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Chapter 4. Analysis of Financial Statements. Three Methods of Analyzing Financial Statements. Vertical analysis
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Chapter 4 Analysis of Financial Statements
Three Methods of Analyzing Financial Statements • Vertical analysis • Vertical analysis is the process of using a single variable on a financial statement as a constant and determining how all of the other variables relate as a percentage of the single variable. • Horizontal analysis • Horizontal analysis is a determination of the percentage increase or decrease in an account from a base time period to successive time periods. • Ratio analysis • Ratio analysis is used to determine the health of a business, especially as that business compares to other firms in the same industry or similar industries. • A ratio is nothing more than a relationship between two variables, expressed as a fraction.
Types of Business Ratios • Liquidity ratios determine how much of a firm’s current assets are available to meet short-term creditors’ claims. • Activity ratios indicate how efficiently a business is using its assets. • Leverage (debt) ratios indicate what percentage of the business assets is financed with creditors’ dollars. • Profitability ratios determine how much of an investment will be returned from either earnings on revenues or appreciation of assets. • Market ratios determine if they should invest capital in the company in exchange for ownership.
Liquidity Ratios • Current Ratio:The current ratio is calculated by dividing total current assets by total current liabilities. • Quick, or Acid Test, Ratio:This ratio does not count the sale of the company’s inventory. It measures the ability of the firm to meet its short-term obligations without liquidating its inventory.
Activity Ratios • Inventory turnover ratio (or, simply, inventory turnover) indicates how efficiently a firm is moving its inventory. It basically states how many times per year the firm moves it average inventory. • A better ratio is the day’s carry inventory.
Activity Ratios (continued) • Accounts receivable turnover ratio allows us to determine how fast our company is turning its credit sales into cash. • A better ratio is Days’ Sales Outstanding or Average Collection Period. DSO is the average number of days that it takes the firm to collect its accounts receivable.
Activity Ratios (continued) • Fixed asset turnover ratio indicates how efficiently fixed assets are being used to generate revenue for a firm. • Total asset turnover ratio indicates how efficiently our firm uses its total assets to generate revenue for the firm.
Leverage Ratios • Debt-to-equity ratio indicates what percentage of the owner’s equity is debt. • Debt-to-total-assets ratio indicates what percentage of a business’s assets is owned by creditors.
Leverage Ratios (continued) • Times-interest-earned ratio shows the relationship between operating income and the amount of interest in dollars the company has to pay to its creditors on an annual basis.
Profitability Ratios • Gross profit margin ratio is used to determine how well management controls the expenses of production. • Operating profit margin ratio is used to determine how well management controls the expenses of running the company.
Profitability Ratios (continued) • Net profit margin ratio tells us how much a firm earned on each dollar in sales after paying all obligations including interest and taxes. • Referred to as the “Bottom Line”. • This is a “muddy” number
Profitability Ratios (continued) • Operating return on assets ratio is also referred to as Basic Earning Power allows us to determine how much we are actually earning on each dollar in assets prior to paying interest and taxes. • It does not include the costs of financing. • Net return on assets (ROA) ratio tells us how much a firm earns on each dollar in assets after paying both interest and taxes. • It includes financing decisions.
Profitability Ratios (continued) • Return on equity (ROE) ratio tells the stockholder, or individual owner, what each dollar of his or her investment is generating in net income.
Market Ratios • Earnings per share ratio is nothing more than the net profit or net income of the firm, less preferred dividends (if the company has preferred stock), divided by the number of shares of common stock outstanding (issued).
Market Ratios (continued) • Price earnings ratio is a magnification of earnings per share in terms of market price of stock. • Illustrates how investors feel about a company’s future • If the PE ratio increases, what does this tell us?
Price Earnings to Growth ratio(PEG ratio) • The price earnings to growth ratio (PEG ratio) compares the company’s price earnings ratio to its expected earnings per share (EPS) growth rate over the next several years. • A fairly prices stock will have a PEG = 1.0. • PEG < 1.0 infers an undervalued stock. • PEG between 1 and 2 infers a fairly priced stock.
Market Ratios (continued) • Operating cash flow per-share ratio compares the operating cash flow on the statement of cash flows to the number of shares of common stock outstanding. • Cash is harder to manipulate than profit.
Free Cash Flow • Free cash flow gives businesses the opportunity to set aside moneys from operating activities and use them to generate growth. • The formula is: http://www.youtube.com/watch?feature=player_detailpage&v=pqWX0nQnhDQ
