Lecture 5 Financial Statement Analysis

8/9/2019 Lecture 5 Financial Statement Analysis

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Chapter 6Van Horne and WachowiczFundamentals of Financial Management (11/e)

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Financial statements (or financial reports) areformal records of the financial activities of abusiness, person, or other entity. Financial

statements provide an overview of a business orperson's financial condition in both short andlong term.

All the relevant financial information of a

business enterprise, presented in a structuredmanner and in a form easy to understand, arecalled the financial statements. There are fourbasic financial statements:

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Balance sheet: also referred to as statement of financialposition or condition, reports on a company's assets,liabilities, and net equity as of a given point in time.

Income statement: also referred to as Profit and Lossstatement (or a "P&L"), reports on a company's income,expenses, and profits over a period of time. Profit & Lossaccount provide information on the operation of theenterprise. These include sale and the various expensesincurred during the processing state.

Statement of retained earnings: explains the changes ina company's retained earnings over the reporting period.

Statement of cash flows: reports on a company's cashflow activities, particularly its operating, investing andfinancing activities.

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Financial statement analysis refers to anassessment of the viability, stability and

profitability of a business, sub-business orproject. It is performed to prepare reports using ratios

that make use of information taken from

financial statements and other reports. Thesereports are usually presented to topmanagement as one of their bases in makingbusiness decisions.

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Profitability- its ability to earn income and sustain growthin both short-term and long-term. A company's degree ofprofitability is usually based on the income statement,which reports on the company's results of operations;

Solvency- its ability to pay its obligation to creditors andother third parties in the long-term;

Liquidity- its ability to maintain positive cash flow, whilesatisfying immediate obligations;

Stability- the firm's ability to remain in business in the long

run, without having to sustain significant losses in theconduct of its business. Assessing a company's stabilityrequires the use of both the income statement and thebalance sheet, as well as other financial and non-financialindicators.

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Past Performance - Across historical time periodsfor the same firm (the last 5 years for example),

Future Performance - Using historical figures andcertain mathematical and statistical techniques,including present and future values, Thisextrapolation method is the main source of errorsin financial analysis as past statistics can be poorpredictors of future prospects.

Comparative Performance - Comparisonbetween similar firms.

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The tools used to assess the financial condition and performance ofthe firm is financial ratios. In finance, a financial ratio or accountingratio is a ratio of two selected numerical values taken from anenterprise's financial statements.

There are many standard ratios used to try to evaluate the overallfinancial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current

and potential shareholders (owners) of a firm, and by a firm'screditors.

Security analysts use financial ratios to compare the strengths and

weaknesses in various companies. If shares in a company are traded in a financial market, the marketprice of the shares is used in certain financial ratios.

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Liquidity Ratios:

Liquidity is the ability of an asset to be

converted into cash without a significantprice concession.

Liquidity ratios are used to measure a firmsability to meet short-term obligations. They

compare short-term liabilities to short-term(current) resources available to meet these

obligations.

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Current ratio shows a firms ability to cover itscurrent liabilities with its current assets

The higher the current ratio, the greater the abilityof the firm to pay its liabilities

Standard current ratio is 2:1

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This ratio concentrates on more liquid assets

It excludes less liquid inventory This ratio provides a more penetrating

measure of liquidity

Standard is 1:1

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Financial Leverage or Debt Ratios: Leverage or leveraging refers to the use of debt to

supplement investment or the degree to which an investoror business is utilizing borrowed money. Financial leveragetakes the form of a loan or other borrowings (debt), theproceeds of which are invested with the intent to earn agreater rate of return than the cost of interest. Companies that are highly leveraged may be at risk of

bankruptcy if they are unable to make payments on their debt;

they may also be unable to find new lenders in the future. Financial leverage is not always bad, however; it can increase the

shareholders' return on their investment and often there are taxadvantages associated with borrowing.

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It shows the extent to which the firm is financed by debt It tells the contribution of creditors for each unit of

money being provided by the shareholders (owners) Lower the ratio better for creditors because higher

cushion Sometimes preferred stocks are included as debt rather

than as equity Low ratio may attract more creditors

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It shows the percentage of firms assets

supported by debt financing

Higher ratio means higher financial risks Lower ratio means lower financial risks

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Total capitalization represents all long-term debtand shareholders equity. So, it is the total long-term debt and all types of equity of a companythat constitutes its capital structure.

It tells us the relative importance of ling-termdebt to the capital structure (long-term financing)of the firm

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Companies can finance their operations through eitherdebt or equity. The debt-to-capital ratio gives users anidea of a company's financial structure, or how it is

financing its operations, along with some insight into itsfinancial strength. The higher the debt-to-capital ratio,the more debt the company has compared to its equity.This tells investors whether a company is more prone to

using debt financing or equity financing. A company withhigh debt-to-capital ratios, compared to a general orindustry average, may show weak financial strengthbecause the cost of these debts may weigh on thecompany and increase its default risk.

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Ratios takes data from income statement and

balance sheet.

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Coverage ratios are designed to relate the financialcharges to its ability to service, or cover, them. It indicates a firms ability to cover interest charges, and

thus avoid bankruptcy. Higher the ratio, greater is the ability of the firm to cover

interest charges. A combination of debt ratios with coverage ratios may

give deeper insight about the ability of a firm to avoid debtrelated risks or financial risks.

A cash flow analysis is also necessary.

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Activity ratios, also known as efficiency or

turnover ratios, measure how effectively the

firm is using its assets.

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Provides insight into the quality of the firms receivablesand how successful the firm is in its collections. This ratio tells us the number of times account receivables

have been turned over during the year. If sales are seasonal, use year end receivables data not

correct. Use average of month end receivables data. In growth case, use average of beginning and end of year

receivables data. Analyze quality of receivables and its liquidity.

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It shows average collection period or state ofliquidity of receivables.

Receivable turnover in days should bereasonable according to standard of theindustry.

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The process of classifying accounts

receivables by their age outstanding as of a

given date. The analysis is based of the term of accounts

receivables (2/10, net 30).

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Firm may analysis its ability to pay suppliers

and its potential as credit customers.

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If purchase data not available cost of goods

sold may be used

Compare payables accounts with terms ofcredit

Beginning Inventory + Purchase COGS =Ending Inventory

Purchase =COGS + Ending Inventory

Beginning Inventory

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How effectively the firm is managing inventory. It tells

how many times inventory is turned over toreceivables through sales during the year

Consider seasonality and growth situations. Higher inventory turnover indicates higher efficiency.

Higher inventory turnover may increase stockout risk.

Stockout is not having enough inventory items ininventory to fill an order. IT ratio may be calculated separately for different

categories of products

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Operating Cycle The length of time from the commitment

of cash for purchases until the collection of receivablesresulting from the sale of goods or services.

Operating Cycle = Inventory turnover in days (ITD) +Receivable turnover in days (RTD)

Cash Cycle The length of time from the actual outlay of cashfor purchases until the collection of receivables resulting from

the sale of goods and services.Cash Cycle = Operating Cycle (ITD + RTD) Payable

turnover in days (PTD) Short operating cycle needs less resource

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Profitability ratios relate profits to sales and

investment.

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Gross Profit Margin= (Net Sales-Cost of

Goods Sold)/(Net Sales)

Net Profit Margin=(Net Profit after

taxes)/(Net Sales)

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Lecture 5 Financial Statement Analysis

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