Tools of Financial Analysis and Control

PERFORMANCE ANALYSIS(Tools for Financial Analysis and Control).

Mr.John Obote.

MBA.

2

Responsibilities of the Financial Manager

1. Managing theworking capital 2. Estimating the

seasonal fund needs

3. Long-term financial planning: forecasting long-term fund requirements4. Determining appropriate investment mix

6. Determining the amount of dividends to be paid

5. Determining appropriate financing mix

Inter-relationships between financing, investment and dividend decisions

Investment: Company decides to take on a large number of attracting new investment projects

Finance: Company will need to raise finance in order to take on projects

Dividends: if finance is not available from external sources, dividends may need to be cut in order to increase internal financing

Dividends: company decides to pay higher levels of dividends to shareholders

Finance: lower level of retained earnings available for investment means company may have to find finance from external sources

Investment: if finance is not available from external sources the company may have to postpone future investment projects

Finance: company finances itself using more expensive sources resulting in a higher cost of capital

Investment: due to a higher cost of capital the number of projects attractive to the company decreases

Dividends: the company’s ability to pay dividends in the future will be adversely affected

Learning Activity

• What are the basic financial statements that should be prepared by a business firm?

• What are the uses of each of the basic financial statements?

Basic Financial Statements

• The Income Statement• The Balance Sheet• The Statement of Retained Earnings• The Statement of Cash Flows

Learning Activity

• What is financial statement analysis and why is it important?

• What is financial statement analysis?”Tearing apart” the financial statements and looking at the relationships

• Financial statements summarize and provide an overview of events relating to the functioning of a firm.

• Financial statement analysis helps identify – a firm’s strengths and – weaknesses – so that management can take advantage of a firm’s strengths

and make plans to counter weaknesses of the firm. • The strengths must be understood if they are to be used to proper

advantage and weaknesses must be recognized if corrective action needs to be taken

Financial Statement Analysis

Significance of Financial Statements Analysis

• For example:– Are inventories adequate to support the projected level of

sales? – Does the firm have too heavy an investment in account

receivable? – Does large account receivable reflect a lax collection policy?– To ensure efficient operations of a firm’s manufacturing

facility, does the firm have too much or too little invested in plant and equipment?

• Financial statement analysis provides answers to all of these questions.

• Who analyzes financial statements?– Internal users (i.e., management)– External users (emphasis of lecture)

• Examples?– Investors, creditors, regulatory agencies & …– Financial analysts – Auditors– Researchers– etc

Who Analyses Financial Statements?

A Firm’s Stakeholders

The firm

Customers

Society

Shareholders

Managers

Employees

GovernmentCreditors

A company has responsibility to different interested parties

• What do internal users use it for? Planning, evaluating and controlling company

operations• What do external users use it for?

Assessing past performance and current financial position and making predictions about the future profitability and solvency of the company as well as evaluating the effectiveness of management


Information is available from– Published annual reports

(1) Financial statements(2) Notes to financial statements(3) Letters to stockholders(4) Auditor’s report (Independent accountants)(5) Management’s discussion and analysis


Information is available from (Cont…)– Other sources(1) Newspapers (e.g., Business Times, Financial

Times )(2) Periodicals (e.g. Forbes, Fortune)(3) Financial information organizations such as:

Moody’s, Standard & Poor’s, Dun & Bradstreet, Inc., and Robert Morris Associates

(4) Other business publications


• Horizontal Analysis

• Vertical Analysis

• Common-Size Statements

• Trend Percentages

• Ratio Analysis

Methods ofFinancial Statement Analysis

Horizontal Analysis

Using comparative financial statements to calculate monetary (Tshs) or percentage changes in a financial statement item from one period to the next

Vertical Analysis

For a single financial statement, each item is expressed as a percentage of a significant total, e.g., all income statement items are expressed as a percentage of sales and all balance sheet items are expressed as a percentage of total assets

Common-Size StatementsFinancial statements that show only percentages and no absolute monetary amounts

Trend PercentagesShow changes over time in given financial statement items (can help evaluate financial information of several years)

Ratio AnalysisExpression of logical relationships between items in a financial statement of a single period (e.g., percentage relationship between revenue and net income)

Horizontal Analysis Example

Assume that the management of UD Co Ltd provides you with comparative balance sheets of the years ended December 31, 2014 and 2013. Management asks you to prepare a horizontal analysis horizontal analysis on the information.

