Financial Statement Analysis

Understanding the Income Statement

The Income Statement

LOS 32.a The Income Statement measures the results of a companys performance over a period of time, typically one year The two main formats for the Income Statement are:
Single-step gross profit not shown Multi-step gross profit is shown

Operating income is also known as operating profit (EBIT) Revenue or turnover is a wider term than Sales Net revenue = gross revenue returns allowances duties and taxes

New York Co. Statement of Consolidated Income For the year ended 12/31/x5 Revenues Cost of Services Gross Profit (from continuing biz ops) Selling, General & Admin Income from Operations Interest Income Other Expense Income before Inc Taxes & Minority Interest Provision for Income Taxes Income before Minority Interest Minority Interest Net Income $250,000 130,000 120,000 45,000 75,000 5,000 (3,000) 77,000 (23,100) 53,900 (2,000) $51,900 12/21/x4 $225,000 125,000 100,000 40,000 60,000 4,500 (8,000) 56,500 (16,950) 39,550 (1,800) $37,750

The Income Statement

ILLUSTRATIVE Here is another format: + Revenue from the sale of goods and services Operating expenses = Operating income from continuing operations + Other income and expenses = Recurring income before interest and taxes from continuing operations Financing costs = Recurring income from continuing operations (pretax) +/- Unusual or infrequent items = Pretax earnings from continuing operations Income tax expense = Net income from continuing operations +/- Income from discontinued operations, extraordinary items, and cumulative effect of accounting changes (all net of tax) = NET INCOME
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Revenue Recognition
LOS 32.b

Some Basics

Revenues arise from the companys primary business activities Gains arise from secondary or peripheral activities What is a gain for one company can be revenue for another and vice versa Gains may be part of
Operating activities >> Scrap Sale Non-operating activities >> Gain on sale of PPE

Companies must disclose their revenue recognition practices in the footnotes (For example: in manufacturing set up revenue is recognized when goods are delivered and invoice is raised on the customer with substantial risks of ownership being passed on to customer; in services industry, say airlines, revenue is booked when services are rendered i.e. at the time of ticket bookings)
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Revenue Recognition
Main questions in revenue recognition: 1. When should revenue be recognized? - Timing 2. How much revenue should be recognized - Measurement 2 Methods

Accrual
Actual transaction has happened Service is complete When payment certain

Cash
Only when actual cash is received Irrespective of actual transaction

Agreement between buyer and seller necessary Price should be determined or determinable
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Revenue Recognition
Criteria for revenue recognition:
Under FASB:
1. 2. 3. 4. Evidence of arrangement between buyer and seller Product delivered or service rendered Price is determined or determinable Reasonable assurance of collection

Under IASB:
1. 2. 3. 4. 5. Transference of significant risks and rewards of ownership No continual managerial involvement nor control Revenue can be measured reliably Probable that economic benefits will flow to the entity Costs incurred can be measured reliably

Revenue Recognition
Revenue Recognition in Special Cases Before goods are delivered or services rendered
Ex: Long-term contract where the outcome can be reliably measured percentage of completion is used

At the time goods are delivered or services rendered

Under normal circumstances use normal revenue recognition criteria

After goods are delivered or services rendered

Ex: Automobile sale where doubt about buyers ability to complete payments installment and cost recovery method are appropriate (Another example Retention Money)
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Appropriate Revenue Recognition Method

1) Recognition at time of sale The earning process should be complete, and payment is reasonably assured The goods are delivered or the service provided to the customer. Sales revenue can be for cash or may be created before customer payments, resulting in an accounts receivable balance on the balance sheet

Before goods are delivered or services rendered completely (Long term contracts)
1. Percentage of completion method: When total costs & revenue can be estimated

Smoother income

Total profit earned is split over the entire contract period 3 step calculation: 1. degree of completion = cost incurred in X year / total estimated cost of the project 2. proportionate revenue to be recognized = degree of completion X total estimated revenue 3. Profit in X year = proportionate revenue cost incurred in X year

2. Completed contract method - When total cost & revenue can not be estimated
Uneven income

Do nothing except in last year In last year, recognize all cost, all revenue and hence all profit

Advisable in case of real estate, EPC contractors to ensure consistency in financial statements
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Appropriate Revenue Recognition Method

Installment Sales: when sales is made and payment is to be received in
parts and there is uncertainty over collection

