University of Technology, JamaicaFundamentals of Finance (FOF) Unit 3: Financial Statements Analysis

Learning Objective #1: Using Ratio Analysis as the first step in the analysis of a Company’s Financial Statements

Ratio Analysis involves examining the relationship between pieces of information in the financial statements for a given accounting period.

Ratios are useful because: (i) They summarize much data and put it in a usable format (ii) They facilitate comparison across different firms and also of the same firm over different periods of time (iii) They are used to highlight the strengths and weaknesses of a company relative to its industry (iv) They can be used as an early warning system, as a means of monitoring management and as a screening tool (v) From an investor’s standpoint, predicting the future is the purpose of financial statement analysis. (vi) From management’s standpoint, it is useful both as a way to anticipate future conditions, and also as a starting point for planning actions that will influence the future course of events.

Note that several ratios should be reviewed during an analysis. When one ratio deviates from the norm, other related ratios should be studied to help determine the cause of the deviation.

We will examine 5 categories of ratios. Different stakeholder groups have different needs, and tend to focus on different categories of ratios. (i) Suppliers and short-term lenders are most interested in liquidity ratios (ii) Stockholders and potential investors are most interested in profitability and market value ratios (iii) Long-term debt holders are most interested in debt and asset management ratios (iv) Managers of the firm would be interested in all ratios because they are responsible for satisfying the interests of all stakeholder groups. (v) Analysts usually perform long-run trend analysis over a 5-10 year period looking for long-term stock maximization.

Liquidity Ratios

Current Ratio = Current Assets Quick (or Acid) Ratio = (Current Assets – Inventory) Current Liabilities Current Liabilities

Cash Flow Ratio = Operating Cash Flow Current Liabilities

Liquidity ratios refer to the firm’s ability to meet short-term obligations. They show the relationship of a company’s cash and other current assets to its current liabilities. Firms with poor liquidity are more likely to fail and default on their debts. Therefore, a higher ratio is better, but one that is too high may suggest inefficient use of resources and reduced returns.

Current Ratio (i) Shows how well the company can meet/cover its short-term obligations. (ii) Provides a margin of safety in shrinkage of non-cash current assets. (iii) Provides a reserve of liquid funds against uncertainties and shocks to cash flows. Some of its limitations are: (i) It can easily become outdated as short-term assets and liabilities are easily changed. (ii) Companies sometimes choose a “year-end” when they are likely to have less short-term debt and more cash. (iii) It is not able to measure and predict the pattern of future cash inflows and outflows. (iv) It is not able to measure the adequacy of future cash inflows to outflows.

Quick or Acid Ratio: This is a more stringent test of a company’s liquidity as it ignores inventory which can take some time to be converted to cash depending on the length of the company’s operating cycle.

Cash Flow Ratio; This ratio shows how well a company can cover its current liabilities from cash generated from its operating activities.

Asset Management Ratios

Total Asset Turnover = Sales Fixed Asset Turnover = Sales (Average) Total Assets (Ave)Fixed Assets

Accounts Receivable Turnover = Sales or Credit Sales Invent. Turnover = Cost of Goods Sold (Ave) Acc. Rec. Inventory

Days sales in Receivables = Accounts Receivableor Ave. Collection Period Average sales per dayor Days Sales Outstanding (DSO)

Days sales in Inventory = Inventory Average sales (or COGS) per day

Asset Management Ratios show how efficiently the company uses its assets to generate sales

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Total Assets Turnover Ratio (TAT) can be improved if the firm (i) increases sales; (ii) Improves efficiency in the use of assets; (iii) Disposes of or replaces some assets; (iv)A combination of the above.

Fixed Asset Turnover: A high ratio may indicate that the company is efficient or it may be working close to capacity with older assets. It may thus prove difficult to generate further business without an increase in invested capital. A low ratio may indicate an inefficient use of assets or resources.

Accounts Receivable Ratios: (i) A high turnover ratio indicates that the company is efficient in the collection of its receivables. (ii) days sales outstanding (DSO) show the number of days it takes the company to collect amounts outstanding. A low figure is desirable but may also indicate an unduly restrictive credit policy. (iii) Remember that when one ratio deviates from the norm, other related ratios should be studied to help determine the cause.

Inventory Ratios (i) Inventory turnover measures the average speed that inventories move through the company i.e. – the number of times per year that the company fills up and then completely empties its warehouses or stores. (i) A high ratio may be a sign of efficiency, high sales or that the company is living from hand to mouth, providing little variety to customers and may sometimes be out of stock. (ii)A low ratio may indicate that the company is holding too much stock or holding damaged or obsolete stock. (iii) The days sales in inventory ratio shows the number of days it takes to sell inventory and is useful in assessing purchasing and production policies.

