Tools of Financial Analysis and Control
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Transcript of Tools of Financial Analysis and Control
PERFORMANCE ANALYSIS(Tools for Financial Analysis and Control).
Mr.John Obote.
MBA.
2
Responsibilities of the Financial Manager
1. Managing theworking capital 2. Estimating the
seasonal fund needs
3. Long-term financial planning: forecasting long-term fund requirements4. Determining appropriate investment mix
6. Determining the amount of dividends to be paid
5. Determining appropriate financing mix
Inter-relationships between financing, investment and dividend decisions
Investment: Company decides to take on a large number of attracting new investment projects
Finance: Company will need to raise finance in order to take on projects
Dividends: if finance is not available from external sources, dividends may need to be cut in order to increase internal financing
Dividends: company decides to pay higher levels of dividends to shareholders
Finance: lower level of retained earnings available for investment means company may have to find finance from external sources
Investment: if finance is not available from external sources the company may have to postpone future investment projects
Finance: company finances itself using more expensive sources resulting in a higher cost of capital
Investment: due to a higher cost of capital the number of projects attractive to the company decreases
Dividends: the company’s ability to pay dividends in the future will be adversely affected
Learning Activity
• What are the basic financial statements that should be prepared by a business firm?
• What are the uses of each of the basic financial statements?
Basic Financial Statements
• The Income Statement• The Balance Sheet• The Statement of Retained Earnings• The Statement of Cash Flows
Learning Activity
• What is financial statement analysis and why is it important?
• What is financial statement analysis?”Tearing apart” the financial statements and looking at the relationships
• Financial statements summarize and provide an overview of events relating to the functioning of a firm.
• Financial statement analysis helps identify – a firm’s strengths and – weaknesses – so that management can take advantage of a firm’s strengths
and make plans to counter weaknesses of the firm. • The strengths must be understood if they are to be used to proper
advantage and weaknesses must be recognized if corrective action needs to be taken
Financial Statement Analysis
Significance of Financial Statements Analysis
• For example:– Are inventories adequate to support the projected level of
sales? – Does the firm have too heavy an investment in account
receivable? – Does large account receivable reflect a lax collection policy?– To ensure efficient operations of a firm’s manufacturing
facility, does the firm have too much or too little invested in plant and equipment?
• Financial statement analysis provides answers to all of these questions.
• Who analyzes financial statements?– Internal users (i.e., management)– External users (emphasis of lecture)
• Examples?– Investors, creditors, regulatory agencies & …– Financial analysts – Auditors– Researchers– etc
Who Analyses Financial Statements?
A Firm’s Stakeholders
The firm
Customers
Society
Shareholders
Managers
Employees
GovernmentCreditors
A company has responsibility to different interested parties
• What do internal users use it for? Planning, evaluating and controlling company
operations• What do external users use it for?
Assessing past performance and current financial position and making predictions about the future profitability and solvency of the company as well as evaluating the effectiveness of management
Financial Statement Analysis
Information is available from– Published annual reports
(1) Financial statements(2) Notes to financial statements(3) Letters to stockholders(4) Auditor’s report (Independent accountants)(5) Management’s discussion and analysis
Financial Statement Analysis
Information is available from (Cont…)– Other sources(1) Newspapers (e.g., Business Times, Financial
Times )(2) Periodicals (e.g. Forbes, Fortune)(3) Financial information organizations such as:
Moody’s, Standard & Poor’s, Dun & Bradstreet, Inc., and Robert Morris Associates
(4) Other business publications
Financial Statement Analysis
• Horizontal Analysis
• Vertical Analysis
• Common-Size Statements
• Trend Percentages
• Ratio Analysis
Methods ofFinancial Statement Analysis
Horizontal Analysis
Using comparative financial statements to calculate monetary (Tshs) or percentage changes in a financial statement item from one period to the next
Vertical Analysis
For a single financial statement, each item is expressed as a percentage of a significant total, e.g., all income statement items are expressed as a percentage of sales and all balance sheet items are expressed as a percentage of total assets
Common-Size StatementsFinancial statements that show only percentages and no absolute monetary amounts
Trend PercentagesShow changes over time in given financial statement items (can help evaluate financial information of several years)
Ratio AnalysisExpression of logical relationships between items in a financial statement of a single period (e.g., percentage relationship between revenue and net income)
Horizontal Analysis Example
Assume that the management of UD Co Ltd provides you with comparative balance sheets of the years ended December 31, 2014 and 2013. Management asks you to prepare a horizontal analysis horizontal analysis on the information.