Installment method: to be used when collectability of cash is reasonably

uncertain Total profit spread over years in ratio of actual cash received 2 step calculation Profit margin = (total revenue total cost) / total revenue Smoother income Profit recognized in X year = Profit margin X Cash received in X year Mainly used for real estate

Cost recovery method: to be used when collectability of revenue is highly

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uncertain Payments received are first set off against cost Uneven income Once costs have been met, payment received = profit

Appropriate Revenue Recognition Method

Barter Transaction
One company exchanges a good they sell (computer equipment) with another company (accounting services) Revenue must be recognized based on fair value of revenue from similar nonbarter transactions

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Revenue Recognition
Single company may use different revenue recognition practices for different businesses or different customers Implications for financial analysis:
Whether the revenue will be recognized sooner or later To what extend estimates must be made In order to compare companies, understand differences in policies

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Expense Recognition
LOS 32.c Expenses are decreases in economic benefits due to: Outflows or depletion of assets Incurrence of liabilities which result in decreases in equity

Direct expense Matching principle Against the corresponding revenue e.g. Inventory, warranty, Discount -

Period cost - Not related to a particular transaction - Expensed in the period it is incurred - e.g. Rent, advertisement

Loses may or may not occur in the normal course of business Some expenditures are incurred with the passage of time i.e. depreciation expense

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The Matching Principle

Example: Suppose your company buys a machine for $2,000. You hope this new machine will generate extra revenue of $1,000 per year for four years. If you account for this only on a cash basis, then you will lose ($1,000) the first year and make +$1,000 in each of years two, three, and four. Performance looks worse than it should the first year and too good the other years. However, if you use the matching principle, then you could capitalize the cost of the machine and expense it at the rate of ($500) per year for four years. Then, you will earn +$500 income each year.
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Expense Recognition
Issues in expense recognition:

1. Doubtful accounts when sale is made on credit, some

customers will not pay, so there will be credit losses Two methods for accounting for this 1. Direct write-off method (not usually consistent with GAAP) 2. Allowance for doubtful accounts usually based on percentage of sales, amount of receivables or amount overdue by specific periods of time

2. Warranties when sale of a product is made and a warranty is

offered, some amount of product will be deficient, so there will be expenses Amount must be estimated, and expense recognized at time of sale
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Expense Recognition
3. Depreciation and Amortization
Long-lived assets are expected to provide economic benefits greater than one year Typically employed in the production process of the firm Cost is allocated over time they provide economic benefits

Common types:
1. Tangible assets have physical existence and include land, buildings and equipment (depreciated, with the exception of land) 2. Natural resources purchased for economic value, taken from the earth and used up over time (depleted) 3. Intangible assets no physical existence, but value is based on advantages or rights conveyed to the owner and include patents, trademarks and goodwill (amortized, with the exception of intangibles with indefinite lives)
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Expense Recognition
4. Inventory costing
The inventory purchased in a period and carried over from prior periods is not the expense Expense (or Cost of Goods Sold) is the amount of inventory sold in a period Basic Inventory/COGS formula: Beginning Inventory + Purchases = COGS + Ending Inventory Three main methods of accounting for inventory:
First in first out (FIFO) Last in first out (LIFO) Weighted Average

The accounting method used is not necessarily (and most likely not) the actual flow of goods
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Expense Recognition
Implications for financial analysis Estimates of doubtful accounts and warranties affect reported net income Choice of depreciation/amortization method, useful live, and residual value affect asset values and reported net income Recognition of expenses sooner than later deemed more conservative Understanding differences in estimates is important to comparisons Footnotes and MD&A are areas to find the policies and estimates used by companies

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Financial Statement Analysis

Depreciation accounting is used in order to spread the cost of a fixed asset over the useful life of that asset, and is a process of allocation of the cost, not of valuation Physical deterioration and obsolescence will eventually limit the useful life of a depreciable asset All fixed PP&E is depreciated except for LAND

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Financial Statement Analysis

Long-term assets are generally reported at carrying value or book value (historical cost less accumulated depreciation, amortization or depletion) Asset impairment may occur if its revenue-generating ability is less than its carrying value

Initial expenditure: Acquisition cost of PP&E includes all expenditures reasonable and necessary to get the asset in place and ready for use

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Financial Statement Analysis

