Finance FINANCIAL ANALYSIS IN ENTERPRISES
Dec 30, 2015
Finance 110631-1165
Lecture outline
Financial statements- structure and
interpretation
Techniques of financial analysis
Finance 110631-1165
Financial statement- definition
A financial statement is a formal record of
the financial activities of a company, person,
or other entity
Finance 110631-1165
Financial statements as an element of financial reporting
The obligation of financial reporting creates
the necessity of financial statements
International rules concerning the structure of
financial statements
International Accounting Standards Board
for the EU, Canada and Australia, Generally
Accepted Accounting Principles in the USA
Finance 110631-1165
Why do companies publish financial statements?
The information about the financial position and performance of the company is essential to many users
Owners and managers Investors/prospective investors Public finance entities Financial markets participants Employees
The structure of financial statements
Balance sheet (statements of financial position)
Income statement (statement of comprehensive income)
Statement of changes in equityCash flow statement
Finance 110631-1165
Finance 110631-1165
Balance sheet
Assets Fixed assets Current assets
Liabilities Equity Borrowed capital
(interest payments) Other liabilities (no
interest payments)
Income statement
All items of income and expense in a given period
Sometimes called the statement of profit and loss
Finance 110631-1165
Finance 110631-1165
Income statement
The statement should include information about revenue, finance cost share of the profit or loss of associates tax expense profit or loss,
Finance 110631-1165
Statement of changes in equity
The statement should include Total comprehensive income with distiction of the
amounts attributable to owners and non-controlling
interest
For each component of equity, the effects of
restrospective application
For each component of equity, the changes between
the amount at the beginning and the end of the period
Finance 110631-1165
Cash flow statement
Cash flow- the movement of money into a
company and out of the company
The statements shows how changes in balance
sheet accounts and income affect cash
The statements involves operating, investing,
and financing activities
Finance 110631-1165
Finance 110631-1165
Cash flow statement-interpretation
Useful in determining the short-term
ablity to meet the financial commitments of
a company
Reflects a firm's liquidity
Finance 110631-1165
The purpose of financial analysis
To evaluate the performance and the financial position of the company given the strategy of the firm, the economic and legal environment, the accounting flexibility and prospects
How is the financial analysis performed?
To evaluate the company’s performance we need a benchmark
Performance compared to past resultsPerformance compared to other
companiesArtificial benchmarks build on economic
experience
Finance 110631-1165
Finance 110631-1165
Non-comparability of financial
statements Changes of the time span of the financial year
Different balance sheet dates
Changes in company structure
Accounting method changes and accounting
estimate changes
Differences in presentation
Finance 110631-1165
Types of financial analysis
Horizontal analysis
Common size analysis
Segmental analysis
Ratio analysis
Horizontal analysis
Also called trend analysis
Aimed at comparing the respective
positions of the financial statement with
previous statements
It usually covers a five year period
Finance 110631-1165
Finance 110631-1165
Common size analysis
Aimed at comparing the performance of
firms usually from the same industry
Size adjustment is needed- the positions
in the balance sheet are expressed
relatively to total assets, in the income
statement relatively to the amount of sales
Finance 110631-1165
Segmental analysis
Aimed at reporting accounts on a breakdown of
the total revenue over the different business
segments
Segmental reporting data may be subject to
manipulation as the company may shift the data
between segments in order to show to desirable
result
Finance 110631-1165
Ratio analysis
The ratio analysis is aimed at answering the following questions: Can the company meet its financial
commitments? How successful, profitable and efficient is the
company? Is the business a good investment for
shareholders?
Finance 110631-1165
Profitability of the firm
The ratio combines the result of a firm with the investments made for the generation of this result
Return on equity
ROE=Profit/EquityReturn on assets
ROA= (Profit before tax+ Interest)/ Total assets
Finance 110631-1165
Profitability of the firm (1)
Return on capital employed
ROCE=(Profit before tax + Long term
interest)/(Equity + Long term debt)
Finance 110631-1165
Profitability of the firm (2)
Which investment base should be taken into
account?
