Week8a.financialStatementsAnalysis Performance

Week 8:Financial Statement

Analysis & Performance

Introduction

Analysis of financial statements for decision-making

Assessment of a business’ past, present & anticipated future.

To identify the weaknesses & strengths. Financial ratios are tools to do this. Liquidity ratios Activity ratios Gearing ratios Profitability ratios

Liquidity Ratios

Measures whether a firm can repay its bills, or financial obligations (debts) on time.

Focus is on cash or near cash assets – more readily available to settle debts (especially current debts).

Current Ratio (CR)Sometimes called the working capital

ratio or bankers’ ratio Measures a company’s ability to pay its

current liabilities.Computed as follows:

The higher the CR, the more liquid the firm’s position.

Rule of thumb, CR should be > 2.

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Current Ratio =Current Assets

Current Liabilities

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Current Ratio

The current ratio for Lincoln Company is computed below.

2012 2011Current assets $550,000 $533,000

Current liabilities$210,000 $243,000

Current ratio 2.6 2.2

$550,000

$210,000

$533,000

$243,000

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Quick Ratio (QR)Measures the “instant” debt-paying

ability of a companySometimes called acid-test ratio. It is computed as follows:

Quick Ratio =Quick Assets

Current LiabilitiesQuick assets are cash and other assets that

can be easily converted to cash. Does not include

inventory & prepayments.

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Quick Ratio (QR)

Better measurement of liquidity as inventory & prepayments are illiquid, i.e. cannot be converted to cash quickly.

Rule of thumb, QR should be > 1.

Quick Ratio =Current Assets – Inventory -

PrepaymentsCurrent Liabilities

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Quick Ratio

The quick ratio for Lincoln Company is computed below.

2012 2011

Quick ratio 1.3 1.0

Quick assets:Cash $ 90,500 $ 64,700Temporary Investments 75,000 60,000Accounts receivable (net) 115,000 120,000 Total quick assets $280,500 $244,700

Current liabilities $210,000 $243,000

$280,500

$210,000 $244,700

$243,000

Working Capital

= Excess of current assets over current liabilities.

Note: not a ratio.Often used to evaluate a company’s

ability to pay current liabilities.Computed as follows:

The larger the figure, the better.

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Working Capital = Current Assets – Current Liabilities

Activity Ratios

Measures how effectively a firm uses its assets to generate revenue.

Also called efficiency, turnover or business asset management ratios.

Inventory TurnoverThe relationship between the volume of

goods (merchandise) sold and inventory.Assesses the efficiency of a firm in

managing its inventory.Tells how many times the inventory is

replaced/sold within an accounting period

The higher the figure, the better – sales are increasing & inventory levels are low.

Computed as follows:

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Inventory Turnover =

Cost of Goods Sold

Average Inventory

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Inventory Turnover

Inventory turnover 3.8 2.8

2012 2011

Cost of goods sold $1,043,000 $820,000 Inventories:

Beginning of year $ 283,000 $311,000End of year 264,000 283,000Total $ 547,000 $594,000Average (Total ÷ 2) $ 273,500 $297,000

Lincoln’s inventory balance at the beginning of 2011 is $311,000.

$1,043,000

$273,500 $820,000

$297,000

LO 2LO 2Number of Days’ Sales in InventoryA rough measure of the length of

time it takes to purchase, sell, and replace the inventory.

Computed as follows:

Number of Days’ Sales in Inventory

Average Inventory

Average Daily Cost of Goods Sold

(Cost of Sales)

=

Cost of Goods Sold/Cost of Sales

365

Average Inventory $273,500 $297,000Average daily cost of goods sold$2,858 $2,247

2012 2011

LO 2LO 2Number of Days’ Sales in Inventory

The number of days’ sales in inventory for Lincoln Company is computed below.

Number of days’ sales in inventory 95.7 132.2

$273,500

$2,858

$297,000

$2,247

Accounts Receivable Turnover

= The relationship between sales and accounts receivable.

Collecting accounts receivable as quickly as possible improves a company’s solvency.

