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FINANCIAL STATEMENT ANALYSIS

The major objectives of financial statement analysis are as follows:

1. Assessment of Past Performance

Past performance is a good indicator of future performance. Investors or creditors are interested in the trend of past sales, cost of goods sold, operating expenses, net income, cash flows and return on investment. These trends offer a means for judging management's past performance and are possible indicators of future performance.

2. Assessment of current position Financial statement analysis shows the current position of the firm in terms of the types of assets owned by a business firm and the different liabilities due against the enterprise.

3. Prediction of profitability and growth prospects Financial statement analysis helps in assessing and predicting the earning prospects and growth rates in earning which are used by investors while comparing investment alternatives and other users in judging earning potential of business enterprise.

4. Prediction of bankruptcy and failure Financial statement analysis is an important tool in assessing and predicting bankruptcy and probability of business failure.

5. Assessment of the operational efficiency Financial statement analysis helps to assess the operational efficiency of the management of a company. The actual performance of the firm which is revealed in the financial statements can be compared with some standards set earlier and the deviation of any between standards and actual performance can be used as the indicator of efficiency of the management.

General Approach to FS Analysis

1. Traditional approach - use of ratio analysis, horizontal and vertical

2. Modern approach both internal and external business environment are taken into consideration. The approach is futuristic as opposed to traditional approach.

Common Size/Vertical Analysis

is futuristic as opposed to traditional approach. Common Size/Vertical Analysis Trend Analysis/Horizontal Analysis VS

Trend Analysis/Horizontal Analysis

is futuristic as opposed to traditional approach. Common Size/Vertical Analysis Trend Analysis/Horizontal Analysis VS

VS

is futuristic as opposed to traditional approach. Common Size/Vertical Analysis Trend Analysis/Horizontal Analysis VS

Financial Ratio Analysis

Question

Category of Ratios Used

1. How liquid is the firm? Will it be able to pay its bill as they become due?

LIQUIDITY RATIOS

2. How has the firm financed the purchase of its assets?

CAPITAL STRUCTURE RATIOS

3. How efficient has the firm’s management been in utilizing its assets to generate sales?

ASSET MANAGEMENT EFFICIENCY RATIOS

4. Has the firm earned adequate returns on investment?

PROFITABILITY RATIOS

5. Are the firm’s managers creating value for shareholders?

MARKET VALUE RATIOS

A. LIQUIDITY RATIOS short term solvency

RATIO

FORMULA

 

FUNCTION

1. Working

Current assets Current Liabilities

It measures how much in liquid assets a company has available to build its business.

Capital

   

Ability to

repay

short-term commitments

2. Current Ratio

Current Assets ÷ Current Liabilities

promptly . (Short-term Solvency) Ideal Ratio is 2:1.High Ratio indicates existence of idle current assets.

3. Quick Ratio or Acid test ratio

(Current Assets - Inventory

&

Ability to Ratio is 1.33:1

meet

immediate liabilities. Ideal

Prepaid Assets) ÷ Current Liabilities

 

4. Absolute Cash

(Cash + Marketable Securities) ÷ Current Liabilities

Availability of cash to meet short-term commitments.

Ratio

Can a Firm Have Too Much Liquidity? A high investment in liquid assets will enable the firm to repay its current liabilities in a timely manner. However, an excessive investment in liquid assets can prove to be costly as liquid assets generate minimal return.

B. CAPITAL STRUCTURE RATIOS

RATIO

FORMULA

FUNCTION

1. Times

   

Interest

EBIT ÷ Interest Expense

Indicates the extent to which operations cover interest expense

Earned

2. Debt Ratio

Total Liabilities ÷ Total Assets

Measures the proportion of the firm’s assets that are financed by borrowing or debt financing.

3. Equity Ratio

Total SHE ÷ Total Assets

Measures the proportion of the firm’s assets that are financed by owners.

4. Debt Equity

 

Measures the proportion of assets provided by creditors compared to that provided by owners. ; Ideal ratio is 2:1.

Ratio

Total Liabilities ÷ Total SHE

5. Fixed Asset to Long-term Liabilities

Fixed Asset ÷ Long-term Liabilities

Reflect the extent of the utilization of resources from long-term debt. Indicates sources of additional funds.

6. Fixed Asset to Total Equity

Fixed Asset ÷ Total Equity

Indicates the over or under investment by owners.

7. Fixed Assets

   

to Total

Net Fixed Asset ÷ Total Assets

Indicates possible over expansion of PPE

Assets

8. BPS on CS

CS equity ÷ # of CS Outstanding

Measures recoverable amount in the event of liquidation if assets are realized at their BV.

