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Financial Statement Analysis PPT

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Financial Statement

Analysis

Objectives of Financial

Statement Analysis

Understand reported financial data

Better manage a business

Provide a base for rational decision

making (though the major focus of

separate analyses and types of decision

under consideration will vary)

Make a reasonable assessment of

future financial condition based on

present and past financial conditions and

on best available estimate of future

economic occurrences

Objectives of Financial

Statement Analysis

Why not accept prepared financial

statements at face value?

Prepared financial statements require

some analysis as first step toward

extracting information from presented

data.

Decisions made on basis of financial

analysis are important and accepting

presented financial data at face value is

poor policy.

Ratio Analysis

Ratio analysis: financial ratios are used to

develop a set of statistics that reveal key

financial characteristics of a company

Ratios are compared with industry standards.

commercial services (i.e. Dun and Bradstreet, Robert Morris

Associates) or through industry trade services.

Analysts may have to develop their own standards by

calculating average ratios for leading companies in same

industry.

time for a particular company.

recessions to determine companys financial strength

during periods of economic adversity

Ratio Analysis

Four major categories of key financial ratios:

1. Profitability: bottom-line ratios designed to

measure earning power and profitability record of

company

2. Liquidity: ratios designed to measure ability of

firm to meet its short-term liabilities as they come

due

3. Operating efficiency: measures of efficiency

with which corporate resources are employed to

earn profit

4. Capital structure (leverage): measures of

extent to which debt financing is employed by

company

Ratio Analysis

1. Profitability:

1. Return on sales (ROS)

2. Return on assets (ROA)

3. Return on equity (ROE)

Ratio Analysis

1. Profitability

1. Return on sales (ROS or net margin)

ROS = Earnings after tax

Net sales

Net sales: dollar volume of sales less any

returns, allowances, and cash discounts

Ratio Analysis

1. Profitability

2.

total assets (ROTA) or return on

investment (ROI)):

ROA = Earnings after tax

Total assets

Ratio Analysis

1. Profitability

3. Return on equity (ROE):

Stockholders

Stockholders equity:

determinedequity

by deducting

ROE =

trademarks)

provide adequate dividends and to fund future

growth.

Ratio Analysis

2. Liquidity:

1.

2.

3.

4.

Current ratio

Quick ratio

Average collection period

Days sales in inventory

Ratio Analysis

2. Liquidity

1. Current ratio:

Current ratio =

Current assets

Current liabilities

accounts receivable, and inventories

Current liabilities: accounts payable, current

notes payable, and currently due portion of

any long-term debt

Ratio Analysis

2. Liquidity

2. Quick ratio (acid test):

Quick ratio =

Current liabilities

be at least 1 to 1.

Quick assets (current assets net of

inventories): assets that can be quickly

converted to cash

Ratio Analysis

2. Liquidity

3. Average collection period: measures

the speed with which receivables are

turned into cash

by firms selling terms

by more than 10-15

Net

sales

Average

days daily sales = 365 days

Average daily sales

Ratio Analysis

2. Liquidity

4. Days sales in inventory:

Inventory

Days sales in inventory =

Average daily sales

of goods sold plus gross profit margin

Not a good measure of physical turnover

Provides important benchmark against which to

compare ratio of sales dollars to inventory stocks of

one business to that of another and how efficiently

management is using its inventory resources to

support sales

Ratio Analysis

3. Operating efficiency ratios:

measure the relationship between

annual sales and investments in

various classes of asset accounts

1. Cost of goods sold to inventory

2. Sales to total assets

3. Sales to working capital

Ratio Analysis

3. Operating efficiency ratios

1. Cost of goods sold to inventory:

provides estimate of physical turnover

Cost ofrates

sales to inventory = Cost of goods sold

Inventory

inventory is being managed

Ratio Analysis

3. Operating efficiency ratios

2. Sales to total assets: measures

relationship between sales and assets

used to support those sales

Net sales

Sales to total assets =

Total assets

capital requirements of different industries

Ratio Analysis

3. Operating efficiency ratios

3. Sales to working capital:

Net sales

Sales to working capital =

Working capital

Recall:

liabilities

Ratio Analysis

4. Capital structure (leverage) ratios

capital to finance its operations

1.