Debt Management Ratios

Total Debt Ratio = Total Assets – Total Equity = Total Debt Total Assets Total Assets Debt to Equity Ratio = Total Debt Total EquityEquity Multiplier = Total Assets = 1 + Debt to equity ratio TIE = EBIT/Interest Total Equity Fixed Charges Coverage = EBIT/ (Int. Exp. + Lease payts.)

Cash Coverage = (EBIT + Depreciation)/Interest

Debt management ratios show how well the company manages or uses debt. Companies use borrowed funds to increase the returns to company owners. By raising funds through debt, the firm avoids diluting stockholder ownership. To have a positive leverage, the company must be able to earn a greater return on the assets the borrowed money is invested in, than the interest cost. If the rate of return on assets is less than the rate of interest on the borrowed money, the interest must be paid, and it will come from the owners of share capital.

Long-term creditors are most interested in debt management ratios. What do they look for? (i) A margin of safety provided by equity capital. Higher equity levels indicate lower risk for creditors (ii) Creditors look at the firm’s past payment history and at the level of income being generated to determine if it can cover repayment of loans with interest (TIE, Fixed Charges Coverage & Cash Coverage) (iii)The debt ratio is used to determine creditworthiness (iv) The expected return on investment should be higher than the interest rate on loan.

Total Debt Ratio: shows how the firm is financed –i.e. – the percentage of the firm that is financed by borrowed funds. When business is good or normal, firms with relatively high debt ratios have higher expected returns, however, when business is poor, they are exposed to risk of loss. The risk of bankruptcy is further increased and there is less cushion against creditors loss in the event of liquidation. Creditors may be reluctant to lend more. It may be costly to raise additional debt capital without first raising more equity capital

Profitability Ratios

Gross Profit Margin = Revenues – Cost of Goods Sold Net Sales

Profit Margin on Sales = Net Income after Tax Return on Total Assets (ROA) = NIAT or Net Profit Ratio Net Sales (Ave) Total

Assets

= Profit Margin X Asset Turnover

Return on Common Equity (ROE) = Net Income after Tax (Average) Total Equity

= Return on Assets X Equity Multiplier

Return on Capital Employed = Net Income after Tax (ROCE) Total Capital

Basic Earning Power Ratio = Earnings before Interest & Tax (BEP) Total Assets

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EBITDA Coverage Ratio = EBITDA + Lease payments Interest + Principal + Lease

Profitability relates to a company’s ability to earn a satisfactory income. Profitability is closely linked to its liquidity because earnings ultimately produce cash flow. All financial statements are pertinent to profitability analysis. Profitability ratios show the combined effects of liquidity, asset management and debt on operating results.

Gross Profit Margin(GPM): (i) A high GPM might indicate that the company is efficient or that its prices are high. (ii) A low GPM could indicate that sales are too low or costs or too high, or both.

Net Profit Margin (NPM): A low NPM may indicate that: (i) Costs are too high (ii) Operations may be inefficient (iii) The company may be heavily in debt, leading to high interest charges

Return on Assets (ROA): This ratio can be derived from multiplying the net profit margin by the asset turnover. The profit margin measures the profitability of the company relative to sales, while the asset turnover ratio measures the effectiveness of the company in generating sales from assets.

Return on Capital Employed (ROCE):(i) is an indicator of the company’s overall profitability. (ii) It relates profits with all methods of financing, (iii) Conveys return on invested capital from different financing perspectives. (iii) is sometimes used in evaluating managerial effectiveness as management is responsible for all company activities. (iv) depends on the skill, resourcefulness, ingenuity and motivation of management.

Basic Earning Power Ratio (BEP): measures the raw earning power of the firm’s assets. It is useful for comparing companies with different financing structures and tax rates.

Return on Equity (ROE)

This ratio can also be derived by multiplying ROA by the Equity Multiplier. This shows that ROE is affected by profit margins, asset use efficiency and financial leverage.

Market Value Ratios

Earnings per Share = Net Income for common shareholders Total # of common shares outstanding

Price/Earnings (P/E) Ratio = Market Price per Share Earnings per Share

Market to Book Value = Market Price per Share Book Value per Share

Market to Cash Flow = Market Price per Share Cash Flow per Share

Book Value per share = Total Common Equity Total # of common shares

Market Value Ratios relate the company’s stock price to the internal performance of the company. They give an indication of how investors feel about the company’s future prospects based on its past performance. High ratios indicate good prospects and is expected if all other ratios are good. Stock prices are expected to be high if all ratios are good.

