Financial Statement Analysis

Financial Statement Analysis Mary Low Waikato Management School The University of Waikato © Mary Low

Business Survival: There are two key factors for business survival: • Profitability • Solvency • Profitability is important if the business is to generate revenue (income) in excess of the expenses incurred in operating that business. • The solvency of a business is important because it looks at the ability of the business in meeting its financial obligations. © Mary Low

Financial Statement Analysis • Financial Statement Analysis will help business owners and other interested people to analyse the data in financial statements to provide them with better information about such key factors for decision making and ultimate business survival. © Mary Low

Financial Statement Analysis Purpose: • To use financial statements to evaluate an organisation’s • Financial performance • Financial position. • To have a means of comparative analysis across time in terms of: • Intracompany basis (within the company itself) • Intercompany basis (between companies) • Industry Averages (against that particular industry’s averages) • To apply analytical tools and techniques to financial statements to obtain useful information to aid decision making. © Mary Low

Financial Statement Analysis Financial statement analysis involves analysing the information provided in the financial statements to: • Provide information about the organisation’s: • Past performance • Present condition • Future performance • Assess the organisation’s: • Earnings in terms of power, persistence, quality and growth • Solvency © Mary Low

Effective Financial Statement Analysis • To perform an effective financial statement analysis, you need to be aware of the organisation’s: • business strategy • objectives • annual report and other documents like articles about the organisation in newspapers and business reviews. These are called individual organisational factors. © Mary Low

Effective Financial Statement Analysis Requires that you: • Understand the nature of the industry in which the organisation works. This is an industry factor. • Understand that the overall state of the economy may also have an impact on the performance of the organisation. → Financial statement analysis is more than just “crunching numbers”; it involves obtaining a broader picture of the organisation in order to evaluate appropriately how that organisation is performing © Mary Low

Tools of Financial Statement Analysis: The commonly used tools for financial statement analysis are: • Financial Ratio Analysis • Comparative financial statements analysis: • Horizontal analysis/Trend analysis • Vertical analysis/Common size analysis/ Component Percentages © Mary Low

Financial Ratio Analysis • Financial ratio analysis involves calculating and analysing ratios that use data from one, two or more financial statements. • Ratio analysis also expresses relationships between different financial statements. • Financial Ratios can be classified into 5 main categories: • Profitability Ratios • Liquidity or Short-Term Solvency ratios • Asset Management or Activity Ratios • Financial Structure or Capitalisation Ratios • Market Test Ratios © Mary Low

Profitability Ratios 3 elements of the profitability analysis: • Analysing on sales and trading margin • focus on gross profit • Analysing on the control of expenses • focus on net profit • Assessing the return on assets and return on equity © Mary Low

Profitability Ratios • Gross Profit % = Gross Profit * 100 Net Sales • Net Profit % = Net Profit after tax * 100 Net Sales Or in some cases, firms use the net profit before tax figure. Firms have no control over tax expense as they would have over other expenses. • Net Profit % = Net Profit before tax *100 Net Sales • Return on Assets = Net Profit * 100 Average Total Assets • Return on Equity = Net Profit *100 Average Total Equity © Mary Low

Liquidity or Short-Term Solvency ratios Short-term funds management • Working capital management is important as it signals the firm’s ability to meet short term debt obligations. For example: Current ratio • The ideal benchmark for the current ratio is $2:$1 where there are two dollars of current assets (CA) to cover $1 of current liabilities (CL). The acceptable benchmark is $1: $1 but a ratio below $1CA:$1CL represents liquidity riskiness as there is insufficient current assets to cover $1 of current liabilities. © Mary Low

Liquidity or Short-Term Solvency ratios • Working Capital = Current assets – Current Liabilities • Current Ratio = Current Assets Current Liabilities • Quick Ratio = Current Assets – Inventory – Prepayments Current Liabilities – Bank Overdraft © Mary Low

Asset Management or Activity Ratios • Efficiency of asset usage • How well assets are used to generate revenues (income) will impact on the overall profitability of the business. For example: Asset Turnover • This ratio represents the efficiency of asset usage to generate sales revenue © Mary Low

Asset Management or Activity Ratios • Asset Turnover = Net Sales Average Total Assets • Inventory Turnover = Cost of Goods Sold Average Ending Inventory • Average Collection Period = Average accounts Receivable Average daily net credit sales* * Average daily net credit sales = net credit sales / 365 © Mary Low

Financial Structure or Capitalisation Ratios Long term funds management • Measures the riskiness of business in terms of debt gearing. For example: Debt/Equity • This ratio measures the relationship between debt and equity. A ratio of 1 indicates that debt and equity funding are equal (i.e. there is $1 of debt to $1 of equity) whereas a ratio of 1.5 indicates that there is higher debt gearing in the business (i.e. there is $1.5 of debt to $1 of equity). This higher debt gearing is usually interpreted as bringing in more financial risk for the business particularly if the business has profitability or cash flow problems. © Mary Low

