3 3 Chapter Financial Information and Analysis Slides Developed by: Terry Fegarty Seneca College.

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Financial Information and Analysis

Financial Information and Analysis

Slides Developed by:

Terry FegartySeneca College

© 2006 by Nelson, a division of Thomson Canada Limited 2

Chapter 3 – Outline (1)

• Financial Information Users of Financial Information Sources of Financial Information The Annual Report

• Ratio Analysis Comparisons Common Size Statements Categories of Ratios Liquidity Ratios Asset Management Ratios


Chapter 3 – Outline (2)

Debt Management Ratios Profitability Ratios Market Value Ratios Dupont Equations Sources of Comparative Information Limitations and Weaknesses of Ratio Analysis Words of Caution


Financial Information

• Financial information—results of business operations in monetary terms Responsibility of management Created by company’s accountants Creates a potential conflict of interest

• Management wants to portray firm in positive light

Published to a variety of audiences


Users of Financial Information

• Investors and Financial Analysts Financial analysts interpret information about

companies and make recommendations to investors Major part of analyst’s job is to study recent financial

statements

• Vendors/Creditors Use financial info to determine if firm is expected to

make good on loans

• Management Use financial info to pinpoint strengths and

weaknesses in operations


Sources of Financial Information

• Annual Report Required from all publicly traded firms Tends to portray firm in positive light

• Brokerage firms and investment advisory services For example: Value Line Investment Survey


The Annual Report

• Typically includes: Letter to shareholders, reviewing the results and

events of past year, and management’s strategies and plans for future

Management discussion and analysis, analyzing and explaining financial results for the year

Audited financial statements for past year and previous year, including income statement, balance sheet, statement of retained earnings, and statement of cash flows

Notes to the financial statements (audited) Other recent and historic financial information.


The Orientation of Financial Analysis

• Accounting—preparing financial statements

• Financial analysis—using financial statements to evaluate businesses Financial analysis is critical and

investigative


Ratio Analysis

• Used to highlight different areas of performance

• Involves taking related numbers from the financial statements and forming ratios with them

• Each ratio is meaningful to operation of the business

• Can vary widely among industries


Comparisons

• When examined separately, ratios don’t convey much information. Ratios are compared with: History—examine trends (how ratio has changed

over time)

Competition—compare with other firms in same industry

Budget—compare actual ratios with expected or desired ratios


Common Size Statements

• First step in financial analysis is usually common size statement

Common size income statement• Presents each line as percent of revenue

Common size balance sheet• Presents each line as percent of total assets


Common Size Statements

$ % $ %Sales 2,187,460$ 100.0% 150,845$ 100.0%COGS 1,203,103$ 55.0% 72,406$ 48.0%Gross margin 984,357$ 45.0% 78,439$ 52.0%

Expenses 505,303$ 23.1% 39,974$ 26.5%EBIT 479,054$ 21.9% 38,465$ 25.5%Interest 131,248$ 6.0% 15,386$ 10.2%EBT 347,806$ 15.9% 23,079$ 15.3%Tax 118,254$ 5.4% 3,462$ 2.3%Net Income 229,552$ 10.5% 19,617$ 13.0%

Alpha Beta

Exa

mpl

e


Categories of Ratios

Liquidity—indicate firm’s ability to pay its bills in short run

Asset Management—show firm’s ability to generate revenue using minimum amount of assets

Debt Management—determine if the firm is using so much debt that it is assuming excessive financial risk

Profitability—allow assessment of the firm’s ability to make money

Market Value—give an indication of how investors feel about firm’s financial future


Liquidity Ratios

• Current Ratio

Current Assets

Current Ratio Current Liabilities

To ensure solvency, current ratio is expected to exceed 1.0

Average is 1.3 for industrial corporations

May be too high if too much money is tied up in receivables and inventory


Liquidity Ratios

• Quick Ratio (or Acid-Test Ratio)

Measures liquidity without considering inventory (least liquid current asset)

May be too high if too much money is tied up in receivables

Current Assets-InventoryQuick Ratio

Current Liabilities


Asset Management Ratios

• Average Collection Period (ACP)

Accounts ReceivableACP =

Average Daily (Credit) Sales

AKA: days sales outstanding (DSO) Measures time to collect on credit sales.

Compare to business credit terms (ex: 30 days)

Accounts Receivable × 365ACP =

Annual (Credit) Sales

or



• Average Collection Period (ACP)• When ACP is too long, we can suspect:

poor credit management inefficient collection procedures risk of uncollectible accounts risk of cash shortages more reliance on bank financing, and more interest expense.



• Inventory Turnover

Measures how many times a year firm uses up an average stock of goods

Higher turnover implies doing business with less tied up in inventory

Indicates quality of inventory as well as how it is managed

Cost of Goods SoldInventory Turnover =

Inventory



• Inventory Turnover• A higher inventory turnover minimizes costs

and risks of: unsaleable stock damage and shortages insurance, storage, and financing costs, and cash shortages

• A higher turnover is essential if inventory is perishable (for example, food) fashionable (for example, women’s fashions) low margin goods (for example, consumer staples)

.



