Financial management - Analysis and intepretation of financial statements

7/29/2019 Financial management - Analysis and intepretation of financial statements

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Financial statements are essentially historical and static documents.They tell us what has

happened during a particular period or seriesof periods of time. The most valuable

information to most users of financial statements orreports, however,concerns what

probably will happenin the future. In this lecture we will discuss how financial statement

analysis can assist statement users in predicting the futureby means of comparing and

evaluating financial trends and cross-sectional positions of firms.

Objectives

At the end of this lecture you should be able to:

1. Discuss the needs of the users of

financial statements.

2. Discuss the types of comparison used

in financial statement analysis

3. Compute financial ratios and use them

to evaluate financial strengths and

weaknesses

4. Use the Dupont system to carry out a

complete ratio analysis of the firm

5. Explain common size and index

analysis

6. Discuss the limitations of financial

statement analysis

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Financial analysis is the process or critically examining in detail, accounting information

given in financial statements and reports. It is a process of evaluating relationship

between component parts of financial statements to obtain a better understanding of a

firms performance. Financial statement analysis involves three basic procedures:

Selection This involves the selection from the total information available about an

enterprise, the information that is relevant to the decision under consideration.

Relation This involves arranging the information in a manner that will bring out a

significant relationship(s).

Evaluation This involves the study of the relationship and interpretation of the result

thereof.

The specific objectives of financial statement analysis are to:

(a). assess the past, present and future earnings of an enterprise,

(b). assess the operational efficiency of the firms a whole and its various divisions or

departments

(c). asses the short term and tong term solvency of the firm,

(d). assess the performance of one firm against another or the industry as whole and the

performance of one division against another.

(e) Assist in the developing of forecasts and preparing of budgets,

(f) Assess the financial stability of the business under review, and

(g) Assist in the understanding of the real meaning and significance of financial

Information.

Financial statements are essentially a record of the past. Business decisions naturally

affect the future. Analysts therefore study financial statements as evidence of past

performance that may be used in the prediction of future performance.

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The first procedure in financial statement analysis is to obtain useful information. The

main sources of financial information include, but are not limited to, the

following;

Published reports

Quoted companies normally issue both interim and annual reports, which contain

comparative financial statements and notes thereto. Supplementary financialinformationand management discussion as well as analysis of the comparative years' operations and

prospects for the future will also be available. These reports are normally made available

to the public as well as the shareholders of the company.

Registrar of Companies

Public companies are required by law to file annual reports with the registrar of

companies. These reports are available for perusal upon payment of a minimum fee.

Credit and Investment Advisory Agencies

Some firms specialize in compiling financial information for investors in annual

supplements. Many trade associations also collect and publish financial information for

enterprises in various industries. Major stock brokerage firms and investment advisory

services compile financial information about public enterprises and make it available to

their customers. Some brokerage firms maintain a staff or research analysis department

that study business conditions, review published financial statements, meet with chief

executives ofenterprises to obtain information on new products, industry trends, negative

changes and interpret the information for their clients.

Audit Reports

When an independent auditor performs an audit the audit report-is usually addressed to

the shareholders of the audited enterprise. The audit firms frequently alsoprepare a

management report, which deals with a wide varietyof Issues encounteredin the course

of the audit Such a management report is not a public document, however, it is a useful

source of financial information.

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Government Statistics and Market Research Organizations

The figures in the financial statements are rarely significantor important in themselves. It

istheir relationships to other quantities, amounts and the directionof change from onepoint in time to another point in time thatis of importance. It is only through comparison

of data that one can gain insight and make intelligent judgments. Analysis thus involves

establishing significant relationships that points to changes as well as trends.

The two comparisons widely used for analytical purpose involve trend and cross-sectional analyses.

Trend Analysis

This is also known as time series analysis, horizontal analysisor temporally analysis. It

involves the comparison of the present performance with the result of previous periods

for the same enterprise. Trend analysis is therefore usually employed when financial data

is available for three or more periods. Developing trends can be seen by using multiyear

comparisons and knowledge of these trends can assist in controlling current operations

and planning for the future. It can be carried out by computing percentages for the

element of the financial statement that is under observation. Trend percentage analysis

states several years' financial data in terms of a base year, which is set to be equal to

100%.

In conducting trend analysis the following need tobe taken into account:

(i) Accounting principles and policies employed in the preparation of financial

statement must be followed consistently for the periods for which an analysis is

being made to allow comparability.

