Financial statement analysis

P.W.Sims Business Program410-650-LW

Finance

Financial statement analysis

Involves looking at• Revenues• Expenses• Liabilities

Uses this raw information from the operation of a business in new ways to • compare period over period results• compare your business to others • compare your business to your industry

Financial statement analysis – Common size statement • First step in financial statement analysis is

usually common size statement

Common size income statement• Presents each line as percent of revenue

Common size balance sheet• Presents each line as percent of total assets

Quantitative factors - Common Size Statements

$ % $ %Sales revenue 2,187,460$ 100.0% 150,845$ 100.0%COGS 1,203,103$ 55.0% 72,406$ 48.0%Gross margin 984,357$ 45.0% 78,439$ 52.0%

Expenses 505,303$ 23.1% 39,974$ 26.5%EBIT 479,054$ 21.9% 38,465$ 25.5%Interest 131,248$ 6.0% 15,386$ 10.2%EBT 347,806$ 15.9% 23,079$ 15.3%Tax 118,254$ 5.4% 3,462$ 2.3%Net Income 229,552$ 10.5% 19,617$ 13.0%

Alpha Beta

Exa

mpl

e

Financial statement analysis - Ratios

• When examined separately, ratios don’t convey much information. Ratios are compared with: History—examine trends (how ratio has changed over

time)

Competition—compare with other firms in same industry• Link to comparison charts http://biz.yahoo.com/p/industries.html

Budget—compare actual ratios with expected or desired ratios

Categories of Financial Ratios

• Profitability Ratios• Market Value Ratios• Liquidity Ratios• Asset Management Ratios• Debt Management Ratios

Categories of Financial Ratios

Profitability—allow assessment of the firm’s ability to make money

Liquidity—indicate firm’s ability to pay its bills in short run Asset Management—show firm’s ability to generate

revenue using minimum amount of assets Debt Management—determine if the firm is using so

much debt that it is assuming excessive financial risk

Profitability Ratios

• Return on Assets

Net IncomeROA

Total Assets

Adds effectiveness of asset management to Return on Sales

Measures ability of firm to utilize assets to earn profit

Often compared to firm’s cost of financing (after tax)

Profitability Ratios

• Return on Equity

Adds effect of borrowing to Return on Assets Measures ability to earn a return on owners’ investment If firm has substantial debt, ROE tends to be higher than

ROA in good times and lower in bad times Compared to returns available from alternate investments

Net IncomeR eturn on Equity =

Shareholders' Equity

Liquidity ratios

• Liquidity ratios measure the ability to convert assets to cash The ability to pay short term bills

Liquidity Ratios

• Current Ratio

Current Assets

Current Ratio Current Liabilities

To ensure solvency, current ratio is expected to exceed 1.0

Standard ratio is 2:1 May be too high if too much money is tied

up in receivables and inventory

Liquidity Ratios

• Quick Ratio (or Acid-Test Ratio)

Measures liquidity without considering inventory (least liquid current asset)

May be too high if too much money is tied up in receivables

Current Assets-InventoryQuick Ratio

Current Liabilities

Debt Management Ratios

• Debt management ratios measure financial risk from borrowing High ratios viewed as risky by lenders and

investors Riskiness associated with debt and interest is

called financial risk High level of debt can burden income statement

with excessive interest, a fixed financial charge Firm may not be able to repay debt and interest if

profits decline

Debt Management Ratios

• Debt Ratio

Need to determine if company is using so much debt that it is assuming excessive financial risk

High debt ratio is viewed as risky by investors and creditors and is negative

Range of 1:1 to 4:1

D

Debt Management Ratios

• Debt-to-equity ratio

Compares what is owned to what is financed

Measures mix of debt and equity within firm’s total capital

High ratio means cie relies to much on debt and should think of reducing debt

Debt to equity ratio

Debt Management Ratios

• Long Term Debt Ratio

Focuses the attention long term debt instead of all the debt

¿debt Ratio=𝑳𝑻𝒅𝒆𝒃𝒕

(𝑳𝑻 𝒅𝒆𝒃𝒕−𝑻𝒐𝒕𝒂𝒍𝒆𝒒𝒖𝒊𝒕𝒚 )

Debt Management Ratios

• Times Interest Earned

EBITTIE

Interest Expense

EBIT stands for Earning before interest and taxes TIE is a coverage ratio

• Reflects how much EBIT covers interest expense• High level of interest coverage implies safety for lenders

High TIE ratio often means a low debt/equity ratio Lowest acceptable ratio 1.5; best result 2 to 3

Debt Management Ratios

• Cash coverage Ratio

Same as previous but looks only at cash expenses (depreciation is an accounting expense)

Lowest acceptable ration 1.5; best result 2 to 3

C ashcoverage=(𝑬𝑩𝑰𝑻 +𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 )

𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕

Debt Management Ratios

• Debt coverage ratio

EBIT stands for Earning before interest and taxes TIE is a coverage ratio

• Reflects how much cash covers interest and principal payments

Lowest results acceptable 2 to 2.5

Debt Coverage Ratio=(𝑬𝑩𝑰𝑻 +𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 )

𝑫𝒆𝒃𝒕𝒑𝒂𝒚𝒎𝒆𝒏𝒕

Debt Management Ratios

• Fixed Charge Coverage

EBIT Lease PaymentsFixed Charge Coverage

Interest Expense Lease Payments

Interest payments are not the only fixed charges

Lease payments are fixed financial charges similar to interest• Must be paid regardless of business conditions

Question

• Debt ratio

Your debt ratio has increased from 50% to 55% in the last quarter, this means:

Your asset value has increased

Your asset value has decreased and so has your liability

Your liabilities have increased faster than your assets

Question

• What does EBIT stand for?• Debt coverage ratio, why do we

add to 𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 𝑬𝑩𝑰𝑻before comparing it to 𝑫𝒆𝒃𝒕 𝒑𝒂𝒚𝒎𝒆𝒏𝒕