dr gourav vallabh financial statement analysis dr gourav vallabh xlri jamshedpur
TRANSCRIPT
Dr Gourav Vallabh
Financial Statement Analysis
Dr Gourav Vallabh
XLRIJamshedpur
Dr Gourav Vallabh
FINANCIAL STATEMENT ANALYSIS
• The way to compare companies of different sizes is to use standard measures
• Financial ratios are standard measures that enable analysts to compare companies of different sizes
Dr Gourav Vallabh
• The objectives of financial statement analysis are to help investors– Predict their expected returns (see the
previous graph)– Assess the risks associated with those
returns
FINANCIAL STATEMENT ANALYSIS
Dr Gourav Vallabh
USING RATIOS TO MAKE BUSINESS DECISIONS
• A ratio expresses the relationship of one number to another
• The ratios used to make business decisions may be classified as follows:– Ratios that measure the company’s ability
to pay current liabilities– Ratios that measure the company’s ability
to sell inventory and collect receivables
Dr Gourav Vallabh
– Ratios that measure the company’s ability to pay long-term debt
– Ratios that measure the company’s profitability
– Ratios used to analyze the company’s stock as an investment
USING RATIOS TO MAKE BUSINESS DECISIONS
Dr Gourav Vallabh
MEASURING A COMPANY’S ABILITY TO PAY CURRENT
LIABILITIES
Working capital is defined as follows:
Working capital = Current assets - Current liabilitiesWorking capital = Current assets - Current liabilities
Dr Gourav Vallabh
• Working capital is widely used to measure a business’s ability to meet its short-term obligations with its current assets
• The larger the working capital, the better able is the business to pay its debts
MEASURING A COMPANY’S ABILITY TO PAY CURRENT
LIABILITIES
Dr Gourav Vallabh
CURRENT RATIO
• The current ratio– Is current assets divided by current
liabilities– Measures the ability of the company to pay
current liabilities with current assets
• The following slides give the comparative income statement and balance sheet of Palisades Furniture, Inc.
Dr Gourav Vallabh
PALISADES FURNITURE, INC.Comparative Income Statement
Year Ended December 31, 20X3 and 20X2
20X3 20X2
Net sales $858,000 $803,000Cost of goods sold 513,000 509,000Gross profit 345,000 294,000Operating expenses: Selling expenses 126,000 114,000 General expenses 118,000 123,000 Total operating expenses 244,000 237,000Income from operations 101,000 57,000Interest revenue 4,000 -0-Interest expense 24,000 14,000Income before income taxes 81,000 43,000Income tax expense 33,000 17,000Net income $ 48,000 $ 26,000
PALISADES FURNITURE, INC.Comparative Income Statement
Year Ended December 31, 20X3 and 20X2
20X3 20X2
Net sales $858,000 $803,000Cost of goods sold 513,000 509,000Gross profit 345,000 294,000Operating expenses: Selling expenses 126,000 114,000 General expenses 118,000 123,000 Total operating expenses 244,000 237,000Income from operations 101,000 57,000Interest revenue 4,000 -0-Interest expense 24,000 14,000Income before income taxes 81,000 43,000Income tax expense 33,000 17,000Net income $ 48,000 $ 26,000
Dr Gourav Vallabh
PALISADES FURNITURE, INC.Comparative Balance Sheet
December 31, 20x3 and 20X2
20X3 20X2AssetsCurrent assets: Cash $ 29,000 $ 32,000 Accounts receivable, net 114,000 85,000 Inventories 113,000 111,000 Prepaid expenses 6,000 8,000 Total current assets 262,000 236,000Long-term investments 18,000 9,000Plant, property and equipment, net 507,000 399,000Total assets $787,000 $644,000
LiabilitiesCurrent liabilities: Notes payable $ 42,000 $ 27,000 Accounts payable 73.000 68,000 Accrued liabilities 27,000 31,000 Total current liabilities 142,000 126,000Long term debt 289,000 198,000 Total liabilities 431,000 324,000
Stockholders’ EquityCommon stock, no par 186,000 186,000Retained earnings 170,000 134,000 Total stockholders’ equity 356,000 320,000 Total liabilities and stockholders’ equity $787,000 $644,000
PALISADES FURNITURE, INC.Comparative Balance Sheet
December 31, 20x3 and 20X2
20X3 20X2AssetsCurrent assets: Cash $ 29,000 $ 32,000 Accounts receivable, net 114,000 85,000 Inventories 113,000 111,000 Prepaid expenses 6,000 8,000 Total current assets 262,000 236,000Long-term investments 18,000 9,000Plant, property and equipment, net 507,000 399,000Total assets $787,000 $644,000
LiabilitiesCurrent liabilities: Notes payable $ 42,000 $ 27,000 Accounts payable 73.000 68,000 Accrued liabilities 27,000 31,000 Total current liabilities 142,000 126,000Long term debt 289,000 198,000 Total liabilities 431,000 324,000
Stockholders’ EquityCommon stock, no par 186,000 186,000Retained earnings 170,000 134,000 Total stockholders’ equity 356,000 320,000 Total liabilities and stockholders’ equity $787,000 $644,000
Dr Gourav Vallabh
The current ratio of Palisades Furniture, Inc., at December 31, 20X3 and 20X2, follow, along with the average for the retail furniture industry:
