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FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS:

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS

PowerPoint Presentation:

Introduction to Balance Sheets and Income Statements: The balance sheet summarizes the financial position of an organization at a given moment, it is a snapshot of the firm. The balance sheet reflects the status of the organization’s assets, (the economic resources owned by the organization), liabilities (debts owned to creditors), and equity (the owner’s investment in the organization).

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS:

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS As its name implies the balance sheet should indicate that these elements are in balance. Assets = Liabilities + Equity This fundamental relationship must always exist, because the assets represent the things owned by the organization and the liabilities and equity indicate how much was supplied by both creditors and owners.

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS:

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS In contrast to the balance sheet, the income statement shows the organization's financial progress over a given period of time. The income statement is also based on equation: Revenues - Expenses = Profit (or Loss)

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS:

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS Revenues are the resources, primarily cash, coming into the organization as a result of goods sold or services rendered. Expenses are the resources used by the organization to provide goods or services. If revenues are greater than expenses, the business has realized a profit. If expenses exceed revenue the business has realized a loss from operations. As you read the following detailed descriptions of balance sheets and income statements, keep in mind that there is a direct and important relationship between the two. The profit (or loss) realized by a business over a period of time affects the amount of equity. Equity in a business comes from two sources: Direct investment by the owners and profits from business operations. Therefore, the bridge between the income statement and the balance sheet is in the relationship between equity and profit or loss.

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS:

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS Income Statements: Exhibit 1 shows a sample income statement (see next page) for a period covering January 1 to December 31, 1989. The company in question earned revenues from two sources: Net sales: All sources earned by the company from the sale of its products and services. Other income: Generally resources from sources as interest on bank accounts, cash dividends from investments in other companies, and interest on bonds.

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS:

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS The following expenses are subtracted from revenues: Cost of goods sold: all the expenses incurred in making the products sold during the period, including the cost of materials, labor, and factory overhead (rent, utilities and maintenance).

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Company X For year ending December 31, 1989 (In LE) Revenues Net Sales 3,787,248 Other Income 42,579 Total Revenues 3,829,827 Expenses Cost of Goods Sold 2,796,459 Administrative & Selling Expenses 637,509 Interest Expenses 47,516 Total Expenses 3,503,545 Earnings Before Income Taxes 326,282 Income Taxes 152,039 Net Earnings 174,243 EXHIBIT 1 SAMPLE INCOME STATEMENT

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS:

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS Administrative and selling expenses: The costs of running and promoting the business, including items like the president’s salary, the salaries of all management personnel, advertising costs and sales commissions. Interest expenses: The interest that the company paid during the year on money that it borrowed.

PowerPoint Presentation:

Other Expenses: This would include any other unusual expenses incurred by the company to run the business not otherwise accounted for above (e.g. research and development expenses, and organizational costs).

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS:

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS Expenses are subtracted from revenues to yield a figure that indicates the company’s earnings, but this figure still does not reflect the company’s profit. During 1989 the company paid over 46 percent of its earnings to the tax department in the form of taxes. Thus, its net earnings, or the amount of profit the company earned in 1989, is LE 174, 243.

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS:

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS Balance sheets Exhibit 2 is the balance sheet for Company X as of December 31, 1989. The first component is assets, current and fixed. Current assets, are those the business expects to turn into cash during the next year. The cash generated from current assets is used to pay expenses and repay liabilities. Current assets include:

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS:

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS Cash. Marketable securities: Temporary investments (generally 90 days) of excess or idle cash; listed at cost, or market value since they are converted into cash within one year. Accounts Receivable: Money owned to the company by debtors, generally for the purchase of goods and services. Inventories: The value of products that have been completed and are in storage waiting to be sold (finished goods), products that have been partially completed (work in process), and raw materials. Prepaid Expenses: The value of items that the company has paid for in advance, such as insurance premiums.

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS:

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS Fixed assets are things of value that will provide benefits to the company for one or more years. Fixed assets are reported in three categories: land, buildings, machinery and equipment. Fixed assets are reported on the balance sheet at the cost to purchase or acquire the asset minus the depreciation accumulated on the assets since the time of purchase. Depreciation is the estimated decline in the useful value of an asset due to gradual wear and tear. Since this decline in value cannot be estimated with certainly, accountants use various standards methods to approximate it.