• Capital Asset Turnover

Appropriate in industries where significant plant or equipment is required

High ratio may indicate full utilization of capacity

Low ratio may reflect new capital assets coming on stream

SalesCapital Asset Turnover =

Capital Assets



• Total Asset TurnoverSales (Total)

Total Asset Turnover Total Assets

More widely used than Capital Asset Turnover

Long-term measure of performance


Debt Management Ratios

• Debt management ratios measure financial risk from borrowing High ratios viewed as risky by lenders and

investors Riskiness associated with debt and interest is

called financial risk High level of debt can burden income

statement with excessive interest, a fixed financial charge

Firm may not be able to repay debt and interest if profits decline



• Debt-to-equity ratio Can be stated as a percentage, or as a x:y

value

Debt-to-Equity LT debt : Common Equity

or

LT DebtDebt-to-Equity

Common Equity

Measures mix of LT debt and equity within firm’s total capital



• Debt Ratio

Long-term debt Current LiabilitiesDebt Ratio

Total Assets

Need to determine if company is using so much debt that it is assuming excessive financial risk

High debt ratio is viewed as risky by investors



• Times Interest Earned

EBITTIE

Interest Expense

TIE is a coverage ratio• Reflects how much EBIT covers interest

expense• High level of interest coverage implies

safety for lenders

High TIE ratio often means a low debt/equity ratio



• Cash Coverage

TIE ratio has problems• Interest is a cash payment but EBIT is not

exactly a source of cash• By adding amortization back into the

numerator we have a more representative measure of cash income

EBIT + AmortizationCash Coverage =

Interest Expense



• Fixed Charge Coverage

EBIT Lease PaymentsFixed Charge Coverage

Interest Expense Lease Payments

Interest payments are not the only fixed charges

Lease payments are fixed financial charges similar to interest• Must be paid regardless of business

conditions


Profitability Ratios

• Return on Sales (or: Profit Margin, Net Profit Margin)

Net IncomeROS

Sales

Measures control of income statement: revenue, cost and expense

Indicates overall profitability of the business Low ROS may be OK for large firm Small firm needs higher ROS



• Gross Profit Margin

Indicates how efficiently firm buys or manufactures its products, and how well it marks up and maintains selling prices

Will vary, depending on industry and product lines involved. • For instance, margin on jewellery typically is much

higher than that on most food products

Gross ProfitGross Profit Margin=

Sales



• Return on Assets

Net IncomeROA

Total Assets

Adds effectiveness of asset management to Return on Sales

Measures ability of firm to utilize assets to earn profit

Often compared to firm’s cost of financing (after tax)



• Return on Equity

Adds effect of borrowing to Return on Assets Measures ability to earn a return on owners’

investment If firm has substantial debt, ROE tends to be higher

than ROA in good times and lower in bad times Compared to returns available from alternate

investments

Net IncomeR eturn on Equity =

Shareholders' Equity


Earnings and Book Value per Share

• Earnings per Share

Indicates how much income was earned for each common share outstanding

Net IncomeEarnings per Share=

Number of Common Shares


Earnings and Book Value per Share

• Book Value per Share

Indicates how much equity was attributable to each common share outstanding

Common EquityBook Value per Share=

Number of Common Shares


Market Value Ratios

• Price/Earnings Ratio (PE Ratio)

Indicates value that stock market places on company

Tells how much investors are willing to pay for a dollar of firm’s earnings

Firm’s P/E is primarily function of investors’ expectations for its growth

Market Price per SharePrice-Earnings Ratio =

Earnings per Share


Market Value Ratios

• Market-to-Book Value Ratio

Healthy company is expected to have market value greater than its book value (Ratio > 1.0)

• Known as going concern value of firm• Future earnings will be worth more than assets are worth

today• High ratio may indicate undervalued property on balance

sheet

A ratio < 1.0 indicates poor outlook for firm

Market Price per ShareMarket - to - Book Value=

Book Value per Share


Du Pont Equations

• Ratio measures are not entirely independent

• Performance on one is sometimes tied to performance on others

• Du Pont equations express relationships between ratios that give insights into successful operation


Du Pont Equations

• Du Pont equation involves ROA, which can be written as:

Net IncomeROA =

Total Assets

States that to run a business

well, a firm must manage pricing,

costs and expenses as

well as generate lots of sales per dollar of assets.

Net Income SalesROA = ×

Sales Total Assets

or


Du Pont Equations

• Du Pont equation involves ROE, which can be written as:

Equity

income NetROE

Equity

assets Total

assets Total

income NetROE

Equity Multiplier

Related to the proportion to

which the firm is financed by other people’s

money as opposed to

owner’s money.

or


Du Pont Equations

• Extended Du Pont equation states that operation of a business is reflected in its ROA However, this result—good or bad—can be

multiplied by borrowing, resulting in ROE The way you finance a business can

exaggerate the results from operations

• Du Pont equations can be used to isolate problems


Table 3.2: Sources of Comparative Information


Limitations and Weaknesses of Ratio Analysis• Ratio analysis requires judgment and

experience Examples of significant problems

• Diversified companies—comparing companies operating in several industries can be a problem

• Window dressing—companies make balance sheet items look better through temporary improvements

• Different accounting principles—similar companies may report same thing differently

• Inflation may distort numbers• Illegal and/or misleading accounting practices may

overstate assets, understate debt, or hide losses


Words of Caution

• Ratios are only as good as information on which they are based

• Ratios become most valuable when: Compared to past, competition, or budget

• When comparing ratios among different firms, ensure the ratios calculated using same method

• Ratios should cause one to ask questions; rarely do they provide answers themselves

3 3 Chapter Financial Information and Analysis Slides Developed by: Terry Fegarty Seneca College.

Documents

financial results

chapter financial information

historic financial information

businesses financial

ratios dont

investigative slide

analysis slides

future management discussion