The P/E ratio shows how much investors are willing to pay per dollar of reported profits. A high P/E ratio may indicate that the market expects an increase in earnings in the future. P/E ratio is usually higher for firms with strong growth prospects. A low P/E ratio usually indicates poorer growth prospects or higher risk or both. Firms that earn high returns on their assets, usually have share prices well in excess of their book values.

Learning Objective #2: Using Trend Analysis to compare financial statements

Trend Analysis is the evaluation of consecutive financial statements or ratios over time. It shows the direction, speed and extent of any trends in the company’s performance. Trend Analysis is also known as Horizontal Analysis because it looks at information horizontally across time. It shows the year-to-year changes in ratios and reveals whether the firm’s condition is improving or deteriorating over time.

Learning Objective #3: Perform a comparative analysis of financial statements

Comparative Analysis seeks to break down each item in the financial statements to enable better comparison. It is also known as Vertical Analysis or Common-size Analysis, because it breaks down all figures into percentages. Comparative or vertical analysis shows the relationship of each item to a specified base, which is the 100% figure. Every other item on the financial statement is then reported as a percentage of that base. On a common-size income statement (profit & loss account), each item is expressed as a percentage of net sales – which is shown as 100%. On a common-size balance sheet, each item is expressed as a percentage of total assets – which is shown as 100%.

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In using comparative analysis, companies should be adjusted for impact of size before making comparisons.

Benchmarking is the practice of comparing a company to other companies both inside and outside its own industry. Common-size statements are also used to compare a company to other companies in benchmarking.

Learning Objective #4: Limitations of using financial statement analysis in decision making

No single ratio or one-year figure is sufficient to provide an assessment of a company’s performance. Financial analysis may indicate that something is wrong, but it may not identify the specific problem or show how to correct it. In using financial statement analysis a single ratio may serve more than one purpose, eg indicating profitability/performance as well as flexibility/adaptability (i) Use ratios in conjuction with other supporting ratios and within the context of the industry, remembering the impact of inflation and size. Inflation can distort a firm’s balance sheet and profits. (ii) Seasonal factors can distort ratios (iii) Sometimes comparing a company with an industry average can be misleading if the company operates in more than one industry. (iv) Interpreting the results of your analysis requires a sound understanding of the company, the industry and the general economic environment. (v) Different accounting practices can distort comparisons.

Learning Objective #5: Considering qualitative factors in the analysis of financial statements

Some other factors to be considered in analyzing a company: (i) Are the company’s revenues tied to 1 key customer? (ii) To what extent are the company’s revenues tied to 1 key product? (iii) To what extent does the company rely on a single supplier? (iv) What percentage of the company’s business is generated overseas? (v) Level of competition to which the company is exposed (vi) Future prospects for growth and expansion (vii) Legal and regulatory environment

Quantitative Information Sources: Financial Statements, Industry Statistics, Economic Indicators, Regulatory Filings, Trade Reports

Qualitative Information Sources: Management discussion and analysis, Chairman’s and CEO’s letter. Annual Report, Mission Statement, Company web sites, Financial Press, Company Press Releases

Financial Statements Public firms are required to publish several different financial statements which together give a picture of the firm’s operations and financial condition. We shall examine two of the most important ones, namely the Income Statement which gives a summary of the firm’s revenues and expenses over an accounting period (eg a year or a quarter) and the Balance Sheet

The income statement reports on operations over a period of time, usually a quarter or a year. It starts with a topline figure or revenue from operations, followed by a series of deductions, and ending in the bottom line or net income. Note that taxes are deducted after most costs are met, as they are regarded as business expenses payable from operating revenue. Net income remains after all expenses are paid, and belongs to the firm’s common shareholders.

The balance sheet reports the firm’s state of affairs at a particular point in time. It lists the firm’s assets on one side (in order of liquidity), and the claims against those assets. Claims are of two kinds; liabilities (money the firm owes), and stockholder’s equity (their ownership stake). Claims are listed in the order in which they must be paid. Thus accounts payable, a liability usually due in 30 days or less, is at the top, while at the bottom is stockholders equity which never needs to be “paid off”. Of the assets, although all are stated in $, only “cash” is actual money.