Future expenditures: Capital expenditure for the purchase or expansion of a long-term asset. Besides initial outlay, include additions, betterments and extraordinary repairs. All are recorded in asset accounts because they benefit future accounting periods. Revenue expenditure for the ordinary repairs and maintenance required to keep a long-term asset in good operating condition. Recorded in expense accounts because their benefit is realized in the current period.
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Financial Statement Analysis

LOS 32.d Factors that affect the computation of depreciation 1. Cost net purchase price 2. Residual Value estimated scrap, salvage or trade-in value as of the estimated date of disposal 3. Depreciable Cost cost less residual value 4. Estimated Useful Life total number of service units expected from a long-term asset. This may be measured in years, units to be produced, miles to be driven, or similar measures
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Financial Statement Analysis

Method used must reflect the pattern of consumption of the economic benefits of the asset No particular method is required

Methods of depreciation: 1. Straight-line equal amounts over each period 2. Diminishing balance accelerated early 3. Production method varies depending on production or usage
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Financial Statement Analysis

Timberlands, Oil and Gas Reserves and Mineral Deposits are natural resource assets Depletion cost per unit is calculated by taking the cost (acquisition of property and exploration/development costs) less the residual value by the estimated number of units available Depletion cost per unit is then multiplied by the number of units extracted (produced) and sold each accounting period Dry holes can either be fully expensed as they occur (successful efforts method) or capitalized (full cost method)

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Inventory Costing Methods Method Description COGS when prices are rising, relative to other methods Lowest Ending inventory when prices are rising, relative to other methods Highest

FIFO (first in first out)

Earliest items purchased sold first Most recent items purchased were sold first

LIFO (last in first out)

Highest

Lowest

Weighted Average

Averages total Middle costs over total units available

Middle

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Gross and Net Reporting of Revenue

Gross Reporting Sales and certain elements of COGS are reported separately Sales are higher under this approach

Net Reporting Sales and certain elements of COGS are reported on Net basis (Gross sales COGS) Sales are lower under this approach Criterion when can a firm use Gross Revenue Reporting under US GAAP
Be the primary obligor under the contract Bear the inventory risk and credit risk Be able to choose its supplier Have reasonable freedom to establish the price
All criterions to be met

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Financial Statement Analysis

LOS 32.e & f

Income and expenses that are not expected to continue in the future are nonrecurring
Discontinued operations Extraordinary items (no longer permitted under IFRS)

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Income and expenses that are not expected to continue in the future
Discontinued Operations
Management may decide to dispose of a business segment, because (i) it is losing money, (ii) it can be sold for a big profit, or (iii) for some other reason To be accounted as a discontinued operation, it must be separate both physically and operationally Measurement Date : When a plan of disposal is decided
Phase out period: time difference b/w actual phasing out and measurement date

The operating results of the segment are reported net of tax separately from income from continuing operations for all the years in which any part of Phase out period falls At the Measurement Date, estimated losses to the date of disposal are accrued Estimated gains are postponed
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Discontinued operations do not affect future continuing income.

Income and expenses that are not expected to continue in the future
Extraordinary Items
To be classified as extraordinary, an item must be (i) unusual, (ii) infrequent, AND (iii) material in amount Extraordinary items are reported net of tax separately from income from continuing operations An outside analyst should examine extraordinary items to be sure they really represent a non-recurring event

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Income and expenses that are not expected to continue in the future
Unusual or Infrequent Items
An event that is either unusual or infrequent, but not both, may be reported pre-tax as part of income from continuing operations It may be reported as part of other income or placed in COGS or SG&A

The analyst should try to separate out any unusual or infrequent items and decide if they really should be considered part of continuing operations (Example: restructuring charges to close plants & considered part of ordinary activities though this will not occur every year. Another example is gain or loss from sale of fixed assets)

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Changes in Accounting
Accounting Policy Changes
The impact of accounting changes is retrospectively application for both IFRS
and US GAAP.

In general, when a change is made from one acceptable accounting method to another, then the firm should retrospectively apply the change for all years shown in the financial report.

