Chapter 4 ANALYSIS OF FINANCIAL STATEMENTS REFFERENCE BOOK
Chapter 4 ANALYSIS OF FINANCIAL STATEMENTS REFFERENCE BOOK: FINANCIAL MANAGEMENT BY TIMOTHY J. GALLAGHER Saeed Akbar
Topics to be covered Ratio Analysis Trend analysis and industry average Preparing standardized/common-size financial statements (vertical analysis) Horizontal analysis The Du Pont System/Equation Internal and Sustainable Growth Rate 2
INTRODUCTION Ratio: A financial ratio is a number that expresses the value of one financial variable relative to another. Ratios may be used to compare: One ratio to a related ratio The firm’s performance to management’s goals The firm’s past and present performances The firm’s performance to similar firms (Industry) Ratio analysis or financial statement analysis provides valuable information to managers, investors and creditors, etc. to make their decisions. 3
BASIC FINANCIAL RATIOS Financial ratios are generally divided into five categories: profitability, liquidity, debt, asset activity, and market value. The ratios in each group give us insights into different aspects of a firm’s financial health Profitability ratios: measure how much company revenue is eaten up by expenses, how much a company earns relative to sales generated, and the amount earned relative to the value of the firm’s assets and equity. Liquidity ratios: indicate how quickly and easily a company can obtain cash for its needs. Debt ratios: measure how much a company owes to others. Asset activity ratios: measure how efficiently a company uses its assets. Market value ratios: measure how the market value of a company’s stock compares with its accounting values. 4
FINANCIAL STATEMENTS OF ACME CORPORATION (Income Statement, December 31, 2012) 5
(Balance Sheet, December 31, 2012) 6
1. Profitability Ratios Gross Profit Margin: The gross profit margin measures how much profit remains out of each sales dollar after the cost of the goods sold is subtracted. 7
1. Profitability Ratios Operating Profit Margin: The operating profit margin measures how much profit remains out of each sales dollar after all the operating expenses are subtracted. 8
1. Profitability Ratios Net Profit Margin: The net profit margin ratio measures how much profit out of each sales dollar is left after all expenses are subtracted—that is, after all operating expenses, interest, and income tax expense are subtracted. 9
1. Profitability Ratios Return on Assets (ROA): The return on assets (ROA) ratio indicates how much income each dollar of assets produces on average. It shows whether the business is employing its assets effectively. Example: Suppose you have two friends (Mr. A and Mr. B) who are running their own small businesses. Mr. A Monthly Income Rs. 100, 000 Total Investment. Rs. 1, 000 Return on Assets 10% NOTE: We usually take average values to calculate ratios which involves values from the balance sheet. 10 Mr. B Rs. 50, 000 Rs. 350, 000 14. 28%
1. Profitability Ratios Return on Equity (ROE): The return on equity (ROE) ratio measures the average return on the firm’s capital contributions from its owners (for a corporation, that means the contributions of common stockholders). It indicates how many dollars of income were produced for each dollar invested by the common stockholders. 11
2. Liquidity Ratios Current Ratio: The current ratio compares all the current assets of the firm (cash and other assets that can be quickly and easily converted to cash) with all the company’s current liabilities (liabilities that must be paid with cash soon). 12
2. Liquidity Ratios Quick Ratio (Acid-test Ratio): The quick ratio is similar to the current ratio but is a more rigorous measure of liquidity because it excludes inventory from current assets as inventory can sometimes include illiquid items. 13
2. Liquidity Ratios Cash Ratio: The cash ratio measures the liquidity of a company but it uses specifically the value of cash and cash equivalents instead of total current assets. Cash equivalents are those items which can be converted into cash quickly like demand deposits or marketable securities. 14
3. Debt Ratios Financial analysts use debt ratios to assess the relative size of a firm’s debt load and the firm’s ability to pay off the debt. The three primary debt ratios are the debt to total assets, debt to equity, and times interest earned ratios. Debt to Total Assets: The debt to total assets ratio measures the percentage of the firm’s assets that is financed with debt 15
3. Debt Ratios Times Interest Earned: The times interest earned ratio is often used to assess a company’s ability to service the interest on its debt with operating income from the current period. 16
3. Debt Ratios Debt to Equity: It is a measure of the degree to which a company is financing its operations through debt versus wholly-owned funds. 17
4. Asset Activity Ratios Financial analysts use asset activity ratios to measure how efficiently a firm uses its assets. They analyze specific assets and classes of assets. The three asset activity ratios we’ll examine here are the average collection period (for accounts receivable), the inventory turnover, and the total asset turnover ratios. Average Collection Period (ACP): The average collection period ratio measures how many days, on average, the company’s credit customers take to pay their accounts. Or, how many days the firm takes to collect its receivables. 18
4. Asset Activity Ratios Inventory Turnover: The inventory turnover ratio tells us how efficiently the firm converts inventory to sales. If the company has inventory that sells well, the ratio value will be high. If the inventory does not sell well due to lack of demand or if there is excess inventory, the ratio value will be low. 19
