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Notes - Chapter 4 - Financial Statement Analysis

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Notes - Chapter 4 - Financial Statement Analysis

Uploaded by

Ms. Smith
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Chapter 4

Financial Statements Analysis

Financial statements provide a wealth of information that is used for wide variety of
purposes by managers, investors, lenders, customers, suppliers and regulators. An
analysis of such statements can provide a company, its SWOT analysis that may lead to
certain strategic decisions of a company.

Such Strategic decisions may include:

➢ Sale of a division
➢ A major Marketing program
➢ Expanding the plant and equipment etc.

Three major financial statements

1. Balance Sheet
2. Income Statement
3. Cash Flow Statement

Ratio Analysis:

Financial statements provide the financial position of a company at a point time or during
a certain period in time.

However, such information about a company can provide insights into the future
performance of a company and if necessary suggest certain remedial actions that can be
taken to improve the performance of the company etc.

The ratio analysis can be divided into four major categories:

Four Categories of Ratios :

1. Short-Term Solvency Ratios – Liquidity Ratios


2. Asset Management Ratios
3. Debt Management Ratios – Long Term Solvency Rations
4. Profitability Ratios

Short Term Solvency Ratios - measures ability to meet short-term obligations

➢ Current Ratio = Current Assets/Current liabilities


➢ Quick Ratio (aka Acid test) = (CA - Inventory) / CL

Asset Management Ratios (how effectively we are using our assets)


➢ Average Collection Period or Days Sales Outstanding (DSO) = AR/Net sales per
day = AR/(annual sales/365
➢ Fixed-Asset Turnover - (how well long-term assets are being managed) net
sales/net fixed assets
➢ Total asset turnover - (how well total assets are being managed) net sales/total
assets
➢ Inventory turnover ratio = determine whether too much or too little is being
invested in inventories

Debt Management ratios (Long Term Solvency Ratios)

Three reasons why it is important for us to know why to what extent a firm uses debt
financing is:

1. By raising funds through debt, stockholders can maintain control of the firm by
limiting their investment. And
2. If firm earns more on borrowed funds , the return to the owners is magnified or
leveraged. however
3. Creditors look at equity not debt for financing because the higher the proportion
of equity in the firm the less is the risk faces by the creditors.

➢ How the firm is financed: Total debt/total assets = debt ratio


➢ Times Interest Earned (called a coverage ratio because it tells us the number of
times interest expense is covered by income). TIE = EBIT / Interest Expense
➢ Ability to service debt: EBITDA coverage = (EBITDA+ lease payments)/
(Interest+ Loan repayments + lease payments)

Profitability Ratios (measure overall management performance)

➢ Net Profit Margin (give % of each sales dollar this is net profit) = NI/net sales =
(EBIT- interest - taxes)/net sales
➢ Basic earning Power: (gives the real earning power of the assets): EBIT / total
assets
➢ Return On Total Assets (measure of return to all providers of capital - S/H and
B/H) - ignores how the assets are financed: ROA = NI/total Assets
➢ Return On Common Equity (measure of return to shareholders) - accounts for
how assets are financed : ROE = NI/Stock holder's equity
➢ Price to earnings ratio: Price per share/ earnings per share includes market
conditions – high ratio indicates high growth.
➢ Price to cash flow ratio: price per share/ cash flow per share
➢ Market to book ratio: Market price per share/ Book price per share – high
indicates high growth high profile firm while low growth firm has lower values.
Tying the ratios together:

➢ Dupont equation: ROA = profit margin * Total assets turnover


➢ ROE = ROA * equity multiplier
➢ Equity Multiplier = Total assets / common equity
➢ ROE = profit margin * Total assets turnover * equity multiplier

Uses of ratio Analysis:

➢ compare over time, (e.g. what is profit pattern in the company)


➢ compare with competitors (e.g. how does ROA compare)
➢ credit analysis at banks
➢ restrictive covenants (e.g. B/H restrict D/E ratio)

Uses and limitations of ratio analysis:

➢ Large Firms – many divisions


➢ Firm that do better than average
➢ Inflation
➢ seasonal factors
➢ Window dressing techniques - managerial book-cooking
➢ different accounting rules
➢ what is good ratio, what is bad?
➢ What about net effects
➢ Important part is Ratio Analysis is a Tool not End

Looking beyond the numbers:

➢ Are company’s revenues tied to one key customer?


➢ Are company’s revenues tied to one key product?
➢ Are company’s revenues tied to one key supplier?
➢ What percentage of company’s revenues are generated overseas?
➢ Competition
➢ Future Prospects
➢ Legal and regulatory environment

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