UD CompanyComparative Balance Sheet, 31 December,2013 and 2012

2013 2012 Increase (Decrease)

Amount %

Assets

Current Assets

Cash 12,000 23,500

Accounts Receivable, Net 60,000 40,000

Inventory 80,000 100,000

Prepaid Expenses 3,000 1,200

Total Current Assets 155,000 164,700

Property and Equipment

Land 40,000 40,000

Building & Equipment, Net 120,000 85,000

Total Land & Equipment 160,000 125,000

Total Assets 315,000 289,700

Calculating Change in Tshs Amounts

TshsChange

Current YearFigure

Base YearFigure

= –


Calculating Change in Monetary Amounts

Since we are measuring the amount of the change between 2012 and 2013, the Tshs amounts for 2012 become the “base” year figures.

TshsChange

Current YearFigure

Base YearFigure

= –


Calculating Change as a Percentage

PercentageChange

Tshs Change Base Year Figure 100%= ×


$12,000 – $23,500 = $(11,500)


($11,500 ÷ $23,500) × 100% = 48.9%



28


• Let’s apply the same procedures to the liability and stockholders’ equity sections of the balance sheet.

UD Co LtdComparative Balance SheetsDecember 31, 2014 and 2013

Increase (Decrease)

2014 2013 Amount %Liabilities and Stockholders' Equity

Current liabilities: Accounts payable 67,000$ 44,000$ 23,000$ 52.3 Notes payable 3,000 6,000 (3,000) (50.0) Total current liabilities 70,000 50,000 20,000 40.0Long-term liabilities: Bonds payable, 8% 75,000 80,000 (5,000) (6.3) Total liabilities 145,000 130,000 15,000 11.5Stockholders' equity: Preferred stock 20,000 20,000 - 0.0 Common stock 60,000 60,000 - 0.0 Additional paid-in capital 10,000 10,000 - 0.0 Total paid-in capital 90,000 90,000 - 0.0Retained earnings 80,000 69,700 10,300 14.8 Total stockholders' equity 170,000 159,700 10,300 6.4Total liabilities and stockholders' equity 315,000$ 289,700$ 25,300$ 8.7

30


• Now, let’s apply the procedures to the income statement

UD Co LtdComparative Income Statements

For the Years Ended December 31, 2014 and 2013Increase (Decrease)

2014 2013 Amount %Net sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)Net income 17,500$ 22,400$ (4,900)$ (21.9)




Sales increased by 8.3% while net income decreased by 21.9%.




There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the increase in sales, yielding an overall decrease in net income (21.9%).

Vertical Analysis Example

Assume that the management of BS Company Ltd asks you to prepare a vertical analysis vertical analysis for the comparative balance sheets of the company.



$82,000 ÷ $483,000 = 17% rounded$30,000 ÷ $387,000 = 8% rounded


$76,000 ÷ $483,000 = 16% rounded

Trend Percentages ExampleAssume that MD Co Ltd provides you with the

following operating data and asks that you prepare a trend analysis.

Trend Percentages Example

Assume that MD Co Ltd provides you with the following operating data and asks that you prepare a trend analysis.

$1,991 - $1,820 = $171$1,991 - $1,820 = $171

Trend Percentages ExampleUsing 2010 as the base year, we develop the

following percentage relationships.

$1,991 - $1,820 = $171$1,991 - $1,820 = $171$171 ÷ $1,820 = 9% rounded$171 ÷ $1,820 = 9% rounded

RATIO ANALYSIS• Financial statements report both on a firm’s position

at a point in time and on its operations over some past period.

