Faculty: Ms. Luvnica RastogiAmity International Business SchoolImp Website: www.investorwords.com Financial Statement Analysis
Financial Analyst and Financial Analysis • Financial Analyst: • The financial analyst can be viewed as any user of available information concerning firms who wishes to use the information for the purpose of decision making. • Financial Analysis: • It is the procedure the financial analyst uses to interpret the information.
Financial Statement Analysis • The art of transforming data from Financial Statements into information that is useful for informed decision making is called Financial Statement Analysis. • The firm itself and outside providers of capital (creditors and investors) all undertake financial statement analysis. • The type of analysis varies according to the specific interest of the party involved.
Examples of External Uses of Financial Statement Analysis • Trade Creditors-- Focus on the liquidity of the firm. • Their claims are short term, and the ability of the firm to pay these claims quickly is best judged by an analysis of the firm’s liquidity.
Bondholders-- Focus on the long-term cash flow of the firm. • Because the Bondholder are more interested in the cash flow ability of the firm to service Debt over a long period of time. • They may evaluate this ability by analyzing the capital structure of the firm, the major sources and uses of funds, the firm’s profitability over time and projection of future profitability.
Shareholders -- Focus on the profitability and long-term health of the firm. • They would also be concerned with the firm financial condition.
Examples of Internal Uses of Financial Statement Analysis • Plan-- Focus on assessing the current financial position and evaluating potential firm opportunities in relation to this current position. • Control– With respect to internal control, the financial manager is particularly concerned with the return on investment provided by the company and with the efficiency of assets management.
Understand –To bargain effectively for outside funds, Financial Manager need to Focus on all aspect of financial analysis for understanding how suppliers of funds analyze the firm.
Primary Types of Financial Statements Income Statement • A summary of a firm’s revenues and expenses over a specified period, ending with net income or loss for the period. • Balance Sheet • A summary of a firm’s financial position on a given date that shows total assets = total liabilities + owners’ equity.
Basket Wonders’ Balance Sheet (Asset Side) a. How the firm stands on a specific date. b. What BW owned. c. Amounts owed by customers. d. Future expense items already paid. e. Cash/likely convertible to cash within 1 year. f. Original amount paid. g. Acc. deductions for wear and tear. Cash and C.E. $ 90 Acct. Rec.c 394 Inventories 696 Prepaid Expd 5 Accum Tax Prepay 10Current Assetse $1,195 Fixed Assets (@Cost)f 1030 Less: Acc. Depr. g (329) Net Fix. Assets $ 701 Investment, LT 50 Other Assets, LT 223Total Assets b $2,169 Basket Wonders Balance Sheet (thousands) Dec. 31, 2003a
Basket Wonders’ Balance Sheet (Liability Side) a. Note, Assets = Liabilities + Equity. b. What BW owed and ownership position. c. Owed to suppliers for goods and services. d. Unpaid wages, salaries, etc. e. Debts payable < 1 year. f. Debts payable > 1 year. g. Original investment. h. Earnings reinvested. Notes Payable $ 290 Acct. Payablec 94 Accrued Taxesd 16 Other Accrued Liab.d 100Current Liab.e $ 500 Long-Term Debtf530Shareholders’ Equity Com. Stock ($1 par)g200Add Pd in Capitalg 729 Retained Earningsh 210 Total Equity $1,139 Total Liab/Equitya,b $2,169 Basket Wonders Balance Sheet (thousands) Dec. 31, 2003
Basket Wonders’ Income Statement a. Measures profitability over a time period. b. Received, or receivable, from customers. c. Sales comm., adv., officers’ salaries, etc. d. Operating income. e. Cost of borrowed funds. f. Taxable income. g. Amount earned for shareholders. Net Sales b $ 2,211 Cost of Goods Sold1,599 Gross Profit $ 612 SG&A Expenses c 402EBITd$ 210 Interest Expense 59 EBT f$151Income Taxes 60 EATg$ 91 Cash Dividends 38 Increase in RE $ 53 Basket Wonders Statement of Earnings (in thousands) for Year Ending December 31, 2003a
Cross Sectional Financial Statement Studies • There is little to be gained by analyzing the financial statements of a company for one year alone. • A “benchmark” is needed by which to judge a company’s performance. • This “benchmark” can be obtained by comparing companies with in the same industries with other companies. • This is known as a cross-sectional study.
