Slide 1: Chapter 5
Financial Statement Analysis FINANCIAL STATEMENTS ANALYSIS-II : FINANCIAL STATEMENTS ANALYSIS-II COMMON-SIZE FINANCIAL STATEMENTS : COMMON-SIZE FINANCIAL STATEMENTS Nature
Year-to-year comparisons and trend analyses are useful in understanding an organization’s performance. But as the size of an organization changes, year-to-year comparisons of peso amounts can be misleading. Comparisons with competing organizations of different sizes are also difficult to interpret with only peso amounts. Thus, to adjust to size differences, analysts and accountants have developed common-size financial statements. Common-size financial statements : Common-size financial statements Translate peso amounts to percentages, which indicate the relative size of an item in proportion to the whole.
Common-size balance sheets – show assets, liabilities and owners’ equity as a percentage of total assets.
Common-size income statements - express revenue and expenses as a percentage of sales revenues. Purposes : Purposes Common-size statements which are also known as “component percentage” or “100 percent” statements enable analyst to:
Comprehend or visualize the changes in individual items that have taken place from year to year in relation to the total assets, total liabilities and owners’ equity or total net sales.
Compare statements of two or more companies or statement of one company with the statements for an entire industry and evaluate their current financial position and operating results.
Point out efficiencies and inefficiencies that might otherwise go unnoticed. Conversion Procedures : Conversion Procedures For the balance sheet, each item therein is converted to percent by dividing it by total assets.
In the income statement, each item is restated as a percentage of net sales or net operating revenue by dividing the former by the latter. Balance Sheet : Balance Sheet Guidelines in the Interpretation of Common-size Statements A common-size balance sheet shows the percent of total assets that has been invested in each type or kind of asset. These percentages may be compared with those of a competitor or the industry to determine whether or not the firm has over or underinvested in one or more of its assets.
The common-size statement will also show the distribution of liabilities and equity, i.e..the sources of the capital invested in the assets. Income Statement : The percentage of current assets may also be related to the percentage of current liabilities to determine debt-paying capacity of the company. Income Statement The common-size income statement shows the amount or percentage of the sales that has been absorbed by each individual cost or expense item and the percentage that remains as net income.
A comparison of year-to-year income statement common-size ratios will show whether a larger or smaller relative amount of net sales was used to meet particular costs or expenses. These percentages may also be compared with a competitor’s statements to determine in order effect a higher profit margin.
Comparison of the gross profit percentages from year to year may also reveal success or failure in the company’ efforts to increase efficiency in the procurement and merchandizing policies ,etc. Illustrative Problem 5.1 Financial Statement Analysis Using Common-size Statement : Illustrative Problem 5.1 Financial Statement Analysis Using Common-size Statement Slide 10: Percent (%) Gilbert Company
Comparative Balance Sheet-Common-Size Percentages
As of December 31 Slide 11: Gilbert Company
Comparative Income Statement-Common-Size Percentages
For the Years Ended December 31, 2002 to 2006 Slide 12: The Gilbert Company’s balance sheets showed that there had been substantial changes in the proportions of current and fixed assets and current and long-term liabilities during the period from Dec. 31, 2002 to Dec. 31, 2006. the percentages showed a declining liquidity in the company’s assets accompanied by a consistent reduction in liabilities over the five-year period.
It can be observed that Cash Balance and accounts receivable as a percentage of total assets had been increasing while investment in inventory in relation to total assets had been decreasing. Considering that the volume of sales was increasing, these changes can be viewed as beneficial to the company. Evaluation of the Financial Position Slide 13: The increase in investment in fixed assets had been financed largely from owner’s investment as indicated in the increasing percentage of equity to total assets.
The decreasing percentage of total liabilities to total assets further indicates lesser reliance of the company from creditors in raising additional capital. This, of course, is favorable as far as the long-term financial position among the creditors. Evaluation of Profitability Favorable changes could be observed in the gross margin percentage in relation to net sales. The increase in percentage over the years could be due to improvement in the company’s mark-up policy or better procurement policy. Slide 14: Selling expenses in relation to sales however, show increasing percentages from 2002 to 2006 while administrative expenses had more or less remained constant. Better control over the selling expenses should be instituted to further improve the profitability of the company.
Decrease in the percentage of other expenses to net sales is traceable to the decreasing amount of notes payable and long-term debts. Slide 15: Is a comparison in fraction, proportion, decimal or percentage form of two significant figures taken financial statements. It expresses the direct relationship b/w two or more quantities in the balance sheet and income statement of business firm. Financial Ratio Analysis Purpose Through ratio analysis, the financial statements user comes into possession measures w/c provide insight into the profitability of operations, the soundness of the firm’s short-term and long-term financial condition and the efficiency with w/c management has utilized the resources entrusted to it. Slide 16: Ratios must be used only as financial tools, that is, as indicators of weakness or strength and not to be regarded as good or bad per se.