9. Times

   

Preferred

Net Income after Tax ÷ Preferred Dividend Requirement

Indicates ability to provide dividends to preferred shareholders

Dividend

requirements

   

10. Times Fixed

Net Income before Taxes and Fixed Charges ÷ Fixed Charges FC=rent+ interest+ sinking fund payment before taxes

 

Charges

Indicates ability to cover fixed charges.

Earned

C.

ASSET MANAGEMENT EFFICIENCY RATIOS

 

RATIO

 

FORMULA

 

FUNCTION

1.

Accounts

   

Receivable

Annual Credit Sales ÷ Ave. Accounts Receivable

Measures how many times accounts receivable are “rolled over” during a year

Turnover

2.

Average

 

Accounts Receivable ÷ Daily Credit Sales or 365 ÷ Receivable Turnover

 

Collection

Measures how fast the firm collects its accounts receivables

Period

3.

Inventory

Cost of Goods Sold ÷ Ave. Inventory

Measures how many times the company turns over its inventory during the year.

Turnover

4.

Average Age

 

Inventory ÷ Daily COGS or 365 ÷ Inventory Turnover

Indicates the number of days before an inventory is sold. Shorter inventory cycles lead to greater liquidity since the items in inventory are converted to cash more quickly.

of Inventory

5.

Operating

Average Collection Period + Average Age of Inventory

Indicates the number of days it takes for inventories to be converted into cash. The shorter the better.

Cycle

6.

Trade

 

This measurement of liquidity measures the number of times account payables turnover in one year. Low turnover is indicative of cash flow problems.

Payables

 

Net Credit Purchases ÷ Ave. Trade Payables

Turnover

7.

Average Age

   

of Trade

 

365 ÷ Payables Turnover

Indicates the number of days it takes for payables to be paid. The longer the better

Payables

 

8.

Cash Flow

 

Operating Cycle - Average Age of Trade Payables

Indicates how fast the company purchases inventories, sell it to customers, collect payment and pay its suppliers.

Cycle

9.

Current Asset

[COGS + OPEX(excluding depreciation & amortization)] ÷ Ave. Current Assets

Measures the movement and utilization of current assets to meet operating requirements

Turnover

10.

Working

   

Capital to

 

Working Capital ÷ Total Asset

Indicates relative liquidity of total assets and distribution of resources employed.

Total Asset

 

11.

Working

   

Capital

 

Net Sales ÷ Ave. Working Capital

Indicates adequacy and activity of working capital

Turnover

 

11.

Sales to Fixed Assets (Plant Turnover)

 

Net Sales ÷ Net Fixed Assets

Test roughly the efficiency of management in keeping plant properties employed

12.

Asset

 

Indicates the revenue generated by total assets. The higher the better.

Turnover

 

Sales ÷ Total Asset

13.

Fixed Asset

 

Measures firm’s efficiency in utilizing its fixed assets.

Turnover

 

Sales ÷ Net Fixed Asset

D.

PROFITABILITY RATIOS

 
 

RATIO

 

FORMULA

 

FUNCTION

1.

Gross Profit

 

It shows how well the firm’s management controls its expenses to generate profits.

Ratio

Gross Profit ÷ Net Sales

2.

Return on Sales

Income ÷ Net Sales

Indicates the amount of income earned for every peso sale.

3.

Operating Profit

EBIT ÷ Net Sales

 

It indicates how well the firm is managing its income statement.

Ratio

4.

Return on Total Asset (ROA)

Income ÷ Ave Total Assets

Indicate the efficiency of managers in using total assets in operating the business.

5.

Return on

   

Owners’ Equity

Net Income ÷ Ave. Equity

Indicates the amount earned on investment.

(ROE)

6.

Earnings Per

(Net Income Preferred dividends Requirement) ÷ Weighted Ave # of CS

Indicate the amount of income earned by each common share.

Share

7.

Rate of Return on Current Assets

Net Income / Ave Current Assets

Indicates the profitability of current assets invested.

***** Du Pont Method: ROE = ROS(Profitability) x Asset Turnover(Efficiency) x Equity Multiplier

E. MARKET VALUE RATIOS

RATIO

FORMULA

FUNCTION

1. Price/Earnings

Price per share ÷ Earnings per share

Indicates the number of pesos required to pay 1 peso of earnings

Ratio

2. Dividend Yield

Dividend per share ÷ Price per share

Indicates the rate of return in the investor’s CS investment

3. Dividend Pay-

Common Dividend per share ÷ EPS

Indicates the portion of earnings distributed as dividends

out

The Limitations of Ratio Analysis

1. Picking an industry benchmark can sometimes be difficult.

2. Published peer-group or industry averages are not always representative of the firm being analyzed.

3. An industry average is not necessarily a desirable target or norm.

4. Accounting practices differ widely among firms.

5. Many firms experience seasonal changes in their operations.

6. Financial ratios offer only clues. We need to analyze the numbers in order to fully understand the ratios.

7. The results of financial analysis are dependent on the quality of the financial statements.

Assignment: Answers to be given next meeting

1. Russell Securities has P100 million in total assets and its corporate tax rate is 40 percent. The company recently reported that its basic earning power (BEP) ratio was 15 percent and that its return on assets (ROA) was 9 percent. What was the company’s interest expense?