(ii) The base year selected must be normal and a representative year.

(iii) Trend percentages should be calculated only for these items, which

have logical relationship.

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(iv) Trend percentages should be carefully studied after considering the

absolute figures, otherwise they may lead to misleading conclusions.

(v) To make meaningful comparisons, trend percentage should be

adjusted in light of price changes to the base year.

Example

Assume that the following data is extracted from the books of ABC Ltd.

2004 2003 2002 2001 2000

Sh. Million Sh. Million Sh. Million Sh. Million Sh. Million

sales 725 700 650 575 500

Net income 99 97.5 93.75 86.25 75

From the above absolute figures, there appears to be a general increase in safes and

income over the years. Whenexpressing theabove date in terms of percentages with

2000 being the base year, the following trend percentage is observed.

. 2004 2003 2002 2001 2000

Sales 145% 140% 130% 115% 100%

Net Income 132 % 130 % 125 % 115 % 100 %

Net income/Sales 13.7% 13.9% 14.4% 15% 15%

From the above table it can be observed that:

i) Sales and net income have grown over the years but at a 'increasing rate,

ii) Net income has not kept pace with growth in sates. When net income is

expressed as a percentage of rates,

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iii) It is further observed that net income as a percentage of sates is decreasing

over the years and this needs to be investigated.

Financial statement analysis is not an end by itself; rather the analyses enable the rightquestions, for which management has to look for answers.

Graph

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percentage

years

2000 2001 2002 2003 2004

150

140

130

120

110

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From the line graph, one can observe that the growth rate for sales has decreased. The

same applies is net income as shown by the slope of the curves. One may also conclude

from the curves that between 2001 and 2000 sales and income have grown at the same

rate. Subsequently, growth in net income failed to keep pace with the growth in sates.

Problems of Trend analysis

(a). To ensure comparability of figures, the results of each year will have to be

adjusted using consistent accounting policies. The task of adjusting statements to

bring them to a common basis could be taunting.

(b). Comparison becomes difficult when the unit of measurement changes in value

due to general inflation. Comparisons become quite difficult over time.

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percentage

years

2000 2001 2002 2003 2004

150

140

130

120

110

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(c). If the enterprise's environment changes over time with the result that performance

that was considered satisfactory in the past may no longer be considered so. More

specific measures rather than general trends may be preferred in such instances.

Cross Sectional Analysis

This involves the comparison of the financial performance of a company against

other companies within its industry or industry averages at the same point in time. It

may simply involve comparison of the present performance or a trend of the past

performance. The idea under this approach is to use bench-marking, whereby areas in

which the company excels benchmark companies are identified, and more

importantly areas that need improvement highlighted. The typical bench-marks used

in cross-sectional analysis may be a comparable company, a leader in the industry, an

average firm or industry norms (averages).

Problems Of Cross Sectional Analysis

(a). It is difficult to find a comparable firm within the same industry. This is because

firms may have businesses which are diversified to a greater or lesser extent.

Further, industry averages are not particularly useful when analyzing firms with

multi-product lines. The choice of the appropriate benchmark industry for such

firms is a difficult task.

(b). Businesses operating in the same Industry may be substantially different in that,

they may manufacture tile same product but one may be using rented equipment

while the another uses its own making comparison difficult .

(c). Two firms may use accounting policies, which are quite different resulting in

difference m financial statements It is usually very difficult for an external user

to identify differences in accounting policies yet one must bear them in mind

when interpreting two sets of accounts.

(d). The analyst must recognize that ratios with large deviations from the norm are

only the symptoms of a problem. Once the reason for the problem is known

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management must develop prescriptive actions for eliminating it. The point to

keep in mind is that ratio analysis merely directs attention to potential areas of

concern; it does not provide conclusive evidence as to the existence of a problem.

The most common tools of financial analysis are ratios. A ratio is simply a mathematical

expression of an amount or amounts in terms of another or others. A ratio may be

expressed as a percentage, as a fraction, or a stated comparison between two amounts.

The computation of a ratio does not add any information not already existing in the

amount or amounts under study. A useful ratio may be computed only when asignificant

relationship exists between two amounts. A ratio of two unrelated amounts is

meaningless. It should be re-emphasized that a ratio by itself is useless, unless compared

with the same ratio over a period of time and/or a similar ratio for a different company

and the industry. Ratios focus attention on relationships which are significant but the full

interpretation of a ratio usually requires, further investigation of the underlying data.