• From management’s viewpoint, financial statement analysis is useful both as a way to– anticipate future conditions and – more important, as a starting point for planning

actions – that will influence the future course of events or – to show whether a firm’s position has been

improving or deteriorating over time.

Ratio Analysis (Cont…)• Ratio analysis begins:

– with the calculation of a set of financial ratios– designed to show the relative strengths and – weaknesses of a company as compared to

• Other firms in the industry• Leadings firms in the industry• The previous year of the same firm

• Ratio analysis helps to show whether the firm’s position has been improving or deteriorating

• Ratio analysis can also help plan for the future

Ratios can be expressed in three different ways: 1. Ratio (e.g., current ratio of 2:1) 2. % (e.g., profit margin of 2%) 3. $ (e.g., EPS of Tshs 225)

CAUTION! “Using ratios and percentages without considering

the underlying causes may lead to incorrect conclusions.”

Ratios

Major Categories of Ratios• Liquidity Ratios

Indicate a company’s short-term debt-paying ability• Asset Management

Measure how effectively the firm is managing/using its assets• Equity (Long-Term Solvency) Ratios

Show relationship between debt and equity financing in a company

• Profitability TestsRelate income to other variables

• Market TestsHelp assess relative merits of stocks in the market place

The 10 Basic Ratios you have to know• Liquidity Ratios

1. Current Ratio (Working Capital Ratio)2. Quick Ratio/Acid Test RatioCash Ratio/Cash Flow liquidity Ratio

• Asset Management Ratios3. Inventory Turnover Ratio4. Days Sales Outstanding5. Inventory Turnover RatioFixed Assets Turnover RatioTotal Assets Turnover Ratio

• Equity (Long-term solvency/Debt Management Ratios6. Equity (stockholders’ equity) ratio - Equity to debtTotal Debt to Total Assets RatioTimes Interest Covered Ratio

The 10 Basic Ratios you have to know• Profitability Ratios

7. Profit Margin - Net income to net sales (return on sales)8. Earnings per share9. Return on average common stockholders’ equity (ROEROE)

• Return on Assets• Return on Equity• Basic Earning Power Ratio• Cash flow margin• Times interest earned• Times preferred dividends earned

The 10 Basic Ratios you have to know• Market Tests

10. Price-earnings ratio• Earnings yield on common stock• Payout ratio on common stock• Dividend yield on common stock• Dividend yield on preferred stock• Cash flow per share of common stock

Ratio Analysis - Example

Ratio Analysis - Example

• Calculate the 10 basic ratios based on Neema Co Ltd’s financial statements

Neema Co Ltd2014

Cash 30,000$ Accounts receivable, net Beginning of year 17,000 End of year 20,000 Inventory Beginning of year 10,000 End of year 12,000 Total current assets 65,000 Total current liabilities 42,000 Sales on account 494,000 Cost of goods sold 140,000

We will use this

informationto calculatethe liquidity

ratios for Neema Co Ltd.

Working Capital*

12/31/14Current assets 65,000$ Current liabilities (42,000) Working capital 23,000$

The excess of current assets over current liabilities.

* While this is not a ratio, it does give an indication of a company’s liquidity.

Current (Working Capital) Ratio

CurrentRatio

$65,000 $42,000

= = 1.55 : 1

Measures the ability of the company to pay current debts as they become due.

CurrentRatio

Current Assets Current Liabilities

=

#1#1

Acid-Test (Quick) Ratio

Quick Assets Current Liabilities

=Acid-Test Ratio

Quick assets are Cash, Marketable Securities, Accounts Receivable (net) and current Notes Receivable.

#2#2


=Acid-Test Ratio

Neema Co Ltd’s quick assets consist of cash of $30,000 and accounts receivable of $20,000.