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SAMPLE BALANCE SHEET Company X December 31, 1989 Assets Liabilities: Current Assets: Current Liabilities Cash 59,770 Notes Payable 48,563 Marketable securities 87,466 Trade accounts payable 207,887 Accounts receivable 559,144 Payrolls & other accurables 411,362 Inventory 618,120 Income taxes 124,684 Prepaid Expenses 49,986 Total Current Liabilities 792,496 Total Current Assets 1,374,486 Long-Term Liabilities 431,350 Fixed Assets: Total Liabilties 1,223,846 Land 25,807 Buildings 716,076 Shareholders’ Equity 1,103,190 Machinery & Equipment 1,010,770 Less allowances for depreciation 800,103 Total Fixed Assets 952,550 Total Assets 2,327,036 Total Liabilties & Equity 2,327,036

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS:

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS The second major section in a balance sheet is devoted to liabilities. Current liabilities are the debts that a company must pay off within the coming year: Notes payable: Money owned to banks or other lending institutions; generally short-term loans (up to one year) used to finance short-term needs.

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS:

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS Accounts payable: Money owed to vendors for the purchase of goods and services. Payrolls and other accurables: Money owed to people for institutions that have performed services, including salaries owed to employees, salaries owed to employees on vacation, attorney fees, insurance premiums, and pension funds. Income taxes: Money owed to the Tax Department; may sometimes be deferred and paid later but must always be paid.

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS:

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS Long-term liabilities are obligations, usually loans, that are due to be paid not in the current year but in some future period. The amount specified in the balance sheet is equal to the total amount borrowed.

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS:

FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS The final major section, the equity section summarizes the owners‘ investment in the business. Individuals and institutions become owners of a company by purchasing shares of the company’s stock. Equity increases as more people purchase stock and the company retains increased profit.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Each type of analysis of financial data has a purpose or use that determines the different relationships emphasized. Therefore, it is useful to classify ratios into four fundamental types: Liquidity ratios, measure the firm’s ability to meet its maturing short-term obligations.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Leverage ratios, measure the extent to which the firm has been financed by debt. Activity ratios, measure how effectively the firm is using its resources. Profitability ratios, measure managements overall effectiveness as shown by the returns generated on sales and investment.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Liquidity Ratios Generally, the first concern of the financial analyst is liquidity. they measures the short-run solvency of a company its ability to meet current debts. Current Ratio The current ratio indicates whether there are enough current assets to meet current liabilities. Current ratio = Current assets Current liabilities

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Current assets normally include: Cash, marketable securities, accounts receivable, and inventories. Current liabilities consist of: accounts payable, short-term notes, payable, current maturities of long-term debt, accrued income taxes, and other accrued expenses (principally wages).

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS When is the company solvent? When the current ratio is 1.0 or greater; that is, the company should have more current assets than current liabilities. Method for Calculating the Current Ratio: Add cash, marketable securities, accounts receivable, and inventories to get current assets.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Add notes payable, trade accounts payable, payrolls and other accurables and income taxes to get current liabilities. Divide the derived current assets figure by the calculated current liabilities figure.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS You have now derived the current ratio. Now, compare the value derived to 1.0. If the current ratio is 1.0 or greater, the company should have more current assets than current liabilities and is financially viable or solvent. If the current ratio is less than 1.0, the company will have more current liabilities than current assets and is financially unviable or insolvent.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS For significance this ratio should be compared to previous years (e.g. the current ratio for five previous years should be derived). This is necessary in order to derive a trend. If the current ratio is rising n an upward fashion, the company is becoming more financially viable. If the current ratio is falling and assuming a downward trend, the company is becoming less financially viable.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS One helpful activity is to also compare the current ratio of the company in question to the current ratio of similar competing companies. If the company in question has a higher current ratio on a regular basis over a number of years than this company is more financially viable. On the other hand, if the company in question has a lower current ratio on a regular basis over a number of years than this company is less financially viable.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS b - Quick Ratio, or Acid Test The quick ratio is calculated by deducting inventory from current assets, and dividing the remainder by current liabilities. Inventories are deducted since they are typically the least liquid of a firm’s current assets. Quick ratio = Current assets - Inventory Current Liabilities

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS When is the company solvent? When the Quick ratio is 1.0 or greater. Which liquidity ratio is more accurate, the current ratio or the quick ratio? The quick ratio, since it excludes inventory, the least liquid asset, and the asset on which losses are most likely to occur in the event of liquidation.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Method for Calculating the Quick Ratio: Add cash, marketable securities and accounts receivable (items 16, 17, & 18 on the sample balance sheet on page 6) to get quick assets (quick assets by definition is current assets - inventory).