UD CompanyComparative Balance Sheet, 31 December,2013 and 2012
2013 2012 Increase (Decrease)
Amount %
Assets
Current Assets
Cash 12,000 23,500
Accounts Receivable, Net 60,000 40,000
Inventory 80,000 100,000
Prepaid Expenses 3,000 1,200
Total Current Assets 155,000 164,700
Property and Equipment
Land 40,000 40,000
Building & Equipment, Net 120,000 85,000
Total Land & Equipment 160,000 125,000
Total Assets 315,000 289,700
Calculating Change in Tshs Amounts
TshsChange
Current YearFigure
Base YearFigure
= –
Horizontal Analysis Example
Calculating Change in Monetary Amounts
Since we are measuring the amount of the change between 2012 and 2013, the Tshs amounts for 2012 become the “base” year figures.
TshsChange
Current YearFigure
Base YearFigure
= –
Horizontal Analysis Example
Calculating Change as a Percentage
PercentageChange
Tshs Change Base Year Figure 100%= ×
Horizontal Analysis Example
$12,000 – $23,500 = $(11,500)
Horizontal Analysis Example
($11,500 ÷ $23,500) × 100% = 48.9%
Horizontal Analysis Example
Horizontal Analysis Example
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Horizontal Analysis Example
• Let’s apply the same procedures to the liability and stockholders’ equity sections of the balance sheet.
UD Co LtdComparative Balance SheetsDecember 31, 2014 and 2013
Increase (Decrease)
2014 2013 Amount %Liabilities and Stockholders' Equity
Current liabilities: Accounts payable 67,000$ 44,000$ 23,000$ 52.3 Notes payable 3,000 6,000 (3,000) (50.0) Total current liabilities 70,000 50,000 20,000 40.0Long-term liabilities: Bonds payable, 8% 75,000 80,000 (5,000) (6.3) Total liabilities 145,000 130,000 15,000 11.5Stockholders' equity: Preferred stock 20,000 20,000 - 0.0 Common stock 60,000 60,000 - 0.0 Additional paid-in capital 10,000 10,000 - 0.0 Total paid-in capital 90,000 90,000 - 0.0Retained earnings 80,000 69,700 10,300 14.8 Total stockholders' equity 170,000 159,700 10,300 6.4Total liabilities and stockholders' equity 315,000$ 289,700$ 25,300$ 8.7
30
Horizontal Analysis Example
• Now, let’s apply the procedures to the income statement
UD Co LtdComparative Income Statements
For the Years Ended December 31, 2014 and 2013Increase (Decrease)
2014 2013 Amount %Net sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)Net income 17,500$ 22,400$ (4,900)$ (21.9)
UD Co LtdComparative Income Statements
For the Years Ended December 31, 2014 and 2013Increase (Decrease)
2014 2013 Amount %Net sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)Net income 17,500$ 22,400$ (4,900)$ (21.9)
Sales increased by 8.3% while net income decreased by 21.9%.
UD Co LtdComparative Income Statements
For the Years Ended December 31, 2013 and 2013Increase (Decrease)
2014 2013 Amount %Net sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)Net income 17,500$ 22,400$ (4,900)$ (21.9)
There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the increase in sales, yielding an overall decrease in net income (21.9%).
Vertical Analysis Example
Assume that the management of BS Company Ltd asks you to prepare a vertical analysis vertical analysis for the comparative balance sheets of the company.
Vertical Analysis Example
Vertical Analysis Example
$82,000 ÷ $483,000 = 17% rounded$30,000 ÷ $387,000 = 8% rounded
Vertical Analysis Example
$76,000 ÷ $483,000 = 16% rounded
Trend Percentages ExampleAssume that MD Co Ltd provides you with the
following operating data and asks that you prepare a trend analysis.
Trend Percentages Example
Assume that MD Co Ltd provides you with the following operating data and asks that you prepare a trend analysis.
