050 Chapter 3

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CHAPTER 3CHAPTER 3

FINANCIAL STATEMENTFINANCIAL STATEMENT

ANALYSIS TOOLSANALYSIS TOOLS

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OBJECTIVESOBJECTIVES

Discuss and interpret the analysis tools of financial statement.

Apply several basic financial statement major ratios and techniques.

Identify the relevant analysis information beyond financial statements.

Explain the types of equity or valuation analysis methods.

Analyze the ways to use the ratio and caution using the financial

tools.

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FINANCIAL ANALYSIS TOOLSFINANCIAL ANALYSIS TOOLS

The basic tools are:

± Comparative financial statement

Horizontal Analysis

Trend Index Analysis

± Common size financial statement

± Ratio analysis Profitability analysis

Credit Analysis

Equity Analysis and Evaluation

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Comparative Financial Statement

Analysis

Comparative financial statement analysis involves a review of changes in

individual account balances on year-to-year or multiyear basis.

The most important information often revealed from a comparative financial

statement analysis is trend . referred to as horizontal analysis.

HORIZONT AL AN ALYS I S: ± Shows the changes between years in the financial data in both amount and percentage form.

AMOUNT CH ANGE = C URRENT Y EAR ± B ASE Y EAR

TREND INDEX AN ALYS I S: ± Trend percentages state several years¶ financial data in terms of a base year, which equals

100 percent

T rend index = Current Year Amount X 100

Base Year Amount

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ABC Corp

BASE YEAR

CURRENT YEAR

Income statements Fiscal year ended December 31

(RM in millions)

2007 2006 Change

analysis

%

Net sales

Cost of goods sold

1,938.0

1,128.5

1,766.2

1,034.5

Gross operating profit 809.5 731.7

Selling, administrative, and other operating expenses

Depreciation & authorization

Other income, net

497.777.1

0.5

445.362.1

12.9

Earnings before interest & taxes 234.2 237.2

Interest expense 13.4 7.3

Earning before taxes 221.8 229.9

Income taxes 82.1 88.1

Net profit after tax

Dividends paid per share

Earnings per share (EPS)

Number of common shares

outstanding ( in millions)

138.7

0.15

2.26

61.8

116.0

0.13

2.17

65.3

Base year Current

year

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Common Size Analysis

Done by proportioning a group or subgroup of the items in the

account . Also called v ertical analysis. Common size financial

statement analysis is useful to understand the internal make up of a

company including the:

± Distribution of financing across liabilities and utilization of assets (for common size

balance sheet) and

± Distribution of expenses and profit over sales (for common size income statement)

There are two types of common size analysis:

± common size income statement

± common size balance sheet.

Specifically in analyzing balance sheet, it is common to express total asset (or

liabilities plus equity) as 100%. Then, accounts within these groupings are

expressed as a percentage of their respective totals.

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ABC Corp

Comparative Balance Sheet

December 31

(RM in millions)

2007 Common size

analysis

Assets

Current assets

Cash

Receivables

Inventories

Other current assets

95.8

227.2

103.7

73.6

Total current Assets 500.3

N oncurrent Assets

Gross Property, plant, & equipment

Accumulated depreciation & depletion

Net Property, plant, & equipmentOther noncurrent assets

771.2

(372.5)

398.7

42.2

Total Noncurrent assets 440.9

Total Assets

Liabilities and Stockholders¶ Equity

Current liabilities

Account payable

Short-term debt

Other current liabilities

941.2

114.2

174.3

85.5

100%

Total Current liabilities 374.0

N oncurrent liabilities

Long-term debt

Other noncurrent liabilities

177.8

94.9

Total noncurrent liabilities 272.7

Total liabilities

S tockholders equity

Common shares

Retained earnings

646.7

92.6

201.9

Total equity 294.5Total Liabilities and Stockholders¶ equity

941.2 100%

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ABC Corp

Income statements

Fiscal year ended December 31

(RM in millions)

2007 Common size

analysis

Net sales

Cost of goods sold

1,938.0

1,128.5

100%

Gross operating profit 809.5

Selling, administrative, and other operatingexpenses

Depreciation & authorization

Other income, net

497.777.1

0.5

Earnings before interest & taxes 234.2

Interest expense 13.4

Earning before taxes 221.8

Income taxes 82.1

Net profit after tax

Dividends paid per share

Earnings per share (EPS)

Number of common shares outstanding ( in

millions)

138.7

0.15

2.26

61.8

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R atio Analysis

Analyzed to identify the company's strengths and

weaknesses and useful insights can be gained

through the process.