2.

3.

4.

leveraged it is said to be.

Debt ratio

Long-term debt to total assets

Debt equity ratio

Times interest earned ratio

Ratio Anaylsis

4. Capital structure ratios

1. Debt ratio: measures relationship

between total assets and amount of

debt used to finance those assets

Debt ratio =

Total debt

Total assets

Ratio Analysis

4. Capital structure ratios

2. Long-term debt to total assets:

measures percentage of total assets

that is financed by long-term debt

Long-term debt

Long-term debt/Total assets ratio =

Total assets

Ratio Analysis

4. Capital structure ratios

3. Debt equity ratio: measures

relationship between capital supplied

by lenders (debt) and capital supplied

by owners (equity)

Debt equity ratio =

Total debt

Equity

Ratio Analysis

4. Capital structure ratios

4. Times interest earned ratio:

interest and taxes (EBIT) to interest

expense

Income tax Earnings before interest and taxes

Interest expense

Ratio Analysis

Interrelationships Among Ratios

Firms profitability, liquidity

position, operating efficiency, and

leverage position are all

interrelated.

Ratio Analysis

DuPont system of analysis: relates

return on investment to firms profit margin

and asset turnover

Net income

=

Total assets

Net income

Sales

__Sales__

Total assets

income/sales) and asset turnover (sales/total assets)

ROA = margin x turnover

ROA is an overall performance measure of profitability

(profit margin) and its operating efficiency (total asset

turnover)

Ratio Analysis

Relationships among ROE, ROA and

leverage position

Net income

=

Stockholders equity

Net income X

Sales

Sales

Total assets

stockholders equity), the higher will be its ROE

relative to ROA.

Equity multiplier: measure of leverage used to show

that use of debt (leverage) is reflected in an increasing

ratio of assets to equity because use of debt allows

firm to add assets without increasing equity

Ratio Analysis

Computation and display of a set of ratios

for a given company in a given year is of

limited usefulness by itself.

performance in other years and

to appropriate standards for

companies of approximately

equal asset size in similar

industries.

Common-Size Statements

Common-size financial

statement: expresses all accounts

on balance sheet and income

statement as a percentage of some

key figure

Common-Size Statements

Common-size balance sheet

Analyzes internal structure and

allocation of firms financial resources

Asset side shows how investments in various

financial resources are distributed among asset

accounts

Liabilities and equities side shows percentage

distribution of financing provided by current

liabilities, long-term debt, and equity capital

Common-Size Statement

Common-size income statement

Shows proportion of sales or revenue

dollar absorbed by various cost and

expense items

Sequence of Analysis

Main objective of analysis determines

relative degree of emphasis to place

on each area of analysis (profitability,

liquidity, operating efficiency, or

capital structure)

But one logical framework can be

employed to systematically

explore financial health of

organization

Sequence of Analysis

1. Specify clearly objectives of analysis

and develop set of key questions

that should be answered to attain

this objective

2. Prepare data (i.e. key ratios and

common-size statements) necessary

to work toward specified goals

Sequence of Analysis

3. Analyze and interpret numerical

information developed in prepared

data

First examine information provided by

ratio analysis in order to develop overall

feel for potential problem areas

Then use preliminary questions and

opinions developed during analysis of

ratio data to focus on information

contained in common-size statements

Sequence of Analysis

4. Form conclusions based on data and

answer questions posed in Step 1

Present specific recommendations,

backed up by available data, along with

brief summary of major points

developed previously

Begin written report with summary of

conclusions developed in this final

phase

Case Study

Technosystems, Inc.

Technosystems: 3-year-old, privately

owned company engaged in wholesale

distribution of plumbing, heating, and air

conditioning

President: John Diamond

specializing in sale and leasing of heavy

construction equipment

President: David Walker

CPA: Carla Gilberti

Case Study

Technosystems, Inc.

