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Analysis of Financial Statements

Analysis of Financial Statements. Financial statements and reports Ratio analysis. The Annual Report Provides. A verbal description of the firms operating results during the past year Discussion of new developments Financial statements. Key Financial Statements. Balance sheet

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Analysis of Financial Statements

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  1. Analysis of Financial Statements • Financial statements and reports • Ratio analysis

  2. The Annual Report Provides • A verbal description of the firms operating results during the past year • Discussion of new developments • Financial statements

  3. Key Financial Statements • Balance sheet • Income statement • Statement of cash flows

  4. Example of Balance Sheets: Assets 2011 Cash 9,000 Short-term inv. 48,600 Acct Receivable 351,200 Inventories 715,200 Total Current Asset 1,124,000 Gross Fixed Asset 491,000 Less: Depreciation146,200 Net Fixed Asset 344,800 Total assets 1,468,800

  5. Example of Balance Sheets: Liabilities and Equity 2011 Accts payable 145,600 Notes payable 200,000 Accruals 136,000 Total Current Liability 481,600 Long-term debt 323,432 Common stock 460,000 Retained earnings 203,768 Total equity 663,768 Total liability and equity 1,468,800

  6. Example of Income Statement 2011 Sales 3,432,000 COGS 2,864,000 Other expenses 340,000 Deprecication 18,900 3,222,900 Tot. operating. costs EBIT 209,100 Interest expenses 62,500 EBT 146,600 Taxes (30%) 43,980 102,620 Net income

  7. Good to Know!! EBITDA (Earnings before interest, taxes, depreciation and amortization To measure cash earnings without accrual accounting, cancelling tax jurisdiction effects, and cancelling the effects of different capital structures.

  8. Statement of Cash Flows • The Statement of Cash Flows reports: • Operating activities • Investing activities • Financing activities

  9. To determine whether a change in a balance sheet account by using these rules Uses of Cash Decrease in a liabilities or equity account - Paying off a loan or buying back stock uses cash Increase in an asset account - Buying fixed assets or buying more inventory uses cash. Sources of Cash Increase in a liabilities or equity account - Borrowing funds or selling stock provides the firm with cash Decrease in an asset account - Selling inventory or collecting receivables provides cash

  10. 2011 Statement of Cash Flows Cash flow from operating activities: Net income $ 44,220 Additions (sources of cash): Depreciation 20,000 Incr. in accruals 4,000 Incr. in accounts payable 29,600 Subtractions (uses of cash): Incr. in receivables (50,800) Incr. in inventories ( 120,800) NCF from operations ($ 73,780)

  11. Cash flow from investing activities: Investment in fixed assets ($ 36,000) Increase in notes payable $ 25,000 Increase in L-T debt 101,180 Common dividends ( 22,000) NCF from financing $104,180 Net increase (decr.) in cash ($ 5,600) Cash at beginning of year 57,600 Cash at end of year $ 52,000 Cash flow from financing activities:

  12. Management Reports • Daily Revenue Report • Daily Payroll Cost Report • Rooms Revenue Forecast • Food and Beverage Menu Abstract • Accounts Receivable Aging Schedule

  13. Daily Revenue Report

  14. Daily Payroll Cost Report

  15. Rooms Revenue Forecast

  16. Food and Beverage Menu Abstract

  17. Accounts Receivable Aging Schedule Aging Schedule for Hanover Country Club

  18. Ratio Analysis Categories • Liquidity • Asset management • Debt management • Profitability • Market value

  19. Liquidity = the ability of a firm to meet its short-term obligations as they come due. • Liquidity analysis requires use of a forecasted cash budget but ratio analysis provides some quick measures of liquidity.

  20. Measures of Liquidity CA CL Current ratio = . To indicate the extent to which the claims of S-T creditors are covered by assets that will soon be converted to cash

  21. CA - Inv. CL To measure how quick the firm can pay off S-T debt without liquidating inventories Quick ratio = .

  22. CA CL Current ratio = . CA - Inv. CL Quick ratio = . 2010 2011 Industry Current Quick 2.3x 0.8x 2.4x 0.8x 2.7x 1.0x A little weaker than average.

  23. Asset Management Ratios • Inventory turnover ratio • Days sales outstanding (accounts receivable) • Fixed assets turnover • Total assets turnover

  24. Sales Inventory Inventory turnover = . (To indicate whether a firm carries too many inventories and whether it manages inventories effectively.) 2010 4.8x 2011 4.6x Industry 7.0x Low inventory turnover--excess inventory for current level of sales.

  25. Problems with Inventory Turnover Measurement • Sales prices include markups but inventories carried at cost. • Sales occur throughout the year, but inventory is at a particular point in time. • Differences in accounting methods may make comparisons difficult (e.g. LIFO vs. FIFO).

