financial statement analysis - muhariefeffendi's website · 2010. financial statement ......

MODUL-8

Financial Accounting

Financial Statement Analysis By

MUH. ARIEF EFFENDI,SE,MSI,AK,QIA

Magister Accounting Program (MAKSI)

BUDI LUHUR UNIVERSITY

Jakarta - Indonesia

2010

Financial Statement Analysis

After studying this topic, students should be able to:

1. Understand the outline of Financial Statement Analysis.

2. Understand the Basic of Financial Statement Analysis.

3. Understand the External & Internal Use of Financial Statement Analysis.

4. Understand the Framework for Financial Analysis.

5. Identify the Tools of Financial Statement Analysis.

6. Understand the Horizontal Analysis and Vertical Analysis.

7. Understand the Objective Ratio Analysis , Rationale Behind Ratio Analysis & Limitations of Ratio Analysis.

8. Understand the Classification of Financial Ratio Analysis (Liquidity, Profitability, and solvency Ratio).

9. Understand the DuPont Model / Method.

10. Understand the Concept of Earning Power, and how Irregular Items are presented.

11. Understand the Concept of Quantitative Market Analysis.

Balance

sheet

Income

statement

Retained

earnings

statement

Basics of

Financial

Statement

Analysis

Horizontal and

Vertical AnalysisRatio Analysis

Earning Power

and Irregular

Items

Quality of

Earnings

Need for

comparative

analysis

Tools of

analysis

Liquidity

Profitability

Solvency

Summary

Discontinued

operations

Extraordinary

items

Changes in

accounting

principle

Comprehensive

income

Alternative

accounting

methods

Pro forma

income

Improper

recognition


The Outline of


Analyzing financial statements involves:

CharacteristicsComparison Bases

Tools of Analysis

Liquidity

Profitability

Solvency

Intracompany

Industry averages

Intercompany

Horizontal

Vertical

Ratio

Basics of Financial Statement Analysis

Examples of External Uses of


Trade Creditors : Focus on the liquidity of the

firm.

Bondholders : Focus on the long-term cash

flow of the firm.

Shareholders : Focus on the profitability and

long-term health of the firm.

Examples of Internal Uses of


Plan : Focus on assessing the current financial

position and evaluating potential firm

opportunities.

Control : Focus on return on investment for

various assets and asset efficiency.

Understand : Focus on understanding how

suppliers of funds analyze the firm.

Analytical Tools Used

Sources and Uses

Statement

Statement of Cash

Flows

Cash Budgets

1. Analysis of the funds

needs of the firm.

Trend / Seasonal Component

How much funding will

be required in the future?

Is there a seasonal

component?

Framework For Financial Analysis

Health of a Firm

Financial Ratios :

1. Individually

2. Over time

3. In combination

4. In comparison


needs of the firm.

2. Analysis of the financial

condition and profitability

of the firm.


Examples:

1. Volatility in sales.

2. Volatility in costs.

3. Proximity to break-

even point.


needs of the firm.



of the firm.

3. Analysis of the business

risk of the firm.

Business risk relates to

the risk inherent in the

operations of the firm.


A Financial

Manager must

consider all

three jointly

when

determining the

financing needs

of the firm.

Determining

the

financing

needs of

the firm.


needs of the firm.



of the firm.


risk of the firm.


Negotiations

with

suppliers of

capital.

Determining

the

financing

needs of

the firm.


needs of the firm.



of the firm.


risk of the firm.


Quantitative Financial Analysis

Common-size & Index Analysis :

1. Common-size Analysis : An analysis of percentage

financial statements where all balance sheet items are

divided by total assets and all income statement items are

divided by net sales or revenues.

2. Index Analysis : An analysis of percentage financial

statements where all balance sheet or income statement

figures for a base year equal 100.0 (percent) and

subsequent financial statement items are expressed as

percentages of their values in the base year.


Financial Ratios : is an index that relates two

accounting numbers and is obtained by dividing one

number by the other.

1. Balance Sheet Ratio.

2. Income Statement & Income Statement / Balance

Sheet Ratio.

Growth / trend Analysis / Horizontal Analysis.

Quarterly analysis.

The DuPont Model / Method.

Earning Quality / Normalizing Earning..


Systematic analysis of key elements based on

analysis context.

Quantitative techniques to standardize

financial information for relevant

comparisons.

In-depth analysis for key factors, including

“red flags”.

Quantitative Financial Analysis :

Common-size Analysis

Overview vs. detail.

Balance sheet: total assets = 100%.

Income Statement: sales (or total revenues) =

100%.

Comparisons over time & across firms (or

industry averages).

Useful starting point for financial overview.