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Add notes payable, trade accounts payable, payrolls and other accurables and income taxes (items 31, 32, 33 & 34 on the sample balance sheet on page 6) to get current liabilities. Divide the derived quick assets figure by the calculated current liabilities figure.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS You have now derived the quick ratio. Now, compare the value derived to 1.0. If the quick ratio is 1.0 or greater, the company should have more quick assets than current liabilities and is financially viable or solvent. If the quick ratio is less than 1.0, the company will have more current liabilities than quick assets and is financially unviable or insolvent.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS For significance this ratio should be compared to previous years (e.g. the quick ratio for five previous years should be derived). This is necessary in order to derive a trend. If the quick ratios is rising in an upward fashion, the company is becoming more financially viable. If the quick ratio is falling and assuming a downward trend, the company is becoming less financially viable.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS One helpful activity is to also compare the quick ratio of the company in question to the quick ratio of similar competing companies. If the company in question has a higher quick ratio on a regular basis over a number of years then this company is more financially viable.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Leverage Ratios Leverage ratios measure the funds supplied by owners as compared with the financing provided by the firm’s creditors.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Implications of leverage ratios: Equity, or owner-supplied funds, provide a margin of safety for creditors. Thus, the less equity, the more the risks of the enterprise to the creditors.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Debt funding enables the owners to maintain control of the firm with a limited investment. If the firm earns more on the borrowed funds than it pays in interest, the return to the owners is magnified. If the firm earns more on the borrowed funds than it pays in interest, the return to the owners is magnified.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Low leverage ratios: Indicate less risk of loss when the economy is in a downturn, but lower expected returns when the economy booms. High leverage ratios: indicate the risk of large losses, but also have a chance of gaining high profits.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Therefore, decisions about the use of leverage must balance higher expected returns against increased risk.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Approaches to examining leverage ratios: Debt ratio: The debt ratio is the ratio of total debt to total assets and measures the percentage of total funds provided by creditors. The debt ratio is: Total debts Total assets

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Method for Calculating the Debt Ratio: Add notes payable to long-term liabilities to get total debts.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Add cash, marketable securities, accounts receivable, inventories, prepaid expenses, land, buildings, machinery and equipment and subtract depreciation to derive the total assets figure. Divide the total debts figure by the calculated total assets figure.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS For significance this ratio should be compared to previous year (e.g. the debt ratio for five previous years should be derived). This is necessary in order to derive a trend. If the debt ratio is rising in an upward fashion, the company is developing a leverage problem. If the debt ratio is falling and assuming a downward trend, the company is investing more of its own resources to generate assets and is becoming less dependent on debts.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS One helpful activity is to also compare the debt ratio of the company in question to the debt ratio of similar competing companies. If the company in question has a higher debt ratio on a regular basis over a number of years, then this company is over leveraged in comparison to its competitors. On the other hand, if the company in question has a lower debt ratio on a regular basis over a number of years, then this is less dependent on debt as a source of financing in comparison to its competitors.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS B - Debt-to-Equity- Ratio: This ratio is a variation of the debt ratio that is commonly used. It compares the amount of money borrowed from creditors to the amount of shareholder’s investment made within a firm. Debt-to-Equity ratio = Total Debts Shareholder’s investment (equity)

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Method for Calculating the Debt-to-Equity Ratio: Add notes payable to long-term liabilities to get total debts.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Look up the shareholder’s investment or equity line item in the blance sheet. Divide the total debts figure by the calculated shareholders’ investment figure.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS For significance this ratio should be compared to previous years (e.g. the debt to equity ratio for five previous years should be derived). This is necessary in order to derive a trend. If the debt to equity ratio is rising in an upward fashion, the company is developing a leverage problem. If the debt ito equity ratio is falling and assuming a doward trend, the company is investing more of its owners resources to generate assets and is becoming less dependent on creditors.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS One other helpful activity is to also compare the debt to equity ratio of the company in question to the debt equity ratio of similar competing companies. If the company in question has a higher debt to equity ratio on a regular basis over a number of years, then this company is over leveraged in comparison to its competitors. On the other hand, if the company in question has lower debt to equity ratio on a regular basis over a number of years, then this company is less dependent on debt as a source of financing in comparison to its competitors.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Profitability ratios Profitability ratios indicate how successful a company really is and how effective management is in operating the business.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS A - Return on assets This ratio shows how much money the company earned on each dollar it invested in assets. It is a measure of overall company earning power or profitability. Return on Assets (ROA) = Net Earnings Total Assets