  26. Days Sales Outstanding (DSO) is the average number of days the firm must wait after making a sale before it receives cash. Receivables . DSO = Sales/day

  27. $402,000 2011 DSO = $3,850,000/360 = 37.59 days.

  28. 2010 2011 Industry DSO 36.8 37.6 32.0 High DSO--firm is collecting too slowly or has overly liberal credit terms.

  29. Sales Fixed assets turnover = . Fixed assets [ To show how effective the firms utilizes its fixed assets to generate sales.] Sales Total assets turnover = . TA [To indicate the extent to which a firm uses its total resources to generate sales.]

  30. 2010 2011 Industry FATO TATO 10.0 2.3 10.7 2.3 10.7 2.6 Fixed assets turnover OK, but total assets turnover is low--indicates problem with current assets (inventory and receivables).

  31. Debt Management Ratios • Debt ratio (balance sheet) • Debt/equity ratio (balance sheet) • Times interest earned (income statement) • Fixed charge coverage (income statement)

  32. Debt Management Ratios D D Debt ratio = = . A D + E [It measures the proportion of a firm’s total assets that is financed with creditors’ funds.] D Debt/equity = . E [It is similar to debt ratio and relates the amount of a firm’s debt financing to the amount of equity financing.]

  33. and Equity multiplier = A/E = 1/(1 - D/A). Times interest earned (TIE) EBIT Interest charges = . [It tells the extent to which the firm’s current earnings are able to meet current interest payments.]

  34. 2010 Industry 2011 DR TIE 54.8% 3.3 58.4% 2.0 50.0% 2.5 Debt ratio high, TIE low and falling. Debt is risky; would have high kd.

  35. Profitability Ratios • Profit margin (PM) • Basic earning power (BEP) • Return on assets (ROA) • Return on equity (ROE) • Return on investors capital (ROC)

  36. NI PM = . Sales [ It gives the profit per dollar of sales.] 2011 1.1% 2010 2.6% Industry 3.5% Indicates: Sales prices are low and/or costs are high.

  37. EBIT BEP = . TA [It shows the raw earning power of the firm’s assets, before influence of taxes and leverage. ] 2010 14.2% 2011 9.1% Industry 19.1% Indicates: Firm is doing a poor job of generating earnings from its assets.

  38. NI NI ROA = . ROE = . Common equity TA [It measures a firm’s net income in relation to the total asset investment.] [It measures the rate of return that the firm earns on stockholders’ equity.]

  39. Profitability Ratios Summary 2011 2010 Industry ROA ROE 6.0% 13.3% 2.7% 6.4% 9.1% 18.2% All profitability measures are low and falling. High inventory, A/R levels lead to low profits.

  40. Market Value Ratios Price/Share P/E = . Earnings/Share [The price the market places on $1 of a firm’s earnings.] Common equity Book value/Share = . # Shares Price/Share Market/Book = . Book value/Share [The higher the rate of return a firm is earning on its common equity relative to the return required by investors (the cost of common equity), the higher will be the M/B.]

  41. 2011 Industry 2010 P/E M/B 9.7% 1.3 13.6% 0.9 14.2% 1.4 P/E ratios can rise if a decline in EPS is not expected to be permanent. M/B ratio is low. “Normalized” P/E probably low too.

  42. NI E NI S S TA TA E = x x . Use the Du Pont Equation to get an overview of the firm’s financial position Profit margin Total asset turnover Equity multiplier ROE = x x

  43. Du Pont Equation Provides an Overview • Profitability measured by ROE • Expense control measured by PM • Asset utilization measured by TATO • Financial leverage measured by EM (debt utilization) • The interaction between the determinants of ROE

  44. ROE = PM x TATO x EM 13.30% 2.60 2.3 2.2 6.40% 1.15 2.3 2.4 18.20% 3.50 2.6 2.0 2010 2011 IND.

  45. What is common size analysis? • Converting income statement and balance sheet values into % to facilitate comparison between firms of different sizes and firms over time. • Income statement: Divide by sales. • Balance sheet: Divide by total assets. • Used to supplement ratio analysis.

  46. Readers of Financial Analysis

  47. Readers of Financial Analysis cont.

  48. Types of Analysis • Vertical Analysis • Used to analyze variable expenses • All accounts are sized using either: • Total revenue or • Departmental revenue • Variable expenses should increase or decrease with the level of sales

  49. Management Decision Making • Employee Scheduling • Based on: • Accurate revenue forecasts • Productivity goals • Customer service goals

  50. Management Decision Making • Food and Beverage Pricing • Track sales of each menu item • Calculate each items gross profitability • Set menu prices • Remove unprofitable items from the menu

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