Chapter 3 Financial Statement Analysis
Jan 05, 2016
Chapter 3
Financial Statement Analysis
Financial Statement Analysis, Some Background
Financial statements reflect the results of actions taken by the management of a company.
Analysis of historical data can give perspective on past performance, and may help to predict future performance.
Financial statement analysis helps to set goals for the company to attain in future periods.
Financial statement analysis allows us to compare the performance of a company to its competitors, wherever possible.
Ratio Analysis, an Important Tool in Financial Statement Analysis
• Expresses relationship among selected items of financial statement data
• Relationship can be expressed in term of:• Percentages – for example, gross profit as a % of net sales,
gross profit percentage
• Rates – 365 days , Days in
(Cost of Goods Sold ÷ Average Inventory) Inventory
• Proportions – Current Assets ÷ Current Liabilities, Current Ratio
Ratio Analysis Comparisons
Intracompany comparisons - covering two years of the same company
Industry average comparisons - based on average ratios for a particular industry
Intercompany comparisons - based on comparisons with a competitor in the same industry
Ratio Analysis Classifications:
Liquidity Ratios - measures of short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.
Solvency Ratios - Measures of the ability of the company to survive over a long period of time.
Profitability Ratios - Measures of the income or operating success of a company for a given period of time.
Common Size Financial Statement Ratios
Relates the components of the financial statements to some reference amount to scale dollar amounts for size.
• Balance sheet – the reference is usually total assets.
• Income Statement – the reference is usually net sales.
• See Table 3.3 and 3.4 for examples of common sized balance sheets and income statements.
Common size financial statement exercise
For Tomorrow
Read Chapter 3 Work through the T/F and Multiple Choice questions,
exercises 42 (a) (b), and 44.
Exam 1 Results
Of 29 students who took the exam, scores were distributed as follows:
90 – 100 (17) 80 - 89 (4) 70 – 79 (3) < 69 (5)
Wednesday June 29Chapter 3 – Financial Statement Analysis
How to use ratios in analyzing financial statements to assess a firm’s:
• Profitability
• Liquidity
• Solvency
Ratios
Great diagnostic tools – they point to areas of operations, financing, or investing that should be researched further before reaching conclusions.
Relatively easy to calculate, however, flexibility in GAAP may mean that there can be some variation in how numbers used in ratios are calculated.
Horizontal and Vertical Analysis
1. Horizontal Analysis:a. Analysis of dollar value and percentage changes.b. Over time c. Sometimes called trend analysis.
2. Vertical Analysis:a. Analysis of dollar value amounts relative to a common
base.b. Top to bottom.c. Sometimes called Common Size Statement Analysis.
From the text, p. 89
Why compare: To see if the:
Current liabilities to current assets
company is able to meet its payroll and pay its suppliers on time.
Accounts receivable to sales company can collect its receivables
Inventory to cost of goods sold company's inventory is turning over quickly enough
Fixed charges to income business can service its debt.
From the text, p. 89 Continued
Why compare: To see if the:
Total debt to total assets business can service its debt.
Total assets to sales company's assets are productive.
Net income to sales company as a whole is efficient.
Analyzing The Balance Sheet
1. Horizontal Analysis: how have assets, liabilities and equities changed over time?
2. Vertical Analysis: express all other accounts relative to total assets.
Analyzing the Income Statement
1. Horizontal Analysis: how have sales, expenses, COGS changed over time?
2. Vertical Analysis: express all other accounts relative to sales.
Factors That Affect Profitability
Sales volume Sales price Expenses – Cost of goods sold, operating expenses.
• Operating expenses are directly related to the efficiency of a firm’s assets
Cost of capital (funds) – interest charges
Factors That Affect Liquidity
Liquidity refers to the ability to meet day-to-day cash needs for business expenses.
The speed with which cash payments are received on accounts receivable.
The delaying of cash payments on accounts payable and other payables.
Working capital requirements – that is the amount of cash needed for day-to-day operations.
Factors That Affect Solvency
Recall that solvency is a longer-term aspect than liquidity.
Financial structure – aka capital structure (debt/equity)
Debt paying ability.
Market-Value Ratios (Table 3.1)
Measures of the income or operating success of a
company for a given period of time
15. Earnings per share ($)
Net Income
Number of shares of stock outstanding
16. Price/earnings ratio (times)
Price per common share
Earnings per common share
Profitability Ratios (Table 3.1)
Measures of the income or operating success of a company for a given period of time
11. Profit margin on sales (%)
Operating Income
Sales
12. Return on sales. (%)
Income after taxes
Sales
Profitability Ratios (Table 3.1)
13. Return on total assets. (%)
Income after taxes
Total assets
14. Return on equity (ROE). (%)
Income after taxes
Owners’ equity
Liquidity Ratios (Table 3.1)
Measure of short - term ability to pay obligations
1. Current ratio (times)
Current Assets
Current liabilities
2. Quick ratio (times)
Quick Assets
Current liabilities
Leverage Ratios (Table 3.1)
Measures of the ability to pay debts in the current year and beyond
3. Debt-to-total-assets (%)
Total debts
Total assets
4. Debt-to-equity (times)
Total debts
Total shareholder’s equity
Leverage Ratios (Table 3.1)
Measures of the ability to pay debts in the current year and beyond
5. Times-interest-earned (times)
Income before tax + Interest charges Interest charges
6. Fixed-charge-coverage (times) – SKIP
Asset-Management Ratios (Table 3.1)
7. Average Collection period (days)
Accounts Receivable
Daily Sales
8. Inventory turnover (times)
Cost of goods sold
(average )Inventory
Asset-Management Ratios (Table 3.1)
9. Capital asset turnover (times)
SKIP
10. Total asset turnover (times)
Sales
Total assets
Horizontal and Vertical Analysis
1. Horizontal Analysis:a. Analysis of dollar value and percentage changes.b. Over time c. Sometimes called trend analysis.
2. Vertical Analysis:a. Analysis of dollar value amounts relative to a common
base.b. Top to bottom.c. Sometimes called Common Size Statement Analysis.
Analysis of The Balance Sheet
1. Horizontal Analysis: how have assets, liabilities and equities changed over time?
2. Vertical Analysis: express all other accounts relative to total assets.
Analyzing the Income Statement
1. Horizontal Analysis: how have sales, expenses, COGS changed over time?
2. Vertical Analysis: express all other accounts relative to sales.
Dupont Method - skip