key ratio analysis of financial statements [read-only]

Key Ratio Analysis of Financial Statements

Presented By:Jeffrey Buchakjian

Matthew Robbins, CPAParenteBeard LLC

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mail: P.O. Box 509 Eau Claire, WI 54702-0509 • telephone: 866-352-9539 • fax: 715-833-3953email: [email protected] • website: www.lorman.com • seminar id: 389875

Prepared By:Jeffrey Buchakjian

Matthew Robbins, CPAParenteBeard LLC

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ByJeffrey M. Buchakjian

AndMatthew Robbins, CPA

1

Agendai. Introduction to Ratio Analysis

a. Usesb. Real World Examples

ii. Key Accounting Conceptsiii. Common Sized Financialsiv. Financial Records Analysis

a. Ratio Analysis/Conceptsb. How to calculatec. How to apply/interpret/limitations

v. Case Studies

Introduction to Ratio Analysis

Involves comparisons of financial information Used to analyze the financial condition and

performance of an entity◦ Strengths and Weaknesses◦ Financial condition (now and over time)◦ Growth capacity (through debt or equity)◦ Specific Company Risk factors (capitalized on

purpose)◦ Efficiency◦ Investment opportunities

3

Ratio Analysis - Types of Ratios

Liquidity Ratios Activity Ratios (Efficiency Ratios) Leverage Ratios Performance or Profitability Ratios

Financial Records Analysis – Key Objectives Provide useful information to financial

statement users

Provide useful information to assess cash flows – timing, amount, uses

Provide useful information regarding financial position

Provide useful information about the financial operations

4

Financial Records Analysis – Key Concepts Relevance – information capable of making a

difference in decision-making Reliability – truthful information; free of bias Comparability – information

measured/reported in similar manner for like-kind companies

Consistency – application of same accounting principles from period to period

Financial Records Analysis – Key Principles Revenue is recognized when earned, not

collected Expenses are recognized when incurred, not

paid Expenses should be matched to revenues they

help generate Materiality – information would make a

difference to informed reader Conservation – select alternative least likely to

overstate assets / understate liabilities

5

Overview of Financial Statements

◦ Income Statement (Statement of Operations)

◦ Balance Sheet (Statement of Financial Position)

◦ Cash Flow Statement

Common Sized Financial Statements

◦ “Common Sized” financial statements convert nominal amounts into percentages in order to make “apples to apples” comparisons. Compare company results year over year Benchmark companies to competitors/peers Comparing companies of different sizes

6


◦ Common Size Income Statements by taking expense and profit line items as a percentage of revenues◦ Common Size Balance Sheets by taking line

item assets as a percentage of total assets, and line item liabilities as a percentage of total liabilities


◦ Horizontal Analysis (% of base year) Benchmark budgeted figures to actual figures

◦ Vertical Analysis (% of sales) Year-to-year comparison of companies with varying

revenues/expenses Benchmark against peers Management/Operations decisions Investment/Credit decisions

7

Ratio Analysis - Liquidity

◦ Liquidity ratios analysis Ability to meet obligations in a timely matter Entity’s ability to manage its assets and liabilities

◦ Relationships between short-term assets and short-term liabilities◦ Liquidity issues may arise when short-term

assets and liabilities not aligned


Short-term Liquidity: The ability of a company to meet its financial obligations as they are due.◦ Accounts Payable (esp. Suppliers)◦ Payroll◦ Fixed costs, such as rent◦ Line of credit zero out

8

Ratio Analysis - Liquidity Short-term Liquidity: ◦ Current Ratio=Current Assets/Current Liabilities

(also quick ratio)◦ Be careful of the 2:1 rule of thumb-Industries

vary◦ If the ratio is low, it can indicate solvency

problems◦ If the ratio is high comparable to the industry, it

can indicate ineffective use of the company’s resources◦ A high ratio could also indicate inefficient A/R

collection or inventory build-up


Liquidity & Growth Syndrome: ◦ Working Capital = Current Assets – Current

Liabilities◦ Working capital is used to finance the cash

conversion cycle.◦ The cash conversion cycle is the time it takes

to turn raw materials into inventory into cash. (Or in the service industry, hours into cash).◦ Growth in revenues creates a need for

additional working capital because of the conversion cycle.

9


Liquidity & Growth Syndrome: ◦ MANY PROMISING, HIGH GROWTH

COMPANIES FAIL DUE TO A LACK OF WORKING CAPITAL!◦ A business plan that incorporates managed

growth, forecasts for adequate working capital and realistic access to capital are essential elements in management, investment and credit decisions.◦ Does entity have the ability to fund the

growth necessary to achieve desired gains?