Time Series Financial Statement Studies • To compare the accounts of one company with its own previous years. Possible to see if a company is improving in certain areas or not. • This is known as a Time series study.
Use of Financial Ratios Types of Comparisons Internal Comparisons External Comparisons A Financial Ratio is an index that relates twoaccountingnumbers and is obtained by dividing one number by the other.
Internal Comparisons • To compare a present ratio with past and expected future ratios for the same company is called Internal comparisons. • For example to compare the Kardan 2008 ratios with Kardan 2007 and 2006 ratios that either they have improved or not.
External Comparison • This involves comparing the ratios of one firm with those of similar firms or with industry averages. • Or • To compare the ratios of one firm with those of similar firms or with industry averages at the same point in time is called External Comparisons. • Similarity is important as one should compare “apples to apples.” • Example: to compare the ratios of Kardan and Bakhtar
How a Ratio is expressed? • As Percentage - such as 25% or 50% . For example if net profit is Rs.25,000/- and the sales is Rs.1,00,000/- then the net profit can be said to be 25% of the sales. • As Proportion - The above figures may be expressed in terms of the relationship between net profit to sales as 1 : 4. • As Pure Number /Times - The same can also be expressed in an alternatively way such as the sale is 4 times of the net profit or profit is 1/4th of the sales.
Why are ratios useful? • Ratios standardize numbers and facilitate comparisons. • Ratios are used to highlight weaknesses and strengths.
Types of Ratios • (i) Liquidity Ratios • (ii) Financial Leverage (Debt) Ratios • (iii) Coverage Ratios • (iv) Activity Ratios • (v) Profitability Ratios • (vi) Investment Ratios
Liquidity Ratios Ratio’s that measure a firm’s ability to meet short term obligations. Or It shows that Can we make required payments? Balance Sheet Ratios Liquidity Ratios
Liquidity Ratios • Liquidity ratios are used to measure a firm ability to meet short term obligations. • They compare short term obligations with short term (or current) resources available to meet these obligations. • From these ratios, much insight can be obtained into the present cash solvency of the firm.
Liquidity Ratios • Current Ratio • Acid test (quick) Ratio Balance Sheet Ratios Liquidity Ratios
Liquidity Ratios Shows a firm’s ability to cover its current liabilities with its current assets. Or It is the relationship between the current assets and current liabilities of a firm. Balance Sheet Ratios Current Ratio
Liquidity Ratios Current Ratio Current Assets Current Liabilities If Current Assets = Rs.1,195 and Current Liabilities = Rs.500 Balance Sheet Ratios Liquidity Ratios Rs.1,195 Rs.500 = 2.39
Current Ratio • Looks at the ratio between Current Assets and Current Liabilities • Ideal level? – 1.5 • A ratio of 2.39 would imply the firm has $2.39 of current assets to cover every $1 in current liabilities • Too high – Might suggest that too much of its assets are tied up in unproductive activities – too much stock, for example? • Too low - risk of not being able to pay Current liabilities.
Liquidity Ratio Comparisons BW Industry 2.39 2.15 2.26 2.09 1.91 2.01 Year 2003 2002 2001 CurrentRatio Ratio is stronger than the industry average.
Liquidity Ratios Shows a firm’s ability to meet current liabilities with its most liquid assets. Or It is the ratio between Quick Current Assets and Current Liabilities. Balance Sheet Ratios Acid test (quick) Ratio
Liquidity Ratios Acid-Test (Quick) Current Assets - Inv Current Liabilities If Current Assets = $1,195 and Current Liabilities = $500 Inventory = $696 Balance Sheet Ratios Liquidity Ratios $1,195 - $696 $500 = 1.00
Acid Test (quick) Ratio • 1 seen as ideal • It has been argued that Inventory takes a while to convert to cash so a more realistic ratio would ignore Inventory. • The omission of Inventory gives an indication of the cash the firm has in relation to its liabilities (what it owes) • A ratio of 1 would imply that the firm has $1 of cash to cover every $1 in current liabilities. • Again if it is too high means that the business is very liquid – may be able to use the cash for other activities to increase performance. • If it is too low then the business may face problems in payment of current liabilities. • Some types of business need more cash than others so acid test would be expected to be higher
Liquidity Ratio Comparisons BW Industry 1.00 1.25 1.04 1.23 1.11 1.25 Year 2003 2002 2001 Acid-Test Ratio Ratio is weaker than the industry average.