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Method for Calculating the Return on Assets Ratio : Derive the net earnings, or net profit figure from the income statement. Net earnings is simply total revenues minus total expenses.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Add cash, marketable securities, accounts receivable, inventories, prepaid expenses, land, buildings, machinery and equipment and subtract depreciation to derive the total assets figure. Divide the net earnings figure by the derived total assets figure to get return on assets.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS For significance this ratio should be compared to previous years (e.g. the return on assets ratio for five previous years should be derived). This is necessary in order to derive a trend. If the return on assets ratio is rising in an upward fashion, the company is making a larger return on funds invested in assets. If the return on assets ratio is falling and assuming a downward trend, the company is making a lower return on funds invested in assets.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS One other helpful activity is to also compare the return on assets ratio of the company in question to the return on assets of similar competing companies. If the company in question has a higher ROA on a regular basis over a number of years, then this company is financially better off in comparison to its competitors. On the other hand, if the company in question has a lower ROA on a regular basis over a number of years, then this company is financially worse off in comparison to its competitors.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS B - Profit Margin : The profit margin is a ratio that shows the relationship between net earnings and net sales and indicates how much profit the company is earning on each dollar in sales. Profit Margin = Net Earnings Net Sales

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Method for calculating the profit margin ratio: Derive the net earnings, or net profit figure from the income statement. Net earnings is simply total revenues minus total expenses.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Derive the net sales line item from the income statement. Divided the net earnings figure by the derived net sales figure to get the profit margin.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS For significance this ratio should be compared to previous years (e.g. the profit margin ratio for five previous years should be derived). This is necessary in order to derive a trend. If the profit margin ratio is rising in an upward fashion, the company is making a larger return on sales. If the profit margin is falling and assuming a downward trend, the company is making a lower return on sales.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS One other helpful activity is to also compare the profit margin of the company in question to the profit margin of similar competing companies. If the company in question has a higher profit margin on a regular basis over a number of years, then this company is making a larger return on sales in comparison to its competitors. On the other hand, if the company in question has a lower profit margin on a regular basis over a number of years, then this company is making a lower return on sales in comparison to its competitors.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS C - Return on equity (or return on net worth) This ratio indicates the amount of net earnings resulting from investments in equity. Shareholders are particularly interested in this ratio, because it shows them how much they are earning on their investments. Return on equity = Net Earnings Shareholders’ investment (Equity)

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Method for calculating the return on equity ratio : Derive the net earnings, or net profit figure from the income statement. Net earnings is simply total revenues minus total expenses.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Lookup the shareholder’s investment or equity line item in the balance sheet. Divide the net earnings figure by the derived shareholder’s investment figure to get return on equity.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS For significance this ratio should be compared to previous years (e.g. the return on equity ratio for five previous years should be derived). This is necessary in order to derive a trend. If the return on equity ratio is rising in an upward fashion, the company is making a larger return on funds invested by shareholders. If the return on equity is falling and assuming a downward trend, the company is making a lower return on funds invested by shareholders.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS One other helpful activity is to also compare the return on equity of the company in question to the return on equity of similar competing companies. If the company in question has a higher return on equity on a regular basis over a number of years, then this company is making a larger return on shareholder’s investment in comparison to its competitors. On the other hand, if the company in question has a lower return on equity on a regular basis over a number of years, then this company is making a lower return on shareholder’s investment in comparison to its competitors.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Activity ratios Activity ratios measures how effectively the firm employs its resources. These ratios involve comparisons between the level of sales and the investment in various asset accounts, like inventories and accounts receivable.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS A - Inventory turnover Inventory turnover tells us how many times during the year the entire stock of inventory was sold. Inventory turnover is calculated as follows: Inventory turnover = Sales Inventory

