1. CHAPTER 5 FINANCIAL STATEMENT ANALYSIS

2. Financial Statement Analysis • Annual reports • Auditor’s report • Director’s report • Statement of Financial Performance (Income statement) • Statement of Financial Position (Balance sheet) • Cash flow statement

3. Objectives of Financial Statement Analysis • Equity investors • Return on capital • Capital preservation • Credit grantors • Short-term – interest cover • Long-term – interest cover and capital preservation • Management • Decision making • Control

4. Objectives of Financial Statement Analysis • Employees • Job security • Wage & salary negotiations • Acquisition and merger analysts • Valuation of potential candidates • Auditors • Analytical review • Other/Tax authorities • Income fairly stated

5. Statement of Comprehensive Income & Statement of Changes in Equity

6. Statement of Financial Position

7. Statement of Cash Flows

8. Approaches • Comparative trend analysis • Index analysis • Common size analysis • Ratio analysis • Economic Value Added (EVA)

9. Approaches continued… • Comparative financial statements: • Direct comparison of current statements to numerous prior year statements to detect any trends. • Index analysis: • Similar to comparative method, but a base year is used to express values as percentages for succinct comparisons.

10. Index analysis • The percentages provide a more relatable comparison

11. Common Size Analysis • Statement of Comprehensive Income • All line items are expressed as a percentage of Sales Revenue

12. Application of Ratio Analysis • Liquidity ratios • Current ratio • Quick ratio • Asset management ratios • Stock (inventory) turnover • Average collection period • Fixed asset turnover • Total asset turnover

13. Application of Ratio Analysis • Debt management ratios • Debt ratio • Times interest earned • Debt equity ratio • Profitability ratios • Gross profit margin • Profit margin • Return on total assets • EBIT • EBIAT • Net profit

14. Application of Ratio Analysis • Cash flow ratios • Cash flow to total debt • Market value ratios • Dividend yield • Earning yield • Price earnings ratio • Dividend cover

15. Liquidity Ratios • Current Ratio current assets/current liabilities • Typical Ltd: 208/120 = 1.73 • Quick ratio (or acid test ratio) (current assets-inventory)/current liabilities • Typical Ltd: (208-65)/120 = 1.19

16. Asset Management Ratios • Stock (inventory) turnover • Cost of sales / inventory (or sales / inventory) • Typical Ltd: 2036/65 = 31.3 times • Average collection period • Accounts receivable/(sales/365) • Typical Ltd: 122/(3573/365) = 12.46 days • Fixed asset turnover • Sales/fixed assets • Typical Ltd: 3573/1227 = 2.91 times • Total asset turnover • Sales/operating assets • Typical Ltd: 3576/(1227 + 208) = 2.49 times

17. Debt Management Ratios • Debt Ratio • Debt ratio = total debt/total assets • Typical Ltd: (400+120)/(1227+208) = 36.24% • Times Interest Earned (TIE) • TIE = EBIT/interest • Typical Ltd: 282/100 = 2.82 times • Debt/Equity Ratio • Debt equity = total debt/total equity • Typical Ltd: (400+120)/915 = 56.83%

18. Profitability Ratios • Gross Profit Margin • GP% = gross profit/sales • Typical Ltd: 1537/3573 = 43% • Net Profit Margin • NP% = net profit /sales • Typical Ltd: 282/3573 = 7.89%

19. Profitability Ratios continued... • Return on Assets (NB) • ROA = EBIT/Assets • Typical Ltd: 282/(1227 + 208) = 19.65% • ROA = EBIAT/Assets • Typical Ltd: (128 + (100x0.72)/(1227 + 208) = 13.94% • ROA = Net profit/Assets • Typical Ltd: 128/(1227 + 208) = 8.92% • Return on Equity (NB) • ROE = Net income / total shareholders’ funds • Typical Ltd: 128/915 = 13.99%

20. Cash Flow Ratios • Cash flow to total debt Cash flow from operations/total debt • Typical Ltd: 219/520 = 42.12% • What does this mean?