The higher the ratio, the more effective the firm in collecting from its credit customers.

Computed as follows:

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Accounts Receivable Turnover =

Net Sales

Average Accounts

Receivable

Accounts receivable turnover 12.7 9.2

Net sales $1,498,000 $1,200,000Accounts receivable (net):

Beginning of year $ 120,000 $ 140,000End of year 115,000 120,000 Total $ 235,000 $ 260,000

Average (Total ÷ 2) $ 117,500 $ 130,000

2012 2011

The accounts receivable turnover for Lincoln Company is computed below.

$1,498,000

$117,500$1,200,000

$130,000

Accounts Receivable Turnover

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Number of Days’ Sales in ReceivablesAn estimate of the length of time (in days)

the accounts receivable have been outstanding.

The fewer number of days, the more efficient the firm is at collecting receivables.

Computed as follows:

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Number of Days’ Sales in

Receivables

Average Accounts

Receivable

Average Daily Sales

=

Net Sales

365

LO 2LO 2Number of Days’ Sales in Receivables

Number of days’ sales in receivables 28.6 39.5

Average accounts receivable(Total accounts receivable ÷ 2) $ 117,500

$ 130,000Net sales $1,498,000 $1,200,000Average daily sales (Net sales ÷ 365) $ 4,104$ 3,288

2012 2011

The number of days’ sales in receivables for Lincoln Company is computed below.

$117,500

$4,104$130,000

$3,288

Measures how effectively the firm uses its non-current assets to generate sales.

The higher the ratio, the more efficient the firm is in using its non-current assets to generate sales.

Computed as follows:

Fixed Assets/Non-Current Assets Turnover Ratio

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Non-Current Assets Turnover

Net Sales

Non-Current Assets (net)

=

Gross sales – sales returns - discounts

Non-current assets – provision for depreciation

Total Assets Turnover Ratio

A measure that shows how effectively a company utilizes its assets – how much sales a firm is able to generate from money invested in total assets.

The higher the ratio, the better.The ratio is computed as follows:

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Total Assets Turnover Ratio

Net Sales

Average Total Assets

=

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Total Assets Turnover Ratio

2012 2011

Net sales $1,498,000 $1,200,000Total assets:

Beginning of year $1,053,000 $1,010,000End of year 1,044,500 1,053,000Total $2,097,500 $2,063,000

Average (Total ÷ 2) $1,048,750 $1,031,500

The ratio of net sales to assets for Lincoln Company is computed below.

Ratio of net sales to assets 1.4 1.2

$1,498,000

$1,048,750 $1,200,000

$1,031,500

Gearing Ratios

Measures how a firm uses outside funds (liabilities) to finance its assets.

Also indicates whether a firm can pay the interest on the use of outside funds & repay the loan amounts.

Also called leverage or debt management ratios.

Debt RatioMeasures the percentage of total liabilities to

the total assets of the firm. Computed as follows:

The lower the ratio, the better the less a firm is financed by outside parties. the higher the firm’s ability to obtain more outside

funds when needed.High ratio

Funds borrowed can be used to generate higher profits (but at higher risk)

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Debt Ratio Total Liabilities x 100

Total Assets=

Times Interest Earned Ratio

Measures the number of times a firm is able to repay fixed interest from its net operating profits.

Also called interest cover ratio.The higher the ratio, the better

More able to repay interest charges.

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It is computed as follows:

Times Interest Earned Ratio

Net operating profit

Interest Expense

=

Times Interest Earned Ratio

Earnings before interest and tax

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The number of times interest charges are earned for Lincoln Company is computed below.

Number of times interest charges earned 28.1 12.2

2012 2011

Income before income tax $162,500 $134,600Add interest expense 6,000 12,000Amount available to meet interest charges $168,500 $146,600

$168,500

$6,000$146,600

$12,000

Times Interest Earned Ratio

Debt to Equity Ratio

Measures long term debt to shareholders’ equity.

Indicates the margin of safety for creditors.

The lower the ratio, the better for the firm.