Prior Period Adjustments

A change from an incorrect to an acceptable accounting method is treated as an error, and its impact is reported as a prior period adjustment Restate prior periods shown in financials Cash Flow, I/S & B/S

Change in estimates
Just current and future statements - prospectively
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Financial Statement Analysis

LOS 32.i & j Comprehensive income change in equity during a period from transactions from non-owner sources. It includes:
1. Net income 2. Other revenue and expense items excluded from net income calculation

Four items are treated as OTHER comprehensive income:

1. 2. Foreign currency translation adjustments the effects of translating foreign subs assets and liabilities at current exchange rates Minimum pension liability adjustments when the divergence between the actual plan assets and the liability becomes too large, the difference is considered a change in comprehensive income Unrealized gains/losses on derivatives contracts accounted for as hedges changes in fair value of these contracts bypass the income statement Unrealized holding gains/losses on available- for- sale securities. Trading securities recognize unrealized gains/losses in the income statement
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3. 4.

Financial Statement Analysis

Understanding the Balance Sheet

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Financial Statement Analysis

LOS 33.a Balance sheet is also known as the statement of financial position. The Balance Sheet is a picture of the state of the firm at one point in time. 1. Assets what the firm owns 2. Liabilities what the firm owes 3. Stockholders Equity difference between Assets and Liabilities claimed by the owners of the firm

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Balance Sheet Format

Liabilities Shareholders' Equity Capital stock Additional paid in capital Treasury stock Retained Earnings Other comprehensive income Minority interest Long Term Debt/Bonds Secured Loans Long term Bonds Long term debt Long term debentures Unsecured Loans Trade and other payables Provisions Unearned Revenues Accrued liabilities Deferred tax liabilities Pension liabilities Amt Assets Property plant and equipments Intangible assets Natural resource assets Investments held till maturity held for resale held for trading financial assets Pension assets deferred tax assets Prepaid expenses Accounts receivable Cash and cash equivalents Cash Bank Balances Short term marketable securities Amt

Assets = Liabilities + Stockholders Equity

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Financial Statement Analysis

LOS 33.b

Types of Balance sheet

Report format assets, liabilities and equity listed in a single column Account format assets listed on the left and liabilities and equity listed on the right Classified balance sheet grouping together of the various classes of assets and liabilities Order of categorizing are current / non-current and order of liquidity Should distinguish between current and non-current first unless a presentation based on liquidity would provide more relevant and reliable information
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Balance Sheet Current Assets

Assets are divided into Current (less than one year) or Long-Term. Current Assets Cash and cash equivalents: Cash or government bills (less than 90 days); Marketable securities: Traded securities, either equity or debt; Accounts receivable: Amounts owed by customers from sales made on credit; Notes receivable: Amounts due from other non-trade activities; Inventory: The total of costs allocated to inventory; Prepaid expenses: Prepayments of future expenses.
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Balance Sheet Long Term Assets

Long Term Assets Property, Plant & Equipment: PP&E is valued at historic cost and other capitalized costs, less accumulated depreciation and impairments. Investments in affiliates: Investments in and advances to affiliates using the equity method of accounting. Includes Goodwill, trademarks, patents, and other assts without a physical shape
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Intangible assets:

Current Liabilities
Liabilities due within one year are classified as current. Current Liabilities Notes payable: Accounts payable: Amounts owed to financial creditors; Amounts owed to trade creditors;

Income taxes payable: Income taxes accrued during the past year that are not yet paid; Current portion of long-term debt: Current portion of capital leases The part of long-term debt due within one year;

The part of capital leases due within one year.

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Long Term Liabilities

Long Term Liabilities Financial obligations due in more than one year. Unearned Revenues Payment for work not yet performed Capital lease obligations: The present value of leases that have the characteristics of debt; Post-retirement benefit costs: The present value of future pension and other benefit costs; Deferred income taxes: Cumulative differences between accounting tax expense and taxes payable on the tax return; Minority interests: Equity of outsiders in the assets of the company. Long term debt:

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Balance Sheet Stockholders Equity

Stockholders Equity Preferred stock: Usually non-voting stock with restricted dividend rights; The total par value of outstanding common stock; Amounts above par received from sale of stock; The accumulation of companys earnings less dividends paid; Cost of repurchased stock;

Common stock: Additional paid in capital: Retained earnings: (Treasury stock):

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Financial Statement Analysis

LOS 33.c

Income statement reflects revenue and expenses reported on an accrual basis Differences between accrued revenue and expenses and cash flows result in assets and liabilities. Specifically:
1. Revenue on I/S before cash is received: results in accounts receivable on B/S 2. Cash received before revenue is reported on I/S: results in unearned revenue (liability) 3. Expense reported on I/S before cash is paid: results in accrued expense (liability) 4. Cash paid before expense is to be reported on I/S: results in
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prepaid expense (asset)