Current ratio =Current ratio = Current assetsCurrent assetsCurrent liabilitiesCurrent liabilities
$262,000$142,000
= 1.85 $236,000$126,000
= 1.87
Palisades’ Current Ratio
Industry Average = 1.70Industry Average = 1.70
20X3 20X2Formula
In general, a higher current ratio indicates a stronger financial positionIn general, a higher current ratio indicates a stronger financial position
In most industries a current ratio of 2.0 is
considered good
Dr Gourav Vallabh
• The acid-test (or quick) ratio – Indicates whether the entity could pay all
its current liabilities if they came due immediately
– Is computed by dividing cash, short-term investments, and net current receivables (accounts and notes receivable, net of allowances) by current liabilities
ACID TEST RATIO
Dr Gourav Vallabh
Palisades Furniture’s acid-test ratios for 20X3 and 20X2 are:
Acid-Test ratio =Acid-Test ratio =Cash + short-term Cash + short-term investments + net investments + net current receivablescurrent receivablesCurrent liabilitiesCurrent liabilities
$29,000 + $0 + $114,000
$142,000=1.01
$32,000 + $0 + $85,000
$126,000= 0.93
Palisades’ Acid-Test Ratio
20X3 20X2Formula
Industry Average = 0.40Industry Average = 0.40An acid-test ratio of 0.90to 1.00 is acceptable in
most industries
Dr Gourav Vallabh
MEASURING ABILITY TO SELL INVENTORY AND
COLLECT RECEIVABLES• Three ratios are presented that
measure the company’s ability to sell inventory and collect receivables– Inventory turnover– Accounts receivable turnover– Days’ sales in receivables
Dr Gourav Vallabh
INVENTORY TURNOVER
• Inventory turnover is – A measure of the number of times a
company sells its average level of inventory during a year
– Computed by dividing the cost of goods sold by the average inventory for the period
Dr Gourav Vallabh
• A high rate of turnover indicates relative ease in selling inventory; a low turnover indicates difficulty in selling
• In general, companies prefer a high inventory turnover
• Inventory turnover varies widely with the nature of the business
INVENTORY TURNOVER
Dr Gourav Vallabh
Palisades Furniture’s inventory turnover for 20X3 is:
Inventory turnover =Inventory turnover =Cost of goods soldCost of goods sold
Average inventoryAverage inventory
$513,000
$112,000 4.58=
Industry Average = 3.00Industry Average = 3.00
FormulaPalisades’ Inventory
Turnover
Palisades Furniture’s turnover of 4.58 times a year is high for its industry, which has an average turnover of 3.00
Palisades Furniture’s turnover of 4.58 times a year is high for its industry, which has an average turnover of 3.00
Dr Gourav Vallabh
ACCOUNTS RECEIVABLE TURNOVER
• Accounts receivable turnover– Measures a company’s ability to collect
cash from credit customers– Is computed by dividing net sales by
average net accounts receivable• The resulting ratio indicates how many times
during the year the average level of receivables was turned into cash
Dr Gourav Vallabh
• In general, the higher the ratio, the more successfully the business collects cash and the better off its operations
• A receivable turnover that is too high may indicate that credit is too tight, causing the loss of sales to good customers
ACCOUNTS RECEIVABLE TURNOVER
Dr Gourav Vallabh
Palisades’ Furniture’s accounts receivable turnover ratio for 20X3 is computed as follows:
Accounts Accounts receivable = receivable =
turnover turnover
Net credit salesNet credit sales
Average net Average net accounts receivableaccounts receivable
$858,000
$99,0008.62=
Industry Average = 31.3Industry Average = 31.3
FormulaPalisades’ Accounts Receivable Turnover
Palisades’ receivable turnover of 8.62 is much lower than the industry average, possibly because larger stores sell their receivables
Palisades’ receivable turnover of 8.62 is much lower than the industry average, possibly because larger stores sell their receivables
Dr Gourav Vallabh
DAYS’ SALES IN RECEIVABLES
• The days’-sales-in-receivables ratio tells– How many days’ sales remain in Accounts
Receivable– Is computed by a two-step process
• First, divide net sales by 365 days to figure the average sales amount for one day
• Second, divide this average day’s sales amount into the average net accounts receivable
Dr Gourav Vallabh
1. One day’s sales =1. One day’s sales =Net salesNet sales
365 days365 days
$858,000
365 days $2,351=
Industry Average = 2 daysIndustry Average = 2 days
FormulaPalisades’ Days’ Sales in
Accounts Receivable
The day’s sales in receivables for Palisades is higher (worse) than the industry average because the company collects its own receivables
The day’s sales in receivables for Palisades is higher (worse) than the industry average because the company collects its own receivables
Average net Average net accounts receivableaccounts receivable
Days’ sales in Days’ sales in average accounts = average accounts =
receivable receivable
2.2.