21. Market Value Ratios • Dividend Yield Dividend per share / share price • Typical Ltd: 10.6/280 = 3.79% • Earnings Yield Earnings per share / share price • Typical Ltd: 25.6/280 = 9.14% • Price-Earnings Ratio Share price / earnings per share • Typical Ltd: 280/25.6 = 10.94

22. Market Value Ratios continued... • Dividend Cover Earnings per share / dividend per share • Typical Ltd: 25.6 / 10.6 = 2.42 times • Market to Book Ratio Share price / NAV per share

23. Du Pont Analysis • Du Pont model • ROA = Net profit margin x total asset turnover • Modified Du Pont model • ROE = ROA x financial leverage multiplier ROE = {(earnings/total assets) x (total assets/equity)} • Impact of income • Impact of activity • Impact of capital structure

24. Du Pont Analysis • From Net profit margin to ROE: • Notice how the “sales” and “assets” items cancel each other out to leave you with: NET PROFIT / EQUITY • What is this ratio called?

25. Failure Prediction • Altman’s model – based on NYSE failures • De la Rey’s model – based on JSE failures • Limitations of MDA (statistical) models • Not industry specific • Presume no fundamental changes over time • Zone of uncertainty exists • Altman’s Z” found to be valid for SA companies

26. Limitations of Ratio Analysis • Using industry averages as a benchmark • Non standard accounting policies • Non standard year-ends • Creative accounting • Subjective assessment • The impact of inflation • ROA may be artificially inflated

27. EVA • Economic value added is used for performance measurement • Value is created by • Improving the return on existing assets • Investing in new assets with a return > WACC • Selling assets with a return < WACC • Reducing the WACC • See use of EVA at SABMiller example in book • EVA = NOPAT – (c x capital) • The PV of expected future EVAs is the MVA

28. Behind the Numbers • Understand the business and the industry sector • What are the company’s strategies? • Why did Warren Buffet invest in Gillette? • Understand management’s motives for selecting accounting policies • Loan covenants • Management incentives • Taxation • Regulatory issues

29. Behind the Numbers continued… • Understand the key drivers of value • Certain ratios are critical to a specific industry • For example: Operating margin in retail • Understand which accounting policies are flexible • Accounting for leases • Operating versus finance leases • Off-balance sheet financing

30. Behind the Numbers continued… • Understand the Warning Signs! • Increase in accounts receivable that exceeds the increase in sales • Increase in inventory that exceeds the increase in sales • Restructuring, non-recurring charges and asset write-downs or sales • Accounting income and tax losses • Accounting income and a negative operating cashflow • Complex company structures and related party transactions • Accounting policies in relation to research and development, depreciation and leasing

31. Behind the Numbers continued… • Accounting policies that differ from the industry norm • Lack of corporate governance • Changes in auditors, qualified opinions or published disagreements with the auditor • Understand the business and financial risks facing the company • Micro and macro factors

32. Additional Factors to Consider When Analysing a Company • Are the directors selling their shares in the company? • Is the company aggressive in recognising revenue in relation to long-term contracts? • Is the company aggressive about acquisitions? • Are the company’s customers performing well? • Is the company under litigation? • Is the company subject to significant operational risks? Does the company have insurance to cover such risks?

33. Additional Factors to Consider When Analysing a Company • Does the company have actual or potential environmental liabilities? (E.g. mining companies) • Are there reports of problems with product quality? • Does the company have strong brands? • Does the company communicate well with its shareholders and analysts? • Is management incentivised to focus on shareholder interests? • Is the quality of management superior to other companies in the sector? • Does the company make optimal use of Information Technology? • Does the company have valuable intangible assets?

34. Sustainable Growth Rate SGR = D/E {R – i}p + {R}p Where: D = Total debt E = Total equity R = ROI = {EBIAT / TA} i = Average after tax cost of borrowing p = Percentage of earnings retained

35. Sustainable Growth Rate

36. Ratios for South AfricaSource: ABSA