The Adjusting Process in Perspective

Advance Cash Payments for Future Services to be Received

Create

Noncash Assets in the Balance Sheet

Transformed by

Expenses in the Income Statement

Expiration of Unexpired Costs

Advance Cash Collections for Future Services to be Rendered

Create

Liabilities in the Balance Sheet

Transformed By Adjustments into

Revenues in the Income Statement

Earnings of Revenues Received in Advance

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The Adjusting Process in Perspective

Recorded by Adjustments as Increases in

Passing of Time and the Continuous Use of Services

Expenses in the Income Statement

and

Liabilities in the Balance Sheet

Decreased by

Later Cash Payments

Accrual of Unrecorded Expenses

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The Adjusting Process in Perspective

Recorded by Adjustments as Increases in

Passing of Time and the Continuous Rendering of Services

Revenues in the Income Statement

and

Noncash Assets In the Balance Sheet

Decreased by

Later Cash Collections

Accrual of Unrecorded Revenues

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Working capital
It is the amount of capital required to run day-today operations of the business Working capital = Current Assets - Current liability

>Current Assets : Likely to be converted into cash within - 1 year - 1 operating cycle >Current Liability : Likely to be paid of within - 1 year - 1 operating cycle >Operating Cycle Inventory holding period + receivable collection period >Cash conversion cycle (also called net operating cycle) = Inventory holding period + receivable collection period Creditors payment period = Operating cycle Creditors Payment period
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Whichever is longer

Whichever is longer

Valuations methods
Examples

1. Historical Value
Initial purchase cost As on acquisition date

Fixed assets Inventory under US GAAP if lower than Cost Current assets or fixed assets at liquidation of the business Assets acquired in a barter Leased fixed asset

2. Current cost (Replacement value)

Value at which an asset can be replaced at present condition

3. Realization Value
Value at which an asset can be disposed off

4. Fair Value
A genuine estimate of value by knowledgeable and willing parties in an arms length transaction

5. Present Value

Different valuation methods are used for different assets according to the nature of each asset

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Marketable securities (Investments)

Valuation

Income (Dividend / Interest)

Realized gain / Loss

Unrealized gain / loss

Held Till Maturity

Historical cost / Amortized cost* Market value Market value Income Statement

Not recognized

Available for Sale Trading

Equity Income Statement

*Note: Amortized cost will be explained in details as part of Financial Liabilities

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Financial Statement Analysis

LOS 33.e Measurement bases for Current Assets 1. 2. 3. 4. 5. 6. Cash and cash equivalents: At fair value Marketable securities: Accounts receivable: Notes receivable: Inventory: Prepaid expenses: Depends on classification Amounts owed by customers less allowances for uncollectible amounts; Amounts due from other non-trade activities less allowances for uncollectible amounts; Lower of cost or net realizable value; Amount of cash outlays not expensed
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Financial Statement Analysis

Measurement bases for Long Term Assets 1. Property, Plant & Equipment: PP&E is valued at historic cost and other capitalized costs, less accumulated depreciation and impairments. If not used in company operations, must be classified as investment assets Investments in affiliates: Investments in and advances to affiliates using the equity method of accounting. Gross carrying amount less accumulated amortization. With finite life should be amortized systematically over useful life, with infinite life should be tested for impairment annually
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2.

3.

Intangible assets:

Financial Statement Analysis

Measurement bases for Current Liabilities Notes payable: Accounts payable: At face value; At face value;

Income taxes payable: Amounts determined and recorded on income statement but not paid Current portion of The part of long-term debt due within one year long-term debt: valued at present value of face amount due; Current portion of capital leases The part of capital leases due within one year. and valued at present value of current year lease obligation

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Financial Statement Analysis

Measurement bases for Long Term Liabilities Present value of future obligations less current year. Capital lease obligations: The present value of leases that have the characteristics of debt; Post-retirement benefit costs: The present value of future pension and other benefit costs; Deferred income taxes: Cumulative differences between accounting tax expense and taxes payable on the tax return; Minority interests: Equity of outsiders in the assets of the company. Long term debt:

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Financial Statement Analysis

LOS 33.f

Financial instrument contract that gives rise to financial asset

of one entity and a financial liability or equity instrument of another Market-to-market cost adjusted to reflect current fair value Includes: 1. Investments in stocks 2. Investments in bonds 3. Notes payable 4. Derivative contracts

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Financial Statement Analysis

Measurement of Financial Assets and Liabilities
Measured at Fair Value Financial Assets Financial assets held for trading Available for sale financial assets Derivatives (either alone or imbedded) Nonderivative instruments w/ derivative hedges Financial Liabilities Derivatives Financial liabilities held for trading Nonderivative instruments w/ derivative hedges
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Measured at Cost or Amortized Cost Financial Assets Unlisted instruments Held to maturity investments Loans and receivables

Financial Liabilities All other liabilities

Financial Statement Analysis

LOS 33.g: List

and explain components of owners equity

1.

