Analysis Of Financial Statements.ppt

The Analysis of Financial Statements • •

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The Use Of Financial Ratios Analyzing Liquidity Analyzing Activity Analyzing Debt Analyzing Profitability A Complete Ratio Analysis 1

The Analysis of Financial Statements •

THE USE OF FINANCIAL RATIOS – Financial Ratio are used as a relative measure that facilitates the evaluation of efficiency or condition of a particular aspect of a firm's operations and status – Ratio Analysis involves methods of calculating and interpreting financial ratios in order to assess a firm's performance and status 2

Example (1)

(2)

(1)/(2)

Year End Current Assets/Current Liab. Current Ratio

2017

$550,000

/$500,000

1.10

2018

$550,000

/$600,000

.92

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Interested Parties Three sets of parties are interested in ratio analysis:

Shareholders • Creditors • Management •

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Types of Ratio Comparisons There are two types of ratio comparisons that can be made: •

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Cross-Sectional Analysis Time-Series Analysis – Combined Analysis uses both types of analysis to assess a firm's trends versus its competitors or the industry 5

Words of Caution Regarding Ratio Analysis • • •

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A single ratio rarely tells enough to make a sound judgment. Financial statements used in ratio analysis must be from similar points in time. Audited financial statements are more reliable than unaudited statements. The financial data used to compute ratios must be developed in the same manner. Inflation can distort comparisons. 6

Groups of Financial Ratios

• Liquidity • Activity

• Debt • Profitability 7

Analyzing Liquidity •

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Liquidity refers to the solvency of the firm's overall financial position, i.e. a "liquid firm" is one that can easily meet its short-term obligations as they come due. A second meaning includes the concept of converting an asset into cash with little or no loss in value. 8 Copyright

1994, HarperCollins Publishers

Three Important Liquidity Measures Net Working Capital (NWC) NWC = Current Assets - Current Liabilities Current Ratio (CR) Current Assets CR = Current Liabilities Quick (Acid-Test) Ratio (QR) Current Assets - Inventory QR = Current Liabilities 9 Copyright

1994, HarperCollins Publishers

Three Important Liquidity Measures Net Working Capital (NWC):

A measure of both a company's efficiency and its short-term financial health. Current Ratio (CR):

A liquidity ratio that measures a company's ability to pay short-term obligations. Quick (Acid-Test) Ratio (QR): A more conservative approach to current ratio.

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Analyzing Activity •

Activity is a more sophisticated analysis of a firm's liquidity, evaluating the speed with which certain accounts are converted into sales or cash; also measures a firm's efficiency 11

Five Important Activity Measures Inventory Turnover (IT)

IT =

Average Collection Period (ACP) in days ACP =

Average Payment Period (APP) in days

Fixed Asset Turnover (FAT)

Total Asset Turnover (TAT)

APP=

FAT =

TAT =

Cost of Goods Sold

Inventory Accounts Receivable Annual Sales/360 Accounts Payable Annual Purchases/360 Sales Net Fixed Assets Sales Total Assets

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Five Important Activity Measures Inventory Turnover (IT): A ratio showing how many times a company's inventory is sold and replaced over a period. Average Collection Period (ACP) in days:

The approximate amount of time in days that it takes for a business to receive payments owed, in terms of receivables, from its customers and clients. Average Payment Period (APP) in days: The measure shows investors how many times per period in days the company pays its average payable amount. Fixed Asset Turnover (FAT): The amount of sales generated for every dollar's worth of fixed assets only. It is calculated by dividing sales in dollars by assets in dollars. Total Asset Turnover (TAT): The amount of sales generated for every dollar's worth of assets. It is calculated by dividing sales in dollars by assets in dollars. 13

Analyzing Debt •

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Debt is a true "double-edged" sword as it allows for the generation of profits with the use of other people's (creditors) money, but creates claims on earnings with a higher priority than those of the firm's owners. Financial Leverage is a term used to describe the magnification of risk and return resulting from the use of fixed-cost financing such as debt and preferred stock. 14

Measures of Debt •

There are Two General Types of Debt Measures –Degree of Indebtedness –Ability to Service Debts

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Four Important Debt Measures Debt Ratio (DR) Debt-Equity Ratio (DER) Times Interest Earned Ratio (TIE)

DR=

DER=

TIE=

FPC=

Fixed Payment Coverage Ratio (FPC)

Total Liabilities

Total Assets Long-Term Debt Stockholders’ Equity Earnings Before Interest & Taxes (EBIT) Interest

Earnings Before Interest & Taxes + Lease Payments Interest + Lease Payments +{(Principal Payments + Preferred Stock Dividends) 16 X [1 / (1 -T)]}

Four Important Debt Measures Debt Ratio (DR): A ratio that indicates what proportion of debt a company has relative to its assets. The measure gives an idea to the leverage of the company along with the potential risks the company faces in terms of its debt-load. Debt-Equity Ratio (DER): A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets. Times Interest Earned Ratio (TIE): It is used to measure a company's ability to meet its debt obligations. Fixed Payment Coverage Ratio (FPC): It is used to measure a company's ability to meet its fixed debt obligations. 17

Analyzing Profitability – Profitability Measures the firm's ability to operate efficiently and are of concern to owners, creditors, and management – A Common-Size Income Statement, which expresses each income statement item as a percentage of sales, allows for easy evaluation of the firm’s profitability relative to sales. 18

Seven Basic Profitability Measures

Gross Profit Margin (GPM)

Operating Profit Margin (OPM)

GPM= OPM =

Net Profit Margin (NPM) NPM= Return on Total Assets ROA= (ROA) ROE= Return On Equity (ROE) EPS = Earnings Per Share (EPS) P/E = Price/Earnings (P/E) Ratio

Gross Profits Sales Operating Profits (EBIT) Sales Net Profit After Taxes Sales

Net Profit After Taxes Total Assets Net Profit After Taxes Stockholders’ Equity Earnings Available for Common Stockholder’s Number of Shares of Common Stock Outstanding Market Price Per Share of Common Stock Earnings Per Share

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Seven Basic Profitability Measures Gross Profit Margin (GPM): it used to assess a firm's financial health by revealing the proportion of money left over from revenues Operating Profit Margin (OPM): A ratio used to measure a company's pricing strategy and operating efficiency. Net Profit Margin (NPM): It measures how much out of every dollar of sales a company actually earns after paying taxes. Return on Total Assets (ROA): The ratio is considered an indicator of how effectively a company is using its assets to generate earnings before contractual obligations must be paid. Return On Equity (ROE): A measure of a corporation's profitability that reveals how much profit a company generates with the money shareholders have invested.

Earnings Per Share (EPS): The portion of a company's profit allocated to each outstanding share of common stock. Price/Earnings (P/E) Ratio:

A valuation ratio of a company's current share price compared to its per20 share earnings.

A Complete Ratio Analysis •

DuPont System of Analysis – DuPont System of Analysis is an integrative approach used to dissect a firm's financial statements and assess its financial condition – It ties together the income statement and balance sheet to determine two summary measures of profitability, namely ROA and ROE 21

DuPont System of Analysis •

The firm's return is broken into three components: –A profitability measure (net profit margin) –An efficiency measure(total asset turnover) –A leverage measure (financial leverage multiplier) 22

Summarizing All Ratios •

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An approach that views all aspects of the firm's activities to isolate key areas of concern Comparisons are made to industry standards (cross-sectional analysis) Comparisons to the firm itself over time are also made (time-series analysis) 23