
Contents • The purpose of analysis • Traditional analysis • Tools of analysis • Analysing financial statements
The purpose of analysis • Different groups of financial statement users with different information needs • Focus will be on needs of equity investors and suppliers of credit • Differing levels of technical expertise • Focus on tools used by a sophisticated user
The purpose of analysis (cont.) • Primary questions relate to company performance and financial strength, but user emphasis may differ • Investment analysts are primarily interested in financial statements as a predictor of future performance • Lenders will primarily focus on the financial strength (default risk) • Each question is the sum of different issues
Traditional analysis • Basis of traditional analysis is relevantcomparison • Comparison over time or in space • Time series analysis: comparing company performance over time • Cross-sectional analysis: comparing company performance with other companies in the same industry (or industry average)
Time series analysis • Horizontal analysis • Using a multi-year information base • Trend percentages • Select a base year • Set item amounts of that year = 100% • Corresponding amount of each following year = % of base mount • Impact of inflation
Cross-sectional analysis • Comparison with other companies in the same industry for the same year • Differences in company characteristics should always be accounted for in interpretation • Comparison with industry averages • Multi-product companies • Definition and size of industry groupings
Tools of analysis • Common-size financial statements • Use of financial ratios • Management performance ratios • Financial strength ratios
Common-size financial statements • Standardizing financial statements by introducing a common denominator • In a common-size balance sheet each component of the balance sheet is expressed as a percentage of total assets • In a common-size income statement each item is expressed as a percentage of sales
Common-size financial statements (cont.) • Allow comparison of companies of different size (in terms of total assets and sales) • Allow (internal) structural analysis of the financial statements of a company • Relative magnitude of asset, liability, equity and income statement components • Combination of horizontal and vertical analysis
Use of financial ratios • A financial ratio expresses the mathematical relationship between two or more financial statement items that are logically linked • Comparison over time and in space • Like must always be compared with like • Combined use of financial ratios is more informative • Financial ratios as indicators of management performance and financial strength
Management performance ratios • Profitability and asset utilization ratios • Margin ratios (return on sales) show how successful management is in creating profit from a given quantity of sales • Return on investment ratios take into account the investment needed to generate the profit • Asset utilization ratios measure how efficient management uses the company’s assets
Margin ratios • Main ratios: • Gross operating margin • Net operating margin • Net profit margin • Measure operating efficiency • Tend to be highly industry-specific
Return on investment ratios • Main ratios: • Return on equity (ROE) • Return on assets (ROA) • Return on capital employed (ROCE) • Each reflects the profit generated by a specific pool of funds, excluding the costs of the specific funds considered • Different denominators (investment base) and numerators (profit figure retained)
ROI - perspectives • ROE measures how much a company has earned on the funds invested by its shareholders (shareholder perspective) • ROA shows how well a company’s funds were used, irrespective of the relative magnitudes of the sources of these funds (current liabilities, debt and equity) • ROCE shows how much a company has earned on invested long-term funds (permanently employed capital = equity + LT debt)
Figure 9.1 Capital employed Capital employed Capital employed
Earnings per share (EPS) • Shows how much of a period’s net profit has been earned by each ordinary share outstanding (basic EPS) or by shares outstanding plus all potential shares (diluted EPS) • Potential shares are equity instruments issued that can be converted into ordinary shares at the option of the holder of the instrument • IAS 33 Earnings per Share requires that listed companies disclose both basic and diluted EPS on the face of the income statement
Price/earnings ratio EPS is used as input to a market ratio, the price/earnings or P/E ratio: • Reflects how the market (market price) judges the company’s performance (growth expectations) • It is an inverted rate of return ratio • Also called the Earnings Multiple
Dividend yield ratio Thedividend yield ratioreflects the relationship between the dividends per share paid to shareholders and the current market price of a share: Both P/E and dividend yield ratios of listed companies are published daily by major financial newspapers
Asset utilization ratios • Main ratios: • Total asset turnover • Fixed asset turnover • Inventory turnover • Receivable turnover • Turnover ratios measure efficiency of use of (categories of) assets • Tend to be industry-specific
Financial strength ratios • Indicate the strength of a company’s financial position from the point of view of long-term solvency risk and short-term liquidity risk • Solvency refers to the long-term ability to generate cash internally or from external sources in order to meet long-term financial obligations • Liquidity refers to the ability to generate cash to meet short-term obligations
Long-term solvency risk ratios • Main ratios: • Debt/equity ratio • Gearing ratio • Interest and dividend cover • Gearing as indicator of default risk • Debt financing introduces financial risk because it implies fixed commitments in the form of interest payments and principal repayment and exposure to interest rate movements
Short-term liquidity risk ratios • Main ratios: • Current ratio and acid-test ratio • Credit given and credit obtained • Days inventory outstanding • Liquidity tests focus on the make-up of working capital and the activity level of its components • Low liquidity implies financial risk as inability to service short-term debt payments may lead to higher interest expense and, eventually, bankruptcy
Analysing financial statements • Decode messages built into financial statements and use them to ‘tell the story’ • Time series analysis of ratios • Combine patterns of financial ratios • Compare cross-sectionally • Ratio analysis is only part of an investment appraisal process - also consider: • Non-financial performance indicators • Broader economic variables • Information about future business plans, etc.