Classifications of ratio that the most commonly

used are:

± Liquidity ± Debt (or Leverage)

± Activity (or Turnover)

± Profitability

± Market ratio

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Liquidity Ratio

Determine a company's ability to pay off its short-terms

debts obligations.

Generally, the higher the value of the ratio, the larger

margin of safety that the company possesses to cover its

short-term debts

It can give a sense of the efficiency of a company'soperating cycle or its ability to turn its product into

cash.

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i) Current Ratio

Measures a company's ability to pay short-term

obligations.

Current R atio = Current Assets

Current Liabilities

Example: Current ratio for ABC corp in 2007 = 500.3 = 1.34

374.0T his figures indicate that ABC had RM 1.34 in short-ter m resources to

ser v ice ev ery dollar of current debt. S uggest that the company has

more than enough current asset to cov er it¶s current liability .

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ii) Acid-Test Ratio

The most stringent liquidity test as it indicates whether a

firm has enough short-term assets to cover its immediate

liabilities without selling inventory.

= ( Cash + Accounts R ecei v able + S hort-ter m Inv est ments)

Current Liabilities

or = T otal Current Asset - Inv entory

Current Liabilities

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iii) Working Capital

Measure of both a company's efficiency and its short-term financial

health. It frequently used to derive the working capital ratio, which is

working capital as a ratio of sales.

W orking Capital = Current Assets ± Current Liabilities

± P ositi v e working ca pital means that the company is able to pay off

its short-ter m liabilities.

± N egati v e working ca pital means that a company currently is

unable to meet its short-ter m liabilities with its current assets (i.e.

cash, accounts recei v able and inv entory).

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iV) Working Capital Turnover

Measure, which compares the depletion of

working capital to the generation of sales over a

given period. This provides some useful

information as to how effectively a company isusing its working capital to generate sales.

W orking Ca pital T urnov er =_____S ales____

W orking Ca pital

the higher the working capital turnover, the better because it

means that the company is generating a lot of sales compared to

the money it uses to fund the sales.

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Leverage Ratio

i) Debt Ratio

Indicates the proportion of debt a company has

relative to its assets. The measure gives an ideato the leverage of the company along with the

potential risks the company faces in terms of its

debt-load.

T otal Debt = T otal Debt T otal Assets

A debt ratio of greater than 1 indicates that a company has more debt

than assets; meanwhile, a debt ratio of less than 1 indicates that a

company has more assets than debt.

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ii) Debt/Equity Ratio Measure of a company's financial leverage calculated by dividing its Long

Term liabilities by stockholders' equity. Debts to Equity ratio also were used

to measure ³Capital Structure´ of a company.

Debt/ E quity R atio = Long T er m Debt

S hareholders¶ E quity

A high debt/equity ratio generally means that a company has been

aggressive in financing its growth with debt. This can result in volatile

earnings as a result of the additional interest expense.

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Activity Ratio

i) Inventory turnover Inventory include the raw materials, work-in-process

goods and completely finished goods

Inventory Turnover = Cost of a Good Sold Average Account Receivables

Example: IT = RM 1,938.0 = 18.69

RM 103.7

T he more sales the company can get out of its inv entory, the better the return on this

v ital resource. A turnov er of al most 19 ti mes a year means that the fir m is holding

inv entory for less than a month ± actually for about 20 days (365/18.9 = 19.5. T he

higher the turnov er figure, the less ti me an item s pends in inv entory and the better the

return the company is able to earn from funds tied u p in inv entory.

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ii) Receivables Turnover Ratio

Number of times that accounts receivable amount

is collected throughout the year.

Accounts Receivable Turnover = Sales___________

Average Accounts Receivable

Some companies' reports will only show sales - this can

affect the ratio depending on the size of cash sales.