Computed as follows:

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Debt to Equity Ratio Long term debts

Shareholders’ Equity

=

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Debt to Equity Ratio

Debt to Equity Debt to Equity Ratio 0.4 0.6

Long term debts $310,000 $443,000Shareholders’ equity $829,500 $787,500

2012 2011

The ratio of liabilities to shareholders’ equity for Lincoln Company is computed below.

$310,000

$829,500$443,000

$787,500

Profitability Ratios

Measures the firm’s ability to produce profits from its assets.

The higher the ratios, the better.Also an indication of firm’s efficiency.Can be divided into:

Profitability ratios based on sales (gross profit margin, net profit margin, operating profit margin)

Profitability ratios based on assets/resources (operating profit to total assets ratio, return on assets ratio, return on common equity)

Gross Profit Margin

Measures the profitability of a firm over a period.

Indicates how much profit is made per sales generated.

Computed as follows:

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Gross Profit Margin Gross Profit x 100

Net sales

=

Net Profit Margin

Indicates what is available to owners from its net sales, after considering all expenses.

Computed as follows:

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Net Profit Margin

Net Profit x 100

Net sales=

Operating Profit Margin

Indicates how much operating profit is made per sales generated.

Computed as follows:

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Operating Profit Margin

Net Operating Profit x 100

Net sales

=

Earnings before interest & tax

Operating Profit to Total Assets Ratiomeasures the amount of operating

profit obtained from utilising assets.The higher the ratio, the more

efficient the firm has been in utilising its assets to generate sales/profit.

It is computed as follows:

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Operating Profit to Total Assets

Net Operating Profit x 100

Total Assets

=

Return on Assets Ratio (ROA)

measures the profitability of assets utilised.

Also known as return on investment ratio.

The higher the ratio, the better the return on the use of assets by the firm.

Computed as follows:

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Return on Assets Ratio Net Profit After Tax x

100

Total Assets

=

Return on Common Equity/Return on Capital Employed (ROCE)measures the net profit against the

amount invested by shareholders/owners.

Indicates what shareholders/owners earn from their investments in the business.

It is computed as follows:

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Return on Common Equity/Capital Employed

Net Profit After Tax – Preferred Dividends

Common Equity/Capital

=

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Lincoln Company had $150,000 of 6% preferred stock outstanding on December 31, 2012 and 2011.

Thus, preferred dividends of $9,000 ($150,000 x 6%) are deducted from net income.

Lincoln’s common shareholders’ equity is determined as follows:

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Return on Common Equity/Return on Capital Employed (ROCE)

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Return on common equity 12.5% 10.9%

2012 2011

Net income $ 91,000 $ 76,500Less: preferred dividends 9,000 9,000 Total $ 82,000 $ 67,500Common shareholders’ equity:

Beginning of year $ 637,500 $ 600,000End of year 679,500 637,500

Total $1,317,000 $1,237,500Average (Total ÷ 2) $ 658,500 $ 618,750

$82,000

$658,500

$67,500

$618,750

Return on Common Equity/Return on Capital Employed (ROCE)

Earnings per share (EPS)

Indicates the net income per share

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Earnings per share (EPS) Net income – Preferred Dividends

Number of shares=

Price earnings ratio (P/E ratio)

Indicates the firm’s future earnings prospects

E.g. P/E ratios: A 17, B 24, C 12, D 8. Market price of A is 17 times more

than its earningsB has the best future earnings

prospects, as viewed by investors

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P/E ratio Market price per share

Earnings per share (EPS)=

Dividends per share (DPS) & dividend yield

DPS = dividends/number of sharesDividend yield = DPS/market price

per share Rate of return to investors in terms of

cash dividends Expressed in percentage

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Inter- & Intra-Company ComparisonsInter-company comparisons

against industry averages/norms Obtained by averaging out the ratios of a

good sample of companies in the industry Firm can benchmark itself accordingly

Intra-company comparisons Trend analysis – over a period of time To see if business has improved/

deteriorated To be used to formulate future strategy

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