Thus ratios are an aid to analysis and interpretation and not a substitute for sound

thinking.

Financial ratios may grouped into four basic categories: liquidity ratios, debt ratios,

activity ratios and profitability and investment ratios.

Liquidity refers to an enterprise's ability to meet its short-term obligations as and when

they fall due. Liquidity ratios are used to assess the adequacy of a firms working capital.

Shortfalls in working capital may lead to inability to pay bills and disruptions in

operations, which may be the forerunner to bankruptcy. The tree basic measures of

liquidity are (1) net working capital, (2) the current ratio, and (3) the quick (acid-test)

ratio. As will become clear, for all the three measures, the higher their values the more

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liquid the firm is. It should however be emphasized that excessive liquidity sacrifices

profitability even as inadequate liquidity may lead to insolvency a trade-off exists

between profitability and liquidity (risk).

Net Working CapitalNet working capital ,although not a ratio is a common measure of

a firms overall liquidity it is calculated as follows:

Net working capital = current assets current liabilities

Net working capital represents current assets that are financed from long term capital

resources that do not require repayment in the short-run, implying that the portion is still

available for repayment of short-term debts.

Example

2004 2003

Sh.000 Sh.000

Current assets 26,400 15,600

Current liabilities (13,160) (6,400)

Net working capital 13,240 9,200.

Inthe year2003 Sh.9.2 million of working capitalis available to repay Sh.6.4 million of

current liabilities and in 2004 Sh.13.24 million is available of working capital to pay

sh.l3.16 million of current liabilities. This reflects a strong liquidity position in the years.

The figure of net working capital, being an absolute figure requires standardization

before its use for comparing performance of different firms. For example net working

capital as a percent of sales can be calculated and used for such comparison. A time-

series comparison of the firms net working capital is often helpful in evaluating its

operations.

Current ratio The current ratio is one of the most commonly cited financial ratios and

tests, in short-term, the debt-paying ability of an enterprise. A high current ratio is

assumed to indicate a strong liquidity position while a low current ratio is assumed to

indicate a relatively weak liquidity position. The RULE of the thumb is that current-assets

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should be twice current liabilities. The current ratio is expressed as follows:

Current ratio = Current assets / Current liabilities

Example

Using the data from the previous example the current ratios for the two years is arrived as

follows.

2004 2003

26400 /13,160 15600/6400

= 2: 1 = 2.4: 1

Observation

The enterprise appears to nave a strong liquidity position. There has been, however, a

slight drop from year 2003 to year 2004.

For every shilling that is owed in 2004, the firm has Sh.2 to pay the debt and for every

shilling0wed in 2003 , the firm has Sh.2.40 available to meet the liability. If the firms

current ratio is divided into 1.0 and the resulting value is subtracted from 1.0, the

difference when multiplied by 100 represents the percent by which the firms current

assets can shrink without making it impossible for the firm to cover its current liabilities.

A current ratio of 2 means that the firm can still cover its current liabilities even if its

current assets shrink by 50 percent ([1.0 (1.0/2.0)]* 100).

.

The currentratio has further been refined to Quick ratio or Acid Test Ratio. This ratio

tests the short-term debt paying ability of an enterprise without having to rely on

inventory and prepayments Inventories are generally the least liquid current asset and

prepayments are generally not convertible to cash. Therefore for a company whose

inventories include work-in-progress, and slow-moving items the quick ratio is a better

indicator of liquidity than the current ratio. The rule of the thumb is for every shilling of

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current liability owed, the enterprise should have a shilling of current quick assets

available to meet it i.e. a quick ratio of 1.0.

It is given by;

(Current assets-inventories-prepayments)/(Current liabilities)

Activity ratios measure the speed with which accounts are converted into sales or cash.

Activity ratios can be categorized into two groups: The first group measures the activity

of the most i9mportant current accounts, which include inventory, accounts receivable,

and accounts payable1.The second groupmeasures the efficiency of utilization of total

assets and fixed assets.

Inventory Ratios

Average sales period ( Age of inventory) This ratio measures the average number of

days taken to sell the average inventory carried by a firm. It is given by:

(Average inventory x 365 days )/(Cost of sales)

Where, average inventory =(Beginning inventory+ Ending inventory)/2

Inventory turnover ratio. Inventory turnover ratio measure the number of times a

company's inventory has been sold during the year.