Tools of Analysis : Horizontal Analysis /

Trend Analysis / Growth Analysis

Horizontal analysis, also called trend analysis, is a

technique for evaluating a series of Financial

Statement (FS) data over a period of time.

Its purpose is to determine the increase or decrease

that has taken place.

Horizontal analysis is commonly applied to the Balance

Sheet (BS), income statement, and Statement of

Retained Earnings (RE).

Quantitative Financial Analysis : Growth

Analysis (Period- By-Period Change)

Long-term trends over time can be significant. Are current year performance measures consistent with earlier years (e.g., maintaining consistent ratios while sales are rising smoothly)?

As a first step, present growth rates (including % increases) for the last 5-10 years.

Declining or negative growth rates might be obvious red flags; Red flags and other indicators of poor growth performance require further analysis.

Quantitative Financial Analysis : Trend

Analysis (Base-Year Analysis)

Set the earliest year, evaluated as the base year, at

100.

[Note: this assumes that earliest year is ―normal.‖]

Calculate growth by dividing the more current

year numbers by the base year number.

This is an alternative presentation to growth rate

percentages over 5-10 years (or more).

Quantitative Financial Analysis :

Quarterly Analysis

The most recent financial data is presented quarterly (e.g., 10-Q). [The one exception is at year end, with annual information is presented].

Financial analysts focus on quarterly data and the quarterly earnings announcement is the most important (& earliest) information.

Common-size and ratios analysis is conducted, and compared over earlier quarters: particularly important are current quarter data to (1) the previous quarter and (2) the same quarter one year ago.

Tools of Analysis : Vertical Analysis

Vertical analysis, also called common-size analysis,

is a technique that expresses each Financial

Statement (FS) item as a percent of a base amount.

On an Income Statement (IS), we might say that

selling expenses are 16% of net sales.

Vertical analysis is commonly applied to the Balance

Sheet (BS) and the Income Statement (IS).

Objective of Ratio Analysis

Standardize financial information for comparisons.

Evaluate current operations.

Compare performance with past performance.

Compare performance against other firms or

industry standards.

Study the efficiency of operations.

Study the risk of operations.

Rationale Behind Ratio Analysis

A firm has resources.

It converts resources into profits through : production of goods and services

sales of goods and services

Ratios : Measure relationships between resources and financial

flows

Show ways in which firm’s situation deviates from Its own past

Other firms

The industry

All firms-

Ratio Analysis

A ratio converts financial information to a percentage, one approach to standardization.

Each ratios provides a somewhat different analysis.

Ratios overlap—a problem in one area should show up as problems in other areas.

The importance of specific ratios differs, based on the purpose of the financial analysis.

Ratios for the most recent period are usually the most important.

Ratio Analysis

When analyzing a firm, we want to know :

if the firm is able to meet its short-term financial

obligations (is it solvent?);

if the firm is able to meet its long-term financial

obligations (going bankrupt in the future?);

how well the assets of the firm are managed;

how well the overall operations of the firm are managed

(is it profitable?);

how the market interprets accounting data and what

expectations are factored in.

Ratio Analysis

Short-term solvency and liquidity ratios: Indicate the firm’s ability

to pay its bills over the short run without undue stress.

Financial leverage: Describe a firm’s long-term ability to meet its financial

obligations

Asset utilization turnover ratios: Describe how efficiently (intensively) a

firm uses its assets to generate sales.

Profitability ratios: Describes how efficiently the firm manages its overall

operations (the higher, the better!)

Market ratios : Describe how the market values the firm.

Limitations of Ratio Analysis

A firm’s industry category is often difficult to identify.

Published industry averages are only guidelines.

Accounting practices differ across firms.

Sometimes difficult to interpret deviations in ratios.

Industry ratios may not be desirable targets

Seasonality affects ratios. Ratios are presented on a percentage basis. Relative size is ignored (e.g., both large & small firms can be

compared). It is assumed that all numbers used are correct (consider both

possible errors and earnings management). If the numbers are not reliable, ratios are not particularly useful.

Financial Statement Analysis :

Comparison Bases

A single ratio by itself is not very meaningful.

Types of Comparisons for

Financial Ratio

Types of Comparisons

1. Internal Comparisons

2. External Comparisons

External Comparisons &

Sources of Industry Ratio

This involves comparing the ratios of one firm with those of

similar firms or with industry averages.

Similarity is important as one should compare “apples to

apples.”

Examples:

1. Risk Management Association.

2. Dun & Bradstreet.

3. Almanac of Business and Industrial Financial Ratios.

Ratio Analysis :

Financial Ratio Classifications

1. Liquidity Ratio :

Measures short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.

2. Profitability Ratio :

Measures the income or operating success of a company for a given period of time.

