Chapter 6: Financial Statement Analysis

Study objectives Review financial statements A possible framework for analysis Balance sheet ratios Income statement and income statement/balance sheet ratios Trend analysis Common size and index analysis 1.What is financial analysis Analysis is to interpret certain information for decision purpose Financial analysis involves analyzing financial statements prepared in accordance with generally accepted accounting principles to ascertain information concerning the magnitude, timing, and riskness of future cash flows Different purpose of financial analysis The firm itself and outside providers of capital---creditors and investors---all undertake financial analysis. The type of analysis varies according to the specific interests of the party involved Trade creditors (suppliers) are interested in the liquidity of a firm The claims of bondholders (bankers or other creditors) are more interested in the cashflow ability of the firm to service debt over a long period of time Investors in a companys common stock are principally concerned with present and expected future earnings as well as with the stability of these earnings about a trend line Management also employ financial analysis for the purpose of internal control and to better provide what capital suppliers seek in financial condition Financial statements See page 128-129 balance sheet and income statement The probable defect of financial statements analysis: window dress (see page 135) 3.Use of financial ratios Financial ratio is an index that relates two accounting numbers and is obtained by dividing one number by the other Financial statements give the analyst a lot of accounting numbers, so why bother with a ratio? For the reason of comparison among firms 3.1Internal comparisons The analysis of financial ratios involves two types of comparison. the comparison of a present ratio with past and expected future ratio for the same company comparing the ratios of one firm with those of similar firms or with industry averages at the same point in time The meaning of internal comparison when financial ratios are arrayed over a period of years, the analyst can study the composition of change and determine whether there has been an improvement or deterioration in the firms financial condition and performance overtime 3.2External comparisons

The purpose of external comparison gives insight into the relative financial condition and performance of the firm; helps us identify any significant deviation from any applicable industry average (or standard). 3.3Types of ratios The commonly used financial ratios are of essentially two kinds. The first kind summarizes some aspect of the firms financial condition at a point in time. We call these balance sheet ratios, because both the numerator and denominator in each ratio come directly from the balance sheet. The second kind of ratio summarizes some aspect of a firms performance over a period of time. These ratio are called either income statement or income statement/balance sheet ratios Income statement ratios compare one flow item from the income statement to another flow item from the income statement Income statement/balance sheet ratio compare a flow (income statement) item in the numerator to a stock item in the denominator Comparing a flow item to a stock item poses a potential problem for the analyst. We run the risk of a possible mismatch of variables. Therefore, where appropriate, we may need to use an average balance sheet figure in the denominator of an income statement/balance sheet ratio to make the denominator more representative of the entire period 3.4Types of ratios Additionally, we further subdivide our financial ratios into five distinct types: liquidity, financial leverage, coverage, activity, and profitability ratios (see figure 6-2 page 134) No one ratio gives us sufficient information by which to judge the financial condition and performance of the firm. 3.5Balance sheet ratios What is liquidity? the ability of an asset to be converted into cash without a significant price concession Liquidity ratios: ratios that measure a firms ability to meet short-term obligations Liquidity ratios compare short-term obligations to short-term resources available to meet these obligations Short-term creditors pay attention to these ratios, because they indicate the present cash solvency of the firm 3.6Liquidity ratios Current ratio: current assets divided by current liabilities. Assumption: the current liability will be due within a year, and current assets will change into cash within a year, so the current liabilities will be paid back by current assets Example: Aldine Manufacturing company page 134, Comparisons with industry averages are meaningful in identifying companies that are out of line The current ratio is regarded as a crude measure because it does not take into account the liquidity of the individual components of the current assets Acid-test (quick) ratio: current assets less inventories divided by current liabilities. Assumption: the current liabilities will be due in a short time, so only those assets with

strong liquidity could be used to meet the obligations It shows a firms ability to meet current liabilities with its most liquid assets Example of Aldine Corporation and summary of its liquidity: page 136 3.7 Financial leverage ratios Financial leverage means that the use of debt financing can bring more earnings ability to firm, because the interest is fixed. If the firms profitability surpasses the interest rate, the firm will earn more with more debt financing. We shall study it later in corporate finance. 3.8 Debt ratios Debt ratios show the extent to which the firm is financed by debt The bigger the debt ratios, the bigger is the firms financial leverage Debt-to-equity ratio is computed by simply dividing the total debt of the firm (including current liabilities) by its shareholders equity The long-term creditors will show great interest in this ratio, because the lower the ratio, the higher the level of the firms financing is provided by shareholders, and the larger the creditor cushion in the event of shrinking asset values or outright losses Depending on the purpose for which the ratio is used , preferred stock is sometimes included as debt rather than as equity when debt ratios are calculated The ratio of debt to equity will vary according to the nature of the business and the variability of cash flows A comparison of the debt-to-equity ratio for a given company with those of similar firms gives us a general indication of the creditworthness and financial risk of the firm Debt-to-total-assets ratio is to divide a firms total debt by its total assets This ratio serves a similar purpose to the debt-to-equity ratio The computation of Aldine is on page 137. how to explain the results? 3.9 Income statement and income statement/balance sheet ratios Coverage ratios: ratios that relate the financial charges of a firm to its ability to service or cover them Bond rating service and creditors (such as banks) make extensive use of these ratios Interest coverage ratio: earnings before interest and taxes divided by interest charges. It indicates a firms ability to cover interest charges. It also sheds some light on the firms capacity to take on new debt For Aldine, in fiscal year 20x2 this ratio is $400000/$85000=4.71. with an industry median average of 4.0, Aldines ability to cover annual interest appears to provide a good margin of safety A broader type of analysis would evaluate the ability of the firm to cover all charges of a fixed nature. We shall discuss the topic later 3.10 Activity ratios Activity ratios, also known as efficiency or turnover ratios, measure how effectively the firm is using its assets how effectively the firm is using its assets is measured by the recycling speed of assets, why? In computing activity ratios for the Aldine, we use year-end asset levels. However, an