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Profitability Ratio

Profitability analysis is a financial metrics that are used

to assess a business's ability to generate earnings as

compared to its expenses and other relevant costs

incurred during a specific period of time.

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Profit Margin

It measures how much out of every dollar of

sales a company actually keeps in earnings.

P rofit M argin = N et Income/ N et P rofit

R ev enue/ S ales

A higher profit margin indicates a more profitable

company that has better control over its costs

compared to its competitors.

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ii) Return on Asset (ROA)

An indicator of how profitable a company is

relative to its total assets. ROA gives an idea as

to how efficient management is at using its assets

to generate earnings.

R eturn on Asset ( ROA ) = N et Income

T otal Assets

ROA tells you what earnings were generated from invested capital

(assets).

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iii) 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.

R eturn on E quity ( ROE ) = N et Income________

S hareholder¶s E quity

The ROE is useful for comparing the profitability of a

company to that of other firms in the same industry.

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DuPont Method

DuP ont M ethod is a method of analysis that breaks down return on equity into the sources

of that profitability. T he method is named for

the company that originally conducted the

analysis.

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(1) (2) (3)

Net Profit

Margin

X Total Asset

Turnover

= Return On

Investment

Net income

Net sales

X Net sales

Total assets

= Net income

Total assets

(3) (4) (5)

Return On

Investment

X Financial

Leverage

= Return On

Equity

Net income

Total assets

X Total assets

Stockholders¶

equity

= Net income

Stockholders¶

equity

The first three ratios reveal that the (3) return on investment (profit generated from the overall

investments in assets) is a product of the (1) net profit margin (profit generated from the sales)

and the (2) total asset turnover (the firm¶s ability to produce sales from its assets). Extending

the analysis, the remaining three ratios show how the (5) return on equity (overall return to

shareholders, the firm¶s owners) is derived from the product of (3) return on investment and (4)

financial leverage (proportion of debt in the capital structure).

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Sources of Company¶s Profit

It is possible to break down the return on equity

(ROE) ratio into several smaller parts. This is

useful because there are five ways for a company

to increase its profits. Four of these ways are

captured in the following equation:

M argin x T urnov er x Le

v erage x T ax effect = ROE

E .B.T x S ales x T otal Assets x 1 ± tax rate = ROE

S ales T otal Assets E quity

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COMPANY STRATEGY«.

± Improve its profit margin by doing a better job of controlling

costs and pricing its products appropriately

± Increase its turnover through leverage on the use of effective

advertising, branding, sales promotions, and training of its

sales force.

± Increases leverage by utilizing bit more to finance the company.

± Reduce the amount of taxes paid as a result of effective

tax planning (although this is generally the least important of the

four factors).

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Investors would rather invest in a company that

is:

± Performing very well in the operations area

(purchasing, production, working etc.) and which is

conservatively financed (i.e., has a low level of debt),

rather than

± Performing very poorly in the operations area and is

very aggressively financed (i.e., has a high level of

debt)?

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HOW TO USE RATIO«.

There are two primary ways to use financial ratios:

± Compare a ratio's value over several periods of

time (trend analysis or time-series analysis). If we

see a deteriorating trend in any ratio's values over severalquarters or years, we can investigate to find the cause.

± Compare the company's ratios to the industry

average (cross-sectional analysis). A single ratio value

by itself usually means nothing - we need a standard, or benchmark , to compare it to. This benchmark is usually the

industry average (i.e., the ratio's average value for all firms in the

industry).

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Cautions in Using Ratios

Ratios don't prove that a problem exists or provide definite answers to any of our questions

Realize that there may be significant differences between the characteristics

of the company and the "average" firm in the industry

Always make sure that you are calculating a ratio exactly as the industry

average ratio is calculated.

Companies frequently don't have the same fiscal year

Companies' accounting practices may differ considerably.

Be careful about depending too much on any one ratio.

Audited financial statements should be used whenever possible.

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END OF CHAPTER 3

TIME TO TEST YOUR UNDERSTANDING«.«.

Get into your group and lets do this exercise !!!!

050 Chapter 3

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