Inventory turnover = Cost of sales/Average Inventory

Accounts Receivable Ratios

Average Collection Period (Age of accounts receivable or days sales outstanding)

The ratio measures the average number ofdays takenby an enterprise to collect its trade

receivables. The ratio is computed as follows

1 In order to calculate activity ratios using current accounts the averages of these amounts during the year

are preferred.. These averages can be approximated by summing the beginning-of-year and the-end-of year

account balances and dividing by 2. When data needed to find the averages are unavailable, year-end

values may be used to calculate activity ratios for current accounts.

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(Average trade receivables X 365 days)/ (Credit sales)

Or, 365 days/(Accounts receivable turnover ratio)

Where, average trade receivables = (Beginning + Ending trade receivables)/2

The average collection period should only be judged in relation to a firms credit terms.

Only then can one draw definitive conclusions about the effectiveness of a firms credit

and collection policies.

Accounts receivable turnover ratio The accounts receivable turnover ratio measures the

number of times an enterprise has turned accounts receivable into cash during the year.

The higher the times the more efficient a company will be assumed to be in collecting itsdebts. The ratio is computed as follows:

Accounts receivable turnover = Annual Credit sates/Average trade receivables

Trade Creditors Ratios

(vi) Average payment period (Age of trade payable) ratio. This ratio measures the

average numberof days taken to pay anaccounts payable. It is computed asfollows:-

(Average trade payables X 365 days)/Credit purchases

Or

365 days/(Accounts payable turnover ratio)

Whereaverage accounts payable=(Beginning + Ending accounts payable)/2

Accounts payable turnover ratio. The accounts payable turnover ratio measuresthe

efficiencywith which firms pay their trade creditors.The higher the number of times, the

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moreefficient the enterprise is assumed to be in paying its creditors. It is calculated as

follows;

Accounts payable turnover ratio = Annual Credit purchases/Average trade payables

A firm is said to be financially leveraged whenever it finances a portion of its assets by

debts. Debts commit a firm to payment of interest and repayment of capital. Borrowing

increasesthe riskof default and it isonly advantageous to shareholders ifthe return

earned on the fundsborrowed isgreater than the cost of the funds. There two

classifications of measures of debt: (1) Measures of the degree of indebtedness measure

the amount of debt relative to other significant balance sheet amounts. Common measure

of the degree of indebtedness include the debt ratio, the debt/equity ratio, and the debt

to-total capitalization, (2) Measures of the ability to service debtassesses a firms ability

to make the contractual payments required on a scheduled basis over the life of the debt.

Commonly referred to as coverage ratios, they include times-interest earned, and the

fixed charge coverage ratios.

Debt to equity ratio This ratiomeasures the proportion of assets provided by

providers of long-term debt funds foreach shilling of assets provided by the

shareholders. It is computed as follows:

Total long term debt/Total stockholders funds

Debt to total assets ratio (Debt ratio) Thisratio measures the proportion of assets

financed by outsiders. It is calculated as follows;

Total liabilities / Total assets

Debt/total capitalization ratio Indicates the proportion of capital provided by outsiders.

The formula for Debt/Total capitalization ratio is;

Long-term debt/(Long-term debt + Shareholders funds)

The times interest earned ratio This is also known as the interest cover ratio.This ratio

measures the ability of a firm to meet its interest payment out of the current earnings. It

reflects the likelihood that creditors will continue to receive their interest payments.

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It is It is computed as follows:-

Earning before interest and tax/Interest expense

Fixed charge coverage ratio The fixed payment coverage ratio measures the firms

ability to meet all fixed payment obligations. Loan interest, principal payments, on debt,

scheduled lease payments, and preferred stock dividends are commonly included in this

ratio. The formula for the fixed charge coverage ratio is as follows:

(Earnings before interest and tax + lease payments)/(interest + lease payments +

{(principal payments + preferred stock dividends)*[1/(1-T)]}

Where T is the corporate tax rate applicable to the firms income. The term [1/(1-T)] is

included to adjust the after tax principal and preferred stock dividend payments back to a

before-tax equivalent that is consistent with the before-tax values of all other terms.

The fixed payment coverage ratio measures the risk the firm will be unable to meet

scheduled fixed payments and thus be driven into bankruptcy. The lower the ratio the

greater the risk to both lender and owners.