$1,991 - $1,820 = $171$1,991 - $1,820 = $171
Trend Percentages ExampleUsing 2010 as the base year, we develop the
following percentage relationships.
$1,991 - $1,820 = $171$1,991 - $1,820 = $171$171 ÷ $1,820 = 9% rounded$171 ÷ $1,820 = 9% rounded
RATIO ANALYSIS• Financial statements report both on a firm’s position
at a point in time and on its operations over some past period.
• From management’s viewpoint, financial statement analysis is useful both as a way to– anticipate future conditions and – more important, as a starting point for planning
actions – that will influence the future course of events or – to show whether a firm’s position has been
improving or deteriorating over time.
Ratio Analysis (Cont…)• Ratio analysis begins:
– with the calculation of a set of financial ratios– designed to show the relative strengths and – weaknesses of a company as compared to
• Other firms in the industry• Leadings firms in the industry• The previous year of the same firm
• Ratio analysis helps to show whether the firm’s position has been improving or deteriorating
• Ratio analysis can also help plan for the future
Ratios can be expressed in three different ways: 1. Ratio (e.g., current ratio of 2:1) 2. % (e.g., profit margin of 2%) 3. $ (e.g., EPS of Tshs 225)
CAUTION! “Using ratios and percentages without considering
the underlying causes may lead to incorrect conclusions.”
Ratios
Major Categories of Ratios• Liquidity Ratios
Indicate a company’s short-term debt-paying ability• Asset Management
Measure how effectively the firm is managing/using its assets• Equity (Long-Term Solvency) Ratios
Show relationship between debt and equity financing in a company
• Profitability TestsRelate income to other variables
• Market TestsHelp assess relative merits of stocks in the market place
The 10 Basic Ratios you have to know• Liquidity Ratios
1. Current Ratio (Working Capital Ratio)2. Quick Ratio/Acid Test RatioCash Ratio/Cash Flow liquidity Ratio
• Asset Management Ratios3. Inventory Turnover Ratio4. Days Sales Outstanding5. Inventory Turnover RatioFixed Assets Turnover RatioTotal Assets Turnover Ratio
• Equity (Long-term solvency/Debt Management Ratios6. Equity (stockholders’ equity) ratio - Equity to debtTotal Debt to Total Assets RatioTimes Interest Covered Ratio
The 10 Basic Ratios you have to know• Profitability Ratios
7. Profit Margin - Net income to net sales (return on sales)8. Earnings per share9. Return on average common stockholders’ equity (ROEROE)
• Return on Assets• Return on Equity• Basic Earning Power Ratio• Cash flow margin• Times interest earned• Times preferred dividends earned
The 10 Basic Ratios you have to know• Market Tests
10. Price-earnings ratio• Earnings yield on common stock• Payout ratio on common stock• Dividend yield on common stock• Dividend yield on preferred stock• Cash flow per share of common stock
Ratio Analysis - Example
Ratio Analysis - Example
• Calculate the 10 basic ratios based on Neema Co Ltd’s financial statements
Neema Co Ltd2014
Cash 30,000$ Accounts receivable, net Beginning of year 17,000 End of year 20,000 Inventory Beginning of year 10,000 End of year 12,000 Total current assets 65,000 Total current liabilities 42,000 Sales on account 494,000 Cost of goods sold 140,000
We will use this
informationto calculatethe liquidity
ratios for Neema Co Ltd.
Working Capital*
12/31/14Current assets 65,000$ Current liabilities (42,000) Working capital 23,000$
The excess of current assets over current liabilities.
* While this is not a ratio, it does give an indication of a company’s liquidity.
Current (Working Capital) Ratio
CurrentRatio
$65,000 $42,000
= = 1.55 : 1
Measures the ability of the company to pay current debts as they become due.
CurrentRatio
Current Assets Current Liabilities
=
#1#1
Acid-Test (Quick) Ratio
Quick Assets Current Liabilities
=Acid-Test Ratio
Quick assets are Cash, Marketable Securities, Accounts Receivable (net) and current Notes Receivable.
#2#2
Quick Assets Current Liabilities
=Acid-Test Ratio
Neema Co Ltd’s quick assets consist of cash of $30,000 and accounts receivable of $20,000.