From the beginning of the year?
An average equity base?
In practice the most common benchmark the
equity base at the end of the year
Finance 110631-1165
Profitability of the firm- benchmarks
Time series or competitor comparisons The proceeds from an investment in risk
free loans as benchmark This measure allows to see if the
owners would be better off selling the company and placing the money in a bank?
Profitability of the firm-breakdown analysis
To see the which components of the firms activity played a role in shaping the profitability one can break down the ROA measure
The components relate to sales results and investment results
ROA=Profit/Total sales * Total sales/Assets
Profit/Total sales- called profit margin reflects operating decisions
Total sales/Assets- called efficiency ratio reflects investment decisions
Finance 110631-1165
Finance 110631-1165
Liquidity and solvency
Useful especially for external stakeholdersInformation about the financial status can
be obtained by analyzing the assets available to the company to meet its liabilities
Short, medium and long term analysis
Liquidity (1)
The subject of analysis are assets able to meet short term liabilities
The structure of working capital mattersCurrent ratio
CR=Current assets/Current liabilitiesAcid test ratio
ATR=(Current assets-Inventory)/Current liabilities
Finance 110631-1165
Liquidity (2)
Current assets are supposed to be converted into cash in the current operating cycle
The acid test ratio excludes inventory as this is the least convertible part of current assets
The benchmark for liquidity ratios depends on the industry
Finance 110631-1165
Solvency (1)
To see if the company is able to meet its long term liabilities one has to analyze the capital structure
Of crucial importance is most of all the ratio of own and borrowed capital
Debt/equity ratio- most popularA high debt/equity ratio implies higher
financial risk due to higher interest payments, pay-off deadlines etc.
Finance 110631-1165
Solvency (2)
Depending on the focus of the analysis the debt/equity ratio can be transformed
Debt/Equity+Debt
Long term debt/EquityOr expressed relatively to assets
Debt/assets
Short term debt/ assets
Finance 110631-1165
Solvency- benchmarks The debt equity ratio could be influenced
by national or institutional differences In bank based economies e.g. Germany,
France the debt/equity ratio will be higher than in countries with shareholder orientation e.g. UK
Firms from similar countries should be used as a benchmark
Finance 110631-1165
Investment perspective (1)
Is the company worth investing?Investment decisions require specific
ratios besides liquidity, efficiency and profitability
Dividends performance, earnings per share, price/ earnings ratio
Finance 110631-1165
Investment perspective (2)
Ratios for shareholders reported in financial statements
Companies can try to influence share prices by communicating to the market outside financial statements
Companies can create their own ratios eg.”like for like sales”, „profit before one-time” expenditures
Finance 110631-1165
Univariate and multivariate ratio analysis
Univariate analysis- one ratio is considered at a time, judgment is based on the respective ratios calculated
Multivariate analysis- the respective ratios are weighted and combined
A popular multivariate measure- the Z-score (Altman 1968)
Finance 110631-1165
The z-score Aimed at predicting company failure A risk measure Based on research in the US manufacturing sector Z-scores are sector specific-e.g.other weightings should
be applied for banks and manufacturing companies
Z=0,012x1+0,014x2+0,033x3+0,006x4+0,999x5 X1-working capital/total assets X2-retained earnings/total assets X3-earnings before interest and tax/total assets X4- market capitalization/book value of debt X5-sales/total assets
Finance 110631-1165
Financial analysis-remarks
The ratio analysis should be accompanied by common size and trend analysis
These methods are complementary
Finance 110631-1165
Finance 110631-1165
Example
Compute and compare the liquidity and
solvency ratios for company A and B Company A finances it’s activity via bank
loans. The value of inventory is 200 the value of financial assets 100, the value of fixed assets is 2000. The value of the bank loan is 1200 from which 500 is due in the current operating cycle.
Finance 110631-1165
Example
Company B leases the production infrastructure. The value of inventory is 200, the value of financial assets 100, the value of fixed assets is 800, the value of leased assets is 1200. The value of current liabilities is 100.