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Method for calculating the inventory turnover ratio : Derive the net sales line item from the income statement. Derive the inventory valuation figure from the balance sheet. Divide the sales figure by the derived inventory figure to get the inventory turnover.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Problems in arising in calculating and analyzing this ratio: Sales are at market prices. If inventories are carried at cost, as they generally are, it is more appropriate to use cost of goods sold in place of sales in the numerator of the formula . Sales occur over the entire year, whereas the inventory figure is for one point in time. This makes it better to use an average inventory, computed by adding beginning and ending inventories and dividing by 2.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS B - Average collection period : The average collection period indicates how quickly the company collects its accounts receivable.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS It is computed in the following way: Annual sales (derived from the income statement) are divided by 365 to get average daily sales. Accounts receivable (derived from the balance sheet) are divided over daily sales to find the number of days’ sales is tied up in receivables.

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS The average collection period represents the average length of time the firm must wait to receive cash after making a sale and is mathematically defined as follows: Average collection period = Accounts receivables Sales/365 days

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS:

ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Evaluation of this ratio is based upon the terms on which the firm sells its goods. For example, if the collection period over the past few years for a given company is lengthy while its credit policy did not change, this would be evidence that steps should be taken to expedite the collection of accounts receivable.

SUMMARY OF FINANCIAL RATIOS:

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II. Ratios indicating asset relations and capital set-up or relating to analysis of long-term solvency A. Equities related to profits and sales 1. Sales to owners’ equity Net Sales Owners’ Equity Numberof times net worth is “turned over” in sales Indicative of the utilization of owner’s capital may reflect over-capitalization in relation to volume of business done. FINANCIAL RATIOS

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HOW TO ANALYZE FINANCIAL POSITION POTENTIAL FOR BUSINESS FAILURE:

HOW TO ANALYZE FINANCIAL POSITION POTENTIAL FOR BUSINESS FAILURE Bankruptcy occurs when the company is unable to meet maturing financial obligations. We are thus particularly interested in predicted cash flow. Financial difficulties affect the price-earnings ratio, and the effective interest rate.

HOW TO ANALYZE FINANCIAL POSITION POTENTIAL FOR BUSINESS FAILURE:

HOW TO ANALYZE FINANCIAL POSITION POTENTIAL FOR BUSINESS FAILURE A comprehensive quantitative indicator used to predict failure is Altman’s “Z-score,” which equals Working capital Retained earnings X 1.2 + X 1.4 Total assets Total assets Operating income MV of common & preferred X 3.3 + X 0.6 Total assets Total liabilities Sales + X 0.999 Total assets N.B. Operating income = Net sales - cost of goods sold

THE SCORES AND THE PROBABILITY OF SHORT-TERM ILLIQUIDITY FOLLOW.:

THE SCORES AND THE PROBABILITY OF SHORT-TERM ILLIQUIDITY FOLLOW . Score Probability of illiquidity or failure 1.80 or less Very high 1.81- 2.99 Not sure 3.0 or greater Unlikely

EXAMPLE:

EXAMPLE A company presents the following information Working capital 280,000 Total assets 875,000 Total liabilities 320,000 Retained earnings 215,000 Sales 950,000 Operating income 130,000 Common stock Book Value 220,000 Market Value 310,000 Preferred stock Book value 115,000 Market value 170,000

PowerPoint Presentation:

Z-score equals 280,000 215,000 130,000 X 1.2 + X 1.4 + X 3.3 + 875,000 875,000 875,000 480,000 950,000 X 0.6 + X 0.999 = 320,000 875,000 0.384 + 0.344 + 0.490 + 0.9 + 1.0846 = 3.2026 The probability of failure is not likely

QUANTITATIVE FACTORS IN PREDICTING CORPORATE FAILURE:

QUANTITATIVE FACTORS IN PREDICTING CORPORATE FAILURE Low cash flow to total liabilities. High debt-to-equity ratio and high debt to total assets. Low return on investment Low profit margin Low retained earnings to total assets Low working capital to total assets and low working capital to sales Low fixed assets to noncurrent liabilities Inadequate interest-coverage ratio Instability in earnings Small size company measured in sales and/or total assets

QUANTITATIVE FACTORS IN PREDICTING CORPORATE FAILURE:

QUANTITATIVE FACTORS IN PREDICTING CORPORATE FAILURE Sharp decline in price of stock, bond price, and earnings A significant increase in beta. (Beta is the variability in the price of the company’s stock relative to a market index) Market price per share is significantly less than book value per share A significant rise in the company’s weighted-average cost of capital High fixed cost to total cost structure (high operating leverage) Failure to maintain capital assets. (e.g. decline in the ratio of repairs to fixed assets

