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CHAPTER 9 Financial statement analysis I

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## CHAPTER 9 Financial statement analysis I

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**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.