4. Asset Activity Ratios Total Assets Turnover: The total asset turnover ratio measures how efficiently a firm utilizes its assets. Stockholders, bondholders, and managers know that the more efficiently the firm operates, the better the returns. If a company has many assets that do not help generate sales (such as fancy offices and corporate jets for senior management), then the total asset turnover ratio will be relatively low. A company with a high asset turnover ratio suggests that its assets help promote sales revenue. 20
5. Market Value Ratios Market value ratios measure the market’s perception of the future earning power of a company, as reflected in the stock share price. The two market value ratios we discuss are the price to earnings ratio and the market to book value ratio. Price-to-Earnings Ratio: Investors and managers use the P/E ratio to gauge the future prospects of a company. The ratio measures how much investors are willing to pay for claim to one dollar of the earnings per share of the firm. The more investors are willing to pay over the value of EPS for the stock, the more confidence they are displaying about the firm’s future growth—that is, the higher the P/E ratio, the higher are investors’ growth expectations. 21
5. Market Value Ratios 22
5. Market Value Ratios Market-to-Book Value: The market to book value (M/B) ratio is the market price per share of a company’s common stock divided by the accounting book value per share (BPS) ratio. The book value per share ratio is the amount of common stock equity on the firm’s balance sheet divided by the number of common shares outstanding. 23
Trend Analysis and Industry Average 24
Trend Analysis and Industry Average 25
The Du Pont Identity As we discussed in the beginning of this chapter that we compare one ratio to another ratio to interpret them. So here we present an equation called the Du -Pont equation which represent the ROA as a product of NPM and TAT 26
The Du Pont System Here we solve the Du Pont equation for Acme Corporation 27
Modified Du Pont Equation 28
Standardized Financial Statements or Common-size Statements A common size financial statement displays all items as percentages of a common base figure. In balance sheet, we divide all the values by the value of total assets while in income statement, we divide all the values by the value of total sales or revenue. We also call it vertical analysis. For example, the value of each current asset of Acme corporation will be converted to common-size as follows. Current Assets Cash Marketable Securities Accounts Receivable Inventory Prepaid Expenses Total Current Assets common-size figures 10, 000 8, 000, 000 10, 000 1, 000 30, 000 10, 000/50, 000 x 100 = 8, 000, 000/50, 000, 000 x 100 = 10, 000/50, 000 x 100 = 1, 000/50, 000 x 100 = 30, 000/50, 000 x 100 = 20% 16% 2% 20% 2% 60% 29
Standardized Financial Statements or Common-size Statements Similarly, in order to prepare the common-size income statement or standardized income statement, we divide each item by total sales and multiply by 100. Income Statement Net Sales Cost of Goods Sold Gross Profit Depreciation Expense S&A Expenses Operating Income (EBIT) Interest Expense Income before taxes Income Taxes Net Income Common-size income statmnt 15, 000, 000 10, 000 2, 000 800, 000 7, 200, 000 1, 710, 000 5, 490, 000 2, 306, 000 3, 184, 000 15, 000/15, 000 x 100 = 100% 5, 000/15, 000 x 100 = 33. 33% 10, 000/15, 000 x 100 = 66. 66% 2, 000/15, 000 x 100 = 13. 33% 800, 000/15, 000 x 100 = 53. 33% 7, 200, 000/15, 000 x 100 = 48% 1, 710, 000/15, 000 x 100 = 11. 4% 5, 490, 000/15, 000 x 100 = 36. 6% 2, 306, 000/15, 000 x 100 = 15. 37% 3, 184, 000/15, 000 x 100 = 21. 22% 30
Common-size Balance Sheet of Coca Cola Company 31
Common-size Income Statement of Coca Cola Company 32
Horizontal Analysis 33
Horizontal Analysis of the Income Statement of Coca-Cola Company 34
Horizontal Analysis of the Balance Sheet of Coca Cola Company 35
Internal and Sustainable Growth Rate Internal growth rate is the maximum rate of growth in sales and assets that a company can achieve using only retained earnings. It is the rate of growth up to which the company might not need any external financing. A growth rate target higher than the internal growth rate must be financed by external sources of capital i. e. debt or equity. Internal Growth Rate = Retention Ratio × ROA Internal Growth Rate = (1 -- Dividend Payout Ratio) × ROA Dividend Payout Ratio = Dividends paid/Net Income x 100 Calculating for Acme Corporation Dividend Payout Ratio = 400, 000/3, 184, 000 x 100 = 12. 56% Now Internal Growth Rate = (1 – 0. 1256) x 0. 064 = 0. 056 or 5. 6% Interpretation: Acme Corporation can achieve 5. 6% growth without going for external financing and financing its growth only with retained earnings. 36
Internal and Sustainable Growth Rate Sustainable growth rate allows for external financing but only in the proportion of its current capital mix, the sustainable growth rate is higher than the internal growth rate. Sustainable Growth Rate = Retention Ratio × ROE Sustainable Growth Rate = (1 -- Dividend Payout Ratio) × ROE CS=Debt+Equity Let's calculate Sustainable Growth Rate for Acme Corporation Sustainable Growth Rate = (1 – 0. 1256) x 0. 122 = 0. 1066 or 10. 66% Interpretation: Acme Corporation can achieve 10. 66% growth if it go for external financing without changing its current capital structure. 37
Try to solve the Self-Test questions and problems in the exercise and let me know if you face any difficulty in solving a problem. Youtube link for the video lecture of this chapter: https: //www. youtube. com/watch? v=u. GYtufr. Qb. NY 38
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