3. Solvency :

Measures the ability of the company to survive over a long period of time.

A Financial Ratio is an index that relates two accounting

numbers and is obtained by dividing one number by the other.

Financial Ratio Classifications :

Liquidity Ratio

Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity.

Ratios include :

1. Current Ratio

2. Quick (Acid-Test) Ratio

3. Receivables Turnover

4. Inventory Turnover.


Liquidity Ratio

Current Ratio (CR) =Current Assets

Current Liabilities

Quick (Acid-Test) Ratio (QATR) =Current Assets - Inventory

Current Liabilities

Receivables Turnover (RT) =Net Credit Sales

Average Net Receivable

Inventory Turnover (IT) = or Inventory Turnover = Cost of Good Sold SalesAverage Inventory Inventory


Profitability Ratio

Income, or the lack of it, affects the company’s ability to obtain debt and equity financing, liquidity position, and the ability to grow.

Ratios include the profit margin, asset turnover, return on assets, return on common stockholders’ equity,earnings per share, price-earnings, and payout ratio.


Profitability Ratio

Profit Margin (PM) = Net Profit Margin (NPM) =Net Income EBIT

Net Sales Sales

Asset Turnover (AT) = Total Asset Turnover (TAT) =Net Sales Sales

Average Assets Total Assets

Return On Assets (ROA) =Net Income

Average Assets

Return On Equity (ROE).Net Income

Total Equity

Return On Common Stockholders’ Equity (ROCSE).Net Income - Preffered Dividends

Average Common Stockholders’ Equity

Earnings Per Share (EPS) = Retention Ratio =Net Income EPS - Dividen

Weighted Average Common Shares Outstanding EPS

Price Earnings Ratio (PER) =Market Price per Share of Stock

Earnings per Shares

Payout Ratio (PR) =Cash Dividends

Net Income


Debt & Solvency Ratio (Leverage)

Debt to total assets and times interest earned are two ratios that provide

information about debt-paying ability.

Debt to Total Assets : Measures the percentage of the total assets that creditors

provide.

Times Interest Earned : Provides an indication of the company’s ability to meet

interest payments as they come due.

Debt to Total Assets Ratio (DAR) =

Total Debt

Total Assets

Times Interest Earned (TIE) =

Income Before Income Taxes and Interest Expense

Interest Expense


Debt & Solvency Ratio (Leverage)

Debt to Equity Ratio : Total Liabilities / Total Stockholders’ Equity

Debt Ratio : Total Liabilities / Total Assets

Interest Coverage : (Income Before Tax + Interest Expense) / Interest Expense [note that the numerator is earnings before interest and taxes or EBIT]*

Long-term Debt to Equity: Long-term Liabilities / Total Stockholders’ Equity

Debt to Market Equity: Total Liabilities at Book Value / Total Equity at Market Value

*alternatively: (income from continuing operations + interest expense + tax expense)/interest expense

Activity Ratio Analysis

Inventory turnover: cost of sales [or COGS]/average inventory

Receivables turnover: sales/average accounts receivable

Payables turnover: sales/average accounts payable

Working capital turnover: sales/average working capital

Fixed asset turnover: sales/average property, plant & equipment

Total asset turnover: sales/average total assets

Activity Ratio in Days

Average days inventory in stock : 365/inventory turnover.

Average days receivables outstanding : 365/receivables turnover.

Average days payable outstanding: 365/payables turnover.

Length of operating cycle: average days inventory + average days receivables

Financial Ratio Analysis :

Summary

Ratios help to:

Evaluate performance.

Structure analysis.

Show the connection between activities and performance.

Benchmark with :

Past for the company.

Industry.

Ratios adjust for size differences.

Ratio & Forecasting

Common stock valuation based on : Expected cashflows to stockholders

ROE and Retention Ratio ® are major determinants of cashflows to stockholders.

Ratios influence expectations by: Showing where firm is now

Providing context for current performance.

Current information influences expectations by: Showing developments that will alter future performance

Sustainable Growth & Stock Returns

In the long run

Sustainable growth and long run capital gains

(g) = ROE x r

Recall the relationship between stock returns (r),

capital gains (g) and forward dividend yields

(D1/P0):

r = g + D1/P0 = g + Do(1+g)/P0

Note:

r & g must be quarterly if D is quarterly and

annual if D is annual

The DuPont Model / Method

Method to breakdown ROE into:

ROA and Equity Multiplier

ROA is further broken down as:

Profit Margin and Asset Turnover

Helps to identify sources of strength and

weakness in current performance.

Helps to focus attention on value drivers.