Acid-Test (Quick) Ratio
#2#2
Quick Assets Current Liabilities
=Acid-Test Ratio
$50,000 $42,000
= 1.19 : 1=Acid-Test Ratio
Acid-Test (Quick) Ratio
#2#2
Sales on Account Average Accounts Receivable
Accounts ReceivableTurnover
=
Accounts Receivable Turnover
= 26.70 times $494,000 ($17,000 + $20,000) ÷ 2
Accounts ReceivableTurnover
=
This ratio measures how many times a company converts its receivables into cash each year.
#3#3 Average, net accounts receivable
Net, credit sales
Number of Days’ Salesin Accounts Receivable
Measures, on average, how many days it takes to collect an account receivable.
Days’ Salesin AccountsReceivables
= 365 Days Accounts Receivable Turnover
= 13.67 days= 365 Days 26.70 Times
Days’ Salesin AccountsReceivables
#4#4
Number of Days’ Salesin Accounts Receivable
In practice, would 45 days be a desirable number of days in receivables?
#4#4Days’ Salesin AccountsReceivables
= 365 Days Accounts Receivable Turnover
= 13.67 days= 365 Days 26.70 Times
Days’ Salesin AccountsReceivables
Inventory Turnover
Cost of Goods Sold Average Inventory
InventoryTurnover =
Measures the number of times inventory is sold and replaced during the year.
= 12.73 times $140,000 ($10,000 + $12,000) ÷ 2
InventoryTurnover =
#5#5
Inventory Turnover
Cost of Goods Sold Average Inventory
InventoryTurnover =
Would 5 be a desirable number of times for inventory to turnover?
= 12.73 times $140,000 ($10,000 + $12,000) ÷ 2
InventoryTurnover =
#5#5
Equity, or Long–TermSolvency Ratios
This is part of the information to calculate the equity, or long-term solvency ratios of Norton
Corporation.
Neema Co Ltd2014
Net operating income 84,000$ Net sales 494,000 Interest expense 7,300 Total stockholders' equity 234,390
Neema Co Ltd2014
Common shares outstanding Beginning of year 17,000 End of year 27,400 Net income 53,690$ Stockholders' equity Beginning of year 180,000 End of year 234,390 Dividends per share 2 Dec. 31 market price/share 20 Interest expense 7,300 Total assets Beginning of year 300,000 End of year 346,390
Here is therest of theinformation
we willuse.
Equity Ratio
EquityRatio = Stockholders’ Equity
Total Assets
EquityRatio = $234,390
$346,390 67.7%=
Measures the proportion of total assets provided bystockholders.
#6#6
Net Income to Net SalesA.K.A. Return on Sales or Profit Margin
Net IncomeTo Net Sales = Net Income
Net Sales
Net IncomeTo Net Sales = $53,690
$494,000 = 10.9%
Measures the proportion of the sales (Tshs)which is retained as profit.
#7#7
Net Income to Net SalesA.K.A. Return on Sales or Profit Margin
Net IncomeTo Net Sales = Net Income
Net Sales
Net IncomeTo Net Sales = $53,690
$494,000 = 10.9%
Would a 1% return on sales be good?
#7#7
Return on Average Common Stockholders’ Equity (ROE)
Return onStockholders’Equity
= Net Income Average CommonStockholders’ Equity
= $53,690 ($180,000 + $234,390) ÷ 2 = 25.9%
Return onStockholders’Equity
Important measure of the income-producing abilityof a company.
#8#8
Earningsper Share
Earnings Available to Common StockholdersWeighted-Average Number of Common Shares Outstanding
=
Earningsper Share
$53,690 (17,000 + 27,400) ÷ 2= = $2.42
The financial press regularly publishesactual and forecasted EPS amounts.
#9#9
Earnings Per Share
Price-Earnings RatioA.K.A. P/E Multiple
Price-EarningsRatio
Market Price Per Share EPS
=
Price-EarningsRatio = $20.00
$ 2.42 = 8.3 : 1
#10#10
Provides some measure of whether the stock is under or overpriced.