Capital contributed by owners includes common stock and preferred stock

Preferred stock usually have rights that take precedence over common stock Common and preferred may have par value or no par (governmental regulations) Number of shares authorized, issued and outstanding must be listed Minority interest equity interest of shareholders when the company consolidates but does not wholly own the subsidiaries

2. 3.

Retained earning (retained deficit)

Cumulatively earned (income statement) Less dividends

4.

Treasury stock (as a contra account)

Repurchase of shares by company management Do not receive dividends nor voting rights

5.

Accumulated comprehensive income

May either increase or decrease equity Not derived from the income statement or any transaction in equity shares
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Statement of Stockholders Equity

LOS 33.h The Statement of Stockholders Equity reconciles the beginning and ending balances of each component of the Balance Sheet Stockholders Equity.
To reconcile retained earnings, this statement reports net income, preferred and common dividends declared, any adjustments for stock splits, stock dividends, and acquisitions or quasireorganizations.

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Statement of Stockholders Equity

The format of the statement of stockholders equity is a matrix with the components of equity listed horizontally, summing to the right with total stockholders equity. Vertically, each event impacting a component of equity is shown.

The beginning balance of each component of equity is at the top, the closing balance is at the bottom, and the events reconciling the two in between.

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Statement of Stockholders Equity Example

Statement of Stockholders Equity For the Year Ended December 31, 20X4
Preferred Stock Opening Balance Stock Issue Conversion of Preferred Shares to Common Shares Stock Dividend Stock Purchase Min Pension Liab Net Income Cash Dividends Closing Balance $25 $450 $200 ($20) $455 ($100) ($15) ($100) ($75) $100 Common Stock $200 $150 $75 Retained Earnings $300 Accumulate Other Treasury Stock Total $600 $150

$25

($25) ($15) ($15) ($100) $200 ($20) $815

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Financial Statement Analysis

Ratio Analysis

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Ratio Analysis
LOS 35.d

Category
1 2 3 4 5

Description How efficiently a company completes day to day tasks Ability to meet its short term obligations Ability to meet long term obligations Ability to generate profitable sales from resources Quantity of asset or flow relative to specified claim

Activity Liquidity Solvency Profitability Valuation

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Analysis of Financial Statements

Activity ratios (also known as asset utilization or operating efficiency) How well does a company manage its assets Efficiency has a direct impact on liquidity, so some activity ratios are useful in assessing liquidity

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Analysis of Financial Statements

(1) Receivables turnover: (Revenue) / (Average receivables) (365 days) / (Receivables turnover)

(2) Days of sales outstanding (DSO):

(3) Inventory turnover:

(Cost of goods sold) / (Average inventory) (365 days) / (Inventory turnover)

(4) Days of inv. on hand (DHO) :

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Analysis of Financial Statements

(5) Payables turnover: (Cost of goods sold) / (Average accounts payable) (365 days) / (Payables turnover)

(6) Number of days of payables :

(7) Working capital turnover

(Revenue) / (Avg. working capital)

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Analysis of Financial Statements

(8) Total Asset Turnover: (Revenue) / (Average Total Assets) (Revenue) / (Average Net Fixed Assets)

(9) Fixed Asset Turnover:

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Analysis of Financial Statements

Liquidity ratios measures firms ability to meet its short term obligations:
(Current Assets) / (Current Liabilities) (Cash + S.T. Marketable Investments (2) Quick Ratio: +Receivables) / (Current Liabilities) (3) Cash Ratio: (Cash + S.T. Marketable Investments)/ (Current Liabilities) (4) Defensive Interval: (Cash + S.T. Marketable Investments + AR) Daily cash expenditures
(this ratio measures how long the company can continue to pay its expenses from its liquid assets without receiving any additional cash inflow)

(1) Current Ratio*:

* Working Capital = Current Assets Current Liabilities

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Analysis of Financial Statements

(5) Cash Conversion Cycle: (net operating cycle) (Days of Inventory holding) + (Days sales outstanding) - (No. of days of payables) The Cash Conversion Cycle measures the length of time required to go from cash (invested in operations) to cash received (result of operations)

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Analysis of Financial Statements

Solvency ratios are two types: debt (balance sheet items) and
coverage (income items). Solvency measures ability to pay debts.