One days’ salesOne days’ sales$99,500$2,351
= 42 days
Dr Gourav Vallabh
MEASURING A COMPANY’S ABILITY TO PAY
LONG-TERM DEBT• Two indicators of a business’s ability to
pay long-term liabilities are the– Debt ratio– Times-interest-earned ratio
Dr Gourav Vallabh
DEBT RATIO
• The debt ratio tells the proportion of the company’s assets that it has financed with debt
• The higher the debt ratio, the higher the strain of paying interest each year and the principal amount at maturity
• The lower the ratio, the lower the business’s future obligations
Dr Gourav Vallabh
Calculation of the debt ratios for Palisades Furniture at the end of 20X3 and 20X2 is as follows:
Debt ratio =Debt ratio = Total liabilitiesTotal liabilitiesTotal assetsTotal assets
$431,000$787,000
= 0.55 $324,000$644,000
= 0.50
Palisades’ Debt Ratio
Industry Average = 0.64Industry Average = 0.64
20X3 20X2Formula
The company’s debt ratio indicates a fairly low-risk debt compared to the retail furniture industry average
The company’s debt ratio indicates a fairly low-risk debt compared to the retail furniture industry average
The average debt ratio for most companies
ranges from 0.57- 0.67
Dr Gourav Vallabh
MEASURING A COMPANY’S PROFITABILITY
• There are four rate-of-return measurements that help evaluate a company’s profitability:– Rate of return on net sales– Rate of return on total assets– Rate of return on common stockholders’
equity– Earnings per share of common stock
Dr Gourav Vallabh
RATE OF RETURN ON NET SALES
• The rate of return on net sales shows the percentage of each sales dollar earned as net income
• The higher the rate of return, the more net sales dollars are providing income to the business and the fewer net sales dollars are absorbed by expenses
Dr Gourav Vallabh
The rate-of-return-on-sales ratios for Palisades Furniture are calculated as follows:
Rate of return Rate of return on saleson sales
Net incomeNet income
Net SalesNet Sales $48,000$858,000
= 0.056 $26,000$803,000
= 0.032
Palisades’ Rate of Return on Sales
Industry Average = 0.008Industry Average = 0.008
20X3 20X2Formula
The increase in Palisades Furniture’s return on sales identifies the company as more successful than the average furniture store
The increase in Palisades Furniture’s return on sales identifies the company as more successful than the average furniture store
==
Dr Gourav Vallabh
RATE OF RETURN ON COMMON STOCKHOLDERS’
EQUITY• Rate of return on stockholders’ equity
(return on equity)– Shows the relationship between net
income and common stockholders’ investment in the company
– Is calculated by dividing net income available to common stockholders by the average stockholders’ equity during the year
Dr Gourav Vallabh
The rate of return on common stockholders’ equity for Palisades Furniture is calculated as follows:
Rate of return Rate of return on common on common
stockholders’ stockholders’ equity equity
Net Net incomeincome
Average common Average common stockholders’ equitystockholders’ equity
$48,000 - $0$338,000
= 0.142
Palisades’ 20X3 Rate of Return on Common
Stockholders’ Equity
Industry Average = 0.121Industry Average = 0.121
Formula
Preferred Preferred DividendsDividends--
==
Dr Gourav Vallabh
• Palisades’ return on equity (0.142) is higher than its return on assets (0.101).
• This difference results from borrowing at one rate (8%) and investing the funds to earn a higher rate (14.2%)
• This practice is called trading on the equity or using financial leverage
RATE OF RETURN ON COMMON STOCKHOLDERS’
EQUITY
Dr Gourav Vallabh
LIMITATIONS OF FINANCIAL ANALYSIS
• Ratios have their limitations
• Financial analysis may indicate that something is wrong, but it may not identify the specific problem or show how to correct it
• Managers must evaluate data on all ratios in the light of other information about the company
Dr Gourav Vallabh
• Ratios should be analyzed over a period of years
• Any one year, or even any two years, may not be representative of the company’s performance over the long term
LIMITATIONS OF FINANCIAL ANALYSIS