Financial ratios are generally computed directly from the company’s financial statements, without adjustment. Conventional financial statements prepared in accordance w/ GAAP have a number of weakness that managers must consider if the ratios are to be meaningful.
Ratios are composite of many different figures– some covering a time period, others are instant time and still others representing averages. Limitations of Financial Ratios Slide 17: Ratios to be meaningful should be evaluated with the use of certain yardsticks. The most common of these are:
Company's own experience (prior years)
Other companies in the same industry (industry averages)
A standard set by management ( a budget)
Rules of thumb Financial Ratio Analysis Liquidity ratios – are ratios that measure the firm’s ability to meet cash needs as they arise( payment of accounts payable, bank loans and operating costs)
Activity ratios - are ratios that measure the liquidity of specific assets and efficiency in managing assets such as accounts receivable, inventory and fixed assets. Slide 18: Leverage ratios – are ratios that measure the extent of the firm’s financing, with debt relative to equity and its ability to cover interest and other fixed charges such as rent and sinking fund payments
Profitability ratios – are ratios that measure the overall performance of the firm and its efficiency managing assets, liabilities and equity. Illustrative Problem 5.2 Financial Ratio Analysis : Illustrative Problem 5.2 Financial Ratio Analysis Slide 20: EBC Enterprises, Inc.
Balance Sheet at December 31, 2006 and 2005
(In thousands) Slide 22: EBC Enterprises, Inc.
Income Statement and Retained Earnings
Fro the Years Ended December 31, 2006, 2005, and 2004 Summary of most Commonly Used Ratios : Their Formulas and Basic Significance : Summary of most Commonly Used Ratios : Their Formulas and Basic Significance Slide 25: Ratios Used To Evaluated Short-Term Financial Position
( Short-Term Solvency And Liquidity ) Slide 26: Ratios Used To Evaluate the Asset Liquidity and Management Efficiency Slide 30: Ratios Used To Evaluate Long-Term Financial Position Or Stability/Leverage Slide 33: Ratios Used To Measure Profitability And Returns To Investors Slide 36: If there is interest-bearing debt, rate of return on assets is computed as follows: a measure of the productivity of assets regardless of how the assets are financed may also be computed as follows: Slide 38: Financial Ratios Analysis I. Analysis of Liquidity or Short-Term Solvency II. Analysis of Asset Liquidity and Asset Management Efficiency III. Analysis of Leverage : Debt Financing and Coverage IV. Operating Efficiency and Profitability Slide 39: Current Ratio – is widely regarded as a measure of short-term debt-paying ability.
Quick or Acid test ratio – is a much more rigorous test of a company’s ability to meet in short term debts.
Cash flow liquidity ratio – considers cash flow from operating activities in addition to the truly liquid assets, cash and marketable securities. I. Analysis of Liquidity or Short-Term Solvency Slide 40: Accounts Receivable Turnover – roughly measures how many times a company’s accounts receivable have been turned into cash during the year.
Average Collection Period – helps evaluate the liquidity of accounts receivable and the firm’s credit policies.
Inventory Turnover – measures the efficiency of the firm in managing and selling inventory. II. Analysis of Asset Liquidity and Asset Management Efficiency Slide 41: Average sale period – the number of days being taken to sell the entire inventory one time, is computed by dividing 365 days by the inventory turnover period.
Fixed Asset Turnover – is another approach to assuring management’s effectiveness in generating sales from investments in fixed assets particularly for a capital-intensive firm. Slide 42: Debt Ratio – measures the proportion of all assets that are financed with debt.
Debt Equity Ratio – measures the riskiness of the firm’s capital structure in terms of relationship between the funds supplied by creditors (debt) and investors (equity). III. Analysis of Leverage : Debt Financing and Coverage Slide 43: Times interest earned ratio – is the most common measure of the ability of a firm’s operations to provide protection to long-term creditors.
Fixed Charge Coverage – measures the firm’s coverage capability to cover not only interest payments but also the fixed payment associated with leasing which must be met annually. Slide 44: Gross Profit Margin – which shows the relationship between sales and the cost of products sold, measures the ability of a company both to control costs and inventories or manufacturing of products and to pass along price increases through sales to customers.
