Finance 110631-1165

FINANCIAL ANALYSIS IN ENTERPRISES

Finance 110631-1165

Lecture outline

Financial statements- structure and

interpretation

Techniques of financial analysis

Finance 110631-1165

Financial statement- definition

A financial statement is a formal record of

the financial activities of a company, person,

or other entity

Finance 110631-1165

Financial statements as an element of financial reporting

The obligation of financial reporting creates

the necessity of financial statements

International rules concerning the structure of

financial statements

International Accounting Standards Board

for the EU, Canada and Australia, Generally

Accepted Accounting Principles in the USA

Finance 110631-1165

Why do companies publish financial statements?

The information about the financial position and performance of the company is essential to many users

Owners and managers Investors/prospective investors Public finance entities Financial markets participants Employees

The structure of financial statements

Balance sheet (statements of financial position)

Income statement (statement of comprehensive income)

Statement of changes in equityCash flow statement

Finance 110631-1165

Finance 110631-1165

Balance sheet

Assets Fixed assets Current assets

Liabilities Equity Borrowed capital

(interest payments) Other liabilities (no

interest payments)

Income statement

All items of income and expense in a given period

Sometimes called the statement of profit and loss

Finance 110631-1165

Finance 110631-1165

Income statement

The statement should include information about revenue, finance cost share of the profit or loss of associates tax expense profit or loss,

Finance 110631-1165

Statement of changes in equity

The statement should include Total comprehensive income with distiction of the

amounts attributable to owners and non-controlling

interest

For each component of equity, the effects of

restrospective application

For each component of equity, the changes between

the amount at the beginning and the end of the period

Finance 110631-1165

Cash flow statement

Cash flow- the movement of money into a

company and out of the company

The statements shows how changes in balance

sheet accounts and income affect cash

The statements involves operating, investing,

and financing activities

Finance 110631-1165

Finance 110631-1165

Cash flow statement-interpretation

Useful in determining the short-term

ablity to meet the financial commitments of

a company

Reflects a firm's liquidity

Finance 110631-1165

The purpose of financial analysis

To evaluate the performance and the financial position of the company given the strategy of the firm, the economic and legal environment, the accounting flexibility and prospects

How is the financial analysis performed?

To evaluate the company’s performance we need a benchmark

Performance compared to past resultsPerformance compared to other

companiesArtificial benchmarks build on economic

experience

Finance 110631-1165

Finance 110631-1165

Non-comparability of financial

statements Changes of the time span of the financial year

Different balance sheet dates

Changes in company structure

Accounting method changes and accounting

estimate changes

Differences in presentation

Finance 110631-1165

Types of financial analysis

Horizontal analysis

Common size analysis

Segmental analysis

Ratio analysis

Horizontal analysis

Also called trend analysis

Aimed at comparing the respective

positions of the financial statement with

previous statements

It usually covers a five year period

Finance 110631-1165

Finance 110631-1165

Horizontal analysis

Finance 110631-1165

Common size analysis

Aimed at comparing the performance of

firms usually from the same industry

Size adjustment is needed- the positions

in the balance sheet are expressed

relatively to total assets, in the income

statement relatively to the amount of sales

Finance 110631-1165

Segmental analysis

Aimed at reporting accounts on a breakdown of

the total revenue over the different business

segments

Segmental reporting data may be subject to

manipulation as the company may shift the data

between segments in order to show to desirable

result

Finance 110631-1165

Ratio analysis

The ratio analysis is aimed at answering the following questions: Can the company meet its financial

commitments? How successful, profitable and efficient is the

company? Is the business a good investment for

shareholders?

Finance 110631-1165

Profitability of the firm

The ratio combines the result of a firm with the investments made for the generation of this result

Return on equity

ROE=Profit/EquityReturn on assets

ROA= (Profit before tax+ Interest)/ Total assets

Finance 110631-1165

Profitability of the firm (1)

Return on capital employed

ROCE=(Profit before tax + Long term

interest)/(Equity + Long term debt)

Finance 110631-1165

Profitability of the firm (2)

Which investment base should be taken into

account?

From the beginning of the year?

An average equity base?