average of monthly, quarterly, or beginning and year-end balance is often employed (more representative of the entire period, not just year end) Receivables activity Receivable turnover ratio=annual net credit sales/average amount of receivables Assume that all 20x2 sales for Aldine are credit sales, Receivable turnover ratio is: $3992000/$678000=5.89. The median industry receivable turnover ratio is 8.1. So Aldines receivables are considerably slower in turning over. This might be an indication of a lax collection policy and a number of past-due accounts. If receivables are far from being current, we may have to reassess the firms liquidity When sales are season or have grown considerably over the year, using the year-end receivable balance may not be appropriate. With seasonality, an average of the monthly closing balances may be the most appropriate. With growth, an average of receivables at the beginning and end of the year might be appropriate Receivable turnover in days=days in the year/receivable turnover Although too high an average collection period is usually bad, a very low average collection period may not be good (maybe a excessively restrictive credit policy) Aging accounts receivables (see page140) The purpose of this is to make out how much receivables is past due, to further understand the liquidity of the firm Payables activity Aging of accounts payable Payable turnover ratio=annual credit purchases/average of accounts payable Payable turnover in days=days in the year/payable turnover The average payable period is valuable information in valuating the probability that a credit applicant will pay on time Inventory activity Inventory turnover ratio=cost of goods sold/inventory For Aldine, the ratio for 20x2 is $2680000/$1329000=2.02, and the industry median is 3.3. What does it mean? As with receivables, growth and seasonality, average amount is always favored Generally, the higher the inventory turnover, the more efficient the inventory management of the firm and fresher the inventory. However, sometimes a high inventory turnover may be a symptom of maintaining too low a level of inventory and incurring frequent stockout Inventory turnover in days=days in the year/inventory turnover Operating cycle Operating cycle is the length of time from the commitment of cash for purchases until the collection of receivables resulting from the sale of goods or services Mathematically, a firms operating cycle is equal to inventory turnover in days plus receivable turnover in days If we want to measure the length of time from the actual outlay of cash for purchase until the collection of cash from sales, cash cycle equals to operating cycle less payable turnover in days

Why worry about the firms operating cycle? The length of the operating cycle is an important factor in determining a firms current asset needs. A firm with a very short operating cycle can operate effectively with a relatively small amount of current assets and relatively low current and acid-test ratios A second look at Aldines liquidity Aldines current and acid-test ratios compared favorably to industry median ratios. However, the turnover ratios for both of these assets, and the resulting operating cycle, are significantly worse than the industry median values. These findings suggest that the two assets are not entirely current, this factor detracts from the favorable current and quick ratios Total asset (or capital) turnover ratio Total asset turnover= net sales/total assets Aldines total asset turnover for fiscal-year 20x2 is $3992000$3250000=1.23. The median total asset turnover for the industry is 1.66, so it is clear that Aldine generates less sales revenue per dollar of asset investment 3.11Profitability ratios Ratios that relate profits to sales and investment Is there a relation between profit and sales/investment? From the viewpoint of industry and the investors Profitability in relation to sales Gross profit margin=(net sales-cost of goods sold)/net sales A measure of the efficiency of the firms operations (why). Price is fluctuate with the total demand and supply, while the cost is determined by internal operation An indication of how products are priced Example of Aldine For Aldine, the gross profit margin for fiscal-year 20x2 is $1312000/$3992000=32.9%. It is significantly above the median of 23.8% of the industry, indicating that it is relatively more efficient at producing and selling products above cost Profitability in relation to sales Net profit margin=(net profit after tax)/net sales A measure of the firms profitability of sales after taking account of all expenses and income taxes Why we make this ratio? All the expenses aim at revenue, while net profit is the final goal of the firm Example of Aldine For Aldine, this ratio for fiscal-year 20x2 is $201000/$3992000=5.04%. It is above the median net profit margin (4.7%) for the industry, which indicates that it has a higher level of sales profitability than most of other firms in the industry Profitability in relation to investment ROI=(net profit after tax)/total assets For Aldine, ROI for fiscal-year 20x2 is $201000/$3250000=6.18%. This ratio compares unfavorably to a median value of 7.8% for the industry. What is the probable cause? ROI and Du Pont Approach ROI=Net Profit Margintotal asset turnover

Why we need ROI? Because neither the net profit margin nor the total asset turnover ratio provides an adequate measure of overall effectiveness Return on equity (ROE) ROE compares net profit after taxes (minus preferred stock dividend, if any) to the equity that shareholders have invested in the firm ROE=net profit after taxed/shareholders equity Investors pay more attention to ROE than to ROI, why? Because it is the real return to the investors Du Ponts ROE ROE=ROIEquity Multiplier ROE=Net Profit Margin total asset turnover (total assets/shareholders equity) ROE tells more about a firms profitability than ROI 4 Trend analysis Trend analysis is to compare the financial ratios for a given company over time to detect any improvement or deterioration in a firms financial condition and performance Example: Table 6-3 page 149 5 Common-size and index analysis Common size analysis is an analysis of percentage financial statements where all balance sheet items are divided by total assets and all income statement items are divided by net sales or revenues The aim of common-size analysis is to compare financial conditions of different periods or different firms Example Index analysis An analysis of percentage financial statements where all balance sheet or income statement figures for a base year equal 100% and subsequent financial statement items are expressed as percentage of their values in the base year The aim is similar to that of common-size Table 6-6, 6-7