Summary of the Liquidity Ratio Comparisons • Strong current ratio and weak acid-test ratio indicates a potential problem in the inventories account. • Note that this industry has a relatively high level of inventories. RatioBWIndustry Current 2.39 2.15 Acid-Test 1.00 1.25
Summary of the Liquidity Trend Analysis • The current ratio for the industry has been rising slowly at the same time the acid-test ratio has been relatively stable. • This indicates that inventories are a significant problem for BW. • The current ratio for BW has been rising at the same time the acid-test ratio has been declining.
Financial Leverage (Debt) Ratios Shows the extent to which the firm is financed by debt. Balance Sheet Ratios Financial Leverage Ratios
Financial Leverage (Debt) Ratios (i). Debt-to-Equity (ii). Debt-to-Total-Assets (iii). Total Capitalization Balance Sheet Ratios Financial Leverage Ratios
Financial Leverage (Debt) Ratios It is the relationship between borrower’s fund (Debt) and Owner’s Capital (Equity). The Debt to Equity ratio is computed by simply dividing the total debt of the firm (including current liabilities) by its share holder’s equity. Balance Sheet Ratios Debt-to-Equity
Financial Leverage Ratios Debt-to-Equity Total Debt Shareholders’ Equity For Basket Wonders December 31, 2003 If Total Debt = 1030 and Shareholder’s equity = 1139 Balance Sheet Ratios Financial Leverage Ratios $1,030 $1,139 = .90
Debt-to-Equity Ratio • The ratio 0.90 tells us that creditors are providing 90 cents of financing for each $1 being provided by shareholder’s. • Creditors would generally like this ratio to be low. • The lower the ratio the higher the level of the firm’s financing that is being provided by shareholder’s, and the larger the creditor cushion (margin of protection) in the event of losses.
Financial Leverage Ratio Comparisons BW Industry .90 .90 .88 .90 .81 .89 Year 2003 2002 2001 Debt-to-Equity Ratio BW has average debt utilization relative to the industry average.
Financial Leverage (Debt) Ratios Shows the percentage of the firm’s assets that are supported by debt financing. or It is the relationship between borrower’s fund (Debt) and total Assets. Balance Sheet Ratios Debt-to-Total-Assets
Financial Leverage Ratios Debt-to-Total-Assets Total Debt Total Assets For Basket Wonders December 31, 2003 If Total Debt = 1030 And Total assets = 2169 Balance Sheet Ratios Financial Leverage Ratios $1,030 $2,169 = .47
Debt-to-Total-Assets Ratio • This ratio highlights the relative importance of debt financing to the firm by showing the percentage of the firm’s assets that is supported by debt financing. • The 0.47 ratio shows that 47 percent of the firm assets are financed by debt and remaining 53 percent of the finance comes from shareholder’s equity.
Once again this ratio points out that the greater the percentage of financing provided by shareholder’s equity, the larger the cushion of protection offered the firm’s creditors. • In short the higher the Debt to total assets ratio, the greater the financial risk; the lower the ratio, the lower the financial risk.
Financial Leverage Ratio Comparisons BW Industry .47 .47 .47 .47 .45 .47 Year 2003 2002 2001 Debt-to-Total-Asset Ratio BW has average debt utilization relative to the industry average.
Financial Leverage (Debt) Ratios Shows the relative importance of long-term debt to the long-term financing of the firm. Total capitalization represents all long term debt and shareholder’s equity. Balance Sheet Ratios Long term Debt to Total Capitalization(i.e., LT-Debt + Equity)
Financial Leverage Ratios Total Capitalization Long Term Debt Total Capitalization For Basket Wonders December 31, 2003 If Long term Debt = 530 And LT-debt + Equity = 1669 Balance Sheet Ratios (i.e., LT-Debt + Equity) Financial Leverage Ratios $530 $1,669 = .32
This measure tells us the relative importance of long term debt to the long term financing of the firm. • The 0.32 ratio shows that 32 percent of the firm total long term financing is provided by long term debt and remaining 68 percent of the finance comes from shareholder’s equity.
Financial Leverage Ratio Comparisons BW Industry .32.30 .34.32 .33.31 Year 2003 2002 2001 Total Capitalization Ratio BW has average long-term debt utilization relative to the industry average.