9/05/2014 Accounting 101

Financial Statement AnalysisRatio Analysis

Financial statement analysis is undertaken to evaluate a business.

- Is the company profitable and operating efficiently?- Do the profits represent a good return on investment?- Is the company financially risky?

The most common technique used to evaluate this is ratios.

- These express relationships between figures shown on the financial statements.- Allow for comparison of different sized firms.

Ratios only provide meaningful information when they are compared with benchmarks. Examples of benchmarks:

- “Rules of Thumb”- Ratio from an earlier period (trend analysis)- Ratio from a competitor or industry (cross-section analysis)

Analysts often like to restate the financial statements:

- Common size statements express each financial statement line item in percentage terms to highlight differences.

- In horizontal analysis each financial statement line item is expressed as a percent of the base year, this highlights growth, useful for trend analysis.

- Vertical analysis expresses each financial statement line as a percentage of the largest amount on the statement. I/S (Net Sales) and B/S (Total assets). This helps distinguish between changes that result from growth and changes that are likely to have arisen from other causes, this can help forecast future profitability.

Ratio analysis is split into 5 major categories: Profitability, Efficiency, Liquidity, Gearing and Investment.

Profitability

Profitability ratios measure two aspects of a company’s profits:

1. Within the income statement, certain income statement subtotals are shown as percentages of net sales: - gross profit percentage

- Profit margin

2. Profitability is related to the assets that helped generate the profit: Return on Assets.

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Gross profit percentage measures the proportion of each sales dollar (net of returns) available to pay other expenses and provide profit for owners.

Gross Profit Percentage = Gross Profit / Net Sales

It indicates the effectiveness of marketing, purchasing, pricing and production decisions.

Can be increased by increasing selling price. Or by reducing COGS.

The profit margin percentage measures the proportion of each net sales dollar that is available to pay interest, taxes, and the owners.

Profit Margin Percentage = EBIT/Net Sales

Different to textbook. EBIT is ‘Earnings before interest and tax’.

The return on assets ratio (ROA) measures the profit earned by total assets.

ROA = EBIT / Average Total Assets

ROA = Net Profit After Tax + Tax Expense + Interest Expense / Average Total Assets

Average total assets are used because the profit relates to the entire period.

Gross profit margin less profit margin = operating expenses

Operating Ratios (Asset Efficiency)

Asset efficiency is a measure of how efficiently a company uses its assets. The principal asset efficiency ratios are measures of turnover, that is, how quickly the business can realize benefits from certain assets.

- Accounts Receivable turn into Cash (when collected).- Inventory turns into COGS (when sold).- Total Assets generate Sales (indirectly).

The faster an asset turns over, the more efficiently it is being used.

Asset turnover ratio: How efficient is the company in generating sales?

Asset Turnover Ratio = Net Sales / Average Total Assets

This combined with profit margin percentage shows that ROA is a mixture of profitability and efficiency.

ROA can be analysed at 3 levels.

Level 1: ROA = EBIT / Average Assets

Level 2: ROA = Profit Margin x Assets Turnover

Level 3: Profit margin ratios and asset turnover ratios

More asset efficiency ratios:

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Inventory Turnover Ratio = COGS / Average Inventory

No. of days = 365 days / Inventory Turnover

AR Turnover Ratio = Net Credit Sales / Average Accounts Receivable

No. of days = 365 days / Accounts Receivable Turnover

For external users of the financial statements, net credit sales must be estimated. But many retailers have insignificant credit sales, e.g., The Warehouse.

Liquidity Risk (Short-term Financial Risk)

This is the risk that a business will not meet its obligations as they become due. Short-term liquidity ratios are most important to short-term creditors, but all stakeholders have an interest.

Current Ratio = Current Assets / Current Liabilities

Acid-test Ratio = Current Assets – Prepayments – Inventory / Current Liabilities

Service companies often see little difference between these 2 methods.

Further liquidity analysis can focus on the Statement of Cash Flows.

Gearing

Financial flexibility is the ability of a business to adapt to change. Gearing is the assessment of debt levels. This is to assess a businesses’ long term flexibility. Too much debt reduces flexibility.

Debt Ratio = Total Debt / Total Assets

Interest Cover Ratio = EBIT / Interest Expense

Investment Ratios

Shareholders have two primary interests:

1. The creation of value2. The distribution of value

Creation:

EPS = Profit / Weighted Average Common Shares Outstanding

This is the only ratio required to be shown on the face of a financial statement.

P/E Ratio = Market price per share / Earnings per share

This is an indicator of market confidence.

Return on Equity = Profit after Tax / Average Equity

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ROE is similar to ROA, except that the other stakeholders’ share of profits (interest and tax expenses) are removed from the numerator, and claims and assets are removed from the denominator.

Distribution:

Dividend Yield Ratio = Dividends per Common Share / Closing Market Price per Share for Year

Usually calculated by an investor who favours dividends over capital gains.

Limitations of Ratio Analysis

1. Effected by quality of financial statements.2. Restricted view of performance.3. No 2 businesses are identical.4. Balance sheet is only a snapshot.