Chapter 3

Financial Statement Analysis

Financial Statement Analysis, Some Background

Financial statements reflect the results of actions taken by the management of a company.

Analysis of historical data can give perspective on past performance, and may help to predict future performance.

Financial statement analysis helps to set goals for the company to attain in future periods.

Financial statement analysis allows us to compare the performance of a company to its competitors, wherever possible.

Ratio Analysis, an Important Tool in Financial Statement Analysis

• Expresses relationship among selected items of financial statement data

• Relationship can be expressed in term of:• Percentages – for example, gross profit as a % of net sales,

gross profit percentage

• Rates – 365 days , Days in

(Cost of Goods Sold ÷ Average Inventory) Inventory

• Proportions – Current Assets ÷ Current Liabilities, Current Ratio

Ratio Analysis Comparisons

Intracompany comparisons - covering two years of the same company

Industry average comparisons - based on average ratios for a particular industry

Intercompany comparisons - based on comparisons with a competitor in the same industry

Ratio Analysis Classifications:

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

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

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

Common Size Financial Statement Ratios

Relates the components of the financial statements to some reference amount to scale dollar amounts for size.

• Balance sheet – the reference is usually total assets.

• Income Statement – the reference is usually net sales.

• See Table 3.3 and 3.4 for examples of common sized balance sheets and income statements.

Common size financial statement exercise

For Tomorrow

Read Chapter 3 Work through the T/F and Multiple Choice questions,

exercises 42 (a) (b), and 44.

Exam 1 Results

Of 29 students who took the exam, scores were distributed as follows:

90 – 100 (17) 80 - 89 (4) 70 – 79 (3) < 69 (5)

Wednesday June 29Chapter 3 – Financial Statement Analysis

How to use ratios in analyzing financial statements to assess a firm’s:

• Profitability

• Liquidity

• Solvency

Ratios

Great diagnostic tools – they point to areas of operations, financing, or investing that should be researched further before reaching conclusions.

Relatively easy to calculate, however, flexibility in GAAP may mean that there can be some variation in how numbers used in ratios are calculated.

Horizontal and Vertical Analysis

1. Horizontal Analysis:a. Analysis of dollar value and percentage changes.b. Over time c. Sometimes called trend analysis.

2. Vertical Analysis:a. Analysis of dollar value amounts relative to a common

base.b. Top to bottom.c. Sometimes called Common Size Statement Analysis.

From the text, p. 89

Why compare: To see if the:

Current liabilities to current assets

company is able to meet its payroll and pay its suppliers on time.

Accounts receivable to sales company can collect its receivables

Inventory to cost of goods sold company's inventory is turning over quickly enough

Fixed charges to income business can service its debt.

From the text, p. 89 Continued

Why compare: To see if the:

Total debt to total assets business can service its debt.

Total assets to sales company's assets are productive.

Net income to sales company as a whole is efficient.

Analyzing The Balance Sheet

1. Horizontal Analysis: how have assets, liabilities and equities changed over time?

2. Vertical Analysis: express all other accounts relative to total assets.

Analyzing the Income Statement

1. Horizontal Analysis: how have sales, expenses, COGS changed over time?

2. Vertical Analysis: express all other accounts relative to sales.

Factors That Affect Profitability

Sales volume Sales price Expenses – Cost of goods sold, operating expenses.

• Operating expenses are directly related to the efficiency of a firm’s assets

Cost of capital (funds) – interest charges

Factors That Affect Liquidity

Liquidity refers to the ability to meet day-to-day cash needs for business expenses.

The speed with which cash payments are received on accounts receivable.

The delaying of cash payments on accounts payable and other payables.

Working capital requirements – that is the amount of cash needed for day-to-day operations.

Factors That Affect Solvency

Recall that solvency is a longer-term aspect than liquidity.

Financial structure – aka capital structure (debt/equity)

Debt paying ability.

Market-Value Ratios (Table 3.1)

Measures of the income or operating success of a

company for a given period of time

15. Earnings per share ($)

Net Income

Number of shares of stock outstanding

16. Price/earnings ratio (times)

Price per common share

Earnings per common share

Profitability Ratios (Table 3.1)

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

11. Profit margin on sales (%)

Operating Income

Sales

12. Return on sales. (%)

Income after taxes

Sales

Profitability Ratios (Table 3.1)

13. Return on total assets. (%)

Income after taxes

Total assets

14. Return on equity (ROE). (%)

Income after taxes

Owners’ equity

Liquidity Ratios (Table 3.1)

Measure of short - term ability to pay obligations

1. Current ratio (times)

Current Assets

Current liabilities

2. Quick ratio (times)

Quick Assets

Current liabilities

Leverage Ratios (Table 3.1)

Measures of the ability to pay debts in the current year and beyond

3. Debt-to-total-assets (%)

Total debts

Total assets

4. Debt-to-equity (times)

Total debts

Total shareholder’s equity

Leverage Ratios (Table 3.1)

Measures of the ability to pay debts in the current year and beyond

5. Times-interest-earned (times)

Income before tax + Interest charges Interest charges

6. Fixed-charge-coverage (times) – SKIP

Asset-Management Ratios (Table 3.1)

7. Average Collection period (days)

Accounts Receivable

Daily Sales

8. Inventory turnover (times)

Cost of goods sold

(average )Inventory

Asset-Management Ratios (Table 3.1)

9. Capital asset turnover (times)

SKIP

10. Total asset turnover (times)

Sales

Total assets

Horizontal and Vertical Analysis

1. Horizontal Analysis:a. Analysis of dollar value and percentage changes.b. Over time c. Sometimes called trend analysis.

2. Vertical Analysis:a. Analysis of dollar value amounts relative to a common

base.b. Top to bottom.c. Sometimes called Common Size Statement Analysis.

Analysis of The Balance Sheet

1. Horizontal Analysis: how have assets, liabilities and equities changed over time?

2. Vertical Analysis: express all other accounts relative to total assets.

Analyzing the Income Statement

1. Horizontal Analysis: how have sales, expenses, COGS changed over time?

2. Vertical Analysis: express all other accounts relative to sales.

Dupont Method - skip