In practice the most common benchmark the

equity base at the end of the year

Finance 110631-1165

Profitability of the firm- benchmarks

Time series or competitor comparisons The proceeds from an investment in risk

free loans as benchmark This measure allows to see if the

owners would be better off selling the company and placing the money in a bank?

Profitability of the firm-breakdown analysis

To see the which components of the firms activity played a role in shaping the profitability one can break down the ROA measure

The components relate to sales results and investment results

ROA=Profit/Total sales * Total sales/Assets

Profit/Total sales- called profit margin reflects operating decisions

Total sales/Assets- called efficiency ratio reflects investment decisions

Finance 110631-1165

Finance 110631-1165

Liquidity and solvency

Useful especially for external stakeholdersInformation about the financial status can

be obtained by analyzing the assets available to the company to meet its liabilities

Short, medium and long term analysis

Liquidity (1)

The subject of analysis are assets able to meet short term liabilities

The structure of working capital mattersCurrent ratio

CR=Current assets/Current liabilitiesAcid test ratio

ATR=(Current assets-Inventory)/Current liabilities

Finance 110631-1165

Liquidity (2)

Current assets are supposed to be converted into cash in the current operating cycle

The acid test ratio excludes inventory as this is the least convertible part of current assets

The benchmark for liquidity ratios depends on the industry

Finance 110631-1165

Solvency (1)

To see if the company is able to meet its long term liabilities one has to analyze the capital structure

Of crucial importance is most of all the ratio of own and borrowed capital

Debt/equity ratio- most popularA high debt/equity ratio implies higher

financial risk due to higher interest payments, pay-off deadlines etc.

Finance 110631-1165

Solvency (2)

Depending on the focus of the analysis the debt/equity ratio can be transformed

Debt/Equity+Debt

Long term debt/EquityOr expressed relatively to assets

Debt/assets

Short term debt/ assets

Finance 110631-1165

Solvency- benchmarks The debt equity ratio could be influenced

by national or institutional differences In bank based economies e.g. Germany,

France the debt/equity ratio will be higher than in countries with shareholder orientation e.g. UK

Firms from similar countries should be used as a benchmark

Finance 110631-1165

Investment perspective (1)

Is the company worth investing?Investment decisions require specific

ratios besides liquidity, efficiency and profitability

Dividends performance, earnings per share, price/ earnings ratio

Finance 110631-1165

Investment perspective (2)

Ratios for shareholders reported in financial statements

Companies can try to influence share prices by communicating to the market outside financial statements

Companies can create their own ratios eg.”like for like sales”, „profit before one-time” expenditures

Finance 110631-1165

Univariate and multivariate ratio analysis

Univariate analysis- one ratio is considered at a time, judgment is based on the respective ratios calculated

Multivariate analysis- the respective ratios are weighted and combined

A popular multivariate measure- the Z-score (Altman 1968)

Finance 110631-1165

The z-score Aimed at predicting company failure A risk measure Based on research in the US manufacturing sector Z-scores are sector specific-e.g.other weightings should

be applied for banks and manufacturing companies

Z=0,012x1+0,014x2+0,033x3+0,006x4+0,999x5 X1-working capital/total assets X2-retained earnings/total assets X3-earnings before interest and tax/total assets X4- market capitalization/book value of debt X5-sales/total assets

Finance 110631-1165

Source: Wikipedia

Financial analysis-remarks

The ratio analysis should be accompanied by common size and trend analysis

These methods are complementary

Finance 110631-1165

Finance 110631-1165

Example

Compute and compare the liquidity and

solvency ratios for company A and B Company A finances it’s activity via bank

loans. The value of inventory is 200 the value of financial assets 100, the value of fixed assets is 2000. The value of the bank loan is 1200 from which 500 is due in the current operating cycle.

Finance 110631-1165

Example

Company B leases the production infrastructure. The value of inventory is 200, the value of financial assets 100, the value of fixed assets is 800, the value of leased assets is 1200. The value of current liabilities is 100.

Finance 110631-1165

Literature

D. Alexander, A. Britton, A. Jorissen, International Finacial Reporting and Analysis, Cengage Learning, 2011