Profitability ratios evaluate the firms earnings with respect to a given level of sales, a

certain level of assets, the owners investment, or share value. Evaluating the future

profitability potential of the firm is crucial since in the long run, the firm has to operate

profitably in order to survive. The ratios are of importance to long term creditors,

shareholders, suppliers, employees and their representative groups. All these parties are

interested in the financial soundnessof an enterprise. The ratios commonly used to

measure profitability include:

Gross Profit Margin

This ratio measures the percentage of each shilling of sales remaining after the firm has

paid for its goods. The higher the gross profit margin the better, and the lower the relative

cost of merchandise sold. The formula for calculating the gross profit margin is as

follows:

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Gross profit margin = (Sales cost of goods sold)/ Net Sales

= Gross profits/ Net Sales

Operating Profit Margin

This ratio measures the percentage of each shilling of sales that remains after paying of

for the goods sold and the operating expenses. This is a measure of pure profits because

they measure only the profits earned on operations ignoring any financial charges and

government taxes. The operating profit margin is calculated as follows:

Operating profit margin = Operating profits/Net Sales

= Earnings before interest and taxes/Net Sales

Net Profit Margin

The net profit margin measures the percentage of each shilling of sales remaining to the

owners of the firm after paying off all expenses, including financing

charges and taxes. The higher the firms net profit margin the better for the

owners. The ratio is calculated as follows:

Net profit margin = Profit after taxes/Net Sales

Return on Total Assets (ROA)

This ratio is also called the return on investment(ROI) and measures how well

managementhas employed availableassets in generating profits from its assets. The

return on total assets is calculated as follows:

Return on total assets = Profit after taxes/ Total assets

Return on Equity (ROE)

The return on equity measures the return earned on the owners investment in the firm.

This ratio measures the ability of an enterprise to generate income for its owners. Return

on equity is calculated as follows:

Return on equity = (Profits after taxes preference dividend)/OrdinaryShareholders funds

Where, ordinary shareholders equity =Total shareholders funds less preference share

capital.

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Investment ratios help equity shareholders and other investors to assess the value of an

investment in the ordinary shares of a company, The value of an investment in the

ordinary shares in a listed company is its market value, and so investment ratios must

have regard not only to information in the company published accounts, butalso tothe

current price. The following are the common investment ratios.

Earnings per Shape (EPS)

This ratio represents or reflects the amountof shillings or cents earnedper ordinary

share. Itis considered so critical that the accounting profession requires its disclosure on

the face of the income statement for quoted companies(IAS 33).

It is given by

EPS = (Profit after taxes -Preference dividends)/The number

of ordinary Shares outstanding

Dividend pay-out ratio.

This ratio reflects a company's dividend policy. It indicates the proportion of

earnings per share paid out to ordinary shareholders as divided. It is

computed as follows:

Dividend pay-out ratio = Dividends per ordinary share / Earnings per share

Where ordinary dividends per share = Ordinary dividends/

Number of ordinary shares

DividendYield Ratio

This shows the dividend return being provided by the share. It is given by

Dividend yield = Dividends per share / Market price per share

Price Earnings Ratio (The P/E Ratio)

This ratio is used in comparing stock investment opportunity. It is an index of

determining whether shares are relatively cheap or relatively expensive. It measures the

amount investors are willing to pay for each shilling of the firms earnings.

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It is given by

PER=Market price per ordinary share/Earnings per share

This price earnings ratio reflects the consideration that investorsare willing to pay for a

stream of a shillings of earnings in the future. The price-earnings ratio is widely used by

investorsas ageneral guideline in gauging stock values. Investors increase or decrease

the price-earnings ratio that they are willing to accept for a share of stock according to

howthey view its future prospects. Companies with ample opportunity for growth

generally have high price-earnings ratio, with the opposite being for companies with

limitedgrowth.

LIMITATIONS OF RATIOS

1. Ratios are insufficient in themselves as a basisof judgment aboutthe future. They

are simply indicators or what to investigate. Therefore, they should notbe viewed as

an end but as a starting point.

2. They are useless when used in isolation. They have tobe compared over time for the

same firm or across firms with the industry'saverage.

3. Ratios are based on financial statements. Any weaknesses of the financial statements

are also captured within the ratios.

4. Comparing ratios across firms may be difficult because the firmsmay not be

comparable. Data among companies may not provide meaningful comparisons

because of factors such as use of different accounting policies and the size of the

company.

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Financial management - Analysis and intepretation of financial statements