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INCOME STATEMENT (P & L)

2006 ($) 2005 ($)Sales 7,035,600 6,034,000Cost of goods sold (C.O.G.S) 5,875.992 5,528,000 Other Expenses 550,000 519,988 Earnings before Interest & Taxes (EBITDA) 609,608 (13,988)Depreciation & Amortization 116,960 116,960 Earnings before Interest & Taxes (EBIT) 492,648 (130,948)Interest 70,008 136,012 Earnings before Taxes (EBT) 422,640 (266,960)Taxes 169,056 (106,784) Net Income (NI) 253,584 (160,176)

BALANCE SHEETAssetsCash 85,632 7,282Accounts Receivable (debtors, AR) 878,000 632,160Inventory 1,716,480 1,287,360 Total Current Assets 2,680,112 1,926,802

Fixed Assets 817,040 939,790 Total Assets 3,497,152 2,866,592

Liabilities & EquityAccounts Payable 436,800 524,160Notes Payable 300,000 636,808Accruals 408,000 489,600 Total Current Liabilities 1,144,800 1,650,568

Long Term Debt 400,000 723,000 Total Liabilities 1,544,800 2,373,568

Common Stock 1,721,176 460,000Retained Earnings 231,176 32,592 Total Stockholders Equity 1,952,352 492,592

Total Liabilities & Equity 3,497,152 2,866,592

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UNIT 3: TUTORIAL QUESTIONS

1. Over the past year MD Ryngaert & Co has realized an increase in its current ratio and a drop in its total assets turnover ratio.. However the company’s sales, quick, and fixed assets turnover ratios have been constant. What explains these changes? (3.1)

2. If a firm’s ROE is low and management wants to improve it, explain how using more debt might help (3.6)

3. Baker Brothers has a DSO of 40 days. The company’s annual sales are $7.3M. what is its level of accounts receivable? (Assume a year of 365 days) (3.1)

4. Graser Trucking has $12B in assets and its tax rate is 40%. The firm’s basic earning power ratio is 15% and its return on assets (ROA) 5%. What is Graser’s TIE ratio? (3.5)

5. The H.R Pickett Corp has $500,000 of debt outstanding and it pays an annual average interest rate of 10%. Annual sales are $2M, its tax rate is 30%, and its net profit margin is 5%. Its bank will refuse to renew its loan, a move which would bankrupt the firm, if it does not maintain a TIE ratio of at least 5. What is its present TIE ratio? (3.8)

6. Midwest Packaging’s ROE last year was only 3%, but management has developed plans to improve it. The new plans call for a total debt ratio of 60%, which will result in interest charges of $300,000/year. Management projects an EBIT of $1M on sales of $10M and expects a total asset turnover of 2.0. The tax rate is expected to be 34%. If the changes are made, what will be the firm’s new ROE? (3.10)

7. Harriett Industries has $7.5B in total assets. Its basic earning power ratio is 10% and its TIE ratio is 2.5. Harriett’s depreciation and amortization expenses total $1.25B. It has $775M in lease payments and $500M must go towards principal payments on its loans and long term debt. What is Harriett’s EBITDA coverage ratio? (3.14)

8. AEI incorporated has $5B in assets and its tax rate is 40%.Its basic earning power ratio is 10% and its ROA is 5%. What is AEI’s times interest earned (TIE) ratio? (3.15)

9. Given the following information, calculate the market price of the firm’s stock: Stockholder’s equity = $3.75B, P/E ratio = 3.5, common stock outstanding = 50M, and market to book ratio = 1.9. (3.16)

10. Harrelson Inc. currently has $750,000 in accounts receivable. Its days sales outstanding (DSO) is 55 days. It wants to reduce its DSO to the industry average of 35 days by pressuring customers to pay on time. The Chief Financial Officer (CFO) estimates that average sales will fall by 15% if the policy is adopted. Assuming the firms achieves the DSO of 35 days and suffers the 15% sales decline, what will be the new level of accounts receivable? Assume 1 year =365 days (3.17)

11. Ebersoll Manufacturing Co. has $6M in sales. Its ROE is 12% and total assets turnover is 3.2 times. Ebersoll is 50% equity financed. What is its net income? (3.19)

12. Complete the following balance sheet using the given information: Debt ratio =50%. Total assets turnover = 1.5, current ratio =1.8, DSO = 36.5 days, gross profit margin on sales [(sales – cost of goods sold)/sales] = 25%, Inventory turnover ratio = 5. (3.21)

ASSETS ($) LIABILITIES & EQUITY ($)Cash Accounts Payable Accounts Receivable Long Term Debt 60,000 Inventories Common Stock Fixed Assets __________ Retained Earnings 97,500 Total Assets 300,000 Total Liabilities & Equity ………..Sales Cost of Goods Sold

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