#2#2


=Acid-Test Ratio

$50,000 $42,000

= 1.19 : 1=Acid-Test Ratio


#2#2

Sales on Account Average Accounts Receivable

Accounts ReceivableTurnover

=

Accounts Receivable Turnover

= 26.70 times $494,000 ($17,000 + $20,000) ÷ 2

Accounts ReceivableTurnover

=

This ratio measures how many times a company converts its receivables into cash each year.

#3#3 Average, net accounts receivable

Net, credit sales

Number of Days’ Salesin Accounts Receivable

Measures, on average, how many days it takes to collect an account receivable.

Days’ Salesin AccountsReceivables

= 365 Days Accounts Receivable Turnover

= 13.67 days= 365 Days 26.70 Times


#4#4

Number of Days’ Salesin Accounts Receivable

In practice, would 45 days be a desirable number of days in receivables?

#4#4Days’ Salesin AccountsReceivables

= 365 Days Accounts Receivable Turnover

= 13.67 days= 365 Days 26.70 Times


Inventory Turnover

Cost of Goods Sold Average Inventory

InventoryTurnover =

Measures the number of times inventory is sold and replaced during the year.

= 12.73 times $140,000 ($10,000 + $12,000) ÷ 2

InventoryTurnover =

#5#5

Inventory Turnover

Cost of Goods Sold Average Inventory

InventoryTurnover =

Would 5 be a desirable number of times for inventory to turnover?

= 12.73 times $140,000 ($10,000 + $12,000) ÷ 2

InventoryTurnover =

#5#5

Equity, or Long–TermSolvency Ratios

This is part of the information to calculate the equity, or long-term solvency ratios of Norton

Corporation.

Neema Co Ltd2014

Net operating income 84,000$ Net sales 494,000 Interest expense 7,300 Total stockholders' equity 234,390

Neema Co Ltd2014

Common shares outstanding Beginning of year 17,000 End of year 27,400 Net income 53,690$ Stockholders' equity Beginning of year 180,000 End of year 234,390 Dividends per share 2 Dec. 31 market price/share 20 Interest expense 7,300 Total assets Beginning of year 300,000 End of year 346,390

Here is therest of theinformation

we willuse.

Equity Ratio

EquityRatio = Stockholders’ Equity

Total Assets

EquityRatio = $234,390

$346,390 67.7%=

Measures the proportion of total assets provided bystockholders.

#6#6

Net Income to Net SalesA.K.A. Return on Sales or Profit Margin

Net IncomeTo Net Sales = Net Income

Net Sales

Net IncomeTo Net Sales = $53,690

$494,000 = 10.9%

Measures the proportion of the sales (Tshs)which is retained as profit.

#7#7

Net Income to Net SalesA.K.A. Return on Sales or Profit Margin

Net IncomeTo Net Sales = Net Income

Net Sales

Net IncomeTo Net Sales = $53,690

$494,000 = 10.9%

Would a 1% return on sales be good?

#7#7

Return on Average Common Stockholders’ Equity (ROE)

Return onStockholders’Equity

= Net Income Average CommonStockholders’ Equity

= $53,690 ($180,000 + $234,390) ÷ 2 = 25.9%

Return onStockholders’Equity

Important measure of the income-producing abilityof a company.

#8#8

Earningsper Share

Earnings Available to Common StockholdersWeighted-Average Number of Common Shares Outstanding

=

Earningsper Share

$53,690 (17,000 + 27,400) ÷ 2= = $2.42

The financial press regularly publishesactual and forecasted EPS amounts.

#9#9

Earnings Per Share

Price-Earnings RatioA.K.A. P/E Multiple

Price-EarningsRatio

Market Price Per Share EPS

=

Price-EarningsRatio = $20.00

$ 2.42 = 8.3 : 1

#10#10

Provides some measure of whether the stock is under or overpriced.