David and Carla had no interest in

operating a new company, but they agree

to become equal partners in financing

Technosystems if John would start up and

manage it.

Technosystems was originally financed

with a $100,000 loan from David and

Carla, payable in ten annual installments

of $10,000 plus 14% interest on declining

balance.

Case Study

Technosystems, Inc.

Key Financial Ratios - See exhibit 6.3

Technosystems is undercapitalized

Debt ratio is extremely high

Total debt is equal to almost 80% of total

assets, compared with industry standard of

50%

Long-term debt is equal to nearly 30% of total

assets, almost double industry standard of 15%

Debt is private debt loaned to company by two

of its partners

Case Study

Technosystems, Inc.

Key Financial Ratios - See exhibit 6.3

Profitability ratios

Overall level and trend of earnings looks

positive

ROS is just below industry average of 3.5%,

and shows rapidly increasing trend

ROA is increasing rapidly and above industry

average

ROE is extremely high due mainly to high

debt position and low equity relative to debt

Case Study

Technosystems,

Inc.

Key Financial Ratios - See exhibit 6.3

Profitability ratios (continued)

ROA has improved as result of improvement in both ROS

ratio and asset turn over ratio:

ROA = (Profit margin) x (Asset turnover)

ROA (2008)= (3.34%) x (4.5) = 15.0%

ROA (2007) = (2.10%) x (3.6) = 7.5%

High rate of ROE of 68.1% is result of high debt position:

ROE = (ROA) x (Total assets/Equity)

ROE = (15.03%) x ($284,100/$62,700) = (15.03%) x

(4.53) = 68.1%

The higher this ratio, the more debt used

Case Study

Technosystems, Inc.

Key Financial Ratios - See exhibit 6.3

Liquidity ratios

Current ratio is below industry average

Quick ratio is approximately equal to industry

average

Average collection period is well below

industry average (indicates that company is

doing excellent job of collecting its receivables)

Inventory control (below-average days sales

in inventory number) is excellent

Case Study

Technosystems, Inc

Key Financial Ratios - See exhibit 6.3

Operating efficiency ratios

Inventory turnover (cost of sales to

inventory ratio), sales to total assets,

and sales to working capital ratios are

all above industry averages

Case Study

Technosystems, Inc.

Common-Size Analysis

Common-size balance sheet (see exhibit 6.4)

Fixed assets as percentage of total assets have

increased since 2001

Increase in retained earnings account and hence

total equity as percent of total assets

Sharp decrease in percentage of total assets financed

by current liabilities and long-term debt

Within working capital accounts, there is steady

decrease in total current assets as percent of total

assets

Case Study

Technosystems, Inc.

Common-Size Analysis

Common-size income statement (see

exhibit 6.5)

From 2006 to 2008, steady improvements:

Gross profit margin has increased from 18.9% to

25.4%

Pre-tax margin has increased from 0.1% to 5.6%

After-tax margin has increased from 0.1% to 3.3%

remained relatively steady and only increased

from 18.9% to 19.8%

Case Study

Technosystems, Inc.

Technosystems Conclusions

Profitability is excellent and improving.

Liquidity position is strong and improving.

Technosystems carries a heavy debt load.

Liquidation is unlikely since lenders are two of

the founders

Repayment of loans is likely since operating

efficiency ratios reflect sound management

and profitability is growing

Fraud and Financial Stress

Enron and Worldcom were two of the largest

corporate bankruptcies related to allegations

of widespread fraud, cover-ups, and criminal

behavior by senior executives of these

corporations and their auditors.

Massive fraud on this scale are now exception

due to increased public scrutiny, but there are

new risks and problems due to combination of

excessive leverage, bad real estate deals,

under-provisioning for loan, insurance or

derivative losses and/or bad management

Fraud and Financial Stress

New regulations will likely prohibit:

Leverage ratios greater than 30 to 1

Ability of homeowners to borrow all or more

than all of value of equity in their homes

Unregulated writing of credit default swaps

without appropriate insurance reserves

(accounting for concentration of risk)

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