Debt ratios measures companys balance sheet ability to fulfill

long term-debt obligations (1) Debt-to-Equity Ratio: (2) Debt-to-Assets Ratio*: (Total Debt) / (Total Equity) (Total Debt) / (Total Asset)

*This ratio is also called Total Debt Ratio

(3) Debt-to-Capital Ratio: (Total Debt) / [Total Capital (Debt + Equity)] (4) Financial Leverage Ratio: (Avg. Total Assets) / (Avg. Total Equity)
Definition of total debt = Interest bearing short term and long term debt

The above ratios try to measure the firms financial stability by looking at the proportion of outside debt, which generally has fixed payment schedules, to owners capital (equity).

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Analysis of Financial Statements

Coverage Ratios- Measures companys earnings ability to cover
debt obligations
(1) Interest Coverage:

(Earnings Before Income Taxes + Interest Expense) / (Interest Payments) = (EBIT) / (Interest Expense)
(2) Fixed Charge Coverage:

(EBIT + Lease Payments) / (Interest Expense + Lease Payments)

(3) Total Fixed Charge Coverage:

[(EBIT+ Lease Payments)] / [(Debt Interest) + (Lease Pmnts) + (Preferred Dividend / (1-Tax))]
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Analysis of Financial Statements

Measures of the firms Risk Profile
(1) Business Risk = Coefficient of Variation of Operating Earnings

OE

= (Standard Deviation of Operating Earnings) / (Mean Operating Earnings)

(2) Sales Variability = Coefficient of Variation of Sales

Sales

= (Standard Deviation of Sales) / (Mean Sales)

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Analysis of Financial Statements

Profitability Ratios: (Return on Revenue)
(1) Gross Profit Margin: (2) Operating Profit Margin: (3) Pretax Margin: (4) Net Profit Margin: (Gross Profit) / (Revenue) (EBIT) / (Revenue) (EBT) / (Revenue) (Net Income) / (Revenue)

The profit margins indicate the rate of profit on sales. The Gross Profit Margin can show the pricing power of the firm. The difference between the Operating and Gross Profits Margins indicates the firms overhead costs. Note: Operating Profits Gross Profits = Overhead
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Analysis of Financial Statements

Profitability Ratios: (Return on Investment)
(1) Return on Total Capital: (Operating income or EBIT) / (Average Total Capital) (Capital here means total capital available to the firm which is Short term & long term debt, equity) (2) Return on Equity (ROE): (Net Income) / (Average Total Equity)

(3) Return on Common Equity: (Net Income Preferred Dividends) / (Average Common Equity) (4) Return on Assets (ROA):(Operating Income or EBIT) / (Average Total Assets) (5) Also, (ROA):[(Net Income)+ Int. Exp (1-Tax Rate)] / (Avg. Total Assets)

The return ratios show the profits derived by the firm from its total capital or assets.
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Financial Statement Analysis

LOS 35.e Important to examine a portfolio of ratios Information from one ratio can help answer questions raised by another

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Analysis of Financial Statements

LOS 35.f

Traditional DuPont System:

ROE= Net Income / Average Shareholders Equity ROE= ROA ( Net Income/ avg total assets) / Leverage (avg total assets/ avg shrds equity) ROE can be decomposed to: ROE = (Profit Margin) x (Total Asset Turnover) x (Financial Leverage) Revenue Average Total Assets x ------------x -----------------Average Average Total Assets Shareholders Equity Note: sometimes spot year prices are used instead of averages Net Income = --------------Revenue

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Financial Statement Analysis

Extended DuPont System:
ROE = Tax burden x Interest burden x EBIT margin x Asset turnover x Leverage ROE = NI x EBT x EBIT x EBT EBIT Revenue Revenue x Avg Tot Assets Avg Tot Assets Avg Shrds Equity