72

The DuPont System• Developed in 1919 by a finance executive at E.I. du

Pont de Nemours and Co• A way of visualizing the information so that everyone

can see it• Is a good tool for getting people started in

understanding how they can have an impact on results• It is a simple and straightforward method for assessing

the factors that influence a firm’s financial performance

73

The DuPont System

• Method to breakdown ROE into:– ROA and Equity Multiplier

• ROA is further broken down as:– Profit Margin (profitability)– Asset Turnover (efficiency in using the assets)

• Helps to identify sources of strength and weakness in current performance

• Helps to focus attention on value drivers

DuPont Chart and Equation

• DuPont Chart and Equation - Tie the Ratios Together– Shows how profit margin, asset turnover ratio, and

equity multiplier determine ROE– Shows how expense control (profit margin), efficient

use of assets in production (asset turnover) and capital structure (equity multiplier) affect return on equity.

– Ties together all aspects of firm - production and financing.

75

Return on Equity - ROE

• This represents the Net income generated by the Equity invested in the business

• The Formula is:

Net Income Equity– This represents amount of profit per Tshs invested

by the shareholders.

76

DuPont System – What is It?• The system identifies profitability as being impacted by

three different levers:– Earnings & efficiency in earnings– Ability of your assets to be turned into profits– Financial leverage

• DuPont analysis tells us that ROE is affected by three things:

– Operating efficiency, which is measured by profit margin.– Asset use efficiency, which is measured by total asset

turnover.– Financial leverage is measured by the equity multiplier

Earnings

Efficiency

Leverage

77

Net IncomeTotal Equity

=Net IncomeSales

XSales

Total Assets

Profitability Asset Usage Efficiency

Net

Profit Margin

ROETotal Asset

Turnover

X

Debt Ratio

Leverage

Total Assets

Total Equity

78

79

The DuPont System

Profi t M argin T ota l A sse t T urnover

RO A E quity M ultip l ie r

RO E

80

The DuPont System

Profi t M argin T ota l A sset T urnover


RO E

Notice that using more debt (and less equity) to finance assets raises the Equity Multiplier. This has two effects for stockholders.

The Equity Multiplier acts as a lever to magnify the effects of ROA on returns for stockholders. If ROA is positive, ROE is a larger positive value, but if ROA is negative ROE is a larger negative.

81

The DuPont System



RO E

Return on Assets is affected by two areas of operations. The Profit Margin measures the degree to which the firm controls expenses. Since expenses comprise the difference between Sales and Net Income, lowering the expenses taken out of each shilling of sales raises the Profit Margin.

At the same time, Return on Assets can be raised by producing sales by using fewer assets. Asset Turnover measures the sales produced with each shilling invested in assets. This is often thought of as sales volume.

Different industries achieve ROA in different ways. Some have low profit margins but high volume, e.g. grocery stores. Others have lower volume but are able to maintain higher profit margins, e.g. car dealerships.

82

The DuPont System



RO E

83

DuPont Equation

EquityCommon Assets Total

Assets TotalSales

SalesIncomeNet

MultiplierEquity TurnoverAsset TotalMarginProfit ROE

84

Operating Profit Margin

Asset Turnover

Return On Assets (less interest adj.)

Financial Structure

Return On Equity

X =

X =

IncomeStream

InvestmentStream

Asset Efficiency Usage

Leverage

DuPont SystemEarnings/Profitability

85

Operating Profit Margin

Asset Turnover

Return On Assets (less interest adj.)

Financial Structure

Return On Equity

X =

X =

IncomeStream

InvestmentStream

Profitability

Efficiency

Leverage

DuPont System Ratios

Problems in Financial Statement and Ratio Analysis

• Developing and Using Comparative Data• Distortion of Comparative Data• Notes to Financial Statements• Interpretation of Results• Differences in Accounting Treatment• Window Dressing• Effects of Inflation

Important Considerations• Need for comparable data

– Data is provided by companies such as Dun & Bradstreet, Standard & Poor’s etc.

– Must compare by industry– Is EPS comparable?

• Influence of external factors– General business conditions– Seasonal nature of business operations

• Impact of inflation