 Taxes (40%) (36) (39.3) Net Income 54 59 Dividends of preference shares 0 0 Earnings available to common stockholders (EAC) 54 59 Common Dividends (29) (27) Addition to retain earnings 25 32 Per Share data (25,000,000 shares): Shares issued (quantities) 25 25 Common stock price €23 €23 Earnings per share €2.16 €2.36 Dividends per share €1.16 €1.08 Lecturer: Chara Charalambous9

10. Evaluating a Firm’s EPS  We can use the income statement to determine the earnings per share (EPS) and dividends.  EPS = Net income/Number of shares outstanding  Example 1: A firm reports a net income €54 million and has 25 million shares outstanding, what will be the earnings per share (EPS)?  EPS = Net income ÷ Number of shares = €54 million ÷ €25 million = €2.16 Book value per share = (Common equity)/Shares €16.60 Market value per share (stock price) €23.00 Earnings per share = (Net income)/Shares €2.16 Dividends per share = (Common dividends)/Shares = 29/25= €1.16 10Lecturer: Chara Charalambous

11. The Balance Sheet Shows the financial position of a firm at a specific point in time. This statement shows the investments made by the firm in the form of assets and the means by which the asset were financed: by borrowing (liabilities) or by selling ownership shares (equity). The retained earnings account is built up over time as the firm ‘saves’ a part of its earnings rather than paying out as dividends. The accounts common stock and paid-in capital regards the funds came from selling stock and the amount of money the owner put up respectively. Lecturer: Chara Charalambous11

12. Comparative Balance sheets as at 31 Dec (millions of Euros) Fixed Assets 2000 1999 Plant and Equipment 680 600 Less: Accumulated Depreciation (300) 380 (250) 350 Current Assets Inventory 270 200 Debtors 180 160 Cash 15 465 40 400 Total Assets 845 750 Equity and Liabilities Owner’s equity Paid – in Capital 0 0 Common stock (25,000,000 shares) 130 130 Retained Earnings 285 260 415 390 Long Term Loans 300 255 Current Liabilities Creditors 30 15 Accruals 100 90 Total Equity and Liabilities 845 750 Lecturer: Chara Charalambous 12

13. 13 Account of Retained Earnings for the Period Ending December 31, 2000 (€ million) Balance of retained earnings, December 31, 2008$260.0 Add: 2000 net income54.0 Less: 2000 dividends paid to stockholders (29.0) Balance of retained earnings, December 31, 2009$285.0

14. Statement of Cash Flow Cash flow statement – How did the cash come and go? cash received and cash spent by the firm over a period of time. Designed to show how the firm’s operations have affected its cash position Examines investment decisions (uses of cash) Examines financing decisions (sources of cash) Lecturer: Chara Charalambous14

15. 15 Ratio Analysis Ratio analysis is used to evaluate relationships between items in the financial statements. The ratios are used to identify trends over time for one company or to compare two or more companies at one point in time. Financial statement ratio analysis focuses on three key aspects of a business: liquidity, profitability, and solvency (debt management ratios).

16. 16 The Purpose of Ratio Analysis Gives an idea of how well the company is doing Homogenize numbers; facilitates comparisons Used to highlight weaknesses and strengths

17. Liquidity ratios Liquidity ratios measure the ability of a company to repay its short-term debts and meet unexpected cash needs. 1. Current ratio. The current ratio is also called the working capital ratio, as working capital is the difference between current assets and current liabilities. This ratio measures the ability of a company to pay its current obligations using current assets. The current ratio is calculated by dividing current assets by current liabilities. Lecturer: Chara Charalambous17 Current Ratio = Current Assets Current Liabilities €465.0 €130.0 == 3.6 times Industry average = e.g.4.1 times Weak liquidity position compared to this of the industry

18. A company needs adequate current assets to meet current debts, to carry enough inventories, and to take advantage of cash discounts. A company that has low current ratio is less able to meet current obligations or to continue operating. A high current ratio suggests a strong liquidity position and an ability to meet current obligations. Lecturer: Chara Charalambous18