QUANTITATIVE FACTORS IN PREDICTING FAILURE:

QUANTITATIVE FACTORS IN PREDICTING FAILURE New company Declining industry Inability to obtain adequate financing, and when obtained there are significant loan restrictions A lack in management quality

CONSOLIDATED BALANCE SHEETS:

CONSOLIDATED BALANCE SHEETS December 31, 1993 1992 Assets Cash 9,150,210 7,679,800 Accounts receivable less allowances 6,952,700 6,411,470 Inventories 5,755,040 5,293,910 Other current assets 897,670 895,760 Total current assets 22,755,620 20,280,940 Investments 304,710 174,640 Property, plant and equipment Land 336,780 292,480 Buildings 4,940,740 4,277,040 Machinery & Equipment 8,791,660 7,783,080 Total Property, Plant & Equipment 14,069,180 12,352,600 Less accumulated depreciation 5,475,040 4,656,370 Property plant & Equipment net of depreciation 8,594,140 7,696,230 Intangibles 1,934,650 1,828,510 Other assets 362,990 468,980 Total Assets 33,952,110 30,449,300 Liabilities Loans payable to Banks 588,600 616,040 Accounts payable & Accrued Expenses 6,030,420 5,267,770 Total current liabilities 6,619,020 5,883,810 Long term Debt 4,415,510 3,679,650 Shareholders’ Equity Total Shareholder’s Equity 22,917,580 20,885,840 Total Liabilities and Shareholders’ Equity 33,952,110 30,449,300

CONSOLIDATED STATEMENTS OF INCOME:

CONSOLIDATED STATEMENTS OF INCOME December 31, 1993 1992 Net Sales 47,443,200 45,684,060 Cost of goods sold 18,371,190 17,995,370 Selling, Admin. & General Expense 16,959,630 15,944,040 35,330,820 33,939,410 Income before interest and taxes 12,112,380 11,744,650 Interest 1,136,970 1,243,780 Income before taxes 10,975,410 10,500,870 Taxes 3,804,010 3,942,590 Net profit 7,171,400 6,558,280

Instruments of Long Term Finance:

Instruments of Long Term Finance Bond --- A long term promissory note Mortgage --- A mortgage is a pledge of designated property for a loan. A mortgage bond is a pledge by the corporation to certain real assets as security for the bond. Debenture --- Is a long term bond not secured to specific property

Common Vs. Preferred Stock:

Common Vs. Preferred Stock Preferred Stock ---- avoids the provision of equal participation in earnings in comparison to common stock Common Stock ---- does not entail fixed charges. There is no legal obligation to pay common stock dividends. Also, common stock has no fixed maturity date

P/E Ratio Calculations:

P/E Ratio Calculations Company X -- Earnings Per Share 1988 1989 1990 0.9 0.8 0.6 Earnings Per Share = Net profit/# of shares issued

Company X Market Price Per Share, Common Stock:

Company X Market Price Per Share, Common Stock 1988 1989 1990 High 9.0 5.0 6.0 Low 7.0 4.0 3.0 Average 8.0 4.5 4.5

Price to Earnings Ratio:

Price to Earnings Ratio Price to earnings ratio = Price/Earnings 1988 1989 1990 P/E 8.9 5.6 7.5

Market to Book Ratio:

Market to Book Ratio Market to Book Ratio = Market value/book Market Price Per Share -- Common 1988 1989 1990 Average 8.0 4.5 4.5 Book Value Common Stock (year end) 4.7 4.9 5.0 MBR = 1.7 0.9 0.9

Eastern Carpets - Issues Working capital is WITHOUT the negative sign Inventory is missing Accounts receivables is missing Why does total current assets appear when accounts receivables and inventory do not? Where is retained earnings?

BOOK CASE ANALYSIS Which U.S. Company is it?:

BOOK CASE ANALYSIS Which U.S. Company is it? 1992 1993 ROA 21.5% 21% ROE 31.4% 31.2% PM 14.3% 15% CR 3.4 3.4 QR 2.5 2.6 DR 12% 13% 1992 1993 D/E 18% 19% IT 5.2 5.9 Z Score 6.25 5.94

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