Ratio

Profit (Return on

Sales)

Activity (Asset

Turnover)

Return on Assets

Solvency (Common

Equity Leverage)

Return on Equity

Calculation

Net Income/Sales

Sales/Avg. Total Assets

(ATA)

Net Income/ATA

ATA/Average Common

Equity (ACE)

Net Income/ ACE


Profit Margin Total Asset Turnover

ROA Equity Multiplier

ROE

EquityCommon

Assets Total

Assets Total

IncomeNet

MultiplierEquity ROAROE




ROE

Assets Total

Sales

Sales

IncomeNet

TurnoverAsset TotalMarginProfit ROA




ROE

EquityCommon

Assets Total

Assets Total

Sales

Sales

IncomeNet

MultiplierEquity TurnoverAsset TotalMarginProfit ROE

Earning Power & Irregular Item

Earning power means the normal level of income to

be obtained in the future.

“Irregular” items are separately identified on the

income statement. Two types are:

1. Discontinued operations.

2. Extraordinary items.

These “irregular” items are reported net of income

taxes.

Quantitative Market Analysis

Stock prices & stock charts.

Earnings per share—actual & forecast.

Price earnings ratios (PE).

Dividend yield.

Market value & market-to-book.

Price earnings to growth ratios (PEG).

Valuation models.

Stock Prices

Prices change continuously.

Using daily closing price.

Stock charts, various periods.

Industry & market comparisons.

Internet sites.

Earnings Per Shares (EPS)

Performance measure on per share basis.

Basic vs. diluted.

Forecasted EPS (Analysts’ Estimates on Yahoo).

Annual vs. quarterly EPS.

Annual—last 4 quarters.

5 year forecasts (relevance vs. reliability).

Prices Earnings (PE) Ratios

Stock price as a market premium for earnings.

Which price? (most current, historic…).

Which EPS? (current year actual--usually last 4 quarters, future forecast, basic vs. diluted).

Closing prices.

Alternatives & how to evaluate them.

Market Based Ratios

Price Earnings (PE) Ratio = Stock price / EPS.

Dividend Yield = Dividend per share / Stock

Price.

Market Value = Stock Price x Shares

Outstanding.

Market-to-book = Market Value / Stockholders’

Equity.

Dividends

Dividends given on a per share basis;

focus on dividends per share, last 4 quarters.

[Note—equivalent to dividends/shares

outstanding.]

Dividend yield = dividends per share/stock

price

—income focus; average yield is about 2% for

the S&P 500.

Dividend payout = dividends per share

/earnings per share.

Market-Related Ratio

Market-to-book = market value /

stockholders’ equity [or measure on a per

share basis—stock price / book value per

share]

why is a ―market premium to book‖ common?

Sales to market value = annual sales to

outstanding shares x (1) year-end closing

market price or (2) most recent closing

market price.

Price Earnings to Growth (PEG)

High PE is usually associated with the expectation of high earnings growth, which can be evaluated with PEG.

―Historic PEG‖ = PE based on actual EPS / 5-year historic earnings growth.

―Forecast PEG‖ = PE based on forecast EPS / 5-year earnings forecast .

PEG is useful to evaluate growth stocks, less useful for income stocks.

Earnings-Based Growth Model

P = kE / (r – g) where P is ―expected‖ stock price, k

is dividend payout rate (actual or predicted), E is

EPS, r is the discount rate, and g the projected

earnings growth rate.

This model requires dividends, the discount rate is

arbitrary (it could be the actual cost of capital—or

based something else), and the growth rate is a

forecast; results can change substantially using

different assumptions.

Stock Screening

The purpose of stock screening is the determine which firms meet specific criteria (such as minimum ROE or dividend yield).

Several internet sites have stock screeners, such as Yahoo.

The technique is useful to limit the number of companies on which to conduct a complete financial analysis.

REFERENCES

1. Brown, Cinthia J., Marylin M. Dutton & Thomas A. Rietz, FinancialStatement Analysis, Curriculum Designed for Use With The IowaElectronic Market.

2. Financial Accounting Standard Board (FASB), http://www.fasb.org3. International Accounting Standard Board (IASB), http://www.iasb.org4. International Financial Reporting Standard (IFRS), http://www.ifrs.org5. Kieso, Donald E., Jerry J. Weygandt & Terry D. Warfield,

Intermediate Accounting, John Wiley & Sons, Inc, 13th Ed, 2009.6. Kuhlemeyer, Gregory A., Fundamental of Financial Management, 12e,

Pearson Education Limited, 2004.7. Weigandt, Kieso & Kimmel, Accounting Principles, John Wiley &

Sons, Inc., Eigth Edition, 2008.

http://www.fasb.org/







http://www.iasb.org/







http://www.ifrs.org/







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