19. Lecturer: Chara Charalambous 19 Industry average = 2.1 times 465.0 - 270.0 130.0 Quick Ratio = Current Assets- Inventories Current Liabilities = == 1.5 times 195.0 130.0 2.The quick or acid test ratio is calculated by deducting stock from current assets and then dividing the amount by current liabilities. Stock is typically the least liquid of a firm’s current assets. Hence it is the asset on which losses are the most probably to occur in the event of liquidation. Therefore the ability of a company to pay short-term obligations without relying on the sale of stock is important. Low quick ratio compared to these of other companies in the industry. But still if the debtors pay their debts to the firm, the company can pay its current liabilities even if it doesn’t liquid its stock.

20. Acid – test ratio assess whether a Company has enough liquid assets to meet its current liabilities. Lecturer: Chara Charalambous20

21. Profitability Ratios Profitability refers to a company’s ability to generate satisfactory return on invested capital. Return is judged by assessing earnings relative to the level and sources of financing. Profitability is also relevant to solvency. Lecturer: Chara Charalambous21

22. 22 Profitability Ratios 1.Net Profit Margin : gives the profit per euro of sales 4.9% Industry Average = Profit margin= Net income Sales 54.0 1,500 0.036 = 3.6% == Net income is calculated by deducting from sales all expenses and costs: regarding this company Its sales are too low or its costs are too high or both.

23. 2.Return on Total Assets: ROA the ratio of net income to total assets provides an idea of the general return on investment earned by the firm. The investments done in assets didn’t give high return because the net profit is low, this means that the company has high loans which makes it pay high interests. Lecturer: Chara Charalambous23 12.3% Industry Average = 54.0 845.0 = 0.064 = 6.4% = ROA= Net income Total assets

24. 3.Return on Common Equity: ROE this ratio measures the rate of return on stockholders investment. Measures how much net income was earned relative to each euro of common stockholders' equity. The investment of the stockholders give lower return compared to this of the industry. Lecturer: Chara Charalambous24 17.7% Industry Average = 54.0 415.0 - 0 = 0.130 = 13.0% = ROE Net income = Owner’s equity

25. Solvency – Debt Management Ratios Solvency refers to a company’s long financial capability and its ability to cover long – term obligations. All of a company’s business activities – financing, investing, and operating – affect its solvency. Lecturer: Chara Charalambous25

26. Solvency – Debt Management Ratios 1.Debt Ratio: measures the percentage of the firm’s assets financed by debt – borrowing. Lecturer: Chara Charalambous26 Debt Ratio = Total liabilities = short + long term Total assets current + fixed =42.0% = 430.0 845.0 = 0.509 = 50.9% Industry Average 130+300 845 The debt is higher than the value of assets. This it will make it difficult to borrow additional funds and also there is greater danger of bankruptcy

27. Lecturer: Chara Charalambous27 TIE = EBIT (Earnings before interest and taxes) Interest charges 3.3 times $40.0 $130.0 = = Industry Average =6.5 times 2.Times Interest Earned : measures the extent to which earnings before interest and taxes can cover interest charges. Failure to cover this obligation can bring legal action by the firm’s creditors, possibly resulting in bankruptcy. This company is covering its interest charges by a low margin of safety. In the future it will face difficulties if it attempts to borrow additional funds.

28. QUESTIONS Lecturer: Chara Charalambous28

29. APPENDIX - Types of share capital Authorised share capital is also referred to as registered capital. It is the total of the share capital which a limited company is allowed (authorised) to issue. – Shares authorised = Shares issued + Shares unissued Shares authorisedShares unissued Issued share capital is the total of the share capital actually issued to shareholders. This may be less or equal to the authorised capital. Called up share capital is the total amount of issued capital for which the shareholders are required to pay. Paid up share capital is the amount of share capital paid by the shareholders. This may be less than the called up capital as payments may be in instalments ("calls-in-arrears"). 29Chara Charalambous CDA COLLEGE