Operating Profit Margin – is a measure of overall operating efficiency and incorporates all of the expenses associated with ordinary or normal business activities IV. Operating Efficiency and Profitability Slide 45: Net Profit Margin – measures profitability after considering all revenue and expenses, including interest, taxes and non operating items such as extraordinary items, cumulative effect of accounting change, etc.
Cash Flow Margin – is another important measure or perspective on operating performance.
ROA and ROE – are two ratios that measure the overall efficiency of the firm in managing its total investment in assets and in generating return to shareholders. Slide 46: Summary of Financial Statements Analysis of EBC, Inc. Slide 47: Short term liquidity analysis is of particular significance to trade and short-term creditors, management and other parties concerned with the ability of a firm to meet near- term demands for cash.
EBC’s current and quick ratios decreased indicating a deterioration of short-term liquidity. However, the cash flow liquidity ratio improved in 2006 after a negative cash generation in 2005. Short Term Liquidity and Activity Slide 48: The average collection period for accounts receivable and the inventory turnover improved in 2006 which could indicate improvement in the quality of accounts receivable and liquidity of inventory. The increase in inventory level has been accomplished by reducing holdings of cash and cash equivalents. This represents a trade-off of highly liquid assets for potentially less liquid assets. The efficient management of inventories is critical for the firm’s ongoing liquidity.
Presently, there appears to be no major problems with the firms short-term liquidity position. Slide 49: The debt ratios for EBC show a steady increase I the use of borrowed funds. Total debt has increased relative to total assets, long –term debt has increased as a proportion of the firm’s permanent financing and external or debt financing has risen relative to internal financing.
Why has debt increased? The statement of cash flows shows that EBC has substantially increased its investment in capital or fixed assets and their investments have been financed largely by borrowing especially in 2005 when the firm had a rather sluggish operating performance and no internal cash generation. Long-Term Solvency Slide 50: Given the increased level of borrowing the times interest earned and fixed charge coverage improved slightly in 2006. these ratios should however be monitored closely in the future particularly if EBC continues to expand. As noted earlier, EBC has increased its investment in fixed asset as a result of store expansion. The asset turnover in 2006, the progress traceable to improved management of inventories and receivable. There has been substantial sale growth which suggests future performance potential. Operating Efficiency and Profitability Slide 51: The gross profit margin was stable, a positive sign in the light of new store openings featuring discounted and “sale” items to attract customers. The firm also managed to improved its operating profit margin in 2006 principally due to the firm’s ability to control operating costs. The net profit margin also improved despite increased interest and tax expenses and a reduction in interest income from marketable security investment.
Return on assts and return on equity increased considerably in 2006. these ratios measure the overall success of the firm in generating profits from its investment and management strategies. Slide 52: It appears that EBC Enterprises, Inc. is well positioned for future growth. Close monitoring the firm’s management of inventories is important considering the size of the company’s capital tied up in it. The expansion in their operation may necessitate a sustained effort to advertised more, to attract customers to both new and old areas. EBC has financed much of its expansion with debt, and so far, its shareholders have benefited from the use of debt through financial leverage. The company should however be cautious of the increased risk associated with debt financing. Conclusion REVIEW QUESTIONS : REVIEW QUESTIONS What is the basic purpose for examining trends in a company’s financial ratios and other data? What other kinds of comparisons might an analyst make?
In financial analysis , why does analyst compute financial ratios rather than simply studying raw financial data? What are the limitations in the use of ratios?
Assume that two companies in the same industry have equal earnings. Why might these companies have different price-earnings ratios? If a company has a price-earnings ratio of 20 and reports earnings per share for the current year of P4, at what price would you expect to find the stock selling on the market. True or False : True or False 1. The asset turnover rate multiplied by the rate of net income earned on sales equals the rate on total assets.
2. If the information were available, financial analysts would be interested in knowing the sales volume volume at the break-even point for a business enterprise.
3. If the amount of current assets exceeds the amount of current liabilities, a decrease in current assets with a corresponding decrease in current liabilities increases the current ratio. Slide 56: 4. The number of day’s sales in receivable at the end of an accounting period is a better measure of the quality of receivable than the receivable turnover rate.
5. Window dressing is a violation of generally accepted accounting principles.
6. The debt ratio is useful to creditors as well as to stockholders, but each of these groups places somewhat different emphasis on it.
7. Short- term creditors generally are more concerned with vertical analysis than with horizontal analysis.
8. Horizontal analysis is possible for both an income statement and a balance sheet.
9. Common-size financial statements show peso change in specific items from one year to the next.
10. A company with 2.0 current ratio will experience a decline in the current ratio when a short-term liability is paid. ****End**** Bienna MarieBSBA II : Bienna MarieBSBA II Prepared by: