FINANCIAL STATEMENT ANALYSIS

Involves careful selection of data from financial statements in order to assess and evaluate the firm’s past performance, its present condition and future business potentials

the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account

Objectives

To evaluate and forecast the company’s financial health. Interested parties can identify the company’s financial strengths and weaknesses and know about the:◦Profitability of the business firm;◦Firm’s ability to meet its obligation;◦Safety of the investment in the business; and◦Effectiveness of management in running the firm

Limitations

Comparison of financial data◦Differences between companies◦Differences in accounting methods and estimates◦Valuation problem◦Timing of transactions and use of averages in applying the

various techniques in FS analysis affect the results obtainedThe need to look beyond ratios

◦The FS does not include all the factors needed for the evaluation

Change in price levels

INFLATION – increase in general price levelDEFLATION – decrease in general price level

*** General price level is inversely related to the purchasing power of money

Impact of Inflation on Financial Management

Higher rates of inflation lead to higher interest ratesIt increases prices of resourcesHigher tax bracketsDistorts profitAccuracy of predictions needed in business planning is

reducedHurts creditors but benefits debtors

Horizontal Analysis

Involves comparison of figures shown in the FS of two or more consecutive periods

Difference between the figures of the two periods is calculated, and the percentage change from one period to next is computed using the earlier period as the base:

Percentage of Change = (Most recent value- Base Period value)

Base Period value

Vertical Analysis

Process of comparing figures in the financial statements of a single period

It is expressing all the figures in the statements as percentages of an important item such as total assets (BS) or total net sales (IS)

The converted statements are called COMMON-SIZE STATEMENTS or PERCENTAGE COMPOSITION STATEMENTS

Ratio Analysis

Ratios are calculated from the financial statements to provide users of such statements with relevant information about the firm’s liquidity, use of leverage, asset management, cost control, profitability, growth and valuation

The Income Statement

Reports on the financial performance of the company in terms of earning revenue and incurring expenses over a period of time and explains, in part, how the company’s financial performance changed between the beginning and ending of a period

Presentation

Sales(Revenue) 1 000Cost of Good Sold (400)Gross Margin 400Expenses (230)Earnings before interest & taxes

170Interest expense (20)Earnings before tax 150Tax ( 45)Net income 105

- It is also called the “Statement of Financial Position”- It reports a company’s financial position at a point in time

The Balance Sheet

ASSETS- Resources of the company

LIABILITIES- It represents what the company owes to outsiders.

EQUITY- Represents funds supplied to businesses by their owners.

It includes:

Cash- money in bank checking accounts plus currency on hand.

Accounts Receivable- credit sales not have been collected.:The Bad-Debt reserve- Allowance for doubtful

accounts.Inventory- product held for sale in the normal course of

business.Fixed Assets- Longer-lived assets/PPE

:Depreciation- spread the cost of the assets over useful life.

ASSETS

Accounts Payable- arise when firms buy from vendors on credit.

Term of sale- length time allowed until payment is due on a credit sale is specified.

Accruals- used to recognized expenses and liabilities associated with transactions that are not entirely complete.

LIABILITIES

Working capital- difference between current assets and current liabilities.

Long-term Debt- a noncurrent liability; usually consist of bonds and long-term loans.

Direct investment by owners- Direct equity investment that is the money paid for the stocks.

Retained Earnings- Earnings kept in the businessPreferred Stock- Security issued by some firms

Total Capital- Sum of long term debt and equity

EQUITY

CASH FLOW ANALYSIS

Detailed study of the net change in cash as a result of OPERATING, INVESTING, and FINANCING activities during the period

Statement of Cash Flows

Reports the cash receipts, cash payments, and net changes in cash resulting from operating, investing and financing activities of the firm during the period

Classification

Operating Activities – cash effects of transactions that create revenues and expenses; relate to changes in current assets and current liabilities

Investing Activities – relate to changes in non-current assets

Financing Activities – relate to changes in long-term liabilities and stockholder’s equity accounts

Additional concepts:

RESIDUAL INCOME (1) = Actual Income – Target Income

RESIDUAL INCOME (2) = Actual Income – (Assets x Target ROI)

ECONOMIC VALUE ADDED (EVA) = Net Operating Income - (Operating Assets x WACC)

FREE CASH FLOW = Net operating profit after taxes +Depreciation expense – Change in net working capital – Capital expenditures

Free Cash Flow (FCF)

Cash generated by operations that is available for distribution to investors

Allows us to estimate whether a company will provide cash or require it in the future

POSITIVE – business operations are likely to fund their own growth and money is available to pay interest and/or dividends

NEGATIVE – continuing will require cash contributions from outside the business

Cash Conversion Cycle (CCC)Race track diagram

Profitability Ratios

Gives us a relative measures of the firm’s money-making success.

Estimates profit per peso of sales made, assets employed, or equity invested

Return on Assets

- A measure of the productivity of assets, regardless of how the assets are financed.

Method of computation:

OPERATING INCOMEAVERAGE TOTALS ASSETS

Example 1: Total assets of Company X on July 1, 2014 and June 30, 2015 were 2,132,000 and 2,434,000 respectively. During the year ended June 30, 2015 it earned net income of 213,000. Calculate its return on assets ratio.

SolutionAverage Total Assets = ( 2,132,000 + 2,434,000 ) / 2 = 2,283,000Return On Assets = 213,000 / 2,283,000 ≈ 0.09 or 9%

Example 2: Total liabilities and total equity of Company Y on Dec 31, 2010 were 942,000 and 1,610,000 respectively. During the year ended Dec 31, 2014 the company earned net income of $315,000. What were the total assets of the company on Jan 1, 2014 given that its ROA for the year was 0.12

SolutionStep 1: Average Total Assets = Net Income / ROA = 315,000 / 0.12 = 2,625,000Step 2: Ending Total Assets = 942,000 + 1,610,000 = 2,552,000Step 3: Beginning Total Assets = ( 2 × 2,625,000 ) − 2,552,000 = 2,698,000

If company A has a higher rate of return on assets than company B, this could be because company A has a ______ profit margin on sales, or a ________ asset turn over ratio, or both.A. Higher, higherB. higher, lowerC. lower, higherD. lower, lower

Return on Equity

- The rate of return earned on the stockholder’s equity in the business

Method of Computation:

NET INCOMEAVERAGE TOTAL EQUITY

OrProfit margin x Total asset Turnover x financial leverage

ROE = ($2,000/$10,000) x ($10,000/$25,000) x ($25,000/$5,000) = 0.20 x 0.40 x 5 = 0.40 or 40%

Example 1: Company A earned net income of 1,722,000 during the year ending march 31, 2015. The shareholders' equity on April 30, 2014 and March 31, 2015 was 14,587,000 and 16,332,000 respectively. Calculate its return on equity for the year ending March 31, 2015.

SolutionAverage Shareholders' Equity = ( 14,587,000 + 16,332,000 ) / 2 = 15,459,500Return On Equity = 1,722,000 / 15,459,500 ≈ 0.11 or 11%

Example 2: Total assets and total liabilities of Company B on Jan 1, 2013 were 2,342,000 and 1,383,000. During the year ended December 31, 2014 it made a net profit of 242,000 and its shareholders' equity increased by 302,000. Calculate ROE of Company B.

SolutionStep 1: Beginning Shareholders' Equity = 2,342,000 − 1,383,000 = 959,000Step 2: Ending Shareholders' Equity = 959,000 + 302,000 = 1,261,000Step 3: Average Shareholders' Equity = ( 959,000 + 1,261,000 ) / 2 = 1,110,000Step 4: Return On Equity = 242,000 / 1,110,000 ≈ 0.22 or 22%

Return on Sales

Measures the percentage of net income to sales

Method of Computation:

Net IncomeNet Sales

Liquidity Ratios

Measures the ability to meet short-term financial obligations

Method of Computation

Current ratio = current assets current liabilities

Quick ratio = current assets – inventorycurrent liabilities

Example 1: On December 31, 2004 Company A had current assets of 100,000 and current liabilities of 50,000. Calculate its current ratio.

SolutionCurrent ratio = 100,000 ÷ 50,000 = 2.00

Example 2: On December 31, 2014 Company B had total asset of 150,000, equity of 75,000, non-current assets of 50,000 and non-current liabilities of 50,000. Calculate the current ratio.

Solution

Current Assets = Total Asset − Non-Current Assets = 150,000 − 50,000 = 100,000Total Liabilities = Total Assets − Total Equity = 150,000 − 75,000 = 75,000Current Liabilities = 75,000 − 50,000 = 25,000Current Ratio = 100,000 ÷ 25,000 = 4.00

Example 3: A company has following assets and liabilities at the year ended December 31, 2009:Calculate quick ratio (acid test ratio)

Cash $34,390

Marketable Securities 12,000

Accounts Receivable 56,200

Prepaid Insurance 9,000

Total Current Assets 111,590

Total Current Liabilities 73,780

.

SolutionQuick ratio = ( 34,390 + 12,000 + 56,200 ) / 73,780 = 102,590 / 73,780 = 1.39   ORQuick ratio = ( 111,590 − 9,000 ) / 73,780 = 102,590 / 73,780 = 1.39

Example 4: Calculate quick ratio from the following information:

Cash 21,720

Treasury Bills 18,500

Accounts Receivable 15,930

Prepaid Rent 6,500

Inventory 17,240

Total Current Assets 79,890

Total Current Liabilities 52,960

SolutionIn this example, treasury bills are marketable securities thus we will calculate quick ratio as follows:Quick ratio = ( 79,890 − 6,500 − 17,240 ) / 52,960 = 56,150 / 52,960 = 1.06   ORQuick ratio = ( 21,720 + 18,500 + 15,930 ) / 52,960 = 56,150 / 52,960 = 1.06

Asset Management

Measures how the firm uses its assets to generate revenue and income

RATIOS FORMULAPURPOSE

Average Collection Period (ACP)

ACP = Accounts Receivable Average Daily Sales

ACP = Accounts receivable x360Sales

Measures the average number of days to collect a receivable

Inventory TurnoverInvty. TO = Cost of Goods Sold

Inventory

Indicates if a firm holds excessive stocks of inventories that are unproductive and that lessen the company’s profitability

Fixed Asset Turnover FA TO = Net Sales Average Net FA

FA TO = Sales FA

Measures the level of use of property, plant and equipment

Total Asset Turnover TA TO = Net Sales Average Net TA

TA TO = Sales TA

Measures the level of capital investment relative to the sales volume

As of December 312008 2007

CASH P 80,000 P 640, 000Notes and AR (net) 400,000 1, 200, 000Merchandise Invty. 720,000 1, 200, 000Machinery and Equip. 1, 240,000 1, 080, 000Land and buildings (net) 2, 720,000 2, 880, 000Bonds payable – LT 2, 160,000 2, 240, 000Accounts Payable – trade 560,000 880, 000Notes Payable – ST 160,000 320, 000

Sales (20% cash, 80% credit sales) P 18, 400,000 P 19, 200, 000Cost of Goods Sold 8, 400 000 11, 200, 000

ACP?INVENTORY TURNOVER?TOTAL ASSETS TURNOVER?

ACP= 18.4xINVENTORY TURNOVER= 8.33xTOTAL ASSETS TURNOVER= 3.03x

- This ratios would tell us how the firm financed its assets as well as the firm’s ability to repay its long-term

debt.

DEBT MANANGEMNT RATIOS

Shows proportion of all assets that are financed with debt.

TOTAL LIABILTIES TOTAL ASSETS

DEBT RATIO:

Indicates proportion of assets provided by owners. Reflects financial strength and caution to creditors.

TOTAL EQUITYTOTAL ASSETS

EQUITY RATIO:

Measures debt relative to amounts of resources provided by owners.

TOTAL LIABILITIES TOTAL EQUITY

DEBT TO EQUITY RATIO:

Reflects extent of investment in long term assets financed from long term debt.

FIXED ASSETS (net) TOTAL LONG-TERM LIABILITIES

FIXED ASSETS TO LONG-TERM LIABILITIES:

Measures the proportion of owners capital invested in fixed assets.

FIXED ASSETS (net) TOTAL EQUITY

FIXED ASSETS TO TOTAL EQUITY:

Measures investment in long-term capital assets.

FIXED ASSETS (net) TOTAL ASSETS

FIXED ASSETS TO TOTAL ASSETS:

Measures how many times interest expense is covered by operating profit.

NET INCOME BEFORE INTEREST AND TAXES ANNUAL INTEREST CHARGES

TIMES INTEREST EARNED:

Tiggie’s Dog Toys, Inc. reported a debt to equity ratio of 1.75 times at the end of 2008. If the firm’s total assets at year-end were $25 million, how much of their assets are financed with debt and how much with equity?

Debt to equity = 1.75 = Total debt/Total equity = Total debt/(Total assets – Total debt)

1.75 = Total debt/($25m. – Total debt) => 1.75 x ($25m. – Total debt) = Total debt

=> (1.75 x $25m.) – (1.75 x Total debt) = Total debt => $43.75m. = 2.75 x Total debt

=> Total debt = $43.75m./2.75 = $15.91m.=> Total equity = $25m. - $15.91m. = $9.09m.

Valuation Ratios

Measure of shareholder value as reflected in the price of the firm’s stock

Ratios Formula Purpose

Market to book ratio Market Price per share Book Value per share

Measures how high is the shares’ market price in relation to book value

Book Value per share Equity Shares Outstanding

Measures the amt. of net assets available to the shareholders of a given type of stock

Price/Earning ratio Market Price Earnings per share

Measures the relationship between the shares’ market price and earnings per share.

Gambit Golf’s market-to-book ratio is currently 2.5 times and PE ratio is 6.75 times. If Gambit Golf’s common stock is currently selling at P12.50 per share, what is the book value per share and earnings per share?

Market-to-book ratio = 2.50 = P 12.50 Book value per share

Book value per share = P12.50/2.50 = P5.00

Price-earnings ratio = 6.75 times = $12.50

Earnings per share

Earnings per share = $12.50/6.75 = $1.85