The DuPont Systems were developed as a way to analyze a companys results by breaking down ROE into its components. You are expected to know the tradeoffs between the components in order to ascertain the trend of the ROE. For example, if all things are equal but the profit margin increases.ROE would increase. On the next slide are other ways of determining some of the ratios shown above.
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In-class Exercise
Balance Sheet for ABC Company as at 31 December for year stated 20X1 Assets Cash Account receivable Inventory $ $ $ Current assets $ 350,000 45,000 125,000 520,000 $ $ $ $ 20X2 403,000 62,000 102,000 567,000

Investment in affiliates Buildings Less: Accumulated depreciation Long-term assets Total assets

$ 175,000 $ 750,000 $ -205,000 $ 720,000 $ 1,240,000

$ 160,000 $ 810,000 $ -240,000 $ 730,000 $ 1,297,000

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In-class Exercise
Liabilities Short-term debt Advances from customers Accounts payable Accrued liabilities Interest payable Taxes payable Dividends payable Current liabilities Bonds payable Total liabilities Common stock Retained earnings Stockholders' equity Total liabilities and equity $ $ $ $ $ $ $ $ $ $ $ $ $ 100,000 13,000 67,000 12,000 9,000 19,000 23,000 243,000 750,000 993,000 190,000 57,000 247,000 $ $ $ $ $ $ $ $ $ 95,000 14,500 100,000 16,000 11,000 8,000 35,000 279,500 762,500

$ 1,042,000 $ $ $ 190,000 65,000 255,000

$ 1,240,000

$ 1,297,000
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In-class Exercise
Income Statement for ABC Company For the Year ended 31 December, 20X2 Net Sales Less: COGS Gross margin Less: Operating expense Depreciation expense Rent expense Interest expense Earnings before tax Less: tax expense Net income Statement of Retained Earnings Beginning balance, 01 January 20X2 Net income Dividends declared Ending balance, 31 December, 20X2 $ $ $ $ 57,000 33,000 -25,000 65,000
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$ $ $

2,125,000 -1,465,000 660,000

$ $ $ $

-385,000 -35,000 -120,000 -70,000

$ $ $ $

-610,000 50,000 -17,000 33,000

In-class Exercise
Use the Balance Sheet and Income Statements for ABC Company to perform the following calculations Compute the following ratios for 20X2:
return on equity profit margin total asset turnover debt-to-equity financial leverage

Use the traditional DuPont System to analyze the three components of 20X2 ROE

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In-class Exercise
return on equity (ROE) ! $33,000 net income $33,000 ! ! ! 0.131 average shrhldr equity $247,000  $255,000 $251,000 2

profit margin !

net income $33,000 ! ! 0.0155 net sales $2,125,000 net sales $2,125,000 $2,125,000 ! ! ! 1.675 average total assets $1,240,000  $1,297,000 $1,268,500 2

total asset turnover !

debt to equity !

total long - term debt $762,500 ! ! 2.99 total equity $255,000 total assets $1,297,000 ! ! 5.086 shrhlder equity $255,000

financial leverage !

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In-class Exercise
return on equity (ROE) ! net income average shrhlr equity net income net sales avg. total assets v v net sales avg. total assets avg. shrhlr equity

! profit margin v total asset turnover v financial leverage $1,240,000  $1,297,000 $33,000 $2,125,000 2 ! v v $247,000  $255,000 $2,125,000 $1,240,000  $1,297,000 2 2 ! 0.0155 v 1.675 v 5.054 ! 0.131
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Financial Statement Analysis

Valuation Ratios
P/E P/CF P/S P/BV Numerator Price per share Price per share Price per share Price per share Denominator Earnings per share Cash flow per share Sales per share Book value per share

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Financial Statement Analysis

Dividend-Related Quantities
Dividend payout ratio Numerator Common share dividends NI attributable to common shares common share dividends b x ROE Denominator NI attributable to common shares NI attributable to common shares

Retention rate (b) Sustainable growth rate

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Limitation of financial ratios



Financial ratios are not useful when viewed in isolation. They are only valid when compared to those of other firms or to the company's historical performance. Comparisons with other companies are made more difficult because of different accounting treatments. This is particularly important when analyzing non-U.S. firms. It is difficult to find comparable industry ratios when analyzing companies that operate in multiple industries. Conclusions cannot be made from viewing one set of ratios. All ratios must be viewed relative to one another. Determining the target or comparison value for a ratio is difficult, requiring some range of acceptable values.

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