2. A firm has a profit margin of 15 percent on sales of P20,000,000. If the firm has debt of P7,500,000, total assets of P22,500,000, and an after-tax interest cost on total debt of 5 percent, what is the firm's ROA?

3. Tapley Dental Supply Company has the following data:

Net income:

P240

Sales:

P10,000

Total assets:

P6,000

Debt ratio:

75%

TIE ratio:

2.0

Current ratio:

1.2

BEP ratio:

13.33%

If Tapley could streamline operations, cut operating costs, and raise net income to P300, without affecting sales or the balance sheet (the additional profits will be paid out as dividends), by how much would its ROE increase?

4. Your company had the following balance sheet and income statement information for 2003:

Balance sheet:

Cash

P

20

A/R

1,000

 

Inventories

5,000

Total C.A.

P 6,020

Debt

P 4,000

Net F.A.

2,980

Equity

5,000

Total Assets

P 9,000

Total claims

P 9,000

Income statement:

Sales Cost of goods sold EBIT Interest (10%) EBT Taxes (40%) Net Income

P10,000

9,200

P

800

400

P

400

160

P

240

The industry average inventory turnover is 5. You think you can change your inventory control system so as to cause your turnover to equal the industry average, and this change is expected to have no effect on either sales or cost of goods sold. The cash generated from reducing inventories will be used to buy tax-exempt securities which have a 7 percent rate of return. What will your profit margin be after the change in inventories is reflected in the income statement?

5. Ruth Company currently has P1,000,000 in accounts receivable. Its days sales outstanding (DSO) is

50 days (based on a 365-day year). Assume a 365-day year. The company wants to reduce its DSO

to the industry average of 32 days by pressuring more of its customers to pay their bills on time.

The company's CFO estimates that if this policy is adopted the company's average sales will fall by

10 percent. Assuming that the company adopts this change and succeeds in reducing its DSO to 32

days and does lose 10 percent of its sales, what will be the level of accounts receivable following the change?

6. The Meryl Corporation's common stock is currently selling at P100 per share, which represents a P/E ratio of 10. If the firm has 100 shares of common stock outstanding, a return on equity of 20 percent, and a debt ratio of 60 percent, what is its return on total assets (ROA)?

7. Oliver Incorporated has a current ratio = 1.6, and a quick ratio equal to 1.2. The company has P2 million in sales and its current liabilities are P1 million. What is the company’s inventory turnover ratio?

8. Kansas Office Supply had P24,000,000 in sales last year. The company’s net income was P400,000. Its total assets turnover was 6.0. The company’s ROE was 15 percent. The company is financed entirely with debt and common equity. What is the company’s debt ratio?

9. The Merriam Company has determined that its return on equity is 15 percent. Management is interested in the various components that went into this calculation. You are given the following information: total debt/total assets = 0.35 and total assets turnover = 2.8. What is the profit margin?

10. Harvey Supplies Inc. has a current ratio of 3.0, a quick ratio of 2.4, and an inventory turnover ratio of 6. Harvey's total assets are P1 million and its debt ratio is 0.20. The firm has no long-term debt. What is Harvey's sales figure?

11. Collins Company had the following partial balance sheet and complete annual income statement:

Partial Balance Sheet:

Cash A/R Inventories Total current assets Net fixed assets Total assets

P

20

Income Statement:

1,000

Sales Cost of goods sold EBIT Interest (10%) EBT Taxes (40%) Net Income

P10,000

2,000

9,200

P 3,020

P

800

2,980

400

P 6,000

P

400

 

160

P

240

The industry average DSO is 30 (based on a 365-day year). Collins plans to change its credit policy so as to cause its DSO to equal the industry average, and this change is expected to have no effect on either sales or cost of goods sold. If the cash generated from reducing receivables is used to retire debt (which was outstanding all last year and which has a 10 percent interest rate), what will Collins' debt ratio (Total debt/Total assets) be after the change in DSO is reflected in the balance sheet?

12. Last year, Quayle Energy had sales of P200 million, and its inventory turnover ratio was 5.0. The company’s current assets totaled P100 million, and its current ratio was 1.2. What was the company’s quick ratio?