Ratio Analysis - Activity

Activity Ratios (aka Efficiency Ratios)◦ Measure the speed in which sales are

converted to cash.◦ Measure the effective use of assets in

generating cash.

10

Ratio Analysis - Activity Activity Ratios◦ Sales/Receivables = Net Sales/Net Trade

Receivables Measures the number of times receivables turn over per

year Tool for assessing credit and A/R policies (Match timing!) Ratio varies widely by industry, so correctly identify

industry benchmarks for a meaningful analysis

◦ Days' Receivables = Net Trade Receivables/(Net Sales/365) Expresses the average time in days that receivables are

outstanding.

Ratio Analysis - Activity◦ Inventory Turnover = Cost of Goods

Sold/Avg. Inventory The higher the ratio, the less time a widget is on

the shelf Excessively high ratios could indicate lost sales

opportunities A low ratio indicates slow moving or unidentified

obsolete inventory

◦ Days' Inventory = Inventory/(Cost of Sales/365) This ratio indicates the average length of time in

days that units are in inventory

11


◦ Cost of Sales/Trade Payables = Cost of Sales/Trade Payables Provides an indication of the average length of time

payables or credit purchases are outstanding

◦ Days' Payables = Net Trade Payables/(Cost of Sales/365) The days' payables ratio yields the average length of

time trade debt is outstanding.


◦ Sales/Working Capital = Net Sales/Current Assets - Current Liabilities (Working Capital) An above average Sales/Working Capital ratio

indicates a relatively low level of working capital

◦ Net Sales/Total Assets = Net Sales/Total Assets This ratio measures the efficiency of the assets in

generating sales.

12

Ratio Analysis - Leverage

◦ How much debt is on the balance sheet?◦ Measures the degree of protection for

creditors and shareholders◦ Measures the ability to meet long term

obligations

Ratio Analysis - Leverage

◦ Debt Ratio = Total Debt/Total Assets Indicates the percentage of total assets which are

funded through debt A higher than normal percentage indicates higher

financial leverage and more risk

◦ Debt to Equity = Debt/Equity Who owns the company? Bank, Creditors or

Owners. A large numerator indicates high leverage, and

potential lack of access to additional capital needed for growth.

13

Ratio Analysis - Leverage◦ Times Interest Earned = EBIT/Interest

Expense Shows the company’s ability to service its debt. Low ratios are a warning signal that the company

may be over-leveraged and high ratios show an inefficient use of equity

◦ Fixed Charge Coverage = (Net Income + Depreciation)/Current Portion of Long Term Debt Indicates the ability of the company to meet its

current debt principal payments from current cash flow

Ratio Analysis - Profitability

◦ Return on Sales or Net Profit Margin = Net Income or Profit before Tax/Sales Measure profit per dollar of total sales and are keys

ratios in detecting problems with expense control

◦ DuPont Analysis A technique that can be used to analyze the

profitability of a company using traditional ratios Net Profit Margin x Total Assets Turnover = (Net

Operating Profit After Taxes / Sales) x (Sales /Average Net Assets)

14


◦ Return on Investment (ROI) = Net Income or Profit before Tax/Total Assets Measure of the company based on total resources

(assets) employed ROI is a key performance measure for management

and owners

◦ Return on Owners' Equity (ROE) = Net Income or Profit before Tax/Tangible Net Worth Measures the owners' return based on their equity

investment in the company.

Ratio Analysis - Profitability◦ Dashboard A dashboard is a limited number of key metrics

used to provide a quick evaluation of a business, a project, or a process status

◦ Company Trends Without some basis of comparison, numbers by

themselves have little meaning

◦ Industry Comparisons Historical financial statements can be analyzed using

ratios which measure the position and performance of the company over time compared to the ratios for the company's industry.

15


◦ Industry Comparison Pitfalls Avoid drawing conclusions solely from industry

comparison. Financial statements and ratios of the company

rarely match industry.

◦ Growth Measurement/Pitfalls Common and useful approaches measure the

percentage change from the prior year and the compound annual average growth rate

Dramatic Growth in sales and profits (product life cycle)

Limitations of Ratio Analysis

◦ Cannot be viewed in a vacuum Consider timing, industry, regulatory issues

(qualitative factors)

◦ Uses in forecasting◦ Availability of financial data and comparative

data◦ Differences in accounting policies and

corporate structures◦ Ratios can be distorted by inflation

16

Key Takeaways

◦ Understanding the relationship between financial statements can provide deeper insight into operations

◦ Ratio Analysis is not always the final answer but the basis for further investigation

Questions

17

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