72
The DuPont System• Developed in 1919 by a finance executive at E.I. du
Pont de Nemours and Co• A way of visualizing the information so that everyone
can see it• Is a good tool for getting people started in
understanding how they can have an impact on results• It is a simple and straightforward method for assessing
the factors that influence a firm’s financial performance
73
The DuPont System
• Method to breakdown ROE into:– ROA and Equity Multiplier
• ROA is further broken down as:– Profit Margin (profitability)– Asset Turnover (efficiency in using the assets)
• Helps to identify sources of strength and weakness in current performance
• Helps to focus attention on value drivers
DuPont Chart and Equation
• DuPont Chart and Equation - Tie the Ratios Together– Shows how profit margin, asset turnover ratio, and
equity multiplier determine ROE– Shows how expense control (profit margin), efficient
use of assets in production (asset turnover) and capital structure (equity multiplier) affect return on equity.
– Ties together all aspects of firm - production and financing.
75
Return on Equity - ROE
• This represents the Net income generated by the Equity invested in the business
• The Formula is:
Net Income Equity– This represents amount of profit per Tshs invested
by the shareholders.
76
DuPont System – What is It?• The system identifies profitability as being impacted by
three different levers:– Earnings & efficiency in earnings– Ability of your assets to be turned into profits– Financial leverage
• DuPont analysis tells us that ROE is affected by three things:
– Operating efficiency, which is measured by profit margin.– Asset use efficiency, which is measured by total asset
turnover.– Financial leverage is measured by the equity multiplier
Earnings
Efficiency
Leverage
77
Net IncomeTotal Equity
=Net IncomeSales
XSales
Total Assets
Profitability Asset Usage Efficiency
Net
Profit Margin
ROETotal Asset
Turnover
X
Debt Ratio
Leverage
Total Assets
Total Equity
78
79
The DuPont System
Profi t M argin T ota l A sse t T urnover
RO A E quity M ultip l ie r
RO E
80
The DuPont System
Profi t M argin T ota l A sset T urnover
RO A E quity M ultip l ie r
RO E
Notice that using more debt (and less equity) to finance assets raises the Equity Multiplier. This has two effects for stockholders.
The Equity Multiplier acts as a lever to magnify the effects of ROA on returns for stockholders. If ROA is positive, ROE is a larger positive value, but if ROA is negative ROE is a larger negative.
81
The DuPont System
Profi t M argin T ota l A sset T urnover
RO A E quity M ultip l ie r
RO E
Return on Assets is affected by two areas of operations. The Profit Margin measures the degree to which the firm controls expenses. Since expenses comprise the difference between Sales and Net Income, lowering the expenses taken out of each shilling of sales raises the Profit Margin.
At the same time, Return on Assets can be raised by producing sales by using fewer assets. Asset Turnover measures the sales produced with each shilling invested in assets. This is often thought of as sales volume.
Different industries achieve ROA in different ways. Some have low profit margins but high volume, e.g. grocery stores. Others have lower volume but are able to maintain higher profit margins, e.g. car dealerships.
82
The DuPont System
Profi t M argin T ota l A sset T urnover
RO A E quity M ultip l ie r
RO E
83
DuPont Equation
EquityCommon Assets Total
Assets TotalSales
SalesIncomeNet
MultiplierEquity TurnoverAsset TotalMarginProfit ROE
84
Operating Profit Margin
Asset Turnover
Return On Assets (less interest adj.)
Financial Structure
Return On Equity
X =
X =
IncomeStream
InvestmentStream
Asset Efficiency Usage
Leverage
DuPont SystemEarnings/Profitability
85
Operating Profit Margin
Asset Turnover
Return On Assets (less interest adj.)
Financial Structure
Return On Equity
X =
X =
IncomeStream
InvestmentStream
Profitability
Efficiency
Leverage
DuPont System Ratios
Problems in Financial Statement and Ratio Analysis
• Developing and Using Comparative Data• Distortion of Comparative Data• Notes to Financial Statements• Interpretation of Results• Differences in Accounting Treatment• Window Dressing• Effects of Inflation
Important Considerations• Need for comparable data
– Data is provided by companies such as Dun & Bradstreet, Standard & Poor’s etc.
– Must compare by industry– Is EPS comparable?
• Influence of external factors– General business conditions– Seasonal nature of business operations
• Impact of inflation