Financial Structure or Capitalisation Ratios • Debt/Equity ratio = Debt / Equity • Debt/Total Assets ratio = Debt *100 Total Assets • Equity ratio = Equity *100 Total Assets • Times Interest Earned = Earnings before Interest and Tax Interest © Mary Low

Market Test Ratios • Based on the share market's perception of the company. For example: Price/Earnings ratio • The higher the ratio, the higher the perceived quality of the earnings by the share market. © Mary Low

Market Test Ratios • Earnings per share = Net Profit after tax Number of issued ordinary shares • Dividends per share = Dividends Number of issued ordinary shares • Dividend payout ratio = Dividends per share *100 Earnings per share • Price Earnings ratio = Market price per share Earnings per share © Mary Low

Horizontal analysis/Trend analysis • Trend percentage • Line-by-line item analysis • Items are expressed as a percentage of a base year • This is a time series analysis • For example, a line item could look at increase in sales turnover over a period of 5 years to identify what the growth in sales is over this period. © Mary Low

Vertical analysis/Common size analysis/ Component Percentages • All items are expressed as a percentage of a common base item within a financial statement • e.g. Financial Performance – sales is the base • e.g. Financial Position – total assets is the base • Important analysis for comparative purposes • Over time and • For different sized enterprises © Mary Low

Limitations of Financial Statement Analysis • We must be careful with financial statement analysis. • Strong financial statement analysis does not necessarily mean that the organisation has a strong financial future. • Financial statement analysis might look good but there may be other factors that can cause an organisation to collapse. © Mary Low

Illustration: Financial statement analysis • The following financial statements of Walker Ltd were prepared in accordance with New Zealand GAAPs. Walker Ltd is a diversified enterprise with its main interests in the manufacture and retail of plastic products. • The financial statements of Walker Ltd need to be analysed. An investor is considering purchasing shares in the company. Relevant ratios need to be selected and calculated and a report needs to be written for the investor. The report should evaluate the company’s performance and position © Mary Low

Additional information: • Credit purchases for the year 2006 were $2,142,800. • General prospects for the major industries in which Walker is involved look good with a forecast glut of oil set to reduce the cost of production and world demand for plastic remaining strong. Benchmarks: • There are no exact benchmarks for Walker Ltd because it is a diversified company. The following are average indicators that relate to the plastic retailing and manufacturing industries for the year 2006. • Gross profit margin 25% • Net profit margin 7% • Inventory turnover 6 times • Debt/equity ratio 0.6 : 1 • Return on Assets 12% • Return on Equity 20% © Mary Low

Relevant ratios Important note: The calculations of the ratios in this illustration did not use “averages” for total assets, equity and inventory. The 2005 and 2006 year end figures were used and this is a slight variation to the formulas provided. © Mary Low

© Mary Low

Report • For the investor considering the purchase of shares in the company, the return they will earn is the key financial factor but an overall evaluation of the company’s performance and position is also important to get a better picture of how well the company is actually doing. • ROE in 2006 is 26%. Whether or not this is attractive depends on the perceived riskiness of this investment and other alternatives available but this return is certainly more attractive than current bank interest rates. • ROE has decreased by 4% but the company’s ROE at 26% is still better than the industry average of 20% • Riskiness of business is being reduced by the significant repayment of loan in 2006. © Mary Low

Profitability • The NP% and ROA ratios show a small downward trend in % over the 2 year period. ROE% ratio show a more significant decrease but is still better than the industry average. • Gross Profit Margin is slightly unfavourable at about 2.3% below the industry benchmark of 25%. • The horizontal analysis information show that Sales have increased by 20%. However operating costs have increased by 34%. • Asset Management • IT has gone down slightly from 5.8 to 5.58 times. • IT is still close to the industry benchmark of 6 times. • AT has increased showing more sales being generated from asset usage © Mary Low

Liquidity • Current ratios of 1.78:1 (2005) and 1.70: 1 are at above acceptable levels but below ideal level. • Quick ratios appear more of a concern being below acceptable levels in both years and even more so in 2006 (0.69:1). • Raises some concerns over the liquidity of the business and inventory management (although IT ratio only shows a slight decline in 2006). • Days Payable is a concern as there may be poor debt payment management. © Mary Low

Financial Structure • Although slightly higher than D/E industry benchmark (0.67:1), business has become less risky due to the significant repayment of loan in 2006. • TIE is extremely good for the business at 39.74 times (well above 5 the standard benchmark). • Cash flow situation • Strong cash flow from operating activities (increased from 160,600 to 185,000). • Spending under investing activities suggest more growth. • Repayment of debt under financing activities imply restructuring of business to have more equity funding rather than debt funding. © Mary Low

Recommendation Given: • the strong forecast for the industry (ie general prospects looking good and world demand for plastic products remaining strong), • the sales growth in this business, • acceptable ratios as they are quite close to the industry averages, • good cash flows from operating activities and • favourable ROE, although it has decreased, it is still better than the industry average ROE. => it is recommended that the investor purchase shares in the Walker Ltd company. © Mary Low

Financial Statement Analysis